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Concepts of Competition

Author(s): John Vickers


Source: Oxford Economic Papers, New Series, Vol. 47, No. 1 (Jan., 1995), pp. 1-23
Published by: Oxford University Press
Stable URL: http://www.jstor.org/stable/2663661
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Oxford Economic Papers 47 (1995), 1-23

CONCEPTS

OF COMPETITION

By JOHN VICKERS*
Institute of Economics and Statistics, University of Oxford, Manor Road,
Oxford OX] 3UL
1. Introduction
IN THIS lecture I would like to discuss some aspects of an old and broad
question: in what ways can competition promote economic efficiency?
As far as resource allocation is concerned, the starting point for addressing
this question is the first fundamental theorem of welfare economics: at
'competitive equilibrium' in an economy that has markets for all relevant
commodities, and firms and households that treat prices as given, there is Pareto
efficiency that is, resources are allocated in such a way that no-one can be
made better off without others becoming worse off. The efficiency of resource
allocation in competitive equilibrium states is not, however, the aspect of the
general question that I want to stress. Rather, the emphasis will be on
productive efficiency' and on concepts of competition that are perhaps closer
to the everyday meaning of the term.
Despite the widespread view, which has considerable empirical support,2 that
competition is important for productive efficiency, it is not so obvious why.
Competition seems very well in practice, but it is not so clear how it works in
theory. One natural and familiar idea is that competitive pressure makes
organizations internally more efficient by sharpening incentives to avoid sloth
and slack. Another is that competition causes efficient organizations to prosper
at the expense of inefficient ones, and that this selection process is good for
aggregate efficiency.3A third is that competition to innovate is the major source
of gains in productive efficiency over time. These concepts of competitionthere are of course others will be the subject of this lecture.
* This paper is based on an inaugural lecture given at Oxford University Press on 2 November
1993.
1 To be more precise, aspects of productive efficiency other than those having to do with allocative
efficiency. On the measurement of components of productive efficiency, see Farrell (1957).
2 Broad-brush but nonetheless powerful evidence on the relationship between competition and
productive efficiency comes from the relative economic performance of countries with and without
competitive market systems. There are numerous detailed studies. For example, Porter's (1990)
industry analysis leads him to conclude that vigorous domestic rivalry promotes success in
international markets, Nickell's (1993) panel data analysis supports the hypothesis that competition
promotes productivity, and Winston's (1993) survey of economic deregulation in the United States
concludes that it has brought large welfare gains.
3Competitive 'selection' is used here in contexts in which agents optimize, and not in the
Darwinian sense of natural selection (see Matthews, 1984). Evolutionary concepts of competition
would be a major part of a comprehensive treatment of concepts of competition, especially in
relation to innovation and dynamics (see Nelson and Winter, 1982) but are not discussed here.
Neither does the paper attempt broad coverage of applied competition questions. For example,
little is said about international trade barriers to competition, or about competition in the market
for corporate control. However, the principles disucussed below have a bearing on those questions.
C) Oxford University Press 1995

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CONCEPTS OF COMPETITION

In addition to its intrinsic interest, motivation for studying this topic comes
from applied competition policy questions. It might therefore be useful, even
though I will be discussing concepts and not policy issues, to have some
practical examples in mind. Let me suggest two. Most people here probably
consume or have consumed the products of both industries concerned.
The first is telecommunications. Consider a question that arose in the 1990
review of the UK government's previous policy of giving British Telecom and
Mercury a protected duopoly of (non-mobile) public network operations. The
issue was how much to open up the industry to competition. The existence of
scale economies provided a possible case for limiting competition, but, as the
telecommunications regulator put it: 'some competition between networks is
likely to be desirable because monopoly suppliers do not normally operate at
the greatest possible level of efficiency'.4 Should market forces be allowed to
resolve the tradeoff, or should government intervene to strike a balance, say
by licensing just one or two additional competitors? Is there a danger that 'too
much' competition might be self-defeating, leading eventually to the return of
monopoly?
The second example concerns whether there should be more competition
between (and within) universities for students, research funding, and so on.
Should rewards be based on performance, especially performance relative to
that of others, or is there already quite enough competitive pressure facing
universities and those who work in them? Are league tables a good way of
promoting competition should there be rivalry for headship of the Norrington
Table as well as for the headship of the river?5
The arguments for and against competition, the criteria for evaluation, and
indeed the vary nature of competition, might be quite different as between these
two cases. You might favour competition in one of them more than in the other.
(I dare say the management of British Telecom feels that way.) But it is not a
coincidence that the word 'competition' can apply to both, and whatever
judgment is reached, it seems important to try to understand the various ways
in which competition works, whether for good or ill.
In what follows I shall first clarify some terms and make a few preliminary
comments about competition, efficiency and welfare (Sections 2 and 3). Second,
there will be some brief remarks about the historical development of concepts
of competition (Sections 4 and 5). Third, the main part of the lecture will
consider concepts of competition relating to incentives, selection, and innovation
(Sections 6, 7, and 8). I will end with some comments on the analysis of
competition policy questions.

4 Oftel, Annual Report, 1989. The government review opted for liberalization. Attention then
shifted to the terms on which rivals could gain access to BT's local networks, and the wider issue
of BT's vertical structure. See Armstrong et al. (1994, ch. 7).
5The Norrington Table ranked Oxford colleges by the examination performance of their
students. The university has stopped publishing the information needed to compile it.

