Managerial Economics/Competition and market structure
- 1 Competition and Market Structure
- 1.1 Perfect competition model
- 1.2 Competitive Selection Model
- 1.3 Monopolistic Competition Model
- 1.4 Monopoly Model
- 1.5 Concluding the differences between a perfectly competitive market and a monopoly
- 1.6 Game Theory
- 1.6.1 Nash Equilibrium
- 1.6.2 Pure vs Mixed strategies
- 1.6.3 Pareto optimality
- 1.6.4 Deriving reaction function
- 1.6.5 Dominant and Dominated Strategies
- 1.6.6 Equilibrium in dominant actions
- 1.6.7 Prisoner's Dilemma
- 1.7 Dynamic Games
- 1.8 Subgame perfect equilibrium
- 1.9 Six Forces Strategic Model
- 1.10 Entry and Exit
- 1.10.1 Entry Cost and Market Structure
- 1.10.2 Endogenous vs Exogenous Entry Costs
- 1.10.3 Barriers to Entry
- 1.11 Summary
- 1.12 Reference/s
Competition and Market Structure
Competition within a market paves the way for the type of market structure that controls the decision making and implications. As a market becomes more competitive, profit maximisation margins become increasingly lower. When a firm enters a market, assumptions are assigned to the market that include product selection, history of information and the ability for a firm to set prices. Factors that impact competition include intensity of rivalry, number of firms and demand 
Perfect competition model
Perfect competition is an ideal market structure which can be thought of as the opposite of a monopoly. The theoretical model of perfect competition assumes the following are true:
- Atomicity: Individual agents (both firms and consumers) are small enough that they have no significant impact on others and cannot influence the market price.
- Price Takers: firms face a horizontal demand curve and have no control over the price. They have to take the price set by the market.
- Product homogeneity: All firms sell an identical product.
- Perfect information: All agents know the price (and quality) of the goods in the market.
- Equal access: All firms have access to all production technologies.
- Free entry: Firms can enter and exit the market freely without cost.
Under these assumptions, each firm would charge price (marginal cost) which results in a Pareto-efficient allocation of resources, thus resulting in an efficient output level with no dead weight loss. In the long run, , implying zero profits.
Under the perfect competition model, we make many assumptions:
- There are many sellers all of whom sell identical goods and services
- Sellers are required to act independently and not as a cartel
- There are a number of buyers who all want to purchase the same good; all of whom will purchase from the seller who offers the lowest price
- All buyers know the sellers price so they are able to choose the lowest price available.
Therefore, under a market with these assumptions a perfectly competitive equilibrium is achieved. 
Perfect Competition Equilibrium
A model that achieves a perfectly competitive equilibrium must have the following characteristics:
- Both buyers and sellers are required to be price-takers. They cannot alter the price that is demanded or offered. 
- A single price is used for all transactions when a good is traded; this is called the law of one price and is where supply=demand 
- Gains from trade must all be realised 
In the long-run, the following equilibrium occurs:
- Price will equal the minimum average cost for each firm. Since all firms are identical, no firm will receive any economic profit.
- There is no entry or exit of firms. (Even at a given point, there should either be entry or exit only - if there are profitable opportunities, firms should be entering and taking advantage of them as a result of free entry; if firms are making losses then all firms start to exit until it goes back to the long-run equilibrium. That is to say, entry and exit won't be seen at the same time)
- Due to the assumption of all firms having the same technology and being the same size, all plants/factories must be of the same size, or, each firm owns one plant only.
Due to the firms being the price takers in the market, the price is fixed and the demand curve of the firms is horizontal. The long-run equilibrium quantity is achieved when the average revenue (AR), marginal cost (MC) and demand curve (D) intersect.
Empirical Evidence of the Perfect Competition Model
Empirical evidence has shown that:
- In the long run, profit rates are persistent across firms.
- Entry and exit take place simultaneously and at much higher rate. The number off firms that are entering and exiting are much higher than the total firms entering the market. Firms typically enter the market young and small and those that exit the market share these traits. This implys that the average size of firms entering and exiting are smaller than the the average industry size.
- When comparing firm sizes between two countries, macroeconomic effects cause significant variation. However it must be noted that the distribution of firm sizes (small, medium, large) is similar between countries, suggesting there are some common underlying factors that determine how firms are positioned.
Competitive Selection Model
The competitive selection model maintains the following assumptions of the perfect competition model:
- Atomicity : Individual agents (both firms and consumers) are small enough that they have no significant impact on others and cannot influence the market price.
- Product homogeneity : All firms sell an identical product.
- Perfect information : All agents know the price (and quality) of the goods in the market.
This model relaxes a number of assumptions made in the Perfect Competition Model: The 'Free Entry' and 'Equal Access' assumptions. In the competitive selection model firms must pay a sunk cost to enter the market and not all firms have access to the same production technology. Resulting in uncertainty in their own efficiency as firms have different amount of efficiency in the industry. Since firms are uncertain about their efficiency when entering, efficiency is discovered through experimenting with their productivity over time. Through choosing a price which they think is equal to their expected marginal costs (unlike perfect competition model, firms in competitive selection model don't know their marginal costs), the firm is able to determine their productivity through a series of signals. If they receive a series of bad signals, such as low demand, they reduce their output and would eventually exit the market. If firms receive a series of good signals, such as high demand, they remain active and increase their output. The competitive selection model is able to explain discrepancies in the perfect competition model.
- Different firms achieve different profits, even in the long run.
- There is simultaneous entry and exit in the industry because some firms want to enter the firm to test their productivity and discover their efficiency, while other firms discovered their efficiency as being too low and exits.
- Firms which enter and exit the industry are smaller than the average firm in the industry, as rational large firms would have no reason to exit. Firms without knowledge of their efficiency are small and enter the market to try and grow their efficiency and in turn grow into larger firms.
