Free entry and social inefficience, Mankiw and Whinston formally established a two-stage model to expose the conditions under which the number of entrants in a free-entry equilibrium is excessive, insufficient or optimal. In their framework, at the first stage firms make entry decisions, and at the second stage the active firms make product decisions. The important insight of their work is that in a industry with homogenous product and fixed cost of entry, imperfect competition and business stealing effect can produce excessive entry from a social stand-point of view. When integer constraints are accounted, the free-entry number of firms can be less than the socially desired number, but not by more than one firm. The tendency toward excessive entry can be reserved as a result of product differentiation. Concerning entry regulation, their analysis shows that regulation can be unnecessary, since there are cases in which fixed cost approaches zero and firms act approximately as price-taker.

By the time of Mankiw and Whinston’s work, i.e. mid-80s, there had been articles demonstrating the idea that when firms must incur fixed set up costs upon entry, the number of entrants at the equilibrium can be insufficient or excessive in the relation to the social optimum. However, the economic forces underlying these entry biases had not been fully exposed, leading to the typical presumption that free entry is desirable. To examine the conditions for establishing the presence of an entry bias, Mankiw and Whinston argue that the aspects of the postentry game played by firms should be given central roles. These aspects are imperfect competition and business-stealing effect – which they define as the effect of the increasing number of firms resulting in incumbent firms’ reduced volume of sales. In the other extreme, business-augmenting effect means that the increase in the number of firms enhances each incumbent’s output. According to Mankiw and Whinston, when there is imperfect competition, the business-stealing effect is a critical determinant of the direction of entry biases.

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Mankiw and Whinston develop a model of two stages that allows them to compare the number of entrants in a free-entry equilibrium and the socially desired number. Similar to von Weizsacker (1980) and Perry (1984), they viewed government intervention as having two types: First-best regulation is the condition in which in order to maximize social surplus, a social planner determines the number of operating firms and sets their outputs. Second-best regulation is the condition in which the planner can only determine the number of firms and not their post entry behavior. In this model, Mankiw and Whiston take as given firms’ non-competitive behavior after entry, and compare the outcomes of the second-best regulation with the outcomes under no intervention (i.e. free entry case). A planner is supposed to have the objective of maximizing total surplus in the market, while oligopolists have a tendency towards rival retaliation. The entry process have two stages: in the first stage there is an infinite number of identical firms decide whether they enter the market or not. If the potential entrant decides to enter, it must incur fixed set-up costs. At the second stage, i.e. the production period, each identical firm behaves as a quantity-setting and profit-maximizing oligopolist. Mankiw and Whinston do not model the postentry game explicitly, arguing that this approach has two advantages: (1) uncovers the reasons behind the presence of the entry biases and (2) provides a set of properties readily to be checked for other application. They propose the assumptions which will be used throughout the paper concerning a firm’s cost function, equilibrium output and profits. In particular, each firm’s cost function specifies economies of scale, equilibrium is symmetric, and equilibrium output is not the efficient one since firms behave strategically rather than act as price-takers. The necessary and sufficient conditions for a number of entrants to be the free-entry equilibrium are that profits are not negative and if there is one more firm enters the profits per firm will be negative. The implications of this assumption are that no firm has entered would have been better-off not entering, and no firm that has not entered would have found it worthwhile to have entered. The model is developed as a partial equilibrium framework in which income effects can be ignored.