American Economic Association

Understanding Rent Dissipation: On the Use of Game Theory in Industrial Organization

Author(s): Drew Fudenberg and Jean Tirole
Source: The American Economic Review, Vol. 77, No. 2, Papers and Proceedings of the
Ninety-Ninth Annual Meeting of the American Economic Association (May, 1987), pp. 176-183
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/1805447
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 GAME THEORYAND INDUSTRIALORGANIZATIONt
Understanding Rent Dissipation: On the Use of Game Theory
in IndustrialOrganization
By DREw FUDENBERG AND JEAN TIROLE*
Game theory has had a deep impact on
the theory of industrial organization, in a
similar (but less controversial) way as the
rational expectations revolution in macro-
economics. The reason it has been embraced
by a majority of researchers in the field is
that it imposes some discipline on theoretical
thinking. It forces economists to clearly
specify the strategic variables, their timing,
and the information structure faced by firms.
As is often the case in economics, the re-
searcher learns as much from constructing
the model (the "extensive form") as from
solving it because in constructing the model
one is led to examine its realism. (Is the
timing of entry plausible? Which variables
are costly to change in the short run? Can
firms observe their rivals' prices, capacities,
or technologies in the industry under consid-
eration? Etc.)
A drawback of the use of game theory is
the freedom left to the modeler when choos-
ing the extensive form. Therefore, economists
have long been tempted to use so-called
reduced forms, which try to summarize the
more complicated real world game, as for
example in the literature on conjectural vari-
ations, including the kinked demand curve
story. This approach is attractive, but has
several problems. The obvious one is that
the modeler can only be sure that the re-
tDiscussants: Timothy F. Bresnahan, Stanford
University; Richard L. Schmalensee, Massachusetts
Institute of Technology; Robert D. Willig, Princeton
University.
*Departments of Economics, University of Cali-
fornia, Berkeley, CA, 94720, and, Massachusetts In-
stitute of Technology, Cambridge, MA, 02139, res-
pectively. We thank Timothy Bresnahan, Richard
Schmalensee, and Robert Willig for helpful comments.
176
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duced form yields the solution of a full-
fledged model if he has explicitly solved the
model. Also, reduced forms are most natural
for the description of steady states, and are
thus ill-suited to describe battles for market
shares (like price wars, predation, entry and
exit), or to study the adjustment paths to
outside shocks or government intervention.
(Reduced forms are not robust to structural
changes.) While the reduced-form approach
is simpler, and so more amenable to applica-
tions, we believe that the focus on "primi-
tives" implied by the extensive-form ap-
proach allows a clearer assessment of the
model. Furthermore, the diversity of "rea-
sonable" extensive forms may to some extent
reflect the wealth of strategic situations in
industries.
This paper illustrates how game theory
sheds light on a particular issue-the hy-
pothesis of monopoly rent dissipation ad-
vanced by Richard Posner (1975).
Because rents accrue from a monopoly (or
oligopoly) position, rent-seeking behavior is
an important phenomenon in industrial
organization. Following the rent-seeking lit-
erature, Posner argues that firms in general
engage in a contest for monopoly power and
suggests that all monopoly profits may be
added to the usual deadweight loss triangle
(associated with monopoly pricing) in the
social costs of monopoly. The main pos-
tulates behind this analysis are 1) The "rent
dissipation postulate": the total expenditure
by firms to obtain the monopoly profit is
equal to the level of this profit, and 2) The
"wastefulness postulate": This expenditure
has no socially valuable by-products.1
'See Franklin Fisher (1985) for a useful discussion of
Posner's argument.
VOL. 77 NO. 2 GAME THEOR Y A ND IND USTRIAL ORGANIZA TION
If there are a great many potential con-
tenders for the rents, all of whom are exactly
as efficient, then one expects that "free en-
try" will ensure that the rent dissipation
postulate is satisfied. Even here, the waste-
fulness postulate is not always appropriate,
as we will see. Moreover, there are many
situations in which neither postulate is ap-
propriate. Extreme incumbency advantages
may allow established firms to blockade en-
try, and appropriate the entire rent; in some
cases, like that discussed in Section III, this
can occur even if the incumbency advantage
seems "small." We will analyze three differ-
ent forms of rent-seeking behavior, assuming
that firms are symmetric or nearly so. We
argue that the game-theoretic approach helps
to illuminate the key features of these con-
texts, and to explain the nature of rent dis-
sipation in each.
