Discussion Paper No. 702

THE PROFITABLE SUPPRESSION
OF INVENTIONS:TECHNOLOGY CHOICE AND
ENTRY DETERRENCE
Anthony CreaneandKaz Miyagiwa

November 2007

The Institute of Social and Economic Research
Osaka University
6-1 Mihogaoka, Ibaraki, Osaka 567-0047, Japan.
The Profitable suppression of inventions:Technology choice and entry deterrence§

Anthony Creane† and Kaz Miyagiwa‡
Abstract
AT&T was known for both funding a world-class research lab and delaying deployment of
useful innovations from the lab. To explain this behavior we consider a model with anincumbent facing a potential entrant. The incumbent can choose from two technologies for
production: old and new. The entrant’s choice is limited to the old. We show that, undercorrelated production uncertainty, use of the common technology exposes the entrant to a greaterrisk. Therefore, the incumbent may suppress a newer, more efficient technology in favor of theold as a means to deter entry.
JEL: D83, L12, L13
Key words: technology choice, entry deterrence, production shocks, correlations of strategies†

Department of Economics, Michigan State University
Institute of Social and Economic Research, Osaka University, and Department of Economics,
Emory University§
We thank Jay Pil Choi for his comments on this paper. Any errors are our responsibility.
‡Often a decade or more passed before new features, such as long-distance direct dialing andtouch-tone phones, would finally percolate throughout the system…Perhaps the most egregious
example of the company’s technological conservatism was the languid introduction of electronic
switching, conceived in the 1930s…. The noisy, clunky relays [of the old technology] opened andclosed circuits to establish continuous physical connections between any two phones. A solidstate switch, on the other hand, would have no moving parts, making it smaller, faster, quieter,
and more reliable. Although electronic switches based on solid-state components had beendeveloped by 1959, AT&T didn’t introduce the first digital switch into the Bell System until 1976.
And electronic switching was still being gradually rolled out well into the 1980s…
- Historian M. Riordan (2005)

1. Introduction
During the 20th century, AT&T was known both for its development of new technologies andneedless delay in deploying them. For example, AT&T waited for twenty years to introduce boththe handset and dial system and the automatic phone (Dunford 1987). Delayed deployment of
new technologies is surprising, given the fact that development costs had been sunk. Further,
AT&T faced competitors and potential entrants in different markets all this time. From the very
beginning Western Union was a rival in the long distance communications market though overtime AT&T steadily gained domination. 1 However, once Western Union for all intents andpurposes disappeared as a rival to AT&T, new ones began to appear in the long distance market:
MCI (Microwave Communications, Inc.) followed by Datran (Data Transmission Company).
AT&T also faced competition at the local level from other phone service providers.
“When Alexander Graham Bell's patents expired in 1893, AT&T was faced with the entry ofcompetitors into its market. The newcomers, known collectively as the Independents, appeared
first in small cities and towns in the Midwest, but quickly spread out across the nation and into

1

“What tied the failure of Western Union to the success of Bell was a porous and shifting boundary between
telegraphy and telephony, between what twentieth-century managers and regulators would later call the record andvoice communications industries. Through the contract of 1879, Western Union attempted to keep Bell out of thelong-distance communications market, which Western Union's managers viewed as the exclusive province oftelegraphy….While regulators propped up Western Union as the only competitor to AT&T, by the 1960s it wasoffering only token competition.” Hochfelder (2002)

2larger cities” (Nix and Gabel 1993). The independents remained through the 20th century, someoutlasting AT&T itself.

Interestingly, AT&T’s main approach to deterring entry was by“developing its long-distance network and through patent litigation against its competitors” (Nixand Gabel 1993).

Furthermore, the Kingsbury Commitment (1913) restricted AT&T fromacquiring the independents and forced it to provide long-distance service to independents(Galambos 1992). Given that AT&T faced potentially entry from independents that it could not
buy out, its delay in introducing superior, patented technology seems even more surprising.
Further, AT&T is not the only company that has allegedly delayed the introduction of a
new technology.

