Excess capacity may also be dictated by marketing considerations. Where distributors’ services are essential to commercial success and manufactures do not integrate forward into distribution, a manufacturer will have to convince distributors to support his product.  Excess capacity will demonstrate a commitment to distributors that the firm that has invested in the capacity is in the market to stay.

But by the same token, an investment in excess capacity will demonstrate this same intent to potential entrants. It will signal to such firms and to existing fringe firms a willingness to defend a dominant market position.

For such a signal to be convincing, the capacity must be sunk. If an investment could be liquidated with relatively small capital losses, it does not demonstrate a commitment to the industry. If excess capacity is sunk, then it, like vertical integration, can help a dominant firm maintain its position without suffering the reduction in profit or of market share predicted by limit price models.

Before World War II, the aluminum company of America Alcoa was the only domestic U.S. producer of aluminum ingot from ore. It faced some competition from recyclers who produced aluminum ingot from scrap aluminum. Alcoa owed its dominant position to licenses that allowed it to use a low – cost production technique under patent protection, bit it maintained its position after the basic patent expired in 1909. In a suit alleging monopolization of the aluminum ingot market the government accused Alcoa of purchasing bauxite deposits beyond its own needs to deny potential competitors access to material necessary for the production of aluminum ingot. The government also alleged that Alcoa had signed contracts with public utilities designed to prevent competitors from purchasing low – cost electric power production of aluminum ingot requires a great deal of electric power. In the view of the courts the government did not succeed in proving that Alcoa had acted to preserve its monopoly.

But the courts did find that Alcoa had monopolized the aluminum ingot industry in violation of section 2 of the Sherman act. The critical factor was Alcoa’s continual expansion of capacity.

It was not inevitable that it should always anticipate increases in demand for ingot and be prepared to supply them. Nothing compelled it to keep doubling and redoubling its capacity before others entered the field. It insists that it never excluded competitors; but we can think of no more effective exclusion than progressively to embrace each new opportunity as it opened and to face every new comer with new capacity already geared into a great organization, having the advantage of experience trade connections and the elite of professional.

Discussion: This case began before the United States entered world war II. The U.S. government constructed a number of ingot plants during the war, and at the end of the war it sold the plants to various producers to promote competition.

This case shows the use of capacity expansion to maintain market position. Bat it raises disturbing policy question. Throughout this period, aluminum faced competition from other metals. There was no demonstration that Alcoa had earned more than a normal rate of return on its investment. What would Alcoa have had to do to avoid being found guilty of monopolization? Should it have restricted output, raised its price, and attracted new firms to the market? What sorts of signals does this decision send of business?

For consumer goods industries, vertical integration from manufacturing to wholesales and retail distribution facilities product differentiation, if only because it promotes the flow of information from consumers of producers. A firm that controls access to final consumers is in a strong position with respect to rivals, especially if that access cannot be duplicated without some sunk investment and some passage of time.

The policy questions raised by product differentiation as a competitive strategy are complex. R and D can create new and more satisfactory products, and advertising can give consumers information that will improve market performance. But these strategies will require costly expenditures and will have the additional effect of increasing market power for the firm that uses them successfully. As we will see in chapter 8, firms with market power are likely to invest too much, from a social point of view, in product differentiation.

Backward integration into the production into the production of the input ensures supplies and reduces the cost of coordinating activities at different stages of production undoubtedly a factor in the vertical integration of steel firms and iron mines. But a decision to integrate, even it made for reasons of efficiency, will have implications for the entry decision of rivals. A decision by a dominant firm to integrate vertically can place an entrant at a cost disadvantage and increase its sunk entry costs. U.S. steel’s control of iron supplies, for example, is thought to have played a pivotal role in maintaining its position during its long dominance of the steel industry.

Consider the plight of a firm considering entry into a manufacturing industry dominated by a vertically integrated firm. If the entrant comes in at the manufacturing level only, it will have to distribute its product through independent wholesalers and retailers. It will have to pay for their support, either directly or by offering the product to the distributor at a lower price recall the Vebco case study.