Discussion Question 3; Chapter 10 (Book Salvatore)
What is the difference between limit pricing and contestable markets?
Limit Pricing
It is a strategy which existing firms in an industry adopt to keep new firms from entering an industry. This strategy prevents new firms from entering the industry, by setting the price lower than average cost. This strategy can only be perfectly applied in an industry; where there are a handful of firms which are willing to work together to keep potential rivals (new firms) from entering the industry.
Contestable Markets
In contrast, contestable markets are such markets, in which entry of new firms negatively influences existing prices. The new entrants intensify the competition, which compels operating firms to reduce their prices, which directly and adversely affects profit. The change in the size of profit affects the capital structure of a firm.
Discussion Question 8
In what way does OPEC resemble a cartel? How successful is it?
OPEC is generally understood as an alliance/cartel, which member countries produce identical goods and the quantity of a produced good is controlled. However, a country always has the initiative to increase its production. From the study of OPEC, as an organization, we learn that it is an effective cartel, which has intra-organization institutions that aid the organization in taking various kinds of quantity and price-related decisions. It is also evident that since the decrease in oil prices, in the international market, the effectiveness of OPEC as an organization has decreased gradually.
Chapter 10 Salvatore; Problems
Problem 1.
Find the Herfindahl index for an industry composed of (a) three firms—one with 70 percent of the market, and the other two with 20 and 10 percent of the market, respectively; (b) one firm with a 50 percent share of the market and 10 other equal-sized firms; (c) 10 equal-sized firms.
Arithmetic/Solution based on the provided information
(a)-One of the Firms with 70% market share and the other two with 20 and 10 % of market share. (Total number of firms 3)
H =70² + 20² + 10²
H=4900 + 400 + 100
H = 5400
(b)-Market-share, of one of the firms, is 50%, whereas rest of the firms, which are 10 in number, have the equal number of market share (5% each).
50² = 2500
5² = 25
25 x 10 = 250
H=2500+250
H= 2750
(c)-In this industry there 10 firms that are equal in size
10² =100
100 * 10 =1000
Problem 14
Since underprice leadership by the dominant firm, the firms in the industry following the leader behave as perfect competitors or price takers by always producing where the price set by the leader equals the sum of their marginal cost curves, the followers break even in the long run. True or false? Explain.
Long-run is characterized by zero profit; firm’s price equals marginal cost. Itis believed that in a competitive market, firms operate at break-even (long run); however, if a dominant firm is earning a profit (long run), followers may also be earning a profit. However, it entirely depends upon the average cost curve of each firm. Though it is quite impossible because a dominant firm’s price equals its average sum of marginal costs in the long run, which is lowest in comparison to the other firms. Therefore, it is improbable for a follower or non-dominant firm to earn a profit. If the firm is earning the profit, then the perceived leading firm must not be a true dominant firm and there are no natural obstacles to stopping a new firm from entering, in the long run (zero-economic profit keeps new firms from entering an industry).
Chapter 10 Froeb; Discussion Questions
Discussion question10.4
Examine the U.S. passenger airline industry using FIVE FORCES. Is this an attractive industry?
Five Forces
- Barriers to Entry: Generally, high fixed cost acts as an obstacle for a new firm that desires to enter the industry. However, fixed costs alone is not the factor which keeps new firms out of the airline industry. As handful firms are operating in selected industry (airline); therefore, the size of the profit is large.
- Low Buyer Power: If the size of the consumer group is large, then consumer group has the market power, and it can affect prices with the change or shift in demand. However, if the consumer group is small, the firm/industry has the market power to manipulate prices. In the United States, a group of airline travelers is large. However, the airline industry still has the market power as the elasticity of demand is quite flexible, which makes the airline industry lucrative and attractive.
- High Supplier Power: There are handfuls of firms which operate in this industry; therefore, the supply is limited, and demand is high, which allows firms that operate in selected industry (airline) to manipulate prices. However, the labor-force of the airline industry is unionized, which reduces the Supplier’s capacity to influence market dynamics. Because of a handful of firms and high demand, the airline industry is attractive, and the supplier has the power. However, because of unionized labor, it becomes a little less attractive.
