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 Monopoly In a monopoly, one firm supplies the market with little or no risk of entry The market demand curve is the demand curve faced by the firm Marginal revenue no longer equals price – elasticity is less than infinity which allows extraction of monopoly rents Firm has control over price In a monopoly, one firm supplies the market with little or no risk of entry The market demand curve is the demand curve faced by the firm Marginal revenue no longer equals price – elasticity is less than infinity which allows extraction of monopoly rents Firm has control over price

5. David Bryce © 1996-2002 Adapted from Baye © 2002 Monopolist’s Marginal Revenue P P Q Q Q Q Demand Elastic Inelastic Unitary Marginal Revenue Marginal Revenue Total Revenue ($) Total Revenue ($)

6. David Bryce © 1996-2002 Adapted from Baye © 2002 Monopoly Power Natural sources –Economies of scale –Economies of scope –Cost complementarities Created sources –Patents and other legal barriers (like licenses) –Tying contracts –Exclusive contracts –Collusion Natural sources –Economies of scale –Economies of scope –Cost complementarities Created sources –Patents and other legal barriers (like licenses) –Tying contracts –Exclusive contracts –Collusion

7. David Bryce © 1996-2002 Adapted from Baye © 2002 Legal Barriers to Monopoly Power Section 3 of the Clayton Act (1914) –Prohibits exclusive dealing and tying arrangements where the effect may be to “substantially lessen competition” Sections 1 and 2 of the Sherman Act (1890) –Prohibits price-fixing, market sharing, and other collusive practices designed to “monopolize, or attempt to monopolize” a market

8. David Bryce © 1996-2002 Adapted from Baye © 2002 Risks of Monopoly Power

9. David Bryce © 1996-2002 Adapted from Baye © 2002 Managing under Monopoly Monopolists choose the optimal quantity given the demand curve – they cannot choose both price and quantity Monopolists earn rents by restricting output which sets price above economic costs Monopoly rents are sustained only if there is no entry Monopolists choose the optimal quantity given the demand curve – they cannot choose both price and quantity Monopolists earn rents by restricting output which sets price above economic costs Monopoly rents are sustained only if there is no entry

10. David Bryce © 1996-2002 Adapted from Baye © 2002 The Power of Monopoly

11. David Bryce © 1996-2002 Adapted from Baye © 2002 Monopoly Profit Maximization $ $ Q Q ATC MC D D MR Produce where MR = MC and charge the price on the demand curve that corresponds to that quantity QMQM QMQM PMPM PMPM ATC Profit

12. David Bryce © 1996-2002 Adapted from Baye © 2002 A Numerical Example Demand and supply conditions –P = 10 - Q –C(Q) = 6 + 2Q Optimal output and price –MR = 10 - 2Q and MC = 2 (Useful rule: linear demand curves are of the form P(Q) = a + bQ and MR(Q) = a + 2bQ) –10 - 2Q = 2 –Q = 4 units –P = 10 - (4) = $6 Maximum profits –PQ - C(Q) = (6)(4) - (6 + (2)(4)) = $10 Demand and supply conditions –P = 10 - Q –C(Q) = 6 + 2Q Optimal output and price –MR = 10 - 2Q and MC = 2 (Useful rule: linear demand curves are of the form P(Q) = a + bQ and MR(Q) = a + 2bQ) –10 - 2Q = 2 –Q = 4 units –P = 10 - (4) = $6 Maximum profits –PQ - C(Q) = (6)(4) - (6 + (2)(4)) = $10

13. David Bryce © 1996-2002 Adapted from Baye © 2002 The View from Both Sides Arguments against monopoly –P > MC  too little output at too high a price –Deadweight loss of monopoly Arguments for monopoly –The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power –Encourages innovation Arguments against monopoly –P > MC  too little output at too high a price –Deadweight loss of monopoly Arguments for monopoly –The beneficial effects of economies of scale, economies of scope, and cost complementarities on price and output may outweigh the negative effects of market power –Encourages innovation

14. David Bryce © 1996-2002 Adapted from Baye © 2002 Deadweight loss of monopoly Deadweight Loss of Monopoly $ $ Q Q ATC MC D D MR QMQM QMQM PMPM PMPM ATC

