foreign penetration and undesirable competition
TRANSCRIPT
Economic Modelling 30 (2013) 729–732
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Economic Modelling
j ourna l homepage: www.e lsev ie r .com/ locate /ecmod
Foreign penetration and undesirable competition
Leonard F.S. Wang a,⁎, Jen-yao Lee b
a Department of Applied Economics, National University of Kaohsiung, Taiwan, ROCb Department of International Business, National Kaohsiung University of Applied Science, Taiwan, ROC
⁎ Corresponding author at: Department of Applied Eof Kaohsiung, No. 700, Kaohsiung University Road, NanTaiwan, ROC. Tel.: +886 7 5919322; fax: +886 7 5919
E-mail address: [email protected] (L.F.S. Wang).
0264-9993/$ – see front matter © 2012 Elsevier B.V. Allhttp://dx.doi.org/10.1016/j.econmod.2012.11.007
a b s t r a c t
a r t i c l e i n f oArticle history:Accepted 6 November 2012
JEL classification:H42L3C72
Keywords:Mixed oligopolyStackelberg competitionFree entryExcessive entry
This paper examines how the order of the firms' moves affects the social efficiency with foreign ownershipand free entry in a mixed oligopoly market. We firstly show that when the foreign shareholding ratio islow, the entry of private followers will lead to a lower consumer welfare and higher social welfare, whilethe profit of the incumbent nationalized firm is higher under entry than under no entry. Further, we findthat there always exists the problem of excessive entry under public leadership regardless of the degree offoreign ownership. Such result is generated by the complementary role played by the leading public firmand the strength of business-stealing effect. Our results thus have important implications for industrial andmarket-opening policies.
© 2012 Elsevier B.V. All rights reserved.
1 Recent works show that entry can be insufficient in an oligopolistic market with
1. Introduction
Is free entry socially desirable? In an influential work, Mankiwand Whinston (1986) showed that the answer to this question isgenerally negative in an oligopolistic market with homogeneousproducts and scale economies. Hence it provides the rationale foranti-competitive entry regulation in certain markets. The reasonfor “excessive entry” in their work is the business stealing effect ofentry. A business stealing effect reduces the equilibrium output ofeach firm as the number of firm increases. As explained by Mankiwand Whinston (1986), the business stealing effect creates a wedge be-tween the entrant's evaluation of the desirability of its entry and the so-cial planner's. It is because entrants care its profits only whereas thesocial planner focuses on both profits of firms and consumer surplus.Moreover, the marginal contribution of an entrant to social surplus isequal to the difference between its profit and the social value of thelost output caused by the output reduction of the other firms. Lastly,the business stealing effectmakes entrymore attractive thanwhat soci-ety warrants. Mankiw andWhinston (1986) thus have created large in-terest in examining the welfare effects of entry in oligopolisticindustries (see, Fudenberg and Tirole, 2000; Okuno-Fujiwara andSuzumura, 1993; Suzumura and Kiyono, 1987, to name a few).Suzumura (2012) provided an excellent review of the excess entrytheorem after 25 years since it was first argued by Mankiw and
conomics, National University-Tzu District 811, Kaohsiung320.
scale economies if there are vertical relationships (Ghosh and Morita, 2007a,b). Stillother researches were conducted within this field considering different issues like spa-tial competition (Matsumura and Okamura, 2006), technology licensing (Mukherjeeand Mukherjee, 2008), market structure (Mukherjee, 2012), and open economy(Ghosh et al., 2010; Marjit and Mukherjee, 2011). These works show that along withbusiness stealing effects, entry creates further effects by either affecting the inputprices, technologies, increasing the elasticity of demand or market leadership.
rights reserved.
