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 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?

• Second-mover advantage

• Direct network externality

• Learning curve effects

• Limit pricing

b. Determine the current profits of the two firms.

Instruction: Enter all responses rounded to 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: Enter all responses to 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?

• No

• Yes

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

• No

• Yes

Answer 1

Given

• Inverse demand function is P = 20 -5Q
• Firm 1’s marginal cost is $2, and Firm 2’s marginal cost is $10
• current market price is $15

a)

option (c) Learning curve effects is correct answer