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MAE 214: ECONOMIC STRATEGY FOR BUSINESS LECTURE 6 Market Structure and Competition; Entry and Exit 1 Case Study: Airbus Versus Boeing Since the end of 1990s, Airbus and Boeing possess a duopoly in the large commercial jet market. https://en.wikipedia.org/wiki/Competition_between_Airbus_and_Boeing Comparisons on Main Models The Airbus A380 is substantially larger than the Boeing 747 The Airbus A350 competes with the high end of the Boeing 787 Dreamliner and the Boeing 777 The Airbus A320 is larger than the Boeing 737-700 but smaller than the 737-800 The Airbus A321 is larger than the Boeing 737-900 but smaller than the previous Boeing 757-200 1

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MAE 214: ECONOMIC STRATEGY FOR BUSINESS

LECTURE 6

Market Structure and Competition; Entry and Exit

1 Case Study: Airbus Versus Boeing

• Since the end of 1990s, Airbus and Boeing possess a duopoly in the large commercial jetmarket.

https://en.wikipedia.org/wiki/Competition_between_Airbus_and_Boeing

• Comparisons on Main Models

—The Airbus A380 is substantially larger than the Boeing 747

—The Airbus A350 competes with the high end of the Boeing 787 Dreamliner and theBoeing 777

—The Airbus A320 is larger than the Boeing 737-700 but smaller than the 737-800

—The Airbus A321 is larger than the Boeing 737-900 but smaller than the previous Boeing757-200

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—The Airbus A330-200 competes with the similar Boeing 767-400ER and the Boeing777-200ER.

• Market Share Trend since 1995 (in net order)

• 2016 Net Market Share

• 2016 Market Shares by Category

• 2011JET ORDERS

—The 2011 sales success of the new A320neo gave Airbus a huge win.

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—Airbus signed up in excess of 600 jet orders more than Boeing.

—Boeing delivered 82 of large jets, compared with 26 superjumbo jets for Airbus.

— So in the dollar value, Boeing scraped just ahead of Airbus: $33 billion in revenue toAirbus’s $32 billion.

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• Gross Orders in the last 10 years

• Deliveries over the last 10 years

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• Air Travel Trend Since 1970

• Air Travel Trend Predicted by Airbus

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• Order Backlogs:

• With the high volume of backlog, Airbus and Boeing look forward to years of guaranteedbusiness?

• On the other hand, the high volume of backlog indicates that market demand cannot besatisfied —attracts new entrants.

• The Boeing-Airbus duopoly could be challenged: Two’s company, five’s a crowd? (TheEconomist, Nov 21st, 2012)

http://www.economist.com/news/21566401-long-running-boeing-airbus-duopoly-will-face-new-competition-twos-company-fives-crowd

—Bombardier of Canada will launch its CSeries, competing in the 100-200-seater “nar-rowbody”market now split between Boeing’s 737 jets and Airbus’s equally successfulA320 family.http://www.reuters.com/article/2013/08/01/bombardier-results-idUSL4N0G22R420130801

—Russia’s United Aircraft Corporation is also working on a larger plane, the Irkut MC-21,to rival the 737 and A320.

—The Russian government said it would pump almost $40 billion into the industry by2025.

—China is at least as determined as Russia to build a globally competitive aircraft in-dustry. Its state planemaker, Comac, has less expertise in design than its Russiancounterpart, but can count on a government with much deeper pockets.

—Brazil’s Embraer, already a successful maker of regional and business aircraft, willdecide whether to follow the Canadians, Russians and Chinese into the market forfull-sized airliners

—The long-term boom in aviation must surely provide space for more than just twomakers of full-sized airliners.

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• Airbus and Boeing have 7 new challengers (Business Insider, May 24, 2017)http://www.businessinsider.com/airbus-boeing-airliner-china-russia-craic-comac-2017-5/

?r=AU&IR=T/#boeing-777x-6

2 Cournot Quantity Competition

2.1 A Simple Duopoly

• In a market with only a few sellers, it is reasonable to expect that the pricing and outputchoices of any one firm will affect rivals’pricing and output and, as a result, will have a tangi-ble impact on the overall market price and output. Economists have produced many modelsof oligopolistic markets. A central element of these models is the careful consideration ofhow firms respond to each other’s choices. Two important oligopoly models: Cournot quan-tity competition and Bertrand price competition. Let us first consider a Cournot quantitycompetition model.

• Consider a market with only two firms: Airbus and Boeing (Duopoly)

• Each firm’s strategy is the amount they choose to produce, q1 for Airbus and q2 for Boeing.

