International Journal of Industrial Organization

20 (2002) 19–39
www.elsevier.com / locate / econbase

Price reactions to new competition: A study of US

luxury car market, 1986–1997
Hideki Yamawaki
Claremont Graduate University, Peter F. Drucker Graduate School of Management,
1021 North Dartmouth Avenue, Claremont, CA 91711, USA

Received 2 September 1999; received in revised form 6 June 2000; accepted 7 June 2000

Abstract

This paper examines the questions of whether the incumbent responds to entry and which
firms respond to entry in an industry, by using a data sample of the US luxury car market
during the period of 1986 and 1997. The statistical analysis finds that the incumbent’s
response varies across firms, but some group of firms responds to entry similarly. In
particular, this paper finds that the German exporters of luxury cars respond significantly to
the entry of a Japanese rival in the US market similarly by reducing their prices and
mark-ups. The extent to which they respond to entry become greater as the Japanese firm’s
market share increases. The statistical test accepts the hypothesis of the equality of
coefficients among the German firms, but rejects the hypothesis when both the German and
British firms are included in the sample.  2002 Elsevier Science B.V. All rights reserved.

JEL classification: L1; L62; F23

Keywords: Entry; Incumbents’ response; Export price

1. Introduction

The questions of whether incumbent firms respond to entry and how they
respond have been addressed in a number of theoretical studies in industrial
organization since the work of Bain (1956) on barriers to new competition.

E-mail address: hideki.yamawaki@cgu.edu (H. Yamawaki).

0167-7187 / 02 / $ – see front matter  2002 Elsevier Science B.V. All rights reserved.
PII: S0167-7187( 00 )00079-5
20 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

Motivated by theoretical studies that propose a number of predictions about

incumbent firms’ response to entry, a small but growing number of empirical
studies have examined the issues of interaction between incumbents and entrants.
Empirical evidence from these existing studies is, however, rather mixed and
suggests that incumbents respond to entry only selectively. This finding may
indicate the behavior of incumbents who do not change their pre-entry output
levels after entry or who ignore and accommodate entrants (Geroski, 1995).
Alternatively, these empirical facts may reflect the presence of several incumbents
in an industry who respond to entry differently one from another. When firms in an
industry possess different structural characteristics, their responses to entry will
differ because they face different threats and opportunities when entry occurs.
While theoretical work has suggested this possibility, it has not been empirically
addressed in the literature on incumbents’ response to entry. Do all the firms in an
industry respond to entry in the same way? Or do some firms respond more
aggressively to entry, while other firms accommodate entry? Asymmetric re-
sponses to entry among incumbents in an industry have been implied in the
theoretical literature using game theory and suggested more explicitly in the theory
of strategic groups. Theoretical work implies that incumbents’ responses may
differ one from another according to their abilities to respond and their beliefs
about rivals, which in turn depend on their characteristics and prior investments.
Characteristics specific to a firm such as size and dominant position (Gaskins,
1971), cost and quality (Kreps and Wilson, 1982; Milgrom and Roberts, 1982),
and production capacity (Spence, 1977; Dixit, 1980; Kreps and Scheinkman,
1983) are all suggested to play important roles in shaping the firm’s decision to
fight entry. The theory of strategic groups argues that incumbent firms differ
systematically in several structural traits but resemble one another, and therefore
constitute subgroups of firms within an industry. Their responses to entry may be
different one from another because barriers to entry become more specific to the
group of firms that have similar traits within an industry (Caves and Porter, 1977).
This paper contributes to this literature and examines if incumbents respond to
entry and identifies which firms respond to entry in an industry, by using a data
sample constructed for the US luxury passenger car market during the period
between 1986 and 1997. The development of the US luxury car market during this
period provides an interesting case because this market, which had been dominated
by US and European manufacturers, experienced the entry of Japanese firms
through the end-1980s, most notably the entry of Toyota in 1989 with the new
Lexus brand. The industry’s market structure is distinctive in that several types of
firms that have different structural traits – US domestic firms and German and
British exporters – compete in this market. Motivated by previous theoretical
studies that suggest that incumbents’ reactions to entry are firm-specific and / or
group-specific within an industry, the empirical analysis of this paper addresses the
following three fundamental questions: (1) do all the incumbent firms in an
industry respond to entry?; (2) do their responses differ significantly one from
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 21

another?; and (3) do they reduce or maintain their local currency prices of their
products in response to entry?
The remainder of this paper is organized as follows. Section 2 reviews the
theoretical and empirical literature on incumbents’ price response to entry. Section
3 develops the hypotheses to be tested, and Section 4 describes briefly the US
luxury car market and the data sample. Section 5 develops a statistical model to
test the predictions of the theoretical models and presents the results from
estimating price equation. Finally, Section 6 summarizes the main findings and
concludes the paper.

