Martin C. Byfordy
Joshua S. Gansz
Abstract
This paper is the …rst to provide a general context whereby potential entry
can permanently reduce the intensity of competition in a market. All previ
ous results found that potential entry would lead to lower prices and greater
competition. Examining markets where entry occurs by the acquisition of ac
cess rights from existing incumbents, we demonstrate that, when competitive
choices are strategic complements, a more e¢ cient entrant may be unable to
acquire those rights from a less e¢ cient incumbent due to the accommodat
ing behavior of e¢ cient incumbents. Similarly, such accommodating behavior
may deter e¢ cient investment by an incumbent or mergers that would gen
erate social welfare improvements. These results have implications as to how
economists view potential entry and its bene…ts.
distinct predictions. First, theories of contestable markets and limit pricing predict
that credible entry threats will induce incumbents to price lower so as to deter that
entry. Second, originating with Selton’s chain store paradox, potential entry will
not induce a prior change in incumbent behavior as it either does not commit them
to maintaining that behavior in the postentry environment or their own forecasted
behavior in that environment is su¢ cient to deter entry in of itself. Resolving the
theoretical tension between the two predictions has relied on considerations of the
actions incumbents can take to commit themselves to tough postentry competition
or the possibility that preentry behavior might signal relevant information regarding
forecasted behavior postentry. Regardless, together, all of these theories predict that
de novo; that is, the entrant adds to the pool of competitors in a market. In contrast,
there are many situations where entry arises by acquisition of an incumbent. While,
market with high sunk entry costs, a natural oligopoly might arise with a ceiling on
the number of suppliers (Gilbert and Newbery, 1992). In this case, entry may only
be credible if it is by acquisition.
Here we consider this by examining a situation where an environment where a
…rm may only participate in the market if it owns one of a strictly limited number
of access rights. These rights could be in the form of complementary assets that are
uneconomic to replicate but critical for competition. Or, alternatively, these rights
the need for broadcasting licenses for television and radio or the rights to spectrum
1
See Davis, Murphy and Topel (2004) for a recent treatment and Wilson (1992) for a review.
1
used by wireless carriers. It could also apply to situations in which …rms need to
port services. Likewise, an asset such as “eyeballs”is necessary to compete in the the
market for internet advertising; particularly targeted advertising connected to web
searches and internet portals. In these markets, entry to a market can only occur by
than one of incumbents in utilising those rights, there would be an incentive for that
incumbent to sell the right to the entrant. Hence, potential entry of this kind would
(a) not result in any change in preentry behavior of incumbents and (b) would result
in eventual entry.
However, this simple intuition neglects the role that rival incumbents might play
in in‡uencing the terms of trade in the acquisition market for the access rights. Using
threat of entry may result in reduced competition. In the model, an ine¢ cient …rm
competes with an e¢ cient …rm in a restricted access market. Potential entry creates
an incentive for the ine¢ cient …rm to sell its rights. Nonetheless, we demonstrate
that, where the actions of …rms are strategic complements, there may exist a Markov
perfect equilibrium in which the e¢ cient incumbent relaxes competition, directing a
stream of pro…ts to the ine¢ cient …rm su¢ cient to eliminate the gains from trade in
the acquisition market and preventing the …rm from selling its access rights. Because
the threat of entry allows the e¢ cient …rm to commit to this less aggressive stance,
even in the absence of collusion, prices are higher. The higher prices, in turn, deter
exit. Interestingly, compared to the situation where no potential entrant existed, both
incumbent …rms enjoy higher pro…ts. Hence, incumbents may be in favour of policies
2
(e.g., spectrum or broadcast resale rights) that freeup entry into such markets.
The key to this result is the fact that potential entry creates the possibility of
trade in access rights and that this possibility drives an incumbent to adopt a softer
competitive stance to deter such trade. This depends critically on the assumption of
strategic complements in key competitive actions. If those actions are strategic substi
tutes (as they are for price and quantity in Cournot competition), preemptive action
to accommodate the ine¢ cient incumbent is too costly for the e¢ cient incumbent
can arise for potential threats to an incumbent in other environments. For instance,
consider an incumbent …rm facing a less e¢ cient rival who, perhaps because a technol
ogy is coming o¤ patent, has the option to invest in greater e¢ ciency. If their actions
are strategic complements, the e¢ cient incumbent has an incentive to soften compe
tition to deter that investment. Similarly, in a situation where there are three …rms
in a market and any two have the option to merge and generate synergies, all three
in markets where competitive actions are strategic complements. This was something
that was thought might only occur when those actions were strategic substitutes (see
There are numerous examples of papers that show that increasing actual competition
in a market can lead to less competition and increased prices (Satterthwaite, 1979;
Perlo¤ and Salop, 1985; Stiglitz, 1987; Schulz and Stahl, 1996; Janssen and Moraga
González, 2004; Gabaix, Laibson, and Li. 2005; Perlo¤, Suslow, and Seguin, 2006;
and Chen and Riordan, 2008). These results are based on the interplay of product
3
di¤erentiation and/or consumer search. In contrast, in the model developed in this
paper competition is greater postentry than the preentry benchmark. Stiglitz (1981)
develops a model whereby potential entry might temporarily cause prices to increase
for a monopolist. He considers a situation whereby a monopolist chooses to extract a
access market. The general form of the model and the central results are set out
in section 2. Section 3 presents two simple examples covering both the cases of
and accommodation with multiple e¢ cient …rms in section 6. The paper concludes
We consider a market where there exists an asset that is required in order for a …rm
De…nition 1. An access right is de…ned as an asset that is (a) necessary for a …rm
In other words, an owner of such an asset may sell, but can never share, its access
buyout.2
2
The rivalry assumption may seem questionable in a world in which regulators frequently require
4
De…nition 2. A restricted access market is de…ned as a market in which there is a
Entry into a restricted access market di¤ers from unrestricted entry insofar as
entry is only possible if the entrant displaces an incumbent …rm. As each incumbent
has control rights over access, the replacement of an incumbent by an entrant must
occur on terms that create bene…ts for both the entrant and the displaced incumbent.
