Class 5 - Industry Structure

Do you have tail winds or headwinds in the industry?

Competition often shapes short run profitability more than long. In the long, structure shapes more

Quantity competition is like price competition under capacity constraints (really reasons that undermine rivalry)

So in a cartel, this is the J curve which is equal shares. The cournot involves constraints that lead to something between equal share and marginal cost where hte latter is the Bertrand curve that falls to marginal cost.

• He shows the 5 forces in one chart. What lowers or raises something on the y axis or brings in or extends out on the x axis

“Firms are going to enter until VP - FC = 0 or VP = FC”;

Competition doesn’t disappear; it remains in the market. Competition to be in this firm. How will you win w/o erasing the profits? (wars of attrition, want to win the war w/o a shot)

The offset of an increasing customer is the increasing costs necessary to attarct them. Markets natural bounds on the behavior and when firms have strong incentives to compete then you will lower the number of firms that can fit in the market.

Intermediate suppliers are more numerous than end consumers because o fthe ad/makreting role

What are the natural signals that inform or dissuade entrants?

Action Items

• Review the relationship between industry structure and firm strategy.
• Analyze the impact of competition on industry structure.
• Consider the role of fixed costs and advertising in shaping industry dynamics.

Key Decisions

• Emphasize the importance of aligning firm strategies with industry forces.
• Recognize the need to adapt strategies based on industry structure changes.

Notes and Observations

• Industry Structure: The discussion has focused on how many firms can fit in an industry and the factors influencing this, such as the number of small versus large firms.
• Strategic Consistency: Strategies should align with industry forces, avoiding entry into industries on the verge of shakeouts.
• Frameworks Discussed: The session has covered frameworks from industry-level perspectives to firm-level perspectives, emphasizing the importance of considering both in strategy formulation.
• Competition and Profitability: The role of competition in shaping industry structure and profitability has been highlighted, including the impact of substitutes, bargaining power, and competitive forces.
• Demand and Cost Assumptions: Assumptions about demand curves and cost structures have been used to illustrate how firms optimize pricing and profits.
• Price Competition Models: Various models of competition, such as Bertrand and Cournot, have been discussed to show their impact on pricing and firm profitability.
• Five Forces Framework: The session has connected the five forces framework to industry structure, showing how factors like rivalry, market size, and fixed costs influence the number of firms in a market.
• Advertising and Fixed Costs: The impact of advertising and fixed costs on industry concentration has been explored, with examples from US and UK markets, and the brewing industry.
• Consumer vs. Institutional Segments: Differences in concentration between consumer and institutional segments have been noted, particularly in the frozen food industry.
• Strategic Implications: The session has concluded with a discussion on how competitive dynamics inform strategy, with a focus on avoiding wars of attrition and deterring competition.

Additional Insights

• Market Size and Rivalry: Larger markets and weaker rivalry allow more firms to fit in, while stronger rivalry reduces the number of viable firms.
• Technological and Advertising Advances: New advertising technologies can lead to industry shakeouts and increased concentration.
• Global Comparisons: The concentration of industries in different countries, such as the US and UK, has been compared to illustrate the impact of market size and advertising on industry structure.

Industry Structure

• Discussion on industry structure and the number of firms that can fit in the industry
• Consideration of industry structure dynamics: small firms vs. large firms
• Importance of aligning strategies with industry forces
• Caution against entering industries on the verge of shakeouts
• Discussion on the potential for more firms to fit in the industry than fewer firms

Firm-Level Strategy

• Shift from industry level to firm level perspective on competitive advantage
• Focus on capabilities and resources of individual firms
• Competition now being emphasized as a factor shaping industry structure
• Interaction between firms' resources and capabilities shapes strategy
• Strategy requires balancing industry and firm perspectives
• Competition shapes profitability through various forces such as substitutes and supplier bargaining power
• Discussion on how industry forces shape industry structure

Analytical Frameworks

• Introduction of a framework to analyze industry structure based on demand and supply assumptions
• Emphasis on understanding the conceptual framework rather than formulas

Demand Scenarios

• Hypothetical scenario: Tim's demand for ice cream based on price changes
• Hypothetical scenario: Demand curve for 75 chimps with identical tastes
• Discussion on price sensitivity and market size (s) in demand scenarios
• Explanation of demand curve steepness indexed by k

Cost and Market Assumptions

• Customers in this market are more price-sensitive
• Assumption of n firms in the market with identical cost structures
• Fixed cost (f) represents the cost of building an ice cream plant
• Marginal cost (c) is the incremental cost of production
• Assumption that marginal cost (c) is zero for simplicity

