In New Yotk, the demand for bottled spring water is given by Q = 121 − 1/2P . There is one known spring in town controlled by the bottler First Spring (FS). In other words, FS is a monopolist in the market for spring water. FS’s cost of production for gallons of water is C(Q) = 2Q. Suppose now that a new spring is discovered in State College. A bottler called New Spring (NS) gains exclusive rights to this spring and is deciding whether or not to set up operations and compete with FS. If NS decides to join the market, NS and FS will be Cournot competitors. Both firms will face the same production costs, whereby C(Q) = 2Q. Nevertheless, NS will have to pay a one time set up cost of $2,000.
1. Suppose that consumers created a Spring Water Authority (SWA) that would subsidize set up costs for new entrants. This subsidy would be funded directly (e.g. dollar-for-dollar) out of consumers’ surplus. Would consumers want the SWA to subsidize the set-up costs for New Spring? What would be the optimal amount of this subsidy? Explain.
2. Suppose that some time after New Spring is in operation, 3rd Spring is discovered near State College. 3rd Spring faces the same technology as its predecesors (e.g. C(Q) = 2Q) and a setup cost of $3,600. Would consumers vote to subsidize 3rd Spring’s set up costs? If so, what is the optimal level of subsidy?