For example, GE delayed the introduction of fluorescent bulbs until a small

rival (Sylvania) began producing them (Dunford 1987). IBM too had been accused of delaying
introducing new main frames until rivals had finally entered the market with the old technology(Scherer 2007).
In this paper we examine the optimality of delayed introduction of new technology for
AT&T’s, IBM’s or any incumbent monopolist. Given the choice between an old technology anda newly patented, lower cost technology, it is clear that a monopolist under normal circumstances
would choose the new technology. We show however that, when facing a potential entrant
having access only to the old technology, an incumbent may have an incentive to shelve the newtechnology even if it is more efficient.
Broadly, this phenomenon occurs when a new technology or product is distinct from theold one and there is technology-specific production uncertainty. In such a case, when theincumbent uses the old technology that is available to the entrant, both the incumbent and theentrant are exposed to common cost shocks.

If instead the incumbent chooses a new,unconnected technology, then they are exposed to independent cost shocks. As a result, with the3introduction of a new technology, an incumbent inadvertently shields an entrant from the shocks
the incumbent faces. In duopolistic competition this shielding raises the expected profit for theentrant, thereby making entry more appealing.
To see why this is so intuitively, consider what occurs when an entrant happens to draw a
low cost and increases its output. If the incumbent uses the old technology, the incumbent too
draws the same low cost realization and increases output. On the other hand, if the incumbent
uses the new technology its cost realization is uncorrelated to the entrant’s, and so the incumbent
is less likely to be increasing output. Thus, the use of the common technology correlates thefirms' strategies. Further, as we show below, correlations of strategies make the profit function
less convex, thereby reducing expected profits for the entrant. As a result, the incumbent may
find it easier to deter entry with the old technology, even though it has access to a new and more
efficient technology. Thus, while technology adoption as entry deterrence is not new in theliterature (e.g., if the new technology has lower cost, the incumbent can undercut potential
entrants), we bring a new perspective to it by emphasizing the role that cost uncertainty plays. 2
Two points are worth emphasizing regarding suppression of innovations as a method ofentry deterrence. First, what drives our result is not risk aversion but the correlations of strategies
induced by a technology choice. To show this we assume risk neutrality of both firms. Secondly,
unlike in previous work in strategic competition, our result holds whether the firms compete inquantities or in prices. We demonstrate this by showing that both Cournot and Hotelling pricecompetition yield the same qualitative result.
In the next section, we briefly review the related literature. In section 3, we consider the
standard model of quantity competition – Cournot competition – in a model in which the2

In Ellison and Ellison (2007) entry costs for the potential entrant are stochastic, but this plays a role in making theeffect of the incumbent’s choice of investment continuous.

4

incumbent first chooses its technology and then the entrant chooses whether to enter with the oldtechnology. In section 4, we consider price competition in the classic Hotelling model, findingthat our result does not qualitatively change. Section 5 concludes.

2. Literature review
The literature on entry deterrence under cost uncertainty includes Maskin (1999),
Waldman (1987) and Harrington (1987). Waldman (1987) considers the effect of uncertainty on
non-cooperative entry deterrence and in particular its effect on the free rider problem. As we
consider a lone incumbent the free rider issue does not arise here. Harrington (1987) examines
the effects of uncertainty on entry deterrence when signaling is possible, while signaling cannot
arise in our model. Closer to our work, Maskin (1999) studies the classic model of capacity
choice by an incumbent facing a possible entrant, each facing a common cost shock, much as inour model when the incumbent chooses the old technology. He shows that cost uncertainty canlead to the incumbent choosing a larger level of capacity to deter entry. Since we consider
technology choice instead of capacity choice, the role of cost uncertainty differs: in our analysis,by choosing the old technology the incumbent makes the strategies more correlated, lowering theentrant’s expected profits. The incumbent thus benefits from the uncertainty. In Maskin (1999)
there is only one technology for the incumbent and the uncertainty forces it to choose a greater
capacity, making deterrence more costly. Thus, the uncertainty harms the incumbent.
Methodologically, our work is perhaps most closely related to that of Choi and Yi (2000),
which examines vertical foreclosure and the choice of input specifications under cost
uncertainty.