,
Whinston, and Suzumura and Kiyono.1
In a closed oligopolistic homogeneous market, Matsumura (1998)and Matsumura and Kanda (2005) demonstrated that partial privatiza-tion is the optimal policy in the short-run, and full nationalization is al-ways optimal in the long run with free entry of private firms. Brandãoand Castro (2007) extendedMatsumura and Kanda's (2005) frameworkto demonstrate that the presence of a public enterprise can be an alter-native to direct regulation for avoiding the excess entry problem. Wangand Chen (2010) considered the efficiency gap between public firm andprivate firms in an open economy and reported that partial privatizationis always the best policy in the long run under free entry. AlthoughMatsumura and Kanda (2005) andWang and Chen (2010) took accountof free entry, both papers failed to notice the problem of excessive entry.
To investigate whether a public enterprise is desirable in a mixedoligopoly, Ino andMatsumura (2010) compared welfare and consum-er surplus under different competition types of product market. Theyshowed that being a leader of a Stackleberg game, a public firm canreduce consumer surplus whereas the private leadership enhancesconsumer surplus. Cato (2012) showed that if the number of firmsis endogenous, then the deterioration of the state-owned firm's
730 L.F.S. Wang, J. Lee / Economic Modelling 30 (2013) 729–732
efficiency will reduce social welfare and cause socially excessive pri-vate entry under Cournot competition. Wang and Mukherjee (2012)compared welfare under different numbers of private firms and fo-cused on the effects of entry. They showed that the entry of privateprofit-maximizing firms increases the public firm's profit, industryprofit and social welfare at the expense of the consumers. However,an important question has not been adequately answered yet: howthe order of the public firm's moves affects social efficiency underfree entry in a mixed oligopolistic market? This concern motivatesus to address the problem of excessive entry.2
It is important to note that the consideration of market leadershas a clear empirical relevance and implication on entry regulationpolicy.3 It has been noticed that excess competition tends to occurin industries such as iron and steel, petroleum refining, petrochemi-cals, cement, paper and pulp, and sugar refining. Mukherjee (2012)pointed out that many of the mentioned industries are characterizedby the existence of dominant players, and showed that in a closedeconomy, entry is always socially insufficient in the absence of scaleeconomies. He also deliberated that the entry can be socially insufficientin the presence of scale economies if the marginal cost difference be-tween the leader and the followers is large. Furthermore, in an openeconomy with a foreign leader, entry is always socially insufficient.
The steel industry in Taiwan comprises two prime firms: thegovernment-managed China Steel Corporation (CSC), and the pri-vate Yueh United Steel Corporation (YUSCO), while there are alsomany small-sized private firms in the market. The considered indus-try is a mixed-market industry in which there is one public firm be-having as a market leader competes against many private firmswhich are allowed for foreign ownership. Wang and Chen (2011),and Cato andMatsumura (2012) explored the impact of foreign pen-etration on privatization in a mixed oligopolistic market. Here, wewant to analyze the public leadership scenario with foreign owner-ship and examine whether private entry is socially desirable. Whatwe are doing in this paper is not only extending Wang andMukherjee (2012), and Cato (2012) but also complementing Inoand Matsumura (2010), and Mukherjee (2012) by obtaining a mea-sure of distortion from social optimum. We show that when the for-eign shareholding ratio is low, the entry of private followers will leadto a lower consumer welfare and higher social welfare, while theprofit of the incumbent nationalized firm is higher under entrythan under no entry. We should also make it clear that the problemof excessive entry does exist under public leadership because of thecomplementary role played by the public firm irrespective of themarket structure and the degree of foreign ownership.
The rest of this paper is organized as follows. Basic modeling isprovided in Section 2. Section 3 derives the equilibrium outcomesand comparative statics under public leadership. Section 4 examinesthe excessive entry theorem under public leadership from the view-point of social efficiency. Section 5 concludes the paper.
2. Basic model
It is assumed that there is one public firm and n private firms engag-ing Stackelberg competition in a homogeneous commoditymarketwithlinear demand function P=a−Q. The supply equation is given by Q=q0+∑qi, where q0 and qi denote, respectively, public firm's and privatefirm's productions.Wealso assume that cost functions of the publicfirmand private firms are C0=cq0 and Ci=dqi, respectively. Without loss ofgenerality, d=0 is assumed. The assumption of d=0 indicates that the
2 Cato and Oki (forthcoming) in a three-stage game showed that when entry is en-dogenous, the equilibrium values, including not only the leader's strategies but alsothe entrants' as well, are independent of such properties of the incumbent competitors.
