Lobbying on Entry Regulations under Imperfect. Competition

Transcription

1 Lobbying on Entry Regulations under Imperfect Competition Dapeng CAI a and Shinji KOBAYASHI b a Corresponding Author. Institute for Advanced Research, Nagoya University, Furo-cho, Chikusa-ku, Nagoya, , Japan, cai@iar.nagoya-u.ac.jp, Tel/Fax: ; b Graduate School of Economics, Nihon University, -3- Misaki-cho, Chiyoda-ku, Tokyo, -836 Japan Abstract e analyze a lobbying game in which an incumbent firm and a potential entrant influence policymakers who decide between granting entry and prohibiting entry. e prove that under all occasions, the policymakers (the common agent) endogenously choose to bargain with only one, and not both firms. e show that the incumbent can successfully persuade the policymakers to prohibit a welfare-enhancing entry when the latter sufficiently value corporate contributions. e also demonstrate the necessity of considering an asymmetric, rather than a symmetric, Nash bargaining solution between the policymakers and one of the firms in the bargaining stage. Keywords: Lobbying; Entry; Spatial competition JEL classification: D7; L3; L5 Authors are listed in alphabetical order; each sharing equal responsibility for the study.

2 . Introduction Consider a regulation in the form of a license or a permit scheme that outright prohibits entry and thus effectively protects incumbent firms from entry by potential entrants. Because firms profits will be affected directly, it is unsurprising to see that both the protected incumbent and the potential entrants are motivated to lobby policymakers: the former in favor of the regulation, and the latter against it. For concreteness, consider the case in which a nonfinancial firm, such as al-mart, seeks approval from the Federal Deposit Insurance Corporation and state regulators to enter the banking business. Clearly, the nonfinancial firm would lobby for entry, whereas the banks would lobby against it. Naturally, whether and how such a lobbying competition can change the status quo merits careful consideration. Nevertheless, despite a large literature on regulation that dates from Stigler (97), Peltzman (976), and Becker (983), and an extensive literature on the political economy of policy formation that stems from the seminal papers of Grossman and Helpman (994) and Dixit et al. (997), this important issue has not been formally analyzed. In this article, we analyze explicitly the effects of a lobbying competition between incumbents and potential entrants on an entry regulation, in which firms seek to influence the political process by means of corporate contributions, and the channels through which they operate. In order to focus our attention on the policymakers endogenous choice of the counterpart for negotiation (the incumbent and/or the entrant) as well as imperfect competition in the product market, we examine a simple linear city model of horizontal See Bernard ysocki, Jr., How Broad Coalition Stymied al-mart s Bid to Own a Bank, all Street Journal (October 3, 6).

3 product differentiation that follows Hotelling (99) and d Aspremont et al. (979). e first show that entry regulations can create both winners and losers: namely, when entry (resp. no entry) is granted to the potential entrant, the entrant (resp. the incumbent) benefits, but the incumbent (resp. the entrant) unambiguously loses. In other words, our model generates an endogenous demand for entry-granting (or entry-prohibiting) regulations, and this motivates affected firms to offer policymakers nonnegative transfers to induce the latter to bend the entry regulation toward their interests. Based on Grossman and Helpman (994), we model such a political interaction under the setting of a bargaining problem. This allows us to analyze explicitly the political interaction among the policymakers, the incumbents, and the potential entrants. 3 In contrast, the existing literature focuses on either policymakers or the competition between interest groups, whereas insufficient attention has been given to the interaction among the policymakers and firms. 4 As for the results, we first show that independent of the particular form of product market competition, when the bargaining powers of policymakers and lobbying firms are equal, the policymakers are concerned with only social welfare and not firms Note that the order of the move of the policymakers in our extensive-form game differs substantially from that of the common agent examined in Bernheim and hinston (986) and Grossman and Helpman (994). 3 In order to focus on the political interactions among policymakers and firms, we abstract from the possibility that consumers (as voters) can also influence the outcomes. This can be justified when either (i) the regulation under consideration is at the discretion of the policymakers, or (ii) the associated information costs can be extremely high to the voters. 4 Stigler (97) and Peltzman s (976) analyses center on a legislator/regulator choosing regulatory policy to maximize political support. In contrast, Becker (983) suppresses the role of the legislator/regulator and focuses instead on competition between interest groups. 3

4 contributions. e then prove a general result showing that when the players have different bargaining powers, the behavior of the policymakers can differ substantially from that when all players have equal bargaining powers, demonstrating the importance of considering the asymmetric Nash bargaining solution rather than the symmetric one. e also prove that the policymakers, being the common agent, choose to bargain with only one firm, and not both of them, when deciding between granting entry and prohibiting entry. More precisely, different from the naïve perception that the lobbying process can be modelled as a common agency problem in which both firms simultaneously lobby the policymakers, we prove that the policymakers are in fact considering two separate bargaining problems, (i) bargaining with the incumbent, and (ii) bargaining with the potential entrant, and will choose strategically the one that generates a higher level of payoff in the extensive-form game described below. Put otherwise, only one firm emerges endogenously as a counterpart for negotiation in the bargaining process. e proceed to demonstrate that the incumbent can successfully persuade the policymakers to prohibit a welfare-enhancing entry when the policymakers value corporate contributions sufficiently. In contrast, the potential entrant can successfully elicit an entry when corporate contributions are not valued highly. To the best of our knowledge, none of the above findings have been reported in the literature. Our results are robust to alternative specifications, including the case of asymmetric production costs, as well as the circular city model of Salop (979). They are also robust to Cournot and Bertrand models, as we show in the Appendix. The intuition of our findings is simple. Policymakers decide on the entry regulation by comparing their potential gains from prohibiting an entry with those derived from granting an entry. Specifically, under our basic model, because entry is always welfare 4

