International Think-Tank on Innovation and Competition
Stackelberg Competition with Endogenous Entry
Google and Microsoft: different leaders for different markets
September 15, 2008
Leading firms can play completely different roles in markets where entry is endogenous (or free) and when is not, according to the new article "Stackelberg Competition with Endogenous Entry" by Federico Etro, published in the September issue of The Economic Journal, the Journal of the Royal Economic Society.
For instance, Google and Microsoft are leaders respectively in the online advertising market and in the software market. However, Google is currently facing competition by a fixed number of rivals in online advertising (virtually only Yahoo! and Microsoft), while the software market is characterized by open access to a fringe of effective and potential entrants (including the open source community). The difference is crucial. On one side, a leader like Google is able to exploit the absence of entry threats by setting high mark ups on its advertising services (at least the double than those of the main competitors), generating high prices in the industry, which ultimately hurts consumers worldwide. On the other side, a leader like Microsoft is forced by the endogenous entry pressure to maintain low mark ups (the price of Vista is estimated between 5 and 20 % of the theoretical monopolistic price), which ultimately induces large welfare gains for the consumers worldwide. Both Google and Microsoft retain large market shares but in markets with different entry conditions, and for this reason antitrust authorities should be more concerned about the moves of the former, for instance the recent agreement with Yahoo! (a deal between number 1 and 2, which would certainly reduce competition and increase prices) than those of the latter.
This research belongs to the recent efforts to characterize endogenous market structures, that is structures of markets where firms interact strategically and entry is endogenous. The main focus of the essay is about competition in the market when a leading firm plays as a first mover (a Stackelberg leader, after the name of the famous German economist). The main result is that the leader is always more aggressive than its followers as long as there is a substantial entry pressure. The lower prices of the leader are associated with its larger market share: in such a case, high concentration and limited entry are a consequence of strong competitive forces and not of market power! The article derives the conditions under which free entry of firms induces the leader to dominate most of a market through low pricing: this happens when firms produce highly substitutable goods and the average costs of production are decreasing (a typical feature of the software market). Finally, the work shows that, as long as entry is endogenous, the aggressive strategy of the leader brings better outcomes for the consumers. Such a result is in contrast to what happens when the leader faces an exogenous number of rivals (as in online advertising). This leads to the policy implications of the article: in investigations concerning abuse of dominance, mergers or similar agreements, a preliminary examination of the entry conditions is crucial to verify whether large market shares of the leaders can be a symptom of dominance or just of competitive pressure on the leaders. Only when entry is not feasible in the medium run, the antitrust investigation should move forward.
The article generalizes previous results by the same author on competition for the market as well (“Innovation by leaders”, Economic Journal, April 2004): in this case, it shows that leaders tend to invest more in R&D as long as IPRs are well protected and entry in the race for the next innovation is endogenous. A general introduction to the endogenous market structures approach to micro- and macro-economics is available in the recent books of the same author (“Competition, Innovation, and Antitrust”, 2007; “Endogenous Market Structures and the Macroeconomy”, 2009).
