COMPETITIVE LONG RUN INDUSTRY EQUILIBRIUM AND FACTOR-PRICE UNCERTAINTY*

In this paper we have considered competitive long run industry equilibrium with factor-price uncertainty. We discussed the long run equilibrium output of firms with risk neutrality, output price and their responses to changes in uncertainty, factor price and industry demand. In the first part of this paper we have derived a result that, given risk neutrality, the firms operate at proper capacity, i.e. where expected long run marginal cost is equal to expected long run average cost, as shown in the case of output-price uncertainty. This result is, however, different from that obtained from Sheshinski and Dréze (1976). From the comparative static analysis we first discovered that even under risk neutrality factor-price uncertainty affects the long run industry equilibrium: that is, a mean preserving increase in uncertainty leads firm's to enter the industry, because they can decrease expected long run costs as the variability of factor price increases. Consequently, output price goes down. In contrast, firm size is kept invariable in response to its increase as long as the cost function is separable, i.e. the separability of the cost function holds when production functions are the Cobb-Douglas and CES types used commonly in empirical work, although firm size might, generally, be affected by the increase. It is an interesting fact that firm size and industry size will express different responses to a change in risk. The result that the long run industry equilibrium with cost uncertainty is explicitly affected is a sharp contrast to the result under output-price uncertainty and provides a new aspect for understanding about the behaviour of the industry with uncertainty. Secondly, increased factor-price causes the number of firms in the industry to decline and output price to rise. In addition, firm's size will expand with its increase if that factor is inferior, while the effect on firm size is ambiguous if it is normal. The firm's output, i.e. firm size, is, however, kept constant if the cost function is separable. Thirdly, the long run equilibrium output of the firm remains intact but the number of firms increases as industry demand rises. This result holds, regardless of the firm's attitude towards risk. Finally, we find throughout the paper that the functional form of the cost function plays a significant role in determining the behaviour of the industry with factor-price uncertainty.     

Oligopolistic Competition and New Technology Adoption under Uncertainty

The paper examines the adoption of a new technology in oligopoly, where there is ex ante uncertainty about variable costs of the new technology. Each firm can either adopt the new process by bearing some up-front investment or may continue to use the old one, after which firms play a Cournot market game. If in equilibrium both technologies are employed, more uncertainty about the new technology increases (decreases) the number of innovating firms and decreases (increases) the product price if the up-front investment is large (small). Our model applies readily to vertical integration if integrated firms neither buy nor sell the intermediate good on the market. However, if buying and selling is allowed, the number of integrated firms is independent of input price uncertainty.     

COMPETITION FOR MARKET SHARE OR FOR MARKET SIZE: OLIGOPOLISTIC EQUILIBRIA WITH VARYING COMPETITIVE TOUGHNESS*

For an industry producing a composite commodity, we propose a comprehensive concept of oligopolistic equilibrium, allowing for a parameterized continuum of regimes varying in competitive toughness. Each firm sets simultaneously its price and its quantity under two constraints, relative to its market share and to market size. The price and the quantity equilibrium outcomes always belong to the set of oligopolistic equilibria. When firms are identical and we let their number increase, any sequence of symmetric oligopolistic equilibria converges to the monopolistic competition outcome. Further results are derived in the symmetric CES case, concerning in particular the collusive solution enforceability.     

Bertrand vs. Cournot equilibrium with risk averse firms and cost uncertainty

Summary. In an oligopoly game with cost uncertainty and risk averse firms, we show that Bertrand and Cournot equilibrium have different convergence properties when the market is replicated. The Cournot equilibrium price converges to the competitive price. Under very typical and somewhat general conditions, the highest Bertrand equilibrium price converges to one higher than the competitive equilibrium. We also give examples to show how to compute the limit of the highest Bertrand equilibrium prices and illustrate the ideas of the proof. We explore conditions under which the supply curve is upward sloping, a useful condition for our results. Received: April 20, 2000; revised version: May 10, 2001     

Long-run industry equilibrium with uncertainty

In this paper we consider the effects of uncertainty on industry equilibrium when firms must commit themselves to production before prices are revealed. We show that (a) an increase in demand uncertainty will (i) not affect the equilibrium number and size of firms if they are risk neutral, (ii) reduce the equilibrium number of firms if they are risk averse, but will have an ambiguous effect on their size. (b) In equilibrium, firms operate at capacity if they are risk neutral, but at excess capacity if they are risk averse.     

Determinants of the premium in forward contracts

Whilst the benefits of forward contracting for goods and services have been extensively researched in terms of mitigating market power effects in spot markets, we analyse how the risk in spot price formation induces a counteracting premium in the contract prices. We consider and test a wide-ranging set of propositions, involving fundamental, behavioural, dynamic, market conduct and shock components, on a long data set from the most liquid of European electricity forward markets, the EEX. We show that part of what is conventionally regarded as the market price of risk in electricity is actually that of its underlying fuel commodity, gas; that market power has a double effect on prices, insofar as it increases spot prices and induces a forward premium; that oil price sentiment spills over and that the premium reacts to scarcity and the higher moments of spot price uncertainty. We observe that considerations of the scale and determinants of the forward premium are at least as important as the market power effects in spot market price formation when evaluating the efficiency of wholesale power trading.     

