EC2212 Industrial Growthand Competition

Lecture 6

Sustaining technology lets skilledearly entrants destroy competitors.

Shakeouts• New products: often rise then fall in number of

producers

• Fall in number of producers often called a“shakeout”

• Most products have shakeouts, within 3+ decadesof when the market forms

• Can be very dramatic: US automobiles went from273 producers to 5

• Concentrated market shares tend to result

1894 1912 1930 1948 1966

0

55

110

165

220

275firms

exit

entry

US Automobile Producers, 1896-1966

Why Do Shakeouts Happen?

• Focus on the main cause

• … in products with severe shakeouts

• You will see– Evidence on entry and exit

– Theory that best fits the facts• approximately, Klepper (1996, 2001)

– Evidence on early-movers, technology

• Then discuss ramifications

1894 1912 1930 1948 1966

0

55

110

165

220

275

0%

32%

Automobiles

firms

exit

entry

%exit

5-yearmovingaverage

1905 1920 1935 1950 1965 1980

0

55

110

165

220

275

0%

25%

Tires

firms

exit

entry

%exit

5-yearmovingaverage

1945 1956 1967 1978 19890

22

44

66

88

110

0%

24%

Televisions

firms

exit

entry

%exit

5-yearmovingaverage

1942 1952 1962 1972 1982 1992

0

6

12

18

24

30

0%

29%

Penicillin

firms

exit

entry

%exit

5-yearmovingaverage

Firms, Entry, Exit in Four Products (US)

1945 1952 1959 1966 1973 1980

$0

$400

$800

$1,200

0

4

8

12

millionsB&W

priceproduced

Televisions

$0

$400

$800

$1,200

0

4

8

12millionsColor

priceproduced

0

2

4

6

1945 1955 1965 1975

0

4

8

12Penicillin

price (10 $/ lb.)3 prod’n (10 lbs.)6

$1,500

$3,000

$4,500

$0

1900 1910 1920 1930 1940

0

1.5

3

4.5Automobiles

price millionssold

0

100

200

300

1910 1919 1928 1937

0

20

40

60

80

price

millions

Tires

sold

index

Price and Output in the Four Products

Explanation of Shakeouts

Part 1 of 3

Entrants and Their Skills

More Skilled Firms Can Earn More Profit

low highcompetence at R&D

% ofpotentialentrants

Potent ial Ent rants in Year X

Shaded region: firmshave enough skill to earnprofi t > 0 after ent ry

Entry & Growth Drive Down Price

• Limited number of firms have skills neededto enter, at any point in time

• Each year some number of firms can enter

• Firms enter fairly small, but then grow

• Entry and growth increase total output

• More output, lower price (demand curve)

Skill Needed to Enter Rises over Time

low highcompetence at R&D

% ofpotentialentrants

Potent ial Ent rants in Year X

Shaded region: firmshave enough skill to earnprofi t > 0 after ent ry

With lower price, needmore skill to earn a profit

Entry Eventually Stops

low highskill

lowskill

high low highskill

%

Entrants need increasing skill to earn profit > 0, since price falls

Time 1 2 3

EXAMPLE:60 potential firms40 enter

300 potential firms70 enter

800 potential firms0 enter

May be more potential entrants, but eventually no entrants

Explanation of Shakeouts

Part 2 of 3

R&D, Size, and Profit

R&D with Imitation

• R&D improves quality, lowers cost

• Decreasing returns to R&D

• Cost-per-unit-of quality c = c(R), c'<0,c''>0

• Firms benefit from R&D during 1 timeperiod

• Firms imitate all past innovations in thenext period

Firm i’s Profit at Time t

• pt price per unit of quality, pt = ƒ(∑Qit)

• [ct – sic(Rit)] cost per unit produced– ct highest possible cost given imitation of past R&D

– si firm i’s skill at R&D

– c(Rit) cost decreases with current R&D, c'<0, c''>0

• Qit output produced

• Rit spending on R&D

• g(Qit – Qit-1) cost of growth, g'>0, g''>0

Π it t t i it it it it itp c s c R Q R g Q Q= − −[ ]( ) − − − −( ) ( )1

Implications of the Profit Function

• Firms choose Rit, Qit to maximize profit

• Larger firms spend more on R&D– Spread cost of R&D over more output

– Remember lecture 3

• Growth is limited– Firms grow each period

– Increasing marginal cost limits growth

• Size (Qit) and skill (si) enhance profit

Explanation of Shakeouts

Part 3 of 3

Exit (given Size and Skill)

Who Exits When?

