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Direct and Strategic Effects: Cournot Competition Assessment 2 Answer

Question 2

Assume that firms engage in Cournot competition and explain the direct and strategic effects which arise from each of the following actions. Indicate whether the strategic effect is positive or negative. 

a) Firm A invests in R and D which reduces MC

b)Firm A and Firm B merge

c) An export subsidy is offered to firm A only



Answer 2: Strategic commitment

Two firms A and B engage in Cournot competition, the direct and strategic effects from each of the following actions are as follows:

  1. Firm A invests in R and D which reduced MC: In cournet model there are two firms in the market and they set their price and outputs at such levels that they are able to meet the demand of the market and maximize their individual profits. In case the Firm A reduces it MC, its MR will increase. Thus the firm can produce more quantity and can sell more quantity by reducing the price of the product keeping the profit margin same. This will result in more sales and hence more profit to Firm A. Firm B will not be able to sell the produced quantity and hence it will reduce the quantity produced. The two firms will readjust their outputs and reach the new equilibrium. The new equilibrium called the Cournet equilibrium is reached. 
  2. Firm A and Firm B merge: the new merged firm will be like a new firm in the Cournet model with the third firm as the competitor. The merged firm will be like the other firm in the industry and choose the output like other firm should do in Cournet Model. The non-merging firm will get a free riding opportunity as it gets the increase in quantity sold and profit by reduction in the number of firms.  

If there are N > 2 firms in the Cournet model and

M>=2 merge than the number of firms in the industry are N-M+1 

If the merged firm wants the profit to be more than their aggregate pre-merger profit there should be increase in demand in linear function which is very difficult for number of firms more than 3.

It should be that (A – c)2/[B(N – M + 2)] > M(A – c)2/[B(N+1)2
which requires that
(N + 1)2  > M(N – M + 2)

It is very difficult for the merger of two firms to be profitable in  Cournet model unless it creates a monopoly.  Thus as the impact the merged firm will have lower profits as compared to pre-merger profits.

An Export subsidy is offered to Firm A only: the competitor in duopoly Cournet market is based upon the assumption of competitor MC and output. In case where the export is subsidy is given only to Firm A, the other Firm B will expect lower MC of products of firm A and will expect higher output from Firm A. As the result firm B will reduce it output to bring the equilibrium in the market.  This will increase the profit of Firm A. The larger the subsidy to Firm A, the larger will be the profit of Firm A. The strategy helps the domestic firms with government subsidy in the market.  The foreign competitor expects the lower MC of the domestic company and expects it to produce higher quantity thereby reducing its output and leading to higher profits to the domestic firm (Collie, D. & Hviid, M., n.d).  

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