power of rivalry: economics of competition and profits

David Bryce © 1996-2002Adapted from Baye © 2002


Power of Rivalry:Economics of Competition and ProfitsPower of Rivalry:Economics of Competition and Profits

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

MANEC 387MANEC 387

Economics of StrategyEconomics of Strategy

David J. BryceDavid J. Bryce



The Structure of IndustriesThe 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”



Market Structure and PerformanceMarket 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



OligopolyOligopoly• 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.



Cournot Model of OligopolyCournot 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



Cournot (Duopoly) ExampleCournot (Duopoly) Example

• 2 firms producing a homogeneous product – inverse demand is

P(Q) = P(q1+q2) = a - q1 - q2

• Profits for firm 1 are1 = 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


P(Q) = P(q1+q2) = a - q1 - q2

• Profits for firm 1 are1 = q1(a – q1 – q2) – cq1 – k



– MC = c– q1 = (a – q2 – c)/2



Cournot Reaction FunctionsCournot 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

• 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



GraphicallyGraphically

q2q2

q1q1

R1(q2)(Firm 1’s Reaction Function)

R1(q2)(Firm 1’s Reaction Function)

q1q1

q2q2

q1q1** MM



Cournot EquilibriumCournot 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



q2q2**


**q1q1

q2q2

q1q1q1q1

R1(q2)R1(q2)

R2(q1)R2(q1)

MMq2q2


MM



Summary of Cournot EquilibriumSummary of Cournot Equilibrium

• The output q1* maximizes firm 1’s

profits, given that firm 2 produces q2*



• 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





• 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



q1q1**

Firm 1’s Isoprofit CurveFirm 1’s Isoprofit Curve

The combinations of outputs of the two firms that yield the same level of profit for firm 1

The combinations of outputs of the two firms that yield the same level of profit for firm 1

q1q1

R1(q2 )R1(q2 )

1 = $1001 = $100

1 = $2001 = $200

Increasing profits for

firm 1

Increasing profits for

firm 1

AA

q2q2

AA

CCBB

q1q1MM



Isoprofits and the Cournot EquilibriumIsoprofits and the Cournot Equilibrium

Firm 2’s ProfitsFirm 2’s Profits

q2q2**

**q1q1

q2q2

q1q1q1q1

R1(q2)R1(q2)

R2(q1)R2(q1)

MMq2q2


MM

Firm 1’s ProfitsFirm 1’s Profits



Stackelberg ModelStackelberg 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.



Stackelberg (Duopoly) ExampleStackelberg (Duopoly) Example


P(Q) = P(q1+q2) = a - q1 - q2

• Profits for firm 2 (follower) are2 = q2(a – q1 – q2) – cq2 – k



– MC = c– q2 = R2(q1) = (a – q1 – c)/2


P(Q) = P(q1+q2) = a - q1 - q2

• Profits for firm 2 (follower) are2 = q2(a – q1 – q2) – cq2 – k



– MC = c– q2 = R2(q1) = (a – q1 – c)/2



• 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

1 = q1(a – q1 – (a – q1 – c)/2) – cq1 – kwhere marginal cost = c and fixed costs = k

– Optimal output choice for firm 1• MR = (a + c)/2 - q1 • MC = c• q1

* = (a – c)/2

• 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

1 = q1(a – q1 – (a – q1 – c)/2) – cq1 – kwhere marginal cost = c and fixed costs = k

– Optimal output choice for firm 1• MR = (a + c)/2 - q1 • MC = c• q1

* = (a – c)/2

Stackelberg (Duopoly) ExampleStackelberg (Duopoly) Example



Stackelberg EquilibriumStackelberg Equilibrium

q2q2**

**q1q1

q2q2

q1q1q1q1

R1(q2)R1(q2)

R2(q1)R2(q1)

MMq2q2

MMq1q1

SS

SSq2q2

Stackelberg EquilibriumStackelberg Equilibrium

Follower’s profits declineFollower’s profits decline

Leader’s profits riseLeader’s profits rise



Stackelberg SummaryStackelberg 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



Bertrand ModelBertrand 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



Bertrand EquilibriumWhy do firms set P1 = P2 = MC?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

• 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



Contestable MarketsContestable 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)

• 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)



Summary and TakeawaysSummary 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.

• 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.

power of rivalry: economics of competition and profits

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