Non-Cooperative Entry Deterrence in a Uniform Price Multi-Unit

Capacity Auction
David Brown

Abstract
Motivated by the development of centralized capacity payment mechanisms in the electricity industry,
this paper characterizes rms bidding behavior in a multi-unit capacity auction with externalities. An
incumbent is willing to bid below its net marginal cost of new capacity investment to deter entry.
However, due to the free-riding incentives associated with non-cooperative entry deterrence there are
cost realizations in which there is underinvestment in entry deterrence. The incumbents can overcome
these free-riding incentives if they jointly bid to deter entry. However, the incumbents are caught in a
prisoners dilemma game in which the benets of cooperation cannot be achieved.

Department of Economics, University of Florida. E-mail: browndp2@u.edu. I would like to thank David Sappington,
Theodore Kury, Jonathan Hamilton, and Sean Meyn for their help and guidance. Financial assistance in the form of a grant
from the Robert F. Lanzillotti Public Policy Research Center is also gratefully acknowledged.
1
1 Introduction
New production capacity is often allocated by way of an auction mechanism. The most prominent examples
are auctions for spectrum licenses in the telecommunications industry and for generation capacity in the
electricity industry. In order for new suppliers to enter into the market they must outbid the incumbents
bids for capacity investment.
1
Hence, the outcome of the auction aects the ensuing market structure. As
a consequence, incumbents are not indierent about which rms bids are accepted by the auctioneer.
Capacity markets are used internationally as instruments to ensure that there is sucient long-term
investment in generation capacity to meet growing electricity demand. Capacity market design has been one
of the most debated elements in electricity market design. Many industry experts argue that capacity auctions
are unnecessary. Others contend that capacity markets are essential to ensure the long-term security of the
electricity industry. Market imperfections such as inelastic demand and imperfect competition have led to
concerns over rms abilities to exercise their market power in order to inate electricity prices [Faruqui and
Eakin (2000)]. These concerns have resulted in regulatory intervention in an attempt to limit market power
execution in energy markets. However, it has been argued that these regulatory rules distort market signals
for long-term investments as they limit scarcity prices induced by high-demand [Rodilla and Batlle (2012)].
Therefore, peak-load units who rely on these infrequent scarcity prices to recover part or all of their capacity
investment expenses now have insucient revenues to cover cost of capacity investment. This problem is
referred to as the missing money problem [Joskow (2008)]. This is commonly cited as the principal cause
for insucient capacity investment and hence, the motivation for a capacity payment mechanism.
While there are many capacity payment mechanisms used internationally, this paper focuses on one partic-
ular design in which there is a centralized capacity market in the form of an auction mechanism.
2
The goal of
these centralized capacity markets is to provide additional payments for new generation capacity investment
in a competitive setting that promotes ecient capacity allocation. This paper evaluates the performance of
these capacity auctions by providing a model that describes rms bidding behavior. Internationally there
are many developing electricity markets considering implementing capacity payment mechanisms to ensure
resource adequacy. Therefore, understanding bidding behavior in these capacity auctions will assist these
countries in evaluating the performance of these centralized capacity payment mechanisms.
In these highly concentrated electricity markets incumbents benet from the lack of competition. How-
1
The focus of this model is on a reverse-auction. Dene the term outbidding as a bid that is below competitors bid(s).
2
Such centralized capacity markets take place in Regional Transmission Organizations (RTOs) PJM and ISO-New England
in the United States, and in Brazil. The auction model in this paper closely relates to PJMs Reliability Pricing Model (RPM).
For a discussion on the dierent capacity mechanisms and the international experiences with each see Pfeifenberger et al. (2009).
2
ever, capacity auctions provide an avenue for entrants to invest in capacity and enter into the market. If
an entrant outbids the incumbents bids for new capacity investment the incumbents experience an exter-
nality from entry, reducing their prot in subsequent market interactions. Therefore, the incumbents have
an incentive to deter entry in order to sustain their market power.
3
When there are multiple incumbents
facing the threat of entry, the problem of preempting entry takes on aspects of a public good in this non-
cooperative setting. If an incumbent deters entry by outbidding an entrant for new capacity investment, all
other incumbents benet. Therefore, a central question in this paper is whether the free-riding incentives
associated with non-cooperative entry deterrence mitigate some of the incumbents entry deterring behavior.
Using an oligopoly framework with two incumbents and a potential entrant, this paper develops a model
that characterizes rms bidding decisions in a capacity auction with externalities. In particular, this model
captures the incumbents incentives to preempt entry by outbidding the entrants bid for new capacity
investment. Firms participate in a sealed-bid, uniform priced, multi-unit capacity auction in which rms
submit bids to supply a fraction of the total capacity demanded. These bids reect the prices at which
rms are willing to install a specied amount of new generation capacity or make their installed generation
capacity available in the subsequent deliver-year energy and ancillary services (E&AS) markets. If a rms
bid is accepted (dispatched) by the auctioneer in the capacity auction, the rm is obligated to make the
stipulated amount of generation capacity in its price-quantity bids available in the specied delivery-years
E&AS markets.
4
Only those rms whose bids are dispatched in the capacity auction are able to participate
the deliver-years E&AS markets.
5,6
Therefore, the outcome of the capacity auction aects the market
structure in the following delivery-years E&AS market interactions.
The incumbents cost of new capacity plays a critical role in their ability to preempt entry. I nd that
the incentive to deter entry induces the incumbents to submit bids for new capacity investment at a level
below their net marginal cost of new capacity in order to deter entry and avoid the externality from entry.
Therefore, there are cost realizations in which the more ecient entrant is deterred. Hence, incentives to
deter entry may lead to inecient allocation of capacity.
If the entrants cost of new capacity is higher than the incumbents costs, then entry is always deterred.
3
The lack of competition in wholesale electricity markets has led to concerns over the incumbents abilities to strategically
withhold capacity in wholesale electricity auctions in order to drive up the market-clearing price. See Kwoka and Sabodash
(2011) for a discussion on dierent forms of strategic withholding and rms abilities to exercise their market power.
4
The length of the forward commitment varies across markets. It can range from a three year forward commitment (PJM
and ISO-NE) to a ve to thirty year forward commitment (Brazil). For more details see Pfeifenberger et al. (2009).
5
In some capacity auction designs it is not a requirement for new generation units to enter through the capacity auc-
tion. However, it is assumed that foregoing the substantial payments from the capacity auction more than oset the costs of
committing capacity to be available during the delivery-years E&AS markets.
6
In practice, rms can also establish bilateral contracts between generation units and load-serving entities. However, this
is beyond the scope of the current analysis. See PJM (2011, p. 124-144) for a detailed discussion.
3
However, if the incumbents cost of new capacity exceeds the entrants cost, entry may or may not be deterred.
For low enough cost realizations an incumbent nds it protable to single-handedly preempt entry. This
results in benets to both incumbents, but only one incumbent incurs the cost of entry deterrence. Therefore,
the non-deterring incumbent free-rides on this entry deterring capacity investment. As the incumbents cost
of new capacity becomes suciently large, no incumbent is willing to single-handedly preempt entry.
If the incumbents are able to collude and submit joint bids they can share the burden of entry deterrence
and deter entry at cost realizations where it is unprotable to deter entry single-handedly. This joint
bidding strategy internalizes the industry-wide benet from preempting entry for both incumbents and hence,
overcomes the free-riding problem. However, a prisoners dilemma arises because an incumbent can always
unilaterally deviate from the joint bidding strategy and free-ride on the other incumbents entry deterring
bid. Therefore, the joint bidding strategy is not a Nash Equilibrium. This results in there being cost
realizations in which there is underinvestment in entry deterring capacity from the incumbents perspective.
The analysis proceeds as follows. The multi-unit capacity auction model is described in Section II. The
Pure Strategy Nash Equilibria are detailed in Section III. Section IV extends the basic model by incorporating
asymmetric cost of new capacity. Before proceeding to the analysis, I discuss the related work in the literature
and explain how my work contributes to the literature.
1.1 Related Literature
Substantial theoretical work has been devoted to analyzing a setting in which an established oligopoly is faced
with the threat of entry and the incumbents can undertake some non-cooperative entry deterring behavior.
7
Entry prevention has properties of a public good as investment in entry deterring capacity by a single rm
leads to benets to the oligopoly as a whole. Public good theory suggests that free-riding incentives will
lead the incumbents to underinvest in entry deterring capacity.
Bernheim (1984) considers a setting in which several incumbents are faced with sequential threats of
entry. Gilbert and Vives (1986) analyze a Cournot game in which incumbents are able to choose their
output prior to the entrants entry decision. These papers nd that even in a non-cooperative environment
the incumbents overcome the public good nature of entry deterrence and preempt entry. However, Waldman
(1987) analyzes these two models in detail and nds that with the addition of uncertainty in the amount
of investment required to deter entry, free-riding incentives facilitates entry. While the model in this paper
7
The focus of the current paper is on oligopolies facing the threat of entry. However, early work in the entry prevention
literature focused on the case where a monopoly incumbent faces entry [Dixit (1979, 1980); Spence (1977); Gilbert and Newbery
(1982) among others].
4
includes no uncertainty in the amount of investment required to deter entry, the free-rider problem arises
resulting in underinvestment in entry deterrence for certain cost realizations.
Similar entry deterring incentives arise in auctions that are followed by an interaction between bidders.
These models are referred to as auctions with externalities. In these auctions, rms valuations are en-
dogenously determined by the allocation of the good(s) in the auction. Jehiel et al. (1996) and Jehiel and
Moldovanu (2000) show that in an auction with externalities, inecient allocations can occur in standard
auction designs due to bidders incentives to avoid externalities. Similar incentives arise in this paper where
there are cost realizations in which an incumbent bids to supply capacity below their net marginal cost in
order to preempt entry resulting in an inecient allocation of capacity.
Previous literature on auctions with externalities focuses on settings where a single good is being auc-
tioned. However, simultaneous auctions for multiple goods are often followed by subsequent market inter-
actions. Ase and Chade (2008) considers a multi-unit auction with externalities. While they extend the
auction with externalities literature by considering a multi-unit auction, they assume that bidders have unit-
demands. I extend this literature by considering a multi-unit procurement auction where bidders are willing
to supply multiple units in a setting where there is an allocation externality. By considering a multi-unit
auction with externalities where bidders have multi-unit supply, I extend the literature of auctions with
externalities to a wider scope of auctions in practice.
Using the methodology established by the literature on wholesale electricity auctions, I can analyze the
performance and bidding behavior of a multi-unit capacity auction with multi-unit supply and allocation
externalities. Wholesale electricity auctions have attracted substantial theoretical and empirical research.
8
In particular, two approaches have been developed to model rms bidding behavior. The rst strand of
literature uses Klemperer and Meyer (1989)s Supply Function Equilibrium [SFE] approach in which rms
choose a continuous supply function that species the amount of energy they are willing to supply at all
potential prices.
9
A standard consensus among SFE models is that market power execution is prevalent in
these wholesale electricity auctions. While the SFE approach promotes tractability, the assumed continuity
of the supply function is an abstraction. In reality, generation units and their bids are not innitesimally
small. Rather, a rms marginal cost and bid functions are discontinuous step-functions.
The second approach takes into account the fact that bidders submit discrete supply step-functions in
8
There is an extensive empirical literature on electricity auctions. These empirical models have found that entry reduces
the market-clearing prices in energy auctions as the incumbents market power is weakened [Newbery (1998); Garca-Daz and
Marin (2003); Baldick et al. (2004)]. This provides motivation for the claim that there is an externality from entry in capacity
procurement auctions.
9
This work was extended to incorporate capacity constraints, asymmetric costs, bilateral contracts, and pivotal suppliers
[Newbery (1998); Baldick and Hogan (2002); Genc and Reynolds (2011)].
5
a multi-unit auction. von der Fehr and Harbord (1993) consider a duopoly setting in which each rm has
a single generation unit with constant marginal cost up to its capacity limit. Both costs and capacity are
common knowledge. These two rms compete in a multi-unit auction with perfectly inelastic demand by
submitting a single bid for their entire capacity. Unlike the SFE models, von der Fehr and Harbord (hereafter,
FH) nd that in the deterministic demand case the discrete nature of the model leads to Bertrand-like price
competition for demand ranges where no rms capacities are constrained.
10,11
In contrast to the continuous
SFE approach, a rm can increase its supply in the auction by a non-innitesimally small amount by
submitting a bid slightly below its rivals bid. Therefore, unlike the SFE models, market power execution is
not prevalent when bidders capacities are unconstrained.
The FH approach has been extended to reect the realities of the electricity industry. In particular, several
authors account for the fact that rms have multiple generation units with heterogeneous cost [Brunekreeft
(2001); Garca-Daz and Marin (2003); Crawford et al. (2007)]. Hence, rms submit left-continuous non-
decreasing step-functions as their bid proles. Introducing heterogeneous costs leads to dichotomous behavior
in which non-price-setting rms bid close to their marginal cost while price-setting rm(s) behave strategically
to raise the market-clearing price.
A related literature is divisible good auction (share auction) models founded by Wilson (1979). Similar to
SFE models, the standard share auction models assume that bidders submit a continuous bid function [Back
and Zender (1993); Wang and Zender (2002); Ausubel and Cramton (2002)]. These papers nd that rms
exercise substantial market power by shading their bids. However, similar to FHs unit-pricing models in the
electricity auction literature, criticisms of this approach have emerged due to the nite nature of auctions
in practice. Kremer and Nyborg (2004) show that the extreme bid shading predicted by continuous bidding
strategies breaks down when the discrete nature of players bid functions are incorporated. Kastl (2011)
compares discriminatory and uniform price share auctions in which bidders submit discrete bid functions
and shows theoretically and empirically that the continuous bid function approach overestimates market
power execution compared to the discrete bid function approach.
The model in this paper follows FHs unit-price auction model and the discrete share auction literature
as it accounts for the discrete nature of auctions in practice. In particular, this paper relates closely to
Garca-Daz and Marin (2003) and Crawford et al. (2007) as it takes into account the multiple generation
unit nature of the capacity auctions and discrete nature of rms bidding strategies. That is, in the current
10
FH also consider the case where demand is stochastic. The authors solve for the mixed strategy equilibrium as there is no
Pure Strategy Nash Equilibrium in the stochastic demand case.
11
Once a rms capacity is constrained the non-constrained rm can submit a bid up to the maximum allowable price.
6
model incumbents have both installed and new potential generation units with heterogeneous costs. This
paper extends this growing literature by incorporating allocation externalities into a divisible good (multi-
unit) auction with discrete bid proles.
2 Oligopoly Model
The basic model is characterized by a sealed bid, uniform priced, multi-unit auction in which two symmetric
incumbents (I
1
and I
2
) and a potential entrant (E) compete to supply capacity with discrete bid functions.
The capacity auction is followed by a subsequent delivery-year where rms compete to supply energy and
ancillary services (E&AS). In order to participate in the delivery-years E&AS markets rms must procure
positive capacity in the capacity auction. Therefore, when rms formulate their bidding decisions in the
capacity auction they form expectations about the resulting earnings from the delivery-years E&AS markets
that will be realized if positive capacity is procured.
Each incumbent has installed capacity equal to

k
I
> 0, while the potential entrant has no installed
capacity. It is assumed that capacity is perfectly divisible. Dene c
0
I
and c
1
I
as the constant marginal cost of
installed and new capacity for both incumbents where c
0
I
represents the marginal operating cost of installed
capacity and c
1
I
represents the marginal cost of new capacity investment. Similarly, c
1
E
represents the constant
marginal cost of new capacity investment for the entrant. Assume that 0 c
0
I
< c
1
j
j {I, E} reecting
the fact that installed capacity has already incurred the large xed costs of generation capacity investment.
Also, it is likely that the incumbents have a cost advantage over the entrant for new capacity investment (i.e,
c
1
I
c
1
E
).
12
However, there is the potential for the incumbents cost of new capacity investment to exceeds
the entrants as the incumbents may not have any potential low-cost capacity investment opportunities at
the time of the capacity auction (i.e., c
1
I
> c
1
E
). Both cost structures will be considered.
Capacity demanded, , represents the auctioneers demand curve and is characterized by the following
assumption.
Assumption 1. Capacity demand is a perfectly price inelastic random variable with a known probability
distribution F() on the support [, ] R
+
with

k
I
< < 2

k
I
and > 2

k
I
. Realizations of are denoted
by

, where

is announced by the auctioneer prior to the capacity auction and hence, is assumed to be
observable by all auction participants.
12
This cost advantage reects the high costs of learning in these complex electricity markets. For example, an incumbent
is likely to have advanced proprietary software that optimizes bids in a particular market. An entrant must undergo these
additional costs when entering a new market.
7
This demand range allows for two cases: (1) Low-Demand

