Power of Rivalry: Economics of Competition and Profits

1. Power of Rivalry:Economics of Competition and Profits MANEC 387 Economics of Strategy David J. Bryce

2. The Structure of Industries Threat of new Entrants Competitive Rivalry Bargaining Power of Suppliers Bargaining Power of Customers Threat of Substitutes From M. Porter, 1979, “How Competitive Forces Shape Strategy”

3. 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: 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. 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.

5. 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

6. Cournot (Duopoly) Example • 2 firms producing a homogeneous product – inverse demand is P(Q) = P(q1+q2) = a - q1 - q2 • Profits for firm 1 are p1 = q1(a – q1 – q2) – cq1 – k where marginal cost = c and fixed costs = k • Optimal output choice for firm 1 • MR = a - 2q1 – q2 • MC = c • q1 = (a – q2 – c)/2

7. Cournot Reaction Functions • Similarly, firm 2’s output decision is q2 = (a – q1 – c)/2 • Output choice is a function of the other firm’s output choice • Each interdependent output choice is known as a reaction function (R1(q2), R2(q1)) • Firm 1’s reaction function (R1(q2)) gives the best response to output decisions of firm 2 • An increase in q2 will lead firm 1 to decrease output q1

8. Graphically q2 R1(q2) (Firm 1’s Reaction Function) q2 q1 q1 q1 M *

9. 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

10. Cournot Equilibrium M q2 q2 * R2(q1) q1 * Cournot Equilibrium q2 R1(q2) M q1 q1

11. Summary of Cournot Equilibrium • The outputq1* maximizes firm 1’s profits, given that firm 2 produces q2* • The outputq2* maximizes firm 2’s profits, given that firm 1 produces q1* • 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. Increasing profits for firm 1 B C A A q1 * Firm 1’s Isoprofit Curve q2 The combinations of outputs of the two firms that yield the same level of profit for firm 1 R1(q2 ) 1 = $100 1 = $200 M q1 q1

13. Cournot Equilibrium M q2 q2 * R2(q1) q1 * Isoprofits and the Cournot Equilibrium q2 R1(q2) Firm 2’s Profits Firm 1’s Profits M q1 q1

14. 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.

15. Stackelberg (Duopoly) Example • 2 firms producing a homogeneous product – inverse demand is P(Q) = P(q1+q2) = a - q1 - q2 • Profits for firm 2 (follower) are p2 = q2(a – q1 – q2) – cq2 – k where marginal cost = c and fixed costs = k • Optimal output choice for firm 2 • MR = a - 2q2 – q1 • MC = c • q2 = R2(q1) = (a – q1 – c)/2

16. Stackelberg (Duopoly) Example • Follower takes leader’s output as given and maximizes profit (Cournot) • Leader chooses output, q1*, on follower’s reaction curve that maximizes profit, R2(q1) • Profits for firm 1 (leader) are p1 = q1(a – q1 – (a – q1 – c)/2) – cq1 – k where marginal cost = c and fixed costs = k • Optimal output choice for firm 1 • MR = (a + c)/2 - q1 • MC = c • q1* = (a – c)/2

17. Follower’s profits decline Stackelberg Equilibrium M q2 q2 * Leader’s profits rise q1 * Stackelberg Equilibrium q2 R1(q2) S q2 R2(q1) S M q1 q1 q1

18. 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

19. 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

20. Bertrand EquilibriumWhy do firms set P1 = P2 = MC? • Suppose MC < P1 < P2 • Firm 1 earns (P1 - 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 P1 = P2 =MC

21. Contestable Markets • Key Assumptions • Producers have access to same technology • Consumers respond quickly to price changes • Existing firms cannot respond quickly to entry by lowering price • Absence of sunk costs • Key Implications • Threat of entry disciplines firms already in the market • Incumbents have no market power, even if there is only a single incumbent (a monopolist)

22. Summary and Takeaways • Rivalry (especially price competition) poses the greatest threat to performance and depends primarily on market structure. • Oligopoly structures may enable economic profits depending on the degree of differentiation and inter-firm rivalry.