American Economic Association

Market Structure and Multiproduct Industries

Author(s): Elizabeth E. Bailey and Ann F. Friedlaender
Source: Journal of Economic Literature, Vol. 20, No. 3 (Sep., 1982), pp. 1024-1048
Published by: American Economic Association
Stable URL: http://www.jstor.org/stable/2724410
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Journal of Economic Literature
Vol. XX (September 1982), pp. 1024-1048

Market Structure
And Multiproduct Industries

By

ELIZABETH E. BAILEY, CivilAeronauticsBoardand

ANN F. FRIEDLAENDER, Massachusetts
Instituteof Technology

We would like to thank Nancy Barrett, William Baumol, Laurits

Christensen,Gerald Faulhaber, Melvyn Fuss, Pauljoskow, John Pan-
zar, Richard Schmalensee, David Sibley, Robert Willig and Edward
Zajac for constructive comments and criticisms of earlier drafts of
this paper.

1. Introduction and Overview conduct in its markets. In many trucking

TRADITIONAL ECONOMIC ANALYSIS of
the theory of the firm has concen-
trated on single-product firms. But, in re-
ality, most businesses produce many prod-
ucts, and many regulatory and antitrust
issues involve only these enterprises. In
recent years, economists and policymak-
ers dealing with antitrust and regulatory
issues have increasingly recognized the
need for a theory that can be used to eval-
uate the efficiency of market structures
in industries dominated by a few firms op-
erating in a diverse range of markets. For
such firms,conventional concepts of struc-
ture and performance such as economies
of scale, measures of concentration, and
barriers to entry do not adequately cap-
ture the complexity of market relation-
ships.
A few examples illustrate the complexi-
ties introduced by the multi-product firm
and highlight the need for a theory that
can be used to evaluate performance and
1024
and air city-pair markets, the efficient
number of carriers appears to be rela-
tively small (perhaps even one). Does this
imply, however, that trucking firms and
air carriers that compete in a wide range
of city-pair markets should be regulated
as natural monopolists or that mergers in-
volving overlapping markets should be
disallowed? In the petroleum industry,
there is a current trend to diversify into
other sources of fuel, and in cable TV mar-
kets there are numerous attempts to inte-
grate vertically. What should economists
look for in evaluating whether these
changes in market structure are moti-
vated by efficiency or by anticompetitive
behavior? For a dominant firm, such as
AT&T, there is a frequent complaint that
the incumbent firm is preventing entry
by "cross-subsidizing"one of its products,
which faces competition by entrants, at
the expense of other of its products. What
kinds of regulatory intervention in pricing
or in market structure must be considered
 Bailey and Friedlaender: Multiproduct Industries
if such cross-subsidy from the regulated
to the deregulated markets is to be pre-
vented?
While these represent only a small frac-
tion of the regulatory and antitrust issues
that have headed the policy agenda of reg-
ulatory agencies, the Justice Department
and Congress over the past decade, they
should indicate the importance to econo-
mists of learning to understand why firms
come to have the scale and product com-
position that they do, how the market op-
erates in the typical multiproduct context,
and the welfare and regulatory implica-
tions of such firm and market behavior.
The complexity of these behavioral rela-
tionships should indicate that simple no-
tions of efficiency related to the scale of
output are insufficiently powerful to be
generally relevant, and that the composi-
tion of output is as important as its scale
in determining costs.
Fortunately, there is a growing litera-
ture dealing with the multiproduct firm
and industry whose theoretical side is
most fully expounded in William Baumol,
John Panzar and Robert Willig (1982).
This literature has begun to grapple with
concepts of efficiency and performance in
market structures populated by large,
multiple-output firms. Since the material
is both relatively new and technical, it has
not yet entered into the mainstream of
economic analysis or policy evaluation.
Nevertheless, it does hold out the promise
of providing a framework that can be used
to evaluate the traditionalindustrial-orga-
nization concepts of structure, conduct
and performance in the context of the
multiproduct firm and industry.
To enhance the process of dissemina-
tion, therefore, we undertake in this paper
to summarize and interpret the new theo-
retical tools and concepts, to show how
these provide a way of thinking about im-
portant industrialorganization issues with
precision, and to discuss their empirical
implementation and relevance for policy.
1025
Section 2 focuses on the nature of costs
and technology and provides new mea-
sures of size-related economies that are
useful in characterizing the multiproduct
firm. Section 3 addresses the issue of mar-
ket conduct and performance and shows
how new concepts of contestability and
sustainabilitycan be used to evaluate firm
and industry behavior in a multiproduct
setting.
2. Cost Conceptsfor the Multiproduct
Firm
The appearance of related papers by
Baumol (1977) and Panzar and Willig
(1975, 1977b) on the definition of natural
monopoly and scale economies in a multi-
product context served to catalyze think-
ing about cost concepts for multiproduct
firms and to develop insights into the be-
havior of the multiproduct firm and indus-
try. Most important, the new literature
has introduced as a complement to the
old concept of "economies of scale," the
new concept of "economies of scope,"
which measures the cost advantages to
firmsof providing a large number of diver-
sified products as against specializing in
the production of a single output.
Section 2.1 provides readers a compact
set of general considerationsfrom the per-
spectives of cost and technology that
would explain why we normally observe
multiproduct, rather than single-product
firms, and why these are larger in scale
and/or more varied in product composi-
tion in some industries than in others.
Section 2.2 clarifies the transition that
must be made in familiarsize-related con-
cepts as we move from single-product to
multiproduct firms. Formal definitions of
multiproduct cost concepts are presented.
In essence, the new literature argues that
while a measure of average incremental
cost is well defined in a multiproduct set-
ting, conventional measures of average
cost are not well defined for a multiprod-
1026 Journal of Economic Literature, Vol. XX (September 1982)
uct firm. There is no single economically
meaningful way to aggregate output. In-
stead, a variety of alternative measures
have been introduced to describe costs
when composition of output changes.
Section 2.3 discusses some empirical ap-
plications of the multiproduct theory and
argues that explicit disaggregation of
product lines is essential for a full under-
standing of the costs and technology of
multiproduct firms.
2.1 Cost Advantages Arising from Econo-
mies of Scope
We start by indicating some reasons
behind the diversity of products within
a single firm. Economies of scope, as intro-
duced by Panzar and Willig (1975, 1981),
is a key new concept in this respect. There
are said to be positive economies of scope
when a single firm can produce a given
level of output of each product line more
cheaply than a combination of separate
firms, each producing a single product at
the given output level. As a general mat-
ter, the authors state that economies of
scope arise from the sharing or joint utili-
zation of inputs. They arise, for example,
if a given factor or input is imperfectly
divisible, so that the production of a small
set of goods would leave excess capacity
in the utilization of that input. Alterna-
tively, the input may have some proper-
ties of a public good so that when it is
purchased for one production process it
will then be freely available to another.
While these examples provide useful in-
sights into the nature of economies of
scope, they are sufficientlygeneral to indi-
cate that the usual characterization of the
production function is inadequate to ex-
plain the way in which economies of scope
arise. Instead, it is necessary to examine
the component parts and stages of produc-
tion to see how inputs may be utilized
by different processes of production. In
this connection, a series of illustrative ex-
amples can be helpful. Consider first the
classic situation of joint production of out-
puts such as wool and mutton. In this case,
once it is decided to raise sheep, it is gen-
erally less costly to use the same sheep
to provide both products rather than to
raise two sets of sheep, one group of which
solely provides mutton while the other
group solely provides wool. Even though
fibers and meat are not normally consid-
ered to be related products in other cir-
cumstances (e.g., cotton versus beef), the
shared factor, sheep, does confer an econ-
omy of scope on the joint production of
wool and mutton. This economy of scope
exists even when there are constant unit
costs in all stages of production (such as
shearing, butchering and raising sheep) so
that scale economies are lacking.
It is interesting to note that even in this
classic example of joint production, the
ability to share economically the factor of
production among products is dependent
on both prices and available technology.
In the middle ages, for example, absence
of refrigeration and the slow speed of
transportation meant that mutton export
was not possible. Yet, there was regional
specialization in wool supply in twelfth
century Flanders, due in part to excellent
local conditions for sheep raising, in part
to the relative ease of transporting cloth,
and in part to an economy of scale arising
from the dangers on trade routes which
made large convoys economical (Henri
Pirenne, 1937). As a result, we imagine
that most sheep in twelfth century Flan-
ders were utilized predominantly to pro-
duce wool.
A modern example provided by the
field of robotics links economies of scale
and of scope to current technology and
methods of production. Assemblyline pro-
duction with human laboris most econom-
ical for single-product runs of large scale.
Combinations of robots and computer-
controlled machine tools are bringing the
benefits of large scale to the production
of even small batches of parts. Here, it
 Bailey and Friedlaender: Multiproduct Industries
is the robot's ability to switch from one
task to another that counts. By varying
the order in which parts are transferred
between different machine tools, the ro-
bot production line has the flexibility to
handle a variety of separate products, and
thus to use economies of scope to achieve
the large quantities necessary to take ad-
vantage of the economies associated with
automation.
