When Demand Increases Cause Shakeouts, American Economic Journal -- Microeconomics
Most canonical models of competition conclude that increases in demand should (weakly) lead to more firms. However, in models where competition is in quality, and quality is produced with fixed costs, increases in demand can lead to a competitive response that brings about shakeouts – higher demand can lead to fewer firms. This paper provides empirical evidence of this effect in the context of hotels and motels in the mid-to-late 20th century, where an important element of quality competition took the form of whether firms supplied recreational amenities such as swimming pools. We first provide evidence that the completion of Interstate highways is associated greater demand for lodging, showing that it is associated with increases in employment in the sector. We then investigate how industry structure adjusts to these shocks; we show that highway completion leads to fewer (but larger) firms. On average in our sample, the completion of highways leads to shakeouts. We then examine whether this effect is greater in warmer areas where the returns to investment in outdoor recreational amenities (i.e., swimming pools) are greater. We show that while the increase in employment in this industry is the same in warmer and cooler regions, highway completion only led to shakeouts in warmer regions. Finally, we investigate whether these effects appear when looking at restaurants, an industry where quality is supplied primarily through variable costs rather than fixed costs (Berry/Waldfogel,2010). Unlike for hotels and motels, we find no evidence that highway completion is associated with shakeouts in this industry. Our evidence connects to an important, but sometimes overlooked, finding of Sutton (1992): shakeouts – which in some cases could take the form or merger or merger waves – can be catalyzed by increases in market size. The competitive responses that lead to shake-outs need not only be initiated by changes in the “technology” that produces quality, but sometimes can be initiated simply by positive demand shocks. Firms’ incentives to grow – and in some cases to merge with other firms -- in response to demand increases need not be motivated by anticompetitive incentives, but rather may be motivated by increased incentives to compete more effectively on nonprice dimensions.