Allocating cost reducing investments over competing divisions

This paper examines a three-stage model of divisionalization wher, first, two parents firms create independent unts, second, the parents firms allocate cost reducing levels over these units, and third, the resulting uits compete in a Cournot mrket given their current costs of production. The introduction of the cost reduction phase is shown to reduce the incentives toward divisionalization severely, relative to other existing models. Namely, the scope for divisionalization in equilibrium reduces as the marginal cost of the cost reducing investment decreases, and eventually vanishes. A second-best welfare analysis shows that, for any given market structure, the equilibrium investment decisions of the parent firms are socially optimal. In addition, the no divisionalization outcome is sustainable in equilibrium only if it is socially optimal.