All Chapters

Chapter 1: Size and structure of firms

Learning objectives
By the end of this chapter and having completed the Essential reading and
Activities, you should be able to:
• describe and evaluate two different approaches to explaining the size
and structure of firms
• explain the notions of ‘transaction costs’, ‘investment specificity’,
‘opportunistic behaviour’, ‘incomplete contracts’ and ‘residual rights of
control’ and their relevance for the theory of the firm
• analyse two different types of inefficiency that can arise in the context
of long-run relationships between firms
• explain the effect of investment specificity on the decision of firms to
enter into contractual relationships or to integrate.
Essential reading
Church, J.R. and R. Ware Industrial Organization: A Strategic Approach.
Chapter 3.
Tirole, J. The Theory of Industrial Organization. Introductory chapter.
Further reading
Books
Hart, O. Firms, Contracts, and Financial Structure. (Oxford: Oxford University
Press, 1995). Chapters 1–4.
Perry, M.K. ‘Vertical Integration: Determinants and Effects’, in Schmalensee, R.
and R. Willig (eds) Handbook of Industrial Organization, volume 1.
(Amsterdam: North-Holland, 1989).
Journals
Hart, O. ‘An Economist’s Perspective on the Theory of the Firm’, Columbia Law
Review (1989) 89(7), pp.1757–1774.
Hart, O. and J. Moore ‘Property Rights and the Nature of the Firm’, Journal of
Political Economy (1990) 98(6), pp.1119–1158.
Joskow, P.L. ‘Contract Duration and Relationship-Specific Investments:
Empirical Evidence from Coal Markets’, American Economic Review (1987)
77(1), pp.168–185.
Klein, B., Crawford, R.G. and Alchian, A.A. ‘Vertical Integration, Appropriable
Rents, and the Competitive Contracting Process’, Journal of Law and
Economics (1978) 21(2), pp.297–326.
Lafontaine and Slade ‘Vertical Integration and Firm Boundaries: The
Evidence’, Journal of Economic Literature (2007) 45(3), pp.629–685.
Monteverde, K. and D.J. Teece ‘Supplier Switching Costs and Vertical
Integration in the Automobile Industry’, Bell Journal of Economics (1982)
13(1), pp.206–213.
Introduction
What explains the size and structure of firms? In fact, you may also ask:
why do agents group together to form firms? This chapter aims to provide
some answers to these questions and also to examine some more specific
9
99 Industrial economics
issues, namely why some transactions take place within firms while others
are conducted through external contractual relationships; what determines,
in the case of contracts between firms, the types of contracts used; and
finally, what are implications of alternative ownership structures are for
efficiency.
This chapter focuses on efficiency explanations for the size and
structure of firms. It is important to understand what ‘efficiency’ means in
this context. Efficiency motives are those associated with minimising costs
or maximising producer surplus in a way that may also be socially
beneficial, that is increase total social welfare. The efficiency of a certain
organisational form refers then here primarily to the firm or firms involved,
not necessarily to society as a whole.
You should bear in mind that there are also market power explanations for
the size and structure of firms. Unlike efficiency motives, market power
motives induce behaviour which, although profitable for the firm or firms
involved, is definitely detrimental to social welfare. For instance, two firms
producing the same product may merge not to reduce costs but simply to
enhance their ability to exercise market power. Much of the second part of
this subject guide is concerned with the behaviour of firms with market
power. So to make an overall assessment of the factors that determine the
size and structure of firms you should first work through most of the guide.
There are two broad classes of efficiency explanations: the technological
view of the firm and the transaction costs–property rights approach.
Technological factors
According to the technological view, optimal firm size and diversification
depend on the degree of economies of scale and scope.1 For instance, a 1
See Tirole (1988), pp.18–21 for
single-product firm may have an average cost curve such as the one details. On the concepts of scale
depicted in Figure 1.1. To minimise average cost, the firm will in this case and scope economies, you can
operate at a size between q1 and q2. also read Church and Ware
(2000), Chapter 3.
AC
AC(q)
q1 q2 q
Figure 1.1
While technological constraints are important, they are not the whole story.
In particular, there are two problems with the technological view of the
firm:
• It may explain the joint use of facilities, but not joint ownership. Why
can’t agents write contracts to exploit economies of scale and scope
without joint ownership?
10
• It is not clear why the AC curve rises at high output. If producing

quantity qA + qB were to cost more than producing qA and qB
separately, why can’t there be a single firm that consists of two
independent divisions producing qA and qB respectively?
The transaction costs–property rights approach
Transaction costs, incomplete contracts and integration

The starting point for this approach is the idea that the choice between
organising activity internally and using the market (or contracts) is
determined by a comparison of the costs and benefits of these two modes
of organisation. Williamson has identified some economic factors that
matter for this choice. There are three elements in his approach:
1. investment specificity
2. opportunistic behaviour
3. bounded rationality.
Many long-run relationships between economic agents involve relation-
specific investments, in other words investments that pay off a maximum
return only if the particular relationship continues for some time. Examples
of specificity are site specificity (e.g. a firm builds a plant next to another
firm’s works to save transport costs); physical asset specificity (e.g. a firm
designs equipment the characteristics of which are specific to a particular
order); and human capital specificity (e.g. an employee invests in acquiring
skills which are specific to a certain job). In all these cases, the first best use
value of an investment is higher than its value in any alternative use.
Now ex ante (i.e. before any investments are made) there is a competitive
situation. For instance, if the relationship is between a buyer and a supplier
of a certain product, there will be many suppliers and buyers and they can
select each other out of the pool of competitive suppliers and buyers. But ex
post (i.e. after investments have been made) there is a bilateral monopoly,
because if the parties trade with each other they can make gains which will
not be made otherwise. This creates the possibility of a ‘hold-up’ or
opportunistic behaviour. Each party wants to appropriate the common
surplus ex post, so there will be bargaining. This can create several
problems, in addition to any costs of haggling:
• The level of trade ex post may not be efficient if there is asymmetric
information. This can occur irrespective of whether the relation
involves ex ante investments or not.
• The level of investment ex ante will not be efficient, even under
symmetric information. The reason is that once a party has sunk the
cost of the investment, it has lost any extra bargaining power. So even if
the efficient volume of trade occurs ex post, the division of the surplus
will be such that the level of investment ex ante is not efficient.
These notions will be made more precise with the help of a formal model
below. But before that, consider the following question. If the parties could
write a contract ex ante specifying the terms of trade ex post, would they be
able to achieve efficiency? The answer is that they might. So why can’t they
write such a contract? This is where the ‘bounded rationality’ idea comes in:
a complete contract is impossible to write. There are several reasons for this,
such as unforeseen contingencies, prohibitive costs of contracting over all
contingencies (even if these are foreseeable), or prohibitive monitoring
costs. As a result, contracts are necessarily incomplete. Some bargaining will
have to take place ex post, and this may lead to inefficiencies.
11
We can now state an important theoretical prediction of the transaction

costs approach: the more specific the investment, the larger the scope for
efficiency losses due to opportunistic behaviour. Hence the more specific
the investment, the higher the probability of integration (i.e. common
ownership) as opposed to a contractual relationship.
A model
Let us formalise some of the above ideas using a simple model of a vertical
relationship between a buyer and a seller.2 There are two periods, t = 1 (ex
2
This part follows Tirole (1988),
ante) and t = 2 (ex post). We first want to focus on the issue of ex post pp.21–29.
efficiency, so assume for now that there is no investment ex ante. The two
parties can, if they wish, trade one unit of an indivisible good in period 2.
Let v denote the value of the good to the buyer (this can be the difference
between the value to the buyer in this relationship and that in an
alternative relationship), c the production cost, and p the price at which the
parties trade. If there is trade, the buyer has a gain of v – p, while the seller
has a gain of p – c. If there is no trade, both gain zero.
If v and c are known to both parties at the beginning of period 2, then the
volume of trade is efficient, which is another way of saying that trade will
occur if and only if there are gains from trade, in other words if and only if
v ≥ c. That is so because, if v ≥ c, the parties will agree to trade at a price p
such that c ≤ p ≤ v rather than make zero surplus.3 While if v < c, at least If v = c, the parties are
3
one party would be making negative surplus if trade were to occur, so this indifferent between trading at p
party will refuse to trade. More generally, it can be shown that under = c = v and not trading, so we
symmetric information we always obtain the ex post efficient outcome. assume for simplicity that they
choose to trade – this is only a ∂
If, however, there is asymmetric information, the volume of trade may be
technical point.
inefficient. Suppose that both parties know c but only the buyer knows v.
All the supplier knows is that v is distributed as a random variable with
cumulative distribution
_ function F(v)
_ and density function f(v) on the
interval [v_, v ] (hence F(v_) = 0, F(v ) = 1).4 Gains from trade exist with
4
Recall that f(v) =∂F(v)/∂v.
_
some probability between 0 and 1, that is v_ < c < v (the problem would be
trivial otherwise). To simplify the problem suppose further that the supplier 5
It would be more realistic to
has all the bargaining power in period 2, so he makes a take-it-or-leave-it assume that both parties have
offer to the buyer at price p.5 The buyer will accept this offer if v ≥ p, so some bargaining power, but this
trade will occur if and only if v ≥ p, that is with probability: would complicate the analysis
v without changing the qualitative
prob(v ≥ p ) = ∫ f ( s )ds = 1 − F ( p ) results.
p
Recall that if trade does not occur the supplier ends up with zero. So the
supplier’s expected profit is given by E(Π) = (p – c)[1 – F(p)]. The supplier
will choose p to maximise this, so:
∂ E (Π )
= 1 − F ( p) − ( p − c) f ( p) = 0
∂p
From this equation it can be seen that in general the supplier chooses p >
c, so there are circumstances where trade does not occur even though there
are gains from trade. In particular, this is the case when p > v ≥ c. In this
case the buyer rejects the supplier’s offer since he would make a loss by
accepting, so trade does not occur even though v ≥ c. For efficiency, on the
other hand, we would require p = c, so that trade occurs if and only if
v ≥ c. More generally, it can be shown that when both value and cost are
private information and gains from trade are not certain, the volume of
trade is not efficient.
12
Activity
Show that, if the parties could sign a contract in period 1 in this simple model, they
could devise a contract such that the efficient volume of trade is obtained.
Answer
The contract should simply give the power to choose the price p in period 2 to the buyer
(i.e. the informed party). The buyer would then set p = c in order to appropriate all the
surplus6. So trade would occur if and only if v ≥ c, which is what we require for
efficiency. The fact that the buyer would appropriate all the surplus is irrelevant as far as 6
Why is the supplier prepared to
efficiency is concerned, because all that efficiency requires is the maximisation of the trade if p = c? Recall that to
‘pie’. In any case, the parties could also specify in the contract a lump sum payment from avoid some purely technical
the buyer to the seller to create any division of the surplus: the outcome would depend problems we have assumed that
on the relative bargaining power of the parties in period 1, when the contract is signed. when a party is indifferent
Note, however, that, unlike our simple model, a complete contract cannot be written in between trading and not trading,
many practical situations. In those cases, asymmetric information will lead to inefficient it chooses to trade. Alternatively,
outcomes. you can imagine that the buyer
offers p = c + ε, where ε is
So far there was no ex ante relation-specific investment in the model. Now positive and very small.
let us assume that one of the parties, say the supplier, can invest in period
1, say in cost reduction. In particular, let c be a function of investment I:
c(I), with c’(I) < 0, c’’(I) > 0. Assume v ≥ c(0) to ensure positive optimal
investment. We want to focus on how ex post bargaining affects the volume
of investment undertaken, so we will further assume that there is
symmetric information and hence the volume of trade ex post is efficient. In
other words we abstract from additional complications created by
asymmetric information. So both v and c are commonly known at the
beginning of period 2 and trade occurs if and only if v ≥ c. Finally assume
for simplicity that the two parties have no ‘outside option’ ex post, that is to
say their only chance to realise a positive surplus is to trade between
themselves (there are no other buyers or sellers in period 2).
In period 2 the trading price p will be determined through bargaining. If
the two parties have equal bargaining power, the ex post surplus will be
split equally between them, namely:
v + c( I )
v − p = p − c( I ) ⇔ p =
2
Recall that v – p is the buyer’s ex post surplus (i.e. his gain over and above
his second-best alternative, which is in this case zero), while p – c(I) is the
seller’s ex post surplus. Note that the cost of investment I is not relevant as
far as the division of the ex post surplus is concerned because this
investment has already been sunk when the two parties bargain.
Now at date 1 the supplier chooses how much to invest. When making this
decision he anticipates what will happen in period 2, that is, he anticipates
that p = [v + c(I)]/2. He chooses I to maximise his net profit, which is
equal to the ex post surplus minus the cost of investment:
v + c( I )
p − c( I ) − I = − c( I ) − I
2
The first-order condition is – c’(I) = 2, and this implicitly defines the
privately optimal level of investment Ip. Is this level of investment efficient?
The efficient level of investment is the value of I that maximises the joint
net profit v – c(I) – I. In other words it is the value of I that maximises the
‘pie’ net of the cost of investment. You can also think of it as the value of I
that would be chosen if the supplier and the buyer merged into a single
entity. The first-order condition is –c’(I) = 1 and this defines the efficient
13
level of investment I*. Since c’’(I) > 0 (i.e. the cost function is strictly
convex) we have Ip < I* (see Figure 1.2). The supplier invests less than
what is required for efficiency.
slope: –2
slope: –1
c (I)
Ip I* I
Figure 1.2
The intuition is simple. Since the ex post surplus is divided between the two
parties, the investing party does not capture all the cost savings from its
investment. This ‘distortion’ of incentives leads to underinvestment. The
model can also be refined to analyse the effect of the degree of investment
specificity on the level of ex ante investment. It turns out that the level of
investment is lower the higher the degree of specificity. Thus the higher the
degree of specificity, the bigger is the incentive for the firms to merge if a
contractual solution is not feasible. (Actually in our example a contractual
solution is feasible, but in more general settings it would not be.)
The above analysis has left some questions unanswered, however. Exactly
why does integration solve or reduce the hold-up problem (i.e. exactly
what changes when two firms merge?). And why then don’t firms always
merge (i.e. why are there limits to integration?).
Property rights
Hart and others have pointed out that, given that contracts are incomplete,
one thing that greatly matters in a relationship is which party has the right
to make decisions in the case of unspecified contingencies. Obviously, it is
the owner of the physical asset(s) who has this right, the ‘residual right of
control’. According to this view, a firm is seen as a collection of physical
assets that belong to it: machines, inventories, buildings, client lists, patents,
cash, etc. – excluding human capital. ‘Ownership’ is defined as the right to
specify all usages of these assets in any way not inconsistent with a previous
contract, custom or law. Note that the possession of residual rights of control
does not rule out ex post renegotiation. What it does is determine the ‘status
quo point’ in the bargaining process, in other words it puts the party that 7
Hart and Moore (1990), in their
has these rights in a better bargaining position. In this way it affects the Introduction, discuss a similar
division of the surplus ex post and therefore also influences the level of example with one asset and three
investment ex ante.7 agents which illustrates many of
Several conclusions have emerged from the property rights approach. the main ideas and results in the
Consider the case of two owner-managed firms that enter into a long-run property rights approach. Tirole
relationship and must both make a relation-specific investment. Then: (1988), pp.29–34, and Hart
(1995), Chapters 2–4, provide a
• Integration reduces opportunistic behaviour because if, say, firm A
more formal treatment as well as
acquires firm B, then the manager of firm B loses control of the
rich informal discussion.
physical assets of firm B, so he has much less bargaining power.
14
• A party is more likely to own an asset if it has a large investment to

make. In other words, efficiency requires that the residual rights of
control rest with the party whose ex ante investment has the larger
effect on the profits of both parties.
• Efficiency requires that highly complementary assets are under
common ownership. On the other hand, independent assets should be
separately owned: there are limits to integration. Why? If firm C
acquires firm D, say, then the manager of firm D will have much lower
incentives to undertake investments since the payoff from these will
be partly appropriated by the owner of firm C. So if assets are
independent, the costs of integration (in terms of underinvestment)
will be higher than any potential benefits.
You should also bear in mind some qualifications. First, the above
conclusions apply more directly to the case of owner-managed firms.
Things are more complicated when there is separation of ownership from
control and delegation of authority within firms, although the general
framework should still be valid. Second, another way of solving the
problem of opportunism may be for firms to try to build a reputation for
non-opportunistic behaviour when they interact repeatedly with each other.
However, this would not necessarily work because the payoff from
behaving opportunistically might be bigger than the payoff from adhering
to non-opportunistic behaviour.8
8
This point will become clearer
when you have studied the
Lowering transaction costs and opportunistic behaviour is not the only
material on repeated interaction
reason for vertical integration (i.e. integration between a supplier and a
in Chapter 4 of this guide.
buyer). As we will see in later chapters of this guide, a firm may also
vertically integrate to eliminate negative externalities that arise in
buyer–seller relationships in the absence of relation-specific investments, or
to price-discriminate, or to increase its market power by hindering the
access of rival non-integrated firms to outlets or sources of supply.
Empirical evidence
Much of the empirical work on the determinants of firm size and structure
that has followed the transaction costs approach has focused on the role of
investment specificity for vertical integration.9 Two examples are discussed
9
Other studies have focused on
below. Lafontaine and Slade (2007) provide a survey of the empirical the related issue of the role of
literature on the boundaries of the firm. investment specificity for the type
and duration of contracts signed
Klein, Crawford and Alchian (1978) describe the story of the 1926 merger
between firms. Joskow (1987) is
between General Motors (GM) and Fisher Body. In 1919 GM, a US car
a good example.
manufacturer, entered a 10-year contract with Fisher Body for the supply of
car bodies. To minimise the scope for opportunistic behaviour the contract
specified that GM should buy all their closed car bodies from Fisher and
also specified the trading price with the additional provision that this price
could not be greater than the average market price of similar bodies
produced by firms other than Fisher.
However, demand conditions changed dramatically after 1919: there was
a large increase in demand for cars, especially cars with closed bodies –
the type manufactured by Fisher. GM thought that Fisher’s cost had gone
down because of scale economies in the production of bodies and were
unhappy with the price they had to pay for Fisher bodies. Also, Fisher
refused to locate their plants close to GM plants – a move which GM
thought would increase production efficiency but which would diminish 10
This is the prevailing view on
the bargaining power of Fisher. These tensions ended in 1926, when GM the GM–Fisher merger. See,
acquired Fisher.10 however, Activity 3 below.
15
Monteverde and Teece (1982) have examined why firms in the automobile
industry produce some components in-house while they buy others from
independent suppliers. One of their main hypotheses was that car
manufacturers will vertically integrate when the production process for
components generates transaction-specific know-how. That is so because it
is then more difficult for them to switch to other suppliers, so there is more
scope for opportunistic behaviour by suppliers.
Monteverde and Teece tested this hypothesis econometrically using data on
127 different components used by two big US car manufacturers. The
dependent variable in their regressions was a binary variable for in-house
production versus production by an external supplier. Their independent
variables included the cost of developing a component (a proxy for the
know-how generated in the production of a component), a dummy variable
for firm-specific components versus generic components, a firm dummy to
control for company effects, and other variables. Their results confirmed
the predictions of the transaction costs approach:
• The higher the development cost of a component, the more likely that
production was in-house.
• Firm-specific components were more likely to be produced in-house
than generic components.
Activities
1. Consider the model of a vertical relationship between a buyer and a seller
analysed above. We have seen that when the supplier can invest in period 1 to
reduce the production cost c, he chooses a level of investment which is not
efficient. Could a contract between the parties restore the efficient outcome?
When should this contract be signed and what should it specify? Assume that a
contract which directly specifies the level of investment that the supplier is to
undertake is not feasible because investment levels, although observable by the
parties, are not verifiable in a Court.
2. During the 1980s and 1990s, there was a trend towards de-integration across
many industries as well as a trend towards more flexible technologies. Could the
two be related and in what way?
3. The Klein, Crawford and Alchian (1978) interpretation of the 1926 merger
between General Motors and Fisher Body has been criticised by some
economists, including the Nobel prize winner Ronald Coase, who have argued
that the reason for the merger had nothing to do with opportunistic behaviour
and hold-up problems. This debate is not just about a particular event in
economic history. It is about one of the most frequently cited examples of market
failure. If the critics are right, then market failure in vertical relations between
firms may be less prevalent than the theory would lead us to believe.
What do you think? Make up your own mind after reading different views on the
GM–Fisher Body case. A good collection of articles – representing the different
views and including contributions by some of the protagonists of the debate –
has been published in the April 2000 issue of the Journal of Law and Economics.
You can also search the internet for more.
16
A reminder of your learning outcomes

• describe and evaluate two different approaches to explaining the size
and structure of firms
• explain the notions of ‘transaction costs’, ‘investment specificity’,
‘opportunistic behaviour’, ‘incomplete contracts’ and ‘residual rights of
control’ and their relevance for the theory of the firm
• analyse two different types of inefficiency that can arise in the context
of long-run relationships between firms
• explain the effect of investment specificity on the decision of firms to
enter into contractual relationships or to integrate.
Sample examination questions

1. Consider the following model of a vertical relationship between a
buyer and a seller. There are two periods and the two parties can, if
they wish, trade one unit of an indivisible good in period 2. Let v
denote the value of the good to the buyer, c the production cost, and p
the trading price. Assume that c < 1/2. Both c and v are commonly
known at the beginning of period 2. The seller can invest in period 1
to increase the value of the good to the buyer (for instance, he can
spend on R&D to increase the quality of the product). In particular,
v(I) = 3I – I2/2. The level of investment I cannot be specified in a
contract because it is not verifiable and therefore such a contract
would not be enforceable in Court.
a. What is the efficient level of investment?
b. In the absence of any contract, what is the level of investment
chosen by the seller if the ex post surplus is to be divided equally
between the two parties? Explain why this level is not efficient.
c. Suppose that the parties sign a contract which gives to the seller
the right to choose the trading price in period 2 (i.e. after the
investment has been made). What will be the level of I chosen by
the seller?
d. Now suppose that the parties sign a contract which gives to the
buyer the right to choose the trading price in period 2. What will
be the level of I chosen by the seller? What is your conclusion
about who should have the power to decide the price in period 2?
Explain the intuition for your results.
2. Analyse how investment specificity affects the ex ante incentives for
investment when there is ex post bargaining over the surplus. Then
explain how investment specificity and the incompleteness of contracts
may affect the decision of a firm to vertically integrate and discuss
briefly any relevant empirical evidence.
17
Chapter 2: Separation of ownership and control
Chapter 2: Separation of ownership and

control
Learning objectives
• explain the implications of the separation of ownership and control in
modern large companies
• analyse optimal incentive mechanisms offered by the owners of a firm
to the firm’s manager
• describe different mechanisms that may restrict managerial discretion
and discuss their limitations
• assess the validity of the profit-maximisation hypothesis.
Essential reading
Chapter 3.
Tirole, J. The Theory of Industrial Organization. Introductory chapter.
Further reading
Books
Holmstrom, B.R. and J. Tirole ‘The Theory of the Firm’, in Schmalensee, R.
(Amsterdam: North–Holland, 1989).
Journals
Abowd, J.M. and D.S. Kaplan ‘Executive Compensation: Six Questions that
Need Answering’, Journal of Economic Perspectives (1999) 13(4),
pp.145–168.
Nickell, S. ‘Competition and Corporate Performance’, Journal of Political
Economy (1996) 104(4), pp.724–746.
Nickell, S., D. Nicolitsas and N. Dryden ‘What Makes Firms Perform Well?’,
European Economic Review (1996) 41, pp.783–796.
Symeonidis, G. ‘The Effect of Competition on Wages and Productivity:
Evidence from the UK’, Review of Economics and Statistics (2008) 90,
pp.134–146.
Introduction
A common assumption in most economic theory is that firms maximise
(expected) profits. This is probably what the owners of a firm would like to
do. However, in modern large companies, it is not the shareholders who
run the firm, but the managers, who are likely to have other objectives than
profit maximisation.
This separation of ownership and control gives rise to several important
issues. First, given that the owners typically have less information than the
managers and cannot perfectly monitor the behaviour of the latter, how can
they design incentive schemes that induce the managers to behave as much
19
as possible according to their (the owners’) interests? Second, given that such
contracts are generally not perfect solutions to the problem of managerial
discretion, what other mechanisms are there that may limit the ability of
managers to pursue their own objectives rather than those of the owners?
Third, is profit maximisation a reasonable description of firm behaviour?
Managerial incentives
An obvious way for the owners to restrict managerial discretion is to offer
monetary or other incentives to managers. Some important insights on the
use of incentives can be drawn from a simple model of a firm run by a
single manager.1 The profit of the firm can take one of two values, Π1 and 1
Π2, with Π1 < Π2. The manager chooses between two levels of effort, high pp.36–39.
and low (for simplicity: zero). His utility is U = u(w – Φ) if he makes high
effort and U = u(w) if he makes zero effort, where u is an increasing and
strictly concave function, w is the manager’s wage, and Φ > 0 is the
monetary disutility of high effort. Note that the strict concavity of u implies
that the manager is risk averse.2 Whether the firm makes Π1 or Π2 depends The strict concavity of u implies
2
on the manager’s effort as well as on the firm’s environment, which is that u’’(w) < 0.
uncertain. In particular, if the manager makes high effort, the profit is Π2
with probability x and Π1 with probability 1 – x. If the manager makes no
effort, the profit is Π2 with probability y and Π1 with probability 1 – y. We
have 0 < y < x < 1.
Now consider the following set-up. First, the owners of the firm choose a
contract (an incentive scheme) for the manager. At this stage, they do not yet
know what the profit of the firm will turn out to be. The contract therefore
specifies the wage of the manager for each of the two possible values of Π.
The objective of the owners is to maximise expected net profit E(Π – w).
Note that this objective function implies that the owners are risk neutral.
Given the incentive scheme chosen by the owners, the manager decides
whether to accept the job or not and, if he accepts, chooses the level of
effort that maximises his expected utility E(U). We assume that he can
always obtain a reservation wage w0, and hence utility U0 = u(w0), by
working outside the firm, so he will never accept to work for the firm if his
expected utility from doing so is less than U0. After the manager has made
his choice, the profit is observed and the manager gets paid. The question
is what incentive scheme the owners should choose to maximise E(Π – w).
If the owners could observe the manager’s effort level, there would be no need
for an incentive mechanism, since the owners could then impose an effort
level on the manager.3 All that they would need to do is ensure that the 3
The contract would provide for
manager accepts the job. This implies ensuring that the manager obtains a severe punishment if the
utility exactly U0: any payment giving him a higher utility would be manager fails to exert the level of
unnecessary and would reduce the expected profit of the firm. If the owners effort prescribed.
wanted no effort, they should pay the manager the reservation wage w0
whatever the profit turned out to be. Faced with this contract, the manager
would accept the job and make zero effort. Net expected profit would be yΠ2
+ (1 – y)Π – w . If the owners wanted high effort, they should pay the
1 0
manager w0 + Φ whatever the profit. The manager would then accept the job
and make high effort. Net expected profit would be xΠ2 + (1 -– x)Π1 – (w0 +
Φ). Obviously, the owners would choose to impose high effort if and only if:
xΠ2 + (1 – x)Π1 – (w0 + Φ) > yΠ2 + (1 – y)Π1 -– w0 <=> (x – y)(Π2 – Π1)
> Φ.
Let us assume that this holds, so the owners would prefer high effort, if
effort were observable – otherwise the problem under unobservable effort
level would be trivial.
20
Activity
Prove that, if effort is observable, the owners offer w0 if they want no effort and w0 + Φ,
if they want high effort. Conclude that, if effort is observable, the risk averse party bears
no risk.
Answer
Solve the following trivial maximisation problem for the owners: choose w to maximise
E(Π – w) subject to the manager getting utility at least equal to U0. Since the manager
gets the same wage whatever the realisation of profit turns out to be, he bears no risk.
All the risk is borne by the owners (the risk neutral party).
The need for an incentive scheme arises when the effort level of the
manager cannot be observed by the owners and hence cannot be prescribed
in the contract. If they want to induce the manager to exert high effort, the
owners must reward the manager with a higher wage in the event that
profit turns out to be Π2 rather than Π1. More specifically, the owners must
design a wage structure wi(Πi), i = 1, 2, that maximises their expected net
profit:
x(Π – w ) + (1 – x)(Π – w )
2 2 1 1
subject to ensuring that the manager accepts the job and chooses to exert
high effort, that is subject to a ‘participation constraint’:
xu(w2 – Φ) + (1 – x)u(w1 – Φ) ≥ u(w0)
and an ‘incentive-compatibility constraint’:
xu(w2 – Φ) + (1 – x)u(w1 – Φ) ≥ yu(w2) + (1 – y)u(w1).
The first constraint says that, under the incentive scheme, the expected
utility of the manager if he exerts high effort is at least U0, so the manager
will accept the job. The second constraint says that the expected utility of
the manager if he makes high effort (the left-hand side of the inequality) is
at least as large as his expected utility if he makes zero effort (the right-
hand side of the inequality), so the manager chooses to make high effort.
It turns out that in this maximisation problem both constraints are satisfied
with equality. The incentive scheme chosen by the owners, if they want to
induce high effort, will have the following properties:
• the manager will be rewarded if profit is high: w2 > w1. This can be
derived from the incentive-compatibility constraint
• the expected wage xw2 + (1 – x)w1 will be higher than w0 + Φ, the
wage under observability of effort. This is a result of the concavity of
u. Hence, the owners’ net profit will be lower.
Note that if the owners want to induce no effort, all they need to do is offer
w0 whatever the profit; this will ensure that the manager participates and
chooses to make no effort. Net profit will be the same as under
observability of effort. What will the owners choose to do, offer a contract
that induces high effort or one that induces no effort? It depends on
whether their maximised net profit is higher under high effort or under
zero effort. We have assumed, of course, all along that (x – y)(Π2 – Π1) >
Φ, that is to say the owners would prefer high effort to zero effort, if effort
were observable. But this does not ensure that the same is true when effort
is unobservable, because unobservability reduces the owners’ net profit
under high effort but not under no effort. In other words, an additional
effect of unobservability is that the owners are more likely to tolerate
managerial slack.
21
Limits to managerial discretion

There are several other mechanisms, apart from direct monetary incentives
of the kind examined above, that can limit managerial discretion and
reduce slack. Some of the most important are as follows:
• The threat of takeovers. The idea is that if managers fail to
maximise profits, the stock market value of the firm will be lower, and
this will induce outsiders to take over the firm and replace the
managers. The effectiveness of this mechanism is reduced by the fact
that the collection of information on the firm by outsiders may be
costly, takeovers may be subject to free-rider problems, and managers
may resist takeovers. Takeovers may also have perverse incentive
effects, for instance they may cause managers to put too much
emphasis on short-term profits to the detriment of long-term profits.
• Reputation effects. Managers care for their careers and are eager
to acquire good reputations. This may reduce slack, and may even
cause managers to work too hard (i.e. harder than the socially optimal
level) early in their career.
• Supervision. Monitoring the managers’ (more generally, the
employees’) performance in order to obtain better information on
their ‘effort’ may be costly but feasible. The effectiveness of this
mechanism may be reduced by the difficulty of measuring individual
effort when team work is important, and also by the possibility of
collusion between supervisors and supervisees.
• Competition in the product market. The effects of product
market competition on managerial incentives can take several forms
and may sometimes be ambiguous.4 One idea is that if a firm does not 4
A review of the literature is
maximise profits, there is a higher probability that it will not be able given in Nickell (1996).
to compete with more efficient firms and will therefore go bankrupt.
Managers wishing to avoid this will work hard to maximise profits.
• Organisational form. The internal organisation of a firm can help
mitigate managerial slack, especially by lower managers. The ‘unitary
form’ firm allows greater specialisation of labour, but supervision by
the top management becomes more difficult as the firm grows. In the
‘multi-divisional form’ firm, on the other hand, it is possible for the
top management to measure the performance of the different divisions
within the firm and compare them with one another. One reason for
the gradual decline of the U-form and the emergence of the M-form
may have been the need to limit managerial discretion.
Empirical evidence
Empirical work on the performance of firms (for instance, Nickell 1996,
Nickell et al. 1996) has looked at a number of factors external to the firm
that are associated with improved productivity growth in UK firms. Three
such factors have been identified: product market competition, financial
market pressure (i.e. a high level of debt) and shareholder control (i.e. the
existence of a dominant external shareholder from the financial sector).
Using industry-level data, Symeonidis (2008) has found clear evidence of a
negative effect of cartels on productivity. Other studies have established a
positive effect of trade liberalisation on the productivity of firms in various
countries.
22
The profit-maximisation hypothesis

Although there are many ways in which managerial discretion can be
restricted, none of them is perfect, so we should expect deviations from
profit maximisation due to the separation of ownership and control. In
addition, performing complex calculations is a time-consuming, effort-
demanding, and sometimes impossible task, especially under conditions of
uncertainty, so members of a firm may often follow simple ‘rules of thumb’.
Ultimately, the question is how significant any deviations from profit
maximisation are likely to be. If we accept, as many economists do, that
large deviations from profit maximisation will not allow a firm to survive in
the long run, then the hypothesis that firms maximise expected profits
seems a reasonable approximation of firm behaviour for most purposes,
and in particular for the analysis of the interaction between firms in the
market, which is the main focus of 99 Industrial economics.

