Is Dynamic Competition Socially Beneficial? The Case of Price as Investment

David A Besanko, Ulrich Doraszelski, Yaroslav Kryukov

Research output: Working paper

Abstract

We study industries where prices are not limited to their allocative and distributive roles, but also serve as an investment into lower costs or higher demand. While our model focuses on learning-by-doing and the cost advantage that it implies, our conclusions also apply to industries driven by network externalities. Existing literature does not have a clear verdict on whether the investment role of prices benefits or hurts the overall welfare, as there are a number of economic forces at work, e.g. motivation to move down the learning curve faster could be offset by the ease of driving a weaker rival out of the market.

We compute both market equilibrium and first-best solution. The resulting deadweight loss appears small, in the sense that eliminating the investment motivation from pricing decision leads to much worse outcomes. Moreover, eliminating price competition has the same effect, and eliminating both competition and investment role of price leads to even worse outcomes. We conclude that competition and dynamic incentives generated by investment roles of prices are equally important and distinct forces that both work to improve the efficiency of market outcome by a substantial degree. Further investigation into components of deadweight loss shows that while pricing distortions are the key driver of it, they are partially offset by more beneficial industry structure, as market equilibrium often results in more active firms that first-best. While this does cause some war-of-attrition losses from the duplicated effort, it benefits the industry in the long term.
Original languageEnglish (US)
Number of pages9
StatePublished - Feb 8 2015

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