Suppose that Coke and Pepsi are the only two producers of cola drinks, making th
ID: 1112265 • Letter: S
Question
Suppose that Coke and Pepsi are the only two producers of cola drinks, making them duopolists. Both companies have zero marginal cost and a fixed cost of $100,000 a. Assume first that consumers regard Coke and Pepsi as perfect substitutes. Currently both are sold for S0.20 per can, and at that price each company sells 4 million cans per day. i. How large is Pepsi's profit? ii. If Pepsi were to raise its price to $0.30 cents per can, and Coke does not respond, what would happen to Pepsi's profit? b. Now suppose that each company advertises to differentiate its product from the other company's. As a result of advertising, Pepsi realizes that if it raises or lowers its price, it will sell less or more of its product, as shown by the demand schedule in the accompanying table Price of Pepsi (per can) 0.10 0.20 0.30 0.40 0.50 Quantity of Pepsi demanded (millions of cans) If Pepsi now were to raise its price to $0.30 per can, what would happen to its profit? c. Comparing your answer to part ai) and to part b, what is the maximum amount Pepsi would be willing to sped on advertisng?Explanation / Answer
(a)
(i)
Total cans sold by Pepsi = 4 million cans
Price per can = $0.20
Fixed Cost = $100,000
Pepsi's profit = Total Revenue - Fixed Cost = (Price * Quantity) - Fixed cost
Profit = ($0.20 * 4 million) - $100,000 = $800,000 - $100,000 = $700,000
The Pepsi's profit is $700,000
(ii)
It has been stated that both Coke and Pepsi are perfect substitutes. This implies that if any one of these companies raise the price while other keeps price constant then in that case entire market demand will shift to the company that keeps its price constant.
So, if Pepsi increases its price to $0.30 per can while Coke keeps the price at $0.20 per can then entire market demand will shift to the Coke and Pepsi would not be able to sell any can.
Pepsi will sell 0 cans.
Profit = Total Revenue - Fixed Cost = (0 * $0.30) - $100,000 = $0 - $100,000 = -$100,000
The Pepsi's profit will decrease and it will incur a loss of $100,000.
(b)
As shown by given table, at price of $0.30 per can, Pepsi can sell 3 million cans.
Calculate Profit -
Profit = Total revenue - Fixed cost = ($0.30 * 3 million) - $100,000 = $900,000 - $100,000 = $800,000
If Pepsi now raises its price to $0.30 per can, it would be able to increase its profit to $800,000.
(c)
Before advertising [part a(i)], Pepsi's profit was $700,000.
After advertising (part b), Pepsi's profit is $800,000.
So, advertising has enabled the Pepsi to change its price and thereby increase its profit by $100,000.
So, the maximum amount Pepsi would be willing to spend on advertising will be $100,000.