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Entry in Monopoly Market

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Research Paper No. 883

Entry in Monopoly Markets

by
Timothy F. Bresnahan
and
Peter C. Reiss

May 1986

Star~ord Business ~
0
 Entry in Monopoly Markets

Timothy F. Bresnahan
Department of Economics, Stanford University
Stanford, California 94305

and

Peter C. Reiss
Graduate School of Business, Stanford University
Stanford, California 94305

ABSTRACT:
Existing empirical, models of entry in concentrated markets make indirect inferences
about the competitive effect of entry. We propose empirical models whose stiuctural equa-
tions are those of several different game-theoretic models of entry. These models are used
to estimate the competitive effect that entry has on the margins of monopoly automobile
dealerships in the U.S.

Draft: May, 1986. Comments welcome.

Seminar participants at Chicago, the Federal Trade Commission, Stanford Business School
and Yale provided helpful comments on earlier drafts of this paper. We also wish to thank
Joy Mundy for her expert assistance in programming the likelihood functions. Margaret
Miller was of great help in developing the data base.

1
1. Introduction

Industrial organization economists have long debated whether firms in concentrated mar-

kets can persistently charge noncompetitive prices. Early empirical work on entry by Bain

(1956) and others suggested that firms in concentrated markets can erect entry barriers and

create market power. Later work by Stigler (1968), Demsetz (1974) , and others offered

both a different theory of entry and a different interpretation of the empirical evidence. Re-

cent game-theoretic models of entry have supported both sides of this theoretical debate.

We now have well-posed theoretical models in which incumbent firms can prevent entry

while earning monopoly rents, as well as other theories which imply that potential entry

disciplines incumbent behavior.’ Although studies have sought to test the implications

of these different theoretical views, their tests are indirect. The most common test is a

cross section regression that relates profits in manufacturing industries to proxy measures

of so-called entry barriers. These studies presume that deviations in profit rates across in-

dustries ‘constitute evidence that entry barriers are present.2 Similar’ inferences are drawn

by studies that relate entry rates to the same entry barriers. (See for example Bain (1956),

Weiss (1974), Orr (1974), Chappell et al. (1974) Hannan (1983) and Geroski (1983).) Nei-

ther type of study is immune to reinterpretations that claim the results are consistent with

perfect competition. For example, important work on perfectly competitive entry by Hause

and du Rietz (1985) has shown that competitive entry rates can vary dramatically with

different patterns of demand growth.

A major reason why empirical studies have not made more direct use of theory is that

the variables identified by the theory are often unobservable. These unobservables include

incumbents’ and entrants’ costs and their beliefs about competitive interaction. Progress

~ For a recent survey of theoretical treatments of entry deterrence, see Roberts (1985).
Baumol (1982) reviews work that shows that potential competition is as effective as actual
competition.
2 See Demsetz for a reinterpretation of the evidence in these studies, and Schmalensee,
(1987, forthcoming) for a summary of what has been learned from this work.

2
in modelling strategic entry therefore requires empirical models that can use observations

on actual instances of entry to draw inferences about these unobservables. This paper

constructs such techniques and uses them to estimate the competitive impact of entry into

monopoly markets. First, we formulate empirical models of strategic interaction among

potential entrants. These models include simultaneous-move and sequential-move games

where the players are the potential entrants into a market. Although these games have

important analytical differences, both can be handled within the same general economet-

ric framework. This framework models each potential entrant’s profits as an unobserved

(latent) variable that is known to the firms but not to the researcher. In this respect, our

models are similar to single-agent discrete choice models.3 An important difference be-
tween our models and single-agent discrete choice models is we model how multiple agents

interact. That is, we specify how each firm’s expected profits (and choices) depend on the

other firms’ actions in equilibrium. As a result, our econometric models have the form

of a simultaneous-equation system with discrete endogenous variables that determine the

number of firms in a market.4

In the second part of the paper, we use these econometric specifications to estimate the

competitive impact of.entry into monopoly automobile markets. Retail trade in new cars

offers a unique opportunity to study strategic entry. Our sample consists of automobile

dealers in a cross-section of small, isolated markets that have at most a few dealers. (The

markets pass a demanding series of tests before we consider them isolated. See Appendix

A for details.) Following Pashigian (1961), we emphasize the importance of fixed and

sunk costs in the analysis of entry and show how geographic variations in demand can be

used to measure the magnitude of these costs for the first firm in the market. Using the

level of demand needed to support one firm as a benchmark, we use different theories of

~ These econometric models (see for example MacFadden (1974, 1982), Amemiya (1974,
1982), and Hausman and Wise (1978)) relate qualitative information about consumption
decisions to threshold conditions involving unobservable utility functions.
~ See for example Heckman (1978) and Lee’s (1981) survey.

3
strategic entry to interpret the observed size of the market that is necessary to support two

firms. That is, we use the size of the market to test whether strategic entry deterrence is

present. We find that the density of demand explains most of the variation in the number

of dealerships across small markets, and that price-cost margins do not fall by much when

entry by the second firm occurs. Moreover, we find entry into monopoly dealer markets is

extremely easy. Specifically, that two firms can be sustained in a market only slightly more

than twice as large as that needed to sustain a monopoly.

2. Models of Entry by the First and Second Firm into a Market

This section derives econometric models of entry by the first and second firm into a market.

The first firm enters when demand is sufficient to cover costs. For the second (and later)

firm, however, strategic interactions affect the profitability of entry, This includes not only

entry “barriers” erected by the first firm, but also the competitiveness of postentry pricing

behavior. We follow the recent theoretical literature by casting the entry problem as a

game between potential entrants. For simplicity we treat the case of two players. Each

firm i picks a binary action a2, action 0 being “do not -enter the market” and action 1 being

“enter”. The possible entry outcomes for this market thus involve zero, one, or two firms in

the market. In this section, we follow the convention of the theoretical literature and treat

‘the equilibrium profits of each firm as given. Later on, we reinterpret these fixed profits as

profits that vary with the price or quantity decisions made by the two firms. Finally, we

temporarily assume that the profits of nonproducers are

Under these assumptions, the payoffs to the firms are those displayed in Table 1. The

monopoly profit for firm i is labelled flu, duopoly profit is labelled 11),, and i~ is the

~ This is a simplifying assumption that can be readily relaxed. Below, we generalize

“profits” to include variation in the value of the entrepreneur/entrant’s time in alternative
occupations.”

4
change in each firm’s profits between monopoly and duopoly.

