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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 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 David Bryce © 1996-2002 Adapted from Baye © 2002 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 David Bryce © 1996-2002 Adapted from Baye © 2002 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 David Bryce © 1996-2002 Adapted from Baye © 2002 Maximizing Economic Performance Optimal Choice of Price and Output • Firm chooses quantity to Price/Cost maximize profits which is the distance between revenue and Revenue costs. • Optimization requires MR(Q) = MC(Q) • Intuition: If MR>MC, one more unit of adds more revenue than Cost it costs. Continue adding units until marginal benefit equals Q* Quantity marginal cost. David Bryce © 1996-2002 Adapted from Baye © 2002 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. David Bryce © 1996-2002 Adapted from Baye © 2002 Price MC(Q)=Supply Curve AC(Q) Quantity 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 David Bryce © 1996-2002 Adapted from Baye © 2002 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 David Bryce © 1996-2002 Adapted from Baye © 2002 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 David Bryce © 1996-2002 Adapted from Baye © 2002 Setting Price $ $ S Pe Df D Market David Bryce © 1996-2002 Adapted from Baye © 2002 QM Firm Qf Setting Output MC $ ATC Profit = (Pe - ATC) Qf* AVC Pe Pe = Df = MR ATC Qf* David Bryce © 1996-2002 Adapted from Baye © 2002 Qf 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 David Bryce © 1996-2002 Adapted from Baye © 2002 Effect of Entry on Price $ $ S Entry S’ Pe Pe’ Df Df ’ D Market David Bryce © 1996-2002 Adapted from Baye © 2002 QM Firm Qf Effect of Entry on the Firm’s Output and Profits MC $ AC Pe Df Pe’ Df ’ Qf ’ Qf David Bryce © 1996-2002 Adapted from Baye © 2002 Q 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 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. • Perfect competition is the antithesis of strategy and compels us to seek out better structures. David Bryce © 1996-2002 Adapted from Baye © 2002