Product Variety as a Barrier to Entry: Evidence from the. Post-Deregulation Korean Soju Market

Transcription

1 Product Variety as a Barrier to Entry: Evidence from the Post-Deregulation Korean Soju Market Sungtak Hong Jinhwa Chung This Version: June 2015 Abstract Firms offer a variety of products not only to compete with firms already in the market but also to preempt the profitable product space and deter potential entry. In this paper, we investigate whether new product launches by the incumbent firms influenced competitors market entry decisions in the Korean soju market context. This market, previously composed of independent geographic markets, each with a protected incumbent producer, became open to nation-wide competition as a result of market deregulation in the early 1990 s. Across the geographic soju markets, we look at the observed pattern of product proliferation by the local firms and identify whether it had any impact on the number of competing firms in the markets. We build an econometric model that accounts for causal structures surrounding the incumbent firms product variety and the number of firms in the market, and the model also takes into account both observed and unobserved heterogeneity across firms and regions. The model parameters are estimated using instrumental variables techniques and we find that product proliferation and dominant market leadership of the incumbent firm served as barriers to entry following market deregulation. Keywords: Product proliferation, entry deterrence, a system of simultaneous equations, instrumental variables Ph.D. candidate in marketing, London Business School, London, UK, NW1 4SA; shong@london.edu Assistant Professor, Department of Economics and Finance, Keimyung University, Daegu, Korea.; jhchung76@kmu.ac.kr The authors thank Bruce Hardie, Don Lehmann, Kanishka Misra, Naufel Vilcassim as well as conference participants at INFORMS Marketing Science 2014, LBS Trans-Atlantic Doctoral Conference 2015 and EMAC Annual Conference 2015 for their helpful feedback. 1

2 2 Hong and Chung: Product Variety as a Barrier to Entry 1. Introduction This paper studies a multi-product firm s use of product variety in its strategic interactions with potential entrant firms. Theories of multi-product firm s product differentiation generally predict that firms will provide greater product variety in the presence of competing firms than monopolist firms will do. The firm s action of expanding the product variety may result from a rivalrous behavior to serve better consumers with heterogeneous demand as the market becomes more competitive. Alternatively, the action may be due to the firm s market-preemptive behavior to deter further entry (Hay 1976, Prescott and Visscher 1977, Eaton and Lipsey 1979, Bonanno 1987; review by Lancaster 1990). For instance, in a contestable market with a threat of potential entry, even the monopolist firm would respond to the threat by proliferating products and preempting the profitable product space. This market-preemptive product proliferation then conveys a credible threat to potential entrants and helps the firm monopolize the market by deterring future entry. In a market with increasing product variety of the incumbent firms along with a few new competitors over time, therefore, there are two distinct views to their expansion of product variety: it could be the firms reaction to changes in competition intensity in the market with free entry, or their market-preemptive action to deter new market entry. In the latter case, despite the observed increase in product variety, the market may exhibit less than optimal product variety from a consumer welfare perspective (in the presence of consumers with strong demand for variety). The negative impact on consumers may take place later when the incumbent firms can offer less variety without further entry by competitors who will have learned from their behavior of product proliferation. The question of whether the incumbent firms exercise preemptive power to inhibit the market competition, and the implications of this on the firms profits and consumer welfare, has been of central interest to policymakers and industrial economists. To answer this question, we need first to investigate whether new product launches by the incumbent firms have influenced competitors market entry decisions. The identification of the causal relationship between the firms product variety and the number of competing firms in the market is, therefore, an important empirical task. In this paper, we aim to document empirical evidence of the entry-deterring impact of an incumbent firm s product proliferation. Despite rich theories, there are few empirical studies that demonstrate the role of product variety offered by the incumbent firm as a barrier to market entry. Empirical researchers have studied how the firm s product variety changes in accordance with the

3 Hong and Chung: Product Variety as a Barrier to Entry 3 level of market competition by looking at the observed product variety and the number of competing firms in the market (Schmalensee 1978, Berry and Waldfogel 2001, Economides et al. 2008, Watson 2009, Ren et al. 2011). Using this data, however, it is difficult to establish an explicit distinction between causes and effects of the variations in the product variety. A major challenge has come from a potentially interactive causal relationship between the observed outcomes: the firms decisions on product variety and competitors decisions on market entry may affect each other. Thus, even if we observe changes in outcomes from both of these decisions, it is often impossible to identify whether the increase in product variety of the incumbent firm suppresses market entry and results in fewer entrants than there would otherwise have been. Given this empirical difficulty in identifying the causes and effects of a firm s product variety in its interaction with potential and actual competitors, previous empirical work looked at limiting cases which enabled researchers to study one or the other. Most early work studying the entry-deterring effect of the firm s product proliferation studied industries where existing firms expanded their product offerings while little market entry was made by competitors during the period. Focusing on such industries that are characterized by a small number of firms and high profit margins, the researchers sought evidence of market-preemptive product introductions by comparing the observed pattern of product launches to theoretical predictions (Schmalensee 1978, West 1981). A shortcoming of this approach is that the actual market entry rarely occurs and it is impossible to know to what extent changes to the established firms product variety were in response to the threat of new entrants. 1 The evidence of entry-deterring impact of product proliferation in this stream of research is, therefore, in large part obtained from conjecture, rather than from quantification of the impact. 2 Another stream of research examines how a firm s product offerings changes depending on the local market competition intensity by looking at an industry snapshot, where both the firms product choices and competition intensity vary across geographic markets. A central problem here is that the observed geographic market structures are potentially endogenous due to unobserved heterogeneity in demand across markets. The researchers have addressed this endogeneity issue 1 This problem has been also commonly acknowledged in the literature on the impact of new product introductions (Hausman 1997, Kadiyali et al. 1999, Petrin 2002, Draganska et al. 2009), where the timing of the new product introduction has been assumed exogenous. 2 As a more recent study, Igami and Yang (2014) search for some direct evidence of multi-outlet firms market preemptive location choices by looking at a sequence of openings of hamburger chains across geographic markets in Canada. Although the competition in locations among multi-store chains serves as a spatial analogy of competition in product space among multi-product manufacturing firms, the finding may not be translated into a context where firms can make prompt and less costly adjustments of their current product portfolio.

4 4 Hong and Chung: Product Variety as a Barrier to Entry either by structurally modeling a firm s market entry and product choice (Mazzeo 2002a,b, Seim 2006), or by estimating the reduced-form relationship through instrumental variable techniques (Watson 2009, Ren et al. 2011). 3 The findings from these studies provide insights into how a firm s product variety changes depending on the level of competition, yet do not account for how the firm can in turn influence the competition by changing its product variety (i.e., the entry-deterring effect). Our approach differs from the above streams of research in that we quantify the entry-deterring impact of product proliferation after accounting for changes in product variety due to actual changes in the number of competing firms in the market. We do this by building an econometric model that accounts for causal structures surrounding the incumbent firms product variety and the number of firms in the market. We apply and estimate the model in the post-deregulation Korean soju market. Soju is a traditional Korean liquor and serves as the cheapest and the most widely consumed alternative in the overall alcohol beverage industry in Korea. According to the Korean Alcohol and Liquor Industry Association, its market size by volume accounted for nearly 40% of the alcoholic beverage industry in The soju market under regulation in the 1980 s was characterized by being divided into a group of geographic markets, each with a protected local producer. Following a series of new government policies implemented in the early 1990 s, however, the previously regulated geographic markets became open to nation-wide competition. While the firm s pricing remained regulated and monitored by the government throughout the periods, the firms were allowed to produce a greater variety of products following market deregulation and this led to product proliferation by the local (incumbent) firms. The history of market regulation and deregulation in the Korean soju market serves as a good empirical context to study the local incumbent firms product strategies as a response to market entry. The government initially defined identities of incumbent firms in each geographic market, and later the deregulatory policies generated incentives for the firms to enter all other markets. As a consequence, each local firm had to react and protect their position as a market leader. The government restricted the market competition strictly among the extant firms and thus the market did not see any new firms nationwide after deregulation. Across the geographic soju markets, we investigate whether the observed product proliferation by the local firms had any impact on the number of competing firms entering that market. 3 Due to a high dimensionality problem, the structural approach has been applied mainly to a market context where single product firms simultaneously make market entry and product choices.

