Entry Deterrence and Product Differentiation

Problem set 5 - 2014

2. (Entry deterrence by investments in R&D) [Optional assignment]
Firm 1 has an initial cost function of TC (q1 ) 5q1 and is the incumbent in a
market with an inverse demand curve p 10 Q . Firm 1 expects a potential
entrant, Firm 2. The entrant operates with the same cost function,
TC (q2 ) 5q2 , but has to bear an additional sunk entry cost of E 0 . Before
Firm 2 enters, Firm 1 can take some entry deterring measures however.
In particular, it can invest 8 monetary units in R&D in order to reduce its
production costs to TC (q1 ) 3q1 .
Let us investigate the situation in a two-stage game with the following
order of moves: first, Firm 1 decides whether to invest or not, then Firm 2
enters the market or stays out. Profits are determined afterwards,
assuming that the firms are competing in quantities a la Cournot.
(a) Draw an extensive-form representation of the game. Find the profits of
the two firms for each possible outcome of the game and add the profit
terms to the game tree.
Case 1: Firm 1 invests, Firm 2 enters
As Firm 1 invests and Firm 2 enters, this means that we are dealing with
Cournot competitors with different cost functions. We are dealing with a
Stackelberg game in which Firm 1 is the leader and Firm 2 is the
follower.
For Firm 2, we find the following profit function:
2 = P*Q2 c*Q2
2 = (10 Q1 Q2)Q2 5*Q2
2 = 10Q2 Q22 Q2Q1 5Q2
2 = 5Q2 Q22 Q2Q1
Setting Firm 2s marginal revenue equal to its marginal cost and solving
for Q2, the reaction function for firm 2 is:
TR = 10Q2 Q22 Q2Q1
MR = 10 2Q2 Q1
MC = TC/Q2 = 5
10 2Q2 Q1 = 5
2Q2 = 5 Q1
Q2 = 2.5 0.5Q1
For Firm 1, we find the following profit function:
1 = P*Q1 c*Q1 8 (investment)
1 = (10 Q1 Q2)Q1 3*Q1 8
firm invests
1 = 10Q1 Q12 Q2Q1 3Q1 8

c = 3 as the

Firm 1, however, need not and will not take Q2 as given. Firm 1 can
predict that if Firm 2 is maximizing its profits, it will follow the strategy
of choosing Q2* by Q2* = R2(Q1).
If we substitute Q2* = R2(Q1) into the market demand curve, the demand
curve that Firm 1 faces, taking into account the quantity response by firm
2, is:
P1(Q1) = 10 Q1 (2.5 0.5Q1)
P1(Q1) = 7.5 0.5Q1
If we substitute this equation into the profit function of Firm 1, we get:
1 = (7.5-0.5Q1)*Q1 c*Q1 8 (investment)
1 = 7.5Q1-0.5Q12 c*Q1 8
Firm 1 finds its profit-maximizing output by setting its marginal revenue
equal to marginal cost.
Marginal revenue: first derivative of total revenue (TR).
TR = 7.5Q1-0.5Q12
MR = TR/Q1 = 7.5 Q1
MC = TC/Q1 = 3
MR = MC
7.5 Q1 = 3
Q1 = 4.5
Q2 = 2.5 0.5*4.5 = 0.25
P = 10 4.5 0.25 = 5.25
The profits:
1 = P*Q1 c*Q1 8 (investment)
1 = 5.25*4.5 3*4.5 8
1 = 23.625 13.5 8
1 = 2.125
1 = 17/8
2 =
2 =
2 =
2 =
2 =

P*Q2 c*Q2
5.25*0.25 5*0.25
0.252
0.0625
1/16

Case 2: Firm 1 invests, Firm 2 stays out

When Firm 2 stays out, Firm 1 remains the monopolist in the market.
As Q2 = 0, we get the following functions for Firm 1:
TR
TR
TR
TC

=
=
=
=

P*Q1
(10 Q1)Q1
10Q1 Q12
3Q1

The MC function of Firm 1 is the first derivative of TC with respect to Q1:

2

TC/Q1 = 3
firm has invested

We use TC = 3Q1 as the

The MR function of Firm 1 is the first derivative of TR with respect to Q1:

