ADVANCE PRODUCTION, INVENTORIES, AND MARKET POWER: AN EXPERIMENTAL INVESTIGATION

Abstract

I. INTRODUCTION Bertrand-Edgeworth games are an important part of any industrial organization economist's toolkit. The unilateral market power created by capacity constraints represents one of economists' primary methods for modeling supra-competitive prices as a static equilibrium outcome in a price-setting game. (1) The standard Bertrand-Edgeworth model, however, rather restrictively assumes that production is demand and that goods are immediately perishable. In the broad swath of modern economies that includes the production and sale of physical products, these assumptions are often not even approximately satisfied. Goods are routinely produced prior to being offered for sale at retail establishments. Similarly, while the effective shelf life of many products is quite short, relatively few products perish immediately, and many have effective shelf lives that extend throughout a sales season, if not longer. This paper reports a laboratory experiment conducted to assess the effects of having sellers make production decisions in advance rather than to demand, and allowing sellers to carry unsold units across periods on market power in a Bertrand-Edgeworth pricing game. By way of preview, we find that both advance production and an inventory option prominently affect market outcomes: advance production reduces profits relative to a baseline condition, while an inventory option reduces both prices and profits. These results are important as they suggest that deviations from the standard oligopoly structures that routinely arise in natural contexts may fundamentally affect market performance. We organize the paper as follows. Following a brief review of the pertinent literature in Section II, we outline equilibrium predictions for baseline, advance production, and inventory treatments in Section III. Section IV describes the experimental design and procedures, and Section V presents the experimental results. The paper concludes with a short Section VI. II. BACKGROUND A. Theoretical Literature Economists have long recognized the restrictiveness of the standard price-setting oligopoly models. Shubik (1955), for example, argues that when evaluating price-setting duopolies economists should consider price-quantity games where sellers simultaneously post prices and quantities in addition to games where price is the only decision variable. (2) Levitan and Shubik (1978) compute the mixed strategy equilibrium for a duopoly given advance production and unlimited capacities. More recently Tasnadi (2004) analyzes the case of advance production for capacity constrained duopolists pertinent to the present investigation. Tasnadi shows that under very general conditions, advance production raises prices, but leaves seller profits unaffected. The only theoretical work that analyzes the links between product durability and market prices of which we are aware is a stream of literature following (1972) regarding the effects of product durability on monopoly power. Specifically, given sufficiently patient consumers, the Coase Conjecture suggests that infinite durability will eliminate monopoly power. Analytical results are driven by consumers, who drive prices down by waiting for future discounts. (3) To the best of our knowledge, no one has analyzed the effects of product durability on production and pricing incentives for capacity constrained, price-setting duopolists. B. Experimental Literature The relevant experimental literature consists of three strands. A first strand consists of a series of papers establishing that laboratory sellers recognize and exercise the unilateral market power induced by capacity constraints. Pertinent seminal references are Davis and Holt (1994) and Kruse et al. (1994), while some relevant related papers include Davis, Holt, and Villamil (2002), Davis and Wilson (2000), and Wilson (1998). A second strand of the experimental literature studies the effects of advance production on posted price markets. …