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Industrial Organization

Theory and Applications

by Oz Shy

The MIT Press

Cambridge, Massachusetts

London, England

Copyright c 1995–2004 Oz Shy. All rights reserved.

The manual was typeset by the author using the L

A

T

E

X2

ε

document preparation software by

Leslie Lamport (a special version of Donald Knuth’s T

E

X program) during the months from

September 1995 to November 1995 while I was visiting the Economics Department of the

University of Michigan. All the ﬁgures are also drawn in L

A

T

E

X using software called T

E

Xcad

developed by Georg Horn, which can be downloaded from various mainframes.

Version 1.0 [Draft 20], (1995): Prepared for the ﬁrst printing of the ﬁrst edition

bkman21.tex ﬁrst draft to be posted on the Web (2000/07/07)

(parallel to the 5th Printing of the book)

v.24 (2004/04/14): 6.1.d, 6.1.e

This version: bkman24.tex 2004/04/14 17:36

Contents

To the Instructor v

2 Basic Concepts in Noncooperative Game Theory 1

3 Technology, Production Cost, and Demand 7

4 Perfect Competition 9

5 The Monopoly 11

6 Markets for Homogeneous Products 17

7 Markets for Diﬀerentiated Products 25

8 Concentration, Mergers, and Entry Barriers 29

9 Research and Development 33

10 The Economics of Compatibility and Standards 35

11 Advertising 37

12 Quality, Durability, and Warranties 39

13 Pricing Tactics: Two-Part Tariﬀ and Peak-Load Pricing 43

14 Marketing Tactics: Bundling, Upgrading, and Dealerships 45

15 Management, Compensation, and Regulation 49

16 Price Dispersion and Search Theory 51

17 Miscellaneous Industries 53

To the Instructor

Before planning the course, I urge the instructor to read carefully the Preface of the book that

suggests diﬀerent ways of organizing courses for diﬀerent levels of students and also provides a

list of calculus-free topics.

The goals of this manual are:

• To provide the instructor with my solutions for all the problems listed at the end of each

chapter;

• to convey to the instructor my views of what the important concepts in each topic are;

• to suggest which topics to choose for diﬀerent types of classes and levels of students.

Finally, please alert me to any errors or incorrect presentations that you detect in the book

and in this manual. (e-mail addresses are given below). Note that the errata ﬁles (according

to the printing sequence) are posted on the Web in PDF format. Before reporting errors and

typos, please view the errata ﬁles to see whether the error you found was already identiﬁed and

corrected.

Haifa, Israel, (April 14, 2004)

E-mail : ozshy@ozshy.com

Backup : OzBackup@yahoo.com

Web-page : www.ozshy.com

Catalog-page : http://mitpress.mit.edu/book-home.tcl?isbn=0262691795

This draft : bkman24.tex 2004/04/14 17:36

Chapter 2

Basic Concepts in Noncooperative Game Theory

An instructor of a short course should limit the discussion of game theory to the four most

important concepts in this chapter that are essential for the understanding most of the analyses

presented in this book:

1. The deﬁnition of a game (Deﬁnition 2.1): It is important that the student will understand

that a game is not properly deﬁned unless the list of players, the action set of each player,

and the payoﬀ functions are clearly stated. It is important that the student will understand

the meaning of the term outcome as a list of the speciﬁc actions chosen by each player

(and not a list of payoﬀs as commonly assumed by students).

2. Nash equilibrium (Deﬁnition 2.4).

3. Welfare comparisons among outcomes (Deﬁnition 2.6).

4. Extensive form games, strategies (compare with actions), subgames, and the SPE (Deﬁ-

nition 2.10).

I urge the instructor to discuss the issues of existence, uniqueness, and multiple equilibria in

class. More precisely, it is important that the student will know that in order to prove existence,

it is suﬃcient to ﬁnd only one NE outcome; however, to prove nonexistence, the student must

go over all outcomes and show that at least one player beneﬁts from unilateral deviation.

I believe that the above can be covered in 2 lectures, or in three hours of instruction. If

you wish to devote more time to game theory, you can introduce the equilibrium in dominant

actions (Deﬁnition 2.3) before teaching the NE equilibrium concept. If you wish to emphasis

more game theory, I advise covering repeated games (section 2.3).

Answers to Exercises

1. (a) It is straightforward to conclude that

R

1

(a

2

) =

WAR if a

2

= WAR

WAR if a

2

= PEACE

and R

2

(a

1

) =

WAR if a

1

= WAR

WAR if a

2

= PEACE.

That is, WAR is each player’s best response to each action taken by the other player

(hence, WAR is a dominant action for each player). Now, (ˆ a

1

, ˆ a

2

) = (WAR, WAR)

is a (unique) NE since this outcome is on the best-response function of each player.

(b)

R

J

(a

R

) =

ω if a

R

= ω

φ if a

R

= φ

and R

R

(a

J

) =

φ if a

J

= ω

ω if a

J

= φ.

There does not exist a NE for this game since there does not exist an outcome the

is on both best-response functions. That is, R

J

(ω) = ω, but R

R

(ω) = φ, but

R

J

(φ) = φ, but R

R

(φ) = ω, so R

J

(ω) = ω, and so on.

2 Basic Concepts in Noncooperative Game Theory

(c)

R

α

(a

β

) =

B if a

β

= L

T if a

β

= R

and R

β

(a

α

) =

L if a

α

= T

R if a

α

= B.

A NE does not exist for this game since R

α

(L) = B, but R

β

(B) = R, but R

α

(R) =

T, so R

β

(T) = L, and so on.

2. (a) If (T, L) is a NE, then

π

α

(T, L) = a ≥ e = π

α

(B, L), and π

β

(T, L) = b ≥ d = π

β

(T, R).

(b) If (T, L) is an equilibrium in dominant actions, then T has to be a dominant action

for player α, that is

π

α

(T, L) = a ≥ e = π

α

(B, L) and π

α

(T, R) = c ≥ g = π

α

(B, R);

and L is a dominant action for player β, that is

π

β

(T, L) = b ≥ d = π

β

(T, R), and π

β

(B, L) = f ≥ h = π

β

(T, R).

Let us observe that the parameter restrictions given in part (a) are also included in

part (b) conﬁrming Proposition 2.1 which states that an equilibrium in dominant

actions is also a NE.

(c) i. (T, L) Pareto dominates (T, R) if (a ≥ c and b > d) or (a > c and b ≥ d);

ii. (T, L) Pareto dominates (B, R) if (a ≥ g and b > h) or (a > g and b ≥ h);

iii. (T, L) Pareto dominates (B, L) if (a ≥ e and b > f) or (a > e and b ≥ f).

(d) Loosely speaking, the outcomes are Pareto noncomparable if one player prefers (T, L)

over (B, R), whereas the other player prefers (B, R) over the outcome (T, L). For-

mally, either

π

α

(T, L) = a > g = π

α

(B, R) but π

β

(T, L) = b < h = π

β

(B, R),

or

π

α

(T, L) = a < g = π

α

(B, R) but π

β

(T, L) = b > h = π

β

(B, R).

3. (a) There are three Pareto optimal outcomes:

i. (n

1

, n

2

) = (100, 100), where π

1

(100, 100) = π

2

(100, 100) = 100;

ii. (n

1

, n

2

) = (100, 99), where π

1

(100, 99) = 98 and π

2

(100, 99) = 101;

iii. (n

1

, n

2

) = (99, 100), where π

1

(99, 100) = 101 and π

2

(99, 100) = 98;

(b) There is no NE for this game.

1

To prove this, we have to show that for every outcome

(n

1

, n

2

), one of the players will beneﬁt from changing his or her declared value. Let

us look at the following outcomes:

1

A typo in the question (ﬁrst printing) leads to this undesirable result (see Basu, K. 1994. “The Traveler’s

Dilemma: Paradoxes of Rationality in Game Theory.” American Economic Review 84: 391–395; for a mechanism

that generates (2, 2) as a unique NE outcome).

Basic Concepts in Noncooperative Game Theory 3

i. If (n

1

, n

2

) = (100, 100), then player 1 can increase his or her payoﬀ to π

1

= 101

by declaring n

1

= 99.

ii. If (n

1

, n

2

) = (99, 100), then player 2 can increase his or her payoﬀ from π

2

= 98

to π

2

= 99 by declaring n

2

= 99. Hence, players always beneﬁt from declaring

a value of one dollar lower than the other player, and so on.

iii. If (n

1

, n

2

) = (2, 2), then player 1 can increase his or her payoﬀ from π

1

= 2 to

π

1

= 98 by declaring n

1

= 100.

4. (a) There are several NE outcomes for this game. For example, (LG, SM, SM) is a NE

outcome since

π

C

(LG, SM, SM) = α ≥ γ = π

C

(SM, SM, SM)

π

F

(LG, SM, SM) = β = β = π

F

(LG, LG, SM)

π

G

(LG, SM, SM) = β = β = π

G

(LG, SM, LG).

Hence, no ﬁrm ﬁnds it proﬁtable to unilaterally change the type of cars it produces.

(b) Again, there are several NE. The outcome (LG, SM, SM) is also a NE for this game,

and the proof is identical to the one given in part (a).

5. (a) There are three subgames: the game itself, and two proper subgames labeled JL

(for Jacob left) and JR (for Jacob right). The three subgames are illustrated in

Solution-Figure 2.1.

•

◦

•

φ

ω

ω

φ φ

ω

Rachel

Jacob

π

R

= 2

π

J

= 1

π

R

= 0

π

J

= 0

π

R

= 0

π

J

= 0

π

R

= 1

π

J

= 2

•

ω

φ

π

R

= 0

π

J

= 0

π

R

= 1

π

J

= 2

•

φ

ω

π

R

= 2

π

J

= 1

π

R

= 0

π

J

= 0

JL JR

Solution-Figure 2.1: Three subgames of the dynamic Battle of the Sexes

(b) One easy way to ﬁnd NE outcomes for an extensive form game is to construct a

normal-form representation.

2

However, the normal-form representation is already

given in Table 2.2. Also, equation (2.1) proves that the NE outcomes involve the

two players going together either to football or to the opera. Formally, it is easy to

verify that the following three outcomes constitute NE:

s

J

=

φ if s

R

= ω

φ if s

R

= φ

and s

R

= φ,

2

This subquestion may confuse students who are already thinking in terms of backward induction. Since our

analysis is based on SPE you may want to avoid assigning this subquestion (only). Also, an instructor teaching

from the ﬁrst printing is urged to change this subquestion to ﬁnding the NE for the entire game only; hence, to

postpone ﬁnding the NE for the subgames to the next subquestion, where the NE of the subgames are used to

ﬁnd the SPE.

4 Basic Concepts in Noncooperative Game Theory

s

J

=

ω if s

R

= ω

ω if s

R

= φ

and s

R

= ω,

s

J

=

ω if s

R

= ω

φ if s

R

= φ

and s

R

= φ.

(2.1)

(c) Using backward induction, we ﬁrst construct Jacob’s strategy (which constitutes the

Nash equilibria for the two proper subgames). Looking at the proper subgames in

Solution-Figure 2.1, we conclude that

R

J

(a

R

) =

ω if a

R

= ω (subgame JR)

φ if a

R

= φ (subgame JL).

Now, we look for Rachel’s strategy (given Jacob’s best response). If Rachel plays

a

R

= ω, then her utility is given by π

R

(ω, R

J

(ω)) = 1. In contrast, if Rachel plays

a

R

= φ, then her utility is given by π

R

(φ, R

J

(φ)) = 2 > 1. Altogether, the strategies

s

R

= a

R

= φ and R

J

(a

R

) =

ω if a

R

= ω

φ if a

R

= φ

constitute a unique SPE.

(d) No! Jacob’s best response is to play φ whenever Rachel plays φ. Thus, Jacob’s

announcement constitutes an incredible threat.

3

Clearly, Rachel, who knows Jacob’s

best-response function in the second stage, should ignore Jacob’s announcement,

since Jacob, himself, would ignore it if Rachel plays φ in the ﬁrst stage.

6. (a) Jacob’s expected payoﬀ is given by:

Eπ

J

(θ, ρ) = θρ ×2 +θ(1 −ρ) ×0 + (1 −θ)ρ ×0 + (1 −θ)(1 −ρ) ×1

= 2 + 3θρ −ρ −θ.

Rachel’s expected payoﬀ is given by:

Eπ

R

(θ, ρ) = θρ ×1 +θ(1 −ρ) ×0 + (1 −θ)ρ ×0 + (1 −θ)(1 −ρ) ×2

= 2 + 3θρ −2ρ −2θ.

(b) The players’ best-response functions are given by

R

J

(ρ) =

0 if ρ < 1/3

[0, 1] if ρ = 1/3

1 if λ > 1/3

and R

R

(θ) =

0 if θ < 2/3

[0, 1] if θ = 2/3

1 if θ > 2/3.

The players’ best-response functions are drawn in Solution-Figure 2.2.

(c) Solution-Figure 2.2 demonstrates that (θ, ρ) = (2/3, 1/3) is a NE in mixed actions.

Also, note that the outcomes (0, 0) and (1, 1) are also NE outcomes in mixed actions

and are the same as the pure NE outcomes.

3

Instructors: Here is a good opportunity to discuss the concepts of credible and incredible threats.

