Innovative Entry: Profit Hidden Beneath the Zero

Abstract

THE traditional models of free entry, zero profit monopolistic equilibrium do not, of course, exclude the possibility that positive profits might still be made by intra-marginal firms if the market is non-uniform, or that collusive actions plus barriers to further entry can almost always be used to convert a zero-profit non-cooperative equilibrium into a structure which is profitable for all existing firms. This paper is concerned with situations giving rise to a local Nash equilibrium (no firm can improve by a marginal move), which are zero profit across all firms, but yet in which it is possible for a new firm to enter and make profits (at least in the short run) without collusive action. Entry in such situations will be referred to as innovative entry, since it involves potential entrants looking behind the zero-profit situation actually existing to a possible different structure in which profits are possible, or in which a larger number of firms can be accommodated without losses. This can be contrasted with passive entry, in which firms simply enter industries where actual profits are positive and do not enter those in which actual profits are nonpositive. We shall restrict ourselves to discussion of uniform cases in which all firms make identical profits at equilibrium so as to avoid any difficulty associated with the term ''zero profit. The general context will be that of monopolistic in which product differentiation takes place by variation in the specifications (combinations of characteristics) of the goods produced. The potential variations are considered as points in a space of characteristics, with dimensionality determined by the number of characteristics actually relevant to consumer choice among the products. The market structure arising within this context when there is free entry, no collusive behavior, frictionless change and complete information, has been termed perfect monopolistic competition by the author, and discussed fully (at least for the case of two characteristics) in Lancaster [5]. Within this structure, it will be shown that innovative entry is possible, even when there is passive entry equilibrium (because actual profits of all firms are zero), in at least two cases: