Why Cournot and Bertrand Models Are Not Dynamic - Essay Example

1. Explain why Cournot and Bertrand models are not dynamic. The Cournot and Bertrand models are not dynamic because firms make once-and-for-all quantity or price choices simultaneously. Also, firms base their future plans on what its competitors have done. Lastly, firms do not use real-time information or strategic decisions that suit their competitors. 4. Why do misreads encourage firms to lower prices? If a firm misreads a decision from its competitors as uncooperative, the firm will likely respond with an uncooperative move to protect its market share. For example, if a firm misjudges the situation and thinks that one of its competitors is behaving in an uncooperative manner, the particular firm may raise its prices in response. 5. “Firms operating at or near capacity are unlikely to instigate price wars.” Briefly explain. If a firm is operating at or near capacity, it is not very likely to instigate a price war because it wants to raise its prices to increase profits. Also, a firm may not have the resources to dramatically reduce the price of a significant product. 6. “Pricing cooperation is more likely to emerge in markets where one firm raises a price and competitors follow suit and market shares remain unchanged. It is less likely to work well in markets where price matching may not leave market shares constant. Evaluate this statement. Can you think of circumstances under which price matching behavior could alter market shares? (a) Evaluate this statement: Greater prices will always benefit a company. Also, it is easier for a company to observe higher prices rather than lower prices. In this instance, the price of a good acts like an identical feature of the market. (b) Can you think of circumstances under which price matching behavior could alter market shares? A firm that could gain a significant market share due to reducing prices would be inclined to employ price matching behavior. Firms that are perceived to produce high quality products may also think about this strategy. 7. Suppose that you were an industry analyst trying to determine whether the leading firms in the automobile manufacturing industry are playing a tit-for-tat pricing game. What real-world data would you want to examine? What would you consider to be evidence of tit-for-tat pricing? (a) What real-world data would you want to examine? The real-world data that I would want to consider would be the advertised price for a product. To get a better understanding of the market, I would compare the current price with the last financial period. (b) What would you consider to be evidence of tit-for-tat pricing? I consider it if a firm continually lowered and raised its prices. I would also take a look at the sales data of that particular product. 8. Studies of pricing in the airline industry show that carriers that dominate hub airports (Delta in Atlanta, USAir in Pittsburgh, American in Dallas) tend to charge higher fares on average for flights into and out of the hub airport than other, non-dominant carriers flying in and out of the hub. What might explain this pattern of prices? First of all, carriers that travel different routes but are based at a specific hub tend to charge its customers more. The reason why dominant carriers can get away with this behavior is that they have a monopoly on all air traffic into a particular airport. American Airlines should not panic about competition because if people really need to travel to Dallas, then they will obviously book their flights on American Airlines. To stay ahead of the competition, an airline company should focus on economies of scale to reduce the overall average cost per flight. 9. It is often argued that price wars may be more likely to occur during low-demand periods than high-demand periods. (This chapter makes that argument.) Are there factors that might reverse this implication? That is, can you think of reasons why the attractiveness of deviating from cooperative pricing might actually be greater during booms (high demand) than during busts (low demand)? A competing firm that has a low market share might deviate from cooperative pricing during a period of high demand. This is because even though demand in the particular industry is high, the firm is still operating at below the industry average. 10. Consider a duopoly consisting of two firms, Amalgamated Electric (AE) and Carnegie-Manheim (C-M), which sell products that are somewhat differentiated. Each firm sells to customers with different price elasticities of demand and, as a result, occasionally discounts below list price for the most price-elastic customers. Suppose AE adopts a contemporaneous most favored customer policy but C-M does not. What will happen to AE’s average equilibrium price? What will happen to C-M’s average equilibrium price? (a) What will happen to AE’s average equilibrium price? In the short term, it will be more difficult for AE to match CM in terms of price. AE’s average equilibrium price will reduce while C-M’s average equilibrium price will remain relatively the same. C-M could choose to raise its prices for customers who are more price inelastic, while lowering its prices for customers who are more price elastic. (b) What will happen to C-M’s average equilibrium price? CM’s average equilibrium price would increase. On the other hand, AE’s will be forced to lowers its prices in order to compete with CM. 12. How might an increase in the number of competitors in a market affect overall product quality? Under what circumstances might a high-quality firm prosper by entering a competitive market? (a) How might an increase in the number of competitors in a market affect overall product quality? An increase in the number of competitor in a market is likely to increase the quality of the product. Quality will be increased because firms have many competitors to try and compete with. This forces them to increase the quality of their products so that consumers will choose their product over another. (b) Under what circumstances might a high-quality firm prosper by entering a competitive market? A high-quality firm can prosper when it enters a competitive market if many of its competitors produce low quality products. Consumers are likely to prefer the higher quality product. 