• explain the implications of the separation of ownership and control in
modern large companies
• analyse optimal incentive mechanisms offered by the owners of a firm
to the firm’s manager
• describe different mechanisms that may restrict managerial discretion
and discuss their limitations
• assess the validity of the profit-maximisation hypothesis.

1. The profit of a firm can take one of two values, Π1 and Π2, where
Π2 – Π1 > 10. The firm is run by a manager who chooses between
two levels of effort, e = 1 (high) and e = 0 (low). The manager’s
utility function is U = w1/2 – e, where w is her wage. Whether the
firm makes Π1 or Π2 depends on the manager’s effort and on the
firm’s environment, which is uncertain. In particular, if the manager
makes high effort, the profit is Π2 with probability 0.8 and Π1 with
probability 0.2. If the manager makes no effort, the profit is Π2 with
probability 0.3 and Π1 with probability 0.7. Before the realisation of Π
is observed, the owners of the firm choose a contract for the manager
which specifies the value of w for each of the two possible values of
Π. The owners’ objective is to maximise expected net profit E(Π – w).
Given the incentive scheme chosen by the owners, the manager
decides whether to take the job and, if she accepts, chooses e to
maximise her expected utility E(U). Her reservation wage is w0 = 4.
After the manager has made her choice, the profit is observed and the
manager gets paid.
a. What is the optimal contract if the owners can observe the
manager’s effort?
b. What is the optimal contract if the owners cannot observe the
manager’s effort?
c. Show that the net profit of the owners is lower if the manager’s
effort is unobservable than if it is observable.
23
2. ‘An optimal incentive scheme offered by the owners of a firm to the

firm’s manager should reward the manager when profits are high and
penalise him when profits are low.’ Discuss this statement with
reference to an economic analysis of the relationship between the
owners and the manager that takes into account the fact that the
manager’s effort level may not be observable by the owners.
24
Chapter 3: Short-run price competition

Learning objectives
• describe and prove the Bertrand paradox
• analyse how the introduction of capacity constraints in the Bertrand
model leads to equilibrium outcomes with price greater than marginal
cost and positive profits
• explain the theoretical foundations of the Cournot model
• analyse the Cournot model for various assumptions regarding the
demand, the number of firms, and the cost structures.
Essential reading
Chapter 8.
Tirole, J. The Theory of Industrial Organization. Chapter 5.
Further reading
Books
Cabral, L. Introduction to Industrial Organization. (Cambridge, MA: MIT Press,
2000). Chapter 7.
Carlton, D.W. and J.M. Perloff Modern Industrial Organization. (Pearson
Addison Wesley, 2005) fourth edition. Chapter 6.
Martin, S. Industrial Economics. (Englewood Cliffs, NJ: Prentice Hall, 1994)
second edition. Chapter 5.
Shy, O. Industrial Organization. (Cambridge, MA: MIT Press, 1995). Chapter 6.
Introduction
This chapter begins our analysis of firms’ conduct in oligopolistic markets.
We will start with the simplest strategic situations. In particular, we will
assume that the only decision firms have to make is to set a price for their
product, or a level of output. In fact, of course, firms can use many
instruments to compete in a market, and subsequent chapters will analyse
several examples of more complex strategic situations. The main reason
why it makes sense to abstract from these additional considerations in this
chapter is that price is an instrument that firms can change relatively
easily in the short run. On the other hand, other instruments are more
difficult to change. These include product design, the level of capacity, an
advertising-based brand image, product quality or cost determined by
research and development (R&D), and so on; ultimately there is also the
decision of whether or not to enter or stay in a market. Since these long-
run decisions are relatively difficult to change, they are taken as given
when making shorter-term decisions. Thus we can proceed to analyse
short-run competition between firms in the context of fixed cost structures
and product characteristics, and with a fixed number of firms in the
market.
25
In this chapter we focus on static models of oligopoly: the firms interact

only once in the market and their actions are simultaneous. Repeated
interaction is the subject of the next chapter.
Throughout Part 2 of the guide, we will be using the theory of non-co-
operative games to model firms’ interaction. The equilibrium market
outcomes are therefore the equilibria of these games. To identify them, we
will be making use of some elementary solution concepts from non-co-
operative game theory: the Nash equilibrium and the subgame-perfect
equilibrium.1 1
See Tirole (1988), pp.423–432,
or Shy (1995), Chapter 2, for an
introduction to these game-
The basic Bertrand model
theoretic concepts and discussion
Consider a very simple set up as follows. There are two firms, 1 and 2, of applications.
producing a homogeneous product (the result easily generalises to N
firms). The two firms interact only once and they simultaneously and
independently set prices p1 and p2 respectively. The market demand for the
product is given by q = D(p), and both firms have the same constant
marginal cost c. The firm with the lowest price gets all the market demand
at that price; if the two prices are the same each firm gets half the market
demand at that price.
The Nash equilibrium outcome of this game is p1* = p2* = c. In other
words, firms price at marginal cost and make zero profit.
Activity
Prove this result.
Answer
The proof consists in distinguishing cases and showing that in all of them except the
case p1 = p2 = c there exists a profitable deviation by at least one firm. Read, for
example, Tirole (1988), p. 210.
The intuition is that unless prices are the same and equal to c, each firm
has an incentive to undercut the other. Note that there is a qualification to
this result for the case of asymmetric marginal costs: in that case, at
equilibrium the low-cost firm sets a price marginally lower than the cost of
the high-cost firm2 and makes positive profit. Still, this profit is small if the 2
Provided this is not higher than
cost difference is small, and the high-cost firm makes no sales and no the monopoly price
profit. The outcome of the simple Bertrand game has therefore justifiably corresponding to its own cost;
been called the ‘Bertrand paradox’. otherwise it sets the monopoly
price.
There are three resolutions to this paradox: repeated interaction, product
differentiation and capacity constraints.
Bertrand competition with capacity constraints

To understand why capacity constraints matter, take the simple model of
the previous section and assume that both firms have production capacity
smaller than D(c), that is to say no firm can cover the entire demand at a
price equal to the common marginal cost. Then p1 = p2 = c is no longer a
Nash equilibrium. Why? If firm i raises its price slightly above c, given that
pj = c, all consumers will want to buy from firm j; however, firm j will not
be able to satisfy the whole demand, so some consumers will end up
buying from firm i. Hence firm i will make positive profit instead of zero.
Since pi = c is not a profit-maximising response to pj = c, p1 = p2 = c is
not a Nash equilibrium.
26
The exact equilibrium outcome in the above model depends on what

specific assumption we make about the way consumers are rationed. In
general, however, models with capacity constraints have Nash equilibria
with price greater than marginal cost and positive profits. Note that rigid
capacity constraints are a special case of decreasing returns to scale (i.e. a
technology such that the marginal cost increases with output). Such models
also have equilibria with price greater than marginal cost.
We now look at a simple model to fix these ideas.3 An additional important
3
implication of this model is that, in certain cases, a game where capacity- pp.212–216.
constrained firms compete in prices is formally equivalent to a game where
firms set quantities and an auctioneer determines the market-clearing price.
Consider a market where two firms, 1 and 2, produce a homogeneous
product. Demand is q = D(p) =_1 – p, _or equivalently p = 1 – _q1 – q2. The
firms have capacity constraints q1 and q2, and we assume that qi < 1/3, i =
_
1, 2. The marginal cost of production is zero for q ≤ q and infinite for qi >
_ i i
qi. Finally, we assume that consumers are rationed according to the ‘efficient’
rationing rule. The rationing of consumers results from the fact that the low-
price firm cannot serve the entire market. The question then arises as to
which consumers end up buying from the high-price firm; this is important
because it determines the shape of the residual demand of the high-price
firm. For instance, suppose that firm 1 is the low-price firm. Then under the
_
efficient rationing rule, the residual demand of firm 2 is given by D(p ) – q
_ 2 1
if D(p2) > q1, and zero otherwise. This is illustrated in Figure 3.1, which
depicts both the market demand D(p) and the residual demand of firm 2
(note that with price p1 the low-price firm 1 sells up to capacity).
residual demand for firm 2
market demand
p1
_ q
q1
Figure 3.1
We will now show that the unique Nash equilibrium outcome of this game
_ _
is for both firms to set the price p* = 1 – q – q . At this price both firms
1 2
sell up to their respective capacities and the market clears. Note that this
price is higher than marginal cost (which is zero), and therefore implies
positive profits for both firms.
To show that this is a Nash equilibrium, we need to show that none of the
firms has an incentive to unilaterally deviate from this equilibrium. Is it
profitable for firm i to set a price lower than p*, given that _ firm j sets price
p*? The answer is no. By charging p* firm i sells exactly q . Now firm i
_ i
cannot produce more than qi anyway, so by reducing its price below p* it
would simply sell the same quantity at a lower price and would therefore
make less profit.
27
Is it profitable for firm i to set a price higher than p*, given that firm j sets
price p*? The answer is again no, but the argument now is slightly more
subtle. Suppose that firm i sets a price p ≥ p*. Then it has residual demand
_
1 – p – q , because at price p total market demand is given by 1 – p and
j _ _
firm j sells qj. Firm i makes profit Π = p(1 – p – qj ). Using the inverse_
demand function, the expression for profit can be written as (1 – q – qj )q,
where q is the quantity_ sold by firm i at price p. Note that the profit
function Π = (1 – q – qj )q is exactly the same as the profit function_ of a
firm that chooses output q given that the rival firm chooses output qj . This _
in q, that is Π″(q) < 0. Also,
_ _∂Π/∂q = 1 – 2q – qj.
profit function is concave
_
Evaluated at q_ = qi this
_ derivative is equal to 1 – 2qi – qj , which is positive
because both q and q are less than 1/3. In other words, if firm i starts from
_ i j
qi and reduces its quantity, its profit will fall.4 This is another way of saying 4
The concavity of the profit
that if firm i starts from p* and increases its price, its profit will fall. function ensures that any
_
We have therefore shown that it is not profitable for firm i either to set a reduction of q below q will
i
price lower than p* or to set a price higher than p*, given that firm j sets reduce profit.
price p*. Hence p1 = p2 = p* is the unique Nash equilibrium of the game.

There are two main conclusions of the above analysis. First, we have seen
how a static pricing game between symmetric firms can lead to Π > 0 if
there are capacity constraints. Second, everything is as if firms put
quantities equal to their capacities on the market and an auctioneer
determines the price that clears the market. The equilibrium of this game is
the Cournot equilibrium (see the analysis of the Cournot model below).
Choice of capacities
One issue which was swept under the carpet in the above discussion is the
choice of capacities.
_ We assumed that firms were capacity constrained, and
significantly so (qi < 1/3, i = 1, 2). But can’t firms build capacities that
would allow them to cut price down to marginal cost and supply the whole
market if they so choose? To examine this question, we would need to
construct a more complex game than the one we have analysed, namely a
two-stage game with choice of capacities in the first stage and price
competition in the second stage, when capacities are taken as fixed. Now
intuitively one would expect firms to strategically refrain from building too
much capacity because this would destroy their profits in the price
competition stage. This is exactly what the formal analysis of such games
predicts. In fact there is a much stronger result, due to Kreps and
Scheinkman: if demand is concave and the rationing rule is the efficient one,
then the outcome of this two-stage game is the same as the outcome of the
one-stage Cournot game (which involves Π > 0, as we will see below).
One difficulty in oligopoly theory has been that the widely used Cournot
model, which assumes that firms compete by setting quantities, may lack
strong foundations, since firms typically compete by setting prices, not
quantities. We have seen, however, that the Cournot model can be
interpreted in either of the following ways:
• as a one-stage pricing game between capacity-constrained firms
• as a reduced-form game for the two-stage game with choice of
capacities in the first stage and price setting in the second stage.
Of course, both these results rest on particular assumptions concerning the
rationing rule, so in more general settings we would not get equilibrium
outcomes that look exactly like the Cournot outcome. However, it is generally
valid to think of quantity competition as a choice of capacity or scale that
determines the firms’ cost function and hence the conditions of price
competition. It is therefore valid to interpret the distinction between price
28
competition (Bertrand) and quantity competition (Cournot) as a difference in

the flexibility of production: if costs rise steeply with output in the short run
in a particular industry, then the Cournot model is more appropriate for this
industry; if not, then the Bertrand model is more appropriate.
The Cournot model

Consider a model of competition between two firms, 1 and 2, producing a
homogeneous product. The inverse demand function has the general form
p = P(q1 + q2), where q1 and q2 are quantities produced by firm 1 and
firm 2 respectively and p is the market price. The demand curve is
downward sloping, so P’(q1 + q2) < 0. The total cost of firm i is given by
Ci(qi), i = 1, 2. The two firms meet only once and they simultaneously set
quantities.
The Nash equilibrium of this game is computed as follows. Firm 1 chooses
q1 to maximise its profit Π1 = q1P(q1 + q2) – C1(q1), taking q2 as given.
The first-order condition for this maximisation problem is:
∂ ∏1
= 0 ⇔ P(q1 + q2 ) − C1′(q1 ) + q1P′(q1 + q2 ) = 0
∂q1
This equation implicitly defines the optimal choice of q1 for any given level
of q . It is called the ‘reaction function’ of firm 1.
2
Similarly for firm 2. That is, it chooses q2 to maximise Π2 = q2P(q1 + q2) –
C2(q2), taking q1 as given. The first-order condition, or the reaction
function of firm 2, is:
∂ ∏2
= 0 ⇔ P ( q1 + q2 ) − C2′ ( q2 ) + q2 P′( q1 + q2 ) = 0
∂q 2
The Nash equilibrium is the solution of the system of the two first-order
conditions.
We can identify some interesting properties of this equilibrium just by
looking at the first order conditions:
• The price is greater than marginal cost, namely:
p – Ci’ = –qiP’(q1 + q2) > 0, i = 1, 2.
• The price is lower than the monopoly price. To see this note that the
first-order condition for a monopolist would be similar to the above
first-order conditions except that the third term would be
(q1 + q2)P’(q1 + q2). Hence the difference between price and
marginal cost would be greater under a monopolist.
• The first-order condition for firm i can be written as (p – Ci’)/p = si/ε,
where si = qi/(qi + qj) is the market share of firm i and ε is the
absolute value of the elasticity of demand: 1/ε = –(1/p)(q1 +
q2)[P’(q1 + q2)]. Thus the price-cost margin (p – C1’)/p (also called
the ‘Lerner index’) increases with the market share of firm i and
decreases with the elasticity of demand.
Activity
Derive the result (p – C1’)/p = s1/ε from the first-order condition for firm 1.
Answer
Straightforward algebraic manipulations yield the result.
29
To derive the equilibrium explicitly, let us further assume a linear demand

function q = a – p and constant marginal costs c1, c2. Then:
∂ ∏1 a − q2 − c1
= a − 2q1 − q2 − c1 = 0 ⇔ q1 = R1 ( q2 ) =
∂q1 2
and:
∂ ∏2 a − q1 − c2
= a − 2q2 − q1 − c2 = 0 ⇔ q2 = R2 (q1 ) =
∂q2 2
The functions R1 and R2 are the reaction functions of firm 1 and firm 2
respectively. Solving the system of the two equations we obtain the
equilibrium quantities:
a − 2c1 + c2 a − 2c2 + c1
q1* = q2 * =
3 3
Thus a firm’s output decreases with own marginal cost and increases with
rival marginal cost: the more efficient a firm the higher its market share. A
firm’s output also increases in the exogenous demand shift parameter a. It
can be checked that the same is true for the equilibrium profits. These are
positive even when the firms are symmetric (c1 = c2), a result which is in
sharp contrast with the Bertrand model.
Activity
Derive the equilibrium profits.
Answer
1 2
Substitute q1* and q2* into the profit functions Π = q1(p – c1) and Π = q2(p – c2) and
1
use the inverse demand function p = a – q1 – q2. You should obtain Π * = (a – 2c1 +
c2)2/9, Π2* = (a – 2c2 + c1)2/9.
The analysis proceeds along similar lines when the number of firms is
greater than two. An interesting property of the Cournot model with N
firms is that, under certain conditions regarding demand and costs, total
industry profits increase as concentration in an industry rises.5 This may be
5
See Tirole (1988), pp.218–223.
taken as one justification for the view that higher concentration increases
prices and profits because firms have more market power. However, bear in
mind that concentration is itself endogenous, and that both concentration
and profitability are ultimately determined by basic industry characteristics,
such as technology and demand. As discussed in Chapter 9 of this guide, a
positive association between the two need not imply a causal link or may
not exist at all once the endogeneity of concentration is taken into account.
Because profits are higher under quantity-setting (Cournot) than under
price-setting (Bertrand), the two models are often interpreted as
representing different degrees of competition. This interpretation is fine for
games where firms do not make any long-run decisions, except perhaps the
decision to enter or not the market. It is not appropriate when firms make
long-run choices such as investment, advertising, R&D, etc. before setting
prices or quantities.6 6
The reason will become clear
when you have read Chapter 5 of
Activities this guide.
1. Consider the model of price competition with capacity-constrained firms analysed

above. Assume, however, that one of_ the firms, say firm 1, has capacity higher
than 1/3. In particular _ that q1 = 2/5. Under what condition is
_ assume
p1 = p2 = p* = 1 – q1 – q2 still the unique Nash equilibrium of the game?
30
2. Consider a market where N symmetric firms produce a homogeneous product

and compete by simultaneously setting quantities. The inverse demand function
is given by p = a – Q, where Q is total quantity produced, that is
Q = q1 + q2 + … + qN. The marginal cost is constant and equal to c for all firms.
a. Derive the Cournot-Nash equilibrium. (Hint: After deriving the first order
condition for firm i, use the symmetry of the model to significantly simplify
the computations.)
b. Derive the equilibrium price, profit for firm i and industry profit, and show
that all three are decreasing in the number of firms N.
3. One way to test the predictions of oligopoly models is to conduct laboratory
experiments. Of course, the conditions in the laboratory are very different from
the conditions that firms face in the real world. For one thing, players in
laboratory experiments are not very experienced and the stakes are much lower.
Nevertheless, there is a large literature on laboratory experiments in industrial
economics. What have we learned from it? Do agents behave as economic theory
predicts? A useful reference is the survey by C.A. Holt, ‘Industrial Organization: A
Survey of Laboratory Research’, published in Kagel, J. and A. Roth (eds),
Handbook of Experimental Economics (Princeton University Press, 1995). It is
also available online at: http://people.virginia.edu/~cah2k/iosurvtr.pdf
Another useful reference is the January 2000 special issue of the International
Journal of Industrial Organization on ‘Experimental Economics and Industrial
Organization’. Both these references cover a range of topics, from simple static
games to more complicated dynamic games with commitment, product
differentiation, asymmetric information, and so on.

• describe and prove the Bertrand paradox
• analyse how the introduction of capacity constraints in the Bertrand
model leads to equilibrium outcomes with price greater than marginal
cost and positive profits
• explain the theoretical foundations of the Cournot model
• analyse the Cournot model for various assumptions regarding the
demand, the number of firms, and the cost structures.

1. a. Describe and prove the Bertrand paradox.
b. Consider a market with two price-setting firms producing a
homogeneous product. The demand function is q = D(p) = 1 – p,
which implies the inverse _demand _ p=1–q _1 – q_2. The two firms
have capacity constraints q1 and q2 , where q_1 + q2 = 3/5. The
marginal cost of production is zero for qi ≤ qi and infinite for
_
qi > qi . Finally, assume that consumers are rationed according to
the efficient rationing rule.
_ _
i. Show that if q1 = q2 , there is a unique _Bertrand-Nash
_
equilibrium where p1 = p2 = p* = 1 – q1 – q2
_ _
ii. Show that when q1 = q2 , the equilibrium under part (i) breaks
down when the firms’ capacities are too dissimilar.
31
2. a. Consider a market with two quantity-setting firms producing a

homogeneous product. The inverse demand function is given by
p = 1 – q – q and the two firms have constant marginal costs c
1 2 1
and c2 such that c1 + c2 = 2c, where c is a constant.
i. Compute the Cournot-Nash equilibrium.
ii. Show that as the two firms become more asymmetric (i.e. ci
moves away from c), total industry profit increases.
iii. Compute an index of concentration in this market and show
that it increases as the two firms become more asymmetric.
b. A researcher has estimated a model of industry profitability using
cross-industry data and has found a positive coefficient on the
concentration variable. He claims that the results show that higher
concentration leads to higher industry profit. What is the
theoretical basis for this claim? Do you agree with this conclusion?
What would your advice be to a policy-maker worried about the
high level of concentration in many industries?
32
Chapter 4: Dynamic price competition

Learning objectives
• explain how firms that act non-co-operatively can collude
• use simple models of repeated games to discuss factors that facilitate
or hinder the stability of collusion and interpret any relevant empirical
findings
• describe and evaluate different theories of price wars
• describe and evaluate an econometric methodology for measuring
market power in any particular industry.
Essential reading
Books
Chapters 10 and 12.
Journal article
Porter, R.H. ‘A Study of Cartel Stability: The Joint Executive Committee,
1880–1886’, Bell Journal of Economics (1983) 14(2), pp.301–314.
Further reading
Books
Bresnahan, T.F. ‘Empirical Studies of Industries with Market Power’, in
Schmalensee, R. and R. Willig (eds) Handbook of Industrial Organization,
volume 2. (Amsterdam: North-Holland, 1989).
2000). Chapter 8.
Addison Wesley, 2005). Chapters 5–6.
Jacquemin, A. and M.E. Slade ‘Cartels, Collusion, and Horizontal Merger’, in
Martin, S. Industrial Economics. (Englewood Cliffs, NJ: Prentice Hall, 1994).
Chapter 6.
Scherer, F.M. and D. Ross Industrial Market Structure and Economic
Performance. (Boston: Houghton Mifflin, 1990). Chapters 7–8.
Symeonidis, G. The Effects of Competition. (Cambridge, MA: MIT Press, 2002).
Journals
Ellison, G. ‘Theories of Cartel Stability and the Joint Executive Committee’,
Rand Journal of Economics (1994) 25(1), pp.37–57.
Fershtman, C. and A. Pakes ‘A Dynamic Oligopoly with Collusion and Price
Wars’, Rand Journal of Economics (2000) 31(2), pp.207–235.
33
Levenstein, M.C. ‘Price Wars and the Stability of Collusion: A Study of the Pre-
World War I Bromine Industry’, Journal of Industrial Economics (1997)
45(2), pp.117–137.
Levenstein, M.C. and V.Y. Suslow ‘What Determines Cartel Success?’, Journal
of Economic Literature (2006) 44(1), pp.43–95.
Slade, M. ‘Strategic Pricing Models and Interpretation of Price-War Data’,
European Economic Review (1990) 34, pp.524–537.
Symeonidis, G. ‘In Which Industries Is Collusion More Likely? Evidence from
the UK’, Journal of Industrial Economics (2003) 51(1), pp.45–74.
Introduction
Attempts by firms to establish arrangements between themselves with a
view to increasing prices and profits are a recurrent theme in business
history and a matter of great concern for public policy. Such behaviour is
generally referred to as collusion and can be either explicit or tacit. It is
illegal under most competition laws, including US and EU law. Collusive
behaviour poses a whole range of questions. Are such arrangements stable?
Under what conditions is collusion more likely to occur? When do price
wars occur and why? How can economists help in identifying the existence
of collusion in particular industries?
In the first part of this chapter, we will examine models where a given set
of firms interact repeatedly for a finite or infinite number of periods. As
mentioned in the previous chapter, repeated interaction is one of the
resolutions to the Bertrand paradox. In particular, this approach is very
useful in explaining how firms can set prices at a higher level than the
static Bertrand or even Cournot prices, even though they behave non-co-
operatively (i.e. they do not sign any binding agreements). In the second
part of the chapter, we will discuss an econometric methodology which can
be used – with variations, depending on the kind of data available and the
type of industry in question – to measure the degree of market power of
firms and detect collusive behaviour in any given industry.
Modelling collusion
Firms that collude have generally three problems to solve. They must co-
1
We focus here on behaviour to
ordinate on a price or a set of prices.1 They must ensure that collusion is
increase prices, or restrict
enforceable (i.e. that none of the parties has an incentive to cheat). And
quantities sold. Of course, firms
they must sustain high profits against entry by other firms. Economic
can also collude in other ways,
theory has focused much more on the second of these issues than on the
(e.g. by regulating capacity
other two.2 There are several ways of modelling collusion using formal
expansion or by allocating
games where firms interact repeatedly. All of them are formalisations of the
territories). Such arrangements
basic idea that firms may be able to sustain collusion by threatening to
seem, however, to be less
retaliate in future periods in the event of a price cut today. You should see
frequent than collusion in price.
these approaches as complementary, since there seems to be a variety of
patterns of oligopoly behaviour in practice. 2
Scherer and Ross (1990) and
Church and Ware (2000) discuss
The simplest, and probably the most popular, approach is the one which is
the co-ordination issue.
based on the theory of repeated games with complete information.3 Recall
the one-shot Bertrand game of the previous chapter: two firms that produce 3
Tirole (1988), pp.253–261,
a homogeneous product and have the same constant marginal cost c presents a not-too-technical
simultaneously set prices. We have seen that the Nash equilibrium involved discussion of alternative
zero profit for both firms. Now suppose that this game is repeated T times, approaches.
where T is finite or infinite, with the outcomes of all preceding plays being
observed by both firms before the next play begins. The resulting game is a
‘repeated game’. At each period the firms choose their prices
simultaneously. Each firm seeks to maximise the present discounted value
of its payoffs from the T stage games.
34
What is the subgame-perfect equilibrium of this repeated game? Two cases

should be distinguished. If T is finite, then the unique subgame-perfect
equilibrium is for the firms to set p = p = c in every period.4 If, on the
4
See Tirole (1988), p. 432.
1 2
other hand, T is infinite, then playing p1 = p2 = c in every period is one,
but is not the unique, subgame-perfect equilibrium. In particular, consider
the following symmetric ‘trigger’ strategies:
M
• each firm sets the monopoly price p in the first period (period 0).
M
Then it sets p in period t if in every period preceding period t both
firms have charged pM; otherwise it sets p = c forever.
These strategies constitute a subgame-perfect equilibrium of the repeated
game if the discount factor δ that firms apply to future profits is high
enough, in particular if δ ≥ 1/2.5 5
δ lies between 0 and 1. δ close
to 1 means that firms care a lot
To prove this result, we start by showing that these strategies constitute a
about future profits and/or that
Nash equilibrium. Suppose firm j adopts the above trigger strategy. We
they interact frequently. A third
need to show that it is a best response for firm i to adopt this strategy as
interpretation of δ allows for the
well. Take the first period. If it adopts the trigger strategy, then co-
fact that the infinite horizon
operation never breaks down, so firm i makes at each period half the
assumption need not be taken
monopoly profit ΠM/2 (assuming that the firms share ΠM equally). The
literally. All that is needed is
present discounted value of its payoffs is:
some positive probability at each
∞
∏M ∏M
∑t =0
δ t ( ∏ M 2) =
2
(1 + δ + δ 2 + L) =
2(1 − δ )
. period that the firms will interact
again next period; the higher this
probability, the higher the value
If, on the other hand, the firm ‘defects’ in period 0, it gets maximum profit
M of δ.
Π in that period (less an arbitrarily small amount ε). Note that when firm
i defects it seeks to maximise its profit for that period given that firm j sets
the collusive price; hence firm i will set a price marginally below pM and
will get the whole market. The firm gets zero profit thereafter, since co-
operation breaks down forever from the next period onwards. The present
discounted value of its payoffs is simply ΠM. Firm i will adopt the trigger
strategy if the present discounted value of its profits is higher when
adopting the trigger strategy than when deviating, namely if:
∏M
≥ ∏ M ⇔ δ ≥ 1 / 2.
2(1 − δ )
The same argument can be made for every period in which all the
M M
preceding outcomes have been (p , p ). Finally, we also need to show that
if firm i finds itself in a period where all the preceding outcomes have not
been (pM, pM), its best response is to set pi = c forever. This is so because
firm j will also set pj = c forever.
We have shown that the trigger strategies form a Nash equilibrium of the
game. To show it is also subgame-perfect, we need to show that it is a Nash
equilibrium in every subgame of the game. This is so, since every subgame
of this infinitely repeated game is identical to the game as a whole.
Thus collusion can be sustained in an infinitely repeated game if firms play
trigger strategies. Note that there are many equilibria of the game just
M M
analysed. Replace p with any price between c and p . Then the trigger
strategies constitute a subgame-perfect equilibrium for δ ≥ 1/2. This is part
of a general result, which is referred to as the ‘Folk theorem’. For the game
analysed above, the Folk theorem says that there exist strategies that form
a subgame-perfect equilibrium such that firm i makes average per period
payoff Πi where Πi ≥ 0 (so the strategies are individually rational) and
Πi + Πj ≤ ΠM (so the strategies are feasible), for δ sufficiently close to 1. In
other words, anything between the static Bertrand profit (Πi = 0) and the
monopoly profit (Πi = ΠM) can be an average per period payoff for firm i.
These results can be generalised to N firms.
35
Activity
Consider a game similar to the one analysed above, but with N, rather than with two,
firms. Show that the specified trigger strategies constitute a subgame-perfect equilibrium
for δ ≥ 1 – 1/N.
Answer
M
Note that the per period payoff of each firm under collusion is Π /N. Then apply the
same argument as for the two-firm case.
Several points should be emphasised with respect to the above analysis.

