A Dynamic Model of Entry and Exit in a Growing Industry

Abstract

The potential demand in a new industry evolves over time. Demand is initially low, but advertising by the industry’s early entrants can speed up demand growth. However, there is intrinsic uncertainty of the demand level in each period and uncertainty of the demand evolution path, which can be affected by the underlying economic environment. We construct a dynamic model that features the stochastically and endogenously expanding demand of a new industry, and we investigate the optimal entry and exit behavior of firms as the industry evolves. We find that firms’ incentive to enter early depends critically on the cost that early entrants have to pay in developing the market. When the cost is high and the benefit spills over to potential entrants, firms have an incentive to wait, and the probability of entry can increase with the number of incumbents under certain circumstances. Firms’ entry strategy is also influenced by the transition of economic states. Firms are more likely to enter under a state that shows the prospect of demand taking off soon. We also find that, in the early stage of an industry, higher demand uncertainty can induce faster entry.