Collusion in capacity under irreversible investment

Abstract

In the usual theory of collusion, the possibility of collusion increases with the discount factor. The firm’s incentive to deviate is short term: the firm increases its immediate profit but reduces its future profits due to how competitors will react. This paper shows that this result is no longer valid when firms require investment to increase their production and that investment is, at least partially, irreversible. In that case, a firm deviating from a collusive agreement increases its capacity of production, preempting its competitor, and may obtain a dominant position on the market. A higher discount rate makes preemption more profitable, and thus collusion harder to sustain.