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COMPETITIVE OUTCOMES in PRODUCT-DIFFERENTIATED OLIGOPOLY Michael J

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COMPETITIVE OUTCOMES in PRODUCT-DIFFERENTIATED OLIGOPOLY Michael J COMPETITIVE OUTCOMES IN PRODUCT-DIFFERENTIATED OLIGOPOLY Michael J. Mazzeo* Abstract—This paper analyzes the effect of market concentration and structure. Firms anticipate the competitive effects of market product differentiation on the observed outcomes of competition among oligopolists. The empirical framework is designed to examine whether structure when making their entry and product-type deci- competition is less intense in markets with equal levels of concentration sions. The market structure variables used to explain the but more differentiation among the products offered. A two-stage estima- observed outcomes, therefore, derive from the related entry tion procedure is proposed to address the endogeneity problem inherent in comparing outcomes across different market structures. I estimate the and product choice stage of the game. As a result, it is competitive effects using data from a cross section of oligopoly motel crucial to allow for correlation between unobserved factors markets located along U.S. interstate highways. The results indicate that that affect the entry and product-type decisions of firms and firms benefit substantially by offering differentiated products. The pres- ence of any market competitor drives down prices, but the effect is much unobservables in the outcome regressions. To correct for the smaller when the competitor is a different product type. Differentiation is potential bias caused by this correlation, an econometric optimal product choice behavior because the resulting competition among model of equilibrium market structure is employed as a firms is less tough when their products are differentiated. selection equation in a two-step estimation procedure. The second-step outcome regressions are modified to reflect the I. Introduction market structure selection. This alternative approach empha- sizes the logical relationship among firms’ entry and product N a differentiated-product oligopoly, a firm’s profits will choice behavior, market structure, and price competition. Idepend on the type of product it chooses to offer, as well Following this introduction, I provide some background as the entry and product-type decisions of its competitors. for the analysis of competitive outcomes in motel oligopo- Price competition may be tougher if the market contains lies. Section III presents the two-step estimation procedure more operating firms. Firms can soften the price competi- developed to measure the effects of concentration and dif- tion found in less concentrated markets, however, by offer- ferentiation on outcomes. This procedure is used to analyze ing differentiated products. Given market demand, quantity the observed outcomes of motels located along interstate will also depend on firms’ relative locations in product highways; the data are outlined in section IV. In section V, space. Using data from a large cross section of motel I present the estimation results. Evidence from the analysis oligopolies, in which firms are differentiated according to of these outcomes help demonstrate why motel firms find the quality of services they offer, this empirical analysis differentiation a profitable product choice strategy. Section measures the impact of both market concentration and VI provides some concluding remarks. product differentiation on competitive outcomes. The empirical work extends a long line of research on the relationship between market structure and the profitability II. Background of firms. Such studies have primarily examined homoge- neous product markets; by analyzing data from a product- This paper analyzes the outcomes of competition among differentiated industry, I can explicitly measure how the differentiated oligopolists. Since Hotelling (1929), a sub- effects of competitors differ according to their relative stantial literature has developed which uses game-theoretic product-space locations. The results demonstrate that com- models to predict equilibrium product-type configurations 1 petitors have a less harmful effect when products are dif- and market outcomes in differentiated product oligopolies. ferentiated. In the case of motels, duopoly prices are about These models propose that firms compete in prices and 5% lower than the monopoly price when the two competi- quantities once all the firms operating in the market have tors offer similar-quality lodging services. If the quality of made entry and product space location decisions. To the the two firms is different, however, there is no price effect extent that consumers gain different utility levels from associated with the second firm. various product types, competing firms can differentiate The paper also proposes an econometric methodology to their products and maintain prices higher than marginal cost address the endogeneity problem that confronts empirical in equilibrium without losing their entire market share. work on the relationship between outcomes and market Some consumers may be inclined to sacrifice the utility associated with paying a higher price, if they have a strong Received for publication March 16, 1999. Revision accepted for publi- product-type preference. The distribution of consumer pref- cation July 27, 2001. erences over product types is crucial: if preferences are * Northwestern University. skewed in favor of a particular product type, the resulting I would like to thank Tim Bresnahan, Steve Berry, Shane Greenstein, Tom Hubbard, Mark Israel, Roger Noll, Paul Oyer, Ariel Pakes, Mike price elasticity for a firm offering the popular type may be Pries, Peter Reiss, Frank Wolak, Gavin Wright, and an anonymous referee smaller. Firms offering an unpopular product type may need for very helpful comments and suggestions. Thanks also to seminar to charge a substantially lower price in order to attract participants at UCLA, Harvard, Carnegie-Mellon, University of Illinois, and the NBER/CEPR Conference on the Economics of Price and Product Competition. All errors are my own. 1 Shapiro (1989) provides a thorough review of this literature. The Review of Economics and Statistics, November 2002, 84(4): 716–728 © 2002 by the President and Fellows of Harvard College and the Massachusetts Institute of Technology COMPETITIVE OUTCOMES IN PRODUCT-DIFFERENTIATED OLIGOPOLY 717 customers.2 This basic tradeoff between price and market examining the relationship between profits and market share underlies the profit-maximizing choices of product structure.5 space locations by firms.3 Nonetheless, some authors proceeded to make improve- The relative product-space location of competitors also ments on these early regressions. Weiss (1989) responded affects the relevant elasticities. In cases where the other with a compendium of studies that explored the relationship firms are located nearby in product space, theory predicts between market structure and prices, rather than profits. He that equilibrium prices will be closer to marginal cost. In contended that since prices are determined in the market, other words, there is a first-order effect that drives down the they would not reflect the technical superiority of operating price of similar competitors—price competition is tougher firms, as profits might. Weiss’s book summarized a collec- when products are not differentiated.4 The impact of com- tion of more that 100 empirical analyses—the typical study petitors’ product-space locations provides the link between regressed price (controlling for variables related to market- the two stages of the game. Firms choose product type level costs) on some measure of concentration for a collec- optimally, anticipating how the competition will proceed tion of markets in a homogeneous product industry—and given their product choice and what their profits will be concluded: “our evidence that concentration is correlated under each product-type configuration. Product differentia- with price is overwhelming.” tion influences the toughness of competition, equilibrium The price and market structure regressions leave a further outcomes, and profits—these in turn determine firms’ entry econometric difficulty unaddressed. Because of the relation- and product choice behavior. ship between price competition and market structure deter- mination, it is likely that underlying shocks (to demand, for example) will affect both. Market concentration measures A. Empirical Profits-Concentration Literature used to explain price may be correlated with unobservables Analyses relating profits and market concentration were a in the price regression, causing bias in its estimated param- fundamental part of the structure-conduct-performance par- eters. To date, remedies for this endogeneity problem have adigm in industrial organization. Regressions that reported a had limited success.6 An effective two-stage least-squares positive correlation were treated as support for the hypoth- procedure relies on instruments that affect market structure esis that firms would earn higher profits if they faced fewer but not prices, which are typically difficult to isolate.7 Reiss competitors. Demsetz (1974) critiqued this literature by and Spiller (1989) employ a promising approach that em- pointing out that even if a positive correlation between beds price and quantity determination, along with some economic profits and concentration could be established, the assumptions about the nature of price competition, directly direction of causation would remain in doubt. For example, within a model of entry. This empirical strategy captures the if firms have different capabilities, some are apt to be more effect of market
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