Answer to Question #314703 in Microeconomics for Cheu Soeur Lonh

Question

EnviroWest can produce recycle paper at a constant marginal cost of $1.5 per pound. Currently, the firm is selling 500,000 pounds each year at $2.00 per pound. This is the price charged by all other firms in the industry. Managers of EnviroWest are considering increasing the price to $2.5 per pound. Demand elasticity is constant and equals –0.6 if the price increase is matched by competitors and –4.0 if it is not matched. Management believes there is a 60 percent chance that other firms will follow EnviroWest's lead and increase their prices.

a/ If managers are risk neutral, should the proposed price change be implemented? Explain

b/ Write equation for the expected profit as a function of the probability that the price increase will be matched by the other firms.

Answer 1

Question 1

The companies MC=1.5 while the Market’s MR= 2 which is equal to the market price. Owing to this, the company is already operating above the firm’s equilibrium. The company’s decision to increase prices will lead to a loss of all their customers or a gain of profits depending on the decision other firms take. However, since in a perfect competitive market, firms are price takers, the move to change prices from the equilibrium price is a risky decision. Since, the managers are risk neutral it is advisable not to change prices.

Question 2

When prices change is followed by other firms then the total demand will decrease by 15%

Calculated as

Q = 0.25*-0.6

 =- 0.15

To calculate profit

0.6 ((100-15) * 500,000*(2.5-1.5))