Endogenous Capacities and Price Competition: The Role of Demand Uncertainty

33 Pages Posted: 14 May 2008

See all articles by Maria Angeles de Frutos

Maria Angeles de Frutos

Universidad Carlos III de Madrid - Department of Economics

Natalia Fabra

Universidad Carlos III de Madrid - Departmento de Economia

Date Written: February 2007

Abstract

This paper analyzes a model of capacity choice followed by price competition under demand uncertainty. Under various assumptions regarding the nature and timing of demand realizations, we obtain general predictions concerning the role of demand uncertainty on equilibrium outcomes. We show that it reduces the multiplicity of equilibria, it may rule out the existence of symmetric equilibria, and it leads to endogenous capacity asymmetries even though firms are ex-ante symmetric. Furthermore, as compared to the certainty equivalent game, demand uncertainty reduces prices and increases consumer surplus, but it also decreases total welfare because of the emergence of idle capacity. By relying on the analysis of firms' reaction functions as well as on the theory of submodular games, we are able to show that a subgame perfect equilibrium always exists and to fully characterize it.

Keywords: Demand uncertainty, investment, price competition, submodular game

JEL Classification: D43, D80, L11

Suggested Citation

de Frutos, Maria Angeles and Fabra, Natalia, Endogenous Capacities and Price Competition: The Role of Demand Uncertainty (February 2007). CEPR Discussion Paper No. DP6096, Available at SSRN: https://ssrn.com/abstract=1132233

Maria Angeles De Frutos (Contact Author)

Universidad Carlos III de Madrid - Department of Economics ( email )

Calle Madrid 126
Getafe, 28903
Spain

Natalia Fabra

Universidad Carlos III de Madrid - Departmento de Economia ( email )

E-28903 Getafe (Madrid)
Spain
+34-91 6249594 (Phone)
+34-91 6249329 (Fax)

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