Regulatory Versus Natural Endogenous Sunk Costs: Observational Equivalence In Rationalizing Lower Bounds On Industry Concentration

Pham Hoang Van (Associate Professor of Economics, Hankamer School of Business, Baylor University) and David D. VanHoose (Professor of Economics and Herman Lay Professor of Private Enterprise, Hankamer School of Business, Baylor University) URL: http://d.repec.org/n?u=RePEc:dpc:wpaper:1413&r=com observe Regulatory Versus Natural Endogenous Sunk Costs: Observational Equivalence In Rationalizing Lower Bounds On Industry Concentration.

ABSTRACT: We propose a theory of 'regulatory endogenous sunk costs'(RESC), in which a captured regulator raises minimum quality standards when market size increases in order to protect incumbent firms. Our RESC theory's predictions that market size is unrelated to industry concentration and positively related to product quality are observationally equivalent to those of Sutton's theory of `natural endogenous sunk costs' (NESC), in which incumbents increase quality investments to compete for a share of a growing market. The NESC theory suggests that, with higher entry costs, incumbents jockey for increased market shares by increasing quality investments. The RESC theory, however, predicts that product quality should be lower with higher entry costs. Entry costs and minimum quality standards each provide incumbents with protection from profit erosions that entry otherwise would produce. A key implication of our analysis is the possibility that some industries might be misclassified as natural oligopolies. We provide a few examples of candidate RESC industries.