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August 3, 2001

The Behavior Of Declining Industries∗

Abstract
This paper examines how the prospect of imminent exit by a competitor in a declining industry affects
the market behavior of that industry prior to exit. We show that “survivor” firms have an incentive
to increase their holdings of inventories and to hold excess capacity before exit occurs. Preparation
for the failure of a rival will also involve increasing output. This will push down the market price and
may hasten the rival firm’s demise. The welfare consequences of these actions is mixed but can be very
different to the same actions in a growing or stable industry. In particular, holding excess capacity or
increased inventories may be procompetitive.

JEL Clasification: D43, L13.

Suggested running heading: Declining industries.

Stephen P. King
Economics Program
RSSS
The Australian National University


I would like to thank Volker Böhm, Jürgen Eichberger, Simon Grant, Bruce Lyons, Stephen Morris, Ben
Polak, an anonymous referee and seminar participants at Harvard, Melbourne and Sydney Universities for their
helpful comments. Any errors are the sole responsibility of the author.
1 Introduction

How does the prospect of the imminent decline and exit of some firms within an industry affect
market behavior? Recent theoretical and empirical research on declining industries has focused
on the order of exit. In contrast, this paper considers how the process of decline affects industry
pricing and production decisions before any actual exit occurs. We show that the process of de-

cline can have a significant influence on a range of business decisions. In particular, late-exiting
firms may engage in a variety of practices to prepare for the departure of early-exiting firms.
These can include aggressive pricing, holding increased inventories or maintaining excess capac-
ity. While such behavior may be viewed as potentially anti-competitive in a growing industry

facing potential entry (eg: Dixit 1980, Bulow et. al. 1985), for an industry facing decline these
practices are a natural consequence of impending exit. In sharp contrast to the literature on
entry deterrence, holding increased inventories and maintaining excess capacity may be viewed
as pro-competitive in a declining industry.

To illustrate our results, consider an industry with a small number of incumbent firms facing
declining demand for their product. The US receiving-tubes industry in the late 1960s and early
1970s provides one example (Harrigan 1980). In contrast to Fudenberg and Tirole (1986) assume
that the firms are aware of their relative levels of efficiency so that the order of exit is predictable.

For example those firms with relatively large plants involving high fixed costs may be the first
to exit (Ghemawat and Nalebuff 1985, see also Fine and Li 1989).
Late exiting firms will have an increased share of a diminishing market. In particular, because
of the “lumpy” nature of exit, surviving firms will tend to face a temporary increase in sales

immediately after one of their competitors has left the industry. This will hold even if firms can
manage their decline by sequentially closing plants (Reynolds 1988 and Whinston 1988) so long
as the rate of decline in demand is not too great. The survivor firms will want to prepare for any
transitory increase in demand that will accompany a competitor’s exit before that exit actually

occurs. This preparation may involve either increasing capacity today, or to the extent that this
is infeasible, lowering the rate of capacity redundancy; mothballing capacity to be brought back
into production at a later date; increasing current production to make use of excess capacity
and either selling that output or storing it as inventory; or making preliminary moves to acquire
the plant and equipment of the failing firm. For example, in the US receiving-tubes industry,
despite an easily predictable pattern of declining demand and the exit of Westinghouse in 1974,
General Electric consolidated its production operations after 1974, including holding its facility

in Kentucky “in reserve in the event that it might be needed again in the future” (Harrigan
1980 p83). After RCA ceased production in 1976, GTE Sylvania purchased some of RCA’s
manufacturing assets.
If the preparation by survivor firms for their competitor’s departure raises current output

then it will tend to reduce the pre-exit market price. This in turn may encourage early exit.
As we show below the degree to which preparation for future exit affects current prices will be
central to the pattern of decline in the industry. Preparation for exit will almost always involve an
expansion of current production by the survivor firm, especially when mergers between survivor

and failing firms are not possible. However, the size of any output expansion will depend crucially
on the possible alternatives for the survivor firms to transfer capacity through time.
The model developed in this paper allows us to examine these strategic issues. It is both a
reduced form and an extension of the model presented by Ghemawat and Nalebuff (1990). Unlike

the Ghemawat and Nalebuff model, we allow for a wide variety of cost functions and numerous
methods to transfer capacity and product over time. However, to keep the analysis tractable, we
only consider two firms interacting over two periods. Because of the presence of fixed costs and
increasing marginal costs, the results of our model markedly differ from those of Ghemawat and

Nalebuff. This in part reflects the difference in focus between their work and this paper. The
analysis here is not concerned with determining the order of exit but rather the consequences for
a declining industry when all participants know which firm will be the first to fail. The pre-exit
behavior which forms the core of our analysis could not be sustained under the highly specific

cost assumptions of the Ghemawat and Nalebuff framework. Our analysis shows that pre-exit
aggressive pricing behavior, increased inventory stocks and mothballed plant, rather than being
an occasional oddity, will be the norm in declining industries.
2 A simple model of a declining industry

Consider an industry with two incumbent firms who both produce a homogeneous good and
compete over a number of periods. The industry is characterized by a declining demand for the
product and both firms know that, after a certain future date, even monopoly production will
be unprofitable. It is convenient to limit potential competition to two periods so we assume that

monopoly production is unprofitable from the third period onwards.


In each period, each firm must first decide whether to continue production or to exit.1 Exit
does not involve an explicit cost but is irreversible. If a firm chooses not to exit in any period
then it must pay a fixed cost. The cost, for example, may represent the expense of readying plant

for production, or payments for administrative overheads which do not depend upon production
volume. The firms who remain in the industry then simultaneously announce their individual
production levels. Production may be limited by capacity. The market price for the period is
set to equate demand with supply.

There is no uncertainty or asymmetry of information in the model. All cost and demand
functions are common knowledge. However, the firms are not identical. The object of this paper
is to consider the pricing and output pattern of the incumbents prior to exit. Consequently, we
will assume that one of the firms is more efficient than the other so that, if there is asymmetric

exit, the less efficient firm will leave the industry first. The exact differences between the firms
are given by the assumptions below.

Capacity and production

For imminent failure to have any effect on industry behavior, there must be a link between current

decisions and future profitability. In this paper we analyze behavior in a declining industry when
capacity constraints link production plans over time.
Each firm in each period can produce output up to its capacity and capacity is represented
as a simple truncation of a firm’s production possibilities. For example, suppose a firm employs

1
The first period in the model can be viewed as following an (unmodelled) interval of market interaction
between the firms. The model abstracts from this pre-period one interaction. This abstraction is without loss of
generality so long as firms’ capacities at the beginning of the first period satisfy the assumptions below.
machines each of which is capable of producing up to a fixed level of output per day. The
firm can alter its daily output level by increasing or decreasing the number of machines in use
and/or the intensity of operation of each machine. Once the firm has chosen the total number
of its machines, however, maximum daily production is fixed by the number of machines times

the maximum daily output per machine. This maximum daily production represents the firm’s
capacity.
It is convenient to assume that firms begin the first period with sufficient capacity so that
each firm, if it so desired, could produce the unconstrained monopoly output in that period.2 A

firm’s capacity in the second period, however, will depend upon its first period actions. Capacity
in the second period can arise from four sources. A firm will retain any capacity actually used for
production in the first period, net of depreciation. The firm may also choose to mothball capacity
in the first period, intending to bring that capacity back into use in the second period. Thirdly,

a firm may initially deplete its capacity then invest in new capacity at a later date. Finally, it
may be possible for a firm to expand its capacity by merging with another firm. We focus on
the first three methods of augmenting capacity. Mergers will briefly be considered separately in
section 6 below.

