Monday, December 19, 2016

More on Contestability and the Baysanto Merger

by Levi Russell
In a previous post, I discussed monopoly concerns with Bayer's acquisition of Monsanto. The deal was recently approved by Monsanto shareholders but will likely face significant scrutiny from anti-trust regulators.

In the previous post, I went through a paper by several Texas A&M economists that examined the likely consequences of the acquisition for several row crop seed prices. In this post, I'll make some other comments on contestability.

The A&M paper sticks to standard IO theory:
Concentrated markets do not necessarily imply the presence of market power. Key requirements for market contestability are: (a) Potential entrants must not be at a cost disadvantage to existing firms, and (b) entry and exit must be costless.
In contrast to standard IO theory, VRIO analysis suggests costs are always lower for incumbent firms. Managers of incumbent firms have experience with the specific marketing, managerial, and financial aspects of the industry that new entrants simply don't or must obtain at an additional cost.

Does this imply that no industry is "contestable" in an abstract sense? No. As I pointed out previously, prices are falling in many industries, even in those in which entry would entail 1) significant advantages for incumbents and 2) significant sunk costs. It does imply that the conditions for "contestability" are broader than the standard definition. The resource-based view of the firm provides an alternative view of contestability: The advantages for incumbents and potential sunk costs must simply be small enough that they are outweighed by an entrepreneur's expectation of economic profit associated with entering the industry.

So, when we see apparent divergences between price and marginal cost, as I see it there are three possibilities:

1) there are costs we as third-party observers don't see
2) the economic profit is associated with short-term returns to innovation (e.g. monopolistic competition)
3) there is a legal barrier to entry that is extraneous to the market itself.

This dynamic perspective (which I argue is easily teachable to undergrads) is much more powerful in advancing our understanding of real-world market behavior. Yes, the more unrealistic assumptions made in standard theory allow for more elegant mathematical modeling, but if our goal is to understand causal factors associated with firm behavior, the resource-based view of the fiirm, VRIO analysis, and other dynamic theories are more useful.

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