[, 2

k
I
] where both of the incumbents
installed capacities can serve the capacity demanded and (2) High-Demand

(2

k
I
, ] where new capacity
investment is necessary to supply all of the capacity demanded.
Prior to making their bidding decisions, rms form expectations about their per-unit earnings from the
delivery-years E&AS markets for each unit of capacity procured in the capacity auction. The outcome of
the capacity auction aects the resulting market structure and hence, the earnings in the delivery-years
E&AS markets. Therefore, these expectations depend on the market structure established by the allocation
of capacity in the capacity auction. Further, the per-unit earnings in the E&AS market is a random variable
as market conditions such as energy demand, the spread between fuel prices, environmental and energy
policies, among other factors are uncertain ex ante. Denote the per-unit earnings from E&AS as
m
j
(;

)
j {I
1
, I
2
, E} where R
n
is a multivariate random variable reecting market uncertainties with a
joint probability density function f(
1
,
2
, ...,
n
) on the non-empty sample space and m = 1, 2, 3 indicates
the number of rms in the market determined by the allocation of capacity in the capacity auction. The
expected per-unit earnings from E&AS are as follows:

m
j
= E[
m
j
(;

)] =
_

m
j
(;

) f(
1
,
2
, ...,
n
) d
1
d
2
...d
n
m = 1, 2, 3 and j {I
1
, I
2
, E}. (1)
Since the incumbents are symmetric,
m
I1
=
m
I2
=
m
I
m = 1, 2, 3. Dene c
i
j

m
j
as the net marginal
cost of a unit of installed (i = 0) or new capacity (i = 1) given m = 1, 2, 3 and j {I, E}. This term will
be factored into each rms bidding decisions as rms consider both the direct physical costs of supplying
capacity, c
i
j
, and the opportunity costs of not supplying a unit of capacity in their bidding decisions,
m
j
.
If both incumbents procure positive capacity in the capacity auction, but fail to preempt entry they must
compete with the entrant in the subsequent E&AS markets reducing their market power. The incentive
to deter entry plays an important role in the incumbents bidding decisions in the capacity auction. The
negative externality from entry is quantied by the following assumption.
Assumption 2. Given both incumbents procure positive capacity, entry into the capacity auction reduces
the incumbents expected per-unit earnings form E&AS by e = (
2
I

3
I
) > 0.
All aspects of the game are common knowledge. In particular, rm j knows rm ks installed and
potential new capacity investment, cost structure, and expected per-unit earnings from E&AS for each
market conguration m = 1, 2, 3 j, k {I
1
, I
2
, E} with j = k.
In the capacity auction, rms submit bids that reect the minimum price at which each rm is willing to
8
supply a unit of new or installed capacity. Each incumbent submits two bids;
0
Ij
represents incumbent I
j
s
bid for installed capacity

k
I
and
1
Ij
represents its bid for new capacity investment j = 1, 2. The entrant
submits a single bid
1
E
for new capacity investment. This bidding prole assumes that each incumbent
submits a single bid (
0
I1
,
0
I2
) to supply all demand up to their installed capacity

k
I
and both the incumbents
and the entrant submit single bids (
1
I1
,
1
I2
,
1
E
) to supply all residual demand max{(

k
I
), 0} with new
capacity investment (assuming max{

0
I
} min{

1
I
,
1
E
}).
13
Hence, the model construction follows the unit-
price procurement auction literature [von der Fehr and Harbord (1993)] and assumes that rms submit
single bids for their entire new and installed capacity units.
14
Denote the vector of incumbent bids as

i
I
= {
i
I1
,
i
I2
} i = 0, 1. Lastly, denote the aggregate bid prole as = (

0
I
,

1
I
,
1
E
).
Firms cannot bid above the reserve price P set by the auctioneer ex ante. To avoid the trivial case where
no rm will provide new capacity investment, P is assumed to exceed max{c
1
I

2
I
, c
1
E

3
E
}.
The auctioneers objective is to minimize the cost of supplying capacity demand. Therefore, the auctioneer
ranks rms bids and their corresponding units of capacity in order of least-cost to form a left-continuous
non-decreasing aggregate supply step function X(p; ). This aggregate supply step function species how
big of a share of

the rms are willing to supply at a price p. Then, given this aggregate supply function, the
auctioneer sets the market-clearing price at the level where aggregate supply is sucient to meet capacity
demand. Therefore, the stop-out (market-clearing) price set by the auctioneer is:
p

= min{p|X(p; )

}. (2)
After the auctioneer determines the stop-out price, rms are dispatched in increasing order of their bids
up to p

. Since the auction mechanism is a uniform price, the stop-out price is paid to all units that the
auctioneer calls upon to supply capacity with its least-cost dispatch algorithm. Dene the rm(s) whose bid
is chosen by the auctioneer to set the stop-out price as the marginal bidder(s) and their price-setting bid as
the marginal bid.
Since the aggregate supply function X(p; ) is a step function, rationing occurs with probability one
except for certain knife-edge cases. In particular, rationing can occur when there is: (i) a single marginal
13
The incumbents and entrants new capacity investments are assumed to be unconstrained such that the bids (
1
I
1
,
1
I
2
,
1
E
)
can be bids to supply the entire capacity demand for any

[, ]. However, it will be shown in Lemma 2 that max{

0
I
}
min{

1
I
,
1
E
} holds in any potential equilibrium such that the incumbents installed capacities are always procured. Therefore,
the rms new capacity investment bids only compete over residual demand max{(

k
I
), 0}, not the unrealistic case where
new capacity supplies up to

. This limits the implications of the unconstrained new capacity assumption.
14
An alternative to this unit-price bidding strategy is for rms to submit nitely many price-quantity pairs for their new
and/or installed capacity (

U
u=1

0
j,u
,

U
u=1

1
j,u
j {I
1
, I
2
, E} where U < is the ex ante specied number of bid segments
for each unit). However, this approach leads to existence issues and multiplicity of equilibria even in an auction model without
externalities, see (Frutos and Fabra, 2009).
9
bidder or (ii) multiple marginal bidders. We assume rationing is ecient on-the-margin. If there is a single
bidder at the margin, residual demand at the margin is rationed fully to this bidder. However, if there are
multiple bidders on-the-margin and if their costs dier, then the generation unit with lowest marginal cost
is called upon to produce rst. Otherwise, the multiple rms split residual demand equally.
15,16
Both the incumbents and the entrant are risk-neutral. Hence, each rm chooses its bids for installed
and/or new capacity investment to maximize the sum of prots from the capacity auction and the discounted
expected per-unit earnings from E&AS markets conditional on the capacity auction outcome. Normalize the
discount rate = 1. Using (1), incumbent I
j
s prot function can be written as:

Ij
= (p

c
0
I
)X
0
Ij
(

; ) + (p

c
1
I
)X
1
Ij
(

; )
+
_
1{X
1
E
(

; ) = 0}
|M
I
|
I
+ 1{X
1
E
(

; ) > 0}
|M
I
|+1
I
_
X
Ij
(

; ) (3)
where X
0
Ij
(

; ), X
1
Ij
(

; ), X
1
E
(

, ) represents incumbent I
j
s installed capacity, incumbent I
j
s new
capacity investment, and the entrants new capacity investment procured in the auction given , respectively.
Denote the total output of incumbent I
j
j = 1, 2 as:
X
Ij
(

; ) = X
0
Ij
(

; ) + X
1
Ij
(

; ). (4)
The indicator functions 1{} = 1 if the interior argument is true, zero otherwise. Denote the aggregate
output from the incumbent rms given as X
I
(

; ) = (X
I1
(

; ), X
I2
(

; )). Incumbent I
j
s installed and
new capacity output in the auction are:
X
0
Ij
(

; ) =
_

_
0 if
0
Ij
> min{

1
I
,
1
E
}
min{

k
I
,

k
I
} if
0
I
k
<
0
Ij
min{

1
I
,
1
E
}
max{
0
Ij

k
I
} if
0
Ij
min{
0
I
k
,

1
I
,
1
E
}
(5)
and
X
1
Ij
(

; ) =
_

_
0 if
1
Ij
> min{
1
I
k
,
1
E
}
max(
1
Ij
[

k
I
], 0) if max{

0
I
}
1
Ij
min{
1
I
k
,
1
E
}

1
Ij

if
1
Ij
< min{

0
I
} and
1
Ij
min{
1
I
k
,
1
E
}
(6)
15
Several papers in the electricity auction literature use ecient rationing on-the-margin to avoid non-existence issues like
those arising in Bertrand games with asymmetric costs (Garca-Daz and Marin, 2003; Fabra et al., 2006; Crawford et al., 2007).
16
As detailed in (Garca-Daz and Marin, 2003), the equilibria of a game using ecient rationing on-the-margin converges
to the set of equilibria where rationing pro-rata on-the-margin is used when bids are restricted to a nite grid. This reects the
reality of capacity auctions in practice.
10
j, k = 1, 2 with j = k. Due to the ecient rationing on-the-margin rule, the capacity is allocated
according to:

0
Ij
=
_
1
|z
0
Ij
|
if
0
Ij
min{
0
I
k
,

1
I
,
1
E
}
and

1
Ij
=
_

_
0 if
1
Ij
=
1
E

1
I
k
and c
1
I
> c
1
E
1
|z
1
Ij
|
if
1
Ij
min{
1
I
k
,
1
E
} and c
1
I
c
1
E
where
z
0
Ij
= {

0
I
: =
0
Ij
}
and
z
1
Ij
=
_

_
{ (

1
I
,
1
E
) : =
1
Ij
} if c
1
I
= c
1
E
{

1
I
: =
1
Ij
} if c
1
I
< c
1
E
j, k = 1, 2 with j = k. In the case where incumbent I
j
is a marginal bidder, z
i
Ij
reects the set of
bids for installed (new) capacity which equal that of I
j
s marginal installed (new) capacity bid
0
Ij
(
1
Ij
)
for i = 0 (i = 1). |z
i
Ij
| 1 denotes the cardinality of the set z
i
Ij
j = 1, 2 and i = 0, 1. When there
are multiple marginal bidders, capacity demand is allocated according to
i
Ij
[0, 1] which represents the
ecient rationing on-the-margin rule j = 1, 2 and i = 0, 1.
The number of rms in the market depends on the number of incumbents who procured positive capacity
in the capacity auction plus the entrant when entry occurs. Dene the set of incumbents producing positive
quantities of capacity given as:
M
I
= {X
Ij
(

; ) X
I
(

; ) : X
Ij
(

; ) > 0}.
Therefore, the number of incumbents is determined by the cardinality of this set: |M
I
|. Hence, if there
is no entry there are |M
I
| rms competing in the subsequent E&AS markets. Whereas, if entry occurs there
are |M
I
| + 1 rms. As dened in (1), this implies that the incumbents expected per-unit earnings from
E&AS are
|M
I
|
I
in the case of no entry and
|M
I
|+1
I
in the case of entry.
Similarly, the entrants prot function is dened as:

E
= (p

c
1
E
)X
1
E
(

; ) +
|M
I
|+1
E
X
1
E
(

; ) (7)
where X
1
E
(

, ) represents the entrants new capacity investment procured in the auction. This can be
11
characterized as:
X
1
E
(

, ) =
_

_
0 if
1
E
> min{

1
I
}
max(
E
[

k
I
], 0) if max{

0
I
}
1
E
min{

1
I
}

if
1
E
< min{
0
I
} and
1
E
min{

1
I
}.
(8)
Due to the ecient rationing on-the-margin rule, capacity is allocated according to:

E
=
_

_
0 if
1
E
= min{

1
I
} and c
1
E
> c
1
I
1
|z
E
|
if
1
E
min{

1
I
} and c
1
E
c
1
I
where
z
E
=
_

_
{ (

1
I
,
1
E
) : =
1
E
} if c
1
E
= c
1
I
1 if c
1
E
< c
1
I
.
In the case where the entrant is a marginal bidder, z
E
reects the set of bids for new capacity investment
which equal that of the entrants new capacity bid
1
E
. |z
E
| 1 denotes the cardinality of the set z
E
. In the
case where there are multiple marginal bidders,
E
represents the ecient rationing on-the-margin rule.
The following assumptions play an important role in the analysis of the model in the next section.
Assumption 3. Given realized capacity demand

:
3.1
m
I

m
E
0 m = 1, 2, 3.
3.2
m
j
>
m+1
j
0 m = 1, 2 and j {I, E}.
3.3 (c
1
I

m
I
) (c
0
I

m+1
I
) (c
1
I
c
0
I
)

k
I

m = 1, 2.
3.4 (c
1
E

m
E
) (c
0
I

m+1
I
) > 0 m = 1, 2.
Assumption 3.1 states that the incumbents expected per-unit earnings from E&AS are weakly greater
than the entrants expected per-unit earnings from E&AS for a given market conguration m. This as-
sumption reects the incumbents presumed strategic advantage in the E&AS markets.
17
Assumption 3.2
states that a rms expected per-unit earnings from E&AS fall as the number of rms increase. There is
substantial theoretical and empirical evidence that supports this assumption (Newbery, 1998; Brunekreeft,
2001; Garca-Daz and Marin, 2003). Assumption 3.3 indicates that an incumbents net marginal cost of new
17
The strategic advantages are likely to be due to economies of learning in these complex electricity markets.
12
capacity investment is suciently larger than an incumbents net marginal cost of installed capacity. Simi-
larly, Assumption 3.4 states that the entrants net marginal cost of new capacity investment is suciently
larger than the incumbents net marginal cost of installed capacity. If Assumptions 3.3 or 3.4 fail to hold,
then rms may be able to outbid incumbents installed capacity bids with bids for new capacity investment
resulting in the higher cost new capacity investment being procured over the low cost installed capacity.
18
The next section analyzes the outcome of this capacity auction model. In particular, it characterizes the
incentives for the incumbents to preempt entry as a function of the externality e = (
2
I

3
I
) for two levels
of capacity demand realizations: low- and high-demand.
3 Analysis of the Model
All results in this section focus on nding the Pure Strategy Nash Equilibria of this capacity auction to
characterize the rms bidding behavior and specify when entry is blockaded, deterred, or allowed.
19,20
The
bidding behavior in the capacity procurement auction and the corresponding Nash Equilibria are detailed
below. See the Appendix for proofs of the results.
3.1 Equilibrium Analysis
There are two critical capacity demand regions; low- and high-demand. Figure 1 provides an example of
a potential bidding prole with
0
I
k
<
0
Ij
min{

1
I
,
1
E
} where

L
and

H
denote the low- and high-
demand realizations, respectively. Under this bid prole, for the low-demand realization,

L
[, 2

k
I
],
incumbent I
k
s capacity is dispatched up to its capacity limit. Therefore, I
j
serves residual capacity demand
(

L


k
I
) with its installed capacity resulting in the stop-out price p

L
=
0
Ij
. Lastly, for the high-demand
realization,

H
(2

k
I
, ], both of the incumbents installed capacities are dispatched up to their capacity
limits. Therefore, the rm whose bid is the min{

