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The Other Side of Limited Liability: Predatory Behavior and Investment Timing

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  • Christian Bayer

    (University of Dortmund)

Abstract

This paper investigates the interplay of investment irreversibility, predatory behavior, and limited liability in a duopoly with aggregate demand uncertainty. We find that limited liability and investment irreversibility is likely to produce predatory behavior in very competitive industries in which prices react strongly to changes in quantity and capacity increases are not too costly. The rationale for this may be summarized as follows: Under limited liability, the owners of a firm have to decide whether they are willing to finance losses from private funds, or whether they rather default on the firms obligations in adverse states. However, market conditions themselves become endogenous in a duopoly since the quantity decisions of all competitors determine the market price. If now investment is irreversible, it is a strong commitment. It hence becomes a device to force others to leave early and allows oneself to commit to leave late. If the ability to promote the exit of a competitor is strong, it may then even result in firms investing only to prey, i.e. firms invest only to consequently monopolize the market. Therefore, the model of this paper explains predatory behavior in a duopoly without invoking reputational, network- or learning-effects. Moreover, this paper's model also does not define predatory behavior as deviations from tacit collusion.

Suggested Citation

  • Christian Bayer, 2004. "The Other Side of Limited Liability: Predatory Behavior and Investment Timing," Industrial Organization 0407001, EconWPA.
  • Handle: RePEc:wpa:wuwpio:0407001
    Note: Type of Document - pdf; pages: 45
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    File URL: http://econwpa.repec.org/eps/io/papers/0407/0407001.pdf
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    References listed on IDEAS

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    1. Chaim Fershtman & Ariel Pakes, 2000. "A Dynamic Oligopoly with Collusion and Price Wars," RAND Journal of Economics, The RAND Corporation, vol. 31(2), pages 207-236, Summer.
    2. Bolton, Patrick & Scharfstein, David S, 1990. "A Theory of Predation Based on Agency Problems in Financial Contracting," American Economic Review, American Economic Association, vol. 80(1), pages 93-106, March.
    3. Ordover, Janusz A. & Saloner, Garth, 1989. "Predation, monopolization, and antitrust," Handbook of Industrial Organization,in: R. Schmalensee & R. Willig (ed.), Handbook of Industrial Organization, edition 1, volume 1, chapter 9, pages 537-596 Elsevier.
    4. Pauli Murto, 2004. "Exit in Duopoly Under Uncertainty," RAND Journal of Economics, The RAND Corporation, vol. 35(1), pages 111-127, Spring.
    5. Kreps, David M. & Wilson, Robert, 1982. "Reputation and imperfect information," Journal of Economic Theory, Elsevier, vol. 27(2), pages 253-279, August.
    6. Cabral, Luis M B & Riordan, Michael H, 1994. "The Learning Curve, Market Dominance, and Predatory Pricing," Econometrica, Econometric Society, vol. 62(5), pages 1115-1140, September.
    7. Milgrom, Paul & Roberts, John, 1982. "Predation, reputation, and entry deterrence," Journal of Economic Theory, Elsevier, vol. 27(2), pages 280-312, August.
    8. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, number 5474.
    9. Drew Fudenberg & Jean Tirole, 1985. "Preemption and Rent Equalization in the Adoption of New Technology," Review of Economic Studies, Oxford University Press, vol. 52(3), pages 383-401.
    10. Meghan R. Busse, 2002. "Firm Financial Condition and Airline Price Wars," Yale School of Management Working Papers ysm281, Yale School of Management.
    11. Lambrecht, Bart M, 2001. "The Impact of Debt Financing on Entry and Exit in a Duopoly," Review of Financial Studies, Society for Financial Studies, vol. 14(3), pages 765-804.
    12. Athey, Susan & Schmutzler, Armin, 2001. "Investment and Market Dominance," RAND Journal of Economics, The RAND Corporation, vol. 32(1), pages 1-26, Spring.
    13. Cabral, Luis M B & Riordan, Michael H, 1997. "The Learning Curve, Predation, Antitrust, and Welfare," Journal of Industrial Economics, Wiley Blackwell, vol. 45(2), pages 155-169, June.
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    Cited by:

    1. Bayer, Christian, 2007. "Investment timing and predatory behavior in a duopoly with endogenous exit," Journal of Economic Dynamics and Control, Elsevier, vol. 31(9), pages 3069-3109, September.

    More about this item

    Keywords

    Real Options; Duopoly; Predatory Behavior; Timing Game;

    JEL classification:

    • C73 - Mathematical and Quantitative Methods - - Game Theory and Bargaining Theory - - - Stochastic and Dynamic Games; Evolutionary Games
    • D92 - Microeconomics - - Micro-Based Behavioral Economics - - - Intertemporal Firm Choice, Investment, Capacity, and Financing
    • L13 - Industrial Organization - - Market Structure, Firm Strategy, and Market Performance - - - Oligopoly and Other Imperfect Markets
    • L41 - Industrial Organization - - Antitrust Issues and Policies - - - Monopolization; Horizontal Anticompetitive Practices

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