The pay-offs to the new entrant are unchanged but for the incumbent firm profit is
lower in the absence of being challenged, since carrying spare capacity carries a cost.
Similarly, if the incumbent firm accepts the new entry, its profits are correspondingly
lower. If there is a price war, total output must be high and the spare capacity is being
used and is therefore not wasted. The best solution for the incumbent firm is still to
remain unchallenged, but in the event of entry its best solution now is to fight since the
cost is less in terms of lost profit. Previously there was no incentive for the incumbent
firm to resist entry but now there is and the new entrant knows that – resisting entry is a
‘credible threat’ since it is in the incumbent firm’s best interest. The new entrant is
deterred and equilibrium occurs in the bottom right-hand box.