Sunk costs,contestability and airline monopoly power

This paper examines the effects of sunk costs and potential competition on pricing behavior in monopoly airline markets. We find little evidence to support the proposition from contestable markets theory that the level of sunk costs influences pricing by monopolists. Rather, the results support the view, consistent with numerous game theoretic oligopoly models, that the costs and the price-cutting reputation of potential entrants influence incumbent behavior. These results suggest that contestability theory may not be robust. Even in the markets characterized by increasing returns to scale, the perfectly contestable market may not be a useful welfare standard.I am grateful to Richard Levin, Merton J. Peck, Sharon Oster, Paul MacAvoy, Dan Kaplan, Michael Levine, David Sappington, Andrea Shepard, and Diana Strassman for their advice. Participants at numerous workshops also made useful comments. Steven Davis, Tadas Osmolshis, and Maeve O'Higgins provided help with the data and technical assistance. I acknowledge financial support from Yale University and the Eno Foundation for Transportation. The usual disclaimer, of course, applies.     

Vertical Contracts and Downstream Entry*

We study the implications of different contractual forms in a market with an incumbent upstream monopolist and free downstream entry. We show that traditional conclusions regarding the desirability of linear contracts radically change when entry in the downstream market is endogenous rather than exogenous. By triggering more entry than two-part tariffs, wholesale price contracts can generate higher aggregate output, consumer surplus, and welfare. In light of this, the upstream monopolist may prefer to trade with wholesale price contracts as well as to give up part of its bargaining power when it is high.     

Robust exclusion and market division through loyalty discounts

We show that loyalty discounts create an externality among buyers because each buyer who signs a loyalty discount contract softens competition and raises prices for all buyers. This externality can enable an incumbent to use loyalty discounts to effectively divide the market with its rival and raise prices. If loyalty discounts also include a buyer commitment to buy from the incumbent, then loyalty discounts can also deter entry under conditions in which ordinary exclusive dealing cannot. With or without buyer commitment, loyalty discounts will increase profits while reducing consumer welfare and total welfare as long as enough buyers exist and the entrant does not have too large a cost advantage. These propositions are true even if the entrant is more efficient and the loyalty discounts are above cost and cover less than half the market. We also prove that these propositions hold without assuming economies of scale, downstream competition, buyer switching costs, financial constraints, limits on rival expandability, or any intra-product bundle of contestable and incontestable demand.     

Sunk Costs,Market Contestability,and the Size Distribution of Firms

In this paper we offer a new economic explanation for the observed inter-industry differences in the size distribution of firms. Our empirical estimates based on three temporal (1982, 1987, and 1992) cross-sections of the four-digit US manufacturing industries indicate that increased market contestability, as signified by low sunk costs, tends to reduce the dispersion of firm sizes. These findings provide support for one of the key predictions of the theory of contestable markets: that market forces under contestability would tend to render any inefficient organization of the industry unsustainable and, consequently, tighten the distribution of firms around the optimum.     

Incumbency and market share within European mobile telecommunication networks

The structure of mobile telecommunication markets varies considerably across Europe, ranging from monopolies with a handful of subscribers to markets with five operators and many millions of subscribers. Where competitive markets occur, there is also an incumbent operator possessing substantial first mover advantages. This paper explores these advantages, asking whether the incumbent has remained the largest operator as the market has developed. This question is investigated using data from 49 European countries. The analysis finds that in most countries the incumbent continues to be the largest operator measured by market share. In some countries, later entrants into the market have struggled to gain market share, contributing to the highly concentrated nature of many mobile markets. The extent to which the geographical footprint of an operator influences its market share is also examined.     