2. Previous studies

2.1. Entry deterrent pricing

Recent theoretical studies of strategic behavior generally assume an asymmetry

of firms in an industry and suggest that incumbents’ response to entry is
firm-specific rather than industry-specific. The classic dominant-firm pricing model
and a dynamic limit pricing model (Gaskins, 1971) assume typically an
asymmetry of pricing and investment behavior between a dominant firm and fringe
firms in an industry. In the dynamic limit pricing model, a dominant firm with a
large market share regulates the entry and expansion of small firms so as to
maximize its long-run profits. Small firms in the industry behave collectively as a
competitive fringe and behave as price-takers.
More recent work analyzes the strategic behavior of a firm assuming asymmetry
between firms in their competitive advantages, which are in turn created by
structural traits specific to each firm. A model of predatory pricing based on
reputation effects suggests that differences in firms’ beliefs about their rivals can
result in entry deterrence (Kreps and Wilson, 1982; Milgrom and Roberts, 1982).
The incumbent who has high cost may be able to build a reputation as a firm that
responds to entry with low prices if it lowers its price in response to entry. The
incumbent preys to signal information about itself as a low-cost firm. The entrant
who infers about the incumbent’s costs from observing its pricing behavior may
then decide not to enter. In this reputation model, the reputation a firm acquires is
clearly specific to the firm, and the firm preys to signal information about its own
production costs and product quality.
In the early limit pricing models (Bain, 1956; Modigliani, 1958; Sylos-Labini,
1962), the key assumption was that the entrant believes that the incumbent will
maintain its output after entry occurs. This threat to produce the same level of
output after entry occurs is not credible since it is not profit maximizing for the
incumbent when both the incumbent and entrant have identical costs. To make the
threat credible, an incumbent needs to commit to a low price after entry. The key
to making the incumbent’s behavior credible is to invest in excess capacity
22 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

(Spence, 1977; Dixit, 1980). An asymmetry between firms is important in this

model in that the incumbent has committed itself in a large sunk investment so that
its threat is credible. Again, it is assumed that one firm has an advantage over its
rivals in the same industry, and its advantage is specific to the firm.
That a firm’s response to rivals in an industry depends on the firm’s ability to
respond has been shown decisively in the previous theoretical literature. Kreps and
Scheinkman (1983) has developed a two-stage game in which capacities are set in
the first-stage by the oligopolists, and production takes place in the second-stage
subject to capacity constraints generated by the first-stage decisions. Their model
thus shows that competitive outcomes depend on the sequence in which decisions
are taken and on the way in which earlier decisions shape firm-specific advantages
and in turn determine the payoffs associated with later decisions (Martin,
forthcoming).
In sum, all these studies incorporate the notion that firms are different from
rivals in an industry in that they possess advantages and disadvantages over others,
and firms interact each other in the industry. One firm’s response to entry,
therefore, may be different from another firm’s response because of the underlying
differences in their characteristics. To examine these issues of firms’ responses to
entry it is necessary to use firm data in empirical analysis.

2.2. Strategic groups

The theory of strategic groups argues that firms in an industry are likely to differ
systematically in their structural characteristics such as the degree of vertical
integration and diversification, the extent to which they advertise and brand their
products, whether or not they use captive distribution channels, whether they are
full-line or narrow-line sellers, whether they operate in the national market or only
regionally, whether they are multinational firms. While these characteristics are
specific to firms and distinguish one firm from another, some firms resemble with
others closely in the industry and recognize their mutual dependence most
sensitively. The industry, therefore, contains subgroups of firms with different
characteristics, which are then referred to strategic groups (Caves and Porter,
1977).
Since strategic groups within an industry are characterized by differing
structural characteristics, their competitive positions in face of entry are different
each other. One group may be well entrenched and protected from new
competition, but another may find new competition more a threat. Barriers to entry
then become specific to the group rather than specific to the industry, and barriers
to mobility between groups may be erected.
This theory suggests, therefore, that one incumbent’s response to entry may
differ from another incumbent’s response, and that their differences are determined
by their strategic positioning in the industry. When they are in the same strategic
group, their response will be more similar. On the other hand, when they belong to
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 23

different strategic groups in the industry, their responses will be significantly

different one from another. Their behavior is thus determined by factors specific to
individual firms as well as mobility barriers.

2.3. Evidence from previous empirical studies

Empirical evidence on the pattern of incumbents’ response to entry has been

derived from studies using surveys and statistical methods. Among the earlier
studies using survey results, Biggadike (1979) found that 46% of the sample of
diversifying entrants perceived no response by incumbents, and Yip (1982) found
that none of his sample of entrants perceived responses by incumbents. Of the 293
US managers who responded to the questionnaire survey by Smiley (1988), nearly
half considered it important to respond to entry. Using a similar survey result in
the UK, Singh et al. (1997) indicated that almost 50% of the respondents would
normally use none or only one of the wide set of actions once entry has occurred.
Among the previous literature using a statistical approach, Cubbin and Dom-
berger (1988) found that the incumbents responded to entry with increasing
advertising expenditures in 40% of the 42 advertising-intensive UK industries they
studied. Lieberman (1987b) studied the post-entry investment behavior of incum-
bent firms in US chemical industries and observed an increase in capacity after
entry. Thomas (1999) studied incumbents’ response to entry in the US ready-to-eat
cereal industry and found that incumbents are more likely to respond to entrants
with an aggressive price response. He also found that incumbents are more likely
to respond when the scale of entry is greater.1
Some of these and other studies address the question of who responds to entry
and suggest that both industry-specific factors and firm-specific factors are
important in determining incumbents’ response. Using historical firm data,
Yamawaki (1985) shows that the pricing and investment behaviors of a dominant
firm are significantly different from those of fringe firms in an industry.
Asymmetric firm behavior was observed in the US Steel industry, where US Steel
responded to a capacity expansion of Bethlehem Steel, while Bethlehem did not
respond to an expansion of US Steel. The work of Cubbin and Domberger (1988)
shows that incumbents are more likely to respond when they are dominant firms in
static markets, suggesting that incumbents’ responses to entry are likely to be
firm-specific and also likely to depend on market structure.
Lieberman (1987b) shows that incumbents are likely to increase capacity in
concentrated industries, suggesting that market structure is important in shaping
incumbents’ decision to respond to entry. Bunch and Smiley (1992) analyzed more
directly the question of who deters entry, but their major concern was to identify
industry characteristics, rather than firm-specific characteristics, as important

