Two firms compete in a homogeneous product market where the inverse demand funct
ID: 1195635 • Letter: T
Question
Two firms compete in a homogeneous product market where the inverse demand function is P = 10 -2Q (quantity is measured in millions). Firm 1 has been in business for one year, while Firm 2 just recently entered the market. Each firm has a legal obligation to pay one year’s rent of $0.4 million regardless of its production decision. Firm 1’s marginal cost is $2, and Firm 2’s marginal cost is $6. The current market price is $8 and was set optimally last year when Firm 1 was the only firm in the market. At present, each firm has a 50 percent share of the market.
a. Based on the information above, what is the likely reason that Firm 1’s marginal cost is lower than Firm 2’s marginal cost?
b. Determine the current profits of the two firms.
Instruction: Round all answers to the nearest penny (two decimal places).
Firm 1's profits: $ million
Firm 2's profits: $ million
c. What would each firm’s current profits be if Firm 1 reduced its price to $6 while Firm 2 continued to charge $8?
Instruction: Round all answers to the nearest penny (two decimal places).
Firm 1's profits: $ million
Firm 2's profits: $ million
d. Suppose that, by cutting its price to $6, Firm 1 is able to drive Firm 2 completely out of the market. After Firm 2 exits the market, does Firm 1 have an incentive to raise its price?
e. Is Firm 1 engaging in predatory pricing when it cuts its price from $8 to $6?
(Click to select)YesNo
Explanation / Answer
Answers:
(a) The reason why Firm 1's marginal cost is lower compared to Firm 2 is because of the "Learning curve effects". A firm that has been in the market for a longer time is bound to gain from its experience and therefore the costs woud be lower.
(b) In the absence of any additional data, we will have to assume that Variable Cost (or operating cost) is equal to Marginal Cost (or the cost of producing any additional unit). We are assuming a long-run situation here.
Based on the inverse demand function
P = 10 - 2Q (Q is quantity in millions)
P = price = $8
Therefore,
For Firm 1
Q = (10 - P)/2 = 2/2 = 1 million
Profit = Total Revenue - Total Cost
Total Revenue = Selling Price x Quantity = 8 x 1 million = $8 million
Total Cost = Fixed Cost + Variable Cost x Q
Fixed Cost for Firm 1 = 0.4 million
Variable Cost = $2
Total Cost = 0.4 + $2 x 1 million = $2.4 million
Therefore, Profit = $8 million - $2.4 million = $5.6 million
For Firm 2
Total Revenue = $8 x 1 million = $ 8 million
Total Cost = 0.4 million + $6 x 1 million = $6.4 million
Profit = $8 million - $6.4 million = $1.6 million
(c) if P = $6 for Firm 1 and $8 for Firm 2 then,
For Firm 1
Q = (10 - 6)/2 = 2 million
Total Revenue = $6 x 2 million = $12 million
Total Cost = $0.4 million + $2 x 2 million = $4,4 million
Profit = $12 million - $4.4 million = $7.6 million
For Firm 2
Q = (10 - 8)/2 = 1 million
Total Revenue = $8 x 1 million = $8 million
Total Cost = $0.4 million + $6 x 1 million = $6.4 million
Profit = $8 milion - $6.4 million = $1.6 million
(d) After Firm 2's exit, Firm 1 would have a monopoly in the market and therefore the customers will become price takers. Therefore Firm 1 would surely benefit by increasing the price.
(e) Yes, Firm 1 is engaging in predatory pricing by reducing the price to $6. The reason being, the Marginal cost for Firm 2 is $6. Firm 2 cannot survive if the price is at or below $6.
Related Questions
drjack9650@gmail.com
Navigate
Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.