Table 1
Player l’s Payoffs Player 2’s Payoffs

a2 = 0 a2 = 1 a2 = 0 a2 = 1

a’=O 0 0 0 rr2

a’=l fl~1 rlk+~’~rrb 0 fl2+&=112

If entrants are uncertain about costs or demand. then we reinterpret these variables as the

players expected profitability assessments.6

2.1. Simultaneous Move Games -

The simplest model of entry is’ one in which potential entrants simultaneously and non-

cooperatively pick their actions.’ The (Nash) equilibrium conditions for this game can be

expressed as a pair of inequalities:

- a’ = 0 ~ l1~+a2L~’0
(1)
a2 = 0
~ 11L+a’~20

Under the economic assumption that duopoly profits are less than or equal to monopoly

profits, ~ ~ 0, this model has substantial empirical content: it determines the equilibrium

number of firms as a function of the exogenous variables fl~,This can be seen by noting

that the inequalities (1) divide the equilibrium outcomes into the five regions of the payoff

6 Extensions to three or more firms and arbitrary payoffs can be handled with this
framework. For subtleties that are introduced when the game has incomplete information
see Bresnahan and Reiss (1986).

5
space given in Table 2.~

Table 2

Region Definition Equilibria

(a1, a2)

fl~<0, fl~<0 (0,0)

fl~,>0, fl~,>0 (1,1)

l1~>0>flb, J1~>0>fl~, (1,0)or(0,l)

flA.~.>0, rr~,<o (1,0)

ri~,<0, rI~> 0 (0, 1)

Upon examining each of these regions, we find that a Nash pure strategy equilibrium always

exists, but that in the third region there are two possible pure strategy equiliria.

Before discussing the importance of this region, we need to complete our econometric

model of this game. Because economic profits of the firms are not perfectly observable, we•

need to specify the distributions of fl~ and fl~,conditional on a set of observables (X)

that shift profits. Let the profits for each firm i be expressed in the additive form

rr~.f= tt~(x)+ E~
(2)
fl}, = tt~(X)+ 4~(X)+ ~

where e’ is a mean zero variable that is known to the firms but not to the investigator.

For example, if the e~are normally distributed and the firms enter when expected profits

In Table 2, the definition of an event in each line implicitly includes “and not any of

the previous‘events.”
6
are positive, then (2) can be cast as a form of probit model where the horizontal and

vertical lines in Figure 1 represent the thresholds. For example, for the line marked —flj~,

monopoly profits are zero for player 1. At all points to the left of this line, monopoly profits

are less than zero for player 1; to the right, player l’s monopoly profits are positive. The

area in the lower left is the region where both monopoly profits are less than zero and no

firms enter. The area in the upper right is the region where both duopoly profits (liD) are

positive and both firms enter. The other regions in Figure 1 also correspond to inequalities

in Table 2. The center rectangle is the set of payoffs where either firm 1 or firm 2 could be

a monopoly.

Figure 1 makes it clear why in general it will be difficult to estimate a model of the

equilibrium strategies. In the center region, both a1 = 1, a2 = 0 and a2 = 1, a1 = 0 solve

the equilibrium equations of the model (1). Note that this indeterminancy is inherent in the

underlying theoretical model and is not a consequence of the econometric specification. In

this range of payoffs, the market is a natural monopoly: neither firm can profitably enter if

the other is already in. These nonunique outcomes csften occur i~nmodels of markets where

there are few firms and strategies are discrete.8

Estimation of the parameters in the firms’ profit functions is only possible if we redefine

observable events so that the outcomes uniquely partition the profit outcomes. Referring

again to Figure 1, it can be seen that if the profit outcomes are partitioned according to the

number of firms that enter the market, then we have unambiguous probability statements

for the number of firms. They are,

Pr(0 firms I X) = P~(1ij1r< 0 and fl~<0 I X)

Pr(2 firms X) = Pr(flb > 0 and H~,> 0 X) (3)

Pr(1 firms I X) = 1 — Pr(0 firms I X) — Pr(2 firms X)

~ For example, in a recent model by Katz and Shapiro (1984) firms have increasing
returns to scale technologies there are equilibria where either of the two firms could be a
natural monopoly.

7
Equation (3) is the basis for the likelihood functions that are used in Section 4.

2.2. Consistency Conditions In Simultaneous-Move Games

Many of the above problems with writing down a consistent econometric model of discrete

outcomes have received considerable attention in the econometric literature. Indeed, it is

easy to see that if the errors in (2) are normal, then the model of a discrete game is similar

to one of Heckman’s (1978) dummy endogenous probit models.9 Although techniques to

estimate these types of models are available, both Heckman (1978) and Schmidt (1981)

have shown that a necessary and sufficient condition for this model to have a well-defined

reduced form is that the model be recursive.10 Recursivity requires A’ x A2 = 0. In

our application, this is an overly restrictive statement about how potential competitors

affect profits. If, for example, we impose recursivity by setting A’ = 0, then monopoly
and duopoly profits are identical for firm 1. In other words, firm l’s incremental profits

from entry are the same, independent of whether the other firm is in the market. Such an

assumption clearly rules out most interesting entry models.

In (3), we escaped the need to impose recursivity by requiring only that the model be

able to make probability statements about the number of firms in the market, not about

the individual actions. As a result, we made the weaker structural assumption A~ 0, not

A’ = 0 for some i. In our application, this is a more natural economic assumption about

the payoffs: duopoly profits for both firms are less than or equal to monopoly profits. (In

Figure 1 this assumption is that the lines marked —flM and ~flD never switch position.)

It is useful, however, to explore what happens when A’ can be positive. When this occurs,

the five regions in Table 2 and Figure 1 do not exhaust all of the possible outcomes. Three

of the new possibilities are disturbing:”

~ It is exactly Heckman’s Case 4 simultaneous probit if A’ is set equal to a constant.

10 Amemiya (1974) makes a similar point for general equation systems with truncated
endogenous variables.
~ The other events have one of the two monopolies as a unique equilibrium.

S
 Table 3

Event Value of Payoffs Equilibria

ri~<o flL<0
El (O,O)and(I,I)

ri~,>o flL<0
E2 None
fl~<0 fl~>0

flL<0
E3 None -

Ii~<0

Relaxing A’ < 0 thus leads to two kinds of problems. First,’when the event El occurs, the

model has two pure strategy equilibria: no firms and two firms. Thus, if event El occurs

with positive probability, the econometrician must treat the outcomes zero and two firms

as observationally equivalent. That is, the econometrician must aggregate the number of

entrant outcomes into the following partition

Event 1: Monopoly

Event 2: No Firms or Duopoly

This partition of the event space enables one to write down a stochastic specification that

is internally consistent. However, this aggregation of outcomes is extremely unattractive

because markets with no firms and duopolies are treated equivalently. In our applied

work, therefore, we will impose restrictions on the errors that preclude these simultaneous

equilibria. The role of economic assumptions in ruling out nonuniqueness should now be

clear. Event El can be ruled out by a plausible economic condition. If this assumption is

not made, then estimation cannot proceed.