Economic efficiency implies an economic state in which every resource is optimally allocated to serve each individual or entity in the best way while minimizing waste and inefficiency. As the firm's prices are equal to the expected marginal cost, resulting in efficient output levels, maximising welfare. Firms absorb the cost and any benefits that arise from entry and exit, resulting in efficient entry and exit levels.
Due to the no barriers of exit, there is the economic profits. If there is the economic profits, it would attract other firms into mn has many sellers and buyers, and it is easy to enter or exit the market. However, each of the firm are offered the differentiation of products. Thus, product differentiation leads to each of the firms has some pricing power. (FMCG industry---which is can be use advertising to show the differentiation with competitors.)
Feature:The demand curve and the marginal revenue curve (MR) are downward sloping, The marginal revenue curve has twice the slope of the demand curve.
It's not easy to find examples where the assumption of homogeneity holds, for several reasons.
- Even if it's exactly the same thing (e.g. bottled water), the label itself might lead to differentiation in terms of what the customers think about the product - consumers might think that the label signals something about the quality of the product;
- Consumers might have some preferences towards certain companies (e.g. consumers might have different feelings towards the same bottle water of different brands');
- That's one reason why marketers spend a lot of their time trying to create these perceived differences in homogeneous goods. If it works, they tend to form some beliefs where the homogeneous good assumption breaks even for identical goods.
- There are also some differences in terms of after-sales service - there might be things associated with the product that differentiate the actual goods (e.g. 5 minutes vs 10 minutes waiting time for calling the customer service center).
Nevertheless, a homogeneous product is one that cannot be distinguished from competing products from different suppliers. To be homogenous, the product needs to be a substitute to other products, as the good won't possess any differentiation in characteristics. For example, in commodities market vegetables, fruits, metals and energy are homogeneous goods.
Monopolistic Competition Model
The monopolistic competition model maintains the following assumptions of the perfect competition model:
- Atomicity: Individual agents (both firms and consumers) are small enough that they have no significant impact on others and cannot influence the market price.
- Perfect information: All agents know the price (and quality) of the goods in the market.
- Equal access: All firms have access to all production technologies.
- Free entry: Firms can enter and exit the market freely without cost.
Due to the differentiation of products under the monopolistic competition model, this means that the demand curve faced by firms is not horizontal and thus firms are not price takers. Product differentiation can include differences in the physical aspects of the product, location the product is sold in, service quality, product perceptions, and many other intangible aspects. As products offered are not homogeneous, externalities upon rivals in the industry is negligible.
The demand curve faced by firms in monopolistic competition is downward sloping, which indicates that firms can raise their prices and not lose all of their customers (like perfect competition and competitive selection) and lower their price to attract more customers.
Monopolistic Competition Equilibrium
In the short-run when firms are making positive economic profit, this will entice new firms to enter the market, driving the economic profits down to zero.
In the long-run, the following equilibrium occurs:
- Firms maximise profits when MR=MC
- Firms make zero profits when P=AC due to free entry
Monopolistic Competition Examples
The in-class activity of trying to find a product that would satisfy the five assumptions of perfect competition highlighted the difference of homogeneity between perfect and monopolistic competition. For instance, bottled water was discussed as a potential product in a perfectly competitive market but as it was found out it suited more a monopolistic competition structure due to varying consumer perceptions based on the different product qualities. While some bottled water brands are able to sell for a higher price (e.g. VOSS, FIJI, Mt Franklin) others sell for much cheaper (e.g. Cool Ridge, Coles and Woolworths home brands) and thus homogeneity between these products is non-existent due to product differentiation characteristics.
While there are generally low barriers to entry in a monopolistic competition structure, high barriers exist within the market to reach the leading group of firms. For example, the monopolistic structure of the cola market includes many different brands and competitors. Coca Cola and Pepsi, however, have managed to remain leaders as top brands in the market due to the perceived value they provide to consumers, their brand equity which they have built over many decades and their advanced distribution networks. These product characteristics maintain high barriers to entry into this leading group of the cola monopolistic market.
There are several types of monopolies that exist today but the most heard of monopoly is a pure monopoly. It is when the firm controls 100% of the market. Although rare in practice, they do exist. A second type of monopoly is when a firm is considered to be a monopoly if it controls more than a certain percentage of the market which is determined by the government. These percentages differ across governments. For eg, the UK follows the 25% rule. A third type of monopoly is a natural monopoly where a firm has significant monopolies of scale due to that firm being the only one in the industry.
Characteristics of a pure monopoly are:
- One single firm sells all products in the market
- There are significant barriers to entry
- There is no close competition in the market
- The monopolist is the price maker, i.e. they choose the price for the product in the market
- There are no close substitutes to the product the monopolist is offering
- The firm is able to maintain super-normal profits both in the short and long run
- Imperfect knowledge
The demand curve faced by monopolists is downward sloping like in monopolistic competition, but with a steeper gradient. This indicates that monopolists have greater market power and can change their prices by large amounts without significantly affecting the demand.
Since the monopolist aims to maximise profits, they operate with a dead weight loss and therefore do not produce at an efficient level.
Monopoly markets are markets where there is only a few suppliers that can provide the highly differentiated products, with strong barriers to entry or exit. The new entrants eat into the profits until the economic profits go down to zero. Thus, under these circumstances, the market reaches the equilibrium of long-term, when the firm only obtains the normal profits when the economic profit equals zero. Due to there being no close substitutes, consumers will have no choice but to pay the high price to the monopoly in order to obtain the product. One example would be in Martin Skhreli who ran a pharmaceutical company and raised the price of one of its vital medicines, Daraprim from $13.50 to $750 overnight. Because there were no close substitutes to this product, many consumers had no choice but to pay the higher amount in order to cure their unique diseases. Monopolies usually have a lack of economic competition in the production of goods and services. As the product is unique and is hard to replace and substitute, the monopoly charges a price that is usually above the marginal cost, hence enabling the monopoly to generate a high profit. In most monopolies, consumers are not aware of the costs and production functions of the product. This is one of the many reasons why monopolies are able to set such high prices. The word “Monopolise” means the ability to increase price or to exclude competitors. A monopoly is defined as a business entity which has a significant market power. These powers include changing the price of the product. Even though many monopolies may engage in big businesses, the size of the business is not a key factor in analyzing whether the firm is a monopoly or not. Moreover, small businesses may still have power in increasing the price in a smaller market or industry. An example of a monopoly is Microsoft. Microsoft is a computer and software manufacturing company that holds more than 75% market share. Microsoft is the leader in this market and virtual monopolist in the tech space.
