Horse-Race Effects: A Contrary Tendency

We have considered several reasons why markets might not allocate "enough" resources to the production of information products for efficiency. These tendencies to underallocation are most pronounced if there is no intellectual property right, but may be present to some extent even if there are intellectual property rights. However, some economists have argued that there may also be tendencies to overallocate resources to the production of some kinds of information products. These tendencies come into play whenever the first person to achieve some result gets a special reward, as, for example, a patent for the first successful design of a new invention. Thus, the economic activity becomes a "horse race" in which only the first horse across the line can win -- and accordingly, we might speak of them as "horse race" effects. Markets affected by these tendencies are often called "winner-take-all" markets, and this sort of competition is called "winner-take-all competition.

To illustrate how this can happen, we look at a potential competitor's decision whether to enter the market or not. A pure winner-take-all market would work like this: it is a market for a good or service that can have greater or lesser quality -- a form of computer software, perhaps, or CD's of performances of a Mozart opera, or an electronic game. The good is produced with strong economies of scale -- the more the company produces, the cheaper they can sell it and still make a profit. Thus, the market will be dominated by a single seller, and the new competitor will be able to sell the product only if they can produce a product of better quality than the one already in the market. On the other hand, if they can do that, they can take over the market and drive the older firm out.

An industry with strong economies of scale is often called a "natural monopoly," since there is a tendency for one firm to dominate the market. We will assume that, before the new competitor enters, the market is dominated by a single firm. Suppose that the demand for that one good is shown by line D₁ in Figure 4 below. Suppose also that the marginal cost is shown by the horizontal line V, so that P is the profit-maximizing price and Q units of output are sold.

Figure 4

Will entry be efficient? We will apply a cost-benefit test: are the benefits greater than the costs? The introduction of the new product will increase consumers' surpluses by area ABC, while industry profits will be increased by CBED. Thus, entry is efficient if the benefits, additional profit plus consumers' surplus, is greater than the cost.

1. Y < ABC + CBED

However, the new entrant will replace the old entrant completely, and so will earn a profit of pBEV. Thus, the potential entrant will decide to enter if

2. Y < pBEV

In the diagram, it appears pretty clearly that ABC + CBED < pBEV. Suppose ABC + CBED < Y The extra profits from monopolizing the market mean that profit-maximizing business will spend too much on product development and on competition to gain control of their markets. Many new goods of higher quality will be produced, and that's a good thing in itself, but only up to the point at which the benefits balance the costs. In "winner-take-all" markets, producers take the development costs beyond that point, making too much of a good thing a bad thing.

Information Oversupply