Question

Subject 2: Oligopolistic Competition (35%) Two firms (Natural Salt and Healthy Salt) compete in the market for Himalayan table salt. Consumers see the salt produced by both firms as perfect substitutes. 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 and P is €/kg. The initial marginal cost of Natural Salt is 50/kg. The respective for Healthy Salt is 406/kg. A process innovation in the production 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? IMar k 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 ecision, on whether to introduce the innovation or not, firms compete in the market by choosing simultaneously 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 payoff matrix. ] IMark 1.5 (e) 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 profits (half of the process innovation's cost) and the remaining profits are equally shared to the merger participating firms. Do both firms have incentives for such a merger, as compared to the equilibrium in (b)? [Mark 0.51 (d) How does the merger change consumer's surplus and social welfare, compared to the respective ones in (b)? [Mark 0.5 [Marking scheme: economic intuition 10%, use of appropriate formulae 4000, correct calculations 30%, overall presentation 20%) 2 SHOT ON MI Al MI DUAL CAMERA

Answer 1

Answer (a) : Firm Natural Salt and Firm Healthy Salt are producing the perfectly substitutable Salt product and are the only two producers of their product in the market. As per the given scenario, the marginal cost of Natural Salt firm in producing one kg unit of Salt is 50 Euros, and that by the Healthy Salt unit is 40$. i.e. from this statement we can understand that Natural Salt is making a comparative loss of 10 Euros on every unit of Salt. Now if any one of the companies is allowed to implement the technological innovation and the other company has to keep producing at the same old technology, then the Natural Salt’s willingness would be more to implement the technological innovation as compared to that of the willingness of the Healthy Salt firm. This is because, Natural Salt is already making a loss of 10 Euros per unit in comparison to that by the Healthy Salt and would want to cover up this gap. Therefore, Natural Salt will be willing to pay up t the different in the marginal cost between the two firms, i.e. up to 10 Euros. Whereas, Healthy Salt is already the gainer among the two firms. Therefore, Healthy Salt will only be willing to pay that much amount for this new technological innovation, as much it will be gaining from it, i.r. maximum up to 6 Euros per kg of Salt.

Answer (b) : If Natural Salt firm has the option to pay 1000 euros to implement the new technological innovation, as the manager of the firm, the advice to Natural Salt will be to quickly take the task to investing the complete amount of 1000 Euros in to the implementation of the new innovation. His is because, Natural Salt is already making a comparative loss of 10 Euros, If Natural Salt does not cover up this gap quickly, then there is every possibility that Healthy Salt may implement the new innovation and this gap f 10 Euros may further increase, this pushing out the Natural Salt company out of the market. As a manager of the Healthy Salt firm, the advice to them would also be to implement the new innovation at the cost of 1000 Euros. This is because, if Healthy Salt can implement the innovation before Natural Salt, then it will be able to produce the products at a lesser marginal cost (34 Euros) and the difference between the marginal cost of the two firms would be 16 Euros. This wide gap between itself and Natural Salt will be decisive in healthy Salt gradually becoming the leader of the Salt market y slowly pushing the Natural Salt firm out of the market.

Answer (c) : If this merger between the Healthy Salt and Natural Salt firm materialize, then the Natural Salt firm will be the clear inner out of the merger. Natural Salt will enjoy better inceptives out of the merger. His is because, as per the merger Healthy Salt will invest 1000 Euros in to the implementation of the new innovation and then take back 500 Euros from the post-merger profit, and then the rest of the profits in the future will be equally divided between the two firms. Here Natural Salt have had to do or pay nothing, even when it is suffering a 10 Euros comparative loss in the market. Without sacrificing anything substantial, the Natural Salt firm will now earn the benefits of the new innovation. Whereas, the Healthy Salt firm was anyway leading the market due to its profit share materializing higher due to lesser marginal cost. The Healthy Salt can only salvage from the fact that after the merger it will get back 500 Euros, but in the longer run, it is in no way beneficial for the firm. The Healthy Salt would have anyway attained the better marginal cost on its own and not enter in the merger. Therefore, the merger will bring better incentives for the Natural Salt.

Answer (d) : Upon this merger between the Healthy Salt and the Natural Salt firms, the consumer surplus in the market will be directly affected. As due to the merger the marginal cost of the merged firm will now be much lesser, the firm may choose to pass on some of the benefits of the reduction in the cost of the product to the consumer, which may bring down the price of per unit kg of Salt, however, in the longer run, the merged firm will be the only firm which would deal with Salt in the market, it will have no competition, therefore it may set any price for the product in the market, as per it desire, this put burden of higher cost on the customer and earning super normal profit. This is directly reducing the consumer surplus. Since the consumer surplus would be recused in the loner run, the long run Social welfare would also be negatively impacted. With the reduction in the consumer surplus, people’s welfare would be reduced, as they now would be left with lesser purchasing power. Thus, this merger will have direct negative effect on the Consumer surplus and Social welfare of the people in the long run.