Question

Assume Company A has created a new market segment for specialized equipment. Suppose the inverse demand is given by P=56-2Q and costs are given by TC=20qi+40 How much would company A have to increase fixed cost to make an entry for a potential competitor (Company B) unprofitable? Provide a numerical value for Fixed Costs. (Hint: Put differently, how much would Company A need to increase fixed costs in order for TTM=0?) Company A knows that the entrant has identical costs and creates identical value for the consumers of specialized equipment. Using game theory, explain whether market entry will occur from the side of the competitor.

Answer 1

For an entry of a potential competitor to be unprofitable, the fixed cost would need to rise to meet the intersection of total cost and demand curves. This occurs for:

56−2Q=20Q+40

=> Q=0.73

Initial fixed costs = $40 (from TC function)

The fixed cost at Q =0.73 => FC=20(0.73)+40= $54.6

As both the firms have identical costs and value creation, so both of them have the possibility to have a good market share, with profits maximized when they cooperate under game theory. So, competitor will make an entry in the market to leverage profits.

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