Basic Concepts in Noncooperative Game Theory 5

✻

✲

ρ

θ

✻

✲

θ

ρ

✻

✲

ρ

θ

1 1 1

1 1 1

1

3

R

R

(θ) R

J

(ρ)

R

R

(θ)

R

J

(ρ)

•

2

3

2

3

1

3

•

•

Solution-Figure 2.2: Best-response functions for the Battle of the Sexes in mixed actions

(d) Substituting (θ, ρ) = (2/3, 1/3) into the players’ payoﬀ functions (deﬁned above)

yield

Eπ

J

(2/3, 1/3) = Eπ

R

(2/3, 1/3) =

2

3

.

(e) The best-response functions in Solution-Figure 2.2 intersect three times, meaning

that in the mixed extension game, there are two equilibria: the two pure NE outcomes

and one NE in mixed actions. In contrast, Figure 2.3 has only one intersection since

in that game NE in pure strategies does not exist, and therefore the best-response

functions intersect only once, at the NE in mixed actions.

Chapter 3

Technology, Production Cost, and Demand

This chapter summarizes the basic microeconomic tools the students need to know prior to

taking this class. My advice for the instructor is not to spend time on this chapter but simply

assign this chapter (with or without the exercises) as reading in the ﬁrst class. However, my

advice is to return (or refer) to this chapter whenever deﬁnitions are needed. For example, when

you ﬁrst encounter a discussion of returns to scale, I urge you to make a formal deﬁnition and

refer the students to Deﬁnition 3.2. Similarly, when addressing elasticity issues, students should

be referred to Deﬁnition 3.3.

Answers to Exercises

1. (a) Let λ > 1. Then, by Deﬁnition 3.2, the technology exhibits IRS if

(λl)

α

(λk)

β

= λ

α+β

l

α

k

β

> λl

α

k

β

,

which holds when α + β > 1. Using the same procedure and Deﬁnition 3.2, this

technology exhibit CRS if α +β = 1, and DRS if α +β < 1.

(b) In this technology, the factors are supporting since

MP

L

(l, k) ≡

∂Q

∂l

= αl

α−1

k

β

,

hence,

∂MP

L

(l, k)

∂k

= αβl

α−1

k

β−1

,

which is greater than zero under the assumption that α, β > 0.

2. (a) Let λ > 1. Then, by Deﬁnition 3.2, the technology exhibits IRS if

(λl)

α

+ (λk)

α

= λ

α

(l

α

+k

α

) > λ(l

α

+k

α

),

which holds if α > 1. Similarly, the technology exhibits DRS if α < 1, and CRS if

α = 1.

(b) MP

L

(l, k) = αl

α−1

. Hence, ∂MP

L

(l, k)/∂k = 0. Therefore, the factors are neither

substitutes nor complements.

3. Let λ > 1. This (quasi-linear) technology exhibits DRS since

λl +

√

λk < λl +λ

√

k = λ(l +

√

k).

4. (a)

AC(Q) =

TC(Q)

Q

=

F

Q

+c, and MC(Q) =

∂TC(Q)

∂Q

= c.

These functions are drawn in Figure 4.2 in the book.

8 Technology, Production Cost, and Demand

(b) Clearly, AC(Q) declines with Q. Hence, AC(Q) is minimized when Q = +∞.

(c) Declining average cost function reﬂects an increasing returns to scale technology.

5. (a) Using Deﬁnition 3.3,

η

p

(Q) ≡

∂Q(p)

∂Q

p

Q

= (−1)

p

Q

= −

99 −Q

Q

.

Hence, η

p

(Q) = −2 when Q = 33.

(b) From the above, η

p

(Q) = −1 when Q = 99/2 = 49.5.

(c) The inverse demand function is given by p(Q) = 99 − Q. Therefore, TR(Q) =

p(Q)Q = (99−Q)Q. Hence, MR(Q) ≡ dTR(Q)/dQ = 99−2Q, which is a special

case of Figure 3.3.

(d) MR(Q) = 0 when Q = 49.5. That is, the marginal revenue is zero at the output

level where the demand elasticity is −1 (unit elasticity).

(e) Using Figure 3.5,

CS(33) =

(99 −33)66

2

= 2178, and CS(66) =

(99 −66)33

2

= 544.5

6. (a)

p

=

A

Q

. Hence, p = A

1

Q

−

1

.

(b)

η

p

=

∂Q(p)

∂Q

p

Q

= A(−)p

−−1

p

Q

=

A(−)p

−

Ap

−

= −.

Thus, the elasticity is constant in the sense that it does not vary with the quantity

consumed.

(c) The demand is elastic if η

p

< −1, hence if > 1. The demand is inelastic if

−1 < η

p

≤ 0, hence if 0 ≤ < 1.

(d) By Proposition 3.3, MR = p[1 + 1/(−)]. Hence,

p

MR

= 1

1 +

1

−

=

−1

which is independent of Q.

Chapter 4

Perfect Competition

A perfectly competitive market is characterized by nonstrategic ﬁrms, where ﬁrms take the

market price as given and decide how much to produce (and, whether to enter, if free entry is

allowed). Most students probably had some discussion of perfectly competitive markets in their

intermediate microeconomics class. However, given the importance of this market structure, I

urge the instructor to devote some time in order to make sure that the students understand

what price-taking behavior means.

It is now the right time to emphasize that, in economics, the term competitive refers to

price taking behavior of agents. For example, we generally assume that our consumers are

competitive, which means that they do not bargain over prices and take all prices and their

income as given. In a competitive market structure, we make a similar assumption about the

ﬁrms.

You may want to emphasize and discuss the following points:

1. The assumption of price taking behavior has nothing to do with the number of ﬁrms in the

industry. For example, one could solve for a competitive equilibrium even in the presence

of one ﬁrm (see an exercise at the end of this chapter). Note that this confusion often

arises since certain market structures yield market allocations similar to the competitive

allocation when the number of ﬁrms increases (see for example subsection 6.1.2 which

shows that the Cournot allocation may converge to the competitive allocation when the

number of ﬁrms increases to inﬁnity).

2. A major reason for studying and using alternative (noncompetitive) market structures

stems from the fact that the competitive market structure very often “fails” to explain

why concentrated industries are observed.

3. Another major reason for studying alternative market structures stems from the nonexis-

tence of a competitive equilibrium when ﬁrms’ technologies exhibit IRS.

Finally, note that this chapter does not solve for a competitive equilibrium under decreasing

returns to scale technologies for two reasons: (i) other market structures analyzed in this book

are also developed mainly for CRS (unit cost) technologies, and (ii) most students are familiar

with the DRS from their intermediate microeconomics class. However, the exercise at the end

of this chapter deals with a DRS technology.

Answers to Exercises

1. Firm 1 takes p as given and chooses q

1

to

max

q

1

π

1

= pq

1

−wL

1

= p

L

1

−wL

1

.

10 Perfect Competition

The ﬁrst and second order conditions are given by

0 =

dπ

1

dL

1

=

p

2

√

L

1

−w,

d

2

π

1

d(L

1

)

2

= −

p

4L

3/2

1

< 0.

Hence, q

1

=

√

L

1

= p/(2w).

2. Given that there is only one ﬁrm, the supply equals demand equilibrium condition yields

that 120 −p

e

= p

e

/2. Therefore, p

e

= 80; hence, q

e

1

= Q

e

= p

e

/2 = 40.

3. From the production function, we can ﬁnd the equilibrium employment level to be L

e

1

=

(q

e

1

)

2

= 1600. Hence,

π

1

= p

e

q

e

1

−wL

e

1

= 80 ×40 −1600 = 1600.

4. Given that the ﬁrms have the same technologies, they have the same supply functions.

Therefore, the supply equals demand condition becomes 120 − p

e

= p

e

/2 + p

e

/2, which

yields p

e

= 60, Q

e

= 120 −60 = 60, hence, q

e

1

= q

e

2

= 30.

5. Clearly, the competitive price is lower and the aggregate production is higher when the

industry consists of two ﬁrms.

6.

✲

✻

p p = 2q

1

q

1

✲

✻

p p = 2q

2

q

2

✲

✻

p p = q

1

+q

2

Q = q

1

+q

2

30 30 60

60

• • •

120

120

p = 120 −Q

Solution-Figure 4.1: Competitive equilibrium with two ﬁrms

Chapter 5

The Monopoly

Most students encounter the monopoly problem in their intermediate microeconomics class.

However, the instructor would probably want to make sure that all students fully understand the

monopoly’s choice problem and the eﬀect of price elasticity on the monopoly’s price, as well as

the arguments against monopoly (section 5.2). I also urge the instructor not to skip discussing

discriminating monopoly (section 5.3).

The remaining sections, the cartel (section 5.4), and the durable goods monopolies (sec-

tion 5.5) are more optional depending on the instructor’s tastes and students’ ability.

Answers to Exercises

1. (a)

η

p

≡

dQ

dp

p

Q

= ap

−−1

p

ap

−

= −.

Hence, the exponential demand function has a constant price elasticity. By Propo-

sition 3.3,

MR(Q) = p

1 +

1

−

= p

−1

.

(b) Equating marginal revenue to marginal cost yields

1

MR = p

M

−1

= c = MC; hence, p

M

=

c

−1

.

(c) As increases, the demand becomes more elastic, hence, the monopoly price must

fall. Formally,

dp

M

d

=

c( −1) −c

( −1)

2

< 0.

(d) The ﬁrst edition (ﬁrst printing) contains a typo. The question asks what happens to

the monopoly’s price when →+1. Clearly, p

M

→+∞. The reason is, that when

= 1, the (entire) demand has a unit elasticity, implying that revenue does not vary

with price (or quantity produced). Hence, given that the revenue is constant (in

fact TR = a when = 1), then the proﬁt maximization problem is reduced to cost

minimization which yields that the monopoly would “attempt” to produce as little

as possible (but still a strictly positive amount).

1

The instructor may want to emphasize to the students that in the case of constant-elasticity demand functions

(exponential demand functions) it is easier to solve for the monopoly’s price ﬁrst (using Proposition 3.3) and then

solve for the quantity produced by substituting the price into the demand function. This procedure becomes very

handy when solving monopolistic competition equilibria analyzed in section 7.2.

12 The Monopoly

(e) Inverting the demand function yields p(Q) = a

1/

Q

−1/

. Thus,

TR(Q) ≡ p(Q)Q = a

1

Q

1−

1

.

Hence,

MR(Q) ≡

dTR(Q)

dQ

= a

1

Q

−

1

1 −

1

.

(f) Equating marginal revenue to marginal cost yields

a

1

Q

−

1

1 −

1

= c,

yielding that the monopoly’s proﬁt maximizing output is

Q

M

= a

−1

c

.

Note that the same result is achieved by substituting p

M

(calculated before) into the

demand function.

2. (a) Solution-Figure 5.1 illustrates an aggregate demand composed of the two groups of

consumers, where each group shares a common valuation for the product.

✲

Q

p

V

H

V

L

n

H

n

H

+n

L

✻

Solution-Figure 5.1: Aggregate demand composed of two consumer groups

(b) The monopoly has two options

2

: setting a high price, p = V

H

, or a low price,

p = V

L

. Solution-Figure 5.1 reveals that the proﬁt levels (revenue since production

is costless

3

) are given by

π|

p=V

H = n

H

V

H

, and π|

p=V

L = (n

H

+n

L

)V

L

.

Comparing the two proﬁt levels yields the monopoly’s proﬁt maximizing price. Hence,

p

M

=

V

H

if V

H

> (n

H

+n

L

)V

L

/n

H

V

L

otherwise.

2

Instructors are urged to assign or discuss this exercise, since it provides a good opportunity to introduce the

student to a discrete (logic based) analysis which is used later in a wide variety of topics (see for example the

section on tying [section 14.1]).

3

The ﬁrst printing of the ﬁrst edition neglects to assume that production of G-Jeans is costless.

The Monopoly 13

Thus, the monopoly sets a high price if either there are many high valuation con-

sumers (n

H

is large) and/or these consumers are willing to pay a very high price

(V

H

is high).

3. (a) In market 1, p

1

= 2 −q

1

. Hence, by Proposition 3.2, MR

1

(q

1

) = 2 −2q

1

. Equating

MR

1

(q

1

) = c = 1 yields q

1

= 0.5. Hence, p

1

= 1.5.

In market 2, p

2

= 4 −q

2

. Hence, by Proposition 3.2, MR

2

(q

2

) = 4 −2q

2

. Equating

MR

2

(q

2

) = c = 1 yields q

2

= 1.5. Hence, p

2

= 2.5.

(b) π

1

= (p

1

− c)q

1

= (0.5)

2

= 0.25, and π

2

= (p

2

− c)q

2

= (1.5)

2

= 2.25. Summing

up, the monopoly’s proﬁt under price discrimination is π = 2.5.

(c) There are two cases to be considered: (i) The monopoly sets a uniform price p ≥ 2

thereby selling only in market 2, or (ii) setting p < 2, thereby selling a strictly positive

amount in both markets. Let us consider these two cases:

i. If p ≥ 2, then q

1

= 0. Therefore, in this case the monopoly will set q

2

maximize

its proﬁt in market 2 only. By subquestion 3a above, π = π

2

= 2.25.

ii. Here, if p < 2, q

1

> 0 and q

2

> 0. Therefore, aggregate demand is given by

Q(p) = q

1

+q

2

= 2−p+4−p = 6−2p, or p(Q) = 3−0.5Q. By Proposition 3.2,

MR(Q) = 3 − Q. Equating MR(Q) = c = 1 yields Q = 2, hence, p = 2.

