ANSWER KEY

Introduction to Answers

The purpose of assigning an essay is to see if the student has processed all of the relevant concepts required by the question. This particular essay question asked the student to contrast two different market structures. There may be various ways a student can respond but he/she should answer each of the four parts and used sound economic analysis. It should become clear that the analysis regarding the perfect competitor is pretty straightforward. The decision making for the oligopoly is more complex. There are different strategies that can be pursued. This is why we are turning more to game theory in our analysis of Oligopolies.

Oligopolies and perfect competitors produce and compete in markets with different characteristics. A perfect competitor does not need to concern itself with the competition. There are so many firms in the market that no one firm can influence the market. BGC has to be aware of what its competitor RDC will do and how RDC will react to anything that BGC does. This is typical of an oligopoly. The firms have an interdependent relationship. In this market each firm has a significant market share and can impact the competing firm in terms of its potential profitability.

Answer to A)

Since our perfect competitor is only one of many suppliers in the market that is producing the same undifferentiated good, it cannot influence price or consumer preference for its product. Consequently the market supply and demand determines the price and every firm in this market is a price taker. Occasionally a product produced in a perfectly competitive market may appear in an advertisement, but if one looks closely she/he will note that the sponsor is a market association and not a firm. For example, “Drink milk!” ads produce by the dairy association. The perfect competitor does not make a product that is any different then the other firms and cannot affect the price it receives for its product. It can sell all it produces. The firm has a perfectly elastic demand curve. Any expenditure for advertising would have no impact on total revenue but would increase total costs. Normal profits would be affected.

Answer to B)

Most oligopolies such as BGC have a product that is differentiated. For example a car may be a car but most of consumers have a preference for a Ford, Camry, or Chevrolet. If one has a preference for a car other than the three listed here, then he/she has also experienced the affects of product differentiation. Since BGC has a product that is differentiated, it is faced with its own downward sloping demand curve. It can influence that demand curve through advertising. At the same time, BGC has to realize that its competitor RDC can also advertise to increase its own demand curve. The increase in

©Dick Brunelle, 2006

consumers for RDC’s product may come from the demand for BGC’s. The two

companies are producing substitute goods. BGC needs an advertising strategy to build brand identification and brand loyalty. Its strategy must also consider how RDC will react. At some level of advertising the firms will reach equilibrium.

As noted above, in perfect competition the market determines the price and the firm is a price taker. Thus, the firm has a perfectly elastic demand and the firm is left with the option of producing as much as it can until its marginal cost is equal to its price (marginal revenue for a perfect competitor).

Answer to C)

Since BGC has its own demand curve it can select what price and output combination will be most profitable. It must however be aware that its demand curve can shift out or shift in depending on what strategy RDC pursues. It may decide that pursuing a strategy of a higher price and producing fewer products will be more profitable but it must consider the impact of RDC’s strategy as well. Of course, some oligopolies might decide to pursue a policy of low prices to prevent one or two other firms from entering the market. Low price can be a barrier to entry.

Answer to D)

A perfect competitor cannot achieve long run economic profit. Economic profit is more than normal profit. When a perfect competitive market allows economic profit in the short run, it attracts more suppliers that are seeking the greater than normal profits available. A characteristic of a perfectly competitive market is ease of entry, thus it would be easy for new suppliers to enter the market. This increase in the supply would decrease the price and the economic profit would disappear for all of the price takers.

Oligopolies such as Big Godfrey Corporation and Red Devil Corporation are in an industry where barriers to entry exist. It is possible for each of them to sustain economic profit in the long run. If they are in an equilibrium that allows for long run profits, they may both be satisfied with this arrangement. They may in fact be engaged in tacit collusion. That is, an unspoken agreement based on past experiences. They may both understand that to pursue more aggressive pricing or market share building will result in an aggressive response by its competitor. This could leave them both worse off.

Perfect competitors do not have to deal with competitors, advertising, nor pricing decisions. Oligopolies do. They can make these decisions in a somewhat cooperative fashion where no firm tries to take too much away from the other. They could also make these decisions with a more non-cooperative strategy that challenges the other firm or firms. Either way, they had better try to anticipate what the other firm or firms will do and be prepared to react.

©Dick Brunelle, 2006