I. NaturalMonopoly
A. Contestability
One of the most provocative contributions
in industrial organization in recent years
has been the theory of contestability (see
William Baumol, John Panzar, and Robert
Willig, 1982), which develops the idea that
potential competition may be as effective as
real competition. This idea is particularly
important for industries in which increasing
returns to scale (for example, fixed costs)
limit the number of firms in the market
(natural monopoly or oligopoly). Suppose
that all firms in an industry have the same
cost function. An industry configuration is a
list of outputs for each firm (zero for the
"entrants," positive for the "incumbents").
A configuration is feasible is there is a price
p at which supply equals demand, and each
firm at least breaks even; it is sustainable if
no entrant (a nonproducing firm) could find
a price pe under p and an output not ex-
ceeding the demand at pe such that it makes
a strictly positive profit, given that the
incumbent firms stick to price p. That is,
in a "perfectly contestable market," entrants
have the same technology as incumbents and
take the latters' price as given.
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177
Let us illustrate the idea in a simple one-
good example.2 Suppose that the common
cost function is C(q) = f + cq if q > O,C(O)
= 0, where f is a fixed cost. Let LIm=
max q{ qP(q) - cq } denote the variable mo-
nopoly profit, where P(-) is the inverse de-
mand function. Suppose f < TItm.The unique
sustainable price is given by (pc - c)D( pC)
= f. Any price under pc yields a negative
profit (price under average cost) and any
price above pc is undercut by an entrant. In
this example, contestability predicts:
Conclusion 1: There is a uniquefirm in the
industry (technological efficiency).
Conclusion 2: Thisfirm makes zero profit.
Conclusion 3: Average cost pricing pre-
vails. Furthermore, the allocation is so-
cially efficient given the constraint that
regulators do not use subsidies.
Conclusion 2 is in accordance with the rent
dissipation postulate of the rent-seeking
literature. Conclusion 3 is at odds with the
wastefulness postulate. Rents are dissipated
in a socially efficient manner by competitive
pricing.
The natural question is which situation the
contestability axioms depict. Unlike the con-
jectural variations approach, contestability
can be given a firm game-theoretic founda-
tion. The price pc is the Nash equilibrium
outcome of a game in which firms choose
their prices first and then decide whether to
produce. The proponents of contestability
have developed a similar justification, based
on the idea of "hit-and-run entry." In this
model, if the incumbent's price exceeds pc,
an entrant will enter at a lower price and
make a profit before the incumbent has time
to lower its own price in response. The hit-
and-run model has been criticized on the
grounds that prices seem to adjust faster
than quantities, even in industries with
"capital on wheels" like the airline industry.
The debate that ensued is, we believe, a
demonstration of game theory's usefulness.
It highlights important aspects of the timing
2This example does not do full justice to the theory
because many interesting aspects of contestability relate
to multiproduct monopolies and cross subsidization.
178 A EA PAPERS AND PROCEEDINGS
and commitment structures of strategic com-
petition in industrial markets.
We next present two alternative, more dy-
namic approaches to natural monopoly, one
at odds with, and the other possibly more
sympathetic to, the contestability approach.
Both reverse the logic of contestability by
assuming that price adjustments are faster
(actually instantaneous) than quantity ad-
justments.
B. War of Attrition
Consider the previous model in continu-
ous time with interest rate r. There are two
firms, and price adjustments are instanta-
neous. If the two firms are in the market,
price equals marginal cost c, and both firms
lose f. If only one firm is in the market, the
price is equal to the monopoly price, and
this firm makes profit flJ - f > 0. Both firms
are in at date 0. Each firm chooses a date at
which to exit (conditional on the other firm
still being in the market at that date). We
claim that the following symmetric behavior
forms a (perfect) equilibrium: If both are
still in at date t, each firm drops out with
probability rf/(I f- ) dt x dt between t
and t + dt and never returns; the remaining
firm remains in forever. To check, note that
each firm's expected profit from any date t
on, given that both firms are still in, is equal
to zero, since the firm is willing to drop out
immediately. By waiting, it loses fdt and
gains the present discounted value of mo-
nopoly profits (fIl' - f)/r with probability
x dt.