Hence, in this case π = (p −c)2 = 2 < 2.25.

Altogether, the monopoly will set a uniform price of p = 2.5 and will sell Q = 1.5

units in market 2 only.

4

4. (a)

π(q

1

, q

2

) = (100 −q

1

/2)q

1

+ (100 −q

2

)q

2

−(q

1

+q

2

)

2

.

(b) The two ﬁrst order conditions are given by

0 =

∂π

∂q

1

= 100 −q

1

−2(q

1

+q

2

)

0 =

∂π

∂q

2

= 100 −2q

2

−2(q

1

+q

2

).

Solving for q

M

1

and q

M

2

yields that q

M

1

= 25 and q

M

2

= 12.5.

(c) Substituting the proﬁt maximizing sales into the market demand functions yield

p

M

1

= p

M

2

= 87.5. Hence,

π(q

M

1

, q

M

2

) = 87.5 ×12.5 + 87.5 ×25 −(12.5 + 25)

2

= 1875.

(d) Now, that each plant sells only in one market, the two ﬁrst order conditions become

0 =

∂π

∂q

1

= 100 −q

1

−2q

1

0 =

∂π

∂q

2

= 100 −2q

2

−2q

2

.

4

Note that consumers in market 1 are better oﬀ under price discrimination than without it, since under no

discrimination no output is purchased in market 1. Given that the price in market 2 is the same under price

discrimination and without it, we can conclude that in this example, price discrimination is Pareto superior to

nonprice discrimination, since both consumer surplus and the monopoly proﬁt are higher under price discrimination.

14 The Monopoly

yielding q

M

1

= 100/3 and q

M

2

= 25.

(e) p

M

1

= 100 −100/6 = 250/3 and p

M

2

= 100 −25 = 75. Hence,

π = π

1

(q

1

) +π

2

(q

2

) =

250

3

×

100

3

−

100

3

2

+ 75 ×25 −25

2

= 2917.

(f) This decomposition increases the monopoly’s proﬁt since the technology exhibits

DRS.

5. By section 5.3, the discriminating monopoly will set quantities to satisfy MR

1

(q

M

1

) =

MR

2

(q

M

2

). Hence, by Proposition 3.3

MR

1

(q

1

) = p

M

1

1 +

1

−2

= p

M

2

1 +

1

−4

= MR

2

(q

2

).

Thus, p

M

1

= 1.5p

M

2

.

6. (a) We solve for the monopoly’s proﬁt maximizing prices starting from the second period.

The second period outcome may depend on two cases:

First-period consumer does not buy in period 1: Clearly, in this case, the sec-

ond period proﬁt maximizing price is p

2

= 50, yielding a proﬁt level of π

2

=

3 ×50 = 150.

First-period consumer buys in period 1: In this case the second period proﬁt max-

imizing price is again p

2

= 50, yielding a proﬁt level of π

2

= 2 ×50 = 100.

Altogether, the second-period price is independent of the action of the ﬁrst-period

buyer in the ﬁrst period. Therefore, the maximum price the monopoly can charge

the ﬁrst-period buyer in the ﬁrst period is p

1

= 150.

(b) The second period outcome may depend on two cases:

First-period consumer does not buy in period 1: In this case, the monopoly has

two choices: (i) charging p

2

= 20, and sell to all three consumers, thereby

earning a second period proﬁt of π

2

= 3 × 20 = 60; or, (ii) charging p

2

= 50,

and selling only to the second period consumers, thereby earning a second-period

proﬁt of π

2

= 2 ×50 = 100.

First-period consumer buys in period 1: In this case the second period proﬁt max-

imizing price is again p

2

= 50, yielding a proﬁt level of π

2

= 2 ×50 = 100.

Altogether, the second period price is independent of the actions of the ﬁrst-period

buyer. Now, in order to attract the ﬁrst-period buyer to purchase in period 1, the

monopoly should set p

1

= 40, thereby extracting all surplus from all consumers.

7. The two cases are illustrated in Solution-Figure 5.2.

(a) Equating marginal revenue to the tax inclusive unit cost yields a − 2Q = c + t, or

Q

M

= (a − c − t)/2. Hence, p

M

= (a + c + t)/2. Now, checking the eﬀect of a

tax rate change on the monopoly’s price yields that dp

M

/dt = 1/2 < 1. Hence, as

illustrated in Solution-Figure 5.2 (left), an increase in t raises the monopoly price by

less than t.

The Monopoly 15

✲

✻

Q

p

c

c +t

MR(Q)

a

✲

✻

Q

p

c

c +t

p

M

(c)

p

M

(c +t)

MR

D

D

p

M

(c +t)

p

M

(c)

•

•

•

•

Solution-Figure 5.2: How the monopoly price varies with a speciﬁc tax

(b) Using Proposition 3.3,

MR = p

M

1 +

1

−2

= c +t, yielding p

M

= 2(c +t).

Now, checking the eﬀect of a tax rate change on the monopoly’s price yields that

dp

M

/dt = 2 > 1. Hence, as illustrated in Solution-Figure 5.2 (right), an increase in

t raises the monopoly price by more than t.

Chapter 6

Markets for Homogeneous Products

The Cournot, Bertrand, and sequential moves market structures are essential for a further study

of industrial organization.

The important issues to discuss and emphasize are:

1. Market structures are assumed by the researcher rather than solved for. Specifying a

market structure is the same as specifying the rules of the game before predictions (e.g.,

equilibrium outcomes) are sought.

2. Cournot and Bertrand market structures select Nash equilibrium outcomes, where under

the Cournot game ﬁrms’ actions are the quantity produced, and in the Bertrand game

ﬁrms’ actions are prices.

3. Free entry versus a ﬁxed number of ﬁrms.

Self-enforcing collusion (section 6.5) is suited for more advanced students. Instructors may

want to go over repeated games (section 2.3) before covering self-enforcing collusion, however,

this topic is written in a way that enables the instructor to teach self-enforcing collusion even

without formally teaching repeated games. Instructors who choose to teach this topic may

want to emphasize that a trigger strategy is a function of the entire history of what each player

has played in earlier periods, including the player’s own earlier actions, and therefore provides

self-discipline which restricts the gains from deviation from the cooperative actions.

Finally, subsection 6.6.2 (preferential trade agreements) provides a good example to the law

of (no) second best, by showing that a partial removal of trade barriers need not be welfare

improving.

Answers to Exercises

1. (a) By Lemma 4.1, both ﬁrms produce a ﬁnite amount of output only if p ≤ c

1

and

p ≤ c

2

. Hence, since c

2

> c

1

, if a competitive equilibrium exists then it must be

that p

e

≤ c

1

. However, if p

e

< c

1

then both ﬁrms produce zero output, but at these

prices demand exceeds zero (since Q(c

1

) = α − c

1

> 0). Hence, if a competitive

equilibrium exists, then p

e

= c

1

. Therefore, q

e

1

= Q

e

= α −c

1

and q

e

2

= 0.

(b) Each ﬁrm i takes the output of its opponent, q

j

, as given and solves

max

q

i

π

i

= (α −q

i

−q

j

)q

i

−c

i

q

i

, i, j = 1, 2, i = j,

yielding ﬁrst order conditions given by

0 =

∂π

1

∂q

1

= α −2q

1

−q

2

−c

1

, and 0 =

∂π

2

∂q

2

= α −q

1

−2q

2

−c

2

.

18 Markets for Homogeneous Products

Solving the two equations for the two variables, q

1

and q

2

yields

q

c

1

=

α −2c

1

+c

2

3

, q

2

=

α −2c

2

+c

1

3

, and Q =

2α −c

1

−c

2

3

.

Then, p

c

= α −q

c

1

−q

c

2

= (α +c

1

+c

2

)/3.

(c) From the ﬁrst order conditions of the previous subquestion we can immediately solve

for ﬁrm 2’s best-best response function. Hence,

R

2

(q

1

) =

α −c

2

2

−

q

1

2

.

In a sequential-moves equilibrium, ﬁrm 1 (the leader) takes ﬁrm 2’s best-response

function as given and chooses q

1

to

max

q

1

π

1

=

¸

α −q

1

−

α −c

2

2

−

q

1

2

q

1

−c

1

q

1

,

yielding the ﬁrst order condition

0 =

∂π

1

∂q

1

= α −2q

1

−

α −c

2

2

+q

1

−c

1

.

Therefore,

q

s

1

=

α +c

2

−2c

1

2

, q

s

2

=

α −3c

2

+ 2c

1

4

, and Q

s

=

3α −c

2

−2c

1

4

.

Hence, p

s

= (α +c

2

+ 2c

1

)/4.

(d) When ﬁrm 2 is the leader, by symmetry (replacing c

1

by c

2

and vice versa in the

previous subquestion) we can conclude that

q

s

2

=

α +c

1

−2c

2

2

, q

s

1

=

α −3c

1

+ 2c

2

4

, and Q

s

=

3α −c

1

−2c

2

4

.

Hence, p

s

= (α +c

1

+ 2c

2

)/4.

Comparing the two sequential-moves equilibria we see that (i) aggregate output

decreases when the less eﬃcient ﬁrm (ﬁrm 2) moves before ﬁrm 1; (ii) price is higher

when ﬁrm 2 moves ﬁrst; (iii) the market share of the less eﬃcient ﬁrm increases

when it moves before ﬁrm 1; (iv) the production of the more-eﬃcient ﬁrm increases

when it moves ﬁrst; and (v) the market share of the more-eﬃcient ﬁrm increases

when it moves ﬁrst.

(e) In a Bertrand equilibrium, the more eﬃcient ﬁrm (ﬁrm 1) completely undercuts the

price set by ﬁrm 2. Assuming that money is continuous, ﬁrm 1 sets its price to

equal the unit cost of ﬁrm 2, thereby ensuring that ﬁrm 2 will not ﬁnd it proﬁtable

to produce any amount. Hence, we can approximate the Bertrand equilibrium by

p

b

1

= c

2

− and p

b

2

= c

2

. Thus, q

b

1

= Q

b

= α − c

2

+ and q

b

2

= 0. Notice that

when the unit costs are not equal (the present case), the Bertrand equilibrium price

exceeds the competitive equilibrium price. Also, instructors should point out to the

students that this is not really a Nash-Bertrand equilibrium since the proﬁt of ﬁrm 1

increases as decreases.

Markets for Homogeneous Products 19

2. (a) We ﬁrst focus on the problem faced by ﬁrm 1. In a Cournot market structure, ﬁrm 1

takes q

2

, q

3

, . . . , q

N

as given and chooses q

1

that solves

max

q

1

π

1

= (100 −q

1

−q

2

−· · · −q

N

)q

1

−F −(q

1

)

2

.

The ﬁrst order condition is given by

0 =

∂π

1

∂q

1

= 100 −2q

1

−q

2

−· · · −q

N

−2q

1

.

Therefore, the best-response function of ﬁrm 1 is given by

q

1

= R

1

(q

2

, . . . , q

N

) =

100 −

¸

N

j=2

q

j

4

.

Given that all ﬁrms have identical technologies (identical cost functions), we can

attempt to search for a Cournot equilibrium where all ﬁrms produce the same output

levels. That is, q

c

≡ q

c

1

= q

c

2

= · · · = q

c

N

. In this case,

q

c

= 25 −

(N −1)q

c

4

, or q =

100

N + 3

, hence, Q =

100N

N + 3

.

Therefore,

p

c

= 100 −

100N

N + 3

=

300

N + 3

, and π

i

= p

c

q

c

−F −(q

c

)

2

=

20, 000

(N + 3)

2

−F.

(b) Under free entry, ﬁrms enter as long as they make above normal proﬁts. Entry stops

when a further entry generates a loss to ﬁrms. Hence, if we approximate the number

of ﬁrms, N, by a real number, under free entry all existing ﬁrms make zero proﬁt.

Thus,

0 = π

i

=

20, 000

(N + 3)

2

−F, or N =

20, 000

F

−3.

Thus, the (endogenously determined) number of ﬁrms in this industry declines with

the ﬁxed cost parameter F.

3. In the third period, ﬁrm 3 takes q

1

and q

2

as given and chooses q

3

to maximize its proﬁt.

The solution to this problem yields ﬁrm 3’s best-response function R

3

(q

1

, q

2

) which is

given in (6.8). Hence, using (6.8) we have it that

R

3

(q

1

, q

2

) =

120 −c

2

−

q

1

+q

2

2

.

In the second period, ﬁrm 2 takes ¯ q

1

and R

3

(¯ q

1

, q

2

) as given and chooses q

2

that solves

max

q

2

π

2

= [120 − ¯ q

1

−q

2

−R

3

(¯ q

1

, q

2

)]q

2

−cq

2

.

The ﬁrst-order condition is given by 0 = dπ

2

/dq

2

= 60 − ¯ q

1

/2 −q

2

−c/2. Therefore, the

best-response function of ﬁrm 2 is given by

R

2

(q

1

) =

120 −q

1

−c

2

.

20 Markets for Homogeneous Products

In the ﬁrst period, ﬁrm 1 takes the best-response functions of ﬁrms 2 and 3 as given and

chooses q

1

that solves

max

q

1

π

1

= {120 −q

1

−R

2

(q

1

) −R

3

[q

1

, R

2

(q

1

)]}q

1

−cq

1

= {30 +

3c

4

−

q

1

4

}q

1

−cq

1

.

