1. David Bryce © 1996-2002 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

2. David Bryce © 1996-2002 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”

3. David Bryce © 1996-2002 Adapted from Baye © 2002 Market Structure and Performance There are few examples of pure perfect competition and monopoly – it is more realistic to allow differentiated products with a few rivals These market structures represent different levels of expected price competition: There are few examples of pure perfect competition and monopoly – it is more realistic to allow differentiated products with a few rivals These 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

4. David Bryce © 1996-2002 Adapted from Baye © 2002 Oligopoly Characteristics of oligopoly –A few, concentrated sellers who act and react to each other –All firms are selling undifferentiated products Few rivals may collectively act like a monopolist (tacit collusion) over market demand. By restricting output, oligopolists can earn price premia and economic profits. Actual performance depends on discipline among rivals to avoid price competition. Characteristics of oligopoly –A few, concentrated sellers who act and react to each other –All firms are selling undifferentiated products Few rivals may collectively act like a monopolist (tacit collusion) over market demand. By restricting output, oligopolists can earn price premia and economic profits. Actual performance depends on discipline among rivals to avoid price competition.

5. David Bryce © 1996-2002 Adapted from Baye © 2002 Cournot Model of Oligopoly A few firms produce goods that are either perfect substitutes (homogeneous) or imperfect substitutes (differentiated) Firms set output, as opposed to price Each firm believes their rivals will hold output constant if it changes its own output (The output of rivals is viewed as given or “fixed”) Barriers to entry exist A few firms produce goods that are either perfect substitutes (homogeneous) or imperfect substitutes (differentiated) Firms set output, as opposed to price Each firm believes their rivals will hold output constant if it changes its own output (The output of rivals is viewed as given or “fixed”) Barriers to entry exist

6. David Bryce © 1996-2002 Adapted from Baye © 2002 Cournot (Duopoly) Example 2 firms producing a homogeneous product – inverse demand is P(Q) = P(q 1 +q 2 ) = a - q 1 - q 2 Profits for firm 1 are  1 = q 1 (a – q 1 – q 2 ) – cq 1 – k where marginal cost = c and fixed costs = k Optimal output choice for firm 1 –MR = a - 2q 1 – q 2 –MC = c –q 1 = (a – q 2 – c)/2 2 firms producing a homogeneous product – inverse demand is P(Q) = P(q 1 +q 2 ) = a - q 1 - q 2 Profits for firm 1 are  1 = q 1 (a – q 1 – q 2 ) – cq 1 – k where marginal cost = c and fixed costs = k Optimal output choice for firm 1 –MR = a - 2q 1 – q 2 –MC = c –q 1 = (a – q 2 – c)/2

7. David Bryce © 1996-2002 Adapted from Baye © 2002 Cournot Reaction Functions Similarly, firm 2’s output decision is q 2 = (a – q 1 – c)/2 Output choice is a function of the other firm’s output choice Each interdependent output choice is known as a reaction function (R 1 (q 2 ), R 2 (q 1 )) –Firm 1’s reaction function (R 1 (q 2 )) gives the best response to output decisions of firm 2 –An increase in q 2 will lead firm 1 to decrease output q 1 Similarly, firm 2’s output decision is q 2 = (a – q 1 – c)/2 Output choice is a function of the other firm’s output choice Each interdependent output choice is known as a reaction function (R 1 (q 2 ), R 2 (q 1 )) –Firm 1’s reaction function (R 1 (q 2 )) gives the best response to output decisions of firm 2 –An increase in q 2 will lead firm 1 to decrease output q 1

8. David Bryce © 1996-2002 Adapted from Baye © 2002 Graphically q2q2 q2q2 q1q1 q1q1 R 1 (q 2 ) (Firm 1’s Reaction Function) R 1 (q 2 ) (Firm 1’s Reaction Function) q1q1 q1q1 q2q2 q2q2 q1q1 q1q1 * * M M

9. David Bryce © 1996-2002 Adapted from Baye © 2002 Cournot Equilibrium Situation where each firm produces the output that maximizes its profits, given the the output of rival firms No firm can gain by unilaterally changing its own output – both firms are simultaneously producing their best response to their rival’s output decision Situation where each firm produces the output that maximizes its profits, given the the output of rival firms No firm can gain by unilaterally changing its own output – both firms are simultaneously producing their best response to their rival’s output decision

10. David Bryce © 1996-2002 Adapted from Baye © 2002 q2q2 q2q2 * * Cournot Equilibrium * * q1q1 q1q1 q2q2 q2q2 q1q1 q1q1 q1q1 q1q1 R 1 (q 2 ) R 2 (q 1 ) M M q2q2 q2q2 Cournot Equilibrium M M

