Question

4. (12 MARKS -6 FOR EACH PART) Two firms produce homogeneous products and compete as Cournot duopolists. Inverse market demand is given by P 30 Q. Firm 1 has a marginal cost of 5 per unit. Firm 2's marginal cost is c2<5. (a) Suppose that c2 falls. What will happen to the Cournot equilibriumi) price, (ii) consumer surplus and total surplus, and (ii) the HHI? Explain your answer. (b) How does this example relate to criticisms of the use of market structure to identify market power? Explain. NOTE: To answer this question you may make use of the fact that under a Cournot duopoly, if inverse demand is given by P A -BQ and Firms 1 and 2 have constant marginal costs cı and c2, the Cournot equilibrium quantities are: CA-21tGz2 and q2 q1 = 3B 3B

Answer 1

Answer 4(a) : Since, the existing market condition states that the marginal cost of firm C2 is lesser than $5 and the marginal cost of firm C1 is $5, this means that Firm 2 is already enjoying a benefit in comparison to firm 1, as it will earn better revenue, due to its marginal cost being comparatively lesser.

                                          (i) Now, if C2 further falls, this would mean that the price prevailing in the Cournot equilibrium will fall. Firm C2 will try to earn better profit and would want to divert all the consumers to it, and hence reduce the price of the commodity.

                                          (ii) As a result of the reduction in the Cournot equilibrium price, the consumers will now have the option to buy the same product at a comparatively lesser price, and the consumers will move to buying the cheaper product. This will lead to an increase in the surplus availability at the hands of the consumer. Total surplus will fall in the short run. As the surplus of Firm 1 will be will fall drastically, as its marginal cost is still the same and the surplus of Firm 2 will also fall, as in order to attract more consumers, firm 2 has reduced the price. Therefore, even though consumer surplus will increase, but Total surplus will fall.

                                          (iii) Herfindahl-Hirschman Index or HHI will remain the same as with the fall in the profit share of firm 1 , the profit share of firm 2 will increase, thus squaring off the deficit as per the Herfindahl-Hirschman Index. However, the index will now show a difference in the level of output and revenue of the firm 1 as lesser as compared to earlier and the level of output and revenue of the firm 2 as greater as compared to earlier

Answer 4(b) : It has been critically examined by economists all over the world that this method of reduction in the cost, either of marginal cost, or b bearing initial loss, is being used by several firms to identify the market power. When some firms are trying to enter the market, or for firms who are already in the market, they reduce the price of the commodity in order to test out the power of sustainability of the other firms who are in competition. The reduction of prices proves which firms can survive even at a lesser revenue. In this process, many smaller firms pull out of the market, and only those players survive, who maintain a greater share of capital or revenue.