Abstract
We analyze a setting typical of industries right after liberalization, or after structural demand and technology changes. An incumbent firm has an exogenous capacity, and a new entrant has to set its capacity level. We find that, in a dynamic context, higher capacity increases the severity of punishment after deviation, thereby favoring the emergence of cartels. The cartel in this case could hurt welfare, not only because of the standard deadweight loss motive, but also because of the cost inefficiency due to high and idle capacity. We conjecture that a competitive arrangement could be both welfare enhancing and profit-maximizing for the incumbent.
Highlights
Many industries evolve over time from an initial monopolistic setting towards more competitive frameworks, with one or more new entrants adding to the incumbent
In a dynamic context, higher capacity increases the severity of punishment after a deviation, thereby favoring the emergence of cartels
The cartel is effective under a high value of the discount factor, where carrying idle capacity would be too costly
Summary
Many industries evolve over time from an initial monopolistic setting towards more competitive frameworks, with one or more new entrants adding to the incumbent. In electricity, the incumbent firms in various countries made their investment decisions in a regulated environment, while they were often enjoying legal monopolies in their home market The former integrated monopolies had neither the incentives nor the mandate to calibrate their capacity in view of future entry. Uncertainty over the technological evolution may suggest the monopolists to calibrate their capacities on the current demand and cost structures, while revising their choices in the future if needed. Following this motivation, in this paper we regard the incumbent’s decision as exogenous, and we analyze a two stage game.
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