Interplay Among Competitors in Concentrated Markets

Notes for Chapter 7 (Supplemental to the written notes (if any) provided in class) (Do not distribute)

Example: Interplay among competitors in a concentrated markets The domestic US airline industry has had a bumpy ride over the past two decades. The 1990s began with a mild recession that left carriers with empty seats. As the marginal cost of filling an empty seat was negligible, some carriers slashed prices. This devastated the industry, with aggregate losses exceeding $4 billion in 1992. The economic recovery of the mid-1990s helped the industry. Flying at or near capacity, carriers raised prices for all passenger classes.

When an airline did have empty seats, it utilized computerized pricing algorithms to selectively reduce prices on a short-term basis. By the late 1990s, record losses had given way to record profits, with the industry earning $4 billion in 1999. The airlines struggled again in 2000 and 2001 to fill planes and prices softened. As the economy revived through the mid-2000s, the airlines filled their planes, raised their prices and returned to profitability. The Great Recession of the late 2000s triggered yet another decline in demand, but this time the industry was ready for it.

Several major carriers had cut capacity. The Delta/Northwest and United/Continental mergers helped reduce the number of competitors. As a result, airfares did not plummet as they had in previous economic downturns. This example illustrates the interplay among competitors in a concentrated market. The major players in the industry understand the need to avoid deep discounting, but they also understand the economics of empty seats. They have pursued some successful strategies (ex, reducing capacity in some routes), and have undone some of the damage done by years of cutthroat competition. But economic principles of competition will still be there!

North American Industry Classification System (NAICS) http://www.census.gov/eos/www/naics/index.html The industry classification systems provide information about different businesses in the US economy. The NAICS is a standardized classification system for the three partners of NAFTA (North American Free Trade Agreement): US, Canada and Mexico. This helps compare industry trends among NAFTA partners. Only the 6thdigit of the NAICS code is country specific (to accommodate special identification needs in different countries).

Example: Consider a US firm having an NAICS code of 448310. The first two digits tell us that the firm belongs to the sector called Retail Trade (44-45). The first three digits show that the firm belongs to a subsector called Clothing and Clothing Accessories Store (448). The first four digits show that the firm belongs to an industry group called Jewelry, Luggage, and Leather Goods Stores (4483) The first five digits show the NAICS industry that the firm is a part of; here Jewelry Stores (44831). The six-digit code shows that the firm belongs to the national industry Jewelry Stores (448310). http://www.census.gov/cgi- bin/sssd/naics/naicsrch?chart_code=44&search=2012 NAICS Search

Concentration Ratios If your friend wants to start a jewelry store, and she wants to know the number of firms in the business, the number of people employed in the industry, the total value of sales etc. You can provide her information about the concentration ratios in the industry. http://www.census.gov/econ/concentration.html https://factfinder.census.gov/faces/tableservices/jsf/pages/pro ductview.xhtml?pid=ECN_2007_US_44SSSZ6&prodType=tabl e In 2012: 23,477 jewelry establishments with a four-firm concentration ratio of 24% and a 20-firm concentration ratio of 34.7%.

Horizontal Merger Guidelines, 2010 Antitrust Division, Department Of Justice (Go to the Horizontal Merger Guidelines, Section 5.3 the section shows how the agency classifies markets into three types, and also the general criteria for analyzing mergers depending upon how they affect the HHI values)

Market Power- Example For many years, the premium brands of coffee at grocery stores sold for prices very close to the prices of generic brands. However, Starbucks Corp. changed the commodity-like nature of coffee serving cappuccinos, lattes, and mochas served in Starbucks caf s designed to look like the coffee-houses in Italy. Although far from being a pure monopolist, Starbucks nonetheless dominated the specialty coffee market for many years. Starbucks enjoyed substantial market power, giving it the ability to price its coffee beans and specialty drinks well above costs and earn good profits for many years.

But overtime, Starbucks got surrounded by rivals offering competing coffee products. Companies like Second Cup, Dunkin Donuts and even McDonald s, attracted by the economic profits in specialty coffees started affecting Starbucks market power and profitability (the profits fell drastically during the recession time). Starbucks was unable to prevent new firms from entering its profitable niche.

Rothschild Index Industry Own Price Elasticity of Market Demand Own Price Elasticity of Demand for Representative Firm Rothschild Index Food -1.0 -3.8 0.26 Tobacco -1.3 -1.3 1.00 Textiles -1.5 -4.7 0.32 Apparel -1.1 -4.1 0.27 Paper -1.5 -1.7 0.88 Chemicals -1.5 -1.5 1.00 Petroleum -1.5 -1.7 0.88

Lerner Index and Markup Factor Industry Lerner Index Markup Factor Food 0.26 1.35 Tobacco 0.76 4.17 Textiles 0.21 1.27 Apparel 0.24 1.32 Paper 0.58 2.38 Chemicals 0.67 3.03 Petroleum 0.59 2.44

Potential for Entry Optimal decisions by firms in an industry will depend on the ease with which new firms can enter the market. Several factors can create barriers to entry (or make entry difficult). Capital requirements. Patents. Economies of scale.

Conduct Behavior of firms: Price markup over costs. Integration and merger. Advertising expenditures. (Check Table 7-6 in the textbook) Research and development expenditures. (Check Table 7-6 in the textbook)

Research and Development Company Industry R&D as Percentage of Sales Bristol-Meyers Squibb Pharmaceuticals 19.7 Ford Motor vehicle and parts 4.1 Goodyear Tire and Rubber Rubber and plastic parts 2.0 Kellogg Food 1.5 Proctor & Gamble Soaps and cosmetics 2.5 Research and development Expenditures made by firms to gain a technological advantage, with the aim of acquiring a patent.

Advertisement Company Industry Advertising as Percentage of Sales Bristol-Meyers Squibb Pharmaceuticals 4.9 Ford Motor vehicle and parts 3.2 Goodyear Tire and Rubber Rubber and plastic parts 2.5 Kellogg Food 9.2 Proctor & Gamble Soaps and cosmetics 11.7 Advertisement Expenditures made by firms to inform or persuade consumers to purchase their products.

Dansby-Willig Performance Index Industry Dansby-Willig Index Food 0.51 Rubber 0.49 Textiles 0.38 Apparel 0.47 Paper 0.63 Chemicals 0.67 Petroleum 0.63 Ranks industries according to how much social welfare would improve if the output in an industry were increased by a small amount.

Structure-Conduct-Performance Structure: Factors like technology, concentration and market conditions. Conduct: Individual firm behavior in the market. Pricing decisions, advertising decisions and R&D decisions, among other factors. Performance: Resulting profit and social welfare that arise in the market. Structure-conduct-performance paradigm Model that views these three aspects of industry as being integrally related.

The Causal View Market structure causes firms to behave in a certain way. this behavior, or conduct, causes resources to be allocated in certain ways. this resource allocation leads to good or bad performance.

The Feedback Critique There is no one-way causal link among structure, conduct and performance. Firm conduct can affect market structure; Market performance can affect conduct and market structure.