Transcript Industry Structure I

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