Potential competition in the presence of stink entry costs: an experiment. Utteeyo Dasgupta* ... multi-market framework, where potential entrants have different home market profits. ... market prices before committing to entry, %011ie incumbents are assumed to be .... firms if they choose the same price in a market. I will call ...
NewZealandEconomicPapers Vol.43,No.2,August2009. 203 225
i t h T a y l o r F r a n c i s G r o u p
Routledge
RESEARCHARTICLE Potentialcompetitioninthepresenceofstinkentrycosts:anexperiment UtteeyoDasgupta*
UniversityofArizona.DepartmentofEconomies:FranklinandMarshall. DepartmentofEconomics,USA
Thispaperstudiestheeffectofsunkentry-costsonpotentialcompetitionin a multi-marketframework,wherepotentialentrantshavedifferenthomemarket profits.Althoughsunk-entry-costsaresupposedtoincreaseentrybarriers,the experimentalresultssuggestthatfirmsviewentrycostsdifferentlydependingon theirhomemarketprofits.It isfoundthatsubjectsarereluctanttoenter.and competeinanothermarketiftheyarealreadyearningmonopolyrents.Subjects instead,colludetacitlyandearnmonopolyrentsinhomemarkets,thereby weakeningtheeffectofpotentialcompetition.Incontrast.subjectswhoearn smalsecurereturnsintheirhomemarketsaggressivelyenterthecontestable marketwhenevertherearescopesforearningnetprofits.Thethreatofentryand theeffectsofpotentialcompetitionarestronginthelattersituation.forcingthe monopolyincumbentstolowerpricestolimit-pricinglevels. Keywords:potentialcompetition:contestablemarkets hit . , sunk c o s t : l i m i t an IsIntroduction p r i c i n g : d Thethreats ofnewentryandcompetitionhavethepotentialtocurbmonopoly power-sofexistingincumbents.However.entryin a marketisusuallycostly.A potenti a l entrant has to incur consi d erabl e entry-costs in an effort to serve a new r uIf theseentry-costsaresunk,theycandampenentryinitiativesconsiderably. market. Hencen,sunk-entry-costsareperceivedtoincreaseentrybarriers,andhelpexistent incumebentstoreinforcemarketpower.Thispaperusesexperimentstoevaluatethe effectsofsunk-entry-costsontheentryinitiatives of potentialentrantsandthe nresponsesofincumbentmonopolistsincontestablemarkets. pricing Batumol(1982)hypothesizedtheexistenceofaperfectlycontestablemarket.where thethreat ofentry,i.e.potentialcompetition,candisciplineanexistingmonopolist.He r suggestedthatamarketwithoutsunk-entry-costswouldbeapanaceafortheprice gouginygmonopolyproblem.Inamarketwithoutsunk-entry-costs,anentrant'would readily; jump-intoundercuttheexistingmonopolist,andexitwhenevertheincumbent lowerspricesandprofitopportunitiesdisappear.Theentrant'shit-and-runbehavior wouldcexertcompetitivepressuresontheincumbent,whowouldlowerpricesinan effortto o %vipeoutprofitableentryopportunities.Baumoletal.(1982.),Brock(1983). Shepalrd(1984)Schwartz&Reynolds(1983)andWeitzman(1983)characterizeda l *Emaiu l:utteeyo.dasguptavtlandm.edu s print/ISSN1943-4863online ISSN0077-9954 2009NiewZealandAssociationofEconomistsIncorporated 1)01:10,1080,00779950903005511 bitp://www o.informaworld.com
204
U
.
Dasgupta
perfectlycontestablemarketto beonewhere: (I) entrantsandincumbentshave identicalproductionfunctionsandhavetheaccesstothesamefactormarkets;(ii) entrantsdonothavecapacityconstraints;(iii)potentialentrantscanreviewexisting marketpricesbeforecommittingto entry,%011ieincumbentsareassumedto be incapableofimmediatepriceretaliation(Bertrand-Nashpricingbehavior)post-entry: andfinally(iv)therearenosunkentryorexitcosts.Thecontestablemarkethypothesis claimedthatinsuchamarketenvironment,thethreatofhit-and-runentrywillforce themonopolyincumbenttolowerpricestoaveragecostlevels.Thecontestablemarket modelwassubsequentlyusedasaframeworkforderegulatingnaturalmonopoly marketsnationallyandinternationally. Lateracademicwork,however,pointedoutthatamarketdevoidofanysunk costsisrareandpavedthewayforalongdebateoverthetheoreticalcontributionof contestabilitytheoryand its applicability in deregulationefforts.Subsequent empiricalworkattemptedtoevaluatetheeffectivenessof thecontestablemarket hypothesisonthosemarketsalreadyderegulated‘vithacontestablemarketframework.Bailey&Panzar(1981).Call&Keeler(1985),Strassmann(1990),Peteraf& Reed(1994)useddatafromtheairlineindustriesandKessides1990.1991)used datafrommanufacturingindustries.Thefindingsremainedinconclusivebecause entrycostswerenoteasytomeasureandthestructuralconditionsofcontestability weredifficulttoverify(seeSchwartz,1986;Gilbert,1989;Evendyn& Williams. 