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Lecture notes session 4

Entry, Exit and Welfare

Stockholm School of Economics

Matilda Orth
Research Institute of Industrial Economics (IFN), Stockholm
matilda.orth@hhs.se

April 9, 2018

Matilda Orth () IO: Entry, exit and welfare April 9, 2018 1 / 46


Free entry and social optimum
Manky and Wiston paper? and CH.4 of the book. Paul Belleflamme.

Under free-entry, firms enter as long as they make positive profits

If we observe n firms in an industry this implies:


π(n) > 0 and π(n + 1) < 0

Is the free-entry number of firms equal to the social optimum number


of firms?
◮ If NO, there is room for regulation and policy intervention

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Free entry and welfare

Homogeneous products
Inverse demand function: P(q), where q is industry output
Number of firms: n
Fixed set-up cost: e > 0
Identical costs: C (qi )
Symmetric equilibrium:
◮ All firms produce the same quantity q(n) (depends on the number of
firms) The quantity each firm will produce depends on the total number of firms.

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Free entry and welfare

GOAL: Compare number of entrants...


◮ at free-entry equilibrium (ne )
◮ by social planner (n∗ )
⋆ second best because planner controls entry but not firm behavior after
entry

Two stages
◮ Stage 1: firms decide whether to enter or not
◮ Stage 2: firms engage in quantity competition (Cournot)

Mankiw and Whinston, The RAND Journal of Economics (1986)

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Free entry and welfare

With n entrants, the equilibrium per-firm profit:

π(n) = P[nq(n)]q(n) − C [q(n)] − e

Assumptions
1 Output per firm q(n) decreases with n such that q(n + 1) < q(n)
Business stealing
∂(q(n))
∂n <0
2 Industry output q increases with n
∂(nq(n))
∂n >0
3 Price above marginal cost for all n
P∗ > C ′ ∀ n

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Free entry and welfare
Free-entry equilibrium number of firms ne satisfies the zero profit
condition: π(ne ) = 0
Social welfare given Cournot competition

Z nq(n)
W (n) = P(s)ds − nC (q(n)) − ne
0

Find n∗ that maximizes social welfare, i.e., satisfies first order


condition W ′ (n) = 0
h i
W ′ (n∗ ) = P(nq(n)) n ∂q(n)
∂n + q(n) − C (q(n)) − nC ′ (q(n)) ∂q(n)
∂n − e
  ∂q(n)
W ′ (n∗ ) = π(n) + n P(nq(n)) − C ′ (q(n))
| {z ∂n }
(*)

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Free entry and welfare

Change in social welfare from an additional entrant


1 DIRECT: profits
2 INDIRECT: change behavior of existing firms

Last term (*) is negative because


∂q(n)
◮ Business stealing ∂n <0
◮ Price above marginal cost P > C ′ ∀n

Social welfare decreases by (*) from an additional entrant

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Free entry and welfare

More attractive for marginal entrant than for social planner


π(n) > W ′ (n) = 0

π(ne ) = 0 and π(n∗ ) > 0

If profits decrease in n, we have


ne > n∗

Free-entry equilibrium number of firms larger than social optimum


number of firms

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Free entry and welfare

Confirm that per-firm profits decrease with n


  ∂q(n) ∂(nq(n))
π ′ (n) = P(nq(n)) − C ′ (q(n)) + q(n)P ′ (nq(n))
| {z ∂n } | {z ∂n }
<0 <0

Because
∂q(n)
1
∂n <0
2 P > C ′ ∀n

3 P ′ < 0 and ∂(nq(n))


∂n >0

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Free entry and welfare

We obtain too much entry because the free-entry equilibrium does


not account for business stealing

This motivates entry regulations

Holds for homogeneous firms!