In Choi and Yi (2000), there are two upstream firms selling inputs to two

downstream firms. Each upstream firm can produce a specialized input for one downstream firm
or a generalized input that can be used by the both downstream firms. The authors show that5vertical integration is anticompetitive because an upstream firm would produce the generalized
inputs in non-integrated vertical structure but, when integrated, it chooses to produce thespecialized input for its downstream firm, thereby foreclosing the rival downstream firm.
Although the environments differ, this result hinges, like ours, on the fact that the reduction of
cost correlation can create a benefit. Specifically, in Choi and Yi (2000) the upstream firms
observe cost realizations and then engage in Bertrand competition when producing thegeneralized inputs. As a result, an upstream firm earns zero profits if the rival firm draws thesame or lower cost realization and captures all of the profit if it has the lower cost realization.
Producing specialized inputs decreases the probability of both firms having the same cost
realization and raises expected profits. 3 Thus the firms benefit from a reduction in correlation.
Our results could also be characterized as raising-the-rival’s-costs strategy (Salop 1979,
Salop and Shefffman 1983, 1987). 4 However, here the means is the choice of technology. By
staying with the old technology the incumbent increases the correlation of the strategies, anddecreases the expected profit to the potential entrant. As a result, the incumbent may choose an
unpatented inferior technology over its patented new technology. Thus, the basic structure hereis the reverse of the effect found in Gilbert and Newbery (1982) and Reinganum (1983), where
the incumbent invents and patents an inferior technology to keep it from falling into the hand of
the potential entrant.

For the same reason our results are distinct from work on network

compatibility and entry deterrence in several respects. For example, since the monopolist in ourmodel has the new technology, our result is distinct from the one of the “excess inertia” found in
Farrell and Saloner (1986) that can lead to predation. Likewise, there is no network externality

3

As Choi and Yi (2000) note this is also reminiscent of Dasgupta and Maksin’s (1987) result that project portfolios
are characterized by excessive correlation.
4
Foreclosure in Choi and Yi (2000) also has the effect of raising the rival’s cost and benefiting the integrated firms.

6

here so the incumbent does not remain with the old system because of the large customer base(Katz and Shapiro 1992).

3. Basic environment
Consider an incumbent monopolist (firm i) under the threat of entry (by firm e). Assume
linear demandp(Q) = 1– Q
if Q ≤ 1 and p(Q) = 0 otherwise. If there is entry, then the firms produce homogeneous products
and compete in quantities (i.e., Cournot competition) with aggregate output Q = qi + qe, where qk
is firm k’s (= i, e) output. Otherwise, the incumbent retains its monopoly position and so Q = qi.

There are two technologies available for production: an old technology (O), which canbe used by either firm, and a new technology (N), which is available only to the incumbent.
Firms adopting either technology are subject to technology-specific cost shocks, which canoccur, e.g., when the new technology results in a drastically different production process fromthe one under the old technology. For simplicity, assume that marginal costs are stochastic but
constant with respect to output. Let⎯cO denote the expected costs of the old technology and σO2
its variance. Analogously, let⎯cN be the expected costs of the new technology and σN2 itsvariance.

The distributions are assumed independent and have support [0, 1), given thenormalization on the demand function. We emphasize that it is not the cost variability itself thatdrives the result, but rather it is the variability combined with the fact that the firms compete
strategically. To emphasize this point we assume that the cost variability is identical to the twotechnologies, i.e.,7

σO2 = σN2 = σ2.
We do assume however that the new technology is a superior technology in the following sense:
the expected marginal cost of production is lower with the new technology:⎯cN ≤⎯cO. We say thetechnology is strictly superior when the inequality is strict.
We model the interaction between the firms in four stages.

In the first stage, theincumbent chooses (and commits to) its technology, incurring fixed cost Ki. In the second stage,
the entrant observes the incumbent’s first-stage decision and chooses whether to enter or not; if itenters the entrant incurs fixed cost, Ke. In the third stage, nature draws values for the firms’
costs and the firms only observe their own costs.