1
I
,
1
E
} serves residual demand (

H
2

k
I
) with new
capacity investment resulting in the stop-out price p

H
= min{

1
I
,
1
E
}. This section characterizes the rms
equilibrium bidding behavior for each of these capacity demand regions.
18
In practice, there is the expectation that if inecient (old) installed capacity units become too costly, new capacity units
will replace these costly units. Therefore, it can be the case that c
0
I
min{c
1
I
, c
1
E
}. If Assumptions 3.3 or 3.4 fail to hold, then
the incumbents installed capacity units are too costly and will be replaced by new capacity units. However, such a scenario
is beyond the scope of this paper.
19
In certain situations in this capacity auction it is necessary to use the -Nash Equilibrium solution mechanism.
20
An -Nash Equilibrium is an approximation to a Nash Equilibrium (Radner, 1980). A bid prole = (
0
I
1
,
0
I
2
,
1
I
1
,
1
I
2
,
1
E
)
is a Pure Strategy -Nash Equilibrium if for each player j there are no other bids
i

j
=
i
j
i = 0, 1 (if j {I
1
, I
2
}) or
1

j
=
1
j
(if j = E) such that rm j can improve its payo by more than by unilaterally deviating to these alternative capacity bids
for some > 0.
13
Figure 1: Low- and High-Demand Outcomes Given
0
I
k
<
0
Ij
min{

1
I
,
1
E
}.
First, it is necessary to establish lower bounds on the players bidding strategies and provide a ranking
of these minimum bids. A rms minimum marginal bid is the bid that if dispatched as the marginal bid
would result in zero prot for the rm. Therefore, any rm that bids below its minimum marginal bid will
earn negative prots if the bid sets the stop-out price. Denote rm I
j
s minimum marginal bid for installed
and new capacity as
0
Ij
and
1
Ij
j = 1, 2, respectively.
21
Similarly, dene the entrants minimum marginal
bid for new capacity investment as
1
E
. The following Lemma details the minimum marginal bids for the
low- and high-demand regions.
Lemma 1. For the cost structure c
0
I
< c
1
I
c
1
E
the minimum marginal bids and their rankings are:
(i) For any

[, 2

k
I
], assuming
0
I
k
min{
0
Ij
,

1
I
,
1
E
}:
0
Ij
= c
0
I

2
I

1
I
k
= c
0
I

k
I

+c
1
I
_
1

k
I

1
I
<
1
Ij
= c
1
I

2
I

1
E
= c
1
E

2
E
j, k = 1, 2 with j = k.
(ii) For any

(2

k
I
, ], assuming max{

0
I
} min{

1
I
,
1
E
}:
1
I
= c
0
I
_

k
I

k
I
_
+c
1
I
_

k
I

k
I
_

2
I
<
1
E
=
c
1
E

3
E
.
For any

[, ], for the cost structure c
0
I
< c
1
E
< c
1
I
the rankings between
1
E
and min{
1
Ij
,
1
I
k
} is
ambiguous j, k = 1, 2 with j = k. However, the minimum marginal bids remain the same.
By eliminating strictly dominated strategies, no rm will submit a marginal bid below its minimum
marginal bid specied above as this results in a negative payo. Assume incumbent I
k
bids its installed
capacity low enough such that its always dispatched [i.e,
0
I
k
min{
0
Ij
,

1
I
,
1
E
}].
22
From Lemma 1, for
the low-demand region (

[, 2

k
I
]) I
k
s installed generation unit is capacity constrained. Therefore, the
21
When applicable, due to symmetry the minimum marginal bids for the incumbents are denoted
i
I
1
=
i
I
2
=
0
I
i = 0, 1.
22
See Lemma 2 for a proof that this is an optimal strategy for rm I
k
in any potential equilibrium.
14
incumbents and entrant compete over residual demand (

k
I
) with the bids (
0
Ij
,

1
I
,
1
E
). Given Assumption
3.3 it is always feasible for incumbent I
j
to undercut (or tie) new capacity investment with its bid for installed
capacity
0
Ij
as
0
Ij

1
I
k
<
1
Ij
and
0
Ij

1
E
j, k = 1, 2 with j = k.
For the high demand range (

(2

k
I
, ]) assume max{

0
I
} min{

1
I
,
1
E
} such that both of the incum-
bents installed capacities are always dispatched.
23
Both of the incumbents are capacity constrained and
hence, their installed capacity bids can never be marginal. Therefore, the incumbents and entrant compete
over residual demand (

k
I
) with the bids (

1
I
,
1
E
). In the cost structure where the incumbents have the
least-cost new capacity investment, c
1
I
c
1
E
, it is always feasible for the incumbents to outbid the entrants
bid for new capacity investment. However, in the case where c
1
E
< c
1
I
, the rankings between the entrants
minimum marginal bid
1
E
and the incumbents minimum marginal bid
1
I
is ambiguous. These minimum
marginal bids play an integral role in establishing the equilibrium bidding outcomes of the model.
It was assumed in Lemma 1 that for any

[, 2

k
I
] incumbent I
k
bids
0
I
k
min{
0
Ij
,

1
I
,
1
E
} j, k =
1, 2 with j = k and for any

(2

k
I
, ] both of the incumbents bid max{

0
I
} min{

1
I
,
1
E
}. Lemma 2
justies these assumptions by showing that both incumbents always submit bids for their installed capacities
below the bids for new capacity investment in any potential equilibrium such that their installed capacities
are always dispatched.
24
Lemma 2. For any

[, ] the incumbents bid max{

0
I
} min{

1
I
,
1
E
} in any potential equilibrium.
Without loss of generality, focus on incumbent I
1
. For any

[, ], it can be shown that regardless of
the magnitude of
0
I2
it is optimal for I
1
to bid
0
I1
min{

1
I
,
1
E
}. Assume there is a bid prole with

0
I1
> min{

1
I
,
1
E
} = p

such that new capacity investment is procured for any

[, ]. There are three
cases to consider: (i) p

=
1
I1
, (ii) p

=
1
I2
, and (iii) p

=
1
E
. I
1
can always unilaterally deviate from

0
I1
> p

to
0

I1
= p

and increase its payo. Dene this new bid prole as

.
From Lemma 1 we know that no rm will submit a marginal bid below its minimum marginal bid. Further,
given Assumptions 3.1-3.4, for any

[, ] and for both cost structures c
0
I
< c
1
I
c
1
E
and c
0
I
< c
1
E
< c
1
I
the
minimum marginal bids for the incumbents and the entrants new capacity investment are at least as large
as the net marginal cost of installed capacity. Therefore, if I
1
s installed capacity is procured at the stop-out
price p

it will earn a non-negative payo as p

= min{

1
I
,
1
E
} min{
1
I1
,
1
I2
,
1
E
}. In case (i) where
p

=
1
I1
, if I
1
unilaterally deviates to
0

I1
= p

I
1
can fully or partially displace its new capacity investment
23
See Lemma 2 for a proof that this is an optimal strategy for both incumbents in any potential equilibrium.
24
In practice, the feasible bid set S = [0, P] R
+
. Therefore, incumbents often bid their installed capacity into the auction
at a price of zero to ensure it is dispatched by the auctioneer. These types of bids reect the incentives for the incumbent to
bid
0
I
low enough to ensure that installed capacity is always procured in any equilibrium outcome.
15
with lower cost installed capacity with no change in the stop-out price. This results in a reduction in I
1
s
total capacity procurement cost and hence, strictly raises its payo. In cases (ii) and (iii), under the bid
prole I
1
procures no capacity in the auction such that its payo equals zero. However, if I
1
unilaterally
deviates to
0

I1
= p

, then I
1
can procure its installed capacity in the auction at a stop-out price at least as
large as its net marginal cost of installed capacity. Hence, I
1
earns non-negative prots under the new bid
prole

.
25
Therefore, for any

[, ] regardless of incumbent I
2
s installed capacity bid
0
I2
it is optimal
for I
1
to bid
0
I1
< min{

1
I
,
1
E
}. By symmetry the same intuition holds for incumbent I
2
.
As shown in Lemma 2, by bidding max{

0
I
} min{

1
I
,
1
E
} the incumbents ensure their installed units
are dispatched prior to any new capacity units. Therefore, for any

[, 2

k
I
] the incumbents supply all
capacity demand in the auction with their installed capacity. However, if

(2

k
I
, ] the incumbents cannot
serve all of the capacity demanded with their installed units as both incumbents capacities are constrained.
The incumbents and entrants compete over residual capacity demand (

k
I
) with the bids (

1
I
,
1
E
).
For any
1
E
[
1
E
, P] the incumbents may be able to undercut this bid and preempt entry. However, the
incumbents face a cost of supplying new capacity investment equal to c
1
I
[

k
I
]. This cost can be view as
the cost of deterring entry. Therefore, outbidding the entrants bid
1
E
and supplying the residual capacity
demand (

k
I
) may not always be protable for either of the incumbents. Proposition 1 characterizes the
equilibrium outcomes of the model. In particular, for the capacity demand region

(2

k
I
, ], Proposition
1 details the incentives facing the incumbents to undercut the entrants bid
1
E
and preempt entry.
Proposition 1. In the Nash Equilibrium of the auction:
26
1. Single Entry Deterrence PSNE: For any

[, 2

k
I
], incumbent I
k
bids
0
I
k
<
0
Ij
, while incumbent I
j
sets the stop-out price p

=
0
Ij
= min{
1
I
k
,
1
E
} preempting entry j, k = 1, 2 with j = k.
2. For any

(2

k
I
, ], max{

0
I
} min{

1
I
,
1
E
} such that the incumbents and entrant compete over
(

k
I
) with their new capacity investment bids. There are three potential equilibrium outcomes
depending on the incumbents cost of new capacity investment:
(i) Blockaded Entry PSNE: For any c
1
I
(c
0
I
, c
1
I
), the incumbents bid
1
I1
=
1
I2
<
1
E
splitting
residual demand (

k
I
) and setting the stop-out price p

= c
1
I

2
I
blockading entry;
(ii) Single Entry Deterrence -NE: For any c
1
I
[c
1
I
, c
1
I
), incumbent I
j
deters entry by undercutting
the entrants bid
1
E
with
1
Ij
setting the stop-out price p

=
1
Ij
=
1
E
for some > 0 and j = 1, 2;
25
I
1
strictly increases its payo except in one special case where
0
I
1
=
1
I
2
for

[, 2

k
I
]. In this special case, it is assumed
that I
1
prefers to procure positive capacity in the auction.
26
The Pure Strategy Nash Equilibrium are denoted PSNE, while the Pure Strategy -Nash Equilibrium are denoted by -NE.
16
(iii) Entry PSNE: For any c
1
I
[c
1
I
, ), the entrant sets the stop-out price p

=
1
E
= p
1
I
resulting
in entry;
where c
1
E
< c
1
I
< c
1
I
are the critical cost levels dened in (9) and (12) and p
1
I
dened in (11) is the
critical bid level where it is no longer protable for an incumbent to single-handedly undercut
1
E
.
From Lemma 2, we know that in any potential equilibrium max{

0
I
} min{

1
I
,
1
E
}. For the low-demand
region

[, 2

k
I
], this implies that all capacity demanded is served by installed capacity. Incumbent I
j
is
the price-setter with its bid
0
Ij
= p

, while incumbent I
k
is the price-taker who bids
0
I
k
suciently low
to ensure that its entire capacity is procured. Conditional on
0
I
k
being suciently low, the incumbents
and the entrant compete to supply the residual demand (

k
I
) with the bids (
0
Ij
,

1
I
,
1
E
). From Lemma
1 we know that I
j
can always outbid the bids for new capacity investment with its installed capacity bid,

0
Ij
, and earn non-negative prot.
27
Intense price competition over residual demand (

k
I
) drives the
bids
0
Ij
,
1
I
k
, and
1
E
down to min{
1
I
k
,
1
E
} where it is no longer protable for rms I
k
and E to undercut
I
j
s bid for installed capacity with their bid for new capacity investment.
28
Lastly, it is optimal for the
price-taker I
k
to bid suciently low as this results in I
k
procuring its entire installed capacity at the stop-
out price p

= min{
1
I
k
,
1
E
} earning non-negative prot.
29
There are no protable unilateral deviations
for incumbent I
k
as deviating weakly reduces its capacity procured in the auction, while the stop-out price
remains unchanged. Therefore, incumbent I
j
preempts entry with its bid
0
Ij
= p

= min{
1
I
k
,
1
E
}.
30
Dene
this PSNE as the Single Entry Deterrence PSNE. This PSNE is unique up to the identity of the price-setting
and price-taking rms I
j
and I
k
j, k = 1, 2 with j = k.
For the high-demand region

(2

k
I
, ] the analysis is more complex. As detailed in Lemma 2 in any
potential equilibrium max{

0
I
} min{

1
I
,
1
E
}. Therefore, both of the incumbents and the entrant compete
over residual demand (

k
I
) with their bids for new capacity investment (

1
I
,
1
E
) as the installed units
are procured up to their capacity limits.
While the incumbents cost of new capacity investment, c
1
I
, is an exogenous parameter. To observe how
the incumbents abilities to deter entry is aected by the magnitude of c
1
I
, we allow this parameter to vary
in the range c
1
I
(c
0
I
, ). c
1
I
(c
0
I
, c
1
E
] reects the incumbents likely cost advantage for new capacity
27
Both incumbents I
j
and I
k
earn positive prots when p

= min{
1
I
k
,
1
E
} except in the special case where
1
I
k
=
0
I
.
28
I
j
does not want to undercut its bid for installed capacity,
0
I
j
, with its bid for new capacity investment,
1
I
j
, because it
is more costly to supply residual demand (

k
I
) with new capacity investment.
29
For any

[, 2

k
I
] both incumbents prefer to be a price-taker as both rms receive the same stop-out price, but the price-
takers capacity is fully procured while the price-setter receives residual demand (i.e., X
I
j
(

; ) =

k
I
X
I
k
(

; ) =

k
I
).
30
Due to the ecient rationing on-the-margin given
0
I
j
= p

= min{
1
I
k
,
1
E
} = min{
1
I
k
,
1
E
} residual demand (

k
I
) is
rationed to I
j
s installed capacity.
17
investment. However, c
1
I
(c
1
E
, ) may arise in special cases where the incumbents have no potential
low-cost new capacity investments to submit into the current capacity auction. As will be detailed below,
the cost structure has a signicant eect on the equilibrium outcome.
First consider the incumbents incentives to undercut each others bids for new capacity investment
abstracting away from the entrants incentives to undercut min{

1
I
}. Since both of the incumbents installed
capacities are always procured in any potential equilibrium, I
j
s incentive to undercut I
k
s bid
1
I
k
with
1
Ij
is purely to earn a positive payo on the (

k
I
) additional units of capacity j, k = 1, 2 with j = k.
31
That is, if I
k
s bid
1
I
k
is dispatched to supply (

k
I
) additional units of capacity, this does not result in a
negative externality on I
j
s inframarginal installed capacity units as the number of rms in the subsequent
E&AS markets remains the same. Therefore, for any
1
I
k
> (c
1
I

2
I
), I
j
increases its prots by undercutting
I
k
s bid with
1
Ij
supplying residual demand at a stop-out price greater than the net marginal cost of new
capacity investment. This intense price competition continues until neither incumbent is willing to undercut
the other. Hence, each incumbent bids
1
I1
=
1
I2
= p

= c
1
I

2
I
and serves half of the residual demand.
32
Next incorporate the entrants incentives to undercut the incumbents bids for new capacity investment.
If the entrant undercuts min{

1
I
} the entrant supplies the entire residual demand (

k
I
). Entry inicts
a negative externality on the incumbents installed capacity units procured in the auction as the number
of rms in the subsequent E&AS markets now equals three reducing the expected per-unit earnings from
E&AS dened in (1) as the incumbents market power is reduced. As shown in Lemma 1, given max{