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J. S. VICKERS

2. Definitions of competition
Although the concept of competition has always been central to economic
thinking John Stuart Mill (1948, p. 147) said that 'only through the principle
of competition has political economy any pretension to the character of a
science'-it is one that has taken on a number of interpretations and meanings,
many of them vague. Let me try to clarify some terms at the outset.
In the New Palgrave, Stigler (1987) describes competition as: 'a rivalry
between individuals (or groups or nations), and it arises whenever two or more
parties strive for something that all cannot obtain'. Let us adopt this as a
general working definition. There are several things to note about it. First and
most obvious is its breadth, which encompasses all sorts of forms of rivalry
(market trading, auctions, races, wars of attrition, etc.), instruments of rivalry
(prices, advertising, R & D, takeover bids, effort levels, etc.), objects of rivalry
(profits, market share, corporate control, promotion, prizes, survival, etc.), as
well as types of rival. More precise definitions of 'competition', tailored to
particular contexts, will be provided later.
Second, competition is defined here in behavioural terms. By contrast,
highly developed analytical concepts under the heading of 'perfect competition'
(including the competitive general equilibrium model mentioned earlier) refer
to states or situations. The old complaint, of course, is that these states are not
very, or at all, 'competitive' in the behavioural sense. More on this later.
Third, the identification of competition with rivalry does not in any way
presume that 'more competition' is necessarily good or an end in itself.6
Indeed, the desirability or otherwise of competition is one of the main questions
to be addressed (another being its sustainability).
What, then, does it mean to say that there is 'more competition' in some
activity? Several meanings are commonly used and need to be distinguished.
They include (i) greater freedom of rivals (for example, freedom to enter an
industry following the removal of legal monopoly rights or barriers to trade);
(ii) an increase in the number of rivals; and (iii) a move away from collusion
towards independent behaviour between rivals. These three senses may be
causally related:thus freedom of entry might result in a greater number of firms
and that might lead to a breakdown of collusion. Another sense of 'more
competition' applies when (iv) the reward for obtaining the thing for which all
are striving, or the penalty for failing to obtain it, is increased or introduced
in the first place.
6 Some influential writers, however, have explicitly incorporated welfare criteria into their
definitions of 'competition'. Robert Bork in The Antitrust Paradox (1978, p. 61) defines the term
as 'designating any state of affairs in which consumer welfare cannot be increased by moving to
an alternative state of affairs through judicial decree'. In adopting this usage Bork is constrained
by the language and history of United States antitrust law, which he argues to be consistent
with economic efficiency criteria. For this reason Bork strongly opposes the identification of
competition with rivalry in antitrust analysis, because it 'invites . . . the wholly erroneous conclusion
that the elimination of rivalry must always be illegal'. But we are not so constrained, and if it is
clear that 'competition' is being used strictly in a positive sense, with no normative or legal
implications, this should not be a source of confusion.

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CONCEPTS OF COMPETITION

3. Competition, efficiency, and welfare-some preliminary remarks


Some types of competition, such as wars, are obviously undesirable, and so are
some forms of economic competition. Von Weizsicker (1980) distinguishes
between three possible 'levels' of economic competition: consumption goods,
production and innovation. Direct competition in consumption is generally
prohibited by systems of property rights: A cannot lawfully compete with B to
occupy B's house. But competition between buyers and between sellers with
respect to the exchange of the property rights relating to consumption is
of course another matter: A can compete with others to buy B's house and B
may be in rivalry with others wishing to sell houses. Restricting competition
at the level of consumption gives incentives (by avoiding free-rider problems
and so on) for productive activities and hence for enhancing the means of
consumption. Analogously, public policy, in the form of patents and other
intellectual property rights, prohibits some kinds of competition in production
in order to stimulate competition in innovation, which in turn expands the
means of production: firm A cannot lawfully compete in production with firm
B using technology patented by B. On this view, it is not just a question of
more or less competition, but of balancing between more competition at one
level and less at another. However, incentives for innovation do not necessarily
requirerestrictionson competition in production they may be non-commercial,
as in the scientific research, or provided by other measures such as R & D
subsidies (see Dasgupta and David, 1987; Spence, 1984).
Loosely one may speak of allocative, productive, and dynamic efficiency,
respectively in relation to these three 'levels' of economic activity. But these
are just aspects of overall economic efficiency as defined by some welfare
criterion. In what follows I shall (implicitly) be using standard 'welfarist'
crtieria Pareto efficiency, consumer surplus, etc. I am not going to discuss or
evaluate competition in relation to wider values of rights and liberty. That was
precisely the subject of the recent Hicks lecture here on 'Markets and Freedoms'
given by Amartya Sen (Sen, 1993).
4. Smith, Cournot, and Edgeworth on competition
This is not the place for a lengthy account of the historical development of
concepts of competition,7 but I think that some historical perspective is useful.
Let me say a few words about three great economists of competition Adam
Smith,8naturally enough, and two pioneers of the formal analysis of competition,
Cournot and Edgeworth.
Adam Smith's concept of competition between the buyers or sellers within a
market has been described as competition 'in the sense of rivalry in a race a
7 See Stigler (1957), Clark (1961), McNulty (1967, 1968), Richardson (1975), Backhouse (1990),
and the entries on competition in the New Palgrave.
8 Adam Smith was not the first to perceive the role of competition in determining market prices
and returns to factors of production. See McNulty (1967) on Cantillon, Turgot, Hume, and Steuart
for example.

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J. S. VICKERS

race to get limited supplies or a race to be rid of excess supplies'.9 That rivalry
forces price towards an equilibrium of supply and demand, but that will be
constantly shifting in response to changing circumstances.An essential condition
for this competition is individual freedom, but the number of rivals can matter
too:
If ... capitalis dividedbetweentwo differentgrocers,their competitionwill tend to
makeboth of themsell cheaper,than if it werein the handsof one only;and if it were
dividedamongtwenty,theircompetitionwould be just so muchthe greater,and the
chanceof theircombiningtogether,in orderto raiseprice,just so muchthe less (Smith
1976,pp.163-4).
Needless to say, Adam Smith's vision of the workings of competition goes far
wider than price determination within markets, and extends to resource
allocation in the economy as a whole, the division of labour and economic
development. For example he spoke of
the competitionof the producerswho,in orderto undersellone another,haverecourse
to new divisionsof labour,and new improvementsof art, which might neverotherwise have been thoughtof,10
and commented that
Monopoly... is a greatenemyto good management,whichcan neverbe universally
establishedbutin consequenceof thefreeand universalcompetitionwhichforcesevery
body to have recourseto it for the sake of self-defence(Smith 1976,pp. 163-4).
Nevertheless, Adam Smith and other classical economists related competition
more to issues of resource allocation and the theory of value than to what
would now be termed productive efficiency.
The first precise analytical treatment of competition between producers was
provided by Cournot (1838), who made some pithy remarks about the failure
of earlier economic writers to develop the idea of competition beyond vague
popular notions. Cournot analyzed the profit-maximization problem of a
producer deciding how much to supply to a (homogeneous goods) market
taking as given the quantities supplied by rivals. He characterized equilibrium
behaviour and investigated the consequences of increasing the number of firms,
proving that 'the result of competition is to reduce price'. He then devoted a
chapter to the large numbers case of 'unlimited competition' in which no seller
has an appreciable effect on market price, which he believed to be a reasonable
approximation for most products of his day. This precursor to models of 'perfect
competition' is thus a limiting case, in which there is no noticeable rivalry to
9 Stigler (1957, pp. 1-2), who follows Marshall (1920, p. 5): 'The strict meaning of competition
seems to be the racing of one person against another, with special reference to bidding for the sale
or purchase of anything'.
10 Smith (1976, p. 748), quoted in McNulty (1968, p. 648), who says that this is little more than
a passing comment (it comes in book V on public finance) and that 'Smith curiously failed to
relate productive technique to the concept of competition'.

