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. 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

4. 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

5. 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 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

6. Maximizing Economic PerformanceOptimal Choice of Price and Output Price/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. Revenue Cost Q* Quantity

7. 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. Price MC(Q)=Supply Curve AC(Q) Quantity

8. 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 p>0, firms will enter, increase supply, and reduce prices until p=0

9. 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

10. 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

11. Setting Price $ $ S Pe Df D QM Qf Market Firm

12. Profit = (Pe - ATC)  Qf* Pe Pe = Df = MR ATC Qf* Setting Output MC $ ATC AVC Qf

13. 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

14. S’ Entry Pe’ Df’ Effect of Entry on Price $ $ S Pe Df D QM Qf Market Firm

15. Df’ Pe’ Qf’ Effect of Entry on the Firm’s Output and Profits MC $ AC Pe Df Q Qf

16. 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

17. 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.