0
I
}
min{

1
I
,
1
E
}, the entrants minimum marginal bid is
1
E
= c
1
E

3
E
such that the entrant is never willing to
bid below its net marginal cost of new capacity investment. Hence, for any min{

1
I
} c
1
E

3
E
the entrant
is willing to undercut (or tie) min{

1
I
} and supply residual capacity demand (

k
I
) resulting in entry.
However, as detailed above, the intense price competition between the incumbents drives their bids for
new capacity investment down to c
1
I

2
I
regardless of the pressures from the threat of entry. It is readily
shown that for any c
1
I
(c
0
I
, c
1
E
], c
1
I

2
I
<
1
E
such that the competition between the incumbents drives the
stop-out price below the entrants net marginal cost of new capacity. There is a critical cost of new capacity
investment c
1
I
> c
1
E
where c
1
I

2
I
=
1
E
:
c
1
I
= c
1
E
+ [
2
I

3
E
]. (9)
31
As long as p

c
1
I

2
I
the incumbent(s) earn a non-negative payo from procuring new capacity investment.
32
Due to the ecient rationing on-the-margin rule the residual demand is rationed equally to both incumbents. In practice,
new capacity investment tends to be lumpy (i.e., not perfectly divisible). However, this result is robust to alternative rationing
rules that allocate residual demand to only one incumbent on-the-margin.
18
Therefore, for any c
1
I
(c
0
I
, c
1
I
), c
1
I

2
I
<
1
E
such that the incumbents bid
1
I1
=
1
I2
= c
1
I

2
I
and split
residual demand (

k
I
). Hence, entry is blockaded for any c
1
I
(c
0
I
, c
1
I
) due to the Bertrand-like price
competition between the incumbents. That is, for this cost realization range the structural dierences in the
incumbents and entrants cost of new capacity investment is sucient to ensure entry does not occur. This
is the unique Blockaded Entry PSNE for any

(2

k
I
, ] and c
1
I
(c
0
I
, c
1
I
).
For any c
1
I
[c
1
I
, ), c
1
I

2
I
<
1
E
no longer holds. Therefore, the entrant has an incentive to undercut
(or tie) the incumbents bids for new capacity investment.
33
Assume that the entrant sets the stop-out price
p

with its bid

1
E
[
1
E
, (c
1
I

2
I
)] such that the price competition between the incumbents is insucient
to prevent entry. Hence, the entrant supplies residual demand (

k
I
) resulting in an externality on the
incumbents procured capacity units. Therefore, the incumbents have an incentive to deter entry.
For any c
1
I
[c
1
I
, ), an incumbent can attempt to deter entry single-handedly by undercutting the
entrants bid. Assume incumbent I
j
undercuts the entrants bid
1
E
= p

with
1
Ij
=
1
E
such that I
j
now
supplies the residual demand (

k
I
) for some > 0 and j = 1, 2. As detailed in the Proof of Proposition 1
in the Appendix, as 0 the incumbent only wants to undercut the entrants bid if and only if the following
inequality is satised at p

:
[
2
I

3
I
]

k
I
> [(c
1
I

2
I
) p

]
_

k
I
_
. (10)
This inequality reect the cost-benet trade-o of supplying new capacity units in order to deter entry.
[
2
I

3
I
]

k
I
represents the additional expected per-unit earnings from E&AS an incumbent would earn on its
inframarginal installed capacity if entry is deterred as the externality is avoided. [(c
1
I

2
I
) p

]
_

k
I
_
reects the cost of entry deterrence (c
1
I

2
I
)
_

k
I
_
adjusted by the additional revenues in the capacity
auction p

k
I
_
from procuring these additional units. For any given stop-out price p

the benets of
entry deterrence must exceed the adjusted-cost.
A critical component in inequality (10) is the endogenous stop-out price p

. Given p

=
1
E
[
1
E
, (c
1
I


2
I
)] with c
1
I
[c
1
I
, ), any incumbent who undercuts the entrants bid
1
E
is called upon to supply new
capacity units at a stop-out price below its net marginal cost of new capacity investment. Therefore, entry
deterrence requires incumbent I
j
to procure capacity for a loss. The incumbent(s) will only undercut the
entrants bid
1
E
if the benets from entry deterrence ([
2
I

3
I
]

k
I
) exceed the loss of supplying new capacity
units at a stop-out price below the net marginal cost of new capacity investment. There is a critical threshold
33
In this cost range c
1
I
> c
1
E
and hence, if the entrants bid
1
E
ties the incumbent(s) bid for new capacity investment by the
ecient rationing on-the-margin rule the capacity is allocated to the entrant.
19
price at which the benets from deterring entry equal the adjusted-cost. Dene the single entry deterrence
threshold price as:
p
1
I
= (c
1
I

2
I
)

k
I

k
I
[
2
I

3
I
]. (11)
Therefore, I
j
will undercut any
1
E
> p
1
I
as the benet from preempting entry exceeds the costs at these
stop-out prices. Otherwise, entry occurs as entry deterrence is too costly. Similarly, the entrant will undercut
any bid for new capacity investment, min{

1
I
}, above its minimum marginal bid,
1
E
. Hence, the equilibrium
outcome is reached once incumbent I
j
or the entrant are no longer willing to undercut each other. That is,
p

= max{p
1
I
,
1
E
} for some > 0. Therefore, the ranking of the critical price levels (p
1
I
,
1
E
) plays an
important role in characterizing the single entry deterrence equilibrium outcome.
It is straightforward to show that p
1
I
is increasing in c
1
I
, while
1
E
is unaected by c
1
I
. Therefore, there
is a critical cost of new capacity investment c
1
I
> c
1
E
where p
1
I
=
1
E
:
c
1
I
= c
1
E
+ [
2
I

3
E
] +

k
I

k
I
[
2
I

3
I
]. (12)
For any c
1
I
[c
1
I
, c
1
I
), p
1
I
<
1
E
. Therefore, if c
1
I
[c
1
I
, c
1
I
) incumbent I
j
single-handedly deters entry by
bidding
1
Ij
=
1
E
for some > 0 and j = 1, 2. That is, if I
j
s cost of new capacity falls within this range,
it is protable for I
j
to deter entry single-handedly in order to avoid the externality from entry. Dene this
equilibrium outcome as the Single Entry Deterrence -NE where rm I
j
procures new capacity investment
(

k
I
) at the stop-out price p

=
1
Ij
=
1
E
< c
1
I

2
I
deterring entry for some > 0. This equilibrium
outcome is unique up to the identity of the entry deterring incumbent I
j
for j = 1, 2.
However, if c
1
I
c
1
I
, then entry occurs with certainty as new capacity investment for the incumbents is
too costly to preempt entry single-handedly. That is, the intense price competition between incumbent I
j
and the entrant drives the bids down to p
1
I
where it is no longer protable for incumbent I
j
to undercut the
entrants bid. Therefore, the stop-out price is p

=
1
E
= p
1
I
where the entrant supplies residual demand
(

k
I
) with its new capacity investment. Dene this unique equilibrium outcome as the Entry PSNE.
Corollary 1. For any

[, 2

k
I
) and for any

(2

k
I
, ] with the cost ranges c
1
I
(c
0
I
, c
1
E
] and c
1
I

[c
1
I
, ) the equilibrium outcome of the auction is allocatively ecient. However, for any

(2

k
I
, ] with
c
1
I
(c
1
E
, c
1
I
), the equilibrium outcome is allocatively inecient.
As detailed above, for any

[, 2

k
I
) capacity demanded is supplied by the incumbents installed
capacity units. For the high-demand range (

(2

k
I
, ]), the incumbents installed capacities are dispatched
up to their capacity limits while the incumbents and entrant compete over (

k
I
) with their bids for new
20
capacity investment. For any

(2

k
I
, ] with c
1
I
(c
0
I
, c
1
E
], the incumbents blockade entry resulting in both
incumbents procuring
_
1
2
(

k
I
)
_
units of new capacity. For any

(2

k
I
, ] with c
1
I
[c
1
I
, ), it is not
protable for an incumbent to solely deter entry. Therefore, the entrant procures (

k
I
) units of new
capacity. Notice in each of these capacity demand and cost ranges the allocation of capacity is ecient as
the least-cost new and installed capacity units are procured. However, for any c
1
I
(c
1
E
, c
1
I
) the equilibrium
outcome is allocatively inecient as the entrants lower-cost new capacity is deterred by incumbent I
j
s new
capacity investment for some j = 1, 2. As the externality from entry increases the range of the incumbents
cost of new capacity investment realizations in which the more ecient entrant is deterred increases.
34
3.2 Free-Riding Incentives and the Prisoners Dilemma
Next, given the Nash Equilibria of the model dened above, I examine the issues associated with non-
cooperative entry deterrence and the potential free-rider problem. In particular, it is shown that the incum-
bents could increase their payo for a wider range of new capacity investment cost realizations if they were
able to cooperate and jointly bid to preempt entry. However, they are caught in a prisoners dilemma game
in which it is always protable for an incumbent to unilaterally deviate from the collusive bidding strategy.
Therefore, there are cost realizations in which the incumbents underinvest in entry deterring new capacity
investment due to the public good nature of entry deterrence in this non-cooperative game.
For the low-demand region (

[, 2

k
I
)) and for the high-demand region (

(2

k
I
, ]) with c
1
I

(c
0
I
, c
1
I
) entry is always deterred or blockaded by the incumbents installed and new generation capacity
units. Therefore, focus on the high-demand range with c
1
I
[c
1
I
, ) where entry is not always prevented.
For any

(2

k
I
, ] with c
1
I
[c
1
I
, c
1
I
) incumbent I
j
single-handedly deters entry by procuring new
capacity investment at a stop-out price below its net marginal cost of new capacity for some j = 1, 2. This
allows both incumbents to avoid the externality from entry. Hence, I
k
benets from I
j
s entry deterring
investment at no cost j, k = 1, 2 with j = k. Therefore, both incumbents prefer that the other incumbent
single-handedly preempts entry as the entry deterring rm is procuring new capacity for a loss. While the
total benet from entry deterrence equals 2(
2
I

3
I
)

k
I
, incumbent I
j
is only willing to preempt entry up to
the point where the adjusted-cost of entry deterrence equals I
j
s benet (
2
I

3
I
)

k
I
from preempting entry as
shown in (10). Therefore, the single entry deterrence -Nash Equilibrium outcome reects aspects of a public
good as incumbent I
k
has an incentive to free-ride on I
j
s entry-deterring new capacity investment. Further,
34
Using (11) and (12), it is straightforward to show that c
1
I
is increasing in e = (
2
I

3
I
) and p

1
I
is decreasing in e = (
2
I

3
I
).
Therefore, as can be seen in the inequality (10), incumbent I
j
is willing to single-handedly deter entry at higher new capacity
investment cost realizations (lower stop-out price levels) as e rises.
21
I
j
only considers his benet from entry deterrence in making his bidding decision, not the industry-wide
benets from entry deterrence accrued by both incumbents.
These free-riding incentives can be eliminated if the incumbents cooperate and jointly bid to deter entry.
For any

(2

k
I
, ], given max{

0
I
} min{

1
I
,
1
E
}, the incumbents and entrant compete over residual
demand (

k
I
) with their bids for new capacity investment. As detailed above, for any c
1
I
[c
1
I
, ) the
incumbents must undertake some entry deterring strategies. Assume the entrant sets the stop-out price with
its bid
1
E
[
1
E
, (c
1
I

2
I
)]. In order for the incumbents to avoid the externality from entry, investigate the
incumbents incentives to collude and undertake the joint bidding entry deterrence strategy
1
I1
=
1
I2
=
1
E

to undercut
1
E
= p

such that I
1
and I
2
split residual demand (

k
I
) for some > 0.
35
As detailed in
the Proof of Proposition 2 in the Appendix, as 0 the incumbents will jointly undercut the entrants bid
if and only if the following inequality is satised at p

for each incumbent:

[
2
I

3
I
]

k
I
> [(c
1
I

2
I
) p

]
_
1
2
_

k
I
_
_
. (13)
This inequality reects each incumbents cost-benet trade-o of supplying new capacity units in order
to deter entry. This inequality is identical to the inequality in (10), except the incumbents now share the
burden of preempting entry and hence, they split residual demand such that new capacity procured in the
auction is
_
1
2
_

k
I
__
for both incumbents.
For any given stop-out price p

the benets of this joint entry deterrence strategy must exceed the
adjusted-cost. The critical threshold price at which the benets from deterring entry equal the adjusted-cost
in the joint entry deterrence setting is:
p
2
I
= (c
1
I

2
I
)
2

k
I

k
I
[
2
I

3
I
]. (14)
Therefore, both incumbents will jointly undercut any
1
E
> p
2
I
as the benet from preempting entry
exceeds the costs at this stop-out price. Similarly, the entrant will undercut any bid for new capacity
investment, min{

1
I
}, above its minimum marginal bid,
1
E
. Hence, this intense price competition persists
until the incumbents or the entrant are no longer willing to undercut each other. That is, p

= max{p
2
I
,
1
E

} in for some > 0. Therefore, the ranking of the critical price levels (p
2
I
,
1
E
) play an important role in
characterizing the outcome of this collusive bidding strategy. Dene c
1
I
to be the cost of new capacity
35
In practice, new capacity investment is lumpy (i.e., not perfectly divisible). In the basic model under the ecient rationing
on-the-margin rule if the incumbents submit joint bids residual demand is shared equally among them. The incumbents
incentives to jointly bid holds under more realistic rationing rules such as randomized rationing on-the-margin where bidders
do not share residual demand as it takes into account the lack of perfect divisibility of new capacity investment.
22
investment where p
2
I
=
1
E
:
c
1
I
= c
1
E
+ [
2
I

3
E
] +
2

k
I

k
I
[
2
I

3
I
]. (15)
For any c
1
I
[c
1
I
, c
1
I
), p
2
I
<
1
E
. Therefore, for the joint entry deterrence case if c
1
I
[c
1
I
, c
1
I
), then
incumbents I
1
and I
2
benet by undertaking the collusive joint entry deterrence bidding strategy
1
I1
=

1
I2
=
1
E
for some > 0.
In this joint entry deterrence bidding strategy both incumbents engage in preempting entry. As shown
in the inequality in (13), this joint bidding strategy compels the incumbents to internalize the industry-
wide benet from preempting entry as the incumbents are willing to deter entry up to the point where
the summation of their adjusted-costs
_
2[(c
1
I

2
I
) p

]
_
1
2
_

k
I
___
equals the industry-wide benet
from entry deterrence [2(
2
I

3
I
)

k
I
]. Therefore, the incumbents are willing to preempt entry for higher
cost realizations ( c
1
I
> c
1
I
) and at lower stop-out prices (p
2
I
< p
1
I
) compared to the single entry deterrence
bidding strategy. Hence, if the incumbents are able to undertake this joint bidding strategy there are no cost
realizations in which there is underinvestment in entry-deterring capacity from the incumbents perspective
as they internalize the industry-wide benet from preempting entry. Therefore, this bidding strategy has
the potential to eliminate the free-riding issues associated with the single entry deterrence -NE.
Proposition 2. In this non-cooperative multi-unit capacity auction there are cost realizations in which there
is underinvestment in entry deterring capacity as the joint bidding strategy is not an -Nash Equilibrium.
An incumbent always has an incentive to unilaterally deviate from the collusive joint bidding strategy.
Assume both incumbents are undertaking the joint bidding strategy
1
I1
=
1
I2
=
1
E
such that entry
is deterred for any c
1
I
[c
1
I
, c
1
I
) and for some > 0. Without loss of generality focus on incumbent I
1
. If
I
1
unilaterally deviates, then I
2
supplies all residual demand (

k
I
) at a stop-out price below its net
marginal cost of capacity. Therefore, rm I
1
now benets from I
2
s entry deterring behavior, but no longer
procures new capacity for a loss. This unilateral deviation places all entry deterring costs on incumbent I
2
.
Hence, the joint bidding strategy is never an -Nash Equilibrium as an incumbent always has an incentive
to unilaterally deviate and free-ride on the other incumbents entry deterring behavior.
As detailed in Proposition 1, for any c
1
I
[c
1
I
, c
1
I
) entry is preempted single-handedly. Therefore, even
though the joint bidding strategy is not sustainable in this cost range, entry is still deterred single-handedly
by incumbent I
j
for some j = 1, 2. Hence, focus on the cost range c
1
I
[c
1
I
, c
1
I
) where it is protable for the
incumbents to collude and jointly preempt entry, but due to the incentives for an incumbent to unilaterally
deviate and free-ride, entry is not deterred. For any