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CONCEPTS OF COMPETITION

speak of, of a model of oligopolistic competition in which there is at least some


kind of rivalry."
Cournot discussed cost as well as price. He showed that firms with low
marginal costs would supply more than higher-cost firms, and that some
high-cost firms might get shut out of production altogether, but that a given
total industry output would be produced at higher cost by competing asymmetric producers than if a monopolist made their production decisions (because
their marginal costs are not equal at equilibrium). Despite the well-known
criticisms of Cournot's oligopoly theory by Bertrand and Edgeworth,"2 it is
now a key component of modern industrial organization theory, and indeed I
will use it later in connection with the points just made about production
costs.
For Edgeworth, indeterminacy was the central feature of oligopoly and
market trading processes in general, and the key issue was its extent.13 In
Psychics (1881) he stated a remarkable and profound result about
Mathemnatical
competition in an exchange economy: if all traders have complete freedom to
contract and recontract with one another, there is free communication between
traders, and complete divisibility of commodities, then, as the number of
traders becomes indefinitely large, the range of indeterminacy vanishes and the
'final settlement' is determinate. Put in more modern terms, the result is that
the 'core' that is, the set of allocations of commodities that no coalition of
agents can by itself improve upon shrinks as the number of agents increases,
and in the limit it is the same as the set of competitive equilibria. Thus in terms
of final outcome, as the number of agents gets indefinitely large, the limit of a
kind of free-for-all bargaining is the same as if there had been passive
price-taking behaviour.14
Thus Cournot and Edgeworth neither assumed price-taking behaviour nor
defined their general concepts of competition in terms of it. Rather, they showed
" Cournot foundations for perfect competition analysis in general equilibrium are examined in
the Symposium in the Journal of EconomnicTheory, 1980. One approach is to consider the limit as
the number of firms is increased. Another approach is based on Cournot equilibrium with free
entry when the minimum efficient scale of production becomes small in relation to demand. See
Novshek and Sonnenschein (1987).
12 Kreps and Scheinkman (1983) proved the remarkable result that, given certain assumptions
about rationing, the Cournot outcome emerges as the perfect equilibrium of a natural two-stage
Bertrand-Edgeworth game in which sellers choose capacities before engaging in price competition
in the market. Another approach, which endogenizes the choice of firms' strategic variables, is
Klemperer and Meyer's (1989) analysis of supply function equilibria under uncertainty.
13 See the symposium of papers on Edgeworth by Hildenbrand, Sutton, and Vives in European
EconomficRevew, 1993.
14 Edgeworth (1881) proved the result for the case of two commodities and two types of agent,
with there being n of each type. In this setting 'more competition' means larger n, but note the
crucial free contracting assumption also. About 80 years passed before more rigorous and general
statements and proofs of Edgeworth's great insight were provided-see Shubik (1959) and Debreu
and Scarf (1963). Aumann's (1964) analysis of equilibrium with a continuum of traders-the
equilibrium of the limit as distinct from the limit of equilibria, as it were-is particularly elegant.
On the use of continuity assumptions Edgeworth (1925, ii, p. 389) cited Clerk-Maxwell's analogy
that gravel could be treated as a continuous substance by a railway contractor digging a tunnel,
but not by a worm.

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J. S. VICKERS

that an important limiting case of real-world interest could be analyzed, with


a large gain in terms simplicity, in terms of price-taking behaviour, and hence
they gave a justification for taking the short cut of assuming 'perfectcompetition'
in some contexts. Systematic analysis of markets and economies characterized
by perfect competition by Jevons, Walras, and Menger in the 1870s eventually
led to the Arrow-Debreu-McKenzie general equilibrium model, a celebrated
landmark in the development of the theory being the work of John Hicks (1939)
(see Arrow and Hahn 1971).
5. Two concepts of competition?
It is often said, however, that the concept of 'perfect competition' just described
is quite divorced from the original and 'real' concept of competition as a process
of rivalry. On the one hand, 'competition' as a seemingly tranquil equilibrium
state in which well-informed agents treat prices parametrically; on the other
hand, competition as rivalrous behaviour with respect to prices and other
variables in a world characterized by flux, uncertainty, and disequilibrium.
A related criticism powerfully made by economists such as Hayek and
Schumpeter (of whom more later) is that models of perfect competition have
little to say about productive and dynamic efficiency, which are arguably more
important than allocative efficiency for economic well-being as a whole (but
we must not underestimate the importance of intertemporal resource allocation,
and risk allocation, in this process).
In view of this, I was rather tempted to call this lecture 'Two Concepts of
Competition'. But a similar title has been used before. Anyway, I think the
claim that there are two concepts of competition is somewhat misleading. As
I hope the discussion of Cournot and Edgeworth indicated, the notion of perfect
competition had its roots in the broad concept of competition as rivalry.
Whether or not it is sensible to assume perfect competition depends on the
question that one wants to address. Perfect competition (including competitive
equilibrium) models are extremely useful for analyzing all sorts of economic
issues taxation policy is one example among many but they are not suitable
for, and were not intended for, thinking about some others.
In particular, questions about competitive processes and their effects on
productive and dynamic efficiencyrequireother approaches. Thanks to advances
in the economics of imperfect information, imperfect competition, and dynamic
processes, these are being undertaken. I now want to illustrate how the scope
of competitive analysis has been and is being broadened.
6. Competition and incentives
Hicks (1935) remarked that 'the best of all monopoly profits is a quiet life'. An
important element of the quiet life is slack or 'X-inefficiency' (see Leibenstein
1966) within an organization inefficiently low levels of effort by its members
to reduce costs, improve quality, and introduce new ways of doing things, and
correspondingly high levels of leisure. (It is in this connection, by the way, that

