David Bryce © 1996-2002 Adapted from Baye © 2002 Power of Rivalry: Economics of Competition and...

David Bryce © 1996-2002Adapted from Baye © 2002


Power of Rivalry:Economics of Competition and ProfitsPower of Rivalry:Economics of Competition and Profits

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

David J. BryceDavid J. Bryce



The Structure of IndustriesThe Structure of Industries

Competitive Rivalry

Threat of newEntrants

BargainingPower of

Customers

Threat ofSubstitutes

BargainingPower of Suppliers

From M. Porter, 1979, “How Competitive Forces Shape Strategy”



The Threat of RivalryThe Threat of Rivalry

• Rivalry is the threat that firms will compete away their profit margins. This occurs through– Price competition– Frequent introduction of new products– Intense advertising campaigns– Fast competitive response– Exit barriers

• Rivalry is the threat that firms will compete away their profit margins. This occurs through– Price competition– Frequent introduction of new products– Intense advertising campaigns– Fast competitive response– Exit barriers



Sources of Increasing RivalrySources of Increasing Rivalry

• Large number of competing firms of similar size (unconcentrated)

• Lack of product differentiation• Slow industry growth• Fixed costs are a significant fraction of

total costs• Productive capacity added in large

increments

• Large number of competing firms of similar size (unconcentrated)

• Lack of product differentiation• Slow industry growth• Fixed costs are a significant fraction of

total costs• Productive capacity added in large

increments



Market Structure and PerformanceMarket Structure and Performance

• The greatest threat to performance is for rivals to dissipate economic profits through price competition.

• Different market structures represent different levels of expected price competition:

• The greatest threat to performance is for rivals to dissipate economic profits through price competition.

• Different market structures represent different levels of expected price competition:Market Structure Intensity of Price Competition

Perfect competition Fierce

Monopolistic competition May be fierce or light depending on degree of product differentiation

Oligopoly May be fierce or light depending on degree of interfirm rivalry

Monopoly Light unless threatened by entry

Market Structure Intensity of Price Competition

Perfect competition Fierce

Monopolistic competition May be fierce or light depending on degree of product differentiation

Oligopoly May be fierce or light depending on degree of interfirm rivalry

Monopoly Light unless threatened by entry



Maximizing Economic PerformanceOptimal Choice of Price and Output

Maximizing Economic PerformanceOptimal Choice of Price and Output

• Firm chooses quantity to maximize profits which is the distance between revenue and costs.

• Optimization requires MR(Q) = MC(Q)

• Intuition: If MR>MC, one more unit of adds more revenue than it costs. Continue adding units until marginal benefit equals marginal cost.

• Firm chooses quantity to maximize profits which is the distance between revenue and costs.

• Optimization requires MR(Q) = MC(Q)

• Intuition: If MR>MC, one more unit of adds more revenue than it costs. Continue adding units until marginal benefit equals marginal cost.

Q*Q*

Price/CostPrice/Cost

RevenueRevenue

CostCost

QuantityQuantity



Marginal Cost and the Supply CurveMarginal Cost and the Supply Curve

• Firm chooses quantity such that MR=MC

• Firm supply follows MC curve for all prices above marginal cost

• Supply curve defines quantities firm is willing to sell for a menu of prices.

• Firm chooses quantity such that MR=MC

• Firm supply follows MC curve for all prices above marginal cost

• Supply curve defines quantities firm is willing to sell for a menu of prices.

MC(Q)=Supply CurveMC(Q)=Supply Curve

QuantityQuantity

PricePrice

AC(Q)AC(Q)



Perfect CompetitionPerfect Competition

• Characteristics of perfect competition– Many sellers– Homogeneous product– Free entry and exit– Many, well-informed customers

• Ease of entry encourages price competition, pushing economic profits to zero– Logic: if firms will enter, increase supply,

and reduce prices until

• Characteristics of perfect competition– Many sellers– Homogeneous product– Free entry and exit– Many, well-informed customers

• Ease of entry encourages price competition, pushing economic profits to zero– Logic: if firms will enter, increase supply,

and reduce prices until



Perfect CompetitionPerfect Competition

• Product homogeneity creates infinitely elastic demand and forces price competition– Logic: If the firm raises price, consumers can

get the same product for less from rivals, so sales fall to zero.