Three problems in applying contestability to regulated markets

The theory of contestable markets emphasizes that the ease of entry rather than the number of existing firms forces incumbents to set prices at optimal levels. The policy implications of this work contrast sharply with past U.S. regulatory and antitrust policies, legitimizing increased industry concentration and decreased regulation. This paper explores three factors that influence the desirability of regulation or antitrust policy despite the apparent existence of a contestable market time lags, technological change, and cyclical macroeconomic fluctuations. Time lags enable incumbents to earnsupra-normal profits and take last-minute action to forestall entry. New technologies can create sunk costs that reduce the contestability of a market. Recessions can depress capital markets, raising the cost of exit, while expansion creates opportunities for entry without threatening monopolistic prices. These shortcomings limi the ability of contestability theory to provide guidelines for the regulation of actual industries.     

Tying in evolving industries,when future entry cannot be deterred

We show that the incentive to engage in exclusionary tying (of two complementary products) may arise even when tying cannot be used as a defensive strategy to protect the incumbent’s dominant position in the primary market. By engaging in tying, an incumbent firm sacrifices current profits but can exclude a more efficient rival from a complementary market by depriving it of the critical scale it needs to be successful. In turn, exclusion in the complementary market allows the incumbent to be in a favorable position when a more efficient rival will enter the primary market, and to appropriate some of the rival’s efficiency rents. The paper also shows that tying is a more profitable exclusionary strategy than pure bundling, and that exclusion is the less likely the higher the proportion of consumers who multi-home.     

Product specification under a threat of entry: Evidence from Airlines’ departure times

I examine how incumbent airlines adjust their departure times in response to the threat of entry by Southwest Airlines. I find that incumbents space their flights more evenly throughout the day when faced with potential entry. This reaction depends strongly on the level of the incumbent’s market share and hub status at the endpoint airports of a market. The evidence suggests that incumbents’ actions are designed to deter, rather than accommodate, entry. I do not find effects on flight frequency, suggesting that incumbents may rely more on the strategic choice of product attributes than on product proliferation to deter entry.     

Insights into the contestability and sustainability of the U.S. petroleum refining industry

Contestable market theory has been advanced in recent years by several authors, the most thorough treatment being the book by Baumol, Panzar, and Willig (1982) (BPW). Although several applications of the theory have appeared in the literature, few (if any) follow the step-by-step procedure set forth in Chapter 16 of BPW. This paper represents one of the first attempts to follow the general procedure in investigating the contestability and sustainability of an industry. The long-run cost structure of petroleum refining is first estimated using a translog multiproduct cost function and company refining data from the Financial Reporting System maintained by the U.S. Energy Information Administration (EIA). The estimated cost function is then used to approximate the optimal (cost-minimizing) industry structure for petroleum refining. Given that the existing structure is significantly different than the optimal structure, the principles of contestable market theory are used in evaluating the contestability and sustainability of the industry in light of adjustments in industry structure and the performance of various classes of refining companies between 1981 and 1987.     

The Influence of Regulation and Disruptive Potential on Incumbents' Submarket Entry Decision and Success in the Context of a Network Industry

