The Timing of Capacity Investment by Start-Ups and Established Firms in New Markets
Posted: 26 Aug 2010
Date Written: August 25, 2010
We analyze the competitive capacity investment timing decisions of both established firms and start-ups entering new markets which are characterized by a high degree of demand uncertainty. Firms may invest in capacity early (when the market is highly uncertain) or late (when market uncertainty has been resolved), possibly at different costs. In our model, established firms choose investment timing and capacity level to maximize expected profits. Start-ups are prone to bankruptcy if profit turns out to be too low, and hence choose investment timing and capacity level to maximize the probability of survival. Surprisingly, we find that in monopoly situations, a start-up is more likely to prefer early investment than an established firm, despite the presence of demand uncertainty. In duopoly situations with one start-up and one established firm competing in the same market, we characterize the equilibria of a strategic capacity investment timing game in which firms choose when to build capacity. We find that when demand uncertainty is high and costs do not decline too severely over time, the unique equilibrium of this game is for the start-up to take a leadership role and invest first in capacity while the established firm follows; by contrast, when two established firms compete in an otherwise identical game, high demand uncertainty leads to both firms investing late. Thus, the threat of bankruptcy leads to an increase in sequential investment outcomes in which the start-up leads, a result that we demonstrate persists even if the start-up is concerned with both profit and bankruptcy risk or profit above the bankruptcy threshold. We conclude that the threat of firm failure significantly impacts the dynamics of competition involving start-ups.
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