15. David Bryce © 1996-2002 Adapted from Baye © 2002 Monopolistic Competition Characteristics of monopolistic competition –Many sellers who do not materially affect their rivals’ pricing decisions –Each seller has a differentiated product Differentiation may allow raising prices because rivals do not respond and some customers will pay for differentiation Performance depends on the degree of differentiation and customer loyalty Characteristics of monopolistic competition –Many sellers who do not materially affect their rivals’ pricing decisions –Each seller has a differentiated product Differentiation may allow raising prices because rivals do not respond and some customers will pay for differentiation Performance depends on the degree of differentiation and customer loyalty

16. David Bryce © 1996-2002 Adapted from Baye © 2002 Responding to the Threat of Entry and Imitation Change; don’t let the long-run set in. Be the first to introduce new brands or to improve existing products and services. Seek out sustainable niches. Create barriers to entry. Guard “trade secrets” and “strategic plans” to increase the time it takes other firms to clone your brand. Change; don’t let the long-run set in. Be the first to introduce new brands or to improve existing products and services. Seek out sustainable niches. Create barriers to entry. Guard “trade secrets” and “strategic plans” to increase the time it takes other firms to clone your brand.

17. David Bryce © 1996-2002 Adapted from Baye © 2002 Maximizing Profits: A Synthesizing Example C(Q) = 125 + 4Q 2  MC = 8Q Determine the profit-maximizing output and price, and discuss its implications, if –You are a price taker and other firms charge $40 per unit; –You are a monopolist and the inverse demand for your product is P = 100 - Q; –You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 - Q C(Q) = 125 + 4Q 2  MC = 8Q Determine the profit-maximizing output and price, and discuss its implications, if –You are a price taker and other firms charge $40 per unit; –You are a monopolist and the inverse demand for your product is P = 100 - Q; –You are a monopolistically competitive firm and the inverse demand for your brand is P = 100 - Q

18. David Bryce © 1996-2002 Adapted from Baye © 2002 Price Taker MR = P = $40 and MC = 8Q Optimal output – set MR = MC –40 = 8Q  Q = 5 units Cost of producing 5 units –C(Q) = 125 + 4Q 2 = 125 + 100 = 225 Revenue of producing 5 units –PQ = (40)(5) = 200 Maximum profits of -$25 Expect exit in the long-run MR = P = $40 and MC = 8Q Optimal output – set MR = MC –40 = 8Q  Q = 5 units Cost of producing 5 units –C(Q) = 125 + 4Q 2 = 125 + 100 = 225 Revenue of producing 5 units –PQ = (40)(5) = 200 Maximum profits of -$25 Expect exit in the long-run

19. David Bryce © 1996-2002 Adapted from Baye © 2002 Monopoly & Monopolistic Competition MR = 100 - 2Q (since P = 100 - Q) Set MR = MC, or 100 - 2Q = 8Q –Optimal output: Q = 10 –Optimal price: P = 100 - (10) = 90 –Maximal profits: PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375 Implications –Monopolist will not face entry (unless patent or other entry barriers are eliminated) –Monopolistically competitive firm should expect other firms to imitate, so profits will decline over time MR = 100 - 2Q (since P = 100 - Q) Set MR = MC, or 100 - 2Q = 8Q –Optimal output: Q = 10 –Optimal price: P = 100 - (10) = 90 –Maximal profits: PQ - C(Q) = (90)(10) -(125 + 4(100)) = $375 Implications –Monopolist will not face entry (unless patent or other entry barriers are eliminated) –Monopolistically competitive firm should expect other firms to imitate, so profits will decline over time

20. David Bryce © 1996-2002 Adapted from Baye © 2002 Summary and Takeaways Rivalry (especially price competition) poses the greatest threat to performance and depends primarily on market structure. Monopoly provides economic profits by eliminating price competition and protecting against entry and imitation. Monopolistic competition may enable economic profits depending on the degree of differentiation and inter-firm rivalry. Rivalry (especially price competition) poses the greatest threat to performance and depends primarily on market structure. Monopoly provides economic profits by eliminating price competition and protecting against entry and imitation. Monopolistic competition may enable economic profits depending on the degree of differentiation and inter-firm rivalry.