Write in a 600 word academic essay. a. Consider the iron ore production industry

Question

Write in a 600 word academic essay.

a. Consider the iron ore production industry, and assume that there are just two producers, FM and BHP. Initially assume that both firms are identical in terms of their production costs. If the two firms can cooperate, what should they do in order to maximise industry profits? How does your answer change if: (i) price discrimination is feasible; or (ii) the two firms have different costs of production? If you are working as a consultant for the ACCC, how would you view cooperation between the two iron ore producers?

b. Now assume that each firm is free to set its production level, but each firm can communicate (via the business press) what they plan to do first. Using an economic model, show that it might be difficult to sustain a cooperative (high-profit) outcome. Given this, how credible do you view any statement on capacity by Twiggy? What do you anticipate would be the impact of the entry of another producer (who we can call RT)?

c. Thinking more broadly than iron ore, how can two oligopolists try to avoid being caught in a competitive outcome? Are any of these relevant for the iron ore industry?

Explanation / Answer

a. When the two firms cooperate and they have same marginal cost function, each firm should produce exactly half the the output level where the marginal revenue curve (derived from market demand curve) intersects a single firm's marginal cost curve (which will also be the industry's marginal cost curve since the marginal costs of both the firms are same). In other words, they should together produce a level of output that would be produced if the market were to be served by a monopolist, and the output level should be split in half.

As shown in the above figure, the firms should charge price P* and equally split the output Q* demanded at this price.

(i) In case price discrimination is possible, the firms should maximize industry profits by charging each consumer its maximum willingness to pay, and then split in half the production of the output level Q** at which the marginal cost curve intersects the market demand curve.

(ii) If two firms have different production costs, then at first, the joint output will be decided the same way as before. That is, the firms will together produce at the output level where the marginal revenue curve (derived from market demand curve) intersects the industry's marginal cost curve. (The industry's marginal cost curve is found by (i) finding an expression for the indistry's total cost function and then (ii) differentiating it with respect to output.) But the output to be produced jointly will not be split in half by the duopolists. Each firm will produce at a level such that the marginal cost of the one firm equals the marginal cost of the other firm.

Antutrust laws are often against the formation of cartels, as they are often detrimental to the health of an economy and result in inefficiency. But in certain situations, cartels can be authorised by ACCC when they can potentially bring benefit to the society, such as large scale cost efficiency. Except for those situations where a cartel may bring about benefit to a society, ACCC consultants are unlikely to see any cartel in positive light and are thus likely to get the cartel between FM and BHP prohibited, possibly with a heavy penalty.

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