Suppose that there are currently four producers of tyres in Australia – Allcar, Bootstone, Carstuff and Duddos. There are no imported tyres in Australia and there are significant barriers to new entry. Allcar has 25 per cent of all tyre sales, Bootstone has 10 per cent of all tyre sales, Carstuff has 40 per cent of all tyre sales and Duddos has 25 per cent of all tyre sales. The marginal cost of producing a tyre is constant and equal to $20 per tyre. The current market price of a tyre is $50. One million tyres are sold each year. Industry estimates suggest that a $10 increase in the market price of tyres will result in a reduction of sales by 100 000 each year. Allcar and Bootstone wish to merge.

They claim that their merger will lead to a $10 reduction in the marginal cost of each tyre that they produce (i.e., the marginal cost for the merged firm will fall from $20 per tyre to

$10 per tyre). Assume that Allcar and Bootstone are making a correct claim about the reduction in marginal cost but that the merger will also lead to a $10 rise in the market price of tyres.

a Draw a diagram showing the deadweight loss associated with the oligopoly in the Australian tyre market before any merger between Allcar and Bootstone.

b Show how the deadweight loss will change if Allcar and Bootstone are allowed to merge. Give an estimate of the size of the change in the deadweight loss.

c What are the cost savings that will be created by the merger? What factors might affect the total size of these cost savings?

d Do you think that the merger between Allcar and Bootstone will increase or decrease social surplus? Why?