Concluding the differences between a perfectly competitive market and a monopoly
From the above discussion it is evident that there are a number of differences between a monopoly (price-setting firm) and a firm that’s perfectly competitive. The following table briefly and clearly presents a summary of the differences between the two;
|Monopoly (Price-setting firm)||Firm in a perfectly competitive market|
|Price makers - the firms want to maximize profits thus set their price and quantity accordingly||Price takers – firms use the given market price and maximize their profits by adjusting their quantity|
|The differentiated products are advertised by the firm||Little to no advertising as it’s a public good|
|Deadweight loss||No deadweight loss|
|The level of output is selected based on when marginal cost<price||The level of output is selected based on when marginal cost = price|
|There is incentive for firms to innovate and they aim to differentiate themselves||There is no incentive for firms to innovate as their ideas will be copied|
Game theory is the study of models of strategic interactions between rational decision-makers, or players. From an economics point of view, a game is any situation where the interactions between two or more parties determine their payoffs. For example, two workers may be competing for a raise, (the workers are the rational decision-makers) each worker must choose how hard to work in order to outperform the other. Each workers payoff will be determined by who works harder and performs the best. Game theory is separated from similar economic interactions because it includes jointly-determined payoffs. The example above represents a jointly-determined payoff because each workers decision impacts the payoff of the other. If worker A works harder than worker B, worker A will reduce the payoff (raise) of worker B and vice versa.
In game theory, players can include firms, governments, individuals or groups of people and any other decision-making group. The choices each player can make are called strategies and the payoffs for each player are determined by the combination of each players strategy, therefore, in game theory when a player changes his or her strategy they affect the payoffs of every other player. The purpose of game theory is to find a solution to a game, it does this by attempting to predict what strategies each player will choose. 
There are many different types of games, some are continuous games, where decisions must be made simultaneously and without knowing what the other players decision will be and some are sequential, where decisions are made in response to one another. Nash equilibrium, sequential move games, the prisoner’s dilemma and sub-game perfect equilibrium are discussed further below.
Definition: Nash equilibrium is an outcome where no players would have incentive to deviate, provided all other players in the game do not deviate.
The stable state derived from an interaction between agents where no agent has incentive to deviate from their initial strategy (i.e. agents cannot benefit from deviating after considering opponents choice).
To find a Nash equilibrium, there are two conditions:
- For every outcome, check for incentives to deviate for every players' actions, the Nash equilibrium is the outcome where no players have alternative actions that incentivise deviation.
- Deriving each players' reaction functions. This is the best action of each player for all other action of rivals. Nash equilibrium is where players' reaction functions are best responses to each other or when the reaction function intersects.
More about Nash Equilibrium:
Nash Equilibrium asks what happens when everyone is doing the best they can, given what everyone else is doing. In other words, Nash Equilibrium is any outcome where each player is choosing their best response to the other players' strategies.
Limits to Nash Equilibrium:
Nash Equilibrium is an equilibrium solution concept. Everyone knows to drive on the left side of the road in Australia because people reasonably expect others to do so too. But there is no reason that people should immediately know which is the ‘equilibrium’. Compare driving with walking and the ‘sidewalk dance’.
Nash Equilibrium is built up in three stages:
1. Players are rational. Ther are best responding to some belief. Therefore never play dominated strategies.
2. Rationality is common knowledge. People cannot expect others to play dominated strategies. Players only employ strategies that survive iterated deletion.
3. Strategies are common knowledge. All players hold correct beliefs about the strategies of others.
Pure vs Mixed strategies
A pure strategy is when a player decides to use a specific action in every possible situation in a game. This player does not change his/her move and always chooses one of the two actions and thus specifies their actions so that other players follow a specific move. A simple example of a pure strategy is the Prisoners Dilemma and a player choosing between “deny” and “confess”.
A mixed strategy is when there is a probability assigned to either of their possible pure strategy actions and a player chooses either of these actions. The probability assigned may get zero weight in some scenarios.
Pareto optimality, also known as “Pareto Efficiency”, means that if an outcome and allocation of resources makes every player as well off as possible, and reallocation of resources would result in making at least one player worse off, means that the outcome of the game is Pareto optimal. This means that every player’s strategy is optimized and will obtain the best possible outcome and will result in equilibrium. A NE is normally not Pareto optimal, meaning that the payoffs of players can be increased.
Kenneth Arrow and Gerard Debreu, both who are economists, stated that under the theoretical model of perfect competition whereby there are a few assumptions present such as atomicity, price taking, perfect information, free entry and equal access, this may mean that the economy has Pareto efficiency.
Deriving reaction function
- Step 1: Derive the profit function where πi = Pi x qi - C(qi)
- Step 2: Set the first order condition (FOC) and find the derivative of πi with respect to either Pi or Qi, depending on either Bertrand or Cournot competition. Set the equation derived equal to 0.
- Step 3: Solve for qi or Pi, which is the reaction function of firm i to firm j. Therefore qi or pi will be written as Ri(qj) or Ri(pj).
- Step 4: Substitute the equations and solve for qNE or pNE
Dominant and Dominated Strategies
- A dominant strategy is an option that gives the player the highest payoff, regardless of what the other person plays. An example of this is shown in the table below: for Player 1, Action B is their dominant strategy as these payoffs (20, 5) are higher than the payoffs from Option A (10, -5) irrespective of what option Player 2 chooses. A dominant strategy is a fairly strong indicator of what option a rational player will choose.