1
The hypothesis that the incumbent builds excess capacity to deter entry has been tested by
Lieberman (1987a), and Masson and Shaanan (1986).
24 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

factors in determining the propensity to deter entry. Their statistical analysis found
that for new products strategic entry deterrents are used more often when markets
are concentrated, populated with large firms, and R&D intensive. These studies
thus provide evidence that incumbents are more likely to respond to entry when
their markets are concentrated. Finally, Thomas (1999) found that the incumbents’
response differs between entry by new firms and entry by existing firms. The
incumbent firms in the US cereal industry are likely to accommodate other
incumbents on price but use advertising to fight entry, while they are more likely
to respond to new entrants on price.
In the empirical literature of strategic groups, previous studies have primarily
focused on the identification of strategic groups and the relationships between
strategic groups and profits at industry, group, and firm levels, rather than strategic
groups’ reaction to new entry. Caves and Pugel (1980) found that the behavior of
firms within an industry varies across different groups in the extent of advertising,
foreign investment, exports, and capital expenditure. While the link between an
industry’s strategic group structure and industry performance has been found,
empirical evidence on the link between group membership and firm profitability
has not been well established (e.g. Porter, 1979; Fiegenbaum and Thomas, 1990).
A missing element to establish a link between group membership and firm
profitability is considered various forms of rivalry within group and between
groups (Cool and Dierickx, 1993). The previous literature in this field has not
examined response differences among incumbents of different strategic groups to
new competition.
In sum, these studies suggest that incumbents, in general, respond to entry
infrequently (Geroski, 1995) and that their decisions to respond depend on
industry as well as firm characteristics. Few of these empirical studies, however,
have addressed the issues of response differences to entry among incumbents in an
industry and among incumbents of different strategic groups within an industry.2

3. Hypotheses

The empirical analysis of this paper uses price data on luxury models in the US
passenger automobile market to test the predictions of the theoretical models. The
theoretical models based on game theory offer a general hypothesis that an
incumbent firm’s response to entry is different from other incumbents’ response.
Response differences among incumbent firms are predicted because firms differ in
their resource endowments and thus in their structural characteristics.3 The theory

2
A recent study by Haskel and Scaramozzino (1997) finds evidence that conjectural variations
among firms depend on the ability of other firms to react, which are measured by physical and financial
capacity.
3
The literature of resource-based view of the firm that firm strategy is constrained by the current
level of resource endowments reinforces this prediction. See, for example, Teece et al. (1997).
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 25

of strategic group offers another general hypothesis that an incumbent firm’s

response to entry is different from another incumbent firm’s response, but their
responses are more similar when both firms belong to the same strategic group
than when they are in different groups. Reaction differences among groups arise
because differences in firm characteristics are more distinctive between groups
than within group. The firms within the same strategic group are more homoge-
neous in resources and characteristics, which in turn induce similar behavior
among them. Therefore, we have two basic hypotheses on incumbent firms’
response to entry:

H1: The extent to which an incumbent firm responds to entry is different across
firms within the industry.

H2: The extent to which an incumbent firm responds to entry is the same within
group but different between groups within the industry.

The evidence from the previous studies suggests that incumbent firms are less
likely to respond immediately to entry. Geroski (1995) suggests that these facts
may be consistent with the behavior of incumbents who do not change their
pre-entry output levels after entry (the Sylos Postulate). The alternative hypothesis
he suggests is that incumbents ignore entrants at least until they are well
established. This hypothesis implies that incumbents do not perceive immediate
threats from entrants when they are still small and new in the industry. Incumbents
are more likely to respond when entrants become large and grab a recognizable
size of market share. Thus, our third basic hypothesis is:

H3: The extent to which an incumbent firm responds to entry is positively related
to the entrant’ s market share. If the incumbent responds in price, its price is
negatively related to the entrant’ s market share.

In sum, this study addresses the fundamental question of who responds to entry
in an industry. Do the incumbent firms in an industry respond to entry? If so, do
they respond differently one from another? Are response differences firm-specific
or group-specific? These hypotheses are tested by using product and firm data and
applying them to a fixed-effect model in the statistical analysis presented in
Section 5.

