NOVA School of Business and Economics Strategy I Academic Year 2013/2014 1st Half of Second Semester

Problem Set 2 Strategy: Industry and Competition

Group 1 1913 Alexandre Ponte 1921 Raquel Oliveira 1928 Jose Ollero Oliveira Assistant Professor Sofia Franco Lisbon, 28th March 2014

PART I
1. Antitrust laws benefit consumers by encouraging and protecting competition. These types of laws prevent companies from acquiring too much market power and forbid the occurrence of non-natural monopolies. In this way, companies do not have enough market power to overcharge for their products and services and to prevent other firms from competing with them. Ultimately, these laws intend to make companies competing on prices or on quality, with continuous innovation, in order to maximize the consumers welfare.

2. The theory of predatory pricing refers to the situation when a company sets low prices in order to eliminate the competition. This is an illegal strategy according with anti-trust agencies, since it makes markets more vulnerable to a monopoly: in one hand, it creates barriers to entry for potential entrants, and, on the other hand, it creates unethical production methods to minimize costs. Furthermore, predatory pricing can be presented in two different ways: limit price or predatory price. Limit price strategy is based on charging the highest price possible which does not invite competition, preventing entry. It is possible, for example, exploiting economies of scale advantage or investing earlier in capacity, which only allows the entrants to break-even. Predatory price is when a firm decreases its price in order to drive rivals out of business and/or scare off potential entrants, and then raises its price when its rivals exit the market. In this case, the incumbent firm is willing to sacrifice its short-run profits, aiming to be compensated by huge long-run profits and a stable and dominate position in the market protected market power in the long- run. In this way, it is clear that the theory of predatory pricing provides a useful contribution to the theory of entry deterrence this theory refers to the situation when a incumbent firm in a particular market takes a strategic action, by decreasing its price in order to discourage potential entrants from entering into competition in that market. There are two general categories of entry-deterring strategies: some strategies increase the expected entry cost for entrants, for instance, through advertising expenditures; other strategies affect the entr ants expectations of the intensity of post-entry competition. In these last strategies, the incumbent firm is thinking ahead and trying to anticipate the behavior of other firms, for instance, through investments in excess capacity and by building a reputation for toughness through predatory pricing. However, predatory pricing imply a good analysis of the market, since it is necessary to understand not only the existence of barriers to entry, but also the future demand. Since the incumbent is willing to sacrifice its short-run profits, aiming to be compensated by huge longrun profits and a stable and dominate position in the market, the recovery is only possible if there are strong barriers to entry, since is the only way to maintain the market power. Otherwise, the new entrants are able to steal market power to the incumbent. Strategies of predatory pricing can also work as a warning to the potential competitors, since there is a treat of using this kind of policies to compete. -1-

3. Barriers to entry are anything that keeps new firms from entering in an industry in which firms are able to earn economic profits. These can exist as a result of government intervention (industry regulation, legislative limitations on new firms, special tax benefits to existing firms, etc.), or they can occur naturally within the business world. Some naturally occurring barriers to entry could be a strong brand identity, strong customer loyalty or high customer switching costs.1 Thus, there are infinite barriers but they can be classified into two general categories of barriers to entry: the natural barriers to entry and the strategic or legal barriers to entry. Strategic or legal barriers to entry are created by firms choices in order to avoid competition within the same market the possibility of entry affects the payoffs of incumbents, while strategies by incumbents are meant to reduce entrants payoffs (if entry occurs). Examples of such strategies include exclusive or superior access by an incumbent undertaking to particular necessary inputs such as patents; copyrights; exclusive contracts with input suppliers; etc. So, these are controlled by intervenients in the market. Entry barriers arising from predatory behaviour are more examples, such as predatory pricing, expansion of capacity, excessive advertising, or the introduction of new products for strategic purposes. Entry impediments give incumbents the opportunity to enjoy monopoly benefits for a certain period of time e.g., the time of attaining a license but are not entry barriers in the strict sense; they only influence how much time incumbents may exercise market power before entry occurs. On the other hand, structural or natural entry barriers are only part of market economy and have not the purpose to distort or prevent competition. 2 So, these are not controlled by the intervenients. However, they can certainly have impact and effect on the market and on the ability of firms to compete on the market natural barriers to entry give rise to natural monopoly. Natural barriers include economies of scales, network effects higher usage of certain products makes them more valuable , ownership of a key input, natural product differentiation, and an absolute cost advantage held by an incumbent over an entrant. Legal barriers (government intervention) or geographic barriers (difficulties for foreign firms to play in domestic markets) are more examples of natural barriers to entry. To conclude, there are barriers to entry over which neither incumbents nor the entrants have direct control the structural barriers to entry. Economies of scales, for example, act as a barrier to entry if the Minimum Efficient Scale (MES) is large to the total size of the market; the firm is operating in the lowest point on the long-run average cost (LRAC) function, allowing them to grow in large size, control the supplies and guarantee that other firms will not be able to compete. So, either the entrant accepts the risk associated with large-scale entry in order to avoid penalty, or it enters at a smaller scale and takes the average cost penalty.3
1 2

