Monday, August 20, 2007

When entry raises price

In simple economic models, entry by a substitute product increases the elasticity of demand for existing products, which results in a decrease in price. For example, the FTC complaint against the Whole Foods/Wild Oats grocery store merger used this logic to conclude that the merging stores are close substitutes for one another:

Entry by Whole Foods into a local market where Wild Oats currently operates causes Wild Oats sales to fall by roughtly 37%, margins to fall by 1-3%, and prices to fall by 1-2%.

This got me to thinking about the obverse question, "Does entry by a substitute product ever raise price?" I came up with two examples, pharmaceuticals and Las Vegas hotel/casinos. When a branded drug faces entry by a generic copy, it will stop promoting the brand (as that increases demand for the generic), and raise price. The brand loses its low-value (and more price-elastic) customers to the generic so that branded demand becomes less elastic. The brand responds by raising price.

The hotel entry result works through a different mechanism. When a new hotel/casino opens up in Las Vegas, it makes the Las Vegas a more attractive destination, particularly for conventions. The increase in demand for Las Vegas as a destination more than offsets the decline in demand for consumers who, once they get to Las Vegas, have more choices from which to choose.


  1. Where is the rise in price evident in Las Vegas? Taxicabs? Airfare? Surely casino "prices" don't go up insofar as gambling is concerned. Perhaps room rates.

    But is this a case of substitutions? The Bellagio may not be considered a perfect substitute for Treasure Island. They're branded and hold monopoly power in their respective micro-markets. One is luxury, another may be called family oriented.

    It brings to mind the idea of a co-op. The farmers market; your local strip mall; your local flea market: sellers gather in common areas offering similar products because increased access to customers increases revenue more than lowering price reduces it.

  2. Other scenerios where entry of a substitute can raise the price will be, when the primary motive behind the buying decision is not just price. How about taking cars as an example? Say Nissan comes up with a new Sedan with human recognition system and starts selling it at $28,000. Honda already sells Accord at $28,000. If Honda can also add human recognition system to Accord, it can increase the price by an amount factoring marginal profit into it. It may sell the Accord for $30,000 considering consumer perceives higher value in Accord's other features.

    Other possible scenerios could be when product quality decides buying behaviour. Launching of a substitute with higher quality may force a firm to improve the quality of its own product and start settling it at a higher price. Will there be a rise in profitability needs to be seen by looking at the data :)


  3. Another example could be health care industry. The number of heart surgeons available in the market is increasing every year. We can safely assume that majority of them are substitutes of each other, but the price patients are paying for a heart surgery is increasing year after year. It will be interesting to see what is happening to the economic profits of hospitals as a result of that.

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