Strategic Reasons for a Dynamic Estimation Model

Abstract

Until now, we have discussed estimating market power under the assumption that firms engage in a sequence of static games: In each period, a firm maximizes its current profit given its belief about how its rivals behave and assuming that actions in other periods do not affect behavior in this period. We now examine how to model games in which firms interact over many periods: where they play a dynamic game. Each firm maximizes its expected present discounted value of the stream of its future profits. When each firm solves a dynamic optimization problem in which its payoff depends on the behavior of other firms, the industry equilibrium is the solution to a dynamic game. We want to use observations on firms' behavior to measure the extent of competition in a dynamic game. The manner in which we estimate market power depends on the reason for the dynamics: the type of game that firms play. We distinguish between two types of reasons – strategic and fundamental – why firms might play a dynamic game rather than a sequence of static games. If dynamic interactions arise because firms think that their rivals will respond in the future to their current action, we say that the reason for the dynamics is strategic. If a firm solves a dynamic rather than a static problem because its current decision affects a stock variable that affects its future profits, we say that the reason for the dynamics is fundamental.