DP14009 Market Size and Competition: A "Hump-Shaped" Result
An active empirical literature estimates entry threshold ratios, introduced by Bresnahan and Reiss (1991), to learn about the impact of firm entry on the strength of competition. These ratios measure the increase in minimum market size needed per firm to sustain one additional firm in the market. We show that there is no monotonic relationship between a change in the entry threshold ratio and a change in the strength of competition or in the price-cost margin. In the standard homogenous goods oligopoly model with linear or constant elasticity demand, the ratio is hump-shaped in the number of active firms, increasing at first and only when additional firms enter it gradually decreases and converges to one. Empirical applications should use caution and interpret changes in the entry threshold ratios as indicative of changes in competition only from the third entrant onwards.
