Brief Summary

This paper proposes a methodology to study a firm’s strategic behavior by combining game theoretic concepts and recent economic developments. It analyses various forms of collusive behavior of firms on two strategic variables-price and advertising- in a differentiated market dominated by a duopoly. The econometric methodology adopted is fully structural. The methodology involves specification of demand and cost functions and hypotheses about the strategic interactions among players. The parameters of the demand functions and the cost functions are estimated under different strategic hypotheses.

Prior work have modeled strategic interactions (output and pricing decisions) in a non-cooperative static method using static conjectural variation models. However, recent developments in game theoretic work as well as experimental evidence have shown evidence of cooperation among players in repeated game contexts even under the assumption on non-cooperative behavior. Such kind of cooperation is referred to as tacit collusion. Given the complexity of empirical study of collusive behavior, the authors deal with the black box of strategic dynamic interactions by selecting a sufficiently rich range of formulations expressing various degrees of collusion. With two observable instruments of competition-price and advertising, the authors offer various simple formulations of collusive behavior and select among them. The merits of each formulation is based on the range of possible levels of collusion.

Since the econometric models are nonnested, tests for nonnested hypotheses is performed to select the most adequate model. The models are estimated by full information maximum likelihood methods. This study also extends the traditional conjectural approach for the empirical analysis of market power. The proposed methodology is then applied to the soft drink industry which is dominated by The Coca-Cola Company and Pepsico duopoly. Three models of non-collusive behavior and three models of collusive behavior is estimated. Based on the results, the hypotheses of non-collusive behavior is rejected. The results suggest some tacit collusive behavior in advertising between the Coca-Cola Company and Pepsico for period covered by the sample data. However, collusion on prices does not seem to be well supported by the data.

The methodology allows for various switching regimes specifications because there is a potential change of behavior in the middle of the sample. The paper estimated models with two regimes- before and after 1976. Results show that Coca-Cola is a Stackelberg leader in price and advertising until 1976, and after 1976 there is collusion in advertising and prices. Results also show an increase in market power for both the firms after 1976 based on the Lerner indices calculations.