This paper uses the theoretical perspectives of disruptive innovation, network externalities, and regulation to study the submarket strategies of incumbent firms that operate in a regulated network industry. In this setting, the impact of potentially disruptive innovations might be different because of the tighter regulation of incumbent firms. By analyzing the entry and success patterns of incumbent mobile network operators (MNOs) in the public hotspot markets in 17 Western European countries, we focus on how regulation and network effects as well as disruption factors influence the incumbent firms' strategies. In doing so, this paper departs from prior research that has primarily focused on unregulated industries and combines contradicting explanations from disruptive innovation theory, the motivation/ability framework, regulation theory, as well as network effects to provide a comprehensive analysis on how incumbents behave in a regulated network industry that is being confronted with a potentially disruptive innovation. In particular, while disruptive innovation theory predicts that the incumbents' vast experience in an industry could cause them to avoid entering new submarkets created by potentially disruptive innovations, the desire to avoid regulation could encourage such submarket entry. Furthermore, in regulated network industries, incumbent firms might have a stronger motivation to enter new submarkets as the importance of single customers and high market shares could be substantially different. These contrasting insights are used to develop an integrative research model and to derive hypotheses on incumbents' submarket entry decision and success. Drawing on cross‐sectional, multicountry data of 62 MNOs that operate in 17 Western European countries, this study uses logit and tobit regressions to test the impact of disruption factors, regulation, and network externalities on the entry decision and success of incumbent firms. The results reveal that the incumbent MNOs are caught in an area of conflict between the regulated industry context and their international technology strategy. The findings suggest that the incumbent MNOs' motivation and ability to escape regulation positively influenced their submarket entry and success in the public hotspot market. Thus, the potentially disruptive scenario was successfully turned into a potentially sustaining one as the incumbent MNOs could enhance their presence in the mobile broadband market. The testing on a multicountry basis as well as the positive influence of ethnocentric technology strategies for public hotspots, which are devised in the headquarters' location and are then brought out internationally, shed new light on an industry that has typically been characterized by country‐by‐country decisions. These findings may also reveal challenges for future research on disruptive innovations in multinational industries and expose future challenges for regulative authorities and managers. This paper thereby adds to the theory of disruptive innovation as it includes the influence of regulation on incumbents in network industries. Additionally, this study expands on previous findings on the disruptive potential of wireless local area network technology by employing a multi‐country analysis in 17 Western European countries.     

The disruptive potential of PWLAN at the country-level: The cases of Germany,the UK,and the USA

This paper analyzes the impact of WLAN technologies for incumbent MNOs based on an empirical cross-country study of the players in the public WLAN-hotspot market using the theory of disruptive innovation and theoretical extensions for the industry- and country-level. The main research question to be analyzed is whether and why PWLAN has shown a disruptive or sustaining impact trend for incumbent MNOs in the hotspot markets of Germany, the UK, and the USA in recent years. The results imply that incumbent MNOs and new entrants have taken advantage of the opportunity provided by PWLAN, but the market success of both types of players varies between the countries analyzed. Incumbent MNOs dominate in Germany but not in the UK and the USA. The reasons for these country-specific differences were further investigated, and the results suggest that the analysis of disruptive potential in telecommunications needs to include country- and firm-specific factors, which are, again, largely influenced by the local regulation.     

Big splash,no waves? Cognitive mechanisms driving incumbent firms’ responses to low‐price market entry strategies

Research Summary: Low‐price market entries, aiming for rapid sales growth, tend to prompt strong competitive reactions. This research explores whether and how firms using low‐price entry strategies can mitigate retaliatory incumbent reactions. An experiment with 656 managers shows that entrants can attenuate the strength of incumbents’ responses by fostering perceptions of high aggressiveness or low commitment. Entrants may be able to accomplish this by adjusting their entry strategy to embed (subtle) cues of aggressiveness and (lack of) commitment. A replication experiment with university students reinforces our overall theoretical argument. However, the results also indicate that the interpretation of cues embedded in the entry strategy may be affected by the experience of incumbent firm managers. Overall, these results clarify the cognitive foundations of competitive responses to market entry. Managerial Summary: What drives incumbents to respond strongly to market entries, and what can the entrant, if anything, do to mitigate those responses? This research offers empirical evidence and theoretical insights for managers faced with these questions by shedding light on the thinking processes preceding competitive responses. The study shows that while managers are motivated to respond strongly to market entries that appear to be highly consequential to their business, these responses may be mitigated if the entrant manages to foster perceptions of high aggressiveness or low commitment to the market. Managers form these perceptions in part on the basis of the entrant’s behavior, creating an opportunity for entrants to adjust their entry strategies in a manner that demotivates strong competitive responses.     