• The game has an infinite number of equilibria. Collusion is
sustainable, but not necessary, and its ‘degree’ can vary. This theory is
silent as to how firms co-ordinate or which equilibrium will be chosen.
• Although the trigger strategies specified above may seem too harsh in
the sense that punishments last forever, similar results are obtained for
strategies that involve punishments that last only for a finite number
of periods, after which firms revert to collusion.
• An objection to the above model is that firms will have an incentive to
renegotiate the agreement once a defection occurs so as to avoid
punishment. But if they can do this, they will not be able to sustain
collusion in the first place. The response to this objection has been to
construct more complicated models of repeated games which have the
property that collusion is sustainable even if renegotiation is feasible.
• In the game we discussed, if firms play the trigger strategies, then
deviations do not occur along the equilibrium path. In other words,
this analysis explains collusion, but not price wars. Price wars can
nevertheless occur in more complicated models of repeated games.
Can this analysis provide any insights as to the factors that facilitate or
hinder collusion? We have seen that collusion is feasible if the discount
factor δ is at least as high as a certain critical value. This was equal to 1/2
in the above example with two firms, but in more general settings it will
depend on various structural characteristics of the industry in question. The
higher this critical value, the smaller is the range of δ’s for which collusion
is feasible, and hence the less likely is collusion to occur. To see how this
6
See Tirole (1988), pp.247–251,
works, consider the following application.6
for more examples.
Suppose that in our two-firm model it takes two periods, rather than one,
to react to a defection. Then the present discounted value of the gain from
co-operation is still ΠM/2(1 – δ), but the present discounted value of the
gain from defection is ΠM + δΠM because the firm that defects can make
the monopoly profit for two periods before punishment begins. Collusion is
sustainable if ΠM/2(1 – δ) ≥ ΠM + δΠM <=> δ ≥ 1/21/2. Note that the
critical value of δ is now higher. In other words, for values of δ between
1/2 and 1/21/2 collusion is not sustainable when the reaction lag is two
periods, although it is sustainable when the reaction lag is one period.
There seems in fact to be some evidence that collusion is more difficult in
industries where firms observe the prices set by their rivals with a
considerable time lag, as when manufacturers sell through specific deals
with a small number of large buyers. Also, there is evidence that firms
rarely collude on ‘long-run’ variables like capacity or R&D. Because these
long-term decisions take time to implement, reaction to rivals’ behaviour is
slower than in the case of price. In both these instances, then, we observe
that retaliation lags hinder collusion. This is consistent with the predictions
of repeated game theory.
36
The theory of repeated games has provided an explanation for some of the
‘stylised facts’ regarding collusion. Other facts, however, have proved more
difficult to explain. For instance, collusion occurs more often in capital-
intensive and in homogeneous good industries than in labour-intensive or
differentiated good industries. You should bear in mind that the theory of
repeated games focuses on the enforcement of collusion. This theory
predicts that enforcement is easier under certain circumstances: when there
is low uncertainty about demand, when monitoring of rivals is easy, when
there is multimarket contact between firms, and so on. However, being able
to establish a collusive agreement and to sustain profits in the face of
potential entry are also necessary for successful collusion in practice. Thus
co-ordination is easier when there are few firms in the industry, the product
is homogeneous, product characteristics, costs and demand are stable over
time, and there are no big cost or size differences between firms. Avoiding
entry is easier in industries with high capital intensity and high entry costs.
Symeonidis (2003) provides an empirical analysis of industry
characteristics that facilitate collusion using data from the UK.
Firms can also take steps to facilitate collusion. These are called ‘facilitating
practices’ and include things such as giving advance notice of a price
change, exchanging information on prices and costs, meeting-competition
clauses (‘We will meet any price that a rival charges’) and most-favoured-
customer clauses (‘We will offer to all our customers the lowest price we
offer to any customer’).
Since collusion is illegal under most competition laws, it must be thought
to reduce social welfare. This is obvious when entry is restricted and the
only choice variable firms have is price, or output. It is less obvious when
entry is free, and especially when firms also make long-run decisions on
things such as product quality or product variety and cannot collude on
these long-run decisions as they can collude on price. Fershtman and Pakes
(2000) and others have shown that product quality and variety can
increase under price collusion, and the benefits for consumers may even
compensate for the negative effect of collusive prices. Symeonidis (2002)
presents evidence that, under free entry, cartels do not raise firms’ profits
but result in excessive entry of firms into the collusive industries.
Price wars: theories and evidence

There are several theories of how and why price wars occur. They should
be seen as complementary because each seems to be relevant for some
industries and not for others. We briefly discuss three theories.
In the Green–Porter model of price wars, there is uncertainty about the
level of demand at the time when firms choose their prices, or output
levels, in each period. Moreover, firms cannot observe the decisions of their
rivals, past or present. So a firm that does badly in any given period does
not know whether this occurred because demand was low or because some
other firm defected from the collusive agreement. In this model a subgame-
perfect equilibrium exists with the following properties: firms collude, but
every now and then a negative demand shock occurs which may trigger a
price war lasting for a certain number of periods before firms revert to
collusion. A distinctive feature of this model is that along the equilibrium
path of the game no firm ever cheats. Thus price wars are accidents.7 7
The firms know this, but
Another feature of certain versions of the model is that firms do not achieve collusion breaks down
the joint monopoly payoff during a collusive period. That is, each of N nevertheless. If it didn’t, then it
(symmetric) firms makes a profit which is lower than ΠM/N. The main would not be sustainable in the
testable prediction of the model is that price wars occur during recessions. first place.
37
An alternative theory of price wars is the one by Rotemberg and Saloner. In

their model demand again fluctuates randomly over time, but firms can
observe the current state of demand before setting their price each period.
They can also observe their rivals’ past (but not their current) actions. Now
the gain from co-operation is not affected by the fluctuations in demand
since in the long run they level out. However, the gain from cheating is
bigger when current demand is high than when it is low. Thus to ensure
the stability of collusion the firms may need to reduce the collusive price
and profit below the joint monopoly level during a boom in order to also
reduce the defection profit and hence the incentive to cheat. Although this
is not actually a price war (collusion does not break down), the main
prediction of the model is that prices may move countercyclically. This is
the opposite of the Green–Porter result. Note, however, that this prediction
is quite sensitive to the assumption that demand shocks are not serially
correlated.
Finally, according to a third theory of price wars, proposed by Slade, firms
have imperfect information about demand or about their rivals’ costs. In
particular, permanent changes in demand or in costs of one firm are
observed imperfectly. So, for instance, a firm whose cost has decreased may
initiate a price war to gain market share; this also serves as a signal to its
rivals. Ultimately collusion is re-established. More generally, price wars in
this theory are devices whereby firms obtain information about the new
conditions in the industry. Unlike Green–Porter-type price wars, which are
punishment phases in a collusive agreement, the price wars caused by
permanent changes in demand or relative costs are actual breakdowns in
collusion and form part of a process of renegotiation of a new agreement
and a redistribution of the collusive profits.
The evidence suggests that each of the three theories is a good description
of collusive behaviour in some industries. Support for the Green–Porter
model seems to come from detailed studies of a US railroad cartel of the
1880s (see next section). Using annual data from 1947 to 1981, Rotemberg
and Saloner have found that prices in the US cement industry have moved
countercyclically during that period. And Levenstein (1997) has found that
some at least of the price wars in the Pre-World War I US bromine industry
were breakdowns of collusion following a change in relative costs of firms
in the industry. In a review of empirical studies of price wars, Slade (1990)
has concluded that perhaps the most robust empirical result is that
unanticipated downturns in demand lead to price wars. Levenstein and
Suslow (2006) provide a comprehensive review of the empirical literature
on the effects and the stability of cartels. They conclude that, while cartels
sometimes break down because of cheating, the biggest problem cartels
face is entry and the need to adjust the collusive agreement in response to
changing economic conditions.
Econometric analysis of market power and collusive

behaviour
The literature offers two types of empirical analyses of collusive behaviour
in individual industries: descriptive industry case studies and econometric
studies. We will examine a particular example of the second approach:
Porter’s study of a nineteenth century US railroad cartel, the Joint Executive
Committee (JEC). This study takes the case of a known cartel and focuses
on the issue of whether price wars occur and why. However, the
methodology used has much wider application. This type of analysis can be
used to examine oligopolistic behaviour in an industry where there is no
38
prior information about the occurrence of collusion. In that case the

objective is to measure the degree of market power of firms in the industry.
The question is whether prices and profits are closer to those in a static
Nash equilibrium or to those under the joint monopoly outcome.
This has significant policy implications. Since collusion is illegal in most
countries, the competition policy authorities are very much interested in
being able to infer the existence of collusion from observed market
behaviour. This is not at all easy. Econometric analysis may help, although
more direct methods – such as raids into company premises and search for
relevant documents in cases of suspected collusion – are also typically used.
Note that if the competition authorities could observe the demand and cost
parameters in an industry, they could easily say whether prices are
‘competitive’ or ‘collusive’. The problem is that they do not observe these
parameters; they often only observe prices and quantities sold. The big
advantage of the econometric approach outlined here is that the
econometrician is in the same position as the authorities.
The JEC operated in the 1880s at a time when cartels were not illegal.
Between 1880 and 1886 there were several periods that look like price
wars. Were there in fact price wars, and why did they occur? What do they
tell us about how these firms colluded?
Porter (1983) builds a supply and demand model. The product is
homogeneous. The econometric specification of the demand function is:
ln Qt = α0 + α1ln pt + α2Lt + u1t
where α1 is the elasticity of demand (a negative number), L is a dummy
variable taking the value 1 for periods where the lakes were navigable (and
therefore an alternative transport mechanism existed) and 0 otherwise, and
u1 is an i.i.d. random variable.
To derive the supply function, Porter starts from the very basic conditions
that characterise firms’ behaviour. A general form of the cost function for
λ
firm i is Ci(qit) = Aiqit + Fi. Profit maximisation implies setting marginal
cost equal to marginal revenue, that is:
⎛ θ ⎞
λAi q itλ −1 = pt ⎜⎜1 + it ⎟⎟
⎝ α1 ⎠
where θ is a ‘degree of collusion’ parameter. To understand what θ is,
consider three behavioural regimes:
• in the Bertrand model, θit = 0, because marginal cost equals price
• in the Cournot model, we have seen in the previous chapter that
(p – Ci’)/p = si/|α1|, where si is the market share of firm i.
Rearranging we get Ci’ = p(1 – si/|α1|). Hence in the Cournot case
θit = sit.
• under joint monopoly (perfect collusion), qit = 1, because for a
monopolist the first order condition for profit maximisation is
Ci’ = p(1 – 1/|α1|).
Thus θ∈[0,1], and the higher the value of θ the larger the ‘degree’ of
collusion.
Porter has no firm data, only industry data, so he aggregates. After some
manipulation, he ends up with an industry supply curve:
⎛ θ ⎞
p t ⎜⎜1 + t ⎟⎟ = DQtλ −1 ,
⎝ α 1 ⎠
where θ t = ∑ sit θ it , Qt = ∑ q it and D is a constant.

i i
39
Taking logarithms of both sides and writing this as an econometric

equation, he obtains:
1n p = β + β 1n Q + β S + β I + u ,
t 0 1 t 2 t 3 t 2t
where S are dummies to account for entry into and exit from the cartel, I is
a dummy taking the value 1 during a collusive period and 0 during a
reversion to ‘competitive’ (Bertrand) behaviour, and u2 is an i.i.d. random
variable. Now the coefficients of this econometric equation are functions of
the structural parameters of the theoretical model. In particular, β0 = lnD,
β1 = λ – 1, and β3 = – 1n(1 + θt/α1). To calculate θt, the degree of
collusion during a collusive period, we need to obtain estimates of β3 and
α1 from the above two-equation econometric model. Note that θt = 0
would imply Bertrand behaviour, θt = Σisi would imply Cournot behaviour,
and θt = 1 would imply perfect collusion.
Two things are particularly important with the procedure outlined above:
• The econometric specification of the supply function was derived
directly from the first-order conditions of the firms’ maximisation
problem. So there is a direct link between theory and econometrics.
• All the data one needs to estimate the supply and demand model are
prices, quantities and some information on the various dummy
variables.8 Demand and cost parameters are not known and they are 8
Porter obtained information on
in fact coefficients to be estimated. It from trade journals.
Alternatively, he used ‘switching
Estimation of the model using two-stage least squares and weekly data over
^ = 0.38. Hence θ ^ = 0.34. Estimation regression’ techniques to infer
four years gave α
^ = – 0.74 and β
1 3 from the data when It = 0 and
using switching regression techniques and maximum likelihood gave
^ = 0.58. In both cases this is lower than 1, which is consistent with the when It = 1.
θ
Green–Porter model (or at least some versions of this model): collusive
behaviour is somewhere between Bertrand and joint monopoly.
However, the other prediction of the Green–Porter model, namely that price
wars are triggered by low demand, was not confirmed. Porter looked at the
residuals of the demand function. According to the Green–Porter model,
these should be negative during the periods preceding a price war, but
Porter did not find this.
Ellison (1994) has re-examined the JEC using a different econometric
technique to model the transition between collusive and competitive
regimes. He also assumed that the error term of the demand equation is
serially correlated and follows an AR(1) process. He estimated the same
two equations as Porter and obtained θ ^ = 0.85, which is much closer to the
joint monopoly outcome than Porter’s estimate. He also found some
evidence that price wars were in fact triggered by low demand (consistent
with the Green–Porter model) and that occasional secret price-cutting
occurred in normal demand states as well (not consistent with the
Green–Porter model).
We now summarise the basic features of econometric analyses of market
power in general:
• They typically involve the estimation of demand and supply equations.
• Data at the firm level may be available, and this allows for a richer
model than the one which only uses industry data.
• Demand and cost parameters, as well as behavioural parameters
associated with the degree of collusion, are not known and must be
estimated.
40
• Typically we need data on prices and quantities over a considerable

time period. This is because we need a lot of variation in p and q to
estimate the model efficiently. This is made easier when there are
shocks in demand, costs or firms’ conduct.
• Several variants of the basic model exist. For example one may
distinguish between firms that are ‘leaders’ and firms that are
‘followers’ by assuming that the two groups of firms have different θ’s.
There are also some limitations of this methodology:
• Some assumptions must always be made (otherwise there will be too
many parameters to estimate), for instance that the elasticity of
demand is constant or that θ is the same for all firms within a group
and over time. The results may depend on the assumptions made.
• The methodology can be extended to differentiated good industries,
but more restrictions need to be imposed for the model to be
estimated.
• The results may depend on the econometric estimation method.
Activities
1. It is often claimed that collusion is harder to sustain in industries where firms
face large and infrequent orders from buyers because infrequency of interaction
between firms hinders collusion. What is the theoretical basis for this claim?
2. Two firms set prices simultaneously, either high (H) or low (L), in each of an
infinite number of periods. The prices are observed by both firms before the next
play begins. The discount factor is δ < 1. The per period payoffs are as follows. If
both firms play H, each gets 10. If both firms play L, each gets 7. If one firm
plays H and the other plays L, their respective payoffs are 5 and 12. Identify the
Nash equilibrium of the one-period game. Then describe a ‘trigger strategy’ that
can enable the firms to reach a Pareto-superior outcome non-co-operatively. How
high must the discount factor be for this outcome to be sustainable?
3. Levenstein and Suslow (2006) write: ‘Cartels break up occasionally because of
cheating or lack of effective monitoring, but the biggest challenges cartels face
are entry and adjustment of the collusive agreement in response to changing
economic conditions. Cartels that develop organizational structures that allow
them the flexibility to respond to these changing conditions are more likely to
survive. Price wars that erupt are often the result of bargaining issues that arise
in such circumstances. Sophisticated cartel organizations are also able to develop
multipronged strategies to monitor one another to deter cheating and a variety
of interventions to increase barriers to entry.’
Assess the empirical evidence on which this statement is based. The Levenstein
and Suslow article is a good starting point, but you are also encouraged to check
for more, including information from antitrust cases. Once you have assessed the
evidence, think about its implications for economic theories of collusion.
4. Do cartels matter much? Assess the empirical evidence on their impact on prices
and profits as well as on non-price variables such as advertising, innovation,
investment, productivity, and concentration. Once again, the Levenstein and
Suslow survey is a good starting point, but you are also encouraged to check for
more, including econometric studies of cartels and information from antitrust
cases.
41

• explain how firms that act non-co-operatively can collude
• use simple models of repeated games to discuss factors that facilitate
or hinder the stability of collusion and interpret any relevant empirical
findings
• describe and evaluate different theories of price wars
• describe and evaluate an econometric methodology for measuring
market power in any particular industry.

1. Consider two identical firms with constant marginal cost c which
compete in quantities in each of an infinite number of periods. The
quantities chosen are observed by both firms before the next play
begins. Inverse demand is given by p = 1 – q1 – q2. The firms use
‘trigger strategies’ and they revert to static Cournot behaviour if co-
operation breaks down.
a. What is the lowest value of the discount factor δ such that the
firms can sustain the monopoly output level?
b. Suppose δ is too small to sustain the monopoly output. In
particular, suppose δ = 1/2. What is the most profitable subgame-
perfect equilibrium that can be sustained using trigger strategies?
(Assume c = 0 for simplicity.)
2. Describe an econometric study of oligopolistic behaviour, including a
discussion of the link between theory and econometric modelling.
What are the limitations of this type of empirical work?
42
Chapter 5: Entry deterrence and entry accommodation
Chapter 5: Entry deterrence and entry

accommodation
Learning objectives
By the end of this chapter and the Essential reading, you should be able to:
• explain the notions of strategic substitutes and strategic complements
• analyse simple models with sequential actions and describe first-mover
advantages in these models
• explain under what conditions a firm may be able and/or willing to
deter the entry of a potential rival
• use reaction functions to analyse strategic investment decisions by
firms in situations where the investment influences the firms’ future
profit functions.
Essential reading
Chapters 13–16.
Further reading
Books
2000). Chapter 15.
Addison Wesley, 2005). Chapter 11.
Gilbert, R.J. ‘Mobility Barriers and the Value of Incumbency’, in Schmalensee,
R. and R. Willig (eds) Handbook of Industrial Organization, volume 1.
Performance. (Boston: Houghton Mifflin, 1990). Chapter 10.
Journals
Bulow, J.I., J.D. Geanakoplos and P.D. Klemperer ‘Multimarket Oligopoly:
Strategic Substitutes and Complements’, Journal of Political Economy
(1985) 93(3), pp.488–511.
Fudenberg, D. and J. Tirole ‘The Fat Cat Effect, the Puppy Dog Ploy and the
Lean and Hungry Look’, American Economic Review, Papers and Proceedings
(1984) 74(2), pp.361–368.
Lieberman, M.B. ‘Excess Capacity as a Barrier to Entry: An Empirical
Appraisal’, Journal of Industrial Economics (1987) 35(4), pp.607–627.
Singh, S., M. Utton and M. Waterson ‘Strategic Behaviour of Incumbent Firms
in the UK’, International Journal of Industrial Organization
16 (1998), pp.229–252.
43
Introduction
One of the most interesting aspects of competition between firms is the use of
irreversible actions that affect the future behaviour both of the firm that takes
the action and of its rivals. In this chapter we examine a variety of strategic
situations involving first-mover advantages, strategies to deter entry, and
strategies to increase future profit by undertaking a costly and not easily
reversible action today. A common theme in all these situations is that it may
be profitable for a firm to limit its own flexibility by making a ‘commitment’,
that is a long-run (difficult to change) decision, because in this way it
influences the behaviour of its rivals. Of course, if a firm cannot influence the
behaviour of its rivals, it will never find it profitable to limit its own flexibility.
This would be the case if the commitment cannot be observed by the rivals.
We start with some preliminaries: the notions of strategic substitutes and
strategic complements. Then we examine a simple model that highlights
the value of irreversible decisions, and we use this model to analyse entry
deterrence and entry accommodation strategies. Finally, we develop a more
general framework that can be used to analyse in a unified way a wide
range of strategic situations. A game-theoretic device that is very useful in
tackling these issues is the multi-stage (usually two-stage or three-stage)
game. Unlike the static games of Chapter 3, these games are dynamic.
Unlike the repeated games of Chapter 4, they do not consist in the simple
repetition of a stage-game. The solution concept for these games is the
subgame-perfect equilibrium and the procedure for solving them is
backward induction.1 1
See Tirole (1988), pp.428–432,
or Shy (1995), pp.22–27.
Strategic substitutes and strategic complements

Recall the Cournot model with two firms. With linear demand D(p) = a – p
and constant marginal costs c1, c2 the reaction functions are:
a − q 2 − c1 a − q1 − c 2
q1 = R1 ( q 2 ) = q 2 = R2 ( q1 ) =
2 , 2 .
When the reaction functions are downward-sloping (Figure 5.1), we say that
the actions of the firms are ‘strategic substitutes’. The interpretation is that
when firm j increases its quantity qj, the optimal reaction of firm i is to
decrease its quantity qi. It can be shown that sign(dRi/dqj) = sign(∂2Πi/∂qi∂qj).
Under strategic substitutability, this expression is negative: if firm j increases qj,
i
the profit that firm i makes from a unit increase in qi (i.e. ∂Π /∂qi) falls.
In the Cournot model the firms’ action is setting quantity. It turns out that
when the strategic variable is quantity, reaction functions are typically
downward-sloping and we have strategic substitutability. However, this may
also be the case for several other decision variables; strategic
substitutability is not tied to any specific strategic variable.
q2 p2
R1(q2) R1(p2)
Nash equilibrium
R2(p1)
R2(q1)
Nash equilibrium
q1 p1
Figures 5.1 and 5.2
44
If, on the other hand, the reaction functions are upward-sloping (Figure
5.2), we say that the actions of the firms are ‘strategic complements’. This is
typically the case when the product is differentiated and firms compete in
prices. Suppose, for example, that demand for good 1 is given by q = a –
1
bp1 + dp2 and demand for good 2 is given by q2 = a – bp2 + dp1, where a,
b, d are all positive parameters.2 The goods are differentiated because, even
2
Note that d > 0 implies that the
if pi > pj, qi = 0 – unlike the Bertrand model for homogeneous products. two goods are substitutes in
Firm i, i = 1, 2, chooses pi to maximise its profit Πi = (pi – ci)qi = (pi – demand. Demand substitutability
ci)(a – bpi + dpj), taking pj as given. The first-order condition is: or complementarity should not be
confused with strategic
∂ Πi a + dp j + bc i substitutability or
= a − 2bp i + dp j + bc i = 0 ⇔ p i = Ri ( p j ) =
∂ pi 2b complementarity.
which defines the reaction function of firm i.
The interpretation is that when firm j increases its price pj, the optimal
reaction of firm i is to also increase its price pi. Now sign(dRi/dpj) =
sign(∂2Πi/∂pi∂pj), and this expression is positive under strategic
complementarity. That is, the profit that firm i makes from a unit increase
in pi (i.e. ∂Πi/∂pi) rises if firm j increases pj. As was the case with strategic
substitutability, strategic complementarity is not tied to any specific
strategic variable.
Entry deterrence and entry accommodation

We begin with the simplest possible model that highlights the value of long-
run commitments. There are two firms in an industry and they play a
multi-stage game. At stage 1, firm 1 chooses a level of capacity K1 which
then remains fixed. At stage 2, firm 2 observes K1 and then chooses a level
of capacity K2. You may think of this as a three-stage game, with the two
firms simultaneously setting prices at stage 3, given their respective
capacities. However, we will abstract from price competition at stage 3 in
what follows to focus on the sequential choice of capacities.
Let the reduced-form profit functions (after solving for short-run price
1
competition with given capacities) be Π (K1,K2) = K1(1 – K1 – K2) and
2
Π (K1,K2) = K2(1 – K1 – K2). Important properties of these profit functions
3 3
If we were solving for the
are ∂Πi/∂Kj < 0 and ∂2Πi/∂Ki∂Kj < 0 – the second of these says that subgame-perfect equilibrium of
capacities are strategic substitutes. To compute the subgame-perfect the three-stage game, we would
equilibrium of the game we use backward induction. At stage 2, firm 2 start from stage 3 and solve for
chooses K2 to maximise Π2 taking K1 as given. Setting ∂Π2/∂K2 = 0, we get the equilibrium prices, taking
K2 = (1 – K1)/2, the reaction function of firm 2. At stage 1, firm 1 chooses capacities as given. Then we
K1 to maximise Π1 anticipating the behaviour of firm 2 at stage 2 (i.e. would substitute these
anticipating its reaction function). That is, it chooses K to maximise Π1 = equilibrium prices into the firms’
1
K1(1 – K1 – K2) subject to K2 = (1 – K1)/2. Substituting the reaction profit functions and we would
function of firm 2 into Π1 we obtain Π1 = K1[1 – K1 – (1 – K1)/2]. Setting thus obtain profit functions in
∂Π1/∂K1 = 0 we obtain the equilibrium value K1* = 1/2. Finally, terms of K1 and K2 only. Then we
substituting this into the reaction function of firm 2 we obtain K2* = 1/4. would proceed backwards to
Equilibrium profits are Π1* = 1/8 and Π2* = 1/16 < Π1*. stage 2.
Now compare these profits with those in a game where firms choose
capacities simultaneously. In that case K^1 = K^2 = 1/3 and Π ^1 =Π ^2 =
1
1/9 < 1/8 = Π * (check these results). We conclude that by exploiting its
first-mover advantage, firm 1 makes higher profit than firm 2 in the
sequential-move game and also makes higher profit than the profit it would
make in the simultaneous-move game. The reason is that, by committing
itself to a given level of capacity, firm 1 influences the choice of firm 2: firm
1 builds more capacity than it would build in a simultaneous-move game
and, as a result, firm 2 builds less.
45
What is crucial for this strategy to work is that the decision is irreversible. If
firm 1 could change K1 at stage 2 of the game, then the overall outcome
would be the Nash equilibrium of the simultaneous-move game. So if
capital can be easily resold in the second-hand market, there is no scope for
a credible commitment. In other words, the investment must be sunk.
So far in this model, firm 1 cannot strategically deter firm 2 from entering
the industry and building some capacity. Let us now extend the model to
allow for this possibility. Assume that there is a fixed cost of entry f < 1/16.
The timing of the game is the same. At stage 1, firm 1 compares its profit
under two possible courses of action. If it decides to ‘accommodate’ the
entry of firm 2, then we have the case already examined above: K1* = 1/2,
Π1* = 1/8 and Π2* = 1/16. Note that these profits are now profits gross of
the cost of entry. Net equilibrium profits are Πi* – f, for i = 1, 2.
What if firm 1 tries to deter the entry of firm 2? Firm 2 will enter as long as
2
its gross profit covers the entry cost, that is Π (K1,K2) = K2(1 – K1 – K2) >
2
f. Now recall that ∂Π /∂K1 < 0: the higher the level of K1, the lower the
4 4
If Π2(K1,K2) = f, firm 2 is
value of Π2. So there will be a level of K1 that just deters the entry of firm indifferent between entering and
b
2. Let K1 denote this level. What we need to compute then is the profit of not entering. Let us assume, to
b b
firm 1 if it installs capacity K1 . To do this, we must first determine K1 . simplify the exposition, that in
Suppose that firm 1 installs capacity K .