However, if the firms have the same

technology, then they can infer each other’s costs from observation of their own. In the fourthstage, if the entrant enters, the firms play a quantity-setting game; otherwise the incumbent
remains a monopoly.
With regards to our assumptions on fixed setup cost we acknowledge that introducing a
new technological system for an AT&T would not be a trivial exercise. While presumably it
would be more costly for AT&T to switch to the new technology, we assume the fixed costs are
the same between two firms, i.e., Ke = Ki = K. This assumption is imposed to prevent AT&T
from choosing the old technology for reasons other than the one considered here (i.e., because
the fixed costs of the new technology is too great), but can be easily relaxed. 5
What is important is that, if the incumbent chooses the old technology and the entrant
enters, then the firms face the same cost ex post. On the other hand, if the incumbent chooses the5

Of course, as with all first mover models, the move (e.g., choosing capacity as in Dixit 1979) needs an irreversible
aspect to it; ALCOA must have been unable to undo its capacity if rivals entered. Furthermore, at least in the caseof AT&T, making the changes to introduce the new technology was a slow process, so even if the potential entrant
entered, it would take time before AT&T would be able to switch.

8

new technology and the entrant enters with the old technology their cost shocks will be lesscorrelated. Furthermore, they cannot infer each other’s cost realization from observing theirown, given independence of distributions O and N.

3. Analysis
3.A. The fourth-stage gameWe solve the model backward, starting with the fourth stage. Consider first the subgame
in which the incumbent chooses the old technology and the entrant enters (and by default is using
the old technology). Nature has drawn the cost c%O from distribution O, which is common forboth firms. Since they can infer each other’s cost by observing their own, the firms play a gameof complete information with identical costs. The equilibrium quantity and operational profit(i.e., ignoring fixed costs) for firm j = i, e are therefore
q Oj = [1 – cO ]/3, and(1)

π Oj (cj,ck) = π Oj ( cO , cO ) = [1 – cO ]2/9, j ≠ k,where the superscript O indicates that the incumbent has chosen the old technology.
If instead the incumbent chooses the new technology and the entrant enters, then naturedraws a cost realization c%N from distribution N for the incumbent and c%O from distribution O forthe entrant. Given independence between O and N, the firms cannot infer each other’s cost
realization. Thus, the game is one of incomplete information, and we look for a Bayesian-Nashequilibrium. Firm j maximizes expected profit
E[(1 – qj – qk – c j )qj].
The first-order condition can be arranged to yield firm j’s best response9qj = [1 – c j – E(qk)]/2.
It is a routine exercise to show that the equilibrium outputs are
qiN = [1 – 2 c N +⎯cO]/3 + [ c N −⎯cN]/6
qeN = [1 – 2 cO +⎯cN]/3 + [ cO −⎯cO]/6

where the superscript N denotes the incumbent choosing the new technology. Firm j, after
setting its output, has fourth-stage operational profits of(2)

π Nj ( c j , ck ) = {[2 + 3 c j + 3 ck –⎯cO –⎯cN]/6} q Nj .
Finally, if there is no entry, the incumbent’s monopoly operational profits are π OM = (1 –cO )2/4 if it chooses the old technology and π MN = (1 – c N )2/4 with new technology, where the M
subscript indicates the monopoly.

Note that if there were no potential entrant, then theincumbent would select the new technology because its expected profits would be greater.

3.B. Entry Deterrence
In stage three Nature moves, revealing the technology-specific cost information to thefirms only if they chose that technology. We now turn to the second stage, in which the potential
entrant makes its entry decision.
Suppose that the incumbent chose the old technology in the first stage. Then the expected
operational profit to the potential entrant is obtained by taking expectations of (1), so the total
expected profit is

(3)
where

E[ ΠeN ] = E[ π eO ] - K = π eO ( cO , cO ) + σ2/9 – K

10π eO ( cO , cN ) ≡ (1 – cO )2/9
is the mean operating profit (i.e., the operating profit if variance equals zero).
If the incumbent chose instead the new technology in the first stage, the firms do notlearn each other’s cost, and hence neither firm reacts to the rival’s cost realizations. It follows
that the competitor’s cost cannot introduce variance into the firm’s profit. 6 Taking expectationsof (2) yields the entrant’s expected profit
E[ ΠeN ] =E[ π eN ] − K = π eN ( cO , cN ) + σ2/4 – K