Revenue Maximization

• Discussion on maximizing revenues with no variable cost, focusing on price times quantity
• Monopolist serves half of the market, selling s/2 at a price of k/2
• Profits calculated as s*k/4
• Higher profits when serving a larger market
• Relationship between prices and the number of firms being analyzed
• Price as a function of the number of firms is being discussed
• Monopolistic scenario with one firm results in price being k/2

Competition Assumptions

• Assumption of perfect collusion among firms, forming a cartel
• Price remains the same as monopoly price (k/2) under cartel assumption
• Profit maximizing price remains the same under monopoly and collusion scenarios
• Three firms colluding still maximize industry profits

Bertrand Competition

• Introduction to Bertrand competition and its implications on pricing

Price Competition

• Two firms choose prices, consumers buy from the firm offering the lowest price
• In equilibrium, prices equal marginal cost as firms profit maximize given the other's price

Zero Pricing Strategy

• Monica and Nico both pricing at zero results in zero profit due to zero margin
• Raising prices leads to loss of sales to competitor, maintaining zero profit
• Lowering prices to negative is not viable, confirming zero pricing as profit maximizing
• Pricing at 99¢ gives a near $1 margin across the entire market, but is not optimal compared to pricing at 1

Equilibrium Pricing Analysis

• Discussion on equilibrium with three firms under current competition assumptions
• Equilibrium price remains zero for all firms, as raising prices leads to loss of sales and lowering prices results in negative profits

Pricing Strategy Observations

• Monica prefers pricing at 99¢ over 1¢, regardless of the number of firms
• Strong price competition drives prices to marginal cost with the entry of a single firm
• Examples discussed are considered rigged due to chosen absence of competition

Product Differentiation Impact

• Product differentiation reduces the impact of price competition
• Introduction of a new firm with a differentiated product (e.g., strawberry vs. vanilla ice cream) does not necessarily lead to loss of customers for existing products

Cournot Competition

• In Cournot competition, firms choose quantities instead of prices, and the market price clears based on these quantities
• Farmers decide daily on the quantity of tomatoes to bring to market in Cournot competition
• Market price is set to clear the market by selling all produced quantities
• Two-stage competition: firms first choose quantity, then prices are determined based on these quantities
• Choosing quantity is akin to setting capacity constraints in Cournot competition
• Farmers cannot serve the entire market even if they lower prices slightly below competitors due to capacity constraints
• Quantity competition is similar to price competition under capacity constraints
• Capacity constraints lead to weaker competition compared to Bertrand assumptions

Variable Profits and Market Structure

• Variable profits discussed in relation to the number of firms in the market
• Monopoly scenario revisited: one firm in the market benefits from a steep demand curve

Collusion and Cartel Profits

• Joint profit estimation discussed for colluding firms
• Per firm profits in a two-firm cartel calculated as half of industry profits
• Variable profits decline as the number of firms increases, dividing the market share

Five Forces Framework

• Five forces framework derived, discussing how profits vary with various factors

Substitutes and Rivalry Impact

• Fewer substitutes from other industries lead to higher profits due to a steeper demand curve
• Stronger rivalry impacts profits as firms move from colluding

Barriers and Bargaining Power

• Barriers to entry limit the number of firms in the industry
• Bargaining power of suppliers can significantly reduce monopolist profits
• Five forces framework is attractive for organizing and is well branded in economic models

Market Entry and Breakeven Analysis

• Firms enter the market until variable profits minus fixed costs equals zero, reaching a breakeven point
• Firms will continue to enter the market until variable profits equal fixed costs, ensuring breakeven
• Assumption made that competition in the industry follows a J-curve
• New entrants are expected when firms are making significant profits
• Profitable opportunities attract new entrants until they are exhausted
• Market becomes unsustainable when variable profits do not cover costs

Industry Rivalry Dynamics

• Increase in industry rivalry shifts competition from collusive to competitive behavior
• Firms will exit the market if they cannot cover fixed costs in the long run
• Higher rivalry means fewer firms can fit in the market
• Weaker rivalry allows more firms to fit in the market
• Increase in size of the potential market affects industry structure
• Changes in market size affect the number of firms that can bid and the number of potential customers

Demand Curve and Market Factors

• Increase in k shifts demand curve, affecting number of firms in the market
• Price insensitivity of customers impacts demand curve
• Changes in fixed costs influence technological barriers

