AEC 422 Announcements

Diamond Foods Case Discussion and preliminary memo – Sept 29 (next Mon.)

Diamond Foods final memo due Wed Oct 1– One comprehensive analysis submitted per group

Preliminary and final memos should follow case analysis format, but especially emphasize key concepts from Unit 1.

Competitors and Competition

AEC 422

Sept 22

Unit 1Microeconomics of the Firm

Industry

An industry is a collection of firms offering goods or services that are close substitutes of each other. (V. Jain, 2007)

North American Industry Classification System (NAICS) replacing the Standard Industrial Class (SIC) codes.

Industry Definitions

NAICS Code

NAICS Description Classification Level

31-33 Manufacturing Sector

312 Beverage and tobacco product manufacturing

Subsector

3121 Beverage manufacturing Industry group

31211 Soft drink and ice manufacturing Industry

312111 Soft drink manufacturing National Industry

For detailed codes: http://www.census.gov/naics/2007/naics07.xls

Other Empirical Approaches

– Bureau of Labor Statistics Market Classes– BLS NAICS Aggregation Titles– http://www.bls.gov/bls/naics_aggregation.htm– Products that belong to the same genre or the

same NAICS class need not be substitutes

Organization of industry

Driven by economics shaping firm size, scope, bounds, and vertical relationships

Substitutes and complements Clusters – shared resources (tourism, port,

university technology park); manufacturing and distribution relationships

Competition

If one firm’s strategic choice adversely affects the performance of another they are competitors

In practice anyone who produces a substitute product is a competitor

Competition can be either direct (between soft drinks) or indirect (soft drinks and milk)

Important implications for product development, advertising, pricing

Taco Bell: Who is my competition?

Taco Bell: Who is my competition?

Other Mexican restaurants– Abuelos?

Other Mexican fast food Other fast food restaurants

– Burgers– Pizza– Chicken– Italian

In-store Mexican RTE meals Convenience stores &

supermarket deli’s

“healthy” fast food? Fine(r) dining restaurants? How do we define “market

share”?....depends how we define the market (later)

Characteristics of Substitutes

Two products tend to be close substitutes when– They have similar performance characteristics

Kroger brand mustard vs French’s Mustard

– They have similar occasion for use and Breakfast cereal vs Pop Tarts

– They are sold in the same (geographic) market area

Various brands of gasoline in an area

Performance Characteristics

Empirical Approaches to Competitor Identification Cross price elasticity of demand

Eab = (∆Qa/Qa)/ (∆ Pb/Pb)– Substitutes, complements, or independent

If Eab > 1….then A and B are substitutes (Pepsi & Coke) If Eab < 1…then A and B are complements (hot dogs & buns)

Price for turkey increases what will happen to the quantity demanded for turkey dressing around Thanksgiving?

Price of gas increases, quantity of cars demanded decreases– Complements: Eab < 0

Price for pizza (fast food substitutes) increases, quantity demanded for Mexican fast food increases

Price for UK tuition increases, quantity demand for BCTC classes increases

– Substitutes: Eab > 0

Larger the magnitude of the cross-price elasticity, the more pronounced the effect.

Occasion for Use

Products may share characteristics but may differ in the way they are used

Orange juice and cola are beverages but (generally) used in different occasions

What about milk? Other examples – similar product – different use:

– Hiking shoes versus court shoes– Desktop vs laptop computer vs iPad

Whole and 1% Milk ConsumptionLb/capita in U.S.

Whole Milk 1% Milk

Market (Geographic) Area

Identical products in two different geographic markets may not be substitutes due to “transportation costs”– Lawn care or construction services– Banks?? Education?? Library?

Bulky products like cement cannot be transported over long distances to benefit from geographic price difference

Geographic Competitor Identification

When a firm sells in different geographical areas, it is important to be able identify the competitor in each area

Rather than rely on geographical demarcations, the firm should look at the flow of goods and services across geographic regions

Two Step Approach to Identifying Competitors in the Area

First step is to find out where the customers come from (the catchment area)

The second step is to find out where the customers from the catchment area shop

With the technological innovations, some products like books and drugs are sold over the internet bringing in virtual competitors– Amazon.com

Market Structure

Markets are often described by the degree of concentration

Monopoly is one extreme with the highest concentration - one seller

Perfect competition is the other extreme with innumerable sellers

Measuring Market Structure

A common measure of concentration is the N-firm concentration ratio - combined market share of the largest N firms (or brands)

– Ice Cream Brands Example Edys, Breyers, Blue Bell, Haagen-Dazs, and Ben &

Jerry’s make up 51.1% of the Ice Cream market share in the U.S.

