5302 Advanced Microeconomics

Lecture 3: Competition as Rivalry

Karl Warneryd
Stockholm School of Economics
September 2017

The welfare costs of monopoly
The figure below contains all you need to know about the
neoclassical theory of monopoly. A monopoly maximizes
its profit by setting its quantity such that marginal revenue
is equal to marginal cost. Since price is then higher and
quantity lower than under perfect competition (which equates
price and marginal cost), the consumer surplus is lower than
under perfect competition. Since the producer surplus, on
the other hand, is greater, the net loss in welfare is equal to
the so-called Harberger triangle.
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 But Tullock (1967) pointed out the following. In
contrast with a firm under perfect competition, the monopoly
makes a positive profit. Hence economic agents would be
willing to invest resources in trying to acquire a monopoly
position in a market. Insofar as these resources have
alternative, productive uses they are an additional welfare
cost of monopoly, since these investments are only made to
effect a transfer of income.
Investments made in order to acquire a monopoly
position (e.g., through advertising or through influencing a
regulatory agency) are called rent-seeking investments. By
rent is here meant the return from a fixed factor. The
classical example of a rent is the return from owning land,
but monopoly privileges in a product market have the same
economic function.
Rent-seeking investments constitute a welfare cost only
insofar as they have alternative productive uses and only
serve to generate transfers of income. Hence, e.g., bribes
paid to politicians or regulatory agencies, if they are made
in cash, are not necessarily social costs. Nor is R&D in order
to acquire a patent, unless it is duplicated by several firms.
Lobbying expenses, expenses on advertising, and other
attempts to erect entry barriers in a market are examples of
rent-seeking investments that may be socially costly.

Rent dissipation
Posner (1975) argued that if rent-seeking itself takes places
under conditions of perfect competition, then risk neutral
agents would in aggregate invest exactly the value of the
rent competed for, i.e., they would dissipate or exhaust the
value of the rent completely in advance. This hypothesis has
the nice empirical implication that the welfare loss due to
rent-seeking activities can be estimated as being equal to the
value of the rent. This is convenient since it may often be
hard to measure rent-seeking investments directly.
Tullock (1980) noted that if, on the other hand, rent-
seeking is not perfectly competitive, then not all of the
surplus need be dissipated. He constructed the following
simple model of a rent-seeking game.

 Suppose we have two hopeful potential monopolists,
Agent 1 and Agent 2. Each values a monopoly position at
v > 0. Since a monopoly for natural reasons is an indivisible
good, only one agent can be the monopolist in the end. Each
agent i {1, 2} can make an investment xi 0. His
probability of winning the rent is then

xi /(x1 + x2 ) if x1 + x2 > 0
pi (x1 , x2 ) =
1/2 otherwise.

Assume both agents are risk neutral, i.e., they maximize

their expected income. Then Agent is expected utility is

ui (x1 , x2 ) = pi (x1 , x2 )v xi .

We can now look for an equilibrium of this game. We first

note that there is no equilibrium such that nobody invests
anything, since given that one agent does not invest, the
other could win for sure by investing arbitrarily little. Hence
we can write, e.g., Agent 1s expected payoff as
x1
u1 (x1 , x2 ) = v x1 .
x1 + x2

We differentiate with respect to x1 and get

u1 (x1 , x2 ) x2
= v 1.
x1 (x1 + x2 )2

 Setting this derivative equal to zero and solving for x1 ,
we get Agent 1s best-reply function

x1 (x2 ) = vx2 x2 .
Similarly, Agent 2s best-reply function is

x2 (x2 ) = vx1 x1 .
The figure illustrates these functions. Are rent-seeking
investments strategic substitutes or complements?
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x?1
x1
In equilibrium, both agents have to play best replies
simultaneously. A simple way of solving for this is to utilize
the fact that the situation is symmetric, i.e., to look for a
solution such that x1 = x2 . We find that
v
x?1 = x?2 = .
4

 We can measure the degree of rent dissipation in
equilibrium as the ratio of aggregate investment and the
value of the rent, i.e., as

x?1 + x?2 2(v/4)

= = = 1/2.
v v

Rent-seeking with more agents
To generalize, assume we have n 2 risk neutral potential
monopolists, each of whom values a monopoly position at
v. Analogously with the two-agent case, we assume the
probability of agent i winning given his investment xi is
 Pn Pn
xi /( j=1 xj ) if j=1 xj > 0
pi (x1 , x2 , . . . , xn ) =
1/n otherwise.
For reasons similar to before, there is no equilibrium such
that nobody invests anything. We may therefore write agent
is objective function as
xi
ui (x1 , x2 , . . . , xn ) = Pn v xi .
j=1 xj

The first order condition for maximizing this function, given

the investments of everyone else, is
Pn
j=1 xj xi
Pn v 1 = 0.
( j=1 xj )2

As before, we can make use of the fact that we have a

symmetric situation. Hence there is an equilibrium where
everybody makes the same investment x? . The above
expression may then be written as
nx? x?
v 1 = 0.
(nx? )2
The solution is therefore
n1
x? = v.
n2

Aggregate investment in equilibrium is

n1
nx? = v,
n
and the rate of rent dissipation is

nx? n1
= = .
v n
With a finite number of participants, therefore, less than
the value of the rent is invested in equilibrium. But as n
approaches infinity, aggregate investment approaches v
and the rate of dissipation approaches 1. Hence perfect
competition in rent-seeking in this model leads to perfect
dissipation.

