Theoretical industrial economics is now dominated by the analysis of firm interactions using game theory. There is relatively little evidence of how firms interact in practice, however. Are large firms aggressive and small ones passive? Or are firms with healthy balance sheets more likely to be tougher than firms in financial distress? In Discussion Paper No. 1194, Research Fellow Jonathan Haskel and Pasquale Scaramozzino present evidence for three UK industries that have not been analysed before, using an alternative methodology to identify aggressive and accommodating interactions. The standard method is to infer aggression and accommodation by looking at the relationship between firm profits and market share. The difficulty with this approach is that the degrees of aggression and accommodation are assumed to be fixed. They are likely to differ according to the circumstances of rival firms, however, and this is the consideration these authors take into account.

The authors allow the response of other firms to depend on two sets of variables. The first is the physical capacity of the other firms. If a firm observes its rival with plenty of spare capacity, it might expect an aggressive response to a price cut since the rival has the spare capacity to enter into a price war. The second set of variables are those relating to the financial health of other firms. The authors' empirical strategy is therefore to take three industries for which there are adequate data and allow the profits of a firm to depend on its market share and the physical capacity and financial health of its rivals. The basic findings are threefold: first, in general, spare physical capacity of rivals leads firms to expect aggressive behaviour; second, the importance of financial variables varies according to industry; and lastly, there are differences in leader/follower behaviour across the industries.

Do Other Firms Matter in Oligopolies?
Jonathan Haskel and Pasquale Scaramozzino

Discussion Paper No. 1194, June 1995 (IO)