Capacity Preemption in a Duopoly Market Under Uncertainty

41 Pages Posted: 9 Apr 2007

See all articles by Jianjun Wu

Jianjun Wu

Compass Lexecon; Princeton Economics Group

Date Written: November 10, 2006

Abstract

This paper introduces a continuous-time real options game to study firms' incentives in capacity preemption. Unlike previous literature usually predicting that the endogenous Stackelberg leader is better off by building a larger capacity than its follower, this paper shows that under fairly general conditions, especially if the market exhibits evolving uncertainty, the first entrant prefers to invest in a smaller capacity so it can credibly preempt its competitor. If it had chosen the larger capacity, its competitor could, and in fact would use a smaller plant to force it out of the market. Further, in contrast to the conventional wisdom, preemption does not destroy option value because both the leader and the follower are able to enter the market at their optimal entry date associated with their chosen capacity. However, competition for Stackelberg leadership results in firms' sizes much smaller than required by welfare maximizing.

Keywords: Capacity Preemption, Real Options, Industry Dynamics

JEL Classification: D4, L1

Suggested Citation

Wu, Jianjun, Capacity Preemption in a Duopoly Market Under Uncertainty (November 10, 2006). Available at SSRN: https://ssrn.com/abstract=973815 or http://dx.doi.org/10.2139/ssrn.973815

Jianjun Wu (Contact Author)

Compass Lexecon

707 State Rd
Suite 223
Princeton, NJ 08540
United States

Princeton Economics Group ( email )

707 State Rd
Princeton, NJ 08540
United States

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