Forward induction and entry deterrence: An experiment

Abstract:     
The Dixit (1980) hypothesis that incumbents use investment in capacity to deter potential entrants has found little empirical support. Bagwell and Ramey (1996) propose a model where, in the unique game-theoretic prediction based on forward induction or iterated elimination of weakly-dominated strategies, the incumbent does not have the strategic advantage. We conduct an experiment with games inspired by these models. In the Dixit-style game, the incumbent monopolizes the market most of the time even without the investment in capacity. In our Bagwell-and-Ramey-style game, the incumbent also tends to keep the market, in contrast to the predictions of an entrant advantage. Nevertheless, we find strong evidence that forward induction affects the behavior of most participants. The results of our games suggest that players perceive that the first mover has an advantage without having to pre-commit capacity. In our Bagwell-Ramey game, evolution and learning do not drive out this perception. We back these claims with data analysis and a theoretical framework for dynamics.

Keywords: Entry, excess capacity, forward induction, equilibrium selection, first-mover advantage

JEL Classifications: C70, C91, D42, L11, L12

Working Paper Series