Uncertainty, Entry Deterrence and Excess Capacity
In a two period strategic model of entry deterrence (a la Dixit, 1980) where the incumbent firm moves before the entrant by installing capacity for production, in a (perfect) equilibrium excess capacity is not observed under a deterministic demand. The question is: Does this result remain valid under demand uncertainty as well? The answer is yes only if the incumbent can produce output beyond the pre-planned capacity, when needed, without incurring any additional cost by expanding its capacity simultaneously while producing output; and no otherwise. Thus a cost reducing investment behavior will lead to excess capacity for an incumbent firm, when there is a potential entrant in the market under demand uncertainty. The other relevant issue that is also analyzed in this paper is to see the impact of the distribution of demand uncertainty on the incumbent's decision, when it faces the choice to deter or accommodate the potential entrant.
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