Davide Vannoni1
(University of Torino and Collegio Carlo Alberto)

Abstract - We analyze a setting typical of industries as they evolve in the years after liberalization, or after structural demand and technology changes have occurred. An incumbent firm has an exogenous capacity, and a new entrant has to decide whether to enter the market, and at what capacity level. We find that, if the incumbent has monopoly capacity, for sufficiently high values of the discount factor, the socially most desirable outcomes require the potential entrant not to enter, or to enter with a small capacity. Indeed, in a dynamic context, higher capacity increases the severity of punishment after deviation, thereby favoring the emergence of cartels. The cartel in this case is hurting welfare, not only because of the standard deadweight loss motive, but also because it duplicates fixed cost and generates the cost inefficiency due to high (and idle) capacity. A competitive arrangement, in which the entrant enters with a small capacity, therefore, would be both welfare enhancing, as well as profit-maximizing for the incumbent.