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CONCEPTS OF COMPETITION

this University is mentioned in the Wealth of Nations. Adam Smith was not
impressed by incentives in 18th century Oxford, where 'the greater part of the
publick professors have, for these many years, given up altogether even the
pretence of teaching.'5 How things have changed since then.)
Intuitive though it seems that competition will tend to eliminate slack within
a firm, say, this idea is not so simple to pin down. It is relatively straightforward
to show how a change in competitive circumstances might lead to higher level
of effort by changing tradeoffs between income and leisure (there are both
income and substitution effects),'6 but this is not quite the point. What needs
to be explained is how competition affects the degree of inefficiency that is,
the extent to which efforts fall short of their (Pareto) efficient level. The threat
of takeover-competition in the market for corporate is a possible mechanism,
though its effectiveness and efficiency are controversial, but I will not go into
that here.
I shall concentrate on the important idea that competition may improve
incentives for efficiency by allowing performance comparisons.'7 'Competitionby-comparison' has a large and increasing number of practical applications,
including the payment of employees partly by their performance relative to
others, and regulating the prices of regional monopolists in utility industries
(so-called yardstick competition).'8 Competition of this sort can affect incentives
in various ways, and it is useful to distinguish between explicit incentives that
are created by design, and implicit incentives that arise naturally from market
forces.
Here is an illustrative principal-agent example,19 which I shall develop in
three steps concerning the impact of competition by comparison on the
insurance, reputation and ratchet effects.
Suppose that Agent A (the manager of a firm, say) is working for principal
P (the firm's owner). Let A's measured performance x, in period t be equal to
the sum of A's effort level et and an exogenous random term zt consisting of
two independent elements A's ability level a, which is constant through time,
and a mean zero measurement error Et that is independent in each period. (The
distinction between a and Et will not matter until dynamics are introduced.)
Thus xt = et + zt = et + (a + Et). Assume that zt is normally distributed with

Smith (1976, p. 761). In the Scottish universities there was performance-related pay.
Hermalin (1992) examines managerial income effects, together with several other effects, in an
agency model.
17 The literature on competition and incentives is large. Among the early papers were Holmstrom
(1982b), Lazear and Rosen (1981), Mookherjee (1984), and Nalebuff and Stiglitz (1983).
18 See Shleifer (1985). The possible advantages of competition by comparison are part of the
case for having a regional rather than nationwide structure in natural monopoly industries. The
1989 Water Act requires the Monopolies and Mergers Commission to take account of the loss of
comparative information that a merger between water companies would entail when deciding
whether or not to recommend that such a merger be prohibited.
19 The example is based on that in Milgrom and Roberts (1992, ch. 7), who discusses the
assumptions made and the restriction to linear incentive schemes.
15

16

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J. S. VICKERS

mean a and variance v. There is a problem of moral hazard: P can observe x,


and indeed can offer A an employment contract specifying A's wage conditional
upon xt, but P does not know the individual contributions to performance of
effort and the random factors (ability and measurement error), so could not
see, for example, whether high xt was caused by high et or lucky z,
Consider first the one-period problem (time subscripts can be dropped here).
Suppose that the wage contract takes the linear from w(x) = oc+ fix. Agent A
does not know z when choosing e. The cost of effort is assumed to be quadratic:
c(e) = 2e2. Principal P is risk-neutral and maximizes the expected value of
x - w(x), but A is risk-averse and is assumed to maximize the expected value
of u(w(x) - c(e)), where the utility function u(w) = - exp (- rw) has the property
of constant absolute risk aversion. It follows from the assumptions that have
been made that A's expected payoff has the certainty equivalent [oC+ l(a-+ e) 1/32rv - {e2]. The optimal effort choice by A clearly satisfies e = /3. This
incentive constraint and also A's participation constraint must be taken into
account when P chooses ocand fi to maximize expected output less payment
to A. At the constrained optimum, /P*= 1/(1 + rv). Thus the power of optimal
effort incentives depends inversely on the variance of the random term.
Risk aversion is at the heart of the incentive problem. Without it, that is if
r = 0, the optimal incentive contract would have the simple form of a lump-sum
payment from A to P. Individual and social incentives would be in accord and
the efficient effort choice e = 1 would be made. All risk would be borne by A,
but this entails no loss in the absence of risk aversion. With risk aversion (r > 0),
on the other hand, a compromise has to be made between the cost of slack
(e < 1) and the cost of risk. The optimal compromise is given by the expression
for f* above. The social cost of the moral hazard problem is measured by the
extent to which (the certainty equivalent of) expected welfare falls short of its
first-best level. This loss is A(v) ={rv/(l + rv), which is an increasing function
of the variance term.
6.1. Competition and the insurance effect
Does it improve incentives if P can observe the performance of another manager
(who might be in the same firm or the manager of some other firm)? In general
it does, because there is 'a richer information base on which to write contracts'
(Holmstrom and Tirole, 1989, p. 96). In particular, comparability allows
risk to be reduced because a manager's effort can be estimated with greater
precision. Suppose that P can also observe the performance of another
symmetrically placed agent B, whose output x = e + z (hats denote corresponding variables for B). The value of this information is that it improves the
incentive-risk tradeoff. Let K be the correlation coefficient between z and z, and
assume that K > 0. The optimal linear incentive scheme for P to set for A now
has the form: w(x, x) = oC+ 8(x - KX). The variance of w decreases from /2v
to (1 - K2)/32v. The optimal value of the incentive coefficient increases to
/3* = 1/[1 + r(1 - K2)V], and the welfare loss falls to {((1 - K2)V).

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10

CONCEPTS OF COMPETITION

If the agent B faces a similar incentive scheme, and assuming no collusion


between them, A and B are in competition in the sense that the reward of each
partly depends on performance relative to that of the other agent. The intensity
of this (controlled degree of) competition in increasing in K, and in the case of
perfect correlation (K = 1), relative performance is all that matters, because
comparability eliminates risk, so /3* = 1 and w(x, x) = oc+ x - x.
In sum, competition by comparison allows risk to be reduced there is less
observation error in assessing A's performance and as a result the optimal
explicit incentive causes effort to be closer to its efficient level.20
6.2. Competition and the reputation effect2"
Now let us return to the single-agent case but add dynamics to this static setting.
Consider implicit incentives, which arise not by design but from exogenous
market forces. Indeed suppose that performance-related pay is impossible, so
there are no explicit incentives. Why would A bother making any effort then?
The answer is that reputation may be important, in particular the desire to
improve future earnings prospects.
Suppose there are two time periods and no discounting. Reputation incentives
will not have any force in the final period, so e2 = 0, but consider period 1.
With perfect competition between owners to hire managers, A's wage in period
2 will be equal to A's expected performance conditional upon first period
performance: w2 = E(x2 I x) = E(a Ix1). This last equality holds because e2 =
E(E) = 0. There is an incentive for A to exert effort in period 1 to the extent
that doing so improves owners' conditional expectation E(a Ix1). Suppose that
z1 and Z2are both distributed like z above, and that the correlation coefficient
between them is T (O< r < 1). Then w2 = E(aI x) takes the simple form:
(1 - T)d + [xl - E(xl)]. The optimal period 1 effort level for A is el = T < 1.
The reputation effect eliminates some but not all slack. The size of T depends
on the ex ante variance of ability a relative to that of measurement error Et.
This is a kind of signal-to-noise ratio. Effort incentives are better (r is closer
to 1) the less measurement noise there is.
How does the presence of another manager affect implicit incentives?
Similarly to before, W2 = E(a Ix1, x1). Effort incentives depend on the coefficient
on x, in this conditional expectation. Let q be the correlation coefficient
between the managers' ability levels a and a, and let p be the correlation between
their measurement errors Etand Etin any period. (These correlation coefficients
are related to K by K = qr + (1 -T)p.) The coefficient on x, in the conditional
20 This discussion has assumed that incentives can be based on cardinal performance information.
If only ordinal performance information i.e. the ranking of agents-is available, then the incentive
system takes the form of a tournament with 'prizes' (for 1st, 2nd, etc.). In some contexts for
example competitions for promotion in firms this sort of tournament structure arises naturally.
Tournament competition increases both incentives and risk. The benefit of the former outweighs
the cost of the latter if the correlation between the uncertainties affecting the agents is sufficiently
great.
21 The following discussion is based on Holmstrom (1982a) and Meyer and Vickers (1994).

