Transcript Industry Structure III

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
Oligopoly
• 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.
David Bryce © 1996-2002
Adapted from Baye © 2002
Cournot 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Cournot (Duopoly) Example
• 2 firms producing a homogeneous product –
inverse demand is
P(Q) = P(q1+q2) = a - q1 - q2
• Profits for firm 1 are
p1 = 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Cournot 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Graphically
q2
R1(q2)
(Firm 1’s Reaction Function)
q2
q1*
David Bryce © 1996-2002
Adapted from Baye © 2002
qM1
q1
Cournot 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Cournot Equilibrium
q2
R1(q2)
Cournot Equilibrium
M
q2
q*2
R2(q1)
q1*
David Bryce © 1996-2002
Adapted from Baye © 2002
M
q1
q1
Summary of Cournot Equilibrium
• The output q1* maximizes firm 1’s profits,
given that firm 2 produces q2*
• The output q2* maximizes firm 2’s profits,
given that firm 1 produces q1*
• 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Firm 1’s Isoprofit Curve
q2
The combinations of outputs of the two firms
that yield the same level of profit for firm 1
R1(q2 )
B
Increasing
profits for
firm 1
C
A
A
p1 = $100
p1 =
$200
q1*
David Bryce © 1996-2002
Adapted from Baye © 2002
M
q1
q1
Isoprofits and the Cournot
Equilibrium
q2
R1(q2)
Firm 2’s Profits
Cournot Equilibrium
M
q2
q*2
Firm 1’s Profits
R2(q1)
q1*
David Bryce © 1996-2002
Adapted from Baye © 2002
M
q1
q1
Stackelberg 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.
David Bryce © 1996-2002
Adapted from Baye © 2002
Stackelberg (Duopoly) Example
• 2 firms producing a homogeneous product –
inverse demand is
P(Q) = P(q1+q2) = a - q1 - q2
• Profits for firm 2 (follower) are
p2 = q2(a – q1 – q2) – cq2 – k
where marginal cost = c and fixed costs = k
• Optimal output choice for firm 2
– MR = a - 2q2 – q1
– MC = c
– q2 = R2(q1) = (a – q1 – c)/2
David Bryce © 1996-2002
Adapted from Baye © 2002
Stackelberg (Duopoly) Example
• 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
p1 = q1(a – q1 – (a – q1 – c)/2) – cq1 – k
where marginal cost = c and fixed costs = k
– Optimal output choice for firm 1
• MR = (a + c)/2 - q1
• MC = c
• q1* = (a – c)/2
David Bryce © 1996-2002
Adapted from Baye © 2002
Stackelberg Equilibrium
q2
R1(q2)
Follower’s profits decline
M
q2
Stackelberg Equilibrium
q*2
S
q2
Leader’s profits rise
q1*
David Bryce © 1996-2002
Adapted from Baye © 2002
R2(q1)
S
q1
M
q1
q1
Stackelberg 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Bertrand 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Bertrand Equilibrium
Why 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
David Bryce © 1996-2002
Adapted from Baye © 2002
Contestable 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)
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.
• Oligopoly structures may enable economic
profits depending on the degree of
differentiation and inter-firm rivalry.
David Bryce © 1996-2002
Adapted from Baye © 2002