2000).Asaresult,thecontestabilityhypothesisremainedacontroversialpolicytool sincethetheoreticalmodelexpectedmarketstobedevoidofsunk-entry-costsbutthe naturalmarketstypicallyhadentry-costs:inaddition,thelevelsofthesunk-costs weredifficulttomeasureandthedegreeofsunk-nesswasnoteasytoquantify. Laboratoryexperimentshaveanobviousadvantageinovercomingmeasurement-relatedconstraints.Experimentsalsoserveas a tool to testandidentify whetherstrategicbehaviorbetweenincumbentsandentrantscanunderminethe predictedeffectsofmarketcontestability.Withthesetwoobjectivesinmind.the paperinvestigatestheextenttowhichsunk-entry-costsactasabarriertopotential competition. Resultsfrommyexperimentssuggestthatentrybehavior(inthepresenceofsunkentry-costs)dependscruciallyontheoutsideoptionavailabletothepotentialentrant. hapotentialentrantisonlyearningnormalreturnsinhercompetitivehomemarket, thenamodestamountofsunk-entry-costdoesnotdiscourageherfromfrequenthitand-runentrybehavior.Asaresult.eveniftherearesunk-entry-costs.entrantsfrom competitivemarketsprovidecompetitivepressuresonincumbentmonopolists'pricing practices.Bycontrast. if anentrantfirmhasherownmonopolymarket,possible retaliatoryactionsoftheincumbentfromtheentrymarketcoupledwithsunk-entrycostsdilutehit-and-runtendenciesandtheconsequentcompetitivepressures. Therest of thepaperisorganizedasfollows:Section2reviewstherelevant experimentalliterature;Section3introducesthemodel:Section 4describesthe design;Section5discussestheresultsandSection6concludes. 2.Literaturereview Coursey,Issac&Smith(1984),Harrison&McKee(1985)andHarrisonetal.(1987) evaluatedexperimentallythecontestablemarkethypothesisinabroadercanvaswhere theeffectivenessof alternativeinstitutionsthatcouldlimitmonopolypowerwas compared.Theyfoundunequivocalsupportin favor of thecontestablemarket
NewZealandEconomicPapers
2
0
5
hypothesisinrestrainingmonopolypower.However,Harrison(I987)pointedoutthat theearlierworkevaluatedalimitedinterpretationofthecontestablemarketbecause thesequentialorderofincumbentpricingfollowedbyentrant'sentrydecisionwasnot incorporated.Instead.theearlierdesignsincorporatedDemsetz's(1968)bidding modelinwhichatleasttwofirmssimultaneouslychosepriceandquantitypairsto contestasinglemarket.similartotheBertrand-pricingmodel.Inaddition,someofthe treatmentshadbuyersassubjectswhocouldwithholddemandtoputpressureonthe selers.Sotherewasn'taclearwaytoidentifywhetherfirmsloweredpricesduetoentry threatsorduetobuyerwithholding.Harrison(1987)modifiedtheabovedesignto introducesequentialmovesbytheincumbentandtheentrantandfoundstronger supportforthecontestableaverage-costpricingoutcome.Millneretal.(1990)useda continuoustimepostedoffermarket,wheretwofirmscompetedtocapturethemarket. Atanyinstantthesellerwiththelowestpricemadethesale.Theothersellercould observethepriceanddecidetoundercutatanyinstance.Apricecutinthissituation capturedthewholemarketinitiallyforthemoment.Theirexperimenthowever,did notfindanystablepricingbehavioroverperiods. Therearethreepapersthatdeservespecialattentionwithinthecontextofthe currentdesign.Brown-Kruse(1991)evaluatedthecontestablemarkethypothesis, wheresheintroducedasafehavenforthecontestingfirm.Inherdesign,afirmcould refrainfromenteringamarketandgetafixedpaymentinstead.Shealsoevaluated theeffectoladiscreteandfiniteactionspaceonthelevelofcollusionbyintroducing, inoneofthetreatments,apricepostingrulewherethesellerscouldonlychoose pricesinincrementsof 0.25cents.Shefoundresultsin-linewiththepredicted averagecostoutcomeofthecontestablemarkethypothesis.Shedidnotfindany significantdifferencebetweenthetreatmentinwhichthefirmshadthesafehaven optionandtheonewheretheydidnot.Shealsofoundthathavingadiscreteand finitenumberofactionsdoesincreasecollusivebehavioramongstparticipating subjects.Dasgupta(2005,2007),evaluatedcontestabilityin amulti-marketframeworkwith zeroentrycostsandincumbentshad a first-moverdisadvantage (Bertrand-Nashpricing).Histreatmentslookedatentrantshavingdifferentlevels ofprofitsintheirhomemarkets.Dasguptafoundthatevenif amarketisperfectly contestable.thethreator h i t a entrant'shomemarketincrease. - potential Coursey.Isaac.Luke&Smith(1984)evaluatedtheeffectsofsunk-entry-costsin acontestabl n d emarket.In theirdesign,asinglemonopolymarketwascontestedby t-wosellers,whosimultaneouslypostedpriceandquantitypairsineachproduction period.To producein thecontestedmarket, a sellerwasrequired to buy a rru n tt(arsunk-cost) y p odnuctioe npermi validforfiveproduction-periods.Asellercouldalso d ecideetocstay out of the market andnotchooseapriceandquantitypair. In this d r e a s e case,thesellerearnedzerorevenue.Theincumbenthadaprotectedmonopolyfor s thefirstfiveperiods.afterwhichtherewasnodistinctionbetweentheentrantandthe incum firms p r beont.Both g the r e swereinasymmetricproductionsituationafterthefirst fiveperiodsandneededtoinvestinsunk-entry-coststoservethecontestablemarket s ventle y therewasn'tanyincumbencyadvantageaftertheinitial subsiequ y.Asl aresult. fiveperiods.Coursey .Isaac.Luke &Smith(CILShenceforth)definedastrong a s contestableoutcome if prices in theexperimentseventuallysettleddown to p o Theyfalsodefinedaweakcontestableoutcomewhereobserved competirtivelevels. ipricessettl t edtoalevelequaltoanarithmeticaverageofthetheoreticalmonopoly p r i c e and the competi t i v e price. They found support for the weak versi o n of the l e v e l s i
206
U
.