The robotics example leads directly to
a traditional class of situations in which
there are economies, namely the presence
of fixed factors of production. Suppose
there exists an indivisible asset, such as
railroad trackage or a machine used to
stamp automobile bodies. Such a fixed fac-
tor is known to lead to economies of scale.
But now, suppose further, that at the cur-
rent level of demand for a single product
this factor of production is not fully uti-
lized. Then the use of the stamping facility
for light trucks as well as cars or of the
railroadtrackage for freight as well as pas-
senger services will provide an economy
of scope.
A third way in which scope economies
can arise relates to economies of network-
ing. In the aviation industry, for example,
the cost per mile of providing a seat is
much lower on big planes than on small
planes. This economy of scale provides an
incentive for airlines to organize the pro-
vision of services by offering a networking
arrangement involving one-stop service.
Individuals with a variety of destination
points are boarded on a single larger
plane. Planes from a variety of such origi-
nating points then stop at a central airport
at approximately the same time. The pas-
sengers to each of the desired destination
points are then combined, again making
it possible to use planes that are larger
than would be the case otherwise. In this
illustration, the economies of scale of a
specialized input, airplanes,can be reaped
if there is a larger scope of operations, in
that an airline can coordinate the schedul-
1027
ing of services to a variety of city-pairmar-
kets. Other examples of network econo-
mies occur in less-than-truckloadtrucking
industries where terminals are located to
consolidate shipments that are dispersed
over a network, and in the telecommuni-
cations industry which has both transmis-
sion and switching networks.
A fourth illustration of multiproduct di-
versification occurs with reuse of an input
by more than one product. Lawrence Pul-
ley and Yale Braunstein (1981a, 1981b) an-
alyze a firm in the information industry
which produces abstracts of articles in
technical journals. The firm produces
three separate indexes of abstracts.In ad-
dition to a large general index, there are
two smaller indexes relating to more spe-
cific fields. Since the two smaller indexes
can be aggregated to form the larger in-
dex, there is clearly an economy of scope
to production of the three products to-
gether. In this case, the scope economy
arises because an intermediate product is
freely available for use in the provision
of a second product. (See also David Star-
rett 1977.)
Another major class of cases leading to
multiproduct diversification comes from
a sharing of intangible assets, such as re-
search activities or other forms of business
knowhow. As the work of Kenneth Arrow
(1971) and Oliver Williamson (1975)
makes clear, there are high costs to obtain-
ing new information in the first place as
well as organizational and strategic
impediments to market transfer of infor-
mation. After all, how can one sell infor-
mation without divulging it? David Teece
(1980) argues that multiproduct firmsmay
emerge when several industries require
similarknowhow but there are transaction
difficulties affecting the transfer of that
knowhow. The inability to write suffi-
ciently complete contracts may make it
less costly for internal trading between
branches of a single firm rather than trad-
ing across firm boundaries. For example,
1028 Journal of Economic Literature, Vol. XX (September 1982)
in locating alternative fuel sources, such
as coal, oil shale and uranium, exploration
techniques as well as geological and geo-
physical expertise are directly transfer-
able. In the field of resource extraction,
technology recently developed in the pe-
troleum industry is also transferable at lit-
tle additional cost to geothermal energy
recovery and for in situ production of
shale oil and coal fluids. Similar examples
abound in the area of resource processing.
Teece concludes that the economies of
scope that can be generated through a
sharing of technological knowhow among
fuels may be one factor driving the cur-
rent diversification of petroleum firms
into alternate fuels.
All of the illustrations we have given
point up a boundary problem in defining
firms and products. As Edward Robinson
(1932) described long ago, as price and
technology change, so do the technologi-
cally determined boundaries as to what
constitutes a production unit. In the case
of inutton and wool production, even if
there is at the present time an economy
of scope conferred by the common factor,
sheep, we need more information about
the interrelationships of production costs
of the separate outputs in order to know
whether we would expect to see separate
sheep farming industries, industries that
buy wool from farmers and convert it into
cloth, and separate butchering and meat
packing industries, or whether we would
expect to find a conglomerate firm that
engages in all of these functions. Similarly,
in the car and truck example, instead of
one firm producing both cars and trucks,
the stamping machine might be owned
by a separate company and leased out to
both the car and the truck manufacturers.
Alternatively, the car manufacturermight
own the stamping machine and sublease
it to a truck manufacturer, in which case
his products would be cars and stamping,
not cars and trucks.
In sum, a useful understanding of econo-
mies of scope requires research going be-
hind neoclassical production function the-
ory. We need to understand component
elements of cost structures and of the
functional components of production and
distribution. Exploration into this aspect
of the new literature is as yet meager. Bau-
mol, Panzar and Willig (1982) provide
some useful information in this area, but
it is clear that much more research is
needed on how and in what circumstances
scope economies arise.
2.2 Cost Conceptsfor the Multiproduct
Firm
We begin by describing the conven-
tional concept of economies of scale in a
single product setting and then introduce
the size-related cost concepts that are rel-
evant in a multiproduct setting. Through-
out it will be useful to illustrate these con-
cepts by considering the example of a
railroad supplying freight and passenger
services.
The traditional concept of scale econ-
omies in the single product firm refers to
the behavior of total costs as output ex-
pands, and economies of scale are said to
exist if total costs rise less proportionately
than output. Formally, economies of scale
are measured by the relationship of aver-
age cost to marginal cost. Total costs are
defined as C = C(Y), where Yis a number
that represents aggregate output, other
arguments of the cost function being sup-
pressed for simplicity. Then, average cost
can be unambiguously defined as AC =
C(Y)/ Y and marginal cost can be defined
as dC/dY. Since average cost will fall as
long as marginal cost lies below average
cost, scale economies are typically mea-
sured as
S-AC/MC- = C(Y)
S ACIMC
YdC/dY
which is simply the reciprocal of the elas-
ticity of cost with respect to output. Thus,
>
S 1, and the firm experiences increas-
 Bailey and Friedlaender: Multiproduct Industries
ing, constant, or decreasing returns to
scale, as the derivative of average cost
with respect to output is negative, zero
or positive. When S > 1 for a firm produc-
ing the industry output or less, monopoly
is a "natural"outcome of market forces.
Any firm supplying the entire market can
price so as to undercut any firm supplying
only part of the market.'
To relate this to the railroad example,
consider railroad trackage as a factor of
production that must be in place before
any service can be provided. Moreover,
assume that freight and passenger service
have identical marginal (and variable)
costs and that it is meaningful to aggregate
them into a single measure of output,
which we assume has constant marginal
cost. Under these conditions, there will
be declining average total cost as traffic
density increases. The economies of scale
that occur in this case are attributed to
the existence of a fixed factor of produc-
tion, trackage, whose costs, once sunk, can
be spread acrossadditionalunits of output.
Clearly, however, this example is quite
artificial since passenger and freight ser-
vices have very different characteristics
and thus different costs. Thus, instead of
aggregating them into a single unit of out-
put (train-serviceunits, which are difficult
to define either conceptually or operation-
ally), it makes sense to treat railroad out-
put as two distinctive services, passenger
and freight. In this case, the total cost
function is given as C = C(Y1, Y2)where
Y, represents the output of passenger ser-
vice and Y2is the output of freight service.
(We continue to suppress the other argu-
ments of the cost function, and also for
simplicity, we will restrict discussion to
the case of two products.) While there is
1 Explorationof the sources of scale economies of-
ten focuses on the empiricalquestion of which indus-
tries are characterizedby firms with falling average
costs and economies of scale. The literature dealing
with this issue is vast, and Bela Gold (1981) has ably
summarized it in a recent volume of this journal.
1029
A
\TRANSRA Y
Y2
PRODUCT RAY
SPECIFIC
....... .. ... ...
F
iSCOPE \J
i
0 E D
Y1
Figure 1: Output-Space for a 2-Product
Firm
still a meaningful definition of marginal
cost in the multiproduct case, e.g., MC1
-aC(Y1,Y2)/ a Y1,there is no single mean-
ingful definition of average cost since
there is no meaningful way to aggregate
freight and passenger services into a single
output measure. Moreover, since the com-
position of output will affect costs, care
must be taken to differentiate between
effects of the scale and the composition
of output upon costs.
The concept of scale economies can be
generalized to a multiproduct setting by
considering two related measures: ray
economies of scale and product-specific
economies of scale. Following Baumol
(1977) and Panzar and Willig (1977b) ray
economies of scale are a straightforward
extension of the concept of single-product
scale economies and indicate the behavior
of costs as the production levels of a given
bundle of outputs change proportionately;
that is, the composition of output is as-
sumed to remain fixed while its scale is
permitted to vary. Ray average costs
(RAC)are a natural generalization of sin-
gle product average costs and are defined
as
1030 Journal of Economic Literature, Vol. XX (September 1982)
RAC(Y) = C(tY) (1)
t behavior can be measured by product-
for a composite commodity whose unit is
the vector YOand whose scale of output
is given, by the scalar t. In terms of Figure
1 the output vector moves along a ray
through the origin of output space, such
as the ray OB.