That is to say, in order to purchase an incumbent’s access rights, the entrant must
pay a fee to the incumbent that is at least as great as the earnings the incumbent
foregoes by exiting the market. At the same time, the fee cannot be greater than the
2 The Model
any time there can be at most two …rms competing in the market. Initially, the
access rights are owned by …rms 1 and 2, with …rm 1 assumed to be more e¢ cient
than …rm 2. We term this the duopoly phase. At some point a potential entrant, …rm
3, arrives; modelled here as the result of an exogenous policy change. For instance,
that policy change may be to allow broadcast or spectrum license resale after some
After the entrant arrives, the game consists of two distinct phases. Each phase
is itself a repeated game with the number of periods in each phase endogenously
determined.
…rms to grant their rivals access to privately owned infrastructure. However, this issue can be resolved
by distinguishing between the market for infrastructure services, and the downstream market for
which the infrastructure is a necessary input.
3
See Cramton (2000) on the e¤ect of the FCC’s "unjust enrichment" requirements on the ability
to resell spectrum.
5
s s s s s
Period t Competition Stage Exit Stage Period t + 1

Firms Select Pro…ts Firm 2 May Exit
Actions (ai ; aj ) Realised (Entry Phase)
yes yes
 
Duopoly Phase Entry Phase PostEntry Phase
6 6 6
no no
1. In the entry phase …rms 1 and 2 compete under the threat of entry by …rm
3. Each period begins with …rms selecting actions and realising instantaneous
pro…ts. Firm 2 then has the opportunity to sell its access rights to …rm 3. If
…rm 2 sells out, the game proceeds to the postentry phase, otherwise the game
2. In the postentry phase, …rms 1 and 3 compete. In each period of the postentry
Because the transition from the entry to postentry phase only occurs with …rm
2’s consent, the game may never reach the postentry phase. Figures 1 and 2 illustrate
involving competition between …rms 1 and 2. Each period of the duopoly phase sees
…rms 1 and 2 simultaneously selecting actions and realising the consequent instan
4
The critical element here — as demonstrated by the investment problem considered in section
4 — is that the technical advancement facilitated by entry is irreversible.
6
taneous pro…ts. As will be demonstrated below, the duopoly and postentry phases
share the characteristic that in a Markov perfect equilibrium market outcomes in
volve …rms considering only instantaneous pro…ts. In contrast, as behavior in the
entry phase might trigger a transition the postentry phase, …rms active in the entry
2.1 Primitives
The common instantaneous pro…t function of …rms 1 and 3 is written (ai ; aj ) where
ai 2 A is the …rm’s own action, aj 2 A is the rival …rm’s action, and A is a
…rm’s own action (@ 2 =@a2i < 0), while for all aj there exists R(aj ) 2 A such that
@ R(aj ); aj =@ai = 0. It follows from the continuity and di¤erentiability of that R
is likewise continuously di¤erentiable. Moreover, if @ 2 =@ai @aj < 0 (> 0) the actions
of …rms are strategic substitutes (compliments) and R0 < 0 (> 0). It is assumed that
that …rm selecting a high value of ai , while a low value of ai is interpreted as the …rm
adopting a passive position. Formally, this characterisation requires the …rm’s pro…t
instantaneous pro…t is given by the function c (a2 ; a1 ) where the subscript c > 0
represents the degree of …rm 2’s ine¢ ciency or cost disadvantage.6 Speci…cally, it
is assumed that limc!0 c = and @ c =@c < 0. As with the pro…t function of the
well as the additional argument c, strictly concave in a2 and there exists Rc (a1 ) 2 A
5
The bounds R0 ensure the existence and uniqueness of an equilibrium in the static game.
6
Note that …rm 2 is never in competition with …rm 3.
7
such that @ c Rc (a1 ); a1 =@a2 = 0 for all a1 and c. Finally, it is assumed that
@ 2 c =@a2 @c < 0. This last condition implies that the marginal return to aggressive
behaviour declines as ine¢ ciency increases. It is also a necessary and su¢ cient con
dition for @Rc =@c < 0. In words, this condition causes the best response function to
shift inward as ine¢ ciency increases.