Dasguptel
contestabilityhypothesisonlyinthe12throundoftheexperimentalmarkets.This ledthemtoconcludethatstructurebyitself(economiesofscale,entrycostlevel.and twopotentialsuppliers)wasnotsufficienttogeneratecompetitiveoutcomes. Harrison(1987)pointedoutthatalthoughimportantbyitsownmerit,the ClLS designdid notagainaccommodateall thenecessarystructuralassumptionsof contestabilityandfurtherexperimentswouldbeilluminating. In particular.he stressedthelackofdistinctionbetweenanincumbentandanentrantinthedesign.In analyzingtheeffectsofsunk-entry-costs.thecriticaldistinctionbetweenanentrant andanincumbentremainsintheentrant'sinabilitytocontestthemarketwithout investingin (sunk)entry-costs:theincumbentdoesnot sufferfromsuch a disadvantageinaccessinghisownhome-market. Thispapercontributesto theexistingliteraturein thefollowingways.(a) It developsamulti-marketmodeltoaddandevaluatetheideaofentrantsdifferingin ownhomemarketprofits,whichrepresentdifferentopportunitycostsofentry.Thisis inline withprevioustheoreticalresearch(seeCairns & Mahabir1988)which supportedtheideaofevaluatingpotentialcompetitioninaframeworkthatspecified thepotentialentrant'sownhomemarketconditions.In thatrespect.thecurrent researchalsoexpandsonBrown-Kruse'sworkbyaddingthecaseof amonopoly marketfortheentrant.(b)Thepaperimplementsthecriticalstructuralassumptionof sequentialdecisionmakingabsentinpreviousexperimentsexceptHarrison(1987). Thesequentialdecisionmakingincorporatestheideaofanentrantevaluatingprofit opportunitiesbeforecontestingamarket.Noticethattheassumptionofsequential decision-makingbecomesespecialyinterestinginthecurrentresearchproblemwhen therearesunk-entry-costs.Ontheonehand.sunkcostsarepossibledeterrentsto competition.workinginfavor ofanexistingincumbent.Ontheotherhand,the sequentialdecision-makingprocessputstheincumbentat a(first-mover)disadvantage.Theexperimentalresultscanhelpusunderstandandobservethecombinedeffect ofthetwo.(c)Thecurrentexperimentdesignimposesacleardistinctionbetweenthe incumbent.whodoesnotpaysunkcoststoaccesshisownhomemarketandthe potentialentrant,whohastoincursunkcoststoenteranothermarket.Aspointedout earlier.thisdistinctionalthoughimportant.wasabsentintheCILSdesign. 3.Model Considera naturalmonopolymarketwith a lineardownwardslopingdemand: D(P)= a bp. Themarketdemandisfixedandcommonknowledge.Thecost functionisdescribedbyC(Q) = S + G(Q),whereSisthesunkaccesscostforthe market,andG(Q)theproductiontechnology.LetG(Q)bequasi-fixed.andSbea non-recoverablecostincurredonlybyanentrant ifshechoosestoenter.Inspirit.the non-recoverablecostissimilartoSutton's(1948)descriptionofadvertisingcoststhat apotential-entrantfirmincurstoenteramarket. LetG(q) F + alwhereF > 0, c > 0, q> O.F isquasi-fixed.ctheconstant marginalcostofproduction.andqtheoutputproduced.Since i; isassumedtobe quasi-fixed.afirmonlyincursF if itactuallysellsinamarket.Assumethatdueto strongreturnstoscale,whenbothfirmschooseztveragecostprices.eachearns negativeprofits.WelookatpricecompetitionwhereafirmcanchoosepricesP>O. LetP„,bethemonopolyprice.DefineFLtobethepriceatwhichentrycanbe deterredbyanincumbent. If theentrantchoosesapricelowerthan P n e g a t i v e net profits. L she g e t s
NewZealandEconomicPapers
2
0
7
Symmetriccase Consideragamewheretherearetwosymmetricmonopolymarketswithidentical demandandcostconditions.Eachmarkethasanexistentincumbentwhohasthe optiontoLintertheothermarket.Entryopportunitiesthenarebi-directional.There aretwostagesinthegame.Instageone,eachincumbentpostsapriceinhisown market.Instagetwo.incumbentsobservethepostedpriceintheirrespectiveentry mtrketsanddecidewhetherto entertheothermarket or not. To enter.the (potential)entranthastopayasunk-access-feeofSandthendecideonapriceto servetheentry-market.Afterentrydecisions(if any)aretaken.andallpricesare chosen,eachfirmgetsprofitsasdescribednext.Ineachmarket,thedemandgoesto thefirmwhichoffersthelowestprice.Demandissharedequallybetweenthetwo firmsiftheychoosethesamepriceinamarket. I willcallthisthecontestabilitygame. Notice,thegameaboveincorporatesallthestructuralconditionsdescribedearlierin points(i)--(iii). Thegamehasafirstmoverdisadvantagefortheexistingincumbentinhisown home-market.Inthestaticone-periodgame,theentrantwillchoosetoenterinthe secondstageandundercuttheincumbent'spostedpriceaslongasprofits,netof sunk-entry-costs,arepositive.Thisimpliesthat, instage I theincumbent'sbest responsewouldbetochooseaprice P entrant earns the latter negative net profits.TheNashequilibrium of the L s u c h t h a t contestabilitygameconsistsofeachincumbentchoosingthelimitprice P not enteri other marketinstage2.TheSPNEoftheTperiodrepeated a1and n y tngathe L i n s g e g istsof theeabovelimitpriceoutcomechosenineveryperiod. pamIfecthe rons i c gameisrepeatedinfinitely,folktheoremcanprovideuswithpossible cPolusiveoutcomes.Whiletherecanbemanystrategies. I considerasimplegrimtri gger-strategy.ConsidPerthefollowing:inanyperiod,anincumbentmonopolist < firmchooses P m Larkeitin thesecondstageprovidedhehasearned11 in allpreviousperiods. If rn n not, thehincumo bentchs ooses e P c h i s s u b s e q uentperiod thereafter .Further,inthesecondstage,wheneverhefindsthe L i n t h e entrant pricing above P n h cie. oLet ms11„, pri the profitfromchoosing P. and FI fL r t be i n t h e b y c h o o s i n g P e L btO.teaIfraha t n hdeec eidesetopstayrinoitsown f i market t thenthepresentdiscounted s g e n t factor firm tL ar of k im s tresam s: fi'm o nr profits .te It h ee O W n n =+ o n a i s us r r e c h o if m e en-te+ m 6 u m e In nstead, the firm r s and u n d e r c u t s the i n c u m b e n t in the entry-market in any ttherdisco m peri o d. a k u n t e e d profit s t r e a m to hi m is: tp h e 2 r i ta . t h Qd=2fl,—S—Orli /(1 - 6 o d r 1 , h tif ethefirmseacnhplaybythe ) describedgrimtriggerstrategy,unilateraldeviationfrom a e 1triggerstrategyisnotoptimal if fr isgreaterthanorequalto n fd th heoutliinedgrim u n d C o m p a r i n g payoffs e re s v + givesthefollowingcondition. d e .fe t i r r c• y 6/(1—6) ? (El u t s m S)/ rs t • tm (lim a g
208
U
.