Just as in the scaler case, ray scale econo-
mies are defined as the elasticity of output
with respect to cost (S = (d Y/Y)/(dC/C)),
measured along a ray, with Y = tY?, d Y!
Y = dt/t and dC/dt = IYi?MCi, which
gives2
S = C(Y) (2)
That is, the degree of ray scale economies
equals the ratio between production cost
and the revenues that would accrue to the
firm from pricing the outputs at their mar-
ginal costs. These revenues exceed, fall
short of, or equal costs as there are de-
creasing, increasing or locally constant re-
turns to scale, i.e., as the derivative of ray
average costs with respect to movements
along the ray is positive, negative, or zero.
In the railroadexample, ray average costs
can be calculated for any given product
mix of freight and passenger services. Be-
cause of the cost characteristics of track-
age, any such ray average cost curve will
exhibit declining average costs. Note,
however, that since product mixes rarely
remain constant as output changes,
changes in ray average costs will typically
not be observed.
While the measure of multiproduct
scale economies describes the behavior of
costs as output expands or contracts along
a given ray, it does not describe the full
behavior of costs as output bundles
2 It should be noted that this is also equal to the
inverse of the sum of the cost elasticities, as well
as other measures that can be directly calculated
from the production transformationfunction (Pan-
zar and Willig 1977b).
change. An additional dimension of this
specific economies of scale which, as de-
scribed in Panzar and Willig (1977a), show
how costs change as the output of one
commodity ch4pges. That is, costs are
measured above FB or EB in Figure 1,
where output of the other commodity is
held fixed in each case.
To arrive at a measure of product-spe-
cific economies of scale, it is necessary to
define another average cost concept that
can be meaningfully used in a multiprod-
uct setting. This is given by average incre-
mental cost (AIC) which is defined as the
addition to total cost associated with pro-
ducing a given product at a specific level
of output as compared with not producing
it at all, divided by the output of that prod-
uct. Thus, average incremental cost of out-
put 1 is the total incremental cost per unit
of output 1
AIC (_y)= C(_Y_, Y2)-_C(O, Y2) (3)
Then, product-specific returns to scale to
output 1 are measured by
AIC, (Y)(4
SI= |MCI (4)
Thus, average incremental and marginal
costs are interrelated in the same way as
gre single-product average costs and mar-
>
ginal costs. Hence, Si 1 as there are in-
creasing, constant, or decreasing returns
to scale with respect to output type i. Con-
sequently, if SI > 1, total incremental cost
(the numerator of (3)) will rise less than
proportionately as the production of Yi
increases, with the quantities of all other
output types held constant.3
To return to the railroad example, it
should be clear that the average cost of
3For earlier treatments of a different, but some-
what related notion of product-specificeconomies
of scale, see Frederick Scherer, et al., (1975) Alan
Beckenstein (1975), and Baumol (1976).
 Bailey and Friedlaender: Multiproduct Industries
freight service or passenger service alone
cannot be unambiguously defined, since
the trackage is shared by both services,
and there is no one correct way to allocate
its costs between the two services. The
incremental cost of either service, how-
ever, can be defined readily. This equals
the total cost of both services less the total
cost of providing one service alone. Since
trackage must be in place in either case,
the incremental cost of either service in
this example is just the variable cost of
that service. If marginalcosts are constant,
there are no product-specific returns to
scale even though there are clearly re-
turns to joint production. Alternatively, if
one class of railroad cars is not fully uti-
lized over some range of output, then
there would be a product-specific econ-
omy if output were increased over this
range. In this case, product-specific scale
economies may exist in conjunction with
economies of joint production.
Although measures of product-specific
scale economies partially reflect the effect
of the output mix upon costs, they neces-
sarily do so only in a partial manner since
they measure the effect on costs of a ce-
teris paribus change in one output type.
Thus, to capture fully the effect of changes
in the composition of output on costs,
more global measures are needed. Two
of these are given by the concepts of econ-
omies of scope and of transray convexity.
Economies of scope are said to exist
(Panzar and Willig, 1975, 1981) if the cost
of producing outputs 1 and 2 jointly is less
than the total cost of separate production,
that is, if
C(Y1, Y2)< C(Y1,0) + C(O, Y2) (5)
where Y1 is the output level of product
1 and Y2 is the output level of product
2. In terms of Figure 1, there are econo-
mies of scope at the output point B,
where, Y1= E and Y2= F, if C(B) < C(E)
+ C(F). A natural measure of the degree
of economies of scope is given by the
1031
proportion of the cost of joint production
that is saved by joint production
C(Y1,0) + C(O, Y2)- C(Y1, Y2)
Sc= C(Y1, Y2)
Thus, Sc > 0 as economies of scope exist
or not. Sc is bounded from above by the
value 1 if marginal costs are non-negative
(or, if there is free disposal) so that the
total costs of separate production cannot
exceed twice the cost of joint production.
In the presence of scope economies, firms
with diversified product mixes will tend
to have total costs lower than the total
costs of firms with specialized product
mixes, for comparable levels of output.
Willig (1979) argues that the concepts
of product-specific scale economies and
economies of scope together produce a
measure of multiproduct scale economies.
Using equation (2) to give a measure of
multiproduct economies of scale, we have
for the two-product case
S1,2= y a Y2) (7)
Thus, the degree of multiproduct econo-
mies of scale equals total costs divided by
the weighted sum of marginal costs, with
the weights representing the different lev-
els of output. If marginal costs are identi-
cal, the multiproduct measure of scale
economies collapses into the conventional
single output measure of scale economies.
By algebraic manipulation of (7), using
(4) and (6), it can be shown that the mea-
sure of multiproduct scale economies can
be related to the measures of product-spe-
cific scale economies and scope economies
as follows:
S1,2= w S1 + (1-w)S2 (8)
where
Ylac/aY1
W Y1aCiyl+ Y2aC/iaY2
1032 Journal of Economic Literature, Vol. XX (September 1982)
which roughly represents the share of the
variable costs of production incurred for
product 1. Thus, the overall degree of
scale economies for both products is a
weighted average of the degrees of scale
economies pertinent to products 1 and 2,
magnified by economies of scope through
the factor 1 / (1 - Se).An interesting impli-
cation of (8) is that sufficientlystrong scope
economies can confer scale economies on
an entire product set, that is S1,2 can ex-
ceed 1 even if there are constant returns
or some degree of diseconomies of scale
in the separate products. Also, it can be
shown that economies of scope and de-
creasing average incremental cost in each
of the product sets together imply overall
scale economies.
To return to the railroad example, it is
clear that the existence of uncongested
trackage can cause economies of scope
since separate production would require
duplicate track while joint production
would only require a single track. More-
over, in the presence of uncongested
trackage, the railroad would exhibit ray
economies of scale as the fixed costs associ-
ated with the track were spread over
higher output levels. That is, even with
product specific constant returns to scale,
Sl = 1, S2 = 1, the presence of economies
of scope, S, > 0, means that S1,2 > 1, as
is apparent from (8).
From the preceding discussion, it
should be clear that changes in the compo-
sition of output can have two different ef-
fects. First, in the presence of product-
specific decreasing returns to scale a ce-
teris paribus increase in output Yj will
cause incremental costs to rise more than
proportionately. But second, in the pres-
ence of economies of scope, costs may be
spread over more products. Roughly
speaking, if the effect of scope economies
is greater than the effect of any product-
specific scale economies, a cost function
is said to be transray convex, that is, as a
firm changes the composition of output
while holding fixed the level of some ag-
gregate measure of output, costs will be
lower for diverse rather than specialized
output mixes.
Although Francis Boddy (1939) appears
to have been the first to recognize this
concept, his work was not published, and
Baumol (1977) recently rediscovered the
idea and provided a name for it. Heuristi-
cally, the existence of transray convexity
implies that the costs of producing a
weighted sum of outputs jointly along any
given transray cross section will be less
than the weighted costs of individual pro-
duction. In terms of Figure 1, the cross-
section of the cost curve must be convex
above the line AD. Thus, for example,
(1/2)C(A) + (1/2)C(D) > C(B) where B =
(1/2)A + (1/2)D.4
In terms of the railroadexample, a mea-
sure of transray economies is obtainable
by varying the proportion of freight and
passenger service while holding the num-
ber of cars constant. If it is cheaper to
provide both services there is said to be
transray convexity. If marginal costs of
both outputs are constant, as may be the
case in the rail services example, costs will
be flat rather than strictly convex along
the transray cross-section that corre-
sponds to the relative marginal costs of
the two services.
To conclude, the cost function of a mul-
tiproduct firm will be sensitive to the com-
position of output as well as to the scale
of output. Thus, as the firm changes its
level of output and its product mix, costs
will typically change in a variety of fash-
ions, perhaps exhibiting both economies
of scale and of scope at one level of output,
but exhibiting only scope economies in
conjunction with product-specific scale
4Formally, a cost function is said to exhibit trans-
ray convexity along the hyperplane MaiYi = K, V
as > 0, if for any A with 0 < A < 1 and any vectors
of outputs Y' and Y" with lajY' = la Y' = K,
the following holds:
C[(XY') + (1 - X)Y"] < XC(Y') + (1 - X)C(Y").