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expectation of A's ability, and hence the optimal effort level e1, are equal to
_2). This term is greater than in the single manager case if and
T(1 K)j
only if K > q, which is the case if and only if p > q. Therefore effort incentives
are greater when there is competition (in the sense of comparability) if and only
if the correlation of measurement errors exceeds that of abilities.
Correlation of measurement errors improves the precision with which the
market can observe performance and so increases the weight attached to
performance in assessing ability. Correlation of abilities, on the other hand,
leads agents to free-ride on each other's efforts. An implication of this argument
is that incentives may be better when agents are in similar environments in
particular when there is greater correlation of the uncertainties that affect
them than when they are in very different environments.
6.3. Competitionand the ratchet effect22
We have seen that competition-by-comparison is good for effort incentives in a
one-period model of explicit incentives but ambiguous in a dynamic model of
implicit incentives. One might expect that competition will be good for
incentives in a dynamic model of explicit incentives what harm could additional
information do when incentive contracts are designed? but things are not
totally straightforward. When future contract terms can be committed in
advance, then it is true that more information is good, and this is often but not
necessarily the case when commitment is impossible. Particularly important is
how competition alters the ratchet effect.23This is the depressing phenomenon
of good performance today resulting in a higher target being set tomorrow. If
anticipated, the ratchet effect weakens effort incentives, and attempts to restore
them by sharpening today's explicit incentives add to risk cost. This issue is
important in the economics of regulation BT's productive efficiency incentives
would be poor if cost-cutting today immediately caused tighter price regulation
tomorrow.
Competition has mixed effects of the ratchet effect, and again it matters how
the correlation between the two managers' abilities compares with that between
the errors in measuring their performances. The strength of the ratchet effect
depends on period 2's explicit incentive multiplied by the coefficient on x1 in
the conditional expectation E(a Ixl, xl, x2). This coefficient is important
because A's wage in period 2 depends on performancerelative to E(a Ix, x, x2).
It can be shown that the coefficient is smaller, which is good for incentives, the
more correlation there is between managers' abilities (i.e. the greater is q),
because more weight is then given to the other manager's performance.
The following discussion is based on Meyer and Vickers (1994).
When explicit incentives can be set, optimal effort incentives are no longer influenced by the
reputation effect. This is because it is costless, and hence optimal, for P to offset implicit incentives
deriving from the reputation effect by adjusting first-period explicit incentives accordingly. What
matters both for effort incentives and for the risk faced by A is the overall incentive, i.e. the sum
of implicit and explicit incentives. In the absence of the power to precommit period 2 incentives
in advance, however, it is impossible to avoid the ratchet effect.
22
23

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CONCEPTS OF COMPETITION

Correlation of measurement errors (i.e. high p), on the other hand, can worsen
the ratchet effect, and this can even outweigh the benefit of the insurance effect.
Thus even when explicit incentives can be set (but not precommitted from the
outset), dynamic influences via the ratchet effect must be considered together
with the insurance effect in the analysis of how comparative performance
information affects effort incentives and efficiency.
Despite its simplicity, I hope that this model has illustrated some of the
ways in which competition-by-comparison can affect incentives for efficiency.
Depending on contracting possibilities and the information structure, competition was shown to improve efficiency in many, but not all, circumstances.
Like all models, its aim was not to explain everything. For example, it did not
capture the influence of head-to-head product market competition between
firms. This could yield comparative information indirectly, for example via the
effect of market prices upon profits, and it might also bring pressure from
efficient firms to bear on slacking ones. Analysis of such influences indicates,
however, that the effects of competition on slack can be subtle and ambiguous.24
Finally, in judging the appropriate extent of competition-by-comparison it is
important in some contexts also to take account of its effect on agents' incentives
to work cooperatively with one another, and on the allocation of efforts between
different tasks (see Holmstrom and Milgrom, 1991). The Norrington Table
question provides a local example of these points an examination league table
might create some competitive incentives for teaching (and studying), but this
could diminish incentives for inter-collegiate cooperation in teaching and for
research (and rowing).
I have been discussing ways in which competition can affect efficiency at the
level of the organization. Now let me put that issue on one side and consider
the role of competition as a process of discovery, and how competititve selection
between organizations can influence efficiency at the aggregate level.
7. Competition, discovery, and selection
Hayek saw the economic problem of society as 'a problem of the utilization of
knowledge which is not given to anyone in its totality'. Whereas in the textbook
competitive model all sellers of a good are assumed already to know the
minimum cost of production, Hayek stressed that 'it is only through the process
of competition that the facts will be discovered' (Hayek 1945, p. 321; 1949, p. 96).
Market prices communicate information that has been discovered,25 and
thereby influence the direction of entrepreneurialenergies, and it is competition,
24 See the contrasting findings of Hart (1983) and Scharfstein (1988). See also Willig (1987),
Martin (1993), Horn et al. (1994), and Schmidt (1994).
25 The aggregation and communication of dispersed information by competitive market prices
has been formalized by the theory of rational expectations equilibria. A central result of the theory
is that, under certain conditions (including complete markets), there exists a rational expectations
equilibrium that could not be Pareto dominated even by a benevolent central planner in possession
of all the information throughout the economy. For a collection of papers on the informational
role of prices, see Grossman (1989).

