Question

3. You are the owner of the firm Organicherry that produces cherries. The firm is located in a country that is part of an economic union so that it freely imports and exports cherries. It is currently part of a market with many competitors so that it is a price taker on the market for cherries.

(a) What market is best to describe this market?

After a referendum, the country has decided to leave the single market, which means that in the near future the firm can no longer import or export cherries without paying levies.

(b) Explain the direct effect on the firm’s profits.

The potentially good news is that the firm will now become a monopolist as all its competitors are located in the other countries that are currently part of the union. As a result of this country leaving the economic union, local consumers will pay a different price for cherries.

(c) Explain how becoming a monopolist affects the firm’s price, output, and profits. You may use diagrams to illustrate your answers.

To increase market competition, a new firm Pesticherry enters into the local market. But under your research & development, you have discovered a natural way to ward off aphids without resorting to pesticides. This advantage has allowed you to enjoy a relatively higher yield than Pesticherry. You use this advantage to be the first firm to choose its output level.

(d) What market (model) is best to describe this market?

The inverse demand function for cherries is P = 120 − 2Q (prices are in £, and Q = QO + QP). Organicherry’s costs are CO(QO) = 4QO, and Pesticherry’s costs are CP(QP) = 8QP. Under profit maximization,

(e) What is Pesticherry’s reaction function?

(f) What is Organicherry’s output level? What is Pesticherry’s output level? What is the market price?

(g) What is Organicherry’s profit? What is Pesticherry’s profit? Which firm has higher profit? Why?

Answer 1

Answer 3.

(a) Since the Organicherry is a price taker on the market for cherries, it indicates that it's too small to make an impact on the prevailing prices, which means that it's operating under perfect competition market model.

(b) In the perfect competition, it makes loss or profit only in the short term, in the long run, each firm earns economic, & normal profit, due to free exit and entry, if cherry firms are making a profit in the short, it will attract more competitive firms to enter into the market and prices will fall inevitably and likewise, if firms are making losses, it will result in the exciting of firms from the market which will result in price rise. This phenomenon will ultimately result in the long-run equilibrium, where all firms will only be earning normal profits. The perfectly competitive market charges a price, where is, Price equals Marginal Cost.

(c) On becoming a monopolist, the firm can keep prices corresponding to where Marginal revenue equals marginal cost, under the monopolist model, the firm earns supernormal profits, by charging more price, above marginal cost, the quantity of output produced is less than what the firm otherwise does in the perfect competition model.

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(d) Since Organicherry firm has taken intensive R&D and has been in the business for long, that it has formed some kind of natural monopoly to an extent, which gives the firm advantage of first-mover advantage over the new firm Pesticherry. The Stackelberg oligopoly market model could describe this market best because Organicherry is the first mover and chooses its output level.

The inverse demand function for cherries is P = 120 − 2Q, where prices are in £, and Q = QO + QP.  -----(given)

Organicherry’s costs are TC1 = CO(QO) = 4QO = 4Q1.  -----(given)

Pesticherry’s costs are TC2 = CP(QP) = 8QP = 8Q2. -----(given)

MC2 = 8; QO = Q1 , QP= Q2, MC1 = 4

(e) Pesticherry’s reaction function?

Step 1: calculating the Pesticherry’s reaction curve ->

profit2 = TR2 - TC2 = P*Q2 - TC2 = ((120 − 2Q)*Q2) - TC2

= ((120 − 2(Q1 + Q2))*Q2) - TC2

= (120*Q2 - 2*Q1*Q2 - Q2^2) - TC2

= (120*Q2 - 2Q2^2 - 2*Q1*Q2) - TC2

Now, differentiate the eq. w.r.t. Q2

d(profit2)/dQ2 = 120 - 4*Q2 - 2Q1 - MC1

for profit maximization, we keep d(profit2)/dQ2 = zero

120 - 4*Q2 - 2Q1 - 8 = zero

reaction curve of firm 2 (Pesticherry’s)=> Q2 = 28 - 0.5*Q1

Step 2: Profit maximization output of leader firm (Organicherry’s) by incoperating the reaction curve of the follower (Pesticherry’s)

Profit function = total revenue - total cost

profit1 = P*Q1 - TC1

= ((120 − 2Q)*Q1) - TC1

= ((120 − 2(Q1 + Q2))*Q1) - TC1

  = (120Q1 − 2*Q1^2 - 2*Q1*Q2) - TC1

Now substituting reaction cuevw of firm 1, into the profit maximizing eq of firm 1; Q2= 28 - 0.5Q1

= (120Q1 − 2*Q1^2 - 2*Q1*(28 - 0.5Q1)) - TC1

= (120Q1 - 2*Q1^2 - 56*Q1 + 1*Q1^2) - TC1

= (120Q1 - 56*Q1 + Q1^2) - TC1

   Now, differentiate the eq. w.r.t. Q1

d(profit1)/dQ1 = 120 - 56 + 2Q1 - MC1 = 120 - 56 + 2Q1 - 4 = 60 - 2Q1

for determining profit maximization output and price level , we equate d(profit1)/dQ1 = zero

60 - 2Q1 = zero => Q1 = 30

Q2 = 28 - 0.5Q1 = 28 - 0.5(30) = 28 - 15 = 13

Price = 120 - 2 (Q1+Q2) = 120 - 2(30+13) = 120 - 2(43) = 120 - 86 = £34

(f) Organicherry’s output level = 30

Pesticherry’s output level = 13

The market price = £34

(g)  Organicherry’s profit = 30*34 - 4*30 = 1020 - 120 = £900

Pesticherry’s profit = 13*34 - 8*13 = 442 - 104 = £338

Clearly, Organicherry firm has a higher profit, because in stakelberg's model, profit of first mover will be more. This is due to the fact that by producing more output, leader firm will force the competitor to produce less output and thereby earn more profits. It is assumed that leader has the information about the reaction curve of the follower firm therefore, leader incorporated the reaction curve of follower in the profit fuctio before maximising its output decision.