Homework Set 6 Due date: 2020 – 04 – 23

Giorgi Tvaltvadze, Justinas Monkus, Nikita Podlesovskyi

1. ​Cost reduction and the Herfindahl and Lerner Indexes. Consider an industry where
demand has constant price elasticity and firms compete in output levels. In an initial
equilibrium, both firms have the same marginal cost, 𝑐. Then, Firm1 by investing heavily in
R&D, manages to reduce its marginal cost to 𝑐′ < 𝑐; a new equilibrium takes place.

Answer the following (in words as same as using formulas (where it is suitable)):
a.​What impact does the innovation have on the values of H and L?
b. ​What impact does innovation have on consumer welfare?

By reducing mc one firm gets an advantage in the market which is shown in its market share
increase. Market share increase leads to the increase in concentration of the market and
increase in market concentration leads to the increase of the market power. So Herfindahl is
market concentration index and Lerner is market power index, thus once increase leads to
H
another’s increase as long as we have constant price elasticity. L= −ε

a) Assume that firms have market 50/50 in SQ and after mc decrease for one firm 75/25

2 2
H= 0.5 + 0.5 =0.5 Market concentration SQ

0.5(p−c) 0.5(p−c) 0.5p−0.5c+0.5p−0.5c p−c

L= p + p = p = p =0.5 SQ

H
L=
−ε

L=ΣSi(P-MC)/P Assumption P=2 c=1 c’=0.5c

2 2
H= 0.75 + 0.25 =0.625

0.75(p−0.5c) 0.25(p−c) 0.75p−0.375c+0.25p−0.25c P −0.625c 2−0.625

L= p + p = p = p = 2 = 0.6875

b) In our case technological advantage of one firm leads to its mc decrease which in
turn implies decrease of the P. And a decrease in price is good for the consumer
welfare.

2.​Barriers to entry and welfare. “Barriers to entry may be welfare improving." What particular
industry characteristics might make this statement valid?

Given the relative homogeneity of the service or product and low elasticity of demand, it is
likely that the business stealing effect is significant.
Based on the business stealing effect theory, when the new firm enters the market its
profits are bigger than the social welfare brought by its entrance. Meaning that this new firm
becomes simply an additional firm in the market which only takes profits from other firms by
luring customers from others and not significantly influencing margins of the firms.
Which results in excessive entry.

3.​Technology and market structure. Consider an industry with market demand 𝑄 = 𝑎 − 𝑝 and
an infinite number of potential entrants with access to the same technology. Initially,
technology is given by 𝐶 = 𝐹 + 𝑐𝑞 . A new technology allows for a lower marginal cost,с ′ < 𝑐
, at the expense of a higher fixed cost, 𝐹′ > 𝐹.

Suppose that a = 10; F = 2; F’ = 3; c = 2; c’ = 1. Determine equilibrium price under each of

the two technologies.

If the amount of firms stays constant, decrease in marginal cost might lead to the
decrease in price but an important factor is to consider change in the number of firms
in the market. And that we can see depends also on the Fixed cost change by
considering those factors it is not entirely clear which of the effects will dominate.

For our case, we have the following situation.

Number of firms in the free entry equilibrium: n = (a − c) × √ S
F -1

P=a-Q/S ​we added S as an representation of market share of the company

Q
1) π = (a − S ) q i -c q i -F q i =q=Q/n P=a-Q/S
Δπ Q qi qn
2) Δqi = a- S - S -c=0 5) S(a-c)=q(n+1) 7) p=a- S
qn q (a−c) n (a−c)
3) a- S - S -c=0 6) S (n+1) =q p= a- S × S (n+1) =
an−nc an+a−an+nc
=a - n+1 = n+1
qn q
4) a-c= S +S
a+nc
p= n+1
a+nc
p= n+1

n1 = [(10-2)
√ -1]=4
1
2

n = [(10-1)
√ -1]=4
1
2 3
a+nc 10+4×2
p1 = n+1 = 5 =3.6
p2 = a+nc
n+1 =
10+4×1
5 =2.8

In our case, changes in fixed cost have not led to the entrance of the new firms, thus
because of the constant amount of firms P decreased based on the mc decrease.