Vertical differentiation in oligopoly and license fees when outside innovator can enter the market: Two‐step auction

When an outside innovating firm has a technology to produce a higher quality good than the good produced at present, it can sell licenses of its technology to incumbent firms, or enter the market and at the same time sell licenses, or enter the market without license. We examine the definitions of license fee in such a situation in an oligopoly with three firms under vertical product differentiation, one outside innovating firm and two incumbent firms, considering threat by entry of the innovating firm using a two‐step auction. We show that in the case of uniform distribution of consumers' taste parameter and zero cost when the quality improvement (the difference between the quality of the high‐quality good and the quality of the low‐quality good) is small (or large), the two‐step auction is (or is not) credible, and license to two firms without entry strategy (or entry without license strategy) is optimal depending on credibility of the two‐step auction.     

Payment types and number of franchisees

Current studies of the franchise system usually assume that the number of franchisees is exogenous and irrelevant to the payment types. However, to a franchise system or a franchiser, the optimal number of franchisees is related to the payment types, e.g., franchise fee, royalty, etc. We develop a game-theoretical model and then use 1998 Bond's Franchise Guide Data for US franchise stores in order to test the theoretical predictions. According to our theoretical predictions, the optimal number of franchisees under a royalty is strictly less than that under a franchise fee. This is because royalties distort the effort incentive of franchisees and the franchiser can increase average revenue by having a smaller number of franchisees. A franchise fee will not distort the effort incentive of franchisees and can help achieve a higher profit for both the franchiser and the franchise system. When demand is certain, the optimal royalty rate to the franchise system is zero. Under a royalty payment, the royalty rate will be greater than zero if the franchiser maximises its own profit. Empirical results support our theoretical predictions: there is no significant relationship between franchise fee and number of franchisees. The number of franchisees has a significantly negative relationship with royalties, while it is significantly and positively correlated with the experience of the franchise system, area, training, and advertising fees required by the franchiser.     

Entry deterrence/accommodation with imperfect strategic thinking capability

Both through empirical research and laboratory experiments it has been shown that managers are heterogeneous in strategic thinking-i.e., not all the managers can accurately conjecture their competitors’ behavior and actions. In this paper, we examine the entry deterrence/accommodation strategy of an incumbent firm facing a potential entrant that may behave less strategically than the incumbent in the way of conjecturing competitors’ actions and beliefs. We adapt the Cognitive Hierarchy model to capture this heterogeneity among the managers of the entrant firm and the incumbent firm. Surprisingly, we show that the incumbent can deter entry by investing in expanding the market size and the competition may increase the incumbent’s incentive to invest in market expansion. If entry does occur, the market expansion in our model also benefits entrant comparing to the case without market expansion. This feature of our result sets it apart from the standard result in the entry deterrence literature, which tends to suggest that incumbent has to either over-invest in actions harmful to entrant if entry occurs. In our model investing in expanding the market size makes the entrant to update its belief about the incumbent’s strategic thinking capability downward and thus, decreases the entrant’s expected profitability, which in turn deters entry. Our research has important implications especially for emerging markets given that the lack of management talent is a particularly severe problem among local firms in emerging markets and multinational companies pioneer in the emerging markets with great market expansion opportunities have to face the potential entry of local companies.     

The Determinants of Dual Distribution Revisited

This paper examines the use of what has been called “dual distribution” by firms. Dual distribution involves a firm using both company-owned stores and independently owned franchises to sell its product or service. Using panel data from 1048 companies for the years 2005 to 2009, I use a variety of estimators to determine the factors that influence the relative use of franchising by companies. A key focus of the paper is to control for the possible endogeneity of the franchise fee, royalty rate, and franchise ratio for the companies in the respective industries. Using a panel data estimator and lagged values of the franchise fee and royalty rate as instruments, I find that one reason the franchise fee and royalty rate do not appear to influence the relative use of franchising is due to industry- and firm-level fixed effects, which capture the variation in royalty rates and franchise fees at the company level.     