5 Hong and Chung: Product Variety as a Barrier to Entry 5 Our econometric model comprises a system of simultaneous equations to quantify causal relationship between the incumbent firm s provision of product variety and the number of competing firms in the market. In the context of the Korean soju market, where the local producer faced a new competition environment which encouraged new entry by competitors, an analysis focusing on either side of the causal relationship between the product variety and the number of competing firms will be mis-specified. In addition, the model takes into account both observed and unobserved heterogeneity across geographic markets. Since each geographic market was also characterized by its own local producer, we address heterogeneity due to market- and firm- specific factors in several ways. First, we include various socio-demographic characteristics of each market and firm-relevant fixed effects in the model. Second, we take into account local market leadership of the incumbent firm in each region. A distinct feature of the Korean soju market was that each region exhibited heterogeneity with respect to market share of the local firm. If such variations in the local firms market shares across regions were partly due to a varying degree of consumer preference toward their local products (e.g., consumers loyalty to the firm or inertia), any analysis ignoring this feature could produce biased estimates of the causal relationship: consumers strong preference toward local products could influence both the local firm s provision of product variety and the competitor s decision to enter that region. We address this issue by endogenizing market share of the local firm within each market. Having an additional equation that accounts for the local firm s market share in the region, the model also produces additional insights into how responsive the market demand was to changes in product variety offered in the market. The complete econometric system is estimated through the 3SLS regression and allows any other unobserved shocks to the market variables to be correlated. In estimating the model, we make use of various institutional background and sources of exogenous shocks which affected each endogenous variable exclusively and thus serve as instrumental variables. The empirical results demonstrate strong evidence of the role of product variety as a barrier to market entry after market deregulation: the local firms were able to exercise a significant negative impact on potential entrants to the market by offering greater product variety in the market. This implies that the local market competition might have been inhibited despite the government s deregulatory policies. On the other hand, the impact of actual changes in the number of competing firms in the market on the local firm s product variety was not statistically significant. The results also show that the higher market share of the

6 6 Hong and Chung: Product Variety as a Barrier to Entry incumbent firm makes market entry more difficult to potential entrants, and this emphasizes the importance of accounting for heterogeneity in consumers preferences toward their local firms. This paper proceeds as follows: Section 2 provides an overview of the Korean soju market and the history of competition policy implementations. Section 3 describes the data and presents initial evidence of the firm s strategic use of product variety against new market entry after market deregulation. The full model and our identification strategy are developed in Section 4, and the empirical results are presented in Section 5. After a discussion of the implications of ignoring simultaneity and endogeneity of the observed market variables, we conclude. 2. The Korean Soju Market Overview Traditionally soju was made from rice through a distillation process. Due to rice shortages during the 1960 s, however, the Korean government banned the use of rice for soju production and provided soju producers with licenses for producing ethanol (the alcohol base made from barley and tubers etc.) from which soju can be made by dilution instead. The unconditional provision of such licenses, however, gave rise to more than 250 small-sized soju production sites nationwide, and unhygienic operations and tax evasion by such small producers became a concern for the government. Consequently, the government became involved in the overall supply chain in order to establish higher industry standards in product quality and to secure the government s tax revenue on alcohol. The government initiated its control over the market by consolidating production sites in each of 11 regions based on which the production licenses were distributed (9 provinces and 2 metropolitan cities, Seoul and Busan). By 1977, the Korean soju market was segmented into 11 regions, each with one local producer. There were 10 producers nationwide; the leading producer, Jinro was assigned to both Seoul and nearby Kyunggi province while the remaining 9 regions were allocated to 9 other local producers. Figure 1 depicts the map of geographic soju markets and market sizes in terms of adult population over 19 years, as of Producer 1 (P1) represents Jinro serving as a local producer in both Seoul and Kyunggi province (Region 0 and 1 respectively), which accounted for about 40% of the total adult population in Korea. In consolidating the geographic soju markets, the government also strengthened the market leadership of the producers in their base regions by implementing two other policies: first, in 1976, the government mandated regional wholesalers to purchase at least 50% of products from their designated local producers. By law, soju producers can distribute their products to consumers only

7 Hong and Chung: Product Variety as a Barrier to Entry 7 Figure 1 Map of Geographic Soju Market and Population by Region via independent liquor wholesalers, and the wholesalers in each region are in charge of product distribution to both on-premises (e.g., restaurants and bars) and off-premises (chain and individual grocery retailers) in the region. 4 This policy, therefore, protected the local producers from nationwide competition. Second, the government controlled price and quantity of ethanol to be supplied to soju producers. Each year, the government determined the total quantity and allocated it to each producer based on the previous year s shipment volume. Price was also controlled in such a way that the producers were required to report to the National Tax Services prior to any changes in prices; only the increase due to the cost increase could be approved by the government. This control over the quantity and price of the soju products prevented the total market size from fluctuations and moreover, resulted in sticky market shares of the individual producers. Overall, the process of market consolidation and protection of the local producers in the 1970 s reshaped the Korean soju market structure: each geographic region had developed as a highly concentrated market for soju. Although these changes enabled the government to monitor closely the price and quantity of products, the lack of competitiveness of protected producers became a pressing issue facing the new wave of trade liberalization in the late 1980 s. 5 During this period, the government started 4 Until the 2000 s, the government also controlled the total number of wholesalers in each geographic market by limiting the number of licenses to wholesale liquor. According to the Tax Office, there were 1,366 wholesalers nationwide as of 1990, which later increased to 3,536 as of As related industries, the market for imported beer was opened in 1984, and the introduction of most foreign liquor products such as wine, vodka and whiskey followed in 1989.

