When should a firm expand its business?: The signaling implications of business expansion

We examine an incumbent's trade-off between the improved efficiency that business expansion facilitates and the signaling role that business expansion plays in conveying information to potential entrants about the state of demand. We demonstrate that both separating and pooling equilibria survive the Intuitive Criterion. Essentially, in contrast to models with asymmetric information about unit cost, incumbents' benefits from investing in a signal are not necessarily monotonic in the state of demand. We investigate how the extent of informativeness of the outcome depends on the enhanced efficiency that the incumbent's expansion facilitates and the priors of the entrant.

Research Highlights► We examine an incumbent's trade-off when deciding to expand its business. ► Expansion improves efficiency but might convey information about demand to potential entrants. ► We demonstrate that both separating and pooling equilibria survive the Intuitive Criterion. ► Incumbents' benefits from investing in a signal are not necessarily monotonic in demand. ► Information transmission depends on the enhanced efficiency of expansion.