3 Recently, there are a growing number of theoretical papers examining Stackelbergleadership (see, Etro, 2008; Ino and Matsumura, 2012; Julien, 2011), while others in-vestigate the preliminary investment of market leaders (see, Cato and Oki, forthcom-ing; Etro, 2004; Etro, 2007; Žigić and Maçi, 2011).
private firms are more cost efficient than the public firm meaning thatthere is an efficiency gap between these two types of firms. The publicfirm's profit is
π0 ¼ Pq0−C0: ð1Þ
For the private firms that maximize profit, the optimization prob-lem is:
Max:qif g
πi ¼ Pqi−Ci; i ¼ 1;2…n: ð2Þ
Following the assumption of literature4 and considering the objec-tive function of the public firm is to maximize domestic social welfare(W),
W ¼ CSþ π0 þ 1−αð Þ∑πi ð3Þ
where CS=Q2/2 is the consumer surplus, and α is the shareholdingratio of the foreigners. It is important to be aware that privatizationor share release is not always the best policy option when a govern-ment tries to improve the efficiency of public firms. Therefore, whenthe share release of public firms is not opened, foreign penetrationof public firms is naturally not allowed.
The Subgame Perfect Nash Equilibrium (SPNE) is used as the equi-librium concept and the game is solved by backward induction.
3. Equilibrium outcomes and comparative static analysis
This section elaborates the scenario of public leadership where thepublic firm chooses output first. The case of non-entry will be exam-ined first in this section and then entry will be put into considerationin the next section.
3.1. Equilibrium outcomes
In the second stage, the maximization problem of private firm i isgiven by
maxqi
:πi:
The first order condition of the above maximization problem is
∂πi
∂qi¼ a−q0−2qi þ∑n
j¼1;i≠jqj ¼ 0: ð4Þ
With symmetric solution, qi=qj, we have qi ¼ a−q01þn .
In the first stage, given Eq. (4), the maximization problem of thepublic firm is given by
maxq0
:W:
The first order condition of the above maximization problem is
∂W∂q0
¼ a−c 1þ nð Þ2 þ 2anα− 1þ 2nαð Þq01þ nð Þ2 ¼ 0: ð5Þ
From Eq. (5), we have q0 ¼ a 1þ2nαð Þ−c 1þnð Þ21þ2nα > 0, if a(1+2nα)−
c(1+n)2>0, and qi ¼ c 1þnð Þ1þ2nα :
4 A public firm may have different targets, such as maximizing the profit, income,employee's income or with management of license, etc. In order to compare with theliterature, we assume that a public firm will maximize social welfare, see De Frajaand Delbono (1989), Katsoulacos (1994), and Pal and White (1998).
5 We appreciate one reviewer pointing out that the profit raising effect of private en-try depends on foreign ownership and needs to be singled out.
6 We appreciate one reviewer pointing out that if αb1/2, then the profit of each pri-vate firm entering the market is increasing in n, but it implies that the free entry equi-librium induced by zero-profit condition is not stable.
