The idea that the existing market structure (e.g., many or few firms) inevitably leads to specific types of conduct by firms (e.g., pricing policies or mergers) which, in turn yield an industry’s performance (e.g., its efficiency in allocating resources and the profitability of the firms in it).  Recently, however, some economists have begun to question the rigidity of linkages between an industry’s structure, its conduct, and its performance.

 

Contestable Markets

No firm with market power enjoys long-run economic profits unless competitors are precluded from entry. The theory of contestable markets pivots on the idea that competitive vigor is less related to the number of firms currently in an industry than to the ease of market access by other firms if prospects for economic profit exist.[1]

Contestable markets theory suggests that easy market entry can force even firms that are the sole current sellers of goods to produce the same output levels and set the same prices as would competitive firms.

Conventional market structure analysis assumes that the number of firms in an industry determines the extent of market power and, thus, the prices charged for output. Contestable markets theory turns this assumption on its head, arguing that the prices buyers are willing to pay for given amounts of goods determine the numbers of firms in an industry if outsiders are relatively free to enter the market. Even if a firm is the sole supplier in a market, that firm is forced to behave as if it were in competition if the market is "contestable." This theory identifies the absence of barriers to entry and exit as the motor that drives the allocative and productive efficiency of vigorous competition.

            Critics argue that many significant barriers are natural (technological) and others result from the conscious strategies of incumbent firms. Building excess capacity is one way firms try to deter entry. Unused excess capacity may not harm existing rivals. If used, however, it may drive some incumbent firms to exit. One example would be building a new plant that raised industry output until all existing rivals suffered losses. Such a new plant (whether used or not) would clearly deter potential new entrants. Excess capacity might be one prong of a predatory strategy.

 

Predatory Behavior

Predation is intended to drive rivals from the market. Predatory tactics include low prices, expanded output, aggressive advertising, the “cloning” of rivals' products, rapid technological innovation, redesigns of existing products to make them incompatible with rivals' products, or monopolizing access to essential resources.

Predatory behavior occurs when a firm attempts to drive rivals from the industry and deter entry.

 

After rivals exit, the predator firm presumably will raise prices to levels consistent with its market power.  Predation is often hard to distinguish from normal competition and thus, is difficult to prosecute in the courts. Firms may use predation to expand market shares while lowering expected rates of profit to other incumbents or potential rivals.

 

            Predatory behavior is forbidden by U.S. antitrust laws, and has been discussed for a century---John D. Rockefeller (founder of the original Standard Oil Company) was charged with predatorially monopolizing oil. Standard acquired a 90 percent market share of the petroleum business between 1870 and 1899. (No proof was ever offered, however, that prices were raised following the demise of competitors. Standard Oil may simply have been the least cost producer of oil.)

 

            Monopoly profits attract potential entrants. Consider the monopoly shown in Figure 9. A rival’s entry would raise industry output, so prices and profits would fall. During a period of predation, an incumbent intent on regaining its monopoly will, for example, set a predatory price of Pp, and try to service industry demand Qp while incurring losses equal to the shaded area facd. After its rival withdrew from the industry, the monopoly would reinstate price Pm.

Figure 9

           

Note that the predatory firm loses substantially more than its rival does---the incumbent must accommodate all demand, while its rival is free to cut output to cut its losses. Presumably, the predatory firm expects to more than offset this loss after re-establishing its monopoly position. One problem for this model is that boosting prices after rivals are driven from the market may be self-defeating because new entry would again be stimulated. Consequently, aggressive firms will try to adopt policies that deter entry or induce exit at the least cost. Some economists have concluded that firms will select strategies whose costs do not rise with market share---strategies that involve fixed expenditures. Examples include research and development (R&D) spending, institutional advertising intended to promote the brand name, and manipulation of regulatory policies.

 

            Consider a predator and a rival who produce identical goods with constant marginal costs, selling output for price P0 in Figure 10. Suppose the predator offers a superior innovation (demand rises to D1) with higher cost, MC1, which buyers value at P1, where P1 > MC1. One strategy is to price the innovation below P1 but above MC1; the rival sells nothing because buyers value the superior product by more than the price difference (ac > ab). The rival eventually exits, enabling the predator to price monopolistically.

 

Figure 10

            Predators may manipulate pricing, timing, and innovation in ways almost impossible to make illegal. Low prices, for example, may signal potential competitors that entry would be a mistake. Dominant firms can also redesign product lines with components incompatible with rival products.

 

            Another tactic is product preannouncement. By announcing plans to enhance its product line soon, an incumbent may bar entry and make it harder for rivals to sell. Software is characterized by substantial demand-side economies of scale, so users often become locked into a given program. (A hackers' cliché: "The best program is the one you already know.") A sufficiently large user base can block sales of rival products. (Microsoft and Lotus, for example, have been accused of this strategy.)  New entrants find it hard to gain a niche in these markets, despite the obsolete nature of many programs and the advances made by other software developers.