Firms are restricted to employing Markov strategies; strategies that depend only on
payo¤ relevant information. This dependance can be captured by describing the value
of the payo¤ relevant variables as a state and de…ning each …rm’s action a function
of the state. In the competition stage of each period the payo¤ relevant variables are
the identity of the …rms in the market, and the existence, or otherwise, of a potential
entrant. This information is entirely captured by the phase of the game. Let the
entry and postentry phases respectively. It follows that …rm 1’s strategy is a triplet
(aD E P P
1 ; a1 ; a1 ), while …rm 3’s strategy is a singleton a3 .
In the exit stage of the entry phase the payo¤ relevant variable is the magnitude
of the pro…t …rm 2 will receive as a result of remaining in the market. Given that
each …rm’s strategy in the competition stage is invariant within a phase, and that
…rm 2 declining to sell its access rights causes the game to remain in the entry phase
E E
2 = c (a2 ; a1 ):
1
8
2.3 Equilibrium Duopoly and PostEntry Phase Pro…ts
Lemma 1. In a Markov perfect equilibrium …rms play their static Nash equilibrium
Proof. Once entered the postentry phase is repeated inde…nitely. It follows that in
a Markov perfect equilibrium …rms 1 and 3 select actions to maximise instantaneous
pro…ts, thus aP1 = aP3 = R R(aP1 ) .
While the game will eventually proceed beyond the duopoly phase, actions in the
duopoly phase neither e¤ect instantaneous payo¤s in later phases nor the probability
of entering the entry phase. It follows that in a Markov perfect equilibrium …rms 1
aD D
2 = Rc R(a2 ) .
Lemma 1 establishes that both prior to the emergence of a potential entrant, and
following the displacement of the ine¢ cient incumbent, the market behaves as in a
one shot game. It is only during the entry phase that the strategic e¤ect of the option
Lemma 1 also de…nes the instantaneous pro…ts for the duopoly and postentry
phases, and therefore both the viability of the potential entrant and the incentive
D
for the e¢ cient incumbent to resist entry. Let = (aD D
1 ; a2 ) and
D
c = D D
c (a2 ; a1 )
represent the equilibrium duopoly phase instantaneous pro…ts of …rms 1 and 2 re
P
spectively; and let = (aPi ; aPj ) represent the equilibrium instantaneous pro…ts of
D P
Lemma 2. In a Markov perfect equilibrium > .
D
= (aD D P D P P
1 ; a2 ) > (a1 ; a2 ) > (a1 ; a3 ) =
P
;
9
where the …rst inequality results from the strict concavity of , while the second is
Lemma 2 unambiguously states that entry has a negative impact on the pro…ts of
…rm 1, and therefore that …rm 1 has an incentive to prevent entry.
D P
Assumption 1. c < .
rights are more valuable to …rm 2. Note that assumption 1 is an assumption over the
form of the pro…t function. It always holds where actions are strategic substitutes as
aD P
1 > a1 and therefore,
D
c = (aD D P D P P
2 ; a1 ) < (a3 ; a1 ) < (a3 ; a1 ) =
P
:
Firm 3 can only enter the market if there exists a fee, acceptable to both …rms 2 and
3, at which …rm 2 is willing to exit the market, trading its access rights to …rm 3. For
the fee to be acceptable to …rm 2 it must be greater than the stream of pro…ts that
The emergence of a potential entrant causes the game to move to the entry phase.
The return to …rm 2 of remaining in the market inde…nitely, thereby preventing the
game from proceeding to the postentry phase, is,
E
2 = c :
1
E E E
Here c = c (a2 ; a1 ) is …rm 2’s instantaneous pro…t in each period of the entry
phase.
If …rm 2 sells out to …rm 3 the game transitions to the postentry phase. Going
P
3 = :
1
10
It is assumed that …rm 2 weakly prefers to stay in the market thus a fee must exceed
2 in order to be preferred.7 Moreover, the fee can be no greater than 3 and still
be acceptable to …rm 3.
E
Let F ( c ) represent the fee that …rm 3 pays to …rm 2 in exchange for …rm 2’s
E E P
F( c ) 2 c ; ;
1 1
P 8
and F 0 0, for all E
c < . In words, F is in the range that is acceptable to both
…rms, and is weakly increasing in the current pro…tability of …rm 2. Given …rm 2’s
weak preference to remain in the market, any fee that would induce …rm 2 to exit
E P
where c would not be acceptable to …rm 3. The following lemma summarises
Lemma 3. In a Markov perfect equilibrium …rm 2 will exit in the entry phase if, and
only if, its instantaneous pro…t is less than …rm 3’s equilibrium instantaneous pro…t
P
in the postentry phase; c = ( 1; ).
Firm 2’s response to …rm 3’s o¤er of F is purely mechanical; an optimal response
to the o¤er at the point in time that the o¤er is made. This must be the case in a
Markov perfect equilibrium as Markov perfect equilibria are sequential. It turns out
that this mechanical behavior extends to the competition stage of the entry phase.
In other words …rm 2’s strategy in the entry phase, does not encompass any strategic
Lemma 4. In a Markov perfect equilibrium …rm 2 always plays its static best response
11
Proof. There two possibilities to consider. If, given …rm 1’s choice of aE
1 , …rm 2 can
select aE
2 such that
E E
c (a1 ; a2 )
P
then selecting aE
1 to maximise c delivers …rm 2
an outcome that is strictly preferred to any fee that …rm 3 is willing to o¤er.
