Bienvenue

Economics

Carine SONNTAG

Professeur associé
Département finance
Bienvenue
Lecture 1 : Understanding competition
 Introduction
Identifying competitors through substitutes
Elasticities
Supply and demand laws
Basic equations and concepts found in economic books
Pure and perfect competition

Reference : Chapter 5 (except counot and Bertand parts) and 6 from reference
book Besanko and al. (2016) Economics for stategy (see my scholarVox account)
 Part I- Identifying competitors by identifying
substitutes

 Direct competitors: strategic choice of one directly affect the performance of the other
>>> Cross-price elasticity on the same market for the same good

Example: between cars of the same segment

 Indirect competitors: when the price change on one market, it influences other markets
>>> cross price elasticity between markets for different goods

Example : between cars and train transportation

 Substitutes and Cross-Price Elasticity

 “In general, two products X and Y are substitutes if, when the price of X increases and
the price of Y stays the same, purchases of X go down and purchases of Y go up.”

 Individuals substitute continually

 Economists measure this relationship with the “cross-price elasticity”

 Elasticity (general)

Measures the reaction of a consequence to a cause

% Variation of the consequence

E = ------------------------------------------------------------

% Variation of the cause

Applications : Price elasticity of the demand = % Variation of quantity demanded (x)

/ % variation in price (x)
Price elasticity of supply = % Variation of quantity supplied / % variation in price
 Cross-Price Elasticity

% change in the quantities of Y

Ecp ------------------------------------------------------------

% change in the price of X

How are the quantities sold in the market for automobiles affected by changes
in the relative price of trucks?

Source next page: Regmi (2000) “Cross-Price Elasticities of Demand Across 114 Countries”;
www.ers.usda.gov/media/142165/tb1925_1_.pdf
 Products tend to be close substitutes when we observe…

 same or similar product performance characteristics (performance of

product > list attributes)

 same or similar occasions for use > where, when, how the product is used

 same geographic market

Example: real estate

 Where? Geographic Market

 Is the product sold by competitors where customers

• are not affected by transportation costs
• costs of time for the consumer to travel to an alternative location to purchase
• costs of shipping the product to the customers location
• are not affected by tax differences
• convenience is not a major factor
 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
 How is the product used?

 To listen to music…
• Radio
• CD Player
• Tape Player
• Eight…. No don’t go there
• MP3 Files
• Napster
 Part II- Defining a market; supply and demand laws on a competitive market

 “that set of suppliers and demanders whose trading practices

establishes the price of a good”
• George Stigler and Robert Sherwin, “The extent of the market”, Journal of Law and
Economcis, 1985

 Do the firms constrain one another’s ability to affect price? Or does the market sets the price?
 Defining the Market

 Market definition is the identification of the market(s) in which the

firm is a player

 Two firms are in the same market if they constrain each other’s
ability to raise the price

 It is important to define the market if market shares need to be

computed (for anti-trust economics or business strategy formulation)
 Well-Defined Market

 If the market is well defined, firms outside the candidate market

will not be able to constrain the pricing behavior of those inside

 A thought experiment: If all the firms inside the candidate

market colluded, can they raise the price by at least 5%? If
they can, the market is well defined
 Firm Elasticity or Industry/Market
Elasticity?

 Clearly differentiate
• If I know the industry has a high cross-price elasticity it means that if industry prices rise people will
substitute other products for my industries’ good or service
• This tells us nothing about firm elasticity's within the industry, which is what firms are often interested in
Bienvenue
Supply and demand
Laws
Analysis
 Figure 1 The Equilibrium of Supply and Demand

Price of
Ice-Cream
Cone Supply

Equilibrium price Equilibrium

$2.00

Equilibrium Demand
quantity

0 1 2 3 4 5 6 7 8 9 10 11 12 13
Quantity of Ice-Cream Cones
Copyright©2003 Southwestern/Thomson Learning
Figure 2 Markets Not in Equilibrium

(a) Excess Supply

Price of
Ice-Cream Supply
Cone Surplus
$2.50

2.00

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
demanded supplied Cones

Copyright©2003 Southwestern/Thomson Learning

 Equilibrium

 Shortage
• When price < equilibrium price, then quantity demanded > the quantity supplied.
• There is excess demand or a shortage.
• Suppliers will raise the price due to too many buyers chasing too few goods, thereby moving toward
equilibrium.

