Two firms compete in a homogeneous product market where the inverse demand function is P = 10 – 2Q (quantity is measured in millions). Firm 1 has been in business for one year, while firm 2 just recently entered the market. Each firm has a legal obligation to pay one year’s rent of $1 million regardless of its production decision. Firm 1’s marginal cost is $2, and firm 2’s marginal cost is $6. The current market price is $8 and was set optimally last year when firm 1 was the only firm in the market. At present, each firm has a 50 percent share of the market.
a. Why do you think firm 1’s marginal cost is lower than firm 2’s marginal cost?
b. Determine the current profits of the two firms.
c. What would happen to each firm’s current profits if firm 1 reduced its price to $6 while firm 2 continued to charge $8?
d. Suppose that, by cutting its price to $6, firm 1 is able to drive firm 2 completely out of the market. After firm 2 exits the market, does firm 1 have an incentive to raise its price? Explain.
e. Is firm 1 engaging in predatory pricing when it cuts its price from $8 to $6? Explain.