Economics: Economic Theory Bulletin

In mentioned cases provide a neat diagram to explain your answer. Make sure to label axes properly. Else points will be deducted. The maximum possible points is 40.

A local firm in Abu Dhabi is operating under a perfectly competitive environment. If price in market is 4 AED and their total cost is 500 AED (including the fixed cost of 200 AED) for output of 30 units, then should they continue to produce or shut down in short run? Provide your answer with a relevant diagram and explain your answer in few words.  (10 points)

Recent research has documented the fact that Coke is something different compared to other soft drinks. In fact related literature states that Coke has already attained the monopoly status. If we assume the research is correct and coke is a monopolist, then a) Do you think that coke actively engages itself in price discrimination? B) If so, what type of price discrimination they are engaged in? Discuss your answer with a relevant diagram. (10 points)

Etisalat and Du are duopolists. If they form a cartel between themselves, then what will happen to price and output in the market. Discuss your answer with a relevant diagram. (5 points)

4). In a recent conversation a policy maker argued that since DEWA is monopolist, they are charging higher price and lower output is produced. He further mentioned that government should split the entire unit into small pieces so that competition can drive down prices. Do you agree with this statement? Explain your answer in few words. Provide a relevant diagram. (5 points)

5) Consider the following pay-off matrix (Numbers in the matrix reflect their respective profit levels) for two gas stations.

If each firm follows their dominant strategy, then what will be their respective profit levels? And if they collude then what is their new profit level?     (5 points)

6) A cosmetic firm operating in a monopolistically competitive market environment spends a lot of money in advertisement and ends up with super-normal profit even in long run. Is it possible? Explain your answer in few words. (5 points)

The market price at Abu Dhabi is 4 AED. The total cost of the firm is 500 AED. The fixed cost incurred by the firm is 200 AED. Therefore, the variable cost of the firm will be (500-200) =300 AED.

The output is 30 units. Therefore, the Average Variable Cost is Total Variable Cost ÷ Total output; i.e. 300 ÷ 30 = 10 AED.

According to the theory of perfect competitive market, a firm will shut down its production if the market price is less than Average Variable Cost (P< AVC) (Shepherd 2015). Here, the market price 4 AED is far below than the average variable cost (10 AED).

Figure 1:Shutdown Point of Production

Source: Created by Author

A firm in the competitive market continues its production even if the price is below Average Cost. This is because; still the price is exceeding average variable cost and firm will operate in the short run to cover its variable cost. At this situation, if the firm shuts down its production, there will be no variable cost but firm has to pay fixed costs. Fixed cost has to be paid by the firm, regardless of the decision of the firm. Hence, instead of AC, the decision will be based on looking into AVC. As long as the price is greater than AVC, the firm will cover all variable cost along with some part of fixed cost. Therefore, below the point where price is equal to AVC, firm is unable to cover its cost of production. At this point, the firm will shut down its production (Rubinfeld and Pindyck 2013).

Coke enjoys monopoly power in the market, so it can actively engage in price discrimination. This will enable the company to maximize its profit. Price discrimination can be of three types namely, first degree; second degree and third degree price discrimination. In the first degree price discrimination, the monopolist charges maximum price that each consumer is willing to pay. This type of price discrimination involves maximum exploitation. In the second degree price discrimination, the monopolist charges different price different quantities. Here lower price is charged for bulk purchase than a single unit. In the third degree price discrimination, monopolist divides the entire market into small groups and charges different prices for different groups of consumers (Aguirre and Cowan 2015).

The coke is the most preferred soft drinks producing company. The demand for coke increases during summer season and falls substantially during winter. The elasticity of demand is high during winter and demand is inelastic during summer.Therefore, the firm can engage itself in the third degree price discrimination. The company can divide its market on seasonal basis and charge different price in different market. It will maximize its profit in summer by charging high price and in winter it will charge low price, as people might become price sensitive during winter. Moreover, Coke is an international company with numerous branches; manufacturing sector and retailers all over the world. The demand for soft drink is higher in the tropical region, where it is mostly summer, for example, in Kenya (Euromonitor.com 2016). The demand for Coke is significantly lower in the temperate or polar zone, where it is mostly cold. The company divides its market according to the climatic zone and charge different price. In the polar zone, it cannot raise its price too much as demand is very elastic in nature. In contrast, the Coke company can maximize its profit by charging high price in tropical climate, s demand is highly inelastic.

Figure 2: Third Degree Price Discrimination

Source: Created by Author

In the above diagram, it has been presented how different prices can be charged for different market. Coke will charge P₁ where demand is inelastic in nature and P₂ where demand is elastic in nature to maximize its profit. Hence, Coke will engage itself in the third degree price discrimination by dividing its market.

Etisalat and Du form a cartel between themselves, it implies the two firms decides to collude rather than competing with each other. There can be made an explicit collusive agreement, where they together decide their price and market sharing. The cartel can be implicit in nature, where collusion is secretive. By trusting each other these two firms create monopoly (Fonseca and Normann 2014). In this case, the firms decide to divide the monopoly output equally between themselves and sell it at the monopoly price. Here, both the firms will earn same amount of profit.