The ﬁrst-order condition is given by 0 = dπ

1

/dq

1

= 30 −c/4 −q

1

/2. Therefore, solving

for q

s

1

, and then substituting into R

2

(q

s

1

), and then into R

3

[q

s

1

, R

2

(q

s

1

)] yields,

q

s

1

=

120 −c

2

, q

s

2

=

120 −c

4

, and q

s

3

=

120 −c

8

.

Hence, Q

s

= q

s

1

+q

s

2

+q

s

3

= 7(120 −c)/8 and p

s

= (120 + 7c)/8.

4. (a) Under zero production cost, all Bertrand equilibrium outcomes yield zero proﬁts to

both ﬁrms. Thus the Bertrand outcome is p

b

1

= 0 and p

b

2

= 0.

(b) We’ll construct an equilibrium in trigger strategies where ﬁrms’ threat point is p

b

1

= 0

and p

b

2

= 0, respectively. Formally, let ﬁrm i’s price strategy, i = 1, 2, be given by

p

i

(τ) =

10 as long as p

1

(t) = p

2

(t) = 10 for all t = 1, . . . τ −1

0 otherwise.

Now, if no ﬁrm deviates in any period, the present value of the sum of discounted

proﬁt to each ﬁrm i is π

i

= 5N/(1 − ρ). If ﬁrm 1 deviates in period τ, then

π

1

= (10 −)N + 0 ≈ 10N (since eﬀective period τ + 1 all ﬁrms revert to p

i

= 0).

Hence, deviation is not proﬁtable to either ﬁrm if 5N/(1 −ρ) > 10N, or ρ > 1/2.

(c) All Bertrand equilibria are of the form p

b

1

= 4 − ≈ 4 and p

b

2

= 4.

(d) We can reconstruct ﬁrms’ trigger strategies where we assume that the punishment

point is now p

b

1

= 4 and p

b

2

= 4. Since now ﬁrms have diﬀerent proﬁt functions, we

need to check proﬁtability from deviation by each ﬁrm separately.

Firm 1: In each period τ, if no ﬁrm deviates, the sum of discounted proﬁts is π

1

=

5N/(1 −ρ). If ﬁrm 1 deviates in period τ, then its sum of discounted proﬁt is

π

1

= 10N +ρ4N/(1 −ρ). Comparing the two proﬁt levels shows that deviation

is not proﬁtable for ﬁrm 1 if ρ > 5/6.

Firm 2: If no ﬁrm deviates, the sum of discounted proﬁt is π

2

= (N/2)(10−4)/(1−

ρ). If it deviates, then the sum of discounted proﬁt is π

2

= (10 − 4)N + 0.

Comparing the two proﬁt levels reveals that deviation is not proﬁtable if ρ > 1/2.

(e) Collusion is less likely to be sustained when one ﬁrm has a cost advantage over the

other because deviation by ﬁrm 1 (low cost) will leave it with a positive stream of

proﬁt compared with a zero proﬁt generated by deviation when the two ﬁrms have

an identical cost structure.

5. (a) Let p

A

k

denote the (tariﬀ inclusive) price consumers in country A pay for a unit of

import from country k, k = B, C. Therefore, under a uniform speciﬁc tariﬀ of $10

per unit of import, p

A

B

= 70 and p

A

C

= 50. Clearly consumers buy from country C,

and the government earns a revenue of $10 per unit. A FTA with country B reduces

p

A

B

to p

A

B

= 60 > 50 = p

A

C

. Hence, A’s consumers still purchase from country C

implying that this FTA is ineﬀective and therefore does not alter A’s welfare.

Markets for Homogeneous Products 21

(b) Now, a FTA with country B reduces p

A

B

to p

A

B

= 60 < 60.01 = p

A

C

. Hence, A’s

consumers switch to buying from country B and no tariﬀ revenues are collected. Note

that in this case the consumer price falls from p

A

C

= 60.01 to p

A

B

= 60 (a reduction

of 1 cent per unit of import). Hence, the FTA hardly changes consumer surplus.

However, in this case the government faces a large reduction in tariﬀ revenues due

to the elimination of a $10 tariﬀ per unit of import. Altogether, with the exception

of highly elastic demand, country A loses from the FTA.

6. (a) Clearly p

L

is a dominant action for each ﬁrm in the static one-shot game. Hence,

by Proposition 2.2, (p

L

, p

L

) is a unique NE for the one-shot game. Therefore, if a

SPE exists, it must yield that both ﬁrms charge p

L

.

We can derive the SPE directly by formulating the extensive form game which is

illustrated in Solution-Figure 6.1 (consider the ﬁrst two stages only).

•

◦

•

p

L

p

H

p

H

p

L

p

L

p

H

Firm 1

Firm 2

π

1

= 70

π

2

= 70

π

1

= 120

π

2

= 0

π

1

= 0

π

2

= 120

π

1

= 100

π

2

= 100

•

p

L

π

1

= 70

π

2

= 70

Firm 1

(II.:)

(I.:)

(III.:)

Solution-Figure 6.1: Sequential price game: Meet the competition clause

From the ﬁgure, it is straightforward to conclude that the following prices constitute

a SPE:

p

2

=

p

L

if p

1

= p

H

p

L

if p

1

= p

L

and p

1

= p

L

.

(b) We now add a third stage to the game, where ﬁrm 1 commits to reduce its price to

ﬁrm 2’s price whenever ﬁrm 2 charges p

L

. This third stage is (partly) illustrated at

the bottom of Figure 6.1. In this case, the SPE if given by

p

2

=

p

H

if p

1

= p

H

p

L

if p

1

= p

L

and p

1

= p

H

,

implying that the ﬁrms charge the industry’s proﬁt maximizing price and earn a proﬁt

of 100 each.

7. Note that the answer for exercise 3 provides a solution for N = 3 ﬁrms, which intuitively

can be generalized to the N > 3 case. In addition, in what follows, I provide a formal

solution for this problem.

22 Markets for Homogeneous Products

(a) Let q

s

i

denote the sequential-moves equilibrium output level produced by ﬁrm i,

i = 1, . . . , N. Deﬁne Q

s

≡

¸

N

i=1

q

s

i

and Q

s

−N

=

¸

N−1

i=1

q

s

i

, for i = 1, . . . , N where

Q

s

−1

≡ 0 for i = 1.

Since there is no ﬁxed cost, there is no limit on the number of ﬁrms that will enter if

free entry is allowed. We therefore look at how the Nth ﬁrm decides on how much

to produce. Firm N solves

max

q

N

π

N

= (a −Q

s

−N

−q

N

−c)q

N

,

yielding q

s

N

= (a −Q

s

−N

−c)/2.

Before we proceed to analyzing ﬁrm N −1, let us deﬁne a

N

≡ a −Q

s

−N

. Hence, it

can be veriﬁed that

a

N−1

= a

N

+q

s

N−1

for allN.

Firm N −1 knows what ﬁrm N will be producing and solves

max

q

N−1

π

N−1

=

¸

(a −Q

s

−(N−1)

−q

s

N−1

) −

a

N

−c

2

−c

q

N−1

=

[a

N

−c]q

N−1

2

=

[a

N−1

−q

N−1

−c]q

N−1

2

.

Hence, q

s

N−1

= (a

N−1

−c)/2.

Also, since a

N

= a

N−1

−q

s

N−1

and a

N

= a

N−1

−q

s

N−1

= (a

N−1

+c)/2,

q

s

N

= (a

N

−c)/2 = (a

N−1

−c)/4.

We now analyze ﬁrm N − 2. Recall that a

N−2

− q

s

N−2

= a

N−1

. Also, recall that

q

s

N

+q

s

N−1

= (1/2 + 1/4)(a

N−1

−c). Therefore, ﬁrm 2 solves

max

q

N−2

π

N−2

=

¸

(a

N−2

−q

N−2

) −

3(a

N−2

−q

N−2

−c)

4

−c

q

N−2

=

[a

N−2

−q

N−2

−c]q

N−2

4

.

The solution is q

s

N−2

= (a

N−2

− c)/2. Hence, q

s

N−1

= (a

N−2

− c)/4 and q

s

N

=

(a

N−2

−c)/8. Therefore,

q

s

N

=

a

N

−c

2

, for all N.

In particular, for N = 1, a

1

= a −Q

s

−1

= a −0 = a. Thus, q

s

1

= (a −c)/2.

Finally, since

q

s

N

=

1

2

k

q

s

N−k

, for all 0 < k < N,

we have it that

q

s

N

=

1

2

N−1

q

s

1

=

1

2

N−1

a −c

2

=

a −c

2

N

.

Altogether, the N-ﬁrm sequential moves equilibrium output levels are

q

s

i

=

a −c

2

i

, for all i = 1, . . . , N.

Markets for Homogeneous Products 23

(b) Aggregate output is given by

Q

s

=

¸

i=1

Nq

s

i

= (a −c)

1

2

+

1

4

+· · · +

1

2

N

.

Using the same arguments as in the proof of Lemma 9.2 (see mathematical appendix,

section 9.9), we can show that

1

Q

s

= (a −c)

1 −

1

2

N

.

(c) As the number of ﬁrms increases, Q

s

→ a − c (competitive output level). Hence,

p

s

→c (the competitive price level).

1

The ﬁrst printing of the ﬁrst edition contains a typo in the speciﬁcation of Q

s

in the question.

Chapter 7

Markets for Diﬀerentiated Products

The ﬁrst section extends the market structures deﬁned in Chapter 6 to markets with diﬀerentiated

products. Using the two-brand environment enables us to analyze the diﬀerence in market

outcomes generated by the Cournot and the Bertrand market structures, and to deﬁne and

contrast the concepts of strategically substitutes and strategically complements best-response

functions.

Section 7.2 (somewhat more advanced) introduces the student to the endogenous determi-

nation of the variety of brands, and its application to the theory of international trade.

Location models (section 7.3), in particular the Hotelling model (subsection 7.3.1), are im-

portant for a further study of industrial organization. The linear city model is used several times

in the manuscript, for example, to distinguish between vertically and horizontally diﬀerentiated

products (see section 12.2). Instructors should cover at least the Hotelling linear city model

which students always ﬁnd very intuitive and therefore very appealing. The existence proof

(Appendix, section 7.5) can be skipped. The instructor can demonstrate the parameter restric-

tions needed to ensure existence by imposing symmetric locations (a = b) into the conditions

of Proposition 7.6.

Answers to Exercises

1. (a) The best-response functions are drawn in Figure 7.1 and are derived as follows:

max

α

1

π

1

⇒ R

1

(α

2

) = 2 +

3

2

α

2

, or, α

2

= −

4

3

+

2

3

R

1

(α

2

);

max

α

2

π

2

⇒ R

2

(α

1

) = 1 +

1

2

α

1

.

✲

✻

α

2

α

1

R

1

(α

2

)

R

2

(α

1

)

8

1

0

−

4

3

14

•

Solution-Figure 7.1: Advertising best-response functions

26 Markets for Diﬀerentiated Products

(b) The two best-response functions are upward sloping, hence strategically comple-

ments.

(c) Solving for a NE yields α

N

1

= 14 and α

N

2

= 8. The ﬁrms’ proﬁt levels in a NE are:

π

1

= 14

2

and π

2

= 8

2

.

2. (a) Given a low reservation price (a low B), we’ll attempt to ﬁnd a monopoly equilibrium

where not all the market is served. Figure 7.2 illustrates the location of the two

indiﬀerent consumers, one on each side of the ﬁrm. The indiﬀerent consumer (on

0 1

1

2

1

2

+a

1

2

−a

2a

✲ ✛

Solution-Figure 7.2: Single-ﬁrm location model

each side) is determined by the reservation utility, that is, B − a − p = 0, or,

a = B −p. Hence, the monopoly chooses p that solves

max

p

π = p2a = 2p(B −p).

The solution is given by

p

M

=

B

2

, a =

B

2

, and π

M

= 2pa =

B

2

2

.

Now, it is easy to verify that 0 < B < 1 implies that 0 < a < 1/2, hence, not all

the market is served.

(b) When substituting B > 1 into the solution for ‘a’ found in the previous subquestion,

we get that the indiﬀerent consumers lie “outside” the city. This implies that for

B > 1, the monopoly can increase the price and still having the entire street purchase

the product. Thus, the monopoly will pick the highest possible price subject to having

the consumers living at the edges of town purchase the product. Formally, set p to

satisfy B −1/2 −p = 0. Hence,

p

M

= B −

1

2

, a =

1

2

, and π

M

= B −

1

2

.

3. (a) The indiﬀerent consumer, denoted by ˆ x, must satisfy

ˆ x ×1 +p

1

= (1 − ˆ x) ×R +p

2

.

Hence,

ˆ x =

R +p

2

−p

1

1 +R

.

(b) Substituting p

1

= p

2

yields ˆ x = R/(1 +R). Hence,

lim

R→∞

ˆ x = lim

R→∞

R

1 +R

= 1.

Markets for Diﬀerentiated Products 27

Therefore, all the consumers will eat in restaurant 1 (i.e., ˆ x = 1) only if the trans-

portation cost for traveling to the east is inﬁnite. Otherwise, some consumers will

always eat at restaurant 2.

4. From (7.24), we can deﬁne the location of the indiﬀerent consumer, ˆ x, by the implicit

function:

F(p

A

, p

B

) ≡ p

A

−p

B

+τ(ˆ x −a)

2

−τ(ˆ x −L +b)

2

= 0.

