Suppose that the Little Varmint Undergarment Corporation is a dominant firm in the market for children’s underwear. The firm is currently earning…

 Suppose that the Little Varmint Undergarment Corporation is a dominant firm in the market for children’s underwear. The firm is currently earning large economic profits due to its dominant position. However, these high economic profits have attracted the attention of a new firm. This firm is considering entering the industry. If it does so, the Little Varmint Undergarment Corporation will have to decide whether or not to fight a price war. The profits from fighting a price war (setting a low post-entry price) or accommodating entry (setting a high post-entry price) are given below with the Little Varmint undergarment Corporation’s profits listed first in each cell. What is the Nash equilibrium outcome? Explain. Potential Entrant     Enter  Stay Out

High Post- 50, 10  90, 0   Entry Price Little Varmint Undergarment Corporation   Low Post- 30, -10   70, 0   Entry Price

Now, suppose that Little Varmint is considering a strategic move to limit entry. It is considering installing capacity beyond what it needs if the potential entrant remains out of the industry. This extra capacity will be costly unless entry occurs and a price war breaks out. Thus, it lowers Little Varmint’s profits by $X unless this occurs. On the other hand, this extra capacity makes it easier to fight a price war if entry does occur. Let’s suppose that the extra capacity increases Little Varmint’s profits and lowers the potential entrant’s profits by $Y if entry occurs and a price war breaks out. This means that if the capacity is installed, the profit rates will become:

Potential Entrant     Enter  Stay Out

High Post- 50-X, 10 90-X, 0   Entry Price Little Varmint Undergarment Corporation   Low Post- 30+Y, -(10+Y)  70, 0   Entry Price Suppose that Y = 5 and X = 20. Should Little Varmint install the extra capacity? Why or why not? Suppose that Y = 5 and X = 10. Should Little Varmint install the capacity?  Why or why not?

 
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