Excess Liquidity against Predation

To investigate why a firm may hold excess liquidity, we examine a duopoly competition in which a shallow-pocket entrant needs the financial support of an outside investor to pay for input costs and launch a business. We allow the investor to terminate the entry if they find the incumbent react too aggressively to the entry plan. However, such an exit option creates a threat of predation by a deep-pocket competitor. To avoid predation, the entrant must raise precautionary liquidity by taking out a loan both larger and further in advance than is actually needed. An entrant with little start-up capital will be less aggressive if the incumbent's capacity size is unverifiable, because the need to raise precautionary liquidity restricts the entrant's feasible capacity size.