Lecture Notes on Market De?nition and Concentration

Sloan School of Management Massachusetts Institute of Technology

15.013 - Industrial Economics for Strategic Decisions Professor Robert S. Pindyck

Lecture Notes on Market Definition and Concentration (August 2006) 1 Markets and Market Definition

Much of this course will deal with the analysis of markets, and the consumers and producers that buy and sell in those markets. We will be particularly concerned with market structure and its implications for strategic decision making. Therefore, it is important to remember what we mean when we refer to a market. A market is the "place" where price is determined. In other words, a market is the collection of buyers and sellers that, through their actual or potential interactions, determine the price of a product or set of products. Market definition is important for a number of reasons. From the point of view of a company, it is crucial to understand who your actual and potential competitors are with respect to the various products you now sell or might sell in the future. It is likewise important to know the product characteristic boundaries and geographical boundaries of one's market in order to be able to set price, determine advertising budgets, or make capital investment decisions. Market definition is likewise important from a public policy perspective. Should the Justice Department allow a merger or acquisition involving companies that produce similar products, or should it challenge it? The answer depends on the impact of that merger or acquisition on future competition and prices, but often this can best be evaluated in the context of a proper definition of the market. In defining a market, we must decide what products to include. For example, is there a single market for digital cameras that includes expensive single-lens reflex (SLR) cameras as well as simple point and shoot cameras, or are these separate markets? Likewise, is 1

Figure 1: Market Boundries there a single market for bicycles, or does it make more sense to think of "private label" bicycles (those sold in stores such as Target) as belonging to a separate market from the more expensive bicycles (Fuji, Cannondale, Trek, etc.) sold by dealers? In addition to deciding what products should be included in the market, it is often necessary to decide on the geographical boundaries. If we wanted to define a regional market for gasoline centered around MIT, how large an area should we include? If we are interested in pricing and competition in the airline industry, should we consider city-pairs as the relevant markets for airline travel, or should we consider travel across different regions of the country, or, for that matter, travel within the entire United States? To answer these questions, we need to consider both demand substitutability and supply substitutability. Remember that a market is the collection of buyers and sellers that determine the price of a product or set of products. Thus, when deciding whether Product B is in the same market as Product A, we would ask whether buyers of Product A might instead purchase Product B if the price of A rose substantially above that of Product B. In other words, are Products A and B close substitutes from the point of view of consumers--i.e., is there high demand substitutability. Recall that the cross-price elasticity of demand for product A with respect to the price of product B is

D EAB =

PB ∂QA = ∂ log QA /∂ log PB , QA ∂PB

where QA (PA , PB ) is the market demand curve. Likewise, we would ask whether an increase in the price of Product A might lead producers 2

of Product B to switch to the production of A and thereby limit the price increase. In other words, is there high supply substitutability. Recall that the cross-price elasticity of supply for product A with respect to the price of product B is

S EAB =

PB ∂QA = ∂ log QA /∂ log PB , QA ∂PB

where in this case QA (PA , PB ) refers to the market supply curve. This is illustrated in Figure ??. Remember that either high demand substitutability or high supply substitutability is sufficient for two or more products to be in the same market. Therefore, when deciding on the boundaries of the market, we must decide whether other firms producing different products might enter if the price of the product or products currently in the market were to rise. Likewise, we must ask whether consumers might respond to a price increase by shifting their purchases to other products that we have not included in the market. Sometimes the answers to these questions are ambiguous, as we will see from the following examples. Example: The Bicycle Industry. Given the fact that one can buy a bicycle for less than $100 or for more than $2000, does it make sense to analyze the industry in terms of a single market? Should we instead think of the industry in terms of ten or twenty different markets--for example, a market for bicycles costing up to $100, a market for bicycles costing $100 to $200, and so on? To answer these questions, we must consider how prices are determined. This, in turn, means examining the extent to which consumers will substitute one type (or brand) of bicycle for another in response to changes in relative prices, and the extent to which producers can shift production from one type of bicycle to another, again in response to changes in relative prices. Analyzing the industry in this way leads to the identification of two distinct markets. (Management consultants would refer to these markets as "strategic groups.") The first is the low-end bicycles, typically costing less than $200, that are mass-merchandised through stores such as Target, Sears, etc. The biggest producers of these bicycles are Murray, Huffy (formerly Huffman), and AMF. The second market or "strategic group" consists of the premium quality bicycles that are sold largely through dealers. 3

Figure 2: The US Bicycle Industry Why does it make sense to think of these two groups as separate markets? First, demand substitutability across the groups is fairly low (but demand substitutability within the group is high). Most consumers who go to Target to buy a bicycle are not concerned with the price of a Fuji, Cannondale, or Trek, and likewise, most consumers choosing among high-end bikes at a dealer simply will not consider the Huffy and Murray bikes sold in a department store or mass merchandiser. Second, supply substitutability across the two groups is low. Huffy and Murray compete by trying to shave a dollar or two