2. Cost competition between firms: system dynamics and other approaches

This paper was first presented and published at the International System Dynamics Conference at St Gallen, Switzerland, in 2012. For the full paper, see: http://www.systemdynamics.org/conferences/2012/proceed/papers/P1283.pdf

Michael Joffe

Imperial College London



The role of system dynamics in modeling the fundamental properties of economic systems has been under-appreciated. The market mechanism displays balancing feedback, and bubbles are widely seen as reinforcing feedback. However, it is less widely understood that the exponential growth tendency in successful modern economies may represent a distinct type of reinforcing feedback.

This paper presents a system dynamics model of an arms race between competing firms based on cost competition, which displays reinforcing feedback: price reduction by one firm encourages the other to invest to reduce its costs and thence its price. The other firm responds in kind. Under these circumstances, costs and price of both firms steadily decline, mimicking the historic decline in real input required for a given product, e.g. measured in labor hours. This system behavior depends on the ability of both firms to respond to the competitor’s price challenge by reducing its costs, but is robust to other changes in the firms (efficiency of investment) or in the market (price elasticity of demand). The ability to produce the same output with lower unit costs (reduced real inputs) is equivalent generating a larger output from the same resources, and is a major source of economic growth.