b
Firm 2 will then respond by this case it does not enter.
1
choosing K2 to maximise Π2 taking K1 as given. The optimal capacity level
b
b
of firm 2 is given by its reaction function K2 = (1 – K1 )/2. Hence the
b
maximum gross profit of firm 2, conditional on K1 , is:
2
⎛ 1 − K 1b ⎞⎛ ⎞ ⎛ 1 − K 1b ⎞
⎟⎜1 − K 1b − 1 − K 1
b
Π 2∗ ( K 1b ) = K 2 (1 − K 1b − K 2 ) = ⎜ ⎟=⎜ ⎟
⎜ 2 ⎟⎜ 2 ⎟ ⎜ 2 ⎟
⎝ ⎠⎝ ⎠ ⎝ ⎠
b 2 b
Since K1 is the capacity level that just deters entry, we have Π *(K1 ) =
b 2 b 1/2
(1 – K1 ) /4 = f <=> K1 = 1 – 2f > 1/2 (since f < 1/16). In other
words, any K1 ≥ 1 – 2f1/2 will deter the entry of firm 2.
We still need to find out under what conditions the entry deterrence
strategy is more profitable than the entry accommodation strategy. The
gross profit of firm 1 when entry of firm 2 is deterred is:
Π 1 = K1b (1 − K1b − K 2 ) = K1b (1 − K1b ) = (1 − 2 f )[1 − (1 − 2 f )] = 2 f (1 − 2 f )
(Note that we have set K = 0.) Hence entry deterrence is more profitable
2
than entry accommodation if and only if 2f1/2(1 – 2f1/2) > 1/8 ⇔ f > 0.0053.5
5
Note that firm 1 will never want
So the choice of firm 1 depends on the magnitude of the entry cost f. This
to install more capacity than K1b.
makes sense. If f is small, then firm 1 must install such a large capacity if it
This is easy to see from the profit
wants to deter the entry of firm 2 that entry accommodation is in fact
function of firm 1 when K2 = 0:
preferable. If f is large enough, then a smaller capacity will do the job and
Π1 is decreasing in K1 for values
entry deterrence becomes preferable to entry accommodation.
of K1 higher than 1/2 and hence
An interesting question in more complex models of entry deterrence than for any K1 > K1b (recall that
the one presented here is whether a firm may have an incentive, as part of K1b > 1/2).
an entry-deterring strategy, to install capacity that it will not use for
production. The theoretical results on this issue are mixed. There is,
however, little empirical support for this view. In particular, Lieberman
(1987) found that in only three out of 38 chemical products in his sample
did incumbent firms hold ‘excess capacity’ to deter entry. More common
was a strategy of capacity expansion by incumbent firms once entry had
occurred in an attempt to deter expansion by the entrants.
A final remark: capacity expansion is only one of a number of possible
entry deterrence strategies available to firms. Others include product
proliferation (see Chapter 6 of this guide), bundling (see Activity 3 below),
46
binding contracts between buyers and sellers, and investment in product

quality, cost reduction, or brand image.
A taxonomy of business strategies

Consider now a more general setup as follows. There are two firms and two
periods. In period 1 one or both firms take an action that influences their
own and the rival’s payoff function in period 2. This can be an investment in
capacity or in R&D which affects marginal cost in period 2. Or it can be an
investment in creating a brand image which increases the consumers’
willingness to pay for the product, or a distribution network, etc. In period 2
the firms compete in prices or in quantities. This kind of setup can be used
to analyse a wide range of strategic situations. What is interesting is that all
these can be analysed on the basis of a small number of basic properties.
To fix ideas, suppose that at stage 1 there is no production and firm 1
chooses a level of investment Ki. Production takes place at stage 2. Assume
a fixed cost of production f and constant marginal costs c1 and c2. Let the
marginal cost of firm 1 depend on its choice of investment: c1 = c1(K1),
with dc1/dK1 < 0.
In determining its choice of K1 firm 1 will compare its overall profit from
two possible courses of action: deterring entry (i.e. production) of firm 2 or
accommodating entry of firm 2. Take first the case of entry deterrence. This
is the relevant case if f is large. The question is: should firm 1 ‘overinvest’
or ‘underinvest’? Let us make precise these notions of overinvestment and
underinvestment. Relative to what? Relative to the level of investment that
would be optimal for firm 1 if firm 2 could not observe K1. In that case
there would be no first-mover effects, so the game would be exactly
equivalent to a simultaneous-move game: firm 1 would not be able to
influence the behaviour of firm 2 by making a commitment. Let us call this
the ‘benchmark’ level of K1.
If competition at stage 2 is in quantities, the reaction functions at stage 2
are downward-sloping. By increasing K1 firm 1 reduces c1, hence it shifts its
stage 2 reaction function outwards. That is, the optimal reply for any given
q2 is a higher q1. Thus a higher K1 leads to more aggressive behaviour by
firm 1 at stage 2. We describe this property of our model by saying that
investment makes firm 1 ‘tough’.6 Now as K1 increases, q1* increases and
6
In other contexts, an increase
q2* decreases. See Figure 5.3, in which point O represents the stage 2 in the strategic variable by a
equilibrium when firm 1 chooses the ‘benchmark’ level of capacity. Also, as firm may induce a less
K1 increases, the stage 2 equilibrium profit of firm 2 gross of the fixed cost f aggressive behaviour by that
decreases. At some point it becomes less than f, so firm 2 will prefer not to firm in subsequent periods. We
produce at all. Thus, to deter the entry of firm 2, firm 1 must overinvest. would then say that investment
makes the firm ‘soft’. See Tirole
q2 (1988), pp.323–328, for more
precise definitions of
R1 R1′
‘toughness’ and ‘softness’ and,
increase in K1
more generally, for a more
O
analytical exposition of the
issues discussed here.
O′
R2
q1
Figure 5.3
47
Activity
Using reaction functions, show that, if stage 2 competition is in prices, we again need
overinvestment to deter entry.
Answer
Under price competition, the reaction functions at stage 2 are upward-sloping. An
increase in K1 shifts the stage 2 reaction function of firm 1 to the left. Equilibrium prices
fall, and profits also fall – at least initially, when starting from the ‘benchmark’ level of
K1. So, unless f is very small, the equilibrium profit of firm 2 will at some point become
less than f and entry of firm 2 will be deterred.
Take now the case of entry accommodation. That is, firm 1 chooses K1 given
that it will have to compete with firm 2 at stage 2. This is the relevant case if f
is small. Should firm 1 overinvest or underinvest, in the same sense as above?
If stage 2 competition is in quantities, an increase in K shifts the reaction
1
function of firm 1 outwards (see again Figure 5.3). An increase in K1 above
the ‘benchmark’ level causes the market share of firm 1 to rise at the
expense of firm 2, so (up to a certain point) the stage 2 equilibrium profit
of firm 1 also rises. In short: because the reaction functions are downward-
sloping, more aggressive behaviour by firm 1 (a rise in q1) leads to a softer
action by firm 2 (a fall in q2). In this situation, firm 1 has an incentive to
overinvest, given that investment makes it ‘tough’.
If stage 2 competition is in prices, an increase in K1 shifts the reaction
function of firm 1 to the left (see Figure 5.4). This is because c1 falls, so for
any price p2 firm 1’s optimal reply is a lower p1. Again a higher K1 leads to
more aggressive behaviour by firm 1 at stage 2, that is investment makes
firm 1 ‘tough’. An increase in K1 above the ‘benchmark’ level causes a fall in
both p1* and p2*, so (up to a certain point) the stage 2 equilibrium profit of
firm 1 falls. In short: because the reaction functions are upward-sloping,
more aggressive behaviour by firm 1 (a fall in p1) leads to a more
aggressive response by firm 2 (a fall in p2). In this situation, firm 1 has an
incentive to underinvest, given that investment makes it ‘tough’.
p2 increase in K1
R1
R1′
R2
O′
p1
Figure 5.4
The framework presented above can be used to analyse a variety of
strategic situations, including product differentiation, learning by doing, the
imposition of price floors or quotas, multimarket contact, etc.7 In all these 7
See Tirole, pp.328–336, and
cases, the investment decision, and, in particular, the decision to Church and Ware, Chapter 16,
strategically over- or underinvest, depends on three things: for discussion of these and other
• does a firm want to deter or accommodate entry? examples.
• does investment make a firm ‘tough’ or ‘soft’?
48
• are the stage 2 actions strategic substitutes (downward-sloping

reaction functions) or strategic complements (upward-sloping reaction
functions)?
Contestable markets
We conclude this chapter with a brief reference to a theory of market
structure proposed by Baumol, Panzar and Willig in the early 1980s. The
main idea is that, if potential entrants can costlessly enter and exit an
industry, incumbent firms must set price equal to average (and in some
cases even marginal) cost, and cannot make positive profits. The
requirements for this mechanism to work is that entry does not involve any
sunk costs and the incumbents are rather slow in responding to entry by
cutting price. These are strong assumptions, and they are generally not
satisfied in practice. It is therefore not surprising that the theory of
contestable markets has had little empirical support. It has rather helped
focus attention on the role of sunk costs for entry deterrence and the
determination of market structure.
Activities
1. It is sometimes claimed that ‘learning-by-doing’ through overproduction is a
profitable strategy since it allows firms to reduce their future costs and even
deter the entry of rivals. Do you agree?
2. A domestic and a foreign firm produce a homogeneous product and compete in
quantities. The government decides to impose a quota on the quantity sold by
the foreign firm. Using reaction curves, show that, if the quota results in only a
small reduction of the foreign firm’s volume of sales, it increases the profit of the
domestic firm and reduces the profit of the foreign firm.
3. The most famous antitrust case of the last twenty years was undoubtedly
Microsoft versus the US competition authorities. This was a complex case.
Microsoft was alleged to have used its market power in the market for personal
computer operating systems to exclude rival firms from the market for web
browsers by ‘bundling’ its operating system together with its web browser.
Moreover, the US competition authorities were concerned that Microsoft’s actions
might stifle potential competition in the market for operating systems itself.
Microsoft argued that its practice of bundling led to efficiency gains and
benefited consumers. Microsoft was later involved in an antitrust case brought by
the European Commission. In both instances, the firm was found in breach of the
competition laws.
The case is included in this chapter of the guide, despite the complex pricing
tactics and the fact that the background was an industry subject to rapid
technological change, because the core issue in the case is the alleged strategic
behaviour of a firm to exclude rivals from a market.
Who was right, Microsoft or the US competition authorities? What lessons can
be learned from this case? Make up your mind after reading different views of
the Microsoft case. Useful collections of articles have been published in the
Summer 2001 issue of the Journal of Economic Perspectives and the March 2001
issue of the Journal of Industry, Competition and Trade. Some of these articles,
and many other papers on the case, including some more recent ones, are
available on the internet.
49

• explain the notions of strategic substitutes and strategic complements
• analyse simple models with sequential actions and describe first-mover
advantages in these models
• explain under what conditions a firm may be able and/or willing to
deter the entry of a potential rival
• use reaction functions to analyse strategic investment decisions by
firms in situations where the investment influences the firms’ future
profit functions.

1. Consider an industry with two firms that produce a homogeneous
product and compete in quantities. Unit costs of the two firms are c1
and c2 and the industry inverse demand function is given by p = a –
(q1 + q2).
a. Find the Nash equilibrium of the single-stage game in which firms
simultaneously set quantities. Show how the equilibrium profit of
firm 1 depends on c1 and c2 and provide an intuition for this result
using reaction curves.
b. Now consider a two-stage game as follows. The second stage is as
described in part a above. In the first stage firm 1 can undertake
R&D to lower its second stage unit cost. In particular, spending R
1/2
yields c1 = c – R , where c is a constant. Discuss the incentives
that firm 1 has to invest in R&D. What is the optimal choice of R
for firm 1? Provide some intuition using reaction curves.
2. Consider a market where there are two differentiated goods. The
demand for good 1 is given by q = a – bp + dp and that for good 2
1 1 2
is given by q2 = a – bp2 + dp1, where a > 0 and 0 < d < b. The
production cost of each good is zero.
a. Suppose that both goods are produced by the same firm (a
monopolist). Compute the prices set by the monopolist.
b. Suppose now that each good is produced by a different firm and
the firms choose prices simultaneously. Compute the
Bertrand–Nash equilibrium prices and confirm that they are lower
than the monopoly prices.
c. Show how an increase in the size of the market (i.e. an increase in
the parameter a) affects the equilibrium prices under part b.
Illustrate using reaction curves.
d. Now assume that each good is produced by a different firm but the
firms set prices sequentially; in particular, firm 2 can observe the
price set by firm 1 before setting its own price. Compute the
subgame-perfect equilibrium price of firm 1 in this two-stage game.
50
Chapter 6: Product differentiation and non-price competition
Chapter 6: Product differentiation and

non-price competition
Learning objectives
By the end of this chapter and the Essential reading, you should be able to:
• analyse how product differentiation relaxes price competition
• analyse how firms choose product characteristics in the context of
simple models of product differentiation
• describe the theory and evidence on product proliferation as an entry
deterrence strategy
• compare horizontal and vertical product differentiation and explain
their different implications for market structure and profitability.
Essential reading
Books
Chapter 11.
Journals
Schmalensee, R. ‘Entry Deterrence in the Ready-to-eat Breakfast Cereal
Industry’, Bell Journal of Economics (1978) 9(2), pp.305–327.
Further reading
Books
2000). Chapter 12.
Journals
George, L. and J. Waldfogel ‘Who Affects Whom in Daily Newspaper Markets’,
Journal of Political Economy (2003) 111(4), pp.765–784.
Judd, K.L. ‘Credible Spatial Preemption’, Rand Journal of Economics (1985)
16(2), pp.153–166.
Salop, S.C. ‘Monopolistic Competition with Outside Goods’, Bell Journal of
Economics (1979) 10(1), pp.141–156.
Shaked, A. and J. Sutton ‘Relaxing Price Competition through Product
Differentiation’, Review of Economic Studies 49(1) (1982), pp.3–13.
Waldfogel, J. ‘Preference Externalities: An Empirical Study of Who Benefits
Whom in Differentiated Product Markets’, Rand Journal of Economics,
(2003) 34(3), pp.557– 568.
51
Introduction
In many markets products are differentiated. Consumers care not only
about product price, but also about product characteristics, quality, the
location of the seller, pre-sale or post-sale services, etc. Thus firms compete
in these dimensions as well as competing on price. An important feature of
differentiated good markets is that the cross-price elasticity of demand is
not infinite at equal prices. That is, a firm can set its price above the price
of another firm and still have some demand for its product – even in the
absence of capacity constraints.
Industrial economists distinguish two types of product differentiation.
Under horizontal differentiation, different consumers prefer different
products when the prices of these products are the same. For instance:
orange cakes and chocolate cakes. Another example is location: if you live
in the centre of town you prefer to buy a product from a shop near your
home rather than buy the same product at the same price from a shop in a
suburb. So ‘spatial differentiation’ is a form of horizontal differentiation.
Under vertical differentiation, all consumers would buy the same
product if all product prices were the same. Of course, since at equilibrium
products have different prices and consumers have different incomes, they
buy different products: the point is that consumers agree over the
preference ordering. A typical example is the case where products are
differentiated by quality. For instance: a Volkswagen versus a Mercedes.
The distinction between horizontal and vertical differentiation is analytical.
In many markets, products are differentiated along both dimensions. In this
chapter we discuss both types of differentiation and their implications for
competition and market structure.
Horizontal product differentiation
The linear location model

We first focus on horizontal product differentiation. We begin by
examining:
• how horizontal product differentiation ‘relaxes’ price competition, that
is to say it leads to equilibrium prices higher than marginal costs even
in the absence of capacity constraints or repeated interaction
• how firms choose the characteristics of their products.
Consider the following stylised model, a variant of which was first analysed
by Hotelling. Consumers are uniformly distributed along a ‘linear city’ of
length L, and at each point on the line lies a single consumer. Each
consumer consumes exactly one unit of the good. There are two firms or
stores, which sell the same physical good. Suppose, to begin with, that the
firms’ locations are given. Firm 1 is located at distance a from the west end
of the city and firm 2 is located at distance b from the east end of the city
(see Figure 6.1).1 The unit cost of the good is c, same for both firms.
1
We assume, without loss
Consumers incur a quadratic transportation cost, that is a consumer of generality, that firm 1 is
situated at distance x away from the location of a firm incurs a cost tx2 to never to the right of firm 2
go to that firm and return back. The firms compete by setting prices (i.e. a + b ≤ L).
simultaneously. We now compute the Nash equilibrium of this pricing
game.
52
p1 p2
west end firm 1 firm 2 east end
marginal consumer
a x b
Figure 6.1
Suppose prices are p1 and p2. Obviously, consumers situated close to firm 1
will prefer to buy from this firm, and those situated close to firm 2 will
prefer to buy from firm 2. To be more precise, we define the ‘marginal
consumer’, that is the consumer who is just indifferent between buying
from firm 1 or firm 2. He or she is located at distance x to the right of firm
1, where x is defined by:
2 2
p1 + tx = p2 + t(L – a – b – x) .
The expression on the left-hand side is the generalised cost (the sum of the
product price and the transportation cost) of the marginal consumer if he
buys from firm 1. The expression on the right-hand side is the generalised
cost of the marginal consumer if he buys from firm 2. These generalised
costs are depicted in Figure 6.1 by the two ‘umbrellas’.
Solving this equation for x we obtain:
L−a−b p1 − p 2
x= −
2 2t ( L − a − b)
All consumers to the left of the marginal consumer buy from firm 1, while
all consumers to the right of the marginal consumer buy from firm 2.
Hence demand for firm 1 is:
L−a −b p1 − p 2
D1 ( p1 , p 2 ) = a + x = a + −
2 2t ( L − a − b)
and demand for firm 2 is:

L−a −b p1 − p 2
D 2 ( p1 , p 2 ) = L − a − x = L − a − +
2 2t ( L − a − b)
1 2
Profits are given by Π (p1,p2) = (p1 – c)D1(p1,p2) and Π (p1,p2) =
(p2 – c)D2(p1,p2) respectively. The Nash equilibrium is the solution to the
system of first-order conditions dΠ1/dp1 = 0 and dΠ2/dp2 = 0. Solving the
system we obtain (check):
a −b b−a
p 1 = c + t ( L − a − b)( L + ), p 2 = c + t ( L − a − b)( L + )
3 3
Hence equilibrium prices are higher than marginal cost c – unless a + b =

L, that is to say firms are at the same location, in which case there is no
differentiation. We conclude that product differentiation by location allows
firms to make positive profits even in a one-shot simultaneous-move pricing
game. To find the equilibrium profits, substitute –p1 and –p2 into the profit
functions Π1 and Π2. It turns out (check):
1 1 2 1
Π = t ( L − a − b)(3L + a − b) 2 , Π = t ( L − a − b)(3L − a + b) 2
18 18
which are positive for a + b = L.

53
Consider now a two-stage game as follows. At stage 1 firms simultaneously

choose their locations, in other words firm 1 chooses a and firm 2 chooses
b. Then at stage 2, given their locations, the firms simultaneously set prices.
The timing of the game captures the important distinction between long-
run and short-run decisions, in particular the fact that prices are easier to
change than locations. We are looking for the subgame-perfect equilibrium
of this game.
We use backward induction. At stage 2, a and b are given, so _our previous
analysis
_2 applies. That is, the second stage equilibrium profits Π 1(a,b) and
Π (a,b) are given by the expressions above. At stage 1, firms 1 and 2
choose a and b anticipating how the stage 2 subgame will be played. In
other words, they anticipate that their choice of location will affect their
choice of price in
_ the next
_ stage and, in particular, they anticipate the
expressions for Π 1 and Π 2.
_1
At stage 1, then, firm 1 chooses a to maximise Π . After some
manipulation, we obtain:
dΠ 1 1
= − t (3L + a − b)( L + 3a + b),
da 18
which is always negative. So to maximise its profit in the two-stage game

firm 1 will choose the lowest possible value for a, namely a = 0, that is it
will locate at the west end of the city. Similarly for firm 2: it will locate at
the east end of the city. Hence we obtain ‘maximal differentiation’ in this
particular model.
The intuition for this result is as follows. There are two effects, working in
opposite directions:
• the demand effect: a firm wants to move towards its rival because in
this way it increases its market share, and therefore its profit
• the strategic effect: a firm wants to move away from its rival because
in this way products become more differentiated, price competition is
‘relaxed’, and profits increase.
In our model the strategic effect dominates, so we get maximal
differentiation.
Note that, although the same two effects operate in more general settings,
the strategic effect need not dominate. For instance, if in our example we
γ
had assumed a transportation cost tx , where γ∈[1,2], then:
• for γ < 1.26, there is no equilibrium in pure strategies
• for 1.26 < γ < 1.67, firms differentiate but not maximally
• for γ > 1.67, firms differentiate maximally.
Activity
Suppose the price is exogenously fixed (by the government or by a manufacturer if the
two firms in the model are retailers) and the two firms only compete by simultaneously
choosing locations. Show that the Nash equilibrium of this game involves ‘minimal
differentiation’: both firms locate at the centre. Interpret the result.
54
Answer
Start by distinguishing cases:
• the firms are not located at the same point
• the firms are located at the same point but not the centre, and
• both firms are located at the centre.
Then show that in all but the third case there exists a profitable deviation by at least one
firm. The main thing to remember is that consumers buy from the nearest firm, so each
firm seeks to maximise its market share given the location of its rival. The intuition for
the result is that in this case there is no strategic effect, since the choice of location does
not affect the prices. There is only a demand effect, which works against differentiation.
More generally, then, the choice of product specification is a trade-off

between forces that promote and forces that oppose differentiation. The
force promoting differentiation is the fact that it relaxes price competition.
Note, however, in this context, that this works only when the second stage
competition is in prices (i.e. the stage 2 actions are strategic complements).
The forces opposing differentiation are two. The first is the demand effect.
This effect is even clearer in markets where demand is concentrated around
a few poles (i.e. where consumers are not uniformly distributed). The
second is the presence of positive externalities that induce firms to locate
close to one another. For instance, lowering consumer search costs in this
way may lead to an increase in total demand for the product.
One final remark: The model presented here can easily be interpreted as a
product differentiation rather than a location model. In particular, a firm’s
‘location’ can be interpreted as a choice of product specification. A
consumer’s ‘location’ would represent her most preferred product
specification (variety). And finally, the ‘transport cost’ would represent the
utility loss from not consuming the preferred variety.
Consumers generally benefit from product diversity. However, when
consumers are not uniformly distributed in the product characteristics
space and fixed costs are significant, some consumers may not get the
variety they want. In particular, the market will provide products which are
preferred by numerous consumers but not necessarily those which are
preferred by small groups of consumers with less prevalent tastes. Or
perhaps small groups will end up having a very restricted choice. An
increase in the size of the larger group might even hurt the smaller group
since firms may then be even less likely to target the smaller group (George
and Waldfogel 2003, Waldfogel 2003).
The circular location model

The linear location model is very useful in analysing the location decision.
In this section we want to study the entry decision in differentiated good
markets. To this end we introduce a slightly different setup. Consumers are
now uniformly distributed with density S (a measure of market size) on a
circle with perimeter 1, and each consumer buys exactly one unit of the
good. This essentially implies that for any distance x along the circle, total
demand is equal to Sx. Transport costs are linear, that is a consumer
situated at distance x away from a firm incurs a cost tx to go to that firm
and return. Firms locate around the circle, each in one location, and
produce the same physical good at the same unit cost c. There is a large
number of potential entrants. Entry is free, in the sense that it is not
restricted or regulated, but there is a sunk cost of entry f.
55
We are looking for a subgame-perfect equilibrium of the following two-

stage game. At stage 1, firms decide whether or not to enter at sunk cost f.
They do not choose location, but are automatically located at equal
distance (1/N) from one another on the circle. At stage 2, those firms that
have entered simultaneously set prices.
Firm i
1/ 1/
Firm i–1 N N Firm i+1
Figure 6.2
We proceed through backward induction. Assume that N firms have
entered and we are at stage 2. Since firms are symmetric,
_ we look for a
symmetric equilibrium where all firms set price p. Now in practice, firm i
competes only with the two neighbouring firms, so we can ignore the
remaining product space (see Figure 6.2).
Let us focus on the decision problem of firm i, taking as given the prices of
the other_firms. As a matter of fact, let us assume that all the other firms
set price p. This will be true in the symmetric equilibrium, so we can
_ that firm i sets price pi, while each of the two
anticipate it. Suppose then
neighbouring firms sets p. A consumer located at distance x away from firm
i is indifferent between buying from firm i or the neighbouring firm if:
t
p+ − pi
⎛1 ⎞ N
p i + tx = p + t ⎜ − x ⎟ ⇒ x =
⎝N ⎠ 2t
Demand for firm i’s product comes from consumers to its left and to its
right, so the total distance
_ covered is 2x. Hence the demand faced by firm i
i
_ Di(pi , p) = _2Sx. The firm chooses _pi to maximise Π = (pi –
is given by
c)Di(pi , p) = (pi – c)S(p+ t/N – pi)/t, taking p as given. The first-order
condition is:
S t
dΠ i / dpi = 0 ⇔ ( p + − 2 p i + c) = 0 .
t N
_
This defines the optimal choice of pi given p for any firm i. Now_ we can use
the fact that at _the symmetric equilibrium we will have pi = p, so the above
equation gives p = c + t/N. This is the second stage equilibrium price,
which is of course a function of N. To find
_ the equilibrium gross profit of
i
each firm as a_ function of N, substitute
_ p into the profit function Π , and
−
also set pi = p. We obtain Π = S(p – c)/N = St/N2.
At stage 1 there is free entry. This means that firms will be entering the
−
industry as long as they can make a non-negative net profit. Note that Π
−
decreases as N rises (i.e. as more firms enter). Initially Π is higher than f,
−
so firms keep entering, thereby causing Π to fall. There will be some point
−
where Π = f, and at that point entry will stop because any further entry is
−
unprofitable. (One additional entrant will cause Π to fall below f, so the
firms will anticipate that they will not be making enough gross profit at
stage 2 to cover the cost of entry at stage 1.) From the free-entry zero-
− 2 1/2
profit condition Π = f, we get St/N = f <=> N* = (St/f) . This is the
equilibrium number
_ of firms in the two-stage game. Substituting into the
expression for p we also get p* = c + (tf/S)1/2.
56
To summarise the two main results of the model:

• the equilibrium price is higher than marginal cost
• the equilibrium number of firms increases in market size S and unit
transport cost t and falls with the entry cost f.
Brand proliferation as an entry deterrence strategy