 Bailey and Friedlaender: Multiproduct Industries
diseconomies at some other level. Thus,
the global cost surface may often exhibit
properties that cannot be represented by
the traditional concepts designed to indi-
cate the structure of costs in a single-prod-
uct setting.
2.3 Empirical Analysis Based on Multi-
product Cost Concepts
Since the preceding discussion has ar-
gued that a full understanding of the
structure of costs and technology requires
an explicit consideration of the multi-
product nature of firms, an obvious ques-
tion to ask is whether quantitative analy-
ses of costs also require an explicit
treatment of the multiproduct nature of
the firm being analyzed. Since there are
relatively few empirical studies of multi-
product cost functions, the evidence is
rather limited.5 Nevertheless, it strongly
supports the theoretical analysis and indi-
cates that seriously biased estimates may
result if the multiproduct nature of output
is not explicitly taken into account. More-
over, only estimation of the multiproduct
cost function can provide the information
necessary to resolve many pertinent pol-
icy issues.
In empirically analyzing the costs of a
multiproduct firm, the basic problem is
one of aggregation. Since most firms typi-
cally produce a wide range of diverse
products, it is generally impossible to in-
corporate all outputs in the analysis, be-
cause of the limited number of observa-
tions relative to the potential number of
parameters that would have to be esti-
mated. Thus, the problem is to aggregate
this diverse group of outputs into mean-
ingful subsets of outputs, within each of
51n addition to the studies described below, for
an early attempt to estimate a multiproduct cost
function for journal publication see Baumol and
Braunstein (1977). Also, Thomas Cowing and Al-
phonse Holtman (1981) have recently estimated a
multiproduct cost function for hospitals. See also,
John Matthews (1981) for a description of multi-
product economies of scale in the securities industry.
1033
which are outputs with comparable pro-
duction characteristics and comparable
marginal costs. To return to the railroad
example, these considerations indicate
that although it may not be meaningful
to aggregate freight and passenger output
into a single measure, it may be meaning-
ful to aggregate different kinds of freight
into a single measure.6
The trucking industry provides a partic-
ularly good example of the importance of
multiproduct analysis in empirical work
since recent estimates of the industry's
cost functions utilize both single and mul-
tiproduct specificationsof output and thus
permit a comparison of measures such as
economies of scale under different specifi-
cations. The evidence clearly indicates
that the multiproduct approach not only
yields more robust empirical results than
the single product approach, but also pro-
vides insights into industry behavior that
cannot be provided by single product
specifications.
Trucking output is by its very nature
heterogeneous. Not only do trucks haul
different commodities with different han-
dling requirements, but they haul them
in different shipment sizes, in different
loads, and for different lengths of haul.
Thus two firms with identical scalar mea-
sures of physical output (e.g., ton-miles,
tons, shipments, etc.) could have very dif-
ferent costs if their operating characteris-
tics were very different. For example, a
firm specializing in short-haul, small-lot
shipments would tend to have different
operating characteristics and costs than
one specializing in long-haul, large-lot
shipments.
Drawing on theoretical work on pro-
duction theory by Daniel McFadden
(1978) and Michael Denny and Melvyn
Fuss (1977), Spady (1979) and Spady and
Ann Friedlaender (1978) attempted to
6 the difficultiesassociated with this aggrega-
tion, see RichardSpady (1979) and Sergio Jara-Diaz
and CliffordWinston (1981).
1034 Journal of Economic Literature, Vol. XX (September 1982)
deal with these issues by introducing the
operating characteristics of the firm ex-
plicitly into the cost function in an at-
tempt to take the composition of output
into account. Utilizing a so-called "he-
donic" cost function, Spady and Fried-
laender defined a "hedonic" output func-
tion that attempted to measure effective
output as a function of physical output (y)
and the characteristics of that output (ql,
* . . , q.) where y was measured in ton-
miles and the q's represented variables
such as shipment size, average load, aver-
age length of haul, percent of less-than-
truckload (LTL) traffic, etc. that at-
tempted to capture the heterogeneity of
output. Thus instead of estimating a con-
ventional cost function as C = C(y,w),
they estimated a cost function as C =
C(+(y,q),w) where +(.) represents "he-
donically" adjusted output and w repre-
sents a.vector of factor prices.
Not surprisingly,they found that the in-
clusion of operating characteristics made
a significant difference.7 When costs are
estimated using physical output alone,
marked economies of scale were found.
However, when operating characteristics
were included, the m-easuredscale econo-
mies disappeared. Since larger firms tend
to utilize longer hauls and larger shipment
sizes, they tend to have lower costs. How-
ever, if smaller firms could have the same
operating characteristics as large firms,
they could presumably achieve compara-
ble economies. Thus this analysis strongly
suggests that many observed scale econo-
7Friedlaender and Spady(1981) have also utilized
a generalization of the hedonic cost function in
which operating characteristicsare separately intro-
duced into the cost function, which is written as C
= C(y,w,q). This specification is generally found to
be superior to the "hedonic" formulation since it
permits operating characteristicsto affect elasticities
of factor substitution and thus does not impose
the conditionof separabilitybetween inputsandoper-
ating characteristics that is implicit in the "he-
donic" formulation. Roger Koenker (1977) has also
estimated a truckingcost function that takes operat-
ing characteristicsinto account.
mies in the trucking industry are of a regu-
latory nature since the limited operating
rights to small firms keep them from
achieving the operating characteristicsof
the large firms.
The analyses of Spady and Friedlaender
(1978) and Friedlaender and Spady (1981)
clearly indicate that "hedonic" output
functions or their variants are quite useful
in the absence of multiproduct data, since
they do capture some of the dimensions
of heterogeneous output and thus provide
a partial adjustment for the composition
of output. Nevertheless, they are not fully
adequate since these aggregate measures
of output not only vary with the scale of
output but also vary with its composition.
Thus, measures of scale economies based
on "hedonic" outputs are necessarily am-
biguous since they may reflect the effects
of both scale and scope upon costs.
In an effort to distinguish between the
economies of scale and economies of scope
in the trucking industry, Shaw-er Wang
Chiang (1981) has recently analyzed
trucking costs by estimating a translog
cost function that incorporates a disaggre-
gate output vector and variables that re-
flect the configuration and utilization of
the network over which the firm
operates.8Her findings show that firmsen-
8 Donald Harmatuck(1981) has also recently esti-
mated a multiproduct translog cost function for the
trucking industry. However, it is considerablymore
aggregated than that of Wang Chiang. It is worth
pointing out, moreover, that the use of the translog
cost function to estimate scope economies may be
inappropriatebecause the translogfunction is unde-
fined where one or more of the outputs is zero. This
problem may be more apparent than real, however,
since scope economies can effectively be measured
by substitutingvery low output levels for zero output
levels. As an alternative approach,a so-calledgener-
alized translog cost function can be utilized, which
transformsthe output vector to permit zero outputs.
This approach is discussed fully by Ernest Berndt
and Mohammed Khalid (1979) and by Douglas
Caves, LauritsChristensenand MichaelThretheway
(1980), and has been successfully used by Fuss and
Leonard Waverman (1981) to estimate economies
of scale and of scope in the Canadiantelecommuni-
cations industry.
 Bailey and Friedlaender: Multiproduct Industries
joy marked economies of network struc-
ture configuration, with networks having
many connected links leading to signifi-
cant savings in inputs, and economies of
network operation, with direct routing
permitting lower costs. These network ef-
fects do much to explain the economies
of scale and of scope that Wang Chiang
observed. In particular,the returns to net-
work operations and structure with re-
spect to the distributionof services appear
to be sufficiently strong to generate fairly
marked network effects and do much to
explain the economies of scale and of
scope that Wang Chiang observed. In par-
ticular, the returns to distribution net-
works appear to be sufficiently strong to
generate fairly marked product-specific
economies of scale and economies of scope
in the intermediate-haul trucking mar-
kets. This gives a clear explanation for the
observed merger movement in the truck-
ing industry since these economies of net-
work utilization and of network config-
uration suggest that there are strong
economies of joint production associated
with short-haul and intermediate-haul
trucking shipments, particularly for small
and medium-sized firms. This suggests in
turn, that in the absence of regulation,
firmswould attempt to merge and to grow
to obtain the full range of economies of
joint production afforded by efficient net-
work utilization. Nevertheless, Wang
Chiang also found that there was no evi-
dence of global economies of scale and
that these product-specific economies dis-
appear for very large firms, suggesting
there may be a limit to the efficient
growth of trucking firms.Thus an analysis
of the multiproduct structure of costs in
the trucking industry indicates that al-
though concentration might increase,
competition should be workable in the
trucking industry in the absence of regula-
tion.