A few remarks about this equilibrium.
First, it is consistent with free entry and exit
(in that it is still an equilibrium under cost-
less exit and reentry). Second, it is not
unique; however, if one allows a sufficiently
large symmetric uncertainty about the rival's
fixed (or opportunity) cost (here, the fixed
cost is common knowledge), the symmetric
equilibrium is the unique equilibrium, as
shown in our 1986 paper. See that paper for
references to the literature.
The war of attrition equilibrium yields
Conclusion 1': There are two firms in the
industry for a (random) length of time
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MA Y 1987
and then one (technological inefficiency).
Conclusion 2': Firms earn no ex ante rents
(but may have ex post profits).
Conclusion 3': Theprice is first competitive
and then is equal to the monopolyprice.
The allocation is not "constrained effi-
cient" (and welfare is lower than under
contestability, as is easily checked).
This war of attrition, like contestability,
satisfies the rent dissipation postulate. How-
ever, there is some wasteful dissipation, al-
though the waste is not complete. Because
consumers pay the monopoly price only after
the shake-out period, welfare is higher than
Posner would predict. So this outcome is
intermediate between the solutions suggested
by Baumol-Panzar-Willig and Posner from
the point of view of the wastefulness pos-
tulate.
C. Short-Run Commitments
Let us now assume that capital is sunk in
the short run. The first theory of short-run
commitments was developed by B. Curtis
Eaton and Richard Lipsey (1981). One unit
of capital is necessary for production, and
gives access to constant marginal cost c.
Capital has cost f per unit of time and has
durability H. If only one firm is active (has
capital), its profit gross of capital cost is
f1m-e(f, 2f). If two firms operate (have
capital), they make zero gross profit. The
firm's sole decision is when to build a new
unit of capital. One firm gets to invest first at
time 0. Eaton and Lipsey construct the fol-
lowing (symmetric) strategies. The incum-
bent firm (the one with a plant) always builds
a new plant A( < H/2) years before its cur-
rent plant depreciates. The other firm invests
in a plant if the incumbent has only one
plant and this plant is more than H- -A
years old. In equilibrium, the length A is
chosen such that at H- A the entrant is
indifferent between entering and not enter-
ing. If he does not enter, the incumbent stays
a monopoly forever, and the entrant makes
no profit. If he enters, the entrant makes
profit (- f ) for A years (because the in-
cumbent is still committed to his old plant),
and then enjoys the monopoly profit forever.
VOL. 77 NO. 2 GAME THEORYAND INDUSTRIAL ORGANIZATION
Let
I --rH
flm e capacity q2, gross of the per period fixed cost
V =
r(-A
r r 1_ e-rH
denote the present discounted profit of the
incumbent from date zero on. If he enters,
the entrant gets V minus the loss in mo-
nopoly profit during A years. That is;
(1) V -I f((l1- e-r")r)
or
(2) flm/f = (1-erH)/(e-rA
It is easily checked that, given our assump-
tions, (2) implies that A < H/2. We are par-
ticularly interested in what happens as length
of commitment H tends to zero. From (1), V
tends to zero. And from (2), A/H tends to
1- (f/f1Im). The Eaton-Lipsey model thus
yields for very short commitments:
Conclusion 1": There is only one firm in
the industryat any point in time. (But the
industry is not technologically efficient,
because thisfirm has two units of capacity
(1 - f/ f m) percent of the time).
Conclusion 2": Firms make no profit.
Conclusion 3": The monopoly price pre-
vails.
This model yields Posner's postulates 1 and
2 exactly, as the monopoly rent is dissipated
in a completely wasteful way. This should
not be surprising-the only possible avenue
for rent dissipation in this model is excess
capital, which (by definition) has no social
value.
Eric Maskin and Tirole (1986) point out
that wastefulness is contingent on Eaton and
Lipsey's assumption that the extra unit of
capital cannot be used for production. They
provide a different, discrete-time model of
short-run commitments to capital in which
firms can produce at zero cost up to their
current capacities, which are locked in for
two periods. Firms choose their capacities
sequentially, and the horizon is infinite.3 Let
3Alternatively, the model is equivalent to a continu-
ous-time model in which firms choose capacities q
which, as in Eaton-Lipsey, depreciate in a one-horse-
shay manner, but according to a Poisson process (sto-
chastic H).