Firm A chooses p

A

that solves max

p

A

π

A

= p

A

ˆ x subject to ˆ x satisfying F(p

A

, p

B

) = 0.

The ﬁrst-order condition is given by

0 =

dπ

A

dp

A

= ˆ x +p

A

∂ˆ x

∂p

A

= ˆ x +p

A

−

∂F

∂p

A

∂F

∂ˆ x

= ˆ x −

p

A

2τ(L −a −b)

.

Similarly, ﬁrm B chooses p

B

that solves max

p

B

π

B

= p

B

(L − ˆ x), yielding a ﬁrst-order

condition given by

0 =

dπ

B

dp

B

= L − ˆ x −p

B

∂ˆ x

∂p

B

= ˆ x +p

B

∂F

∂p

B

∂F

∂ˆ x

= L − ˆ x −

p

B

2τ(L −a −b)

.

(a) Under a = b, we search for a symmetric solution. Substituting a = b and ˆ x = L/2

into ﬁrm A’s ﬁrst-order condition (or B’s ﬁrst-order condition) yields that

p

A

= p

B

= τL(L −2a).

Note that p

A

= p

B

→0 when a →1/2, reﬂecting the fact that prices drop to zero

when the two brands become homogeneous.

(b) We now investigate the total eﬀect of varying the location of ﬁrm A (varying a) on

the proﬁt of ﬁrm A.

1

Using the two ﬁrst-order conditions, we have it that p

A

= 2τ(L − a − b)ˆ x and

p

B

= 2τ(L −a −b)(L − ˆ x). Substituting into the function F(, ) = 0 yields

F(, ) = 2τ(L −a −b)(2ˆ x −L) +τ(ˆ x −a)

2

−τ(ˆ x −L +b)

2

= 0.

Using the implicit function theorem, we have it that

∂ˆ x

∂a

= −

−(2ˆ x −L) −2(ˆ x −a)

2(L −a −b) + 2(ˆ x −a) −2(ˆ x −L +b)

=

x=1/2

a=b

1

4

.

Now, using A’s ﬁrst-order condition, we can express A’s proﬁt by π

A

= p

A

ˆ x =

2τ(L −a −b)(ˆ x)

2

. Therefore,

dπ

A

da

< 0 whenever −(ˆ x)

2

+ (L −a −b)2ˆ x

1

4

< 0,

which always hold since L − 2a < L. Hence, ﬁrm A increases its proﬁt by moving

toward point 0. Similarly, ﬁrm B increases its proﬁt by moving toward point L.

1

This problem may be too diﬃcult for most undergraduate students since it involves deviating from the

symmetric solution.

Chapter 8

Concentration, Mergers, and Entry Barriers

This chapter contains four major topics: How to measure concentration; merger and merger

guidelines; entry barriers; and entry deterrence. I urge the instructor not to skip the discussion

of concentration measures (section 8.1) and the appendix on merger regulations and guidelines

(section 8.6).

Regarding all other topics, the instructor will ﬁnd a wide variety of models to choose from.

Most of the topics are logical and require minimum calculations and very little calculus (if

any).

1

Finally, note that you can combine the topic of double monopoly markup, analyzed

under the topic of dealership (subsection 14.3.1), with the analysis of vertical integration given

in subsection 8.2.2.

Answers to Exercises

1. (a) I

4

= 20 + 20 + 20 + 10 = 70.

(b) I

HH

= 4 ×10

2

+ 3 ×20

2

= 1, 600.

(c) i. After the merger of ﬁrms 1 and 2, I

HH

= 20

2

+ 10

2

+ 10

2

+ 3 ×20

2

= 1, 800.

ii. ∆I

HH

= 1, 800 −1, 600 = 200.

iii. The merger may be challenged by the FTC or the Justice Department since the

postmerger I

HH

exceeds 1, 000 and ∆I

HH

= 200 > 100.

2. (a) The solution for a Cournot equilibrium with N ﬁrms is given in (6.9) and (6.10).

Substituting c = 0 (zero production cost) and N = 3 yields q

c

i

= 25 and π

c

i

= 625,

i = 1, 2, 3.

(b) Substituting N = 2 into (6.10) yields π

1

= π

4

= 1111.111 . . ..

(c) Since ﬁrms 2 and 3 split the proﬁt from the merged ﬁrm, π

2

= π

3

= π

4

/2 = 555 <

625. Hence, ﬁrms 2 and 3 lose from this merger whereas ﬁrm 1 gains.

(d) A merger into a monopoly cannot reduce aggregate proﬁt, simply because a monopoly

can always mimic the same production pattern of any oligopoly. To see this, sub-

stituting N = 1 into (6.10) yields a monopoly proﬁt of π

M

= 2500. Hence,

π

i

= 2500/3 = 833

1

3

> 625 > 555. Thus, the proﬁt per ﬁrm is the highest

under the monopoly market structure (cartel).

(e) The diﬀerence between the two mergers is as follows: When two out three ﬁrms

merge, competition is reduced to a duopoly; however, the extra aggregate industry

proﬁt generated from the change in the number of ﬁrms is equally divided between

1

Subsection 8.4.2 can be presented using diagrams only. However, the ﬁrst printing of the ﬁrst edition lacks a

justiﬁcation why ﬁrm 1’s (high and low) best-response functions do not shift with a change in

ˆ

k. In the second

printing I intend to add an appendix at the end of this chapter which derives both best-response functions. Also,

note that the equilibrium ﬁrst-period capital level in Figure 8.7 is

ˆ

k

3

and not

ˆ

k

2

as wrongly stated in the ﬁrst

printing.

30 Concentration, Mergers, and Entry Barriers

the two unmerged groups of ﬁrms. Thus, this share of the change in aggregate

industry proﬁt is lower than the proﬁt each ﬁrm makes under the triopoly.

In contrast, merging into a monopoly can only increase proﬁt since a monopoly can

always produce like a duopoly, and under monopoly, all industry proﬁt is equally

divided between the three ﬁrms.

3. (a) We look for a Nash equilibrium in prices.

2

The X-seller takes p

Y

as given and solves

max

p

X

π

X

= p

X

Q = p

X

(α −p

X

−2p

Y

), yielding p

X

=

α

2

−p

Y

.

The Y -seller takes p

X

as given and solves

max

p

Y

π

Y

= p

Y

2Q = 2p

Y

(α −p

X

−2p

Y

), yielding p

Y

=

α −p

X

4

.

Hence,

p

N

X

=

α

3

, p

N

Y

=

α

6

, p

N

S

=

2α

3

, Q

N

=

α

3

, π

N

X

= π

N

Y

=

α

2

9

.

(b) We deﬁne a system as one unit of X bundled with two units of Y . Then, the merged

ﬁrm chooses a system price p

S

that solves

max

p

S

π

S

= p

S

(α −p

S

) yielding p

S

= Q

S

=

α

2

, and π

S

=

α

2

4

.

(c) To make a welfare judgment on the gains from this merger it is suﬃcient to compare

prices and proﬁt levels. Before the merger, the price of one system is p

0

S

= p

X

+

2p

Y

= 2α/3 > α/2 = p

1

S

which is the price after the merger. Also, before the

merger, aggregate proﬁt is π

X

+π

Y

= 2α

2

/9 < α

2

/4 = π

1

S

which is the proﬁt after

the merger takes place. Since the system price falls and industry proﬁt increases, the

merger is welfare improving.

4. In view of Deﬁnition 8.1, Figure 8.1 shows that the pair (p

I

, q

I

) = (20, 10) constitutes a

contestable-market equilibrium.

Formally, the (incumbent’s) industry conﬁguration (p

I

, q

I

) = (20, 10) is feasible since

demand equals supply and the incumbent makes a nonnegative proﬁt. It is also sustainable

since no potential entrant can undercut the incumbent’s price while making a positive

proﬁt.

2

A typo in the ﬁrst printing of the ﬁrst edition: the question should state that Q = x = y/2.

Concentration, Mergers, and Entry Barriers 31

✲

q

I

✻

p

I

✒

20

10

p = 60 −4Q

AC(q

I

) =

100

q

+q

•

Solution-Figure 8.1: Contestable-markets equilibrium

Chapter 9

Research and Development

Most of the topics in this chapter are not technically demanding (and less tedious in terms

of technical derivations). The classiﬁcations of process innovation (section 9.1) uses only de-

mand and supply diagrams. Innovation race (section 9.2) relies on simple discrete probability

calculations. Cooperation in R&D (section 9.3) relies on a Cournot market structure in the

second stage and a Nash equilibrium in R&D in the ﬁrst stage. The calculation of the optimal

patent life (section 9.4) does not reach a closed-form solution. However Figure 9.3 enables the

instructor to explain the cost and beneﬁt of the patent system without performing any calcu-

lations. Then, the instructor can simply reproduce the government-innovation two stage game

and demonstrate how to build the social welfare function for calculating the optimal patent

life. Licensing of innovation (section 9.5) uses supply and demand analysis. The international

analysis (section 9.6) is divided into a simple matrix game of product innovation and a two stage

subsidy Cournot game of process innovation. Finally, the appendix sections discuss patent law

and R&D joint ventures (sections 9.7 and 9.8) and can be assigned as homework reading.

Answers to Exercises

1. Using Deﬁnition 9.1, innovation is major if the monopoly price is below the initial unit

cost; that is if p

M

< c

0

. Innovation is minor if p

M

> c

0

. To ﬁnd p

M

, the monopoly solves

MR(Q

M

) = a − 2Q

M

= c

1

= 2c

0

− a. Therefore, the monopoly’s proﬁt maximizing

output is Q

M

= a − c

0

. Hence, p

M

= c

0

. Therefore, according to Deﬁnition 9.1 the

present innovation is neither major nor minor.

2. (a) The expected proﬁt of a ﬁrm engaged in R&D, given that the other two ﬁrms are

also engaged in R&D, is the prize times the sum of the probability that the ﬁrm

discovers while the other two do not, plus twice the probability that it discovers

while one competing ﬁrm discovers and one does not, plus the probability that all

the three discover simultaneously, minus innovation cost. Formally, for each ﬁrm i,

i = 1, 2, 3,

Eπ

i

=

1

2

1

2

1

2

V +

1

2

1

2

1

2

V

2

(×2) +

1

2

1

2

1

2

V

3

−I =

7V

24

−I.

Thus, all the three ﬁrms ﬁnd it proﬁtable to engage in R&D if V > 24I/7 = 24/7

(since I = 1).

(b) The now single ﬁrm can operate zero, one, or two labs.

Operating a single lab: In this case, Eπ|

1 lab

= V/2 −I.

Operating two labs: In this case, the probability of discovery is one minus the

probability that none of the labs discovers. Thus,

Eπ|

2 labs

=

1 −

1

2

1

2

V −2I =

3V

4

−2I.

34 Research and Development

Now, Eπ|

2 labs

> Eπ|

1 lab

if V > 4I, which constitutes a suﬃcient condition for

having the ﬁrm choosing to operate two labs.

3. (a) The probability that a ﬁrm does not discover is (1 −α). Hence, the probability that

none of the n ﬁrms discovers at a particular date is (1 −α)

n

.

(b) Clearly, one minus the probability that none discovers. Hence, 1 −(1 −α)

n

.

(c) Similar to the derivation given in (9.5),

ET(n) = [1 −(1 −α)

n

] ×1 + (1 −α)

n

[1 −(1 −α)

n

] ×2

+ (1 −α)

2

n[1 −(1 −α)

n

] ×3 + (1 −α)

3

n[1 −(1 −α)

n

] ×4 +· · ·

Therefore,

ET(n) = [1 −(1 −α)

n

]

∞

¸

t=1

[(1 −α)

n

]

t−1

×t

(Lem 9.1)

=

1 −(1 −α)

n

[1 −(1 −α)

n

]

2

=

1

α(2 −α)

.

4. (a) If the EC provides Airbus with a subsidy of 10 (contingent on developing the megacar-

rier, then Airbus’ dominant action is to develop.

(b) If the U.S. government provides Boeing with a subsidy of 10 (contingent on devel-

oping the megacarrier, then Boeing’s dominant action is to develop. Note that this

U.S. subsidy is independent whether the EC provides Airbus with a subsidy of 10 or

15.

(c) None! After the EC subsidy to Airbus is implemented, Airbus’ dominant action is to

develop (hence, independent of the U.S. subsidy to Boeing).

(d) Like any other welfare argument in economics, there are pros and cons to having

both governments subsidizing the development of the new megacarrier. Arguments

against the subsidies include (i) duplication of R&D which require twice the amount

of resources needed to develop and test the plane, (ii) the government may not

possess the means to determine whether the beneﬁts from the development to their

own economy dominate the cost, (i.e., economists generally believe that the private

sector can collect more accurate information), and (iii) income distribution eﬀects;

that is, some economists claim that the development of the Concord by some EC

countries constitute a net transfer from poor to rich people, since most poor and

middle-class people do not get to ﬂy in the Concord.

Arguments for the subsidy include the introduction of more competition between

aircraft manufacturers that would reduce aircraft prices, boost the airline industry,

and may therefore increase the amount of travel.

Chapter 10

The Economics of Compatibility and Standards

The introduction to this chapter provides some basic terminology and a simple “Battle of the

Sexes” game of product standardization, which can be taught to the less technically proﬁcient

students. The behavior of a monopoly telephone company under network externalities (Sub-

section 10.1.1) uses very simple calculus (basically one ﬁrst-order condition). The remainder of

section 10.1 is devoted to a simple discrete (noncalculus) standardization-variety tradeoﬀ model.