(4)
where

π eN ( cO , cN ) ≡ [1 – 2 cO + cN ]2/9
is the “mean” operation profit, and the variance term corresponds to shocks to the oldtechnology..
Comparing the two expected profits for the entrant in (3) and (4), the variance term issmaller when the incumbent chooses the old technology. Therefore, if the expected marginal
costs are identical across technologies, the entrant’s expected profit is smaller when theincumbent chooses the old technology. This result stems from two effects entailed by theincumbent choosing the same technology that is available to the entrant.
First, the exposure to the common cost shocks results in a correlation of the firms’
strategies. To understand this effect intuitively, note first that profits are convex in costs. Now,
suppose that the entrant has a lower-than-average cost shock and expands its output. If it chosethe new technology, being uninformed, the incumbent would not react to the entrant having
drawn a low cost, given that cost shocks are uncorrelated across technologies. With the old6This is because the rival’s cost enters the firm’s profit function linearly.

11

technology, however, the incumbent draws the same cost realization that the entrant does. Hence,
the incumbent also faces the low cost and expands its output as well. With the incumbent also
expanding output, the entrant’s profit does not increase as much as it does with separate
technologies. Similar observations obtain when the entrant draws a higher-than-average cost. As
the incumbent also draws a higher cost and contracts output, the entrant’s profit does not fall as
much as when the incumbent had chosen the new technology. Thus, the incumbent, by choosing
the same technology as available to the entrant, makes the entrant’s profits less convex and theentrant worse off relative to the choice of the new technology.
Second, without correlations in the cost shocks, the entrant would rather the incumbent
choose the old, less efficient technology; i.e., cN < cO . However, as we will show below, thispreference ranking can be reversed with cost correlations and sufficiently high variance. That is,a potential entrant could prefer the new technology even if that gives the incumbent strictly
lower expected marginal cost.
Comparing the entrant’s expected operational profits in (3) and (4) leads toE[ π eN ] > E[ π eO ] ⇔(5)

σ2 > (4/5)( cO – cN )(2 – 3 cO + cN )In particular, if cN = cO , the right-hand side of (5) is zero and so the above inequality holds.
However, even if cN < cO , the above inequality holds if cN is sufficiently close to cO or if σ2 issufficiently large.
When (5) holds, we have(6)

E[ π eN ] – K > E[ π eO ] – K.

12Define KB ≡ E[ π eN ] and⎯KE ≡ E[ π eO ]. If K∈( K E , KB), then we haveE[ π eN ] – K > 0 > E[ π eO ] – K.
For such values of K, entry is deterred only if the incumbent firm chooses the old technology.
For this reason, call ( K E , KB) the entry-deterrence set.
On the other hand, if K > KB, both sides of (6) are negative, indicating that there will be noentry regardless of the incumbent’s technology choice. This case is known as blockaded entry. If K<⎯KE, both sides of (6) are positive, so there will be entry regardless of the incumbent’s technology
choice. For both these cases (either K > KB or K <⎯KE), the incumbent’s technology choice has

no effect on the potential entrant’s entry decision, and hence the incumbent clearly will choose
the new technology.
We now determine the incumbent’s decision. To determine when the incumbent would
choose the less efficient old technology to deter entry we must determine the incumbent’s profit
with the old technology and compare it with its profit with the new technology. Given that K isin the entry deterrence set, if the incumbent chooses the old technology then it is a monopoly(since entry would be deterred) and its operational profit would beE[ π OM ] = (1 – cO )2/4 + σ2/4
On the other hand, choosing the new technology would result in expected operating profit ofE[ π iN ] = E[ qiN ]2 = πiN( cN , cO ) + σ2/4
where

π iN ( cN , cO ) ≡ [1 – 2 cN + cO ]2/9.
Thus,

13

E[ π OM ] ≥ E[ π iN ] ⇔(7)0 ≥ (5 – cO – 4cN )[4( cO – cN ) – (1 – cO )]/9.

From (7) it is clear that if the two technologies have identical marginal cost, then the incumbent
selects the old technology. Moreover, even if the new technology is strictly superior, the⎛(1− cO ) ⎞incumbent still chooses the old technology so long as cN ∈ ⎜ cO −, cO ⎟ . Finally, if
4⎝⎠introducing a new technology requires a greater fixed cost than keeping the old technology, theincumbent will choose the old technology.
The next proposition summarizes what we found in this section.