Berry and Waldfogel (1999), “Free entry and social inefficiency in
radio broadcasting,” the RAND Journal of Economics
◮ Empirical application with homogeneous firms – Radio stations
◮ Too much entry as compared with social optimum

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Free entry and welfare

Heterogeneous firms
◮ Less clear relationship between free/social optimal entry and welfare

Trade-off
◮ How consumers value different firms/products
◮ Degree of business stealing + duplication of costs

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Entry regulations

OECD-countries have entry regulations

Zoning regulation and urban planning


Stringency of regulation varies across countries
◮ More restrictive in the US than in the UK
◮ Tendency towards more liberal in several countries (Pozzi and
Schivardi, 2016)
◮ For instance, the UK has introduced a square-meter roof

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Entry regulations

Power to local authorities to decide over new entry


◮ Application for new entry to local authorities
◮ E.g., Sweden: Plan och Bygglagen (PBL) – use of land, water and
buildings

Assessment:
◮ supply of stores/products
◮ market shares, accessibility
◮ traffic and public transport
◮ environmental issues
◮ ...

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Entry regulations

Government intervention
◮ Reduce competition, higher prices, lower quantities, less product
variety, lower employment,...

Protect smaller stores vs quality of life of households


Identical stores:
◮ Too much entry, social inefficient entry

Differentiated product markets – heterogeneous stores


◮ Consumers’ valuations of different products/store types
◮ Nature of competition between store types
◮ Welfare implication is an open empirical question!

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Overview

Part 2: Dynamic analysis of entry and exit


o Dunne, Roberts, Samuelson (RJE, 1988)
◮ introduction to dynamics – entry and exit rates

o Dunne, Klimek, Roberts, Xu (RJE, 2013)


◮ dynamic model of entry and exit
◮ homogeneous firms

o Maican and Orth (IER, 2018)


◮ dynamic model of entry and exit
◮ heterogeneous firms
◮ demand
◮ welfare

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Entry and exit

So far we have considered two-period static models of imperfect


competition, or entry strategies by a single firm
But firms compete over time and...
◮ repeated choices, adjust their behavior and strategies
◮ form expectations about future outcomes

Entry and exit rates


◮ Compare markets with different market sizes

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Entry and exit measures

Construct variables
◮ NEmt = no. of stores that enter market m between year t − 1 and t
◮ NSmt = total no. of stores in market m in year t, including stores that
enter market m between year t − 1 and t
◮ NXmt−1 = no. of stores that exit market m between year t − 1 and t

Define entry and exit rates in market m between t − 1 and t


NEmt
◮ ERmt = NSmt−1
NXmt−1
◮ XRmt = NSmt−1

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Correlation entry and exit rates in US Manufacturing

Table 2: Dunne, Roberts and Samuelson (1988)

Correlation Between Industry Entry and Exit Rates at 4 Digit


Industries

Period Correlation
1963-1967 0.18
1967-1972 0.45
1972-1977 0.36
1977-1982 0.24

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Entry and exit in Swedish retail

250
200
150
100
50

2002 2003 2004 2005 2006 2007

Number of entry Number of exit

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Entry and exit rates in Swedish retail

.08
.06
.04
.02
0

2002 2003 2004 2005 2006 2007

mean entry rate mean exit rate

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Stylized facts: theory and empirical work

Entry and exit rates are positively correlated

Entry induces exit of some incumbents

Entry rates can be high but entrants rarely have large market shares

Small entrants are less likely to survive than large entrants

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Stylized facts: theory and empirical work

Product differentiation is positive for survival

High entry rates at early stage of an industry

Entry by new firms increases competition and stimulates innovation

Dunne et al (1988), Geroski (1995) and Caves (1998)

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Limitations of two-period static entry models

Cannot explain empirical patterns of simultaneous entry and exit


observed in many datasets

No distinction between incumbents and potential entrants

Cannot distinguish sunk entry costs from fixed costs

Not explicitly dynamic, no role for market/firm history to matter

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POPULATION STORE FORMAT

GEOGRAPHIC COORDNATES

ACCESIBILITY TRAVELING TIME COMPETITION

SOCIAL TRENDS DYNAMICS

CONVENIENCE LOCAL MARKETS

ENVIRONMENT STRUCTURAL CHANGES

PRICE
PRODUCT RANGE REGULATION

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Dynamic models of entry and exit

Fully dynamic models of entry, exit and market equilibrium


◮ Distinguish incumbent’s decision to continue or exit from potential
entrant’s decision to enter or not

IDEA: Quantify three determinants of market structure


◮ (1) toughness of competition, i.e., how n affects variable profits
◮ (2) fixed costs (determines exit)
◮ (3) sunk entry costs (determines entry)

High-dimensional and complex models!