Five Forces Framework

• Five forces framework is applied to industry structure to identify generic factors affecting profitability
• Highlighting special results is useful for organizing information
• Strong rivalry limits the number of firms that can fit in the market

Market Viability and Rivalry

• Two firms in the market are not viable if neither can cover fixed costs in the long run
• Strong rivalry makes it difficult for more than one firm to be viable in the long run

Profitability and Competition

• Variable profits exceeding fixed costs lead to a profitable position, attracting more competitors

Market Entry and Competition Dynamics

• Entry is low when price-cost margins fall significantly with the introduction of an initial burner
• Situations arise where the market is big enough for one firm but not for two, affecting competition dynamics
• Long-term competition between two firms at price level affects market dynamics

Competitive Strategies

• Forward-looking profits can lead to wars of attrition in competitive markets
• Best strategy for a firm is to deter competition by signaling lower costs and long-term viability

Price Competition Dynamics

• Extremely strong price competition can exist even with very few firms in the market
• Competition shifts from in-market to for-market dynamics in such scenarios

Graphical Analysis

• Summarizing results in a single overview is beneficial for forward-looking analysis

Market Size and Firm Dynamics

• Number of firms can be mapped as a function of market size: one firm in small markets, proportional increase in larger markets
• Inverse relationships in market dynamics can be visualized through graph movements

Framework Limitations

• Assumptions in the framework limit its applicability to certain cases
• Fixed costs are a key assumption in the model, necessary to enter the market
• No fixed cost associated with R&D, but product development is a fixed cost that can be spread over many customers
• Fixed costs can also be associated with advertising, as successful campaigns can be leveraged across a wide audience
• Advertising campaigns can be spread across many customers, acting as a fixed cost

Advertising Sensitivity and Investment

• Assumptions about fixed costs affecting quality and customer attraction have been made
• Firms can choose to make investments that increase perceived quality, considered as fixed costs
• Scalable quality investments can lead to industry concentration regardless of market size or rivalry strength

Market Entry Requirements

• High market entry requires positioning in the upper chart area
• Large markets with price-insensitive consumers and weak rivalry dynamics

Advertising Strategy Implications

• Exclusive advertising rights can significantly impact customer acquisition and retention
• Significant profit potential in large markets with competitive advertising strategies
• Stealing 10% of competitors' customers is a strong incentive for advertising

Market Dynamics with Productive Advertising

• High advertising costs can deter market entry despite potential benefits
• Productive advertising creates strong incentives for firms to compete

Fixed Costs and Quality Investments

• High fixed costs and quality enhancing investments increase firms' incentives, but also raise sunk costs
• In markets with productive advertising, increased market size without price competition leads to more firms entering the market
• Increasing market size provides more incentive to advertise due to potential customer base growth
• Upper bound on number of firms depends on incentives to compete with quality enhancing fixed costs

Competitive Incentives and Market Limits

• Stronger incentives to compete can lower the upper bound on the number of firms

Industry Concentration Comparisons

• US consumer industries are as concentrated as those in smaller markets like the UK
• Despite the US being six times larger than the UK, the number of firms in industries does not proportionally increase
• Advertising sales ratio is higher in the US than in the UK, indicating stronger competition in larger markets

Historical Advertising Technology Shifts

• Introduction of television as a new, more productive advertising technology led to a shakeout in the brewing industry between the 1950s and early 1970s
• Shakeouts in the US brewing market occurred regionally due to regulatory licensing by the FCC in the 1950s
• Regional differences in marketing strategies influenced the timing of industry consolidation
• Early adoption of television advertising in certain regions led to earlier consolidation in the beer industry

Consumer Segment Concentration

• End consumer segments, such as frozen food, tend to be more concentrated
• Institutional segments like restaurants and hospitals use the same production technology as consumer segments
• Grocery segment shows high levels of concentration with few major producers
• Institutional segment has more producers compared to consumer segment
• Advertising sales ratio differs between consumer and institutional segments, with consumer segments being more advertising sensitive

Recent Developments in the Hotel Industry

• Recent developments in the hotel industry have roots in the Kellogg EMBA classroom

Counot Competition

Good morning. As we sit here in Evanston, imagine two new, competing coffee roasters decide to open up shop to serve the local community and Northwestern students. They both need to figure out how much coffee to roast and supply each week. If they both roast too much, the market price will plummet. If they both roast too little, they'll leave profits on the table.

This scenario, where a small number of firms compete by choosing how much product to produce, is the essence of Cournot competition.

What is Cournot Competition?