- A dominated strategy is an option that will not give a player the highest payoffs possible. As in the example below, Action A is a dominated strategy for Player 1 as it does not provide higher payoffs as Option B. Equilibrium can be found through the elimination of dominated strategies, as the economic assumption of rationality dictates that a player would not reasonably choose an action that would be dominated by another action.
|Action A||Action B|
|Player 1||Action A||10, 10||-5, 20|
|Action B||20, -5||5, 5|
Strongly Dominant Strategy
- The best choice available among all strategies for each and every state.
Weakly Dominant Strategy
- One of the best choices available among all strategies and there is a state where players are strictly better off.
- Conditions: The weakly dominant strategy cannot be the best for only one state (does not qualify) and the choice does not need to be a single state where the weakly dominant choice is strictly better than every other strategy available.
Strongly Dominated Strategy
- The worst choice available among all strategies for each and every state.
- Conditions: All other choices must be better, not just for one choice. You cannot use different dominating choices for different states.
Weakly Dominated Strategy
- Another strategy is no worse than one strategy for each and every state and there is at least one state where one choice is strictly better than another.
- A weakly dominated strategy is never the best response because there is always a strategy at least as good as another.
Equilibrium in dominant actions
Equilibrium in dominant actions requires each player's actions to be their dominant action among all other option. Thus, providing a good prediction of what a player chooses rationally.
- The prisoner's dilemma is a special game between two captured prisoners that illustrates why it is difficult to maintain cooperation even when it is mutually beneficial. The prisoner's dilemma is a typical example of a non-zero-sum game in game theory. Although the dilemma itself is only a model nature, the reality of price competition, environmental protection, interpersonal relations, and other aspects of the frequent occurrence of similar situations.
- In 1950, Merrill Flood and Melvin Dresher from Rand Corporation formulated the theory of relevant dilemma. Later, Albert Tucker, a consultant, elaborated it in the way of prisoner and named it "prisoner's dilemma". The two conspirators were put in prison, unable to communicate with each other. If two people do not expose each other, each is imprisoned for a year because the evidence is uncertain. If one person exposes and the other is silent, the whistleblower is immediately released because of his meritorious service, and the silent one is sentenced to ten years in prison for non-cooperation. If they blow the whistle on each other, they will be sentenced to eight years in prison because the evidence is conclusive. Since prisoners cannot trust each other, they tend to expose each other rather than keep silent. Finally, the game model leads to Nash equilibrium only on the non-cooperative point.
- The prisoner's dilemma tells the story of two suspects who were caught by the police and held in different rooms for interrogation. The police knew that the two men were guilty, but lacked sufficient evidence to charge them. The police told the prisoners: if both deny it, each will get a year in prison; If both confess, each gets eight years; If one of the two confesses and the other denies, if he confesses, he is sentenced to ten years. Thus, every prisoner faces two choices: confess or deny. However, no matter what the accomplice chooses, the best choice for each prisoner is to confess: if the accomplice denies, and if he confesses, he will be released. If he denies, he will be sentenced to one year. If the accomplice confesses and he confesses, eight years is better than ten years of denial. As a result, both suspects confessed and were sentenced to eight years each. If they both denied it, they each would have gotten a year, which is obviously a good result. The profound problem reflected in the prisoner's dilemma is that individual rationality of human beings can sometimes lead to collective irrationality -- intelligent human beings can become trapped by their own intelligence or harm the interests of the collective.
- A single multiple
Single and multiple prisoner's dilemma, the result will not be the same. In the repeated prisoner's dilemma, the game is played over and over again. Thus each participant has the opportunity to "punish" the other participant for the previous round of non-cooperation. At this point, cooperation may emerge as a balanced outcome. The motivation to cheat may then be overcome by the threat of punishment, which may lead to a better, cooperative outcome. In repeated, nearly infinite repetitions, Nash equilibrium tends to Pareto Optimality, from mutual betrayal to mutual loyalty.
- Theory of substance
Prisoners, through each others cooperation, can bring all the best interest (acquitted), but in each other's performance under the condition of an unknown, because selling partner can bring their interest (remission), also because can bring his accomplices to hire their own interests, therefore betray each other are in violation of the best common interests, it is his own best interests. In practice, however, it is impossible for law enforcement agencies to set up such a situation to induce all prisoners to confess, because the prisoners must consider factors other than the term of imprisonment (retaliation for betraying their partners, etc.), and cannot take the interests (the term of imprisonment) established by the law enforcement as the necessary factors.
- Classic Example
The dilemma was theorized in 1950 by Merrill Flood and Melvin Dresher, who worked for the Rand Corporation, and later described as a prisoner's dilemma by the consultant Albert Tucker. The classic prisoner's dilemma is as follows: The police arrested two suspects, a and b, but did not have enough evidence to charge them. The police then held the suspects separately, met them separately and offered them the same options: If one person plead guilty and testified against the other (" betraying ", in the jargon), and the other remained silent, the person would be released immediately and the silent person would be sentenced to 10 years in prison. If they both remained silent, known in the jargon as "co-operating", they would also be sentenced to one year in prison. If they both turned on each other (the term is "betrayal"), they would both be sentenced to eight years in prison.
- Real-World Economic Example
Real Estate Industry, Tariff/Trade Wars (e.g China VS. U.S.A ongoing trade war), Armament Race Between Superpowers (e.g again, The race of technologies development in military equipments between China, Russia, and U.S.A), other applicable scenarios: advertising competition, track and field competition, cycling race etc.
A dynamic game is where players can condition their optimal actions based on previous iterations (i.e. when agents best respond to each other's interactions). These dynamic games are sequential, where players can choose their actions according to rival's chosen action and often represented in a game tree or commonly known as "extensive form".
Description of game tree:
- Have starting nodes, decision nodes, terminal nodes and branches that links the decision nodes.
- List of players.
- Player at each decision node entitled to choose and complete the set of actions.
- Payoffs of these actions are represented at each terminal node.