The second problem introduced by a failure to assume A’ ~ 0 arises in events E2 and

E3. There the game does not have an equilibrium in pure strategies. That is, there is no

9
pair of 0’s and l’s that solve (3). In our application, it is again possible to rule out these

events by assuming that A~is negative with probability one.12

2.3. Sequential-Move Equilibria

The idea of barriers to entry is often associated with the asymmetric treatment of incum-

bents and entrants. Most commonly, the asymmetry is assumed to arise because incumbents

move first; that is, that the game is a sequential-move entry game and not a simultaneous-

move game. In our very simple framework, even though the only choice variable is whether

to be in or out -of the market, there is a considerable difference between the predictions of

sequential-move and simultaneous-move empirical models.

In a sequential move game with the same payoffs as the last sections and where player

2 moves first, the equilibrium conditions are:

a’=O ~ flj~+a2A’0 - -

fl~~0 (4)
a2=0 ~ or
fl%0flLandflb0

(This assumes for simplicity that duopoly profits are less than monopoly profits for each

player with probability 1.) The effects of changing the equilibrium concept can be easily

seen in Figure 1, by comparing inequalities (4) to (1). Comparing the simultaneous-move

and sequential move equilibrium conditions, we see that the conditions determining duopoly

and no entrants are the same. The conditions determining monopoly differ however. First,

the two monopolies are now observationally distinct because there are no regions with

nonunique equilibria under the sequential-move concept. Second, whenever both firms are

profitable monopolies, firm 2 is able to establish itself as the monopolist by moving first.

Thus, the center rectangle in Figure 1 represents firm 2’s advantage to moving first.

12 Bresnahan and Reiss (1986) considers how to model games with mixed strategy
equilibria. ‘

10
 The equilibrium probabilities under the sequential move concept are thus:

Pr(0 firms I X) = Pr(fl~ <0 and fl~<0 I X)

Pr( Duopoly I X) = Pr(fl~,> 0 and 1i~,,> 0 I X)

(5)
Pr(Monopoly for Firm 1 IX) = Pr(fl~ > 0 and nL <0 I X)
+ Pr(flb > 0 and fl~,<0 < 11L~IX)

The probability of a firm 2 monopoly is calculated as a residual.

3. Entry and Profits In Retail Auto Markets

Any ‘empirical study of entry confronts two basic problems: how to identify instances of

entry and how to identify whether entry has occured in a specific market. These problems

make it very difficult to study strategic entry in a cross section of manufacturing industries.

The retail sector, however, provides an ideal setting for the systematic study of entry into

monopoly markets because most retail operations are confined to geographic regions. By

selecting isolated retail markets for large durable goods such as automobiles, it is possible

to identify proper markets, count entrants, and to ensure that local market conditions are

all that affect the profitability of dealers.’3 Further, any empirical study maintains the

hypothesis that non-random differences across observations are captured by observables;

this assumption is much easier to ensure in retailing than it is in a cross section of different

manufacturing industries.’4 ‘For instance, it is more reasonable to assume dealers in Win-

nemucca, Nevada are like dealers in Circle, Montana than it is’ to assume steel firms are

like frozen food companies.’5

13 A great deal of information about auto dealer markets can be found in Pashigian(1961).
More recent information on the institutional and regulatory environment in this industry
is available in Smith(1982).
~ This point has been made by Rosse (1970) in his work on cross-sections of newspaper
markets and by’ Rhoades (1982) in his work on cross-sections of banking markets.
‘~ Following Pashigian (1961) and Rosse (1970), we interpret the cross section variation
in dealers’ as reflecting changes in long run profits. For approaches to detecting departures
from the predictions of long run equilibrium models see Rosse (1970), Hause and du Rietz
(1984) and our discussion below.

11
3.1. Empirical Specification

The following subsections adapt our empirical models to our specific application. We first

specify an economic model of profit as a function of the number of firms and of exogenous

observables. The crucial feature of this model is our interpretation of how the density of

demand affects the profitability of entry.

3.1.1. Restrictions on fl~and fl~,

Economic theory puts remarkably few restrictions on a firm’s profit function in the

presence of market power.’6 We draw our main results from three assumptions. First,

we assume that dealers have constant marginal costs in the relevant range.’7 Second, we

assume that we can observe a variable which measures ‘the size of the market, and that

when we double the size of the market, sales are twice as large if we maintain the same

price. Specifically, we write the long run profit of each firm as:

2rj(qj, ~ 5, W, Z)’= (P~(q~,

~, Z) — c~(W))q~6 F~(W)
— (6)

where

q, is the per capita unit sales for firm i.

q, is the per capita unit sales for firms other than i.

PQ is the per capita (inverse) demand function and the Z are exogenous variables

affecting demand.

S is the size of this market, i.e. the number of customers.

C, (W) is marginal cost for firm i, and the W are exogenous variables affecting costs.
16 For example, the profit function is not necessarily homogeneous in prices. However,
see Lau (1975). -

17 The assumption that marginal costs are constant is reasonable for the sample of
small automobile dealers we analyze. Although Davisson and Taggart (1974) do report
accounting data that suggest that average costs decline for a wide range of sales volumes,
these volumes are much larger than the 25-200 units for firms in our sample. Second, it is
reasonable to infer from the typical sizes of auto dealerships in large, competitive markets
that average ~osts first turn up at volumes outside those in our sample.

12
 F,(W) is the (per-period) fixed cost for firm i.

Our third assumption is that dealers maximize their long-run profit function ignoring po-

tential entrants. That is, they consider only actual competitors in setting quantities.

At first glance, it might seem that the assumption that there is no limit pricing is

very restrictive. It is easy to design models in which monopolists will limit price only when

entry is more probable. This could cloud inferences based upon variations in the density of

demand because fl, will not be linear in S for all values of S (although it certainly will be

for some).’8 Even if this occurs, however, it may not affect our interpretations very much.

•Note that our empirical inferences are drawn from threshold conditions on monopoly and

duopoly profits. As an empirical matter, estimates of the monopoly profit function flM

are most influenced by those observatiOns (densities) where monopoly profits are near zero.

Inframarginal monopolies—those far from the boundary with the nonopoly region—will as a

practical matter have little influence on our estimates of flM.

In contrast to monopoly profits, the linearity of duopoly profits in density may be

complicated by factors such as private information on the part of incumbent firms, signalling

opportunities, etc. Here, we interpret profit functions as embodying all knowledge held by

the firms.’9 Thus, unless signalling strategies depend on density, the linearity of profits in

density is again preserved.

