#GerzenseeInsights "Models of Endogenous Market Structure"

Few numbers carry as much weight in competition policy as the Herfindahl-Hirschman Index (HHI), the sum of squared market shares, which measures how concentrated a market is. A high HHI indicates a market dominated by a few large firms. The common view is that the fewer and larger the firms, the weaker the competition between them. As a result, firms charge higher markups over their costs — increasing their own profits but leaving consumers worse off. But does a high HHI generally signal weak competition?

The Cournot (1838) model is the classic justification for this view. When a fixed number of firms producing a homogeneous good — say corn — compete by choosing how much to produce, the average markup is proportional to the HHI. Lower concentration — for instance, more firms of equal size — means lower prices for consumers and lower profits for firms. From a policy perspective, the natural way to reduce markups is then to increase the number of firms. But this neat relationship is a particular feature of the Cournot model, not a general economic law.

Bertrand (1883) already offers a striking counterexample. If firms sell an identical product and compete on price — instead of quantity — just two firms suffice to drive prices down to marginal cost: a market with an HHI that would alarm any competition authority is in fact perfectly competitive. Baumol, Panzar, and Willig (1982) go even further: a single firm may be enough. In what they call a contestable market, where firms can enter and exit without incurring sunk costs, the mere threat of entry forces a single firm to keep its price at cost.

Sutton (1991) turns the question around: rather than asking how competitive a given market structure is, he asks what drives this structure. Unlike Baumol, Panzar, and Willig, he assumes that entering the market requires a sunk cost. Since two price-setting firms would never recover it — price competition drives markups to zero — only one firm enters. High concentration therefore does not signal weak competition; rather, the market is highly concentrated precisely because price competition would be so fierce.¹

Therefore, a high HHI does not generally signal weak competition, and a closer look at the market is necessary to make an informed decision.

A common view in economic policy is that potential competitors should be free to enter any market; regulatory barriers to entry, such as licensing requirements, should therefore be removed. Free entry, the argument goes, ensures the right number of firms. Mankiw and Whinston (1986) show that this is not generally the case: a market with homogeneous goods and free entry tends to attract too many firms.

To understand this, note that a new firm entering a market affects it in several dimensions. For one, resources are used to set up the firm: new buildings, hiring staff, etc. For another, the additional firm produces more goods, which expands total output — a benefit for society. The efficient number of firms therefore balances these two forces.

Free entry, however, creates a business-stealing externality that entices too many firms to enter relative to the efficient number.

The intuition is the following: when considering whether to enter, a firm compares the profits it expects to earn with the cost of setting up. Part of these profits, however, does not come from additional output: the entrant simply takes over customers that incumbent firms would otherwise have served. Since entrants count this stolen business as a private gain — although for society it is immaterial which firm serves these customers — entry continues beyond the point that is socially desirable.²

A Beethoven entering the “market for classical music”, however, is not just another Mozart, so the result comes with an important qualification: when products are differentiated, a new entrant also creates value by adding variety. In that sense, the firm, while “stealing business” from others, also benefits consumers by offering a new variety of goods. Without perfect price discrimination, customers who value the new product more than they pay for it keep the difference, so the entrant does not capture the full value it creates, which pushes in the direction of too little entry.³

Whether a market has too many or too few firms is therefore an empirical question, not something we can settle by appealing to the invisible hand.

Markups are at the forefront of policy issues. De Loecker, Eeckhout, and Unger (2020) find large increases in markups since 1980, which they interpret as a rise in market power. In response, many have called for policy measures such as stricter antitrust enforcement (e.g., Eeckhout 2021).

Interpreting markups as market power follows directly from the textbook static model of perfect competition, where prices equal marginal cost and firms earn zero profits. From this perspective, one can indeed interpret high markups or persistent profits as evidence of market power. However, once we recognize that firms make decisions over time, high markups need not signal market power.

The classic example is due to Hotelling (1931). Consider the owner of an oil field in a perfectly competitive market. Every barrel sold today is a barrel that cannot be sold tomorrow, since oil is a limited resource for the owner. By selling a barrel today, the owner forfeits the option of selling it tomorrow. Therefore, today’s price exceeds the cost of extraction to compensate the owner for losing that option. This gap is called the Hotelling rent, and it arises even when no firm has any market power.

A similar logic applies whenever capacity is scarce and slow to adjust. Kalouptsidi (2014) studies dry bulk shipping, an industry with many small shipowners. Since new ships take years to build, a surge in demand cannot be met by entry in the short run. Freight rates shoot up and existing ships earn large profits until new capacity arrives. These profits are not the result of collusion but a reward for owning a scarce asset at the right time.

In the dynamic competitive model of Hopenhayn (1992), successful firms earn positive profits after entry, to compensate for the risk of starting a firm: whether a new business will succeed is far from clear, and many entrants fail. On average, entrants just break even. In that sense, profits can be interpreted as the market's reward for taking risk.

This distinction matters for the current debate on rising markups. A markup that arises because firms strategically restrict output may call for a policy response. A markup that reflects scarce resources, limited capacity, or risk is part of how a competitive market allocates resources over time; suppressing it, for example through price caps, can have unintended consequences such as excessively fast depletion of resources, underinvestment in capacity, or too few firms.