At different decision nodes, player can apply their strategy, which is a complete list of actions for each decision node of the entitling the player to choose an action. Strategies can be left to representative of the player, such as lawyers, to assist in completing the set of actions.
Games can be dynamic if:
- Interactions between players are able observable to the actions of other players before deciding an optimal response.
- Game can be repeated a number of iteration, and players observe the outcome of previous games before continuing with the game.
Dynamic or sequential games can be divided into two different categories, games with perfect information or imperfect information. Perfect information describes a game where player have access to every previous action made by other players. However imperfect information characterizes a game in which at least one player does not know all the actions chosen before. Concerning this latter, the strategy describing the whole game has to include every choice the player does depending on the actions chosen by prior players. In other words in a dynamic game with imperfect information there is at least one information set with more than one node.
Subgame perfect equilibrium
Subgame perfect equilibrium (SPE)
A subgame is a decision node from the original game at which a player is called upon to act, along with the decision nodes and terminal nodes following this nodes. Only when there is a beginning node, and all information sets and strategic moves remains on the subgame then a subgame is considered to be a well defined game. An SPE cannot contain a non credible threat while a NE can contain a non-credible threat. Similar to Nash Equilibrium, an outcome is a subgame perfect equilibrium if it induces a nash equilibrium in every subgame of the original game. To find a SPE in a game with infinite horizon, we can use backward induction by defining trigger strategies that shows which actions the player should take depending on which conditions are fulfilled.
- SPE is achieved if it provokes a Nash Equilibrium in every subgame of the original game.
- SPE can be found by backward induction, this involves looking for the Nash equilibrium in a subgame and working backwards from there, starting with the last subgame.
Backward induction can solve any finite games with perfect information and is also a SPNE. However, in any extensive-form games with imperfect information, the player might encounter problematic backward induction as the most optimal action is dependent on the node that she is at.
Six Forces Strategic Model
The Six Forces Strategic Model is a model that allows an organisation to assess the potential attractiveness of a market. Every industry is shaped by these six forces. Six forces are frequently used to analyse the micro-environment of an industry because a healthy industrial structure should be as much a significant concern to managers as their company’s own position (Porter，2008, pp78-93). Understanding industry structure is important to efficient brand positioning. Defending against the competitive forces and converting them to do company's favour is also important to strategy. Six forces strategic model is an extension of the original Porter's five forces model that was introduced in 1979: Aiming to gain a greater presence in the market, a company should keep an eye on not only existing competitors but also the competition in the industry which has been rooted in its underlying economics. Customers, new entrants, substitutes as well as suppliers are all competitors (Porter,1979,pp137-145). However, with the rapid development of technology, the market gets squeezed since more and more services are offered by high-tech; thus here comes the sixth force influencing the industry. The six forces when considering the attractiveness and competitiveness of a market consist of:
1. Potential Entrants
- Economies of Scale: Firms can achieve economies of scale when their average cost per unit decreases as they increase their output level. Existing firms who have exploited the economies of scale will have a significant advantage over potential entrants, consequently acting as a deterrent to entry.
- Switching Costs: If switching costs are high, entrants will be at a disadvantage due to customers being less willing to switch over to their products.
- Access to Distribution Channels: Existing firms have access to distribution channels that entrants may not. If a market has notoriously difficult access to distribution channels, it may not be desirable for new entrants.
- Product Differentiation: If an entrant is not able to deliver a differentiated product that can compete with existing products in the market, then entering the market may not be an attractive option.
- Public Policy/Legal Restrictions: Government and legal requirements may deter entry and benefit firms already existing in the market.
2. Buyer Power
- Buyer Concentration: If buyer concentration is high (or at least more than seller concentration), then buyer power is also high. If there are fewer buyers, they are able to improve their bargaining power by threatening to switch to different products or no longer purchase from specific suppliers.
- Potential for Backward Integration: Backward integration occurs if an organisation merges with a supplier in order to internalise a greater portion of their supply chain. If potential for backward integration is high, then bargaining power of buyers is also high.
- Network Effects: Network effects refer to the phenomenon whereby a good/service increases in value when the number of people using it increases. An example of this could be social media such as FaceBook. The more individuals using the service increases its value provided to its consumers. Therefore, if network effects are high in a particular industry, then buyer power is also high.
- Industry Overcapacity: If overcapacity exists in an industry, it implies that there are more goods/services being provided for than what is currently in demand. This implies that if overcapacity exists, buyer power will be high.
-Homogenous Product: If an industry contains homogenous products, then buyers can easily purchase different goods/services due to low switching costs (ie can get the same product from somewhere else). Therefore in a market with homogenous products, buyer power is high.
3. Supplier Power
- Powerful suppliers can put pressure on participants in an industry by charging a higher price or reducing produce's quality. Thereby, a powerful supplier can squeeze profitability out of a company (Porter,1979,pp140). The number of Suppliers also matters;if there are a high number of potential suppliers, then the supplier power is low due to the fact that buyers can choose from many different suppliers. Vice versa, if there aren't many suppliers in an industry, then supplier power will be high.
- Supply Shortage/Surplus: A supply shortage implies high supplier power, whereas a surplus is indicative of low supplier power.
- Potential for Forward Integration: Forward integration occurs when a firm merges with a customer in an effort to gain control of the distribution and supply of their product. If the potential for forward integration is high, then supplier power is also high.
- Unique supplier product - If a supplier's product is differentiated, then bargaining power will be high.
4. Intensity of Rivalry
- Intensity of rivalry: Existing firms bring about pressure on the other firms in the market. It involves how many firms are in an industry and how dynamic competitiveness is.
- Factors that increase rivalry intensity:
- Concentration of rivals: A firm will possess ever-less market share if the number of competitive firms are increasing or these firms are getting stronger. It is commonly measured by the 4-firm ratio which represents the share of the market held by the 4 largest firms or by the Herfindahl–Hirschman Index which takes every firm in the certain industry into the calculation.
- Lower growth rate: If firms cannot efficiently find the economies of scale or operate slowly, they have to compete with other competitors to steal the profit and market share.