8 8 Hong and Chung: Product Variety as a Barrier to Entry lifting previous restrictions in a large number of industries. In 1990, they announced their plan for market deregulation in 21 industries, and the soju market was one of them. Deregulation of the soju market in the 1990 s can be summarized as three major policy changes: 1) The mandatory local product purchase policy imposed on the wholesalers, which guaranteed at least 50% market share of local manufacturers in their base regions, was phased out in steps until it was removed from all regions at the end of Following lobbying by small local producers, several regions (except the three biggest region 0, 1 and 2) became regulated again in 1996 but that did not last for more than a year. 2) The government s central allocation of ethanol was ruled unconstitutional in December Following the removal of this policy, the firms were able to adjust quickly their shipment volume to market demand and thus, competition was promoted. 3) The policy banning the use of rice and some other starch was relaxed as of July After this change, the firms started developing new products using newly allowed ingredients. In fact, most of the firms product differentiation at this time was conducted through blending distilled ethanol from rice with traditional alcohol base. In sum, by the end of 1991, every geographic soju market became open to national competition and the formerly protected (i.e., having 50% local market share secured) local firms were encouraged to produce a greater variety of products. As to the producers power as price setters, there was no change during this period and their pricing was still monitored by the government. 3. Data and Motivating Analysis The main source of data for this study is retail data from Nielsen Company Korea. The data tracks bi-monthly product-level retail sales volume and value data across geographic markets for the period Price per unit volume sold can be computed from these two data. The classification of the geographic markets in the data is consistent with that presented in the market overview. Region 10 (Jeju island) and its local producer have been excluded due to their small size, and thus the final data set spans 9 firms across 10 regions. In our main analysis, we exploit this data to investigate how the local firm based in each region responded to competitors market entry using product variety after market deregulation. As a motivating analysis prior to the main study, we demonstrate that the Korean soju market after 1994 makes a good empirical context where we could identify the causal relationship between local incumbent firms product variety and market entry of competitors. The goal of this preliminary analysis is twofold: 1) we show that the market exhibited rich variations in new market

9 Hong and Chung: Product Variety as a Barrier to Entry 9 entry and product variety offered by each local firm during the observed period, and that 2) the variations are largely attributed to the new competitive environment brought about by market deregulation. Overall, in this section, we document some initial evidence that the local incumbent firms used product variety as a strategic tool after market deregulation. Since our retail data do not contain data for the period under market regulation (i.e., before 1991), we obtained another data set from the Korean Alcohol and Liquor Industry Association (KALIA) for this motivating analysis. Notwithstanding some limitations, the data span the time period from 1986 to 1999 and allow us to illustrate how market deregulation in the early 1990 s influenced the structure of the local market competition and the local incumbent firms marketing strategies. We now describe these data and a course of the analysis Shipment Data Description Yearly and quarterly firm-level volume shipped to each geographic market was recorded by KALIA for the initial time period of , and more detailed product-level shipment data are available for the subsequent period until Although sales at the product level are not available before 1994, the data contain descriptions of product variants offered by every firm for the entire period. The included product information is brand, ABV (alcohol-by-volume, %) and packsize, as well as price which the manufacturers charged to wholesalers. Brand information was often missing and we complemented the data by conducting online research on the history of brand launches by each firm. The sources of complementary online research included news articles, company websites and product blogs. Table 1 summarizes the market size (in volume) of each product type included in the final data set. The original data set covers sales from every channel including on- and off- premises, exports, and non-taxed supply for the military. For the present analysis, we exclude the volume shipped to channels other than on- and off- premises. 6 Among the total volume shipped to these two channels, roughly 99% of soju products contained alcohol between 20% and 25%. As to packsizes, the vast majority of the shipment volume (i.e., more than 98%) came from either small sized products in a range between 0.3 and 0.4 liter or 1.8 liter bottles. In fact, soju manufacturers offered their flagship brands in both small and large sizes, and the industry standard for the small size lay around 350ml. In addition, we note that products in packsizes larger than 1.8 liter (i.e., 2.7 and 3.6 liter) were 6 Although our retail data do not include on-premises sales, it is not possible to separate the on-premises volume from the shipment data. For the periods when both the retail and shipment data are available ( ), we compared market shares of each firm within each region computed from each data and confirmed that they were almost identical (the yearly correlations lay between and 0.996).

10 10 Hong and Chung: Product Variety as a Barrier to Entry Table 1 Soju Market Size in Volume by Product Type Product Attribute Variant % ABV 20-25% 752, , , , , ,906 30% 6,325 6,325 5,691 5,855 5,398 7, L 3,356 3,460 3,385 3,251 2,421 3,036 Packsize L 600, , , , , , L 16,111 13,237 12,966 11,876 11,678 13, L 138, , , , , ,554 Total Volume 759, , , , ,459 1,007,657 Notes: Market sizes in volume are in thousand liters. designed and advertised to serve distinct consumer needs; these products often contained more than 30% alcohol and the consumers used this type of soju products as an alcohol base from which they created other variations of liquor for their own (e.g., fruit wine). We, therefore, exclude this product type for the final data set. We define product variety of a firm as the number of distinct product variants in terms of two major product attributes; brand and ABV. We do not distinguish products of a given brand and ABV offered in several sizes because the firms decisions on packsize largely followed the industry standard and we do not observe that the firms changed or added a size of product under a given brand following its launch. Instead, the firms attempted product differentiation by developing new products which differed in ABV, either within a brand or as a new brand. As an illustration, product variety of producer 9 during the observed period is presented in Figure 2. Before market deregulation, the firm produced a limited line of products that varied mostly by ABV. This line of products served as the firm s flagship products and accounted for a majority of its sales throughout the observation period. When the market became deregulated in the early 1990 s, the firm managed a broader product portfolio. During this period, the restriction on the use of ingredients (rice in particular) was relaxed and the firm introduced new products by blending the newly allowed distilled ethanol from rice and adding other starches to the traditional alcohol base. The blending determined the degree of ABV and flavors for these products. This pattern of expansion of the firm s product portfolio was consistently observed across the firms. Both the number of firms operating in each geographic market and the incumbent firms product variety can be obtained from the sales data. For example, firms or product variants that recorded

11 Hong and Chung: Product Variety as a Barrier to Entry 11 Figure 2 An Example of Product Variety of a Soju Producer positive sales in each period can be counted. In the data, however, we observe that the firms occasionally shipped negligible (yet non-zero) volume of products whose production had been discontinued, possibly to clear out their inventory. 7 To account for the presence of such a lagged sales, we define active firms and product variants as ones whose sales exceeded certain thresholds: we treat the firms whose market shares exceeded 0.2% in a region as active in that region. Similarly, we count only the product variants of which the firms shipped more than 2,000 liters nationwide during each period. 8 Table 2 provides a snapshot of regional market structure in 1990 and 1994, which represent before and after market deregulation respectively. As a measure for regional competition intensity, we consider the Herfindahl-Hirschman Index (HHI) by region. A main feature of the market in 1990 is that each geographic market was characterized by the dominance of its local firm and a weak presence of a few other firms. On the other hand, in 1994, most geographic markets became less concentrated with more competing firms and the local incumbent firms offered significantly more product variants to consumers. It is also noteworthy that there is heterogeneity across regions with respect to the degree of the local firm s dominance in the base region. In the following section, we investigate further how these market variables changed continuously over time, and present 7 We identified such cases by comparing the sales record of major brands with its time of launch and delisting obtained from other sources such as company websites and news articles. 8 The presented results remained constant using 1,000 liters as an alternative threshold.

