A Look on the Cost Side: Market Share and the Competitive Environment

In this paper we develop a model relating market share to average costs. We start with a theoretical model of the factors that affect the firm's average cost curve, partitioning these factors into (a) measurable firm and competitive environment characteristics, and (b) unobserved factors that are either fixed, random, or follow a first-order autoregressive process. We then link this theoretical model to an empirical model in which we specify three average cost equations for the organizational areas of purchasing, production, and marketing. Main effects for initial (lagged) market share position, as well as their interactions with factors characterizing the firm's competitive environment, represent the variables of key theoretical interest in our equations. We estimate these equations using PIMS data, and control for fixed, contemporaneous, and autoregressive unobservable factors. Our results suggest that market share can often lead to market power in the form of lower average costs. However, the firm's operating environment greatly moderates the effect of market share on average cost. In particular, we find that market share position only leads to lower average costs when the organizational unit operates in a competitive environment that gives it motivation and ability to realize power from its market share position.