Industrial Organization is the area of economics that studies the markets as institutions, the state of competition and strategic interaction among firms, the industrial policy and the business decisions firms make within the market framework. The course looks at the markets from three different perspectives: the economic theory, the applied business perspective and the institutional and legal perspective. The focus of the course is split equally between the economic theory and business perspective but there is a significant legal component incorporated in various topics. The course includes economic modeling, game theory, numerous real life examples and several case studies. We explore interesting topics of market organization such as negotiations, antitrust, networks, platforms, electronic markets, intellectual property, business strategies, predation, entry deterrence and many others. The basic objective of the course is to enable the student to understand the structure of markets and the nature of strategic competition. Knowledge in this course will be valuable for the students in acquiring managing and governance skills, enriching their understanding of the institutional framework of business, and improve their analytical ability in negotiations. Prerequisites: The course requires understanding of basic economic modeling, knowledge of intermediate microeconomics (especially production/cost theory), knowledge of basic concepts and methodologies of game theory, intermediate econometrics and basic calculus.
5. Proliferation
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From the course by National Research University Higher School of Economics
Industrial Organization: Strategy and Competition in Business
1 rating
National Research University Higher School of Economics
1 rating
From the lesson
Product differentiation
In our previous lectures we have come to the conclusion that when firms compete with price, the Bertrand paradox leads those firms to lose their entire market power. In today’s lecture we will try to resolve this paradox assuming that the firms can differentiate their products. Differentiation has two dimensions. The horizontal, where beliefs for the quality of the product are subjective; and the vertical, where beliefs for quality are objective. We will present two models for horizontal differentiation: the linear and the circular city. We will also cover the Nobel award winning model of differentiation in quality. We will talk about brand proliferation and will examine how it can be effective as a deterrence mechanism. Additionally, we will have two entertaining case studies on the costs of withdrawal and rebranding.
Meet the Instructors
Kosmas MarinakisAssistant Professor
ICEF and Faculty of Economics Sciences, HSE
In several industries, firms enter the markets with more than one brands.
This is a very usual phenomenon that we call it proliferation.
And our basic understanding is
that once you have a product and this product is going very well in the market,
why would you want to enter another product from
the same firm and cause competition between your existing product.
Why do firms want to proliferate.
What is the reason behind that.
One of the reasons is that firms cover more needs.
Let's see some examples and let's try to understand if they will help what is going on.
So, you go to the supermarket than you want to buy the simplest thing, like toothpaste.
And the same company, Colgate,
has different brands: Colgate whitening,
Colgate total, fresh breath,
tartar control, sensitive teeth,
and if you go to the store and this
creates a problem to you when you decide because you say,
sure, I want my teeth to be white,
but I also want total protection,
and I would love my breath to be fresh,
and I also need to have low tartar,
and also my teeth are a little bit sensitive.
So which one should I buy?
So in this case this creates a problem into how you will decide which one you want.
Same with beverages, Coca-Cola Company,
they come up in the market with coke, with Sprite,
with Fanta, with Coca-Cola Zero here in Europe,
Diet Coke in the United States.
They have several different brands that they enter the market with.
Candy also, the Mars company has Mars bounty,
Snickers, M&M's, Maltesers, Twix,
and probably several others that they even
compete with each other with other companies brands too,
but also with each other.
And then even in the technology market in the mobile,
if you go to the Apple store right now that we are filming this course,
you'll see that the iPhone is not only one,
they have the SE, the 6s,
the 6s plus, the 7,
and the 7 plus right now in every store of Apple.
They have these five different phones that you can select one from.
And in some cases you might say, oh yes,
I would like to have a nice phone and iPhone 7 is good,
but iPhone 6 s is cheaper right now and it's not much worse.
So, when you go to the market,
maybe you are determined to buy iPhone 7 but you say wait a second,
I can spend a little less money if I buy 6 s,
and therefore you buy a 6 s. So they actually prevent you from buying
the better brand if this was what you were going to the store for.
And we understand that proliferation does have a cost for those firms,
and the natural question is why do they do it.
Let's consider salps model that we learned before,
and let's see what this model has to tell us about
the answer to this important question that we're curious to know.
Assume that you have the incumbent firms,
and they face a new entrant.
The incumbent firms however have
already entered and not only they entered with one product,
but they have proliferated with N brands.
So they're already N brands into the market.
They have taken their spots.
They have been scattered around the circle in equal distances,
and therefore this model has already been
running not in period one but period two from since a lot of time ago.
So, brands are already scattered along the circle,
and then the price is p of N meaning how many firms have entered N firms,
and profit is p of N. And sometimes forgive me for
calling the Greek letter pi p. The letter is Greek so am I.
In my country we call it p and sometimes it's very difficult for me to change the name.
So if there is no price involved,
the English p letter that we use I call it p.
I think that so far you have already understood me about that.
