David Bryce © Adapted from Baye © 2002 Power of Rivalry: Economics of Competition and Profits MANEC 387 Economics of Strategy MANEC 387 Economics of Strategy David J. Bryce

David Bryce © Adapted from Baye © 2002 The Structure of Industries Competitive Rivalry Threat of new Entrants Bargaining Power of Customers Threat of Substitutes Bargaining Power of Suppliers From M. Porter, 1979, “How Competitive Forces Shape Strategy”

David Bryce © Adapted from Baye © 2002 The 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

David Bryce © Adapted from Baye © 2002 Sources 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

David Bryce © Adapted from Baye © 2002 Market 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

David Bryce © Adapted from Baye © 2002 Maximizing Economic Performance Optimal 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* Price/Cost Revenue Cost Quantity

David Bryce © Adapted from Baye © 2002 Marginal 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 Curve Quantity Price AC(Q)

David Bryce © Adapted from Baye © 2002 Perfect 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 

David Bryce © Adapted from Baye © 2002 Perfect 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

David Bryce © Adapted from Baye © 2002 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

David Bryce © Adapted from Baye © 2002 Setting Price Firm QfQf QfQf $ $ DfDf DfDf Market QMQM QMQM D D S S PePe PePe $ $

David Bryce © Adapted from Baye © 2002 $ $ QfQf QfQf ATC AVC MC Q f* ATC Setting Output P e = D f = MR PePe PePe Profit = (P e - ATC)  Q f*

David Bryce © Adapted from Baye © 2002 A Numerical Example Demand and supply conditions –P=$10 –C(Q) = 5 + Q 2 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 + Q 2 Optimal output –MR = P = $10 and MC = 2Q –10 = 2Q –Q = 5 units Maximum profits –PQ - C(Q) = (10)(5) - (5 + 25) = $20

David Bryce © Adapted from Baye © 2002 Effect of Entry on Price Firm QfQf QfQf $ $ DfDf DfDf Market QMQM QMQM $ $ D D S S PePe PePe Pe’Pe’ Pe’Pe’ Df’Df’ Df’Df’ S’ Entry

David Bryce © Adapted from Baye © 2002 Effect of Entry on the Firm’s Output and Profits $ $ Q Q AC MC PePe PePe DfDf DfDf Pe’Pe’ Pe’Pe’ Df’Df’ Df’Df’ QfQf QfQf Qf’Qf’ Qf’Qf’

David Bryce © Adapted from Baye © 2002 Summary 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

David Bryce © Adapted from Baye © 2002 Summary 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.