 Surplus
• When price > equilibrium price, then quantity supplied > quantity demanded.
• There is excess supply or a surplus.
• Suppliers will lower the price to increase sales, thereby moving toward equilibrium.
Figure 3 Markets Not in Equilibrium

(b) Excess Demand

Price of
Ice-Cream Supply
Cone

$2.00

1.50
Shortage

Demand

0 4 7 10 Quantity of
Quantity Quantity Ice-Cream
supplied demanded Cones

Copyright©2003 Southwestern/Thomson Learning

 Equilibrium

 Law of supply and demand

• The claim that the price of any good adjusts to bring the quantity supplied and the quantity demanded for
that good into balance.
• Works perfectly if markets are in “Pure and perfect competition”, if not it gives the tendency of the change
in price but dynamic of the market is influenced by the market structure.
 Figure 4 How an Increase in Demand Affects the
Equilibrium
Price of
Ice-Cream 1. Hot weather increases
Cone the demand for ice cream . . .

Supply

$2.50 New equilibrium

2.00
2. . . . resulting
Initial
in a higher
equilibrium
price . . .
D

0 7 10 Quantity of
3. . . . and a higher Ice-Cream Cones
quantity sold.
Copyright©2003 Southwestern/Thomson Learning
Variable that influence Buyers
Variable that influence Sellers
 Annex Equations and concepts to understand (to be able to read some
economic books)

 Production costs

 Marginal cost

 Total and marginal revenue

 Profit equation

 First derivatives (basic)

 A) Economic costs in the short run
TABLE Costs concepts A summary
TERM DEFINITION EQUATION
Accounting cost “Out-of-pocket costs” or costs defined in -
accountancy. Explicit Costs
Economic cost Include opportunity cost of all inputs. -
Implicit + explicit costs
Total fixed cost Do not depend on quantity produced TFC

Total variable cost Vary with the level of production TVC

Total cost Economic cost TC = TFC + TVC

Average fixed cost Fixed cost per unit produced AFC = TFC/q
Average variable cost Variable cost per unit produced AVC = TVC/q
Average cost Economic cost per unit produced AC= TC/q
AC = AFC + AVC
Marginal cost Additional total cost due to the production MC = DCT/Dq
of an additional unit (first derivative of
total cost)
B) Implicit and explicit costs

Opportunity cost The most valuable alternative

choise that you have to give up to realise an action

Explicit cost Implies a monetary spending (invoice,

accountancy)

Implicit cost Non monetary opportunity cost

 B) Marginal cost

• Additional total cost due to the production of an additional unit

Cma = DCT/Dq
How much does it cost to produce one additional product?

For very small variations= ∂CT /∂q

• Means first derivative of total cost WITH REGARD (not divided) to
quantities
 C)Total and marginal
revenue

• Total Revenue (TR) = Price*quantities

• Marginal Revenue: How much additional revenue is earned when

one additional product is produced (and sold)?
• Also computed as the first derivative of TR with regard to
quantities
 4) How much should be
produced?

• The optimal level of production is the one which maximises the profit of the firm:
• Profit ( ) = Total revenue – Total cost
• Total revenue(R) = Price*quantities
• Total cost depends on the cost function

Maximisation of profit :
Max  (q) implies Rma (q) = Cma (q) (any market structure other than
PPC) or Price = = Cma (q) in CPP
 4) How much should be
produced?

Remarks:
The objective of the company is to maximise profit, not production. (Is
different from its strategy which can derive from a larger objective)
Every profit maximisation accepts as a first order condition Rma=Cma.
The production decision (quantities produced, price) depends of the
market structure (Pure and perfect competition, monopoly, oligopoly,
monopolistic competition).
E) First derivatives (basic)
• Contact

carine.sonntag@icn-artem.com

• ICN Business School

• 86 rue du Sergent Blandan
• CS 70148
• FR 54003 Nancy Cedex