Identification and estimation of firms' marginal cost functions with incomplete knowledge of strategic behavior

Abstract

In this paper I develop a new approach for identification and estimation of the parameters of an oligopoly model, without relying on a potentially unverifiable equilibrium assumption. Rather, I consider inference on model parameters when the researcher does not know precisely what decision rule firms use, but is willing to consider a set of possibilities. In contrast to traditional approaches in the literature, the proposed methodology allows firm behavior to vary flexibly across observations, in a manner consistent with many Nash Equilibria. I derive identification results for both homogeneous product and differentiated product markets. Due to the flexibility afforded to firm behavior, the arameters of firms' marginal cost functions may only be set identified rather than point identified. The restrictions of the model are, however, still informative. I find that the size of the identified set for marginal cost parameters depends on the elasticity of market demand, the set of decision rules considered, and the functional form assumptions imposed. I formulate how to compute consistent set estimates for marginal cost parameters and demonstrate the proposed methodology with price and quantity data on the Joint Executive Committee, a 19th century railway cartel. To perform statistical inference implement the methodology of Rosen (2005) to construct asymptotically valid confidence regions for the partially identified marginal cost parameters. The application illustrates how the precision of estimated marginal costs depends on the elasticity of market demand as well as the extent to which firm behavior is allowed to vary.