TR/Q1 = 10 2Q1
Setting MR = MC, we get:
10 2Q1 = 3
2Q1 = 7
Q1 = 3.5
P = 10 3.5 = 6.5
The profit function of Firm 1 is:
1 = P*Q1 c*Q1 8 (investment)
If we fill in the Q1 and P we just found, we get:
1 = 6.5*3.5 3*3.5 8
1 = 3.52 8
1 = 12.25 8
1 = 4.25
1 = 17/4
As Firm 2 stays out, the profits of Firm 2 are equal to zero: 2 = 0.
Case 3: Firm 1 does not invest, Firm 2 enters
As Firm 1 does not invest and Firm 2 enters, this means that we are
dealing with Cournot competitors with the same cost functions. We are
dealing with a Stackelberg game in which Firm 1 is the leader and Firm
2 is the follower.
For Firm 2, we find the following profit function:
2 = P*Q2 c*Q2
2 = (10 Q1 Q2)Q2 5*Q2
2 = 10Q2 Q22 Q2Q1 5Q2
2 = 5Q2 Q22 Q2Q1
Setting Firm 2s marginal revenue equal to its marginal cost and solving
for Q2, the reaction function for firm 2 is:
TR = 10Q2 Q22 Q2Q1
MR = 10 2Q2 Q1
MC = TC/Q2 = 5
10 2Q2 Q1 = 5
2Q2 = 5 Q1
Q2 = 2.5 0.5Q1
For Firm 1, we find the following profit function:
1 = P*Q1 c*Q1
1 = (10 Q1 Q2)Q1 5*Q1
firm invests
1 = 10Q1 Q12 Q2Q1 5Q1

c = 5 as the

Firm 1, however, need not and will not take Q2 as given. Firm 1 can
predict that if Firm 2 is maximizing its profits, it will follow the strategy
of choosing Q2* by Q2* = R2(Q1).
If we substitute Q2* = R2(Q1) into the market demand curve, the demand
curve that Firm 1 faces, taking into account the quantity response by firm
2, is:
P1(Q1) = 10 Q1 (2.5 0.5Q1)
P1(Q1) = 7.5 0.5Q1
If we substitute this equation into the profit function of Firm 1, we get:
1 = (7.5-0.5Q1)*Q1 c*Q1
1 = 7.5Q1-0.5Q12 c*Q1
Firm 1 finds its profit-maximizing output by setting its marginal revenue
equal to marginal cost.
Marginal revenue: first derivative of total revenue (TR).
TR = 7.5Q1-0.5Q12
MR = TR/Q1 = 7.5 Q1
MC = TC/Q1 = 5
7.5 Q1 = 5
Q1 = 2.5
Q2 = 2.5 0.5*2.5 = 1.25
P = 10 2.5 1.25 = 6.25
1 = P*Q1 c*Q1
1 = 6.25*2.5 5*2.5
1 =15.625 12.5
1 = 3.125
1 = 25/8
2 =
2 =
2 =
2 =
2 =

P*Q2 c*Q2
6.25*1.25 5*0.25
1.252
1.5625
25/16

Case 4: Firm 1 does not invest, Firm 2 stays out

When Firm 2 stays out, Firm 1 remains the monopolist in the market.
As Q2 = 0, we get the following functions for Firm 1:
TR
TR
TR
TC

=
=
=
=

P*Q1
(10 Q1)Q1
10Q1 Q12
5Q1

The MC function of Firm 1 is the first derivative of TC with respect to Q1:

TC/Q1 = 5
We use TC = 5Q1 as the
firm has invested
The MR function of Firm 1 is the first derivative of TR with respect to Q1:
4

TR/Q1 = 10 2Q1
Setting MR = MC, we get:
10 2Q1 = 5
2Q1 = 5
Q1 = 2.5
P = 10 2.5 = 7.5
The profit function of Firm 1 is:
1 = P*Q1 c*Q1
If we fill in the Q1 and P we just found, we get:
1 = 7.5*2.5 5*2.5
1 = 2.52
1 = 6.25
1 = 25/4
As Firm 2 stays out, the profits of Firm 2 are equal to zero: 2 = 0.

