Consider a Cournot competition model with two firms. Inverse demand is given by p = 24 – Q. Firms have a marginal cost of 2c (c for the labor cost of one unit of output and c for the capital cost of one unit of output). Firm 2 has a fixed cost of f. Firm 1 has the possibility to give long-term labor contracts before its production decision up to an equivalent of K units of output. Everyone with a long-term contract cannot be fired.

The timing of the game is as follows. In period 1 firm 1 decides on K. In the beginning of period 2 firm 2 decides whether to enter or not. If he enters there will be Cournot competition in period 2; if there is no entry, firm 1 is a monopolist.

1. Derive the reaction function of firm 1 in period 2 when c=2 and K=7.

2. If f=0, derive the Cournot-Nash equilibrium in period 2 when c=2 and K=7.

3. Derive the Cournot-Nash equilibrium in period 2 for any K if f=0 and c=2.

4. Will firm 1 want to deter entry in case f=0 and c=2? If so, which K will it produce?

5. Will firm 1 want to deter entry in case c=2, f=30? If so, which K will it choose?

If c=3, for what values of f will the incumbent want to engage in entry deterrence?