Issue: Winter 1996
Pages: pp. 660-680
Authors: Kyle Bagwell and Garey Ramey
Title: Capacity, Entry, and Forward Induction
Abstract: When avoidable fixed costs are introduced into the entry model of Dixit (1980) and Ware (1984), there arises a coordination problem in selecting among postentry Nash equilibria. Elimination of weakly dominated strategies allows the entrant to use a market-capturing strategy, consisting of a large capacity commitment that selects the entrant's preferred postentry equilibrium and drives the incumbent from the market. Deterring the entrant's market-capturing strategy typically requires the incumbent to reduce its initial capacity choice. As avoidable fixed costs rise, the incumbent must restrict its capacity by a greater amount, and the relative advantage of the entrant rises.