The Capacity Strategy of the Incumbent under Capacitated External Market

We study the optimal capacity strategies of an incumbent firm facing potential entry in a capacity-constrained market: either allowing the entrant to enter or maintaining monopoly power by buying out external capacity. To capture the interaction between the incumbent and the potential entrant, we employ a two-stage game. Our analysis shows that it is optimal for the incumbent to adopt a buyout strategy to deter entry only when both the external market capacity and its consumer preference are low. Regarding the entrant, we find that developing a differentiated product is not always the best choice. When the incumbent’s consumer preference is relatively low, it is more profitable for the entrant to introduce a similar product, thereby intensifying competition and driving the incumbent out of the market. Finally, we show that when a firm’s consumer preference is high, stronger competition instead induces the firm to set a higher product price.