Incentive Compatible Collusion and Investment

Hongbin Cai

and

Uday Rajan

We consider a two-stage model in which two firms first invest in R & D to reduce their marginal production costs, and then either compete or collude in the output market. When they collude, they bargain over a cartel agreement to divide the collusive profit. If bargaining breaks down, they revert to duopolistic competition. For both a location model and a linear demand model, we show that firms invest more in R & D in the first stage under collusion than under competition. We demonstrate via example that social welfare may be greater under collusion than under competition in the location model.