Dasglipta
where > 0isassumedtobeverysmallandignoredforconvenience.Let(j*bethe smalest()thatsatisfiestheaboveinequality. Ifeachfirmdiscountsfuturebyatleast 6*andplaysbythegrimtriggerstrategydescribedabove,inequilibriumeachfirm %vilchoosemonopolypriceinhishome-marketanddoesnotentertheothermarket. Asymmetriccase Consideranothergamewithanincumbentin themonopolymarket(described above).and a potentialentrantearningnormalreturns.Considertwostagesof decision-makingasabove.Instageone.theincumbentin themonopolymarket postsapriceinhishome-market.Instagetwo,theentrantobservesthepriceand decideswhethertoenterthemonopolymarketornot.Toentershehastopaythe sunkaccessfeeSandthendecideonapricetoservethemarket.Thestaticgame Nashequilibriumconsistsoftheincumbentinthemonopolymarketpostingaprice PLinstage I andthepotentialentrantstayingout. In theSPNEofthe T period repeatedgame.thestagegameNashequilibriumisrepeatedeveryperiod. Ifthegameisrepeatedinfinitely,folktheoremcanagainprovideuswithvarious colusiveoutcomes.Iconsiderasimplegrim-trigger-strategy.Considerthefollowing: anincumbentmonopolistchooses P m arke tprovi dtedh heheasearnedIL, inallpreviousevenperiods. If not.theincumbent in i n choosesP f eriodrthereafter p s t (i.e.revertsto thestaticNashequilibrium).Theentrantfirm tc hoostestoaenter andeundercutthepriceinthemonopolymarketonlyinoddperiods s g _ proviidnedshehasearned (1 e e the r myonopolymarketthereafter,ineveryperiod,whenevershe c oo sev stoenter h -oh i s bserveesthefirst staigepric etobd egreaterthan P p r o h 1 o b e f o re.letthemonopolyprofitlevelbedenotedby11111andtheprofitlevelassociated L i theP nS wi m — p ted rnedfromevenperiodsis: .IherIiodthen a sihis sdisucou mn eprofiteay s -i> n 0mQC= (51 h o ,m a al n l d a e - to e -thestaticNashequilibriumeveryperiodthenhisdiscounted If h e reverts pl a yi n g rb p k r e e v i o v e r y 1„, + profit i s F I tu sm a l l . s 6 iL o d d O A s .p e r i - 3 d n Ifeachfirmchoosesthendescribed1grim-trigger-strategy,unilateraldeviationforthe Ito monod polyincsumbe.ntisnotoptim;alwhenncisgreaterthan Q g i v e s the following condi t i o n fh m 7 Id o te • • f. C o m p a r i n611 g ) i s 0. fh n p a y o o f f or, 6 11 ( ie t , 1 ,5 2 rm t h o s e Itisstraightforwardtonverify ) thattheentrant.whootherwiseearnsnormalreturns, n twill e prefernthisstrategy t /becau Fseitprovidesahigherdiscountedstreamofprofits.So o s r a n ( 1I ) L tp
o**>non.-ri[)
NewZealandEconomicPapers
2
0
9
theasymmetricmarketcansustaincollusiveoutcomesaswell in an infinitely repeatedgamecontext.providedfirmsdiscountfutureby6**andplaybytheabovementionedgrim-trigger-strategy. 4.Design Theexperimentswereprogrammedwiththez-Treesoftware(Fischbacher,1999)and conductedintheEconomicScienceLaboratory(ESL)attheUniversityofArizona withundergraduatestudentsubjects. I have apaired-marketdesignwhereeach subjectisrandomlyassignedtooneofthemarketsasanincumbent.Amarket-pair consistsofanincumbentfirminamonopolymarketandanotherincumbentinthe 'treatment'market.Thebaselinetreatmentconsistsofanincumbentin astylized competitivemarket,earningafixedreturnof1experimentaldollar,pairedwithan incumbentin amonopolymarket.Mysecondtreatmentconsistsof asymmetric monopoly-market-pair.Here,eachsubject isassignedas anincumbent in a monopolymarket.Eachincumbenthastheoptiontoentertheothermarketand affecttheexistingincumbent'sownhome-marketprofits.Bycontrast,tileexisting incumbent'sfixedpaymentinthecompetitivemarketisnotaffectedbyentry,inthe baselinetreatment.Thereareneitheranycostsofproduction,norcostsofentryin thecompetitivemarket.Theoptiontoenterthecompetitivemarketwasimposedto maintainsymmetryinsubjectinstructionsandsoftwareprogramming.llenceforth, I referto thebaselinetreatmentas thecompetitiontreatmentand thesecond treatmentasthemonopolytreatment. Ineachtreatmentthesubjectstakedecisionsin twostages. In stageone, incumbentmonopolistsprivatelychooseprices in theirhome-markets. In the beginningofstagetwo,theincumbentinthepairedmarketisnotifiedofthatprice. Eachincumbent,nowapotentialentrantfortheirrespectivepairedentry-markets, decideswhethertoinvestinanentrycost(exceptforentryintothecompetitive market)togainaccesstotheentry-market. If anincumbentinvestsinentrycostshe getstopostapriceinthepairedentry-market.At theendofthetwostages,one 'productionperiod