The Other Side of Limited Liability: Predatory Behavior and Investment Timing

This paper investigates the interplay of investment irreversibility, predatory behavior, and limited liability in a duopoly with aggregate demand uncertainty. We find that limited liability and investment irreversibility is likely to produce predatory behavior in very competitive industries in which prices react strongly to changes in quantity and capacity increases are not too costly. The rationale for this may be summarized as follows: Under limited liability, the owners of a firm have to decide whether they are willing to finance losses from private funds, or whether they rather default on the firms obligations in adverse states. However, market conditions themselves become endogenous in a duopoly since the quantity decisions of all competitors determine the market price. If now investment is irreversible, it is a strong commitment. It hence becomes a device to force others to leave early and allows oneself to commit to leave late. If the ability to promote the exit of a competitor is strong, it may then even result in firms investing only to prey, i.e. firms invest only to consequently monopolize the market. Therefore, the model of this paper explains predatory behavior in a duopoly without invoking reputational, network- or learning-effects. Moreover, this paper's model also does not define predatory behavior as deviations from tacit collusion.