Sunk Cost and Market Structure.

• Author: Stewart, John F.

Most industrial organization economists, be they tradition structure-conduct-performance empiricists or game theorists, would likely approve of the central goal of Professor Sutton's book: a reconciliation of the diverse worlds of pure theoretical results based on the tools of modern game theory and the body of observed statistical regularities generated by over thirty years of cross sectional empirical studies. The task is approached with a combination of pure theory, empirical test and detailed cross-country industry studies.

Sutton properly notes that principal shortcomings of the game theoretic approach to understanding markets are the sensitivity of the results of game theoretic models to the details of the model's specification and the possibility of multiple equilibria with unexplained (or unexplainable) factors determining which equilibrium will be observed. Sutton develops a general set of game theoretic models and attempts to identify those results that are robust to changes in the details of the models and lend themselves to empirical test. These "robust" results are then used as the basis for standard cross sectional empirical analysis. The class of models employed could be described as two stage games in which firms first decide whether or not to enter a market (and incur a given exogenous level of sunk cost) and then, in the second stage, the firms interact to determine market price. Equilibrium in the market is defined by a zero profit condition.(1) The generality of the model is provided by an assumed exogenous factor, "the toughness of price competition," which defines the assumptions under which the post entry price (quantity) determination game is played.(2) The model is also generalized from cases of homogeneous products to differentiated products where advertising decisions become a part of the model and the "effectiveness of advertising" becomes a second exogenous factor.

The robust results from this class of models concern the relationship between market size and the equilibrium market structure as measured by concentration. Specifically the results are obtained for the lower bound of equilibrium market concentration as a function of the exogenous sunk cost to market size ratio. The actual level of equilibrium market concentration can exceed the lower bound depending on the exogenous "toughness" of price competition. In the homogenous good case, the model predicts that the lower bound on concentration will decrease...