The three assumptions also have basic implications for the form of the equilibrium

18 Such an argument rests on assumptions about the credibility of the monopolist’s strat-
egy. If the monopolist cannot credibly commit to a limit price once the entrant enters, then
sub-game perfection equilibrium arguments would suggest that all that is relevant for the
entrant’s decision are profits given the nature of post-entry competition.
19 In many of the models surveyed in Roberts (1985), incumbents have an incentive to
manipulate the entrant’s information structure. If our markets have a separating equilib-
rium (see Milgrom and Roberts (1982)) then our interpretation of flD is it is as if the entrant
knows the incumbent’s information. Alternatively, pooling equilibria have the feature that
the entrant cannot ihfer all of the incumbent’s private information before entering. In this
case, the entrant will be uncertain about profit and we will be estimating the relationship
between the exogenous variables and the entrant’s expectation of profit.

13
profit functions. These profit functions have the structural form

fl~..,(Z,W,S)_~~(q,~S,Z,W) N = M,D,

where q* are the equilibrium quantities and M and D stand for monopoly and duopoly re-

spectively. The third assumption implies that a monopoly dealer always picks the monopoly

output; that is, that output that would be selected in the absence of potential competition.

This assumption implies the following reduced form for profits:

- fl~(Z,W,S)E 7r~(q,0;S,Z,W)=h~(Z,W)S— F’(W) (8)

where h~is a positive function. This profit function has two important characteristics .that

are independent of the functional form of the demand curve: it is linear in S and additively

separable in the fixed cost variables.20

We can use similar’ arguments to derive a corresponding reduced form profit function for

duopolists. If we assume that duopolists have arbitrary but exogenous “conjectures” about

the response of the other firm in the market then once again both equilibrium quantities

and prices will be independent of S. This implies total sales are linear in density and

reduced form profits are of the form

rI’~(S,Z,W)= h),(Z,W)S — F,(W), (9)

In (6) we assumed that the per capita demand functions do not depend upon the size

of the market, S. That is, we have assumed that density proportionately shifts the market

demand curve. In essence, this implies that if we took the populations of two identical

rural markets in our sample and relocated them in one market, their individual demand

curves would be unaffected by the doubling of population. This assumption does not say
20 It is easy to establish that this result holds by direct calculation. Clearly we require
that the functional forms are such that q * is well-defined. Also, it is clear that the functional
form of the demand curve will be a determinant of the shape of the variable profit function

14
that all rural areas have the same per capita demand (or tastes) for cars. The per capita

demands can vary because of exogenous factors (such as land prices, household income, and

demographic variables) that are correlated with density in the cross section of places. What

our interpretation does require, however, is that we have included enough other observables

in W and Z so that density is not a proxy for omitted variables. In our empirical section

we will therefore be careful to over-parameterize h(.) and F(.) in terms of cost and demand

variables.21

3.2. Specification and Data

Our data consist of a cross section of retail markets for new automobiles in rural U.S. coun-

ties. Market definitions are based on information from the 1983 R.L. Polk and Company

Dealer Census, (DC), the Yellow Pages of some of the localities in our, sample (PB), the

Bureau of the Census’s 1985 County and City Data Book (CCDB),22 and other miscella-

neous data sources described below. Sources and’ definitions of all variables are summarized

in Table 4. ‘

3.2.1. Sample

The DC is a complete enumeration of automobile dealers in the United States and the

brands they carry as of the end of 1982. From this dealer census and population census

information we identified small retail markets that had only a few automobile dealers. The

specific procedures that we used to define markets and our sample are described in Appendix

A. Our selection criteria require (among other things) that consumers in the market have

at least at 50 mile round trip for purchase and warranty service. We are reasonably certain

that we have a sample of well-defined markets. Some of these markets have no dealer, some

have a single dealer, and some have two or more dealers. There are no monopoly dealers
21 In using this assumption for rural areas, we are not asserting that it necessarily applies
for all possible densities of demand. There may, for example, be agglomeration economies
that cause per capita demand to vary with the size of urban areas. In our small markets,
however, the agglomeration economies are unlikely to be important.
22 Obtained through the Inter-University Consortium for Political and Social Research.

15
that sell the brands of more than one manufacturer. In the estimation, we treat all markets

with more than two firms as duopolies. Because the structural equations of our model are H
crossing conditions, this implies that we assume that if there are three firms in the market,

it is safe to infer that a second firm thought it was profitable to enter.

3.2.2. Demand and Market Size

The density term (5) is the dealer’s expectation of the number of demanders in the market.

In our most general specification, this variable has the form

S = TOWNPOP + .X, OTHERPOP + “2 NEGGROW + A~POSGROW,

where TOWNPOP is the population of the town where the dealer(s) locate (hereafter Town

1), OTHERPOP is the population within 10 miles of Town 1 but not in Town 1,23 and

NEGGROW and POSGROW represent respectively the negative or positive population

growth of Town 1 between 1970 and 1980.24 This specification of density implies that

.people around Town 1 patronize the local dealer, but to differing degrees than those in

town. Specifically, we expect that A, should be less than unity because people outside of

town face greater costs in purchasing cars and having them serviced. They also may differ

in their tastes for cars. Following Hause and du Rietz (1984), we include the asymmetric

growth variables to take into account how exit barriers or transactions costs affect dealer

entry and exit decisions. In particular, if there are large sunk costs to dealerships, then

these costs should serve as a barrier to exit should population in the town unexpectedly

decline. Similarly, the positive part of population growth is included because dealers may

enter markets in anticipation of population growth.

Finally, we need to consider how variable profits may change with demand-side char-

acteristics of the’ population. Although a great many demographic variables are known to

23 OTHERPOP includes an explicit enumeration of other towns plus imputed population

not living in a town.
24 This specification for the growth variables is similar to Hause and du Rietz (1984).

16
shift automobile demand, we found that few demographic variables affected the results we

reported below. Therefore, we only report the effect that the average income of residents

in the county (INCOME) had on variable profits.25

3.2.3. Costs

Information on the market environment in these counties comes from the CCDB, which

provides cost-side information (our W). Specifically, it provides information on the county

retail wage (RET WAGE) 26 and the value of agricultural land (LANDVAL) ~27 As in many

businesses, entry into automobile retailing involves not only the purchase of market inputs

but also the formation of contractual links to suppliers of key inputs and capital. In our

market, the key supplier is clearly the automobile manufacturer. Manufacturers in fact im-

pose restrictions on dealers before they will sign the franchise contract. In particular, they

require relevant experience; force construction of adequate facilities; and require substantial

equity participation (unborrowed capital) by the potential dealer. It appears therefore that

the capital commitments required by the manufacturer increase the degree to which costs

are sunk rather than the degree to ~.vhichthey are fixed. These capitalization requirements,

together with the fact that bank loans to automobile dealers are almost always secured,

mean that imperfections in the local capital market arTe largely irrelevant for auto dealers.28

Moreover, in very small towns these facilities requirements are modest. As a result, we in-

terpret the manufacturers restrictions as part of the cost function of being an automobile

dealer.