Where …rm 2’s choice of aE
2 cannot result in
E
c
P
…rm 2 will exit at the end
of the …rst period of the entry phase. Nevertheless, maximising c remains in …rm
2’s best interests as it maximises …rm 2’s instantaneous payo¤ in the single period of
the entry phase as well as weakly increasing the fee …rm 2 receives from …rm 3.
It follows from lemma 4 that there exist at most two Markov perfect equilibria to this
game: A competitive equilibrium in which …rm 2 exits in the …rst period of the entry
inde…nitely. The following lemmas characterise …rm 1’s strategies in each of these
equilibria.
E
c Rc (aE E
1 ); a1 =
P
:
E
c Rc (aE E
1 ); a1
P
: (2.1)
E
To exclude the inequality note that c Rc (aE E E
1 ); a1 is strictly decreasing in a1 . Given
D P
that c < it follows that in order to satisfy (2.1) aE D
1 < a1 and thus from the
E
Suppose to the contrary that c Rc (aE E
1 ); a1 > P
in a Markov perfect equilib
rium. Given the continuity and concavity of , …rm 1 can increase its instantaneous
12
enough increase (2.1) will continue to hold and …rm 2 will remain in the market. A
Contradiction.
Lemma 6. In a Markov perfect equilibrium in which …rm 2 exits in the …rst period of
the exit phase — a competitive equilibrium — …rm actions and instantaneous pro…ts in
the entry phase are identical to their actions and instantaneous pro…ts in the duopoly
phase.
Proof. It follows from lemmas 2, 3 and 4 that it is only necessary to show that
aE D
1 = a1 . To see that this must be the case note that …rm 1’s only concern in the
It follows from lemma 5 that a necessary condition for the existence of an accom
as great as the pro…t …rm 1 receives from deviating to its static best response in the
…rst period of the entry phase, followed by in…nite repetition of the postentry game.
Note that there exists a 2 (0; 1) such that (2.2) holds if, and only if,
aE E
1 ; Rc (a1 ) >
P
: (2.3)
Similarly, from lemma 6 it follows that a necessary condition for the existence of
a competitive equilibrium,
D P 1
+ (a1 ; aD
2 ); (2.4)
1 1
D P
where a1 solves c (a2 ; a1 ) = . This condition is the converse of (2.2). Firm 1 will
not attempt to accommodate …rm 2 so long as the return from accommodating …rm 2
is weakly less than the return from playing static best responses in every phase of the
D
game. As > (a1 ; aD
2 ), condition (2.4) is always satis…ed for su¢ ciently close to
zero.
13
Proposition 1. (a) Where the actions of …rms are strategic complements there exists
a c > 0 and 2 (0; 1) such that for all c 2 (0; c) and 2 ( ; 1) there exists an
accommodating equilibrium. (b) Where the actions of …rms are strategic substitutes
there does not exist an accommodating equilibrium.
P
c Rc a(c) ; a(c) = ;
and note that a(c) is continuous, strictly decreasing in c, and that as c ! 0, a(c) ! aP1 .
The continuity of all functions in c guarantees that there exists numbers c^ > 0 and
^E
a P
1 < a1 such that for all c 2 (0; c aE
^), a(c) 2 (^ P
1 ; a1 ).
For a given c > 0, there exists 2 (0; 1) such that an accommodating equilibrium
exists if, and only if, (2.3) holds. Note that in the limit, as c ! 0, (2.3) holds with
d @ (ai ; aj ) @ (ai ; aj )
a(c); Rc a(c) = a0 + a0 Rc0 : (2.5)
dc @ai @aj (ai ;aj )=[a(c);Rc (a(c))]
The …rst term on the RHS of (2.5) is unambiguously negative as a(c) < R Rc (a(c)) ,
and approaches zero as c ! 0. The second term is negative (positive) where the
It follows that where actions are strategic substitutes the LHS of (2.3) is decreasing
in c. As (2.3) holds with equality in the limit as c ! 0, (2.3) is never satis…ed for
c > 0, proving (b).
For (a) note that for arbitrarily small c > 0, the …rst term on the RHS of (2.5) is
likewise arbitrarily close to zero and therefore (2.5) is positive. It follows that there
exists c~ > 0 such that (2.3) is satis…ed for all c 2 (0; c~). De…ning c = minf^
c; c~g
completes the proof.
14
that the distortion away from static equilibrium behaviour, necessary to implement
Proposition 2. For su¢ ciently high 2 (0; 1), an accommodating equilibrium deliv
ers …rms 1 and 2 outcomes that are strictly preferred to a competitive equilibrium.
equilibrium.
entry phase.
aD
2 .
that coincides with the arrival of a potential entrant can be entirely attributed to
the model: First, …rms are playing Markov strategies and are therefore unable to
play strategies that are contingent on the past behaviour of rival …rms. Speci…cally,
the threat of exit is never used by …rm 2 to discipline …rm 1. Second, …rm 2 does
nothing to facilitate the accommodation. In a Markov perfect equilibrium …rm 2
always plays its static best response. This failure to assist …rm 1 is the reason why
an accommodating equilibrium cannot exist where actions are strategic substitutes.