- Lower switching cost: If the switching cost is lower for consumers, the rivalry intensity would be high. Consumers can easily switch the products.
- Lower brand loyalty: Rivalry would be high if the firm has lower brand loyalty. Not managing to build customer loyalty, a firm may lose its customers as they easily turn to its competitors.
- Price competition: Low-cost firms may cut prices to make high-cost rivals exist. Consumers are more willing to buy cheap products if this product is homogenous.
5. Substitutes and Complements
- Substitutes: A substitute product has similar characteristics or functions. (e.g Butter and Margarine; Coca-Cola and Pepsi) The change in quantity demanded is relatively responsive to change in price if the product belongs to substitute.(e.g consumers will choose to buy margarine if butter price increase.)
- Substitute products will steal business and increase rivalry intensity.
- Substitute products will limit profit potential.
- Complement: A complement product will compatible with another product but these two products have different functions and characteristics. (e.g Ink cartridges; pencils and erasers; cars and petrol) The change in quantity demanded is less related to change in price. (e.g if the price of car decrease, the quantity demand of car will increase. An increase in car demand will also lead to increase the petrol demand.)
6. Threat of Disruptive Technologies
- This refers to the likelihood that firms would develop a technology that replaces and disrupts existing technology, simply because the attributes of the technology are recognisably superior. This significantly alters the way that consumers, industries or businesses operate. Disruptive technology applies to hardware, software, networks and combined technologies. Disruptive technologies are a threat to firms as firms are designed to work with sustaining technologies. Firms excel at knowing the market, staying close to their customers and developing slightly improved technology and this is disrupted when other firms develop disruptive technology. An example of a disruptive technology is cryptocurrency and the use of social media for communication.
Entry and Exit
Entry Cost and Market Structure
- S means the market size
Firm profit in equilibrium:
- (a-c) means marginal cost of the firm;
- (n+1) means the No. of the firm;
- F means the Fixed cost
- cqi represents the variable cost, c*q of i firm
Free- entry equilibrium:
- no active firm wishes to leave the market: , which explains that when the number of firms in the industry remains constant, the firms in the industry would not leave the market as profits are above 0.
- no inactive firm wishes to enter the market: , explains that when the number of firms in the industry remains constant and a new entrant enters, leading to profit levels smaller than 0, then no firms would enter.
Equilibrium number of firms:
- Market concentration: When market size becomes 4 times bigger, the number of firms only doubles instead of quadruples. This is because when the market size gets bigger, more firms would want to enter, which would also put pressure on the firms' markups. As a result, firms end up being not as profitable and their profit margin decreases. This limits the number of firms that the market can sustain, the number of firms does not increase as much as the market size increases.
Endogenous vs Exogenous Entry Costs
- Endogenous entry costs are costs derived based off a firm’s own decision that deter potential entrants.
- The number of firms in a market does not always increase with market size. If entry costs are endogenous with respect to market size, then the number of firms is less sensitive to changes in market size.
- Exogenous entry costs are fixed costs.
Examples of endogenous entry cost:
- Advertising costs: An incumbent will already be producing more quantities as compared to the entrants. This is because of the incumbent’s economies of scale advantage due to being in the market for a longer period of time compared to entrants. Say the incumbent produces 10000 products, entrant produces 1000 products and the advertising cost is a static $10000. Therefore, per product, the advertising cost for a product would be $10000/10000 = $1 for the incumbent and $10000/1000= $10 per product for the entrant. In this case, the incumbent has the advertising cost advantage over the entrants.
- Entry license fees that are determined via an auction.
Examples of exogenous entry cost:
- Start-up costs
- Acquiring industry know-how: This information is fixed regardless of the size of the firm.
Markets are perfectly contestable if there is free entry and exit. This is achieved when there is an absence of barriers to entry and barriers to exit in the market.
Barriers to Entry
Firms that possess market power are able to hold onto their position of influence if it is to difficult or costly for new rivals to enter the market. These barriers can be formed intentionally through actions initiated by the incumbent, thereby known as strategic barriers. Alternatively, there are structural barriers that exist naturally in the market. Examples of structural barriers would be high research and development costs and network effects.
Structural Entry Barriers
Structural barriers to entry refers to natural advantage rather than incumbents make strategic moves aggressively to prevent new entrants to the market. Structural barriers exist when there is a natural resource advantage or natural cost advantage hold by incumbents, or the governmental regulations and legislations is in incumbents' favor, and does not encourage new comers to enter the industry. It can be considered as a protection from the government. For instance, local government protect domestic companies and lift up the tariff for international companies. International logistics and Telecommunications and are the two industries with some of the highest barriers to entry with government regulations.
There are three specific structural barriers in basic industry prevent new entrants to the market
- Absolute cost advantage:
It refers to the ability of a business to produce more, sell more of a good or service than competitors, using the same amount of resources.
- Economies of scale and scope:
Large-scale production that requires a large amount of capital makes it challenging for new entrants to enter due to the large sunk costs involved. Existing incumbents already have the first-mover advantage and this increases the switching costs for consumers.
- Product differentiation
- When a firm has a very well-known brand, consumers tend to prefer well-known brand products, which increases the entry barriers of industry
- The first-mover advantage describes companies that are first to market, which gives them a competitive advantage over other companies, resources, or technologies that follow.Such as the brand leadership and brand loyalty which increase the switching cost of the consumer.In other words, increase the entry barriers.
- Network effects: It refers to the value of the product increases with the number of consumers who purchase the product and its compatible products. For example, In telecommunications, there is no value in installing telephones when no one is using them, and the more widespread the telephone, the more valuable it becomes. Network effect exists widely in the Internet, media, air transportation, finance and other industries.
- Switching costs: Switching cost refers to the cost incurred when a customer terminates the customer relationship with a particular enterprise and turns to establish customer relationship with other enterprises, including the cost of interest loss, cost of relationship loss, cost of organization adjustment, cost of evaluation of new suppliers, cost of learning how to use new products, etc. Customer transfer costs include not only financial losses but also energy, time and emotional losses.