• Firms exit if Πit < 0

• Growth causes exit at every t– Growth → ΣQit → pt → profit

• Exiting firms are smallest, least-skilled– Since size and skill enhance profit

• Earlier entrants are larger, ceteris paribus– Have had more time and incentive to grow

• Skilled early entrants are long-run survivors

Summary in Course Notes, p. 89

low highcompetence of managers

% ofpotentialent rants

incompetent :higher costs

competent:lower costs

(Potent ial) Ent rants 1895-1904

low highcompetence of managers

% ofpotent ialentrants

(Potential) Entr ants 1905-1909

low highcompetence of managers

% ofpotent ialentrants

(Potential) Entrants 1910-1916

(By mid-1920s,entr y becomesimpossible.)

How big are f irms that entered in 1895-1904? How big... entered in 1905-1909? How big... entered in 1910-1916?

circa 1904

circa 1909

circa 1916

small

medium (but 80% have exited)

large (but 90% have exited)

small

medium (but 80% have exited) small

Firms always enter at small sizes.As t ime goes on, surviving f irms grow.At any point in t ime, earlier ent rants are larger t han later ent rants.

Size and competence reduce a f irm's costs. Because ofsurvival of the f itt est, f irms in each group are forcedout unt il only competent early ent rants remain.

Implications of the Theory

• Shakeout– Entry eventually stops

– Exit continues forever, causing shakeout

• Earlier entrants have lower chance of exit– Maybe not at first (depends on skill distribution)

– But eventually even high-skilled late entrants exit

• Earlier entrants do more R&D

• Firms successful at R&D survive better

% Survival by Entry Date of Automobile Producers

0 14 28 42 56 70

100%

0.1%

Years of Production

Firms Surviving

Entrants in 1895-1904

1905-09

1910-66

31.6%

10.0%

3.2%

1.0%

0.3%

S 1S 2

0 14 28 42 56 70

100%

0.1%

Automobiles

Years of Production

Firms Surviving

Entrants in 1895-1904

1905-09

1910-66

31.6%

10.0%

3.2%

1.0%

0.3%

S1S2

0 20 40 60 80

100%

31.6%

10.0%

3.2%

1.0%

Tires

Years of Production

Firms Surviving

Entrants in 1901-1906

1907-16

1917-22

1923+

S1

S2

S3

0 9 18 27 36 45

100%

31.6%

10.0%

3.2%

1.0%

Televisions

Years of Production

Firms Surviving

Entrants in 1946-1948

1949-1951

1952+

S2

S1

0 10 20 30 40 50

100%

31.6%

10.0%

3.2%

1.0%

Penicillin

Years of Production

Firms Surviving

Entrants in 1943

1945-52

1953+

S1

S2

% Survival by Entry Date in the Four Products

0 7 1 4 2 1 2 8 3 5

1 0 0 %

3 1 . 6 %

1 0 . 0 %

3 . 2 %

1 . 0 %

Pens, Ballpoint

% Survival by Entry Date in a Non-Shakeout Product

Entrants 1946-50

1951-54

1955-67

1968-79

Years of production

Innovation, % Adoption, by Entry Time in the Four Products

Use same entry-time cohorts as previously, but divide tires cohort 1

Product Innovation type Cohort 1 Cohort 2 Cohort 3Automobiles Product 9 2 1Automobiles Process 3 0 0.1Tires Product 1 0 0Tires Cord 1917 36% 8%Tires Cord 1920 100% 73% 62%Tires Balloon 1923 63% 16% 7%Televisions Product 2 1 0Televisions Process 63 7 0Penicillin Process 5 0 0

Relative innovation rates by product & innovation type — compare cohorts

0

.28

.21

.14

.07

Aut omobi les

1895 1967194919311913

Smoot hed Hazard

Non-Innovat ors

Innovato rs

Innovation and Exit

0

.28

.21

.14

.07

Aut omob i les

1895 1967194919311913

Smoot hed Hazard

Non-Innovat ors

Innovat ors

0

.24

T i r e s

1920 1980

Smoothed Hazard

Non-Innovat ors

Cord &Balloon Tires

Cord Tires

.06

.12

.18

196519501935

0

.24

1952 1980

Smoot hed Hazard

Non-Innovat ors

Te lev is ions

Innovato rs

1966 19731959

0

.36

.18

.27

.09

Pe n i c i l l i n

1959 1992

Smoot hed Hazard

Non-Innovat ors

1983.751975.51967.25

Semisynt hetic Producers

Innovation and Exit in the Four Products

Ramifications of Shakeouts

• In industries with strong sustaining R&D

• High-skilled early entrants dominate

• Other firms may profit for a while– But eventually forced to exit

• Enter early, keep up with R&D, to survive

• Concentration is a natural result– Anti-trust authorities often investifate

– But expect concentration with legal behavior