ABSTRACT We analyze a setting typical of industries right after liberalization, or after structural demand and technology changes. An incumbent firm has an exogenous capacity, and a new entrant has to set its capacity level. We find that, in a dynamic context, higher capacity increases the severity of punishment after deviation, thereby favoring the emergence of cartels. The cartel in this case could hurt welfare, not only because of the standard deadweight loss motive, but also because of the cost inefficiency due to high and idle capacity. We conjecture that a competitive arrangement could be both welfare enhancing and profit-maximizing for the incumbent.
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