A multiproduct analysis of railroads by
Jara-Diaz and Winston (1981) using a
1035
quadratic cost function9 also indicates the
importance of network effects.10Analyz-
ing the structure of costs of a Class III
railroad at the totally disaggregate level
of the point-to-point shipment, they found
that economies of scope existed with re-
spect to shipments throughout the net-
work. To assess the significance of disag-
gregating the output vector, they also
estimated their model using aggregate
output measures and found that substan-
tial biases resulted concerning measures
of economies of scale and elasticities of
substitution. Thus their analysis provides
further evidence of the need for output
disaggregation.
While the utilization of the network
provides an explanation of the advantages
of joint production in the transportation
industries, it is clear that multiproduct
firms exist in many other industries. An
initial attempt to examine the economies
of joint production in the auto industry
by Friedlaender, Winston and David
Kung Wang (1982) found that costs in the
automobile industry were highly sensitive
to both the scale and the composition of
output. For example, estimates of the ray
economies of scale for the majordomestic
auto producers indicated that General
Motors (GM) enjoyed mild economies of
scale and that Ford experienced mild dis-
economies of scale. If, however, Ford
were able to achieve GM's product mix
while maintaining its existing level of out-
put, it would then achieve greater ray
9 Because a quadraticcost function is well defined
for zero output levels, it is appropriateto use in esti-
mating multiple output cost functions.Althoughcare
must be used to ensure that a quadraticcost function
is homogeneous of degree one in factor prices, Bau-
mol, Panzar and Willig (1982) and Berndt, Fuss and
Waverman (1979) have developed normalization
procedures that ensure that this homogeneity condi-
tion can be met.
10In addition to the paper cited above, Theodore
Keeler (1974), Harmatuck (1979), George Hasen-
kamp (1976) and Spady (1979) have estimated multi-
ple output cost functions for the railroadindustry.
These studies did not take the railroadnetwork ex-
plicitly into account.
1036 Journal of Economic Literature, Vol. XX (September 1982)
economies of scale than GM. This is in
accordance with intuition, since it implies
that ray economies of scale diminish with
output. It also indicates however, that the
composition of output may have an even
greater impact upon costs than the scale
of output. It is also interesting to note that
the econometric evidence indicates that
Ford would enjoy substantially greater
economies of scope than it currently expe-
riences if it could achieve GM's product
mix. Thus,just as the benefits of increased
output depend upon the product mix, so
do the advantages of joint production.
In conclusion, then, it seems clear from
the existing econometric studies of multi-
product industries that explicit disaggre-
gation of the output vector to take the
heterogeneity of output into account pro-
vides information and policy guidance
that cannot be gained from an aggregate
single-product analysis. Preliminary work
in this area has already been undertaken
in the trucking, rail, auto, telecommunica-
tion, publishing, securities and hospital in-
dustries, and presumably could be under-
taken in a wide range of other industries
characterized by diverse output sets. It
seems clear that a full quantitative under-
standing of market structures in multi-
product industries requires a knowledge
of the effects of product mix as well as
the effects of scale upon costs. Thus, fur-
ther empirical work on the cost structure
of multiproduct industry would be highly
desirable.
3. Barriers to Entry, Contestability and
Natural Monopoly
Cost conditions are not the only deter-
minant of the product-structure of firms.
Demand conditions can be just as impor-
tant. In the rail example, there would be
no need for the provision of freight as well
as passenger service on the same trackage,
if trackage could be fully utilized by either
service alone. But since sales cannot be
expanded without eventually subjecting
the firm to declining revenue, the avail-
able spare capacity in some of the firm's
activities or factors of production can best
be exploited by adding new product lines
for which marginal revenue is expected
to be higher. Economies of scope become
the substitute for the economies of scale
which firmscannot achieve given the mar-
ket conditions they face. The efficiency
of the composition of the product line that
emerges must then be determined.
Section 3.1 discusses the nature of mo-
nopoly in a multiproduct setting. It seeks
to identify which, if any, of an industry's
products are subject to natural monopoly
in the cost-minimizing sense and in addi-
tion, which of these products can be
priced in the marketplace in a way that
sustains the monopoly.
Section 3.2 then goes on to consider how
effectively the threat of entry works as a
deterrent to market power and, con-
versely, to establish whether entry barri-
ers and high concentration may act to
block the achievement of an efficient and
stable industry equilibrium. A generaliza-
tion of the concept of perfectly competi-
tive markets, namely contestable markets,
is described. These markets, in which exit
as well as entry is costless, are shown gen-
erally to be characterized by efficient be-
havior, yet they apply to the full range
of industry structures.
Section 3.3 reviews the policy implica-
tions of the sustainabilityand contestabil-
ity concepts, attempts to distinguish be-
tween policy issues that the concepts deal
with fully, policy issues for which they
may provide a frameworkfor decision, but
to which they can be applied only with
care, and, finally, policy issues where they
cannot offer ready solutions for decision-
makers.
3.1 Natural Monopoly, Subadditivity and
Sustainability
Gerald Faulhaber (1975) pointed out
that subadditivity of costs, not economies
of scale, is the correct concept to be used
 Bailey and Friedlaender: Multiproduct Industries
to provide an appropriate formal defini-
tion of natural monopoly. This is true be-
cause monopoly is the efficient form of
supply whenever a single firm can pro-
duce the current industry output at lower
cost than two or more firms. In any such
circumstance, economic efficiency re-
quires that the market be dominated by
that one firm. Formally, subadditivity is
said to exist if the costs of joint production
are less than the costs of separate produc-
tion for any scale of output or combina-
tions of outputs, that is,
C(I Yi) < I C(Yi)
where each portion of total output Yi may
range over all levels of output up to : Yi.
Faulhaber has shown that subadditivity
extends into the region of output where
S < 1.11 In such a region, he argues that
monopoly may not be a "natural" out-
come of market forces, since a firm that
produces the level of output correspond-
ing to the lowest point on the average cost
curve can always price its product in a
manner that undercuts a monopoly that
attempts to produce all that is de-
manded.'2 Thus, Faulhaber proved that
there can be a situation in which there
" Faulhaber'sresultsare derived using a game the-
oretic approachin which the lack of a stable pricing
strategy is depicted as an empty core of a cooperative
game. This approach has been utilized by others to
study equilibrium(generalor partial)in a production
economy with increasing returns. See e.g., the work
of Herbert Scarfand T. Hansen (1973),P. Champsaur
(1975), John Sorenson,John Tschirhartand Andrew
Winston (1978), Stephen Littlechild (1975), William
Sharkeyand Lester Telser (1978) and Sharkey(1978,
1981).
12 Faulhaberuses a simple example of water supply
to three towns, where the cost of serving any one
neighborhood is $300, of any two neighborhoods is
$400, and to all three neighborhoods is $650. The
least expensive alternativeis to have all three neigh-
borhoods supplied jointly since that cost ($650) is
less than the cost of three separate companies ($900),
and is also less than the cost of two separate compa-
nies, one serving two neighborhoods and the other
serving one neighborhood ($700). Yet, the solution
is not stable since any two neighborhoodscan supply
themselves at lower average cost ($200 apiece)
than they incur with joint supply ($216.67) to all
three.
1037
is a natural monopoly in the sense of a
"cost advantage" (subadditivityof produc-
tion cost), but in which monopoly supply
might be difficult to preserve in the free
marketplace. He thus introduced a dis-
tinction not present in traditional litera-
ture, which suggests that monopoly is the
natural outcome of competitive forces,
and arises from such cost advantages as
declining average cost. The modern the-
ory shows that a "cost advantage" (i.e.,
monopoly in the sense of least cost produc-
tion for a single firm) may exist in the ab-
sence of "sustainability"(i.e., monopoly as
a natural outcome of market forces).
Baumol (1977) and Panzar and Willig
(1977a) have shown that no simple condi-
tions that are both necessary and sufficient
for subadditivity can be devised from the
multiproduct cost concepts they have in-
troduced. Since cost functions can be sub-
additive in the presence of locally rising
average costs (ray or single-product),mul-
tiproduct economies of scale are neither
a necessary nor a sufficient condition for
the existence of subadditivity. Product-
specific economies of scale for each prod-
uct line at all levels of output up to the
given level, in conjunction with econo-
mies of scope at that level are, however,
sufficient for subadditivity. In addition,
transray convexity of costs and overall
scale economies guarantee that the econo-
mies of scope are sufficientlystrong to out-
weigh any product-specific diseconomies
of scale, and hence, imply subadditivity.
Thus, even though it is difficultto establish
quantifiable conditions for subadditivity
that are both necessary and sufficient, it
is possible to establish quantifiable suffi-
cient conditions for subadditivity.
Panzar and Willig (1977a)also show that
the potential instability of a natural mo-
nopoly carries over to the multiproduct
case, where it can arise for different rea-
sons. In particular,if product-specificscale
economies are more important than econ-
omies of scope, a firm specializing in a
single output can render unstable a natu-
1038 Journal of Economic Literature, Vol. XX (September 1982)
ral monopoly that is jointly producing that
good and other outputs that are demand S
substitutes. In contrast, if product-specific
diseconomies of scale are presents,greater
economies of joint production will make C ~~~E
the existence of a sustainablepricing strat-
egy more likely.