Good intentions,poor outcomes: Telecommunications reform in South Africa

As the first decade of democratic rule draws to a close in South Africa, this paper reviews the telecommunications reform process in terms of the performance of the sector against the twin national policy objectives of affordable access to communications services and accelerated development to meet the needs of a modern economy. It critiques the implementation of international reform models which have in practice tended to emphasise privatisation at the expense of other reform mechanisms—including competition and, in particular, regulatory measures. It argues that this has impacted negatively on affordable access and has inhibited market innovation.This paper identifies the root of the problem as the market structure. Designed around the vertically integrated incumbent operator, it induces inherently anti-competitive impertives that demands a resource-intensive regulatory response. The regulator has often not had the statutory powers, and seldom the capacity, to circumscribe the behaviour of the incumbent so that it does not impact negatively on new entrants. Without effective regulation, the assumed benefits of liberalisation—including more affordable access through improved management of the incumbent and more efficient allocation of resources in the market through competition—do not materialise.The paper argues that developing country telecommunications markets demand more from a regulator than simply meeting the threshold requirements of transparency and predictability via so-called international “best practice” models. Such a limited approach will not be sufficient to meet the challenges facing most developing countries. The highly imperfect nature of developing country markets, and the enormous income disparities and inequities that exist, require strategic regulation. This is necessary to enable innovative service provision, especially to under-serviced areas, and to facilitate fair competitive markets that promote the viability of the new entrants needed to build the information infrastructure—the infrastructure necessary for a country's participation in the global network economy.Simply removing all market-entry restrictions, however, is likely to place an even more onerous burden on already-struggling regulators and is unlikely to contribute to universal access and other developmental goals. A new policy approach involving the fundamental restructuring of the market is needed to remove the anti-competitive incentives that exist in the vertically integrated market structure that generally accompanies privatisation in developing countries. While a more horizontally structured market will not remove the incumbent advantage entirely, it is likely to reduce the need for constant adjustment of anti-competitive behaviour on the part of the incumbent, freeing up regulatory resources for more strategic regulation towards achieving national developmental objectives.     

Economic implications of a co-investment scheme for FTTH/PON architectures

Due to the high costs associated with the deployment of the passive infrastructure of FTTH networks, a few alternative operators have pondered the possibility of making co-investments based on a network sharing model. The purpose of this article is to explore economic aspects of a co-investment scheme for present and future FTTH/PON architectures. The article describes the cost reductions that can be achieved when a co-investment scheme is used, as well as the relationship between market shares and the cost per home connected. A cost model was employed to calculate the investment per home passed and the investment per home connected. The investment per home passed for an alternative operator indicates significant cost reductions when a co-investment scheme is used. On the other hand, the results show that when the incumbent's market share is equal or higher than the total market share of all the alternative operators that share the network infrastructure, the investment per home connected for an alternative operator is higher than that for the incumbent operator. Moreover, to be cost competitive with the incumbent operator, the necessary market share that each alternative operator should achieve is much lower than that of the incumbent operator.     

Contestability and creative destruction: Two approaches to monopoly

The theory of contestability ’attempts to base a model of economic efficiency on oligopolistic markets, thereby justifying adoption of laissez-faire policies in the absence of atomistic competition. The analysis is similar to Schumpeter’s condemnation of government intervention in the theory of creative destruction: both theories claim that superior economic performance is associated with concentrated rather than competitive market structures. Yet in many respects the contestability analysis is less convincing than Schumpeter’s. Whereas Schumpeter admitted the existence of short rum profits and restrictive strategies, arguing that these inefficiencies, are outweighed in the long run, the theory of contestable markets is based on short run efficiency and cannot accommodate evidence of excess profits nor many of the existing models of oligopolistic strategies, including collusion and predatory pricing. Furthermore, the theory lacks a logical explanation of investment, by entrants and convincing empirical support for its claim that concentrated markets maximize consumer welfare.     

Can evidence of pricing power help market power assessment? Broadband Internet in Ireland and the Netherlands

This article proposes a simple hedonic price test to assess whether firms may have pricing power. The test allows NRAs to compare prices of providers of differentiated products on a like-for-like basis. Testing for pricing power could be a useful complement to market share analysis. This is especially the case in market reviews periodically undertaken by European communications regulators. As an illustration the test was applied to broadband Internet access services in Ireland and the Netherlands. Results appear encouraging as they are broadly aligned to the decisions of the regulatory authorities in both countries that the incumbent DSL operators had market power at the time.     

