Competition: Highly Competitive Markets and Monopolies

Session 7 – Thinking Like an Economist – Prof. Carlos Serrano

OPENING STORY: : GOOGLE VS. OPENAI CHATGPT

CREATIVE DESTRUCTION AT WORK

How Google missed this moment?

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After years of preaching that conversational search was its future, Google stood by Open AI launched the conversational AI powered chat named ChatGPT on November 30, 2022. By December 4, 2022, ChatGPT already had over 1M users. Currently, ChatGPT has over 300M users.

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“Is this [only] a case of an incumbent being so careful about its business, reputation, and customer relationships that it refused to release similar, more powerful tech?” as Alex Kantrowitz conjectures.

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What else?

Source: Kantrowitz, A (2022) “Why Google Missed ChatGPT,” Big Technology, https://www.linkedin.com/pulse/why-google-missed-chatgpt-alex-kantrowitz/

LEARNING OBJECTIVES

WHAT WE AIM FOR IN THIS SESSION

At the end of the session, you should be able to…

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Define the two most extreme degrees of competition

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Understand the outcome they lead to

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Draw business implications from each, especially in terms of reinvention and in terms of differentiation

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THE THEORY

WHAT MAKES A MARKET HIGHLY COMPETITIVE?

When the firm meets a lot of other firms

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Can you think of examples of markets in which competition is very high?

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Markets of agricultural products like potatoes, carrots, grain, oranges, olive oil, coffee, tea, etc.

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WHAT MAKES A MARKET HIGHLY COMPETITIVE?

Here’s a definition

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Microeconomics provides a very narrow and unrealistic definition of competition. However, it is extremely useful because:

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• It replicates quite well what happens in a highly competitive market (that is, when there are a lot of substitutes), albeit a bit simplistically in the opinion of some;

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• It will therefore help us determine the options a firm has to face the challenges of a highly competitive market;

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• It is a benchmark against which regulators compare reality and has thus largely shaped anti-trust regulations in Europe and in the USA.

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Consider this model for what it is: a benchmark with regulatory and business implications we’ll consider now and far more later.

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WHAT MAKES A MARKET HIGHLY COMPETITIVE?

Here’s a definition

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Competition is pure when:

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• The market is atomic: There are so many players than none can influence market forces, in particular price. Suppliers are therefore ‘price-takers’ and the demand curve for a firm is a horizontal line equal to the equilibrium price.

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• Products are homogeneous: They are perfect substitutes and there is no differentiation.

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• Free entry and free exit is guaranteed: There are no legal, institutional, technical or financial barriers to entry and an entrepreneur can exit without losing everything. In particular, when there are profits to be made in a specific market, new firms are attracted to this market. They leave if prospects become poorer.

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WHAT MAKES A MARKET HIGHLY COMPETITIVE?

Here’s a definition

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Competition is perfect when:

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• It is pure.

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• Information on the market is perfectly transparent: There is no uncertainty about the competitor’s price, about the characteristics of the goods which are all homogeneous or about what the consumer’s preferences and tastes

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• Production factors – namely labor and capital – are perfectly mobile: There are no barriers to reconversion.

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WHAT MAKES A MARKET HIGHLY COMPETITIVE?

Here’s the outcome

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Remember: the lowest price firms will be willing to charge marginal cost.

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If all five conditions of pure and perfect competition are united, then:

• A firm looking to charge slightly less than marginal cost will make losses
• A firm looking to charge slightly more will either:
• Attract new firms because the market is profitable and prices will drop
• Or lose all the demand which will go to its competitors

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All firms are price-takers: price is imposed by market forces. In the long run, prices will drop to marginal cost as a result. Firms don’t make any profits and consumer welfare is maximized (in theory). The demand curve for the firm is essentially flat (i.e., hyper-reactive).

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WHAT MAKES A MARKET HIGHLY COMPETITIVE?

Why this is significant

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This model replicates quite well what happens on a market in which all products are more or less homogeneous – that is, a market in which there are a lot of substitutes.

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In this case, the firm has no real leverage as it is a price taker and is the victim of market dynamics which it cannot influence.

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What is a way out of this?

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WHAT MAKES A MARKET NOT COMPETITIVE?

When a firm is alone (or highly dominant)

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Can you think of examples of markets in which competition is inexistent?