Competition within the firm
The model we just considered is an example of competition
in a slightly different sense from in the notion of perfect
competition. Perfect competition is a situation where no
agent thinks he can affect the aggregate outcome (e.g., he
takes the market price as given). But this is more or less the
exact opposite of the everyday meaning of competition as
rivalrystriving to outdo others. The rent-seeking model
is a model of competition in a sense closer to everyday
terminology. In economic theory, this type of model is often
termed a contest.
Rent-seeking contests may lead to inefficient, socially
wasteful results, as we have just seen. But contests may also
be used as incentive instruments. Lazear and Rosen (1981)
argue that, e.g., high salaries for executives may be viewed
as a way of constructing an efficient contest in the firm,
which makes employees exert optimal effort. (This is also
an example of contract theory, something we shall return to
later in the course.)

 The idea here is to reward the employee who produces
the most by promoting him to a more highly paid position in
the firm.
Suppose, for simplicity, that there are only two
employees. There are two positions to be filled, Boss and
Worker. Appointments are made after a first period in which
the employees produce something. The one who produced
the most gets to be Boss and gets the salary wB , the runner-
up gets to be Worker and gets the salary wW .
The output of individual i is given by

qi = ei + i ,

where ei is his effort and i is a random term. The problem

for the firms owner is that, because of the random term,
individual efforts are not observable.

 We shall assume that the difference in random terms
is distributed according to the cumulative distribution
G with expectation 0, and that the expectation of each
individual random term also is 0. Let pi be the probability
that individual i wins the contest (note that this probability
is a function of both efforts), and let c(ei ) be his cost of
exerting effort. Individual is expected income is then

ui = pi wB + (1 pi )wW c(ei ).

Individual i therefore maximizes his expected income by

choosing his effort ei such that

pi
(wB wW ) c0 (ei ) = 0.
ei

 We can expand the winning probability pi further. We
have that

pi = Prob(ei + i > ej + j ) =
Prob(j i < ei ej ) = G(ei ej ).

It follows that
pi
= g(ei ej ),
ei
where g is the density of G.
Since the situation is symmetric, we know there is a
symmetric equilibrium, i.e., an equilibrium where we have
e1 = e2 = e? . The equilibrium condition is therefore

(wB wW )g(0) = c0 (e? ).

It seems reasonable to assume that the marginal cost of effort

c0 is increasing. We then see that the equilibrium effort e? is
increasing in the wage difference.

Here is a figure to illustrate the situation.

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e e? e0
e

 We now also see that the lower is g(0), the lower is
equilibrium effort. If the distribution is symmetric around 0,
the value g(0) is a measure of the importance of the random
term for output, or, alternatively, the degree of risk in the
production process. (See the figure below.) The lower is g(0),
the greater is the importance of the random factor.
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0
1 2

 Next consider the firms problem. Given that the
employees behave rationally, the owner wishes to maximize
his expected profit

= E(2e? + 1 + 2 wB wW ) = 2e? wB wW .

Suppose the employees have reservation incomes equal to

zero. Then we must also have that

1/2(wB + wW ) c(e? ) = 0

in order for it to be rational for the individuals to accept

employment (accept the contract). We can substitute this
participation constraint in the expression for to get

= 2(e? c(e? )).

This quantity is maximized when we have that

0 ? e?
= 2(1 c (e )) =0
wB wB

and
0 ? e?
= 2(1 c (e )) = 0.
wW wW
We can see that this implies c0 (e? ) = 1, which is the same
thing as saying that the optimal contest structure is such
that it makes the individuals exert optimal effort from the
point of view of the firm (i.e., the effort at which marginal
cost is equal to marginal product).

 Returning to the equilibrium condition of the employees,
and utilizing that c0 (e? ) = 1, we find that

1
wB wW = ,
g(0)

i.e., the wage difference in an optimal wage structure

is increasing in the degree of risk in production (or,
equivalently, the degree of inobservability of effort).
One major point of this analysis is that the
reasonableness of the size of, e.g., executive salaries, cannot
be evaluated without taking into account the entire structure
of wages, since the analysis implies that executive salaries
function as incentives for employees on lower levels to exert
effort. Just looking at the executives marginal product
misses the point.

Problem. Two risk neutral individuals are involved in a
legal dispute over some property that is worth y to each of
them. If individual i {1, 2} spends xi on preparing his case
in court, the probability that he wins is xi /(x1 + x2 ).
a) Find equilibrium expenditures when the individuals play
directly themselves.
b) Next assume an individual can hire an attorney to
represent him in court. The attorney makes the legal
expenditure decision and pays for it out of his own pocket.
The client only observes whether the case is won or lost.
Consider contingent-fee contracts between the client and
his attorney, i.e., contracts where the attorney is paid some
fee w > 0 if he wins the case and zero otherwise. Find
the equilibrium contracts when both parties hire attorneys.
Compare the utility of an individual in this case with that
under direct play.
c) Would both parties in fact hire attorneys?

Problem. Individuals 1 and 2 live on an isolated island and

are at war with each other. There is a consumption good of
value y > 0 to both of them. If they expend efforts x1 and
x2 , respectively, on aggressive activities, then the probability
of Individual 1 gaining control of the good is
a + x1
p(x1 , x2 ) := ,
2a + x1 + x2
where a > 0. The individuals are both risk neutral, and the
cost of effort x is simply x. Show that there are values of a
such that in the unique equilibrium nobody expends effort on
aggressive activities.