1
I
, the entrant has an incentive to bid aggressively by
23
undercutting any min{

1
I
}
1
E
with its bid
1
E
. Figure 2 provides an analogy for the current Prisoners
Dilemma facing the incumbents conditional on the entrants aggressive bidding behavior. If both incumbents
choose Joint, then the joint entry deterrence outcome detailed above arises. If incumbent I
j
chooses Joint,
while I
k
chooses to Deviate, then I
j
single-handedly deters entry by bidding
1
Ij
=
1
E
for some > 0 for
some j, k = 1, 2 with j = k. Lastly, if both incumbents choose Deviate, then the game reverts to the entry
outcome dened in the Entry PSNE. Denote
J
Ij
,
D
k
Ij
,
Dj
Ij
, and
E
Ij
as incumbent I
j
s payo: (i) under
the joint entry deterrence outcome; (ii) if incumbent I
k
unilaterally deviates resulting in I
j
single-handedly
deterring entry; (iii) if incumbent I
j
unilaterally deviates resulting in I
k
single-handedly deterring entry; and
(iv) under the Entry PSNE j, k = 1, 2 with j = k, respectively.
Figure 2: The Joint Entry Deterrence Prisoners Dilemma Analogy.
As in the standard Prisoners Dilemma game, in the current setting the ranking of the payos for each
player are as follows:
D1
1
>
J
1
>
E
1
>
D2
1
and
D2
2
>
J
2
>
E
2
>
D1
2
. Both incumbents have
an incentive to unilaterally deviate from the outcome (Joint, Joint) as they can free-ride on the other
incumbents entry deterring bid. In this cost realization range it is too costly for an incumbent to single-
handedly deter entry. Therefore, the outcomes (Deviate, Joint) and (Joint, Deviate) are never -Nash
Equilibria because the incumbent who is preempting entry single-handedly prefers to allow entry. Hence,
conditional on the entrants aggressive bidding behavior, for any c
1
I
[c
1
I
, c
1
I
) the game reverts to the Entry
PSNE (i.e., (Deviate, Deviate)). While the incumbents prefer the joint entry deterrence outcome (Joint,
Joint) to (Deviate, Deviate), it is not sustainable in this non-cooperative game as there is an incentive to
unilaterally deviate from the joint bidding strategy and single entry deterrence is not protable for the entry
deterring rm. Therefore, there are cost realizations in which there is underinvestment in entry deterrence
from the incumbents perspective as entry occurs in the cost realization range c
1
I
[c
1
I
, c
1
I
) where the industry-
wide benet from entry deterrence exceeds the cost. As detailed in Corollary 1, if the incumbents were able
to overcome the free-rider problem there would be a wider range of cost realizations in which the more
ecient entrant is deterred.
24
4 Asymmetric Incumbents
In this section, the basic model is extended by allowing the incumbents to have asymmetric cost of new
capacity investment. Assume that c
1
I1
< c
1
I2
such that incumbent I
1
has the more ecient new capacity
investment. As in Lemma 2, the incentives for the incumbents to bid max{

0
I
} min{

1
I
,
1
E
} such that
their installed capacities are dispatched carries forth to this asymmetric setting as both incumbents earn a
non-negative prot from procuring their installed capacities.
36
Therefore, as detailed in Proposition 1, for
the low-demand region

[, 2

k
I
] the incumbents deter entry by supplying all of the capacity demanded
with their installed generation units. Proposition 3 describes the Nash Equilibria of the capacity auction
with asymmetric incumbents for the high-demand region

(2

k
I
, ] where both the incumbents and the
entrant compete over residual demand (

k
I
) with their bids for new capacity investment (
1
I1
,
1
I2
,
1
E
)
given max{

0
I
} min{

1
I
,
1
E
}.
Proposition 3. For any

(2

k
I
, ], in the Nash Equilibrium of the auction with asymmetric incumbents:
(i) If c
1
I2
(c
0
I
, c
1
I
) entry is blockaded, (ii) if c
1
I2
c
1
I
and c
1
I1
(c
0
I
, c
1
I
) entry is deterred single-handedly by
an incumbent and (iii) if c
1
I1
> c
1
I
entry occurs.
Similar to the symmetric case, intense Bertrand-like competition between the incumbents drives the
incumbents bids
1
I1
and
1
I2
down to I
2
s net marginal cost of new capacity investment. As dened in (9),
if c
1
2
< c
1
I
then c
1
I2

2
I
<
1
E
= c
1
E

3
E
such that the entrant is unwilling to undercut the incumbents bids
for new capacity investment
1
I1
=
1
I2
= c
1
I2

2
I
. Hence, if c
1
2
< c
1
I
entry is blockaded and I
1
s bid for new
capacity investment is dispatched due to the ecient rationing on-the-margin rule.
If c
1
2
c
1
I
the intense price competition is insucient to blockaded entry as the entrant wants to undercut
(or tie) the incumbents bids
1
I1
=
1
I2
= c
1
I2

2
I

1
E
= c
1
E

3
E
. However, as long as c
1
I1
(c
0
I
, c
1
I
)
an incumbent is willing to single-handedly preempt entry by undercutting (or tying) the entrants bid
1
E
driving the stop-out price down to p

=
1
Ij
=
1
E
(p

=
1
Ij
=
1
E
) for some > 0 as the inequality
dened in (10) holds for rm I
j
.
37
That is, as long as the cost of new capacity investment is suciently low
an incumbent nds it to be protable to avoid the externality from entry by bidding to preempt entry.
If c
1
I1
c
1
I
, the cost of new capacity investment is suciently large such that the incumbents are no longer
willing to deter entry single-handedly as the inequality dened in (10) fails to hold for both incumbents. As
36
This result comes from adjusting Assumption 3.3 to (c
1
I
1

m
I
) (c
0
I

m+1
I
) (c
1
I
1
c
0
I
)

k
I

m = 1, 2.
37
If c
1
I
1
(c
0
I
, c
1
E
) and c
1
I
2
c
1
I
, then incumbent I
1
deters entry by bidding
1
I
1
=
1
E
= p

as the residual demand is

rationed to I
1
(i.e., j = 1). If c
1
I
1
[c
1
E
, c
1
I
) and c
1
I
2
c
1
I
or c
1
I
1
[c
1
I
, c
1
I
) and c
1
I
2
c
1
I
, then incumbent I
1
deters entry by
bidding
1
I
1
=
1
E
= p

for some > 0 (i.e., j = 1). If c

1
I
1
c
1
I
and c
1
I
2
[c
1
I
, c
1
I
), then incumbent I
j
deters entry by bidding

1
I
j
=
1
E
= p

for some > 0 and j = 1, 2 (i.e., j = 1, 2). For more details see the Technical Appendix.
25
detailed in Section 3.2, in the symmetric case if the incumbents undertake the joint bidding strategy they
could increase their payo by preempting entry for a larger range of new capacity cost realizations. However,
this strategy is not an -Nash Equilibrium due to the incentives to free-ride. Similar incentives hold in the
asymmetric case as long as c
1
Ij
[c
1
I
, c
1
I
) j = 1, 2. However, due to the ecient rationing on-the-margin
rule, this joint bidding strategy is no longer feasible because if
1
I1
=
1
I2
= p

<
1
E
the auctioneer rations the
residual demand to incumbent I
1
. Therefore, even if the incumbents were able to jointly bid, the incumbents
can no longer share the burden of supplying new capacity investment for a loss to preempt entry.
38
Corollary 2. In the multi-unit capacity auction with symmetric or asymmetric incumbents, the free-rider
problem associated with non-cooperative entry deterrence exists.
Corollary 2 describes the implication of the non-existence of a joint bidding strategy for both the sym-
metric and asymmetric settings. For any c
1
I1
c
1
I
entry occurs as it is too costly for an incumbent to preempt
entry single-handedly and joint entry deterrence is not feasible.
5 Conclusion
I have examined an oligopoly model in which two incumbents face the threat of entry from a potential
entrant in a multi-unit capacity auction. I have identied conditions under which entry will be blockaded,
deterred, or allowed. The incentives to deter entry induce the incumbents to bid below their net marginal
cost of new capacity resulting in cost realizations in which the more ecient entrant is deterred. Hence,
there are cost realizations in which the allocation of capacity is inecient. Further, I nd that the free-rider
problem associated with non-cooperative entry deterrence arises in this setting. The incentives to free-ride
results in cost realizations in which the incumbents underinvest in entry deterring capacity.
In the low-demand region

[, 2

k
I
] the incumbents supply all of the capacity demanded with their
installed units and deter entry. In the high-demand region

(2

k
I
, ], Bertrand-like competition between
the incumbents blockades entry when the incumbents cost of new capacity investment is suciently low
(i.e., c
1
I
(c
0
I
, c
1
I
)). However, if the incumbents cost of new capacity is suciently large (c
1
I
c
1
I
) entry is not
blockaded. For low enough cost realizations (c
1
I
[c
1
I
, c
1
I
)), an incumbent nds it protable to single-handedly
preempt entry. Once the cost of new capacity investment becomes too large (c
1
I
c
1
I
) no incumbent is willing
to single-handedly preempt entry as it is too costly. If the incumbents undertake a joint bidding strategy they
38
In this asymmetric setting, under an alternative rationing rule, even if the incumbents were able to share the burden of
supplying new capacity investment this joint bidding strategy is not an -Nash Equilibrium as an incumbent always wants to
unilaterally deviate and free-ride on the other incumbents entry deterring bid.
26
can internalize the industry-wide benet from entry deterrence, overcome the free-rider problem associated
with the single-entry deterrence case, and preempt entry for a larger range of cost realizations. However,
the joint bidding strategy is not a Nash Equilibrium because the incumbents face a prisoners dilemma game
in which it is always protable for an incumbent to unilaterally deviate from this collusive strategy and
free-ride on the other incumbents entry deterring bid.
The main objectives of this centralized capacity auction are twofold; (i) to provide a transparent price
signal that reects the value of capacity in order to attract new capacity investment to ensure resource
adequacy is satised and (ii) to facilitate competition for new generation investment to ensure that the bids
for capacity reect their underlying cost. This paper nds mixed evidence on the performance of this capacity
auction at achieving these objectives. Sucient capacity is procured to serve capacity demand at a stop-out
price at or below the net marginal cost of new capacity investment. However, the incumbents distort their
bids for new capacity investment in order to deter entry. While for some cost realizations this reduces the
procurement costs of capacity, the incumbents sustain their market power in the industry. Therefore, to
prevent inecient allocation of capacity and to facilitate competition in the electricity industry, restricting
the incumbents abilities to distort their bids in the capacity auction may be a favorable objective.
These concerns are likely to be amplied in international markets with developing electricity industries as
these markets are often highly concentrated and hence, the incumbent(s) are likely to have a larger incentive
and ability to preempt entry. Therefore, when international electricity markets consider adopting centralized
capacity auction designs they must account for the entry deterring incentives and their eect on hampering
competition in subsequent market interactions.
Further research might also consider uncertainty in the rms costs of capacities, multiple installed and
new capacity generation units for each rm, and bilateral contracts for capacity. While these extensions
would add some useful practical considerations into the analysis, I conjecture that the basic forces I have
identied that drive the rms bidding behavior will persist.
27
APPENDIX
Proof of Lemma 1: Dene S = (, P] to be the rms strategy space.
39
The minimum marginal bid
is the bid that if dispatched as the marginal bid would yield zero prot for the rm. That is, using (2),
(3), and (7) the minimum marginal bid p

=
i
j
is implicitly dened by
j
|
p

=
i
j
= 0 j {I
1
, I
2
, E} and
i = 0, 1. Any marginal bid below the minimum marginal bid would generate negative prot for the bidder.
Therefore, it is a strictly dominated strategy for a rm to submit a bid that will set the stop-out price below
its minimum marginal bid.
Low-Demand

[, 2

k
I
]. Assume
0
I
k
min{
0
Ij
,

1
I
,
1
E
} j, k = 1, 2 with j = k such that incumbent
I
k
s installed capacity is always dispatched (Lemma 2 shows such a strategy by rm I
k
is optimal in any
potential equilibrium bid prole). Hence, all other rms compete over residual demand (

k
I
) with their
bids (
0
Ij
,

1
I
,
1
E
) S [or if
0
Ij
=
0
I
k
, then I
j
and I
k
split

equally].
First consider the case where I
j
sets the stop-out price such that
0
I
k
p

=
0
Ij
< min{

1
I
,
1
E
}. I
j
s
minimum marginal bid,
0
Ij
is determined by:

Ij
|
p

=
0
I
j
= (
0
Ij
c
0
I
)X
0
Ij
(

; ) +
2
I
X
0
Ij
(

; ) = 0

0
Ij
= c
0
I

2
I
. (16)
Next, consider both of the incumbents bids for new capacity investment
1
Ij
and
1
I
k
such that
0
I
k

=
1
I
k
< min{
0
Ij
,
1
Ij
,
1
E
} or
0
I
k
p

=
1
Ij
< min{
0
Ij
,
1
I
k
,
1
E
} j, k = 1, 2 with j = k. Notice that the
incentives of rms I
k
and I
j
dier because I
k
always bids
0
I
k
low enough to be dispatched by assumption
such that X
0
I
k
(

; ) =

k
I
, while X
0
Ij
(

; ) = 0 given
0
Ij
> p

. Characterizing each incumbents minimum

marginal bids (
1
Ij
,
1
I
k
) provides:

Ij
|
p

=
1
I
j
= (
1
Ij
c
1
I
)[

k
I
] +
2
I
[

k
I
] = 0

1
Ij
= c
1
I

2
I
(17)
and

I
k
|
p

=
1
I
k
= (
1
I
k
c
0
I
)

k
I
+ (
1
I
k
c
1
I
)[

k
I
] +
1
I

= 0

1
I
k
= c
0
I

k
I

+ c
1
I
(1

k
I

)
1
I
(18)
Lastly, consider the case where the entrant supplies all residual demand with its bid for new capacity
investment such that
0
I
k
p

=
1
E
< min{
0
Ij
,

1
I
}. The entrants minimum marginal bid,
1
E
is determined
by:

E
|
p

=
1
E
= (
1
E
c
1
E
)[

k
I
] +
2
E
[

k
I
] = 0

1
E
= c
1
E

2
E
. (19)
Case (i). For the cost structure c
0
I
< c
1
I
c
1
E
, we show that
1
E

1
Ij
>
1
I
k

0
Ij
. Given c
1
I
> c
0
I
and

1
I
>
2
I
from Assumption 3.2, it is straightforward to show that
1
Ij
>
1
I
k
:
39
In practice, the strategy space is restricted to the set [0, P]. However, for notational simplicity rms can submit bids in
the set S = (, P]. The results are robust to this specication of the strategy space.
28