• Once they are committed to production, the market price is determined by the followingmarket demand function:

p = 100− q1 − q2

• Suppose that both firms have the following total costs of production:

TC1(q1) = 10q1

TC2(q2) = 10q2

• Therefore both firms have constant marginal costs of $10.

• How much will each firm produce?

• Because both Airbus and Boeing are aware that the market price depends on the totalproduction they produce, the amount that Airbus desires to produce depends on how muchit expects Boeing to produce, and vice versa.

• A Cournot equilibrium, which is a special case of Nash equilibrium, requires that

1. Airbus’s optimal level of production is the best response (i.e., maximizes its profits) tothe level it expects Boeing to choose

2. Boeing’s optimal level of production is the best response (i.e., maximizes its profits) tothe level it expects Airbus to choose

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• Specifically speaking, a Cournot equilibrium is a pair of outputs (q∗1, q∗2) that satisfies the

following conditions:

q∗1 maximizes Airbus’s profits given Boeing’s choice is q∗2

q∗2 maximizes Boeing’s profits given Airbus’s choice is q∗1

• The profit-maximizing outputs q∗1 and q∗2 are determined by the standard marginal revenueequals marginal cost condition. The marginal revenue for Airbus is

MR1 = 100− 2q1 − q2,

and the marginal revenue for Boeing is

MR2 = 100− 2q2 − q1.

Hence q∗1 and q∗2 are determined by the following two conditions:

MR1 = 100− 2q1 − q2 =MC1 = 10MR2 = 100− 2q2 − q1 =MC2 = 10.

Solving these two equations gives us

q∗1 = 30

q∗2 = 30

• The market price is p = 100− q1 − q2 = 100− 60 = 40.

• What happens when the cost structures are asymmetric? Consider the following situation:

TC1(q1) = 10q1

TC2(q2) = 20q2

• Go over Figure 5.2 and Table 5.5 to understand the Cournot adjustment process in reachingthis equilibrium.

• What if there are more than two firms in the market?

• We should expect the following results when more sellers in the market:

—Lower market price

—Higher market quantity

—Lower individual firm quantity

—Lower profits

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2.2 Example 5.5 Application of Cournot Eq to Corn Wet Milling In-dustry in 1970s

• Porter and Spence’s case study of the corn wet milling industry in 1970s.

• Firms convert corn into cornstarch and corn syrup.

• Corn syrup was a stable oligopoly with 11 major sellers in the 1970s.

• In 1972, the production of high-fructose corn syrup (HFCS) became commercially viable

• Firms had to decide how to add capacity to accommodate the expected demand

• The Cournot Eq can be used to predict the capacity expansion process

• Each firm’s expansion decision was based on:

—A conjecture about the overall expansion of industry capacity,

—Market Demand, and

— Sugar Prices

• The predicted and actual capacity expansions are shown below:1973 1974 1975 1976 After 1976 Total (Pounds)

Actual Capacity 0.6 1 1.4 2.2 4 9.2 billionPredicted Capacity 0.6 1.5 3.5 3.5 0 9.1 billion

• The predictions came remarkably close to the actual pattern of industry capacity expansion.

3 Bertrand Price Competition

• In Cournot’s model, each firm selects a quantity to produce, and the resulting total outputdetermines the market price. Alternatively, one might imagine a market in which each firmselects a price and stands ready to meet all the demand for its product at that price.

• In a model of Bertrand price competition, each firm selects a price to maximize its own profits,given the price that it believes the other firm will select. In Bertrand’s model with firmsproducing idential products, rivalry between two firms result in the perfectly competitiveoutcome. When firms’products are differentiated, as in monopolistic competition, pricecompetition is less intense.

• The Cournot and Bertrand models make dramatically different predictions about the quan-tities, prices, and profits that will arise under oligopolistic competition. One way to reconcilethe two models is to recognize that Cournot and Bertrand competition may take place overdifferent time frames. Cournot competitors can be thought of as choosing capacities andthen competing as capacity-constrained price setters. The result of this two-stage competi-tion (first choose capacities and then choose prices) is idential to the Cournot equilibrium

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in quantities. More cutthroat Bertrand competition results if the competitors are no longerconstrained by their capacity choices, either because demand declines or a competitor miscal-culates and adds too much capacity. The Cournot model applies most naturally to marketsin which firms must make production decisions in advance, are committed to selling all oftheir output, and are therefore unlikely to react to fluctuations in the rivals’output. Thismight occur if the majority of production costs are sunk, or because it is costly to holdinventories —commodities such as natural gas and copper.