5 enhancing, policymakers choose to prohibit entry only when the contributions from the incumbent firm dominate the welfare loss, as well as the potential contributions that will otherwise be contributed by the entrant. Nevertheless, we argue that the incumbent can be more successful for two reasons. First, the incumbent s losses from an entry are greater than the gains of the potential entrant from an entry under moderate conditions; hence, their willingness-to-pay for prohibiting an entry is higher than that of the potential entrant. Second, when the policymakers value a dollar in their hands more highly than one in the hands of firms, there exists a magnifying effect that magnifies any difference between firms contributions, thus giving the incumbent, whose willingness-to-pay is higher, a further advantage. Consequently, when the magnifying effect is sufficiently large, the incumbent will be able to outspend the potential entrant and cover the welfare loss, hence inducing the policymakers to prohibit entry. In contrast, when the magnifying effect is sufficiently small, it is then possible for the potential entrant to elicit an entry. In other words, under our model setting, there exists a bias against potential entrants, and the potential entrants will be biased even more when the magnifying effect is larger, as is the case under a more corrupt regime. Our results also show that under certain conditions, an economy can fall into a no-entry trap in which the policymakers are successfully bribed by the incumbent firm to block a welfare-enhancing entry. Such traps are more likely to occur in economies where the policymakers are less driven by social welfare concerns (because, for example, their behaviors are not effectively disciplined as under a corrupt regime), consumers willingness-to-pay for the product is higher, and the initial level of competition is higher. The last two are also the conditions under which the incentives of the incumbent to lobby policymakers to prohibit entry are greatest. 5

6 Clearly, our results lend formal support to the well-known findings of public choice theory: that despotic regimes are more likely to be captured by incumbents and to have stricter regulatory systems aimed at maximizing the bribes and profits of a few cronies than to address market failures, whereas such rent extraction should be moderate under better governments to the extent that outcomes in such regimes come closer to representing the preference of the public (see, for example, Olson, 97; De Long and Shleifer, 993). In the literature, it has been widely argued that the incumbents are favored largely because they face lower information and organization costs than do the dispersed consumers. Unlike the literature, we analyze an extensive-form game involving bargaining between the policymakers and the firms to demonstrate that such an outcome can be the result of a different mechanism. The incumbents can be more successful because they tend to outspend the potential entrant in terms of political contributions, and when the policymakers are sufficiently avaricious over contributions, they are further advantaged because their contributions are magnified in the eyes of the policymakers, thus being capable of outspending the potential entrant and dominating the accompanied social loss. e believe that these new insights are relevant to the public debate on the influence of corporate lobbying that has arisen recently in the discussions on campaign finance reform. Our work also contributes to the literature that considers explicitly the influence of firms political participation on the formation of policies. Modeled as common agency problems, Bernheim and hinston (986) and Dixit et al. (997) characterize the equilibrium for a class of such problems. Their approach has been applied to firms 6

7 lobbying behavior behind the formation of trade policy. 5 Nevertheless, the focus of the current article, lobbying competitions on entry regulations between incumbents and potential entrants within the same industry, so far has not been formally analyzed despite the importance of the issue. Our work is also related to a growing empirical literature that examines the firms political participation and existence of entry barriers, which demonstrate how political factors such as democratic accountability (politicians sensitivity to public welfare) can affect actual entry rates. 6 Using data from 85 countries, Djankov, La Porta, Lopez-De-Silanes, and Shleifer () show that countries with heavier regulation of entry have higher corruption, whereas countries with more democratic and limited governments have lighter regulation of entry. Perotti and Volpin (4) also demonstrate that democratic accountability reduces entry barriers. It is reported that in Russia, where the government is described as a grabbing hand, large incumbents have been favored, whereas the entry of new firms is strictly prohibited (Frye and Shleifer, 997; Solanko, 3). Our predictions are broadly consistent with the findings of these studies. No explanation, however, has been provided as to why in these countries, the magnitudes of the entry regulation can vary substantially across industries under the same set of political factors. Our model offers a potential explanation for such variation, because we show that the resulting structure can also depend on the characteristics of the economy that are independent of political factors, such as the consumers willingness-to-pay for the 5 For a survey of studies on the political economy of trade policy, see Maggi and Rodríguez-Clare (998), Grossman and Helpman () and Bombardini (8). 6 See Djankov (9) for an extensive review of the literature. 7