A piece of cost information that we do lack is information on the value of the en-
25 Other variables that were included were: median age, median years of schooling, pro-
portion male, proportion of females -who were heads of households, and dummy variables
for region of the country.
26 Average hourly earnings, based on the 1977 Census of Retail Trade.
27 Land and labor prices account for an estimated 70% of the typical auto dealers ac-
counting costs (aside from the cost of cars at wholesale which does not vary much by these
rural localities).
28 The secured loans include mortgages and inventory loans secured by cars on the lot.
The required dealer facilities depend on their assessed “planning potential” of the local
market. -.

17
trepreneur’s time in alternative occupations. In theories of entry, it is often convenient to

assume that all firms have access to the same technology and have zero opportunity profits.

This assumption is unattractive for our problem because it amounts to the assumption that

the local supply curve of well-funded entrepreneurial talent is perfectly elastic in all local-

ities. We prefer the assumption that there might be considerable cross-section variation

in this supply curve. It is quite possible that only a few potential entrepreneurs may be

knowledgeable about a business and a market. We therefore specify fixed costs as inho-

mogenous in factor prices, with the unobservable portion of the entrepreneur’s opportunity

cost being treated as part of the error. The precise form for the stochastic error will be

discussed more fully below.

3.2.4. Descriptive Statistics

Table 5 contains sample means and standard deviations for all our variables and information

on the types of firms in the market. Table 5 indicates that the average duopoly has less

than twice the town population as the average monopoly, and the average triopoly is less

than three times the size of the average monopoly.

4. Stochastic Specifications and Results

In Section 3, we specified two profit functions, fl~ and 11b~that characterize the

payoffs that firms would receive in monopoly and duopoly markets. For the specifications

described below, we use multivariate normal stochastic specifications. There were two

reasons for this. First, we wish to have models that can be compared to existing probit

dummy endogenous variable models. Second, the normality assumption permits us to

model easily correlated error structures. However, in general there is no reason why the

specifications we propose below could not be extended to other distributions such as the

multivariate logit.

18
 The addition of an error structure implies the following equations for dealer profits:

fl~=h’~(Z,W)6 F~(W)+ e~ -

r1)~=hb(Z,W)S-F~(W)+b i= 1,2.

To these equations, we add the constraints that monopoly profits are greater than duopoly

profits with probability one. The following subsections explore alternative ways in which

this constraint can be imposed. We start with very simple models. By comparing these

models to conventional dummy endogenous variable models, we proceed to generalize the

error structures to handle alternative assumptions about unobserved costs and market

characteristics.

4.1. Perfectly Dependent Errors.

The first model is a baseline model for more complicated specifications. In it we assume

that both potential entrants are identical not only in expected profits but in the error term.

Further, we assume that the error term is the same for monopoly as for duopoly profits.

This implies: ‘ -

flf = rr~= flM+~

~b = ri~,= rID +e

where ~ is a standard normal random variable and we assume

rIM = hM(Z,W)S- F(W)

flD liM+025f2

We shall consider two specifications in turn:

1) hM=Oo

F(W) = fo ; and,

2) hM = 8~+ O1INCOME + O~RETWAGE+O1LANDVAL

~with F = fo + f~RETWAGE+fj LANDVAL.

19
where the 9, and the f, are parameters to be estimated.

Using system (3), a simultaneous-move game leads to the following likelihood function

for this model:

P0 = Pr(No Dealers) = Pr(ITM <.e) = 1 — ~(iTM)

P2 = Pr(Duopoly) = Pr(ITD> —~).=~(~) -‘

P, = Pr(Monopoly) = 1 — Po — P2
Inspection of these probabilities shows that this model is an “ordered probit.” That is,

the outcomes are determined by the error crossing the monopoly and duopoly zero profit

thresholds.

Results for this specification are presented in Table 6. As can be seen from the table,

the conditions for a well-specified problem are satisfied by this specification: both ~2 and 12

are negative, implying HM > T!i~,.These estimates suggest there are important differences

between monopoly and duopoly profits. Consider first the relationship between marginal

profit in monopoly and duopoly. Under’ our assumptions, the ratio of variable profits is,

- OO+92_PD—C ‘

Go ‘PM-C’

or the percentage that duopoly price-cost margins are- of monopoly margins. Both columns

in Table 6 indicate this quantity is about .67 with a standard error of .21. That is, entry into

a monopoly dealer market reduces the monopolist’s price-cost margin by about one-third.

Accordingly, we conclude that auto dealer duopolies are not very competitive. There are at

least two obvious reasons for this. First, duopolies may be highly collusive. Second, most

of the duopolies in our sample consist of firms offering non-overlapping lists of brands, The

resulting product differentiation could lead to substantial market power even if conduct is

not collusive.

Although entry does not appear to substantially affect the price-cost margin of a

monopolist, it is important to consider when the second firm decides to enter. From Table

6 we can estimate how large the market has to be for entry to occur. Estimates of the

20
required market size for monopoly (5k) and duopoly (sb) can be obtained by setting

expected monopoly and duopoly profits equal to zero. The estimates in the left column of

Table 6 imply that the critical long run population density needed to support a monopoly

is 667 people, while 1,589 people are required to support a duopoly. Thus, duopolies occur

at roughly 2.4 times the breakeven monopoly density. This ratio clearly rules out the

possibility that there are significant entry barriers in these markets.

The inclusion of factor -prices and demand variables in the second specification does

not change any of the above inferences, as can be seen by comparing both columns of Table

6. Moreover, the income and of the factor prices are individually and jointly insignificant.

Finally, dropping the factor prices from either fixed’ costs or variable profits to reduce

possible collinearity among the variables does not substantially change any of the other

estimates. Similarly, the results suggest that the population outside of Town 1 is not’

nearly as important in supporting dealers as people in town. Thus, it appears that market

size in town is the overriding variable determining the equilibrium number of firms.

