Mini Case Study: Emerging Competition and its Effects on Equilibrium

In the city of Utopia, the computer industry is dominated by two players: Apenx (AP) and Avonx (AV). The two firms have distinguished themselves in niche categories, AP in computer chips and AV in computer software. Both markets have been very lucrative mainly because of lack of competition. The success of both companies causes their executive management to reflect on the basis of their objectives. AV believes it best to focus on profit maximization theory as the method for determination of the point where maximum profit is attained. AP counters that the "general scientific methodology" is an over-simplification of business into two simple variables (i.e., marginal revenue and marginal costs) and makes the theory useless. In 2009, a new company, Allnox motivated by profits in the computer software industry, became Avonx's competitor; both companies make an identical product and have the same cost function. Both firms decide independently, and without knowledge of the other's choice, the quantity of computer software to produce each week. As a strategy to earn higher profits, Allnox decided to increase its price. It only realized later that it will lose 60% of its customers and sales to other firms if it does. By the year 2020, a few more firms entered the industry because of improvements in technology and globalization. The Government of Utopia employs an economist in 2021 to study the complete system of all markets in the economy, assuming that each market is perfectly competitive. One reason the Government was interested in modeling all markets jointly is to determine how to allocate the resources of the economy efficiently. The economist's findings led the Government to introduce corporation taxes. As a consequence, profits in the industry eroded over time, causing some firms to exit the market.

Question 1. Why did Allnox's strategy cause Avonx to gain 60% of both its sales and customers? Discuss [be sure to clearly state the theory used to support your answer]