12 12 Hong and Chung: Product Variety as a Barrier to Entry Table 2 A Snapshot of Regional Market Structure: Pre- Vs. Post- Deregulation Regional Market Structure Local Firm s Performance HHI # Active Firms Market Share # Product Variants Region R R R R R R R R R R some evidence that the variations after market deregulation were due to competitive interactions between the local firms and competitors from other regions (i.e., potential entrant firms) Motivating Analysis In order to investigate changes of key market variables - the regional soju shipment volume, HHI and the number of active firms in the regions - over time, we first regress yearly observations of the variables with year fixed effects. The year 1991 is set as the base year throughout the regressions to see if there was any significant change before and after that year. We also account for unobserved sources of heterogeneity across regions by adding regional fixed effects. Figure 3 illustrates point estimates and 95% confidence intervals of the year fixed effects (in relation to 1991) in each regression. Since the market volume and the number of competing firms may increase over time along with the growth in population, we obtained data of regional adult population (i.e., population over legal drinking age 19) from the Statistics Korea and included as a covariate in both regressions. After accounting for the population growth, the regional market volume stayed at a constant level until the end of the observed period. On the other hand, the regional market structure in terms of concentration and the number of competing firms exhibited some significant fluctuations during the 1990 s. Following the implementation of market deregulatory policies, we expect the regional markets to become more competitive and their concentration (e.g., HHI) to decrease significantly. Yet, the result suggests that market deregulation might have a small and temporary

13 Hong and Chung: Product Variety as a Barrier to Entry 13 Figure 3 Pre- and Post- Deregulation Market Trend * Notes: The shaded area represents the middle 95% confidence intervals (base year=1991). impact. Similarly, as to the number of active firms within regions, we do not observe any drastic or permanent increase in the number despite some fluctuations since the early 1990 s. To investigate whether the market deregulation indeed induced significantly more frequent market entry of the competitors into each market, we conduct further analysis on the firm s decisions on market entry. The analysis also takes into account some more observed sources of heterogeneity across regions. Analysis on market entry. We build a model for each firm s entry decisions into 9 regions outside its base region. This firm-level entry model incorporates heterogeneity across firms and geographic markets that may account for profits from entry, thus the market s attractiveness to potential entrants. Formally, the model is written using latent profit from entry of firm j into region r ( r j) at year t, π jrt and the observed binary entry decision (1 if entered and 0 otherwise), Entry jrt : π jrt = f j (Region F actors rt ) + β j F irm j + γ P olicy rt + ɛ jrt, (1) Entry jrt = 1[π jrt > 0]. (2)

14 14 Hong and Chung: Product Variety as a Barrier to Entry f j (Region F actors rt ) refers to factors in each region r at year t that may affect demand for firm j or the costs associated with entry. To account for the impact of the market size, regional adult population and real GDP (per adult population) are selected. We also consider two location variables: 1) a measure of distance between producers and regions (defined as the number of regions to pass in the shortest path to move from one region to the other region), and 2) the route from each market to the target market. Acknowledging that more than 40% of the adult population resided in Seoul and the surrounding Kyunggi region (Region 0 and 1), we treat the market covering these regions as the target market. We then construct the path from each market to this target market based on the Korean highways, to see if the firms are more likely to enter the regions that they pass through on their way to the target market. Specifically, we operationalize a binary variable which indicate the regions for each firm to pass through to reach the target market. Further descriptions of the location variables based on the highway map are provided in Appendix A. In addition to the regional factors, the model accounts for heterogeneity across firms using firmspecific dummies, and P olicy rt captures the impact of market deregulation on the firms entry decisions after accounting for the observed and unobserved sources of heterogeneity. For the sake of simplicity, we use a variable indicating the period after 1992, when all the major regulatory policies were terminated. Further, to capture any impact of the temporary re-introduction of the local product purchase policy in 1996, we add a year- and region- specific variable indicating the regions that were regulated during Combined with an assumption that idiosyncratic error term ɛ jrt follows a standard normal distribution, the formulation becomes the Probit model, and the model is estimated based on yearly observations of the firms entry decisions from 1986 to Firm 1 entered every region throughout the period and was therefore excluded from this analysis. Table 3 presents the results from various model specifications: first of all, we confirm that there was significantly more frequent entry after market deregulation after accounting for heterogeneity across regions and firms. The population and income mattered but population became less important as we accounted for the target market and the paths to it separately. The negative effect of regional income can be attributed to the fact that soju is the cheapest alternative among alcohol beverages that appeal to the population with low income. Both distance measures turned out significant with expected signs; the further the market is the less likely a firm is to enter the market, and the firm is more likely to enter the

15 Hong and Chung: Product Variety as a Barrier to Entry 15 Table 3 Parameter Estimates from The Probit Regression on Firm s Entry (I) (II) Correlations Covariates Coefficients SD Coefficients SD Coefficients Policy Variables: Deregulation since ** (0.127) 0.507*** (0.140) Temporary Regulation in (0.211) (0.230) Market Size and Location: Adult Population (Mil.) 0.345*** (0.032) (0.062) Real GDP (per adult pop.) 0.036** (0.017) 0.042** (0.018) 0.357*** Distance 0.411*** (0.065) 0.436*** (0.078) 0.406*** 0.104*** Route to Target Markets 1.967*** (0.231) 0.656*** 0.187*** 0.269*** Target Market (R0 and R1) 0.969** (0.385) Firm Fixed Effects: Log Likelihood Observation 1,008 1,008 *** Significant at 1% level;** 5% level Notes: The dependent variable in the model is a binary outcome of each firm s market entry decision (1 if entered, and 0 otherwise). Firm 1 entered every market throughout the period and was excluded from the analysis. The base year for real GDP is markets they need to pass through on their way to the target market. The identified geographic variables can serve as predictors for the number of competing firms in each market. 9 Although the results from the firm-level entry model show that the market deregulation influenced the firms decisions to enter the other markets, the earlier presented Figure 3 suggested that it did not have either drastic or permanent impact. A possible explanation is that the local incumbent firms managed to deter some new market entry by competitors. We now turn to the local firms marketing actions in their base regions. In particular, acknowledging that the firms pricing was regulated both pre- and post- deregulation period, we look at how the local firms changed their product variety after the market deregulation, and seek some evidence that they used product variety as a strategic tool in competing with (potential) entrants from the other regions. 10 Analysis on product variety. We begin by regressing the yearly observations of product variety that each firm offered to their base markets on year- and firm- specific dummies. The regression also includes adult population and income (per adult population) in the base region 9 We considered several alternative models to account for the firm s performance outside its base region and confirmed that they produced consistent results. See Appendix B. 10 A time-series regression on price of flagship product variants (which were available throughout the whole period) showed that their prices indeed remained constant after accounting for yearly inflation and changes in the amount of alcohol (%). The results are available upon request.

16 16 Hong and Chung: Product Variety as a Barrier to Entry Figure 4 Geographic Differences in Timing of Product Proliferation 1. All observations ( ) 2. Regions based on the time of mandatory local product purchase policy removal ( ) Notes: Group 1 includes region 2, 5, 8 and 9 where local product purchase policy was removed between 1990 and 1991, and group 2 includes region 3 and 4 where the policy remained in effect until the end of as covariates. Figure 4 depicts the estimated time trend and it highlights a significant increase in the number of product variants since Such a product proliferation, however, could have been simply due to the new policy allowing the use of new ingredients in production in July Seeking evidence that the degree of the product proliferation could also have been accounted for by the degree of local competition each local firm faced, we exploit the fact that there were geographic differences in terms of the time until which the local firms were able to secure their market shares. Specifically, while the use of rice became allowed for every firm at the same time, the timing of removal of mandatory local product purchase policy differed by region. The geographic coverage of the policy decreased in steps: Region 0, 1, 6 and 7 whose local firms were the three largest nationwide were exempt from the policy earlier in During the market deregulation in the

