Economics 161 Exercise Set 2 1st Semester 2013-2014 Due Date: August 8, 2013 1.

Suppose each of two firms must simultaneously choose to set either a high price or a low price. The normal-form representation of this game is

_________________________________________ ____________________ Firm 1__________ High Price Low Price ____Firm 2________________________________ High Price $5 $5 -$5 S10 Low Price $10 -$4 $0 $0__ where profits are shown in the cells. How many Nash equilibria are there? Identify each equilibrium. 2. An industry consists of two firms with identical costs C(q) 5q /2. The firms can either collude or compete. If both collude, they each produce (half the monopoly output Qm). If one firm colludes and the other competes, the latter produces the output that maximizes its profits given that the other firm produces qm. If both compete, they play Cournot and each produce . Calculate these outputs and the resulting profits if market demand is Q 125 p. Represent your results as a normal-form game. What is the Nash equilibrium if the game is only played once? An industry consists of two firms which can either collude or compete in each period. The per period payoffs of doing either are as follows:

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__________________________________ __ ________ Firm 1__________ Firm 2 Collude Compete__ Collude $50 $50 -$10 $75 Low Price $75 -$10 $45 $45_ If the firms initially collude, either of them can earn $25 extra by cheating on the agreement and competing instead. The other firm can retaliate, however, by refusing to collude in subsequent periods. (i) (ii) (iii) (iv) For how many periods would such retaliation have to last to deter cheating if the interest rate is 0%, so that the firms do not discount future profits? Would this minimum retaliation period be longer if the interest rate were positive? Why or why not? What is the minimum retaliation period if the interest rate is 10%? Is there an interest rate so high that no retaliation ever deters cheating? If so, what is it?

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Show graphically that if a firms MC=AC=a constant, it will produce a product if it is socially desirable for that product to be produced. An econometrician estimates the relationship where is the demand for a product, is the effect on that demand of a unit change in the price of the product itself, and is the effect of a unit change in the price of a rival product. It is found that and are significantly different from zero, but insignificantly different from each other. What does this suggest about the appropriate model for analyzing the market for these products, assuming there is free entry into that market? Recalculate columns 2 to 4 of Table 7.2 in the text, letting marginal costs be 68 rather than 28. What do your results suggest about the effect a per unit sales tax would have on the equilibrium in a monopolistically competitive industry with homogeneous goods, given the assumptions of linear costs and demand? All firms in a Cournot monopolistically competitive industry have the same cost function C(q) 25 10q. Market demand is Q 110 p. (i) (ii) (iii) Calculate the equilibrium price, firm output, total output and number of firms in the industry. How would these values change if a franchise tax of $75 were imposed on each firm? What if a technical innovation were to reduce unit production costs to $5? A unit circle representing the dimension of mouth feel in breakfast cereals has 200 consumers spread uniformly along it. All consumers buy either one package of cereal a week or none at all (in which case they eat bread) and incur disutility c 200 from each unit distance by which a brand deviates from their favorite mouth feel. They derive utility v 20 from eating bread. (i) (ii) (iii) What is the equation for the demand curve facing cereal makers? (Distinguish the monopolistic and competitive segments, but ignore the supercompetitive segment.) What is the symmetric equilibrium under free entry if the cereal makers costs are C(q) 128 4q? What if fixed costs fall to 100? In models of monopolistic competition, entry of comparable goods makes each competitors residual demand curve retreat until it is just tangent to the average cost curve. Students are told that each competitor then prices at average cost, for a profit of zero. Students often ask why firms are not producing a quantity (and setting a price) according to the usual condition, that marginal cost equals marginal revenue. Using a linear demand curve, prove that there is no contradiction between the two positions. An industry consist of three firms with identical costs = 150 p. (i) . Market demand is Q

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What is the industry equilibrium (price, output and profits) if the firms have Cournot beliefs.

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(iii) 11.

Would it pay for Firm 1 and Firm 2 to merge, if, after the merger, the remaining firm plays Cournot? (Hint: carefully consider if the merged firm would produce using both original firms plants or just those of one firm.) What happens if their costs are C(q) = 18q instead?

Firms A and B are the only ones in a market, and they decide to merge and become a monopoly. To decide how to allocate production between the divisions A and B (previously two independent firms), management must determine the monopolys merged marginal cost. Assuming that the divisions still produce separately, calculate the monopolys marginal cost if The divisions cost were given by: (i) (ii) (iii)