Proposition 1: Suppose that firms compete in quantities and that the new technology issuperior to the old technology in that the marginal cost is distributed with a lower expected⎛(1− cO ) ⎞, cO ⎟ .
value cN ∈ ⎜ cO −4⎠⎝
A. If there is no potential entrant, then the incumbent chooses the new technology.
B. If there is an entrant and its fixed (entry) cost K satisfies (6), then the incumbent chooses
the old technology and deters entry.

We emphasize that what drives the result is not risk aversion; after all, we have assumed
that both firms are risk neutral.

Rather, our results are driven by the fact that different

technologies have different cost distributions, combined with the fact that the firms compete
strategically. As a consequence, the incumbent could choose the less efficient, older technology
regardless of whether the older technology is riskier than the new technology. To emphasize this14

point we have assumed that the two technologies are equally risky (that is, have the same
variance since higher order moments do not play a role).
This is not to argue that changes in variance (or risk) cannot have effects. Consider what
happens if all technologies have an identical increase in variance. To begin with, as an inspection
can readily confirm, an increase in variance raises E[ π eN ], expanding the upper bound of theentry deterrence set, KB. As a result, the entry deterrence set now contains some higher values ofK that did not initially belong there. For those values of K now included in the set, if cN ∈⎛(1− cO ) ⎞c−, cO ⎟ , the incumbent now prefers the old technology while when variance was⎜⎝ O
4⎠smaller it preferred the new technology.

That is, an increase in variance changes theincumbent’s technology choice, not because of risk aversion but because it wants to deter entry.
An increase in variance also increases E[ π eO ], thereby raising the lower bound of theentry deterrence set,⎯KE. Therefore, some low values of K drop out of the set. For those values⎛(1− cO ) ⎞, cO ⎟ , then the incumbent will change
of K now outside the deterrence set, if cN ∈ ⎜ cO −4⎠⎝
the technology choice from the old technology (deterring entry) to the new technology(accommodating entry). However, a further inspection reveals that an increase in varianceincreases E[ π eN ] more than E[ π eO ] so that the entry deterrence set expands. That is, as varianceis increased, the incumbent is more likely to use the old technology and deter entry.

3.C Publicly observed cost shocks
We have so far assumed that the cost shocks are privately observed. Consider now what occurs
if the cost shocks were publicly observed. This does not affect the game when both use the old15

technology, but now the firms play a game of complete information when using different
technologies. Then it is a straightforward calculation to show that both the incumbent’s and theentrant’s expected profits are greater with publicly observed costs when using different
technologies. (This is a well-known result in the information sharing literature; see, e.g., Gal-Or
1986 or Vives 1990).
While it does not change our result qualitatively, the case of publicly observed costshocks yields two interesting results. First, E[ π eN ] increases while E[ π eO ] remains unchanged.
That is, KB rises but⎯KE remains intact, indicating that the entry deterrence set has expanded
upward. Therefore the incumbent is more likely to use the old technology to deter entry whencosts are publicly observed.
Second, while in quantity competition a firm is normally made better off when its costshocks are publicly observed, in the model here the incumbent could be made worse off when its
cost shocks are publicly observed. 7 To see how the firm could be harmed, recall that KB, theupper bound of the entry deterrence set, is increased when the cost shocks become publicly
observed. That is, the entry deterrence set now contains some values of K that were not in theset when shocks were publicly unobservable. For those values of K, with publicly observed
costs, the incumbent must use the old technology to deter entry, and would use the old(1 − cO )⎛⎞technology if cN ∈ ⎜ cO −, cO ⎟ . In contrast, if instead those costs were not publicly
4⎝⎠

observable, then for those same values of K the incumbent would be able to keep its monopoly
position with the choice of the new technology, i.e., entry would be blockaded.

4. Price competition
7

See, e.g., Gal-Or (1986) or Vives (1990).