Our results do suggest, however, that there are important dynamic dimensions to the

size of the market. Both POSGROW and NEGROW have significant coefficients. The

interpretation of these coefficients is not straightfoiward because the variables are the

growth of TOWNPOP and not of the total size of the market, 6. At the mean of our data,

the POSGROW coefficient implies the following. For growing or static markets, the size of

the market is the minimum of size in 1980 and the size in 1970. (The negative coefficient

on POSGROW means that if growth has occurred, we subtract it from current market

size.) Thus, the entry response to market growth appears very slow in this industry.29 For

declining markets, the coefficient of NEGROW implies that future declines are anticipated.

Thus, we infer exit is a much more rapid process in this industry than entry.

29 Some people have suggested the possibility that this reflects the presence of entry
regulations in high-growth sunbelt states (see Smith (1982).) -However, those laws do not
affect entry in our markets, since they do not give the monopoly dealer of one brand the
right to bar entry by a dealer offering a different brand. ‘

21
 An obvious drawback in the above specification is the assumption of perfectly depen-

dent errors. This assumption is particularly troubling because unobserved dealer charac-

teristics (such as the opportunity cost of time) may be included in the error term. With

perfectly dependent errors, we also rule out the possibility that monopolies are the result

of unobservable differences in entrepreneurial talent. That is, the specification presumes

that the supply curve of dealers is flat. In Table 6 there is some evidence to suggest that

this is not true. The coefficient 12 is an. estimate of the difference between fixed costs for

monopoly and duopoly profits. Among other things, it can be interpreted as the expected

value of the opportunity value of time for the second-best dealer. As this is only an average

value across all markets, we later will, treat differences in dealers’ opportunity costs as a

random rather than a fixed effect.

4.1.1. Simultaneous Probit with Arbitrary Covariance.

In the left column of Table 7 we report a specification for a simultaneous-move game

with a simultaneous probit structure ‘that relaxes the perfectly dependent errors assump-

tion. Specifically, this specifications assumes that the errors are joint normal with an

unknown covariance, p. More formally, the system of equations now takes the form:

flX4=HM+E’ 1=1,2

- flbflD+e’ 1=1,2

Where (e’, e2) are joint normal with zero means, unit variances, and covariance p. For

arbitrary p the likelihood function can be reduced to univariate probability integrals. Sim-

plifying computational strategies for these integrals are well known. (See Hausman and

Wise (1978) and Daganzo (1980).)

This specification allows the unobserved opportunity costs and entrepreneurial abilities

of dealers to differ within a market. That is, it allows for the possibility that the local supply

curve of entrepreneurial talent is not flat. Because we specify that ~M and flD ‘are the

22
same for each dealer, this implies that the error terms are essentially order statistics for

dealer fixed costs or entrepreneurial talent. The assumption that the errors are correlated

also allows for us to see whether there are unobserved town or market effects are present.

The results in Table 7 show that differences between the monopolist’s and the dupolist’s

fixed costs (as summarized in 12) have disappeared. That is, by permitting the errors to be

less than perfectly correlated, we reestimate 12 = 0.30 We interpret this result as evidence

that the supply curve of local entrepreneurial talent is not perfectly elastic and that there

are important unobserved (random) differences among local entrepreneurs. However, the

errors in the first and second firms’ profits are highly correlated (p = .75) so that the

importance of random “town effects” is reinforced. It is interesting to note that most of

the other economic inferences we drew in the previous section are unchanged for this more

general model.3’ This is true even if we impose that (in estimates not shown) the errors

are independent (p = 0).

In other estimates’ not shown, we relax the’ symmetry of the profit functions and

change the model so that fl~differs from fly, by -a term linear in the size of the market

for N = M, D. This, too, permits an economically sensible alteration to arise: firms can

be different. This generalization, too, makes little difference. Of course, an important

reason for that is our sequential-move models do not permit distinguishing firms that offer

different brands.

4.1.2. A Sequential Move Game

In the previous models we have treated the dealers symmetrically in the observables. In this

subsection we relax this assumption. Of our 42 monopolies, 24 to offer GM brands, though

30 In fact, we find we must impose /2 = 0 to prevent negative values. If we did not

impose this constraint, then we would violate our consistency assumption that rIM <rID
for some values of the exogenous variables.
~‘ The ratio of variable profits, (Go + 92)/GO, is now .68, so that the inference about
monopoly versus duopoly marginal profit is essentially unchanged. The inference about
the size of the market in which duopolies and monopolies can be expected is also little
changed, although the calculations are now more complex.

23
 )

only a fifth of dealers nationwide offer GM brands. As GM is the largest domestic manu-

facturer, it is interesting to consider whether GM monopolies differ from the monopolies of

other brands.32

Here we explore for possible differences by changing the game form. Specifically, we

estimate a sequential-move model entry where GM is assumed to be the leader. Section

3.4 worked out the equilibrium conditions for this sequential-move game assuming that

monopoly profits were greater than duopoly profits for both players. In contrast to the

simultaneous-move game, we saw that in the sequential-move game that we could distin-

guish between the monopoly outcomes provided we knew which player moved first. To

compare simultaneous-move and sequential-move results, we maintained the same para-

metric specifications on the reduced form profit functions and the errors. We then explored

for possible differences between -GM dealers and dealers of other brands by specifying GM

as the leader and allowing its profits to differ in either because, of different fixed costs or

different vari~bleprofits. The specification in the right hand column of Table 7 is t.he first - - *

of these two. (The other specification yields similar results and is therefore not reported.)

The first striking thing about this specification is that both °2 and f2 are estimated

to be zero. Once we allow differences between brands, there is -no difference between the

monopoly and the duopoly profit function. While we do not wish to make to much of this,

we do think it reinforces our earlier finding that duopolies are not less competitive than

monopolies in this industry. Although the issue is not completely resolved, the finding

points toward a product-differentiation theory of the lack of duopoly competitiveness. We

also observe that fixed costs are lower for GM dealers. (When it is the variable profits which

are allowed to differ across brands, the GM variable profits are larger.) Thus the leader-

follower model does not explain all of the preponderance of GM monopolies by allocating all

indeterminate natural monopolies to GM. Instead, it reports that GM is the more valuable
32 GM dealers may differ both because GM has a better dealer placement policy and
because dealers of GM cars are better dealers (either because of the product or dealer
selection policies).

24
monopoly.

The range of sizes of the market leading to monopoly is a slightly more complex calcu-

lation in this instance. We define it as those sizes of the market for which the probability

of zero firms is less than .5 and the probability of two firms is less than .5. The upper limit

of this range is 2.144 as large as the lower. Thus the GM-leader model implies even fewer

barriers to entry than the anonymous-dealer mdoels.

