A Simple Pedagogical Model of the Impact of Foreclosure on Investment

Abstract

This pedagogical note sets out a simple model to illustrate the impact of foreclosure on investment incentives. The model can be applied to either customer foreclosure or input foreclosure. The basic model is an application of the seminal Dorfman-Steiner model, as applied to investment instead of advertising. 1 The static model of customer foreclosure shows that reducing a rival's potential market significantly reduces its incentive to invest in activities that increase demand for its product. This reduced investment then has a feedback effect on demand, further reducing the rival's sales. For example, if the constant elasticity of demand with respect to investment with is 0.5, customer foreclosure that initially reduces the rival's potential market by 20% will lead to a 40% reduction in sales, once the impact on its investment incentives is taken into account. This output reduction could drive the rival's sales below the breakeven level and cause it to exit. However, even when the rival does not exit, this impact of foreclosure on investment incentives and the impact of the reduced investment can "marginalize" the competitive constraint that a rival places on a dominant firm. As a result, even a modest amount of foreclosure can lead to a substantial reduction in competition in steady-state. In a real world market, of course, this marginalization effect will occur over time, not all at once.