8 product, the level of competition, and the cost asymmetry between the incumbents and the potential entrants. The article is structured as follows. Section describes our model. Section 3 characterizes the equilibrium outcome of the lobbying competition under Hotelling s linear city model. Section 4 discusses the robustness of the main results by examining the case in which there are asymmetric production costs for both the incumbent firms and the potential entrant. e also consider the circular city model of spatial price competition of Salop (979). Brief concluding remarks follow.. The basic model e consider a horizontal product differentiation model due to Hotelling (99) and d Aspremont et al. (979), where a linear city of length lies on the abscissa of a line, and consumers are uniformly distributed with density along this interval. An incumbent (firm ) and a potential entrant (firm ) produce homogeneous products at zero marginal cost, the prices of which are p and p, respectively. e assume that there exists no fixed cost of entry. 7 Let the locations of firms and be l [,] and l [,], and let the transport costs be td, where d is the distance shipped. The unit transport cost t can be regarded as a measure of the level of product market competition because a reduction in t has the effect of reducing the equilibrium price cost margin (see, for example, Aghion and Schankerman, 4). For expositional simplicity, we assume that 7 This assumption is made for the sake of tractability, but it does not affect our analysis in any major way. Clearly, in the presence of a fixed entry cost f, a firm chooses to enter if and only if its profits are at least as large as f. 8

9 l l. ithout loss of generality, we assume that firm locates at point originally. 8 Consumers have unit demands; i.e., each consumes one or zero units of the good. Each consumer derives a surplus s from consumption (gross of price and transportation costs). e assume that s is sufficiently large that every consumer consumes one unit of the product. A consumer living at p p () x l l l l t would be indifferent about which firms to buy from. Thus, demands for the two firms, D and D, are () D min max x,,, D D. e use superscript e for the entry case, and n for the no-entry case. hen firm enters the market, the social welfare e is (3) e D e e e s t y dy ( y l) dy s t l ( D )( l D ), e D 3 and the firms profits are e e e e e e (4) pd p D,. 8 This assumption does not affect our analysis in any major way. 9

10 On the other hand, under the no-entry case, firm is a monopolist and chooses to serve the whole market by setting the price optimally at s t, so that the consumer at n point is just willing to purchase from it. Hence, the monopoly profit equals s t. 9 n Social welfare is then s t y dy s t. 3 Firms may offer corporate contributions to the policymakers, who are in a position to set the decision concerning the entry of the potential entrant. Formally, as in Bernheim and hinston (986), we assume that the two firms contemplate influencing policymakers decisions by offering them a lump-sum contribution C i, where i,. The policymakers are assumed to care about the total level of corporate contributions and about social welfare, with their objective function having social welfare and total contribution receipts as arguments and is given by (5) G C C,, where is an index of the degree to which corporate contributions drive the policymakers decision, which depends on the effectiveness of the underlying checks and balances in the political system. Clearly, a larger indicates that the policymakers are less driven by social welfare concerns because, for example, their behaviors are not 9 Because the incumbent is protected by a regulation, it does not need to consider possible entry from a competitor. Lump-sum monetary contributions are one of the most common tools interest groups resort to when trying to influence the political process to further the interests for their members. Spending on lobbying has grown precipitously in the United States, as well as in other democratic societies (Grossman and Helpman, ).

11 effectively disciplined. hen, the policymakers place a higher value on corporate contributions compared with social welfare; i.e., they value a dollar in their hands more highly than one in the hands of firms, which is similar to the case examined in Grossman and Helpman (994). On the other hand, when, corporate contributions are not valued higher than social welfare by the policymakers. Finally, when, the policymakers become social planners that do not value corporate contributions. Let e n e n G G G be the changes in the policymakers payoff when entry is granted. Because the chosen policy can only be entry or no-entry, we assume that e n entry will be granted if and only if G. In contrast, entry will not be granted when e n G. e n e n Moreover, let be the changes in social welfare when entry is granted to firm. e assume that a social planner that maximizes chooses to e n grant entry if and only if. The resulting payoff for the firm i that contributes is given by (6) i i C i. Accordingly, the payoff for the firm j that chooses not to contribute is j j. The necessary condition for a firm to participate in lobbying is that doing so increases its payoff as compared with the status quo; i.e., the no-entry case. Formally, compared with e n hen G, the policymakers are indifferent between granting entry and not granting entry. Thus, e n there could be mixed strategies at equilibrium for the policymakers when G. e, however, focus e n on pure strategies and assume that entry will not be granted when G.

12 e n e n the status quo, firm lobbies for an entry only if Ci Ci. e assume e n that no lobbying takes place if. hen firms lobby the policymakers to make entry decisions that are in their interests, after a policy is chosen by the policymakers, the policymakers and either the incumbent or the entrant engage in bargaining to divide the maximum level of mutual benefits (joint net benefits). Let n JS be the joint net benefits when entry is prohibited, and let the joint net benefits when entry is granted. e JS be e consider a four-stage game. The players are the policymakers, the incumbent firm, and the potential entrant. The policymakers have two strategies available: granting entry and prohibiting entry. The strategies available to the incumbent and the potential entrant are corporate contributions, location choices, and product competition. The payoffs to the policymakers are social welfare and corporate contributions, whereas those received by the incumbent and the potential entrant are profits minus corporate contributions, respectively. In Stage, the policymakers choose between granting entry and prohibiting entry and then choose a firm to bargain with. By Lemma below and without loss of generality, we can suppose that the policymakers choose to bargain with the incumbent when entry is prohibited, and bargain with the entrant when entry is granted. In Stage, the policymakers bargain with the chosen firm. Because the policymakers can only choose between granting entry and prohibiting entry, if Altogether, there are six strategies from which the policymakers can choose in Stage. Nevertheless, from Lemma below, we can exclude the following four strategies in our extensive form game: (i) granting entry and bargaining with the incumbent; (ii) granting entry and bargaining with both firms; (iii) prohibiting entry and bargaining with the entrant; and (iv) granting entry and bargaining with both firms.

