A note on the free rider problem in oligopoly (Q1802095)

In a market with multiple incumbents the individual incumbent may free- ride on the entry deterring investments of its rivals [Bernheim, Rand J. Econ. 1984]. The literature offers somewhat contradictory results concerning the question of whether investments are too high or too low when non-cooperative solutions are compared with collusive ones. The paper explains the ambiguity by two independent sorts of externalities. There is a direct externality effect resulting from the impact which precommiting investments by a given firm have on the profits of other incumbents when taking the probability of entry as given. This is a standard externality and it is not directly related to entry deterrence. There is an indirect externality effect resulting from the change in the probability of entry. The effect depends on the impact of precommitments on the profit of the entrant. Unambiguity follows only when both effects are in the same direction. E.g. under-investment results if a higher precommitment increases other incumbents' profits and if it decreases the probability of entry. The focus is on subgame perfect Nash equilibria in a two-stage game. In the first stage firms make their investments. In the second stage, given these precommitments and once some exogenous uncertainty is resolved, incumbents and the potential entrant make their profit maximizing ex-post decisions.