University revenues from technology transfer: Licensing fees vs. equity positions

This paper analyzes the financial return of universities' taking equity in their spin-off companies, and the prevailing attitudes toward taking equity. The reasons for taking equity include: the flexibility it gives licensing managers in structuring deals, the possibility that the university will still hold something of value if their technology is replaced, and, the reduced time required to generate revenue compared to a traditional license. A traditional license is preferred when the technology is not suitable for a spin-off company, or when the technology is one of the rare jackpot licenses that bring in millions of dollars every year.The financial reward of taking equity was determined by comparing the value of equity sold in public spin-off companies to the return on an average license. A traditional license consists of a license issue fee between $10,000 and $250,000 and an annual royalty on sales. In 1996 the average annual income from a traditional license was $63,832. The average value of equity sold in 16 university spin-off companies is $1,384,242. If one assumes that half the spin-offs fail before they go public, the average value of equity is $692,121. This is more than 10 times the average annual income from a traditional license, and is significantly higher than the amount usually received as a license issue fee.The high average value of equity depends on the presence of a few million-dollar equity sales. If those sales are excluded, the average value of equity is $139,722, which is within the range that can be received as a license issue fee. There is a high correlation between million-dollar equity sales and the amount of venture capital spending in the region. The million-dollar sales in this study all occurred in the top 11 states in the country in terms of venture capital spending in 1997.From a financial viewpoint it makes sense for licensing managers to take equity in their start-up companies. Our data show that even if none of the start-ups produces a million-dollar equity sale, the financial return of equity will be within the range normally received as a license issue fee. Taking equity leaves the door open for the occasional jackpot, which will bring in significantly more money than a standard license. When combined with a strong program of traditional licensing, taking equity in start-up companies maximizes the financial return that universities realize from their intellectual property.     

How incumbent firms foster consumer expectations, delay launch but still win the markets for next generation products

Consumers learn quality of many durable products through word-of-mouth information while firms launch new and improved products frequently in these markets. This paper examines firm incentives to invest in R&D to compete for patents in makets where consumers rely on word-of-mouth information and have expectations about the new products before launch. When its loss due to a possible entry is above a threshold, an incumbent has more incentives than a potential entrant to invest in R&D for patents. Moreover, if the current product is more profitable, its true quality is above consumer priors and the quality of the new product is below a threshold, it is optimal for the incumbent to launch the new product after a time lag. The later the optimal time of launch, the greater is the incumbent’s potential loss if entry occurs and greater its incentives is to invest in R&D versus that of the entrants. While potential entrants are generally thought to have more incentives to invest in a drastic innovation which results in a race to launch the new products, we show that the more drastic the innovation, the later the optimal time of launch and greater are the incumbent’s incentives to invest in R&D when the value added of the new product can be conveyed to all the consumers. Only when consumers are uncertain about the value added of the new product, the incumbent’s incentives are lower. We also demonstrate that by promoting consumer expectations about the new product before launch, an incumbent has more time to launch and higher probability of dominating its market.     

Potential FDI causing large distortions in domestic production

When a foreign firm enters a domestic market, either via exports or through foreign direct investment (FDI), one factor determining the most favourable entrance mode is the profitability of the market, which may not be directly observed by the foreign firm. If the domestic trade protection policy is within a certain range that causes the foreign entrant's decision to swing between the two entry modes, the final choice will depend on the foreign firm's belief about the profitability. In such a situation, a domestic incumbent firm wishing to prevent FDI will heavily distort its production downward to convince the foreign competitor that the market is not profitable. When making trade policy, such strategic behaviour on the part of the domestic firm should be taken into account.     

Entry encouragement

In this paper, we investigate the possibility that a dominant firm will encourage rather than deter entry of a potential competitor. We find that entry can be encouraged by a dominant firm in order to induce a new entrant to resolve the demand uncertainty in a new market. We propose a specific incentive mechanism that the incumbent can use to encourage entry and find plausible circumstances under which entry encouragement is a dominant competitive strategy.INSEADInstituto de Analisis EconomicoINSEAD     

Should Variable Cost Aid to Attract Foreign Direct Investment be Banned? A European Perspective

The purpose of this paper is to analyze the European Commission’s approach to state aid to attract foreign direct investment (FDI) in a competition policy framework. The Commission considers variable cost aid (VCA) to be more distortive than start-up or fixed cost aid (FCA). This paper addresses that issue and checks whether allowing FCA while banning VCA is an optimal strategy for a supranational Competition Authority maximizing welfare. The model shows that a domestic government maximizing welfare always prefers VCA to FCA if both the incumbent and the entrant are foreign firms and if granting VCA does not cause the incumbent firm to exit the market. The model shows that banning VCA may lead to sub-optimal equilibria where welfare is not maximized.     

Challenges of Existing in a Market as a Small,Low-quality Producer

This paper explores the strategy of a small firm entering a monopolist's market thereby creating a duopoly market. The small firm avoids competing with the larger, incumbent firm by producing a lower-quality product at a lower price. The model here establishes an equilibrium under a specific set of assumptions and examines how exogenous factors affect prices, qualities and profits. Although the strategy might allow the firm to enter and earn a profit, the market conditions may make this position much less desirable to that of the large firm for several reasons. In the case explored here where tastes for the product are uniformly distributed, the small firm's profit is about six percent of that of the larger firm. The smaller firm is more severely threatened by the entrance of a third firm. Furthermore, even if the smaller firm can cut costs, its position is not well suited for exploiting such increases in efficiencies.     