If the firms produce a durable good, then transferring the product between periods can
substitute for transferring production capacity. A firm can ‘over produce’ the product in one
period then hold inventory stocks for sale at a later date. The use of inventories will be considered
in section 5. Initially, however, we assume that the product is not storable so that inventories

are impractical.
It simplifies our analysis to assume that depreciation is small enough to be ignored. This
assumption does not affect the qualitative results presented below so long as the rate of depre-
ciation per period is less than 100%. In other words, our results are valid so long as utilizing

capacity in first period production results in some capacity being transferred to the second pe-
riod. That said, the production behavior described below will become less important as the level

2
This assumption is purely for ease of exposition. The analysis presented below would follow so long as first
period capacity exceeds qs∗ + ks∗ and qv∗ (as defined below) for the two firms. The assumption eliminates the need
to explicitly model the process by which the firms reach the first period and is reasonable for an industry suddenly
faced with a decline in demand.
of depreciation rises ceteris paribus.

Notation

We denote the two firms in the industry by s and v. Firm s is the more efficient short-term
“survivor” while v is the less efficient “victim” of early failure. The per period fixed cost for each

firm is given by Fi , where i refers to a generic firm, i ∈ {s, v}. The fixed cost can differ between
firms but is constant for each firm over all periods. Let ci (qi ) represent firm i’s variable production
costs in period t when output in that period, qi , is no greater than productive capacity. Variable
production costs are infinite when qi exceeds capacity.

Periods of competitive interaction are denoted by t. By assumption, only the first two periods
will be relevant. Any firm remaining in the industry at t = 3 will always choose to exit as any
further production cannot be profitable. The (inverse) demand curve facing the industry in any
period is denoted by P (Q, t), where Q is the total industry output; Q = qs + qv .
In each period, if both firms remain in the industry then they simultaneously set quantities
subject to their capacities. We denote these capacities by Ks and Kv . In general, the equilibrium
quantities chosen by the firms need not be equal to those that would be chosen in a one-shot
Cournot game. However, it will be convenient to compare outcomes to those of the one-shot

game. Let πsc (t) − Fs and qsc (t) refer to the capacity unconstrained, one-shot profit and output
for s. While these provide useful benchmarks, more general notation is also required. Denote
the profits of firm s in period t from output qs when firm v is producing qv by πs (qs | qv , t) − Fs .
The output level(s) that maximizes this profit is the firm s one-shot best response to qv in period
t; q̂s (qv , t). Symmetric notation is used for firm v.
If only one firm remains active in any period, then it will act as a capacity constrained
monopolist. πsm (Ks , t) − Fs and qsm (Ks , t) refer to the firm s one-shot profit and output levels
as a monopolist in period t. If s is not capacity constrained in period t then we denote one-shot

monopoly profits and output by πsm (t) − Fs and qsm (t).3 Again, symmetric notation is used for

3
If s is a monopolist in period t it will set qs to solve maxqs P (qs , t)qs − cs (qs ) − Fs subject to qs ≤ Ks . By
assumptions 1, 2 and 3 below, profits for firm s are strictly concave. If qsm (t) > Ks then the capacity constraint
will bind and s will set qs = Ks with profits πsm (Ks , t) − Fs . Otherwise s will set qs = qsm (t) and gain profits
πsm (t).
firm v.
The industry is in decline in the sense that q̂i (qj , t), πic (t), qic (t), πim (t), qim (t) are all mono-
tonically declining in t. Finally, let δ be the identical discount factor for each firm.

Assumptions

The focus of our analysis is on the behavior of a declining industry in the period leading up
to the exit of one firm. Because of this, it is useful to introduce two complementary sets of
assumptions. The first set will ensure that there is a well defined and unique equilibrium to
the one-shot quantity setting game. The second set will ensure that the only relevant equilibria

involve firm v choosing to exit before production commences in period two, while firm s produces
until the end of period two.
First, we make standard assumptions on demand and costs to ensure the existence of a unique
Cournot equilibrium. We assume that

(1) In each period, each firm’s variable production cost, ci (qi ), is twice continuously differentiable
up to capacity, with (∂ci /∂qi ) ≥ 0 and (∂ 2 ci /∂qi2 ) ≥ 0. In period t, ci (qi ) = ∞ if qi > Ki (t).

(2) The inverse demand curve P (Q, t) is twice continuously differentiable with (∂P/∂Q) < 0.
P (0, t) is finite.
(3)
∂ 2 P (qi + qj , t) ∂P (qi + qj , t)
∀qi , qj and t 2
qi + <0 i 6= j and i, j ∈ {s, v}
∂Q ∂Q

These assumptions guarantee, given the other firm’s output, that each firm has a concave
profit function in each period. Consequently, each firm has a well-defined best-response function.
While the first and second assumptions are self evident, the third assumption is less obvious.
It requires that industry demand is not “too convex”. This is a relatively standard assumption

for models based on a Cournot game. It is easy to show that Cournot interaction can lead to
rather unrealistic results with highly convex demand functions (see Shapiro 1989).4 The three
assumptions also imply that there is a unique one-shot Cournot equilibrium in all periods, and

4
For example, if Cournot duopolists face a demand curve with constant (absolute) elasticity less than unity,
then an exogeneous rise in marginal costs, say due to a sales tax, can lead to a rise in profits.
that at this equilibrium the reaction functions of the two firms intersect in the “normal” way.
Specifically, −1 < [∂ q̂i (t)/∂qj (t)] < 0.5
The second set of assumptions focus on the identity of the first firm to exit. As noted above,
we assume that firm s is more efficient than firm v. More formally

(4) πsc (2) > Fs , πvc (1) > Fv and πim (t) > Fi for both firms and both periods. But πim (t) < Fi for
both firms from period three onwards. Most importantly πvc (2) < Fv .

Assumption (4) requires that capacity unconstrained monopoly production is profitable for
both firms up to and including the second period. However, it is never profitable to remain in

the industry after period two.


A crucial element of assumption (4) is that, while capacity unconstrained one-shot Cournot
interaction is profitable for firm s in both period one and two, this does not hold for firm v. Firm
v would prefer to exit in period two rather than participate in a one-shot Cournot game. It is in

this sense that firm s is more efficient than firm v.


