Question

At a time when demand for ready-to-eat cereal was stagnant, a spokesperson for the cereal maker Kellogg’s was quoted as saying, “ . . . for the past several years, our individual company growth has come out of the other fellow’s hide.” Kellogg’s has been producing cereal since 1906 and continues to implement strategies that make it a leader in the cereal industry. Suppose that when Kellogg’s and its largest rival advertise, each company earns $1 billion in profits. When neither company advertises, each company earns profits of $6 billion.

If one company advertises and the other does not, the company that advertises earns $42 billion and the company that does not advertise loses $2 billion. For what range of interest rates could these firms use trigger strategies to support the collusive level of advertising?

Answer 1

To determine the range of interest rates for which trigger strategies could support the collusive level of advertising, one must analyze the profits and losses associated with advertising decisions in a monopolistic competition scenario and calculate present values under different strategies.

Step-by-step explanation:

The question investigates the dynamics of advertising strategies in the framework of monopolistic competition, particularly in relation to Kellogg's and its rivals. To determine the range of interest rates that would allow firms to use trigger strategies to support a collusive level of advertising, one has to consider the payoffs from both advertising and not advertising and compare it to the potential losses over time.

Given the profit matrix, the firms would prefer not to advertise and earn $6 billion each. However, if one advertises while the other does not, the advertiser will earn a significant profit while the non-advertiser incurs a loss. It becomes necessary to calculate the present value of future profits under collusive and non-collusive strategies and determine at which interest rates a trigger strategy, involving punishing a defector by reverting to a non-collusive outcome indefinitely, would make cheating on the collusive agreement unprofitable.