• Go over Example 5.6 on p.178 to understand what caused an electricity price spike in January2014 in Mid-Atlantic and Midwest.

4 Strategic Commitment

• Strategic commitments are decisions that have long-term impacts and are diffi cult to reverse.

• Investing in a new production facility is a strategic commitment.

• Strategic commitments influence the choices made by rival firms

• A decision to expand capacity might deter new firms from entering the market

• Making strategic commitments could make a firm better off.

• Consider the following capacity expansion game:Firm 2

Expand NotFirm 1 Expand 12.5, 4.5 16.5, 5

Not 15, 6.5 18, 6

— If they move simultaneously, there is a unique Nash eq: Firm 1 chooses "Not" and Firm2 chooses "Expand"

—The payoff is 15 for Firm 1 in the unique Nash eq

—However, Firm 1 can improve his payoff by committing to choose "Expand"

—This strategic commitment transforms the simultaneous-move game into a sequential-move game

—Firm 2 chooses its strategy after observing Firm 1’s choice.

—The unique Subgame Perfect Nash equilibrium (SPNE) is the following: Firm 1 chooses"Expand", and Firm 2 chooses "Not" when Firm 1’s choice is "Expand" and chooses"Expand" when Firm 1’s choice is "Not".

—Firm 1’s payoff now is 16.5

—A strategic commitment makes Firm 1 better off.

• Strategic Commitment Example: Airbus versus Boeing

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— In December 2000, Airbus formally committed to spend about $12 billion to developand launch the A380 —super-jumbo jet with capacity of around 550.

—Boeing also announced to launch 747X, a higher-capacity version of the 747, to competewith Airbus.

—The high-capacity aircraft market is estimated to have only 400 units in demand —could allow only one firm to make a profit

—Airbus made a credible commitment by securing over 60 early orders from SingaporeAirlines, Qantas, Virgin Atlantic, UPS, and Fedex

—Boeing failed to secure any orders.

—A few months later, Boeing announced to abandon its plans to build 747X.

—Airbus’ strategic commitment successfully deterred Boeing from entering the super-jumbo market.

—However, as strategic commitments are hard to reverse, they are inherently risky

— It is not clear yet whether Airbus could make a profit from this investment:The super-jumbo of all gambles, The Economist, Jan 20, 2005http://www.economist.com/node/3577842Oversize Expectations for the Airbus A380, New York Times, Aug 9, 2014http://www.nytimes.com/2014/08/10/business/oversize-expectations-for-the-airbus-a380.html?_r=0Airbus isn’t giving up on its A380 superjumbo, CNN Money, Jan 11, 2017http://money.cnn.com/2017/01/11/news/companies/airbus-aircraft-orders-a380-boeing/index.html

5 Entry and Exit

• MySpace and Facebook. Long before the filmThe Social Network made Facebook founderMark Zuckerberg a household name, another social networking web site was taking the Inter-net by storm. Founded in 2003 by ex-employees of Friendster (a very early social networkingsite), MySpace allowed members to create user communities, post content to communityboards, publicize parties, and send instant messages to fellow community members. Perhapsthe most exciting feature in the early days was the ability of MySpace members to createtheir own web pages. MySpace and its parent company were purchased in 2005 by RupertMurdoch for $580 million, and by 2008, MySpace had over 100 million unique visitors eachmonth, making it the most popular social networking Internet site.

Few people realized it at the time, but the decline of MySpace began in 2004, when Zucker-berg launched Facebook. Facebook differed from MySpace in several critical ways. Facebookrequired that members use their actual names and that their web pages conform to a stan-dard format. In contrast, MySpace members routinely used online pseudonyms, and theirweb pages were bastions of creative design. Facebook developed an iPhone app in 2007;

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MySpace did not respond until a year and 12 million iPhones later. Facebook made an ex-plicit effort to be business friendly, for example, by restricting search results. MySpace, withits roots in the Southern California music scene, was much slower to reach out to business.The rest, as they say, is history. By 2009, Facebook had over 250 million unique visitorsmonthly, while MySpace was on the decline. Today, MySpace hangs on by a thread, largelybecause there are few ongoing costs associated with maintaining the site.

• Entry is the beginning of production and sales by a new firm in a market. Exit is thereverse of entry —the withdrawal of a product from a market, either by a firm that shutsdown completely or by a firm that continues to operate in other markets. A recent study ofmanufacturing firms shows that entry and exit are pervasive:

— two-year entry and exit rates are 16 percent

— after five years, 65 percent of firms have exited

— entry and exit is more common in leather goods, footwear, and offi ce machinery, butuncommon in metal manufacturing, synthetic fibers, and plastics processing

• What structural factors affect entry and exit decisions?