Named after French economist Augustin Cournot, this is a model of oligopoly (a market with a small number of firms) where companies compete by setting their output quantity. The key elements are:

1. Competition on Quantity: Firms decide how much to produce, not what price to charge. The total quantity supplied by all firms then determines the market price based on the market demand curve.
2. Simultaneous Decision: Each firm chooses its production quantity independently and at the same time, without knowing what the other firm has chosen.
3. Homogeneous Product: The firms are assumed to sell identical or very similar products. In our example, the coffee from both roasters is essentially interchangeable from the consumer's perspective.

The core tension in the Cournot model is that each firm's optimal production quantity depends on the quantity it expects its competitor to produce.

How It Works: The "Best Response"

Let's go back to our two Evanston roasters, "Wildcat Beans" and "Lakefront Roasting."

The manager of Wildcat Beans has to think: "If I believe Lakefront is going to produce 100 pounds of coffee this week, what is the best quantity for me to produce to maximize my own profit?" This optimal quantity is Wildcat's best response.

They might calculate that if Lakefront produces 100 pounds, their best move is to produce 80 pounds. But if they believe Lakefront is only going to produce 40 pounds, their best response might be to produce 110 pounds.

Each firm has a "best response function"—a formula that calculates its own profit-maximizing output for any given output level of its competitor.

The Cournot Equilibrium

So where does this end? The market settles at a Cournot equilibrium, which is a type of Nash Equilibrium. This occurs when both firms are producing a quantity that is a best response to the other's quantity.

Imagine Wildcat Beans decides to produce 90 pounds, and Lakefront Roasting also decides to produce 90 pounds.

• At this point, given that Lakefront is producing 90 pounds, Wildcat's best possible move is to produce 90 pounds. They have no incentive to change.
• Similarly, given that Wildcat is producing 90 pounds, Lakefront's best move is to produce 90 pounds. They also have no incentive to change.

When no firm can unilaterally increase its profit by changing its production level, the market has reached a stable Cournot equilibrium.

Key Outcomes of Cournot Competition

The Cournot model predicts an outcome that lies somewhere between a perfect monopoly and perfect competition.

• Price and Quantity: The total quantity produced is higher than a monopoly would produce but lower than in a perfectly competitive market. Consequently, the market price is lower than a monopoly price but higher than the competitive price.
• Profit: Firms in a Cournot oligopoly are able to earn some economic profit, but not as much as a single monopolist could.
• Effect of More Firms: As you add more firms to the model (a third or fourth coffee roaster in Evanston), the Cournot equilibrium gets closer and closer to the perfectly competitive outcome. Total output increases, the price falls, and firm profits shrink.

In essence, Cournot competition is a foundational model for understanding strategic decision-making in industries from oil production (like OPEC members deciding on output quotas) to manufacturing, where firms must commit to a production volume before knowing the exact market conditions.

It looks like “corno” is a typo—what you probably want is Cournot competition (pronounced koor-NOH), one of the classic models of how a few firms compete when they choose quantities rather than prices.

Cournot competition in one chart & one sentence

• Setup: Each firm decides how many units to produce, all at once and without collusion.
• Outcome: Total quantity pushes market price down along the demand curve; each firm’s profit depends on both its own output and its rivals’ output, which it treats as fixed when deciding.

That simultaneity and “quantity first, price follows” is the Cournot hallmark.

Key features (why economists love it)

Simple numerical example (duopoly)

• Inverse demand: P = 100 – Q, where Q = q₁ + q₂
• Marginal cost: c = 10 for both firms

For Firm 1, profit = (P – c)·q₁ = (100 – q₁ – q₂ – 10)·q₁.

Set ∂π₁/∂q₁ = 0 → 90 – 2q₁ – q₂ = 0 → best response: q₁ = (90 – q₂)/2.

Symmetry gives q₂ = (90 – q₁)/2.

Solve simultaneously → q₁ = q₂ = 30, so Q = 60, P = 40.

Compare:

Cournot sits neatly between monopoly and full competition.

When is the Cournot lens useful?

• Bulk commodities where firms plan capacity well before sales (e.g., potash, oil, cement).
• Industries with limited price flexibility (e.g., regulated tariffs) but freedom to expand or idle output.
• Strategy class shorthand: many course notes label the Cournot outcome the “C-curve” in profit-vs-number-of-firms graphs, bracketed by “J” (joint/cartel) and “B” (Bertrand) curves.

So, whenever you hear professors contrast Bertrand price competition with Cournot quantity competition, just remember: Cournot = choose Q, watch P adjust; the more players, the closer it slides toward perfect competition.