Question: The VaVaVoom model is a complete success in Europe and thus the Renault CEO believes that they should expand the production of this car and market it on a global scale. The number of competitors in this class is enormous and it leads you to the assumption that this new global market in which you are expected to operate is perfectly competitive.

(a) Do you expect Renault to earn Supernormal profits in the long run? Explain this to the manager through the use of the perfectly competitive model.

(b) The CEO makes a wise decision, and decides to remain in the European market. Here, VaVaVoom’s main competitor is the Frescoli, produced by Renaults’ main rival in this market, Fiat. A degree of rivalry has built up between both firms over the years. Your own firm, Renault, and your rival, Fiat, are deciding whether to manufacture a sports version of the respective car models. Given your past success you have been drafted in to decide on Renault’s strategy. The two options are, manufacture an expensive sports version of the VaVaVoom or manufacture a cheap version of the VaVaVoom . Fiat also has these two strategies open to it for their Frescoli model. You work out the following information.

If Renault and Fiat build an expensive sports model, each earns €900,000 in profits. If Renault builds an inexpensive model Fiat builds an expensive model, Renault earns €2.5 million and Fiat earns - €250,000. If Fiat builds an inexpensive model and Renault builds an expensive model, Fiat earns €2.5 million and Renault earns - €250,000. If both firms build an inexpensive model, then both earn €750,000.

(i) Construct the payoff matrix based on the data above

(ii) Explain in detail to the CEO the dominant strategies of both firms and the Nash equilibrium

(iii) How will the equilibrium condition change if the CEO suggests a new strategy of manufacturing a medium priced sports version of the VaVaVoom. Suppose there is a leakage of this suggested plan through industrial espionage and Fiat also consider the third strategy of manufacturing a medium priced sports version of the Frescoli. The payoffs of each strategy are related in the matrix below.

Find the new equilibrium/equilibria. Explain in detail how you reach your results.

(c) You now suggest to the CEO that the completion between Renault and Fiat is hindering the profit making potentials of both firms. As a result, you suggest that Renault should cooperate with Fiat in a bid to set prices and earn additional profits. Outline and explain to the CEO the factors that would favour and hinder coordination between the two firms.

(d) The legal implications of a cartel situation are too onerous for the CEO; however, one proposal is that Fiat and Renault could merge their production activities. This potential merger would result in the following market shares: A merged Renault and Fiat Company – 61 %, Opel – 23%, Skoda – 10% and Volvo – 6%.

(i) You must compute the Herfindahl Index for the proposed market situation.

(ii) You think, based on your result, that that the competitive arm of the European Commission would have serious concerns over the merger. Explain why.

(iii) You now suggest that this market definition could be altered to show a more favourable situation.

How and why would this change the Herfindahl?