Assessing the Effects of Establishment Entry on Competition and Variable Profits
This paper utilizes plausibly exogenous variation in Washington's recreational cannabis market to demonstrate that new retail entry significantly reduces incumbent variable profits primarily by decreasing sales quantities rather than prices, with the most pronounced effects occurring in jurisdictions where regulatory caps had previously constrained competition.
Original paper licensed under CC BY 4.0 (https://creativecommons.org/licenses/by/4.0/). This is an AI-generated explanation of the paper below. It is not written or endorsed by the authors. For technical accuracy, refer to the original paper. Read full disclaimer
In the study of how businesses interact, economists have long understood a simple truth: when a new shop opens in a neighborhood, the existing shops usually make less money. This happens because the new arrival splits the customers, forcing the old shops to either lower their prices or sell fewer items. For decades, researchers have tried to measure exactly how much profit disappears with each new competitor, but they have faced a major obstacle. In most industries, the private financial records of companies are hidden from view, making it impossible to see the actual profit numbers. Furthermore, it is difficult to tell if a new store opened because the neighborhood was already booming, or if the neighborhood boomed because a new store arrived. To solve this, scientists look for natural experiments where rules, rather than market forces, decide where new businesses are allowed to open.
A team of researchers turned their attention to the recreational cannabis market in Washington state, a setting that offered a rare glimpse into these hidden financial mechanics. When Washington legalized recreational cannabis in 2012, the state created a tightly controlled system where the government decided exactly how many stores could open in each town. This was not a free-for-all; the state used a complex formula based on population and geography to assign a specific number of licenses to each area. In many towns, more people applied for these licenses than there were spots available, so the state held a random lottery to decide who got to open a shop. Later, in 2016, the state increased the total number of allowed stores, creating a sudden shift in the rules that allowed more shops to open in places that had been waiting for permission. Because these openings were driven by government rules and random lotteries rather than by the shops' own predictions of profit, the researchers could treat them as a natural experiment to see what happens when competition increases.
The researchers had access to a unique treasure trove of data called a "seed-to-sale" tracking system. Every single transaction in the state's legal cannabis market was recorded, linking the wholesale purchase of the product by the store to the final sale to the customer. This allowed the team to calculate, for the first time, the actual variable profits of individual stores—the money left over after paying for the product itself, but before paying for rent or staff. By combining this detailed financial data with the records of which stores opened and when, the team could measure the precise impact of a new competitor on an existing store's bottom line.
Their analysis revealed a clear and measurable effect: for every new store that opened in a local market, the monthly variable profits of the existing stores dropped by about 4.2 percent. The total revenue, or the amount of money coming in from sales, fell by about 3.6 percent. However, the way this money disappeared was surprising. The researchers found that the existing stores did not lower their prices to compete with the new arrival. Instead, they sold significantly fewer products. The decline in profits was driven almost entirely by a drop in the quantity of goods sold, while the price per gram remained stubbornly unchanged. This suggests that in this highly regulated market, store owners do not react to new competition by cutting prices; they simply lose customers to the new shop.
The study also showed that this effect was not the same everywhere. The drop in profits was much more severe in towns where the government had previously been very strict about how many stores were allowed. In these places, where the license cap had been a tight constraint, the arrival of a new store represented a sudden and significant increase in competition, causing a sharp 7.5 percent drop in profits for existing shops. In towns where the rules were already more relaxed and there was room for more stores, the impact of a new competitor was smaller, reducing profits by only about 2.8 percent. This indicates that the damage caused by a new rival depends heavily on how scarce the competition was to begin with.
To ensure their findings were solid, the researchers tested their results in several different ways. They checked if the results changed when they looked at stores located near the edges of town boundaries, where customers might shop across town lines. They also redefined what counted as a "local market" by measuring how long it took to drive to a competitor, rather than just looking at town borders. In every case, the main story remained the same: new entry reduces profits and sales volume, but it does not force prices down. The study concludes that while new competitors certainly hurt the earnings of existing businesses, the mechanism in this specific market is a shift in sales volume rather than a price war. This provides a clear picture of how regulated markets behave differently from the free markets often described in economics textbooks, showing that when rules limit competition, the arrival of a new player changes the quantity of sales without necessarily changing the price tag.
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