- The threat posed by Substitutes: There are very few substitutes for the airline industry, and these substitutes are not perfect substitutes. For instance, the train is considered a substitute for an airline; however, they fail to be a perfect substitute because of the time factor and the number of destinations. Intra-industry substitutes are also few, and these substitutes generally do not engage rivals in price war; therefore, industrial, and intra-industry substitutes do not pose a serious threat. It keeps profit high, which makes the industry lucrative and attractive.
- Mild Rivalry within the Industry: From a systematic review of the airline industry, it is quite evident that the competition among the airline industry firms is very low. Airline industry firms deliberately try to avoid price competition to attract customers, because it may/perhaps affects the profits adversely.
From analysis, we have concluded that the airline industry is an attractive industry, as it is highly lucrative with very few substitutes and very mild competition.
Salvatore Chapter 11; Discussion Questions
Discussion Question 11
Do the duopolists in a Cournot equilibrium face a prisoners’ dilemma? Explain.
It is quite evident that in a given scenario (Cournot Equilibrium), the duopolists face prisoner’s dilemma. At the Cournot equilibrium, both the producers produce 4 units each, at the price of $4. If these duopolists can establish a monopoly, then the outcome of the consequence of monopoly is 6 units at the price of $6. In a monopoly, the producer is producing more than previous and selling it price that is high (of $6); and is able to generate $36 in revenue.
Each producer will earn around $15, if the producers compete with one another; however, if these producers decide to establish a monopoly, each producer will produce around 3 units, and each producer will earn a profit of $18 (the splitting of profit). However, each producer will have the initiative/incentive to expand production (produce more than 3 units), which will affect the cooperative strategy. Therefore, the situation manifests prisoner’s dilemma.
Discussion Question 12
How did the 1971 law that banned cigarette advertising on television solve the prisoners’ dilemma for cigarette producers?
If firms in the scenario, which operate in the tobacco/cigarette industry, decide not to advertise then the cost of cigarettes will be reduced, which benefits all companies. However, if any of the firms/companies decides to advertise, then the profit of that company will increase, as the market-share size will swell. In a scenario where both firms decide to advertise, the cost will increase, and profit will diminish, which will disturb the capital structure of all firms.
From the analysis, we can conclude that dominant strategy is the most potent/result-producing strategy. However, this strategy will reduce the size of profit, which would 2 instead of 3 (if the firms decide to advertise).
The most potent or result-producing strategy is a dominant strategy because it ensures that a firm would not lose market share because of an advertisement strategy / policy of the rival firm. Market share has great significance as it strongly affects the size of revenue and profit. If both firms do not intend to increase the cost and keep market-share same, then they must agree not to advertise; however, each firm will have the incentive/initiative to advertise.
Problem 2
From the following payoff matrix, where the payoffs are the profits or losses of the two firms, determine (a) whether firm A has a dominant strategy, (b) whether firm B has a dominant strategy, (c) the optimal strategy for each firm, and (d) the Nash equilibrium, if there isone.
Solution/Answer
- It is evident from the information provided, in the form table, that if firm B sets a price low, then firm A will also set a price that is not high (low). We also learn that if firm-B decides to demand a price that is considered high, then firm-a will also charge a price that is not low (high). Evident it is that firm-B’s strategy is dominant, because firm A follows the strategy of firm-B; Firm A changes the price, because of firm-B.
- We also learn that when firm-A demands a price that is not high (low), then firm-B will reduce the price (low charge price). When firm-A decides to increase the price, firm-B will continue to charge low prices. It suggests that firm-B’s strategy prevails (dominant).
- From the information provided we can deduce that there exists Nash equilibrium, which is low-low. It is because firm-B will set the price low, irrespective of the strategy of another firm and whenever firm-B decides to lower the price, firm A will follow.
Problem 6
Explain why the payoff matrix in Problem 1 indicates that firms A and B face the prisoners’ dilemma.