We arrive at the following extensive form:

The profits of Firm 1 are denoted in red; the profits of Firm 2 are denoted
in blue.
(b) Suppose, for the moment, that there wouldnt be the threat of entry by
Firm 2. Would Firm 1 invest into the R&D project?
5

If there is no threat of entry by Firm 2, Firm 1 has to choose between the

following two scenarios:
Firm 1 invests, Firm 2 stays out
Firm 1 does not invest, Firm 2 stays out
This leads to the following edited extensive form:

The first scenario yields profits of 17/4: the second scenario yields profits
of 25/4.
As 25/4 > 17/4, Firm would choose not to invest into the R&D project
when there is no threat of entry by firm 2.
Investigate the entire game in the following:
(c1) For which values of the entry cost E is a situation of Blocked Entry
the Subgame Perfect Nash equilibrium of the game, i.e. a situation where
the Entrant would not enter irrespective of the R&D investment?
In a situation of Blocked Entry, all the payoffs of Firm 2 should be equal
to or smaller than zero.
The profits of Firm 2 are already zero if Firm 2 does not enter.
If Firm 1 invests and Firm 2 enters, the profits of Firm 2 are 1/16.
If Firm 1 does not invest and Firm 2 enters, the profits of Firm 2 are
25/16.
With entry cost E of E25/16, we get:
If Firm 1 invests and Firm 2 enters, the profits of Firm 2 are equal to or
smaller than -24/16
-24/16
If Firm 1 does not invest and Firm 2 enters, the profits of Firm 2 are
equal to or smaller than 0 0
As in both cases the profits of Firm 2 are 0, there is a situation of
Blocked Entry: Firm 2 would not enter irrespective of the R&D
investment.
We assume that if the profits are zero, a firm decides not to enter.
6

Firm 2 will never choose to enter because profits in case of entering are
lower than in case of staying out.
As Firm 1 anticipates this, it will choose not to invest because profits are
higher in case it does not invest and Firm 2 stays out than in the case it
invests and Firm 2 stays out (25/4 > 17/4).
(c2) For which entry costs is a situation of Accommodated Entry the
Subgame Perfect Nash equilibrium, i.e. a situation where the Entrant
enters irrespective of the R&D investment?
In a situation of Accommodated Entry, the payoffs of Firm 2 should be
bigger than zero in case of entry.
If Firm 1 invests and Firm 2 enters, the profits of Firm 2 are 1/16.
If Firm 1 does not invest and Firm 2 enters, the profits of Firm 2 are
25/16.
With entry cost E of 0<E<1/16, we get:
If Firm 1 invests and Firm 2 enters, the profits of Firm 2 between 0 and
1/16 0 < < 1/16.
If Firm 1 does not invest and Firm 2 enters, the profits of Firm 2 are
between 24/16 and 25/16 24/16 < < 25/16.
As in both cases the profits of Firm 2 are >0, there is a situation of
Accommodated Entry: Firm 2 enters irrespective of the R&D investment.
Firm 2 will always choose to enter because profits in case of entering are
higher than in case of staying out.
As Firm 1 anticipates this, it will choose not to invest because profits are
higher in case it does not invest and Firm 2 enters than in the case it
invests and Firm 2 enters (25/8 > 17/8).

(c3) For which entry costs is a situation of Deterred Entry the Subgame
Perfect Nash equilibrium, i.e. a situation where the Entrant enters only, if
the incumbent has not done the R&D investment?
In a situation of Deterred Entry, the payoffs of Firm 2 should be bigger
than zero in case Firm 1 has not invested and should be equal to or
smaller than zero if Firm 1 has invested.
If Firm 1 invests and Firm 2 enters, the profits of Firm 2 are 1/16.
If Firm 1 does not invest and Firm 2 enters, the profits of Firm 2 are
25/16.
With entry cost E of 1/16 E > 25/16, we get:
If Firm 1 invests and Firm 2 enters, the profits of Firm 2 are between
-24/16 and 0, including 0 -24/16< 0.
If Firm 1 does not invest and Firm 2 enters, the profits of Firm 2 are
between 0 and 24/16, including 24/16 0 < 24/16
7

As the profits of Firm 2 are only >0 if Firm 1 has not invested, there is a
situation of Deterred Entry: Firm 2 enters only if Firm 1 has not done the
R&D investment.
Firm 2 will only choose to enter in case Firm 1 has not invested.
As Firm 1 anticipates this, it will choose to invest because profits are
higher in case it invests (and Firm 2 stays out) than in case it does not
invest (and Firm 2 enters): 17/4 > 25/8.