2. Dunne, Roberts, and Samuelson found that industries with high entry rates tended to also have high exit rates. Can you explain this finding? What does this imply for pricing strategies of incumbent firms? Industries that have high entry and exit rates tend to exhibit low economies of scale. They also require not much investment in specialized assets. Firms that are placed in an industry with no entry barriers will face increased demand because of the many competitors that choose to enter. If these firms begin to earn significant profit, then new market entrants will enter the market, especially if there are little or no exit barriers. As demand decreases, many firms choose to exit the industry. 3. “All else equal, an incumbent would prefer blockaded entry to deterable entry.” Comment. An entry is blockaded if the incumbent does take any entry-deterring strategies in order to prevent entry. A blockaded entry may result when there are structural entry barriers, or perhaps because production requires significant fixed investment. A blockaded entry may also result if the entrant expects unfavorable post-entry competition, perhaps because the entrant’s product does not differentiate from those of the incumbents. Entry is deterred if the incumbent can keep the entrant out by employing entry-deterring strategies, such as limit pricing, predatory pricing, and capacity expansion. Moreover, the cost of the entry-deterring strategy is more than offset by the additional profit that an incumbent enjoys in a less competitive environment. However, entry-deterring strategies are generally met with varying degrees of success. 4. Under what conditions do economies of scale serve as an entry barrier? Do the same conditions apply to learning curves? Low costs and economies of scale serve as an entry barrier. If current technology requires a large scale investment, then this prevents companies from entering the market. An entrant early in the learning curve must reach high enough during a period of low sales revenue to become efficient. The learning curve’s limit contestability because it requires this investment to train the workforce. 5. How a firm behaves toward existing competitors is a major determinant of whether it will face entry by new competitors. Explain. If a firm is “tough” towards existing competitors, then the firm will face less entry barriers because entrants will expect a lower profit. However, if the incumbent has a “soft” stance towards the existing competitors, the entrant may take this a signal for some accommodation of entry. The incumbent signals what post-entry competition will be like through its current behavior toward competing firms. 6. Why is uncertainty a key to the success of entry deterrence? An incumbent knows what the costs and market demand conditions are like, but a potential entrant can only guess these costs and demand conditions from incumbent behavior. Potential entrants can be dissuaded from entry if incumbents charge prices that are lower that the would-be entrant expects. 7. An incumbent firm is considering expanding its capacity. It can do so in one of two ways. It can purchase fungible, general-purpose equipment and machinery that can be resold at close to its original value. Or it can invest in highly specialized machinery which, once it is put in place, has virtually no salvage value. Assuming that each choice results in the same production costs once installed, under which choice is the incumbent likely to encounter greater likelihood of entry and why? The investment that is more visible, understandable, and irreversible is more likely to deter entry. In general, a significant investment in a highly specialized relationship specific asset has a high commitment value. The value is greater because the asset has no other use. Essentially the firm whose investment has no outside option has increased its own exit barrier. Exit barriers can limit the incentives for the firm to stop producing even when the prevailing conditions are such that the firm would not have entered in the first place. Given the firm is less likely to exit during poor industry conditions, market entry is less attractive as the industry downturn will generate lower overall profits than if firms could redeploy their assets to other uses. 9. Recall the discussion of monopolistic competition in Chapter 6. Suppose that an entrepreneur considered opening a video store along Straight Street in Linesville. Where should the entrepreneur position the store? Does your answer depend on whether further entry is expected? The entrepreneur should position his store in an area where his customers have low transportation costs to get to his store. It would be at the center of Straight Street. Since it is located at the place where customers pay less for transportation costs, the company can charge more for the convenience of the customers. 10. Consider a firm selling to products, A and B, which substitute for each other. Suppose that an entrant introduces a product that is identical to product A. What factors do you think will affect (a) whether a price war is initiated, and (b) who wins the price war? (a). Some factors that might affect a price war. Some of the factors are whether the incumbent can shift greater production to product B while maintaining the same profitability. Also, it depends on if incumbent feels that it has a cost advantage over the entrant. (b). Who wins the price war is determined by factors such as: At the end, a firm whose marginal costs are lower will last longer. Whichever firm has deeper pockets is better able to sustain losses. Firms that face barriers such as commitments to pay workers and other suppliers regardless of production may be indifferent at producing at a loss. Read More