Strategic capacity commitment

Question 1

What model underscores the importance of strategic commitment?

Answer 1

The Stackelburg model

Question 2

Why is commitment so important?

Answer 2

It can alter the competitive landscape – for example, by deterring entry due to the implied future output levels or price competition.

Question 3

How can over-investment be used as a way to influence capacity decisions of potential entrants

Answer 3

By over-investing, the incumbent can flood the market, reducing prices and making it less attractive for the entrant to come in. This is done in the hope that the potential entrant will decide that entering the market is not profitable and will choose to stay out.

Question 4

What does The Two-period Game of Entry Deterrence involve?

Answer 4

The game is set in two periods to account for the timing of decisions and actions. In the first period, the incumbent makes a decision about capacity investment, and in the second period, the entrant observes this and decides whether to enter the market. This is where the incumbent’s commitment is critical – if the investment is large enough to deter entry (and is a sunk cost), the incumbent may continue to enjoy monopoly profits.

Question 5

Why are the profit functions critical for the incumbent firms decision making process?

Answer 5

They determine the optimal level of capacity to either deter entry or to maximize profits if entry occurs.

Question 6

What do the profit functions take into account for firm 1 and firm 2?

Answer 6

For the incumbent firm (firm 1), the profit function takes into account the capacity level it sets ( 1 k 1 ​ ) and its output ( 1 x 1 ​ ), and for the potential entrant (firm 2), the profit function considers its decision to enter the market and its subsequent output ( 2 x 2 ​ )

Question 7

How does the incumbent’s capacity choice impact the entrant’s decision?

Answer 7

It alters the profitability of entering the market

Question 8

True or false:

If the incumbent chooses a high capacity level, it signals a willingness to compete aggressively, which could make market entry less attractive to Firm 2 due to lower expected profits.

Answer 8

True

Question 9

How does the incumbent firm determine optimal capacity level?

Answer 9

The incumbent aims to choose a capacity level that maximises its profits while considering the potential responses from Firm 2. This involves analysing how different capacity levels affect the market and the potential profits under various scenarios, including monopoly (if entry is deterred) and duopoly (if entry is accommodated)

Question 10

What happens in the second period if firm 2 decides to enter?

Answer 10

Both firms choose outputs ( 1 x 1 ​ and 2 x 2 ​ ) in a manner that is consistent with Nash equilibrium—where each firm’s output decision best responds to the other firm’s decision, given the capacity commitments made in the first period.

Question 11

A stable equilibrium is one where…

Answer 11

After any arbitrary deviation in strategies, the adjustment process of both firms will converge back to the equilibrium point, this stability ensures predictability in the firms’ behaviours, which is crucial for long-term planning and strategy execution. Another way to think about it is its concerned with whether the firms reach a point where no one has an incentive to change their strategy, given the strategy of the other

Question 12

What advice would you give to the incumbent firm?

Answer 12

Consider the cost of deterring entry versus the potential profit from accommodating a new entrant.
Use the first-period capacity decision as a strategic commitment that influences the entrant’s decisions.
Understand that achieving a stable Nash equilibrium is important for maintaining a predictable and profitable market environment

Question 13

What does the equilibrium analysis determine?

Answer 13

The exact levels of capacity investment that lead to entry deterrence or accommodation.

Question 14

What does the Bain Sylos Postulate refer to?

Answer 14

Where the potential entry is assumed to believe that the incumbent firm will continue to maintain the same action as it did upon entry

Question 15

Does the theory for the Bain Sylos Postulate hold under a subgame perfect equilibrium?

Answer 15

No, under a subgame perfect equilibrium, the incumbent firm will not find it profitable to utilise its entire capacity even when entry does occur

Question 16

What is the unrealistic belief imposed by the Bain-Sylos theory?

Answer 16

That investing in excess capital can provide the incumbent firm with a credible threat by which the potential entry will be convinced that entry is unprofitable. Under a subgame perfect equilibrium, overaccumulation of capacity as a deterrent is not a rational strategy for the incumbent because the entrant, anticipating this strategy, would understand that the incumbent is unlikely to utilize all this excess capacity, which would be unprofitable.

Question 17

What is the main implication of the sub-game perfect equilibrium analysis

Answer 17

Rational firms will not invest in capacity beyond what is profitable to utilise, and thus capacity over investment cannot serve as a credible deterrent to entry. This means that the incumbent must use other strategies or accept that the market may become competitive.