11. David Bryce © 1996-2002 Adapted from Baye © 2002 Summary of Cournot Equilibrium The output q 1 * maximizes firm 1’s profits, given that firm 2 produces q 2 * The output q 2 * maximizes firm 2’s profits, given that firm 1 produces q 1 * Neither firm has an incentive to change its output, given the output of the rival Beliefs are consistent: –In equilibrium, each firm “thinks” rivals will stick to their current output – and they do The output q 1 * maximizes firm 1’s profits, given that firm 2 produces q 2 * The output q 2 * maximizes firm 2’s profits, given that firm 1 produces q 1 * Neither firm has an incentive to change its output, given the output of the rival Beliefs are consistent: –In equilibrium, each firm “thinks” rivals will stick to their current output – and they do

12. David Bryce © 1996-2002 Adapted from Baye © 2002 q1q1 q1q1 * * Firm 1’s Isoprofit Curve The combinations of outputs of the two firms that yield the same level of profit for firm 1 q1q1 q1q1 R 1 (q 2 )  1 = $100  1 = $200 Increasing profits for firm 1 A A q2q2 q2q2 A A C C B B q1q1 q1q1 M M

13. David Bryce © 1996-2002 Adapted from Baye © 2002 Isoprofits and the Cournot Equilibrium Firm 2’s Profits q2q2 q2q2 * * * * q1q1 q1q1 q2q2 q2q2 q1q1 q1q1 q1q1 q1q1 R 1 (q 2 ) R 2 (q 1 ) M M q2q2 q2q2 Cournot Equilibrium M M Firm 1’s Profits

14. David Bryce © 1996-2002 Adapted from Baye © 2002 Stackelberg Model Few firms – producing differentiated or homogeneous products Barriers to entry preserve concentration Firm one is the leader – the leader commits to an output before all other firms Remaining firms are followers – they choose their outputs so as to maximize profits, given the leader’s output. Few firms – producing differentiated or homogeneous products Barriers to entry preserve concentration Firm one is the leader – the leader commits to an output before all other firms Remaining firms are followers – they choose their outputs so as to maximize profits, given the leader’s output.

15. David Bryce © 1996-2002 Adapted from Baye © 2002 Stackelberg (Duopoly) Example 2 firms producing a homogeneous product – inverse demand is P(Q) = P(q 1 +q 2 ) = a - q 1 - q 2 Profits for firm 2 (follower) are  2 = q 2 (a – q 1 – q 2 ) – cq 2 – k where marginal cost = c and fixed costs = k Optimal output choice for firm 2 –MR = a - 2q 2 – q 1 –MC = c –q 2 = R 2 (q 1 ) = (a – q 1 – c)/2 2 firms producing a homogeneous product – inverse demand is P(Q) = P(q 1 +q 2 ) = a - q 1 - q 2 Profits for firm 2 (follower) are  2 = q 2 (a – q 1 – q 2 ) – cq 2 – k where marginal cost = c and fixed costs = k Optimal output choice for firm 2 –MR = a - 2q 2 – q 1 –MC = c –q 2 = R 2 (q 1 ) = (a – q 1 – c)/2

16. David Bryce © 1996-2002 Adapted from Baye © 2002 Follower takes leader’s output as given and maximizes profit (Cournot) Leader chooses output, q 1 *, on follower’s reaction curve that maximizes profit, R 2 (q 1 ) –Profits for firm 1 (leader) are  1 = q 1 (a – q 1 – (a – q 1 – c)/2) – cq 1 – k where marginal cost = c and fixed costs = k –Optimal output choice for firm 1 MR = (a + c)/2 - q 1 MC = c q 1 * = (a – c)/2 Follower takes leader’s output as given and maximizes profit (Cournot) Leader chooses output, q 1 *, on follower’s reaction curve that maximizes profit, R 2 (q 1 ) –Profits for firm 1 (leader) are  1 = q 1 (a – q 1 – (a – q 1 – c)/2) – cq 1 – k where marginal cost = c and fixed costs = k –Optimal output choice for firm 1 MR = (a + c)/2 - q 1 MC = c q 1 * = (a – c)/2 Stackelberg (Duopoly) Example

17. David Bryce © 1996-2002 Adapted from Baye © 2002 Stackelberg Equilibrium q2q2 q2q2 * * * * q1q1 q1q1 q2q2 q2q2 q1q1 q1q1 q1q1 q1q1 R 1 (q 2 ) R 2 (q 1 ) M M q2q2 q2q2 M M q1q1 q1q1 S S S S q2q2 q2q2 Stackelberg Equilibrium Follower’s profits decline Leader’s profits rise

