MARKET LEADERS AND INDUSTRIAL POLICY by Federico Etro* *Associate Professor of Economics, University of Milan

1. MARKET LEADERSAND INDUSTRIAL POLICYby Federico Etro**Associate Professor of Economics, University of Milan

2. Theory of market leaders >> >> Implications for industrial policy • Antitrust policy (abuse of dominance) • Strategic export promotion • R&D policy

3. Ch. 1-2: Behaviour of Market Leaders under quantity and price competition (2006, RAND Journal of Economics) • Ch. 3: Patent races and innovation by leaders (2004, Economic Journal) • Ch. 4: Abuse of dominance and Microsoft case (2006, Europ. Compet. Journal) • Ch. 5: Schumpeterian growth • Ch. 6: Strategic Export Promotion • Ch. 7: R&D policy coordination (2005, American Economic Review)

4. Theories of market structure

5. Question:are market leaders aggressive? • With barriers to entry the leader: • is aggressive under strategic substitutability. Ex: quantity competition (the leader sets higher production) • is accomodating under strategic complementarity. Ex: price competition (the leaders sets higher prices), patent races

6. Main result • With endogenous entry, the leader is always aggressive: • with quantity competition sets higher quantities (and lower prices) • with price competition sets lower prices • in a patent race invests more in R&D

7. A Simple Example: Quantity competition • Quantity competition, linear demand and cost • Profit function:

8. 1st stage: the leader chooses strategy s • 2nd stage: • each follower chooses strategy x • endogenous entry of followers

9. After entry, each follower would produce: • with profits: • hence endogenous entry implies:

10. The profit of the leader would be: • Hence the leader will just deter entry with:

11. General Theory • Strategic variable: • profit functions: • Assumptions: and has a unique maximum for each • can be positive (SC) or negative (SS)

12. Ex.1: Quantity competition • Quantity of firm i: • Inverse demand: • Profit function: perfect substitutability:

13. Ex.2: Price competition • Demand: • Assumptions: • Profit function:

14. Dixit-Stiglitz case: • Isoelastic demand: • Just define: • Profit function:

15. Ex.3: A patent race • Fixed investment in R&D by firm i: • Arrival rate of innovations: • Expected profits: where V is the value of innovation and r the interest rate

16. Stackelberg Eq. with endogenous entry • 1st stage: the leader chooses strategy • 2nd stage: • each follower chooses strategy • free entry of followers • In the second stage there is a symmetric equilibrium with the same strategy x for each entrant

17. Optimal strategy x for the followers given the strategy s of the leader: • Endogenous entry condition: • Notice that but

18. Profit function of the leader: • Interior optimum for the leader’s strategy: • It follows that: s > x

19. Theorem:With free entry the leader is always more aggressive than the followers The result is robust to: • Multiple strategic variables (on average) • Multiple leaders • Asymmetries between leaders and followers (if small)

20. The result applies also to the Fudenberg-Tirole (1984) model: • 1 stage: strategic investment by the leader • 2 stage: Nash competition • the leader is always aggressive in the market (Etro, 2006, Rand Journal of Economics)

21. No puppy dogs, just top dogs Under quantity and price competition: • Overinvestment in cost reductions, quality improvements, advertising, product differentiation (against Bulow et al., 1985) • Bundling (not necessarily entry-deterring; against Whinston, 1990) • Vertical Restraints (with subsidized inputs; see Bonanno-Vickers, 1985)

22. Multimarket competition • Ex: Joint economies of scope Overproduce in one market to reduce costs in the other • Ex: Learning by doing Overproduce initially to reduce costs on the learning curve This always (independently from SS/SC) under free entry!

23. Application 1: Quantity competition • Quantity of firm i: • Inverse demand: • Profit function:

24. Assume perfect substitutability • free entry: >> • leader’s profit:

25. If C(x) is convex: • If C(x) is linear or concave: ENTRY DETERRENCE

26. There is entry by followers when: • marginal costs are strongly increasing Ex. Profit function:

27. imperfect sustitutability is strong Ex. Profit function:

28. In general, Stackelberg competition is Pareto superior to Cournot competition • By Mankiw-Whinston (1986) the number of entrants is too much with Cournot competition • Stackelberg competition reduces the number of entrants (without changing total production) hence it saves fixed costs!

29. Application 2:Undercutting with price competition • Demand: • Assumptions: • Profit function:

30. Strategic complementarity holds: with barriers to entry the leader sets a higher price to increase also the prices of the followers • With free entry: • Leader’s profit: • Leader’s price:

31. Stackelberg competition is Pareto superior to Nash competition (with free entry) • Same prices by the followers • Lower price by the leader • Fewer firms

32. Welfare rankingunder price competition: • Free entry with a leader • Free entry without a leader • Barriers to entry without a leader • Barriers to entry with a leader

33. Anti-trust implications • Anti-trust authorities should fight barriers to entry, not market leaders • Leadership should actually be promoted • One firm in a market with positive profits: • is perfectly consistent with free entry • is a constrained optimum if there is free entry

34. Digression: Optimal Trade policy • Nash competition in a foreign market • Traditional results with barriers to entry: • Export subsidies with quantity competition (Brander-Spencer, 1984) • Export taxes with price competition (Eaton-Grossman, 1986) • With free entry: Export susbsidies are always optimal

35. Optimal subsidy with quantity competition is the inverse of the elasticity of demand: • Optimal subsidy with price competition: • conquering market shares abroad is a priority in a globalized world!

36. Digression: Competitive Devaluations • Nash competition in a foreign market (with domestic production) • Results with barriers to entry: • Strategic incentive to CD with quantity competition (Dornbusch, 1987) • No strategic incentive to CD with price competition • With free entry: Always a strategic incentive to CD

37. Application 3:Innovation by Leaders (Etro, 2004, Economic Journal) • Investment in R&D by firm i: • Arrival rate of innovations: • Expected profits: where V is the value of innovation and r the interest rate

38. With free entry: - free entry condition: • R&D by the followers:

39. Profit of the leader (using the free entry condition): • R&D by the leader: • hence s > x

40. The same holds even if the leader is the incumbent monopolist, with current profits • Under free entry in the patent race, monopolists invest more than the outsiders in R&D (the Arrow paradox disappears!) • Monopolies based on patents tend to persist • A leadership by the monopolist improves welfare

41. The Economist (May 22, 2004) “the fact that a dominant firm remains on top might actually be strong evidence of vigorous competition … The very ease of entry, and the aggressiveness of the competitive environment, are what spur monopolists to innovate so fiercely”

42. Digression: Schumpeterian growth • Sequence of innovations with patent races, 1,2,…,k,k+1,.. • Flow of profits for the k-innovator: • Recursive value of being the k-innovator:

43. Anti-trust implications • Leading firms invest a lot in innovation only if they are in a competitive environment: hence persistence of monopolies is signal of a competitive environment! • Again: Anti-trust authorities should fight barriers to entry in the market for innovation, not persistent monopolies

44. The Economist (May 22, 2004) “antitrust authorities should be especially careful when trying to stamp out monopoly power in markets that are marked by technical innovation. It could still be that firms like Microsoft are capable of using their girth to squish their rivals; the point is that continued monopoly is not cast-iron evidence of bad behaviour”

45. The End