Econ. 359: Industrial Organization
Spring 2008
 

Answers to Problem Set Number 6

1. The firm charges $10 to residential customers, and sells 200,000 lines (reading from the demand table). Revenues are $2 million per month.
 
b. The demand table for commercial lines shows increments of 50,000 lines. The marginal cost of an additional 50,000 lines at $5 per line per month is $250,000 per month. Marginal revenue falls to zero above 200,000 commercial lines. The profit-maximizing price will lie between $30 and $40 for commercial customers (either price is a correct answer). If it is $30, the firm has $6 million in commercial revenues. Total revenues are $8 million, variable costs are $2 million, fixed costs are $4 million, so the firm earns $2 million per month.
 
2. If firm B enters, both its and firm A's commercial demand is half of what is in the table. Marginal cost equals marginal revenue at the same price as before. If firm B enters, both firms maximize profits by charging a price of $30 to commercial customers, but each earns only$3 million from that market. Firm B has variable cost of $500,000 and fixed costs of $2 million, so it earns $500,000 per month. Firm A has the same revenues in commercial -- $3 million -- plus the $2 million from residential, variable costs of $1.5 million, and fixed costs of $4 million, yielding a loss of $500,000 per month. Firm A could keep B out by charging $20 per month. At this price, B's revenues fall to $2.5 million, variable costs increase to $625,000 (because demand increases), and B cannot cover fixed costs. At a commercial price of $20, A can therefore keep the entire market. It would have $5 million in commercial revenues, plus $2 million residential, for $7 million overall. Variable costs would be $2.25 million, yielding earnings after fixed costs of $750,000 per month. Firm A will therefore lower its price to $20 to keep B out. In this case, the threat of competition benefits commercial consumers in the regulated industry even if entry does not actually occur.