A D
Baumol, Elizabeth Bailey and Willig
(1977) carry the extension of the analysis
to markets with sustained prices even fur-
ther. They use (as do Panzar and Willig,
1977) a formal definition of a sustainable
price vector as one that enables the mo-
nopolist to be financially viable and that
prevents any feasible output price vector
for a potential entrant from yielding suffi-
cient economic profits to cover the cost s
of entry. They then show that if the mo-
nopoly selects prices that satisfy the condi-
tions for Pareto optimality under a profit
Figure 2: Cost Surface for a 2-Product
constraint, then it can sustain that set of Firm
prices,in the marketplace if the cost func-
tion exhibits ray economies of scale and lies on or above the cost surface at y2ym,
transray convexity. This is an important so the monopolist can cover his costs, but
finding since it implies that a monopolist only if the cost surface lies above the reve--
has an incentive to utilize the same price nue plane at every other point in the zone
and output vectors that a welfare-maxi- of potential profits.For then, at every pos-
mizing public utility would if it were oper- sible pair of entrant outputs, the entrant
ating under a breakleven constraint.
To provide an intuitive explanation, as-
sume that the cost function takes the
shape displayed in Figure 2 where there
are ray economies of scale on each ray
Oa, Qb, Od, in conjunction with transray
convexity depicted by the curve CABDE.
A revenue plane can be constructed at
fixed prices, h = (h1, h2), announced by
the monopolist (see Figure 3). A potential
entrant must plan to set prices at or below
these levels (on or below the revenue
plane in Figure 3)13if he is to sell the prod-
ucts. By choosing prices pim = hi, the
monopolist will set output ym. These
prices are sustainableif the revenue plane

13 revenue plane has the form of a revenue

function T;hiyi,but does not represent market reve-
Y,
nue because the prices hi are held fixed, while quan-
tities vary freely without regard to demand condi-
tions. Figure 3: Cost Surface and Revenue Plan
 Bailey and Friedlaender: Multiproduct Industries
vented by pricing at the depicted tan-
gency point, T, in Figure 3.
The efficiency of the resulting sustain-
able price vector is ascribable, essentially,
to the same reason that makes the com-
petitive price vector efficient. In the
purely competitive model, producers
treat prices parametrically because their
output levels are assumed to be suffi-
ciently small to leave prices unaffected.
The monopolist who seeks stationary
prices that can protect him from entry,
like the perfect competitor, has an incen-
tive to choose outputs that maximize prof-
its for the set of parametrically fixed mar-
ket prices which preclude profit to an
entrant. But by so doing, the monopolist
fortunately maximizes net social welfare,
subject to non-negative profits, since with
parametric prices profits provide a local
approximation to welfare.
Paul Joskow and Roger Noll (1981) criti-
cize several aspects of the sustainability
literature. They are concerned with the
assumption that entrants are confined to
producing a subset of the monopolist's
products. They feel that it is more likely
that the entrant's output levels and prod-
uct mix will not be identical to those of
the monopolist. Once the product mix is
permitted to differ, however, they believe
that even with pervasive economies of
scale and of scope, the optimal market
structure might well be monopolistic com-
petition rather than monopoly. Moreover,
Joskow and Noll also believe that if an in-
cumbent has advantages because of estab-
lished business relationships and informa-
tion costs, the incumbent could always
undermine a potential entrant by dupli-
cating its product mix. Similarly, it could
also forestall entry by reducing its product
mix and thus lowering its cost.
Two other authors, William Brock and
Jose Scheinkman (1981), have introduced
a notion of quantity sustainability. Quan-
tity sustainability is based on Cournot's
concept of equilibrium, in which firms set
quantity, in contrast with price sustain-
1039
ability, which is derived from Bertrand's
equilibrium, in which firms set prices.
Brock and Scheinkman's work is similar
to that of Baumol, Bailey and Willig in
that both sets of authors recognize the
importance of the ability to price a set
of products in such a way that fixed costs
are covered. But the two approaches dif-
fer in their assumption about the reaction
of incumbents.14 Baumol, Bailey and Wil-
lig implicitly assume a period of time in
which incumbent firms hold prices fixed,
such as might occur if there were regula-
tory oversight of prices. Brock and
Scheinkman assume instead that an en-
trant will assume output rigidity on the
part of the incumbent firm. They have
in mind a multiproduct extension of a
model in which a single-product firm has
an incentive to maintain its production
level and to let prices adjust to absorb the
additional output coming from the en-
trant. Brock and Scheinkman find that suf-
ficient conditions for a natural monopoly
to be quantity sustainableare much easier
to satisfy than those for it to be price sus-
tainable. Intuitively, a monopolist that is
not quantity sustainable is inherently
weak, for it cannot even protect itself
from entrants who must anticipate the
large declines in market prices that would
occur if their outputs are added to the
present outputs of the monopolist. The au-
thors also find that the quantity-sustain-
able equilibrium does not have the strong
socially desirable properties that occur in
the case of price-sustainability,since the
resulting equilibrium cannot be related to
any welfare-maximizing equilibrium.
3.2 Barriers to Entry, Concentration and
Contestability
Even though global subadditivity
(that is, subadditivity over the entire out-
put set) and natural monopoly are not the
norm, many multiproduct industries are
14 For a discussion of these sustainabilitynotions
in the context of pre- and post-entrygames, see Avi-
nash Dixit (1982).
1040 Journal of Economic Literature, Vol. XX (September 1982)
subject to economies of scale and of scope
over a sufficientlywide range of their out-
puts so that small numbers of firms are
the outcome. Yet, there has been a long
tradition in which economists have noted
that even in highly oligopolistic industries
barriersto entry are not always sufficiently
great to permit the reaping of monopoly
profits. Competition may in effect be
"workable," especially when there are
few sunk costs.
This tradition traces its roots back to Ed-
win Chadwick (1859) and, more recently,
Harold Demsetz (1968).15Demsetz argues
that even in a natural monopoly market,
monopoly pricing power would be pre-
vented if potential entrants could proffer
bids to serve the market at a lower unit
price. The idea that market power might
be limited even when suppliers are few
has recently been generalized to the case
of multiple markets in the notion of con-
testability. Willig (1980) defines a market
as idealized (or later as perfectly contest-
able; e.g., Chapter 10 in Baumol, Panzar
and Willig, 1982) if it meets certain condi-
tions under which potential entry can ex-
ercise socially reliable control even in the
presence of economies of scale or scope.
A perfectly contestable market has the fol-
lowing properties: (1) potential entrants
are assumed to face the same set of pro-
ductive techniques and market demands
as those available to incumbent firms; (2)
there are no legal restrictions on market
entry or exit, and no special costs that
must be borne by an entrant that do not
fall on incumbents as well, that is, the
technology may offer scale economies, but
must not require sunk costs; and (3) in-
cumbent firms can only change prices
with a non-zero time lag (the price-sus-
tainability assumption),but consumers re-
15See also, e.g., George Stigler (1968), Edward
Chamberlin (1962), Jesse Markham (1950), Joseph
Bain (1956), Michael Spence (1976, 1977), Richard
Caves and Michael Porter (1977), Scherer (1980),
Christien von Weizsacker (1980) and Demnsetz
(1982).
spond to price differences with a shorter
lag.
In essence, a market is perfectly con-
testable if incumbent firms must post
prices and abide by them for some period,
say t days. It is further supposed that all
capital needed by potential entrants is mo-
bile from market-to-marketor that there
is a well-developed lease or resale market
for capital, so that capital could be salable
or reusuable with no unusual loss in value
t days after its use in a particularmarket.
Then, an entrant could "hit"immediately
after the incumbent's prices were posted
and "run" t days later, when the incum-
bents are first free to respond, all without
cost disadvantage. It should be noted that
the costs of holding capital for t days may
be unavoidable, even for a firm wishing
to produce only a small amount by utiliz-
ing the capital for less than t days. Conse-
quently, the relevant average costs of pro-
duction may decline with output over
some range, despite the possibilityof "hit-
and-run"entry. In such circumstances, an
entrepreneur will enter the market if he
expects to obtain a positive profit by un-
dercutting the incumbent's price and
serving some portion of the market de-
mand at the new lower price. If the in-
cumbent readjusts his price, reducing it
beneath that of the entrant, then the new
competitor can readily exit from the mar-
ket without loss of any sunk investment.
Thus, potential entrants are undeterred
by prospects of retaliatory price cuts by
incumbents and instead are deterred only
when the existing market prices leave
them no room for profitable entry.
Intuitively, contestability can be viewed
as providing conditions under which econ-
omies of scale, per se, pose no threat to
market efficiency because they are not
necessarily associated with barriers to en-
try. Economies of scale, if they reflect
properties of production processes availa-
ble to all firms, do not constitute a barrier
to entry. Without such a barrier,Demsetz'
 Bailey and Friedlaender: Multiproduct Industries
(1968) argument holds that excess profits
can lead to competition for the market
rather than competition in the market.