How to protect your premium product from low-price competitors: Price,quality, or portfolio adjustment?

In a game-theoretic framework, I analyze how a brand manufacturer can thwart new entrants into its market. Three strategic options are considered, a price adjustment of the premium product, a quality adjustment of the premium product and a portfolio adjustment of adding a fighter brand. In a basic setup, I show that the incumbent's best response to entry is to choose a portfolio adjustment. If, however, the incumbent is uncertain about whether the rival firm will enter the market, a price adjustment of the premium product might be the better alternative if launching the fighter brand is associated with costs. Moreover, if technological progress improves the efficiency of product development, a combined quality and portfolio adjustment might be the best alternative for the incumbent.     

Learning to export: Export growth and the destination decision of firms

I find evidence that the geographic expansion of firm exports occurs slowly over time and that a large share of export growth is due to incumbent exporters entering new destinations. New exporters enter large countries and destinations with characteristics similar to their domestic market. Less similar, distant or less developed countries are entered by firms already exporting to other destinations. I formulate a dynamic general equilibrium model to test if these patterns are due to firms learning how to export (as other recent empirical findings have suggested) or other factors considered in the literature. In this model, heterogeneous firms experience learning in the form of market entry costs that depend on export history. Using Russian firm level data, I find that learning plays a significant role in explaining the observed entry patterns, which standard trade models cannot account for.     

Tie-in contracts with downstream competition

A tie-in contract has frequently come under scrutiny for its role as an exclusionary device. A firm that is a monopolist in a primary market can utilize such contracts to exclude a more efficient rival in a secondary market. When the firms sell through competing retailers, the leveraging firm may offer tie-in contracts to the retailers inducing them to purchase both primary and secondary products entirely from it such that the rival is excluded. We examine whether such tie-in contracts are profitable for an incumbent firm under different conditions of (i) the ability to commit to prices by the upstream firms and (ii) downstream competition among the retailers. We show that when retailers compete in prices, then regardless of whether the entrant is able to commit to its own prices, an exclusionary tie-in strategy is profitable (not profitable) for the incumbent when it is able (unable) to commit to prices. However, when retailers compete in quantities, the entrant’s commitment ability does matter. Specifically, an exclusionary tie-in strategy (i) may be unprofitable for an incumbent when both upstream firms are able to commit to their prices, depending on the degree of cost advantage of the entrant; (ii) is always profitable when it alone can commit to its price; and (iii) is unprofitable when both upstream firms cannot commit to their prices. Our results extend to situations where the products are complementary or substitutes and where the retailers may be asymmetric in nature.     

Creative destruction and regional productivity growth: evidence from the Dutch manufacturing and services industries

Do firm entry and exit improve the competitiveness of regions? If so, is this a universal mechanism or is it contingent on the type of industry or region in which creative destruction takes place? This paper analyses the effect of firm entry and exit on the competitiveness of regions, as measured by total factor productivity (TFP) growth. Based on a study across 40 regions in the Netherlands over the period 1988–2002, we find that firm entry is related to productivity growth in services, but not in manufacturing. The positive impact found in services does not necessarily imply that new firms are more efficient than incumbent firms; high degrees of creative destruction may also improve the efficiency of incumbent firms. We also find that the impact of firm dynamics on regional productivity in services is higher in regions exhibiting diverse but related economic activities.     

Incumbent innovation and domestic entry

This paper analyzes the escape-entry incentive for innovation by incumbent firms. The threat posed by the possibility of leading-edge firms entering the market influences incumbent innovation. To overcome problems of endogeneity, we apply an instrumental variable approach to analyze a rich firm-level dataset (1987–2000) for Germany. We find evidence that domestic entry has a negative effect on incumbent product innovation, which is a strong indication of new entrants’ comparative advantage in commercializing new ideas. In contrast, domestic entry has a positive effect on incumbent process innovations, an effect also known as the escape-entry effect.     

