2. Consider the following Stackelberg model with 2 firms. Let firm 1 be the incumbent and firm
2 the potential market entrant.
• Incumbent firm faces a marginal cost of $c = 4$.
• Potential entrant faces a marginal cost of $c = 2$ and entry cost $F$.
• The market demand curve is $P = 12 - Q$.
• The incumbent decides $q_1$ first, then the potential entrant decides $q_2$. $q_2 = 0$ if firm 2
decides not to enter.
(a) What is the incumbent firm's monopoly price, quantity and profit? (10 Marks)
(b) Suppose $F = 0$. What are the equilibrium quantities and profits for both firms? What is
the equilibrium price? (10 Marks)
(c) For which values of $F$ is firm 2's entry into the market blockaded, accommodated or
preyed upon? When firm 2's entry is preyed upon, which quantity, $q_1$, does firm 1 use to
dissuade firm 2 from entering? (15 Marks)
(d) Suppose that now $F = 0$ naturally. That is, there no is barrier to entry for firm 2.
However, now suppose the firm 1 can spend $x$ on creating artificial barriers to entry. For
example, $x$ may be the cost of litigation over extending expiring patents. Let
$F(x) = \alpha \times x$ be the fixed entry cost for firm 2 when firm 1 spends $x$. For which values
of $\alpha$ does firm 1 prevent firm 2's entry? (15 Marks)