1
Ij

1
I
k
=
_
c
1
I

2
I
_

_
c
0
I

k
I

+ c
1
I
_
(1

k
I

_

1
I
_
= (c
1
I
c
0
I
)

k
I

+ (
1
I

2
I
) > 0.
Next, given c
1
I
c
1
E
and
2
I

2
E
from Assumption 3.1, it is straightforward to show that
1
E

1
Ij
:

1
E

1
Ij
= c
1
E

2
E
[c
1
I

2
I
] = (c
1
E
c
1
I
) + (
2
I

2
E
) 0.
Lastly, from Assumption 3.3 we know that (c
1
I

1
I
) (c
0
I

2
I
) (c
1
I
c
0
I
)

k
I

. Therefore, it is straight-
forward to show that
1
I
k

0
Ij
:

1
I
k

0
Ij
= c
0
I

k
I

+ c
1
I
_
1

k
I

_

1
I

_
c
1
I

2
I

= (c
1
I

1
I
) (c
0
I

2
I
) (c
1
I
c
0
I
)

k
I

0.
Case (ii). For the cost structure c
0
I
< c
1
E
< c
1
I
, the ranking between
1
Ij
>
1
I
k

0
Ij
remains the same,
but given c
1
I
> c
1
E
there is a case where
1
E

1
Ij
and
1
E

1
I
k
fail to hold for large enough c
1
I
and hence,
the ranking of
1
E

1
Ij
and
1
E

1
I
k
can not be established without further assumptions.
High-Demand

(2

k
I
, ]. Assume that max{

0
I
} min{

1
I
,
1
E
} such that the incumbents installed
capacities are always procured up to their capacity limits (Lemma 2 shows that this bidding behavior is
optimal). Therefore, the incumbents and entrant compete over residual demand (

k
I
) with the bids
(
1
I1
,
1
I2
,
1
E
). Therefore, the set of potential minimum marginal bids is (
1
I1
,
1
I2
,
1
E
) S
First consider the case where incumbent I
j
supplies all residual demand (

k
I
) such that max{

0
I
}
p

=
1
Ij
< min{
1
I
k
,
1
E
} j, k = 1, 2 with j = k. I
j
s minimum marginal bid,
1
Ij
is determined by:

Ij
|
p

=
1
I
j
= (
1
Ij
c
0
I
)

k
I
+ (
1
Ij
c
1
I
)[

k
I
] +
2
I
[

k
I
] = 0

1
Ij
= c
0
I
_

k
I

k
I
_
+ c
1
I
_

k
I

k
I
_

2
I
. (20)
By symmetry
1
Ij
=
1
I
k
=
1
I
j, k = 1, 2 with j = k.
Lastly, consider the case where the entrant supplies residual demand (

k
I
) with the bid prole
max{

0
I
} p

=
1
E
< min{

1
I
}. The entrants minimum marginal bid,
1
E
is determined by:

E
|
p

=
1
E
= (
1
E
c
1
E
)[

k
I
] +
3
E
[

k
I
] = 0

1
E
= c
1
E

3
E
. (21)
Case (i). For the cost structure c
0
I
< c
1
I
c
1
E
, show that the ranking of the minimum marginal bids is:

1
E
>
1
I
. Given
2
I
>
3
E
from Assumption 3.2 and c
0
I
< c
1
I
c
1
E
:
29

1
E

1
I
= (c
1
E

3
E
)
_
c
0
I
_

k
I

k
I
_
+ c
1
I
_

k
I

k
I
_

2
I
_
=
_
c
1
E

_
c
0
I
_

k
I

k
I
_
+ c
1
I
_

k
I

k
I
___
+ (
2
I

3
E
)
=
_
c
1
E
(

k
I
) c
0
I

k
I
c
1
I
(

k
I
)

k
I
_
+ (
2
I

3
E
)
=
_
[c
1
E
c
1
I
](

k
I
) + [c
1
I
c
0
I
]

k
I

k
I
_
+ (
2
I

3
E
) > 0. (22)
Case (ii). For the cost structure c
0
I
< c
1
E
< c
1
I
, the ranking of
1
E
and
1
I
detailed in (22) is ambiguous
for large enough (c
1
I
c
1
E
) > 0.
Proof of Lemma 2: For any

[, ] I show that it is optimal for rm I
j
to bid
0
Ij
min{

1
I
,
1
E
}
regardless of the ranking of
0
I
k
j, k = 1, 2 with j = k.
Part 1: First consider the case where
0
I
k
min{

1
I
,
1
E
}. Assume there is a bid prole = (

0
I
,

1
I
,
1
E
) S
with
0
I
k
min{

1
I
,
1
E
}, show that
0
Ij
min{

1
I
,
1
E
} is I
j
s optimal strategy given I
k
s bidding behavior.
Assume
0
Ij
> min{

1
I
,
1
E
} with
0
Ij
. Therefore, p

= min{

1
I
,
1
E
}. There are three cases (i) p

=
1
Ij
,
(ii) p

=
1
I
k
, and (iii) p

=
1
E
.
40
Show that I
j
can weakly increase its payo by unilaterally deviating to

Ij
p

for each case.

41
Dene this new bid prole as

Case (i). Using (4)-(6), given the bid prole with

0
I
k

1
Ij
= p

< min{
0
Ij
,
1
I
k
,
1
E
}, X
Ij
(

; ) =
X
1
Ij
(

; ) = (

k
I
). Using (3)-(6), I
j
s payo from unilaterally deviating rises if the following holds:

DIFF1
Ij
=
Ij
|

I
j
=p

Ij
|

0
I
j
>p
> 0
(p

c
0
I
)X
0
Ij
(

) + (p

c
1
I
)X
1
Ij
(

) +
2
I
X
Ij
(

) (p

c
1
I
)[

k
I
]
2
I
[

k
I
] > 0.(23)
Low-demand range

[, 2

k
I
]. For this demand range there are two possible scenarios for the bid prole

:
(1) if
0
I
k
< p

, then X
0
Ij
(

) = (

k
I
) and X
1
Ij
(

) = 0 or (2) if
0
I
k
= p

, then X
0
Ij
(

) =
1
2

and
X
1
Ij
(

) = 0.
First, if
0
I
k
< p

, then X
0
Ij
(

) = (

k
I
) and X
1
Ij
(

) = 0 then the inequality in (23) holds given

c
1
I
> c
0
I
and

>

k
I
:

DIFF1
Ij
= (c
1
I
c
0
I
)[

k
I
] > 0.
Next, if
0
I
k
= p

, then X
0
Ij
(

) =
1
2

and X
1
Ij
(

) = 0 resulting in (23) simplifying to:

40
There are additional cases where there are multiple marginal bidders. However, it is straightforward to show that the
intuition in this proof holds for these cases.
41
It will be shown that I
j
strictly increases its payo except in one setting where
0
I
j
=
1
I
k
dened in (16) and (18). In this
case, I assume that I
j
would rather procure positive capacity by bidding
0

I
j
p

even though
I
j
|

I
j
=
I
j
|

0
I
j
.
30

DIFF1
Ij
= (p

c
0
I
)
1
2

+
2
I
1
2

_
(p

c
1
I
)[

k
I
]
2
I
[

k
I
]
_
> 0
p

[
1
2
(2

k
I


)] c
0
I
1
2

+ c
1
I
(

k
I
) +
2
I
[
1
2
(2

k
I


)] > 0. (24)
Hence, p

must be large enough. From Lemma 1, for

[, 2

k
I
] given
0
I
k
p

we know that

1
Ij
= p

1
Ij
dened in (17) must always hold. Hence, if the inequality (24) holds at p

=
1
Ij
it will hold
for any p

>
1
Ij
. Assume p

=
1
Ij
dened in (17), show that (24) holds given c
1
I
> c
0
I
:

DIFF1
Ij
= (c
1
I

2
I
)[
1
2
(2

k
I


)] c
0
I
1
2

+ c
1
I
(

k
I
) +
2
I
[
1
2
(2

k
I


)] > 0
(c
1
I
c
0
I
)
1
2

> 0.
High-demand

(2

k
I
, ]. For this demand there is a unique outcome for the bid prole

as I
j
s installed
capacity is constrained resulting in X
0
Ij
(

) =

k
I
and X
1
Ij
(

) = (

k
I
). As detailed above X
0
Ij
(

) =

k
I
and X
1
Ij
(

) = (

k
I
). Show that the inequality in (23) holds given c
1
I
> c
0
I
.

DIFF1
Ij
= (p

c
0
I
)

k
I
+ (p

c
1
I
)[

k
I
] +
2
I
[

k
I
] (p

c
1
I
)[

k
I
]
2
I
[

k
I
] > 0
(c
1
I
c
0
I
)

k
I
> 0.
Case (ii) - (iii). Using (4)-(6), given
0
I
k
min{
1
I
k
,
1
E
} = p

< min{
0
Ij
,
1
Ij
}, X
Ij
(

; ) = 0. Hence,

Ij
= 0. Show I
j
is better o by bidding
0

Ij
= p

such that I
j
procures X
0
Ij
(

) > 0. For I
j
s new bidding
strategy to be protable the following inequality must hold:

DIFF2
Ij
=
Ij
|

I
j
=p

Ij
|

0
I
j
>p
0
(p

c
0
I
)X
0
Ij
(

) +
m
I
X
0
Ij
(

) 0 0
p

c
0
I

m
I
. (25)
Low demand

[, 2

k
I
]. For this demand range m = 2 because I
j
s capacity is unconstrained. If p

=
1
I
k
,
from Lemma 1 we know that p

=
1
I
k

1
I
k
dened in (18) must hold. Therefore, show that even if p

=
1
I
k
the inequality p

c
0
I

2
I
in (25) holds given Assumption 3.3:

1
I
k
[c
0
I

2
I
] = c
0
I

k
I

+ c
1
I
_
1

k
I

_

1
I
[c
0
I

2
I
] 0
(c
1
I

1
I
) (c
0
I

2
I
) (c
1
I
c
0
I
)

k
I

. (26)
Similarly, if p

=
1
E
, from Lemma 1 we know that p

=
1
E

1
E
dened in (19) must hold. Therefore,
show that even if p

=
1
E
the inequality p

c
0
I

2
I
in (25) holds given
2
I

2
E
from Assumption 3.1 and
c
1
E
> c
0
I
:

1
E
[c
0
I

3
I
] = (c
1
E

2
E
) (c
0
I

2
I
) = (c
1
E
c
0
I
) + (
2
I

2
E
) > 0.
High demand

(2

k
I
, ]. In this demand range I
j
s installed capacity is constrained if it is dispatched.
31
Therefore, if p

=
1
I
k
, then m = 2 and if p

=
1
E
, then m = 3. The minimum marginal bids in Lemma 1
assumed max{
0
I
} min{

1
I
,
1
E
} which does not hold in the current setting. Therefore, we must establish
the minimum marginal bids
1
I
k
and
1
E
for the bid prole with
0
Ij
> min{

1
I
,
1
E
}.
First, consider case (ii) where
0
I
k
p

=
1
I
k
< min{
0
Ij
,
1
Ij
,
1
E
}. The minimum bid
1
I
k
is dened as:

I
k
|
p

=
1
I
k
= (
1
I
k
c
0
I
)

k
I
+ (
1
I
k
c
1
I
)[

k
I
] +
1
I

= 0

1
I
k
= c
0
I

k
I

+ c
1
I
_
1

k
I

_

1
I
. (27)
This is identical to the minimum marginal bid for the low demand case dened in (18). It has already
been proven in (26) that the inequality in (25) holds for any p

=
1
I
k

1
I
k
. Next, consider case (iii) where

0
I
k
p

=
1
E
< min{
0
Ij
,

1
I
}. The minimum bid
1
E
is dened as:

E
|
p

=
1
E
= (
1
E
c
1
E
)[

k
I
] +
2
E
[

k
I
] = 0

1
E
= c
1
E

2
E
. (28)
If p

=
1
E
, we know that p

=
1
E

1
E
dened in (28) must hold. Therefore, show that even if p

=
1
E
the inequality p

c
0
I

m
I
in (25) holds given Assumption 3.4 and m = 3:

1
E
[c
0
I

3
I
] = (c
1
E

2
E
) (c
0
I

3
I
) > 0.
Therefore, given
0
I
k
min{

1
I
,
1
E
}, it is optimal for I
j
to bid
0
Ij
min{

1
I
,
1
E
} j, k = 1, 2 with j = k
for any

[, ].
Part 2: Next, assume there is a bid prole = (

0
I
,

1
I
,
1
E
) S with
0
I
k
> min{

1
I
,
1
E
}, show that

0
Ij
min{

1
I
,
1
E
} is I
j
s optimal strategy given I
k
s bidding behavior j, k = 1, 2 with j = k for any

[, ]. Assume
0
Ij
> min{

1
I
,
1
E
} with
0
Ij
. Therefore, p

= min{

1
I
,
1
E
}. There are three cases
(i) p

=
1
Ij
, (ii) p

=
1
I
k
, and (iii) p

=
1
E
.
42
Show that I
j
can strictly increase its payo by unilaterally
deviating to
0

Ij
p

. Dene this new bid prole as

.
Case (i). Using (4)-(6), given
0
I
k

0
Ij
> min{

1
I
,
1
E
} and p

=
1
Ij
< min{
1
I
k
,
1
E
}, X
1
Ij
(

; ) =

and
X
0
Ij
(

; ) = 0. Show I
j
raises its payo by bidding
0

Ij
= p

=
1
Ij
resulting in I
j
s installed capacity being
dispatched. Using (3)-(6), given c
1
I
> c
0
I
:

DIFF3
Ij
=
Ij
|

I
j
=p

Ij
|

0
I
j
>p
> 0
(p

c
0
I
)

k
I
+ (p

c
1
I
)[

k
I
] +
1
I

_
(p

c
1
I
)

+
1
I

_
> 0
(c
1
I
c
0
I
)

k
I
> 0.
Case (ii)-(iii). Using (4)-(6), given
0
Ij

1
Ij
> min{
1
I
k
,
1
E
} = p

, X
Ij
(

; ) = 0. Hence,
Ij
= 0. Show
I
j
is better o by bidding
0

Ij
= p

such that I
j
procures X
0
Ij
(

) > 0.
42
There are additional cases where there are multiple marginal bidders. However, it is straightforward to show that the
intuition in this proof holds for these cases.
32

DIFF4
Ij
=
Ij
|

I
j
p

Ij
|

0
I
j
>p
0
(p

c
0
I
)X
0
Ij
(

) +
2
I
X
0
Ij
(

) 0
p

c
0
I

2
I
. (29)
If the inequality in (29) holds at p

=
1
I
k
and p

=
1
E
, then it is optimal for I
j
to deviate to
0

Ij
. The
minimum marginal bids established in Lemma 1 assumed for any

[, 2

k
I
] that
0
I
k
min{

1
I
,
1
E
} and
for any

[, 2

k
I
] that max

0
I
min{

1
I
,
1
E
}. However, these conditions are not satised in the bid prole
and hence, we need to establish the minimum marginal bids
1
I
k
and
1
E
when
0
I
k

0
Ij
> min{

1
I
,
1
E
}.
First, take case (ii) where p

=
1
I
k
< min{

0
I
,
1
Ij
,
1
E
}. The minimum bid
1
I
k
is dened as:

I
k
|
p

=
1
I
k
= (
1
I
k
c
1
I
)

+
1
I

= 0

1
I
k
= c
1
I

1
I
. (30)
Similarly, consider case (iii) where p

=
1
E
< min{

0
I
,

1
I
}. The minimum bid
1
E
is dened as:

E
|
p

=
1
E
= (
1
E
c
1
E
)

+
1
E

= 0

1
E
= c
1
E

1
E
. (31)
If p

=
1
I
k
, we know that p

=
1
I
k

1
I
dened in (30) must hold. Therefore, show that even if p

=
1
I
k
the inequality p

c
0
I

2
I
in (29) holds given Assumption 3.3:

1
I
k
[c
0
I

2
I
] = (c
1
I

1
I
) [c
0
I

2
I
] > 0.
Similarly, if p

=
1
E
, we know that p

=
1
E

1
E
dened in (30) must hold. Therefore, even if p

=
1
E
the inequality p

c
0
I

2
I
in (29) holds because of Assumption 3.4:

1
E
[c
0
I

2
I
] = (c
1
E

1
E
) (c
0
I

2
I
) > 0.
Hence, regardless of
0
I
k
, it is optimal for I
j
to bid
0
Ij
min{

1
I
,
1
E
} j, k = 1, 2 with j = k. Therefore,
max{

0
I
} min{

1
I
,
1
E
} is the optimal bidding strategy for the incumbents for any

[, ]. Notice that
this proof holds regardless of the sign of (c
1
I
c
1
E
). Therefore, the results in this Lemma hold for both cost
structures (0 c
0
I
< c
1
I
c
1
E
) and (0 c
0
I
< c
1
E
< c
1
I
).
Proof of Proposition 1: Low-Demand