http://www.investopedia.com/terms/b/barrierstoentry.asp http://www.diva-portal.org/smash/get/diva2:19800/FULLTEXT01.pdf 3 Lipczynski, J.; Wilson, J.; Goddard, J.; Goddard, J.; Industrial Organization: Competition, Strategy, Policy, 2nd Edition, FT Press.

-2-

4. Although concentration ratios are useful indicators of possible market power, they are not perfect measures of market power, since it is almost impossible to gather the necessary information on prices and mainly costs. High concentration ratios do not prove firms are using market power to charge high prices or to practice anticompetitive behavior. Market power is the ability of a firm to profitably raise the market price of a good or service over marginal cost.4 A firm with high market power has the ability to individually affect either the total output or the prevailing price in the market. Price makers face a downwardsloping demand curve, such that price increases lead to a lower quantity demanded. The decrease in supply as a result of the exercise of market power creates an economic deadweight loss which is often viewed as socially undesirable. But, industries can also be profitable or have high concentration levels because they have successfully met the consumers needs and wants, and then, being large is not prejudicial. So, it is important to evaluate whether or not firms on oligopoly markets are using market power to charge high prices and avoid competition. An analysis between prices and concentration levels is mostly useful when there's data available for several geographic areas with different concentration levels and the alleged problem arises in only one (or a few) of these areas. As a result, if there isn't a correlation between price and a wide range of concentration in a narrow market, then higher prices isnt related with the increase in concentration. By contrast, if price is steadily higher where concentration is higher, maybe firms are beneficiating of their market power to set higher prices. Another approach is to compare profits of small and bigger firms. If the bigger companies in a market with similar profit rates of the smaller ones, they are not taking advantage of economies of scale; it suggests the market power is not being used to leverage prices. Otherwise, it can be that small firms are not willing to engage in price wars, hence, they charge a similar price as the larger firms. A comparison of profit' rates among an industry and other industries with less concentration ratios is also a useful way to study this issue. However, alongside with this consideration, it is essential to examine where come from those profits. For example, low costs of production due to: economies of scales; better negotiation power with suppliers; lower margins earned by suppliers; product differentiation; or low competition levels. Finally, if there is high concentration overtime in a market, and it does not become less concentrated over the following years, it is probable that firms in that market may be colluding to avoid the entrance of new competitors, especially if considering a rapid growing and attractive market. Thus, in markets that are highly concentrated, the anti-trust entities should closely control the actions of the firms with higher market power, to ensure they are not using it unlawfully and in a way that is anticompetitive and adverse for consumers.

Perloff, J: Microeconomics Theory & Applications with Calculus page 369. Pearson 2008.

