7/27/2019 H8Answers
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Homework 8: Monopolistic Competition/Oligopoly (to be handed in
on Thursday 15 th April)
1. What are the key characteristics of a monopolistically
competitive market? Some experts haveargued that too many brands of
breakfast cereal are on the market. Give an argument to support
thisview, and an argument against this view. ( 1.5 points )
The key characteristics are that firms sell differentiated
products and there is free entry and exit(ensures zero economic
profit). In a monopolistically competitive market, too many brands
of any single product signals excess capacity, implying an output
level smaller than the one thatwould minimize average cost. On the
other hand, consumers value variety.
2. Explain the meaning of a Nash equilibrium when firms are
competing with respect to price, andgive an example. Why is the
equilibrium stable? Why dont the firms raise prices to the level
thatwould maximize joint profits? ( 1.5 points )
A NE in prices occurs when each firm chooses its price, taking
its rivals price as fixed: each firmis making the best response to
each other. The equilibrium is stable as firms are maximizing
profit and have no incentive to deviate (they are making their
best responses!). To maximize joint profits requires colluding
which is very difficult to enforce as firms have an incentive
todeviate from the collusive arrangement. I.e. by lowering its
price, the cheating firm can increasemarket share and profits.
3. Because firms in any industry can always make greater profits
by colluding, there is an inevitabletendency for competitive
industries to become cartels over time. Applying the
Prisonersdilemma, briefly discuss the validity of this statement (
1 point )
Applying the lessons learned from the Prisoners Dilemma, the
dominant strategy (i.e. the bestchoice whatever your rival does) is
to deviate from the collusive agreement. Thus, the incentiveto
cheat is high, which makes it highly unlikely that industries
become cartelized over time.
4. Suppose that two identical firms, Firm 1 and Firm 2, produce
widgets and that they are the onlyfirms in the market. Their total
costs are given by C i = 30Q i, which means MC 1 = 30; MC 2 =
30.The two firms choose their output levels simultaneously, and
market demand is given by P = 150 Q, where Q = Q 1 + Q 2. The
marginal revenue schedules for each firm are as follows:
MR 1 = 150 2Q 1 Q 2MR 2 = 150 2Q 2 Q 1
a) Determine each firms reaction function and find the
Cournot-Nash equilibrium. Determine theoutput, price and profit of
producing widgets for each firm. ( 2 points )
Reaction function: each firm chooses its profit maximizing
output level taking the others outputas given.
Firm 1: MR 1 = MC 1. Thus, MR 1 = 150 2Q 1 Q 2 = 30. Q 1 = 60 Q
2. By symmetry (identicalfirms), Q 2 = 60 Q 1. In equilibrium, Q 1
= 60 [60 Q 1]. Thus, Q 1 = 30 + 1/4Q 1 so Q 1 = 40.By symmetry, Q 2
= 40. Market price = $150 (Q 1+Q 2) = 150 80 = $70.
Profit for each firm = TR TC = (70*40) (30*40) = $1600
