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PART II (4 points) Please evaluate the veracity and discuss each of the statements presented below.

Whenever appropriate provide examples. Question 1 (2 points): In a Stackelberg game moving first is always better than following. (max one and 1/2 pages).

In a Stackelberg game, that is a sequencial decision game where a firm (the leader) will move first and the other firm (the follower) will move after there can be advantages to moving second. Assuming homogenous firms and homogenous products a firm that moves first will gain an advantage if competing in quantities because as a leader it gets to set its equilibrium quantity and assuming this commitment is credible forces the follower to accept this as the equilibrium of the market because deviations will hurt the follower firm, naturally the leader will set an equilibrium with the highest possible profits for itself leaving the follower to pick up the scraps, the decisions of the firms are strategic substitutes, that is if one firm increases quantity it forces the other firm to respond by decreasing quantity. However should firms compete in prices under the same assumptions as before it is unlikely that the first mover will gain an advantage over the follower, the opposite is in fact more likely. Under Stackelberg price competition the leader will choose first and assuming that he chooses a price that is greater than its marginal costs (ie: that there is room to decrease the price) then the follower observing the action of the leader will naturally respond by setting its own price lower and gaining the upper hand in the market, the follower experiences second-mover advantage. In equilibrium the price of the good must be set equal to marginal cost by both firms because setting it higher than that will give the other firm the advantage and lower will bankrupt the company, this result is identical to Bertrand competition. Should products not be identical, but only broadly speaking similar then even under price competition there can be significant advantages to moving first depending on how much it costs the consumer to switch to a different (cheaper but still similar) alternative, a firm that enters the market after the leader will have to give consumers a very good deal as otherwise the switching costs will not compensate the move to the lower priced alternative.

Firms offering similar but not identical products can also gain first mover advantages through effects outside of their control, for example a first mover in an online business can capture network externalities that encourage more and more people to adopt their service and discourage users from moving to different services. If the firms themselves are not identical then there are other factors (unique to the firms) outside the games mechanisms themselves that can give the leading firm the upper hand, for example by virtue of being first to the market firms can optimize production techniques that they can keep secret giving them a lower cost curve than their competitors so that even under price competition they will have the upper hand. However being the first to develop technology or production process can be a double edged sword because if a follower firm can gain access to that technology then they can effectively free ride on the first movers investments giving them the advantage.

Question 2 (1 point): Although a monopolist has a smaller incentive to invest in a cost-reducing innovation than a perfectly competitive firm, at least it reduces the price it charges after the innovation, thereby benefiting consumers. (max one page)

In a competitive market the incentive to innovate is immense, a firm that successfully innovates gains an advantage over the rest of the market and should its competitors not be able to keep up it can leverage that advantage to gain market share and profit. Should its competitors be unable to match its innovations the innovating firm can even find it-self becoming a monopoly. The profit and market share a firm can gain from outdoing the competition and the disadvantages it can have from being outdone provide the primary incentive to innovate in a competitive market. The consumer will obviously benefit as the innovating firm will lower prices to try and gain market share and force all the other firms to do try and do the same.

It is interesting to note that in a perfectly competitive market with perfect knowledge diffusion there is no reward for innovation as the innovating firm will see its innovation immediately copied by all firms in the market and will thus never be rewarded for innovating, this is one of the justifications for a patent system. Se calhar apagamos este paragrafo para reduzir espao In the case of a monopolist firm things are not so clear, the firm faces no competition and so the primary incentive to innovate in a competitive market is gone, however the firm still has a profit motive as innovations that reduce costs will still lead to increased revenues for the company and facing a traditionally convex demand curve the company will still lower costs for consumers, in that sense innovation by a monopoly will still benefit consumers.

However the hypothesis that a monopoly will innovate is suspicious, after all innovation requires risk taking, it demands that the company incur costs today with the perspective of in the future making enough profits from their innovation to recoup those costs, it does not know at the moment it incurs costs if their investment will ever pay off. Faced with risks a monopoly may simply choose not to invest in innovation, the incentive of future profits without the threat of competitors overtaking it may not be enough to make a monopolist invest in cost cutting technology due to its natural risk aversion.

Question 3 (1 point): Selling a product below cost is predation. (max page)

Selling a product at below cost can be a strong indicator of predatory pricing, a firm that sells at below industry cost and has enough capital to absorb the losses that this practice entails can effectively take the entire market forcing others to leave or to go bankrupt if they try to keep up it is therefore appropriate that firms who engage in below cost pricing are put under scrutiny. In order for a predatory pricing strategy to succeed the firms that are expelled from the market must face significant barriers to re-entry when the predator decides to raise prices to reap the rewards of its strategy otherwise the predator will simply end up in a similar situation where it began and the losses it took from its predatory pricing will not be offset. However a firm may also have legitimate and not anti-competitive reasons to price goods at below cost and in some industries it has effectively become the norm to practice below cost pricing under re-occurring circumstances for example the clothing industry which has re-occurring sales periods where prices are cut to the bone in order to liquidate inventory it accumulated in a given season. These kind of huge sales are also part of a legitimate business strategy where a company will put certain goods on sale selling them potentially below cost in order to entice customers to visit its store this is seen in traditional industries such as supermarkets but also in new online stores such as amazon.com or the Steam games platform. A business may also choose to sell at below costs in order to liquidate its inventory before or in a desperate move to prevent closure; this practice is very often seen during recessions.

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