Investment Flexibility as a Barrier to Entry
33 Pages Posted: 31 Jul 2017 Last revised: 8 Nov 2019
Date Written: November 7, 2019
This paper presents a model of investment in a duopoly with firms that choose the scale and timing of investment. The extent of economies of scale and investment flexibility determine an incumbent's ability to deter entry by a potential competitor. Entry occurs when economies of scale are very strong or very weak, because the effect of increased industry capacity on the incumbent's assets-in-place is the same regardless of which firm invests. For moderate economies of scale, the incumbent is able to deter entry by making a smaller, earlier investment than the potential entrant. The smaller investment scale protects the incumbent's assets-in-place, which offsets the incumbent's cost disadvantage from not exploiting the economies of scale as well as the entrant. Nevertheless, the threat of entry constrains the incumbent's investment behavior and limits its profitability. The model is solved using a combination of best-response iteration and the projected successive over-relaxation method.
Keywords: investment-timing games, barriers to entry, real options, best-response iteration, projected successive over-relaxation
JEL Classification: D21, D25, D43, D92, G31
Suggested Citation: Suggested Citation