Strategic (re)actions in a learning environment: a theoretical approach

We study a two period model with an incumbent that is already in the market for a long time, an entrant that enters the market in period one and a consumer that decides whether to buy a unit of the product from the incumbent, the entrant or to not buy a product at all. We show that the incumbent has to make a strategic development decision to drive the entrant out of the market at the end of period one. The entrant also has to make a strategic development decision to be profitable in period two. We use a learning model where the consumer learns about the ability of the producers at the end of period one. We show that the optimal strategy for the incumbent is to follow his own private signal in both periods and that the entrant has to distinguish himself from the incumbent in both periods, to be able to make profit in the second period. Furthermore, we show that the incumbent will not change his behaviour in case there is uncertainty about whether the incumbent will be a monopolist after the first period entrant is out of the market, or that a new entrant will enter. Finally, we show that the mere presence of an inferior entrant is enough to discipline the incumbent to always follow his signal and to charge a price that is lower than the monopoly price.