Rivalry Restraint as Equilibrium Behavior

• DOI: http://doi.org/10.1111/jems.12081
• Date: 01 March 2015
• Author: Clemens Löffler,Engelbert J. Dockner
• Published date: 01 March 2015

Rivalry Restraint as Equilibrium Behavior

ENGELBERT J. DOCKNER

Department of Finance, Accounting and Statistics

Vienna University of Economics and Business

Welthandelsplatz 1, A-1020 Vienna, Austria

engelbert.dockner@wu-wien.ac.at

CLEMENS L¨

OFFLER

Department of Business Administration

University of Vienna

Oskar-Morgenstern-Platz 1, A-1090 Vienna, Austria

clemens.loeffler@univie.ac.at

Rivalry restraint has received a lot of attention as a theory of profits in recent research on

business strategy. Its economic rationale is explained as the consequences of either exogenous

or endogenous anticompetitive forces present in different industries. In this paper, we use a

dynamic oligopolistic industry model and show that rivalry restraint emerges as equilibrium

behavior among firm owners who delegate decisions to managers. In the corresponding two-stage

game, managers choose optimal production rates in a dynamic Cournot market and owners

set incentives for managers, acting sequentially rational. Equilibrium incentives correspond to

rivalry restraint, that is, managers are less aggressive in the product market with lower outputs

and increasing profits for all firms in the industry.

1. Introduction

A large body of the management literature explores the economic mechanisms that boost

economic performance measured by firm profits. Different branches of that literature

have looked at different endogenous and exogenous forces that generate and sustain

attractive levels of profits even in the long run. In the resource-based theories (RBT), it is

argued that a firm’s resource base including organizational and technological processes

and existing capabilities generates competitive advantages that distinguish firms from

their rivals and hence enhances long-run profitability (see, e.g., Makadok, 2001; Barney,

1991; Wernerfelt, 1984; Teece et al., 1997; Eisenhardt and Martin, 2000). The value-based

approach (VBA) that is more directly rooted in the industrial organizations literature

(see Brandenburger and Stuart, 1996; Brandenburger and Nalebuff, 1996) has its central

focus on value capture, that is, how total industry value is created and divided among

its competitors (see Chatain and Zemsky, 2011). A central theme of the VBA is related

to market imperfections such as in oligopolistic industries in which firms are capable of

earning economic rents due to the lack of existing competition. If strategically interacting

firms tacitly collude, for example, the industry is governed by rivalry restraint resulting

in attractive firm profits.

We thank Richard Makadok and Maarten Janssen for helpful comments on earlier versions of this paper. We

also thank participants of the 2009 EARIE and the commission for Industrial Organization of the Vereinf ¨

ur

Socialpolitik 2011.

C2015 Wiley Periodicals, Inc.

Journal of Economics & Management Strategy, Volume24, Number 1, Spring 2015, 189–209

190 Journal of Economics & Management Strategy

Although many theoretical and empirical approaches in the management literature

highlight profit generating mechanisms in isolation, Makadok (2011) explores the joint

effects of four theories of profit: competitive advantage (the core mechanism in the

RBT), information asymmetry, commitment timing, and rivalry restraint. Information

asymmetry theories are based on differences in how firms assess the value of their

inputs and output. If a firm has better information about the value of a resource it can

exploit this information to its advantage. Even if firms have a similar resource base their

profits may differ due to different flexibility when to make decision and enter strategic

commitments. Finally, rivalry restraint theories advocate those forces that decrease the

level of competition in an industry and hence create value and improved profitability of

firms.

1.1 Rivalry Restraint

Makadok (2010) defines rivalry restraint as any condition that (i) concurrently limits all

competitors in an industry from aggressively competing with each other; (ii) preserves

each firm as an independent competitor in the industry; and (iii) does not require

side payments between competitors. This definition is consistent with exogenous and

endogenous forces that limit competition in an industry. Entry barriers, high switching

costs, customer loyalty, or price regulation are standard examples for exogenous forces

that reduce aggressive behavior in the product market. Cartels with output quotas,

price fixing, or the division of a market in segments are endogenous forces that limit

competition. Theories that deal with rivalry restraint trace back to the classical structure-

conduct-performance paradigm (SCP) of early developments in industrial economics

(see Bain, 1956; Scherer and Ross, 1990; Brandenburger and Nalebuff, 1996).

Rivalry restraint as a theory of persistent firm profits has received a lot of atten-

tion lately as researchers have looked into the interaction effects of alternative profit

generating mechanisms. Makadok (2010) studies the interaction of rivalry restraint and

competitive advantage within a simple analytical model and finds that there is a negative

interaction effect, that is, competitive advantage and rivalry restraint do not reinforce

but instead undermine and dampen each other. This is an important insight for man-

agement. Although both rivalry restraint and competitive advantage generate persistent

profits when applied in isolation, pulling both of these levers simultaneously generates a

trade-off. Hence, a strategy that limits competition does not go well along with a strategy

that tries to win competition. The economic intuition of this result is clear: any compet-

itive advantage must be reflected in a larger quantity of output produced while rivalry

restraint requires output to shrink. This does not go well together. Makadok (2011)

summarizes the existing but growing literature on interaction effects among alternative

profit generating mechanisms.

This paper contributes to the existing management literature by advocating a new

endogenous explanation for rivalry restraint. We demonstrate that strategic delegation

where owners set management incentives in an oligopolistic industry and managers are

responsible for production decisions results in a market outcome with reduced output

and increased prices and persistent profits.

1.2 Strategic Delegation

The theory of rivalry restraint as proposed here is based on a strategic delegation

mechanism implemented through manager incentives. Shareholders delegate strategic