Entry mode selection and its impact on an incumbent supply chain coordination

This paper considers a supply chain where a manufacturer sells its product through a retailer. In such a market, a potential entrant can make a substitute product by imitating the incumbent's product and then sells it to the common market with one of three alternative entry modes: (i) selling through the incumbent's retailer, (ii) selling through another independent retailer, or (iii) selling directly to consumers. Faced with the entrant's entry, the manufacturer has managed to offer a value-added service to add to its product's value at a cost. We investigate the entrant's optimal entry mode when the manufacturer offers profit-sharing contracts to the retailer and when it does not, and discuss the impact of the potential invader's entry on the incumbent firms' performances. The results show that: (1) the entrant sells directly to consumers when faced with weak value competition, and sells through another retailer against fierce value competition. (2) If the value competition is relatively fierce and the efficiency of the value-added service is relatively high as well, the incumbent firms can benefit from the new entry. (3) A profit-sharing contract, as a coordination policy, can fully coordinate the incumbent supply chain no matter whether there exists a potential entrant or not, yet the entry can affect the distribution of the profits between the incumbent manufacturer and retailer.     

Flirting with the enemy: online competitor referral and entry-deterrence

Internet retailers often compete fiercely for consumers through expensive marketing efforts like search engine advertising, online coupons and a variety of special deals. Against this background, it is somewhat puzzling that many online retailers have recently begun referring their website visitors to their direct competitors. In this paper, using an analytical model, we examine this counterintuitive practice and posit that an entry deterrence motive can potentially explain this marketplace puzzle. Specifically, we develop a model where two incumbents compete for consumers” business while facing a potential entrant who is deciding whether to enter the market. In addition to setting the price, each incumbent firm could potentially display a referral link to its direct competitor. Our analysis reveals that when confronted with a potential entry, an incumbent may refer consumers to its competitor, intensifying the market competition that could result in shutting off the entrant. Furthermore, we show that when referral efficiency is exogenous, it is possible that in equilibrium only one incumbent refers its customers to competitor (i.e., one-way referral) or both incumbents refer their customers to each other (i.e, two-way referral). When referral efficiency is endogenous, the ex-ante symmetric incumbents may choose asymmetric referral efficiencies ex-post. We extend the model in a number of directions including making the entrant share endogenous and allowing incumbents to be asymmetric. Overall, our results indicate that firms may be motivated by entry deterrence to voluntarily refer consumers to their direct competitors even when they are paid nothing for the referral.     

Identification and counterfactuals in dynamic models of market entry and exit

This paper addresses a fundamental identification problem in the structural estimation of dynamic oligopoly models of market entry and exit. Using the standard datasets in existing empirical applications, three components of a firm’s profit function are not separately identified: the fixed cost of an incumbent firm, the entry cost of a new entrant, and the scrap value of an exiting firm. We study the implications of this result on the power of this class of models to identify the effects of different comparative static exercises and counterfactual public policies. First, we derive a closed-form relationship between the three unknown structural functions and the two functions that are identified from the data. We use this relationship to provide the correct interpretation of the estimated objects that are obtained under the ‘normalization assumptions’ considered in most applications. Second, we characterize a class of counterfactual experiments that are identified using the estimated model, despite the non-separate identification of the three primitives. Third, we show that there is a general class of counterfactual experiments of economic relevance that are not identified. We present a numerical example that illustrates how ignoring the non-identification of these counterfactuals (i.e., making a ‘normalization assumption’ on some of the three primitives) generates sizable biases that can modify even the sign of the estimated effects. Finally, we discuss possible solutions to address these identification problems.     

Raising Rivals’ Fixed Costs

This article demonstrates that raising fixed costs can serve as a credible mechanism for a well placed firm to exclude its rivals. We identify a number of credible avenues, such as increased regulation, vexatious litigation and increased prices for essential inputs, through which such a firm can raise fixed costs. We show that for a wide range of oligopoly models this may be a profitable strategy, even if the firm’s own fixed costs are affected as much (or even more) than its rivals and even if it is less efficient. The resulting reduction in the number of firms in the market is detrimental to consumer welfare and hence worthy of scrutiny by competition and regulatory authorities.     

Can Mergers to Monopoly,Price Fixing,and Market‐Division Agreements Raise Welfare?

Naked market division, price fixing agreements and mergers which result in dominant positions have long been opposed by the courts and the government because of the high likelihood that they will result in a reduction in output and an increase in price. We show that the opposite may be true if the market is characterized by marketing spillovers. When marketing investment is required to educate consumers about the general capabilities or qualities of a product, marketing efforts by one producer will benefit rival producers. A theoretical model of these types of markets shows that marketing spillovers can forestall entry altogether or force incumbent firms to engage in ‘limit marketing’ that leaves the market underserved from a welfare‐maximizing perspective. Under these circumstances, market output and social welfare are potentially raised not only through horizontal agreements among competitors, but also through cost‐raising strategies and commitments to predatory behavior by incumbent firms.