So, prices p of N and then profit is pi of N,
and we saw that the profit is a decreasing function of N. More firms entering,
profits are going down because more competition is going on.
So suppose now that there is another new firm,
an entrant, a potential entrant,
that is interested in to placing a brand,
boss talk, after the model has already been working,
you come afterwards and you say oh,
you guys already started that without me,
what if I tried to enter to put the brand inside the model right now,
after all the other firms have already started competing.
So introducing a brand,
first of all implies a sunk cost f,
meaning that if you want to enter the game now,
you have to still pay a sunk cost f as we saw in the beginning with the salps model.
Another very important feature is that existing firms do not
want to relocate on the circle in order to accommodate you.
Relocation would mean for those other firms that they will have
very big cost either for rebranding or withdrawing the product for good.
They don't want to change position.
They have the brands,
they paid money in order to create those brands right there.
And relocating them, rebranding in other words
or withdrawing them will have to face huge costs for that,
and you should not expect that your rivals will be doing this.
So, the entrant therefore must squeeze between two already existing firms.
You cannot go in and say,
oh guys, scooch so I can also put my brand there.
You will have to go and squeeze a wedge between two already existing brands.
So this means that this is the initial situation like I showed you here,
that we have our localized competition,
and then you have the new guy the new entrant that will
have to squeeze between the two firms like that.
Now, let's observe this little graph here because it shows some very useful information.
First of all, for entry to happen,
automatically means that the entrant has to struggle for market space.
Market space is not free and once you enter,
you have to go into the smaller slots in
the market and therefore you will not have the same market space like the others.
So wedging between two existing brands means that your market space
will be smaller from the market space that the existing brands already have.
This means that for other firms,
the distance from their neighbors is one over N. For you from both sides,
it will be one over 2N,
smaller distance from your opponents.
Now, I will show you a Matrix in which shows
the three possible situations that firms can be after the late entry of someone.
That is, in general,
the others in these firms,
the firms that they will be across the circle from where you locate,
the ones that they will not be affected from you because
competition is local and you will compete locally,
you will cause trouble only to the brands that are next to
you not to the all the brands in the circle.
Then the other, the firm that will not be affected,
they have what they had in the beginning a distance from others,
a market share, in other words,
equal to one over N. Half of the one side,
half from the other side.
Total one over N market share.
What you will have is one over 2N.
Half of one over 2N from one side,
half on the other side.
The only people that you are causing problem to are the neighbors from where you are
entering because your neighbors will get a market share of three over 4N.
And this is because on the one side they have one over N distance,
on the other side where you are located they have a distance of one
over 2N and adding these two together will give you three over 4N.
So we have a different situation for you the entrant,
a different situation for your neighbors that you are causing problems to,
and a different situation for the firms up there,
away from the entry and they will not be affected.
This of course will affect the profits.
Now the profits for the others will be what it was before,
pi of N. The profit for you will be pi of 2N as if
2N firms have entered because this is
the much smaller part of the circle that you enjoy now market space on.
And then, they are your neighbors that they have p over 2N over two,
and p over N over 2.
In other words we're taking the average between the others
and you and this will give the profit for your neighbors.
Recall that in stage one,
p or pi of N* is the equal to F.
This is the optimal stopping conditions where firms will stop entering.
This means that N entry should be aborted,
should be no doubt should be cancelled if and
only if the profit that the entrant will have,
pi of 2N is smaller or equal to f. In this case they should not enter.
This means that the pi of 2N should be smaller or equal than pi of N*,
which is the maximum amount of firms and star is the maximum amount of
firms that this industry can accommodate.
So this means that I took that from the relationship above it that
seems p of N* is equal to f. I can substitute this f with pi of N*.
And star then because this is a decreasing function,
I can take on the argument after I reverse the direction of the inequality.
So, the entrant will abort if and only if 2 times N is greater or equal than N*.
And this means that we'll abort if N is greater or
equal the maximum amount of firms that can be accommodated divided by two.
This is a very important result.
It's a striking result.
Why? Because, the entrant will abort if N is above N* over 2,
means that if the incumbents proliferate
even 50 percent of the total market capacity just 50 percent not take the entire market.
Just go around to the 50 percent of what is maximum required,
entry is blocked for the new firms.
So this is a very effective and efficient blocking method for the entrants.
Deterrence method by just proliferating.
Therefore, it is important to understand that in
order to make others to not enter into your business,
again, commitment is necessary.
Once you locate somewhere, you,
by definition have commitment because you located there,
you are not going to relocate.
Why you're not going to relocate?
Because costs of withdrawal or rebranding are very large.
But why are costs of withdrawal or rebranding very high?
Don't take my word for it.
In the next segment, we're going to have two different case studies and we
will see what happened to firms that they tried to rebrand for some reasons,
and we had some results that they were actually terrifying for them. Stay with us.
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