[, 2

k
I
]. From Lemma 2 max{

0
I
} min{

1
I
,
1
E
} holds in any
potential equilibrium. Show that the bid prole = (

0
I
,

1
I
,
1
E
) S with
0
I
k
< p

=
0
Ij
= min{
1
I
,
1
E
} =
min{

1
I
,
1
E
} is the unique Pure Strategy Nash Equilibrium conditional on the identity of the price setter
I
j
j, k = 1, 2 with j = k where the non price-setter I
k
bids
0
I
k
low enough. Using (3) - (8), this
results in all capacity demand being procured by installed capacity as X
I
k
(

; ) = X
0
I
k
(

; ) =

k
I
and
X
Ij
(

; ) = X
0
Ij
(

; ) = [

k
I
].
Assume there is a bid prole = (

0
I
,

1
I
,
1
E
) S with
0
I
k
< p

=
0
Ij
min{

1
I
,
1
E
} with
0
Ij

0
Ij
33
dened in (16). Using (3) - (8), this implies that
E
|
p
= 0, while
Ij
|
p
0 and
I
k
|
p
0 given
X
I
k
(

; ) =

k
I
, X
Ij
(

; ) = [

k
I
], and p

=
0
Ij

0
Ij
=
0
I
dened in (16).
First, assume that I
k
bids
0
I
k
low enough. Therefore, both of the incumbents and the entrant compete
over residual demand (

k
I
) with the bids {
0
Ij
,

1
I
,
1
E
}. Show that rms I
k
and E have an incentive to
deviate from unless p

=
0
Ij
min{
1
I
k
,
1
E
} dened in (18) and (19).
43
From Lemma 1, using (16), (18),
and (19) we know that
0
Ij
min{
1
I
k
,
1
E
}. Hence, it is always feasible for I
j
to outbid (or tie)
1
I
k
and
1
E
with
0
Ij
.
Dene
1
h
= min{
1
I
k
,
1
E
}. If
0
Ij
> min{
1
I
k
,
1
E
} rm h bids
1

h
=
0
Ij
for some > 0 and sets a
new stop-out price p

where h {I
k
, E}. Given
0
Ij
> min{
1
I
k
,
1
E
}, for an arbitrarily small > 0 rm h
earns
h
|
p
> 0. Therefore, if
0
Ij
> min{
1
I
k
,
1
E
}, then the bid prole is not a PSNE. This intense price
competition drives the bids
0
Ij
and min{
1
I
k
,
1
E
} down to min{
1
I
k
,
1
E
}. If
0
Ij
min{
1
I
k
,
1
E
}, then rm
h no longer nds it optimal to undercut I
j
s bid
0
Ij
with their bid on new capacity investment
1
h
.
Next, show that I
j
can unilaterally deviate and raise its payo if
0
Ij
< min{
1
I
k
,
1
E
}. If
0
Ij
<
min{
1
I
k
,
1
E
}, there are two potential cases: (i)
0
Ij
= min{
1
I
k
,
1
E
} or (ii)
0
Ij
< min{
1
I
k
,
1
E
} using
(16), (18), and (19).
44
Case (i). I
j
bids
0
Ij
below their minimum marginal bid and hence, earns negative prots. Therefore, I
j
is strictly better o by bidding
0
Ij
=
0
Ij
and earning a payo of zero at this stop-out price.
Case (ii). If I
j
submits a bid
0
Ij
<
0
Ij
< min{
1
I
k
,
1
E
}, the stop-out price equals p

=
0
Ij
and

Ij
|
p
> 0.
45
However, I
j
can increase its payo by bidding
0

Ij
= min{
1
I
k
,
1
E
} as this raises the stop-out
price to p

=
0

Ij
= min{
1
I
k
,
1
E
}, while I
j
s capacity procured in the auction remains the same.
Next, we need to show that I
k
wants to bid
0
I
k
low enough given p

=
0
Ij
= min{
1
I
k
,
1
E
} =
min{
1
I
k
,
1
E
}. Using (16), (18), and (19), we know that p

=
0
Ij

0
Ij
such that
I
k
|

0
I
k
0.
46
If I
k
unilaterally deviates to any
0

I
k
p

, there are two scenarios: (1) if

0

I
k
= p

or (2) if
0

I
k
> p

. In
the rst scenario the stop-out price is unchanged. However, I
k
s capacity procured weakly decreases as
capacity demand is allocated equally to the incumbents due to the ecient rationing rule (i.e., using (5)
X
0
I
k
(

) =
1
2

X
0
I
k
(

; ) =

k
I
). Hence,
I
k
|

I
k

I
k
|

0
I
k
. In the second scenario I
k
s installed capacity
is no longer dispatched resulting in
I
k
|

I
k
= 0 which is weakly less than the prot under
0
I
k
:
I
k
|

0
I
k
0.
Therefore, I
k
has no incentive to unilaterally deviate from bidding low enough.
Lastly, we need to dene what is low enough for
0
I
k
. That is, when will unilaterally deviating from

0
Ij
to
0

Ij
=
0
I
k
for some > 0 not be protable? Bidding
0

Ij
results in a new stop-out price
p

=
0
I
k
as I
j
is now dispatched up to its capacity limit, while I
k
becomes the price-setter who supplies
residual demand (

k
I
). Using (3)-(6):
43
I
j
doesnt want to under cut
0
I
j
= p

with
1
I
j
as this just raises I
j
s production costs reducing its payo.
44
The rst case only arises when the inequality in Assumption 3.3 holds with equality.
45

0
I
j

0
I
j
< min{
1
I
k
,
1
E
} is also possible. However, I
j
earns negative prots and hence, can submit a new bid
0

I
j

0
I
j
and be strictly better o.
46

I
k
|

0
I
k
> 0 except for the special case where
0
I
j
=
1
I
k
.
34

DIFF5
Ij
=
Ij
|

0
I
j

Ij
|

I
j
0
(p

c
0
I
)[

k
I
] +
2
I
[

k
I
] (p

c
0
I
)

k
I

2
I

k
I
0
p

k
I
] +
2
I

c
0
I

k
I
where p

= min{
1
I
k
,
1
E
} and p

=
0
I
k
min{
1
I
k
,
1
E
}
_

k
I

k
I
_

_
c
0
I

2
I
_
_

k
I
_

0
I
k
(32)
As long as I
k
bids
0
I
k
such that it satises the inequality in (32), then I
j
has no incentive to undercut

0
I
k
with its bid for installed capacity.
47
The bid prole with
0
I
k
<
0
Ij
= p

= min{
1
I
k
,
1
E
} = min{

1
I
,
1
E
} characterizes the PSNE for any

[, 2

k
I
] j, k = 1, 2 with j = k where I
j
is the price-setter and I
k
is the price-taker who bids
0
I
k
low
enough. Without loss of generality let j = 1 and k = 2. Using (2), (4), and (8) the equilibrium outcome of
the game is:
O() = {X

I1
(

; ), X

I2
(

; ), X
1

E
(

; ), p

} = {

k
I
,

k
I
, 0, p

=
0
I1
= min{
1
I2
,
1
E
}}.
Conditional on the identities of the price-setting rm I
j
and price-taking rm I
k
, this PSNE is unique
up to the identity of the incumbents.
High-demand

(2

k
I
, ]. From Lemma 2, max{

0
I
} min{

1
I
,
1
E
} holds in any potential equilibrium
such that the incumbents installed capacities are procured up to their capacity limits. Therefore, both the
incumbents and the entrant compete over residual demand (

k
I
) with the bids (

1
I
,
1
E
). c
1
I
is allowed to
vary in the range (c
0
I
, ) in order to see how the incumbents abilities to deter entry is aected.
First, investigate the incumbents incentives to undercut each other. For now, disregard the entrants
incentives to undercut p

. Assume there is a bid prole = (

0
I
,

1
I
,
1
E
) S with max{

0
I
}
1
Ij
= p

<
min{
1
I
k

1
E
} with
1
Ij
>
1
Ij
dened in (20) j, k = 1, 2 with j = k. Using (3) - (8), this implies that
X
I
k
(

; ) =

k
I
and X
Ij
(

; ) = [

k
I
]. Therefore,
E
|
p
= 0, while
Ij
|
p
> 0 and
I
k
|
p
> 0 given
p

=
1
Ij
>
1
Ij
dened in (20).
I now show that rm I
k
has an incentive to unilaterally deviate from any bid prole unless p

=
1
Ij
=

1
I
k
= c
1
I

2
I
>
1
Ij
. Assume
1
I
k
> p

=
1
Ij
c
1
I

2
I
. Show that rm I
k
unilaterally deviates by bidding

I
k
= p

(
1

I
k
=
1
Ij
) for some > 0 resulting in a new bid prole

if
1
Ij
> c
1
I

2
I
(
1
Ij
= c
1
I

2
I
)
setting the new stop-out price p

= p

(p

= p

). Using (3)-(6):

DIFF6
I
k
=
I
k
|

I
k

I
k
|

1
I
k
=
_
(p

c
0
I
)

k
I
+ (p

c
1
I
)X
1

I
k
(

) +
2
I
[

k
I
+ X
1

I
k
(

)]
_

_
(p

c
0
I
)

k
I
+
2
I

k
I
_
= (p

k
I
+ (p

c
1
I
)X
1

I
k
(

) +
2
I
X
1

I
k
(

). (33)
If p

=
1
Ij
> c
1
I

2
I
, then p

= p

such that X
1

I
k
(

) = (

k
I
). As 0, given p

=
1
Ij
> c
1
I

2
I
47
Notice that X
I
k
(

; ) X
I
j
(

; ), but rms I
j
and I
k
both receive the same stop-out price. Hence,
I
k
|
p

I
j
|
p
.
Therefore, both rms prefer to be the non price-setter. This supports the argument that I
k
wants to bid low enough. In
practice we often observe such price-taking bids as rms submit capacity bids of zero for their installed capacities.
35
it is straightforward to show that
DIFF6
I
k
> 0 such that I
k
wants to deviate. Using (33):

DIFF6
I
k
= (p

c
1
I
)(

k
I
) +
2
I
(

k
I
) > 0
p

> c
1
I

2
I
.
If
1
Ij
= p

= c
1
I

2
I
, then I
k
bids
1

I
k
=
1
Ij
such that p

= p

and X
1

I
k
(

) =
1
2
(

k
I
). It is
straightforward to show that
DIFF6
I
k
0 such that I
k
wants to deviate.
48
Using (33):

DIFF6
I
k
= (p

c
1
I
)
1
2
(

k
I
) +
2
I
1
2
(

k
I
) 0
p

c
1
I

2
I
.
Next, assume
1
I
k
p

=
1
Ij
with p

=
1
Ij
< c
1
I

2
I
. This implies that incumbent I
j
is supplying new
capacity for a loss. Therefore, I
j
is better o by unilaterally deviating to
1

Ij
= c
1
I

2
I
as I
j
is no longer
procuring new capacity units for a loss. Therefore, assuming
1
Ij
<
1
E
always holds, no rm will submit a
bid below their net marginal cost of supplying capacity. Hence, the intense price competition over residual
demand (

k
I
) between the incumbents drives the stop-out price down to p

=
1
Ij
=
1
I
k
= c
1
I

2
I
j, k = 1, 2 with j = k resulting in new capacity investment being split equally between the incumbents.
However, the entrants bidding behavior has been overlooked. Assume there is a bid prole =
(

0
I
,

1
I
,
1
E
) S with max{

0
I
}
1
Ij
=
1
I
k
= p

<
1
E
as detailed above. Assume the entrant unilat-
erally deviates by bidding
1

E
= p

for some > 0 setting a new stop-out price p

. Using (7) and (8), the

entrant raises its prots by bidding
1

E
if the following inequality holds:

DIFF7
E
=
E
|
p

E
|
p
> 0
(p

c
1
E
)[

k
I
] +
3
E
[

k
I
] > 0
p

> c
1
E

3
E
=
1
E
(34)
As 0, this inequality requires p

> c
1
E

3
E
=
1
E
to hold where
1
E
is the minimum marginal bid
dened in (21). As detailed above, p

=
1
Ij
=
1
I
k
= c
1
I

2
I
due to the intense price competition between
the incumbents. Therefore, the entrant will undercut (or tie) the incumbents bids as long as c
1
I

2
I

1
E
.
49
Consider the cost structure c
0
I
< c
1
I
c
1
E
. It is straightforward to show that the inequality c
1
I

2
I
<

1
E
= c
1
E

3
E
holds because c
1
E
c
1
I
and
2
I
>
3
E
from Assumption 3.2.
Alternatively, consider the cost structure c
0
I
< c
1
E
< c
1
I
. c
1
I

2
I

1
E
= c
1
E

3
E
no longer holds with
certainty. Rather, there exists a c
1
I
(c
1
E
, ) where
1
E
= c
1
I

2
I
:

1
E
= c
1
I

2
I
(c
1
E

3
E
) (c
1
I

2
I
) = 0
c
1
I
= c
1
E
+ [
2
I

3
E
] (35)
Therefore, any c
1
I
(c
0
I
, c
1
I
) the entrant has no incentive to undercut p

as p

= c
1
I

2
I
<
1
E
= c
1
E

3
E
48
Since
1
I
j
= p

= c
1
I

2
I
,
DIFF6
I
k
= 0. It is assumed at this indierence point I
k
prefers to tie I
j
s bid
1
I
j
and split
residual demand (

k
I
) with new capacity investment given that capacity is perfectly divisible by assumption. These same
incentives hold under alternative rationing rules such as randomized rationing on-the-margin which accounts for the lumpy
nature of capacity in practice.
49
It is assumed that if c
1
I

2
I
=
1
E
, then the entrant prefers to deviate from
1
E
> p

to
1

E
= p

in order to procure
positive capacity even though
E
|

1
E
=
E
|

E
.
36
due to the intense price competition between the incumbents. While for any c
1
I
c
1
I
the entrant has an
incentive to undercut (or tie) the incumbents bids
1
Ij
=
1
I
k
= p

. Therefore, for c
1
I
(c
0
I
, c
1
I
), the bid
prole with max{

0
I
}
1
I1
=
1
I2
= p

= c
1
I

2
I
<
1
E
characterizes the PSNE. Using (2), (4), and (8)
the equilibrium outcome of the game for any c
1
I
(c
0
I
, c
1
I
) is:
O() = {X

I1
(

; ), X

I2
(

; ), X
1

E
(

; ), p

} =
_
1
2

,
1
2

, 0, p

=
1
I1
=
1
I2
= c
1
I

2
I
_
.
This PSNE is unique for any c
1
I
(c
0
I
, c
1
I
). Hence, entry is blockaded for this cost structure as the intense
price competition between the incumbents drives the stop-out price to levels below the entrants minimum
marginal bid. Dene this equilibrium as the Blockaded Entry PSNE.
However, for any c
1
I
[c
1
I
, ), c
1
I

2
I
<
1
E
no longer holds and hence, the entrant has an incentive to
undercut (or tie) the blockaded entry equilibrium as detailed in (34). Assume that p

=
1
E

1
E
, investigate
an incumbents incentive to undercut
1
E
and preempt entry.
For any c
1
I
[c
1
I
, ), assume there is an aggregate bid prole = (

