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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