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Dynamic models of entry and exit

Dunne et al, RAND Journal of Economics (2013)

Maican and Orth, International Economic Review (2018)

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Counterfactual analysis

What would be the outcome for consumers, firms and society under
an alternative public policy?
◮ Without subsidy, new subsidy design, taxes, pricing, product mix,
tariffs, regulations, new markets,...
◮ Not trivial to provide an accurate answer! Highly relevant to policy
makers, firms, consumers and society!

Structural modeling: close link between theory and empirics, explicit


assumptions/error terms

Advantage: perform so called counterfactual simulations

Exogenous change in a (public) policy – real-life and/or hypothetical

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Counterfactual analysis

Road-map
◮ Estimate the model, interpret, cross-check with observed data
◮ Impose a policy change (parameter of the model): re-solve the model
under alternative public policy
◮ Varies by research question: e.g., prices, quality, market shares,
markups, profits, entry/exit,...

Have been applied broadly — IO, health, labor, trade, environmental


economics,...

Example: Merger analysis in Empirical Workshop 3

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Counterfactual analysis
Compare
◮ Counterfactual outcome, i.e., the market outcome after an
exogenous policy change
◮ Factual outcome, i.e., the market outcome observed in the data

Randomized experiment?

Controversial for public policy makers to impose [change design of]


policy interventions randomly to different individuals, firms and/or
regions!
◮ Analytical tools for understanding the mechanisms behind observed
outcomes!
⋆ Assumptions under Diff-in-Diff or RDD
⋆ Time-series and data-driven analysis
⋆ Complementary!

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Dunne et. al., RAND Journal of Economics (2013)

Background: Simultaneous entry and exit within local geographic


markets

Public policy: Health Professional Shortage Areas (HPSA)


◮ Entry subsidies to underserved markets
◮ Lower entry costs – policy design

Goal: Analyze the impact of entry subsidies on the evolution of


market structure and profitability in professional health care services

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Dunne et. al., RAND Journal of Economics (2013)
Model: Dynamic discrete model of entry and exit
◮ Behavioral set-up:
⋆ incumbents (continue/exit)
⋆ potential entrants (enter/not enter)
⋆ endogenize flows of entry and exit
◮ Who observes what and when?
◮ Short-run and long-run
◮ Static per-period profits
◮ Value function: Firms maximize long-run payoffs, form perceptions of
rival’s actions
◮ These perceptions need to be consistent with competitors optimal
actions (Markov Perfect equilibrium)
◮ Recover fixed costs and sunk entry costs
Counterfactual simulations: effects of entry subsidies on long-run
profitability and market structure

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Dunne et. al., RAND Journal of Economics (2013)

Incumbents J, potential entrants E


Simultaneous decisions in the beginning of each period
Incumbents
◮ Continue to operate or not
◮ Draw of fixed cost λ ∼ G λ before decision
◮ Fixed cost draws are i.i.d. across markets and time
◮ Observe their own draw, not rivals but distribution is known to all

Incumbents maximize expected discounted future profits. Exit if fixed


costs are higher than the value of continuing.

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Dunne et. al., RAND Journal of Economics (2013)

Potential entrants
◮ Enter or to stay out
◮ Draw of entry cost κ ∼ G κ
◮ Entry draws are i.i.d across markets and time
◮ Observe their own draw, not rivals but distribution is known to all
◮ Start to operate next year

Potential entrants enter if the expected discounted future profits are


larger than the sunk entry costs.

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Dunne et. al. (2013), RAND Journal of Economics (2013)

Independent local markets, i.e., a separate game is played in each


local market
State variables s = (n, z)
n evolves endogenously: n′ = n + e − x
Exogenous profit shifters z, public information, evolve exogenously
according to a first order Markov process P(z ′ |z)
All stores are identical up to the draw of the fixed cost and entry fee

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Incumbents

V (s; λ, θ) = π(s; θ) + max{δVC (s; θ) − δλ, 0}

Expectations over number of entrants, exits and possible values of


profit shifters

Distributional assumption on fixed costs – probabilities

pexit (s; θ) = Pr (λ > VC (s; θ)) = 1 − G (VC (s; θ)), where G (·) is the
cumulative distribution function