16

Often in strategic competition the results hinges critically on the type of strategiccompetition. In this section we examine whether our findings from quantity competition holdwhen firms compete in prices. To that end, we consider the Hotelling model. 8
Let there be a linear city of unit length with the incumbent located at 0 and the potential
entrant, if it enters, is located at 1. Consumers have identical value for the product, v, and linear
transportation costs t, which are normalize to one. Assuming the market is “covered,” v > ci +3t/2, it is straightforward to derive demand (see, e.g., Tirole 1988):
qi = (1 – pj + pk)/2.
Operational profits for firm j are
πj = (pj − cj)(1 – pj + pk)/2
with its first order condition(8)

1 – 2pj + pk + cj = 0.

Otherwise, the assumptions (specifically, regarding the cost distributions) are as before. The
remainder of the analysis closely follows the steps from the previous section and so we only
sketch the main points.

4.A The fourth stage
Again using backward-induction we start with the fourth stage. In the subgame in which
the incumbent chooses the old technology and the entrant entered with the old technology, eachfirm has observed the common marginal cost cO and so the fourth stage is a game of complete

8

The standard duopoly model of price competition, which specifies ad-hoc demand functions such as qi = 1 – pj +δpk, δ ∈(0,1) has the unattractive implication that profits are greater in a duopoly than in a monopoly. Therefore themodel is not suited for having a meaningful comparison of the monopoly and the duopoly outcome.

17

information. Using (8), the equilibrium prices and operational profit for firm j = i, e arep Oj = 1 + cO , and(9)

π Oj (cj,ck) = π Oj ( cO , cO ) = 1/2. 9
If instead the incumbent chooses the new technology and the entrant enters, then naturedraws a cost realization c N from distribution N for the incumbent and cO from distribution O forthe entrant. This fourth stage is a game of incomplete information, and following the outline ofthe previous section, the Bayesian-Nash equilibrium prices are
piN = (3 + 2 c N + cO )/3 + ( cN – c N )/6
peN = (3 + 2 cO + cN )/3 + ( cO − cO )/6

In this case it is convenient to use firm j’s expected fourth stage profits given its cost c j (since
the rival’s cost enters firm j’s profit linearly):(9)

E[ π Nj | c j ] = ( p Nj − c j )2/2 = (6 – 3 c j + c j − ci )2/72.
Finally, if there is no entry, the incumbent’s monopoly profits are as before: π MO = (v –cO )2/4 if it chooses the old technology and π MN = (v – c N )2/4 with new technology.

4.B. Entry Deterrence
Turning to the second stage, the potential entrant’s expected profits from entering giventhat the incumbent chose the old technology is

9

While with the Hotelling model costs do not enter into the profit expression when the same technology is used, thequalitative aspect of technology choice (an incumbent by choosing the old technology would lower the rival’s profit)
would also hold with an ad hoc model such as qi = 1 – pj + δpk, δ∈(0,1). However, the latter ad hoc model has theunattractive implication that profits are greater in a duopoly than a monopoly.

18

(10)

E[ π eO ( cO , cO )] = π eO ( cO , cO ) = 1/2.
If the incumbent chooses instead the new technology in the first stage, the firms do notlearn each other’s cost, and hence neither firm reacts to the rival’s cost realizations. Taking
expectations of (9) yields the entrant’s expected profit(11)

E[ π eN ] = π eN ( cO , cN ) + σ2/8

where

π eN ( cO , cN ) ≡ (3 – 2 cO + 2 cN )2/18
is the “mean profit” and the variance term corresponds to the old technology cost term.
As with quantity competition, the variance term is smaller when the incumbent chooses
the old technology and so again, if the expected marginal costs are identical across technologies,
the entrant’s expected profit is smaller when the incumbent chooses the old technology. The
intuition for this follows as with quantity competition. As a result, the entrant is worse off when
the incumbent chose the old technology both in price and quantity competition. This is unusual
since generally these interactions depend on the type of competition.
Comparing the entrant’s expected profits in (9) and (11) leads toE[ π eN ] > E[ π eO ] ⇔(12)

σ2 > 4( cO – cN )(6 – cO + cN )/9. 10

As with quantity competition, if cN = cO , the right-hand side of (12) is zero and so the above
inequality holds. Even if cN < cO , (12) holds when cN is sufficiently close to cO . When (12)holds, there is again a K such that:
10

The condition is σ2 > 4(cO − cN )[2(2+δ) − 2cO (2 − δ 2 )+δ(cO +cN )] / (2+δ) 2 (4 − 3δ) in the ad hoc model where

demand is specified as qi = 1 – pj + δpk, δ∈(0,1).

