Product Differentiation, Strategic Divisionalization, and Persistence of Monopoly

Abstract

This paper analyzes the strategic incentive of oligopolists to create autonomous rival divisions when products are differentiated. We consider a two‐stage game where firms choose the number of autonomous divisions in the first stage and all the divisions engage in Cournot competition in the second. It is shown that product differentiation ensures the existence of an interior subgame perfect Nash equilibrium (SPNE), and the equilibrium number of divisions increases with the degree of substitution among products and the number of firms. Further, if divisions are allowed to divide further, they always will, which leads to total rent dissipation. Thus, parent firms have incentives to unilaterally restrict their divisions from further dividing. In the free‐entry equilibrium, it is found that the possibility of setting up autonomous divisions is a natural barrier to entry. Incumbents may persistently earn abnormally high profits. In the cases where product differentiation is difficult, the only pure‐strategy free‐entry SPNE is the monopoly outcome even if the entry cost is relatively low.

Sequential Divestiture and Firm Asymmetry

“…One solution to the divestiture paradox is to make divestitures costly [2]. A second solution is to let firms produce differentiated products so that the response from rival products is weakened [3,4]. Surprisingly, all previous studies have assumed that firms divest simultaneously.…”

“…Economically the two situations produce the same effect of weakening the interaction between Cournot competitors. That is why either setting can solve the divestiture paradox: even with constant mc, the scope of divestitures will be limited if products are differentiated [3,4]. Although mathematically equivalent, assuming increasing mc has the advantage of avoiding the complication of dealing with different degrees of substitution for products within and across groups.…”

“…Nevertheless, there are some subtle differences between the two formulations, as will be explained. More importantly, this paper's conclusions are based on the endogenized order of divestitures, while Ziss [3] and Yuan [4] both assumed simultaneous divestitures.…”

“…By contrast, Ziss [3] and Yuan [4] showed that the incentive to divest can also be reduced by product differentiation; that is, the number of divisions decreases when products are more differentiated. 4 As a result, the divestiture paradox can be solved by introducing product differentiation: each firm will divest into a finite number of divisions when products are sufficiently differentiated, and perfect competition will not result. 5 This paper assumes homogeneous products with increasing marginal costs.…”

“…This seemingly unreasonable prediction, that divestiture should always be profitable, can be called the divestiture paradox. Some solutions to the paradox have been offered: divestitures will be limited if they are costly [2] or products are differentiated [3,4]. Those solutions assume that firms divest simultaneously.…”