Credible Capacity Preemption in a Duopoly Market under Uncertainty

This paper explores firms’ incentives to engage in capacity preemption using a continuous-time real options game. Two ex ante identical firms can choose capacity and investment timing regarding the entry into a new industry whose demand grows until an unknown maturity date, after which it declines until it disappears. Previous literature usually predicts that the Stackelberg leader, whether endogenously or exogenously determined, is better off by building a larger capacity than its rival. In contrast, this paper proves that, under certain conditions about the demand function and the market growth rate, in equilibrium the first mover enters with a smaller capacity. If it had chosen the larger capacity, its competitor could, and in fact would use a smaller plant to force it out of the market. The result is driven by two facts: first, the large capacity firm lacks the incentive to preempt its competitor, because of its higher option value, which tends to delay its investment; second, the large firm also lacks commitment to fight for the market if its leadership is challenged by a smaller firm, because the smaller firm can credibly commit to stay in the market. ∗Department of Economics, The University of Arizona, Tucson, AZ 85721-0108. E-mail: [email protected]. I am very grateful to David Besanko and Mark Satterthwaite for numerous helpful conversations and precious encouragement throughout this project. I also want to thank James Dana, David Dranove, Martin Dufwenberg, Peter Eso, Yuk-Fai Fong, Francisco Ruiz-Aliseda, Rakesh Vohra, and seminar participants at the University of Arizona, UC Davis, and Northwestern University for their valuable comments.