Power of Rivalry: Economics of Competition and Profits

David Bryce © 1996-2002Adapted from Baye © 2002

Power of Rivalry:Economics of Competition and Profits

MANEC 387MANEC 387Economics of StrategyEconomics of Strategy

David J. Bryce


The 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 Rivalry• Rivalry is the threat that firms will

compete away profit margins. This occurs through– Price competition– Frequent introduction of new products– Intense advertising campaigns– Fast competitive response– Exit barriers


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


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:Market Structure Intensity of Price CompetitionPerfect competition FierceMonopolistic competition May be fierce or light depending on degree of product differentiationOligopoly May be fierce or light depending on degree of interfirm rivalryMonopoly Light unless threatened by entry


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.

Q*

Price/CostRevenueRevenue

CostCost

Quantity


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.

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

Quantity

Price

AC(Q)AC(Q)


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


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


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


Setting Price

Firm Qf

$

Df

Market QM

D

S

Pe

$


$

Qf

ATC

AVC

MC

Qf*

ATC

Setting Output

Pe = Df = MR

Pe

Profit = (Pe - ATC) Qf*


A 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


Effect of Entry on Price

Firm Qf

$

Df

Market QM

$

D

S

Pe

Pe’ Df’

S’Entry


Effect of Entry on the Firm’s Output and Profits

$

Q

ACMC

Pe Df

Pe’ Df’

QfQf’


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


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.

Documents

Power of Rivalry: Economics of Competition and Profits