Hedging and temporal permit issuances in cap-and-trade programs: The Market Stability Reserve under risk aversion

Cap-and-trade programs such as the European Union's Emissions Trading System (EU ETS) expose firms to considerable risks, to which the firms can respond with hedging. We develop an intertemporal stochastic equilibrium model to analyze the implications of hedging by risk-averse firms. We show that the resulting time-varying risk premium depends on the size of the permit bank. Applying the model to the EU ETS, we find that hedging can lead to a U-shaped price path, because prices initially fall due to negative risk premiums and then rise as the hedging demand declines. The Market Stability Reserve (MSR) reduces the permit bank and thus, increases the hedging value of the permits. This offers an explanation for the recent price hike, but also implies that prices may decline in the future due to more negative risk premiums. In addition, we find higher permit cancellations through the MSR than previous analyses, which do not account for hedging.     

The effects of abandonment options on operating leverage and forward hedging

This paper examines the behavior of the competitive firm under output price uncertainty when the firm is endowed with an abandonment option and has access to a forward market for its output. When the realized output price is less than its marginal cost, the firm optimally exercises its abandonment option and ceases production. The firm lets its abandonment option extinguish, thereby producing up to its capacity, only when the realized output price exceeds its marginal cost. The ex post exercising of the abandonment option as such convexifies the firm's ex ante profit with respect to the random output price. We show that neither the separation theorem nor the full-hedging theorem holds in the presence of the abandonment option. The firm under-hedges its output price risk exposure in the forward market wherein the forward price contains a nonpositive risk premium. When the set of hedging instruments is expanded to include options, we show that both the separation and full-hedging theorems are restored. We further show that the firm prefers options to forwards for hedging purposes when both types of contracts are fairly priced.     

Forward Markets and the Behaviour of the Competitive Firm with Production Flexibility

This paper examines the production and hedging decisions of the competitive firm under output price uncertainty when a forward market for its output is available. The firm possesses production flexibility in that it makes its production decision after the resolution of the output price uncertainty, albeit subject to a capacity constraint on production. We show that the firm optimally acquires a higher level of capacity investment than an otherwise identical firm with no production flexibility. We further show that production flexibility allows the firm to implicitly hedge against its output price risk exposure by the ex post production decision. The firm as such under‐hedges its output price risk exposure in the forward market wherein the forward price contains a non‐positive risk premium.     

Search, common knowledge, and competition

This paper analyzes the effects of buyer search costs and seller private and common knowledge on seller competition. It shows that lack of common knowledge results in the equilibrium price continuously decreasing to the perfectly competitive one as buyer search costs for price decrease from positive for all buyers to zero for all buyers, even if each market agent's uncertainty (in the private knowledge) is small. At the same time, if the uncertainty of each seller about buyer valuations is small, the effects of a small change in the search costs or of information structure on pricing may be large (but continuous).     

Product line pricing in a vertically differentiated oligopoly

Abstract This paper examines the joint pricing decision of products in a firm’s product line. When products are distinguished by a vertical characteristic, those with higher values of that characteristic will command higher prices. We investigate whether, holding the value of the characteristic constant, there is an additional price premium for products on the industry and/or the firm frontier, that is, for the products with the highest value of the characteristic in the market or in a firm’s product line. We also investigate the existence of price premia for lower‐ranked products and other product line pricing questions. Using personal computer price data, we show that prices decline with the distance from the industry and firm frontiers, even after holding absolute quality constant. We find evidence that consumer tastes for brands is stronger for the consumers of frontier products (and thus competition between firms weaker in the top end of the market). There is also evidence that a product’s price is higher if a firm offers products with the immediately faster and immediately slower computer chip (holding the total number of a firm’s offerings constant), possibly as an attempt to reduce cannibalization. Finally, a product’s price declines with the time it is offered by a firm, suggesting intertemporal price discrimination.     

Monopolization through endogenous vertical mergers

While endogenous merger analysis has been applied to horizontal mergers, the thrust of vertical merger analysis has been based on exogenous mergers. The goal of this paper is to analyze endogenous vertical mergers. I consider a market structure with a downstream monopolist and an oligopolistic upstream industry. The downstream monopolist chooses to buy a certain number of the upstream firms. Mergers are endogenous, in the sense that the bids made by the downstream firm must be accepted by each of the integrated upstream firms, and must not exceed the increase in the profits of the downstream firm. It is shown that the unique equilibrium is complete monopolization: the buyer buys all the firms in the upstream industry. This result is consistent with the result that vertical mergers are profitable. However, it is in contrast with horizontal endogenous mergers, where complete monopolization is generally not an equilibrium.     

