Capacity Preemption in a Duopoly Market Under Uncertainty

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