Losing by winning: The danger zone of adverse competitor replacement

Research Summary: We use a formal model, motivated by a case study from the airline industry, to consider an industry structure wherein a firm may find that improving its competitiveness hurts its performance. Specifically, we examine the possibility that a superior incumbent may, by getting stronger, drive a weak rival from the market, and thereby allow a stronger rival to enter in its place. Such “adverse competitor replacement” reduces the profit of the superior incumbent and may even, in an extreme case, cause the superior incumbent to be driven from the market as well. We show that adverse competitor replacement can arise under a rational equilibrium and may become more likely if a firm improves its capability for self‐improvement. Managerial Summary: Managers are consistently advised to improve the competitiveness of their firms and beat the competition. We examine the possibility that beating out the competition may have adverse consequences. Specifically, a strong incumbent may, by getting stronger, outcompete a weaker rival to such an extent that the weaker rival exits the market, thereby creating an open market niche for a stronger rival to enter, in effect, a form of adverse competitor replacement. Competing with this stronger rival may in turn reduce the strong incumbent's profits below what they had been before driving the weak rival out. We illustrate adverse competitor replacement with a case study from the airline industry and discuss implications for a firm's investment in its own competitiveness.     

The Competitive Effect of Exclusive Dealing in the Presence of Renegotiation Breakdown

This paper analyzes the seller’s incentive to write exclusive contracts with buyers (“exclusive dealing”) and the welfare implications of such contracts in the presence of renegotiation breakdown whereby exclusive dealing is able to affect both the incumbent seller’s investment and a rival’s entry. The analysis shows that the probability of renegotiation breakdown plays a central role in determining the competitive effect of exclusive dealing. Exclusivity is likely to be anticompetitive for intermediate levels of renegotiation breakdown risk, while it is likely to be procompetitive for a very low breakdown risk under linear pricing (and for a very high breakdown risk under two-part tariffs). The result suggests that the competitive effect of exclusive dealing is decided by the interaction between investment promotion and foreclosure, which in turn depends on the probability of renegotiation breakdown and the pricing scheme that sellers can choose.     

De novo venture strategy: arch incumbency at inaugural entry

By definition, de novo industry ventures do not share many market‐contact points with incumbents—itself an important source of competitive ‘stability’ through mutual forbearance. As such, these ventures are often subject to aggressive retaliation at the outset, which could threaten their very survival. In this study, the notion of an arch incumbent is developed, hypothesizing that, in general, a large market overlap with an incumbent lowers the survival odds of a de novo entrant. However, a large market overlap with the arch incumbent combined with an aggressive inaugural market entry or a different market positioning reduces the probability of retaliation by the arch incumbent (and subsequently other incumbents as well), and hence increases the probability of survival for a de novo entrant. The empirical experience of de novo ventures in the intra‐European passenger airline industry supports these hypotheses. Copyright © 2009 John Wiley & Sons, Ltd.     

Cheap Exclusion in Markets with Multiple Complements

We extend the theory of exclusive dealing in first-mover environments to settings where the incumbent seller’s product is used with multiple complements in a distribution chain and the incumbent can sign exclusive dealing contracts with more than one of them. The model is motivated by the market for biosimilar pharmaceuticals, where incumbent sellers that face a threat of entry can sign exclusionary contracts with both providers and insurance carriers prior to entry. We show that when the incumbent’s complementors are vertically related, it can be profitable for the incumbent to sign exclusive contracts with indirect buyers, who operate downstream from the direct buyers of the product. Under linear pricing, such exclusion is profitable if the pass-through rate is sufficiently low, and under nonlinear pricing and symmetric Nash bargaining, it is profitable for all pass-through rates. Complementors face a more severe coordination problem than independent buyers that can make anticompetitive exclusion more likely and especially cheap.