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Perfect competition, game theory and monopoly

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1. Consider a perfectly competitive, constant-cost industry with market demand curve Q = 540 -30P
In the short-run, there are 100 -rms
operating in the market. Each -rm has TV C(q) = q 2 and -xed costs
of $20. For 50 of the -rms, $4 of these -xed costs are sunk, and for the
other 50, all $20 are sunk. What is the short-run equilibrium price P

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Q=540-30P or P=18-Q/30
Initially let us assume that all 100 firms are identical, we will have Q=100q
For perfect competition MR=P=18-10q/3
For profit maximization, equating MR=MC, we get
q=3.375 P=18-3.375*10/3=6.75
Now calculate the profit for individual firms
Profit = -8.61
Thus, each firm will incur a loss of -8.61
The first 50 firms (call Type 1), which have only $4 as sunk cost for their fixed cost, can decrease their losses from $8.61 to $4.00 by stopping their production. Thus, these firms will have two options either to produce and incur higher losses or not to produce.

For the remaining 50 (call Type 2), the entire $20 is sunk cost, so they will incur a loss of $20 if they stop production and hence it is better for them to keep producing.
If type 1 firms do not produce, there will be short supply in the market and the effective price for type 2 firms will earn be
Profit = 10.38

Now, knowing fully well that it is not beneficial for the other 50 firms to be in the market and produce, the rest 50 firms may increase their quantity. If only 50 firms will produce, we will have
For perfect competition MR=P=18-5q/3
For profit maximization, equating MR=MC, we get
q=4.91 P=18-4.91*5/3=9.82
Now calculate the profit for individual firms
Profit = 4.11
Thus, each firm producing the output will produce q=4.91 and sell at P=9.82 and will earn a profit of 4.11.

However, in a situation when type 1 produce 3.375 and type 2 produce 4.91, the ...

Solution Summary

This post solves an actual past exam paper in microeconomics and can be used as a good practice for exams.