– Logic: If the firm lowers price, it gets all market demand but does so for lower price than it could

• The average firm is a “price taker” (P=MC) with no profits

• Some firms may still earn economic profits/rents

• Product homogeneity creates infinitely elastic demand and forces price competition– Logic: If the firm raises price, consumers can

get the same product for less from rivals, so sales fall to zero.

– Logic: If the firm lowers price, it gets all market demand but does so for lower price than it could

• The average firm is a “price taker” (P=MC) with no profits

• Some firms may still earn economic profits/rents



Why Learn if Assumptions are Unrealistic?Why Learn if Assumptions are Unrealistic?

• Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms

• It is a useful benchmark• Explains why governments oppose

monopolies• Illuminates the “danger” to managers of

competitive environments– Importance of product differentiation– Sustainable advantage

• Many small businesses are “price-takers,” and decision rules for such firms are similar to those of perfectly competitive firms

• It is a useful benchmark• Explains why governments oppose

monopolies• Illuminates the “danger” to managers of

competitive environments– Importance of product differentiation– Sustainable advantage



Setting PriceSetting Price

FirmFirmQfQf

$$

DfDf

MarketMarketQMQM

DD

SS

PePe

$$



$$

QfQf

ATCATC

AVCAVC

MCMC

Qf*Qf*

ATCATC

Setting OutputSetting Output

Pe = Df = MRPe = Df = MR

PePe

Profit = (Pe - ATC) Qf*Profit = (Pe - ATC) Qf*



A Numerical ExampleA Numerical Example

• Demand and supply conditions– P=$10 – C(Q) = 5 + Q2

• Optimal output– MR = P = $10 and MC = 2Q– 10 = 2Q– Q = 5 units

• Maximum profits– PQ - C(Q) = (10)(5) - (5 + 25) = $20

• Demand and supply conditions– P=$10 – C(Q) = 5 + Q2

• Optimal output– MR = P = $10 and MC = 2Q– 10 = 2Q– Q = 5 units

• Maximum profits– PQ - C(Q) = (10)(5) - (5 + 25) = $20



Effect of Entry on PriceEffect of Entry on Price

FirmFirm QfQf

$$

DfDf

MarketMarket QMQM

$$

DD

SS

PePe

Pe’Pe’ Df’Df’

S’S’EntryEntry



Effect of Entry on the Firm’s Output and ProfitsEffect of Entry on the Firm’s Output and Profits

$$

QQ

ACACMCMC

PePe DfDf

Pe’Pe’ Df’Df’

QfQfQf’Qf’



Summary of Logic of Perfect CompetitionSummary of Logic of Perfect Competition

• Short run profits leads to entry• Entry increases market supply, drives

down the market price, increases the market quantity

• Demand for individual firm’s product shifts down

• Firm reduces output to maximize profit• Long run profits are zero

• Short run profits leads to entry• Entry increases market supply, drives

down the market price, increases the market quantity

• Demand for individual firm’s product shifts down

• Firm reduces output to maximize profit• Long run profits are zero



Summary and TakeawaysSummary and Takeaways

• Rivalry (especially price competition) poses the greatest threat to performance and depends primarily on market structure.

• Perfect competition is the antithesis of strategy and compels us to seek out better structures.

• Rivalry (especially price competition) poses the greatest threat to performance and depends primarily on market structure.

• Perfect competition is the antithesis of strategy and compels us to seek out better structures.

David Bryce © 1996-2002 Adapted from Baye © 2002 Power of Rivalry: Economics of Competition and...

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Transcript of David Bryce © 1996-2002 Adapted from Baye © 2002 Power of Rivalry: Economics of Competition and...