The firms are not engaged in a simple repeated Cournot game. Consequently, assumptions
(1) to (4) are not sufficient to guarantee that firm v is the always the first to exit from the
declining industry. It is not difficult to construct situations where there are two equilibria, one

in which firm v exits first and one in which firm s exits first.
While firm v may appear the likely candidate to exit first, it may be possible for firm v to
force s to exit first in equilibrium. Firm v may be able to credibly raise production in the first
period. Given this output and the cost of mothballing and augmenting capacity, it then may be

optimal for firm s to produce the one-shot best response to v in the first period and then exit in
the second period. This possibility is ruled out by assumption (5).
(5) If qvm (2) > qvc (1) then let φ = q̂s (qvm (2), 1). If φ ≤ qsc (2) then:

P (φ + qvm (2), 1)φ − cs (φ) + δ[P (φ + q̂v (φ, 2)φ − cs (φ)] ≥ Fs + δFs

and
P (φ + q̂v (φ, 2), 2)φ − cs (φ) ≥ Fs

5
For the conditions for the uniqueness of Cournot equilibrium see Shapiro (1989). See also the appendix of
this paper.
Assumption (5) prevents firm v from credibly expanding production and forcing s to exit.
The potential for firm v to expand first period production will only arise if qvm (2) > qvc (1) so
that v can credibly deviate from a one shot best response at t = 1. By assumption 4, firm s
will only exit in the second period if its capacity is below the one shot Cournot level which, at a

minimum, requires that φ as defined in assumption 5, is less than qsc (2). Assumption 5 considers
this case and states that even if in period one firms v and s believe firm s will exit in the second
period, and firm v produces the highest possible credible output in period one so that s will be as
capacity constrained as possible in the second period, firm s will in fact choose not to exit in the

second period. Assumptions (4) and (5) together ensure that all subgame perfect equilibria in
the declining industry will involve firm v exiting in the second period leaving s as a monopolist.6

The cost of augmenting and mothballing capacity

Assumptions (1) to (5) guarantee that firm v will exit at period two in equilibrium. Consequently,
the exact combination of mothballing and augmentation used by firm s to transfer capacity
between periods one and two can have no strategic relevance. Firm s will merely transfer any
capacity in the cheapest possible way.

Assume that the total costs of both mothballing and augmentation are each non-negative
and twice continuously differentiable with non-negative first and second derivatives. We sim-
ply combine mothballing and augmentation into a single minimum-cost transfer function for
capacity. This is expressed in period one dollars and is denoted by M(k) where k is the capacity

transferred by mothballing and/or augmentation. M (k) is continuously differentiable with M 0 (k)


non-negative and non-decreasing. We normalize M (0) to be equal to zero.

Timing

The timing of decisions in the industry is illustrated in figure 1. Note that each firm knows the

other firm’s entry decision and capacity level before it produces in each period. The gross payoff

6
Assumption 5 is clearly satisfied if Fs is sufficiently low. The assumption is only necessary to ensure a unique
pure strategy equilibrium for industry decline, and the assumption can be removed without affecting any of the
existence results given below.
to firm i in each period is given by:
P (qi , qj , t)qi − ci (qi ) − Fi if firm i chooses not to exit
0 if firm i chooses to exit in this or any previous period.
We will analyze the subgame perfect Nash equilibria for the industry.

INSERT FIGURE 1 ABOUT HERE

3 Industry Equilibrium Without Intertemporal Linkages

It is useful to establish a base-case where there are no intertemporal capacity linkages. If M (k) =

0 for all k then capacity is freely adjustable in any period. Firm s has no need to prepare for the
departure of firm v. After v exits, firm s can act as an unconstrained monopolist. The unique
equilibrium behavior in the industry is easily established by solving backwards from period three.
By assumption (4) both firms will exit in period three if they have not already done so. In

period two, firm v will choose to exit if s remains in the industry. Conversely, s will never choose
to exit. This also follows from assumption (4). Finally, in period one, neither firm will choose
to exit, as Cournot interaction is mutually profitable. By assumptions (1) to (3) the Cournot
equilibrium is unique in every period. Consequently, in the absence of any capacity constraints,

the unique equilibrium will involve both firms producing one-shot Cournot outputs in the first
period. Firm v will then exit while firm s acts as an unconstrained monopolist in the second
period. Finally, firm s will exit in the third period.
The equilibrium without capacity linkages is formally stated in the following proposition.

Proposition 1 If M (k) = 0 ∀k then the unique subgame perfect equilibrium outcome is for both
firms to remain in the industry at t = 1 and play one-shot Cournot; then for v to exit at t = 2
and s to behave as a monopolist.

4 Industry Equilibrium With Capacity Constraints

The behavior of the firms will alter in a number of ways when capacity constraints become
relevant. Firm s will tend to become more ‘aggressive’ in the first period if v remains in the
industry. s will have an incentive to raise output above the one-shot Cournot level because this
will help alleviate any capacity constraint in the second period. Firm v will tend to reduce its
own output in response to any expansion by firm s. This will lower firm v’s profits in the first
period, possibly to the point where firm v finds it optimal to exit the industry in period one.
Overall, capacity constraints in a declining industry can affect the absolute and relative outputs

of firms and the market prices both before and after exit. They may also hasten some exit
decisions.
To see these effects, let M (0) = 0 and M 0 (0) > 0. It is costly to transfer capacity over time by
either mothballing or augmentation. Consider that firm v naively follows the strategy outlined in

proposition 1. In other words, v chooses to remain in the industry in the first period and produce
the one-shot Cournot output, qvc (1). Firm v then exits in the second period. Let firm s transfer
capacity ks between the first and second periods using mothballing and/or augmentation. If s
produces an output level qs (1) in the first period then their capacity in the second period is

given by Ks = ks + qs (1).7 Thus, firm s will have a second period capacity equal to the sum
of the capacity used in the first period and the capacity transferred by either mothballing or
augmentation. The total profits for firm s are given by

[P (qs (1) + qvc (1), 1)qs (1) − c(qs (1)) − Fs ] (1)

+δ[πsm (Ks = qs (1) + ks , 2) − Fs ] − M (ks )

Firm s will be capacity constrained in the second period if it is unable to produce the profit-
maximizing monopoly quantity. For example, consider that the one-shot Cournot output for

firm s in period one exceeds the second period monopoly quantity; qsc (1) ≥ qsm (2). Then if firm
s produces its one-shot best response to firm v in the first period, it will be unconstrained in the
second period. The capacity transferred ‘in use’ more than meets the firm’s capacity requirements
in the second period. No capacity will be transferred by mothballing and/or augmentation. The

strategies outlined in proposition 1 remain an equilibrium.