It has been unfortunate that Demsetz' in-
stitutional context of franchise bidding has
obscured his fundamental insight (e.g.,
Williamson, 1976). While it is true that the
transfer of capital from one franchise to
another may pose insuperable difficulties
in practice, this problem is caused by the
presence of sunk costs, not economies of
scale. As Baumol and Willig (1981) indi-
cate, it is not surprising that sunk capital
in place should constitute an entry barrier,
since such costs must be borne by a poten-
tial entrant, but do not have to be paid
by an incumbent again. However, this
phenomenon is distinct from that of econ-
omies of scale.16
The concept of a contestable market
can readily be distinguished from the
textbook notion of a perfectly competitive
market. Both concepts involve markets in
which there is frictionless free entry. But,
the purely competitive model assumes
that there is such a large number of firms
in the market that each considers its pro-
duction decisions to have no effect on mar-
ket prices. In contrast, both incumbents
and potential entrants in a contestable
market realize that they cannot sell more
than consumers demand at given prices,
without bidding market prices down.
Consequently, a contestable market need
not be populated by a great many firms.
Indeed, contestable markets may contain
only a single monopoly enterprise or they
may be comprised of duopolistic or oligop-
olistic firms.17
"6See also, B. Curtis Eaton and Richard Lipsey
(1980) and for an early treatment of fixed costs, John
Clark(1923) and W. ArthurLewis (1949). For a mod-
ern treatment see RichardSchmalensee (1981).
17For a good discussion of the optimal number
of firmsin a market,see Baumoland Dietrich Fischer
(1978).For a discussionof the existence of sustainable
equilibria, see Baumol, Panzar and Willig (1982).
They argue that if cost curves have substantial re-
gions over which average costs are roughly constant,
a small-numbers,stable equilibrium can easily exist.
1041
The welfare properties of contestable
markets, as analyzed in Baumol, Panzar
and Willig (1982) and summarized in Bau-
mol (1982) make clear that something
much better than the old notion of work-
able competition can occur in the small-
number, multiproduct industry. Specffi-
cally, in perfectly contestable markets, the
hit-and-run option of potential entrants
ensure that profits are zero in any equilib-
rium, since any positive profit provides an
opportunity for a hit-and-run entrant to
set up business, replicate the incumbent's
output at the same cost as his, yet under-
cut the incumbent's prices slightly while
still earning a profit. Moreover, produc-
tion is efficient even in the presence of
monopoly or oligopoly (Willig, 1979). For
any unnecessary cost, like any positive
profit, constitutes an invitation to entry.
For the same reason, price must equal
marginal cost in equilibrium, except in
sole supply situations where the profit
from "hitting" may not exist because out-
put and price are constrained by elasticity
of demand. Even here, however, some-
thing akin to Adam Smith's "weak invisi-
ble hand" may be at work as we saw in
Baumol, Bailey and Willig.
The conditions required for perfect con-
testability or for some close approach to
it are demanding. They involve easy ac-
cess to the market on equal terms for new
entrants and old incumbents. They de-
mand that durable capital goods be easily
transferable by second-hand sale or alter-
native deployment that recoups their cost.
They require that industry-specifichuman
capital should not be market-specific but
should be transferable from market to
market to avoid large personnel costs from
hitting and running. They demand that
price reductions not be matched immedi-
ately but instead that there be a delay be-
fore incumbents can meet an entrant's
price.
Empirical research is required to reveal
how widespread such conditions may be
1042 Journal of Economic Literature, Vol. XX (September 1982)
and how closely they may be approached
in a variety of industries. Public policy can
and should be designed to encourage the
establishment of conditions in which con-
testability is fostered. If this is done, then
forces will be at work to ensure that cost
minimization is realized, not only for the
firm, but also for the industry. Potential
entry not only provides incentive for each
firm to set prices at competitive levels,
but it also ensures that each firm will oper-
ate at a scale of output that minimizes to-
tal industry cost. Monopolies and oligopo-
lies that represent an efficient utilization
of resources can exist in contestable mar-
kets; where there is freedom and costless-
ness of exit as well as entry, monopoly
power may be absent even in the pres-
ence of monopoly. Consequently, this re-
search provides a theoretical basis for the
proposition that even though small may
be beautiful, big isn't necessarily bad.
3.3 Policy Implications of the Contest-
ability and Sustainability Literature
There are a number of circumstances
in which consideration of contestability in
a multiproduct setting can be used to pro-
vide an excellent guide to policy. A first
aim of the policy-analyst should be to de-
termine the obstacles to contestability and
to evaluate the difficultyof their reduction
or elimination. Bailey (1981) has pointed
out that agencies such as the Interstate
Commerce Commission (ICC) and the
Civil Aeronautics Board (CAB) have be-
gun to realize that, instead of conferring
only route authorities that are actually
used, there is a benefit to having a pool
of potential competitors who can respond
to profit opportunities by entering the
market. Once such a pool exists, tight con-
trols over rate authority can be loosened.
In contrast, in cases where there are sunk
costs, such as in airports, railroads, bus
terminals, or local telephone cable, con-
tinued regulation may be appropriate.
One purpose of such regulation is to
ensure nondiscriminatory access to these
facilities. Without appropriate regulation
and the threat of competitive access, the
firms involved can reap the monopoly
rents associated with sole supply of the
services of sunk facilities and extend their
monopoly to potentially competitive ser-
vices that require access.18
Since the contestability of markets im-
plies that efficiency can be obtained with-
out intervention, a second aim of policy-
makers should be to assess the degree of
contestability that characterizes any in-
dustry under scrutiny. Because there may
well be sunk costs and entry barriers at
an industry level, a market-by-market
analysis within the industry may have to
be undertaken. If each market is readily
contested, there may be no need to fear
concentration at the industry level. The
airline industry offers an example. This in-
dustry has capital costs which, while sub-
stantial, are not sunk costs. The bulk of
airline capital (i.e., aircraft) can be flown
(recovered) from any particularmarket at
little cost, making entry and exit easy in
most city-pair markets. Such markets,
even if actually served by only a single
firm, have the cost attributes necessary to
approximate contestability. Similar con-
siderations hold in the regulated trucking
markets. A third, somewhat more com-
plex case occurs in the rail industry. Here,
a recent decision by the ICC provides an
illustration of how to base policy on the
concept of contestability. The ICC sought
to determine rail submarkets in which
truck competition would serve as a com-
petitive check on rail rates. According to
Darius Gaskins and John Voytko (1981),
this consideration was important in the
Commission'sdecision to deregulate rates
on rail shipments of fresh fruit and vegeta-
bles (361 ICC 74, 1979). There was, how-
"I For an excellent summary of the theory of net-
work access pricing in telecommunicationssee Wil-
lig (1979). See also, Roy Morris and Robert Preece
(1982).
 Baileu and Friedlaender: Multiproduct Industries
ever, no decision to deregulate rates for
the transport of coal to electric utilities,
however, since these markets were
deemed not to be contestable.
It is also possible to use aqalytic methods
rather than just a heuristic assessment to
measure the degree of contestability in
particular markets. Bailey and Panzar
(1981) have recently used concepts of con-
testability to determine whether the ben-
efits of airline deregulation as reflected in
lower prices, can result from the threat
of potential entry or whether they can
only result from actual new entry. They
argue that this depends on the contestabil-
ity or ease of entry into given airline
routes. Using data generated in 1979 and
1980, they showed that potential (rather
than actual) competition by trunk carriers
appeared to provide an effective competi-
tive check on the pricing behavior of local
service carriersin long- and medium-haul
routes during this period. Thus, even in
the presence of observed economies of
scale in the supply of flights in the city-
pair markets, the threat of entry by the
trunk carriers was sufficient to impose an
effective price ceiling and keep the local
service prices below the higher levels per-
mitted to them. For other aviation mar-
kets, such as those served by the trunk
carriers, the ability of carriers to match
prices virtuallyinstantaneously along with
at least some advantage for incumbent
carriers in attracting business19has meant
that all the criteria of contestability may
not be met. Here, the competitive spur
seems to be coming from actual rather
than potential entry and from a series of
price and market-share battles as incum-
bent carriers attempt to rationalize their
route systems, and new entrants attempt
19For an airline model in which an incumbent
carrierhas a marketing advantage at identical price,
see Judith Gehnan'and Steven Salop (1982). Their
model also explores the usefulness of a low price/
low capacity strategy in inducing an incumbent firm
to accommodate entry.
1043
to gain a market share for their low-fare
but no-frills service.
Another important policy application of
the theory of contestability is in antitrust
law. The theory suggests that there is no
need to fear mergers in contestable mar-
kets, even if they create concentration.
