Assume that the above graph represents the market demand facing an oligopoly, wh
ID: 1223366 • Letter: A
Question
Assume that the above graph represents the market demand facing an oligopoly, which sells an undifferentiated product and the cost conditions of a typical firm in that oligopoly. Explain why there will be no more than 4 firms in this market. Assuming that there are 4 firms in this market what will be the price, which maximizes the overall level of profits in this industry? If this oligopoly organizes itself into a cartel and agrees on the joint profit-maximizing price, what output quota will be assigned to each firm? Explain why it may be difficult for the cartel to maintain the profit maximizing price. The following quote appeared in a recent Wall Street Journal article on the recent sharp increase in gasoline prices. "Mark Lazarus, owner of two Myrtle Beach, S.C., racetracks with more than 250 gasoline-powered go-carts and bumper boats, expects the spike to reduce profit by at least $21, 000 during the busy season that begins today. 'I can't raise my ticket prices to cover it at this point,' he says. 'I think we would start losing customers if we started raising our price." Is Mr. Lazarus making a mistake? Should he raise prices? Might your answer depend on whether you assume the market in which his go-cart business competes is an oligopoly market or a monopolistic competitive market? Draw a diagram (or possibly 2 diagrams) to illustrate your answer.Explanation / Answer
The diagram provides some hidden information market demand that can be harnessed. Note the choke price (reservation price) is $90 and the slope of the market demand curve is (70 - 90)/(4 - 0) = (50 - 70)/(8 - 4) is constant at -5. Hence te market demand equation is P = 90 - 5Q. Marginal revenue, the derivative of total revenue is given by:
MR = dTR/dQ
= d(90Q -5Q2)/dQ = 90 - 10Q
Whether the market is monopolistically competitive or oligopoly, it must be equating marginal revenue and marginal cost. From the digram, plot MR and extend MC. The equilibrium quantity is 5.5 millions and the price is $65 per unit. At this level of output, ATC is $25 so it is quite small compared to the price charged. Hence the firm is earning profits amounting to (P - ATC)*Q or $110 millions.
If gasoline price rises, MC and ATC will shift upwards squeezing the profits, IF the industry resembles monopolistically competitive, then the firm will incur losses since then it cannot increase its prices to a certain extent. Oligopoly will provide some market power to the firm making the demand more inelastic. Hence, the firm can prevent itself from losses in oligopolistic market.