Dean Foods, Kraft Foods, and Land O’ Lakes made up 37.5% of the dairy processing sales in the U.S. in 2005

Also measured as 4-firm CR or 20-firm CR

Industry Number of firms 4-firm CR 20-firm CR

Bookstores

Computer & software

Casino Hotels

Full service restaurants

Florists

12751

10133

283

195492

22753

62

51

44

9

2

70

65

76

16

4

Besanko et al, p.210, 5th Ed

Measuring Market Structure

Herfindahl index is another which measures concentration as the sum of squared market shares– Sum of the squared market shares of all the firms

in the market

Ie a market divided between 2 firms would be:– 0.52 + 0.52 = 0.5

Four Classes of Market Structure

Structure Herfindahl Index Intensity of Price Competition Perfect Competition

Usually < 0.2 Fierce

Monopolistic Competition

Usually < 0.2 Depends on the degree of product differentiation

Oligopoly 0.2 to 0.6 Depends on inter-firm rivalry Monopoly > 0.6 Light unless there is threat of

entry

Dairy Products, U.S., 2007Source: The Food Institute

Market Structure and Competition

A monopoly market may produce the same outcomes as a competitive market (threat of entry)

– Think of the one ice cream shop in a growing town

A market with as few as two firms can lead to fierce competition

With monopolistic competition, how well differentiated the products are will determine the intensity of price competition

Perfect Competition

Many sellers who sell a homogenous product and many well informed buyers (transparent market)

Consumers can costlessly shop around and sellers can enter and exit costlessly

Each firm faces infinitely elastic demand– Smallest hike in prices pushes them out of the

market

Conditions for Fierce Price Competition

Even if the ideal conditions are not present, price competition can be fierce when two or more of the following conditions are met– There are many sellers– Customers perceive the product to be

homogenous– There is excess capacity

Vertical and Horizontal Differentiation

Vertically differentiated products unambiguously differ in quality (USDA grade#1 tomatoes vs #2s)

– Bourbon? Wine? Horizontally differentiated products vary

in certain product characteristics to appeal to different consumer groups (cage free eggs, FSC)

An important source of horizontal differentiation is geographical location – taking same products to different geographic markets

Geography and Horizontal Differentiation

Video rental outlets (or grocery stores) attract clientele based on their location– Move to movie downloads?

Consumers choose the store based on “transportation costs”

Transportation costs prevent switching for small differences in price

Idiosyncratic Preferences

Tastes differ substantially across consumers– Food products, beverages, entertainment, apparel

Horizontal differentiation possible with idiosyncratic preferences

Easier to segment the market Location and Taste are important sources of

idiosyncratic preferences

BlueberryVinegar

BlueberrySyrup

N 196 243

Variable (t-ratio)ConstantMaleAgeIncomeEducationHealth Knowledge

2.0791 (4.13)***0.1994 (1.14)-1.1639 (-2.33)**0.0580 (2.75)***0.7587 (2.31)**0.0917 (0.40)

2.3174 (5.83)***0.2196 (1.68)*-1.0765 (-2.76)***0.0445 (2.46) **0.6447 (2.38)**0.4646 (2.63)***

R2 0.12 0.12Statistically significant at the 90% (*), 95%(**), or 99%(***) confidence level.

Willingness-to-pay across selected demographic variables

Search Costs and Differentiation

Search cost: Cost of finding information about alternatives

Search costs discourage switching when prices are raised

Low cost sellers try to lower the search costs (Advertising, distribution)

Some markets have high search costs (Example: ie. highly regulated products – medical care)

Switching Costs and Monopolistic Competition

An important determinant of a firm’s demand is customer switching

Switching is less likely when– Customer preferences are idiosyncratic

Dentists, hairstylists, favorite restaurant

– Customers are not well informed about alternative sources of supply

– Customers face high transportation or search costs (what has the Internet done to this lately?)

Price-Cost Margins and Concentration

Theory would predict that price-cost margins will be higher in industries with greater concentration (fewer sellers)

There could be other reasons for inter-industry variation in price-cost margins (regulation, accounting practices, concentration of buyers and so on)

Price-Cost Margins and Concentration

It is important to control for these extraneous factors if one needs to study the relation between concentration and price-cost margin

Most studies focus on specific industries and compare geographically distinct markets

Evidence on Concentration and Price

For several industries, prices are found to be higher in markets with fewer sellers

See MacDonald’s 1999 ERS article Lysine, infant formula, western railroads,

cattle slaughter See Hendrickson & Heffernan

Economies of Scale and Concentration

Industries with large minimum efficient scales compared to the size of the market tend to have high concentration

The inter-industry pattern of concentration is replicated across countries

When production/marketing enjoys economies of scale, entry is difficult and hence profits are high

Concentration and Profitability

The concentration and profitability have not been shown to have a strong relationship

Possible explanations– Differences in accounting practices may hide the

differences in profitability– When the number of sellers is small it may be due

to inherently unprofitable nature of the business