Question

Question: Suppose you are the buyer of a good that you value at 1. It costs a seller 0.5 to produce the good. There is another seller (a “potential entrant”) working hard in his garage to produce an identical good at less than 0.5 so he can enter the market, undercut the incumbent seller and sell to you.

(a) Suppose the entrant burns down his garage and gives up. The incumbent remains a monopolist and charges you a price of 1. Will you accept this price?

(b) Suppose the entrant succeeds in producing the good at a cost of 0. Can there ever be an equilibrium where you pay more than 0.5 for the good? (Think Bertrand competition with no product differentiation).

(c) Suppose before the entrant either burns down his garage or succeeds, the incumbent offers you an exclusive contract that forces you to buy from the incumbent at a price p or face damages

d. If it’s 50/50 whether the entrant burns or succeeds, would you accept (p, d) = (1, 0.5) (i.e. a locked in price of 1, and damages of 0.5 if you break the contract and buy from the entrant)?

Answer 1

a). Yes, I will accept the price. Because I value the product at price of 1, which is also the price that the incumbent monopolist charges me.

b). Yes, there can be an equilibrium. This will be when:

the price charged by the incumbent = price charged by new entrant = price paid by the consumer.

Any deviation from this will not be Pareto optimum.

d). Yes, I would accept the locked price. This is because the expected price that I will have to pay is

0.5(1) + 0.5(0.5) = 0.5+0.25 = 0.75 which is lesser than 1.

And hence, I would accept (p,d) = (1,0.5)