-3-

PART II
1. In a Stackelberg game, that is a sequential decision game where a firm (the leader) will move first and the other firm (the follower) will move after there can be advantages to moving second. Assuming homogenous firms and homogenous products a firm that moves first will gain an advantage if competing in quantities because as a leader it gets to set its equilibrium quantity and assuming this commitment is credible forces the follower to accept this as the equilibrium of the market because deviations will hurt the follower firm, naturally the leader will set an equilibrium with the highest possible profits for itself leaving the follower to pick up the scraps, the decisions of the firms are strategic substitutes, that is if one firm increases quantity it forces the other firm to respond by decreasing quantity. However should firms compete in prices under the same assumptions as before it is unlikely that the first mover will gain an advantage over the follower, the opposite is in fact more likely. Under Stackelberg price competition the leader will choose first and assuming that he chooses a price that is greater than its marginal costs (ie: that there is room to decrease the price) then the follower observing the action of the leader will naturally respond by setting its own price lower and gaining the upper hand in the market, the follower experiences second-mover advantage. In equilibrium the price of the good must be set equal to marginal cost by both firms because setting it higher than that will give the other firm the advantage and lower will bankrupt the company, this result is identical to Bertrand competition. Should products not be identical, but only broadly speaking similar then even under price competition there can be significant advantages to moving first depending on how much it costs the consumer to switch to a different (cheaper but still similar) alternative, a firm that enters the market after the leader will have to give consumers a very good deal as otherwise the switching costs will not compensate the move to the lower priced alternative. Firms offering similar but not identical products can also gain first mover advantages through effects outside of their control, for example a first mover in an online business can capture network externalities that encourage more and more people to adopt their service and discourage users from moving to different services. If the firms themselves are not identical then there are other factors (unique to the firms) outside the games mechanisms themselves that can give the leading firm the upper hand, for example by virtue of being first to the market firms can optimize production techniques that they can keep secret giving them a lower cost curve than their competitors so that even under price competition they will have the upper hand. However, being the first to develop technology or production process can be a double edged sword because if a follower firm can gain access to that technology then they can effectively free ride on the first movers investments giving them the advantage.

PART II
2. In a competitive market the incentive to innovate is immense, a firm that successfully innovates gains an advantage over the rest of the market and should its competitors not be able to keep up it can leverage that advantage to gain market share and profit. The profit and market share a firm can gain from outdoing the competition and the disadvantages it can have from being outdone provide the primary incentive to innovate in a competitive market. The consumer will obviously benefit as the innovating firm will lower prices to try and gain market share and force all the other firms to do try and do the same. P

CS1 P1 P2 CS2

MC1 = AC1 MC2 = AC2

Q1

Q2

It is interesting to note that in a perfectly competitive market with perfect knowledge diffusion there is no reward for innovation as the innovating firm will see its innovation immediately copied by all firms in the market and will thus never be rewarded for innovating, this is one of the justifications for a patent system. In the case of a monopolist firm things are not so clear, the firm faces no competition and so the primary incentive to innovate in a competitive market is gone, however the firm still has a profit motive as innovations that reduce costs will still lead to increased revenues for the company and facing a traditionally convex demand curve the company will still lower costs for consumers, in that sense innovation by a monopoly will still benefit consumers. However, the hypothesis that a monopoly will innovate is suspicious, after all innovation requires risk taking, it demands that the company incur costs today with the perspective of in the future making enough profits from their innovation to recoup those costs, it does not know at the moment it incurs costs if their investment will ever pay off. Faced with risks a monopoly may simply choose not to invest in innovation, the incentive of future profits without the threat of competitors overtaking it may not be enough to make a monopolist invest in cost cutting technology due to its natural risk aversion.

PART II
3. Selling a product at below cost can be a strong indicator of predatory pricing, a firm that sells at below industry cost and has enough capital to absorb the losses that this practice entails can effectively take the entire market forcing others to leave or to go bankrupt if they try to keep up it is therefore appropriate that firms who engage in below cost pricing are put under scrutiny. In order for a predatory pricing strategy to succeed the firms that are expelled from the market must face significant barriers to re-entry when the predator decides to raise prices to reap the rewards of its strategy otherwise the predator will simply end up in a similar situation where it began and the losses it took from its predatory pricing will not be offset. However, a firm may also have legitimate and not anti-competitive reasons to price goods at below cost and in some industries it has effectively become the norm to practice below cost pricing under re-occurring circumstances for example the clothing industry which has reoccurring sales periods where prices are cut to the bone in order to liquidate inventory it accumulated in a given season. These kind of huge sales are also part of a legitimate business strategy where a company will put certain goods on sale selling them potentially below cost in order to entice customers to visit its store this is seen in traditional industries such as supermarkets but also in new online stores such as amazon.com or the Steam games platform. A business may also choose to sell at below costs in order to liquidate its inventory before or in a desperate move to prevent closure; this practice is very often seen during recessions.