3 Examples
This section presents two simple examples that illustrate the results of the previ
ous section. The …rst is price competition on the Hotelling line, an illustration of
15
strategic complements. The Hotelling example demonstrates that in an accommo
dating equilibrium, not only is competition reduced, but …rm pro…ts increase with
the emergence of a potential entrant. The second example is Cournot competition.
Illustrating the nonexistence of an accommodating equilibrium where actions are
strategic substitutes.
Two …rms are located at either end of a unit line. A unit mass of consumers is
uniformaly distributed along the line with each consumer having unit demand and
linear transport cost t > 0 per unit travelled. The market is assumed to be covered
in each phase. Firm 1 is locates at the left end of the line and faces a marginal cost
of zero, while …rm 2 is located at the right end of the line and faces a marginal cost
of c 2 (0; 3t).9 If …rm 3 replaces …rm 2 in the entry phase it takes …rm 2’s position at
Each period …rms compete by simultaneously setting prices. Given that low prices
its price. The instantaneous pro…t functions for this game are,
pj pi + t pj pi + t
= pi ; c = (pi c) ;
2t 2t
where pi is the …rm’s own price and pj is the price set by the rival …rm. The corre
sponding best responses are given by the functions,
pj + t pj + t + c
R(pj ) = ; Rc (pj ) = :
2 2
Employing the results of the previous section, this structure is su¢ cient to establish
the Markov perfect equilibrium behaviour of …rms in both the duopoly and postentry
9
The upperbound on c ensures that …rm 2 will always produce a strictly positive quantity in a
static equilibrium.
16
phases. Lemma 1 implies,
2
1 1 1
pD
1 = t + c;
D
= t+ c ;
3 2t 3
2
2 1 1
pD
2 = t + c;
D
c = t c ;
3 2t 3
t
pPi = t; P
= :
2
P D D P
It is straightforward to see that > c and > .
The value of the variables in the entry phase depend on the nature of the equilib
pE
1 Rc (pE
1)+t t
c Rc (pE E E
1 ); p1 = Rc (p1 ) c = = P
:
2t 2
E t+c E t
= ; c = :
2 2
that there exists 2 (0; 1) such that (2.2) holds. R(t+c) = t+c=2 thus (2.2) becomes,
2
1 t+c 1 1 t
t+ c + ;
1 2 2t 2 1 2
2
c
c ;
1 4t
c 1
2 0; :
4t + c 7
In words, an accommodating equilibrium exists for all c 2 (0; 3t) and 2 (1=7; 1); a
17
indicating that …rm 1 enjoys higher pro…ts in the entry phase than it does in ei
ther the postentry or duopoly phases. Intuitively, with prices strategic complements
in Hotelling competition, the ine¢ cient incumbent responds to a relaxation of com
petition by itself reducing competition. In turn this reduces the cost to …rm 1 of
fact that …rm 2 will sell out to an e¢ cient entrant should the ‡ow of pro…ts to the
…rm fail to match the value of the access rights to the entrant.
forward. The twin assumptions of market coverage and unit demand imply that social
where the e¢ ciency of both …rms gives rise to a zero cost of production. In the
duopoly phase the ine¢ cient …rm serves a fraction q2D = (3t c)=6t of the market
at a marginal cost of c. In other words, going forward the welfare gain that results
not only prevents the e¢ ciency gain WGain but also concedes market share to its
ine¢ cient rival. In turn this results in the cost of production rising to c=2 each period;
higher than the cost of production in either the duopoly or postentry phases. In fact,
welfare loss,
c2
WLoss = :
1 6t
18
The c2 term represents the fact that as the ine¢ cient …rm’s cost disadvantage in
creases, so too does the share of the market that the e¢ cient …rm must sacri…ce to
the ine¢ cient …rm in an accommodating equilibrium. At the same time the higher
value of c increases the welfare cost of any given market share that e¢ cient …rm
sacri…ces.
The order of prices — implied by proposition 3 and illustrated in this example —
have implications for cases in which demand is downward sloping. In an accommo
dating equilibrium prices are highest in the entry phase and lowest in the postentry
phase. This suggest that in addition to the loss of productive e¢ ciency, accommoda
tion may also increase the magnitude of the deadweight loss in the market.
market for a homogeneous good. The model retains the same basic structure as the
preceding Hotelling example with each …rm’s action now the quantity that it selects.
Firms 1 and 3 have a constant marginal cost of zero, while …rm 2 has a constant
marginal cost of c 2 (0; 1=3). Each period demand in the market is D(p) = 1 p.
= qi (1 qi qj ); c = qi (1 qi qj c);
where qi is the …rm’s own quantity and qj is the quantity set by the rival …rm. The
1 qj 1 qj c
R(qj ) = ; Rc (qj ) = :
2 2
The Markov perfect equilibrium behaviour of …rms in both the duopoly and postentry
19
phases is summarised by,
2
1+c 1+c
q1D = ; D
= ;
3 3
2
1 2c 1 2c
q2D = ; D
c = ;
3 3
1 1
qiP = ; P
= :
3 9
In order to accommodate …rm 2, …rm 1 must select its quantity such that,
1
c Rc (q1E ); q1E = Rc (q1E ) 1 q1E c Rc (q1E ) = = P
;
9
1 1
which in turn implies q1E = 3
c and q2E = Rc 3
c = 13 . To see that these quantities
1 1
aE E
1 ; Rc (a1 ) = c2 < = P
;
9 9
tutes and as such when …rm 1 relaxes competition to accommodate …rm 2, …rm 2
responds by adopting a more aggressive position. This increases the cost to …rm 1
itable approach. Thus, in this model, potential entry performs its conventional role
of having no impact on behavior until such time as that entry becomes actual.