Consider, however, that qsm (2) > qsc (1). If firm s sets its one-shot Cournot output level in
the first period, and transfers no other capacity, then it will be unable to produce the profit

7
Remembering that depreciation is set to zero for convenience.
maximizing monopoly output level in the second period. In general, this will not be optimal
for firm s. Rather, firm s will set qs (1) and ks to maximize total profits, (1). This will always
involve firm s setting first period output above the one-shot Cournot level.8
Transferring capacity ‘in use’ is costless for firm s at the margin. If firm s slightly exceeds its

one-shot best response output in the first period then this only leads to a second order loss of
profits in that period. However, when firm s is capacity constrained in the second period, trans-
ferring capacity ‘in use’ leads to a first order gain in profits to the firm when it is a monopolist.
Transferring capacity by other means, such as mothballing, always involves a positive marginal

cost. Consequently, it always pays firm s to expand output beyond the simple first period best
response whenever qsm (2) > qsc (1).
While this discussion has been predicated on firm v following a naive strategy, it illustrates a
general point. If the surviving firm is likely to be capacity constrained after the other firm exits,

then it will pay the surviving firm to increase output before any exit occurs. Of course, knowing
this, firm v will respond by altering its own first period output level. It may even pay firm v to
exit earlier than otherwise.
To formalize the equilibrium strategies for the declining industry when capacity transfer

is costly, consider the pair of outputs (qs∗ , qv∗ ) and capacity ks∗ which simultaneously solve the
following pair of optimization problems:

max [πs (qs | qv∗ , 1) − Fs ] + δ[πsm (Ks = qs + ks , 2) − Fs ] − M (ks ) (2)


qs ,ks

max πv (qv | qs∗ , 1) − Fv (3)


qv

Given our assumptions, a unique solution (qs∗ , qv∗ , ks∗ ) exists with qs∗ ≥ qsc (1) and qv∗ ≤ qvc (1). The
proof of uniqueness is given in the appendix.
There are three separate cases suggested by the above discussion – where qsm (2) ≤ qsc (1) so

that s is not capacity constrained; where qsm (2) > qsc (1) but firm v finds it profitable to remain
in the industry in period one; and where qsm (2) > qsc (1) and it pays v to exit in the first period.
Proposition 2 considers the first two of these cases. Proposition 3 considers the final case.

8
This is easily verified by solving the first order conditions for (1) and showing that qs (1) ≤ qsc (1) cannot be
a solution when M 0 > 0 for all non-negative ks .
Broadly speaking, the propositions show that whenever qsc (1) < qsm (2), firm s, in competition
with firm v in the first period, will increase output beyond the ‘one-shot’ Cournot level. This
‘aggressive’ behavior will cause firm v to contract output in period one if the firm continues in
production (proposition 2) or to exit before period one commences (proposition 3). Early exit

by v is more likely if qs∗ is relatively large. This may arise if mothballing and augmentation are
relatively expensive or if the rate of decline in demand between periods one and two is relatively
small but even one-shot Cournot production in period one by v would only yield small profits.
Proofs of the propositions are given in the appendix.9

Proposition 2 Assume that πv (qv∗ | qs∗ , 1) − Fv > 0. The unique subgame perfect equilibrium
path for the two firms involves both firms not exiting at t = 1 with s producing qs∗ and v producing
qv∗ ; v exiting at t = 2 and s remaining as a monopolist at t = 2.

Proposition 3 Assume that πv (qv∗ | qs∗ , 1) − Fv < 0. Then the unique equilibrium path of the
game involves v choosing to exit at t = 1, while s enters and behaves like a monopolist in both
periods.

If the one-shot Cournot output for firm s in the first period is at least as great as its profit
maximizing monopoly output in period 2, then the capacity constraint has no practical relevance.
In equilibrium, both firms simply produce the one-shot Cournot outputs in period one. Firm
s cannot credibly raise its period one output. In this case, the equilibrium path described in

proposition 2 is identical to that in proposition 1.10


In contrast, if one-shot best responses in period 1 lead firm s to face a binding capacity
constraint in the second period, then s will increase its period one production, qs∗ > qsc (1). By
assumptions (1), (2) and (3), firm v will respond by lowering its output, qv∗ < qvc (1). Firm v’s

profits in the first period will fall. If it is still profitable for v to enter in the first period then
market prices will be lower in that period but higher in the second period relative to the base-case
without capacity constraints.11

9
The propositions do not cover the case where πv (qv∗ | qs∗ , 1)−Fv = 0. In this case firm v is indifferent between
remaining in the industry in the first period and exiting. The equilibirum paths given by both propositions apply
but are not unique.
10
If depreciation was positive then the relevant condition would be that the capacity used to produce the
first period Cournot output for firm s is at least sufficient to produce the second period unconstrained monopoly
output after depreciation.
11
This follows from [∂ q̂v (t)/∂qs (t)] > −1.
To an outside observer the behavior by firm s may appear ‘predatory’ in that firm s raises its
quantity in the short run then its competitor chooses to exit. However, it is the fact that firm v
will choose to exit in period 2 that enables firm s to raise output in the first period. Rather than
forcing firm v to exit, s is simply reacting to that exit. In fact, in contrast to standard notions

of predation, firm s may actually reap higher profits in the first period when capacity transfer is
constrained.
When both firms produce in the first period, firm s will prepare for v’s departure by moth-
balling capacity and raising output. Predicting such aggressive behavior, however, firm v may

prefer to exit in the first period. If πv (qv∗ | qs∗ , 1) − Fv < 0 then firm v will exit the industry
at period 1 in equilibrium. In this case, the threat of aggressive output expansion by s as it
prepares for v’s departure actually hastens that departure.12 Firm s will be a monopolist in
both periods and, relative to our capacity unconstrained base-case, prices will be higher in the

first period but unchanged in the second period.


The cost of both mothballing and augmenting capacity will affect the pattern of decline. For
example, consider an equilibrium where ks∗ > 0. From the first order conditions for (qs∗ , qv∗ , ks∗ ), if
M 0 (k) were to fall for all positive values of k then qs∗ would also fall. In other words, if it becomes

less expensive at the margin to transfer capacity by mothballing or augmentation, then firm s
will transfer more capacity through these means and rely less on transfer ‘in use’. If firm v would
enter anyway in equilibrium then cheaper mothballing/augmentation will lead to lower prices in
the second period when s is a monopolist, but to higher prices in period one. The welfare effects

of such a change are ambiguous.


In contrast, if firm v exits in period one in equilibrium, then a fall in the marginal cost of
mothballing or augmentation will reduce the threat of ‘overproduction’ by s and may enable v
to remain an active producer in the first period. In this sense ‘excess’ capacity can act as a

procompetitive influence on the market, albeit that entry by v will still have ambiguous welfare
consequences with prices relatively lower in period 1 and higher in period 2.
The possibility that holding ‘excess’ capacity may aid competitive survival stands in stark

12
Note that, so long as any new entrant would be no more efficient than firm v, firm s need not worry about
entry after firm v has exited as such entry could never be profitable.
contrast to the role of capacity in the literature on entry deterrence. Of course, this contrast
hinges on the different role played by ‘excess’ capacity in a declining industry. Rather than
creating a threat of future aggression, the ability to hold excess capacity over time in a declining
industry reduces the possibility of current aggressive behavior.

5 Inventories

So far, we have assumed that the final product cannot be stored for later sale. However, if the
product is durable and storable, then firm s can increase its second period sales by overproducing

in the first period and holding inventory stocks. If storage is possible, then holding such stocks
will provide an alternative to capacity transfer. Further, increasing production for storage enables
firm s to transfer capacity ‘in use’ without changing first period sales. This suggests that holding
inventories may reduce or eliminate the behavior described in propositions 2 and 3.