Labour Relations and Asset Returns

This paper proposes a dynamic GE model with standard business cycle properties that also achieves a satisfactory replication of the major financial stylized facts. We ride on two major ideas. First, we show that operating leverage, originating in the priority status of wage claims given the observed business cycle characteristics of the latter, magnifies the risk properties of the residual payments to firm owners and justifies a substantial risk premium. Further we build on the observation that the low frequency variations in income shares constitute a significant source of risk, one that is unlikely to be insurable. When we price this risk in an incomplete market framework, we obtain a GE model with return volatilities close to observations and a sizable equity premium. This is accomplished in a world of low risk aversion and standard utility function but with agent heterogeneity. Workers with restricted access to financial markets are insured by firms and the consumption and preferences of firm owners solely determine the pricing kernel.     

Indeterminacy and directed search

The directed search approach assumes each seller posts a fixed price and, ex post, randomly allocates the good should more than one buyer desire the good. This paper assumes sellers can post prices which are contingent on ex post realized demand; e.g. an advertisement might state the Bertrand price should there be more than one buyer, which corresponds to an auction outcome. Competition in fixed prices and ex post rationing describes equilibrium behavior. There is also real market indeterminacy: a continuum of equilibria exists which are not payoff equivalent. Sellers prefer the equilibrium in auctions.     

An asymptotic property of equilibrium on futures markets arising from speculation

This paper presents an asymptotic property of a joint spot-futures market equilibrium established in Cheng-Magill (1982). As speculators diversity over a large number of markets, the equilibrium risk premium converges to an asymptotic premium, the behaviour of which depends solely on the stochastic dependence between the spot price and an index of average returns on other markets. Risk arising from the variability of the spot price itself is diversified away. The results are related to the arbitrage pricing theory of Ross (1976).     

Pricing to Firm: an Analysis of Firm‐ and Product‐level Import Prices*

We use Hungarian Customs data on product‐level imports of manufacturing firms to document that the import price of a particular product varies substantially across buying firms. We relate the level of import prices to firm characteristics such as size, foreign ownership, and market power. We develop a theory of “pricing to firm” (PTF), where markups depend on the technology and competitive environment of the buyer. The predictions of the model are confirmed by the data: import prices are higher for firms with greater market power, and for more essential intermediate inputs (with a high share in material costs). We take account of the endogeneity of the buyer’s market power with respect to higher import prices and unobserved cost heterogeneity within product categories. The magnitude of PTF is big: the standard deviation of price predicted by PTF is 21.5%.     

The asset price incidence of capital gains taxes: evidence from the Taxpayer Relief Act of 1997 and publicly-traded real estate firms

We provide new evidence on the asset price incidence of corporate-level investment subsidies by examining the relative stock price performance of publicly traded companies in the real estate industry that should have been differentially affected by the capital gains tax rate reduction enacted in the Taxpayer Relief Act of 1997. By comparing real estate firms that have an organizational structure that allows entities who sell property to it to defer capital gains taxes and that plan to use the structure to acquire property with those that do not, we isolate the effect of the tax cut from industry trends and firm-level heterogeneity. When we examine the time period surrounding the reduction in the capital gains tax rate, our results suggest the tax change was substantially capitalized into lower share prices for these firms and the benefit of the seller’s capital gains tax deferral accrued mainly to the buyer of an appreciated property.     

Time-varying global and local sources of market and currency risks in Russian stock market

In this paper we study international asset pricing models and the pricing of global and local market risks as well as currency risk in the Russian stock market from an international investors' point of view using weekly data from 1999 to 2009. In our empirical specification, we utilize the multivariate GARCH-M framework of De Santis and Gérard (1998). We find currency risk to be priced in the Russian market. The price of currency risk is found to be time-varying and affected for example by the price of oil. Moreover, our results suggest that the Russian market is partially segmented and the local market risk is priced in the market. Our model implies in-sample risk premium for the Russian equity market that is, on average, almost ten times higher than that of the US and that the Russian risk premium is on average caused mostly by the local and currency risk components.     

The Effect of Exchange Rate Volatility on Trade in Durables

Because durable goods have the quality of an asset, risk-averse consumers wan to pay a lower price for durable than for nondurable goods so that they are compensated for the risk of price changes; they require risk premium. Since the exchange rate is a strong source of uncertainty in import prices, exchange rate volatility has a negative effect on the demand for imported durables. In an imperfectly competitive market, the volatility of the exchange rate is predicted to reduce the relative price of imported durables. The prediction is supported by an empirical investigation of US imports.     

Moral hazard,Bertrand competition and natural monopoly

In the traditional model of Bertrand price competition among symmetric firms, there is no restriction on the number of firms that are active in equilibrium. A symmetric equilibrium exists with the different firms sharing the market. I show that this does not hold if we preserve the symmetry between firms but introduce moral hazard with a customer-sensitive probability of exposure; competition necessarily results in a natural monopoly with only one active firm. Sequential price announcements and early adoption are some equilibrium selection mechanisms that help to pin down the identity of the natural monopolist. The insights of the basic model are robust to many extensions.