Allocating cost reducing investmentsover competing divisions

This paper examines a three-stage model of divisionalization where, first, two parentfirms create independent units, second, the parent firms allocate cost reduction levelsover these units, and third, the resulting units compete in a Cournot market given theircurrent costs of production. The introduction of the cost reduction phase is shown toreduce the incentives toward divisionalization severely, relative to other existingmodels. Namely, the scope for divisionalization in equilibrium reduces as themarginal cost of the cost reducing investment decreases, and eventually vanishes. Asecond-best welfare analysis shows that, for any given market structure, theequilibrium investment decisions of the parent firms are socially optimal. In addition,to no divisionalization outcome is sustainable in equilibrium only if it is sociallyoptimal....