13 bargaining fails, the status quo would prevail. In Stage 3, if entry is granted, both firms choose their locations. Otherwise, the incumbent stays at point. In Stage 4, firms engage in price competition. e employ backward induction to solve this game. 3. The outcome of the lobbying competition In the case where entry is granted, the two firms compete, and maximum e differentiation occurs, with the firms sharing the market equally; i.e., D / e t e t e t (d Aspremont et al., 979). e then have,, s. e propose the following. Proposition. It is welfare enhancing to grant entry to the potential entrant. e n t Proof. Evident because. Q.E.D. 4 The intuition behind Proposition is straightforward. Social welfare improves here because the entry of a new firm reduces the overall transport costs. Moreover, assuming that the surplus that consumers derive from consumption is sufficiently large, i.e., s t, we immediately have the following. 3 Lemma. Given the policymakers decision and assuming that consumers reservation price is sufficiently large, only one firm chooses to lobby. 3 hen s is small, consumers disutility from transport costs relative to the surplus derived from consumption (gross of price and transport costs) can be high. Consequently, firms may set prices higher under duopoly than under monopoly to take advantage of this situation. Clearly, in this case, there would be no divergence of interests. e assume that s t to avoid such cases. 3

14 Proof. Suppose that policymakers choose to grant entry. Firm lobbies and contributes e n e e n n C only when pd C p D, which does not hold because e n e n p t p s t and D / D. Similarly, firm will not lobby when the policymakers choose to prohibit entry. Q.E.D. Lemma shows that when entry is granted to firm, firm will have no incentive to make contributions because doing so further worsens its payoff. Similarly, anticipating that prohibiting entry is to be chosen by the policymakers, firm chooses to make no contributions. The intuition underlying Lemma is straightforward: a rational firm will never try to bribe the policymakers when it knows for certain that it will not request their services. Following Lemma, we model the lobbying process as a bargaining problem. Altogether, there are two possible cases. Case I: Entry is prohibited, and only the incumbent lobbies. Case II: Entry is granted, and only the potential entrant lobbies. A comparison of the firms profits under the entry case and those under the no-entry case reveals that there exists a divergence of interests between the incumbent and the potential entrant concerning the entry regulation: the potential entrant benefits from its entry, whereas the incumbent loses from it. 4 This divergence of interests generates an endogenous demand for entry-granting (or entry-prohibiting) regulations. Indeed, because any individual who is affected by government policy has an incentive to influence the policymaker (Bernheim and hinston, 986, p. 3), it would be 4 e n e n e n e Note that / 3t s, whereas / t. 4

15 unsurprising to observe that the incumbent and the potential entrant will lobby the policymakers with conflicting interests, with the potential entrant pushing for entry, whereas the incumbent pushing against it. Next, we characterize the equilibrium outcome of such a lobbying competition. Given the policy decision on entry, the bargaining problem that we consider is a pair, D, where is a set of possible payoff pairs obtainable through agreements, and D is the disagreement point represented as a utility pair obtainable if the players fail to reach an agreement. e assume that for case I, the policymakers and firm have respective bargaining powers of (,) and, and for case II, the policymakers and firm have respective bargaining powers of (,) and. The bargaining powers are exogenously given before the start of the game. e proceed to present the conditions under which the policymakers would choose to grant entry or to prohibit entry, which are given as Lemma below. To derive Lemma, however, we need to specify the maximum payoffs that the two parties would obtain as a result of being able to reach agreement (Claim ), as well as the conditions under which the two cases hold, respectively (Claim ). e first see the following. Claim. The Pareto frontier f of the set consists of the maximum pairs of the net potential gains that the two parties would obtain as a result of being able to reach agreement. Clearly, the Pareto frontier can be represented by the joint net benefits. The joint net benefits between firm and the policymakers, n JS, are given by 5

16 n n e n e 6 t (7) JS s, 4 which represents the net potential gains that the two parties would share when bargaining n takes place. Clearly, JS when t s 3t. Similarly, the joint net benefits the policymakers to grant entry, can be expressed by e JS for Case II, in which firm successfully lobbies e e n e t (8) JS 4. In the first stage, the policymakers choose their optimal strategy based on their payoff given by (5). Nevertheless, for bargaining to occur, both the policymakers and the firms must benefit from doing so. e then have the following. n e n e Claim. For Case I to occur, we need C and C, which n e n e n implies JS. Likewise, for Case II to occur, we need e n e e JS. Moreover, each firm s contributions need to be feasible; i.e., contributions must be nonnegative and no greater than the aggregate income available to each firm (Grossman and Helpman, 994). e first consider Case I, in which the incumbent lobbies the policymakers to prohibit entry. Anticipating that entry will be chosen by the policymakers when bargaining breaks down, firm provides no contributions unless entry is prohibited. Consequently, the disagreement point is assumed to be the case in which firm makes no 6