is over,andprofitsareannouncedfor thatperiod.Oncea productionperiodisoverlifestartsalloveragain,andeachfirmgetsanopportunity totakeentrydecisions(andinvestinentrycosts)again.Sothestaticgamedescribed inthemodelsectionrepresentsoneproduction-periodintheexperiment.Thegameis repeatedfor25periodswithfixedmatching.Subjectsgetaprofitmatrixalongwith theinstructions.Marketdemandiscomputerizedandfullyrevealedtoeachsubject throughtheprofitmatrices.Eachincumbentisalsogivenastart-upfund of100 experimentaldollarsthattheycanusefortheentryfees.Anyunusedportionofthe fundispaidbacktothesubjectsaspart of theirexperimentalearnings.Table1 describesthemarketparameters. Thetwotreatmentsshare acommonfeature ofsunk-entry-costsposingas possibleentrybarriersinthemonopolymarket.Althoughpotentialentrantsearn differenthomemarketprofitsineachtreatment,thestaticorthefinitelyrepeated gameanalyzedearlierpredictsthesamelimit-pricingoutcomeineachtreatment. However,thefixed-matchingrepeated-playbringsupsomefurtherconsiderations thatcanaffecttheentrydynamicsinthemonopolytreatment.Theentrantmightnot enteranothermarketinapprehensionoffutureretaliationinherownmarket. It is notjustthesunk-cost,butthepossibilityoflosingfutureprofit-streamsinherown home-marketaswell,thatcanleadhertoavoidenteringthepaired-marketeven
210
U
.
Dasgupta
Table1.Descriptionofmarketparameters. Cost Benchmark N o . ofmarket Entry function: G Demand Pricesobservations Incumbent cost: S ( ( 2 ) 8 Monopoly 1 0 3 2 +2Q P 20 —Q P -=5 m 7* Com— petitive 0I 01 F i x e d Incumbent payoffof I d o e s not choose prices •Notethatinthecompetitivetreatmentacompetitivemarketincumbentispairedwithanincumbentfrom amonopolymarket.
xvhennetprofitopportunitiesexistinanyperiod.Consequently,onemightexpect sustainednon-entrybehaviorasasignoftacit-collusionbetweenfirms.Thisintertemporalcollusiveincentiveisarguablyweakerinthecompetitivecasebecausethe profitintheentrant'sown(competitive)home-marketisunaffectedbyentry. In thecompetitivecase,a primereasonforobservingapaucity of entryintothe monopolymarketcanbethattheincumbentchoosesentry-deterring-limitprices. Notethat inaninfinitelyrepeatedgameonemightobservetacit-collusioninthe competition-treatment if thefirmsarepatientenoughtotaketurnstoshareintertemporalmonopolyrents.However,in afinitelyrepeatedgame.onewouldexpect thatthesmallerthenumberofrepetitions.thestrongerwouldbethehit-and-run tendencies. 5.Results
Thediscussionhereisdividedintothreesub-sections.Subsection5.1reportsthe averagepricebehavior,subsection5.2reportstheentrybehaviorandsubsection5.3 providessomefurtherinsightsondynamicsubjectbehavior. 5.1. Pricingbehavior
Theevolutionofaveragepricesinthecontestablemonopolymarketsisthefirst variable of interest.Figure I reportstheevolution of averageprices in each treatment.Theaveragepriceiscalculatedusingthelowerof'thetwopostedprices (firstandsecondstagechoices)ineachmonopolymarket,i.e.thewinningpricefor everyperiod.Thetreatmenteffectslookpronounced.Toformalizeresults, I test threewellsupportedhypothesesasdescribedbelow.Table2reportsthetests.test statistics,p-valuesanddecisions. H tIreatmentversusHIA:Averagepriceinthemonopolytreatment>Averageprice inthecompetitiontreatment. : Observedpricesinthemonopolytreatment—9versusH2A:observedprices A inthemonopolytreatment>9. v e r
Nett.ZealandEconomicPapers
211
12 11 10 9
7 6
• 4
1
1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 --O—MonopolyTreatment-10—CompetitiveTreatment Figure Evolution ofaveragefinalprice. Table2.Hypothesesandresults. Hypotheses T e s t T e s t Statistic P valueandDecision 11 Fil vs. H 1 lb vs.NIA t - t e s t t = —8.93 P = 0.00RejectH3infavorofH3Aat1% 2A v [s t. e H3;Observedprices in the competitivetreatment = 7 versusH3A:observed s H t pricesinthecompetitivetreatment chisquare=0.0001,*denotessignificanceatthe 10 l1) eveland**denotessignificanceatthe5%level, /0
inthepreviousperiodsthenthereis a higherprobabilitythattheentrantwill cooperatethisperiodandnotentertheincumbentqsmarket.Entryissignificantly higher(comparedtothemiddle15periods)inthelastfiveperiods,whichseemsto supporttheearlierhypothesisofcooperationbreakingdownduetoendgameeffects. Entryisalsohigher(althoughnotsignificant)inthefirstfiveperiodswhensubjects mightbeunclearoftheinter-temporalgainsfromcooperationin themonopoly treatment.