PART III
1. Firms can construct excess capacity in a noncooperative strategic way or not. Markets with excess productive capacity (with more than one incumbent) may involve strong price competition and so will tend to present an unattractive panorama to potential entrants. So, the investment in capacity can be an entry-deterring strategy but will not provoke antitrust suspicion, since it may serve as a credible commitment to expand output and drop price. Excess capacity can deter entry by forming expectations on the part of potential entrants that dominant firms are capable of responding aggressively to threats. We concentrate on the duopoly case to allow for a graphical representation. In this situation, firm 1 is the incumbent firm (I), and firm 2 is the potential entrant (E). Because the decision can be made sequentially, it may be in the best interests of the incumbent firm to make a strategic commitment (moves first in a credible manner) that acts as a strategic entry barrier. Furthermore, there will be two stages in this game: in the first stage, the only player in the market is the incumbent firm and can choose a particular amount of capacity ( ); in the

second stage, the entrant makes its entry decision. As the incumbent can take advantages of being in the market, it has the first move advantage, and so we assume that each one extra unit invested in capital ( ) leads to one extra unit of production. On the other hand, the entrant needs to invest in capacity to enter in the market; it pays a fixed cost. Relation between MC and capacity:
E

0 E

In case of deciding to enter in the market, the new entrant will have to invest in capacity and its marginal costs will at least equate those of firm 1. As we can see from the graph the marginal costs curve for firm 1 is kinked at . Firms have the same production costs they have fixed costs of production (1 unit of labor W and 1 unit of capacity R). In order to prevent firm 2 from entering into the market, the incumbent firm has to invest in capacity in a way that firm 2 profits will be equal to zero; this means firm 1 has to choose its initial capacity investment level so that best response of firm 2 will be its break-even point. In a more drastic way, firm 1 has to choose its initial capacity investment level so that best response of firm 2 will be the shutdown point the potential entrant will be quick out of the market while the incumbent keeps its monopoly. 7

As both firms have the same cost structure, so they have constant and equal marginal costs. Besides, since firms choose any quantity to produce, and they make their quantity choices simultaneously while playing the game, they are competing la Cournot.
PSD

In the graph below, the best response function of the incumbent is further that point, the best response function of the incumbent is

(W) until

, and point,

(W+R). Thus, at

the best response function is the link of the previous functions. These are the reasons why the reaction function of the incumbent, which is represented in light green, has different slopes. On the other hand, the potential entrants reaction function (W+R) is the function in dark

blue. Since both firms are competing la Cournot, their optimal quantities are strategic substitutes: if , then will necessarily decrease, and so it will be lower than
2.

For this

reason, if the entrant decides to continue operating in this market, its profit will decrease as well, and, in fact, the entrant firm will earn negative profits. By contrast, if possible for firm 2 to produce more than
2.

, it will be

As result, the entrant firm will earn positive profits

if one decides to continue operating in the market.

2 1

Cournot Equilibrium with

2

So, the equilibrium is achieved by the intersection of both reaction functions. At Cournot Equilibrium point, on the second stage, equals , and the incumbent firm will operate at full

capacity. The incumbent was not able to quick out the entrant. As consequence, the best the entrant can do is to break-even ( ), and
2

is the exact amount that break even. Therefore,

To conclude, the potential entrant doesnt have incentive to enter in this market, since its entrance is blocked when compete in the market. 8 equals . Thats why the potential entrant will decide to not