- Government Regulations or Licensing: Some industries are heavily regulated by the Government and thus entering them can be a difficult or expensive process.
- Access to Patents or Special Know-Hows: Established incumbents may have already purchased patents and developed special know-hows which gives them an immediate benefit over new comers.
Eg. Brand name and Brand Loyalty: Certain companies can have such an impact on an industry, that their brand name becomes and their brand loyalty are so prevalent that any potential entry for new entrants is extremely difficult. Sometimes the brand name becomes synonymous with the product they are selling and Australians begin to refer to the product as the brand name. An extremely common example of this is Velcro. The product became so prevalent that it ended up being named after the company that was producing the product.
Strategic Entry Barriers
Strategic entry barriers are the result of conscious strategic actions, aggressive strategic actions by the incumbent, intended to keep the entrant out of the industry.
Examples of Strategic Entry Barriers:
Excess Capacity is when a firm is actually producing at less than its maximum or optimal capacity is. This is an indicator that the demand for the product in the market is less than the supply of the product in the market. Therefore, if an incumbent firm commits to investing in the additional manufacturing capacity, it acts a strategic barrier to entry for new entrants. Based on some sources, the amount of excess capacity shows the health of the industry and also shows the demand of the products that the market produces. It is also seen as an advantage to consumers, as excess capacity shows that it is unlikely that price inflations will occur during periods of near-full capacity. A company with a huge excess capacity is most likely to lose a sizeable amount of money if it is not able to meet the high fixed costs that are associated with producers.
Limit pricing is when a firm or firms are able to obtain monopoly rents from customers, such as firms in monopolistic competitions, oligopoly or monopoly market structure, deliberately lower the price of their goods to drive out existing incumbent firms or block new entrants. The limit price is usually equal or less than the short-run marginal cost of production (they lose money per unit transaction). However, in the short run, these incumbent firms are able maintain a loss-making price by producing more quantity with a lower price to capture more market share. Therefore, leaving less room for new entrant firms. The lower profit earned by said company will also mislead potential entrants making it seem that the profit levels are not that high and there are less opportunity to earn supernormal profit than there actually is.
This method may not be as effective if the new entrants have the capacity to absorb the losses and match the incumbent firm.
Predatory pricing occurs when an incumbent firm sets a low price for its good and services that other competitors cannot compete at, therefore forcing these competitors out of the market and leads to more profits and larger market shares. Set low prices does not necessarily mean that firms are incurring in predatory pricing. There are some characteristics to be considered as predatory pricing.
*Short-run cost-based rule - firms can change average variable costs within a relevant time of period . For example, the low price period is longer as costs become variable during the same time of period. Therefore, when the price is set below the average variable cost, it is considered as a illegal activity because the firm is incurring in predatory pricing.
*Long-run cost-based rule - The predator could eliminate an equally or more efficient competitor (lower long-run marginal cost). However, marginal costs are difficult to determine, companies would substitute average costs from the firm's balance sheet. When there is excess capacity (shift in demand), the defendant could price at short-run marginal cost from the market. .
*Otput expansion rule - Dominant firms expect to invest in additional capacity in order to produce at high output in response to entry. Williamson argues that These effect can be avoided by a rule in which dominant firms would be prohibited from expanding output in response to entry (for 12-18 months). Dominant firm increases output and lower price before etry the market officially. In terms of efficiency, the rule consists in increase output and lower price before entry to the market. This will result in better plant utilisation and lower average cost in that period. Therefore, output comes at lower average cost under an output restriction..
An incumbent firm can eliminate the threat posed by new entrant firms by acquiring sufficient shares of said firm to take control of them or even go one step further and conduct a complete buy-out.
Switching costs are the costs that are a consumer faces when they switch from one supplier/brand/product to another. Examples of these are most prominently monetary switching costs, such as the fees incurred from cancelling a contract. However, other switching costs can include time-based, effort-based or psychological switching costs. These examples include the time required to find a new supplier, the lack of access to a supplier during the transitional period and the time used in learning how to operate new products (such as switching from a QWERTY keyboard layout).
Three Entry Conditions
Joe S. Bain discussed three different entry conditions in terms of structural and strategic entry barriers and whether incumbents can benefit from deterring entrants by apply strategic barriers (whether the deterring strategy is viable or not in preventing new entrants).
- Blockaded Entry Incumbents do not need to make any strategic moves in order to deter external entrants. The market structural barriers are effective to prevent new entry. Eg. Government regulations that are favorable to incumbents. Large initial capital investment (i.e. initial sunk costs). Incumbents achieve cost advantages compare to entrant's homogeneous product.
- Accommodated Entry Accommodated entry occurs when structural barriers are relatively low compare to blockaded entry, or the strategic deterring moves considered ineffective or cost of deterring entrants and keep them out is higher than the benefits from deterring entrants and gain from dominating the market for incumbents. It is better to let entrant in rather than aggressively deter them in this scenario. E.g. Innovative technological market with large demand and fast growth rate in demand which is attractive to new entry. Incumbents should consider rationally and not waste resources in deterring entrants.
- Deterred Entry Deterred entry occurs when incumbent's deterring strategic moves successfully stop new entry and reduce the motivation for rivals to fight back with favorable profit gains and effectively lower the cost for incumbent. This case takes place only when incumbents has decided to conquer the market and defeat potential rivals. E.g predatory acts by incumbents.
- Complementary Notes Bain distinguished the incumbents and new entrants as incumbents have already took place in the market and new entrants are not yet doing it. Nonetheless, most of the strategies that are applicable for incumbents are also feasible for entrants to use. There are usually some pecuniary advantages, established market reputation and market share taken for incumbents. However, in recent innovated industries like high-end technology areas, incumbents do not have these advantages compare with new comers. E.g Artificial Intelligence, which Amazon and Microsoft have advantage both financially and technologically compare with those existing small firms in the market. Mergers and acquisitions may occur as these large firms join the market.
