Entry Deterrence in a Duopoly Model

The ability to restrict access to distribution channels or input suppliers is commonly thought to be a barrier to entry. Many have argued that a monopolist can use vertical integration as means of foreclosing entry. We consider a duopoly market and ask whether duopolists who control access to distribution can deter entry into upstream production. Specifically, we consider a model of capacity competition in which two incumbent firms each have access to distribution while a single entrant does not. We show that, absent collusion, access to distribution alone does not deter entry. After producing its own capacity the entrant induces the duopoly incumbents to bid against one another to acquire the capacity. The entrant takes advantage of a negative externality: each incumbent realizes that the entrant's capacity will be sold to the other firm if they don't buy it, so they ignore the effect of the additional capacity on the market price of the final good. Consequently, each incumbent may be willing to pay a premium for the entrant's capacity even though they would not have increased their capacity on their own. If capacity costs are sufficiently small, the incumbents can still deter entry by preemptively building greater capacity. For very small capacity costs, the incumbents share the entry deterrence equally. For larger capacity costs, entry deterrence is achieved only with asymmetric capacity commitments - one firm produces more than the other. If on the other hand capacity costs are sufficiently high, entry is accommodated and the firms produce the same capacity that they would have if the entrant had had equal access to distribution. The inability of the incumbents to commit not to buy the entrant's capacity causes the entrant to act as if it had equal access.