Economics Working Papers

Publication Date

1-31-2020

Number

20003

Abstract

We present a model of firm entry in an industry that is managed with a production cap-and- trade (CAT) regulation. Firms are heterogeneous in productivity; each knows its own productivity but is uncertain about where it ranks in the entrant population. Entry is modeled as a simultaneous move game with incomplete information. Under CAT, firms compete to secure shares of the fixed permit supply. Entry payoffs are determined by own and rival entrant pro- ductivity; if average productivity of rival entrants is low, permit prices are low and returns to vested capital are high. The opposite holds when average productivity of rival entrants is high. We derive Bayesian Nash equilibrium entry and show that under certain conditions placement uncertainty increases entry, relative to a full information benchmark. We also obtain conditions under which this result is reversed. We extend the model to consider placement bias, i.e., firms believe they attain better than average productivity. Bias exacerbates the excess-entry problem. Our main finding, that placement uncertainty alone can cause excess market entry and inefficiency, has been overlooked in the literature. The new mechanism offers an alternative explanation for competitive blind spots in entrepreneurs.

JEL Classification

L2, C72, Q58

Version History

Original Release Date: January 31, 2020

Departments

Department of Economics, Iowa State University

File Format

application/pdf

Length

63 pages

Share

COinS