Parameters to estimate θ, λ; Discount rate is given by δ

Similarly for potential entrants

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Dunne et. al., RAND Journal of Economics (2013)

Empirical implementation:
◮ Static per-period profits, value of continuing, value of entering
◮ Operating profits, observed entry and exit decisions
◮ State variables: s = (n, z)
◮ Distributional assumptions on fixed costs and sunk costs

Data:
◮ Dentist and chiropractors in the US
◮ Five-year panel 1982-2002
◮ 400 local markets
◮ ”Panel version of Bresnahan and Reiss”

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Dunne et. al., RAND Journal of Economics (2013)

Results
◮ (1) Source of competitive pressure: combination of direct effect of n on
toughness of competition, entry costs and fixed costs
◮ (2) As n increases: prob(exit) rises, prob(entry) falls

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Dunne et. al., , RAND Journal of Economics (2013)

Counterfactual analysis: entry subsidy in HSPA-markets


◮ Different mechanisms on fixed cost (all firms) of entry cost (only
entrants)
⋆ Entry costs: competitive pressure from potential entrants, increase
both entry/exit, decrease profits
⋆ Fixed costs: increase profits for incumbents, less exit

◮ Magnitudes: A 7 percent reduction in entry costs corresponds to shift


from n equals 1 to 2 for dentists
◮ More costly with policies on fixed costs (need to pay all firms!)

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Maican and Orth (2018) – Purpose

Goal: Analyze the impact of local market regulations on store


dynamics and profitability in retail food

Policy: Entry regulations common and frequently debated in OECD,


food products affect the daily life of everybody and stands for a high
share of the private consumption

Data: Store characteristics of all Swedish retail food stores, price


data, regional- and regulatory data 2001-2010

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Maican and Orth (2018) – Empirical facts

Simultaneous entry/exit and trend toward larger but fewer stores


Product differentiation is key: - evaluate trade-offs small vs large
stores
◮ Well-defined store types
◮ Large has 20% of no. of stores
◮ 60% of aggregate sales and sales space

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Empirical facts: Small and Large Stores 2001-2008
ICA Axfood Coop
1,500
1,000
500
0

2001 2002 2003 2004 2005 2006 2007 2008 2001 2002 2003 2004 2005 2006 2007 2008 2001 2002 2003 2004 2005 2006 2007 2008

Bergendahls Others
1,500
1,000
500
0

2001 2002 2003 2004 2005 2006 2007 2008 2001 2002 2003 2004 2005 2006 2007 2008

Number of large Number of small

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Maican and Orth (2018) - Model

Dynamic discrete model of entry and exit + differentiated products


(store types)
◮ Demand to construct static per-period profits, short-run price
competition
Recover sunk cost of entry and sell-off values of exit in markets with
restrictive or liberal entry regulations

Welfare analysis: Consumer Surplus + Producer Surplus

Counterfactual simulations: quantify the impact of entry regulations


on long-run profitability, market structure and welfare

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Maican and Orth (2018) – Results

Results: Short- and long-run


◮ (I) Average price-cost margin higher for large stores than small stores
(10% vs 8%) – operating profits
◮ (II) Asymmetries: Small stores compete intense with other small
stores, large stores compete with all stores
◮ (III) Long-run discounted CS increases by 2-4% from an additional
large store, and by 1% from an additional small store — CS increases
in number of stores
◮ (IV) Long-run discounted PS decreases three times more from a large
store than a small store – might be non-monotonic depending on the
nature of competition between store types

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Maican and Orth (2018) – Counterfactual analysis

Re-calculate the new equilibrium: firm values (long-run profitability),


entry/exit (market structure)
Counterfactual simulations of a more liberal entry regulationd
◮ Welfare increases in local markets that are large enough: dynamics of
entry, exit and new entry + consumers benefit
◮ Similar dynamics is missing in smaller markets (limited demand)
◮ Important to emphasize heterogeneous stores and markets for designing
and implementing public policies!

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Suggestions for further reading

Methodological papers on estimation of dynamic games: Bajari,


Benkad and Levin, Econometrica (2007) Pakes, Ostrovsky and Berry,
The RAND Journal of Economics (2007)

Empirical applications of dynamic games: Collard-Wexler,


Econometrica (2012) Ryan, Econometrica (2012) Sweeting,
Econometrica (2013)

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