6.Conclusion Thispaperevaluatestheeffect ofsunk-entry-costsonpotentialcompetitionin a contestablemarketframework.Experimentalresultsindicatethatthebehavioral implicationsforpotentialcompetitionneedto bequalified,keepinginmindthe outsideoptionsavailabletoanentrant.Whethersunkcostsconstituteanentrybarrier ornotdependsonthenatureofinteractionandthealternativeprofitopportunities available.Whenanentrantearnssecurecompetitivereturns,amodestamountof sunk-costdoesnotdeterentryiftherearenetprofitopportunities.Asaresult,frequent hit-and-runentryforcesexistingincumbentstolowerpricestoentry-deterringlevels. However,wheneverfirmseachhavetheirownmonopolymarkets,vulnerabletohitand-runentry,theytendtoavoidenteringtheother'smarket,fearingfutureretaliation intheirrespectivehome-markets.Theabovetwoobservationssuggestthat the contestablemarketframeworkprovidesastrongsecond-moveradvantageto the entrant,whichisnoterodedbyasunkcostofentry.Thelevelsofsunkcostscanonly affecttheoutcomeintermsoftheconsequentlimitpricelevel.However.theintensity ofhit-and-runentrydependscruciallyoninter-temporalprofitconsiderations.Afirm willbereluctanttocontestamarketeven if ithasasecondmoveradvantageif it anticipatesasimilarattackinitsownmarketthatwilldepressitsfutureprofitlevels. Acknowledgements
thankmembersofmydissertationcommitteeattheUniversityofArizonaforproviding guidanceandsupport.FinancialsupportfromtheEconomicScienceLaboratoryat the UniversityofArizonaisgratefullyacknowledged.Thecurrentversion of thepaperhas benefitedalotfromexcellentsuggestionsandcommentsfromtwoanonymousreferees.All
remainingerrorsaremine. Note
TheupperandloweradjacentvaluedefinedbyTukey(1977)isasfollows.Let x pthpercentile.DefineUas x tri t1751 he x b e- t h e adjacentvalueisdefinedasthex,suchthat x i /2(x( 3 i > L a n d x s5 7 i u 1 x
NewZealandEconomicPapers
2
2
1
References Bailey, & Panzar, if. (1981).Thecontestabilityofairlinemarketsduringthetransition toderegulation.bittiandContemporaryProblems,44.125-145. Baumol,W.(1982a).Contestablemarkets:anuprisinginthetheoryofindustrystructure. AmericanEconomicReview,72,1-15. Baumol,W.,Panzar,J..&Willig,R.(1982b).Contestablemarketsandthetheoryofindustry structure.NewYork:HarcourtBraceiovanovich. Brock,W.(1983).Contestablemarketsandthetheoryofindustrystructure:areviewarticle. JournalofPoliticalEconomy,91,1055-1056. Brown-Kruse,J.(1991).Contestabilityinthepresenceofanalternatemarket:anexperimental examination.TheRandJournalofEconomics,22,136-147. Cairns,DR., &Mahabir,D.(1988).Contestabilityarevisionistview.Economica,55,269276 Call,G.D., &Keeler, I.E. (1985).Airlinederegulation,fares,andmarketbehavior:some empiricalevidence.In A.F.Daughety(Ed.),Analyticalstudiesintransporteconomics(pp. 221-247).Cambridge:CambridgeUniversityPress. Cleveland,W.S.(1993).VisualLingdata(pp.25-27).Summit,NJ:HobartPress. Coursey,D. Issac,R., &Smith,V. (1984).Naturalmonopolyandcontestedmarkets:some experimentalresults.JournalofLawandEconomics,27,91-113. Coursey,D..Issac,R.,Luke,M.,&Smith,V.(1984).Marketcontestabilityinthepresenceof sunk(entry)costs.TheRandJournalofEconomics,15,69-84. Dasgupta.U. (2005).Mindingyourownbusiness. In ProgrammingCommittee of the HayashibaraForum2004andtheOpenResearchCentre of theGraduateSchoolof KyotoSangyoUniversity(Eds.),ProceedingsofTheExperimentalEconomicsWeekin HonourofDrVernonL.Smith.Japan:KyotoandOkayama. Dasgupta,U. (2007).Whenfirmscontestinmarkets:anexperiment.In S.H.Oda(Ed.), Developmentsonexperimentaleconomics:newapproachestosolvingreal-worldproblems. Springer. Demsetz,H.(1968).Whyregulateutilities?JournalofLawandEconomics,11,55-65. Evendyn,RD., & Williams,A.W.(2000).Contestability:thedebateandindustrypolicy. EconomicAnalysisandPolicy,30,75-91. Fischbacher,U. (1999). Tree - ZurichToolboxforreadymadeeconomicexperiments experimenter'smanual.WorkingPaper Nr. 21, Institute for EmpiricalResearchin Economics.UniversityofZurich. Gilbert,R.i.(1989).Theroleofpotentialcompetitioninindustrialorganization.TheJournal ofEconomicPerspectives,3.107-127. Harrison,G. (1987).Experimentalevaluation of thecontestablemarketshypothesis. In E. Bailey(Ed.),Publicregulation.TheMITPress. Harrison,G., & McKee, M. (1985).Monopolybehavior.decentralizedregulation,and contestablemarkets:anexperimentalevaluation.RandJournalofEconomics,16,51-69. Harrison,G.,McKee,M., &Rutstrom,E.E.(1987).Experimentalevaluationsofinstitutions ofmonopolyrestraints.In L.Green&J.Kagel(Eds.),Advancesinbehavioraleconomics, Vol.2(pp.54-94).Norwood,NJ:AblexPress. Kessides,1.(1990).Marketconcentration,contestabilityandsunkcosts.ReviewofEconomic Statistics,72,614-622. Kessides,I. (1991).Entryandmarketcontestability:theevidencefromtheUnitedStates.In P. Geroski & J.Schawalback(Eds.),Entryandmarketcontestability:aninternational comparison.Oxford:Blackwell. Millner,EL., Pratt,M.D.,&Reilly.R.J.(1990).Contestabilityinreal-timeexperimentalflow markets.RandJournalofEconomics,21,584-599. Peteraf,A.M., &Reed,R. (1994).Pricingandperformanceinmonopolyairlinemarkets. JournalofLaw&Economics,37.193-213. Schwartz,M.. &Reynolds,R. (1983).Contestablemarkets:anuprisingin thetheory of industrystructure.CommentAmericanEconomicReview,73,488-490. Schwartz,M.(1986).Thenatureandscopeofcontestabilitytheory.OxfordEconomicPapers, NewSeries,38,Supplement:StrategicBehaviorandIndustrialCompetition.pp.37-57. Shepherd.W.(1984).Contestabilityvs.competition.AmericanEconomicReview,74,572-587.
