Dynamic oligopoly models of investment behavior

by 1977- Erdem, Erkan

iii This thesis consists of three chapters on dynamic oligopoly models. In the first chapter, I emphasize the importance of strategic behavior by entrants. I provide a model of endogenous entry in which potential entrants can influence their product quality in the entry stage by varying the level of sunk investments they make at the time of entry. If the entrants are allowed to influence the distribution of quality in their favor, I demonstrate that they act strategically and their decisions depend on the market structure, i.e., the state vector of the incumbents. Whenever the industry consists of firms with low quality goods, entrants invest substantially and vice versa. In the second chapter, I focus on the effects of import competition on the investment incentives and the productivity of domestic firms. Firm-and plant-level empirical studies typically find that trade liberalization squeezes price-cost margins among importcompeting firms, that this heightened competitive pressure induces productivity gains among these same firms, and that further efficiency gains come from market share reallocations. Using a computable industrial evolution model to simulate the dynamic effects of import competition, we explore what types of managerial behavior, long-term transition paths and welfare effects are consistent with this set of stylized facts. In the third chapter, I analyze the linkages between entry costs, firms’ investment incentives in oligopolistic markets and welfare. Policy makers argue that high entry costs create significant economic inefficiencies in perfectly competitive markets. Hence, it is argued that policies that promote entry can improve welfare. However, the response in an iv oligopolistic market is not clear. Increased entry can potentially discourage investments and lead to a welfare loss in the long run. In this study, I analyze empirically how policies that lower entry costs affect welfare and find evidence that such policies might lead to a welfare loss. To do this analysis, first, I develop a structural industrial evolution model with strategic interactions in which firms choose prices in the static game and enter, exit, and invest in the dynamic game, subject to uncertainty and idiosyncratic shocks. Then, I estimate the parameters of both the static and the dynamic game for the Colombian engines and turbines industry. The estimation recovers the demand and cost parameters as well as the investment costs and scrap value and sunk entry cost distributions. I then simulate the model to analyze the effects of sunk entry costs on the investment behavior and the strategic use of investments. I find that lower sunk entry costs lead to a decrease in welfare by reducing incentives to invest. The industry is dominated by high-cost firms which charge higher prices. Firms also find it optimal to accommodate entry rather than spend resources on entry deterrence.