4. US luxury car market

This study uses data on the luxury segment of the US passenger car market to
test the hypotheses derived in the preceding section. This market is chosen for
statistical analysis because it provides us an example of significant entry by
established firms into a new market segment. Three Japanese car manufacturers,
26 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

Honda, Nissan, and Toyota, entered into this segment through the 1980s and
established new brand names and dealer networks for the marketing of Acura
(introduced in 1986), Infiniti (1989), and Lexus (1989), respectively. Among these
three Japanese entrants, Toyota’s Lexus was the most significant entry because it
offered a model (LS 400) based on a new platform that was designed to compete
in this particular market. Another important feature of Lexus was that it
established a network of small numbers of well-focused exclusive dealers in order
to assure a high level of sales per dealer.
Before the entry of Japanese firms, the luxury sedan / coupe segment of the US
passenger car market was competed mainly among US and European brands such
as Cadillac, Lincoln, Audi, BMW, Mercedes-Benz, and Jaguar.4 Among these
brands, at least three distinct groups of producers seem to emerge: a group of US
domestic producers; a group of German exporters; and a British exporter, Jaguar.
While the US parents of these brands are full-line producers and offer much wider
ranges of cars, the European producers, particularly BMW, Mercedes-Benz, and
Jaguar, are highly focused in the luxury / performance automobile segment. On the
contrary, Audi offers a range of up-scale models that share the same platforms
with its parent’s models (VW). The price range for BMW and Mercedes-Benz is
set slightly higher than that of Audi in the US market, reflecting the difference in
their positioning. These three German firms produce cars for this particular
segment almost exclusively in their main plants located in Germany and export
them to the US market,5 and, similarly, Jaguar produces all the cars in the United
Kingdom and exports to the US market. The product range of the three German
firms is highly overlapping, and they compete in virtually every sub-category (e.g.
small-sized, medium-sized, and large-sized sedans) within the luxury segment.
Fig. 1 shows the development of unit sales for the six incumbent firms and the
new entrant in this market over the 1986–1997 period. Fig. 1 does not include unit
sales of convertibles and SUV models because at the time of Lexus’s entry to this
market these types of vehicles were not considered the brand’s important
substitutes. There are at least four distinctive patterns emerging from Fig. 1. First,
Lexus established its position in the market quickly after entry. It entered the
market in 1989, and its unit sales grew rapidly and reached to an initial peak of
95,000 units by 1993. Second, the behavior of unit sales for BMW over time is
very similar to that of Mercedes-Benz. In fact, unit sales for BMW and Mercedes-
Benz declined steadily during the 1986–1991 period, but regained growth in the
subsequent period. Third, Cadillac’s unit sales show a declining trend over the
1986–1997 period, while Lincoln’s unit sales are more volatile with a large
increase in 1990. Finally, Jaguar continues to be a smaller niche seller with less

4
Ford acquired Jaguar in 1989.
5
While BMW and Mercedes-Benz own production facilities in the United States, only sports models
and SUV models are produced in these assembly plants. These models are not included in this study’s
statistical analysis.
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 27

Fig. 1. US unit sales of luxury cars, 1986–1997.

than 20,000 units in this market. Jaguar depended more heavily on the US market
than its German rivals, exporting approximately a half of total shipments to that
market through the 1980s.
During the second half of the 1980s, this market underwent a series of important
tax reforms. The most significant was an imposition of luxury tax of 10% in 1991
that was levied on any sale price in excess of $30,000. Another measure was a
doubling of the gas guzzler tax in the same year which was designed to discourage
owning cars falling below certain fuel efficiency standards. The luxury segment of
the US market shrunk approximately by 24% in unit sales during this period.

5. Statistical analysis

5.1. Statistical model

To test the hypotheses derived in Section 3, this section develops a model which
follows the spirit of the recent empirical literature on the determinants of exchange
rate pass-through in international trade and finance. In analyzing the incumbent
firms’ response to entry in this market one needs to address the issues on the
underlying relationship between prices in the US market and costs in the source
28 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

country for the European exporters of luxury cars. In other words, the relationship
between local currency prices and changes in exchange rates needs to be addressed
in the statistical analysis. Previous work in this literature finds that foreign
exporters change local currency prices of their products less than fully in response
to changes in exchange rates, and price responses are industry-specific and
destination-specific (e.g. Feenstra, 1989; Knetter, 1989; Goldberg and Knetter,
1997 for a survey). A statistical model in this study is therefore developed to
examine the extent to which the incumbent firm changes its local currency prices
in response to the entry of Lexus, given changes in exchange rates.
The model is developed based on the profit-maximizing behavior of foreign
exporters and domestic firms. Demand in the destination market is assumed to
have the general form qit ( pit , p) where qit is quantity demanded for product i in
period t, p is a scalar of prices for n21 varieties of the product, and pit is price in
terms of local market currency. The exporter’s costs and the local firm’s costs are
given by c fit and c jt , respectively, and c fit is in the exporter’s currency, while c jt is
in terms of local currency. Since all the exporters locate production facilities for
the luxury models in question in this study in their source countries, the impact of
local cost factors on the exporter’s price as suggested in the previous literature
(Gron and Swenson, 1996) is likely to be unimportant.
The exporter maximizes the profit function, P fit 5 qit ( pit , p)pit 2 (c fit /e t )qit 2 fi ,
and the domestic firm maximizes the profit function, Pjt 5 q jt ( pjt , p)pjt 2 c jt q jt 2
fj , where e t is the exchange rate expressed as the exporter’s currency per unit of
local currency, and f is fixed costs incurred in the local market. The first-order
condition yields pit 5 lit [ei , uit ; n t ]c itf /e it and pjt 5 l jt [ej , ujt ; n t ]c jt where e
is2( p /q) o j ≠qi / ≠pj the own and cross elasticity of demand with respect to local
currency prices, and u is d(o i ±j pj ) / dpi , i 5 1, . . . , n. This price equation shows
simply that the local currency price of a luxury model produced by firm i is
determined by costs, the foreign exchange rate, and the mark-up. The mark-up
term depends in turn on the elasticity of demand and the conjectural variation,
which in turn depends on the number of varieties through the summations in the
elasticity and conjectural variation.6
Since the main focus of this study is to examine the effect of entry on the
incumbent’s local price, the mark-up term in the price equation is modeled to
capture this effect. Entry of a new firm obviously changes the number of the firms
in the industry and the demand structure. The incumbent may eventually form a
new set of beliefs about the actions of the existing and new rivals in the industry.
The elements of the mark-up term are, therefore, considered to be a function of the

