You are the manager of a firm that competes against four other firms by bidding

Question

You are the manager of a firm that competes against four other firms by bidding for government contracts. While you believe your product is better than the competition, the government purchasing agent views the products as identical and purchases from the firm offering the best price. Total government demand is Q = 1800 -8P and all five firms produce at a constant marginal cost of $110. For security reasons, the government has imposed restrictions that permit a maximum of five firms to compete in this market; thus entry by new firms is prohibited. A member of Congress is concerned because no restrictions have been placed on the price that the government pays for this product. In response, she has proposed legislation that would award each existing firm 20 percent of a contract for 760 units at a contracted price of $130 per unit. If this legislation is passed, by how much should you expect your profits to change?

Explanation / Answer

Firms are as of now under Bertrand competition. Under Bertrand competition, there is price competition. And Nash equilibrium occurs where each firm charges a price equal to the marginal cost of $110. Why? Because no firm has any incentive to deviate from this point. If any firm charges more than the marginal cost, then that firm will lose all market share to the other firm, as the good is homogenous. If any firm charges less than the price, it will get all the market share, but will lose some amount for each unit sold, and therefore end up making a loss. So the Nash equilibrium is the point where the price is $110. At this level no firm makes any profit.

But if the legislation is passed then each firm will get to supply 20% of 760, that is, 152 units, at the price of $130 per unit.

Total revenue of the firm = 130*152 = $19760

Total cost = $110*152 = $16720

Profit of the firm = $19760 - $16720 = $3040.

Therefore, the profits will rise by $3040.

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