Allocating cost reducing investments over competing divisions

This paper examines a three-stage model of divisionalization where,first, two parent firms create independent units, second, the parent firms allocate costreduction levels over these units, and third, the resulting units compete in a Cournotmarket given their current costs of production. The introduction of the cost reductionphase is shown to reduce the incentives toward divisionalization severely, relative toother existing models. Namely, the scope for divisionalization in equilibrium reducesas the marginal cost of the cost reducing investment decreases, and eventually vanishes.A second-best welfare analysis shows that, for any given market structure, theequilibrium investment decisions of the parent firms are socially optimal. In addition,the no divisionalization outcome is sustainable in equilibrium only if it is sociallyoptimal. (JEL classification: L11, L13, L22).