Two firms compete in a homogeneous product market where the inverse demand funct

Question

Two firms compete in a homogeneous product market where the inverse demand function is P = 20 -5Q (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 $1.2 million regardless of its production decision. Firm 1’s marginal cost is $2, and Firm 2’s marginal cost is $10. The current market price is $15 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?

( ) Learning curve effects

( ) Second-mover advantage

( ) Direct network externality

( ) Limit pricing

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 $10 while Firm 2 continued to charge $15?

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 $10, 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?

( ) Yes

( ) No

e. Is Firm 1 engaging in predatory pricing when it cuts its price from $15 to $10?

( ) Yes

( ) No

Explanation / Answer

Ans
a)Firms 1's marginal cost is lower than that of firm 2 because of
Learning curve effects.

b)P=20-5Q
P=15
15=20-5Q
Q=1
Each firm has 50% of mrket share then each produce
0.5 quantity.
Q1=Q2
TR for firm 1= p.Q1=15*0.5=7500000
TC for firm 1=Q.MC + 1200000=1000000+1200000=2200000
profit for firm 1=TR-TC
=7500000-2200000
=5300000

TR for firm 2=p.Q2=15*0.5=7500000
TC for firm 2=Q.MC + 1200000=5000000+1200000=6200000
profit for firm 2=TR-TC
=1300000

c)TR for firm 1= p.Q1=10*0.5=5000000
TC for firm 1=Q.MC + 1200000=1000000+1200000=2200000
profit for firm 1=TR-TC
=5000000-2200000
=2800000

Since firm 2 does not change his price his profits will
remain at 1300000

d)Yes

e)Yes

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