On cost-cutting incentives

Reducing costs remains an important objective of business strategy, driving choices such as production process redesign, technology adoption, and outsourcing. This paper examines how the intensity of price competition affects firms' marginal benefits from lowering per-unit variable costs in a differentiated-products duopoly. Applying the conjectural-variations framework, we show that symmetric firms face a non-monotonic relationship between competitive intensity and their marginal benefits from cost reduction. In contrast, when there are significant asymmetries in firms' initial costs, this relationship becomes monotonic, which may differ in directions across competing firms. We also show that while higher competitive intensity increases the social welfare gain from a firm's cost reduction in case of symmetric firms, it can increase or decrease the social welfare change from a firm's cost reduction in case of asymmetric firms.