731L.F.S. Wang, J. Lee / Economic Modelling 30 (2013) 729–732
The equilibrium outcomes in the short run are
P� ¼ c 1þ nð Þ1þ 2nα
; ð6Þ
Q � ¼ a− c 1þ nð Þ1þ 2nα
; ð7Þ
π0 ¼cn 1−2αð Þ a 1þ 2nαð Þ−c 1þ nð Þ2
h i
1þ 2nαð Þ2 ; ð8Þ
πi ¼c2 1þ nð Þ21þ 2nαð Þ2 ; ð9Þ
CS ¼a 1þ 2nαð Þ−c 1þ nð Þ2h i2
2 1þ 2nαð Þ2 ; ð10Þ
W ¼ c2 1þ nð Þ2 þ a2 1þ 2nαð Þ−2a cþ 2cnαð Þ2þ 2nα
: ð11Þ
3.2. Comparative static analysis
Differentiating the equilibrium outcomes with respect to n, wehave
∂Q �
∂n ¼ c 2α−1ð Þ1þ 2nαð Þ2
b¼>0 if α
<¼>
12;
∂q0∂n ¼ −
2c 1þ nþ −1þ n2� �
α� �
1þ 2nαð Þ2 b0
∂qi∂n ¼ c 1−2αð Þ
1þ 2nαð Þ2>¼b0 if α
<¼>
12
∂π0
∂n ¼ c 2α−1ð Þ −a 1þ 2nαð Þ þ c 1þ nð Þ 1þ 3nþ 2 n−1ð Þnα½ �f g1þ 2nαð Þ3
>¼b0
if α<¼>
12
and a >c 1þ nð Þ 1þ 3n−2nα þ 2n2α
� �
1þ 2nα≡ a;
∂πi
∂n ¼ −2c2 1þ nð Þ 2α−1ð Þ1þ 2nαð Þ3
>¼b0 if α
<¼>
12;
∂CS∂n ¼ c 2α−1ð Þ a−c 1þ nð Þ þ 2anα½ �
1þ 2nαð Þ3<¼>0 if α
<¼>
12;
∂W∂n ¼
c2 1þ nþ n2−1� �
αh i
1þ 2nαð Þ2 > 0:
Note that the condition of a>ā guarantees a(1+2nα)−c(1+n)2>0, and q0>0 for all α∈ [0,1]. The comparative staticanalysis obtained here extends the result of Wang and Mukherjee(2012) in which the entry of private profit-maximizing firms increasesthe public firm's profit, industry profit and social welfare at the expenseof the consumers. In this paper we show that whether greater competi-tion makes consumers better off depends upon how open the market isfor the foreign owners even though it definitely improves social welfare.When the configuration of social welfare is decomposed into consumersurplus and producer surplus, it can be shown that the changes in con-sumer surplus move in the opposite direction vis-à-vis changes in pro-ducer surplus regardless of foreign ownership. Lastly, when αb1/2, asdemonstrated that entry of private profit-maximizing firms makes theconsumer worse off. However, the entry improves social welfareirrespective of the foreign shareholding ratio when the nationalizedfirm behaves as a Stackelberg leader under private entry. We have thefollowing proposition.
Proposition 1. If foreign shareholding ratio is less than 1/2, entry is un-desirable for domestic consumer, and the profit of the incumbent nation-alized firm is higher under entry than under no entry.
In our analysis without zero-profit condition, the consumer isworse off with private entry, and the profit of the incumbent firmsmay increase when αb1/2 with a relative large market size.5 The rea-soning is that with a lower foreign ownership in private firms, theentry of private firms will decrease the total output and raise theprofit of private firms when the production substitution effect is notstrong enough. Moreover, due to the presence of the profit-shiftingeffect and a lower total output, the inefficient public firm may notearn positive profit when maximizing social welfare unless if thereis a relative large market size, then the public firm may earn a higherprofit with foreign ownership.
In a different context, the profit-raising entry was pointed out byMukherjee and Zhao (2009) and Ishida et al. (2011). Mukherjee andZhao (2009) showed that Stackelberg leadership affects the incum-bents' perception of market demand and marginal cost resulting inthe increases in the output and profit of the cost efficient incumbent.Namely, entry increases the profit of the leader firm if it is sufficientlycost efficient than the other firms. However, entry always reduces theprofit of the cost inefficient incumbent. Ishida et al. (2011) investigat-ed a Cournot model with strategic R&D investments wherein efficientlow-cost firms compete against less efficient high-cost firms. Theyfound that an increase in the number of high-cost firms can stimulateR&Ddone by the low-costfirms,while it always reduces R&D conductedby the high-cost firms. This force can be influential enough to make upthe losses caused by greater competition and raise the profit of thehigh-cost firms. The low-cost firm is induced to make more investmentas the number of high-cost firm increases when the high-cost firms areex ante sufficiently (but not too) inefficient than the low-cost firm. Insum, as the market become more competitive when the high-costfirm increases, the low-cost firms may be benefitted from it and theirprofits can be higher.
