Sunk costs, entry, and the timing of cost-reducing investment

Abstract

The traditional IO literature asserts that firms with monopoly power produce less efficiently than competitive firms and that they often reduce costs only after entry delivers a `wake-up call'. A model with sunk costs and uncertainty can explain this phenomenon. If becoming more efficient entails sunk costs, incumbents have an incentive to wait until a competitor's efficiency is revealed by actual entry before deciding whether to make the investment. This `uncertainty resolution' incentive can outweigh incumbents' incentives to attempt entry preemption.