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Lecture

ECN 104 Lecture Notes - Sales Promotion, Herfindahl Index, Natural Monopoly


Department
Economics
Course Code
ECN 104
Professor
Tom Barbiero

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Answers to Assignment Nine
1. Consider the following payoff matrix in which the numbers indicate the profit in
millions of dollars for a duopoly based either on a high-price or a low-price
strategy.
Firm A
High-price Low-price
High-price
A = $500
B = $500
A = $650
B = $300
Firm B
Low-price
A = $300
B = $650
A = $400
B = $400
(a) What will be the result when each firm chooses a high-price strategy?
(b) What will be the result when Firm A chooses a low-price strategy while Firm
B maintains a high-price strategy?
(c) What will be the result when Firm B chooses a low-price strategy while Firm
A maintains a high-price strategy?
(d) What will be the result when each firm chooses a low-price strategy?
(e) What two conclusions can you draw about collusion?
(a) Each firm will earn $500 million in profit for a total of $1,000 million for the
two firms.
(b) Firm A will earn $650 million and Firm B will earn $300 million. Compared
to the high-price strategy, Firm A has an incentive to cut prices because it will
earn $150 million more in profit and Firm B will earn $200 million less in profit.
Together, the firms will earn $950 million in profit, which is $50 million less
than with a high-price strategy.
(c) Firm B has an incentive to cut prices because it will earn $650 million and
Firm A will earn $300 million. Compared to a high-price strategy, Firm B will
earn $150 million more in profit and Firm A will earn $200 million less in profit.
Together, the firms will earn $950 million in profit, which is $50 million less
than with a high-price strategy.
(d) Each firm will earn $400 million in profit for a total of $800 million for the
two firms. This total is $200 million less than with a high-price strategy.
(e) (1) The two firms have a strong incentive to collude and adopt the high-price
strategy because there is the potential for $200 million more in profit for the two
firms than with a low-price strategy, or the potential for $50 million more for the
two firms than with a mixed-price strategy.

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(2) There is also a strong incentive for each firm to cheat on the agreement
and adopt a low-price strategy when the other firm maintains a high-price
strategy because this situation will produce $150 million more in profit for the
cheating firm compared to honouring a collusive agreement for a high-price
strategy.
2. Why is the economic analysis of oligopoly so difficult? What two
generalizations can be made about the pricing behaviour of oligopolists?
Oligopoly is hard to analyze because it covers many different market situations.
There are both homogeneous and differentiated oligopolies. The number of
firms that dominate oligopolies can vary substantially, for example from two or
three firms to ten firms. Mutual interdependence among rivals also makes it
difficult to estimate a demand curve for a firm. Each firm must consider the
reaction of rivals in establishing its price policy.
Despite the difficulties of analyzing oligopolies, two important generalizations
can be made about this market structure. First, oligopolies tend to have
inflexible prices. Second, oligopolies tend to change price simultaneously.
3. An oligopoly producing a homogeneous product is composed of three firms that
act like a cartel. Assume that these three firms have identical cost schedules.
Assume also that if any one of these firms sets a price for the product, the other
two firms charge the same price. As long as they all charge the same price they
will share the market equally; and the quantity demanded of each will be the
same.
Below is the total-cost schedule of one of these firms and the demand schedule
that confronts it when the other firms charge the same price as this firm.
Complete the marginal-cost and marginal-revenue schedules facing the firm.
Total Marginal Quantity Marginal
Output cost cost Price demanded revenue
0 $ 0
1 60 $_____ $260 1 $_____
2 100 _____ 240 2 _____
3 160 _____ 220 3 _____
4 240 _____ 200 4 _____
5 340 _____ 180 5 _____
6 460 _____ 160 6 _____
7 600 _____ 140 7 _____
8 760 _____ 120 8 _____
(a) What price would be charged, what output would be produced, and what
profit would be made by this firm?
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