Capacity, Entry and Forward Induction

Kyle Bagwell and Garey Ramey

No 888, Discussion Papers from Northwestern University, Center for Mathematical Studies in Economics and Management Science

Abstract: We introduce avoidable fixed costs into the capacity and entry model of Dixit (1980) to produce a coordination problem among multiple postentry equilibria. Elimination of weakly dominated strategies makes it possible for the entrant to play a knockout strategy, consisting of a large capacity commitment which selects the entrant's preferred postentry equilibrium and drives the incumbent from the market. The incumbent must respond to the knockout threat by using judo tactics, involving a reduction in its capacity commitment. In subgame perfect equilibria which are robust to elimination of weakly dominated strategies, the incumbent must accept a market share smaller than the entrant's if avoidable fixed costs are sufficiently high, or cede the market to the entrant if avoidable fixed costs are higher still.

Date: 1990-05
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Journal Article: Capacity, Entry, and Forward Induction (1996)
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