Submission for Annual ASSA-AREUEA Conference 2006
Developer’s Reputation and Market Structure: Why is real estate market an
oligopoly?
Dong, Zhi*1, Sing, Tien Foo*2 and Shilling, James D.*3
Date: March 24, 2005
Abstract
Eaton and Schmitt [9] develop a theory of market structure for manufacturing firms,
which is developed using Hotelling model as kernel, and the theory suggests that
flexibility in manufacturing technology promotes concentration through preemption,
mergers and cartels. They also examine how flexible manufacturing technology can be
utilized by first movers in the industry to preempt new entrants under two conditions:
perfectly price inelastic demand and responsive demand.
Real estate market is inherently local in nature. Product is highly segmented and
differentiated at the submarket level. The development technology for real estate product
is, however, less sophisticated and yet labor intensive. It, therefore, does not fit into the
specification of flexibility technology in the early model by Eaton and Schmitt [9]. Why
is real estate market then dominated by few developers? What are the factors that
promote concentration in the real estate market? Does the concentration of market
structure through monopoly pre-emption lead to welfare-optimal equilibrium in real
estate market? There is, as far as we know, no literature in real estate that specifically
examines the questions of market structure, and the welfare effects of the market
concentration in the real estate market.
Combining the literature on market structure for manufacturing firms (Baumol [3],
Baumol et al. [4], Eaton and Lemche [8], Eaton and Schmitt [9], Mazzeo [24]),
reputation and information (Kreps and Wilson [19], Shapiro [30], Shapiro [31], Allen [1],
Fudenberg and Kreps [12], Tadelis [34], Hörner [15]), and predatory pricing (Spence [33],
Rosenthal [27], Milgrom and Roberts [26]), this paper develops a model that links
developer’s reputation to the evolution of a concentrated market structure in real estate
market, taking into account of various constraints in development technology and product.
Understanding the formation and implication of real estate market structure will also help
to identify sub-game optimal strategies for developers in the process of market share and
reputation building over the long run.
Reputation is an endogenous variable in a repeated game framework. It is a valuable asset
to developers, and good reputation will take time to cultivate (Tadelis [34], and Hörner
[15]. In our proposed framework with two developers and one market place with two real
estate sectors, one of the developers has already established its foothold in one sector of
the market, whereas the second developer is new entrant to the market. For the incumbent
developer, he has an option of either expanding the product type to meet demand of other
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users in the market or focusing on the current product segment that he is already involved
in. The sunk costs for both strategies include land costs. The product expansion/
diversification strategy, however, incurs additional fixed cost, which is consistent with
the flexible technology assumption in Eaton and Schmitt [9]. To the new entrant, he will
have to incur a fixed product development cost, if he plans to develop one of the real
estate types in the new market. Given that new supply of lands is a sequential process, the
new entrant has to compete by bidding for new land parcel at a cost, which is exogenous
in the model. The incumbent developer may adopt a monopoly pre-emption strategy that
will drive out the new entrant, or he may choose to continue to expand the market share
in his preferred market sector. In the second period, both developers may explore
“merger” or “cartel” options in the optimal sub-game strategies that will lead to
concentration in the market, or they may continue to pursue non-cooperative strategies.
The dynamic market ownership structures under various sub-game scenarios are analyzed
and the results are compared with those found by Eaton and Schmitt’s [9] models in
manufacturing industry.
In Eaton and Schmitt’s [9] model, entry is independent on product ownership structure
given that all firms can manufacture flexibly. In our model, when reputation building is
taken into consideration, it may be in the long run benefits of incumbent developers to
exert some forms of deterrence to new entrant. In merger case, reputation may have
negative profit externality on relative developers, a result which contrasts the earlier
findings of Eaton and Schmitt [9], which proposes that merger has no influence on other
relative firms. In our proposed model that is not dependent on flexible technology,
reputation building and its associated costs appear to be important factors in promoting or
limiting the concentration of real estate market. Differences in reputation costs between
the incumbent developer and the new entrant, coupled with various sub-game optimal
strategies adopted by them, may provide some explanation on the formation of real estate
market structure. The model can also be extended to cover multiple players with different
product space, {(x, q) = [(x1, q1), (x2, q2), …. ,(xm, qm)]} where xi denotes the product i
type in the attribute space, qi denotes the quantity of product xi, and m denotes the
maximum product type in the market space, and the cooperative strategies in the
reputation building and entry deterrence processes can also be evaluated.
Key words (JEL Classification): Market Structure (L13), Economics of Information
(L15), Reputation.
*1
*2
*3
Department of Real Estate, National University of Singapore (rstdz@nus.edu.sg)
Department of Real Estate, National University of Singapore (rststf@nus.edu.sg)
School of Business, University of Wisconsin – Madison (jshilling@bus.wisc.edu)
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