Consider an economy in which there is initially one firm, HealthyBran, in the ma
ID: 1122938 • Letter: C
Question
Consider an economy in which there is initially one firm, HealthyBran, in the market for breakfast cereal. A new firm, TastyCereal, is deciding whether to enter the market, which would then change the market to a duopoly. HealthyBran can choose to sell its cereal to grocery stores at either a high or a low price. As a monopolist, it can earn $5.5 million by selling at a high price or $2.5 million by selling at a low price. If TastyCereal enters the market and HealthyBran sells at a high price, each firm makes $0.5 million; if TastyCereal enters the market and HealthyBran sells at a low price, each firm has a loss of $3.5 million. suppose that HealthyBran can't set long-term contracts with the grocery stores that sell its cereal. The following diagram shows this game: first, TastyCereal decides whether to enter or not, and then HealthyBran decides whether to sell at a high or low price. $3.5 Million for HealthyBran $3.5 Million for TastyCereal Low Pric Enter $0.5 Million for HealthyBran $0.5 Million for TastyCereal High Price $2.5 Million for HealthyBran $0 Million for TastyCereal Low Price High Price $5.5 Million for HealthyBran $0 Million for TastyCereal TastyCereal decides HealthyBran decides Suppose HealthyBran issues a press release saying that if TastyCereal enters the market, it will sell at a low price.Explanation / Answer
(A)
According to the game tree,
=> If TastyCereal decides to enter the market despite the threat, HealthyBran would earn -$2.5 million if it chose to set a low price, and it would earn $1.5 million if it chose to set a high price.
As TastyCereal enters, it can be seen that HealthyBran earns higher by setting a higher price.
=> Therefore, HealthyBran's threat is not credible, and TastyCereal would enter the market.
(B)
=> If HealthyBran decides to sign a contract at a low price, TastyCereal would earn -$2.5 million if it chose to enter the market, and it would earn $0 million if it chose to stay out. Therefore, if HealthyBran signed a contract at a low price, TastyCereal would not enter the market, and HealthyBran would earn $3.5 million.
=> On the other hand, if HealthyBran decides to sign a contract at a high price, TastyCereal would earn $1.5 million if it chose to enter the market, and it would earn $0 million if it chose to stay out. Therefore, if HealthBran signed a contract at a high price, TastyCereal would enter the market, and HealthBran would earn $1.5 million.
=> Anticipating TastyCereal's response to its pricing contract, HealthyBran will sign a contract at a low price.