2. First, it is important to define what a horizontal merger is. It is a merger between firms that provide similar products or services. It allows the surviving firm to control a greater share of the market and, it is hoped, gain economies of scale5. Therefore, horizontal mergers can result in anti-trust problems in the marketplace by reducing competition. The antitrust agencies typically have to investigate whether potential positive merger effects are likely compensated by potential anticompetitive effects, such as the increase of prices, caused by the merger. Nevertheless, if the intention of the merger is to decrease the cost structure and get some cost savings, and if that goal is achieved in reality, firms can actually lower the price in that market. The fact that the number of firms has fallen increases market power and puts upward pressure on price, but if the cost savings were high enough, the firms may actually lower price in the market. Even if the price does rise, total welfare may still improve if there are cost advantages. If the merger makes the firms much more efficient and thus yields greater profits without increasing the price to consumers by much, total welfare may improve. In sum, just because a horizontal merger reduces the number of firms in an industry, it is not necessarily true that the price will be raised and, consequently, hurting total welfare hurting total welfare total welfare will not be harmed as long as area C > area B. The tradeoff that arises when a merger simultaneously produces cost savings and higher prices due to greater market power: P
A: Increase in the Producer Surplus B: DWL C: Transfers from Consumers to Producers

P2 P1 A C
MC2

MC1

Q2

Q1

http://www.ask.com/question/what-is-a-horizontal-merger

3. In 2013, Apple faced accusations of colluding with major publishing houses to fix eBooks prices that they sell on the iBookstore. The company refused such allegations and even stated that they provided a valuable service to consumers, by fighting Amazons eBook monopoly. The court Judge had then to decide if the companies had been enduring conspiring to fix prices prior to the iPad launch in 2010. In oligopolistic markets, such as the eBooks, there is a strong incentive for companies to collude and to become better off than if they competed regularly. They fix the price above the competitive market equilibrium to steal surplus from the consumers (and some also becomes dead weight loss). The following graph illustrates the incentives that firms have to collude.

Firm 1 Reaction Function

Firm 2 Reaction Function

By colluding, these firms can operate together as a monopoly, achieving the maximum welfare and higher profits than they would get in a free competitive market. Thats why they engage in this sort of behavior. However, this brings undesired effects for consumers, and that is why market regulators intervene, to protect the consumers best interest, which was what the U.S. government was doing in this case.

10

PART IV
a) We are facing a market whose inverse demand is given by and two firms

operate in this market. Both firms have constant marginal costs of 40 and, since firms choose any quantity to produce, and they make their quantity choices simultaneously, they are competing la Cournot. In order to find the Nash equilibrium of this game, we had plotted the FOC of each firm. From the FOC of firm 1, we obtained the output that maximizes the profits of firm 1 as a function of the output of firm 2 the best response of firm 1:

As both firms are identical and have the same cost structure, they will have the same reaction function. So, reaction functions: Hence, the equilibrium is achieved by the intersection of both

The Nash equilibrium is characterized by the quantities that each firm had produced 60 and by the industry price Profits are given respectively by: = 160.

b) In order to find the monopoly output, that maximizes the total industry profit, the marginal revenue equals the marginal cost (MR=MC). So, .

Since both firms are competing la Cournot, their optimal quantities are strategic substitutes: if increases, then decreases as well as , and vice-versa. Therefore, if each 45), the best-response would

firm produces one half the monopoly output ( be

. This makes sense because their reaction functions have negative

slope. Thus, a firm reduces its output to 45, the other will increase its initial output to 67.5. However, knowing that firm 2 produces 67.5, the best-response of firm 1 is not to produce 45 but to produce 56.25 . Hence, half of the monopoly output is not a Nash

equilibrium outcome. This happens because firms will compete until the Nash equilibrium is achieved.

c) In the new situation, firms have now different cost structures: firm 1 has a cost advantage (its unit cost is 25) and firm 2 still has a unit cost of 40. Again, in order to find new outcome, we had plotted the FOC of each firm. From the FOC of firm 1, we obtained the output that 11

maximizes the profits of firm 1 as a function of the output of firm 2 the best response of firm 1 and the output that maximizes the profits of firm 2 as a function of the output of firm 1 the best response of firm 2:

Hence, the equilibrium is achieved by the intersection of both reaction functions:

Firms will have now different profits, individual outputs and the industry price will differ from a). The Nash equilibrium is characterized by the quantities that each firm had produced and by the industry price Profits are given respectively by: 8450 6612.5 = 155.

12