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Google has dominated the search engine market, maintaining an 92% market share as of June 2021. Majority of Google revenues are generated through advertising.

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What do Oakley, Ray-Ban and Persol have in common?

They are all owned by Luxottica, an Italian company that produces about 70% of all name brand eyewear.

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WHAT MAKES A MARKET NOT COMPETITIVE?

Here’s a definition

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A market is said to be highly competitive when…

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• The market is atomic
• Products are homogeneous
• Free entry and free exit is guaranteed
• It is perfectly transparent
• Production factors – namely labor and capital – are perfectly mobile

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So, what happens when one or more of these conditions are not verified?

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WHAT MAKES A MARKET NOT COMPETITIVE?

Here’s an illustration

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Consider the example of the De Beers, producing and selling diamonds. As any profit maximizing firm, it will look to set marginal revenue and marginal cost equal.

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But contrary to the firms in a perfectly competitive model, it will have more margins to set the price, most likely above marginal cost, in order to get a profit. This profit results from the monopoly’s market power which is reduced to nothing in a highly competitive market.

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However, this market power is not unlimited raising the price will indeed increase the firm’s revenue, but only if the fall in demand is not too significant. Consider the following numbers.

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Source: Paul Krugman, Robin Wells, Microeconomics, Worth (3^rd Edition), pp. 382-385

Source: Paul Krugman, Robin Wells, Microeconomics, Worth (3^rd Edition), pp. 382-385

Source: Paul Krugman, Robin Wells, Microeconomics, Worth (3^rd Edition), pp. 382-385

Quantity effect dominates the price effect until 10 units are produced: the raise in price compensates the fall in demand

Price effect dominates the quantity effect beyond 10 units: the fall in demand cannot be compensated by the raise in price

Source: Paul Krugman, Robin Wells, Microeconomics, Worth (3^rd Edition), pp. 382-385

We assume that marginal cost is equal to 200

The monopoly chooses the quantity that maximizes its profits, that is the point at which marginal revenue and marginal cost are equal

The perfectly competitive industry would have continued to trade until all opportunities to create value had been exhausted

Source: Paul Krugman, Robin Wells, Microeconomics, Worth (3^rd Edition), pp. 382-385

Profit of the monopoly

WHAT MAKES A MARKET NOT COMPETITIVE?

Why is this significant

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In microeconomics: WE DON’T LIKE MONOPOLIES

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They charge more and supply less.

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They make a profit off the back of consumers.

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They entail waste…

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BUT…

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WHY THIS MATTERS

COMPETITION vs. NO COMPETITION

But…

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Who, in fact, has a greater incentive to innovate?

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COMPETITION vs. NO COMPETITION

But…

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Who, in fact, has a greater incentive to innovate?

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The “profit of the monopoly” is the carrot of innovation and differentiation. Without it, there is no incentive to ameliorate products. Once they have it, monopolies will look to protect it through further innovation.

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In addition, it is the price the consumer pays, in order to enjoy new products, some might argue…

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COMPETITION vs. NO COMPETITION

But…

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In fact, a monopoly may be facing far more competition than what you think!

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From whom?

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COMPETITION vs. NO COMPETITION

Identify fault lines in order to make the required strategic shifts

Source: Mark Bertolini, David Duncan, and Andrew Waldeck, “Knowing When to Reinvent,” Harvard Business Review, December 2015

CREATIVE DESTRUCTION AT WORK

CREATIVE DESTRUCTION AT WORK

CREATIVE DESTRUCTION AT WORK

HOW COULD THIS END UP ON THE MIDTERM AND FINAL TEST

WHAT COULD YOU SEE ON A MIDTERM AND FINAL TEST

You may be asked to…

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• Give the price in a highly competitive market

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• Write down the profit equation of a monopoly

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• Explain that you assume it maximizes profits and show how much it will produce

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• Calculate the price it will charge

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• Compare that outcome to the one on the highly competitive market, and explain why it might not be great

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Remember…

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The problem sets are here to help. You will practice each of these points in a problem set at some point. So pay attention to them.

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KEY TAKE-AWAYS

WHAT WE AIM FOR IN THIS SESSION

At the end of the session, you should be able to…

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Define the two most extreme degrees of competition

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Understand the outcome they lead to

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Draw business implications from each, especially in terms of reinvention and in terms of differentiation

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