4. Entry and social efficiency
In this section, we consider the role of endogenous entry. Due tothe profit rising entry at low foreign shareholding ratio implyingthat the free entry equilibrium induced by zero-profit condition isnot stable, we restrict that α>1/2 at free entry equilibrium.6 Theequilibrium number of private firms (n) under free entry is given by
πi ¼c2 1þ nð Þ21þ 2nαð Þ2 −f ; or
c2 1þ nð Þ21þ 2nαð Þ2 ¼ f ð12Þ
where f is the fixed cost of entry.The social welfare is given as
W ¼ c2 1þ nð Þ2 þ a2 1þ 2nαð Þ−2a cþ 2cnαð Þ2þ 2nα
− nþ 1ð Þf : ð13Þ
The welfare-maximizing number of firms is given by
∂W∂n ¼ 0;⇒
c2 1þ nþ n2−1� �
αh i
1þ 2nαð Þ2 ¼ f : ð14Þ
732 L.F.S. Wang, J. Lee / Economic Modelling 30 (2013) 729–732
Defining Δ=[LHS of (14)−LHS of (12)], we have
Δ ¼ −c2 1þ nð Þ n 1−αð Þ þ α½ �1þ 2nαð Þ2 b0: ð15Þ
It can be seen that Δb0 suggesting excessive entry when the pub-lic firm is a market leader in production. We thus have the followingproposition.
Proposition 2. When the public firm acts as a market leader, the freeentry of private followers is socially excessive irrespective of the degreeof foreign ownership.
According to Proposition 2, the result of “excessive entry” undermixed oligopoly is robust when the public firm acts as the marketleader and commits to social welfare maximization. This result isalso obtained in Cato (2012), who considered Cournot competitionbut no foreign ownership. He reported that the reduction of socialwelfare and excess entry of the private firms is owing to the lower ef-ficiency of the state-owned firm and the production substitution ef-fect. The business stealing effect is another reason, which worksagainst the public firm.
Proposition 2 is in contrast to Mukherjee (2012) in which there is nopublic firm. Entry in his analysis creates both business-stealing effect andbusiness-creation effect. If the number of followers increases, it reducesthe outputs of the followers. Hence the usual business-stealing effect isgenerated, which is stressed in Mankiw and Whinston (1986) where allfirms produce simultaneously. The strength of the business-stealing ef-fect increases with the marginal cost difference between the inefficientleader and the efficient followers. However, if n increases, it raises theoutput of the leader when there is cost asymmetry between the leaderand the followers, thus generating a business-creation effect. As the costasymmetry between the leader and the follower decreases, it reducesthe impact of the business-creation effect. While the business-stealing effect is responsible for excessive entry, the business-creation effect is crucial to insufficient entry. Accordingly, if themarginal cost difference between the leader and the followers issmall (large), the business-stealing effect dominates (is dominat-ed by) the business-creation effect that results in the outcome ofthe excessive (insufficient) entry.
In our analysis, because of the social benevolent of the public firm,if the number of firm increases, it reduces the output of the publicleader when the cost asymmetry between the leader and the fol-lowers exists. It means, once again, the business-stealing effect is gen-erated from the cost asymmetry. The business-stealing effect is veryimportant here in this paper because the strength of such effect andthe leading public firm create the different mechanisms fromMukherjee (2012), and it deliberates the reason why the entry is al-ways excessive in our mixed leader–followers setting.
5. Concluding remarks
We have examined how the order of the firms' moves affects thesocial efficiency with foreign ownership and free entry in a mixed ol-igopoly market. We firstly show that when the foreign shareholdingratio is low, the entry of private followers will lead to a lower con-sumer welfare and higher social welfare, while the profit of the in-cumbent nationalized firm is higher under entry than under noentry. Further, we find that there always exists the problem of exces-
sive entry under public leadership regardless of the degree of foreignownership. Such result is because of the complementary role playedby the leading public firm and the strength of business-stealing effect.Our result, therefore, has important implication for industrial andmarket-opening policies.
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