Original article (link) posted: 30/10/2005
Maskin (1999) “Uncertainty and entry deterrence” Economic Theory, 14
A model where capacity installation by an incumbent firm serves to deter others from entering the industry is considered. The paper shows that uncertainty about demand or costs forces the incumbent to choose a higher capacity level than it would under certainty. The intuitive reason is explained in Introduction, which is stated as follows;
To deter entry, the incumbent must install enough capacity so that, if entry occurred, the entrant’s profit would be zero (or negative). Under certainty, the incumbent will install no more capacity than it would use were entry to occur. With uncertainty, when demand is high, an incumbent that has installed the certainty level of capacity still continues to produce at capacity; price simply rises to reflect the higher demand. But, when demand is low, the incumbent will wish to produce at less than full capacity. This means that the fall in price when demand is low is not so large as the rise in price when demand is high, and so if the entrant’s is zero under certainty, it is positive with certainty. To deter entry, therefore, the incumbent must increase capacity above the certainty level to ensure that when demand is high it produces enough to drive the entrant’s expected profit back down to zero.