Can incumbent firms in an industry ‘crowd’ the product space by producing
many different brands as a way to deter entry and maintain profits? What
is required for this strategy to work? The theoretical discussion on brand
proliferation was triggered by an antitrust case. In the 1970s the four
biggest US producers of ready-to-eat breakfast cereals were alleged to have
successfully deterred entry by other firms in that market through brand
proliferation.
Some facts about this particular industry: concentration was very high
throughout the 1950s and 1960s; market growth was rapid; profitability was
high; advertising was heavy; there were no significant scale economies; the
six leading producers introduced 80 new brands between 1950 and 1972;
and there was no significant entry. How can the lack of entry be explained?
The brand proliferation model relies on three assumptions.
1. There are increasing returns to scale at the brand level. For example,
the cost of producing a brand may be given by f + cq, where q is
quantity produced. If there were no fixed cost f, then it would be
profitable to produce a brand for each point in the product space and
satisfy everyone’s exact preferences. A firm could enter and make
positive profit by selling to a single consumer, so there would be no
scope for entry deterrence.
2. There is localised competition between brands. If each brand were to
compete with all other brands and not just with neighbouring brands,
then there would be no scope for deterring entry by brand proliferation.
3. There are substantial costs of repositioning a brand in the product
space or of withdrawing a brand. If there were no such costs, the
incumbent firms would not be committed to their chosen locations; so
entry would occur and the incumbents would relocate until we get to
a situation where everyone makes zero net profit.
The circular model of horizontal differentiation presented above satisfies all
three assumptions. Consider the following situation along the circle. There
is a group of firms that produce N brands along the circle. The price of
each brand is p(N), with dp/dN < 0. For each brand there is a sunk cost f.
Gross profit per brand is given by Π[p(N),N], with ∂Π/∂p > 0 and ∂Π/∂N 2
This is strictly true if the two
< 0. Hence the overall effect of N on Π is given by the total derivative
neighbouring firms can charge
dΠ/dN = ∂Π/∂N + (∂Π/∂p)(dp/dN) < 0.
_ different prices to consumers on
The critical number
_ of _ brands N that yields
_ zero net profit per brand is their left than to those on their
defined by Π[p(N ), N ] = f. For any N < N , Π[p(N),N] > f and therefore right – so that the entry of a
the incumbents make positive profits. single firm between two existing
What profit will an entrant make by establishing a new product? An entrant ones has no repercussions
will locate midway between two existing brands on the circle. Because elsewhere on the circle.
competition is localised, its market share will be roughly 1/2N and its gross Otherwise, the gross profit of the
profit will be approximately Π[p(2N),2N], that is to say the profit that entrant will in fact be somewhat
corresponds to a situation with 2N symmetric brands on the circle.2 Hence higher than Π[p(2N),2N], but still
much lower than Π[p(N),N], so
_ long as _Π[p(2N),2N] < f. A sufficient condition for
entry will not occur as
this to hold is 2N > N ⇔ N > N /2. Hence incumbents can make positive net the qualitative results will be the
profits and deter entry through brand proliferation: they simply need to same.
57
_ _
ensure that N /2 < N < N . Intuitively, this says that the number of brands
must be sufficiently low so that they can all enjoy positive net profits, and
at the same time sufficiently high so that a potential entrant cannot enjoy
positive net profits.
Schmalensee has used an expanded version of this model to explain the
lack of entry into the US ready-to-eat breakfast cereal industry. In
particular, he has also included advertising and argued that high levels of
advertising were an additional entry-deterring mechanism. Also, he has
discussed additional complications stemming from the fact that the market
was growing and that entry did occur in the 1970s when a new market
segment (‘natural cereals’) emerged.3 All in all, it seems that the lack of 3
See Schmalensee (1978) for
entry into this industry may be explained by the joint effect of two different details.
mechanisms: the brand proliferation mechanism and the advertising
escalation mechanism. The latter refers to a situation where, as market size
increases, firms spend more on advertising and this prevents concentration
from falling.4
4
See Chapter 9 of this guide for
more on the advertising
Although the model of brand proliferation as an entry deterrence strategy
escalation mechanism.
has been much discussed because of the welfare issues involved, you
should bear in mind that product proliferation can also simply be a search
for successful products. Recall that repositioning costs and exit costs must
be substantial for the brand proliferation strategy to work. It probably
makes sense to assume high repositioning costs, but why is it costly to
withdraw a brand in the ready-to-eat cereal industry or most other
industries? This is a valid objection. One possible answer might be that the
cost is in terms of reputation: if an incumbent withdraws one brand in the
face of entry, then he will face more entry, while if he doesn’t, he may
convince other potential entrants that he is not likely to be withdrawing
brands and thereby discourage them from attempting to enter.
Activity
Suppose that in the model analysed above exit costs are zero. Show that in this case
brand proliferation does not deter entry.
Answer
Suppose the entrant enters at exactly the location of an existing brand, say brand i. Then
price competition drives the price of that brand down to marginal cost and the gross
profit of the entrant as well as of the incumbent producing brand i down to zero. Also,
the increased competition will lead to price reductions for the neighbouring brands, i–1
and i+1, and this will in turn affect brands i–2 and i+2, and so on. So if the firm that
produces brand i also produces some other brands, it will see its profits from those other
brands fall as a result of entry at location i. In this situation, the incumbent firm will have
an incentive to withdraw brand i since this is costless and will raise its overall profit by
relaxing competition overall (the firm is making zero profit from brand i anyway). So
brand proliferation cannot deter entry in the absence of exit costs.
Vertical product differentiation

Under vertical differentiation, products differ in some characteristic which
we will denote by u and generally call ‘quality’ in what follows. This can be
related to a physical characteristic of the product or to its brand image.
Essentially, as we will see below, u is a measure of the consumers’
willingness to pay a higher price for a product.
Underlying most of the literature on vertical product differentiation is a
two-stage game as follows. At stage 1, each firm i chooses ui. In many
models there is a fixed and sunk cost F(u ), for instance advertising or R&D,
i
58
which is incurred at this stage and increases the value of u: dF/du > 0. At
i
stage 2, firms compete in prices or in quantities. The choice of ui affects
stage 2 competition through its effect on the firms’ demand functions: given
the prices and the u’s of all the rival firms, an increase in ui shifts the
demand curve of firm i outwards (i.e. it increases the consumers’
willingness to pay for product i). In some models, the choice of ui also
affects the marginal cost c(ui): dc/dui > 0.
Vertical product differentiation implies that, if u1 > u2 and p1 = p2, then all
consumers would buy product 1. At equilibrium u1 > u2 ⇒ p1 > p2, so
some consumers buy good 2, but the point is that consumers have the same
ranking of the products.
We now briefly sketch a simple model of vertical product differentiation,
focusing on the structure of the model and the basic results.5 Firms offer
5
A detailed discussion of the
products which vary in quality u. Consumers are uniformly distributed with model can be found in Shaked
density S (a measure of market size) according to their income t, which lies and Sutton (1982).
between a and b. Each consumer buys one unit of a single product or none.
A consumer has utility U(t,0) = u0t if she doesn’t buy and U(t,k) = uk(t –
pk) if she buys good k at price pk, where t is income prior to any purchase.
The marginal cost of production is independent of quality; assume, for
simplicity, that it is zero. Finally, the game has three stages: at stage 1 firms
decide whether or not to enter the industry at a small sunk cost ε, at stage
2 each firm chooses a level of u, and at stage 3 firms set prices.
The main results of this model are the following:
• the ‘finiteness property’: there exists a lower bound to the number of
firms that can survive (i.e. make non-negative profit) at equilibrium,
which is independent of market size S and the entry cost ε
• the equilibrium number of firms is increasing in the degree of income
heterogeneity. For instance, if b/a ≤ 2, only one firm can survive; if
2 < b/a ≤ 4, there is room in the market for exactly two firms; and so
on
• suppose that 2 < b/a ≤ 4, so exactly two firms enter. Then the firms
choose different qualities and they both make positive net profits.
You should compare these results to those obtained under horizontal
product differentiation. In the circular location model, for example, we
found that, as S → ∞, N* → ∞. Also, free (and simultaneous) entry implied
zero net profit at equilibrium. In our simple vertical differentiation model,
in contrast, as S → ∞, N* does not change. Also, there are positive net
profits in the long run even under free and simultaneous entry.
How robust are the results of our vertical differentiation model? It turns
out that the crucial feature of the model is the assumption that marginal
cost is independent of quality. The ‘finiteness result’ in particular still holds
if marginal cost does not increase too fast with quality, but it breaks down
if marginal cost increases fast with u. In practice, then, the finiteness
property is likely to hold when most of the cost of quality is a fixed cost,
such as advertising or R&D, rather than a variable cost. Actually the
finiteness result still holds under general conditions in markets with both
horizontal and vertical differentiation, provided that c(u) is relatively flat.
59
Activities
1. Consider the linear location model and assume that the location decisions are
taken sequentially. This is now a three-stage game: choice of location by firm 1,
then by firm 2 (which observes the choice of location by firm 1), then price
competition. Compute the subgame-perfect equilibrium.
2. Consider the circular location model and assume that the transportation cost is
quadratic rather than linear. Compute the equilibrium price, profit and number of
firms under free entry.

• analyse how product differentiation relaxes price competition
• analyse how firms choose product characteristics in the context of
simple models of product differentiation
• describe the theory and evidence on product proliferation as an entry
deterrence strategy
• compare horizontal and vertical product differentiation and explain
their different implications for market structure and profitability.

1. Discuss the view that incumbent firms in an industry can use a
strategy of product proliferation to deter entry. Present the basic
argument using a model of horizontal product differentiation, examine
critically the assumptions necessary for this strategy to work, and
briefly discuss any relevant empirical evidence.
2. Describe, with reference to any appropriate economic models, at least
two different reasons why firms can make considerable net profits in
the long run even under conditions of free entry.
60
Chapter 7: Price discrimination

Learning objectives
• explain the notions of first-degree, second-degree and third-degree
price discrimination
• analyse simple models of third-degree price discrimination, derive the
inverse elasticity rule and discuss welfare implications and
applications of the analysis
• describe the use of a two-part tariff by a monopolist that practices
second-degree price discrimination
• describe the use of tie-in sales as a form of second-degree price
discrimination.
Essential reading
Chapter 5.
Further reading
Books
2000). Chapter 10.
Addison Wesley, 2005). Chapters 9–10.
Chapter 15.
Stole, L.A. ‘Price Discrimination and Competition’, in Armstrong, M. and R.
Porter (eds) Handbook of Industrial Organization, volume 3. (Amsterdam:
North-Holland, 2007).
Introduction
Firms often sell the same product at different prices to different consumers,
or even to the same consumer. This practice is called price
discrimination. There is also a more subtle form of price discrimination,
namely using different qualities of a good or different packages in order to
separate consumers into different groups. In all these cases, the objective of
the firm is to increase its profit by capturing a larger fraction of consumer
surplus than it would capture under uniform pricing or by offering a single
quality or package. The scope for price discrimination is higher in those
markets where the possibilities for arbitrage are lower. Arbitrage is the
practice whereby consumers with low reservation price buy the good to
resell it to consumers with high reservation price.
61
We distinguish three types of price discrimination.

1. First-degree (or perfect) price discrimination occurs when a firm
manages to capture all the consumer surplus by selling each unit of a
good at its reservation price. This is a useful benchmark, although it is
unlikely to occur in practice, because a firm typically does not have
exact information on each consumer’s preferences and also because of
extensive possibilities for arbitrage.
2. Second-degree price discrimination occurs when a firm has
incomplete information about consumer preferences, but extracts part
of the consumer surplus by using self-selecting devices, such as
different packages or options, that separate consumers into different
groups according to their preferences. That is, the firm designs options
in such a way that different groups of consumers select different
options. Examples include business versus economy class fares,
hardback versus paperback editions of books, end of season sales, and
last-minute bargain holidays.
3. Finally, under third-degree price discrimination a firm extracts part
of the consumer surplus by using direct signals about demand of
different groups of consumers, such as age, occupation, location, etc.
That is, the firm has some information on differences in preferences
between these groups and uses this information to price-discriminate.
Examples include special prices for students and senior citizens,
different journal subscription prices for libraries and individuals, and
different prices across countries for a variety of products
(pharmaceuticals, DVDs, cars, and so on).
Many of the interesting issues regarding price discrimination can be analysed
in the context of a single firm, abstracting from oligopolistic interaction
between firms. We follow this approach below. The firm is formally a
‘monopolist’, but you should think of this as meaning, more generally, ‘firm
with market power’ (possibly operating in an oligopolistic industry).
First-degree price discrimination

We briefly sketch a simple model of first-degree price discrimination. A
monopolist offers a single good and there are N identical consumers, each
with the demand function q = D(p)/N. This demand function is known by
the monopolist. Under standard linear pricing, the firm maximises profit
by charging the monopoly price for each unit sold and makes monopoly
profit, but it cannot capture any of the consumer surplus at that price.
However, the firm can make a higher profit by using a two-part tariff, in
other words a pricing schedule of the form T = A + pq: this implies that in
order to have the right to consume the good, each consumer must pay a
fixed premium A.1 Suppose the firm charges price p per unit sold; then each 1
Under linear pricing, A=0.
consumer would be willing to pay an amount up to her net consumer
surplus at that price. What is the combination of p and A that yields
maximum profit to the firm?
It turns out that the firm maximises profit by setting p equal to the
‘competitive’ price (i.e. the price given by the intersection of the aggregate
demand curve D(p) and the marginal cost curve) and A equal to the net
consumer surplus of each consumer at that price. Thus the firm
appropriates the entire social surplus (producer surplus plus consumer
surplus) at the ‘competitive’ price.
62
Third-degree price discrimination

The main feature of third-degree price discrimination is that the monopolist
can separate the aggregate demand into m ‘groups’ or ‘markets’ on the basis
of some exogenous and observable buyer characteristic. These m groups
have m distinct demand functions for the product, all of which are known
to the monopolist. Assume that there is no arbitrage between groups, but
the monopolist cannot price-discriminate within a group. In this situation
the monopolist’s problem is to choose a linear tariff (a per unit price) for
each of the m markets. That is, the monopolist chooses prices p1, p2, …, pm
to maximise profit:
∑i=1 p i Di ( pi ) − C (q)
m
where Di(pi) denotes the quantity demanded in market i and:
∑i =1
m
q= Di ( p i )
The optimal set of prices is then given by the inverse elasticity rule:
pi − C ′(q ) 1
=
pi εi
for each market i, where εi is the absolute value of the price elasticity of
demand in market i. Thus the monopolist should charge a higher price in
markets with the lower elasticity of demand. This may well explain why
profit-maximising firms offer discounts to students and senior citizens, why
many utilities charge different business and household rates, or why
differences in the price of a product across regions or countries are
sometimes hard to explain solely in terms of cost differences and trade
restrictions. Note, however, that before attributing any such cases to price
discrimination, one has to check that arbitrage between markets is
impossible or costly.
We now prove the inverse elasticity rule for the case where the monopolist
serves two different markets (the proof is similar for the general case of m
markets). The firm chooses prices p1 and p2 to maximise profit Π =
p1D1(p1) + p2D2(p2) – C[D1(p1) + D2(p2)]. The first-order conditions are
given by ∂Π/∂pi = Di(pi) + piDi′(pi) – C′[D1(p1) + D2(p2)]Di′(pi) = 0, for i
= 1,2. Now move the term Di(pi) to the right-hand side, divide both sides
by piDi′(pi) and set q = D1(p1) + D2(p2). We obtain:
p i − C ′( q) 1
=
pi − p i Di′ / Di
for i = 1, 2, which is the inverse elasticity rule since –piDi′(pi)/Di is the

absolute value of the price elasticity of demand in market i.
The welfare implications of third-degree price discrimination are as follows.
Consumers in low-elasticity markets are hurt by price discrimination since
they pay a higher price, buy a smaller quantity and enjoy less consumer
surplus than under uniform pricing. The reverse is true, however, for
consumers in high-elasticity markets. Moreover, producer surplus increases.
So the overall effect on social welfare is ambiguous. Note that this is so
when the monopolist serves both markets in the absence of price
discrimination. However, if price discrimination were prohibited, say, then
there is a chance that the firm would choose not to serve the low-elasticity
market at all, and that would definitely result in lower welfare than under
price discrimination.
63
What if a monopolist that sells a product to different groups of buyers and

wants to price-discriminate is prevented from doing so by arbitrage? An
interesting case arises when the monopolist is selling an intermediate
product to other producers. Suppose, for instance, that the monopolist sells
to two different groups of buyers, the demands of which are independent,
with elasticities ε < ε . It turns out that, if price discrimination is not
1 2
feasible, the monopolist can still achieve the same profit as under price
discrimination by vertically integrating into the market with the high
elasticity of demand (i.e. market 2).
Activity
Prove this result.
Answer
The monopolist can buy a firm in market 2, sell to it at a low price, according to the
inverse elasticity rule for market 2, and sell to all the other firms in markets 1 or 2 at a
higher price, according to the inverse elasticity rule for market 1. This will drive all the
other firms in market 2 out of business, and the monopolist will achieve the same profit
as under price discrimination.2
2
See Tirole (1988), p.141, for
details.
Second-degree price discrimination

Suppose now that there is no observable characteristic on the basis of
which the monopolist can separate consumers into different groups. In this
case the firm can still discriminate indirectly by offering various packages
so that different groups buy different packages (i.e. self-select). A simple
form of second-degree price discrimination is a two-part tariff T(q) = A +
pq. This essentially offers a continuum of bundles (q,T) for consumers to
choose from. Two-part tariffs are quite common, although more complex
non-linear pricing schemes are optimal for the firm, at least if
implementation and monitoring costs are not too high.
To fix ideas, consider a model where the firm can only use a two-part tariff 3
to price-discriminate.3 There are two types of consumers, with utility
pp.143–46.
function U = θV(q) – T if they consume q units of the good and pay T, and
U = 0 if they do not buy. We assume that V(0) = 0, V′(q) > 0, and V″(q) <
0. θ is a taste parameter that differs across the two consumer types, with θ2
> θ1. The firm produces the good at constant marginal cost c < θ1. It
knows the values of the θ′s, but it cannot tell the consumers apart.
A type θi consumer chooses qi to maximise Ui. The first-order condition,
setting T = A + pqi, is given by θiV′(qi) – p = 0 ⇔ p = θiV′(qi). This is the
inverse demand function of the firm for type θi consumers. Since V″(q) < 0
and θ2 > θ1, it immediately follows that, for any given per unit price p, q2
> q1. That is, the demand curve for θ2 types is always above the demand
curve for θ1 types (see Figure 7.1). It can also be seen from Figure 7.1 that
the net consumer surplus is larger for θ2 types than for θ1 types, for any
given price p. Let Si(p) denote the net consumer surplus of type θi.
64
p area ABC: net consumer surplus for θ1 types
B area ADE: net consumer surplus for θ2 types
demand for θ2 types

A E C
demand for θ1 types
Figure 7.1
In these circumstances, the monopolist will compare the profits from two
possible courses of action. The first is to serve only the type θ2 consumers.
In this case the problem reduces to one of choosing the optimal two-part
tariff for first-degree price discrimination applied to type θ2 consumers.4 4
Recall that all consumers of
The second is to serve both types of consumers. The problem then is to a certain type are identical, so
choose the two-part tariff that maximises total profit subject to giving an arbitrage within a group is not
incentive to both types to buy. Suppose the per unit price is p. Then the an issue.
highest fixed premium that a type θ1 is willing to pay for the right to
consume the good is A = S1(p). A type θ2 is also willing to pay this fixed
fee because S2(p) > S1(p). On the other hand, the firm has no reason to set
a lower premium for any given p. So the firm will in fact set A = S1(p) and
its problem then will be to choose the per unit price p that maximises its
overall profit:
Π = NS1(p) + (p – c)D(p),
where N is the number of consumers and D(p) is the aggregate demand of
the N consumers at price p.5 Setting ∂Π/∂p = 0 implicitly defines the 5
In Tirole’s exposition the
optimal per unit price p*, and hence also the optimal fixed fee A* = number of consumers is
S1(p*). The monopolist will therefore offer the two-part tariff A* + p*q, normalised to 1, so the
and type θ2 consumers will choose to consume a higher quantity than type aggregate demand as defined
θ1 consumers. here is N times the aggregate
M FD SD demand as defined in Tirole.
To conclude, let p , p and p denote the per unit prices under uniform
You can see that N is simply a
monopoly pricing, first-degree price discrimination and second-degree price
multiplication factor in this
discrimination in the above model, on the assumption that both consumer
model with constant marginal
types are served. Use similar superscripts for profits Π and total social
cost and its value does not
welfare W (the sum of producer and consumer surplus). It can be shown
affect the results.
that pM > pSD > pFD = c, ΠM < ΠSD < ΠFD, and WM < WSD < WFD. Note
that in these comparisons the higher the per unit price, the lower the
welfare, because the fixed fee is just a redistribution from consumers to the
firm and hence does not affect W.
The above framework can be used to analyse how a firm may use tie-in
sales as a price discrimination device. Suppose that a firm is the sole
producer of a ‘basic’ good that is consumed in fixed quantity and jointly
with a ‘complementary’ good which is consumed in variable amounts and
can be supplied by a competitive industry at a price equal to its marginal
cost. For instance: photocopying machines and copying paper. Suppose, as
above, that there are two types of consumers, with utility function U =
θV(q) – T if they consume q units of the complementary good and pay T,
and U = 0 if they do not buy. Consumers buy only one unit of the basic
65
good, or none. θ is a taste parameter that differs across types, with θ < θ .
1 2
The marginal cost of the basic good is c0, while the marginal cost of the
complementary good is c. The reason why the above analysis of two-part
pricing is relevant in the present case is that the basic good can be seen as
a prerequisite for consuming the complementary good. Hence the
maximum amount a consumer would be willing to pay for the basic good is
the net surplus he or she derives from the consumption of the
complementary good.
Suppose that the manufacturer of the basic good can make the purchase of
the complementary good a condition for the sale of the basic good to any
buyer and can also prevent arbitrage. The firm then sets a price p for the
complementary good and a price A for the basic good. On the assumption
that the firm serves both types of consumers, it will set A = S1(p) and
choose p to maximise Π = NS1(p) + (p – c)D(p) – Nc0, so the result will be
the same as in our model of two-part pricing above.6 In particular, p* > c.
6
The cost of production of the
If the firm could not use tie-in sales, the price of the complementary good basic good is a fixed cost, so it
would be equal to its marginal cost c, and the producer of the basic good does not affect the firm’s
would set A = S1(c) > S1(p*). In other words, the result of tie-in sales is a maximisation problem over p.
higher price for the complementary good and a lower price for the basic
good. This amounts to price discrimination hurting type θ2 consumers. Note
that p* > c implies that welfare is unambiguously lower under tie-in sales
if both consumer types are served – the fact that A is lower is irrelevant
since this is a redistribution from the manufacturer of the basic good to
consumers. On the other hand, you must bear in mind that, if tie-in sales
are not allowed, the chances increase that the firm will choose to serve the
θ2 types only, so welfare could in fact increase under tie-in sales.
Another thing you should bear in mind is that price discrimination is not
the only reason for tie-in sales. Tying may be used to increase efficiency, as
in the case of goods that are usually consumed together. Or tie-in sales may
be used by a firm with market power in one market to eliminate or restrict
competition in another market (the one for the tied good) where it has
little market power. In an oligopolistic industry, tie-in sales may also serve
as a product differentiation device if some but not all firms use them.
As mentioned above, a two-part tariff is just one form of second-degree
price discrimination. In many situations, a monopolist can use a more
complex, but more profitable, pricing policy. This consists in offering
different packages, each directed to one consumer type. These packages are
chosen to maximise the firm’s profit subject to participation constraints (i.e.
each type must be willing to buy) and incentive-compatibility constraints
(i.e. no type must have an incentive to buy a package intended for another
type). For example, there may be two options for membership of a gym,
one that involves a fixed monthly fee and unlimited visits at no extra cost
and one with no fixed fee but a relatively high price per visit: the first
option would be intended for frequent users, the second for occasional
visitors. Or the options may be differentiated by quality, if different
consumers have different willingness to pay for quality. Or the same
product may be sold at a higher price initially, when availability is
guaranteed, and a lower price after a certain time, and possibly also subject
to availability – in an attempt to separate less patient or more committed
customers from more patient or less committed ones. When there are two
consumer types and therefore two packages, it turns out that one important
feature of the optimal pricing policy is that low-demand consumers derive
no net surplus, while high-demand consumers derive a positive net surplus,
just as in our model of two-part pricing.
66
Activities
1. Starworks Ltd. sells to two types of consumers, with respective demand functions
q = 1 – p (in proportion λ) and q = 2 – p (in proportion 1 – λ). Its unit
production cost is zero. The firm faces a fringe of competitive firms selling the
same good at price p0 < 1 (presumably these firms have unit cost equal to p0).
a. What is the optimal pricing policy of Starworks Ltd under standard linear
pricing (i.e. in the absence of any price discrimination)?
b. If the firm can tell consumers apart and prevent arbitrage, what is the
optimal pricing policy of Starworks Ltd?
2. Consider the same setup as in the previous question, but now assume that the
firm cannot tell consumers apart. What is the optimal two-part tariff under
second-degree price discrimination?

• explain the notions of first-degree, second-degree and third-degree
price discrimination
• analyse simple models of third-degree price discrimination, derive the
inverse elasticity rule and discuss welfare implications and
applications of the analysis
• describe the use of a two-part tariff by a monopolist that practices
second-degree price discrimination
• describe the use of tie-in sales as a form of second-degree price
discrimination.

1. There are two types of consumers of a certain good, with utility
function U = θV(q) – T if they consume q units of the good and pay T,
and U = 0 if they do not buy. Assume that V(q) = [1 – (1 – q)2]/2,
the same for all consumers. θ is a taste parameter that differs across
types: it takes the value θ1 for a fraction λ of the total population of
consumers and the value θ2 > θ1 for the remaining fraction 1 – λ. The
total number of consumers is normalised to 1 for simplicity. A
monopolist produces the good at unit cost c < θ1 and knows the
values of θ1, θ2 and λ.
a. Compute the demand function and the net consumer surplus for
the two types and show that the net consumer surplus is higher for
θ2 types.
b. Derive the aggregate demand function. (Hint: define θ = 1/[λ/θ1
+ (1 – λ)/θ2] to simplify the algebra.)
c. Suppose that, because of full arbitrage between consumers, the
monopolist cannot engage in any form of price discrimination.
Derive the optimal linear tariff on the assumption that the firm
chooses to serve both types of consumers.
d. Now suppose that the firm can observe each consumer’s type and
there is no arbitrage between types, so it can practice first-degree
price discrimination. Derive the optimal two-part tariff for each
type.
67
e. Finally, suppose that the firm cannot tell the consumers apart and
there is no full arbitrage, so it practices second-degree price
discrimination by setting a two-part tariff. Derive the optimal two-
part tariff on the assumption that the firm chooses to serve both
types of consumers.
2. Analyse how tie-in sales can be used as a price discrimination device
and discuss the welfare implications of this practice.
68
Chapter 8: Vertical relations

Learning objectives
• analyse models of a vertical relationship between a manufacturer and
a retailer and show how vertical restraints can be used to eliminate
inefficiencies in such a relationship
• evaluate various efficiency arguments for vertical restraints in the light
of any relevant empirical evidence
• explain at least three different reasons why vertical restraints can
restrict competition
• use the theory on vertical restraints to discuss any relevant empirical
evidence and evaluate public policy in this area.
Essential reading
Books
Chapter 22.
Journals
Rey, P. and J. Stiglitz. ‘The Role of Exclusive Territories in Producers’
Competition’, Rand Journal of Economics (1995) 26(3), pp.431–451.
Further reading
Books
2000). Chapter 11.
Competition Commission New Cars: A Report on the Supply of New Motor Cars
within the UK, Cm 4660 (London: TSO, 2000). Available online:
www.competition-commission.org.uk/rep_pub/reports/2000/439cars.htm
Chapter 17.
Monopolies and Mergers Commission (MMC) New Motor Cars, Cm 1808
(London: HMSO, 1992). www.competition-
commission.org.uk/rep_pub/reports/1992/313newmotorv1.htm
Katz, M.L. ‘Vertical Contractual Relations’, in Schmalensee, R. and R. Willig
(eds) Handbook of Industrial Organization, volume 1. (Amsterdam: North-
Holland, 1989).
Journals
Cooper, J.C., L.M. Froeb, D. O’Brien and M.G. Vita ‘Vertical Antitrust Policy as
a Problem of Inference’, International Journal of Industrial Organization
(2005) 23, pp.639–664.
Mathewson, G.F. and R.A. Winter ‘An Economic Theory of Vertical Restraints’,
Rand Journal of Economics (1984) 15(1), pp.27–38. 69
Introduction
In nearly all the topics discussed so far in Part 2 of this guide we have
made the simplifying assumption that firms produce goods which they then
sell directly to the final consumers. In this chapter, we focus on situations
where ‘upstream’ firms possessing market power are selling to ‘downstream’
firms which, in turn, sell to the final consumers. Examples include
manufacturers selling to retailers, or manufacturers of an intermediate
good selling to manufacturers of the final good. We will be using the terms
‘manufacturer’ and ‘retailer’ to denote respectively the upstream and the
downstream firm in what follows.
In these situations, manufacturers sometimes impose contractual restraints
on retailers, such as:
• resale price maintenance (RPM) – the imposition by the
manufacturer of a fixed or minimum retail price
• franchise fee or two-part pricing – the payment by the retailer of
a fixed fee in order to carry the manufacturer’s product
• exclusive territories – the allocation to each retailer of exclusive
rights to sell in a territory
• exclusive dealing – the requirement that a retailer does not sell
products of rival manufacturers.
What is the reason for imposing these vertical restraints? In particular,
are they used to restrict competition, in which case they unambiguously
reduce social welfare? Or are they used to increase the efficiency of the
vertical relationship, in which case they may be socially beneficial as well?
In this chapter we examine efficiency arguments for vertical restraints as
well as theories that view them as restrictions on competition. Some
empirical evidence is also discussed and policy implications are drawn.
Efficiency arguments for vertical restraints
The basic vertical externality

We start with the simplest setup involving one manufacturer and one
retailer.1 The manufacturer sells to the retailer at price pw > c, where c is the
1
unit production cost. Assume that c < 1. The retailer takes pw as given and pp.174–178.
chooses the retail price p. Demand by consumers is given by q = D(p) = 1 – p.