The remaining two sections, the supporting services approach (section 10.2) and the compo-

nents approach (section 10.3) are somewhat more diﬃcult despite the fact that no calculus is

used. In particular, whereas the components approach model is very simple, some students may

get confused because of the existence of multiple equilibria under incompatibility, in which case,

the instructor may want to construct only one equilibrium and compare it to the equilibrium

under compatible systems.

The important points to emphasize are:

• A network externality is a particular type of a consumption externality, where a consumer’s

utility is aﬀected by the number of consumers purchasing the same brand. Thus, network

externalities constitute an assumption about consumer preferences.

• The supporting services and the components approaches do not assume any externality.

The “network eﬀects,” where the utility of a consumer is aﬀected by the brand choices of

other consumers is an equilibrium result (rather than an assumption).

1

Thus, the network

eﬀects are generated by having hardware and software (or other types of hardware) treated

as perfect complements.

Answers to Exercises

Unfortunately, the two exercises cover only the supporting services and the components ap-

proaches. In future printings/editions, I intend to add two exercises covering the two topics

analyzed in the network externalities section.

1. (a) Firm A gains control over the entire market when

ˆ

δ = 1. In this case, by (10.10),

p

B

has to be suﬃciently high to satisfy

1 =

ˆ

δ =

Y −p

A

2Y −p

A

−p

B

, or p

B

= Y.

(b) i. Let

¯

δ denote the market share for ﬁrm A after income has doubled from Y to

2Y . Then, by (10.10) we have that

¯

δ =

2Y −p

A

−p

B

4Y −p

A

−p

B

>

ˆ

δ =

Y −p

A

−p

B

2Y −p

A

−p

B

1

Some authors use the term indirect network externalities to describe the behavior generated by the supporting

services and the components approaches. I feel that this term was poorly chosen since externalities are either

assumed or not assumed at all, and therefore the term indirect cannot be used to describe models that do not

explicitly assume any externality.

36 The Economics of Compatibility and Standards

if p

A

> p

B

. This result can also be demonstrated by diﬀerentiating

ˆ

δ with

respect to Y , yielding

d

ˆ

δ

dY

=

p

A

−p

B

(2Y −p

A

−p

B

)

2

> 0 if p

A

> p

B

.

Thus, the ﬁrm with the lower market share increases its market share when

consumer income rises.

ii. Since

ˆ

δ increases, by (10.9) N

A

/N

B

must increase.

2. (a) Potential equilibria can be classiﬁed into two types: (i) Firm A sells to consumers AA,

and AB; and ﬁrm B sells to BB and BA (alternatively, Firm A sells to consumers

AA, and BA; and ﬁrm B sells to BB and AB). (ii) Firm A sells to AA, AB, and

BA; whereas ﬁrm B sells to BB only (alternatively, ﬁrm A sells to AA only, whereas

ﬁrm B sells to BB, AB, and BA).

In what follows we will demonstrate, by a way of contradiction, that both types of

equilibria do not exists.

i. Under this type, p

I

A

= p

I

B

since consumers AB and BA are indiﬀerent between

systems AA and BB as long as the prices are equal. However, this prices

cannot support a Bertrand-Nash equilibrium since ﬁrm A can increase its proﬁt

by undercutting ﬁrm B by charging p

A

= p

I

B

− which will cause consumer BA

to switch to system AA (this is the usual Bertrand undercutting argument).

ii. Under this type, we must have that p

I

B

= p

I

A

+ 2λ (otherwise ﬁrm B is not

maximizing its proﬁt). However, since consumers’ reservation utility is zero, see

equation (10.12), equilibrium prices must satisfy p

I

B

≤ 2λ, hence, p

I

A

= 0 and

π

I

A

= 0. However, ﬁrm A can always increase its proﬁt by raising its price by

thereby making strictly positive proﬁt.

(b) Following the proof of Proposition 10.14, it can be established that there exists an

equilibrium in which each consumer buys his or her ideal system. In this equilibrium,

p

x

A

= p

y

A

= p

x

B

= p

y

B

= λ, and π

c

A

= π

c

B

= 4λ.

Chapter 11

Advertising

From a technical point of view, the analyses given in this chapter are pretty much straight

forward, perhaps, with the exception of the calculation of the socially optimal level of persuasive

advertising given in equation 11.13, where an integral is computed. The appendix describing

advertising regulations can be assigned as a home reading.

Answers to Exercises

1. (a) Since

A

=

%∆Q

%∆A

= 0.05, and

p

=

%∆Q

%∆p

= −0.2,

then by the Dorfman-Steiner condition (Proposition 11.1), we have that the proﬁt

maximizing ratio of advertising to revenue is

A

M

pQ

M

=

A

−

p

=

1

4

.

Hence, A

M

= $2.5 mil..

(b) Now,

p

= −0.5. Therefore A

M

= 10 ×0.05/0.5 = $1 mil..

(c) When the demand becomes more price elastic, the monopoly reduces the ratio of

advertising expenditure to revenue.

2. (a) A

α

= A

β

= 1 implies that n

α

= n

β

= 3, hence, π

α

= π

b

= 30 − 1 = 29.

When A

α

= A

β

= 2, we have it that n

α

= n

β

= 3, hence, π

α

= π

b

= 30 −2 = 28.

Conclusion: if both ﬁrms spend the same amount on advertising, then industry proﬁt

is maximized at A

α

= A

β

→0. That is, advertising in this city serves as a mean by

which each ﬁrm attracts consumers from the competing ﬁrm, but cannot increase

industry sales beyond the level determined by zero advertising.

(b) Fortune teller β takes A

α

as given and chooses A

β

to maximize his or her proﬁt.

The ﬁrst-order condition is given by

0 =

∂π

β

∂A

β

=

30A

α

(A

β

)

2

−1.

The second-order condition can be easily veriﬁed. Hence, A

β

= R

β

(A

α

) =

√

30A

α

.

By symmetry, A

α

= R

α

(A

β

) =

30A

β

. The two best-response functions are drawn

in Solution-Figure 11.1.

(c) Solution-Figure 11.1 illustrates that the two best response functions intersect twice,

reﬂecting the fact that there exist two Nash equilibria for this advertising game. For

the purpose of this question, we deﬁne 0/0 (yes, zero divided by zero) as equal to 1.

38 Advertising

✲

............................... .

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

.

A

α

A

β

0 30

30

R

β

(A

α

)

R

α

(A

β

)

✲

✻

✲

✻

Solution-Figure 11.1: Fortune tellers’ advertising best-response functions

Then, clearly A

α

= A

β

= 0 constitutes one NE. To obtain the other NE, substituting

R

α

(A

β

) into R

β

yields A

β

=

30

30A

β

. Hence, A

N

α

= A

N

β

= 30 which is also

illustrated in Solution-Figure 11.1.

(d) In the interior NE, π

N

i

(30, 30) = 30 − 30 = 0, i = α, β, which is lower than

π

N

i

(1, 1) = 29. Thus, the industry’s proﬁt is not maximized at the interior NE. How-

ever, at the other NE, industry’s proﬁt is maximized and each ﬁrm earns π

N

i

(0, 0) =

30.

(e) The interior NE (30, 30) is stable. The interior NE (0, 0) is unstable since any

unilateral deviation by one of the ﬁrm would trigger a sequential chain of responses

that would move the advertising equilibrium to (30, 30) (see Solution-Figure 11.1

for an illustration). Thus, in this example, the NE that maximizes industry proﬁt is

unstable.

3. In order for (I, P) to constitute a NE outcome, we need to show that unilateral deviation

is not proﬁtable for each ﬁrm. That is, using Table 11.1,

π

2

(I, P) = N ≥ π

1

(I, I) = (1 −θ)E when θ ≥ 1 −N/E;

π

1

(I, P) = θE ≥ π

1

(P, P) = N/2 when θ ≥ N/(2E).

Chapter 12

Quality, Durability, and Warranties

This is a long chapter with a wide variety of topics dealing with supply and demand for quality.

The analyses are pretty much straight forward and do not require any preparation with the

exception of section 12.2 that relies on the knowledge of location models developed in Chapter 7.

Other sections use only simple calculations of expected values. The appendix on the legal

approach to liability (section 12.8) may be assigned as a home reading.

An Alternative Model for Section 12.6

The model suggested below provides some improvement as it assumes that consumers are ex-

pected utility maximizers (similar to what is assumed in Section 12.5).

1

Suppose that consumers

believe that the monopoly is a high-quality producer with probability α, and a low-quality pro-

ducer with probability 1 − α, where 0 < α < 1. Then, without any additional information,

EU = αH + (1 −α)L −p. Therefore, the maximum price that consumers are willing to pay is

¯ p = αH +(1 −α)L. Then a low-quality producer could set the price at ¯ p, and make a proﬁt of

(¯ p −c

L

) · 1 = αH + (1 −α)L −c

L

= αH + (1 −α)L −c

L

> 0. (∗)

The price and quantity pair in Proposition 12.10 should be modiﬁed to

p

m

= H and q

m

=

αH + (1 −α)L −c

L

H −c

L

.

Had the monopolist been a low-quality producer, he or she could have made the same proﬁt by

setting ¯ p and selling to all consumers [as is indicated in (*)] rather than setting p = p

m

and

q = q

m

. Therefore, in choosing this price-quantity pair the monopolist could signal his or her

quality to the consumers. Finally, since H > L > c

H

> c

L

,

(H −c

H

)

αH + (1 −α)L −c

L

H −c

L

> αH + (1 −α)L −c

H

= (¯ p −c

H

) · 1.

Hence, the high-quality monopoly would indeed ﬁnd it proﬁtable to signal its high quality to the

consumers.

1

I thank Keiichi Koda for proposing this improvement.

40 Quality, Durability, and Warranties

Answers to Exercises

1. (a) Using the utility function (12.2) and the zero reservation utility assumption, the

consumer who is indiﬀerent between purchasing from A and not purchasing at all

must satisfy U

z

(A) = az −p

A

= 0, yielding z = p

A

/a.

(b) Follows directly from (12.4).

(c) For a given p

B

, ﬁrm A chooses p

A

to

max

p

A

π

A

= p

A

¸

p

B

−p

A

b −a

−

p

A

a

, yielding 0 =

p

B

−2p

A

b −a

−

2p

A

a

.

For a given p

A

, ﬁrm B chooses p

B

to

max

p

B

π

B

= p

B

¸

1 −

p

B

−p

A

b −a

, yielding 0 = 1 −

2p

B

−p

A

b −a

.

Second-order conditions are easily obtained. Solving the two ﬁrst-order conditions

yield the equilibrium prices. Substituting into the proﬁt functions yield the equilibrium

proﬁt levels.

(d) We ﬁrst verify that given b

e

= 1, the proﬁt maximizing location of ﬁrm A is a

e

= 4/7.

Thus, given b

e

= 1, ﬁrm A chooses a

e

to

max

a

π

a

=

a(1 −a)

(4 −a)

2

, yielding a

e

=

4

7

.

We now verify that given a

e

= 4/7, ﬁrm B would choose to locate on the east edge

of the street.

2

For a given a

e

ﬁrm B chooses b

e

to maximize π

B

which is given

above. We would like to show that for a

e

= 4/7,

0 <

∂π

B

(4/7, b)

∂b

≈ 49b

2

−21b + 8 ≡ φ(b).

To demonstrate this inequality, we need to prove that φ(b) > 0 for all b ∈ [0, 1].

Clearly φ

**(b) = 98b − 21, which is negative for 0 ≤ b < 21/98 and positive for
**

b > 21/98. Hence, the function φ hits a minimum at b = 21/98. Now, φ(21/98) =

5.75 > 0. Hence φ(b) = ∂π

B

/∂b > 0 for all b ∈ [0, 1] implying that ﬁrm B would

locate at b

e

= 1.

2. Let U

i

(k) denote the utility of consumer i when he buys the brand with quality k, k = H, L

and i = 1, 2. We want to show that

U

2

(L) = L(I

2

−p

L

) > H(I

2

−p

H

) = U

2

(H).

From (12.1), we have it that since consumer 1 buys the low-quality brand, then

U

1

(L) = L(I

1

−p

L

) > H(I

1

−p

H

) = U

1

(H).

Therefore,

(H −L)I

1

< Hp

H

−Lp

L

.

Now, since I

2

< I

1

by assumption, (H−L)I

2

< Hp

H

−Lp

L

, implying that H(I

2

−p

H

) <

L(I

2

−p

L

).

2

Many students will ﬁnd this part of the proof to be diﬃcult.

Quality, Durability, and Warranties 41

3. Under these prices, we seek to characterize the demand and supply patterns of our agents.

3

New buyers (who do not yet own a car): Recalling our assumption that N

L

= U

L

=

0, if a new buyer buys a new car, then his or her expected utility is V

b

= 0.5N

G

+0.5N

L

−

¯ p

N

= 0. In contrast, if a new buyer buys a used car then V

b

= 0.5U

G

+0.5U

L

− ¯ p

U

> 0.

Hence, under the assumed prices, new buyers buy used cars.

Good-used-car sellers: The question simply assumes that good-used-car owners must

leave the country and therefore sell their good-used cars.