17 Hong and Chung: Product Variety as a Barrier to Entry s, the policy was removed from region 2, 5, 8 and 9 between 1990 and 1991 while it remained in effect in region 3 and 4 until the end of In Figure 4, we also present the quarterly average number of products in two groups of regions that differ in timing of the policy removal, and they indicate that the incumbent firms in regions where they were able to secure their market shares until a later period, introduced new products later. 12 This finding serves as initial evidence that the local incumbent firm and competitors from the other regions became involved in competitive interactions with respect to their decisions on market entry and product variety after market deregulation. 4. Full Model 4.1. A System of Simultaneous Equations for Endogenous Market Outcomes The primary objective of this paper is to identify the entry-deterring impact of an incumbent firm s product proliferation. In the post-deregulation Korean soju market context where a group of local incumbent firms with limited pricing power faced new market entry from competitors based in the other regions, we achieve this goal by establishing a causal relationship between two observed market outcomes - how many firms competed in the market and how much product variety the incumbent firms offered to local consumers. The model comprises a system of simultaneous equations that represent causal structures of region-level variables that are jointly determined. This analysis at the region level takes advantage of the soju market context where these regions serve as separate geographic markets each with a local firm that was exogenously assigned by government policy. We first write two equations for the number of competing firms in the market and the local firm s product variety. Another important feature of the geographic soju markets is that there was heterogeneity across firms and regions. In particular, we noted earlier that the market leadership of the local firms in their base regions varied even before the market became deregulated. Such a variation in the local firms market shares across geographic markets emphasizes the need to take into consideration the potential heterogeneity in consumer preference for the local firm. Choi et al. (2013) show that the strong market leadership by the local firm can be in part accounted for by the consumer s choice of local brands as an expression of their local identity. Acknowledging that the market shares of the local 11 It is noteworthy that this order of market deregulation was based on the national market share of the firms and was not necessarily based on their capability of new product development. Annual reports published by the firms often acknowledged that the process of soju production varied little across the firms. 12 A firm-level ordered Probit model of product variety produced the consistent results. See Appendix C.

18 18 Hong and Chung: Product Variety as a Barrier to Entry firms could be endogenously determined by the firms actions being targeted to such local demand, we endogenize the variable in the complete system. The full model, therefore, comprises three simultaneous equations to recover causal relationship among the local firm s market share and product variety, and the overall number of competing firms at the region level: ln(nfirm rt ) = α 1 + β 1 ln(incumb.shr rt ) + γ 1 ln(incumb.nprod rt ) + θ 1 X + φ 1 Z firm + ɛ 1rt, (3) ln(incumb.nprod rt ) = α 2 + β 2 ln(incumb.shr rt ) + γ 2 ln(nfirm rt ) + θ 2 X + φ 2 Z prod + ɛ 2rt, (4) ln(incumb.shr rt ) = α 3 + β 3 ln(incumb.nprod rt ) + γ 3 ln(nfirm rt ) + θ 3 X + φ 3 Z share + ɛ 3rt, (5) ɛ rt MV N[0, Σ] ; Eɛ irt ɛ jrt = σ ij, (6) where Nfirm rt, Incumb.Nprod rt and Incumb.Shr rt refer to the number of firms, the local firm s number of product variants and its market share within their base region r at time t. These three variables are included in logarithm for potential non-linear relationships, and the unit of time for our analysis is bi-monthly. 13 X contains various fixed effects common in the three equations while {Z firm, Z prod, Z share } is a group of equation-specific explanatory variables which could also serve as instrument variables for each endogenous variable. Lastly, Σ captures any unobserved correlations among the three market outcomes. For a system of equations to be structural and allow us to infer causality, each equation in the system needs to have its own meaningful interpretation (Wooldridge 2010). Such autonomy of each equation can be obtained by deriving the model from counterfactual reasoning based on economic principles (e.g., demand and supply equations). Ideally, the system would account for endogenous variables that are outcomes of decisions made by distinct economic units and our model falls into this category. First, the number of firms operating in the market is an outcome of market entry decisions made by competitors from outside. Equation (3), therefore, contains covariates that influence the competitors decisions of entry into that region. By including the local firm s product variety as an influential factor, we allow the model to identify the role of the local firm s product variety as a barrier to market entry (i.e., γ 1 < 0). Second, Equation (4) accounts for causal effects of explanatory variables on the local firm s decisions on how much variety to offer to the market. The set of explanatory variables include the number of firms in the market as an endogenous variable 13 According to the annual reports published by soju producers, the firms were able to develop and launch a new product in less than three months during the period of our study.

19 Hong and Chung: Product Variety as a Barrier to Entry 19 and γ 2 captures the firm s reactive product strategy depending on the degree of local competition. Lastly, the market share of the local firm in the region represents local consumers choices over the firm and Equation (5) will help us quantify the demand for product variety offered within the local firm and demand for variety across firms; β 3, if positive, captures the local firm s potential share gain from offering more products while γ 3, if negative, accounts for the loss due to the presence of the new firms. The proposed model is similar to one in a related study by Bayus and Putsis (1999) in which they build simultaneous equations to account for determinants and outcomes of a firm s product line decisions in the personal computer industry. By having market share, price and product line length of an individual firm as dependent variables, however, the focus of their model lies in endogenizing jointly the firm s decisions on price and product variety. Although they observed that the number of firms operating in the overall industry grew during the observation period, the scope of their model is limited to the firm s decisions conditional on market entry. 14 In the Korean soju market, firms lacked pricing power and we place an exclusive focus on the impact of the firm s product strategy on market entry. It is noteworthy that our model not only treats the market share of the local firm as the outcome of the market competition but also allows the market share of the firm to have a direct impact on the firm s product strategy (β 2 ) and the competitors entry decisions into that region (β 1 ). There are two possible accounts that predict the direct impact of the firm s market share on its product variety. First, the higher market share could induce a firm to produce more variety because the firm s production capacity may grow with the market share. On the other hand, a firm as a dominant market leader may have a weaker incentive to invest in new product development and thus to offer less variety of products. While the former argument predicts the positive impact of the market share on the product variety, the latter predicts the negative impact. The estimated sign of the impact can inform us whether the effect of firm capacity (measured by the market share in the base region) dominated the incumbency effect on provision of soju products. We also expect the local firm s market share to have an impact on the competitors entry decisions. The higher market share of the local firm could indicate to the potential entrants how receptive the local demand would be to new entrants (e.g., a degree of consumer inertia or loyalty to a firm leading to high firm-switching costs), and thus induce fewer firms to enter. The negative 14 The study tests indirectly the market preemptive effect of product proliferation by investigating whether the firm could charge a higher price when it offered greater variety of products, and do not find significant evidence.

20 20 Hong and Chung: Product Variety as a Barrier to Entry sign of the estimated coefficient will support this reasoning. In sum, accounting for endogeniety of the local firm s market share in the system will uncover the role of consumer demand for the local firm in the firm s employment of competitive product strategies and competitors entry decisions. Besides the three endogenous variables, each equation contains a set of exogenous covariates. We consider time-specific dummy variables in X to capture the impact of any temporal shocks to the soju market, common across regions. Among various specifications, we present a result using a variable indicating the Korean economic crisis. 15 In mid-1997, the East Asian economic crisis hit Korea and after a chain of the conglomerates default on debts, Korea fell into the IMF bailout program in November Thus we capture the impact of this economic crisis on the Korean soju market using the variable indicating years after {Z firm, Z prod, Z share } represents each set of exogenous variables included in the respective equation. We discuss the selected variables in the subsequent section Identification Strategy Empirical identification of the proposed model not only relies on variations in the selected variables across geographic markets and over time but also on exclusion restrictions. The motivating analysis confirmed that the market exhibited sufficient variations of the three endogenous variables. To satisfy the exclusion restrictions, we need a set of exogenous variables which account for each endogenous variable yet are uncorrelated with any unobserved factors that may affect the other endogenous variables in the system. More specifically, for our system of three equations having all three endogenous variables appearing in each equation, we need at least one instrumental variable that is unique to each equation. In this section, we document the set of explanatory variables and rationales for the selection in light of our empirical context. Figure 5 summarizes the set of instrumental variables which help us identify the system. The number of firms. To account for how many firms are competing in each geographic market, we use regional characteristics that could potentially affect the profitability of the firms entry into that region. In particular, we use the variables that were identified from the firm-level entry model presented earlier. The results of the model indicated that the level of population and income of a region influenced the firms entry decision into that region. In addition, the results indicated that the geographic locations of the regions with respect to the biggest target area (R0 and 1) would predict well the number of the firms in the regions; one of the identified predictors 15 We confirm that our main results do not depend on the selection of this time-specific control variable; e.g., the results remained consistent when we used year fixed effects instead.

