Excess Liquidity against Predation

We consider precautionary liquidity holding as counter-strategy for the entrant to protect himself from predation. Threat of predation, even if avoided in equilibrium, affects the financial contract to raise precautionary liquidity and the equilibrium outcome in the product market competition. When the incumbent’s strategy is unverifiable, the entrant with small start-up capital cannot raise large enough precautionary liquidity; consequently, he shrinks his business so as to avoid predation. Predation evolves in the model only as perturbation from equilibrium strategy. We provide the revelation principle for a sequential equilibrium to select a sensible outcome by imposing robustness to such perturbation.