The first-best or ‘efficient’ outcome is the one which maximises the
aggregate profit (i.e. manufacturer’s profit plus retailer’s profit). This is
found by assuming that the two firms merge into an ‘integrated structure’.
In this case the problem is to choose p to maximise (p – c)(1 – p). The first-
I
order condition is –(p – c) + (1 – p) = 0 ⇔ p = (1 + c)/2. Substituting
into the profit function, we obtain total profit ΠI = (1 – c)2/4.
What happens if the two firms make separate decisions? First the
manufacturer chooses pw, then the retailer observes pw and chooses p. This
is a two-stage game, so we use backward induction. At stage 2 the retailer
chooses p to maximise his profit (p – pw) (1 – p). The first-order condition
gives pNI = (1 + pw)/2. Substituting into the retailer’s profit function, we
obtain the retailer’s profit ΠR = (1 – pw)2/4. At stage 1 the manufacturer
chooses pw to maximise his profit (pw – c)(1 – p) anticipating the retailer’s
reaction, in other words anticipating that p = (1 + pw)/2. The
manufacturer’s problem is therefore to choose pw to maximise (pw – c)[1 –
(1 + pw)/2]. The first-order condition gives pw = (1 + c)/2. Note that this
70
also implies pNI = (3 + c)/4 and ΠR = (1 – c)2/16. Substituting the value

for pw into the manufacturer’s profit function, we obtain the manufacturer’s
profit ΠM = (1 – c)2/8. Therefore the total profit ΠM + ΠR = 3(1 – c)2/16
< (1 – c)2/4 = ΠI. Moreover, pNI = (3 + c)/4 > pI. The conclusion is that
the non-integrated industry makes lower total profit than the integrated
structure. Also, the price to consumers is higher if the industry is not
integrated. This is the result of double marginalisation. Our example
shows that double marginalisation is bad both for firms and for consumers.
This is a general result: it holds also for a general demand function.
Obviously, vertical integration would eliminate double marginalisation and
restore efficiency. How can this be achieved through the use of appropriate
vertical restraints? One solution is as follows. The manufacturer must set
pw = c, and extract the retailer’s profit through a franchise fee A = (1 –
c)2/4. Given that pw = c, the retailer will choose p to maximise (p – c)(1 –
p). As we have seen above, this gives p = (1 + c)/2 = pI and profit equal
to (1 – c)2/4 (i.e. the same as for the integrated industry).
Note, however, that there are also some problems with franchise fees in
more general settings. In particular, the retailer bears all the risk if demand
or cost is uncertain; the retailer may possess private information about
demand or cost, so it may be hard to extract his profit; and in a model with
many retailers, franchise fees are not sufficient to extract ΠR.
Provision of services
Let us now extend and generalise this model. Suppose the manufacturer
sells to the retailer at price pw > c, where c is the unit production cost. The
retailer takes pw as given and chooses the retail price p. However, the
retailer can also supply pre-sale services – information, free delivery,
advertising in the local press, etc. – that increase demand for the product.
The retailer then chooses the level of services s along with the retail price.
Assume that the manufacturer cannot specify the level of s in the contract
with the retailer, since s is difficult to observe. Demand by consumers is
given by q = D(p,s), with Dp = ∂q/∂p < 0 and Ds = ∂q/∂s > 0. Finally,
assume that supplying a level s of services costs the retailer Φ(s) per unit of
services, with Φ′ = dΦ/ds > 0. So the total cost of services is qΦ(s).
The first-best outcome is the one which maximises the aggregate profit (i.e.
manufacturer’s plus retailer’s):
max [ p − c − Φ ( s )]D ( p, s ) = ( pw − c ) D ( p, s ) + [ p − pw − Φ ( s )]D ( p, s )
p ,s
This maximisation problem gives first-order conditions:

(pw – c)Dp(p,s) + [p – pw – Φ(s)]Dp(p,s) + D(p,s) = 0 (1)
and:
(pw – c)Ds(p,s) + [p – pw – Φ(s)]Ds(p,s) – Φ′(s)D(p,s) = 0 (2).
m m
Denote by p , s the values of p, s that maximise the aggregate profit. These
are the efficient choices (from the point of view of the integrated structure).
Now what happens when the two firms make separate decisions? First the
manufacturer chooses pw, then the retailer chooses p and s. The profit of
the retailer is [p – pw – Φ(s)]D(p,s). The retailer chooses p and s to
maximise this, which gives first-order conditions:
[p – pw – Φ(s)]Dp(p,s) + D(p,s) = 0 (3)
and:
[p – pw – Φ(s)]Ds(p,s) – Φ′(s)D(p,s) = 0 (4).
71
Now compare equations (1) and (3). The term (p – c)D (p,s) < 0 is
w p
missing in (3). In other words, when choosing p the retailer does not take
into account the effect of this choice on the manufacturer’s profit. In
particular, the retailer sets p > pm. Compare also equations (2) and (4).
The term (pw – c)Ds(p,s) > 0 is missing in (4). That is, when choosing s the
retailer does not take into account the effect on the manufacturer’s profit.
In particular, the retailer sets s < sm: services are underprovided. In both
cases there is a ‘vertical externality’ which occurs because both the
manufacturer and the retailer have market power.
One solution, through the use of vertical restraints, is for the manufacturer
to set pw = c, and extract the retailer’s profit through a franchise fee A =
[pm – c – Φ(sm)] D(pm,sm). Given that pw = c, the retailer will choose p and
s to maximise [p – c – Φ(s)]D(p,s), which is the same as the maximisation
problem of the integrated structure. So the retailer chooses pm and sm and
makes profit A. Hence the first-best outcome is attained.
Extensions: horizontal externalities, free riding and quality

certification
A more complicated, and more realistic, situation involves one
manufacturer and many retailers. In addition to the vertical externalities
identified above, there are in this case ‘horizontal externalities’, that is
externalities among retailers. An example is the provision of pre-sale
services. These create a public good problem, because each retailer cannot
fully appropriate the returns from supplying such services; for instance, a
consumer may obtain information about the product from one shop, then
buy it from another. The result is that retailers free-ride on each other and
services are undersupplied.
Mathewson and Winter (1984) have constructed a model to examine this
situation. There are N retailers, differentiated by location. Retailers can
boost demand by advertising the product. In particular, there are two
classes of consumers, informed and uninformed, and a retailer can
advertise to increase the number of informed consumers.2 However, a
2
Advertising that boosts demand
proportion of advertising messages ‘spill over’, that is some consumers who but not the willingness to pay a
get a message from retailer i ultimately buy from another retailer. In this higher price is called
setup there are both vertical and horizontal externalities. The efficient ‘informative’. Retailers’
outcome (from the point of view of the integrated structure) can be advertising is often of this kind.
attained through various combinations of vertical restraints which Advertising that increases the
internalise these externalities. For example, franchise fee plus resale price willingness to pay, as in the
maintenance does the trick. RPM encourages consumers to buy where the vertical product differentiation
services are provided since they cannot find a better price elsewhere, so it models discussed in Chapter 6 of
deals with the horizontal externality. The fixed fee takes care of the vertical this guide, is called ‘persuasive’.
externality. Manufacturers’ advertising is
often of this kind: it aims to
It should be emphasised again at this point that, in all the above discussion,
create a brand image for the
‘efficiency’ refers to the optimal outcome for the ‘integrated structure’ (and
product. Note, however, that
– through the ultimate appropriation of the retailer profit by the
these are basically analytical
manufacturer via a franchise fee – for the manufacturer). This may or may
categories and sometimes
not be welfare-enhancing for society as a whole. For instance, vertical
advertising is both ‘informative’
restraints such as RPM or exclusive territories may well increase the level of
and ‘persuasive’.
services provided, but they may also lead to higher prices. The welfare
implications are not clear.
The horizontal externality argument is often invoked as an explanation,
and justification, for resale price maintenance. However, RPM has often
been imposed on goods that involve few inappropriable pre-sale services.
What explains its use in such cases?
72
One story, a generalisation of the free-riding argument, is that the retailer

offers ‘quality certification’. The idea is that pre-sale services are not tangible;
rather the simple fact that a retailer carries the product may signal that the
product is of high quality. Now such a retailer may be unwilling to store the
product if this can also be found in a discount store at a low price. Hence the
manufacturer imposes RPM or/and refuses to supply discount stores.
A well-known case where the use of RPM may have been linked to an
attempt to offer quality certification is the case of Levi Strauss jeans. Until
the mid-1970s Levi Strauss fixed a minimum retail price for their jeans.
They distributed jeans through two sorts of outlets: traditional outlets, such
as department stores, and specialty stores (i.e. chains of jeans shops). They
refused, however, to sell through discount stores. Quality certification is one
likely reason for RPM and for refusing to sell to discount stores. In any
case, RPM prevented competition between retailers. Following a Federal
Trade Commission complaint, Levi Strauss abandoned RPM in 1977 – but
still kept their jeans out of discount stores. Price-cutting started from jeans
stores and spread to department stores and to other brands of jeans as well.
The result was a large increase in sales and profit of Levi Strauss. Also,
since prices were lower, consumer surplus increased.
One would conclude that RPM was in this case not profitable for Levi
Strauss, at least under the demand conditions of the mid-1970s. Demand
proved to be much more elastic than Levi Strauss had thought, so a low-
price strategy was in fact better than RPM not only for consumers but also
for Levi Strauss. Or was it? The above is not the end of the story. In 1980
the boom faded and profits of Levi Strauss and other jeans makers fell. It is
not clear whether this had something to do with the entry in 1979 of
‘designer jeans’ into the market. These filled the gap left by the move of
Levi Strauss to the low-price segment of the market, but may have
happened anyway. Overall, it is not clear whether RPM was a sensible
strategy for Levi Strauss in the long term or not.
Vertical restraints as instruments that restrict

competition
There are various stories in the literature, three of which will be mentioned
here. Perhaps the most common argument against resale price maintenance
is that it may be used to restrict competition between retailers. Suppose
that unrestricted competition between retailers would result in a _retail price
p*. If the manufacturers impose a fixed or minimum retail price p > p*,
3
competition between retailers_ will become less intense. This will increase
3
Think of this in terms of our
retailers’ profits (provided p is not too high) and will reduce welfare, since analysis of reaction functions in
output will be further away from the socially optimal level than in the no- Chapter 5 of this guide.
RPM case. Things may in fact be even worse in the presence of efficiency
differences between retailers. RPM may then allow the survival of the less
efficient by preventing the more efficient from cutting price and hence
gaining market share. You should bear in mind that exclusive territories
may have similar effects on retailer competition as RPM.
A second story focuses on the effect of exclusive dealing on competition
between manufacturers. The basic idea is that exclusive dealing can be
used as a barrier to entry into the ‘upstream’ market. The reason is that it
may force new manufacturers to set up their own distribution network,
which is costly. As a result, new manufacturers will be less inclined to enter.
Finally, a third story argues that vertical restraints such as RPM or exclusive
territories may also be used to restrict competition between manufacturers.
We present this argument through the analysis of a simple model, based on
73
Rey and Stiglitz (1995), that involves the use of exclusive territories. There
are two manufacturers, producing a differentiated product. Final demand
for good 1 within any given territory is given by q = 1 – p + bp , while
1 1 2
final demand for good 2 is q2 = 1 – p2 + bp1, where 0 < b < 1 – so that
the own-price effect on demand is stronger than the effect of the rival’s
price. Assume, for simplicity, that the production cost is zero. The products
are distributed through retailers. Assume zero retail costs.
Consider first the case where there are no exclusive territories. In any given
territory, good 1 is distributed by a large number of retailers who all
compete with each other. Assume, for simplicity, that there is no spatial
differentiation between retailers (consumers have zero travel costs), so the
retail price of good 1 is driven down to w1, which is the price at which the
manufacturer of good 1 sells it to retailers. Thus p1 = w1. Similarly for
good 2: p2 = w2. In this case the retailers make no profits. The
manufacturers’ profits in any given territory are Π1 = w1(1 – w1 + bw2)
and Π2 = w2 (1 – w2 + bw1). The two manufacturers move simultaneously.
Manufacturer i chooses wi to maximise Πi taking wj as given, where i = 1,
2, j ≠ i. Solving the system of the two first-order conditions and also
substituting into the profit functions, we obtain equilibrium prices and
profits w1* = w2* = p1* = p2* = 1/(2 – b), Π1* = Π2* = 1/(2 – b)2
(check these results). Everything is as if the manufacturers sold directly
to consumers.
Consider now the case where each manufacturer grants exclusive territories
to the retailers carrying his product. Hence intra-brand competition is
eliminated. The only competition now is between good 1 and good 2 in any
given territory. Take two competing retailers, one selling good 1, the other
selling good 2. Their profit functions are respectively (p1– w1)(1 – p1 +
bp2) and (p2 – w2)(1 – p2 + bp1), where w1 and w2 have already been set
by the manufacturers and are taken as given by the retailers. The two
retailers move simultaneously. Retailer i chooses pi to maximise his profit
taking pj as given, where i = 1, 2, j ≠ i. Solving the system of the two first-
R
order conditions, we obtain equilibrium prices pi = (2 + b + 2wi +
bwj)/(4 – b ), with corresponding quantities qi = (2 + b – 2wi + b2wi +
2 R
bwj)/(4 – b2), where i = 1, 2, j ≠ i.

Competition between the retailers takes place at stage 2 of a two-stage
game. At stage 1 the manufacturers move simultaneously, each of them
anticipating the way the retailers will act at the next stage. Manufacturer i
chooses a wholesale price wi and a fixed fee Fi that the retailer of good i
must pay if he wants to carry the good.
What do manufacturers do at stage 1? For one thing, each of them can use
the fixed fee to extract all the profit made by his retailer at stage 2. Also,
each of them can make some additional profit by charging a wholesale
price above marginal cost (which is zero). The total profit of manufacturer
R R R
1 in any territory is therefore given by w1q1 + F1 = w1q1 + (p1 – w1)
R R R
q1 = p1 q1 , an expression which is a function of w1, w2 and b (see
above). Similarly for manufacturer 2. Manufacturer 1 then chooses w1 to
R R
maximise p1 q1 taking w2 as given, and similarly manufacturer 2 chooses
R R
w2 to maximise p2 q2 taking w1 as given. Solving the system of the two
first-order conditions, we get the equilibrium wholesale prices ^ w1 = ^ w2 =
2 2
b /(4 – 2b – b ). Substituting into the respective profit functions p1Rq1R and
p2Rq2R, we obtain the equilibrium profits ^Π1 = ^Π 2 = (4 – 2b2)/(4 – 2b –
2 2
b).
74
Activity
Go through the computations in the above model. In particular, derive the expressions
^ i, where i = 1, 2.
^ i and Π
for piR, qiR, piRqiR, w
Answer
Straightforward.
Are the profits Π1 and Π2 higher than those made by the manufacturers in
the absence of exclusive territories, that is Π1* and Π2*? It can be easily
verified that ^
Π i > Πi* ⇔ b3(4 – 3b) > 0, which is always true for b∈(0,1),
i = 1,2 (check). It can also be checked that the quantities produced are
lower than those produced without exclusive territories – which were
already lower than the socially optimal ones, given for w1 = w2 = 0. So
total welfare decreases.
In this model, then, exclusive territories restrict competition between
manufacturers. The model can be extended in two ways: (1) retailer i may
not be able to observe w , or (2) fixed fees cannot be used, say because of
j
arbitrage. In both cases the basic results carry through if b is high enough
(i.e. if the products are close substitutes).
Policy towards vertical restraints

The economic analysis of vertical restraints suggests that they can be used for
different purposes and they can have ambiguous welfare effects. The
empirical evidence supports this: there are case studies to support each of the
theoretical stories. In fact, one recent survey of empirical evidence on vertical
restraints (Copper et al. 2005) has concluded that, on the whole, they appear
to reduce prices and/or increase output. Most competition laws acknowledge
these ambiguities. As a result, most vertical restraints are not subject to an
outright prohibition, but are judged on a case by case basis.4 See Chapter 10 4
The only exception is resale
of this subject guide for more on policy towards vertical restraints. price maintenance, which is
prohibited in many competition
laws.
A case study
To gain further insight on the implications of vertical restraints and the
complexity of the issues involved in trying to assess their effect on welfare,
we focus now on a case study of a particular industry. The UK market for
new cars was investigated by the UK Monopolies and Mergers Commission
(MMC) in 1992 and again by its successor, the Competition Commission, in
2000. The industry was relatively concentrated in 1992 (the combined
market share of the three largest producers was 55 per cent), but market
shares tended to fluctuate. The distribution system of the industry had, as
in many other countries, two important features, namely exclusive dealing
and exclusive territories. In particular:
• dealers of any make of cars were allocated territories in which they
had primary responsibility for selling and servicing cars of that make
• a dealer was allowed to sell outside his territory but there were
restrictions regarding (among other things) advertising outside the
designated territory, the number of a manufacturer’s dealerships held
by a single dealer, and the volume of a manufacturer’s cars a dealer
could sell
• a dealer was not allowed to sell competing makes at the same site,
and usually also within a designated territory. Sometimes there were
restrictions on selling competing makes even outside the designated
territory.
75
The MMC concluded that the vertical restraints were likely to have both an
efficiency effect and a market power effect. Overall, the MMC concluded
that profits of manufacturers and dealers did not appear excessive – and
that while prices were sometimes higher than in Europe, this could not be
attributed to the vertical restraints.
The main arguments for and against vertical restraints in the new car
market can be summarised as follows:
• The system of exclusive territories, combined with the restrictions on
sales outside the designated territory, restricts intra-brand competition.
It also prevents efficient dealers from expanding.
• On the other hand, this system encourages dealer investment and
provision of services.
• Exclusive dealing prevents consumers from directly comparing
competing makes, so it reduces inter-brand competition.
• On the other hand, since search costs are low relative to the cost of a
new car, consumers may visit many showrooms to make comparisons.
Also, economies of scope from retailing different makes may be
limited by the fact that the dealers also provide after-sale services.
• There is an efficiency gain from exclusive dealing in that dealers
concentrate more effectively on selling the particular make; this
indirectly promotes inter-brand competition.
Note that the MMC seemed to be less concerned with the effects of vertical
restraints on manufacturers’ incentives and competition between
manufacturers than with the effects on dealers’ incentives and competition.
Accordingly, the main objective of the MMC’s recommendations was to
increase competition between dealers. In particular, the MMC
recommended that the system of exclusive territories and that of exclusive
dealing both stay in place, but a number of ancillary restrictions be
eliminated, namely the restriction on advertising outside the designated
territories, the restriction on the selling of competing makes within or
outside the territory, and the restriction on the volume of cars a dealer may
sell.
Nearly 10 years later, the UK car market was again subject to an
investigation by the Competition Commission, the successor of the MMC.
The Commission found that car prices in the UK had been about 10 per
cent higher than in Germany, France and Italy for similar makes and
models. It concluded that the main cause was the restrictive distribution
system operated by car manufacturers through their dealer networks. It
therefore recommended several changes in the system of car distribution,
most of which were accepted by the UK government. These included:
• prohibiting suppliers from discriminating in pricing between fleet
buyers and private buyers
• allowing dealers to advertise car prices other than recommended retail
prices for new cars
• prohibiting car manufacturers from refusing to sell cars to dealers who
sell below recommended prices, and
• ensuring that dealers can take advantage of cheaper prices of cars by
importing from other European countries without restrictions.
The report did not, however, recommend abolition of the selective and
exclusive distribution system operated by car manufacturers, since this was
at the time allowed by the European Union. In 2002 the EU system was
modified. See also Activity 3 below.
76
Activities
1. A manufacturer produces a homogeneous good at constant unit cost c and sells
to a single retailer at price w. The retailer resells the good to final consumers at
price p. No services are provided. Explain why in this setup ‘double
marginalisation’ will create an inefficiency for the firms and will also be welfare-
reducing for consumers. Describe how double marginalisation can be eliminated.
2. Explain what are the ‘vertical’ and ‘horizontal’ externalities in a relationship
between a manufacturer and retailers.
3. Compare and contrast the two official reports on the UK car market and their
conclusions. How can one explain the differences in the conclusions of the
reports? If you were trying to defend the practices of the car manufacturers at
the time of the 2000 investigation, what would your arguments be? Perhaps you
would highlight some consumer benefits from the vertical restraints and the
potential harm in case they were abolished. Or you might put forward alternative
explanations for the price differentials between European countries.
In order to ‘decide’ the case, you will need to know more about the European car
market and about EU policy toward the car industry. There are several studies on
price discrimination in the European car market, including some available on the
internet. Moreover, until 2002 the car industry in the EU was allowed to operate
a selective and exclusive distribution system: each manufacturer could select
authorised dealers and grant them territorial exclusivity. The system was modified
in 2002: manufacturers may now impose either selectivity or exclusivity, but not
both. The UK, as part of the EU, has been affected by this legislation. The website
of the European Commission has a page on competition issues in the car
industry, with numerous links to various sources of information, including
regulations, news, reports and economic research:
http://ec.europa.eu/comm/competition/sectors/motor_vehicles/overview_en.html

• analyse models of a vertical relationship between a manufacturer and
a retailer and show how vertical restraints can be used to eliminate
inefficiencies in such a relationship
• evaluate various efficiency arguments for vertical restraints in the light
of any relevant empirical evidence
• explain at least three different reasons why vertical restraints can
restrict competition
• use the theory on vertical restraints to discuss any relevant empirical
evidence and evaluate public policy in this area.
77

1. a. A monopoly manufacturer of a good sells to a monopoly retailer.
The consumers’ demand for the good is q = 1 – p, where q is
quantity sold and p is the final price. The retailer has zero cost and
the manufacturer’s cost function is C(q) = q2/2. The timing is as
follows: first the manufacturer chooses a tariff, and then the
retailer chooses the final price.
i. What are the manufacturer’s and the retailer’s profit under the
optimal linear tariff, T(q) = pwq, for the manufacturer?
ii. What are these profits under the optimal two-part tariff, T(q) =
A + p q, for the manufacturer?
w
b. With the same setup as in part a, suppose now that before the
manufacturer chooses the tariff, the retailer can choose to invest to
increase demand. In particular, the retailer has two possible
choices: either spending amount ε (where ε is small and positive),
in which case the demand is increased from q = 1 – p to q = 2 – p,
or spending amount 0, in which case the demand remains q = 1 –
p. The timing is as follows: first the retailer makes the investment
choice, then the manufacturer observes this choice and chooses a
tariff, and then the retailer chooses the final price.
iii. What is the retailer’s level of investment and the manufacturer’s
profit under a linear tariff?
iv. What is the retailer’s level of investment and the manufacturer’s
profit under a two-part tariff? Compare the manufacturer’s
profit under (i)–(iv) and provide intuition.
2. Discuss the view that vertical restraints can have ambiguous welfare
effects. Include in your answer an analysis of at least two different
arguments for the use of vertical restraints and a brief discussion of
any relevant empirical evidence.
78
Chapter 9: The determinants of market structure
Chapter 9: The determinants of market

structure
Learning objectives
activities, you should be able to:
• explain the notions of exogenous and endogenous sunk cost industries
• analyse the determinants of market structure in exogenous and
endogenous sunk cost industries
• compare the theory of market structure with the S–C–P paradigm and
explain why concentration may not be a good predictor of the state of
competition in an industry
• describe the empirical evidence on the determinants of market structure.
Essential reading
Sutton, J. Sunk Costs and Market Structure. Various chapters.
Sutton, J. ‘Market Structure: Theory and Evidence’, in Armstrong, M. and R.
Porter (eds) Handbook of Industrial Organization, volume 3. (Amsterdam:
North-Holland, 2007) Working paper version available at:
http://personal.lse.ac.uk/sutton/market_structure_theory_evidence.pdf
Further reading
Books
2000). Chapters 9 and 14.
Chapter 8.
Performance. (Boston: Houghton Mifflin, 1990). Chapters 3–4.
Symeonidis, G. The Effects of Competition. (Cambridge, MA: MIT Press, 2002).
Journals
Sutton, J. ‘Technology and Market Structure’, European Economic Review
(1996) 40, pp.511–530.
Symeonidis, G. ‘Price Competition and Market Structure: The Impact of Cartel
Policy on Concentration in the UK’, Journal of Industrial Economics (2000)
48(1), pp.1–26.
Introduction
This chapter examines the theory and empirical evidence on the
determinants of market structure. It attempts to shed some light on
questions like:
• why are some industries more concentrated than others?
• what is the link between competition and concentration, and between
technology and concentration?
79
• should we expect that economic integration will lead to lower

concentration in the international economy than in national
economies?
• what is the role and what are the limitations of policies that influence
the level of concentration, such as merger policy?
This chapter describes a comprehensive framework for the analysis of
market structure, which is associated with the so-called bounds
approach to market structure. This approach has set out to identify a
number of economic mechanisms that hold across industries or for a class
of industries. It aims therefore to provide results with broad application.
However, market structure in any particular industry depends on a number
of factors, some of which are either not observable or not systematic. This
means that for any given set of observable and systematic industry
characteristics, there is a multiplicity of possible outcomes. The bounds
approach essentially consists in distinguishing between those outcomes that
are possible or likely and those that are impossible or unlikely. Thus it turns
out that we cannot generally predict the actual level of concentration in an
industry on the basis of its observable and systematic characteristics,
because this will also depend on unobservable features of the industry as
well as its history, which is to some extent the product of chance. What we
can predict, however, is the ‘lower bound’ to concentration, that is its
minimum possible level. The economic mechanisms that determine this
lower bound turn out to be quite general.
The analysis of the determinants of concentration in this chapter will also
clarify the way market structure interacts with firm conduct. This has
always been an issue of great interest for economists and a major concern
for policy. An old idea in industrial economics, which is at the heart of the
‘Structure–Conduct–Performance (S–C–P) paradigm’, is that concentration
increases profitability in an industry because it facilitates the exercise of
market power by firms – or, to put it in another way, because it facilitates
collusion. Moreover, profits are sustained through ‘barriers to entry’ such as
economies of scale, product differentiation through advertising or R&D, etc.
This view has been subject to several criticisms.
One such criticism, the so-called ‘Demsetz critique’, is that high profitability
in an industry may be due to large efficiency differences between firms: as
the more efficient firms get bigger and make high profits, concentration
increases at the same time – but it is not the cause of high profitability.
Another criticism is that concentration itself is affected by firm conduct, for
instance by the intensity of competition in a market and by firms’ strategies
regarding advertising or R&D. While some versions of the S–P–C paradigm
have recognised the existence of these feedback effects, the interaction
between firm conduct and market structure has only relatively recently
been properly understood and modelled using the distinction between
firms’ ‘long-run’ and ‘short-run’ decisions. This distinction is an important
element in the analysis of the determinants of market structure, as you will
see below.
Basic concepts
Sutton (1991, 1996, 2007) has proposed and developed the bounds
approach to market structure and has produced many of the theoretical
and empirical results discussed in this chapter. A basic distinction in his
analysis of market structure is between exogenous sunk cost
industries and endogenous sunk cost industries.
80
In exogenous sunk cost industries, the only significant sunk costs are the
costs of setting up a plant of minimum efficient scale, and these are
exogenously determined by technology. You should see the notion of an
exogenous sunk cost industry as a useful approximation which captures
two things. First, the fact that firms must operate at a level close to
minimum efficient scale in order to be able to compete; it is for this reason
that setup costs are said to be exogenously determined by technology.
Second, the fact that in many industries there is limited scope for
advertising or Research and Development (R&D), that is for investment
that enhances brand image or product quality or reduces marginal cost.
Thus this category comprises both homogeneous good industries and
industries characterised by horizontal product differentiation (including
spatial differentiation).
In endogenous sunk cost industries, on the other hand, there are, in
addition to the exogenously determined sunk cost of entry, endogenous
sunk costs, such as advertising or R&D. These costs are fixed, they are sunk
before any price decisions are taken by the firms, and they are endogenous
because they can vary depending on each firm’s own decisions. This
category comprises industries characterised by vertical product
differentiation as well as homogeneous good industries in which there is
scope for cost-reducing R&D.
The notion that certain costs are sunk is closely linked to the distinction
between ‘long run’ and ‘short run’. Entry, advertising, or R&D are long-run
choices, while pricing behaviour is a short-run decision. This provides a
way of unravelling the two-way link between firm conduct and market
structure. In the short run, structure is given and we analyse short-run
conduct (i.e. pricing behaviour). In the long run, structure is not given and
we analyse long-run choices and the determination of structure. Thus:
• in exogenous sunk cost industries, competition can be modelled as a
two-stage game: entry at an exogenously fixed sunk cost, then
competition in prices or quantities
• in endogenous sunk cost industries, competition can be modelled as a
three-stage game: entry at an exogenously fixed sunk cost, then
decision to spend on advertising or R&D, then competition in prices or
quantities.
Theory of market structure in exogenous sunk cost

industries
Let us start with the case of a homogeneous good and assume further that
each firm operates a single plant. We model competition in such an
industry as a two-stage game. At stage 1 firms simultaneously decide
whether or not to enter at an exogenously fixed setup cost f. At stage 2 they
simultaneously set prices or quantities. Assume also that the firms are
symmetric. At stage 2 we solve for the Nash equilibrium, given the number
of firms N. Denote the stage 2 equilibrium (gross) profit of firm i Πi(N,S,t),
where N is the number of firms that have entered at stage 1, S is market
size (assumed to be exogenous), and t is the ‘intensity of price competition’:
1
See the Folk theorem
this depends on firms’ pricing strategies,1 which in turn partly depend on
mentioned in Chapter 4.
exogenous institutional factors, such as the climate of competition policy
and the degree of economic integration.2 Standard assumptions are: ∂Πi/∂S 2
‘Price competition’ is here
> 0, ∂Πi/∂N < 0, and ∂Πi/∂t < 0. The second of these is the main equivalent to ‘short-run
prediction of the S–C–P approach; in other words the present analysis competition’, whether firms set
embodies the insights of that approach. The third inequality says that more prices or quantities.
intense price competition lowers gross profit for given N.
81
At stage 1, N is determined by the free entry zero-profit condition Πi(N,S,t)