0
I
,

0
I
,
1
E
) S with
1
E

1
E
such
that max{

0
I
} p

=
1
E
min{

1
I
} resulting in X
E
(

; ) = (

k
I
) and X
Ij
(

; ) =

k
I
j = 1, 2 from
(4) - (8).
50
First, investigate I
j
s incentives to solely deter entry by bidding
1

Ij
=
1
E
setting a new
stop-out price p

= p

and supplying all residual demand (

k
I
) for some > 0 and j = 1, 2. Using
(3):

DIFF8
Ij
=
Ij
|
p

Ij
|
p
> 0
{(p

c
0
I
)

k
I
+ (p

c
1
I
)[

k
I
] +
2
I
[

k
I
]} {(p

c
0
I
)

k
I
+
3
I

k
I
} > 0
(p

k
I
+ (p

c
1
I
)[

k
I
] +
2
I
[

k
I
]
3
I

k
I
> 0.
As 0,
(p

c
1
I
)[

k
I
] +
2
I
[

k
I
]
3
I

k
I
> 0
[
2
I

3
I
]

k
I
> [(c
1
I

2
I
) p

](

k
I
). (36)
(36) implies that the benet from deterring entry ([
2
I

3
I
]

k
I
) must oset the adjusted-cost of entry
deterrence ([(c
1
I

2
I
) p

](

k
I
)). There is a critical stop-out price at which this expression holds with
equality. Dene p
1
I
to be the threshold price at which the benet from undercutting
1
E
just equals the cost:
p
1
I
= (c
1
I

2
I
)

k
I

k
I
[
2
I

3
I
]. (37)
Therefore, incumbent I
j
will undercut
1
E
as long as
1
E
> p
1
I
. Assume there is the aggregate bid prole
detailed above with p

=
1
E
>
1
E
p
1
I
. Therefore, as detailed in (36), I
j
wants to undercut
1
E
resulting
in a new stop-out price p

= p

and higher prots for I

j
for an arbitrarily small > 0. However,

E
|
p
= 0. Therefore, the entrant undercuts p

with
1

E
. This intense price competition persists until one
rm is unwilling to cut the other. That is, the nal stop-out p

= max{p
1
I
,
1
E
for some > 0. There is
a critical cost for the incumbent c
1
I
(c
1
I
, ) where
1
E
= p
1
I
. Using (21) and (37):
50
If
1
E
= min{

1
I
}, then the capacity is allocated to the entrant due to ecient rationing on-the-margin as c
1
E
< c
1
I
in this
cost range.
37

1
E
= p
1
I
c
1
E

3
E
= (c
1
I

2
I
)

k
I

k
I
[
2
I

3
I
]
c
1
I
= c
1
E
+ [
2
I

3
E
] +

k
I

k
I
[
2
I

3
I
] (38)
For c
1
I
< c
1
I
,
1
E
> p
1
I
and for c
1
I
c
1
I
,
1
E
p
1
I
. Therefore, in the single incumbent entry deterrence
case; for any c
1
I
[c
1
I
, c
1
I
), p

=
1
Ij
=
1
E
for some > 0 and for any c
1
I
[c
1
I
, ), p

=
1
E
= p
1
I
.
51
For any c
1
I
[c
1
I
, c
1
I
) it must be shown that
1
E

1
I
> 0 in (20) and (21) such that at p

=
1
E
the
incumbent does not earn negative prots contradicting that
1
I
is I
j
s minimum marginal bid. From (22),

1
E

1
I
> 0 requires:

1
E

1
I
> 0
_
[c
1
E
c
1
I
](

k
I
) + [c
1
I
c
0
I
]

k
I

k
I
_
+ (
2
I

3
E
) > 0
[c
1
E
c
0
I

k
I

k
I
+ (
2
I

3
E
)] > c
1
I
_

k
I

k
I
_
c
1
I
<
_

k
I

k
I
_
[c
1
E
c
0
I

k
I

k
I
+ (
2
I

3
E
)]. (39)
If (39) holds at the upper bound of this costs range c
1
I
, then it holds c
1
I
< c
1
I
. Using c
1
I
in (38):
(
1
E

1
I
)|
c
1
I
> 0 c
1
E
+ [
2
I

3
E
] +

k
I
(
2
I

3
I
)

k
I
<
_

k
I

k
I
_
[c
1
E
c
0
I

k
I

k
I
+ (
2
I

3
E
)]
c
1
E
_

k
I

k
I
1
_
c
0
I

k
I

k
I
+ (
2
I

3
E
)
_

k
I

k
I
1
_

k
I
(
2
I

3
I
)

k
I
> 0

_

k
I

k
I
_
_
(c
1
E
c
0
I
) + (
3
I

3
E
)
_
> 0.
Given c
1
E
> c
0
I
,

> 2

k
I
, and
3
I

3
E
from Assumption 3.1; (
1
E

1
I
) > 0 holds for c
1
I
= c
1
I
and
hence, holds c
1
I
< c
1
I
. Therefore, for any c
1
I
[c
1
I
, c
1
I
), incumbent I
j
undercuts
1
E
deterring entry for some
j = 1, 2. The bid prole with max{

0
I
}
1
Ij
= p

=
1
E
<
1
E
=
1
E

1
I
k
characterizes the -Nash
Equilibrium j, k = 1, 2 with j = k for some > 0.
52
Without loss of generality, let j = 1 and k = 2. Using
(2), (4), and (8) the equilibrium outcome of the game for any c
1
I
[c
1
I
, c
1
I
) is:
O() = {X

I1
(

; ), X

I2
(

; ), X
1

E
(

; ), p

} =
_

k
I
,

k
I
, 0, p

=
1
I1
=
1
E

_
.
For any c
1
I
[c
1
I
, c
1
I
), entry is deterred by the single incumbent I
j
for some j = 1, 2. Dene this equilibrium
as the Single Entry Deterrence -Nash Equilibrium. This is the unique Nash Equilibrium for this cost range
conditional on the identity of the entry deterring incumbent I
j
for some j = 1, 2.
Finally, for any c
1
I
[c
1
I
, ) entry deterrence by a single incumbent is too costly as
1
E
p
1
I
. The intense
51
At c
1
I
= c
1
I
, p

1
I
=
1
E
by denition. However, given c
1
I
> c
1
E
, due to ecient rationing on-the-margin the capacity is
allocated to the entrant in this special case.
52
It is straightforward to show that rm I
k
does not want to undercut
1
I
j
by bidding
1

I
k
=
1
I
j
for some > 0 as this
would require I
k
to procure new capacity for a loss and it has no entry deterring benets as the entrant is already deterred.
38
price competition over residual demand (

k
I
) drives the stop-out price to p

=
1
E
= min{

1
I
} = p
1
I
and
due to the ecient rationing on-the-margin rule residual demand is allocated to the entrant. The bid prole
= (

0
I
,

1
I
,
1
E
) with max{

0
I
}
1
E
= p

= p
1
I
= min{

1
I
} characterizes the PSNE for any c
1
I
[c
1
I
, ).
Using (2), (4), and (8) the equilibrium outcome of the game for any c
1
I
[c
1
I
, ) is:
O() = {X

I1
(

; ), X

I2
(

; ), X
1

E
(

; ), p

} =
_

k
I
,

k
I
, (

k
I
), p

=
1
E
= p
2
I
_
.
Therefore, for any c
1
I
[c
1
I
, ) entry is allowed as single-handedly undercutting any
1
E
p
1
I
is not
protable for an incumbent as the cost of entry deterrence is too large. Dene this equilibrium as the Entry
PSNE. This is the unique Nash Equilibrium for this cost range.
Proof of Corollary 1. Follows directly from Proposition 1.
Proof of Proposition 2. For any c
1
I
[c
1
I
, ), investigate the incumbents incentives to jointly bid in
order to preempt entry. That is, consider the case where the incumbents collude and bid
1
I1
=
1
I2
=
1
E

for some > 0 and split residual demand (

k
I
). Denote this joint bid as
1
s
I
.
First, given max{

0
I
} min{

1
I
,
1
E
} from Lemma 1, characterize the minimum joint marginal bid
1
s
I
where both incumbents earn zero prot if the joint bid is the marginal bid. Using (3):

Ij
|
p

=
1
s
I
= (
1
s
I
c
0
I
)

k
I
+ (
1
s
I
c
1
I
)
1
2
[

k
I
] +
2
I
1
2
[

k
I
] = 0

1
s
I
= c
0
I
_
2

k
I

_
+ c
1
I
_

k
I

_

2
I
. (40)
Any joint bid below the minimum joint marginal bid
1
s
I
results in negative prots for both incumbents.
Therefore, the incumbents will not submit joint bids below the minimum joint marginal bid as this is a
strictly dominated strategy.
Next investigate the incumbents incentives to jointly deter entry by bidding
1
I1
=
1
I2
splitting residual
demand (

k
I
) . For any c
1
I
[c
1
I
, ), assume there is an aggregate bid prole = (

0
I
,

0
I
,
1
E
) S
with
1
E

1
E
such that max{

0
I
} p

=
1
E
min{

1
I
}. Assume I
1
and I
2
jointly deter entry by bidding

I1
=
1

I1
=
1
E
setting a new stop-out price p

= p

resulting in each rm splitting all residual

demand (

k
I
) such that X
1
I1
(

) = X
1
I2
(

) =
1
2
[

k
I
] from (6) for some > 0. Using (3):

DIFF9
Ii
=
Ii
|
p

Ii
|
p
> 0 i = j, k
{(p

c
0
I
)

k
I
+ (p

c
1
I
)
1
2
[

k
I
] +
2
I
1
2

} {(p

c
0
I
)

k
I
+
3
I

k
I
} > 0
(p

k
I
+ (p

c
1
I
)
1
2
[

k
I
] +
2
I
1
2

3
I

k
I
> 0.
As 0,
(p

c
1
I
+
2
I
)
1
2
[

k
I
] + [
2
I

3
I
]

k
I
> 0
[
2
I

3
I
]

k
I
> [(c
1
I

2
I
) p

](
1
2

k
I
). (41)
The benet from deterring entry ([
2
I

3
I
]

k
I
) must oset the adjusted-cost of entry deterrence ([
2
I

39

3
I
]

k
I
> [(c
1
I

2
I
) p

](
1
2

k
I
)). There is a critical stop-out price at which this expression holds with
equality. Dene p
2
I
to be the threshold price at which the benet from jointly undercutting
1
E
just equals
the cost:
p
2
I
= (c
1
I

2
I
)
2

k
I

k
I
[
2
I

3
I
] (42)
Therefore, the incumbents will jointly undercut
1
E
as long as
1
E
> p
2
I
. Assume there is the aggregate
bid prole detailed above with p

=
1
E
>
1
E
p
2
I
. Therefore, as detailed in (41), the incumbents want to
jointly undercut
1
E
resulting in a new stop-out price p

= p

and higher prots for both incumbents for

an arbitrarily small > 0. However,
E
|
p
= 0. Therefore, the entrant undercuts p

with
1

E
. This intense
price competition persists until the incumbents or entrant are no longer willing to undercut the other. That
is, the nal stop-out price p

= max{p
2
I
,
1
E
} for some > 0. There is a critical cost for the incumbent
c
1
I
(c
1
I
, ) where
1
E
= p
2
I
. Using (21) and (42):

1
E
= p
2
I
c
1
E

3
E
= (c
1
I

2
I
)
2

k
I

k
I
[
2
I

3
I
]
c
1
I
= c
1
E
+ [
2
I

3
E
] +
2

k
I

k
I
[
2
I

3
I
]. (43)
For c
1
I
< c
1
I
,
1
E
> p
2
I
and for c
1
I
c
1
I
,
1
E
p
2
I
. Therefore, in the joint bidding case; for any c
1
I
[c
1
I
, c
1
I
),
p

=
1
I1
=
1
I2
=
1
E
for some > 0 and for any c
1
I
[c
1
I
, ), p

=
1
E
= p
2
I
.
53
For any c
1
I
[c
1
I
, c
1
I
) it must be shown that
1
E

1
s
I
> 0 dened in (21) and (40) such that at p

=
1
E

the incumbents are not earning negative prots contradicting that

1
s
I
is the incumbents joint minimum
marginal bid. From (21) and (40),
1
E

1
s
I
> 0 requires:

1
E

1
s
I
> 0 (c
1
E

3
E
)
_
c
0
I
_
2

k
I

_
+ c
1
I
_

k
I

_

2
I
_
> 0
c
1
E

2c
0
I

k
I

+ (
2
I

3
E
) > c
1
I
_

k
I

_
c
1
I
<
_

k
I
_
_
c
1
E

2c
0
I

k
I

+ (
2
I

3
E
)
_
(44)
If (44) holds at the upper bound of this costs range c
1
I
, then it holds c
1
I
< c
1
I
. Using c
1
I
in (43):
(
1
E

1
s
I
)|
c
1
I
> 0 c
1
E
+ [
2
I

3
E
] +
2

k
I
(
2
I

3
I
)

k
I
<
_

k
I
_
_
c
1
E

2c
0
I

k
I

+ (
2
I

3
E
)
_
c
1
E
_

k
I
1
_
+ (
2
I

3
E
)
_

k
I
1
_
c
0
I
2

k
I

k
I

k
I
(
2
I

3
I
)

k
I
> 0

_
2

k
I

k
I
_
_
c
1
E
+ (
2
I

3
E
) c
0
I
(
2
I

3
I
)
_
> 0

_
2

k
I

k
I
_
_
[c
1
E
c
0
I
] + (
3
I

3
E
)
_
> 0
53
At c
1
I
= c
1
I
, p

2
I
=
1
E
by denition. However, given c
1
I
> c
1
E
, due to ecient rationing on-the-margin the capacity is
allocated to the entrant in this special case.
40
Given c
1
E
> c
0
I
,

> 2

k
I
, and
3
I

3
E
from Assumption 3.1; (
1
E

1
s
I
) > 0 holds for c
1
I
= c
1
I
and
hence, holds c
1
I
< c
1
I
. Therefore, for any c
1
I
[c
1
I
, c
1
I
), the incumbents have an incentive to jointly bid and
undercut
1
E
to deter entry.
However, this joint bidding strategy is not an -Nash Equilibrium. Focus on the cost region c
1
I
[c
1
I
, c
1
I
).
Assume there is a bid prole with min{

0
I
}
1
I1
=
1
I2
= p

=
1
E
<
1
E
=
1
E
for some > 0
such that installed capacity is procured up to its capacity limit, while the incumbents split residual demand
(

k
I
) with their new capacity investment (i.e., using (6) X
1
Ij
(

; ) =
1
2
[

k
I
] j = 1, 2).
Without loss of generality focus on incumbent I
1
. I
1
can unilaterally deviate and increase its payo.
Assume I
1
unilaterally deviates from
1
I1
= p

to
1

I1
> p

such that it is no longer dispatched to procure

new capacity investment. Dene the new bid prole to be

. Using (3), investigate I

1
s incentives to
unilaterally deviate:

DIFF10
I1
=
I1
|

I
1

I1
|

1
I
1
> 0
(p

c
0
I
)

k
I
+
2
I

k
I

_
(p

c
0
I
)

k
I
+ (p

c
1
I
)
1
2
[

k
I
] +
2
I
_
1
2
[

k
I
] +

k
I
__
> 0
[(c
1
I

2
I
) p

]
_
1
2
[

k
I
]
_
> 0 (45)
where p

=
1
E
for some > 0. For any c
1
I
[c
1
I
, c
1
I
),
1
E
(c
1
I

2
I
) such that any incumbent who
preempts entry is procuring new capacity at a stop-out price p

< c
1
I

2
I
. Therefore, the inequality in (45)
is satised such that incumbent I
1
has an incentive to unilaterally deviate as I
1
can free-ride on I
2
s entry
deterring bid
1
I2
= p

<
1
E
.
Proof of Proposition 3 and Corollary 2. Follows from Lemma 2, Proposition 1, and Proposition 2. For
a detailed proof see the Technical Appendix.
41
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