Market Structure and Competition Dynamics

Chapter 5 Market Structure and Dynamic Competition

Market Structure Concentration As long as the industry is symmetric, the number of sellers accurately measures market concentration but in the real world there is typically great heterogeneity among firms One of the traditional tasks in industrial organization has been to develop a statistic that allows a single number to reasonably measure the concentration of an industry A concentration index is exclusively concerned with actual competition and ignores potential competition

Concentration Concentration ratio Economists have devised many indices to measure concentration, but the measure with the longest history is the concentration ratio A fundamental problem with concentration ratios is that they describe only one point on the size distribution of sellers The most widely available concentration ratios are those compiled by the U.S. Bureau of the Census The North American Industry Classification System (NAICS)

Concentration Herfindahl-Hirschman Index (HHI) Orris C. Herfindahl and Albert O. Hirschman invented the HHI Since 1992, the merger guidelines of the Antitrust Division of the U.S. Department of Justice (DOJ) and the Federal Trade Commission (FTC) have used the HHI, as it is the most useful concentration index currently available The HHI is defined as HHI = (100s1)2 + (100s2)2+ + (100sn)2 One of the attractive features of the HHI is that it has foundations in oligopoly theory

Concentration Market concentration and the price-cost margin: causation versus correlation Empirical evidence has shown that a market s concentration index and its price-cost margin are positively correlated, but this raises the key question of what we should make of this empirical relationship Developing possible explanations of why a correlation exists between concentration indices and price-cost margins The market power hypothesis The differential efficiency hypothesis

Entry Conditions Equilibrium under free entry There are two reasons why entry conditions are important: 1) The number of active firms is partially determined by the cost of entry 2) Entry conditions determine the extent of potential competition Entry into a market means acquiring the ability to produce and sell a product, but there is some cost to entry in almost every market Free-entry equilibrium It is the asymmetries among firms that explain the observed inequality in market shares

Entry Conditions Does a free-entry equilibrium result in a socially optimal market structure? In most oligopolies, entry will expand industry supply and thereby lower price The root of the problem is that the profitability of entry is partly arising from a business stealing effect In an oligopolistic market, the private interests of a potential entrant will not coincide with social interests Entry is profitable if and only if it raises social welfare

Sources of Concentration Scale economies on the supply side and demand side Why are some markets highly concentrated? Should we be concerned? One explanation is that high concentration may be a reflection of efficiency Vocabulary Economies of scale: e.g., Walmart or Amazon Minimum efficient scale Network effect: e.g., online auction sites

Sources of Concentration Barriers to entry Perhaps no other subject has created more controversy among industrial organization economists than that of barriers to entry Three different definitions of a barrier to entry have been proposed by: Joe Bain George Stigler Christian von Weizs cker Two-stage inquiry

Sources of Concentration Contestability and sunk costs William Baumol, John Panzar, and Robert Willig s theory of contestable markets A market is perfectly contestable if three conditions are satisfied 1) New firms face no disadvantage vis- -vis existing firms 2) There are zero sunk costs 3) The entry lag . . . is less than the price adjustment lag for existing firms The central result is that if a market is perfectly contestable, then an equilibrium must entail a socially efficient outcome

Dynamic Competition The role of firm conduct Vocabulary Dynamic competition Strategic entry deterrence Limit pricing Predatory pricing

Limit Pricing Bain-Sylos theory of limit pricing How can incumbent firms affect a potential entrant s decision to enter, and if they can influence that decision, how does this ability affect the behavior of incumbent firms? Joe Bain and Paolo Sylos-Labini created the earliest model of limit pricing, know as the Bain-Sylos postulate The Bain-Sylos postulate is a bad assumption because an incumbent firm will typically not choose to behave in the manner assumed. Additionally, entry decision is wholly independent of the incumbent firms preentry output

Limit Pricing Strategic theories of limit pricing A central goal in the literature on dynamic competition is to identify and explore the intertemporal linkage between incumbent firms preentry behavior and the postentry structure in terms of cost and demand functions Switching costs Two important conclusions derive from the limit-pricing literature 1) Preentry output or price can affect the postentry equilibrium in different ways and thereby influence the decision to enter 2) Even if entry is deterred, the threat of entry will generally induce incumbent firms to set a low price

Limit Pricing Limit pricing in the airline industry An implication of the theory of limit pricing is that, in response to a heightened threat of entry, incumbent firms will lower prices for the purpose of making entry less likely Review the examination of the above hypothesis involving airline route markets for 1993 2004

Investment in Cost-Reducing Capital Strategic capacity expansion in the casino industry Avinash Dixit s seminal paper that provided some fundamental insight that fueled much of the research on strategic entry deterrence Review the examples given of the Dixit game Consider the examination of the use of capacity investment to deter entry involving the casino industry

Raising Rivals Costs Consider one of the several strategies for raising the cost of a rival

Preemption and Brand Proliferation Review the brand proliferation strategy outlined in the text Incumbent firms offer new brands in order to fill niches in the market that would have provided room for profitable entry

Preemption and Brand Proliferation Brand proliferation in ready-to-eat breakfast cereals Describe the argument made against General Foods, General Mills, and Kellogg in which the FTC accused the leading manufacturers of ready-to-eat breakfast cereals of using an entry-deterring strategy of brand proliferation What was the judge s verdict?

Summary Chapters 4 and 5 analyzed the feedback relationship between market structure and firm conduct This chapter explored dynamic competition and found many ways in which firms can impact their future market share and the number of firms in the market Entry conditions are partially determined by the behavior of established firms through, for example, the strategic setting of price and investment, and evidence of this was presented