19

(13)

E[ π eN ] – K > 0 > E[ π eO ] – K,

that is, for K satisfying the above condition, the entrant does not enter if the incumbent firmchooses the old technology, but does enter if the new technology is chosen.
Turning to the incumbent, if (13) holds, then when it chooses the old technology theincumbent earns the monopoly profit:
E[ π MO ] = (v – cO )2/4 + σ2/4,
while choosing the new technology would result in expected duopoly profit[ π iN ] = π iN ( cN , cO ) + σ2/8
where

π iN ( cN , cO ) ≡ (3 – 2 cN + 2 cO )2/18.
To begin with, if cN = cO , then E[ π MO ] ≥ E[ π iN ] and the incumbent chooses the old technology.
However, with Hotelling competition, the variance term is greater with the monopoly profits (oldtechnology) than with duopoly profits, which makes the old technology even more attractive. To
abstract from this effect, let σ2 = 0. In that case, if v is sufficiently large relative to cO , that is v
≥ √2 (1 + cO (2+3√2)/6), then even without the variance effect a monopoly with the oldtechnology is more profitable than a duopoly with the new technology no matter how efficient is
the new technology. However, if v is sufficient small (and the market remains covered), then the⎛ v 2 −2⎞
, cO ⎟⎟ no matter how small σ is.
old technology is still more profitable if cN ∈ ⎜⎜ 3
⎝ 2+3 2⎠

Proposition 2: In a Hotelling model, suppose that the new technology is superior to the old20

technology in that marginal cost is distributed with a lower expected value cN ∈⎛ v 2 −2⎞
, cO ⎟⎟ .
⎜⎜ 3⎝ 2+3 2⎠
A. If there is no potential entrants, then the incumbent chooses the new technology.
B. If there is an entrant and its fixed (entry) cost K satisfies (13), then the incumbent
chooses the old technology and deters entry.

Note that, given our discussion preceding the proposition, as σ increases, the lower bound on cN⎛ v 2 −2⎞
, cO ⎟⎟ is sufficient but not necessary for thedecreases. That is, the condition cN ∈ ⎜⎜ 3
⎝ 2+3 2⎠incumbent to choose the old technology to deter entry.
Another similarity with quantity competition is the effect that a uniform increase invariance has on the entry deterrence set. By an analogous logic it can be shown that an increasein variance increases the entry deterrence set. However, with price competition there is a neweffect: the incumbent’s profits are differently affected depending on its technology choice.
Specifically, an increase in variance increases the incumbent’s monopoly profits due to deterred
entry more than it does its duopoly profits due to accommodated entry. As a result, entry
deterrence is more attractive to a monopolist and so more likely to occur. Thus, both effects goin the same direction: an increase in variance makes entry deterrence more likely.

5. Concluding remarks

While holding a monopoly position during the 20th century AT&T was known for both
funding a world class research lab and supposedly delaying beyond reason deployment of useful
innovations from the lab. In this paper we present a new explanation as to why AT&T and other21

incumbent monopolists, when faced by potential entry, may want to suppress a new and more
efficient technology they have developed. Our analysis shows that the suppression of newtechnology can occur when it is sufficiently distinct from the old technology such that, should
the incumbent adopt it and the entrant enter with the old technology, the two firms will be
exposed to uncorrelated cost or production shocks. That is, when the incumbent chooses the newtechnology, the entrant would be shielded from the cost shocks affecting the incumbent. As aresult, the entrant finds entry more appealing than when the incumbent keeps the old technology.
One question that may remain would be: why then did AT&T, IBM and others spend
resources on the developing the technologies? The answer, of course, is that, although theywould not implement them so long as the old technology could work to deter entry, theenvironments could change in the future. In particular, when the demand grows sufficiently
strong, the entrants would choose to enter despite the incumbent’s choice of the old technology,
at which time the incumbent would introduce the new technology. And indeed, once thecompetitors made enough inroads, the incumbents such as IBM and GE introduced the newtechnologies.

22

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