Question

            Suppose a hypothetical oil market consists of two oil producers Jack & Jill. Suppose the marginal cost of pumping oil is equal to zero, while the demand for oil is described by the following schedule.

           

Quantity                               Price                         Total Revenue (and total profit)

0 gallons                                $120                                                               $   0

10                                            110                                                                  1100

20                                            100                                                                 2000

30                                            90                                                                    2700

40                                            80                                                                    3200

50                                            70                                                                    3500

60                                            60                                                                    3600

70                                            50                                                                    3500

80                                            40                                                                    3200

90                                            30                                                                    2700

100                                         20                                                                    2000

110                                         10                                                                    1100

120                                         0                                                                            0

a.         What would be the equilibrium outcome (price and quantity) if the markets were either competitive or monopolistic?

b.         If both Jack & Jill form a collusion, what quantity and price would they try to set?

c.         If both the duopolists don’t act together but instead make production decisions independently, what quantity would they produce and price they would set?

d.         Explain and give reasons for your answers.

Answer 1

a) In a competitive market, P = MC

Here, MC = 0

Thus, in a competitive market, P = 0, and Q = 120 gallons

Here, profits are zero.

On the contrary, in a monopoly, P is set as per maximum profits ($3600).

Thus, maximum profits are at P = $60 and Q = 60 gallons

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b) A collusion effectively acts as a monopoly. Jack and Jill will ensure that the market quantity remains at 60 gallons. They will each produce 30 gallons.

They will each make a profit of $1800.

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c) Independently, each producer will attempt to maximize profits. Each will try to gain the profit maximizing market share, that is 60 gallons. It is in the best interest to cooperate, but they may not.

Starting from a collusion, if one of the producers pumps 60 gallons, and the other 30 gallons. The market reaches an output of 90 gallons, and a price of $30 per gallon. Profits reduce to $2700.

If each produces 60 gallons, the market actually produces 120 gallons. The market thus becomes competitive. Price becomes 0.

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d) If both firms cooperate and produce 30 gallons each, they can jointly earn a profit of $1800 each.

If one firm produces 60 gallons and the other 30 gallons, they earn $1800 and $900 respectively.

If both firms produce 60 gallons each, they earn zero profits.

This is exactly the prisoner's dilemma - whether to cooperate or not. Acting as a duopoly and cooperating is most profitable.