Econ. 359: Industrial Organization
Spring 2008
Problem Set Number 5
Due February
25, 2008
Suppose that the supply of cocaine reaching the North American market
from all countries other than Colombia is constant. If Colombian producers
do not sell any cocaine in North America, the market price is $2,000 per
kilo. Colombian producers are able to produce an essentially unlimited amount
of the drug for a constant marginal cost of $100 per kilo. However, Columbian
supply is initially nonexistant, because no one can raise the necessary fixed
cost of $400 million to establish and maintain a black market distribution
network.
1. A group of producers centered in the city of Cali forms a cartel
in order to raise the $400 million and enter the North American market. For
insurance against prosecution in their own country, they pay the equivalent
of an additional marginal cost of $100 per kilo in bribes to police, politicians
and judges, in addition to the $100 marginal production cost (total variable
cost=$200/kilo) . As they begin to supply the North American market, they
discover that for each million kilos sold, the price drops by $100 per kilo.
Assuming that all cocaine sells for the same price,
a. What is marginal revenue for the cartel
for each million kilos they supply?
b. How much would the Cali cartel send to North America annually?
c. What would be the market price?
d. How much profits would the cartel earn?
2. Now a group of cocaine producers near the city of Medellin notices
how rich the Cali producers are getting, and forms another cartel. They
also need to spend $400 million in fixed costs. They can use guns to protect
their operation, which keeps their marginal costs at only $150 per kilo, including
the cost of "protection". If the Medellin cartel assumes that the supply
to the market from all other sources (including Cali) remains constant, what
would be their:
a. Marginal revenue cartel at each million
kilos they supply?
b. Quantity Medellin would supply to maximize their own profits?
c. New market price?
d. Profits (net of fixed costs)?
3. Now the Cali cartel realizes they have potential competition from
Medellin, and holds a meeting to decide whether to increase supplies and
reduce the price in order to keep Medellin out or let them in and accommodate
the new supply.
a. How low would the Cali cartel need to get
the price to make it unprofitable for Medellin to enter, how much would they
have to sell to get the price that low, and what would be their profits?
b. If they let Cali in, what would be the equilibrium price, quantities,
and profits that each cartel would supply where neither has an incentive
to change production (the Cournot-Nash equilibrium)? Remember, in this round
Cali does not have fixed costs, but Medellin does.
c. Which strategy is best for Cali? What do they decide to do?