Figure 3: Cartel in Duopoly

Source: Created by Author

However, the output of cartel is not on their best response curve. Therefore, it is possible that a firm cheats and produces best response output. Here, the total output will be best response output of firm 1 plus the cartel output of firm 2, which is more than total monopoly output (shared between these two firms). The market price will be lowered as well. The firm who cheated will earn higher profit and the firm who did not cheat will lose.

If both firm cheats, the total output will be best response output of firm 1 and best response output of firm 2 that is greater than before. However, in such case, the price will be so low that the both firm will earn lesser profits than profits earned by forming cartel.

Individual firm will be benefitted by cheating if another firm is not cheating. So cheating is better option for each firm. However, it is better not to cheat because, as cheating by both firms will lead to lesser profits earned by both firms. Therefore, price and output of cartel depends on trust (Bernheim and Madsen 2013).

Figure 4: Best Responsive Function

Source: Created by Author

DEWAis charging high price and producing lower output. By splitting the entire unit will improve its production efficiency; improved product and will lower down the unit costs. However, as DEWA is the Electricity and water supplier, this is a case of natural monopoly.Splitting may not increase competition in the traditional way. However, there will be a type of cost competition as each unit would be encouraged to be more efficient than others (Moszoro 2014).

While DEWA charged high price for low output the profit of the firm is very high. After splitting into several units, it produces or supplies high level of output but faces loss due to low price. In general, splitting of production increases competition traditionally, as different units are less likely to share their information with other units. However, as DEWA is providing essential goods like electricity and water, the information cannot be kept secret. Hence, units might not achieve competitive advantage over other goods. Therefore, it can be concluded that, government decision of splitting DEWA into small units in order to increase competition, cannot be fully agreed.

The following diagram represents the case of natural monopoly. It has illustrated the fact that, high price and low output indicates inefficiency in the market but the firm is earning high profit. However, low price and high output is efficient for society but there is no incentive for the firm as it will suffer from losses. Therefore, it can further be concluded that there is no improvement in the competition by splitting the firm as there is no incentive for the firm to produce at lower price, when it is operating in natural monopoly.

Figure 5: Consequences ofNatural Monopoly

Source: Created by Author

A strategy is said to be dominant for a player if he gets better payoff by selecting that strategy, regardless of what another player has chosen (Myerson 2013).From iterated elimination, the dominant strategy can be obtained.

From the above pay-off matrix, the pay-off for Gas Station B is higher when it adopts low price regardless the choice of Gas Station A. If A choses High Price strategy, then B will be better off by choosing low price strategy, as 500,000 AED is greater than 200.000 AED. Similarly, if A selects Low price strategy, then also B will be better off by selecting low price strategy again, as 800,000 AED is higher than 400,000 AED. Therefore, low price strategy is the best possible choice for Gas Station B. Now, as B will always select low price strategy, Gas Station A will be better off by selecting low price strategy as the profit level will be higher in this case (800,000 AED > 400,000 AED). The respective profit level will be 800,000 AED for both the firms

When the firms collude with each other, it implies that it aims to maximize their joint profit. When the strategy is (Low Price, Low Price) then the joint profit of both firms will be maximized and the profit level will be 800,000 AED for both of them. So, there will be no change in their profit level.

In the short run, the monopolistically competitive firm, the firm maximizes the profit where MR=MC. The average cost is lower than this level, and thus the firm earns super-normal profit. This is represented in panel (a) of the following diagram. However, in the long run, the supernormal profit attracts new firm and the demand (AR) curve becomes more elastic (Roberts 2014). Therefore, at the point where MR=MC, the firm faces neither profit nor loss. This is represented in the panel (b).

However, the cosmetic firm spends more money on advertisement.This has helped the firm to differentiate its product from other companies and establish significant brand loyalty. As a result of this, the AR or the demand curve does not become inelastic for the product of this company. Hence, in real world example, through advertisement, it is possible to earn super-normal profit even in the long run.

Figure 6: Supernormal Profit in Monopolistically Competitive Market

Source: Created by Author

Aguirre, I. and Cowan, S.G., 2015. Monopoly price discrimination with constant elasticity demand. Economic Theory Bulletin, 3(2), pp.329-340.

Bernheim, B.D. and Madsen, E., 2013. Business Stealing in Imperfect Cartels. Working paper.

Euromonitor.com. 2016. Soft Drinks in Kenya. [online] Available at: https://www.euromonitor.com/soft-drinks-in-kenya/report [Accessed 10 Aug. 2016].

Fonseca, M.A. and Normann, H.T., 2014. Endogenous cartel formation: Experimental evidence. Economics Letters, 125(2), pp.223-225.

Moszoro, M.W., 2014. Public-Private Monopoly.

Myerson, R.B., 2013. Game theory. Harvard university press.

Roberts, K., 2014. The limit points of monopolistic competition. Noncooperative Approaches to the Theory of Perfect Competition, 3, p.141.

Rubinfeld, D. and Pindyck, R., 2013. Microeconomics. Pearson Education.

Shepherd, R.W., 2015. Theory of cost and production functions. Princeton University Press.