21 Hong and Chung: Product Variety as a Barrier to Entry 21 Figure 5 Instrument Variables for Endogenous Market Variables for a firm s entry decision to a certain region was whether that region was passed through by that firm en route to the target area. In our equation for the number of firms at the regional level, we include a modified version of this variable - the number of firms that used the region as a through route to the target area. The advantage of the use of these regional characteristics is that we do not expect them to have any direct impact on the market share of the local firm; any impact on the market share will be via either the number of competing firms or the product variety of the local firm. That said, it is important to note that the population and the income level in a region could influence its local firm s product variety since the firm may determine how much product variety to offer to its base market based on such characteristics of customers. Thus, these two variables are also used to account for the local firm s product variety. On the other hand, the location variable should influence uniquely the number of the firms in the region and serve as a valid instrument variable for the number of firms. Product variety of the local firm. In addition to regional population and income, we consider two variables unique to the equation for the local firm s product variety. We look at agricultural production volume in each region. Until 1992, the use of rice in soju production was banned and

22 22 Hong and Chung: Product Variety as a Barrier to Entry thus the firms made the products by diluting ethanol and adding starch supplements such as those from tubers. Since the implementation of a new policy allowing the use of rice in soju production, the firms introduced new products utilizing distillation from rice. As indicated in Figure 2, most of the new products launched during the observed period ( ) were made from rice. We, therefore, suspect that the firm s decision of whether to produce new products using rice or to stick to the flagship product line that relied on tubers was made with respect to their supply of product variety. The two instrument variables to account for the product variety are: the annual regional production volume of rice and tubers (V ol rice + V ol tuber ), and the ratio between their volume (V ol rice /V ol tuber ). Although these variables are available only annually, the data varied by region. We expect to observe greater product variety at times (and in regions) of abundance of potential ingredients of rice and tubers. And given the total production volume of the ingredients, the more rice was produced compared to tubers, the greater number of new products we expect from the firms. According to annual reports of food grain consumption by the Korean Statistics (2012), the rice consumption quantity for soju production varied indeed in accordance with the level of the annual supply. For these variables to satisfy the exclusion restrictions required to identify the model, we need the variables to influence the other endogenous variables only indirectly through their impact on product variety. For example, the restriction will be violated if the total amount of rice supplied is correlated with the average price of soju products produced by the local firm and thus with the firm s performance (i.e., market share) and with the competitors decisions to enter the market (i.e., the number of firms in the market). We checked this correlation and found that there was no significant correlation between the relative abundance of rice production and the final soju price at the firm level at least. 16 This is possibly due to the fact that the rice served as an alternative among other potential ingredients for soju and the use of rice in production is largely optional. During the time of low supply of rice with possibly high price, the firms could choose to use less or none of it for some products, hence there was not necessarily a strong correlation with the price at the firm level. The decision on the level of rice consumption across product variants also supports the hypothesized direct impact on the product variety of the firm. 16 We constructed the firm-level average price per volume (liter) sold and also obtained market price data of rice and tubers from Statistics Korea to check for a chain of correlations. As expected, the ratio between production volume of rice and tubers were negatively correlated with their price ratio ( 0.131; P=0.017). Neither the price ratio nor the volume ratio was, however, correlated with the final price of soju products at the firm level (0.084; P=0.126 and 0.023; P=0.683 respectively).

23 Hong and Chung: Product Variety as a Barrier to Entry 23 Due to the firm-specific nature of the decisions on product variety, we also consider a set of additional fixed effects to capture some unobserved heterogeneity across the firms. Although the local firm in every region was designated as part of the government policy at the same time (i.e., the length of the firm s history is the same), we acknowledge that there could still be unobserved heterogeneity with respect to their managerial resources and capacities in new product development. 17 Producer 1 and 2 are the two Korean conglomerates ( Chaebol ) which participated in many other industries; Producer 1 (Jinro Corporation) was the national leader of soju production and in addition to the soju market, the group invested in such diverse areas as convenient stores, department stores and marine engineering to list a few. Another conglomerate, Producer 2 (Doosan Corporation) previously participated mainly in technology and infrastructure support businesses, and entered the soju market by acquiring a local producer in region 2 in During the period of our study ( ), these two producers might have possessed distinct levels of managerial resources or capacities compared to the other local producers solely focusing on the soju industry. To account for any impact that these distinctions had on their decisions on product variety, we include separate fixed effects for the two producers. Given the similar nature, these conglomerate-specific fixed effects are also included in the equation for the firms market shares. Market share of the local firm. As a unique variable for the firm s market share, we consider the manufacturer price of the firm s flagship product line as a percentage of their retail price. As noted, soju producers had limited power as price setters; their pricing was monitored by the National Tax Office throughout the period of study. As a result, they set their manufacturer price uniformly at the national level for a given product variant (Korea Fair Trade Commission 2006). Given the uniform manufacturer prices, the firms could subsidize trade promotions occasionally to lower their retail prices. To account for the impact of such changes in retail prices on the market share, we computed the manufacturer price of a product variant as a percentage of its retail price; (P rice manu /P rice retail ). This was done by matching product descriptions in our manufacturers shipment data and retail data, and comparing the observed national shipment price and regional retail prices. The higher the percentage was the heavier trade promotion the firm might have subsidized at the expense of its production margin and thus the higher market share the firm could have gained. 17 The model already takes into account some of this aspect by including the market share of the firm in the region. The proposed fixed effects will thus quantify effects due to any firm-specific characteristics which did not correspond to their market shares.