17 contributions and the policymakers grant entry to the potential entrant (the status quo); i.e., e e D,. The asymmetric Nash bargaining solution solves the following maximization problem: (9) max C C, n n C, C n e n e where n n f n e n e C, C : C and C. Figure illustrates the asymmetric Nash bargaining solution. Clearly, (9) is equivalent to () max ln C ln C. C n e n e The contribution level C is the weighted average of the welfare loss that the policymakers sustain by preventing the potential entrant from entering the market and changes in firm s profit because of the protection, and is expressed as follows: 5 n e n e 3 () C t s t 4. given by For Case II, the bargaining problem between the policymakers and the entrant is () max C C, C e n e 5 Note that although bargaining power appears in firms contributions, it disappears in the joint net benefits. This is because the bargaining power only affects the distribution of the joint net benefits between the firm and the policymakers. 7

18 and the asymmetric Nash bargaining solution of which is illustrated by Figure. Similarly, the contribution level C for Case II, in which firm successfully lobbies the policymakers to grant entry, can be expressed by e n e t (3) C. 4 Clearly, C when C when. e n e. In particular, when, (Figures and around here) Together with Claims and, we immediately have the following result. e n n Lemma. Entry will be prohibited when G and JS, whereas entry will be e n granted when G and C. Next, we consider the behavior of the policymakers when the bargaining powers of the policymakers and each firm are equal; i.e.,. Clearly, now the bargaining solution in the second stage of our game corresponds to the symmetric Nash bargaining solution. It is then interesting to note that under such a case, the policymakers do not directly care about social welfare when making decisions. Instead, they only value firms gross payoffs. The theorem below demonstrates that when we adopt the symmetric Nash bargaining solution, the policymakers equilibrium strategy is irrelevant to social welfare and is neutral to an index representing the degree to which corporate contributions drive the policymakers decision. To the best of our knowledge, such irrelevancy has not been 8

19 reported in the literature. It is also noteworthy that this result is fairly general in that it does not depend on the particular form of product market competition. Theorem. Suppose that the bargaining powers of the policymakers and each firm are equal. Then, for any, the policymakers strategy at the subgame perfect equilibrium is determined solely by the sign of the difference between the producer surplus without entry (the incumbent s payoff) and the producer surplus with entry (the sum of the two firms payoff). Proof. Define the equilibrium contribution level of the incumbent by C arg max C C. T n e n e Additionally, define the equilibrium contribution level of the potential entrant by C arg max C C. T e n e e then have G C C e n e T n T. e n e e n e n e e Clearly, if, then G if and only if n. Q.E.D. The intuition of this theorem is as follows. Bargaining functions as a redistribution mechanism through which the benefiting firm may use contributions to compensate the policymakers for their possible losses as a result of changes in the entry decisions, as well as to outspend its rivals. As shown in () and (3), the firms contributions consist of two 9

20 parts: a partial compensation for the changes in social welfare, and a part of the firm s gain in its payoff, with the size of each depending on the magnitudes of the bargaining powers. hen, in both cases, exactly half of the changes in social welfare, e n, are contributed to the policymakers, in addition to a half of the firm(s) gain in its payoff. 6 Hence, there is no need for the policymakers to care about e n. The theorem also suggests that when the bargaining powers of the policymakers and each firm are equal, the policymakers optimal decisions are independent of ; i.e., they become indifferent to firms contributions. Nevertheless, when is sufficiently large, i.e.,, the policymakers attach a heavier de facto weight to the changes in social welfare compared with changes in producer surplus, whereas when, they place a higher value on changes in producer surplus. e proceed to examine the situation in which the firms and the policymakers have unequal bargaining powers, we note that Theorem. Suppose that the bargaining power of the policymakers is relatively large, i.e., e n e, we note that (a) if, then for e n e e n, e n we have G and C ; (b) if 6 Because social welfare worsens when entry is prohibited, the incumbents compensate half of the reduction in social welfare, in addition to half of their payoff. In contrast, when entry is granted, because social welfare increases, the potential entrant adjusts its contribution to share a half of the gain in social welfare, although it also transfers a half of its payoff gains to the policymakers.

21 e n e e n, then for, we have G and C. In contrast, when the bargaining power of the policymakers is relatively small, i.e.,, we e n e note that (a) if, e n, then for, we have G ; (b) if e n e e n, then for max,, we have G and C. Proof. Evident from the proof of Theorem. Q.E.D. Clearly, Theorem shows that in general, the behavior of the policymakers when the players have different bargaining powers can differ substantially from that when all players have equal bargaining powers, demonstrating the importance of considering the asymmetric Nash bargaining solution rather than the symmetric one. e next look at the effects of changes in the parameters on the equilibrium contribution level. C In what follows, we assume that. Clearly, C 6 t C s, and 4 t when ; s 3t C 3, t 4 and C t when 6 ; C ; s C 4 t. Put otherwise, the incumbent firm would contribute more either when consumers are willing to pay more for the product or when the policymakers value the corporate contributions less. The effects of the bargaining power and the level of competition, on the other hand, depend crucially on the magnitude of policymakers valuation of the corporate contributions. Moreover, we see that C t C ; ; 4 t 4 C ; s C 4 t. Hence, the potential entrant would contribute more either when its bargaining power is lower, or when the policymakers valuation of the corporate

