Entry Threats and Inefficiency in ‘Efficient Bargaining’

AuthorBibhas Saha,Rupayan Pal
Date01 July 2016
Publication Date01 July 2016
Rupayan Pal* and Bibhas Saha**
We study limit pricing in a model of entry with asymmetric information, where
the incumbent firm’s wage is endogenously determined through ‘efficient bargain-
ing’ with its union. In the presence of entry threat, the incumbent firm-union pair
may face a conflict between rent sharing and transmitting its cost information.
When the wage is not observable to outsiders and employment is the only signal-
ling instrument, over-employment features in all entry deterring contracts. When
the wage is also observable, information transmission becomes easier. Most of
the time, then, but not always, the efficient contract deters (induces) entry
against the low (high) cost incumbent.
In recent years, due to greater integration of product and labour markets,
entry of new firms has increased by manifolds in most industries around the
world. Empirical studies also suggest that threat of entry significantly affects
the outcomes of both product and labour markets by influencing investment
and/or export (Abraham et al., 2009; Boulhol et al., 2011; Ahsan and Mitra,
2014). Hence, studying the effects of entry threats assumes greater importance
in the era of increasing globalization. It is not hard to see that entry threat
affects the existing firms’ strategic postures in the product market, and yet at
the same time it creates frictions in the process of rent allocation within the
firm, particularly with crucial input suppliers, such as the labour unions. Both
sides need to cooperate to achieve a common goal of deterring entry in future,
but that also requires giving up individual rents at present. Whether they
would succeed in achieving their common goal is the central question of this
We adapt the classic model of limit pricing due to Milgrom and Roberts
(1982) by introducing wage bargaining. In the MilgromRoberts model, the
entrant does not know the true marginal cost of the incumbent, which is
either high or low, and entry is profitable only if the incumbent’s marginal
cost is high. The entrant, however, can infer the incumbent’s marginal cost
*Indira Gandhi Institute of Development Research (IGIDR)
**Durham University Business School
Scottish Journal of Political Economy, DOI: 10.1111/sjpe.12091, Vol. 63, No. 3, July 2016
©2015 Scottish Economic Society.
from the pre-entry price by invoking game-theoretic reasoning. Generally two
types of equilibrium are highlighted separating (i.e. information revealing)
and pooling (i.e. information non-revealing). The first equilibrium occurs
when the entrant is optimistic about post-entry profit.
In this case, the low
cost incumbent signals his competitiveness by charging a sufficiently low price.
The second equilibrium occurs when the entrant is pessimistic about his post-
entry profit. The high cost incumbent then can pretend to be the low cost
type. For not being able to extract any new information, the entrant would
stay away. Thus, there are two alternative scenarios of limit pricing both
resulting in entry deterrence.
In this framework, we introduce a labour union in the incumbent firm and
allow simultaneous bargaining over both wage and employment, which is
known as efficient bargaining (McDonald and Solow, 1981). The entrant does
not know the true reservation wage of the union, which can be high or low;
he has some priors about these reservation wages.
Introduction of wage bargaining immediately complicates the Milgrom
Roberts model by requiring limit pricing to be jointly incentive compatible for
the firm and the union. A second issue concerns decoupling of bargaining
from surplus creation. Ordinarily under efficient bargaining this decoupling is
achieved seamlessly, because bargaining is shifted only to the surplus part,
while the production decision is based on the reservation wage, which is a key
requirement for efficiency.
Under asymmetric information whether that will
still be the case is not obvious. We know from the existing literature that
when other bargaining protocols are used such as the right-to-manage bar-
gaining (Nickell and Andrews, 1983), not only is employment distorted but
also bargaining frictions can render signalling difficult (see, for example, Dew-
atripont, 1987, 1988; Ohnishi, 2001; Pal and Saha, 2006, 2008). But as these
studies have used inefficient bargaining protocols, it is difficult to ascertain
how much of the production inefficiency is attributable to limit pricing and
how much to bargaining frictions.
Using the efficient bargaining protocol,
one may gain further insight into inefficiency.
Although bargaining and limit pricing are intertwined, conceptually they
can be separated. Bargaining frictions are likely to arise when the surplus is to
be sacrificed for strategic reasons. On the other hand, the scope for limit pric-
ing depends on what is observable to the entrant and what is not. More spe-
cifically, whether the entrant observes the wage in addition to price is crucial.
Optimism refers to the entrants’ expected profit being positive, where the expected profit
is calculated on the basis of his priors about the entrant’s marginal cost. Pessimism refers to
negative expected profit.
Efficiency remains intact even with sequential bargaining, provided that the union’s (and,
hence, firm’s) bargaining power at the stage of bargaining over wage does not differ from
that at the stage of employment bargaining (Manning, 1987).
It has been noted that inefficient bargaining protocols can also produce efficient outcomes
if profit-sharing is introduced (Pohjola, 1987; Anderson and Devereux, 1989). But the work-
ers’ incomes in that case will be more volatile and even the risk of unemployment may rise
(Holmlund, 1990; Schmidt-Sorensen, 1992; Koskela and Stenbacka, 2006). Therefore, simul-
taneous bargaining over both wage and employment, which is sufficient to generate efficient
outcome under complete information, remains a superior protocol than any other.
Scottish Journal of Political Economy
©2015 Scottish Economic Society

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