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179
fl(ql, q2) denote the per period profit of a
firm with capacity q, when its rival has
f (the usual assumptions on II are made,
including a negative cross-partial derivative).
Let 8 = e -rT denote the discount factor (T
is the period length). As in Eaton-Lipsey,
there exists a unique symmetric Markov per-
fect equilibrium. For sufficiently large 8, a
firm chooses to enter if and only if its rival
=O has capacity less than the entry-deterring
capacity q; if it enters, it accumulates capac-
ity q itself. In equilibrium, q is such that the
e- rH)
entrant is indifferent between entering and
not entering:
8 f
(3) fl(q, ) + fl_8 ( 1-8
(The entrant gets ft(q, 4) - f < 0 when en-
tering and then becomes an "entry-deterring
monopolist" forever.)
From (3), we see that for very short com-
mitments, the per period monopoly profit
U ( q, 0) - f converges to zero. To investigate
the wastefulness postulate, we must wonder
whether the monopolist's capacity q is equal
to or exceeds this production. For this, as-
sume that capacity installation has unit cost
co and fixed cost f. So, if q denotes produc-
tion, (q, 0)-f = maxq < q {qP(q) - (cO4 +
f )}. It is easily checked that if the installa-
tion cost is large, the monopolist produces to
capacity: q = q. We thus conclude in this
case that for very small commitments, the
outcome is exactly that predicted by con-
testability. Rent dissipation operates through
price reduction, rather than through excess
capacity.
II. The Adoption of New Technology
Now we turn to a model in which the
"strategic" choice variable for the firms is
the time to adopt a new technology. All
firms know that due to technological pro-
gress, the cost of adopting the technology
will fall over time. The model is set in con-
tinuous time, with interest rate r. Let p(t)
be the (perfectly foreseen) cost, in time-
zero dollars, of adopting the technology at
180 A EA PAPERS AND PROCEEDINGS
time t: this is a sunk cost. We assume that
( p(t)exp(rt))' < 0, that ( p(t)exp(rt))" < 0,
that p(O) is "large" (no one wants to adopt
at zero) and that exp(rt)p(t) -* 0 as t -*,
(so that if there are gains from adoption,
then eventually adoption will occur).
We will consider two different forms of
the rent that the new technology provides,
and also two specifications of the informa-
tion structure. As in our 1985 paper, we
focus on the case of negligible information
lags, where firms can observe and respond to
their opponent's action without delay. Here,
the firms may be tempted to adopt the tech-
nology "early" in order to delay or prevent
adoption by an opponent. There is always an
equilibrium in which rents are completely
dissipated by "preemptive adoption." In our
first example, this is the only (perfect) equi-
librium. The second example shows that for
a different specification of the "product
market," there is also an equilibrium in which
the firms can credibly arrange to postpone
adoption until the time that is privately opti-
mal, and thus retain some of the rents.
Changing the information structure of the
game yields dramatically different results.
The "open-loop" information structure con-
sidered by Jennifer Reinganum (1981) corre-
sponds to infinite observation lags, that is,
the firms cannot observe their opponent's
play. In this case, firms are not tempted to
adopt preemptively, and rents are only par-
tially dissipated.
A. Imitation DeterringInnovation
To illustrate our first outcome, consider a
Bertrand duopoly, in which the two firms
initially have constant unit cost co. Each
firm makes no profit. Adopting the innova-
tion reduces the unit cost to c1 <co. Let
V= (co - c1)/r. When only one firm has
adopted, this firm makes Bertrand profit (co
- c1) per unit of time, assuming that co does
not exceed the monopoly price at cost c1
("4nondrastic"innovation). Note that imita-
tion never occurs in this extreme model,
because Bertrand competition with identi-
cal costs yields zero-flow profit. The equilib-
rium time of adoption, tC, is given by V=
p(tc)ert. If one firm, say firm one, planned
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MA Y 1987
to wait to adopt after tC, then firm two
would do better to adopt just slightly earlier.