= f. In other words, firms will enter up to the point where the cost of entry
is equal to the profit they expect to get at stage 2. Taking the total
differential of this equation, we obtain dΠi = (∂Πi/∂S)dS + (∂Πi/∂N)dN +
(∂Πi/∂t)dt = df. From this we obtain dN*/dS = – (∂Πi/∂S)/(∂Πi/∂N) > 0,
dN*/dt = -– (∂Πi/∂t)/(∂Πi/∂N) < 0, and dN*/df = 1/(∂Πi/∂N) < 0, where
N* is the long-run equilibrium number of firms. These results are illustrated
in Figure 9.1.
1⁄
N
increase in t
S/
f
Figure 9.1
The intuition for these results is easy to see. Take, for instance dN*/dS > 0.
i
As S increases, given N, Π rises. So starting from an equilibrium of the
two-stage game where each firm makes zero net profit, we now have Πi >
f. Hence entry will occur, which will cause Πi to fall (since ∂Πi/∂N < 0),
until we have again Πi = f. At the new equilibrium N* will be larger. The
intuition is similar for dN*/dt < 0 and dN*/df < 0.
Activity
As mentioned in Chapter 3 of this guide, the Cournot model can be interpreted as
representing less intense competition than the Bertrand model in games where firms do
not make any long-run decisions other than the decision to enter the market or not. The
present analysis predicts therefore that the equilibrium number of firms N* in a two-
stage game with free entry at cost f > 0 at stage 1 will be smaller under price-setting
than under quantity-setting at stage 2. Prove this for the case where demand is given by
q = a – p and all firms have the same constant marginal cost c.
Answer
If stage 2 competition is in quantities, you already know from Activity 2 in Chapter 3 that
2
stage 2 equilibrium profit is Π = (a – c)/(N + 1) . With free entry at stage 1, we get Π =
(a – c) /(N + 1) = f, which can be solved for N to give N* = [(a – c)/f1/2] – 1. So, in
2 2
general, we have N* > 1 when firms set quantities.3 If stage 2 competition is in prices, 3
N* cannot take any values less
then there are two possibilities for the second stage. Either only one firm has entered at than 1, since this does not make
stage 1, in which case it makes monopoly profit ΠM at stage 2, or more than one firm sense. And it is equal to 1 only
have entered, in which case each of them makes zero profit at stage 2. Now go back to in a very special case.
stage 1. If only one firm enters at stage 1, it makes overall (net) profit ΠM – f, while if
more firms enter, each of them makes negative overall profit – f. So there exists no
subgame-perfect equilibrium of the two-stage price-setting game with more than one
firms entering; the only subgame-perfect equilibrium outcome is N* = 1.
Next, consider the case of a horizontally differentiated product. In this case,

each firm can in general produce one or more varieties of the product. This
includes the case of spatial differentiation where each firm can operate in
one or more locations. There exists now a multiplicity of equilibria: the
82
most fragmented equilibrium is the one where each firm produces one
variety (operates in one location), while various more concentrated
equilibria, symmetric or asymmetric, can occur if firms produce more than
one variety (operate in more than one location). This is illustrated in Figure
9.2. Thus there is a lower bound to concentration which declines
indefinitely with the ratio of market size to setup cost S/f and rises with the
intensity of price competition t. The actual level of concentration can be
anywhere above the bound.
concentration
increase in t
S/
f
Figure 9.2
Whether we will get a more fragmented or a more concentrated structure
for given values of S, f and t depends on various factors, including chance.
For instance, economies of scope in setup costs favour more concentrated
equilibria. Also, strategic asymmetries such as first-mover advantages
favour more concentrated equilibria (recall our discussion of brand
proliferation).
The positive effect of the intensity of price competition on market
concentration that emerges from the theory of market structure has
important implications. Traditionally economists have regarded
concentrated markets as markets where firms make high profits at the
expense of consumers: high concentration was thought to imply a low
degree of competition and high profits. This view is not incorrect, but it
relies on assuming that incumbent firms can deter the entry of potential
rivals. With free (although not costless) entry, profits will be relatively low
and tougher competition among firms will tend to increase the level of
concentration in a market.
Theory of market structure in endogenous sunk cost

industries
Competition in an endogenous sunk cost industry can be modelled as a
three-stage game. At stage 1 firms simultaneously decide whether or not to
enter at an exogenously fixed setup cost f. At stage 2, given the number of
firms N that have entered, each firm chooses to incur an endogenous sunk
cost A (advertising or R&D), which increases the consumers’ willingness to
i
pay for the firm’s product. At stage 3, taking N and the Ai as given, firms
simultaneously set prices or quantities. A central assumption of this model
is that Ai is a fixed cost which is incurred prior to the price or quantity
competition stage. In particular, a higher level of advertising or R&D is not
associated with any significant increase in the marginal cost of the firm.
83
An equilibrium in this three-stage game (for the symmetric case) is a pair

(N*, A*) defined by two necessary conditions:
• the free entry condition Πi(N,S,t,A ,A ) = f + A
i -i i
• the first order condition for the choice of Ai: ∂Πi/∂Ai = 1 for all i.
The second condition says that each firm spends on advertising/R&D up to
the point where the cost of an extra unit of advertising/R&D is equal to the
gross profit it creates at stage 3 of the game.4 4
Π i is the equilibrium stage 3
It can be shown that for a broad class of models – robust to strategic profit, for given N and Ai.
asymmetries, price-setting versus quantity-setting, single-product versus

multi-product firms – the following results emerge (see Figure 9.3):
• Non-convergence: the lower bound to concentration does not
converge to zero as market size S increases. That is, there is a
minimum level of concentration no matter how large the market
becomes.
• Non-monotonicity: minimum concentration may rise or fall as S
increases.
concentration
Figure 9.3
The intuition is as follows. If S is below a threshold market size,
advertising/R&D is not profitable since the gross profit generated is not
enough to cover the fixed cost Ai. So minimum concentration declines as S
increases. For S above the threshold, advertising/R&D begins and the above
results apply. The reason we get these results is that as S increases, firms
have an incentive to spend more on advertising/R&D. Consider the free
entry condition Πi = f + Ai. As S increases, Πi rises, but at the same time Ai
rises as well. If the right-hand side increases by more (less) than the left-
hand side, given the initial number of firms N, then N must fall (rise) to re-
establish the equality Πi = f + Ai. In either case, the escalation of
advertising/R&D spending prevents the emergence of a fragmented
industry structure.
There are some further results for R&D-intensive industries in particular. In
these industries there is a trade-off between spending on R&D to enhance
the quality of an existing product and spending to develop a new product.
Whether firms opt for one or the other of these strategies depends to a
large extent on:
• The cost of achieving quality improvements on an existing product (a
technological characteristic) and the consumers’ willingness to pay for
these improvements (a demand characteristic). These determine the
returns from spending to enhance technical performance or quality.
84
• The degree of horizontal product differentiation (a demand

characteristic). That is, the degree to which demand is fragmented
due to the existence of a variety of customer tastes or requirements.
This is a measure of the returns from introducing a new product.
In industries where there are high returns from product improvement and
demand is not fragmented, firms will choose a product enhancement
strategy. As a result these industries will have both high R&D intensity and
high concentration. Firms will get caught in a process of R&D escalation. To
cover their large R&D costs, they need to produce a lot of output, so there
is only room for a few firms. On the other hand, in industries where there
are low returns from product improvement and demand is fragmented,
firms will choose a product proliferation strategy. As a result these
industries will have high R&D intensity but relatively low concentration.
The possibility to develop varieties that match the needs of particular
buyers leads to a proliferation of varieties and attracts entry.
Empirical evidence
The empirical evidence comes both from cross-industry studies and from
case studies of particular industries. We focus here on cross-industry results.
Symeonidis (2000, 2002) provides evidence on the price competition effect
on concentration. There was a major shift in UK competition policy in the
late 1950s, which led to the abandonment of price-fixing agreements
between firms. It is therefore possible to compare the group of industries
affected by the legal changes, which experienced an increase in the
intensity of price competition, with a ‘control’ group of industries in which
no restrictive agreements had existed. The econometric analysis suggests a
strong positive effect of price competition on concentration both in
exogenous and in endogenous sunk cost industries. For instance, the
change in the competition regime caused the five-firm concentration ratio
to increase, on average, by five to six percentage points in exogenous sunk
i
cost industries. What probably happened is that as t increased, Π fell, so
firms, or less efficient firms, could no longer cover their fixed costs. Hence
there was exit and mergers until the fall in N* caused Πi to rise sufficiently
to cover fixed costs.
High market concentration has traditionally been seen by policy makers as
a cause of concern, since it has been thought to facilitate the abuse of
market power by firms. An interesting policy implication of the results in
Symeonidis (2000, 2002) is that, under free entry and exit, higher
concentration need not be associated with less price competition; the
opposite may sometimes be the case, as more intense competition reduces
profit margins and the number of firms that can survive in an industry. So
competition policy authorities should perhaps be less concerned with
concentration than with ensuring that competition between firms is
‘effective’, that is, firms do not collude or otherwise abuse their market
power and there are no barriers to entry.
Sutton (1991) provides evidence on the market size–concentration
relationship using cross-section data on 20 food and drink industries for six
countries. Six of the industries were exogenous sunk cost industries (H)
and 14 were advertising-intensive (A). Sutton applies two types of
econometric tests.
The first test is to estimate the lower bound to concentration separately for
the two groups of industries, using non-standard econometrics. The
estimates imply that as S/f → ∞, the four-firm concentration ratio C4
approaches 19 per cent for the A group (non-convergence) and six per cent
85
for the H group (convergence). Also, the estimated lower bound for the A
group is not just an upward shift of the bound for the H group, which
supports the view that advertising is an endogenous sunk cost, in contrast
with the older view of advertising as an exogenous barrier to entry.
The second test is to run a standard regression of C4 on ln(S/f) separately
for the two groups of industries. The theory predicts a negative relationship
for the H group and no clear relationship for the A group. This is confirmed
5
See Sutton (1991), Chapter 5,
by the empirical results.5
for details.
Sutton (1996) presents empirical results on R&D-intensive industries. He
tests the following theoretical prediction: as the number of ‘technological
trajectories’ within an industry rises, suggesting that product proliferation
increasingly dominates product enhancement, the lower bound to
concentration is expected to decline. Using data on US industries with
R&D-sales ratio higher than four per cent, Sutton obtains results that 6
Sutton’s more recent work has
confirm the theory.6
addressed issues such as the size
The bounds approach to market structure has implications for competition distribution of firms in an industry
policy. It suggests that there are constraints in the use of merger and anti- and market share dynamics.
trust policies. In particular, one cannot use such policies to try to impose a
market structure below the lower bound, as this is not sustainable. On the
other hand, merger and antitrust policies can be used above the lower
bound to influence the level of concentration in an industry.
Activities
1. The competition law in the country of Wonderland prohibits all mergers that
result in a single firm having more than 75 per cent of any market. Do you think
the law makes sense? Why or why not? What would your advice be to a new
government that proposes to make changes to the law?
2. The photographic film industry and the instrument industry are both
technologically progressive, with high levels of R&D intensity. However, the
former is much more concentrated than the latter. Do you think that this
difference can be explained on the basis of technological and demand
characteristics of these industries?
3. Sutton (2007) writes: ‘One reason for [the] continuing interest in market
structure is that this is one of the few areas in economics where we encounter
strong and sharp empirical regularities arising over a cross-section of industries.
That such regularities appear in spite of the fact than every industry has many
idiosyncratic features suggests that they are moulded by some highly robust
competitive mechanisms.’
What are the empirical regularities and the robust mechanisms Sutton refers to?
Do you agree with his statement above? What are, on the other hand, the
factors behind the idiosyncratic features of every industry and how important are
they? You will need to read both the theory on the determinants of market
structure and (especially) some of the empirical evidence, which is of two kinds:
econometric studies that focus on the general mechanisms, and case studies that
sometimes provide additional evidence on the working of these mechanisms and
sometimes shed light on particular features of every industry.
Studies by Sutton himself and by Symeonidis are good starting points, as is the
work of B. Lyons, S. Davies, C. Matraves and others on economic integration and
industrial market structure in the European Union. Recent empirical papers on
market structure include Ellickson’s ‘Does Sutton Apply to Supermarkets?’ and
Berry’s and Waldfogel’s ‘Product Quality and Market Size’. You can also find
reviews of Sutton’s two books Sunk Costs and Market Structure and Technology
and Market Structure by well-known economists such as T. Bresnahan, R.
Schmalensee, F.M. Scherer and others.
86

• explain the notions of exogenous and endogenous sunk cost industries
• analyse the determinants of market structure in exogenous and
endogenous sunk cost industries
• compare the theory of market structure with the S–C–P paradigm and
explain why concentration may not be a good predictor of the state of
competition in an industry
• describe the empirical evidence on the determinants of market structure.

1. Consider the following two-stage game. There is a large number of
potential entrants in a market for a homogeneous product. At stage 1
firms simultaneously decide whether or not to enter at a cost of entry
f. At stage 2 those firms that have entered simultaneously set
quantities. The demand function is given by Q = S/p, where Q is total
quantity produced and S is total expenditure on the product (here a
measure of market size, and hence exogenously fixed). The marginal
cost is constant and equal to c for all firms.
a. Derive the stage 2 Cournot–Nash equilibrium.
b. Derive the stage 2 equilibrium price, profit for firm i and industry
profit, and show that all three are decreasing in the number of
firms N.
c. Compute the long-run equilibrium number of firms N* and show
that it increases in S and decreases in f. Provide some intuition for
these results.
d. Now suppose that at stage 2 firms collude to raise prices above the
Cournot–Nash price that you computed in part (ii). Do you expect
COLL
the long-run equilibrium number of firms N to be higher or
lower than N*? Explain.
2. Describe the theory of market structure in ‘endogenous sunk cost
industries’. Then describe alternative approaches to testing this theory
and discuss the empirical evidence on the theory.
87
Chapter 10: Competition and industrial policy
Chapter 10: Competition and industrial

policy
Learning objectives
• explain the rationale for competition policy and for industrial policy
towards R&D
• describe the difficulties and dilemmas in competition policy with
respect to mergers, restrictive agreements, and abuses of market power
• discuss the practice of competition policy
• describe and evaluate the main forms of government policy towards
R&D.
Essential reading
Church, J.R. and R. Ware, Industrial Organization: A Strategic Approach.
Various chapters.
Further reading
Books
Addison Wesley, 2005).
Geroski, P. ‘Markets for Technology: Knowledge, Innovation and
Appropriability’, in Stoneman, P. (ed) Handbook of the Economics of
Innovation and Technological Change. (Oxford: Blackwell, 1995).
Kwoka, J.E. and L.J. White (eds) The Antitrust Revolution: Economics,
Competition, and Policy. (Oxford: Oxford University Press, 2004). Also the
companion website: www3.oup-usa.org/sc/0195161181/
Martin, S. Industrial Economics. (Englewood Cliffs, NJ: Prentice Hall, 1994)
second edition.
Mowery, D. ‘The Practice of Technology Policy’, in Stoneman, P. (ed) Handbook
of the Economics of Innovation and Technological Change. (Oxford:
Blackwell, 1995).
Performance. (Boston: Houghton Mifflin, 1990).
Whinston, M. ‘Antitrust Policy Toward Horizontal Mergers’, in Armstrong, M.
and R. Porter (eds), Handbook of Industrial Organization, volume 3.
Journals
Carlton, D.W. ‘Does Antitrust Need To Be Modernized?’, Journal of Economic
Perspectives (2007) 21(3), pp.155–176.
Hall, B.H. ‘The Assessment: Technology Policy’, Oxford Review of Economic
Policy (2002) 18(1), pp.1–9 (special issue: Technology Policy).
89
Introduction
Government policy towards industry is necessary because firms may behave
in ways that reduce social welfare or may be prevented from behaving in
ways that would benefit society. Government policies fall into various
categories. Broadly, the role of competition policy – or antitrust
policy, as it is called in the US – is to design and enforce a set of rules
which ensure that competition is ‘effective’, in other words competing firms
behave in a way that results in the best possible allocation of resources. The
objective is to improve efficiency, which of course here refers to society as a
whole – so the appropriate measure is the sum of producers’ and
consumers’ surplus. Much of industrial policy is concerned with
promoting the best possible intertemporal allocation of resources, through
the provision of incentives to firms to undertake appropriate investments in
circumstances where market imperfections prevent them from doing so.
Regulation is the subject of the next chapter.
This chapter is an introduction to competition policy and industrial policy
towards R&D, with an emphasis on the economic issues rather than on the
legislative and institutional frameworks in different countries. You should
consult the readings given above for more details on how these policies are
operated in various countries. In the case of competition policy, these
readings also contain extensive discussion of particular cases; going
through these cases is essential for appreciating the complexities involved
in the design and implementation of competition policy.1 1
Especially good in this respect
are Carlton and Perloff (2005),
Church and Ware (2000), Kwoka
Competition policy: objectives and difficulties in design
and White (2004), Martin (1994)
and implementation and Scherer and Ross (1990).
The principal goal of competition policy is to set rules for competition
between firms so as to achieve improved market efficiency. There are,
however, three distinct aspects of efficiency. The first is static allocative
efficiency. Thus a central concern of competition policy authorities is the
extent to which firms can exercise market power by pricing above marginal
cost; this is because, as is well known, pricing above marginal cost results
in a ‘deadweight loss’ for society. The second aspect is static productive
efficiency (i.e. the internal efficiency of firms). And the third aspect is
dynamic efficiency, allocative or productive.
There are several reasons why the design and implementation of
competition policy are far from straightforward.
• Firm conduct which may improve one aspect of efficiency may also
worsen another. For example, a horizontal merger between two firms
may result in higher price-cost margins, which is bad for static allocative
efficiency, but it may also lead to lower current costs, which is good for
productive efficiency, or lower future costs or better products through
increased investment in R&D, which is good for dynamic efficiency.
• In many cases, the effect of a particular business practice on welfare
may not be clear, even when only one aspect of efficiency, say static
allocative efficiency, is considered. Recall, for instance, our discussion
of the welfare effects of price discrimination and vertical restraints in
previous chapters of this guide.
• Some practices, such as tacit collusion, are difficult to detect, thus
making the implementation of policy difficult even in cases where the
welfare implications of firm conduct are thought to be relatively
unambiguous.
90
• It is not always easy to identify the degree of market power which is

acceptable in a particular industry, given the technological and other
constraints faced by firms in the industry. Some degree of market power
is necessary under conditions of increasing returns to scale: price has to
be higher than marginal cost, so that firms can cover their fixed costs,
including investment and research costs. Moreover, a firm may obtain
market power because it is efficient or innovative, which surely cannot
be bad in itself. Recall our discussion in Chapter 9 of the constraints on
competition policy imposed by the endogeneity of market structure.
• The efficiency goal has not been the only objective of competition
policy in practice. In the United States, for instance, there has been a
debate between proponents of the efficiency approach and those
arguing for a competition policy that focuses more specifically on
consumer welfare or even a policy with wider social and political
objectives, including the protection of small firms and the dispersion of
economic power. Competition policy in the European Union has
traditionally put specific emphasis on consumer welfare as well as on
overall efficiency, and has also served to promote economic integration.
• Conflicts may also arise between competition policy and other
government policies, such as industrial or trade policy. In Japan, for
instance, competition policy has traditionally been subsidiary to other
concerns, such as the creation of strong domestic firms that are able to
compete with foreign firms in some sectors, or the rationalisation of
production through government-sanctioned cartel arrangements in
other sectors. The wish to create dominant firms able to compete with
non-EU firms has often influenced EU policy as well.
A central issue in most competition cases is the assessment of the market
power of the firms involved, or the assessment of the change in market
power which has been or may be brought about by a certain action of the
firms. This may be complicated because of difficulties in defining the
relevant product or geographical market, the absence of precise
information about firms’ costs and perhaps also about demand parameters,
and the need to take into account market dynamics that may influence the
extent to which market power is likely to persist in time. These difficulties
are particularly severe in research-intensive industries which are subject to
rapid and constant change. Thus when assessing the degree of market
power, the competition authorities are likely to consider several direct or
indirect indices, none of which is conclusive in itself. For instance:
• the market share of the firm or firms involved in the relevant market
• the volatility of market shares in the industry (since high volatility
may indicate low persistence of market power)
• any evidence on price–cost margins and/or the profitability of the firms
• estimates of the elasticity of demand for the product in question (since
high elasticity suggests low market power)
• estimates of the degree of substitution between the product in
question and other products
• the extent to which competition operates at a local, national or
international level
• the degree of actual or potential competition from imports
• the significance of entry barriers, including those created by sunk
investments in capacity, by technological superiority, by brand image,
or by vertical relationships
• the bargaining power of buyers.
91
Competition policy in practice
Merger policy
With merger policy the competition authorities can influence market
structure in particular industries by preventing certain mergers between
firms from taking place. The rationale for merger policy is that a
consequence of many mergers is the creation of additional market power.
In the case of horizontal mergers, the primary concern is the rise in market
share. In the case of vertical mergers, the primary concern is the possibility
that vertical integration hinders the access of non-integrated firms to
outlets or sources of supply. However, a large number of mergers do not
have any significant effect on competition. Moreover, even a merger which
creates more market power can have countervailing benefits, such as
current or future efficiency gains. Finally, some mergers that lead to a more
concentrated industry structure are made necessary by exogenous market
forces, such as a decline in demand or the intensification of competition
caused by stricter competition law or economic integration.
To ensure that competition authorities are not occupied with mergers that
have no significant effect on competition, competition laws typically specify
criteria that a merger must satisfy in order for it to be contestable. In
particular, a merger would be contestable if the level of concentration
and/or market shares after the merger are higher than specified thresholds.
For mergers that are in principle contestable, the next step is to examine
what are the likely effects on competition. This involves assessing the
market power of the firms involved as well as changes in market power
brought about by the merger. In the case of horizontal mergers, the primary
concern is the rise in market share and in industry concentration. In the
case of vertical mergers, the primary concern is the possibility that vertical
integration hinders the access of non-integrated firms to outlets or sources
of supply.
Then, for mergers that are thought to involve market power issues, the
competition authorities must examine whether the merger should be
allowed despite its effect on competition. This can be justified if customers
in the industry under question have significant ‘buyer power’. Or it can be
justified on efficiency grounds, if, for instance, the merger is thought to
result in lower average costs, better management, improved R&D
capabilities, alleviation of the double marginalisation problem (in the case
of a vertical merger), or some other efficiency gain. In practice, both in the
US and in the EU, there has been a certain reluctance to clear mergers on
efficiency grounds, and several European countries which had favoured the
creation of ‘national champions’ during the 1960s and 1970s have since
adopted a tougher attitude towards mergers. Note, finally, that mergers
may often be made necessary by changes in market conditions influencing
market structure. So, for instance, under the US and EU legislations a
merger can be allowed if it can be shown that one of the firms will
otherwise go out of business.
Policy towards restrictive practices

Horizontal agreements between firms to fix prices or output levels or to
allocate customers or geographical areas are typically detrimental for
competition and not defensible on efficiency grounds. This is so whether
such arrangements are explicit or tacit. Thus they are generally prohibited
in most competition laws, including those of the EU and the USA.
92
There are also some exceptions, the most important of which concerns
agreements to co-operate in research and development.2 In the EU, some 2
See the section on policy toward
agreements for co-operative joint ventures in the production and R&D for a discussion of research
distribution of goods have also been allowed on efficiency grounds. In some joint ventures.
countries, such as Germany or Japan, cartels that have the purpose of
reducing capacity in declining industries have been allowed.
The main difficulty regarding horizontal restrictive practices is detection. As
was explained in Chapter 4 of this guide, it is not easy to distinguish
between collusive and non-collusive behaviour on the basis of the data
typically available to competition authorities. For instance, parallel pricing –
the similarity of prices and price changes – is not sufficient for concluding
that collusion exists. As a response to the detection problem, competition
authorities have also focused on secondary agreements that may facilitate
collusion, such as agreements between firms to exchange information on
prices, costs, etc. However, information exchanges may also improve the
knowledge of market conditions and thus promote competition. A
distinction sometimes applied is between exchanges of individual firm data
and dissemination of aggregate industry data; only the former are
suspected of being used to sustain collusion.
Policy towards the abuse of a dominant position

Competition authorities are not so much worried by the mere existence of
market power as by the possibility that firms which possess market power
abuse it, that is, use it in a way that eliminates, restricts or distorts
competition. Therefore the authorities will intervene to control firm
conduct whenever this is thought to be abusive. There are a variety of
business practices that may constitute abuses under different legislatures,
including ‘excessive’ prices, strategies that deter entry or expansion of
rivals, price discrimination, tying, predatory pricing, and vertical restraints.
Now some of these practices, such as price discrimination or vertical
restraints, can have ambiguous welfare effects. Others, such as introducing
new products or building capacity in anticipation of a rise in demand, can
be legitimate competitive actions even if they also deter entry. And still
others, such as predatory pricing, which means reducing prices in order to
drive a competitor out of the market and make high profits thereafter, are
definitely welfare-reducing and hence illegal, but are also difficult to detect.
Most legislatures therefore recognise the need for a detailed investigation
when it comes to assessing whether a firm or group of firms have abused
their market power. This is the so called ‘rule of reason’ approach. Such an
investigation involves establishing the existence of market power and then
examining whether there has been an abuse.
Nevertheless, some legislatures take a tough stance against some particular
practices. One such case is resale price maintenance. This is illegal under
many competition laws, although its effect can be similar to the effect of
granting exclusive territories, a practice often judged under a rule of reason
or even permitted under conditions. The reason for prohibiting resale price
maintenance may be the presumption that it will typically restrict
competition, so the gain from reduced administration costs and from
creating a more certain environment for firms more than compensates for
the loss from cases where resale price maintenance could be efficient.
Another case is price discrimination in EU as well as in US competition
policy. In the European Union, the effective prohibition of geographic price
discrimination is due to the concern for promoting economic integration in
addition to economic efficiency. The European Commission has been tough
93
on producers that have made agreements with distributors barring the

distributor from selling the goods to customers in other than its own
country. In the United States, the hostility against price discrimination
stems from social and political in addition to economic objectives (in
particular, the wish to protect small distributors). However, US competition
authorities have often been reluctant to attack price discrimination.
Among those practices that are typically subject to a rule of reason
approach since they are potentially anti-competitive, some of the most
important ones are those which may create barriers to entry or expansion
by rivals, as is shown in the following examples.
• It may be abusive conduct for a firm which controls an input that is
essential for the supply of the final product to consumers to refuse to
sell that input to other firms. This input can be a raw material,
technological know-how, access to a network, etc. However, firms also
have the right to profit from their investments, otherwise they will not
undertake investments in the first place. So there is sometimes a
dilemma for competition authorities.
• Exclusive dealing can be used by a dominant firm to hinder or prevent
entry by rivals. But since it can also lead to efficiency gains, the
competition authorities must assess its effect in each particular case.
In some competition laws, there is a presumption that both exclusive
dealing arrangements and exclusive territories are normally not anti-
competitive, although they may be in certain cases. Thus EU law is
generally more lenient than US law toward such practices provided
they do not raise concerns about market foreclosure or geographical
price discrimination.
A disadvantage of the rule of reason approach is high administrative costs,
and this is why economists have also been trying to come up with some
simple rules to guide policy on abuses by dominant firms. In the case of
predatory pricing, for instance, a simple rule is that predation exists
whenever a firm sets a price lower than its average variable cost (a proxy
for short-run marginal cost). But note that circumstances exist where a firm
may set a price below marginal cost without being involved in predation;
for instance, in markets with significant ‘learning by doing’, where selling a
lot today significantly reduces production costs in future periods. Also,
there are circumstances where a firm that uses a predatory strategy does
not need to price below marginal cost; for instance, when the firm enjoys a
cost or brand image advantage over a rival. So predatory pricing is
currently judged under a rule of reason.
Policy towards research and development

Government policy towards R&D is necessary because the market
mechanism cannot generally be relied upon to produce the socially optimal
amount of R&D. There are several reasons for this, relating to market
imperfections and the nature of the R&D process itself. In particular:
• Research involves significant sunk costs. On the other hand,
innovations, in the form of new or improved products or processes,
can be imitated, some more easily than others. Hence there is an
incentive problem for potential innovators. If they cannot appropriate 3
In Chapter 1 of this guide we
a significant part of the returns from their innovations, they will not discussed, in a different context,
be able to cover their research costs, and hence they will not the inefficiencies generated when
undertake any R&D in the first place.3 a firm cannot appropriate the full
returns from a sunk investment.
94
• Research activities often involve a high level of uncertainty, so firms

may have difficulty in obtaining external finance for some R&D
projects that are nevertheless worth undertaking. Such market
imperfections may be due to asymmetric information between firms
and financial institutions.
• Some R&D projects are so expensive that it is difficult even for large
firms to undertake them.
Policy towards R&D can take many forms, including the patent system, the
treatment of R&D joint ventures, and government funding of private firms’
R&D.4 4
In addition to promoting the
production of innovations,
governments can implement
Patents
policies to achieve a faster rate of
Patents provide an innovator with exclusive rights to a new product or adoption of innovations. Mowery
process. The patent system is therefore designed to alleviate the (1995) discusses both types of
appropriability problem and thus directly promote innovation. Moreover, it policies.
is meant to encourage disclosure of new discoveries and thus indirectly
increase the rate of technological progress. On the other hand, since
patents also reduce competition after an innovation is made by granting a
legal monopoly, too much patent protection would not be welfare-
enhancing. The discussion on optimal patent design has mostly focused on
how long patents should apply and how broad their scope should be. As for
the effectiveness of patents in protecting innovations, the empirical
evidence suggests that it is limited and varies considerably across
industries. The main reason is that competitors can legally ‘invent around’
patents. Other reasons may include stringent legal requirements for proving
that a patent is valid or that it is being infringed, and the fact that a firm
may want to avoid disclosing information through patents.5 5
However, firms also use other
means of appropriation, such as
Research joint ventures secrecy, lead time, investment in
marketing and customer service,
Research joint ventures are agreements between firms to co-operate by
and learning by doing.
sharing expenditures as well as benefits associated with given research
projects. They are generally allowed in many competition laws, including
US and EU law. Research joint ventures may be welfare-enhancing because:
• They may prevent needless duplication of R&D expenditures and/or
allow firms to exploit complementarities in their research capabilities.
• They may allow firms to pool resources for R&D projects that are too
expensive for a single firm to undertake.
• They may improve incentives by reducing the appropriability problem.
Note, however, that research joint ventures may also reduce incentives to
perform R&D because they soften competition. Also, they may facilitate
price collusion in the production/distribution stage. Notwithstanding these
deficiencies, R&D co-operation has not only been allowed but also in many
cases specifically subsidised in the EU, the USA and Japan. The empirical
evidence on the effectiveness of these policies is mixed.
Government subsidies
Government financing of R&D performed by individual firms is an obvious
way to attempt to increase total R&D expenditure. Government subsidies
can be horizontal, for instance implemented as tax allowances based on a
firm’s total R&D spending. The USA, Japan and other countries have such
schemes. Or they can be more selective, for instance being given as grants
and targeted towards particular sectors, technologies or projects. Most
countries as well as the EU use such grants. Horizontal subsidies have some
95
drawbacks, for example they may fail to have much effect on firms’ R&D
decisions or they may encourage firms to undertake projects with limited
value. On the other hand, a problem with selective financing of R&D is that
governments may have less good information than firms on the likelihood
of making a discovery or on its value. Note that to assess the effectiveness
of R&D subsidies and grants one must examine whether any additional
R&D performed as a result of these policies more than compensates for the
public revenues lost. As with co-operative research agreements, the
empirical evidence on this issue is not conclusive.
Activities
1. Suppose you are asked to assess the likely effects of a proposed horizontal
merger in a particular industry. What are the things you would look at and how
would each of these help you make your assessment?
2. Suppose you are asked to examine whether a firm that has exclusive dealing
agreements with its distributors is guilty of abusing market power. What are the
things you would look at and how would each of these inform your
investigation?
3. The case studies included in Kwoka and White (2004) are strongly recommended
reading if you wish to obtain a better understanding of competition policy issues.
If access to this book is difficult, you can use the companion website:
www3.oup-usa.org/sc/0195161181/
This website contains more than 20 US antitrust policy case studies from
previous editions of the book, many of them written by well-known economists.
They cover horizontal mergers, collusion, strategic entry deterrence, horizontal
anti-competitive practices, vertical integration and vertical restraints. The authors
provide not only the facts and the outcome for each case, but also an economic
analysis and an assessment. Read critically the arguments for and against, and
assess the decision of the court and the author’s conclusions.