4 An Investment Game
version of the model developed in section 2 in which the ine¢ cient incumbent …rm is
20
given the opportunity to invest in a cost reducing technology. This might arise, for
…rm 2 investing in the technology and the e¢ ciency of the market increasing. The
second is an accommodating equilibrium in which …rm 1 directs a stream of prof
its to …rm 2 that is su¢ cient to remove the incentive to invest. It is shown that
su¢ ciently high , the accommodating equilibrium is preferred by both …rms to the
competitive equilibrium.
The model follows the structure laid out in section 2 with the following amendments:
1. The game only involves two players, …rms 1 and 2. As before …rm 1 is e¢ cient
with pro…t function , while …rm 2 is ine¢ cient with pro…t function c.
2. The duopoly phase occurs unless a new technology emerges in which case an
3. At the end of each period of the investment phase …rm 2 decides whether or not
to invest in the new technology. If …rm 2 invests, it pays the one time cost C 0
21
It follows that …rm 1’s Markov strategy remains a triplet (aD I P I
1 ; a1 ; a1 ), where a1 is
…rm 1’s action in each period of the investment phase. While …rm 2’s Markov strategy
is a tuple (aD I P
2 ; a2 ; a2 ; c) where c is the set of investment phase instantaneous pro…ts
that would lead …rm 2 to implement the cost reducing technology.
ment problem almost unchanged. Lemma 1 continues to hold and as such …rms play
their static best responses in the duopoly and postinvestment phases. Once again
lemma 1 de…nes duopoly and postinvestment actions and pro…ts in both the duopoly
Lemma 3, which de…nes the range of instantaneous pro…ts which will cause …rm 2
to exit, must be modi…ed for the investment game. Due to the cost of implementing
P
2 = C:
1
It follows that …rm 2 will make the investment if, and only if,
E P 1
c < C:
Once again it is assumed that …rm 2 weakly prefers not to make the investment.
From lemmas 4 and 5 it follows that in order to accommodate …rm 2, …rm 1 must
select aE
1 such that,
1
c Rc (aE E
1 ); a1 =
P
C P
: (4.1)
The inequality in (4.1) indicates that it is (weakly) easier for …rm 1 to accommodate
…rm 2 in the investment game than the entry game. Given this structure the condition
22
Proposition 4. Suppose that the action of …rms are strategic complements and that
Proof. The case in which C = 0 holds by proposition 1. Similarly, the case in which,
D
C c ;
1
can be dismissed as aE D
1 = a1 is su¢ cient to accommodate …rm 2. For the remaining
advantage in a restricted access market. One …rm achieves a technological lead over
its rival, defending it by o¤ering its rival an inducement not to match the e¢ ciency
gain. So long as further entry into the market is not viable this accommodation is
advantage not pursuing patent protection but instead committing to an open tech
nology. In this respect, it is related to Gallini (1984) who showed that an incumbent
might license its technology to an entrant to prevent that entrant from leapfrogging
the incumbent’s technological leadership. A key di¤erence between Gallini and the
result presented here is that the presence of the R&D opportunity from the entrant
harms the incumbent. In contrast, here that potential improves the pro…ts of both
23
via accommodation where the e¢ ciency of the entrant lies strictly between that of
the two incumbents. In each of these cases the willingness to pay o¤ the potential
entrant is reduced; either by the need to cover the cost of entry or reduced postentry
pro…ts resulting from reduced e¢ ciency. Consequently, the stream of pro…ts that
the e¢ cient …rm must direct to its rival — in order to prevent the ine¢ cient …rm
from selling out to the entrant — is reduced, and the magnitude of the distortion
that must be created in order facilitate accommodation is likewise smaller. In other
words, the more e¢ cient is a potential entrant, and the is lower the cost of entry that
the entrant faces, the greater will be the distortion away from a competitive outcome
in an accommodating equilibrium.
5 E¢ cient Mergers
This section presents a simple example in which …rms can employ an accommoda
tion strategy to prevent a socially e¢ cient merger. Unlike the model of the previous
sections, three exante identical …rms are active in the market. A new class of ac
commodation is possible; one in which all three …rms set prices that are greater than
their instantaneous best responses in order to prevent any two …rms from merging.
The model presented in this section is based on Salop’s (1979) circular city. Three
identical …rms — indexed 1, 2 and 3 — are evenly spaced around the unit circle. In
each period …rms compete by setting prices. Firms are assumed to have unlimited
capacity and a common constant marginal cost that is normalized to zero. The circle
Otherwise the model has the same structure as the models of the previous sections.