Thus, any proposed equilibrium adoption
time t with t> tc is vulnerable to preemp-
tive adoption. This intuition was informally
put forward by Partha Dasgupta and Joseph
Stiglitz (1980). (The equilibrium turns out to
require mixed strategies of a special kind,
which we developed in our 1985 paper.)
The outcome satisfies Posner's postulates
1 and 2. There is complete rent dissipation,
and the rent dissipation is socially wasteful
(the consumer price remains to co after the
innovation). The model is extreme in several
respects. First, product differentiation, say,
could lead the preempted firm to follow suit
in the long run. Second, the preempted firm
does not exit in spite of zero gross profit, an
assumption inconsistent with the existence
of fixed costs. Third, that the outcome is
completely wasteful relies on our assumption
that the innovation is not drastic. All these
features can easily be incorporated into the
model to enhance its realism.
B. Delayed Joint Adoption
To give a simple example of delayed adop-
tion, consider the following discrete time
model: Each duopolist initially makes profit
HI> 1 per period. The current cost of adopt-
ing a new technology, p, is constant over
time (this violates our previous assumptions,
but in an irrelevant way,) with 1 < p < (1 +
r)/r where r is the per period rate of inter-
est. If only one firm (the "leader") has
adopted the technology, its flow rent is I + 1
and its rival (the "follower") has flow rent
HI-1. If both firms have adopted, their flow
rent is H again. Thus, the innovation serves
merely to transfer profits from one firm to
the other. At each date, each firm chooses
whether to adopt (if it has not adopted yet)
depending on the previous history.
There are several perfect equilibria in this
game. We focus on the Pareto-inferior and
Pareto-superior ones. Note first that one al-
ways has immediate reaction: If one firm
adopts at t, then the other adopts at t +1,
because the flow profit associated with adop-
tion, equal to 1, exceed the interest pr/(1 + r)
on the adoption cost. The Pareto-inferior
VOL. 77 NO. 2 GAME THEORYAND INDUSTRIAL ORGANIZATION
(preemptive) equilibriumhas each firm adopt
at each date (conditional on not having
adopted before) independently of whether its
rival has yet adopted. In this equilibrium,
both firms adopt at date 0 and have payoff
H -((1 + r)/r)- p < H ((1 + r)/r). Firms
are made worse off by the introduction of
the innovation (" super" rent dissipation).
The Pareto-superior (delayed adoption) equi-
librium has each firm adopt only if its rival
has adopted before. Thus, adoption never
takes place. Each firm's payoff is U ((1+
r)/r). This is an equilibrium because p > 1.
There is no (super) rent dissipation.
It is interesting to note that in the open-
loop information structure (firms do not ob-
serve their opponent's choice), the unique
equilibrium outcome is the preemptive one
described above: given that the rival's adop-
tion date cannot be influenced, it is a domi-
nant strategy to adopt as early as possible,
because the extra flow profit exceeds the
interest saved by delaying adoption by one
period.
This stylized example may be a good model
of an arms race, but it is not a good repre-
sentation of market competition. However,
the example does contain all the intuition
required to understand economically more
interesting examples. Adoption in economic
contexts is studied in our 1985 paper (see
also Michael Katz and Carl Shapiro, 1985).
Let L ( t) and F( t) denote the equilibrium
payoffs of both the leader and the follower
as a function of the time of first adoption.
These curves are displayed for continuous
time in Figure 1. Let T2* denote the fol-
lower's optimal reaction time given that the
leader has adopted at t < T2* (in the absence
of goodwill effects or the like, T2* is inde-
pendent of t). For t 2 t2*, the follower fol-
lows suit immediately so that L(t) = F(t).
The payoff to simultaneous adoption is de-
noted by M(t).
Figure la is similar to imitation deferring
innovation. Only the preemption equi-
librium, with dates T1 for the leader and T2*
for the follower, exists. Figure lb is similar
to delayed joint adoption. In addition to
Pareto-inferior preemption equilibrium at
(T1, T2*), there also exists a Pareto-superior,
delayed joint adoption equilibrium at T2.
