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

  • Christian Bayer

    (University of Dortmund)

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.

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File URL: http://128.118.178.162/eps/io/papers/0407/0407001.pdf
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Paper provided by EconWPA in its series Industrial Organization with number 0407001.

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Length: 45 pages
Date of creation: 05 Jul 2004
Date of revision:
Handle: RePEc:wpa:wuwpio:0407001
Note: Type of Document - pdf; pages: 45
Contact details of provider: Web page: http://128.118.178.162

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  1. Avinash K. Dixit & Robert S. Pindyck, 1994. "Investment under Uncertainty," Economics Books, Princeton University Press, edition 1, volume 1, number 5474.
  2. 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.
  3. 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.
  4. Cabral, L. & Riordan, M., 1992. "The Learning Curve, Market Dominance and Predatory Pricing," Papers 39, Boston University - Industry Studies Programme.
  5. Pauli Murto, 2004. "Exit in Duopoly Under Uncertainty," RAND Journal of Economics, The RAND Corporation, vol. 35(1), pages 111-127, Spring.
  6. Paul Milgrom & John Roberts, 1980. "Predation, Reputation, and Entry Deterrence," Discussion Papers 427, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
  7. Athey, Susan & Schmutzler, Armin, 2001. "Investment and Market Dominance," RAND Journal of Economics, The RAND Corporation, vol. 32(1), pages 1-26, Spring.
  8. 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.
  9. 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 155-69, June.
  10. Kreps, David M. & Wilson, Robert, 1982. "Reputation and imperfect information," Journal of Economic Theory, Elsevier, vol. 27(2), pages 253-279, August.
  11. Fershtman, C. & Pakes, A., 1998. "A Dynamic Oligopoly with Collusion and Price Wars," Papers 26-98, Tel Aviv.
  12. Meghan R. Busse, 2002. "Firm Financial Condition and Airline Price Wars," Yale School of Management Working Papers ysm281, Yale School of Management.
  13. Fudenberg, Drew & Tirole, Jean, 1985. "Preemption and Rent Equilization in the Adoption of New Technology," Review of Economic Studies, Wiley Blackwell, vol. 52(3), pages 383-401, July.
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