Entry, Sunk Costs and Renegotiation in Duopoly

In this paper we examine the relationship between sunk costs, market structure and welfare in a dynamic duopoly model. We consider a model in which two firms make sequential capacity choices and then play a continuous time game in outputs. It is assumed that the equilibria in the quantity choice stage of the game are renegotiation-proof, and study two polar extremes in this set. It is assumed that either firm one or firm two receives all the ex post rents. In both cases we find, in contrast to most previous studies, that low sunk costs are associated with low welfare.