Free Entry and Social Efficiency under Vertical Oligopoly

Abstract

We offer a new perspective on social efficiency of free entry through analyzing a successive vertical oligopoly model that explicitly incorporates vertical relationships between industries. We demonstrate that free entry in an industry that produces a homogeneous product can lead to a socially insufficient, rather than excessive, number of firms. This is in contrast to the previous findings in the theoretical industrial organization literature, which found that, in homogeneous final-product markets with Cournot oligopoly and fixed set-up costs, level of entry in the free-entry equilibrium is always socially excessive. In our framework, this previous finding arises as a special case where the downstream or the upstream sector has no market power. It has often been argued that this standard result can provide a justification for apparently anticompetitive entry regulations. Our insufficient entry result indicates that such a justification is not necessarily valid, when vertical relationships are taken into account. This yields an important policy implication, given that entry regulations have often been imposed on industries that produce relatively homogeneous intermediate products.