6
As is well known, the conjectural variation approach is generally rejected from a theoretical point
of view (e.g. Shapiro, 1989). However, Dockner (1992), Sabourian (1992), Lapham and Ware (1994),
and Cabral (1995) have provided a formal justification for using the conjectural variation approach on
practical grounds. These studies have shown that under certain conditions the outcome of a static
conjectural model is consistent with the outcome of a dynamic model.
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 29

entrant’s market share (Entry) in period t, ln lit 5 a 0 1 a 1 Entry t . Since the

entrant’s market share is zero in the pre-entry period and takes a positive value
post-entry, this specification allows us to test the predictions of the theoretical
models. Taking the logarithm of the price equation, substituting the mark-up term
into it, the basic price equation for the exporter is given by
ln pit 5 ai 1 ft 1 b1i Entry t 1 b2i ln e it 1 b3i ln c fit 1 u it (1)
where ai is a firm-specific fixed effect, ft is a time-specific effect, and u it is an
i.i.d. error term. The time-specific effect is included to capture macro-economic
effects common to each automobile model in the industry. It is modeled in a
general way by including a time trend.
In Eq. (1), the coefficient for Entry estimates the extent to which the incumbent
firm responds to entry. Hypothesis 1 implies that b1 differs statistically across
different firms, and Hypothesis 2 implies that b1 differs among different groups of
firms. A negative sign for this coefficient suggest that the incumbent reduces price
in response to entry, and the magnitude of price response becomes larger as the
entrant grows in the market.
A negative sign for the coefficient for the exchange rate, b2 , suggests that
changes in currency values are passed through on local price, while a positive sign
implies that changes in currency values are adjusted by changes in the mark-up.
Knetter (1993) finds evidence that German exporters of small cars (1.1–2 liters)
reduced their mark-ups approximately by 3–5% when German mark appreciated
by 10% during the 1975–87 period, while he finds little evidence for such
behavior for German exporters of large automobiles (over 2.1 liters).
The incumbent’s response to entry may take a more subtle form rather than
reducing price directly. Instead, the incumbent may decide to keep the price level
constant while reducing the mark-up when the value of its home currency
appreciates against the value of local currency. An appreciation of home currency
increases costs at home and gives an incentive for the incumbent to reduce the
mark-up. This provides us an additional hypothesis:

Hypothesis 4: The extent to which the incumbent adjusts the mark-up in response
to changes in the exchange rate is larger after entry occurs.

This hypothesis will be tested by using a variable interacted between the exchange
rate and the entrant’s market share in the statistical analysis.
Since the price data in this study defined at the level of individual model, Eq.
(1) is rewritten taking into account additional factors

ln pkt 5 ak 1 ft 1 b1k Entry t 1 b2k ln e it 1 b3k ln c fit 1 b4k Entry t * ln e it

1 b5k Tax t 1 b6k NewModel t 1 u kt (2)
where subscript k denotes model k, and subscript i denotes firm i. The coefficient
30 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

for the interaction variable, Entry t * ln e it , tests Hypothesis 4. Tax controls for the
structural break that may be imposed by the luxury car tax and gas guzzler tax in
1991, and NewModel controls for the introduction of a new model in a specific
product class. All the coefficients are specified to vary across different models and
will be tested statistically if they differ across models, firms, and groups: a 5 ai
and b 5 bi .

5.2. Data and variables

The data sample in this study is constructed at the level of luxury models
offered in the US market. Three German firms, BMW, Mercedes-Benz, and Audi,
and one British firm, Jaguar, and two US firms, Cadillac and Lincoln, are included
in the sample because these brands are considered to be major competitors of
Toyota’s Lexus. The number of models included in the sample varies across firms
according to the availability of price series within a particular model class over the
1986–1997 period and the offering in the US market of models by individual
firms. For example, three models are included for BMW (3-series, 5-series, and
7-series) and Mercedes-Benz (C-class, E-class, and S-class); but only one model is
used as a sample for Audi (A6). While these firms currently produce and sell other
types of luxury cars such as sports, convertibles, and SUV models for the US
market, these models are not included in the statistical analysis of this paper. This
is because Lexus at the time of entry in 1989 was primarily targeted at the
sedan / coupe segment of the market.
All the variables are constructed annually for the period of 1986–1997. The first
observation year, 1986, was chosen to circumvent the effect of the dramatic
change in foreign exchange rates that occurred in 1985. Import price is expressed
in units of the destination market’s currency (US$), while costs are expressed in
units of the source country’s currency. The foreign cost variable is measured as the
source country’s aggregate hourly earnings (Wage). The exchange rate variable is
measured as the average annual nominal exchange rate (Exchange Rate) and is
expressed in units of the exporter’s currency per US$.7
The extent of entry is measured by the entrant’s market share (Entry) and
defined as a ratio of Lexus’ unit sales to total unit sales in the US luxury market.8
When the market share of Lexus is included as a right-hand side variable in Eq.
(2), it is possible that this variable is susceptible to simultaneity. The statistical

