Homework 8:Monopolistic Competition/Oligopoly (to be handed in on Thursday15th April)

  1. What are the key characteristics of a monopolistically competitive market? Some experts have argued that too many brands of breakfast cereal are on the market. Give an argument to support this view, and an argument against this view. (1.5 points)
  1. Explain the meaning of a Nash equilibrium when firms are competing with respect to price, and give an example. Why is the equilibrium stable? Why don’t the firms raise prices to the level that would maximize joint profits? (1.5 points)
  1. “Because firms in any industry can always make greater profits by colluding, there is an inevitable tendency for competitive industries to become cartels over time”. Applying the Prisoner’s dilemma, briefly discuss the validity of this statement (1 point)
  1. Suppose that two identical firms, Firm 1 and Firm 2, produce widgets and that they are the only firms in the market. Their total costs are given by Ci = 30Qi, which means MC1 = 30; MC2 = 30. The two firms choose their output levels simultaneously, and market demand is given by P = 150 – Q, where Q = Q1 + Q2. The marginal revenue schedules for each firm are as follows:

MR1 = 150 – 2Q1 – Q2

MR2 = 150 – 2Q2 – Q1

a)Determine each firm’s reaction function and find the Cournot-Nash equilibrium. Determine the output, price and profit of producing widgets for each firm. (2 points)

b)Suppose that the two firms collude and form a cartel. What will be the resulting output, price and profit for each firm? [Hint: market marginal revenue is 150 – 2Q, because total revenue = P*Q = (150-Q)*Q] (1 point)

c)Suppose Firm 1 were the only firm in the market. How would the market output and Firm 1’s profit differ from that found in your answer to 4b) above? (1 point)

  1. Suppose that the airline industry consisted of only two firms: American and Texas Air Corp. Let the two firms have identical cost functions, C(Q) = 40Q; MC = 40. Assume the demand curve for the industry is given by P = 100 – Q and that each firm expects the other to behave as a Cournot competitor. The marginal revenue schedules for each firm are as follows:

MRA = 100 – 2QA – QT

MRT = 100 – 2QT – QA

a)Calculate the Cournot-Nash equilibrium for each firm, assuming that the each firm choose the output level that maximizes profits taking its rival’s output as given. What are the profits for each firm? (1 point)

b)Suppose that Texas Air’s costs dropped to AC = MC = 25, and American costs remained at AC = MC = 40. Work out the equilibrium quantity, price and profit for each firm. (1 point)