Lemon-used-car sellers: If a lemon-used-car seller sells his or her lemon and buys a new

car, then V

s,L

= 0.5N

G

− ¯ p

N

+ ¯ p

U

= ¯ p

U

. In contrast, if she or he buys a used car then

V

s,L

= 0.5U

G

− ¯ p

U

+ ¯ p

U

= 0.5U

G

. By assumption ¯ p

U

< 0.5U

G

, hence, lemon-used-car

sellers buy (and sell) used cars.

Altogether, under the assumed prices, nobody buys a new car.

4. (a) The monopoly’s production cost is the initial production cost plus the expected (as

most once) replacement cost, which is equal to c + (1 −ρ)c = (2 −ρ)c.

(b) The maximum monopoly price is the expected consumer surplus from purchasing

this product with this type of warranty. This surplus equals V if the product does

not fail at all and if the product fails only once (in which case it is replaced). The

probability of a double failure is (1 −ρ)

2

. Hence, the probability of no double failure

is 1 −(1 −ρ)

2

= ρ(2 −ρ). Therefore, p

M

= ρ(2 −ρ)V .

(c) If the monopoly provides this warranty, then π

W

= ρ(2 − ρ)V − (2 − ρ)c = (2 −

ρ)(ρV − c). If the monopoly sells with no warranty, then π

NW

= ρV − c. Hence,

π

W

> π

NW

since it is assumed that ρV > c. Thus, the monopoly will bundle the

product with this warranty.

3

The purpose of this question is demonstrate that used cars are traded when some good-used-car owners are

“forced” to sell their car, say, because they leave the country. Note: If you are using the ﬁrst printing of the ﬁrst

edition, change the last sentence in this question to “. . . the four types of agents. . . .”

Chapter 13

Pricing Tactics: Two-Part Tariﬀ and Peak-Load Pricing

The analyses given in this relatively short chapter rely mainly on logical arguments and therefore

do not require any special technical preparation. Section 13.4 presents an attempt to endogenize

the seasons in determining proﬁt maximizing peak-load pricing, and therefore may be given a

lower priority in case the instructor is short of time.

1

Answers to Exercises

1. (a) The two cost functions are drawn in Solution-Figure 13.1.

✲ ˜

k (# copies)

✻

$

TC(k) = 0.05k

TC(k) = 300 + 0.02k

•

˜

k

300

Solution-Figure 13.1: The cost of photocopying with or without two-part tariﬀ

(b) The number of copies yielding identical cost under the two payment systems is found

by equating 0.05

ˆ

k = 300 + 0.02

ˆ

k. Therefore,

ˆ

k = 10, 000 copies. Thus, for k >

ˆ

k,

the two-part tariﬀ system is less costly, and for k <

ˆ

k, the ﬁxed-per-unit price system

is less costly.

2. (a) By Proposition 13.4, to ﬁnd the proﬁt maximizing pricing structure we need (i) to

equate the “high-season” marginal revenue to the cost of an aircraft seat plus the

per-passenger cost, and (ii) to equate the “low-season” marginal revenue to the

per-passenger cost only.

Given that the Summer demand curve lies completely below the Winter demand

curve, we can conclude that Winter is the high season. However, since the two

demand curves are “relatively close,” we need to be careful about the capacity con-

straint determined by the Winter condition.

In the Winter, capacity is determined by having the monopoly equating

MR

W

(q

W

) = 10 −2q

W

= r +c = 2, and MR

S

(q

S

) = 5 −q

S

= c = 1.

1

If you are using the ﬁrst printing of the ﬁrst edition note that the calculations of consumer surplus in

section 13.2 are wrong. Ask for the errata ﬁle by e-mail.

44 Pricing Tactics: Two-Part Tariﬀ and Peak-Load Pricing

The ﬁrst equality implies that q

W

= 4, hence, p

W

= 6. The second equality implies

that q

S

= 4, hence, p

S

= 3. Altogether, π

I

= 6 ×4 + 3 ×4 −2 ×4 −1 ×4 = 24.

(b) Similar to the previous subquestion, the monopoly equates

MR

W

(q

W

) = 10 −2q

W

= r +c = 4, and MR

S

(q

S

) = 5 −q

S

= c = 1.

The ﬁrst equality implies that, q

W

= 3, hence, p

W

= 7. The second equality implies

q

S

= 4 > 3 = q

W

. Hence, due to the capacity constraint, the airline will ﬂy only

3 passengers during the Summer season. Thus, p

S

= 5 − 3/2 = 3.5. Altogether,

π

I

= 7 ×3 + 3.5 ×3 −4 ×3 −1 ×3 = 16.5.

Chapter 14

Marketing Tactics: Bundling, Upgrading, and Dealerships

This chapter introduces several topics related to proﬁt enhancing marketing tools that were not

discussed (at least not in full) in earlier chapters.

Answers to Exercises

1. (a) Under pure tying, we need to check two options: (i) Under p

T

= 4, all three con-

sumers buy the packages, hence, π

T

(4) = 3 × 4 = 12. (ii) Under p

T

= 10, only

consumer 2 buys a package, hence, π

T

(10) = 10. Clearly, the ﬁrst option maximizes

the proﬁt under pure tying.

(b) The proﬁt maximizing product and package prices are p

MT

X

= p

MT

Y

= 4 and p

MT

=

8. Under this price structure, consumer 1 buys one unit of X, consumer 3 buys one

unit of Y and consumer 2 buys the package (or one unit of each good). Altogether,

π

MT

= 4 + 4 + 8 = 16.

(c) Notice that mixed tying yields the same proﬁt maximizing pricing structure as no

tying, since in the present example, the monopoly cannot charge consumer 2 more

than the sum of the prices of the two products sold separately. In fact, in the

present example, pure tying is proﬁt reducing. Therefore, mixed tying (which yields

an identical allocation as no tying) generates a higher proﬁt than pure tying.

2. (a) We need to compare the proﬁt levels under the commitment of not introducing a

new edition, in which case the publisher can charge a higher price in the ﬁrst period

by adding the resale value to the price, to the proﬁt level when no commitment is

made and the monopoly introduces a new edition.

By (14.17), the proﬁt level under commitment is nV , and under no commitment is

2n(V − c) − F. Comparing the two proﬁt levels reveals that commitment not to

introduce a new edition is more proﬁtable if F > nV −2c.

(b) Indeed, this condition in weaker (i.e., implied by) the condition given in (14.17) since

it compares in the case of commitment, in which ﬁrst-period students believe that

no new edition will be published, hence the monopoly can raise the book’s price

by its resale value, to the case where there is no commitment and a new edition is

introduced.

In contrast, the condition given in (14.16) and hence in (14.17) is derived by com-

paring the monopoly’s second period proﬁt only and therefore yields the condition

under which a new edition will not be introduced in the second period. In other

words, the condition given in (14.16) and (14.17) “does not take into account” that

ﬁrst period price can be raised by the resale value when a commitment is made not

to introduce a new edition.

3. (a) When a new edition is not introduced in the second period, the monopoly competes

with period 1 students on selling the ﬁrst edition. First period students will undercut

46 Marketing Tactics: Bundling, Upgrading, and Dealerships

the monopoly (since ﬁrst-period students do not have any production cost) and for

a given p

N

2

will set p

U

2

so that

V −p

N

2

≤ αV −p

U

2

.

Now, in a Bertrand equilibrium, if used-book sellers can undercut the monopolist,

then the monopoly price is reduced to cost( p

N

2

= c). Hence, the maximum price

user-book sellers can charge is

p

U

2

=

c −(1 −α)V if c ≥ (1 −α)V

0 otherwise

Notice that if c < (1 − α)V , or α < 1 − c/V , then the monopoly undercuts the

used-book sellers (since consumers do not value used books very much). Under this

condition, the monopoly would set p

N

2

= (1 − α)V , and therefore earn a proﬁt of

π

N

2

= n[(1 −α)V −c].

(b) There are two cases:

High value for used books (α > 1 −c/V ): A new edition would yield a second-

period proﬁt of π

N

2

= n(V − c) − F. When a new edition is not introduced, then

π

2

= 0. Hence, a new edition is introduced if F ≤ n(V − c), which is the same as

condition (14.16) when α = 1.

Low value for used book (α < 1 − c/V ): When α is low, used book sellers

are undercut by the monopoly. In this case, if a new edition is not introduced in

the second period, then p

N

2

= (1 − α)V − c (the monopoly undercuts used-book

sellers). Hence, π

N

2

= n[(1 − α)V − c]. Altogether, a new edition is introduced

if n(V − c) − F ≥ n[(1 − α)V − c], or if F ≤ nαN, which is diﬀerent from

condition (14.16).

4. (a) Under this contract, the dealer chooses Q (sales) to

max

Q

π

d

= (1 −φ)[p(Q)Q−cQ] = (1 −φ)[(a −Q)Q−cQ].

The ﬁrst-order condition yields Q

d

= (a − c)/2, p

d

= (a + c)/2, and π

d

= (1 −

φ)(a − c)

2

/4. Thus, the dealer’s sales and price are independent of (1 − φ) (share

of the proﬁt of the dealer). Under this contract, the industry proﬁt is

π

M

+π

d

= φ

(a −c)

2

4

+ (1 −φ)

(a −c)

2

4

=

(a −c)

2

4

,

which equals the industry’s proﬁt when the ﬁrms vertically integrate into a monopoly

given in (14.24).

(b) Under this contract, the dealer chooses Q that solves

max

Q

π

d

= (1 −φ)p(Q)Q−cQ = (1 −φ)(a −Q)Q−cQ.

Marketing Tactics: Bundling, Upgrading, and Dealerships 47

The ﬁrst-order condition is (1 −φ)(a −2Q) −c = 0, hence,

Q

d

=

a

2

−

c

2(1 −φ)

, and p

d

=

a

2

+

c

2(1 −φ)

.

Now, industry proﬁt is given by the sum

π

M

+π

d

=

φQ

d

p

d

+

(1 −φ)Q

d

p

d

−cQ

d

=

p

d

−c

Q

d

=

a

2

+

c −2(1 −φ)c

2(1 −φ)

a

2

−

c

2(1 −φ)

=

a −c

2

a

2

−

c

2(1 −φ)

<

(a −c)

2

4

.

Thus, this contract yields a lower proﬁt than the industry’s proﬁt when the ﬁrms

vertically integrate into a monopoly given in (14.24).

(c) Whereas the “proﬁt sharing” contract analyzed in part (a) is optimal (i.e., maxi-

mizes industry’s proﬁt) it is rarely observed since it requires having the manufacturer

monitoring the proﬁt made by the dealer. This monitoring may be too costly for the

manufacturer. In contrast, the per-unit contract analyzed in the text, despite being

not optimal, does not require any monitoring since the dealer pays up front for each

unit it acquires from the manufacturer.

5. We will demonstrate how a monopoly can beneﬁt from establishing a trade-in procedure

by constructing a simple model. Suppose that there are two consumers: one owns an old

refrigerator and one that is a new buyer. The utility from using an old refrigerator is V

U

whereas the utility from buying a new one is max{V

N

−p

N

, 0}, where V

N

> V

U

> 0. We

further assume that V

N

< 2V

U

.

Single price policy: I will argue that the proﬁt maximizing price is p

∗

N

= V

N

, thereby

selling only to the ﬁrst-time buyer and earning a proﬁt of π

∗

= V

N

. To see this, note that

the monopoly can set a lower price, p

L

= V

N

−V

U

, thereby selling two units and earn a

proﬁt of π

L

= 2(V

N

−V

U

). However, by assumption, π

L

< π

∗

.

Trade-in price policy: We now show that by employing a trade-in price policy, the

monopoly can price discriminate between new buyers and old-model owners. Suppose

that the monopoly announces that current users can trade-in their old refrigerator for a

new one for a price of p

TI

= V

N

−V

U

, whereas the price with no trade-in is p

N

= V

N

. Note

that under these prices, current users trade-in their old refrigerator for a new one, and also

a new buyer buys a new one. Altogether, π

TI

= V

N

−V

U

+V

N

= 2V

N

−V

U

> V

N

= π

∗

.

Chapter 15

Management, Compensation, and Regulation

Instructors who choose to teach from this chapter are urged to go over the principal-agent

problem (section 15.1), which is developed three times in order to allow for a a gradual in-

crease in the degree of diﬃculty. More precisely, the ﬁrst subsection illustrates the problem

with no uncertainty. A subsequent subsection introduces uncertainty with no risk aversion.

The third subsection of introduces risk aversion implicitly by assuming asymmetric information.

Altogether, these three subsections analyze the principal-agent problem in diﬀerent degrees of

complexity, thereby enabling the instructor to stop at the level that exceeds the students’ ability.

Section 15.2 introduces a simple free-rider team eﬀort problem. Section 15.3 introduces

Fershtman-Judd model, which is recommended only if the students are capable of solving

Cournot-type problems very easily. The remaining sections: executives’ compensation (sec-

tion 15.4) and the regulation of the ﬁrm (section 15.4) do ﬁt the more advanced students.

Answers to Exercises

1. (a) Under collusion, the “social planner” chooses a common eﬀort level for all scientists

e that solves

max

e

w −e

2

=

V

N

−e

2

=

Ne

N

= e −e

2

,

yielding e

∗

= 1/2.

(b) Each scientist i takes all other eﬀort levels (e

j

, j = i) as given and solves

max

e

i

U

i

=

V

N

−(e

i

)

2

=

¸

j=i

e

j

+e

i

N

−(e

i

)

2

,

yielding a NE where e

i

= 1/(2N) for all i = 1, 2 . . . N.