7
In the auto industry labor costs may be considered effectively fixed. This is particularly the case for
Japan where the ‘lifetime’ employment system was in effect in the years of the study and for the EU
where labor-management relationships were institutionalized. This consideration, however, does not
affect importantly the specification of estimating equations because the exchange rate, e, and costs, c,
are included in an additive way in Eq. (1). The coefficient for e is expected to measure the response of
the markup to fluctuations in foreign exchange.
8
The US luxury market is represented by seven brands: Audi, BMW, Mercedes-Benz, Jaguar, Lexus,
Cadillac, and Lincoln. Convertibles and SUVs are not included in the calculation of Entry.
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 31

analysis uses an instrumental variable to control for possible simultaneity of

market share and compare the results based on the specification including Entry as
it is and the alternative one including an instrumental variable using lagged
independent variables as instruments. The definitions of the variables used in the
statistical analysis are described in detail in the appendix of this paper.

5.3. Statistical results

5.3.1. European firms

Table 1 presents the fixed-effects estimates of luxury car price in the US market
for European car manufacturers. Eq. (1) includes both German and British firms,
while Eq. (2) includes only German firms in the sample. One of the important
findings that emerge from these two equations is that the estimated coefficients for
the three German firms are statistically the same, while the coefficients for the
German and British firms are statistically different. The F-test for the equality of
coefficients (ai , b 5 ai , bi ) for Eq. (1) rejects the null hypothesis at the 1% level
of significance. On the contrary, the F-test for Eq. (2) can not reject the hypothesis
of the equality of coefficients. This result suggests that the incumbents respond to

Table 1
Fixed-effects estimates of luxury car price in the US market: European firms a
Variable German and German
British firms firms
(1) (2)
Entry 1.038 22.410
(3.001)*** (2.107)**
Exchange Rate 20.248 20.741
(2.282)** (4.101)***
Wage 0.177 0.159
(1.899)* (1.657)
Entry*Exchange Rate 20.275 6.093
(0.820) (3.252)***
Tax 20.068 20.040
(1.721)* (0.870)
New Model 0.037 0.032
(1.877)* (1.469)
Time 0.021 0.014
(3.968)*** (2.297)**
Adjusted R-squared 0.945 0.950
F-test for b 5 bi 2.495(56, 36) œœ 1.749(42, 28)
No. of Models 9 9
N 108 84
a
Notes: t-statistics are in parentheses. The levels of significance for a two-tailed t-test are: *510%,
**55%, and ***51%. The levels of significance for a F-test are: œ 55%, and œœ 51%. For both
equations, the hypothesis that a, b 5 ai , bi is rejected at 1% level of significance.
32 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

entry differently, but some of them behave similarly within the industry, providing
evidence that is consistent with the predictions of Hypotheses 1 and 2.
In Eq. (2), which includes only German firms in the sample, the coefficient for
Entry is negatively signed and statistically significant as expected. This result
provides evidence that supports Hypothesis 3 and suggests that the three German
firms are likely to reduce their local prices in response to Lexus’ entry in the US
market.
The coefficient for the Exchange Rate is statistically significant and has a
negative sign, indicating that the German firms increase local prices when their
home currency appreciates against US dollar. While such behavior of passing
changes in currency values on local price is observed for the pre-entry period, it is
significantly constrained during the post-entry period. Indeed, the coefficient for
the interaction variable, Entry*Exchange Rate, is highly significant and positively
signed. Evaluated at the value of Entry during the pre-and post-entry periods, the
pass-through coefficient for the pre-entry period is 20.74, while it ranges between
20.20 and 0.23 in the post-entry period. The German exporters initially reduced
their pass-through responding to the entry of Lexus. However, as Lexus’ market
share increased and reached to 15% of the US market, they squeezed mark-ups
approximately by 2% when German mark appreciated by 10%. The German
exporters enjoyed increasing their prices approximately by 7% when the German
mark appreciated by 10% before Lexus entered in the US market. This result
supports the prediction of Hypothesis 4.
Table 2 presents the fixed-effects estimates of luxury car price for individual
European firms. As the result of the F-tests in Table 1 suggests, the estimation
result for Jaguar is different from those for the three German firms particularly in
that the coefficient for Entry is insignificant and positively signed, and the
coefficient for Wage is highly significant and positively signed in Eq. (4) of Table
2. On the other hand, the effect of the exchange rate on local price is comparable
between the German exporters and Jaguar. This result provides evidence that
supports Hypothesis 4 that the extent to which the incumbent firm adjusts the
mark-up in response to changes in the exchange rate is larger after entry occurs.
The F-tests for BMW, Mercedes-Benz, and Jaguar for the equality of coefficients
can not reject the hypothesis that b coefficients are the same between models
within the firm, suggesting that the pricing policy is likely to be consistent across
models for each firm.

