HE401 Tutorial Exercise I

Question 1 Consider an oligopoly in which three type of firms X, Y and Z produce a homogeneous product with quantity x, y and z, respectively. The inverse market demand for the product is given by p = D(Q), with D ≤ 0. The conventional assumption that Q = x + y + z applies, i.e., the actual market price adjusts to the demand so as to clear the market at every period. All firms are assumed to have an identical technology and hence an identical convex cost function C(q), that is, C (q) > 0 and C (q) > 0 for all q > 0. The profit of each firm is thus given by π (q, Q) = D (Q) q − C (q). For the convenience, we shall denote q = Q − q as the rest outputs of the industry for q = x, y, z. For instance, ˜ x = Q − x = y + z. ˜ Firm X is assumed to be a price-taker, whose current production x is determined by equating the marginal cost incurred with the price. That is, for any given x, the output response x = Rx x˜ is implicitly determined from the ˜ following identity: D = C (x) . (1)

Firm Y is a myopic absolute-profit optimizer (Cournot optimizer) with full information of the market. The output y = Ry y ˜ is implicitly but uniquely determined from the following first-order profit maximization condition: D + D y = C (y) . (2)

Firm Z, in contrast, is a relative-profit optimizer whose objective is to maximize its relative-profit with respect to the average profits of rest firms in the industry: max π (z, Q) −
z z

1 (π (x, Q) + π (y, Q)) 2

= max D (Q) z − z ˜ /2 + (C (x) + C (y)) /2 − C (z) As a result, the relative-profit maximizing response z = Rz z ˜ is implicitly derived from the following first-order condition: 1 D + D · (z − z ˜ ) = C (z) 2 Assume that the marginal revenue condition is always satisfied, that is, D + qD < 0 for all q = x, y, z. Answer the followings: 1. Comparing the responses of the three types of firms for a given identical rest outputs, that is, ranking Rx q ˜ , Ry q ˜ and Ry q ˜ . 2. Let (¯, y , z ) be a Nash-equilibrium so that no firm has incentive to change. Comparing the equilibrium outputs x ¯ ¯ and the equilibrium profits. 3. What happens if one of the firms exits the market? (3)