Capacity Constrained Firms and Expansion Subsidies: Should Governments Avoid Generous Subsidies?

Abstract

This paper examines entry deterrence and signaling when an incumbent firm experiences capacity constraints. Our results show that if the costs that constrained and unconstrained incumbents incur when expanding their facilities are substantially different, separating equilibria can be supported under large parameter values whereby information is perfectly transmitted to the entrant. If, in contrast, both types of incumbent face similar expansion costs, subsidies that reduce expansion costs can help move the industry from a pooling to a separating equilibrium with associated efficient entry. Nonetheless, our results demonstrate that if subsidies are very generous entry patterns remain unaffected, suggesting a potential disadvantage of policies that significantly reduce firms’ expansion costs.

Keywords: capacity constraints, business expansions, signaling, entry deterrence, subsidies

JEL Classification: L12, D82