Consider a market for a homogeneous good with a market demand given by: Q = 10 –

Question

Consider a market for a homogeneous good with a market demand given by:

Q = 10 – P. There is an incumbent (Firm 1) and a potential entrant (Firm 2). The incumbent’s marginal cost is constant and equal to $2. The potential entrant’s marginal cost is also constant and equal to $2. In order to enter, the potential entrant has to incur an entry cost of $5 and, if it decides to enter, the two firms will compete in a Cournot fashion. If the potential entrant decides not to enter, its profit will be zero. Suppose that before the potential entrant decides whether or not to enter, the incumbent can invest $10 and lower its marginal cost to 0. Further assume that the potential entrant can observe the incumbent’s investment decision before it (i.e., the entrant) decides whether or not to enter.

Should the incumbent make the investment and lower its marginal cost? (10 marks)

Suppose now that when the entrant decides whether or not to enter he cannot observe the incumbent’s investment decision and he only learns about it if and after he enters (and before the firms simultaneously choose their quantities). Should the incumbent make the investment decision in this case? (10 marks)

Explanation / Answer

No in both scenarios 10 dollar investment to reduce marginal cost to 0 will not be justified.

Maximum demand can be only 10. In order to increase demand, prices would have to be lowered. Total price reduction will be far more than the marginal cost savings.

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