Defendo has decided to introduce a revolutionary video game. As the first firm in the market, it will have a monopoly position for at least some time. In deciding what type of manufacturing plant to build, it has the choice of two technologies. Technology A is publicly available and will result in annual costs of
CA(q)  10  8q
Technology B is a proprietary technology developed in Defendo’s research labs. It involves a higher fixed cost of production but lower marginal costs:
CB(q)  60  2q
Defendo must decide which technology to adopt. Market demand for the new product is P  20  Q, where Q is total industry output.
a. Suppose Defendo were certain that it would maintain its monopoly position in the market for the entire product lifespan (about five years) without threat of entry. Which technology would you advise Defendo to adopt? What would be Defendo’s profit given this choice?
b. Suppose Defendo expects its archrival, Offendo, to consider entering the market shortly after Defendo introduces its new product. Offendo will have access only to Technology A. If Offendo does enter the market, the two firms will play a Cournot game (in quantities) and arrive at the Cournot-Nash equilibrium.
i. If Defendo adopts Technology A and Offendo enters the market, what will be the profit of each firm? Would Offendo choose to enter the market given these profits?
ii. If Defendo adopts Technology B and Offendo enters the market, what will be the profit of each firm? Would Offendo choose to enter the market given these profits?
iii. Which technology would you advise Defendo to adopt given the threat of possible entry? What will be Defendo’s profit given this choice? What will be consumer surplus given this choice?
c. What happens to social welfare (the sum of consumer surplus and producer profit) as a result of the threat of entry in this market? What happens to equilibrium price? What might this imply about the role of potential competition in limiting market power?