24
There is an oligopoly phase (O) in which the three …rms are engaged in a repeated
price setting game. A merger between two (or more) …rms is not a possibility during
the oligopoly phase. This prohibition against mergers can be interpreted as the
product of regulatory policy. If the prohibition against mergers is dropped the game
pro…ts — the …rms that create the greatest surplus by merging — are then given the
opportunity to merge. In this way the identity of the two …rms which will have the
stage. If the highest instantaneous pro…t is realized by more than one …rm then two
…rms are randomly matched.10 If the two …rms who achieved the lowest instantaneous
pro…ts fail to reach an agreement, the game repeats. On the other hand, a merger
As was the case in the preceding models, the postmerger phase is an in…nitely
repeated price setting game with no further opportunity for entry or merger. It can
and that the returns to entry are insu¢ cient to cover the cost.
stituent …rms but sets a common price across locations. It follows from the welfare
analysis of the Hotelling line example that for a merger to be e¢ cient in this market
it must produce cost savings for the merged entity. Suppose that, if two …rms merge,
a synergy of magnitude s 2 [0; t) is created within the …rm. The synergy is inter
preted as the reduction in the marginal cost of production resulting from e¢ ciencies
achieved through the merger. In this way the merger creates the classic dilemma for
25
in productive e¢ ciency — however consumers on the short arc between the merged
…rm’s locations become captives of that …rm, giving the merged …rm an incentive to
raise its price. Once again the assumption that the market is covered means that
prices have no impact on e¢ ciency. More generally, where demand is downward slop
ing the incentive for the merged …rm to raise prices creates an e¢ ciency loss that
o¤sets the reduced cost of production to some degree.
The demand for …rm i’s product, in any given period, is given by the expression,
pj +pk t
2
pi + 3
qi = 2 ;
2t
where pi is the …rm’s own price and pj and pk represent the prices posted by the rival
…rms. Firm i’s instantaneous pro…t and best response functions are therefore,
pj +pk t
2
pi + 3 pj + pk t
i (pi ; pj ; pk ) = pi ; R(pj ; pk ) = + :
t 4 6
It follows from lemma 1 that in a Markov Perfect equilibrium all …rms set the price
phase.
Following a merger, the merged …rm’s market share in any given period is given
by the expression,
1 pi pm + 3t
qm = + 2 ;
3 2t
where pm is the merged …rm’s price while pi is the price of the remaining …rm. The
…rst term on the RHS of this equation represents the consumers who are captives
of the merged …rm, while the second term represents the set of consumers on the
contested arcs that purchase from the merged …rm. The pro…t and best response
26
It follows that in a Markov perfect equilibrium,
4 1 5 2
pP = t s; pPm = t s;
9 3 9 3
2 2
P 1 4 1 P 1 5 1
= t s ; m = t+ s :
t 9 3 t 9 3
P
Note that , as well as all prices, are strictly decreasing in s for all s 2 [0; t).
Interestingly, where the value of the synergy is su¢ ciently low, the …rm excluded
P P
from the merger bene…ts from being excluded. Formally, m =2 for all s 2 [0; s ]
where, p
8 5 2
s =t p :
6+3 2
For larger values of s the excluded …rm receives strictly less than half the merged
…rm’s pro…t.
cant for two reasons: First, for all s 2 [0; s ) the …rm excluded from the merger is
for small synergies the incentive for the merged …rm to raise prices, exploiting cap
tive consumers, is greater than its incentive to lower prices to take advantage of the
reduction in marginal cost. Conversely, for all s 2 (s ; t) the excluded …rm is un
ambiguously worse o¤ as a result of the merger. Second, for synergies less (greater)
than s , postmerger equilibrium prices are greater (less) than premerger prices.
desirable.
Before proceeding with the analysis of pricing behaviour in the merger phase it is
necessary to make some assumptions concerning the process of negotiation between
27
division of the post merger value of the …rm,
P
m = m:
1
Suppose that …rm’s i and j have the lowest instantaneous pro…ts and therefore enter
into merger negotiations at the end of a period. The surplus created by a merger is
therefore,
P P P P P P P
S= m i (pi ; pj ; pk ) j (pj ; pi ; pk ) :
1
In line with the Nash bargaining solution it is assumed that the this surplus is di
vided evenly between the two partners to the merger. As previously, it is assumed
that …rms weakly prefer not to merge and, therefore, the sum of the merger phase in
P
stantaneous pro…ts of any two …rms must be at least equal to m in order to facilitate
an accommodating equilibrium.
Proposition 5. For all s 2 (s ; t) there exists 2 (0; 1) such that symmetric ac
Proof. First note that if all …rms set the price pM in the merger phase all …rms realise
28
The necessary and su¢ cient condition for the existence of a 2 (0; 1) that satis…es
P P
(5.1) is m =2 > which holds for all s 2 (s ; t).
tition lowest in the merger phase. Moreover, accommodation prevents the realisation
of synergies that would reduce the cost of production.
though the …rm excluded from the merger earns a pro…t in the postmerger phase
that is higher than its pro…t in the oligopoly phase. It is only where the synergy is so
P
low that the excluded …rm earns a pro…t in excess of m =2 — that is where s 2 [0; s ]
Unlike the entry and investment games described above, the merger case requires
all players to take actions that deviate from their static best responses in the merger
phase. The behavior of …rms in this example has a lot in common with multi …rm
period is punished by the remaining …rms merging, reducing the ‡ow of pro…ts to the
deviating …rm in all subsequent periods. However, unlike collusion, the folk theorem
does not operate here and there is only one pro…t level that can be support in an
deviation by one …rm necessarily causes the combined pro…ts of the remaining …rms
to fall below the post merger level.