• explain the rationale for competition policy and for industrial policy
towards R&D
• describe the difficulties and dilemmas in competition policy with
respect to mergers, restrictive agreements, and abuses of market power
• discuss the practice of competition policy
• describe and evaluate the main forms of government policy towards
R&D.

1. Describe the difficulties faced by competition authorities in the design
and implementation of merger policy. Include in your answer a
discussion of the possible economic causes and consequences of mergers
and any evidence from the operation of merger policy in practice.
2. Explain the rationale for government policy towards research and
development in the form of (a) a patent system, and (b) R&D
subsidies. Then discuss the advantages and disadvantages of these
policies, with reference to any relevant empirical evidence.
96
Chapter 11: Regulation

Learning objectives
• describe different ways of regulating a firm under symmetric
information
• analyse the links between type of regulation, incentives, productive
efficiency and allocative efficiency under asymmetric information
• explain the implications of a dynamic analysis of regulation
• describe the links between liberalisation and regulation.
Essential reading
Armstrong, M., S. Cowan and J. Vickers Regulatory Reform. Chapters 1–6 and
11.
Chapters 24 and 26.
Further reading
Books
Armstrong, M., S. Cowan and J. Vickers Regulatory Reform. (Cambridge, MA:
MIT Press, 1994). Chapters 7–10.
Braeutigam, R.R. ‘Optimal Policies for Natural Monopolies’, in Schmalensee, R.
Church, J.R. and R. Ware Industrial Organization: A Strategic Approach. (Irwin
McGraw-Hill, 2000) Chapter 25.
Joskow P.L. and N.L. Rose ‘The Effects of Economic Regulation’, in
Journals
Armstrong, M. and D.E.M. Sappington ‘Regulation, Competition, and
Liberalization’, Journal of Economic Literature (2006) 44(2), pp.325–366.
Helm, D. and T. Jenkinson ‘The Assessment: Introducing Competition into
Regulated Industries’, Oxford Review of Economic Policy (1997) 13, pp.1–14
(special issue: Competition in Regulated Industries).
Vickers, J. ‘Regulation, Competition, and the Structure of Prices’ Oxford Review
of Economic Policy (1997) 13, pp.15–26 (special issue: Competition in
Regulated Industries).
Introduction
In some industries effective competition is difficult or impossible since firms
possess a lot of market power and are likely to abuse it. In such cases the
direct regulation of firms becomes necessary. This is typically the case in
industries with ‘natural monopoly’ elements, that is industries whose
technological characteristics are such that average industry cost is
97
minimised when a single firm serves the whole market. The utilities are
examples of industries which combine naturally monopolistic activities,
such as transmission networks, with potentially competitive activities, such
as the provision of services over the networks. These industries pose two
sets of questions, namely what is the best industry structure and what is the
best way to regulate firm behaviour.
In many cases these questions have been posed during the process of
privatisation of previously state-owned monopolies. While privatisation may
often improve the productive efficiency of firms, it may also worsen
allocative efficiency; hence the need for public policy following the
privatisation of a monopoly. This can take the form of liberalisation: the
removal of restrictions on competition such as restrictions on entry. Or it
can involve the restructuring of the industry: the breaking up of the
monopoly. Or it can involve the regulation of firm conduct. Or, finally, it can
be a combination of these. This chapter examines some of the theory and
practice of regulation as well as the links between liberalisation and
regulation.
Regulation of firms with market power under

symmetric information
The simplest possible setup involves a monopolist producer of a single good
and a regulator whose only objective is to maximise the sum of producer
and consumer surplus. Moreover, there is symmetric information about
market demand and the monopolist’s costs, and the analysis is static. In this
framework, a simple rule for the regulator would be to require that price
equals marginal cost. However, if the firm operates under increasing
returns to scale – which is a sufficient, though not necessary, condition for
being a natural monopoly – it will make a loss, since price will be lower
than average cost.
One response to this problem is to set a uniform price that maximises
welfare – or any weighted sum of consumer and producer surplus with
more weight put on the former – subject to the condition that the firm
breaks even. It turns out that, in the absence of direct subsidies to the firm,
this is the price pA given by the intersection of the demand curve with the
average cost curve (figure 11.1).
pA
AC
demand
qA q
Figure 11.1
Since the AC curve is everywhere declining under increasing returns to
scale, the firm will produce exactly quantity q : if it produces less it will
A
make losses, while if it produces more it will not be able to sell the extra
98
quantity. Why is this optimal under the circumstances? For one thing, the
price cannot be lower than pA, since the firm will then not be able to sell a
sufficient quantity to achieve p = AC and will therefore make a loss. If, on
the other hand, the price is set by the regulator higher than pA, the
(possibly weighted) sum of producer and consumer surplus clearly
decreases. Note that, since AC > MC at price pA, we have p > MC; so
average cost pricing results in some allocative inefficiency.
An even better solution is a two-part tariff – a pricing schedule of the form
T(q) = A + pq. This is in fact fully efficient when all consumers are
identical, so that they can be regarded as a single consumer with a surplus
function (gross of any fixed fee) V(p). Suppose that the regulator chooses a
price p and a fixed fee A to maximise the sum of consumer surplus and
profit, namely W = [V(p) – A] + [A + pq(p) – C(q(p))], subject to a
consumer participation constraint V(p) – A ≥ 0 and a firm breakeven
constraint A + pq(p) – C(q(p)) ≥ 0. It turns out that price should be set at
the level given by the intersection of the demand curve with the marginal
cost curve, where p = MC and the market clears. In addition, the fixed fee
A should be set at a level such that both constraints are satisfied.1 1
When the objective function of
the regulator is a weighted sum
Activity of producer and consumer
Prove this result. surplus with more weight put on
consumer surplus, A should be
Answer set to just allow the firm to break
Ignore for the moment the two constraints and maximise W with respect to p, noting even and price should again be
that ∂V(p)/∂p = –q(p). The first-order condition implies p = ∂C(q)/∂q. Provided that equal to marginal cost. The
V(p) ≥ pq(p) – C(q(p)), A can then be chosen so that both constraints are satisfied. reason is that the problem then
reduces to simply choosing price
When consumers are not identical, a two-part tariff can again be used to to maximise consumer surplus
improve welfare relative to a uniform price, but it will not achieve full subject to the firm making zero
efficiency since it will involve a price higher than marginal cost.2 However, profit.
welfare could be improved through more general nonlinear pricing 2
Compare with the analysis of
schemes, such as different packages directed to different consumer types. second degree price
We have assumed so far that the monopolist produces a single product. discrimination in Chapter 7 of
What about the case of a multiproduct monopolist? Note that this guide.
‘multiproduct’ may also refer here to a single product sold to different 3
The definition of a natural
classes of consumers, or in different areas, on in different periods. Marginal monopoly has to do with the
cost pricing will again result in the firm making losses if it is a natural technological characteristics of an
monopoly.3 Therefore one solution is ‘Ramsey pricing’, that is the set of industry, and is distinct from the
linear prices that maximise the weighted sum of consumer surplus and question of whether an actual
profit subject to the firm breaking even. In the special case of independent monopoly exists in the industry.
demands for the products, Ramsey pricing gives (pi – ∂C/∂qi)/pi = λ/εi, ∀i, See Armstrong et al. (1994),
where εi is the elasticity of demand for product i and λ is chosen so that the pp.49–50, for a formal definition.
firm makes zero profit. An even better solution is to use nonlinear pricing.
In the case of a single product sold during different periods, some with a
higher demand than others, an additional problem is that capacity may be 4
See Armstrong et al. (1994),
costly to adjust over time, so there is a trade-off between excess capacity pp.51–58, and Church and Ware
during off-peak times and rationing during peak times.4 In practice, Ramsey (2000), for details on these
pricing is not often used, for a number of reasons, including the regulators’ schemes.
imperfect information about demand elasticities and the political
unacceptability of price discrimination in the utility industries driven by
differences in demand or service costs.
99
Regulation under asymmetric information

Firms are typically better informed than regulators about cost and demand
conditions in their industry. Moreover, cost usually partly depends on the
firm’s cost-reducing effort, and the regulator is less well informed than the
firm about that effort as well. So regulatory schemes must be devised that:
• take into account the existence of asymmetric information about
industry conditions, and
• provide appropriate incentives to the firm to reduce costs.
The theoretical literature suggests that optimal regulation under asymmetric
information must involve lump-sum transfers from the government to the
firm, in addition to setting a price for the product. In practice, however,
regulators do not typically have the power to make lump-sum transfers, so
the problem becomes one of regulating price (and possibly quality as well).
The regulatory authority is then faced with the following dilemma. If it fixes
a price in advance, it gives good incentives to the firm to reduce its cost, but
the price may end up being much higher than cost; so productive efficiency
is served, but allocative efficiency is not. If, on the other hand, the regulator
makes the price dependent on the actual cost realisation, the firm makes no
excessive profits, but it has little incentive to cut costs; so the scheme
improves allocative efficiency, but it worsens productive efficiency.
Examining this trade-off can provide some insights to an important policy
issue, namely the choice between ‘price-cap regulation’, which refers to
specifying a price independently of the realised cost, and ‘rate of return
regulation’, where price closely reflects realised cost. A form of price-cap
regulation has been used in the UK following the privatisation of utilities
and other industries, while rate of return regulation has traditionally been
used in the US.5 5
Carlton and Perloff (2005),
Chapter 20, and Church and
The following simple model of regulation of a single-product firm captures
Ware (2000), Chapter 26,
some of the links between regulation, incentives and efficiency.6 The firm’s
provide detailed discussions of
unit cost is given by c = θ – e, where θ is a random variable and e ≥ 0 is
rate of return regulation.
the effort level chosen by the firm. Effort has a cost for the firm, given by
the function ψ(e) = e2/2. The regulator does not observe θ, although he 6
This part follows Armstrong et
knows that it is distributed according to the density function f(θ), with al. (1994), pp.39–42.
mean μ and variance σ2. Neither does the regulator observe the level of e
chosen by the firm. However, he observes the realised marginal cost c. We
also assume that when the firm makes its decision about effort, it does not
know the value of θ, and so it faces some uncertainty about its profit. The
firm is also assumed to be risk averse. In particular, its objective function is
given by E(Π) – (γ/2)var(Π), where E(Π) is expected profit, var(Π) is the
variance of profit and γ is a measure of risk aversion. This is not an
unrealistic assumption, since it is probably the manager of the firm who
will take the decision on effort rather than the shareholders. Note that the
case of a risk-neutral firm (γ = 0) and the case of no cost uncertainty (σ2 =
0) are special cases within this model. To simplify, we abstract from the
question of output choice by assuming that demand is perfectly inelastic
and equal to 1 at all prices.7 7
This implies that total
The timing of the game between the regulator and the firm expenditure on the product is
_ is as follows. At
stage 1, the regulator sets a price rule of the form p(c) = p + (1 – ρ)c, equal to the product’s price.
where ρ∈[0,1] is a parameter which determines the sensitivity of price to
unit cost: ρ = 1 represents a pure price cap, while ρ = 0 is a form of rate
of return regulation since it implies that the price-cost differential is fixed.
100
At stage 2, the firm observes this rule and chooses e to maximise its
objective function.
_
Suppose the objective of the regulator is to choose p and ρ to minimise
expected total expenditure on the product,
_ _
E[p(c)] = p + (1 – ρ)E(c) = p + (1 – ρ)(μ – e),
subject to the participation constraint E(Π) – (γ/2)var(Π) ≥ Π , where Π is
0 0
the (non-random) reservation ‘utility’ level of the firm (if Π0 = 0, this
reduces to a form of breakeven constraint). Note that minimising total
expenditure is here equivalent to maximising consumer surplus, since
quantity is fixed and equal to 1.
We start with the firm’s action at stage 2 of the game. Its profit (i.e.
revenue minus production cost minus the cost of effort) is
_ 2 _ 2
p + (1 – ρ)(θ – e) – (θ – e) – e /2 = p – ρ(θ – e) – e /2.
Hence its expected utility is
_ 2 2 2 _
E(Π) – (γ/2)var(Π) = p – ρ(μ – e) – e /2 – γρ σ /2.8 8
Note that var(Π) = var[p - ρ(θ
_ - e) - e2/2 ] = var(-ρθ) = ρ2σ2.
The firm chooses e to maximise this, taking p and ρ as given. The first-
order condition gives e* = ρ.
Now we go back to the regulator’s decision at_stage 1. Since_the regulator
anticipates that e* = ρ, he will choose ρ and_ p to minimise p + (1 – ρ)(μ –
ρ) subject to the participation constraint p – ρ(μ – ρ) – ρ2/2 – γρ2σ2/2 ≥ Π .
0
Clearly, whatever the optimal value of ρ, total expenditure minimisation
_
implies that p will be set at the lowest level that allows the firm to make at
least utility Π0. In other words, it will be set so that the firm makes exactly _
Π0 and hence the participation constraint holds with equality. Substituting p
from the participation constraint (with equality) into the regulator’s objective
function, the problem simplifies to choosing the value of ρ that minimises
2 2 2
Π0 + ρ(μ – ρ) + ρ /2 + γρ σ /2 + (1 – ρ)(μ – ρ).
2
You can check that the first-order condition gives ρ* = 1/(1 + γσ ).
To summarise the main results of this model:
• The lower the value of ρ, the lower the effort level of the firm. This result
is independent of the values of γ and σ2. Thus price-cap regulation is
better for productive efficiency than rate of return regulation.
• If the firm is risk-neutral (γ = 0) or both the firm and the regulator
2
have perfect information about cost (σ = 0), then ρ* = 1, that is the
optimal scheme is pure price-cap regulation. The more risk averse the
firm or the higher the cost uncertainty, the more sensitive should the
regulated price be to cost. Thus price-cap regulation may be
problematic if there is significant cost uncertainty.
Finally, what does this model say about the trade-off between allocative and
productive efficiency? Note that the assumption of perfectly inelastic
demand does not allow us to directly introduce the allocative efficiency issue
in this model. Nevertheless, this is introduced somewhat indirectly through
the risk aversion of the firm. For instance, think what would happen if the
regulator chose ρ* = 1 in the interest of productive efficiency even if γ and
σ2 were both positive. Then total expenditure would not be minimised
_
because p would have to be higher to ensure that the firm participates. By
reducing ρ* the regulator sacrifices some cost savings to improve the firm’s
insurance, and hence also improve allocative efficiency. When γ = 0 or σ2 =
0, this effect no longer operates, and so ρ* = 1 is optimal. In a more general
setting, demand would be elastic and the allocative issue would be directly
introduced. In this case, a value of ρ* between 0 and 1 would normally be
optimal even if γ or σ2 were equal to 0.
101
When deciding on the form of price regulation for a multiproduct

monopolist, an important question is whether to regulate the price of each
individual product or some measure of the average of the prices set by the
firm. The regulator is likely to have less good information than the firm
about costs, so an advantage of having a single constraint is that it allows
the firm to adjust relative prices according to relative costs. The
disadvantage is that the firm is likely to practice price discrimination even
when this is not socially beneficial. In general, however, some form of
average price regulation is desirable.9
A form of price regulation that has been applied to many privatised utilities
in the UK is the so-called RPI-X regulation. A firm subject to RPI-X
regulation is constrained to have a weighted average of price increases 9
Armstrong et al. (1994),
during one year not greater than the percentage increase in the Retail Price pp.66–74 and 79–83, give
Index (RPI) minus a factor X. In essence, the regulator sets targets for cost details on possible schemes, both
reduction over time, adjusted to allow for inflation. If the firm reduces cost in a static and in a dynamic
by more than the target, it can keep the profits. X is fixed by the regulator, framework.
does not change between regulatory reviews, and the number of years
between regulatory reviews is normally also fixed. There is some flexibility
in the system to allow for price adjustments when there are unanticipated
changes in the cost of certain inputs. Also, the price cap applies to an
average of prices and firms have some freedom with respect to relative
prices, although this freedom is not complete. Because of the danger of
underprovision of quality or distortion of investment incentives under price-
cap regulation, quality is also regulated and capital investment is
monitored. Finally, the factors that are taken into account by the regulators
when setting the factor X include the value of the firm’s existing assets and
the cost of capital (in order to ensure that the firm will be financially
viable), expected rates of demand and productivity growth, and the
progress of competition in activities which are potentially competitive.
Extensions: dynamic issues and regulatory capture

Regulation is a dynamic process that involves interaction between the firm
and the regulator, whether this takes place continuously, as in rate of return
regulation, or with a ‘regulatory lag’, as in price-cap regulation. Hence
present actions are influenced both by past actions and by anticipated
future actions. In particular, the regulator can exploit information revealed
by the firm or the sunk nature of the firm’s investments and impose a
tougher regime in the future. Since the firm realises this, it behaves
strategically to obtain a more favourable regime.
One problem, which occurs under asymmetric information, is that the firm
may not want to reveal that its costs are low or make considerable effort to
reduce them, because then the regulator will have better information and
may set a price to reduce the firm’s profits in the next regulatory review. It
can be shown, in fact, that social welfare might be higher if the regulator
could commit not to use the information revealed by the firm today when
setting the price tomorrow. In practice, this results in a trade-off regarding
the length of the regulatory lag. If price is kept fixed for a long period, the
firm has greater incentives to reduce cost (especially in the beginning of the
period), but consumers may pay excessive prices for a long time. If, on the
other hand, the regulatory lag is short, prices reflect costs more closely, but
the incentives for cost reduction are lower.
102
Another problem is that the firm may underinvest because, when the
regulator next reviews the price, the investment will be sunk and the firm
may be prevented from capturing the returns from its investment.10 A
10
Compare with a similar
solution to this problem may be to give the firm a ‘fair’ return on all ‘useful’ situation in Chapter 1 of this
investments. This can be explicitly specified as a right of the firm or left to guide.
be implicitly enforced by the fact that the regulator will want to build a
reputation of being fair.
Finally, you should bear in mind that regulators are not necessarily the
benevolent agents we have so far assumed them to be. Rather than
maximising social welfare, they may act in the interest of incumbent firms
in the regulated industry (which, in turn, may engage in wasteful
lobbying). To reduce the scope for ‘regulatory capture’, it is therefore
desirable to limit the regulators’ discretion.
Liberalisation and regulation

Starting from a situation where there is a protected monopolist in a
potentially competitive activity, there are three questions that can be asked:
• should there be completely free entry into the industry or should entry
be restricted?
• should the monopolist be broken up or left intact?
• given that liberalisation cannot always fully substitute for regulation,
how should the two be related?
There are some advantages of liberalisation relative to regulation. It may
promote productive and allocative efficiency by overcoming asymmetric
information problems and it can help avoid problems with policy credibility
and regulatory capture. On the other hand, liberalisation also has problems.
The most important is that it may simply not be sufficient to generate
effective competition, because of significant sunk costs, first-mover
advantages, or for other reasons. Or, conversely, it may lead to inefficient
entry, such as ‘cream-skimming’ – although there seems to be little evidence
that technological conditions in the utility industries favour cream-
skimming.
It has also been argued that franchising – selling the right to serve a market
for a certain period to the lowest bidder – could be an alternative to
regulation in some cases. The idea is that in circumstances where
competition in a market is not feasible, competition between firms to
obtain the contract (‘competition for the market’) may improve efficiency
by dissipating excessive profits. Franchising has been used for relatively
simple products and services that involve low sunk costs (for instance,
rubbish collection or train services), but it is impractical for most activities
in the utility industries because:
1. Simple and complete contracts cannot be specified, so monitoring and
enforcement are difficult and costly.
2. A firm which obtains the contract once may have a significant
advantage in subsequent rounds of bidding.
3. A firm which fails to get its contract renewed must receive
considerable compensation for its sunk costs.
In some cases where franchising has been used, such as in rail services in
the UK, the need for price and quality regulation has remained.
Rather than being substitutes, liberalisation and regulation can be
complements. For instance, some degree of competition in regulated
industries may facilitate regulation by improving the information available
103
to the regulator. Moreover, the utility industries combine naturally

monopolistic activities with potentially competitive ones. Unless there are
significant economies of scope between the two types of activities, there is
no reason why competition should not be introduced where it works. Thus,
although transmission networks (for instance, electricity distribution) are
run by natural monopolies that must be regulated, there is usually a case
for competition in the provision of services over the networks (electricity
generation or supply of electricity to customers). There are then several
issues that must be addressed:
• If there is room for only a few firms to be given the right to use the
network, should firms compete for that right, by periodic allocation of
franchises, and if so how should that be organised?
• Should the firm which runs the network be allowed to also compete in
providing services over the network?
• How should the government regulate the terms on which this firm
gives network access to other firms?
The choice of industry structure involves assessing efficiency effects against
market power effects, as in many other policy issues. Several of the topics
discussed in previous chapters of this guide are relevant here. For instance,
the larger the economies of scope and the lower the chance of a ‘hold-up’
problem, the higher the likelihood of a welfare gain from allowing the
monopoly to operate in the competitive market segment. The larger the
chance that vertical integration raises the cost of access of non-integrated
firms to the network, the higher the likelihood of a welfare loss. Of course,
the access price can be regulated too. On the one hand, the socially optimal
access price should not be too high, since this will discourage efficient entry
and provide incentives for entrants to duplicate the network. On the other
hand, it should not be too low, since this will encourage inefficient entry
and reduce the incentive of the incumbent to invest in the network.
Activities
1. Consider the model of regulation of a single-product firm under asymmetric
information analysed above, but assume that the regulator’s objective is to
maximise profit minus total expenditure.
_ Show that this does not affect the
optimal choice of ρ and that p can be set anywhere between a lower bound (so
that a firm’s expected utility is at least Π0) and an upper bound (so that
consumers have non-negative expected utility).
2. Lump-sum transfers to firms are not generally used in regulation. Can you think
of any reasons why?
3. The deregulation of the Californian electricity sector in the 1990s has been the
subject of considerable criticism. How can we explain the experience of this
sector, including the much publicised crisis of 2000–2001? What are the lessons
to be learned? There is a large literature on this topic, including review articles by
P.L. Joskow in the Journal of Economic Perspectives, vol. 11, no. 3, 1997, and the
Oxford Review of Economic Policy, vol. 17, no. 3, 2001, and S. Borenstein in the
Journal of Economic Perspectives, vol. 16, no. 1, 2002. You can also search the
internet for more.
4. Not all regulated industries are natural monopolies. In fact, many are not, and
some would even appear to come close to the textbook example of perfect
competition! Take, for instance, taxi services. There are many buyers, many sellers,
and the cost of entry is low. Yet taxi services are regulated throughout the world.
Entry is restricted by limiting the number of licenses, and often prices are
regulated too. What could be the justification for this? Does regulation of taxi
services increase social welfare?
104
You may want to read two recent official reports about taxi service regulation in
the UK to find out more: The Regulation of Licensed Taxi and PHV Services in the
UK (2003) and Evaluating the Impact of the Taxi Market Study (2007). Both are
available online at the Office of Fair Trading website, together with additional
information:
www.oft.gov.uk/advice_and_resources/resource_base/market-
studies/completed/taxis
A lot more is available on the internet, both on entry regulations in general and
the taxi industry in particular, including a US Federal Trade Commission report on
taxicab regulation: www.ftc.gov/be/econrpt/233832.pdf
and numerous references to articles in academic journals.

• describe different ways of regulating a firm under symmetric
information
• analyse the links between type of regulation, incentives, productive
efficiency and allocative efficiency under asymmetric information
• explain the implications of a dynamic analysis of regulation
• describe the links between liberalisation and regulation.

1. ‘Price-cap regulation is more efficient than rate of return regulation’.
Discuss this statement, with reference to an economic analysis of the
links between type of regulation, incentives of regulated firms to
reduce costs, allocative efficiency, and productive efficiency.
2. Describe, with reference to theory as well as empirical evidence, the
ways in which competition and regulation may interact. Include in
your answer a discussion of situations where the two are viewed as
substitutes, as well as of situations where they are viewed as
complements.
105

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Chapter 1: Size and structure of firms

Chapter 1: Size and structure of firms

• It is not clear why the AC curve rises at high output. If producing

The transaction costs–property rights approach

Transaction costs, incomplete contracts and integration

We can now state an important theoretical prediction of the transaction

• A party is more likely to own an asset if it has a large investment to

A reminder of your learning outcomes

Sample examination questions

Chapter 2: Separation of ownership and

Limits to managerial discretion

The profit-maximisation hypothesis

A reminder of your learning outcomes

Sample examination questions

2. ‘An optimal incentive scheme offered by the owners of a firm to the

Chapter 3: Short-run price competition

In this chapter we focus on static models of oligopoly: the firms interact

Bertrand competition with capacity constraints

The exact equilibrium outcome in the above model depends on what

residual demand for firm 2

price p*. Hence p1 = p2 = p* is the unique Nash equilibrium of the game.

competition (Bertrand) and quantity competition (Cournot) as a difference in

The Cournot model

To derive the equilibrium explicitly, let us further assume a linear demand

1. Consider the model of price competition with capacity-constrained firms analysed

2. Consider a market where N symmetric firms produce a homogeneous product

A reminder of your learning outcomes

Sample examination questions

2. a. Consider a market with two quantity-setting firms producing a

Chapter 4: Dynamic price competition

What is the subgame-perfect equilibrium of this repeated game? Two cases

Several points should be emphasised with respect to the above analysis.

Price wars: theories and evidence

An alternative theory of price wars is the one by Rotemberg and Saloner. In

Econometric analysis of market power and collusive

prior information about the occurrence of collusion. In that case the

where θ t = ∑ sit θ it , Qt = ∑ q it and D is a constant.

Taking logarithms of both sides and writing this as an econometric

• Typically we need data on prices and quantities over a considerable

A reminder of your learning outcomes

Sample examination questions

Chapter 5: Entry deterrence and entry

Strategic substitutes and strategic complements

Figures 5.1 and 5.2

Entry deterrence and entry accommodation

Suppose that firm 1 installs capacity K .

Π 1 = K1b (1 − K1b − K 2 ) = K1b (1 − K1b ) = (1 − 2 f )[1 − (1 − 2 f )] = 2 f (1 − 2 f )

binding contracts between buyers and sellers, and investment in product

A taxonomy of business strategies

• does investment make a firm ‘tough’ or ‘soft’?

• are the stage 2 actions strategic substitutes (downward-sloping

A reminder of your learning outcomes

Sample examination questions

Chapter 6: Product differentiation and

Horizontal product differentiation

The linear location model

west end firm 1 firm 2 east end

and demand for firm 2 is:

Hence equilibrium prices are higher than marginal cost c – unless a + b =

which are positive for a + b = L.

Consider now a two-stage game as follows. At stage 1 firms simultaneously

which is always negative. So to maximise its profit in the two-stage game

More generally, then, the choice of product specification is a trade-off

price p. Hence p1 = p2 = p is the unique Nash equilibrium of the game.