Question

Subject 2: Oligopolistic Competition (35% Two firms (Natural Salt and Healthy Salt) compete i Consumers see the salt produced by both firms as perfect substitutes. n the market for Himalayan table salt In this market, each firm chooses what output to produce and price is determined by aggregate output. Market demand is given by Q 450-2P, where Q is kgs ard Pis €/kg. The initial marginal cost of Natural Salt is S0 kg. The respective for Healthy Salt is 40/kg. A process innovation in the proxduction technology of Himalayan table salt would reduce the Natural Salt's marginal cost to 44 and Healthy Salt's marginal cost to 34 (a) Consider that only one of the two firms can introduce the aforementioned process innovation in its production technology, while its rival firm still produces with its initial marginal cost. How much would each firm be willing to pay so as to introduce the aforementioned process innovation in its production technology? IMark 1.0 (b) Consider that each firm has the option to pay 1,000 euros so as to introduce the aforementioned process innovation in its production technology. Given each firm's decision, on whether to introduce the innovation or not, firms compete in the market by choosing simultancously their level of output. If you were the Natural Salt's manager would you suggest the introduction of the innovation or not? What would you suggest if you were the Healthy Salt's manager? (Hint: Construct a payof matrix.] IMark 1.5 (c) Assume that Natural Salt and Healthy Salt decide on the following: Healthy Salt pays 1.000 euros and introduces the process innovation. Then, the two firms merge and produce with marginal cost equal to 34. Healthy Salt keeps 500 euros of the post-merger firm's ess innovation's cost) and the remaining profits are equally shared profits (half of the proc to the merger participating firms. Do both firms have incentives for such a merger compared to the equilibrium in (b)? [Mark 0.5 (d) How does the merger change consumer's surplus and social welfare, compared to t respective ones in (b)? IMark 0.5 [Marking scheme: economic intuition 10%, use of appropriate form ulae 40%, correct calculations 30%, overall presentation 20%)

Answer 1

Answer (a) : From the Given situation, it is understood that firm Natural Salt and firm Healthy Salt are producing products which are perfect substitutes of each other and are the two firms which are sharing the profit in the Salt market. It is also seen that Natural Salt produces one additional unit of its product, i.e. the marginal cost of 1 kg of Salt by Natural Salt is 50 Euros and that of the Healthy Salt is 40 Euros. This means that Natural Salt is incurring a comparative loss of 10 Euros as compared to the firm Healthy Salt. If the technological innovation can be implemented by only one of the two firms and the other firm will need to continue producing using its old means, in that case, the willingness to implement this innovating would be higher at the end of the firm Natural Salt. Natural Salt will be willing to pay up to the comparative loss it is making in the production of per kg of Salt, i.e. 10 Euros per kg. While since Healthy Salt is already making a comparative profit in the marginal cost of its one kg Salt , the willingness to pay for the implementation of the new innovation would be comparatively lesser, i.e. it would be willing to pay only up to that amount which would get reduced as a result of the implementation of the innovation, i.e. up to 6 Euros.

Answer (b) : As per the current market share condition , although both the firms are enjoying the divided profit share of the Salt market, however, being the manager of the Natural Salt firm, it can be seen that the Natural Salt firm is making a comparative loss of 10 Euros, since its marginal cost of production of per Kg unit of Salt is higher by 10 Euros as compared to that of the Healthy Salt firm. Therefore, the advice would be to use up the complete amount of 1000 crores to implement the new technological innovation, as this would reduce the marginal cost of the firm by ab out 6 Euros per Kg unit. That means, although there would-be one-time investment, but the company would be in profit in the longer run. Being the manger of the Healthy Salt company, the advice would be to use up the 1000 cores amount in the implementation of the new innovation, because it will then reduce the marginal cost of production of per kg unit of Salt by the Healthy Salt company to 34 Euros. This means that Healthy Salt will be making huge profits in comparison to the Natural Salt firm ( profit difference of at least 16 Euros ). This will gradually male the Healthy Salt company the leader in the Salt market.

Answer (c) : If the merger is implemented , i.e. if Healthy Salt company pays the total implementation cost of 1000 crores at a condition that Healthy Salt would keep 500 crores after the post-merger profit and the remaining profits in future would be shared by the two firms , in that case, The Natural Salt firm would be comparatively at a better incentive receiving end, since it is already making a loss of 10 Euros as compared to the Healthy Salt firm over the marginal cost. Now, after merger, Natural Salt would have to pay nothing, and its marginal cost would drastically reduce to 34 Euros. At the same place, Healthy Salt would also make incentive, the incentive only being the first 500 crores of net profit which it will take away. The rest of the reduction in the marginal cost for Healthy Salt firm would be there even if it carries out the innovation out of the merger all by itself. Therefore, the Natural Salt firm would be receiving a better share of the merger incentives.

Answer (d) : If the merger between the Natural Salt and Healthy Salt firms is implemented, the consumer surplus is feared to go down. This is because, both the firms would make profits out of the merger, however, it is a natural tendency that the firms merged company might want to pass some amount of the price reduction of the Salt to the consumers, and initially the price of per unit kg of Salt might go down. However, in the longer run, the merged firm will be the sole entity in the alt market and would dominate the supply of Salt. This means that the merged firm no longer has the obligations of a competitive market and may tend to rise the prices of Salt at any time and earn super normal profit. Therefore, the long run consequence of the merger would be negative with respect to consumer surplus. Accordingly in the shorter run, the social welfare may tend to be increasing , as the firms may reduce the price of Salt initially, however, if the firms increase the price in the longer run, which is most likely, the social welfare would also be negative, as the consumer would now need to pay higher for the same quantity , thereby affecting their capacity to pay for the welfare.