24 24 Hong and Chung: Product Variety as a Barrier to Entry The challenge of including this variable in the firm s base region is that it is potentially endogenous. That is, the estimate for the variable will be biased if the retail margin was correlated with other unobserved factors affecting the market share of the firm such as advertising campaigns. Also, for this variable to serve as a valid instrument for the market share, it should not affect the firm s product variety decisions or competitors entry decisions via any other channels. The firm may adjust jointly product variety and retail margin for individual product variants, and the firm s aggressive trade promotions in its base region could also deter the competitors entry into that region. We address these issues by; 1) using the average percentage across the regions outside the firm s base region and 2) using the percentage computed for the firm s flagship product line only. The rationale for the use of the average percentage outside the base region is similar to that for the use of price in other markets in estimating the price effects on consumer demand (Hausman 1997, Nevo 2001); the unobserved characteristics (e.g., media advertising) are assumed independent across the regions although the retail margin for the standard product line can be shared across regions to some degree; in our context, this is also likely due to the uniform manufacturer prices. In addition, we note that the firm s decision on product variety is less likely to be influenced by this variable computed for the flagship products outside the base region. This is based on an observation that, the firms focused on their flagship product line and rarely expanded product variety outside their base market, regardless of changes in their product portfolio in the base market. 18 In sum, we suspected that this variable outside the base region could have co-varied with that in the base region due to the firm s national trade policy, but have not necessarily varied in accordance with the firm s decision on product variety. The proposed full model is applied to the bi-monthly sales data we obtained from Nielsen Company and estimated using the 3SLS regression. Table 4 provides summary statistics of the key variables in the data. Among the covariates, population, income and production volume are transformed in logarithm in the estimation. We discuss additional details with respect to tests of endogeneity and model specification in Appendix D. 18 The average number of the total product variants that the local firms offered to their own market during the observed period ( ) is (SD: 2.81, Mode: 9) while the figure outside their base regions is significantly smaller at 4.62 (SD: 2.80, Mode: 1) - excluding the regions the firms did not enter. Also, in 52.79% of the observations outside the base regions, the flagship products accounted for more than 80% of the total number of products offered in the region.

25 Hong and Chung: Product Variety as a Barrier to Entry 25 Table 4 Summary Statistics of Market Variables Local Firm-Specific Regional-Specific Product Variety Market Share P rice M /P rice R # Firms Real GDP Population Rice/Tubers R ,796, (1.197) (0.041) (0.043) (0.637) (806,199) (0.022) (3.998) R ,728, (1.219) (0.042) (0.043) (0.788) (977,236) (0.491) (3.998) R ,013, (1.269) (0.046) (0.044) (1.371) (912,476) (0.018) (0.095) R ,949, (0.893) (0.054) (0.126) (0.517) (1,108,028) (0.032) (4.116) R ,748, (1.410) (0.065) (0.054) (0.631) (888,083) (0.076) (3.570) R ,621, (0.564) (0.032) (0.067) (0.500) (838,502) (0.017) (1.795) R ,884, (1.083) (0.039) (0.068) (0.933) (1,050,918) (0.043) (0.735) R ,471, (1.061) (0.164) (0.093) (0.667) (792,430) (0.080) (1.946) R ,974, (0.834) (0.052) (0.092) (0.394) (2,109,320) (0.085) (0.569) R ,665, (0.933) (0.194) (0.031) (0.484) (706,555) (0.021) (16.651) * Notes: P rice M /P rice R for a producer is averaged across regions outside its base region. Population is bimonthly population over age 15. Unit of population and real GDP per population are mil. and KRW. Rice/tubers ratio is the ratio between the annual regional production volume of rice and tubers. Real GDP (base year: 2005) and rice/tubers ratio are only available at the yearly level. 5. Empirical Results 5.1. Interactions Between Local Firms and Competitors Entry-deterring effects of product proliferation. Table 5 summarizes the main results from the estimation. Most importantly, the model quantifies both directions of the causal impact between the local firm s product variety and the number of competing firms within the region. The results indicate that the local firms observed increase in product variety was not due to the actual changes of competitors in the market; the impact of the change in the number of firms in the market on the incumbent firm s product variety is not statistically significant at 10%. By offering greater variety of products, however, the local firms were able to reduce significantly the number of competitors.

26 26 Hong and Chung: Product Variety as a Barrier to Entry Table 5 Parameters from the Full Model Dependent Variable (I) Number of Firms (II) Product Variety (III) Market Share Covariates Parameter SD Parameter SD Parameter SD Endogenous Variables: Number of firms (0.159) 1.305*** (0.090) Local firm s product variety 0.143** (0.070) 0.339*** (0.066) Local firm s market share 0.436*** (0.066) (0.119) Instruments: # firms passing through 0.123*** (0.018) Adult population in the region 0.139*** (0.023) 0.539*** (0.040) Income in the region (0.047) (0.071) Total production volume of rice and tubers 0.111*** (0.013) Production volume ratio between rice and tubers 0.004*** (0.001) Ave. P rice M /P rice R outside the base region 0.294*** (0.106) Fixed Effects: Conglomerate 1 (P1) 0.600*** (0.064) 0.514*** (0.050) Conglomerate 2 (P2) 0.310*** (0.056) (0.042) Economic Crisis ( ) 0.072*** (0.022) 0.104*** (0.025) 0.090*** (0.027) Observations *** Significant at 1% level;** 5% level As an illustration of the effect, Producer 3 (P3) offered five product variants to their region where there were six other competitors in the mid 1999 s. The estimated results suggest that P3 could have had one fewer competitor if they had doubled the product variety from 5 to 10. This is the impact uniquely due to the change in product variety, holding others constant, and this result implies that the firm s preemptive motives might have played a role in the observed product proliferation. The magnitude of the entry-deterring impact of the product proliferation seems small yet it is only a partial effect ignoring any corresponding chains of the effects. The estimated total effects via chains of the effects are to be discussed with the role of the local firm s market leadership. The use of product variety as a strategic tool in the soju market was also supported by a positive consumer response to product variety. Offering a greater variety of products to the local consumers generated additional market share for the firm. Despite the positive impact of the product variety on the market share, a negative impact due to new entrants implies that the consumers also maintained strong demand for variety at the firm level. In fact, the new entrant attracted more demand than a new product variant introduced by the local firm. As noted earlier, in many cases,

27 Hong and Chung: Product Variety as a Barrier to Entry 27 the new entrants did not bring to the market their complete selection of products from their base regions. In general, each new entrant offered only a small number of products (if not one), often from its flagship product line. We can conclude, therefore, that the consumers in the soju market valued standard products from various producers more than additional variety offered by their local firm, and this finding suggests a potentially negative impact of entry-deterring product proliferation on consumer welfare. The role of market leadership of the local firms. In addition to bringing insights into the local consumer s demand for variety, our model also reveals the role of the firm s local market leadership in the interactions with potential competitors. First, it quantifies a direct impact of such leadership on the firm s decision on product variety. We were agnostic about the sign of the impact ex-ante. On one hand, we conjectured that the impact could be negative if the firm exploited the dominant position in the region and produced less variety, all else being equal. On the other hand, we also expected that the firms could grow with a higher market share and thus become more capable of producing greater variety. The estimated impact is not statistically significant at 10%, possibly due to these diverging effects. In addition, we allowed the model to identify a direct impact of the local firm s market share on competitors entry decisions (thus the resulting number of firms). This impact is significant and negative; the higher the market share that the local firm has, the fewer entrants into the market they could expect. This implies that the potential entrants might have taken into account how strong the incumbent firm was in their base region to learn about how receptive the local demand would be to new entrants. Together with product variety of the incumbent firm, therefore, the strong market leadership of the firm served as a barrier to market entry. Returning to the illustration of Producer 3 above, by offering 10 product variants instead of 5, it could have also captured higher market share. And taking into account the complementary entry-deterring impact due to this higher market share, it could have had two fewer competitors by offering greater product variety. The impact of regional characteristics. The impact of various market characteristics on the three endogenous variables are mostly significant and of expected signs. First, the findings from the equation of the number of firms replicated those we obtained from the firm-level entry model; an attractive market to enter was characterized by large population with lower income (although not significant at 10%), and its location which required frequent through passage by the other firms en route to the capital region. Second, the results from the equation of the local firm s product variety show that the firms produced greater variety as the market became more populated. They also did

