Capacity, entry deterrence, and horizontal merger

Abstract

This dissertation examines the free-rider problem of entry deterrence, the profitability of a horizontal merger, and the effects of a horizontal merger on the outsiders’ profits and industry prices, in the markets where firms' capacity costs are sunk.

We investigate the free-rider problem of entry deterrence in the subgame perfect Nash equilibria of a three-stage game in which in the first stage multiple incumbent firms choose their capacities simultaneously and independently, in the second stage a potential entrant, after observing the incumbent firms’ capacity vector, chooses its capacity, and in the third stage the firms engage in capacity-constrained Cournot competition. We show that the free-rider problem may occur: there are situations where both entry prevention and allowing entry are equilibria but entry prevention is Pareto superior for the incumbent firms. We also show that increasing the number of incumbent firms may cause the equilibrium price to increase and thus consumer welfare to decrease. The free-rider problem is still manifested in a modified model in which multiple potential entrants choose their capacities sequentially after the first stage incumbents’ capacity decisions.

Several recent papers which theoretically analyze the profitability of a horizontal merger and its effects on the outsiders’ profits and industry prices, all observe that a merger never decreases industry prices, a merger to a monopoly is always profitable, and a merger never hurts the outsiders.

However, we demonstrate, in a market for a homogeneous product where firms with sunk capacities compete in quantities and there are potential entrants, that a merger can decrease industry price and a merger of incumbent firms to a monopoly may not be profitable. We also show, in a market for a homogeneous product where firms with sunk capacities engage in capacity-constrained price competition, that a merger can hurt the outsiders.