The possibility that more than two …rms can operate in a market also raises questions
for the entry model outlined in section 2. Speci…cally, can multiple …rms collectively
29
engage in accommodating behaviour? And, is there the possibility that an e¢ cient
…rm will free ride on the accommodating behaviour of its rival? In this section we
again employ Salop’s (1979) unit circle in order to develop an elementary extension
of the Hotelling example in which 3 …rms may operate in the market simultaneously.
Once again, the model sees three …rm’s evenly distributed around the circular
city. Suppose that two of the …rms are e¢ cient with marginal costs of zero, while
the remaining ine¢ cient …rm has a marginal cost of c 2 (0; 5t=6).11 In the entry
phase a third e¢ cient …rm emerges which can only enter the market by purchasing
The pro…t and best response function of …rms in this market are,
pj +pk t
2
pi + 3 pj + pk t
(pi ; pj ; pk ) = pi ; R(pj ; pk ) = + ;
t 4 6
for the ine¢ cient incumbent. It follows that in the oligopoly and postmerger phases,
2
t c 1 t c
pO = + ; O
= + ;
3 5 t 3 5
2
t 3c 1 t 2c
pO
c = + ; O
c = ;
3 5 t 3 5
t t
pP = ; P
= :
3 9
The following proposition characterises the symmetric and free rider accommo
dating equilibria.
11
At c 5t=6 the ine¢ cient …rm will not trade with any consumers in a static equilibrium.
30
Proposition 6. There exists 2 (0; 1) such that (a) for all c 2 (0; 5t=6) there exists
t
a Markov perfect equilibrium in which both e¢ cient …rms set the price pE = 3
+ c in
the entry phase; (b) for all c 2 (0; 20t=63) there exists a Markov perfect equilibrium
t 7c
in which one e¢ cient …rm, …rm i, sets the price pE
i = 3 + 5 in the entry phase, while
the remaining e¢ cient …rm, …rm j, sets its price according to their its best response
function. In both cases the ine¢ cient …rms remains in the market inde…nitely.
Proof. From lemma 4 we know that the ine¢ cient …rm plays it’s static best response
t
in the entry phase. For (a) …rst note that pE
c = Rc 3
+ c; 3t + c = t
3
yielding
t 7c t t 3c t 7c t 3c t
pE
j = R + ; +c = + ; pE
c = Rc + ; + = + c:
3 5 3 3 5 3 5 3 5 3
receives,
E 1 t 7c t 3c
i = + ;
t 3 5 3 5
P
which is strictly greater than if, and only if, c 2 (0; 20t=63).
…cient …rms is shared, and accommodation with a free rider in which one e¢ cient
incumbent opportunistically free rides on the e¤orts of its e¢ cient rival. In this latter
equilibrium the free rider earns an instantaneous pro…t of,
2
E 1 t 3c
j = + ;
t 3 5
in each period of the entry phase. This pro…t is greater than both …rm i’s instanta
neous pro…t in the free rider equilibrium, and the pro…t of either e¢ cient …rm in a
symmetric accommodating equilibrium. It follows that an e¢ cient …rm will always
31
prefer to free ride in equilibrium. However, free riding has consequences for the via
It follows that there is a sense in which accommodation becomes more di¢ cult
where one or more …rms free ride. However, for values of c where accommodation
with free riding is not an equilibrium, there remains the possibility that e¢ cient …rms
7 Conclusion
This paper provides a general context where potential entry can reduce the intensity
where entry requires the acquisition of critical incumbent assets and key competitive
variables are strategic complements. In this situation, an ine¢ cient incumbent may
the pro…tability its rival to such an extent that there are no gains to trade in selling
out to a more e¢ cient entrant. We demonstrated that the same mechanism might
the face of potential entry. For instance, in 2008, Microsoft proposed to takeover
Yahoo! and create a stronger second force to Google in the search engine market.
12
Partial free riding is also a possibility here. It is straightforward to verify that any price pair
which satis…es,
pE E
i + pj t t 3c
= + c; minfpE E
i ; pj g + ;
2 3 3 5
will support an accommodating equilibrium. The …rm with the low price can be regarded as partially
free riding on the e¤orts of the higher priced …rm, even where its price is above its static best response.
Across the admissible range of prices the pro…t of each …rm is decreasing in its own price, and the
maximum value of c for which an accommodation can be sustained is increasing in the minimum of
the two prices.
32
That market is limited by customer attention that itself was constrained by switching
costs or behaviorial inertia. In response, Google proposed a more limited joint venture
deal with Yahoo! causing it to reject Microsoft’s o¤ers. The Google response could
be viewed as an accomodating one designed to remove the gains of trade between
its two rivals (as per the merger model presented in the paper). In the end, anti
trust concerns prevented the GoogleYahoo! deal and arguably the MicrosoftYahoo!
merger as well.
Similarly, the result in this paper should make economists somewhat more cau
tious in advocating reforms that will improve potential entry in markets. In some
circumstances, we have shown that those reforms may lead to reduced welfare. Of
course, the extent to which the theoretical conclusions reached here are of relevance in
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