222
U
.
Dasgttpta
Strassmann, DI. (1990).Potentialcompetitionin thederegulatedairlines.TheReviewof EconomicsandStatistics,72,696-602. Sutton,J.(1948).Sunkcostsandmarketstructure.Cambridge,Massachusetts.London:The MITPress. Takey.J.W.(1977).Exploratorydataanalysis.Reading.MA:Addison-Wesley. Weitzman,M.(1983).Contestablemarkets:anuprisinginthetheoryofindustrystructure: comment.AmericanEconomicReview,73,486-487.
Appendix.Subjectinstructions Incumbent,MonopolyTreatment'MonopolyincumbentinCompetitionTreatment] Introduction Welcometothismarketexperiment.Youwillbematchedwiththesameparticipantfortherest oftheexperiment.Eachexperimentaldollarisworth0.01U.S.dollar. Inaddition.youwillalsoget5U.S.dollarsforparticipatingintheexperiment.
Instructions Therearetwomarkets.Youaretheonlysellerinyourhomemarket.Thereisalsooneseller justlikeyouintheothermarket.Thereare25periodsoftheexperiment. [Therearetwomarkets.Youaretheonlysellerinyourhomemarket.Thereisanothey marketwhichhasonesellerwhogetsa1experimentaldollareveryperiod,forbeingasellerin thatmarket.Thereare25periodsoftheexperiment.] Ineachperiodtherearetwostagesofdecision-making. StageI: Youchooseapricebetween4and I I inyourhomemarket.Theotherselleralso choosesapricefromthesamesetofpricesinhishomemarket. [Youchooseapricebetween4and I I in_rourhomemarket.Theothersellerhasno decisionstotakeinthisstage.] Stage2:Youareshownthepricechosenbytheothersellerinhishomemarket.Alsotheprice youhavechoseninyourhomemarketisshowntotheotherseller. Decidewhethertosellintheotherseller'shomemarketornotsellinhismarket.Howeverto selintheothermarketyouneedtopurchaseasalepermittoenterthatmarket,whichcosts10 experimentaldollars.Onceyoubuythepermitfortheothermarketyoucansubmitapricein thatmarket.Theotherselleralsodecideswhethertosellinyourmarketornotsellinyour market. Ifhechoosestosellinyourmarkethehastosimilarlybuyapermitforyourmarket. Apermitifboughtisvalidforthecurrentperiod,afterwhichhehastore-purchasethepermit againifhedecidestosellinyourmarket. {Thepriceyouchoseinyourhomemarketisshowntotheotherseller.Hethendecides whetherhewantstosellinyourhomemarketornotsellinyourmarket.Howevertosellin yourmarketheneedstopurchaseasalepermitwhichcosts10experimentaldollars. Ifhebuys thepermithecansubmitapriceinyourmarket.Apermit ifboughtisvalidforthecurrent period,afterwhichhehastore-purchasethepermitagainifhedecidestosellinyourmarket.] AfterboththesellershavecompletedtheStageIandStage2decisions,oneperiodisover, Thematricesattachedattheenddetermineyourprofitforthatperiod.Noticetheprofitin yourhomemarketdependsonthepriceyouchooseinthefirststageandwhattheotherseller doesinthesecondstage.Similarly,theprofitintheothermarketdependsonthepricethe othersellerchoseinthefirststageandwhatyoudointhesecondstage. [Inaddition, ifyouchoosetoentertheotherseller'shomemarketinanyperiod,youget1 experimentaldollarfromthatmarket.] Eachofyouwillget100experimentaldollarsasstart-upfundsforbuyingthesalepermits. Ifyouuseupall of itinthecourseoftheexperiment.yourearnedprofitswillbeusedifyou decidetobuypermitsinsubsequentperiods. [Eachofyouwillget100experimentaldollarsasstart-upfunds.Theothersellerwilluse thestart-upfundsforbuyingthesalepermits. Ifheusesupallhisstart-upfundsinthecourse oftheexperiment,hisprofitswillbeusedifhedecidestobuypermitsinsubsequentperiods.]
NewZealandEconomicPapers
2
2
3
Thecomputerscreenwillshowyourprofits,thepricesineachmarketandthestart-up Fundsleftaftereveryperiod. AttheendoftheexperimentyourtotalearningsfromallperiodswillbeconvertedtoU.S. dollarsinthementionedexchangedrateandpaidtoyou.
