Entry Sunk Costs And Market Structure

Sunk Costs and Market Structure bridges the gap between the new generation of game theoretic models that has dominated the industrial organization literature over the past ten years and the traditional empirical agenda of the subject as embodied in the structure-conduct-performance paradigm developed by Joe S. Bain and his successors.

This paper develops a dynamic econometric framework for the analysis of entry, exit, and competitive conduct in oligopolistic markets. This framework only requires panel data on the demand and producer counts of geographically dispersed markets over time. It is a dynamic extension of Bresnahan and Reiss's (1990, 1991) framework for the analysis of static competition in a cross-section of markets. Our extension to the infinite-horizon model facilitates the empirical analysis of the dynamic determinants of market structure and competition: sunk entry costs and uncertainty. Moreover, it is needed for the consistent measurement of static market primitives, such as the toughness of competition. Our model's timing and expectation assumptions help to select an essentially unique Markov-perfect equilibrium that can be computed quickly by solving a finite sequence of dynamic programming problems with low-dimensional state spaces. We apply our model to the empirical re-analysis of sunk costs and the toughness of competition in the US market for dental services, using Bresnahan and Reiss's (1993) panel data on the number of dentists across geographical markets in the US.

March 1995 Exports respond unpredictably to a change in real exchange rates, suggests evidence from the 1980s. Recent theoretical work explains this as a consequence of the sunk costs associated with breaking into foreign markets. Sunk costs include the cost of packaging, upgrading product quality, establishing marketing channels, and accumulating information on demand sources. The authors use micro panel data to estimate a dynamic discrete-choice model of participation in export markets, a model derived from the Krugman-Baldwin sunk-cost hysteresis framework. Applying the model to data on manufacturing plants in Colombia (1981-89), they test for the presence of sunk entry costs and quantify the importance of those costs in explaining export patterns. The econometric results reject the hypothesis that sunk costs are zero. The results, which control for both observed and unobserved sources of plant heterogeneity, indicate that prior export market experience has a substantial effect on the probability of exporting, but its effect depreciates fairly quickly. The reentry costs of plants that have been out of the export market for a year are substantially lower than the costs of a first-time exporter. After a year out of the export market, however, the reentry costs are not significantly different from the entry costs. Plant characteristics are also associated with export behavior: large old plants owned by corporations are more likely to export than other plants. Variations in plant-level cost and demand conditions have much less effect on the profitability of exporting than variations in macroeconomic conditions and sunk costs do. It appears especially difficult to break into foreign markets during periods of world recession.

We combine a structural model with cross-sectional micro data to identify the causes and consequences of rising concentration in the US economy. Using asset prices and industry data, we estimate realized and anticipated shocks that drive entry and concentration. We validate our approach by showing that the model-implied entry shocks correlate with independently constructed measures of entry regulations and M&As. We conclude that entry costs have risen in the U.S. over the past 20 years and have depressed capital and consumption by about seven percent.

I discuss a model of endogenous innovation that brings to the forefront the in-house R&D activity of the modern corporation. In a symmetric oligopoly, firms undertake cost-reducing R&D subject to a research technology with incomplete spillovers. Concentration of sales and R&D resources determine the optimal scale and the efficiency of firms' R&D operations and, thus, the rate of productivity growth. In addition, R&D expenditures (a sunk cost) are one component of total fixed costs and determine the number of active firms in zero-profit equilibrium. This feed-back makes the price, investment, entry, and exit decisions interdependent. A rich characterization of the balanced growth path, defined as the rate of growth and the number of firms that the market supports in general equilibrium, emerges. Multiple equilibria may exist and firms' expectations about rivalry determine the economy's performance.

This volume discusses crucial issues in the overlap between industrial organization and strategic management.