International Think-Tank on Innovation and Competition
A Manifesto for the Endogenous Market Structures Theory
November, 2007
The foundation of the modern economic theory is based on neoclassical models developed within the constant returns to scale / perfect competition framework. In this framework, entry of firms is endogenous in the sense that all firms expect zero profits at each point in time, but the market structure is indeterminate: whether one or infinite firms produce each good is irrelevant as long as there are constant returns to scale, and strategic interactions do not play any role. This happens in the standard theory of real business cycles and in the neoclassical theory of trade (which are both based on perfect competition in the goods markets), and even in the standard theory of Schumpeterian growth (based on constant returns to scale and no arbitrage condition determining the aggregate investment in R&D).
In the last three decades, economists have emphasized the importance of increasing returns to scale and market power, and these factors have been introduced and widely used in the modern theories of international trade (Krugman, 1980), of the business cycle (Blanchard and Kiyotaki, 1987), and of endogenous growth (Romer, 1990). Nevertheless, most of the literature has adopted the monopolistic competition framework of Dixit and Stiglitz (1977) in which strategic interactions do not play any role given the high number of players, and the number of firms has been often kept exogenous (typically in the theory of business cycles). Therefore, the macroeconomic literature has systematically neglected either the strategic interactions between firms or the endogeneity of entry. We believe that the lack of consideration for the rationality of the entry decisions and of the interaction between these and the strategic decisions of the firms are a crucial limit of the modern economic literature, especially because the rest of it is largely (and sometimes excessively) relying on the rationality of all the agents and of their expectations.
Recent microeconomic investigations on market structures where entry is endogenous have provided a number of applications for the theory of industrial organization, especially for the understanding of investments in R&D and in advertising, of the determinants of the financial structure, and of the behaviour of market leaders (with particular reference to predatory strategies, price discrimination, bundling and vertical restraints), of the effects of mergers and of the effectiveness of price fixing agreements (which of course have crucial consequences for antitrust policy). Many of these applications have been and are widely described and discussed by Intertic. The endogenous entry approach, however, may be relevant also for the analysis of macroeconomic issues.
The main role of a theory of endogenous market structures in macroeconomic analysis is to clarify a new channel through which competition in markets affects the aggregate economy. We may describe it in a simple way taking in consideration the theory of business cycles. Most of the modern theory of the business cycle, starting with Kydland and Prescott (1982), is based on the constant returns to scale/ perfect competition/ flexible price framework of the RBC literature. Since a wide macroeconomic evidence, at least starting with the work of Hall (1986, 1990), suggests the relevance of departures from the perfectly competitive model, economists have introduced increasing returns to scale and monopolistic competition and have widely used them in the modern general equilibrium newkeynesian literature (together with price rigidities for monetary analysis). Nevertheless, most of this literature has neglected both the strategic interactions between firms and the endogeneity of entry. Strategic interactions have been neglected because they are absent in the standard monopolistic competition model, and because competition in quantities has never ben taken in consideration in a literature that was mainly interested in introducing price rigidities to study the real effects of monetary shocks (and therefore always focused on price choices). Entry has been almost always considered exogenous because the crucial consequences of price rigidities (due to small menu costs or imperfect price adjustments) depended on the existence of market power and positive profits of the firms. As a consequence, macroeconomics has been virtually silent on the fluctuations of the number of firms, on the degree of competition in the markets, on the endogenous mark ups, and on the interaction between these fluctuations and those of the aggregate variables as output, consumption, and employment. We believe that the lack of consideration for the rationality of the entry decisions, and of the strategic decisions is a crucial limit of the modern literature on the business cycles.
To see how the endogenity of the market structures can play a crucial role in propagating the business cycle beyond what happens in standard neoclassical models, we will consider the impact of a standard productivity shock. Suppose that the marginal cost of production exhibits a temporary reduction in all the sectors (for intance because of a temporary reduction in the oil price). In a perfectly competitive sector, all prices equate the marginal costs of production and the shock is instantaneously transferred to the prices: since the price reduction follows the reduction in the marginal cost and is temporary, consumption has a temporary boom which in turn pushes the economy. Now consider sectors characterized by few firms competing in quantities and entering endogenously in the markets. Since firms price at a mark up on the marginal cost, the shock has an initial positive impact on the individual profits, which attracts entry of new firms. Entry strengthens competition which reduces the equilibrium mark ups. This in turn implies that the prices are reduced by more than the reduction in the marginal cost, and the boom in consumer demand is therefore magnified by the competition effect (compared to a perfectly competitive economy). Of course over time the strengthening of competition reduces the individual profits and brings back entry to the initial level. This mechanism has been developed in Endogenous Market Structures and the Business Cycle by Federico Etro and Andrea Colciago (November 2007).
The same mechanism works in an international context as well. For instance, a similar shock in one country may induce further entry of its firms in the local sectors for non tradable goods or in the global sectors for tradable goods, reducing the respective mark ups and magnifying the impact of the shock in the domestic market or in the global market as well. Finally, entry driven by profitable opportunities is what drives investments in R&D and therefore technological progress, and is at the basis of the theory of Schumpeterian growth. Further work is needed in particular at the borders between the three cited fields where the theory of endogenous market structures can provide a contribution: growth, business cycles and trade. The theory of Schumpeterian growth with endogenous market structures in the competition for the market could be used to investigate the impact of shocks on growth performance. The theory of business cycles with endogenous market structures could be extended to open economies, but also to monetary frameworks. Finally, the theory of trade with endogenous market structures could be used to study global endogenous growth.
