Investment Flexibility as a Barrier to Entry

Abstract

This paper presents a model of investment in a duopoly with firms that choose the scale and timing of investment. Decision-making flexibility and the costs saved by investing in large steps rather than sequences of small steps determine an incumbent’s ability to deter entry by a potential competitor. Entry occurs when these cost savings are very small or very large, because the effect of increased industry capacity on the incumbent’s assets-in-place is the same regardless of which firm invests. In intermediate cases, the incumbent is able to deter entry by making a smaller, earlier investment than the potential entrant. The smaller investment scale protects the incumbent’s assets-in-place, which offsets the incumbent’s cost disadvantage from investing in smaller steps than the entrant would choose. Nevertheless, the threat of entry constrains the incumbent’s investment behavior and limits its profitability. The model is solved using a combination of best-response iteration and the projected successive over-relaxation method.