If firm s can hold inventories, however, this may be beneficial to firm v even when capacity
constraints are irrelevant. Consider that firm s does not face a capacity constraint in either
period but has strictly convex production costs. If it is not too expensive to store output, then
firm s will want to balance intertemporal production to maximize the present value of its profits.

By storing some first period output for sale in the second period, firm s may be able to lower
its total costs of production. This raises the relative cost of first period sales and has strategic
consequences. For any given output of firm v, firm s will tend to reduce its first period sales.
To see this, let I denote inventory levels for firm s. The cost of storage is given by γ(I),

with γ(0) = 0 and γ 0 (I) positive and non-decreasing for all I ≥ 0. Assume that capacity is
freely transferable over time and that second period monopoly output for firm s exceeds first
period Cournot output. If firm s produces qs (2) in the second period, the marginal cost of this
production in first period dollars is δc0s (qs (2)). Alternatively, second period sales can be increased
by producing more in the first period and storing the extra output. The marginal cost of this
production depends upon the level of sales in the first period, qs (1), and the current level of
inventories, I, and is given by c0s (qs (1) + I) + γ(I). Optimal production will equate these two
marginal costs. Inventories connect period one and period two production costs. The production
of output for storage in the first period raises the marginal cost of production for immediate sales.
Consequently, for any given level of qv , firm s will tend to sell less in period one than if inventories
were infeasible. In particular, firm s will set qs (1) to satisfy

P 0 (qs (1) + qv , 1)qs (1) + P (qs (1) + qv , 1) − c0s (qs (1) + I) = 0

If c00s > 0 and I > 0 then it is clear that qs (1) must be less than the one-shot best response for
firm s. The ability to transfer inventories will tend to make firm s ‘less aggressive’ in the first
period regardless of capacity constraints.
Our focus here is not on the effects of inventories per se, but rather how storage can offset

intertemporal capacity constraints. Consequently, it is convenient to retain the one-shot Cournot


production levels as a base case for comparison. This can be achieved without affecting the
qualitative interaction between storage and capacity by assuming that firm s has linear costs. If
c00s = 0 then the intertemporal cost incentives associated with inventories disappear, and we can

simply focus on the capacity effects. For convenience, we also set M 0 (0) arbitrarily large so that
we can ignore mothballing and augmentation.13 Finally, as shown in the previous sections, for
capacity constraints to be of interest we require that the first period Cournot output for firm s
is less than the second period monopoly output. We restrict attention to this case.

Let firm v produce qvc (1) in period one. Lemma 4 shows that an optimal strategy for firm s
will always involve production at capacity in the second period.
Lemma 4 Let firm v follow a strategy that involves producing qv in the first period then exiting
in the second period. If qsm (2) > q̂s (qv , 1) then the best response for firm s involves setting second
period production at capacity, qs (1) + I, with sales of qs (1) + 2I.

Now, let qv = qvc (1). Using lemma 4, firm s will set its first period output and inventory level
to maximize

P (qs (1) + qvc (1), 1)qs (1) − cs (qs (1) + I) − γ(I) + δ[P (qs (1) + 2I, 2)(qs (1) + 2I) − cs (qs (1) + I)]

The first order conditions for this problem are given by

P 0 (Q, 1)qs (1) + P (Q, 1) − c0s + δ[P 0 (qs (1) + 2I, 2)(qs (1) + 2I) (4)

13
This clearly has no qualitative effect on the analysis as if s produces more than the one shot best response
with inventories when M 0 (0) is arbitrarily large, then s will continue to do so as long as M 0 (0) > 0.
+P (qs (1) + 2I, 2) − c0s ] = 0

−c0s − γ 0 (I) + δ[2P 0 (qs (1) + 2I, 2)(qs (1) + 2I) (5)

+2P (qs (1) + 2I, 2) − c0s ] ≤ 0 = 0 if I > 0

The one-shot best response for firm s in period one, qsc (1) cannot be a solution to this pair of
equations. To see this substitute qsc (1) into (4). This implies that P 0 (qsc (1) + 2I, 2)(qs (1) + 2I) +
P (qs (1) + 2I, 2) = c0s . In other words, qsc (1) + 2I = qsm (2), so that inventory levels must be
positive. But by (5) we have (δ − 1)c0s − γ 0 (I) = 0 which cannot hold if γ 0 > 0. Similarly, it is
easy to rule out any solution with lower output by firm s. Firm s will sell more than the one-shot

best response in the first period so long as marginal inventory costs are always positive.
Inventories do not act as a perfect replacement for capacity transfer ‘in use’. But if storage
costs are low the ability of firm s to credibly expand first period output will be greatly reduced.
There are likely to be many situations where storage costs are low compared to other methods

of transferring capacity. Also, if firm s has strictly convex costs, the ability to hold inventories
will make it ‘less aggressive’ than otherwise even when capacity issues are not relevant. These
factors all suggest that declining industries are less likely to be characterized by aggressive
survivor behavior when cost effective storage is available. In particular, the process of decline in

industries where inventory storage is either impossible, as with service production, or expensive,
as with highly perishable goods is likely to differ markedly from the process of decline in durable
goods industries.

6 Merger

Merger offers an alternative way for a surviving firm to increase capacity. Firm s can buy firm
v’s capital at the end of period one to augment its own capital stock. In so doing, firm s can
reduce and possibly eliminate any second period capacity constraint.

A complete analysis of mergers is beyond the scope of this paper. Rather we will briefly
consider those factors which will link merger to the behavior of the firms in the first period.
Merger will only eliminate capacity constraints for firm s if the post merger capacity is at least
equal to the second period monopoly output. If post-merger capacity is no greater than separated
capacity, this requires at a minimum that qvc (1) + qsc (1) ≥ qsm (2). However, the ability of firm s
to integrate any new capacity that it purchases from firm v will also influence the decision to
merge. In particular, the cost function of the merged entity may exceed the sum of the stand
alone costs of the two firms. The likelihood of merger will also depend on the cost to firm s of

buying v. This will depend on any alternative uses for firm v’s capital.
If firm s can buy firm v cheaply after exit; the merged entity has costs that do not greatly
exceed the sum of the stand-alone costs; and combined capacity can produce at least monopoly
output in period 2; then the expectation of future merger will eliminate the need for firm s to

transfer capacity by other means. In particular, firm s will be unable to credibly raise output in
the first period.
Whether merger is relevant clearly depends on both industry and country specific factors.
For example, if merger with a failing firm is legal, but requires expensive justification through

the courts, then firm s may prefer not to attempt to merge with firm v ex post because of the
potential legal costs. Where relevant, however, merger, like inventory storage, may significantly
alter the path of industry decline.