Answer/Solution
From the information provided in payoff matrix, we can deduce that Firm A and Firm B, face Prisoner’s Dilemma. Quite evident it is from the information provided that when Firm B demands a price that is not low (high), the other firm (Firm A) does not demand price that is high (sets low price) and when Firm B sets price that is low, the other firm also sets a price that is not high (sets price that is low). Therefore, it is Firm A, which has employed a prevailing strategy (strategy that we can identify as dominant), which is about charging price low.
We also learn that whenever Firm A sets a price that is not high (sets a low price), Firm B also sets that price, which is not high (price). However, whenever Firm A sets a price that is not low (high), Firm B sets a price that is not high (sets a low price). Therefore, the prevailing strategy (that we identify as dominant) is of Firm B. the Nash equilibrium suggests that firms will set the price that is not high (sets the price that is low) (a non-cooperative equilibrium would establish).
Problem 10
Given the following payoff matrix, (a) indicates the best strategy for each firm. (b) Why is the entry- deterrent threat by firm A to lower the price not credible to firm B? (c) What could firm A do to make its threat credible without building excess capacity?
Solution/Answer
- From the information provided in payoff metric, we learn that whenever the new firm, which is Firm B, enters the industry/market, the other/existing firm will increase the price (charge more). In case, the new firm, which is Firm B, does not enter the industry/market, the existing firm will continue to demand high price. It suggests that for an existing firm (Firm A) the prevailing strategy is setting or demanding a high price. If the arrival of a new firm, in a market / industry, does not change the strategy of Firm A of charging higher, then Firm B will enter will surely enter the market/industry.
- The deterrent of the existing firm is not effective or credible, as setting the price not high (setting it low) will only reduce profit, which is why Firm A must charge high.
- The lowest price is the only market tactic that may keep new entrants out of the market/industry; however, to keep new entrant out, the operating/existing firm must sacrifice its profit and surrender its dominant strategy.
Foreb Chapter 15; Problems
Problem 15.4
The below figure represents the potential outcomes of your first salary negotiation after graduation. Assuming this is a sequential-move game with the employer moving first, indicates the most likely outcome. Does the ability to move first give the employer an advantage? If so, how? As the employee, is there anything you could do to realize a higher payoff?
Answer/Solution
From the information provided, we can deduce the most probable outcome would be a low salary offer. The rationale for this is that employees will be of the view that employees will take the offered salary, instead of walking away.
The player who moves first will affect the outcome; it is because if an employer moves first and offers a price that is not high (offer a price that is low), the potential employee will accept the offer instead of walking out. If an employee takes the initiative and demands a salary that is not low (salary that is high), then employer may accept the demand to hire the employee.
Problem 15.5
Renegotiating Employment Contracts Every year, management and labor renegotiate a new employment contract by sending their proposals to an arbitrator who chooses the best proposal (effectively giving one side or the other $1 million). Each side can choose to hire, or not hire, an expensive labor lawyer (at the cost of $200,000) who is effective at preparing the proposal in the best light. If neither hires lawyers or if both hire lawyers, each side can expect to win about half the time. If only one side hires a lawyer, it can expect to win three-quarters of the time. 1. 2. 3. Diagram this simultaneous-move game. What is the Nash equilibrium of the game? Would the sides want to ban lawyers?
Answer/Solution
Labor
- If management has no intention of acquiring the services of an attorney, in this situation, labor will hire a lawyer.
- If management acquires the services of a lawyer, labor will also hire a lawyer.
Management
- If the labor has no intention of hiring a lawyer, management will surely hire a lawyer.
- If labor hires a lawyer, management will also hire a lawyer.
We identify acquiring services of a lawyer or an attorney by both labor and management as Nash Equilibrium, as it is the prevailing strategy (strategy that we have identified as dominant).
No, both will not agree to the cooperation, as one of the two groups benefits more than the other group by mutually agreeing not to acquire the services of a lawyer or attorney.
Required Textbooks:
Froeb, L. M., McCann, B. T., Ward, M. R., & Shor, M. (2016). Managerial economics: A problem solving approach (4th ed.). Boston, MA: Cengage Learning. ISBN: 9781305259331.
Salvatore, D. (2015). Managerial economics in a global economy (8th ed.). New York, NY: Oxford University Press. ISBN: 9780199397129.
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