 

            Predatory pricing works especially well if a firm (or a cartel) has significant cost advantages. For example, Walmart was convicted in an Arkansas court of predatorily pricing some prescription pharmaceuticals below cost driving several local drug stores out of business. And OPEC, for example, set prices that significantly exceeded the marginal costs of oil for all OPEC member countries during 1974--1980. U.S. oil companies, assuming that oil prices would continue to climb, invested tremendous resources into developing relatively high-cost sources of domestic oil. When world oil prices plummeted in the early 1980s, many high-cost oil projects (e.g., conversion of oil shale in the Rocky Mountains) were abandoned, and U.S. oil companies absorbed enormous losses.

 

            When oil prices subsequently rose, few oil companies even considered reopening their high-cost U.S. projects. They recognized that OPEC could simply cut prices to levels that would impose further losses on high-cost operations. Thus, even if the current price would support a project, it was not pursued because of the potential for OPEC to undercut the price. The dynamics of this semipredatory situation also fit under the umbrella of limit pricing models.

 

Limit Pricing

The vigor of competition is largely determined by outsiders' ability to enter a market. A classic model of strategic behavior is limit pricing. The limit pricing model postulates an incumbent firm and potential entrants with the same cost curves (this simplifies the analysis). Further, new entrants can expect to capture only that part of the market not satisfied by the incumbent. Thus, the new entrant believes that total industry output after entry will equal the incumbent's current output plus its own.

 

            The average total cost curve and industry demand facing incumbents and potential entrants are shown in both panels of Figure 11. In Panel A, the incumbent has set a price of $8 and sells 200,000 units. If another firm enters, and the incumbent firm continues to produce 200,000 units, total output will rise and industry prices will fall. As Panel A shows, the demand curve facing a new entrant will be DNew Entrant (the difference between industry demand and incumbent sales at each price), and the only equilibrium for this market will be 300,000 units sold at $5 (the incumbent sells 200,000 units and the entrant sells 100,000).

 

put Figure 11 here MISSING!!

            Consequently, as Panel B shows, the incumbent firm can deter entry by setting a price slightly below $8 because any potential entrant would expect losses upon entry. At any price below $8 (e.g., $7 in Panel B), the residual demand of the new entrants would be below their average total cost curves, imposing losses to the new entrants. Notice that the limit price is not the monopoly price, but an incumbent firm can earn long-run economic profits with this strategy.

 

Sunk Costs as Entry Barriers

Economists express several reservations about this version of a limit price. First, why should potential entrants believe an incumbent will maintain old output levels after entry of a competitor? Both firms might gain if industry output were reduced. Second, if both have the same cost curves, what distinguishes potential entrants from incumbents? And if entrants have superior financial resources, why couldn't they force an incumbent to exit?

 

            Developments in game theory have added a rich array of strategic possibilities to limit pricing models. Our earlier discussion of game theory demonstrated that the ability to make binding commitments makes a threat more credible. Just how can an incumbent firm make its threat to continue producing 200,000 units seem credible?

 

            One way to see the answer is to envision two armies trying to occupy an island connected by bridges from opposite sides, as shown in Figure 12. Each army will let the other have the island rather than fight. (Fighting is very costly!) If Army 1 immediately burns its bridge, Army 2 will allow Army 1 to occupy the island since Army 1 now only has one option left---to fight. This analogy suggests than an incumbent firm can commit to a large output by acquiring considerable excess capacity, signaling to any potential rivals that huge increases in output will punish any firm rash enough to enter the market.

Figure 12

            Economists have recently begun to explore the role that sunk costs play in entry decisions.[2] An irreversible capital decision may be an effective deterrent to entry, the more slowly capital depreciates and the more specific capital is to a particular firm. If a viable used market for capital exists, the less likely entrants will be deterred.

 

            A reconsideration of limit pricing models is based on information asymmetry.[3] Incumbents do not charge low prices because of high capacity; low prices are used to signal potential entrants that demand is insufficient to sustain another firm or that the incumbent has low production costs. Some firms use low prices to acquire market share to learn the intricacies of a particular product line or business. This learning-by-doing approach can drive average costs down as experience is gained, providing firms with competitive advantages well into the future.

 

Accommodation

Some economists have concluded that the costs to firms of limit pricing or predation far outweigh accommodation of entry. Several game theory models indicate that nonprice techniques or buying rivals at premium prices avoid predation costs or allow greater profits than occur under limit pricing.12 Alternatively, entry may simply be accommodated without a fight, depending on the payoffs. For example, if a small, cheap hotel were built in a resort area, an existing resort might use the small hotel to handle overflow customers. The more the small hotel focused on specialized customers, the less threatening it would be to the resort and the greater the likelihood of accommodation.

 

            Modern economists view prices, capacity, and innovation as weapons competitors use to acquire or maintain competitive advantages in specific markets. Competitive advantages extend beyond product markets, so this analysis is increasingly used to investigate resource markets and firms' financial decisions.

 

            Most advocates of this newer approach recognize that conventional market structure analysis provides some valid insights into how firms behave. Instead of totally scrapping the traditional approach, their research is intended to refine its insights and to correct what they perceive as its errors in charting a direction for government policy, especially antitrust laws.

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