Incumbent,CompetitionTreatment Introduction Welcometothismarketexperiment.Youwillbematchedwiththesameparticipantfortherest oftheexperiment.Youwillget100experimentaldollarsasstart-upfunds.Incaseyoudonot useupallyourstart-upfundsduringtheexperiment,theleftoverwillbepaidbacktoyouin additiontowhatyouearninexperimentaldollarsasprofitsduringtheexperiment.Each experimentaldollarisworth0.01U.S.dollar. Youwillalsoget5 US.dollarsforparticipatingintheexperiment.
Instructions [herearetwomarkets.Youaretheonlysellerinyourhomemarket.Youget1experimental dollarforbeingasellerinthismarketeveryperiod.Thereisanothermarketwhichistheother seller'shomemarket.Thereare25periodsoftheexperiment. Ineachperiodtherearetwostages. Sta d ecisionstotakeinthisstage. g Smile2:Youareshownthepricechosenbytheothersellerinhishomemarket.Decidewhether teosellintheotherseller'shomemarketornotsellinhismarket.Howevertosellintheother marketyouneedtopurchaseasalepermittoenterthatmarket,whichcosts10experimental I : lars.Onceyoubuythepermitfortheothermarketyoucansubmitapriceinthatmarket. dol A permit ifboughtisvalidforthecurrentperiod,afterwhichyouhavetore-purchasethe T permitagain ifyoudecidetosellintheothermarket. h Theotherselleralsodecideswhetherhewantstoenteryourmarketornot.Hedoesnot havetobuyapermit. Ifhechoosestoenteryourmarkethegets1experimentaldollaraswell e beinginyourhomemarket. for o OnceyouandtheothersellerhavetakentheStage1andStage2decisions,oneperiodisover. T t hematricesattachedattheenddetermineyourprofitintheotherseller'shomemarketfor thatperiod.Noticetheprofitintheotherseller'shomemarketdependsonthepricetheother h sellerchoseinthefirststageandwhatyoudointhesecondstage. Inyourhomemarket.youwillget I experimentaldollareveryperiodregardlessofwhat e youearnintheotherseller'shomemarket. r Eachofyouwillget100experimentaldollarsasstart-uphinds. Ifyouuseupallofitinthe courseoftheexperiment,yourearnedprofitswillbeusedif youdecidetobuypermitsin subsequentperiods.Incaseyoudonotuseupallyourstart-upfundsduringtheexperiment, theleftoverwillbepaidbacktoyouinadditiontowhatyouearninexperimentaldollarsas e profitsduringtheexperiment. l Thecomputerscreenwillshowyourprofits,thepricesintheothermarketandthestart-up fundsleftaftereveryperiod. l AttheendoftheexperimentyourtotalearningsfromallperiodswillbeconvertedtoU.S. dollarsinthementionedexchangedrateandpaidtoyou. e r i n h i s h
224
U
.
Dasgupta
Theboldlymarkedareyourchoicesandyourassociatedprof's.r[henon-boldaretheother fmn'schoicesandpayoffs.Allnumbersareexpressedinexperimentaldollars.Each ,experimentaldollarisworth0.01USdollars. YourHOMEMARKET
Not enter
YourdecisioninyourHOMEMARKET (I II sprier•10p t a g e )riteir9 pricell ,prireS price7 50 49 46 41 34 0 0 0 49 41 34
price.11 9
0 15
2nce-10 49 Oh:r limes &dace
46
Ycur hcmc titykd
pricy
sow)
,.
41
83
46 0
0 46
0
41
7
_pnce-6
2$
34
pnce-4 1
0
4.5
25 0
34 0
41
rIrt---4 1
14
1
14
1 1
0 25
0
0
34
25
14
34
25
14
1
25
14
4.5 0
0 34
25 0
14
41
7
34
25
0
0
41 0
34
0
p re-6 Iprired 25 14
-3.5
25 0
25 0
-3.5 0
14
14
14
14
14
1
1
1
1
1
1 1
14
. 00
-9
1 -15.5
1
-15.5
*Notethat given theexperimentalparameters,choosing a price of 4shouldgive a payoff of zero experimentaldollars to theincumbent in themonopolymarket.However,1wanted to avoidsubject behaviorduetozeropayoffsandincreasedpayoffsateverypricelevelbyaunit of1in thepayoffmatrix. Consequently, if thesolemonopolyincumbentchargesaprice of4hegetsapayoffof I. Thispayoffisalso comparableto the 6 normal r e t u r n s ' p a y o f f o f 1 e x p e r i m e n t a l d o l l a r i
225
NewZealandEconomicPapers Theboldlymarkedareyourchoicesandyourassociatedpayoffs.Thenon-boldaretheother firmschoicesandpayoffs.Allnumbersareexpressedinexperimentaldollars.Each experimentaldollarisworth0.01USdollars_ Otherfirm'sHOMEMARKET YourdecisionisotheOTHERFIRM'SHOMEMARKET (Z ed s t a g e ) iriee•41 •rke•7 Noentry price prict-10 09 49 46 41 34 11 price 1i
50
price.10 49 •
Ottoirfirm's
dedston InObiHOME MARKET(1 sine) 11
8,.5 49
8,5
46 0
41 0
41
•Tict6 price5 25 14
34 0
34
25 0
gtice9 46 price-8 41
41
pricel7 34
41
41
4.5
34
34
34
1
price-6 25
2S
25
2.5
25
25
-3.5
14 1 p t 1 c pnce-4 e S
14
14
14
14
14
14
1
1
1
1
1
1
25
rict4
14 0
14
25
14
25
14
-3.5
14
0
-153 1
-15.5
