Thursday, October 22, 2015

Iron Ore Mining

The Wall Street Journal reports that even though iron ore prices are falling and the demand for iron ore to slow that the three largest iron ore miners are increasing production.  This seems inconsistent with the profit maximizing model - and it is.  Yet it is also strategic and is consistent with the limit output model of Cournot oligopoly.

Basically the limit output model looks at whether a firm (or group of firms such as in this case) can increase output such as to limit the amount of output that their rivals produce (in the extreme case drive the rival firms out of the market).  Since the firms are choosing the amount of output to produce this is consistent with the Cournot oligopoly model.

For this to work, the incumbent (or in this case the larger firms) have to have greater economies of scale than their rivals - which seems to be true as the larger firms have lower average variable costs than smaller iron ore mining firms.  Thus as discussed in class - here is an excellent example of firms trying to increase their profits by increasing production such that other firms decrease their production.  Having lower average variable costs can still result in greater profit even with falling prices due to increases in the firms production offsetting the decline in margins.

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