Download Industry Structure II

Power of Rivalry:
Economics of Competition and Profits
MANEC 387
Economics of Strategy
David J. Bryce
David Bryce © 1996-2002
Adapted from Baye © 2002
The Structure of Industries
Threat of new
Entrants
Bargaining
Power of
Suppliers
Competitive
Rivalry
Threat of
Substitutes
From M. Porter, 1979, “How Competitive Forces Shape Strategy”
David Bryce © 1996-2002
Adapted from Baye © 2002
Bargaining
Power of
Customers
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
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
David Bryce © 1996-2002
Adapted from Baye © 2002
Monopolist’s Marginal Revenue
P
Demand
Total
Revenue
($)
Q
Marginal
Revenue
Q
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
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
David Bryce © 1996-2002
Adapted from Baye © 2002
Risks of Monopoly Power
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
David Bryce © 1996-2002
Adapted from Baye © 2002
The Power of Monopoly
David Bryce © 1996-2002
Adapted from Baye © 2002
Monopoly Profit Maximization
Produce where MR = MC and charge the price on the
demand curve that corresponds to that quantity
$
MC
Profit
ATC
PM
ATC
D
QM
David Bryce © 1996-2002
Adapted from Baye © 2002
MR
Q
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
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
David Bryce © 1996-2002
Adapted from Baye © 2002
Deadweight Loss of Monopoly
Deadweight loss
of monopoly
$
MC
ATC
PM
ATC
D
QM
David Bryce © 1996-2002
Adapted from Baye © 2002
MR
Q
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
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.
David Bryce © 1996-2002
Adapted from Baye © 2002
Maximizing Profits: A Synthesizing
Example
• C(Q) = 125 + 4Q2  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
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 + 4Q2 = 125 + 100 = 225
• Revenue of producing 5 units
– PQ = (40)(5) = 200
• Maximum profits of -$25
• Expect exit in the long-run
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
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.
David Bryce © 1996-2002
Adapted from Baye © 2002