5.3.2. US firms
Table 3 shows the fixed-effects estimates for the US firms. The model
specification for the US firms is different from that of the European firms
presented in Tables 1 and 2 because of their domestic status. Eq. (1) in Table 3 is
the specification derived from model (1) without the exchange rate. In this
specification, the coefficient for Wage is highly significant and has a positive sign.
The coefficient for Entry is also statistically significant but has an unexpected
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 33

Table 2
Fixed-effects estimates of luxury car price in the US market: individual European firms a
Variable BMW Mercedes-Benz Audi Jaguar
(1) (2) (3) (4)
Entry 23.133 20.922 25.487 0.138
(1.978)* (0.565) (2.034)* (0.166)
Exchange Rate 20.578 20.669 20.657 20.444
(2.033)* (2.617)** (1.800) (2.879)**
Wage 20.008 0.049 2.954 1.687
(0.051) (0.359) (1.958) (6.163)***
Entry* 5.626 4.558 11.978 4.016
Exchange Rate (2.148)** (1.706)* (2.745)* (3.209)***
Tax 20.006 20.081 20.081 0.088
(0.092) (1.231) (0.710) (3.793)***
New Model 0.036 0.030 0.065 0.014
(1.182) (0.953) (1.246) (1.127)
Time 0.031 0.004 20.090 20.039
(3.607)*** (0.460) (1.580) (3.143)***
Adjusted R-squared 0.956 0.946 0.924 0.990
F-test for b 5 bi 0.882 2.098 n.a. 1.094
(14,12) (14,12) (7,8)
No. of models 3 3 1 2
N 36 36 12 24
a
Notes: t-statistics are in parentheses. The levels of significance for a two-tailed t-test are: *510%,
**55%, and ***51%. The levels of significance for a F-test are: œ 55%, and œœ 51%. The
F-statistics shown test the equality of coefficients among models for a particular firm. The hypothesis
that a, b 5 ai , bi is rejected at 1% level of significance in all the equations.

positive sign, suggesting that the US firms are likely to increase prices after the
rival’s entry into their home market. This result is not consistent with Hypothesis
3.
Eq. (2) includes two exchange rates, Japanese Yen and German Mark per unit of
US dollar, to test the hypothesis that US firms change their prices in response to
changes in rivals’ home currencies. US firms may exploit the disadvantages faced
by their rivals when their home currencies appreciate against US dollar. When both
exchange rates are included in the equation, the coefficient for Yen / $Exchange
Rate becomes statistically significant and has a negative sign. On the other hand,
the coefficient for DM / $ Exchange Rate is insignificant, suggesting that US firms
are less likely to respond to changes in German Mark, but more likely to increase
their prices when Japanese Yen appreciates.

5.3.3. Difference in pricing across firms within the same product class
The statistical finding so far has been presented without making any distinction
among different model classes. Table 4 presents the F-test results for different
model classes on the equality of coefficients. The F-statistics shown in this Table
thus test the hypothesis that the b coefficients are different across firms within the
34 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

Table 3
Fixed-effects estimates of luxury car price in the US market: US firms a
Variable US Firms US Firms
(1) (2)
Entry 0.584 0.807
(2.208)** (2.952)***
Wage 1.469 1.168
(11.198)*** (8.860)***
Tax 0.004 20.033
(0.130) (1.048)
New Model 0.015 20.002
(0.852) (0.121)
Yen / $ Exchange Rate 20.249
(3.438)***
DM / $ Exchange Rate 20.009
(0.097)
Adjusted R-squared 0.943 0.958
No. of Models 5 5
N 60 60
a
Notes: t-statistics are in parentheses. The levels of significance for a two-tailed t-test are: *510%,
**55%, and ***51%.

same product class. The result in Table 4 for the European firms reinforces the
previous result from Table 1 in this paper. In all the three product classes (small,
medium, and large), the coefficients for the German firms are statistically the same
within each size class. On the contrary, when Jaguar is included in the sample in

Table 4
F-tests for the equality of coefficients across firms within the same product class a
Firms in the sample F-test for b 5 bi
Small size
BMW and Mercedes-Benz 1.545 (7, 8)
Medium size
BMW and Mercedes-Benz 1.358 (7, 8)
BMW, Mercedes-Benz, and Audi 2.086 (14, 12)
Large size
BMW and Mercedes-Benz 1.804 (7, 8)
BMW, Mercedes-Benz, and Jaguar 2.317 (21, 16)œ
Small, medium, and large sizes
BMW and Mercedes-Benz 1.465 (35, 24)
US luxury models
Cadillac and Lincoln 1.518 (20, 30)
a œ œœ
Notes: The levels of significance for a F-test are: 55% and 51%. F-statistics shown test the
equality of coefficients among firms within a particular size class. The model specification for the
European firms is the fixed-effects model presented in Table 2. The specification for the US firms is the
fixed-effects model presented as Eq. (1) in Table 3. See Appendix of this paper for the models included
in each size class.
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 35

the large size class, the coefficients for BMW, Mercedes-Benz, and Jaguar are
found to be statistically different, thus rejecting the null hypothesis at the 5% level
of significance. This result again reinforces this paper’s earlier result that Jaguar’s
pricing behavior is statistically different from that of the three German luxury
makes.
Finally, the pricing behavior of the two US brands, Cadillac and Lincoln, is
likely to be the same as shown in the last row of the table. The F-test can not
reject the null hypothesis in this case. The question of whether US firms behave
differently from European firms is not statistically tested here because the model
specification on the exchange rate is different between these firms.