The report by David Sibley and SusanJol-
lie (1982) puts forth the view that reliance
on the market share and concentration ra-
tio analysisthat is typical of the structural-
ist approach to mergers is not pertinent
in the aviation industry. Instead, the focus
in merger cases should be shifted toward
the conduct of the firm in its specific
markets and on the underlying degree of
contestability in market supply as the de-
terminants of market performance. If per-
formance in the market or markets at is-
sue is satisfactory, and if it appears likely
to remain so, there is little justificationfor
antitrust intervention even in the pres-
ence of some economies of scale and
increased concentration. Bailey (1981)
provides a concrete example in her de-
scription of Board reasoning in permitting
Texas International to acquire National
Airlines. In that case, the Department of
Justice recommended disapproval based
in part on market share data. They rea-
soned the share of the two leading firms
in the Houston-New Orleans market was
51 percent and would be almost 75 per-
cent after a combination of Texas Interna-
tional and National. This number was
greater than comparable figures in merg-
ers declared unlawful by the Supreme
Court. The CAB countered by arguing
that concentration ratios were not instruc-
tive in this case since with the passage
of ttie Airline Deregulation Act of 1978
(Pub. 1. 95-504), there was now relative
ease of entry, even for small carriers, into
such markets. In the Houston-New Or-
leans market in particular, there were
eleven carrierswith stations and function-
ing facilities already in place at both ends
of this market. Therefore, the CAB rea-
1044 Journal of Economic Literature, Vol. XX (September 1982)
soned that the markets were readily con-
tested and did not find that a merger
would be anticompetitive. Indeed, by the
time the CAB order was written, a small
regional carrier, Southwest Airlines, had
entered the market with a low fare turn-
around service and was offering approxi-
mately 25 percent of the capacity of the
markets. (See, CAB Order 79-12-163,
164, 165.)
It is important to note, however, that
there are industries in which one might
suspect that a merger would reduce the
degree of contestability in the market.
This might occur, for example, if a U.S.
firm with an apparent domestic monopoly
in a particular product wished to merge
with a Japanese firm that was the only
potential entrant in the U.S. market. In-
ternational competition should also be
taken into account in cases such as IBM,
where the potential entry from abroad
should be factored into a correct analysis
of the extent of monopoly power (William
Landes and Richard Posner, 1981).
These latter examples lead us naturally
to consider areas in which the new litera-
ture may provide a framework for policy,
but where the theory can be applied only
with great caution. Joskow and Noll (1981)
are concerned about the implication from
the sustainability literature that, where
unsustainability is a problem (as in the
Faulhaber example) entry should be care-
fully scrutinized to ensure that society
captures all the benefits of natural monop-
oly. The heart of the problem, as they see
it, is that a single firm's natural monopoly
over all commodities and all output vec-
tors normally cannot be verified on the
basis of the data that are likely to be avail-
able. A regulatory agency, imposing entry
restrictions in order to ensure least cost
provision to society, may actually allow
the monopolist to provide products that
can be produced more efficiently by sepa-
rate firms. Judgment must then be used
in evaluating entry, recognizing that, on
the one hand, complete freedom of entry
into an industry exhibiting economies of
scale and of scope may lead to inefficient
supply while, on the other hand, complete
restriction of entry can encourage monop-
oly supply of products that might be bet-
ter provided by independent suppliers.
One possible interpretation of this prob-
lem is that there exists some boundary be-
tween regulated and unregulated portions
of an industry. In the past, policymakers
have tended to decide the placement of
these boundaries on the basis of techno-
logical considerations. But technology
changes, and reliance on technologically
determined boundaries may prove mis-
placed. On the other hand, determination
of boundaries on the basis of subadditivity
of costs is difficult because of the difficul-
ties associated with measuring costs. Al-
though a boundary setting procedure
based on contestability is not free of diffi-
culties of changing technology or mea-
surement, it gives at least a framework
that may help to cut through to the essen-
tials of the problem.
An application of these considerations
has arisen in telecommunications regula-
tion. Policymakers began their regulation
of this industry under the assumption that
all of the products and services provided
come within the boundariesof naturalmo-
nopoly. In recent years, they have tended
to fence in those portions of the business
characterized by large sunk costs, such as
local cables and wires, and treat this as a
natural monopoly. Other portions of the
industry that have technologies or manu-
facturing processes that appear to be more
inherently capable of competitive supply
are being opened to new entrants. In a
series of decisions involving the supply of
terminal equipment, such as the Carter-
fone Decision and the Equipment Regis-
tration Program, the Federal Communi-
cations Commission (FCC) has attempted
to avoid inefficiencies in the utilization of
the network while permitting a variety
 Bailey and Friedlaender: Multiproduct Industries
of firms to supply the many terminal
equipment devices that are now available
for business and household use. With the
advent of wireless transmissions systems,
such as microwave services and satellites,
policymakers have acted on their belief
that the provision of network services has
lost some of its technologically based attri-
butes of either scale or scope or entry bar-
riers. As a result, through a series of FCC
decisions, new entrants are being permit-
ted to compete in the broadest sense with
network service offerings of the tradi-
tional telephone companies. (For a discus-
sion, see Jerry Duvall and Michael Pelcov-
its, 1980).
The boundary problem between regu-
lated and unregulated portions of an in-
dustry also ties into the issue of cross-subsi-
dization. The issue arises in the U.S. Postal
Service which is a monopoly carrier for
first class mail yet competes with various
firms in parcel delivery. The issue also
arises in telecommunications regulation
where the FCC has concerned itself (in
Docket 18128) with whether American
Telephone and Telegraph (AT&T) could
increase prices in its monopoly MTS-
WATS markets in order to finance "un-
fair" competition against firms competing
with AT&T in other markets. AT&T'spo-
sition before the FCC and Congress is that
prices to the users of monopoly services
can be lower by providing services jointly
than if the joint provision of the various
services is not allowed. By paying prices
in excess of incremental costs in competi-
tive markets, consumers in those markets
make some contribution towards covering
costs that are common to the provision
of both competitive and monopoly ser-
vices. Thus, as long as revenues cover in-
cremental costs in each market, no cross-
subsidy can be said to occur.
Although this argument is intuitively
appealing, Kenneth Baseman (1981) ar-
gues that there is another side of the issue.
He poses a situation in which there are
1045
diseconomies of scope for a multiproduct
firm. Such a firm is given a monopoly fran-
chise in one commodity and competition
is permitted for the second product. Al-
though both goods may be priced above
incremental cost, he shows that the mo-
nopolist can price so high in its protected
market that it can prevent entry in the
competitive market even though the costs
of joint production by the monopolist ex-
ceed the costs of separate production.
Clearly, coihsumers are worse off in this
circumstance. The problem is caused by
the grant of a monopoly franchise (i.e.,
prohibition of entry) in a market in which
there is no longer a cost justification for
such a franchise.20
This outcome indicates that major pol-
icy issues may arise in cases where there
is a lack of contestability. Janusz Ordover
and Willig (1982) provide another illustra-
tion that highlights this issue. They argue
that there are strong incentives for anti-
competitive behavior in the cable TV in-
dustry in spite of a number of public policy
measures that have been adopted in an
attempt to control this behavior. In this
industry, the cable systems operators who
provide transmission services are locally
franchised monopolies. Programming
transmitted over the systems is divided
into two broad categories: basic program-
ming and pay programming. Over 90 per-
cent of pay TV programming services are
provided by three companies: HBO,
Showtime and the Movie Channel. Al-
though cable systems operators have in-
tense political and community pressures
to provide expensive public services (like
local programming, free cable service to
hospitals, churches, etc.) and although
there are elaborate bidding procedures
for franchises and there is regulation of
basic programming rates, Ordover and
20For further discussion of cross-subsidy and
predatory pricing issues, see e.g., Baumol (1979),
Ronald Braeutigam (1979, 1980), Joskow and Alvin
Klevorick (1979) and Edward Zajac (1978).
1046 Journal of Economic Literature, Vol. XX (September 1982)
Willig do not view these markets as con-
testable because once built, the local cable
systems embody costs that are mostly
sunk. There is evidence of substantial
profits to be earned in pay programming,
with cable system operators and pay net-
works vertically integrated and excluding
other pay programmers.
The cereals case of the Federal Trade
Commission provides yet another exam-
ple of a situation where technological con-
siderations may create an entry barrier
that inhibits the contestability of markets,
at least by potential new entrants not cur-
rently in the cereal industry. Schmalen-
see's (1978) study of the cereal industry
suggests that the minimum efficient sized
firm in the ready-to-eat cereal industry is
a multiple of the minimum efficient brand
size. Schmalensee argues that new en-
trants must simultaneously establish three
to four normal-sized new brands if entry
is to be successful. In contrast, an existing
firm can readily introduce one brand at
a time. This suggests that some aspects
of cereal production or distribution con-
fers what can be called an economy of
scope entry barrier (Willig, 1979).
These illustrative examples of policy is-
sues all make clear that concepts of econo-
mies of scale, ecbnomies of scope, sub-
additivity, and contestability can shed
considerable insight into the behavior and
structure of industries characterized by
multiple outputs. The theoretical litera-
ture is quite well developed in this area
and its empirical and policy applications
are beginning to appear. It has already
provided a framework to analyze a num-
ber of questions dealing with policy and
market structure relating to firm size and
competitive behavior in the transporta-
tion and telecommunications industries
and can usefully be applied in empirical
and policy analyses of many of the indus-
tries in the U.S. economv.
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