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Pricing and Market Concentration in Oligopoly Markets

Stern School of Business, New York University, New York, New York 10012
Graduate School of Business, The University of Chicago, Chicago, Illinois 60637
vsingh{at}stern.nyu.edu
tzhu{at}chicagogsb.edu

This paper investigates the relationship between prices and market concentration in the auto rental industry. We assemble an original database that includes the number of auto rental operators and other exogenous demand and cost conditions at every commercial airport in the country. The data are interesting because we observe a large variation in market structure, ranging from more than 100 monopoly and duopoly markets to several competitive airports with more than eight firms. In addition, we collect daily rental prices in each market that are regressed against the number of operating firms and other control factors. Due to potential biases in treating market participants as exogenously assigned, we employ a two-stage estimation procedure in which an equilibrium model of endogenous market structure provides correction terms for the second-stage price regression. Results show that ignoring the endogeneity of market structure severely underestimates the impact of additional competitors on prices, with the competitive interaction parameters doubling in magnitude after the correction procedure. The downward bias in the competitive parameter can have important implications for horizontal mergers, which may incorrectly appear innocuous when using a model that ignores the endogeneity of market structure. More generally, our results serve as a warning on the potential biases to a large number of applications in marketing and economics that attempt to relate outcome variables such as prices, markups, or profits to the observed market structure.

Key Words: pricing; market structure; entry; horizontal mergers; endogeneity
History: Received: July 14, 2006;