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Underinvestment and Market Structure * by Volker Nocke STICERD, London School of Economics The Toyota Centre Suntory and Toyota International Centres for Economics and Related Disciplines London School of Economics and Political Science Discussion Paper Houghton Street No.EI/22 London WC2A 2AE February 1998 Tel 0207 955 7719 * This paper is based on chapter 2 of my Ph.D. thesis submitted at the London School of Economics. I am grateful to John Sutton for his advice and encouragement. I would also like to thank Markus Brunnermeier, Adam Ostaszewski, Martin Peitz, Sönje Reiche, Patrick Rey, Rani Spiegler and Jean Tirole for helpful comments. Moreover, I am grateful to seminar participants at various universities and conferences. Financial support by the European Commission (Marie Curie Fellowship) is gratefully acknowledged.

Underinvestment and Market StructureUnderinvestment and Market Structure* by Volker Nocke STICERD, London School of Economics The Toyota Centre Suntory and Toyota International Centres

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Page 1: Underinvestment and Market StructureUnderinvestment and Market Structure* by Volker Nocke STICERD, London School of Economics The Toyota Centre Suntory and Toyota International Centres

Underinvestment and Market Structure*

by

Volker Nocke STICERD, London School of Economics

The Toyota Centre Suntory and Toyota International Centres for Economics and Related Disciplines London School of Economics and Political Science Discussion Paper Houghton Street No.EI/22 London WC2A 2AE February 1998 Tel 0207 955 7719 * This paper is based on chapter 2 of my Ph.D. thesis submitted at the London School of Economics. I am grateful to John Sutton for his advice and encouragement. I would also like to thank Markus Brunnermeier, Adam Ostaszewski, Martin Peitz, Sönje Reiche, Patrick Rey, Rani Spiegler and Jean Tirole for helpful comments. Moreover, I am grateful to seminar participants at various universities and conferences. Financial support by the European Commission (Marie Curie Fellowship) is gratefully acknowledged.

Page 2: Underinvestment and Market StructureUnderinvestment and Market Structure* by Volker Nocke STICERD, London School of Economics The Toyota Centre Suntory and Toyota International Centres

Abstract This paper analyses a dynamic game of investment in R&D or advertising, where current investments change future market conditions. It investigates whether under- investment can be supported in equilibrium by the threat of escalation in investment outlays. When there are no spillovers, or there is full patent protection, underinvestment equilibria are shown to exist even though, by deviating, a firm can get a persistent strategic advantage. When there are strong spillovers and weak patent protection, underinvestment equilibria fail to exist. This implies that weaker patent protection can actually lead to more investment in equilibrium. Furthermore, potential entry is introduced into the model so as to address issues of market structure. It is shown that underinvestment equilibria can be stable with respect to further entry, independently of market size and entry cost. Finally, the “nonfragmentation” result of statis stage games (Shaked and Sutton, 1987) is proved to hold in this dynamic game. That is, fragmented outcomes cannot be suppoorted in any equilibrium, no matter how large the market, and despite the existence of under-investment equilibria. Keywords: Dynamic game, investment, collusion, industry structure. JEL classifications: L13, D43, O31. © by Volker Nocke. All rights reserved. Short sections of text, not to exceed two paragraphs, may be quoted without explicit permission provided that full credit, including © notice, is given to the source

Page 3: Underinvestment and Market StructureUnderinvestment and Market Structure* by Volker Nocke STICERD, London School of Economics The Toyota Centre Suntory and Toyota International Centres

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