5.3.4. Simultaneity between price and market share

Since market share is used as a right-hand side variable, it is plausible that
simultaneity bias exists in estimation. To control for possible simultaneity of
market share an instrumental variable was used instead of actual value of Entry in
specification (2). Lagged independent variables were used as instruments for this
variable. In the same specification as Eq. (2) in Table 1, all the signs of the
coefficients and their levels of significance for the three German firms remain
virtually unchanged except for Wage. The coefficient for this variable becomes
statistically significant with a positive sign.
The result for Jaguar, however, changes more significantly. In the same
specification as Eq. (4) in Table 2, the coefficients for Exchange Rate and
Entry*Exchange Rate are no longer statistically significant when an instrumental
variable is used. The coefficient for the instrumental variable for Entry remains
insignificant, but its sign changes to negative. For the US firms, the results remain
unaffected with the use of an instrumental variable for market share. This result
after controlling for possible simultaneity further reinforces the finding that the
pricing behavior of the three German firms is different from that of the British firm
in this market.

6. Conclusions

This paper has examined the questions of whether the incumbent responds to
entry and which firms and groups respond to entry within an industry. The
statistical analysis finds, most importantly, that the incumbent’ response to entry is
specific to the firm, but some of the incumbents respond similarly to entry. The
data sample used in this paper on the US luxury market in the period between
1986 and 1997 shows that among the European firms in the sample German
exporters are likely to behave similarly, but the British exporter behaves
differently from the German firms. The data also finds the response of the US
firms to new entry is different from the European firms.
Secondly, this paper shows that incumbents’ price response to new entry may
36 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39

take a more subtle form when they export from their home countries to the
destination market. The European exporters, particularly the German car manufac-
turers, are likely to adjust their mark-ups in the destination market when their
home currencies appreciate to compete with the Japanese rival. The incumbent
exporter thus squeezes the mark-up to neutralize the effect of an increase in cost at
home on local currency price particularly when it faces new competition.
The finding of this paper that incumbents’ response to entry is specific to the
firm as well as to the sub-group within an industry provides a general support to
the predictions of theoretical work. While this paper does not elaborate what
factors determine the difference in pricing behavior between the incumbents within
the industry, the result in this paper suggests at least that the characteristics
common to the firms from the same base country are likely to be important in
shaping their pricing behavior. Whether the similar response by the German firms
to the entry of the Japanese firm in the US market is motivated by rivalry among
themselves is not unequivocally ascertained in this paper. Future research is
needed to address this issue.

Acknowledgements

I am grateful to Marvin Lieberman and Steve Martin for their comments and
suggestions.

Appendix A. Variable definitions and sources

Entry Market share of Lexus, defined as

Lexus’ unit sales divided by total
unit sales of Audi, BMW, Mercedes-
Benz, Jaguar, Lexus, Cadillac,
and Lincoln. Unit sales of convertibles
and SUV are not included.
(0.089, 0.061).
Exchange Rate Annual average nominal exchange rate
expressed in units of the
source country’s currency per unit of
US dollar (in logarithm).
(0.299, 0.436).
Wage Annual average hourly earnings in
terms of the source country’s
currency (in logarithm). (3.117,
1.373).
 H. Yamawaki / Int. J. Ind. Organ. 20 (2002) 19 – 39 37

Tax Dummy variable equal to one for the

1991–97 period, and zero for
the 1986–90 period. (0.583, 0.495).
New Model Dummy variable equal to one if a new
model is introduced, and zero
otherwise. (0.167, 0.374).
Time Time trend. (6.500, 3.468).
Price Annual dealer list price for a basic
model in the model class in terms
of US dollar (in logarithm). (10.605,
0.318).
Numbers reported in parentheses are (Mean, Standard Deviation) for the
European manufacturers (N5108) used to estimate Eq. 1 in Table 1.
Exchange Rate and Wage are obtained from the IMF Statistics Department,
International. Financial Statistics Yearbook. Entry, Price, and New Model are all
constructed from the data published in Automotive News and Ward’ s Automotive
Yearbook.
Price is constructed for the following models: Audi, 5000-series /A6; BMW,
3-series (325 / 328), 5-series (525 / 528), and 7-series (735 / 740); Mercedes-Benz,
190 / C-class (C-280), E-class (300 / 320), and S-class (420); Jaguar, XJ-6 / XJ-40 /
XJ8, and Vanden Plus; Cadillac, DeVille, and SeVille; Lincoln, MKVII / VIII,
Town Car, and Continental.
In Table 4, small models include 3-series and 190 / C-class, medium models
include 5-series, E-class, and 5000 /A6, and large models include 7-series, S-class,
and Jaguar.

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