18. David Bryce © 1996-2002 Adapted from Baye © 2002 Stackelberg Summary Stackelberg model illustrates how first mover advantages through commitment can enhance profits in strategic environments Leader produces more than the Cournot equilibrium output –Larger market share, higher profits –First-mover advantage Follower produces less than the Cournot equilibrium output –Smaller market share, lower profits Stackelberg model illustrates how first mover advantages through commitment can enhance profits in strategic environments Leader produces more than the Cournot equilibrium output –Larger market share, higher profits –First-mover advantage Follower produces less than the Cournot equilibrium output –Smaller market share, lower profits

19. David Bryce © 1996-2002 Adapted from Baye © 2002 Bertrand Model Few firms –Firms produce identical products at constant marginal cost –Each firm independently sets its price in order to maximize profits Barriers to entry preserve concentration Consumers enjoy –Perfect information –Zero transaction costs Few firms –Firms produce identical products at constant marginal cost –Each firm independently sets its price in order to maximize profits Barriers to entry preserve concentration Consumers enjoy –Perfect information –Zero transaction costs

20. David Bryce © 1996-2002 Adapted from Baye © 2002 Bertrand Equilibrium Why do firms set P 1 = P 2 = MC? Suppose MC < P 1 < P 2 Firm 1 earns (P 1 - MC) on each unit sold, while firm 2 earns nothing Firm 2 has an incentive to slightly undercut firm 1’s price to capture the entire market Firm 1 then has an incentive to undercut firm 2’s price. This undercutting continues... Equilibrium: Each firm charges P 1 = P 2 =MC Suppose MC < P 1 < P 2 Firm 1 earns (P 1 - MC) on each unit sold, while firm 2 earns nothing Firm 2 has an incentive to slightly undercut firm 1’s price to capture the entire market Firm 1 then has an incentive to undercut firm 2’s price. This undercutting continues... Equilibrium: Each firm charges P 1 = P 2 =MC

21. David Bryce © 1996-2002 Adapted from Baye © 2002 Bertrand Equilibrium What if firms’ marginal costs are not equal (but the products are)? Suppose MC 1 < MC 2 Firm 1 simply sets price to just below MC 2 and takes the whole market Firm 1 earns (P 1 = MC 1 – ε ) – MC 2 on each unit sold, while firm 2 earns nothing Equilibrium: Firm 1 takes the market Suppose MC 1 < MC 2 Firm 1 simply sets price to just below MC 2 and takes the whole market Firm 1 earns (P 1 = MC 1 – ε ) – MC 2 on each unit sold, while firm 2 earns nothing Equilibrium: Firm 1 takes the market

22. David Bryce © 1996-2002 Adapted from Baye © 2002 Differentiated Bertrand Previous discussion assumes oligopolistic firms produce identical products The world is a bit different—usually some differentiation among products exists during price competition In this case, one firm cannot capture all of its rival’s customers by undercutting the rival’s price Thus, firms can charge prices that exceed marginal cost How should rivals price? Previous discussion assumes oligopolistic firms produce identical products The world is a bit different—usually some differentiation among products exists during price competition In this case, one firm cannot capture all of its rival’s customers by undercutting the rival’s price Thus, firms can charge prices that exceed marginal cost How should rivals price?

23. David Bryce © 1996-2002 Adapted from Baye © 2002 Differentiated Bertrand P1P1 P2P2 P1*P1*P 1 min P 2 min P2*P2* Reaction function of firm 1* Reaction function of firm 2* *Represents the profit maximizing price of a firm’s product at each possible price of rival’s product Differentiated Bertrand Equilibrium (Also a Nash equilibrium) Differentiated Bertrand Equilibrium (Also a Nash equilibrium)

24. David Bryce © 1996-2002 Adapted from Baye © 2002 Differentiated Bertrand –The case of Boeing and Airbus

25. David Bryce © 1996-2002 Adapted from Baye © 2002 Differentiated Bertrand In differentiated Bertrand competition, tacitly “negotiated” price increases (above marginal cost) may be sustainable The greater the differentiation, the more pricing leeway that exists for each rival—leading to higher possible sustainable prices Rivals may still undercut, however, to win marketshare, but they can never capture the whole market—and doing so may undermine profit maximization Rivals must understand the nature of the game they’re playing or they risk “ruining” the industry with price competition In differentiated Bertrand competition, tacitly “negotiated” price increases (above marginal cost) may be sustainable The greater the differentiation, the more pricing leeway that exists for each rival—leading to higher possible sustainable prices Rivals may still undercut, however, to win marketshare, but they can never capture the whole market—and doing so may undermine profit maximization Rivals must understand the nature of the game they’re playing or they risk “ruining” the industry with price competition