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181
L
0
F
Tl T1 T2 t2 time
(a)
L,F, M
L
F
T* T S 2 time
(b)
FIGURE 1
Is this joint adoption equilibrium plausi-
ble? F. M. Scherer (1980) argues that some-
thing of this sort may explain the delay of
the American automobile industry in intro-
ducing seatbelts. Our model predicts that the
joint-adoption outcome is more plausible in
an industry where adoption by one firm trig-
gers a fast response by its rival, which may
be the case for seatbelts.
Joint adoption also requires that players
can and will respond to early adoption by
adopting early themselves. This sort of re-
sponse is ruled out by the open-loop infor-
mation structure considered by Reinganum.
Her results show that in any pure-strategy
open-loop equilibrium, one firm adopts at
T2*, and the other at the time T1*,T1< T1*
< T2*, which is the best response for a firm
whose opponent is certain to wait until T2*.
This outcome is not an equilibrium when
firms can respond to their opponent's ac-
tions: since F(t*) < L(T1*), the firm which
is meant to adopt at T2* would prefer to
deviate and adopt just before T1*, thus pre-
182 A EA PAPERS AND PROCEEDINGS
empting its opponent. Payoffs in the open-
loop equilibrium are intermediate between
those in the preemptive and joint-adoption
equilibria discussed above.
Of course, both negligible information lags
and infinite ones are extreme cases and not
exactly descriptive of any market, so one
might wonder how game theory has contrib-
uted to our understanding of the adoption
problem. Our answer is that without the
discipline imposed by the requirement that
strategy spaces are clearly specified, the cru-
cial role that information lags play in this
problem might be overlooked. Also, our ini-
tial conjecture was that with negligible in-
formation lags, the preemptive outcome
would necessarily occur. The exercise of
characterizing the set of equilibria led us to
discover the possibility of delayed joint
adoption, which seems to be not an artifact
of the model, but the appropriate prediction
in some circumstances.
III. PatentRaces
The final situation we consider is that of
patent races, where we will again see the key
role played by the extent of information
lags. The model here is much like that of
Section II, Part A, except that "winning" is
a multiple-step process. The "race" is a very
stylized notion of the R&D process: Obtain-
ing the patent requires completing a pre-
specified number of steps in a fixed order
and the first one to do so wins the patent.
For simplicity, we further assume that this
process is completely deterministic, and takes
the following form: spending zero maintains
a firm's position, spending 1 increases the
position by 1, and spending 3 increases the
position by 2. There is no discounting, so
that the efficient program is to progress one
step per period. Firms move simultaneously,
and at the start of each period firms are
perfectly informed about their opponents'
past progress. This is the model of Fuden-
berg et al. (1983); Chris Harris and John
Vickers (1985) consider a sequential-move
version with a more general R&D technol-
ogy.
Dasgupta and Stiglitz conjectured that if
one firm had a slightly higher payoff for
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MA Y 1987
winning the patent, or a headstart in the
race, then in equilibrium it would not only
win, but do so while spending no more on
R&D than if it were a monopolist, that is,
there would be no rent dissipation at all.
This prediction is radically different than the
equilibrium outcome in the model of Section
II. The basis for the no-dissipation conjec-
ture is that the favored firm ("FF") can
break even at an investment speed that would
be unprofitable for any opponent. Thus the
FF's opponents predict that it will always
choose to spend just enough to remain ahead,
and so the FF is able to proceed unopposed
at the low, efficient speed.
The key to this argument is that if another
firm did compete for the patent, the FF will
learn of its activities quickly enough to
maintain a lead. This is where the informa-
tion lags resurface. The no-dissipation argu-
ment presupposes that FF cannot be "caught
napping" by an opponent who suddenly ap-
pears on the scene with a commanding lead.
In our special model, this requires that FF
to have a lead of at least 2. More generally,
the FF's lead must exceed the most progress
that can be made in a single period without
spending more than the monopoly value of
the resulting position. Thus, if the time be-
tween periods (the observation lag) is long,
the FF must have a substantial initial ad-
vantage to capture the monopoly rents, as
the observation lag shrinks, the required
asymmetry lessens. Information lags favor
rent dissipation here, contrary to the model
of Section II. Once again, we see that the
extent of rent dissipation is highly depen-
dent on the game-theoretic aspects of the
situation.
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