22 contributions is higher, or when the level of competition is lower. Finally, consumers willingness-to-pay for the product has no impact on the potential entrant s contributions. Using the expressions for n e,, n, e, and e, we can write (4) e n 3 t, s, t,, G t s. 4 Let, and 4 s 3 t. t For tractability and without loss of generality, we assume that. Furthermore, assuming that the policymakers bargaining power is sufficiently high, i.e. s 3 t, s t we propose the following. Proposition. hen the policymakers value corporate contributions sufficiently, the incumbent can successfully persuade the policy makers to prohibit a welfare-enhancing entry. In contrast, when the policymakers valuation of corporate contribution is low, the e n potential entrant can successfully elicit a welfare-enhancing entry. Formally, G n e n and JS when ; G and C when. Proof. Evident from (4) and the assumption that s t, together with Lemmas and. Moreover, C when. Q.E.D. (Figure 3 around here) The intuition behind Proposition is simple. Equation (4) implies that in order for the incumbent firm successfully to lobby the policymakers to prohibit entry, the policymakers, who take the contributions from the incumbent while incurring a social loss, must be better off than they would be if they took the contributions from the

23 potential entrant and realized a welfare increase. Nevertheless, the incumbent can be more successful for two reasons. First, under moderate conditions, the incumbent s loss from an entry would be greater than the gains of the potential entrant from an entry; hence, their willingness-to-pay for prohibiting an entry is higher than that of the potential entrant. 7 Second,, the index of the degree to which corporate contributions drive the policymakers decision, functions like a magnifying lens when ; i.e., when a dollar in the policymakers hands is valued more highly than one in the hands of firms. This magnifying effect enlarges any existing gap between the two firms actual contributions, which gives the more willing to pay incumbent a further advantage. Consequently, when the magnifying effect is sufficiently large, it is possible for the incumbent to be able to outspend the potential entrant and to cover the welfare loss, hence inducing the policymakers to prohibit entry. In contrast, when, functions like a reducing lens and produces a reducing effect that reduces any gap between the two firms contributions. Hence, when is sufficiently small, its presence would advantage the potential entrant, enabling it successfully to elicit an entry. t Moreover, we see that s s 3 t t ; i.e., the critical value is larger when the consumers are willing to pay less for the product, whereas s t s 3 t t ; i.e., is higher when the level of competition is lower. 7 e n e Because s / 3 t, whereas / t, under the assumption that s t, we see that s t. 3

24 Clearly, when s is sufficiently large (as compared with t ), can be smaller than. An immediate corollary can then be given as follows. Corollary. elfare-enhancing entry can be blocked even by policymakers who value social welfare more highly than corporate contributions; i.e., when. Corollary suggests that the presence of relatively benign policymakers (who attach a heavier weight on social welfare, as compared with corporate contributions) alone does not necessarily guarantee a welfare-enhancing entry. Besides the degree to which corporate contributions drive the policymakers decisions, the outcome of the lobbying game also depends on other parameters of the economy, such as the degree to which consumers value the good s and the unit transport cost t. Together, they determine the levels of the payoffs of the players. Some comparative statics of, s, t,, are of particular interest. e propose the following. Proposition 3. elfare-enhancing entry is less likely to be granted either (i) when policymakers are less constrained when taking corporate contributions, or (ii) when there is an increase in competition, or (iii) when consumers are more willing to pay for the good. Proof. (i) 3 t s, hence decreases when increases; (ii) t 6, 4 hence decreases when t decreases; (iii) s, hence decreases when s increases. Q.E.D. 4

25 To summarize, the economies that are most vulnerable to a no-entry trap are those where the policymakers are less driven by social welfare concerns (because, for example, their behaviors are not effectively disciplined by the political institutions), consumers willingness-to-pay for the product is higher, and the initial level of competition is higher. Clearly, the last two are also the conditions under which the incentives of the incumbent to lobby policymakers to prohibit entries are greatest. 8 For tractability, we have assumed that there exists no fixed cost of entry. Clearly, our analysis can be easily extended to the case of a fixed cost of entry. The presence of the fixed entry cost would further disadvantage the potential entrant, because would be less likely to remain positive in the presence of a fixed entry cost. 4. Discussions This section aims at checking the robustness of the preceding results. More importantly, it analyses and quantifies the effects of an asymmetric cost structure on the outcome of the lobbying competition on entry. It also considers the case of a circular city model, à la Salop (979). 4.. The Case of Asymmetric Production Costs. The case of asymmetric production costs is denoted by superscript a. The basic setup and notation of the preceding sections is preserved here, except that now we assume that the unit production cost for each firm is 9 c. Moreover, for tractability and without loss of generality, we assume that. i e n n 8 This is because d / ds and d / dt / 3 ; i.e., the more the consumers are e willing to pay for the product, or the higher the level of competition, the larger is the incumbent s loss. 9 To focus on the effects of asymmetric production costs, again we assume zero fixed entry cost. 5

