Forward induction and market entry with an endogenous outside option

Abstract

We consider a two-player sequential game in which players first choose whether to engage in a productive (market game) or unproductive activity (contest game) and then, if both players have chosen to enter the market, they compete in prices. Both economic activities are linked because the rents in the contest game are a fraction of the market profits. Subgame perfection predicts competitive pricing and a battle-of-the-sexes reduced-form game with two asymmetric Nash equilibrium, where only one firm enters. Our experimental results reject the prediction based on backward induction but are easily explained by forward induction arguments. The payoffs from the rent-seeking activity (outside option) influence pricing behaviour and prices do not converge to marginal costs. When the size of the rent seeking activities is large, firms coordinate better on economic activities and, in the event of market competition, prices converge to full collusion.