Finally, note that the GM-leader model appears to have a poorer fit because of its lower

log-likelihood value. However, this model is different because it distinguishes between two

types of monopoly. Hence, the average sample probability of an outcome can fall even

though the model has predictive power. In particular, if we completed the specification of

one of the simultaneous-move games by adding an ad hoc probability, AGM, that a monopoly

would offer the GM brands, the log likelihood would fall by 24AGM + 18(1 — AGM). At the

maximum likelihood estimate of AGM = 24/42, this would lower the likelihood of those

specifications by 28.7. Thus the fit of the sequential-move and simultaneous-move models

is seen to be nearly identical. -

4.2. Monopoly and Duopoly Profit Not Perfectly Correlated

Finally, the restriction that monopoly and duopoly profits are perfectly correlated is

a potential misspecification that could cause the average duopoly to appear collusive. If

there is substantial heterogeneity across markets in the unobservable ways monopoly dealers

adapt to entry, then our results could understate the true loss in variable profits. Therefore,

in this section, we allow the unobservables to differ across the equilibrium states.

In specifying this new error structure, we must still enforce our restriction that mon-

opoiy profits are greater than duopoly profits for each firm. A convenient way to do this is

to restrict the support of the duopoly error. Here, we do this in the following way:

I flM + EM if Monopoly
HN~_
I. rID + EM — r~ if Duopoly

25
where EM 15 a normal error and ,~is a positive half normal that is independent of EM. This

stochastic structure produces the following likelihood function

P0 = Pr(No Dealers) = Pr(1TM <Ei) = 1 — c~(ifM)

P2’= Pr(Duopoly) = Pr(ITD > ‘i — E~)

= cI(ffD)+2f~ (~~~‘)
,)d~,

P, = Pr(Monopoly) = 1 — Po — P2

where ~(.) is the standard normal cumulative distribution function and O’Z is the standard

deviation of the untruncated distribution of ,~relative to the standard deviation of E.33 A

second version of’ this model (for which results are not reported here) has it be variable

profits, not fixed costs, which are random across markets.

Results for this specification are reported in Table 8. The striking result that /2 =

62 = 0 is repeated. In this case, our interpretation is somewhat different. The half-normal

error i~ has a positive expected value. Thus monopoly profits are larger than duopoly

profits in expectation in this specification. The size of this effect is quite consistent with

those reported in earlier specifications. Again defining the monopoly interval as the range

of market sizes for which both duopolies and zero firms have probabilities less than .5, we

find that the top of this range is 2.3 as large as the bottom.

5. Conclusion

This paper has shown how it is possible to estimate structural econometric models of entry

in monopoly markets. The crucial ingredients~of these models are the profitability of the first

and second firm in the market. Inferences about profitability, and about the comparative

statics of profitability in the size of the market, lead to estimates of a ratio of price-cost

~ Weinstein (1964) appears to be the first to have derived the distribution function of
the sum of an independent normal and half normal. The literature on frontier production
functions has relied quite heavily on applications of the density function (see Schmidt, et
al. (1977)). In Appendix B we derive the likelihood function for this case.

26
margins. Further, they allow inferences about the quantitative importance of entry barriers.

We have obtained estimates of the important magnitudes from a sample of retail automobile

markets. These estimates suggest several conclusions. First, the simultaneous-probit results

indicate that there are few if any barriers to entry in small markets. This conclusion is

also supported by the data in Table 3 that indicates the band of “sizes of the market”

in which monopolies are predominant is very narrow. As a purely descriptive matter, the

market size at which the second firm enters is not much above twice the market size at

which monopolists enter. Our economic inference about entry is also robust to alternative

treatments of the game between firms: it changes little whether we treat firms carrying

GM brands as leaders and all others as followers, or all brands as moving simultaneously.

Given the importance of strategic advantage in the theory of entry and entry deterrence,

we were somewhat surprised by this finding.

Finally, the conclusion that there are not high entry barriers in auto retailing does

not imply that there is little market power in the industry. Our estimate of the ratio of

the duopoly price-cost margin to the monopoly price-cost margin is around two thirds.

As the “rational expectations” approach to entry suggests, noncompetitive duopolies are

quite consistent with frequent and successful entry. However, it is worth noting that our

dynamic results suggest that the lags to exploitation of profitable opportunities are quite

long, typically longer than ten years.

27
Table 4 Variable Names, Definitions and Sources

DTOTAL Total number of automobile dealers in the market. (Polk and PB)
TOWNPOP 1980 population of the town with the dealer(s) or the largest town
in the county if there is no dealer (1980 CP or RM).
OPOP 1980 population within 10 miles of the town with the dealer(s) or
the largest town in the county if there is no dealer (1980 CF or RM).
NEGROW Negative population growth in the dealer’s town from 1970
to 1980 (zero otherwise). (CP)
POSGROW Positive population growth in the dealer’s town from 1970
to 1980 (zero otherwise). (CP)
INCOME Per Capita income in 1979 dollars. (1980 CP)
LANDVAL Average market value of land and buildings per acre of farm land
in 1978. (CCDB series 208) , *

RETWAGE Average annual wage of paid employees in retail establishments in

1977 (CCDB series 181/180)
CONSTANT - A constant term. -

Sources:

Polk The 1982 R.L. Polk Dealer Census.

CP The 1980 and 1970 Census of Population.

CCDB The 1980 County and City Data Book.

PB Phone Books.

RM The 1985 Rand McNally Commercial Atlas and Marketing Guide.

28
TABLE 5 Descriptive Statistics’1

Variable Mean Stand. Dev.

‘ TOWNPOP 1885 1353

OPOP ‘ 653 584

INCOME 5789 1109

LANDVAL 284 207

RETWAGE 5.23 0.93

NEGROW -58 117

POSGROW - , 162 349

N ‘ ‘ 149

‘ Sample Means -

MARKETS OBS. TPOP OPOP NEGROW

NONOPOLIES 34 827 561 -56

MONOPOLIES 42 1507 555 -43
DUOPOLIES 40 2282 691 -80
TRIOPOLIES 25 2844 717 -51
QUADOPOLIES + 8 3396 1171 -57

‘1 Population variables are divided by 1000 in the estimation.

