There is an incumbent monopolist (I) and a potential entrant (E) in the Maryland soap market. Soap is homogenous and market inverse demand is P = 150 - Q where Q is total output. The firms move as follows:
Period 1: I can spend $K to reduce its marginal cost from 40 to 20.
Period 2: E observes what I spent in the first period and then decides whether to pay F to enter the market. If it enters it has a marginal cost of 40.
Period 3: If E has entered the firms compete Cournot. Otherwise I chooses its output as a monopolist.
[Note: here the incumbent just has two options in period 1, so it is simpler than the Dixit model (where the choice was continuous): spend $K and have marginal cost of 20, dont spend $K can have marginal cost of 40].
(i) For what values of F can entry not be deterred? (i.e. for what values of F will E enter even if I has invested?)
(ii) Suppose F = 2000. Is entry blockaded? (i.e., will E enter if I does not invest?)
(iii) If F = 0; so entry happens for sure, for what values of K will I choose to invest?
(b) It has been widely noted that when Southwest Airlines becomes a potential entrant on an airline route, but is not yet serving it, incumbent carriers cut prices significantly.
(i) What type of strategic investment model might explain this type of pattern?
(ii) What might be another explanation for this pattern? [Hint: we did not discuss possible explanations in class, so this your chance to be creative]