Unobserved Capacity Constraints and Entry Deterrence

This paper examines entry deterrence and signaling when an incumbent firm experiences a capacity constraint, arising from either her productive efficiency or the high market demand she faces. In both cases, we demonstrate that separating and pooling equilibria can be sustained. Our results show that if the costs that constrained and unconstrained incumbents face when expanding their facilities are substantially different, the separating equilibrium can be supported under large parameter values. In this case, information is perfectly transmitted to the entrant. If, in contrast, both types of incumbent face similar expansion costs, a policy reducing expansion costs can help move the industry from a pooling equilibrium to the separating equilibrium with associated efficient entry. Nonetheless, our results show that if this policy is overemphasized entry patterns remain unaffected, suggesting a potential disadvantage of policies that significantly reduce firms’ expansion costs.