Economies of Scale
Economies of scale (EOS) are the cost advantages realised when production is efficient. Economies of scale is generally achievable by increasing production and lowering costs. EOS occurs as productions costs (variable and fixed) are spread over a large number of goods. Larger businesses often reap EOS more often as there are larger cost savings. EOS can be realised both internally and externally. Internal EOS arise though ‘internal’ management decisions whereas external EOS is achieved though market forces and other outside factors. 
Companies attempt to achieve EOS as it outlines their cost efficiency and competitive scope in their specific industry. However, smaller companies often struggle to achieve economies of scale.
Larger companies achieve EOS as they have a lower per-unit costs though specialization of labor and technological integration which both improve production volumes. Additionally, EOS arise from bulk purchases and a lower cost of capital. Smaller companies are unable to commit to large capital outlays. Moreover, large companies enact in Internal spreading of costs which reduces their per-unit costs. 
For example, the greater the output produced by the firm results in a drop in variable costs and also reduces the per unit fixed cost. Hence, this can deter the entry of new firms i.e. small companies.
The network effect is the added benefit a consumer receives when the number of total consumers grows. If the market already possesses an established network, entry is deterred as a new entrant requires sufficient users to develop their own network effect. The social media market is a good example of such a market.
If a firm controls access to a scarce but necessary resource there is a substantial barrier to entry.
If a market is defined by high sunk costs, a barrier to entry exists. A sunk cost is a cost which cannot be recovered upon exit from the market. The majority of set-up costs are sunk costs which heightens the risk to potential entrants. For example, a new firm will incur costs such as legal work, location site, rent, etc.
Restrictions on Market Entry
Existing firms in the market are able to exercise market power through setting prices above marginal cost, in the case that firms which are as efficient as market firms cannot easily enter.
- Setup costs: in many markets there will be sizeable setup costs, resulting in people who have difficulty obtaining capital struggling to enter the market. If capital markets are not working well, then even people with great ideas and capabilities may not be able to start a business
- Entry Licences: these can vary, some are overly expensive to purchase, some may be linked to caps on entrants. This is an explicit barrier to entry.
- Patents: although you may know how to produce something, you cannot compete until the pattern has expired.
- Caps on number of entrants: when only a certain number of suppliers are allowed.
- Exit costs (sunk costs that cannot be recovered): exiting the market means you have to give up on investment and pay a large sunk cost. It is risky to invest in a market when the sunk costs are high, even though they are only paid at the end, which can result in people entering other markets with cheaper exit costs. This restriction is not an issue if you are planning on staying in the market, although the possibility of exiting should always be taken into account.
The below section aims to briefly summarising the key takeaways of this topic.
Perfect Competition: In a perfectly competitive market the below assumptions hold:
- Price Takers
- Homogeneous product
- Perfect information
- Equal technological access
- Free entry and exit
Theory suggests in the LR supernormal profits go to zero. Empirical evidence disagrees. It finds that profits are persistent in the long run. Entry and exit are happening all the time and those entering and exiting are usually of smaller scale than the average firm in the industry.
Competitive Selection Model:
- With respect to the 'Perfect Competition' model, the free entry & exit assumption is relaxed, as well as the equal tech access
- Initially firms do not know their efficiency. Their efficiency is learned over time. This allows for them to set P=MC.
- Model Implications:
- Different firms earn different profit rates, even in the LR
- Entry and exit is simultaneous
- Firms that enter and exit are smaller than the average firm
- With respect to the 'Perfect Competition' model only the product homogeneity assumption is relaxed
- This means firms are no longer price takers and have some influence over price. Therefore, firms set MR=MC. However, due to free entry, new firms will notice that incumbents are generating supernormal profits and enter the market, causing in the long run, the incumbent firms make no supernormal profit, and price is charged at P=AC.
- Nash Equilibrium (NE)
- Sequential Move Games - at each decision node the decision is made by alternating players
- Sub-game Perfect Equilibrium (SPE) - when a NE is induced in every sub-game of the original game. This is most commonly found using backward induction
- Strategy: a strategy is a complete plan outlining what decision will be made in reaction to another players choice (covers all contingencies)
Six Forces Model: Porter’s 5 forces model and adds in how to choose a strategy in a market to sustain your position (6th force). The 6 forces include – substitutes and complements, supplier power, buyer power, intensity of rivalry, potential entrants, threat of disruptive technology
Entry and Exit: Incumbents can create market power by setting up entry barriers. Some barriers include: setup costs, entry licenses, patents, caps on the number of entrants, exit costs (irrecoverable sunk costs). Relevant formulas can be found above.
Endogenous vs. Exogenous Entry Costs: When entry costs are endogenous (i.e. influenced by market size – e.g. advertising costs or entry license fees determined by auction – i.e. a limited number of licenses sold at an open auction), then the number of firms in a market is less sensitive to changes in market size.
Perfectly Contestable Markets: When there is free entry and exit so firms have incentive to enter whenever P exceeds AC (very rare)
Entry Barriers: A cost that must be incurred by an entrant, but not by an incumbent. Examples include:
- Absolute cost advantage – due to technology available to the incumbents.
- Economics of Scale – Entrants cannot reach MES due to lack of capital and size of production.
- Product Differentiation – gives market power and gives advantages such as brand loyalty, first-mover advantage, and network effects
- Porter Michael E. (2008). The Five Competitive Forces That Shape Strategy. Harvard Business Review, 86,1, 78-93.
- Porter Michael E. (1979). How Competitive Forces Shape Strategy. Harvard Business Review, 57, 2, 137-145.
- Bain J.S. (1954) Conditions of Entry and the Emergence of Monopoly. In: Chamberlin E.H. (eds) Monopoly and Competition and their Regulation. International Economic Association Coference Numbers 1–50. Palgrave Macmillan, London, <https://doi.org/10.1007/978-1-349-08434-0_11>.