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13

on this view, that is above all vital to its discovery (see Kirzner 1992, ch. 8, on
this distinction).
Consider the following simple example from the theory of auction competitions,26 which will be developed further below. Suppose that a number of
risk-neutral firms are competiting to sell to a buyer. Let the unit cost level of
firm i be ci, and let pi denote its 'bid' the price at which it offers to supply the
buyer's needs. One strand of auction theory deals with the case of 'common
values'. In our setting this means that all firms have the same cost level c but
that no firm knows what c is. Suppose that firms are symmetric and that each
privately recieves some imperfect information about c. It follows from Wilson's
(1977) result that, under fairly general conditions, as the number of bidders gets
large, the winning bid and hence the resulting price p converge to the true cost
level c. This happens even though no firm knows what c is and there is no
communication of information either directly or via prices. Dispersed imperfect
information is aggregated in the competitive process.
This result for common value auctions has been generalized and also
extended to other kinds of competition. Palfrey (1985) examines a linear
Cournot oligopoly model in which firms independently receive imperfect
information about the common cost level c (or more generally about the
differencebetween the demand intercept and c). Under fairly general conditions,
as the number of firms gets large, the (Bayesian) Cournot equilibrium price
converges in probability to the true cost level c. Thus there is marginal cost
pricing in the competitive limit even though no firm knows the level of marginal
cost and there is no communication of dispersed information: it is as though
there is price-taking behaviour and perfect information. (The assumption of
constant marginal costs matters for this result; see Vives 1988).
However, it is a different strand of auction theory that dealing with
independent values or costs that I shall focus on now. When firms' costs differ,
competition can play an important role in selecting more efficient firms from less
efficient ones.27 Suppose for simplicity that each firm's cost level is an
independent draw from some cost distribution F(c) on support [c, J]. In various
standard forms of auction (first-price, second-price, etc.) the lowest cost firm
wins the competition. As the number of firms increases, the expected cost level
of the winner decreases a clear sense in which competition can be good for
productive efficiency (but any fixed costs of competing must also be taken into
account). Not only do expected costs fall as the number of competitors
increases, but it can only be shown that there will not be too much entry under
laissez-faire, because the expected externality i.e. the sum of the changes in
For a survey of auction theory, see McAfee and McMillan (1987).
Demsetz (1973) has stressed this point. Formal analyses of competitive selection include
Jovanovic's (1982) model of industry evolution. Each firm has decreasing returns and treats price
parametrically. Firms learn about their costs, which are subject to random influences, over time.
Low cost firms grow and survive, while high cost firms shrink and exist. The dynamic stochastic
equilibrium is welfare optimal. Other models of competitive selection with price-taking firms include
Lippman and Rumelt (1982) and Hopenhayn (1992).
26
27

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CONCEPTS OF COMPETITION

consumer surplus and the profit of other producers caused by the entry of an
additional competitor is zero (if demand is inelastic) or positive (if it is elastic).28
Auction competitions of this kind, like Bertrand competition between firms
with constant marginal costs, have the property that the most efficient firm will
win. What happens if competition, and hence selection, are imperfect? Does
more competition, in the sense of more firms, improve the effectiveness of
selection, and hence of productive efficiency? In particular, how might the
selecting role of competition affect the externalities associated with entry, and
hence the case for policy intervention to affect competition?
A natural context in which to pursue these questions is the standard Cournot
oligopoly model with constant unit production cost per firm, and fixed (and
sunk) entry costs. A well-known result in homogeneous goods oligopoly models
of this kind with symmetric firms is that there tends to be too much competition
under laissez-faire by the criterion of welfare as the equally weighted sum of
consumer surplus and profits.29 The reason is a tradeoff between allocative
efficiency and productive efficiency more competition, in the sense of there
being more firms, causes price to fall towards marginal cost, but less advantage
is taken of scale economies, which exist because of the fixed entry cost, and so
average cost rises. Under rather general conditions, the negative externality that
an additional entrant imposes on existing firms by taking business from them
outweighs the positive externality to consumers in terms of lower price. In this
very simplified setting, then, competition is good for allocative efficiency but bad
for productive efficiency,and the net effect is a tendency for there to be too much
entry.
Of course, a framework as simple as this should not be taken too seriously as
a basis for policy analysis. A tendency to excess entry is a necessary condition
for policy intervention to restrict entry but by no means sufficient. There are
well-known factors that can overturn or at least reduce the 'excess entry' result.
They include product differentiation, collusion and strategic entry deterrence,
and according to consumer surplus a greater welfare weight than profits. There
are integer issues, and of course regulatory failures have to be considered if
policy intervention is under consideration. But quite apart from all those points,
a striking feature of the simple, albeit commonly used, framework was the
absence of any possibility that competition might be good for productive
efficiency(the virtue of competition stressed by the telecommunications regulator
in the initial example!).
In particular, if all firms are assumed to be symmetric, competition cannot
enhance productive efficiency via selection. To see how symmetries can make a
significant difference to the welfare effects of entry when there is imperfect
competition, let me describe an example involving Cournot competition. (See
the Appendix for more details.) Among other things, the example illustrates
28 See Hansen (1988) for a comparison between first-price and second-price auctions when
demand is elastic.
29 See Mankiw and Whinston (1986) and Suzumura and Kiyono (1987). It is important to note
that these models do not allow for strategic entry deterrence by incumbents.

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effects that Cournot noted more efficient firms getting larger market shares
than less efficient ones and inefficient firms possibly being driven out of
production altogether.
Suppose that the elasticity of demand is one.30 Then industry revenue is a
constant, independent of price. Suppose that each firm discovers its own unit
cost level, and that of its rivals, once it has entered the industry, which involves
payment of a fixed cost. Let there be two possible unit cost levels, H and L, and
assume that cost level H is twice as high as cost level L. Suppose that there are
three firms already in the industry. A fourth might want to enter. Should it be
restricted in view of the scale economies resulting from the fixed entry cost? A
necessary, but far from sufficient, condition for such a limitation of competition
is that there be a negative externality from entry.
If welfare is the simple sum of consumer surplus and profit, then there is a
negative externality from entry if all firms have the same cost level. It is equal
to about -2.8% of industry revenue (the welfare effects are exactly the same if
all firms have cost H as if they all have cost L). Various things happen in the
asymmetric cases.
If the entrant is high-cost while two or more of the incumbents are low-cost,
then the entrant ends up not producing because competition between the
other firms means that price is no higher than the entrant's cost level and the
net externality of entry is zero. If the entrant is high-cost and only one of the
incumbents is low-cost, then entry causes a negative externality, but it is small
(-0.4%) because the entrant does not get a large market share, and 'business
stealing' is entirely from the inefficient incumbent firms (the efficient one
actually produces more after entry).3'
Turning to asymmetric cases where the entrant is low-cost, if none of the
incumbents is low-cost, then even though entry is very beneficial for consumers,
the net externality is negative (-2.1o%) but not as much so as in with symmetry.
If two of the incumbents are low-cost, then the third is shut out of production
anyway, and the situation is the same as if a third symmetric firm enters an
industry with two incumbents. The net externality from entry is positive
(+ 1.O%).32It is more positive (+ 3.3%) in the final case, where just one of the
three incumbents is low-cost. Here, entry reduces the number of active firms
30 This unit-elastic demand example is chosen to illustrate the main points sharply. It has the
feature that outputs are strategic complements over some ranges. Preliminary investigations of
other parameterizations suggest that it is unusual in reversing the excess entry result when cost
draws are independent, but that negative externalities from entry are often reduced when
competition plays a role in selection (or, to put it another way, that the weight that needs to be
given to consumer surplus relative to profit in order to reverse the excess entry result becomes
smaller).
31 This result does not generalize far, but it is generally true that entry reduces the output of
inefficient firms more than that of efficient firms if demand is convex. With linear demand this
differential effect does not exist.
32 This positive externality is consistent with Mankiw and Whinston (1986), who show that the
optimal number of firms is no more than one greater than the free entry equilibrium number of
firms when there is business stealing, and with Suzumura and Kiyono (1987), whose main result
assumes strategic substitutes, whereas with unit-elastic demand, reactions functions are not
monotonic.