7 Conclusion

By focusing on the pre-exit effects of decline, the model presented in this paper has highlighted
a number of important characteristics of declining industries. In particular, those firms who
will outlive their competitive rivals in a declining industry will have an incentive to prepare for

market interaction after their rivals have failed. This will lead to changes in behavior prior to
any exit. Survivor firms will have an incentive to raise current output, mothball plant, increase
inventory holdings and investigate the possibility of merger with failing rivals. While the size
and influence of each of these factors will vary considerably with the rate of decline, the nature of

the relevant product and the cost of the various competitive options, some or all of these factors
will occur in many situations of industry decline.
Our results are based on two key assumptions. First, unlike the Ghemawat and Nalebuff
(1990) model, exit is a “lumpy” decision which tends to remove production capacity from the
industry. Thus, the exit of a rival may lead to temporarily higher sales to surviving firms despite
continuous decline in demand. Secondly, capacity is linked over time. It is neither costless to
transfer capacity over time nor to augment capacity in the future. This link necessitates survivor
firms to prepare for their rivals departure.

The consequences of the behavior highlighted in this paper stand in stark contrast to the
standard analysis of growing or stable industries, particularly the literature on entry deterrence.
In a declining industry, both excess capacity and increased inventory holdings can have a pro-
competitive effect in that they can reduce the speed of a rival firm’s departure and lead to lower

prices over time. Similarly, mergers can be pro-competitive. Observing aggressive pricing by
survivor firms in a declining industry may not reflect an attempt to force exit, even when a
period of such pricing is immediately followed by a rival’s exit or when the prediction of such
behavior hastens exit. Rather, it is the prospect of exit that makes such pricing credible as a

survivor firm prepares for the departure of their rival.


The behavior analyzed in this paper suggests an alternative route for empirical investigation.
As with the theoretical literature, the empirical literature on declining industries has tended to
focus on the question of who leaves and who survives in the industry (eg. Deily 1988, Baden-

Fuller 1989, and Franklin 1974). A recent study (Schary 1991) has modeled the determinants
of decline, but there has been little empirical work on the pricing and production behavior in
declining industries. While there is some anecdotal and case-study based evidence to support the
importance of firms in a declining industry preparing for exit, more formal analysis is needed.

Appendix
Proof of uniqueness of {qic } and {qi∗}

To see that the assumptions imply a unique Cournot equilibrium, note that each firm’s best
response must satisfy:
P 0 qi + P − c0i = 0 ∀qj (6)

where P 0 refers to the partial derivative of industry demand with regards to quantity. Taking
the total derivative of (6) with regards to quantities yields:

dqi P 00 qi + P 0
= − 00
dqj P qi + 2P 0 − c00i

Our assumptions ensure that the slope of the reaction functions are between zero and negative

one. To see that this gives a unique Cournot equilibrium, note that this ensures that the best
response functions for the two firms cannot intersect twice. Also, concavity of the profit functions
is easily seen by taking the own quantity derivative of (6).
Note that capacity constraints imply that (dqi /dqj ) = 0 for qi ≥ Ki so that for any Ki , Kj
the slope of the reaction functions is either between zero and negative one or equal to zero at
capacity. Thus for any Ki , Kj the best response functions for the firms still cannot intersect
twice so that there is a unique one-shot Cournot equilibrium for any Ks , Kv and any t if both s
and v have not exited by period t.

For the uniqueness of (qs∗ , qv∗ , ks∗ ), note that v must be on its one-shot best response function
when setting qv∗ . It is thus sufficient to show that the “augmented” reaction function for firm s
has a slope bounded by zero and negative one.
If qsm (2) ≤ qsc (1) then it is trivial to show that (qs∗ , qb v∗, ks∗ ) = (qsc , qvc , 0) which we have shown

to be unique above. If qsm (2) > qsc (1) then in equilibrium either ks∗ = 0 or ks∗ > 0. In either case,
because transfer of capacity always has a positive marginal cost firm s will always operate at
capacity in period 2. If not and if ks∗ > 0, s would clearly achieve profits by reducing s. If s did
not operate at capacity in period 2 and ka∗ = 0 then (qs∗ , qv∗ ) could only be equilibrium quantities
if they equaled (qsc , qvc ). But it is easily verified that this solution cannot satisfy the first order
conditions of (2) if qsm (2) > qsc (1).
By equation 2, if ks∗ = 0 then qs∗ solves:

P 0 (Q, 1)qs + P (Q, 1) − c0s + δ[P 0 (qs , 2)qs + P (qs , 2) − c0s ] = 0 ∀qv (7)

Taking the total derivative with regards to each firms output yields:

dqs P 00 (Q, 1)qs + P 0 (Q, 1)


= − 00
dqv P (Q, 1)qs + 2P 0 (Q, 1) − c00s + δ[P 00 (qs , 2)qs + 2P 0 (qs , 2) − c00s ]

But this is strictly greater than −1 but no greater than zero by our assumptions.
If ks∗ > 0 then by the first order conditions for (2):

P 0 (Q, 1)qs + P (Q, 1) − c0s (qs ) + δ[P 0 (qs + ks , 2)[qs + ks ]+ (8)

P (qs + ks , 2) − c0s (qs + ks )] = 0 ∀qv

and
−M (ks ) + δ[P 0 (qs + ks , 2)[qs + ks ] + P (qs + ks , 2) − c0s (qs + ks )] = 0 ∀qv (9)

Taking total derivatives and applying Cramer’s rule yields:

dqs [P 00 (Q, 1)qs + P 0 (Q, 1)][−M 00 (ks ) + δD]


= − 00 (10)
dqv [P (Q, 1)qs + 2P 0 (Q, 1) − c00s (qs ) + δD][−M 00 (ks ) + δD] − δ 2 D2

where D = P 00 (qs + ks , 2)[qs + ks ] + 2P 0 (qs + ks , 2) − c00s (qs + ks ). Rearranging (10) gives:

dqs [P 00 (Q, 1)qs + P 0 (Q, 1)][−M 00 (ks ) + δD]


= − 00
dqv [P (Q, 1)qs + 2P 0 (Q, 1) − c00s (qs )][−M 00 (ks ) + δD] − M 00 (ks )δD

which is strictly greater than −1 but no greater than zero by our assumptions. Thus the “aug-
mented” reaction function for firm s always has the required slope. 2

Proof of Proposition 2

First, consider period t = 2 for any arbitrary capacity levels. The previous proof noted that for

any Ks and Kv , if both firms remain in the industry at t = 2 there is a unique (one-shot) quantity
setting equilibrium. Denote the relevant quantities in such an equilibrium by qse (Ks , Kv , 2) and
qve (Ks , Kv , 2) with (variable) profits of πse(Ks , Kv , 2) and πve (Ks , Kv , 2). Similarly, for period t = 3
onwards, we can define unique Cournot quantities qse (Ks , Kv , t) and qve (Ks , Kv , t).

Note that the second part of assumption 5 implies that πse (Ks , Kv , 2) ≥ Fs for Ks = φ =
q̂s (qvm (2), 1) and any Kv .
Now, to see that the path of activities given in proposition 2 represents the outcome of a
subgame perfect Nash equilibrium, consider the following strategies:14

σs :

14
The strategies presented below separate the equilibrium and off-equilibrium path actions for firms s and v
in period t = 2. This is purely for exposition.
1. At t = 1 do not exit. If v also does not exit at t = 1 then produce qs∗ and set ks = ks∗ at
t = 1. If v exits at t = 1 then produce qsm (1) and set ks = 0 at t = 1.