26 Again, we assume that s, the surplus that consumers derive from the consumption of the product, is sufficiently high that the total demand is equal to one for the range of prices considered. Ziss (993) shows that under the current model formulation, if marginal cost differences between the two firms are sufficiently small, i.e., c t c c t, a price and location equilibrium exists in which both firms produce and maximum differentiation occurs. In contrast, if marginal cost differences are sufficiently large, a location equilibrium does not exist. In what follows, we assume that c t c c t, which allows us to neglect the a a analysis of Stage 3 by simply assuming that l and l. Taking this as given, we see that when entry is granted and two firms compete in the market, their demands are ea c c 3t D 6t ea c c 3t and D, respectively. e then derive 6t (5) ea c c 3t ea c c 3t,. 8t 8t Social welfare when entry is granted is then given by (6) ea 5 c c 8 c c s t 3 t. 36t In contrast, when entry is prohibited and the incumbent remains a monopolist, its na profit is, na s t c and the social welfare is s c t 3. e propose the following. 6

27 Proposition 4. The social planner allows a potential entrant that is not relatively too inefficient (i.e., c c 3t 5 ), as compared with the incumbent firm, to enter the market. Proof e n a c c t c c t 36t From the assumption c t c c t, we see that c c 3t t. Hence, e n a when 5c 5c 3t, i.e., c c 3t 5. Q.E.D. The intuition behind Proposition 4 is straightforward. Allowing a potential entrant that is absolutely more efficient than the incumbent to enter channels some production to this low-cost firm, and this reduces average production costs (the efficiency-improving effect). On the other hand, having one more firm competing in the market reduces transport costs for some consumers (the transport-costs-saving effect). Because of the above two effects, when the potential entrant is not relatively too inefficient, allowing it to enter can be welfare enhancing. Similar to the symmetric cost case examined in the preceding section, a comparison of firms profits under the entry case and those under the no-entry case reveals that when s is sufficiently large, i.e. s 5c c 6 t / 3, there exists a divergence of interests between the incumbent and the potential entrant concerning the entry regulation: the former loses from the entry of a new firm, whereas the latter benefits from its own entry. Clearly, this divergence of interests motivates the two firms to lobby the policymakers. Assuming that s 5c c 6 t / 3, we immediately note that Lemma holds under the As in footnote, s 5c c 6 t / 3 is also imposed here to avoid the possibility that firms may set prices higher under duopoly than under monopoly. 7

28 case of asymmetric production costs: given the policymakers decision, only one firm chooses to lobby the policymakers: when entry is granted, only the potential entrant chooses to lobby (Case Ia), whereas when entry is prohibited, only the incumbent chooses to lobby (Case IIa). e proceed to examine the outcome of such a lobbying competition. e first consider Case Ia. The asymmetric Nash bargaining solution solves the following maximization problem: (7) max C C. a C na a ea na a ea The joint net benefits between the incumbent and the policymakers are JS na na ea na ea (8) c c 5 6 c 3 c s 9 6 t t. 36 na Clearly, JS when 8ct 8ct 5 c c 9t. c t 4c t c c 54t 36st The a contribution level C is given by C na ea a na ea (9) ( c c ) (5 5 ) (6 ) t 36 t 4 c 3 3 c s. 6 8

29 Similarly, for Case IIa, the joint net benefits of the potential entrant and the policymakers are JS ea ea na ea () c c 3t c c 5 3 t 36t, a and the contribution level C is given by () C ea na a ea c c 3t c c t 36 t. a e see that C when 5 5 c c 3t c c 6 t. Using the expressions for na ea,, na, ea, and ea, we can write, s, t,, c, c G e n a ea na ea ea na () 5c 5c 3t c c 3t t 36 c c c s t 9t. Let 5c 5c 3t c c 3t t 36 c c c s t 9t. e propose the following. 9

30 Proposition 5. The incumbent can successfully persuade the policymakers to prohibit an entry when the policymakers valuation over corporate contributions is sufficiently high. In contrast, the potential entrant can successfully illicit an entry when the policymakers valuation over corporate contributions is not high. e n a Proof. From (), we see that when, G when. In contrast, e n a a when, G and C when. Q.E.D. Proposition 5 extends Proposition 3 to the case of asymmetric costs. It first shows that when the policymakers value corporate contributions sufficiently, the incumbent can successfully lobby policymakers to prohibit entry. In contrast, when the policymakers valuation of corporate contributions is not high, the potential entrant can successfully lobby the policymakers to grant entry. Put otherwise, Proposition 3 largely holds in the presence of asymmetric production costs. Clearly, this again can be attributed to the incumbent firms two advantages, as analyzed in the preceding section. 4.. Salop s (979) Circular City Model. In this subsection, we consider another horizontal differentiation model, the circular city model à la Salop (Salop, 979). Superscript is used to denote this case. A continuum of consumers having mass normalized to uniformly distributes on a circumference of unitary length, with points on it identified by numbers in the range,. The values increase in a clockwise direction, and the northernmost point is considered to be both and. Let the locations of the incumbent (firm ) and the potential Clearly, the incumbents willingness-to-pay for prohibiting an entry is higher than that of the potential entrant because a( e n) a( e n) c t / 9 s c c t when s 5c c 6 t / 3. 3