28 28 Hong and Chung: Product Variety as a Barrier to Entry so in years and regions of rich production of potential ingredients and more so when the availability of rice dominated that of traditional ingredients, tubers. Product strategies employed by the two conglomerates differed; while Doosan corporation (P2) managed a larger selection of products than that of the other small producers, Jinro corporation (P1) did the opposite. Lastly, the manufacturer price of the flagship product line as a percentage of the retail price was a significant predictor for the local firm s market share. The impact of this variable was significant and positive indicating that the more the producer was able to set the retail price closer to the manufacturer price (e.g., through subsidizing trade promotions etc.) the higher market share the firm was able to obtain The Importance of Accounting for Local Consumer Demand Our empirical results have identified both the incumbent firm s product variety and the current market leadership as barriers to market entry in the post-deregulation Korean soju market. To highlight the importance of accounting for the role of the local firm s market share in understanding the entry-deterring effects of product proliferation, we also estimate a pairwise model omitting the market share completely from the system. The model still identifies the causal relationship between the incumbent firm s product variety and the number of competing firms in the market, but do not take into account how the incumbent and potential entrant firms incorporate the consumer demand for their local products into their decisions. The results from the pairwise model are presented in Table 6. The model produces the results consistent with those from the full model in terms of the impact of exogenous variables. Yet, the results differ significantly in terms of the implications on the firms product strategies. Without accounting for the market share, the model leads to an upward bias of the magnitude of the effect of entry-deterrence through product proliferation. Also, one may conclude that new market entry actually reduced significantly the incumbent firm s product variety. The reason behind these biases in identification is twofold: 1) the pairwise model does not take into account the impact of the signal to the potential entrants through the local firm s dominance in the region. The results from the full model indicates that the consumers in the soju market exhibit demand for variety and firms offering greater variety generally enjoyed the higher market share. The higher market shares of the firms then made market entry more difficult to potential entrants. The pairwise model does not distinguish this impact of the signal to the potential entrants through the local firm s dominance in the region. Instead, it captures the aggregate impact of offering a large selection of products on the entrant firms market entry. 2) The model does not recognize the mechanism that the competitors, once entered, could weaken significantly the market share of the local firm. In

29 Hong and Chung: Product Variety as a Barrier to Entry 29 Table 6 Parameters from the Pairwise Model without Market Share Dependent Variable (I) Number of Firms (II) Product Variety Covariates Parameter SD Parameter SD Endogenous Variables: Number of firms 0.282*** (0.097) Local firm s product variety 0.427*** (0.078) Instruments: # firms passing through 0.176*** (0.021) Adult population in the region 0.129*** (0.031) 0.470*** (0.032) Income in the region (0.067) 0.175** (0.076) Total production volume of rice and tubers 0.130*** (0.014) Production volume ratio between rice and tubers 0.006*** (0.001) Fixed Effects: Conglomerate 1 (P1) 0.418*** (0.065) Conglomerate 2 (P2) 0.280*** (0.049) Economic crisis ( ) 0.065*** (0.024) 0.113*** (0.022) Observations *** Significant at 1% level;** 5% level the presence of consumer demand for variety, the negative impact of the entrants could be larger on local firms that managed less variety in the market. Thus, in regions where the local firms were damaged badly by the new entrants, the model would mis-attribute the firm s lower level of product variety to the firm s reactive adjustment against the market entry. 6. Conclusion In a market with frequent new market entry, empirical identification of the incumbent firms strategic use of product variety and its impact on market entry is a challenging task largely due to the potentially interactive causal relationship between the two market outcomes. Depending on the direction of the causality, the incumbent firms action of product variety expansion can be viewed as a competitive outcome corresponding to the growing number of competitors, or as an entrydeterring one which could be detrimental to consumers. Our empirical results in the Korean soju market demonstrate the role of product variety as a significant barrier to entry and suggest that

30 30 Hong and Chung: Product Variety as a Barrier to Entry Table 7 Parameter Estimates from Regressions of the Number of Firms (I) OLS (II) 2SLS (III) 2SLS (IV) 3SLS Full Model Endogeneity (Instrumented) None Product Variety Product Variety; Share Product Variety; Share Correlations in system errors No No No Yes Coefficients SD Coefficients SD Coefficients SD Coefficients SD Covariates Local firm s product variety (0.043) 0.325*** (0.073) 0.241*** (0.075) 0.143** (0.070) Local firm s market share 0.344*** (0.047) 0.308*** (0.049) 0.467*** (0.068) 0.436*** (0.066) # firms passing through 0.135*** (0.020) 0.110*** (0.022) 0.080*** (0.024) 0.123*** (0.018) Adult population 0.119*** (0.025) 0.182*** (0.029) 0.200*** (0.030) 0.139*** (0.023) Income (0.060) (0.063) (0.064) (0.047) Economic Crisis ( ) 0.057*** (0.021) 0.079*** (0.022) 0.084*** (0.022) 0.072*** (0.022) Observation *** Significant at 1% level;** 5% level Notes: Presented coefficients are from the regression of the number of firms as a dependent variable the firm s entry-deterring motives could have been a driver of the observed product proliferation after market deregulation. Table 7 presents the entry-deterring effect of product proliferation estimated from various model specifications and highlights the contribution of our approach. The OLS specification disregarding the endogeneity of the market outcomes cannot identify the entry-deterring power that the incumbent firms could exercise in the market. Taking into account only the simultaneity between the incumbent and entrant firms actions can still produce a biased estimate by missing the complementary entry-deterring impact due to the strong market leadership. Allowing any unobserved sources of correlation between market variables also improves the results. Our study motivates further work in the field of strategic interactions between incumbent and potential entrant firms that compete in a given set of geographic markets. In the Korean soju market, a fixed set of firms competed in multiple geographic markets. Such multi-market contacts among the firms in repeated competition might have generated a new environment for collusion (Bernheim and Whinston 1990). For example, firms located in adjacent markets could have been involved in more cooperative interactions. Although we do not observe any obvious pattern of such collusion with respect to market entry (e.g., firms from close regions are more likely to enter each other s market), it would be an interesting avenue for future research to investigate whether there were any sustainable collusive behaviors in the presence of the multi-market contacts. Another possible extension of the study is the entrant firm s strategic choice of product variety. Multi-product firms may customize their product offerings across geographic markets depending

31 Hong and Chung: Product Variety as a Barrier to Entry 31 on the competitive environment in each market, and this could complicate the dynamics with the incumbent firm in the market. In the present context, conditional on entry, most entrant firms product offerings were limited to their flagship product line, and thus we abstract away from the entrant firms joint decisions of market entry and product variety. In some other markets where we may observe large variations in product variety of both the incumbent and entrant firms, this dynamic between the firms in product space could be an important topic to explore.

32 32 Hong and Chung: Product Variety as a Barrier to Entry Appendix A: Construction of Location Variables In this appendix, we present a map of the Korean highways connecting geographic regions. We located soju production factories of local firms (P2 - P9) in the map and identified the shortest path to Region 1 (Kyunggi, which surrounds Seoul) from each production site. Each factory was located with easy access to the highways. In the model accounting for a firm s decision to enter a certain region, we accounted for whether the firm must pass through that region en route to the target market of R1 as a binary measure. In our full model at the region level, for each region, we counted the number of competitors that used each region as a through passage. The map and the order of destinations are presented below. The Map of Major Korean Highways and Local Production Sites * Notes: The location of each producer s factory (P2-9) is marked on the map. The Order of Destinations in the Shortest Route to Region 1