29
 )

TABLE 6 Simultaneous Move Probits with Dependent Errors

Variable Coefficient Coef. Estimate Coef. Estimate

(t Statistic) (t Statistic)

OPOP Al .203 .177

(1.21) (.856)

NEGROW 2.511 2.516

(3.82) (3.44)

POSGROW A3 -1.401 -1.397

(-3.29) (~2
.55)

F-monopoly fo 0.961 .987

(3.05) (.719)

F-duopoly /2 0.574 .580

(1.76) (1.69)

F-RETWAGE 1~~ -.017

(~.001)

F-LANDVAL ft .104
(.39)

h-monopoly Go 1.440 - 1.414

(4.62) (1.14)

h-duopoly 92 - .474 -.487

(-1.60) (-1.50)

h-INCOME 9’ -.067
(-.414)

h-RET WAGE 9,. - .042

(.19)

h-LAND VAL .064

(.65)

Log Likelihood -117.5 -116.9

N 149 149

30
TABLE 7 Simultaneous Probits

Simultaneous Move GM Leader

Variable Coefficient Coef. Estimate Coef. Estimate

(t Statistic) (t Statistic)

OPOP A1 .203 .253

(1.21) (1.54)

NEGROW A2 2.512 2.182

‘ (3.83) (3.515)

POSGROW A3 -1.403 ‘ -1.393

(-3.31) (-3.665)

fo
F-monopoly 1.197 ‘ 1.185
‘ (4.65) , (5.394)

F-duopoly /2 ‘ 0.00 0.00

(0.00) (0.Oo)’
F-GM only IGM ~~.177
‘ (-0.931)

h-monopoly 9~ 1.375 .976 ,

(4.03) (7.40)

h-duopoly ~2 -.445 0.00

(~1.46) (0.00)

Covariance p .7508
(2.88)

Log Likelihood -117.48 -148.3

N 149 149

31
 )

TABLE 8 Duopoly Profit Differs by Half-Normal

‘ Simultaneous Move

Variable Coefficient Coef. Estimate

(t Statistic)

OPOP A, .158
(1.04)

NEGROW A2 2.405 -

(4.04)

POSGROW A3 -1.374 ‘

(~2.70) . -

F-monopoly to 1.153
‘ (3.39) ‘

h-monopoly 9~ ‘ 1.666 ‘

(4.90) ‘

Std. Dev. ~2 1.335

- (2.25)

Log Likelihood -116.4

N 149

32
 Appendix A

Data and Sample Selection Descriptions

Our search for proper retail markets was structured by the availability of data. We
started by identifying all counties in the U.S. that could be considered small and isolated.
Our first criterion was that the county have 1980 census population less than 10,000 people
(in the CCDB). We then used the DC to tell us where dealerships were located in these
counties. For each dealer, we have the name, address (including county), and brands that
the dealer carries. When the dealer carried more than one brand (a “dual”), we counted the
dealer as a single dealer carrying multiple brands.34 Using the Rand McNally Commercial
Atlas, we then refined our notion of a market by collecting population and distance data
on the towns and cities in or near all of these counties. All distances to the largest town in
the county or town with a dealer (Town 1) are measured in straight line distances.35 The
distance and population criteria for inclusion in our sample were:

i. No other town with population over 1000 lies within 25 miles of Town 1.
ii. No town or city with population over 1000 is so large and near that its population
divided by its distance (in miles). from Town 1 is over 600.
Thus, our sample consists of rural counties that contain isolated towns. They are not in an
archipelago of small towns nor are they exurban. These selection criteria led to a sample of
149 counties that included 34 nonopolies, 42 monopolies, 40 duopolies and 33 markets with
more than two firms. Coincidentally, all dealers were located in Town 1 and no monopolies
were duals.

We are reasonable certain a priori that these selection criteria mean that we have a
sample of genuine markets. For example, the twenty five mile minimum distance implies
a new car buyer has at least a fifty-mile round trip for all warranty service. The average
distance from Town 1 to the next town over over 1,000 people is over 40 miles in our sample.

~ An ambiguity arises with listed dealers who had no automobile brands. For example,
several dealers had names— “Broadus Truck Supply”, “Highway Garage” —that suggested
their primary line of business was not automobile retailing. We excluded counties involving
such dealers, rather than designating those dealers as either one or zero firms.
~ When there are other small towns within two miles of Town 1, we take them to be
part of TownS ‘1 for our analysis.

33
Both distances and populations in and out of town were collected and cross checked from
several sources (see Table 4). The variable OPOP is an imputed population measure that
was constructed as follows. It includes all population in towns within ten miles. We then
counted all (significant) population in towns in the county and subtracted this from the
reported Census population from the county.36 The appropriate density outside of town
and within 10 miles was computed using this residual population. (We assumed that this
population was uniformly distributed within the county.)
As the market definition is crucial to the definition of our dependent variable, we tested
this definition by including the distance to the next town and similar leakage variables in
our basic specifications. To try and test for the adequacy of our geographical market
selection, we expanded the above specification of density to include two additional terms:
TOWN2POP, which is the population of the next largest town of over 500 people37, and
OUTCTY, which is the number of people who regularly work outside of the county. As
our sample of counties was chosen so that the nearest (large) town was at least 25 miles
by road, TOWN2POP should have no significant effect on density. We included OUTCTY
as a further check on how likely (or easy it is) for people to reach dealers outside this
market. These variables are systematically insignificant when included in the specifications
reported in Tables 6 and 7, and do not qualitatively change the other coefficients. (The
OUTCTY coefficient is always consistent with the idea that people who leave the county
are less bound to the local dealer. -

36 In some cases seasonal population variations, Indian reservations, and geographical

peculiarities led to minor modifications of this procedure.
~ Often this town is in the next county.

34
 Appendix B

This appendix derives the likelihood function for the model where the dealer’s mon-
opoly error terms are perfectly correlated normal random variables and the- duopoly errors
are the sum of the monopoly error and a negative half normal.

A. No dealers

The probability of observing no dealers is given by

P0 = Pr(No Dealers) = Pr(111 < E~) = 1 —

where ~(.) is the standard normal cumulative distribution function.

B. Duopoly

The probability of observing two dealers is given by

P2 = Pr(Duopoly) = Pr(Tr2 > 172 — Ej).

This probability statement requires us to eval~iatethe cumulative density function of a half

normal (HN) minus a normal (N) random variable. Assume that E
1
has variance 1 and that
‘12 corresponds to a normal random variable ~ with variance o~that has been truncated
at zero. It is well known that -

‘12 > 0
pdf(172) =
0 172<0

where ~(.) is the standard normal density function. Thus

Pr(fl’2 > ‘12 — Ei) =

~‘OO

j —

fl
J~fl +ci

0
2
pdf(112) d172 ~(e’) dE1
2

=f~2 [2~(f12÷Ei) _1]~(i)dEi

= ~(—ir2) — 1 + 2f ~ (iT2+ El) ~ dE1.

35
 )

Duopoly
Figure 1: Simultøneous Moves -

Monopoly
41 Profitable for I Profitable for I

Monopo’Iy-2
~ :UOPO1Y
‘I

- ~-~--

111111111111111111111I’l ‘I’ll

No Firms Monopoly-i
~ UI

-ii~
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