Dissipative Competition: Evidence from a Quasi‐Natural Experiment

• Author: Yuk Ying Chang,Martin Young
• Date: 01 June 2015
• DOI: http://doi.org/10.1111/irfi.12050
• Published date: 01 June 2015

Dissipative Competition: Evidence

from a Quasi-Natural Experiment

YUK YING CHANG AND MARTIN YOUNG

School of Economics and Finance, Massey University, Palmerston North,

New Zealand

ABSTRACT

We document that contrary to the conventional view, the costs of domestic

f‌irms in terms of selling, general and administrative expenses and cost of

goods sold increase signif‌icantly following exogenous shocks that increase

competition, namely material import tariff cuts affecting US manufacturing

industries over the period 1974–2005. Incompatible with an agency expla-

nation, the cost increase is more pronounced among f‌irms with higher

CEO/insider/board ownership. We further f‌ind that the cost increase is more

evident among f‌irms with smaller market share and among focused f‌irms.

Generally, our results are consistent with the notion of ‘dissipative compe-

tition’ discussed in the seminal papers by Tullock.

Competition is commonly a topic for discussion and study.1The conventional

view is that competition faced by f‌irms is a cornerstone of f‌irm eff‌iciency (Smith

1776; The Sherman Antitrust Act 1890; Porter 2008). Yet, it has long been

known that competition can also induce ineff‌iciency (Tullock 1967; Krueger

1974; Spence 1976a, 1976b; Dixit and Stiglitz 1977; Bhagwati 1982; Mankiw

and Whinston 1986; Nickell 1996).2Tullock (1967, 1980), a pioneer for research

in this area, discusses the concept of ‘unproductive competition.’ He builds

models in which self-interested contestants make costly extra effort and/or

spend more resources to increase their probability of winning or their share of

a prize or rent, even when these increased efforts/resources generate no addi-

tional overall value. This is dissipation through competition, which has been

studied theoretically and analytically in a wide variety of contexts, such as

monopolies, trade protection, patent races, political lobbying and sibling rivalry

(Hillman and Katz 1984; Hillman and Ursprung 1988; Baye and Hoppe 2003;

Faith et al. 2008). However, empirical evidence on this important issue is

1 ‘This year’s prize (Nobel Prize 2014) in economic sciences is about taming powerful f‌irms,’

noted Staffan Normark, the permanent secretary for the Royal Swedish Academy of Sciences

that awarded the prize.

2 See Dulleck et al. (2011), Muthoo and Mutuswami (2011) and Cason et al. (2012) for examples

of recent work that explores the dimension of information asymmetry or communication.

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International Review of Finance, 15:2, 2015: pp. 169–198

DOI: 10.1111/irf‌i.12050

© 2015 International Review of Finance Ltd. 2015

surprisingly limited.3In this study, we provide empirical evidence that compe-

tition can lead to ineff‌iciency via dissipation. To do so, we exploit the quasi-

natural experiment of cuts in US import tariffs imposed on foreign

manufacturing f‌irms over the period between 1974 and 2005 and examine how

an exogenous change in competition intensity, following material tariff reduc-

tions, affects f‌irm eff‌iciency.4

When there is a material decrease in the tariff imposed on foreign importing

f‌irms, there will be an increase in the supply from these foreign f‌irms in the

domestic market. As a result, the market share of each domestic f‌irm will

generally decrease. According to standard economic theory, when the output of

domestic f‌irms is lower, there will be a decrease in demand for factors of

production. We should, therefore, generally observe a lower cost of production

(Marshall 1890). Product market competition also reduces managerial slack

(Hart 1983; Raith 2003; Giroud and Mueller 2011). In a more competitive

environment, principals will be better informed about agents’ action so that

there is less room for agents’ discretionary behavior. An increase in competition

also increases the probability that a f‌irm becomes unprof‌itable and must be

liquidated, which induces managers to work harder to keep their jobs (Schmidt

1997). As a result, competition should lower cost and improve f‌irm eff‌iciency.

However, when facing stronger competition from foreign f‌irms, local f‌irms may

incur more selling expenses such as advertising expenditure [ref‌lected in the

accounting entry ‘selling, general and administration’ (SGA) in income state-

ments]5to boost sales, and more other expenses to provide better service and

distribution [shown up in the accounting entry ‘cost of goods sold’ (COGs) in

income statements] to maintain their market share. Moreover, f‌irms may have

to treat employees better and hence spend more resources to induce relation-

specif‌ic investment if survival is threatened (Freeman 1984). Meanwhile, man-

agers may have lower incentive to work hard because the f‌irm prof‌it level is

3 Nickell (1996) mentions the paucity of empirical evidence and summarizes the theories as to

why the effect of competition on corporate performance is in general ambiguous. Berry and

Waldfogel (1999) document a welfare loss to f‌irms and advertisers with free entry into the

radio industry, which has extreme characteristics of high f‌ixed costs and zero marginal costs.

The reason for this ineff‌iciency is that entrants ‘steal business’ from incumbents, which leads

to a wasteful use of resources on f‌ixed costs, by new entrants, while consumers do not obtain

additional benef‌it. Cockburn and Henderson (1994) study 10 major pharmaceutical f‌irms and

f‌ind that rivals’ results are generally positively correlated with research productivity of a f‌irm.

The authors consider this as evidence for positive spillovers, and hence conclude that the

more extreme forms of dissipation in ‘winner take all’ models identif‌ied in the literature are

probably a poor characterization of the reality of competition in pharmaceuticals. Sheremeta

(2010) conducts an experimental study of one-stage and multi-stage contests and f‌inds

signif‌icant over-dissipation in both contests and in both stages of the competition where the

actual dissipation exceeds the theoretical predicted dissipation.

4 Feenstra (1996), Feenstra et al. (2002), Valta (2012) and Frésard and Valta (2014) provide

evidence and arguments to support the notion that the import tariff cuts are exogenous to

f‌irm decisions.

5 Firms sometimes report expenses associated with product promotion in the ‘cost of goods

sold’ account.

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