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CONCEPTS OF COMPETITION

from three to two: competition gets too hot for the inefficient firms. The efficient
incumbent is again induced to increase output.
Note that out of all the possibilities in this example, the negative externality
of entry is greatestwhen there is symmetrybetween firms,hence when competition
has no role in selection. Of the other six cases, the externality is negative in
two, zero in two, and positive in two. Assumptions about probability distributions
are necessary to derive the expected externality. With anything less than perfect
correlation between firms' costs, the externality will be less negative than if
symmetry is assumed. With independent draws from a distribution with an
equal probability of high and low cost, the expected externality of entry is
positive (+ O.25%).
It would be wrong to attach too much significance to one particular example,
especially when it has been chosen to illustrate a point sharply, but it does
suggest that the role of competition in selection can matter in models of
imperfect competition. Assuming that all firms are symmetric is to deprive
competition of one of its main functions.33
8. Innovation and competitive dynamics
Schumpeter urged that the essential fact about capitalism is the dynamic process
of Creative Destruction. Firms operate in its perennial gale, not a perennial
lull, and what matters is not static competition but
competitionfromthe new commodity,the new technology,the new sourceof supply,
the new typeof organization.. . -competition whichstrikesa decisivecost or quality
advantageand whichstrikesnot at the marginof profitsand the outputsof existing
firmsbut at theirfoundationsand theirvery lives (Schumpeter1943,p. 83).
Schumpeter went on to hypothesize that firms that have market power, not
just the prospect of market power, were the driving force in this process a
view that empirical studies have somewhat called into question,34 but which
has nevertheless had some influence on industrial policies.
In the last 15 years there has been an explosion of work on the economic
theory of technological competition some involving the creative destruction
of earlier work not only in industrial economics,35 but now also in the analysis
33Olley and Pakes (1992) find empirical evidence of selection effects of competition improving
productivity in their study of the US telecommunications equipment industry after deregulation.
Productivity growth increased at industry level but not for the average of plants. The explanation
is that capital was reallocated towards more efficient firms.
34 See Scherer's (1992) survey. In addition to the difficulties of measuring innovation, empirical
analysis must contend with the endogeneity of market structure, differing technological opportunities across industries, and so on. Geroski (1990), using UK panel data from the 1970s, finds quite
strong evidence against the proposition that greater competition, as measured by various indicators
of rivalry, is bad for innovation, and concludes that 'competition-desirable on other groundscertainly seems desirable in this area too'.
3 For example, see Spence (1984), Dasgupta (1986), Stiglitz (1986), who incorporates incentive
issues into the analysis, the survey by Reinganum (1989), and Dixit (1988), who provides a general
welfare analysis of competition to make a single innovation.

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17

of macroeconomic growth (e.g., Aghion and Howitt, 1992). I want to make just
two remarks about it now.
The first is methodological. Earlier I mentioned the view that competition
should be viewed as a dynamic process of rivalry. The requirements for a model
of a rivalrous process would seem to include one or more state variables that
evolve over time in response to the rivals' behaviour, and which the rivals
therefore strive to influence strategically.36 Recent models of technological
competition contain these ingredients. They include models of competition
between rivals during the course of a race such as a patent race, and models
of continuing rivalry to reduce costs or improve quality, for example when there
is a sequence of innovative opportunities.37 Frameworks of this kind are
explicitly about the dynamic process of competition. One can ask how the
current state of competition affects behaviour for example, is rivalry most
intense when the rivals are neck-and-neck? and how the state of competition
tends to evolve as a result for example, is there a tendency for one competitor
to become increasingly dominant?
The second remark concerns the robustness of dynamic competition. In some
models of dynamic competition, the answers to the questions above are that
competition is most intense when the rivals are neck-and-neck, but that, partly
as a result, the intensity of competition can wind down as one competitor
becomes increasingly or persistently dominant. I hasten to add that competition
is not so transient in some other models of dynamic rivalry, and that this whole
line of research is at a very preliminary stage (partly because the models are
hard to solve). There seem to be some good open questions about the robustness
of various processes of dynamic competition, which perhaps deserve examination
in parallel with normative analysis of their desirability.
9. Competition policy analysis
In the last 10 years the most important advances in the theoretical analysis of
public policy towards firms with market power have been in the field of
monopoly regulation. A large and sophisticated body of regulatory theory has
been developed (see Laffont and Tirole, 1993). Over the same period the practice
of monopoly regulation has been transformed too, notably but not only in
Britain. Partly because of regulatory reforms, competition policy questions have
become increasingly important, both nationally and at EC level, for example in
network industries that are being liberalized. And in Eastern Europe, of course,
frameworks for competition are being created virtually from scratch.
36 Much of the vast topic of dynamic oligopoly theory concerns either (i) repeated games in
which there is no (strategic behaviour towards) state variable, as in many tacit collusion models
and some games of timing, or (ii) games in which there is an initial round of strategic behaviour,
as in many strategic entry deterrence models. Models with continuing strategic interaction and
variables appear harder to analyze-see Fudenberg and Tirole (1991, ch. 13) on both methods and
some recent literature on applications.
3 A non-representative sample being Harris and Vickers (1985, 1987) and Budd et al. (1993).
A general framework, due to Ericson and Pakes, is set out in Olley and Pakes (1992) and used in
the empirical analysis mentioned in footnote 33 above.