31 entrant (firm ) be l,/ and l,, respectively. ithout loss of generality, we set l l. Both firms produce a homogeneous product at zero marginal cost, and we again assume that there exists no fixed cost of entry. A consumer living at x [ l, l ] incurs a transportation cost of t x l or t l x when he/she purchases the product from firm or, respectively. In contrast, a consumer living at y [ l,] incurs a transportation cost of t y l or t y l when he/she purchases the product from firm or, respectively. Finally, a consumer living at z [, l ] will only choose to purchase the product from firm, incurring a transportation cost of t l z. Consumers have unit demands, and each consumer derives a sufficiently large surplus from consumption (gross of price and transportation costs); i.e., s 3 / 4 t. Again, for tractability and without loss of generality, we assume that. Other specifications of the model follow as in the preceding sections. ithout loss of generality, we assume that l in equilibrium. Following standard procedures, it can be shown that there exists a subgame-perfect equilibrium in pure strategies with the equal distance location pattern (Kats, 995); i.e., l /. As in footnote, we assume that s 3 t / 4 to avoid the possibility that firms may set prices higher under duopoly than under monopoly. 3

32 Let e n o 3 t t G t s, 4 8 6, and t t t 6. s Assuming that 8s 5t, it is easy to show that our results for the linear city largely 8s 4t hold for a circular city. Proposition 6. (i) The social planner grants entry to the potential entrant because its entry is welfare enhancing. (ii) hen the policymakers value corporate contributions sufficiently, the incumbent firm can successfully persuade policymakers to prohibit a welfare-enhancing entry. In contrast, the potential entrant can successfully elicit an entry when the policymakers do not value corporate contributions sufficiently. (iii) elfare-enhancing entry is less likely to be granted either (a) when policymakers are less constrained to take corporate contributions, or (b) when consumers are willing to pay more for the good. The impact of the level of competition depends on the policymakers valuation of the corporate contributions. n t e t n t e t Proof. e have s, s, s,, 48 8 t 8 e. Clearly, (i) e n t n ; (ii) and C if ; whereas and JS 6 if ; (iii) 3, 4 t s 3, t with t if, and. s Q.E.D. Clearly, Proposition 6 is consistent with Proposition and 3, suggesting that our main results hold under the circular city model. 3

33 5. Concluding remarks It is commonly believed that in a regulated market, the incumbent firms are advantaged because they tend to face lower information and organization costs. In this article, we have shown that even if the incumbents and the potential entrants have the same information and organization costs, the incumbents still tend to be more successful in lobbying the policymakers to bend the regulation toward their interests. e argue that this is not only because the incumbents willingness-to-pay for prohibiting entry is higher, and thus they tend to outspend the potential entrants in terms of political contributions, but also because the differential of firms contributions tend to be magnified in the eyes of the policymakers who value a dollar in their hands more highly than one in the hands of the firms. e have also shown that entry regulations tend to persist in industries where the policymakers are less driven by social welfare concerns, consumers willingness-to-pay for the product is high, and the initial level of competition is high. Our results also demonstrate the possibility that welfare-enhancing entry can be blocked even by relatively benign policymakers who value social welfare more highly than corporate contributions. Finally, our results also highlight the importance of considering the asymmetric Nash bargaining solution rather than the symmetric one. e believe that these new insights are relevant to the public debate on the influence of corporate lobbying, which has arisen recently in discussions on campaign financing reforms. In our model, it has been assumed that consumers cannot influence the formation of policies. One possible extension of the current work could consider the interaction among the policymakers, firms, and consumers in the formation of policies. On the empirical side, however, there is a need for more micro-level research to test the implications of the lobbying competition on entry regulations, as predicted by the model. 33

34 Appendix This Appendix considers () the case of Cournot competition, () the case of heterogeneous firms, and (3) the case of Bertrand competition. A.. The Case of Cournot Competition. e use superscript c to denote the Cournot competition case in which both firms produce a homogeneous product at zero marginal cost. The inverse demand function is c c c (A) p a q, q where c c p is price and a represents the market size. The social welfare,, is the sum of firms profits and consumer surplus CS c c c c (A) CS, c c c where p q, i,, and i i c c q q c c c c c c c a q dq q q q q CS ( ) p ( ) ( ) /. nc Under the no-entry case, firm remains a monopolist, with p a /, and nc a The social welfare is then 3 a / 8. e first prove Lemma. nc / 4. Lemma. Given the policymakers decision, only one firm chooses to lobby the policymakers. Proof. Suppose that entry is granted, and firm lobbies the policymakers and contributes c C only when p q C p q, which does not hold because ( e n) c ec ec c nc nc ec nc ec nc q q and p p. The no-entry case can be proved similarly. Q.E.D. From the first-order conditions, we derive the equilibrium outcome 34

35 ec ec (A3) q a / 3, p a / 3, a / 9, a / 9. ec ec Social welfare is given by (A4) ec 4 a / 9. e propose the following. Proposition 7. It is welfare enhancing to grant entry to the potential entrant. Proof. Evident because e n c 5 a / 7. Q.E.D. The intuition behind Proposition 7 is straightforward. Allowing the potential entrant to enter the market increases social welfare because an oligopoly with two identical firms would be more efficient than a monopoly with either one of them: the increase in consumer surplus ( ( e n) c ec nc CS CS CS 7 a / 7 ) dominates the loss in producer surplus ( ( e n) c ec nc PS PS PS a / 36 ). For tractability and without loss of generality, we assume that. e first consider Case Ic, in which firm lobbies the policymakers and entry is prohibited. The asymmetric Nash bargaining solution solves the following maximization problem (A5) max c C C C. nc c ec nc c ec The joint net benefits nc JS are (A6) nc nc ec nc ec 5a JS. 7 nc Clearly, JS when. 35