2. If no deviation has been observed when period t = 2 is reached then at t = 2 do not exit.
If v also does not exit at t = 2 then produce qse (qs∗ + ks∗ , qv∗ , 2) at t = 2. If v exits at t = 2

then produce min{qs∗ + ks∗ , qsm (2)}. Exit at t = 3.

3. If period t = 2 is reached and v exited at t = 1 then do not exit and produce min{Ks , qsm (2)}
so long as the resultant profit exceeds Fs . Otherwise exit at t = 2. If do not exit at t = 2
then exit at t = 3.

4. If period t = 2 is reached and if both s and v choose not to exit in period t = 2 then set
qs = qse (Ks , Kv , 2). Exit in period t = 3.

5. If period t = 2 is reached and at least one player has deviated in production and/or capacity

choice in period t = 1 and

(a) if πse(Ks , Kv , 2) < Fs but πve (Ks , Kv , 2) ≥ Fv then exit at t = 2.

(b) if πse (·) ≥ Fs then do not exit at t = 2. If v also does not exit at t = 2 then produce
qse (Ks , Kv , 2). If v exits at t = 2 then produce min{Ks , qsm (2)}. Exit at t = 3.

(c) if πse (·) < Fs , πve (·) < Fv and πsm (Ks , 2) ≥ Fs then do not exit. If v exits produce
min{Ks , qsm (2)}. If v also does not exit produce qse. Exit at t = 3.

(d) if πse (·) < Fs and πsm (Ks , 2) < Fs then exit at t = 2.

6. Always exit after period t = 2 if have not already exited. If fail to exit then produce the

minimum of capacity and qsm (t) in period t if v has exited. If v has not exited, produce
qse (Ks , Kv , t).

σv :

1. At t = 1 do not exit. If s also does not exit at t = 1 then produce qv∗ and set kv = 0 at
t = 1. If s exits at t = 1 then produce qvm (1) and set kv = 0 at t = 1.
2. If no deviation has been observed when period t = 2 is reached then at t = 2 announce
exit.

3. If period t = 2 is reached and s exited at t = 1 then do not exit and produce min{Kv , qvm (2)}
so long as the resultant profit exceeds Fv . Otherwise exit at t = 2. If do not exit at t = 2
then exit at t = 3.

4. If period t = 2 is reached and at least one player deviated in production and/or capacity
choice in period t = 1 and if both s and v choose not to exit in period t = 2 then set
qv = qve (Ks , Kv , 2). Exit at t = 3.

5. If period t = 2 is reached and at least one player has deviated in production in period t = 1
and

(a) if πve (Ks , Kv , 2) < Fv but πse (Ks , Kv , 2) ≥ Fs then exit at t = 2.

(b) if πve (·) ≥ Fv then do not exit at t = 2. If s also does not exit at t = 2 then produce
qve (Ks , Kv , 2). If s exits at t = 2 then produce min{Kv , qvm (2)}. Exit at t = 3.

(c) if πve (·) < Fv , πse(·) < Fs and either πsm (Ks , 2) ≥ Fs or πvm (Kv , 2) < Fv then exit at
t = 2.

(d) if πse (·) < Fs , πve (·) < Fv , πsm (Ks , 2) < Fs and πvm (Kv , 2) ≥ Fv , do not exit at t = 2. If
s exits produce min{Kv , qvm (2)}. If s also enters produce qve . Exit at t = 3.

6. Always exit after period t = 2 if have not already exited. If fail to exit then either produce
the minimum of capacity and qvm (t) in period t if s has exited. If s has not exited, produce

qve (Ks , Kv , t).

To show that these strategies form a subgame perfect Nash equilibrium, we can work ‘back-
wards’ from period 2. First, if both players enter in period 2 they will play the one-shot Nash
equilibrium. This is included in steps 2 and 4 of σs and step 4 of σv . Knowing this, each player
will only remain in the industry in period 2 if they believe that they can cover their fixed costs
given the other players choice of either exiting or not. This is included in steps 2, 3 and 5 of
σs and σv . The strategies are thus Nash equilibrium strategies given the industry configuration
in period 2 and are subgame perfect in period 2 when each firm makes its exit decision. Note
that if it is unprofitable for each firm if both firms to remain in the industry in period 2 but it
is profitable for each firm to remain in given that the other firms exits, then we have arbitrarily
chosen v to exit. This is included in step 5c for σs and σv . As this only arises off the equilibrium

path, it does not effect uniqueness as discussed below.


It immediately follows that at t = 2, if there has been no deviation, then it will not pay s to
deviate. If v does not enter then s makes monopoly profits while if v enters, s makes Cournot
profits, both of which exceed Fs . Similarly, it does not pay v to deviate at t = 2 if there has been

no previous deviation. Such a unilateral deviation would lead to Cournot profits in the second
period that are less than Fv .
We now need to consider whether the strategies are subgame perfect given the industry
configuration in period 1. This trivially follows if only one firm remains in the industry in

period 1. If both firms remain, then we need to confirm that neither would want to deviate.
First, consider a unilateral deviation by v. Given the production of qs∗ by firm s, a deviation
in production by v will lower v’s first period profits. This is because qv∗ is the one-shot best
response to qs∗ at t = 1. A deviation by v could only be profitable if it raised v’s period 2 profits

to more than offset this loss. This can only occur if s chooses to exit in period t = 2, as, given
qs∗ ≥ qsc (1) > qsc (2), if s does not exit at t = 2 the maximum profit firm v could make in period
two will be the Cournot profit which is less than Fv . But no deviation by v can lead s to exit
at t = 2 as qs∗ ≥ qsc (1) > qsc (2) so that, at worst, s will make Cournot profits at t = 2. As these
are greater than Fs , any deviation by v in period 1 production cannot deter s from remaining in
the industry in the second period and can only lower firms v’s profit.
Secondly, a unilateral deviation by firm s in period 1 when both firms remain in the industry
will never be profitable. If v still exits at period 2 after such a deviation, then the deviation is

clearly not profitable by definition of qs∗ and ks∗ . If v does not exit at t = 2 after the deviation by
s then s cannot earn more than Cournot profits at t = 2. In fact, s must earn strictly less than
this level of profits otherwise v would not enter at t = 2. But these profits must be less then the
profits s can achieve by not deviating in period 1 as s always has the option of producing the

Cournot level of output at t = 2 but selling it as a monopolist if s does not deviate at t = 1.


Finally, it trivially follows that neither firm will deviate in their exit decision in period 1.
For uniqueness of the equilibrium path actions, we need to consider if there are any equilibria
in which v does not exit at t = 2. v will only choose to remain in the industry in period 2 in
equilibrium if either

1. v expects s to exit the industry at t = 2, or

2. v expects s to exit the industry at t = 1, or

3. s is so limited in capacity that duopoly is profitable for v in equilibrium in period 2.

We will show that neither of these situations can arise in equilibrium.