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CONCEPTS OF COMPETITION

One analytical approach to competition policy questions is to extend the


application of regulatory contract theories from monopoly to imperfect competition. Steps in this direction include analysis of competitions for monopoly
franchises, the regulation of dominant firms that face some competition, and
the regulation of oligopolists.
But in most imperfectly competitive industries the regulation of market power
is typically indirect. Competition is the main regulator, and the task for public
policy is to see that it is not undermined. In these terms the problem is not
one of optimal mechanism design but of ad hoc intervention to safeguard and
maintain a mechanism that is more or less good and more or less robust intervention to see that there is no 'prevention, restriction or distortion' of
competition as antitrust law puts it. From time to time the authorities consider
questions about structure (e.g. mergers and vertical integration) and about
conduct (e.g. possible predatory or exclusionary practices). Particularly difficult
policy problems arise in industries where naturally monopolistic and potentially
competitive activities coexist, because regulatory decisions can have a major
influence on competition.
The telecommunications example that I mentioned at the beginning is a case
in point. The government review did end the BT/Mercury duopoly policy, but
the effectiveness and efficiency of competition will be greatly influenced by the
terms on which rivals can interconnect to BT's network. A 'level playing field'
between BT and others is hard to achieve not least because BT is vertically
integrated. Related problems in the gas industry were the reasons for the
Monopolies and Mergers Commission's recent recommendation that British
Gas be broken up." and the policy of vertical separation between network
infrastructureand service provision in the British railway industry is yet another
example.
Questions such as these, and competition problems generally (including
questions about the appropriate scope and nature of competition in the public
sector) are by no means easy to analyze. Faith in some general and undiscriminating notion of competition offers little reliable guidance as to their solution.
Reasoning about competition problems requiresbetter theoretical understanding,
and of course empirical analysis, of how competition (of different kinds) works
(in different circumstances). In particular it requires frameworks that explicitly
address effects on productive efficiency. Here I have discussed incentives,
selection, and innovation. These are three of the fronts on which advances are
being made. The concept of competition as equilibrium resource allocator is not
the only model of a modern microeconomist.

ACKNOWLEDGEMENTS
I am very grateful to Mark Armstrong, Chris Harris, Paul Klemperer, Meg Meyer, Hunter Monroe,
38

The government did not follow this recommendation.

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J. S. VICKERS

19

Derek Morris, Steve Nickell, Peter Sinclair, and the referees for their helpful comments and
suggestions, and above all to Jim Mirrlees.

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22

CONCEPTS OF COMPETITION
APPENDIX

1. Cournot example with selection


1.1 The miodel
Demand is assumed to be unit-elastic: Q(p) = I/p. This corresponds to the indirect utility function
is r(p) = - log (p), where E is a large constant. There are n >, 2 active firms initially, with unit
cost levels c, < c, <_ ' * < c,. Cournot behaviour implies that (p - ci)/p = si, where si is the
market share of firm i, and i's profit (net of any fixed costs) is equal to s7. Therefore industry profit is
_
equal to the Herfindahl index H =
The initial price p0 satisfies
p0 = np/l(n-l1)

(A 1)

where 1it= (X ci)/n is average unit cost. A new firm with cost level c enters. Suppose that the entrant
produces and that entry causes the (n - m) > 0 highest cost firms to exit from the market. Let
_(X'c)/m be the average cost level of the ni firms who stay. Price with fall from p0 to p, where
p = (mx + c)/n1i

(A2)

Let HO and H respectively denote the Herfindahl indices before and after entry, and let
entrant's profit. Then the external effect of entry is given by
X = [t,(p) - v(p0)] - (HO - H + 7[) = log (po/p)-(HO

-H

+ 7A)

it

be the
(A3)

The first term in (A3) is the gain to consumers and the second is the loss to incumbent firms.
If all firms are symmetric, then the entry externality is
X(71) =

log

11
-

Lfl2

(t 1)

(A4)

Expressed as a percentage of revenue pQ = 1, we have X(2) = + 1.0%and X(3) = -2.8%.


Now suppose that firms may have asymmetric costs. In particular, assume that there are two
unit cost levels c = L and c = H, and that H/L = 2. Without further loss of generality as far as
the welfare expressions are concerned, set L = I and H = 2. The three-firm case is described in the
table. The first row relates to the symmetric case (already discussed) where the three incumbents
all have cost L and the entrant has cost L also hence the shorthand 'LLL/L'. Entry causes price
to fall from 3 to 4, so po/p = 9, the log of which is 11.8 of revenue. Entry causes the market
share of each incumbent to fall from s9 = 3 to si = 4. The Herfindahl index falls from - to -, but
the entrant makes profit m= 1 6, so the three incumbents jointly lose 14.6%.Thus the net externality
from entry is -2.8',, as above.
A feature of this example is that a high cost firm does not produce if there are two or more low
cost firms. Therefore the entrant does not produce in cases LLL/H and LLH/H, and the externality
TABLE 1

Price, profit, and external weela'reeffects of entry


Case

p0

HO

si

log(p0/P)

LLL/L
LLL/,H

LLHI'L

28.8

2,

LHH/,L

22.3

35, 5,

LHH/H
HHH/L
HHH/H

73
3

3
3

6.9
25.1
11.8

3,433

2,

si

H- i

33.3

4,-,

18.8

-2.8
0.0

50.0

3, 3,

22.2

+ 1.0

44.0

2,

0, 0

25.0

+ 3.3

44.0
33.3
33.3

36.7
6.1
18.8

-0.4
-2.1
-2.8

0.0

LLH,/H

444
3,3,3
3

47,7,7
4

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J. S. VICKERS

23

from entry is zero. In case LLH/L, the low cost incumbent was not producing anyway, so the
situation is as in the symmetric case with ,i = 2 and the entry externality is + 1.0%.In case LHH/L,
entry causes the two low cost incumbents to stop producing (so m = 1 < n = 3), and the externality
is + 3.3%. This is associated with the fact that the low cost incumbent produces more after entry
than before (4 versus ' ). The externality is negative but small in case LHH/H and also negative
in case HHH/L. Finally, HHH/H is again a symmetric case.
In this example, then, the largest negative externality from entry occurs when there is
symmetry the externality is less negative or positive in all other cases. If costs were drawn
independently from a distribution with Prob (L) = Prob (H) = 2, then the expected externality
EX = +0.25%.
Questions about innovation can be addressed in this framework too. A firm reducing its cost
from H to L is equivalent to the exit of a firm with cost H and the entry of one with cost L. So
if one of four high cost firms reduces its cost, the net external effect is (2.8% - 2.1%) = +0.7%.

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