• Incumbent firms should take entry into account when making their strategic decisions

• Entrants threaten incumbents in two ways:

— they take market share away from incumbent firms – - share the profit pie

— entry often intensifies competition – - reduce the size of the profit pie

• Barriers to Entry allow incumbent firms to earn positive economic profits while making itunprofitable for newcomers to enter the industry

• Barriers to entry could be structural or strategic

—Structural Entry Barriers Structural entry barriers exist when the incumbent hasnatural cost or marketing advantages, or when the incumbent benefits from favorableregulations.

—Strategic Entry Barriers Strategic entry barriers result when the incumbent takesaggressive actions to deter entry.

• Structural Entry Barriers:

—Control of Essential Resources: an incumbent is protected from entry if it controls aresource or channel in the vertical chain and can use that resource more effectively thannewcomers.

—Economies of Scale and Scope

—Marketing Advantages of Incumbency

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• Scale Economies in Advertising: US Soft Drinks

• Control of Essential Resources

—DeBeers in diamonds

—Alcoa in aluminum

—Ocean Spray in cranberries: in 2002 Northland Cranberries flied an antitrust lawsuitagainst Ocean Spray, alleging that Ocean Spray had used its dominant position toprevent rivals from having access to retailers. The private litigation ended in 2004,when Ocean Spray acquired Northland Cranberries’production facilities.

—Patent wars in the smartphone market

• Economies of Scale and Scope.The breakfast cereal industry enjoys a cost advantage from economies of scope:

—For several decades, the industry has virtually no new entry

—Kellogg, General Mills, General Foods, and Quaker Oats dominates the market

— Significant economies of scope in producing cereal – flexibility in materials handlingand scheduling from having multiple production lines within the same plant

—For entry to be worthwhile, a newcomer would need to introduce 6 to 12 successfulbrands – substantial capital requirements

• Entry-Deterring Strategies

—Limit Pricing

—Predatory Pricing

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—Capacity Expansion

— Strategic Bundling

• Limit pricing refers to the practice whereby an incumbent firm discourages entry by charginga low price before entry occurs

• Limit pricing may not be credible (it is not a SPNE) (go over p.196-p.200 for the followingexample)

• Predatory pricing: a large incumbent sets a low price to drive smaller rivals from the market

• Wal-Mart and American Airlines enjoy a reputation for toughness earned after fierce pricecompetition led to the demise of rivals

• However, Wal-Mart lost its battle in Germany. Go over Example 6.6 on page 204.

• Capacity Expansion. By holding excess capacity, an incumbent may affect how potentialentrants view postentry competition and thereby blockade entry

• Strategic bundling

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—An incumbent firm that dominates one market can use its power to block entry intorelated markets through a practice known as strategic bundling. Bundling occurs whena combination of goods or services are sold at a price that is less than what it wouldcost to buy the same item separately.

— Some examples: McDonald’s Happy Meals bundle sandwiches, French fries, and softdrinks. Vacation packages bundle transportation and lodging. Netflix bundles DVDrentals with internet streaming.

6 Industry Analysis

• How to access industry and firm performance? How changes in the business environmentaffect performance?

• Profitability of US Industries 1999-2005

• Michael Porter’s Five Forces Analysis

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• Internal rivalry refers to the jockeying for share by firms within a market. Firms mayinvolve in price competition in order to gain market share. The following factors intensifyprice competition: (i) Many sellers in the market, (ii) The industry is declining, (iii) Firmsare asymmetric, (iv) Some firms have excess capacity, (v) Products are homegeneous/buyershave low switch costs, (vi) There are large/infrequent sales orders, (vii) There is high industryprice elasticity of demand

• Entry. Entry heats up internal rivalry. Some factors that affect entry: (i) Economiesof scale/scope, (ii) Government protection, (iii) Consumers’brand loyality, (iv) EssentialResources/know-how

• Substitutes and Complements. Substitutes erode profits while complements boost the de-mand for the product.

• Supplier Power and Buyer Power. The following factors affect supplier power and buyerpower: (i) Competitiveness of the input market, (ii) The relative concentration of the indus-try in question/its upstream and its downstream industries, (iii) Availability of substituteinputs, (iv) Relationship-specific investments by the industry and its suppliers.

• Go over the textbook for detailed discussions of each force and understand how the five-forces analysis can be applied to evaluate the profitabilities of Airbus and Boeing in the nearfuture.

Reading List: Ch 5 and Ch 6

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