Consider the first situation, where s exits at t = 2. This can only arise in equilibrium if
πse (Ks , Kv , 2) < Fs on the equilibrium path. However, this can never be the case by assumptions
4 and 5.
To see this, note that the maximum value of Kv in equilibrium is given by the maximum of

{qvc (1), qvm (2)}. If qvc (1) ≥ qvm (2) then in the first period v can never credibly raise its output
above the Cournot level as it will be capacity unconstrained in the second period even if it is
a monopolist. If qvc (1) < qvm (2) then in the first period v could credibly raise its output if in
equilibrium it will be a monopolist in period 2. However, it cannot credibly raise its output
above qvm (2) as it would never require more than this capacity in period 2. Formally, it follows
from the slope of the reaction functions (as shown in the proof of uniqueness given previously
in this appendix) that q̂v (q̂s (Qv , 1), 1) < Qv for all Qv > qvc (1), so that even if s believed that v
was going to produce Qv > qvm (2) > qvc (1) in period 1, and consequently s produced the one-shot
best response to Qv in period 1, firm v would deviate and produce strictly less than Qv as such
a deviation cannot have any effect on period 2 profits, and will raise period 1 profits.
Now consider a putative equilibrium where v produces qvc (1) in period 1 and s exits in period 2.
In this putative equilibrium s would have to produce qsc (1) in period 1. But then, by assumption

4, s will want to deviate and not exit in period 2 as it will be capacity unconstrained in Cournot
equilibrium in period 2 and such an equilibrium is profitable. Hence, the putative equilibrium is
not a subgame perfect Nash equilibrium.
Secondly, consider a putative equilibrium where v produces qv ≤ qvm (2) in period 1 and s
exits in period 2. In this putative equilibrium s would have to produce q̂s (qv , 1) in period 1,
which is at least as great as φ defined in assumption 5. But, by the second part of assumption
5, s will want to deviate and not exit in period 2 as this is always profitable. Hence the putative

equilibrium is not a subgame perfect Nash equilibrium.


Consider the second situation where s exits at t = 1. This will only arise in equilibrium
if s believes that competition in the first period will lead to negative profits. As noted above,
the maximum that v can produce in period 1 in competition to s is given by the maximum of

{qvc (1), qvm (2)}. Clearly, if this maximum is qvc (1) then s will always enter in period 1 as it can
play (profitable) Cournot competition then exit in period 2. If the maximum is qvm (2) then by
assumption 5, it is profitable for s not to exit in period 1, to produce the one-shot best response
to qvm (2) and then also not to exit in period 2. Thus, there is no equilibrium where s will exit in
period 1.
Thirdly, consider a putative equilibrium where s is so capacity constrained that v can prof-
itably remain in competition with s in period 2. In this putative equilibrium, qs (1) ≤ Ks <
qsc (2) < qsc (1) as by assumption 4 the one-shot Cournot equilibrium in period 2 is unprofitable

for v. But this has two implications:


(a) in period 1, qv (1) > q̂v (qs (1), 1) > qvc (1). This follows from the slope of the reaction functions
noting that if the first inequality did not hold then s could deviate, play a one-shot best response
to v in period 1 and have sufficient capacity to produce qs (2) in period 2. Such a deviation would
raise period 1 profits for firm s and not lower period 2 profits. In brief, this simply says that
firm s will only restrict period 1 output and hence period 2 capacity if firm v ‘floods’ the market
in period 1.
(b) in period 2, firm s will be capacity constrained. To see this consider that s was not capacity

constrained in period 2 in equilibrium. Then Ks = qs (1) as it would be wasteful to set ks > 0.


Also, as Kv ≥ qv (1) > qvc (1) > qvc (2) and Ks < qsc (2) then qv (2) = max{Kv , q̂v (qs (2), 2)}. But, as
s is not capacity constrained, qs (2) = q̂s (qv (2), 2). But these conditions on period 2 quantities can
only hold either if the firms are playing the one-shot Cournot equilibrium or if Kv < qvc (2). As

neither of these conditions can hold, we have a contradiction, so in period 2 qs (2) = Ks ≥ qs (1).
It follows that Kv ≥ qv (1) > q̂v (qs (1), 1) ≥ q̂v (Ks , 1) = q̂v (qs (2), 1) > q̂v (qs (2), 2). In other
words, in the putative equilibrium, firm v has excess capacity in period 2. But this can never
be a subgame perfect Nash equilibrium, as it would always pay v to deviate and lower output
in period 1. This would not effect period 2 profits for v as it cannot effect the capacity (and

output) of firm s in the second period and v has excess capacity at t = 2, but it would raise
v’s first period profits as v produces above the one-shot best response in period 1 and v’s profit
function is concave. As v always prefers to deviate, the putative equilibrium is not a subgame
perfect Nash equilibrium.

We have shown that there can never be an equilibrium where v does not exit at t = 2.
Uniqueness then follows from the definition of qs∗ , qv∗ and ks∗ , and the assumption that πv (qv =
qv∗ | qs = qs∗ , t = 1) − Fv > 0. 2

Proof of proposition 3

To see that the path of activities given in proposition 3 represents the outcome of a subgame
perfect Nash equilibrium, consider the following strategies:
σ̂s : play σs .
σ̂v : Exit at t = 1. If fail to exit at t = 1, play σv .

where σs and σv are the strategies given in the proof of proposition 2.


Clearly, by proposition 2 these strategies form a subgame perfect Nash equilibrium after exit
decisions have been made for period 1. By assumption, entry at t = 1 gives negative profits to firm
v in equilibrium, so the strategies also form a subgame perfect equilibrium for the whole game.

Uniqueness follows immediately from the assumption that πv (qv = qv∗ | qs = qs∗ , t = 1) − Fv < 0
and from proposition 2. 2

Proof of lemma 4

If I = 0 then the lemma follows directly. For I > 0, consider that second period production is

less than capacity. We shall show that firm s can always increase profits by altering production.
In particular, let qs (2) = qs (1) + I − 2ε where ε > 0. Total profits for firm s are given by

P (qs (1) + qv , 1)qs (1) − cs (qs (1) + I) − γ(I) + δ[P (qs (2) + I)(qs (2) + I) − cs (qs (2)) (11)
Now consider an alternative production plan where inventories are reduced by ε (or to zero if
I < ε originally) and second period production is increased to qs (2) + ε (or increased by I) to
hold total output in the second period constant. Note that this alternative production is at
capacity. Total profits of firm s are now given by

P (qs (1) + qv , 1)qs (1) − cs (qs (1) + I − ε) − γ(I − ε) + δ[P (qs (2) + I)(qs (2) + I) − cs (qs (2) + ε) (12)

Subtracting (11) from (12), we observe that profits have risen under the new production plan
by

[1 − δ][cs (qs (1) + I) − cs (qs (1) + I − ε)] + [γ(I) − γ(I − ε)] (13)

+δ[cs (qs (1) + I) − 2cs (qs (1) + I − ε) + cs (qs (1) + I − 2ε)]

But (13) is strictly positive if either c00s > 0 and/or δ < 1 and/or γ 0 > 0. Thus the new plan
with production at capacity gives firm s higher profits and the original plan can not have been

optimal. 2

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Figure 1: