In problem 9, suppose that firm 2 acts as a price leader and can commit in advan
ID: 1178044 • Letter: I
Question
In problem 9, suppose that firm 2 acts as a price leader and can commit in advance to setting its price once and for all. In turn, firm 1 will react to firm 2's price, according to the profit-maximizing response found earlier, P1=52.5+.25P2. In committing to a price, firm 2 is contemplating either a price increase to P2=$73 or a price cut to P2=$67. Which price constitutes firm 2's optimal commitment strategy? Justify your answer and explain why it makes sense.
Reference to use for problem 9:
Two firms produce differentiated products. Firm 1 faces the demand curve Q1 = 75 - P1 + 0.5P2. Firm 2 faces an analogous demand curve Q2 = 75 - P2 + 0.5P1. For each firm, AC=MC=30.
Explanation / Answer
An oligopoly is a market form in which a market or industry is dominated by a small number of sellers (oligopolists). Oligopolies can result from various forms of collusion which reduce competition and lead to higher costs for consumers. [1] Alternatively, oligopolies can see fierce competition because competitors can realize large gains and losses at each other's expense. In such oligopolies, outcomes for consumers can often be favorable.
Because there are few sellers, each oligopolist is likely to be aware of the actions of the others. The decisions of one firm influence and are influenced by the decisions of other firms. Strategic planning by oligopolists needs to take into account the likely responses of the other market participants.
Oligopoly is a common market form where a small number of firms are in competition. As a quantitative description of oligopoly, the four-firm [concentration ratio] is often utilized. This measure expresses the market share of the four largest firms in an industry as a percentage. For example, as of fourth quarter 2008, Verizon, AT&T, Sprint, and T-Mobile together control 89% of the US cellular phone market.
Oligopolistic competition can give rise to a wide range of different outcomes. In some situations, the firms may employ restrictive trade practices (collusion, market sharing etc.) to raise prices and restrict production in much the same way as a monopoly. Where there is a formal agreement for such collusion, this is known as a cartel. A primary example of such a cartel is OPEC which has a profound influence on the international price of oil.
Firms often collude in an attempt to stabilize unstable markets, so as to reduce the risks inherent in these markets for investment and product development.[citation needed] There are legal restrictions on such collusion in most countries. There does not have to be a formal agreement for collusion to take place (although for the act to be illegal there must be actual communication between companies)%u2013for example, in some industries there may be an acknowledged market leader which informally sets prices to which other producers respond, known as price leadership.
In other situations, competition between sellers in an oligopoly can be fierce, with relatively low prices and high production. This could lead to an efficient outcome approaching perfect competition. The competition in an oligopoly can be greater when there are more firms in an industry than if, for example, the firms were only regionally based and did not compete directly with each other.
Thus the welfare analysis of oligopolies is sensitive to the parameter values used to define the market's structure. In particular, the level of dead weight loss is hard to measure. The study ofproduct differentiation indicates that oligopolies might also create excessive levels of differentiation in order to stifle competition.