(c) Yes, since the optimal eﬀort level is e

∗

= 1/2 which is independent of the number of

scientists. In constrast, the NE eﬀort levels decrease further below the optimal level

when the number of scientists increases, reﬂecting a stronger free-rider eﬀect.

2. (a) The manager of ﬁrm 1 chooses q

1

that solves

max

q

1

M

1

= 0.5[(a −q

1

−q

2

)q

1

+ (1 −c)q

1

],

yielding a best-response function given by

q

1

= BR

1

(q

2

) =

a −c + 1 −q

2

2

.

The best response function of ﬁrm 2 (the ﬁrm that maximizes proﬁt only) is given

by q

2

= BR

2

(q

1

) = 0.5(a − c − q

1

). Therefore, the equilibrium output levels are

given by

q

e

1

=

a −c + 2

3

, and q

e

2

=

a −c −1

3

.

50 Management, Compensation, and Regulation

Clearly, q

e

1

> q

e

2

conﬁrming that the managerial compensating scheme of ﬁrm 1 is

output increasing at the expense of the ﬁrm that maximizes proﬁt only (ﬁrm 2).

(b) The owner of ﬁrm 1 earns π

O

1

= π

1

−M

1

. From the previous calculation we conclude

that p

e

= (a − 2c − 1)/3. Hence, π

e

1

= (a − c − 1)(a − c + 2)/9. We now set µ

1

suﬃciently small (as in [15.29]), so that we approximate the owner’s proﬁt by the

ﬁrm’s proﬁt. Formally, π

O

1

= π

1

.

Finally, comparing the proﬁt of the owner of ﬁrm 1 under the present managerial

compensation scheme to her proﬁt when this manager maximizes proﬁt only (the

simple Cournot proﬁt given in (6.7)) yields that π

O

1

≥ π

c

1

if and only if a ≥ 2 + c.

That is, the present compensation scheme dominates a simply Cournot behavior

(given that the other ﬁrm behaves in a Cournot fashion) if the demand intercept is

suﬃciently higher than the unit production cost.

Chapter 16

Price Dispersion and Search Theory

Price dispersion (section 16.1) demonstrates that a discount store and an ‘expensive’ store can

coexist in a market where consumers have diﬀerent search costs (resulting, say, from diﬀerent

values of time). The analysis relies on a simple of location model. Thus, the students should

ﬁnd this section easy to follow. Search theory (section 16.2) is introduced with no calculus, so

the analysis relies on simple probability arguments.

Answers to Exercises

1. (a) To see what happens, we look at the equilibrium prices when L → 0. From (16.9)

we see that

lim

L→∞

p

e

D

= lim

L→∞

p

e

ND

= 2αH and ˆ s

e

→0.

Hence, when L becomes small (i.e., some consumers have a negligible search cost),

both stores charge the same price, implying that there is no discount store.

(b) When α = 3/2, the consumer indiﬀerent between searching or buying at random is

located at L. Hence, when α = 3/2 all consumers buy at random. When α = 1,

ˆ s

e

< L implying that the discount store a negative market share (which is ruled out

by out assumption that α > 3/2).

2. (a) Using (16.13), we have it that

s 0 1 2 3 4 5

¯ p 1 4.77 6.52 7.86 9.00 10.0

Solution-Table 16.1: Reservation price as a function of the search cost parameter

(b) Solution-table 16.1 reveals that for s ≥ 4 the consumer reservation price is ¯ p = 9,

implying that the consumer will accept any price in the ﬁrst store visit.

(c) Solution-table 16.1 reveals that ¯ p = 1 when s = 0 (i.e., when search cost is zero).

(d) When s = 0,

1

the probability that the consumer ﬁnds the price higher than 1 (i.e.,

the reservation price) in a single store visit is σ = 8/9. The probability that prices

exceed 1 in two store visits is σ

2

= (8/9)

2

. Hence, the probability that this consumer

ﬁnds prices exceed 1 in all store visits is lim

T→∞

(8/9)

T

= 0.

Note also that this result can be inferred from (16.16) where the calculated expected

number of stores visited is µ = 1/(1 −σ) = 9 < +∞.

1

The ﬁrst printing of the ﬁrst edition does not specify which search cost is assumed. This question should

read, under the search cost you found in the previous subquestion, calculate....

Chapter 17

Miscellaneous Industries

The purpose of this chapter is to demonstrate to the student that there is no general model

that can describe all industries; however, I also wish to demonstrate in this last chapter that

the tools developed in this book are indispensable to the analysis of most industries, and are,

therefore, worth learning.

This chapter discusses four types of industries that require special attention since (perhaps

like any other industry) they do not fall in any category and therefore cannot be analyzed by

simply picking one of the market structure analyzed earlier in the book. In future editions I

will attempt to expand this part of the book by introducing at least three more industries: the

health industry, the defense industry, and (you guessed, of course), the lawyers.

Answers to Exercises

1. From the deﬁnition, this technology (cost function) exhibits economies of scope if

TC(n, n, n) = (n

α

+n

α

+n

α

)

β

< (n

α

)

β

+ (n

α

)

β

+ (n

α

)

β

= TC(n, 0, 0) +TC(0, n, 0) +TC(0, 0, n),

or,

(3n

α

)

β

< 3n

αβ

, therefore if 3

β

< 3, hence if β < 1.

2. The main message here is that the introduction of a binding price cap by the regulator

will cause the monopoly airline to reduce ﬂight frequency (or any other quality aspect of

the service).

(a) Under the FC network, each route can be analyzed separately. Now, from the utility

function of route 3 passengers (17.2), we see that the monopoly extracts maximum

surplus when p

3

= δ +

√

f

3

. Since the airfare is regulated (i.e., p

3

= ¯ p

3

) we have it

that the minimum frequency that the airline must provide on route 3 (at this airfare)

is

¯

f

3

= (¯ p

3

−δ)

2

. Clearly, as ¯ p

3

decreases, the corresponding frequency

¯

f

3

decreases.

(b) Under the HS network, the ﬂight frequency on route 3 is the (minimum) frequency

on routes 1 and 2.

1

Hence, similar to (17.5), but with a given ¯ p

3

, the monopoly

chooses

˜

f ≡

˜

f

1

=

˜

f

2

that solves

max

f

π

h

= n¯ p

3

+ 2nδ + 2n

f −2cf,

1

The ﬁrst printing of the ﬁrst edition contains a typo: Replace “...charges an airfare

¯

f

3

” with “airfare ¯ p

3

.”

54 Miscellaneous Industries

yielding a ﬁrst order condition given by 0 = 2n/(2

˜

f) −2c. Hence,

2

˜

f =

n

2c

2

<

3n

4c

2

= f

h

.

Therefore, under the HS network, a price cap on route 3 will reduce the ﬂight

frequency on all routes.

3. The analysis here follows the same stages as in section 17.4, but it uses a diﬀerent driving

time function.

3

(a) If some people take the train and some drive a car, it must be that L

T

= L

C

. Thus,

v +φ = v(n

C

)

3

, implying that n

e

C

=

v +φ

v

1/3

.

(b) The social planner chooses n

s

C

that solves

minL

s

= (N −n

c

)(v +φ) +n

C

V (n

C

)

3

,

yielding

n

s

C

=

v +φ

4v

1/3

< n

e

C

.

Thus, the social planner would recommend a policy that would result in a reduction

in the number of people who drive a car.

(c) Let τ denote the highway toll on this route. Then, to set the toll that would generate

the socially optimal number of highway users, the social planner sets τ

s

that solves

v +φ = v(n

s

C

)

3

+τ = v

v +φ

4v

+τ,

yielding that τ

s

= 3(v +φ)/4.

2

One has also to check that, in this equilibrium, the airfare on route 3, ¯ p

3

, is lower than the sum of the airfares

on routes 1 and 2; that is, we need to verify that (or ﬁnd the conditions under which) ¯ p

3

≤ p

1

+ p

2

. Otherwise,

route 3 passengers can purchase two separate tickets and reach their destination at a lower airfare.

3

The ﬁrst printing of the ﬁrst edition contains a typo. Simply set t

C

= (n

C

)

3

(the equation stated in this

question equals to the value of the driving time, L

C

and not t

C

).

Copyright c 1995–2004 Oz Shy. All rights reserved.

A The manual was typeset by the author using the LTEX 2ε document preparation software by Leslie Lamport (a special version of Donald Knuth’s TEX program) during the months from September 1995 to November 1995 while I was visiting the Economics Department of the A University of Michigan. All the ﬁgures are also drawn in LTEX using software called TEXcad developed by Georg Horn, which can be downloaded from various mainframes.

Version 1.0 [Draft 20], (1995): Prepared for the ﬁrst printing of the ﬁrst edition bkman21.tex ﬁrst draft to be posted on the Web (2000/07/07) (parallel to the 5th Printing of the book) v.24 (2004/04/14): 6.1.d, 6.1.e This version: bkman24.tex 2004/04/14 17:36

Contents

To the Instructor 2 3 4 5 6 7 8 9 v 1 7 Basic Concepts in Noncooperative Game Theory Technology, Production Cost, and Demand Perfect Competition The Monopoly 11 17 25 29 35 9

Markets for Homogeneous Products Markets for Diﬀerentiated Products Research and Development 37 33

Concentration, Mergers, and Entry Barriers

10 The Economics of Compatibility and Standards 11 Advertising 12 Quality, Durability, and Warranties 39

13 Pricing Tactics: Two-Part Tariﬀ and Peak-Load Pricing 14 Marketing Tactics: Bundling, Upgrading, and Dealerships 15 Management, Compensation, and Regulation 16 Price Dispersion and Search Theory 17 Miscellaneous Industries 53 51 49

43 45

.

(e-mail addresses are given below).com OzBackup@yahoo.tcl?isbn=0262691795 bkman24. Before reporting errors and typos. • to convey to the instructor my views of what the important concepts in each topic are. (April 14. Haifa. • to suggest which topics to choose for diﬀerent types of classes and levels of students. Israel. I urge the instructor to read carefully the Preface of the book that suggests diﬀerent ways of organizing courses for diﬀerent levels of students and also provides a list of calculus-free topics. 2004) E-mail Backup Web-page Catalog-page This draft : : : : : ozshy@ozshy.mit. Finally. please view the errata ﬁles to see whether the error you found was already identiﬁed and corrected.ozshy. please alert me to any errors or incorrect presentations that you detect in the book and in this manual.edu/book-home. The goals of this manual are: • To provide the instructor with my solutions for all the problems listed at the end of each chapter.com www.To the Instructor Before planning the course.tex 2004/04/14 17:36 . Note that the errata ﬁles (according to the printing sequence) are posted on the Web in PDF format.com http://mitpress.

.

but RR (ω) = φ.Chapter 2 Basic Concepts in Noncooperative Game Theory An instructor of a short course should limit the discussion of game theory to the four most important concepts in this chapter that are essential for the understanding most of the analyses presented in this book: 1.3) before teaching the NE equilibrium concept.4). and the SPE (Deﬁnition 2. 2. 4. but RJ (φ) = φ. Answers to Exercises 1. . strategies (compare with actions). and so on. uniqueness. subgames. (a) It is straightforward to conclude that R1 (a2 ) = WAR if a2 = WAR WAR if a2 = PEACE and R2 (a1 ) = WAR if a1 = WAR WAR if a2 = PEACE. There does not exist a NE for this game since there does not exist an outcome the is on both best-response functions. Extensive form games. WAR is each player’s best response to each action taken by the other player (hence. Welfare comparisons among outcomes (Deﬁnition 2. Now. (b) That is. you can introduce the equilibrium in dominant actions (Deﬁnition 2.1): It is important that the student will understand that a game is not properly deﬁned unless the list of players. The deﬁnition of a game (Deﬁnition 2. I advise covering repeated games (section 2. but RR (φ) = ω. WAR) a ˆ is a (unique) NE since this outcome is on the best-response function of each player.3). and multiple equilibria in class. I believe that the above can be covered in 2 lectures. More precisely. and the payoﬀ functions are clearly stated. If you wish to emphasis more game theory. a2 ) = (WAR. (ˆ1 . 3.10). That is. it is important that the student will know that in order to prove existence. WAR is a dominant action for each player). It is important that the student will understand the meaning of the term outcome as a list of the speciﬁc actions chosen by each player (and not a list of payoﬀs as commonly assumed by students). RJ (aR ) = ω if aR = ω φ if aR = φ and RR (aJ ) = φ if aJ = ω ω if aJ = φ. I urge the instructor to discuss the issues of existence.6). however. If you wish to devote more time to game theory. so RJ (ω) = ω. it is suﬃcient to ﬁnd only one NE outcome. Nash equilibrium (Deﬁnition 2. the student must go over all outcomes and show that at least one player beneﬁts from unilateral deviation. RJ (ω) = ω. to prove nonexistence. or in three hours of instruction. the action set of each player.

n2 ) = (100. 2. R) if (a ≥ g and b > h) or (a > g and b ≥ h). L) and π α (T. that is π β (T.2 (c) Rα (aβ ) = Basic Concepts in Noncooperative Game Theory B if aβ = L T if aβ = R and Rβ (aα ) = L if aα = T R if aα = B. K. L) = a ≥ e = π α (B. we have to show that for every outcome (n1 . L) = f ≥ h = π β (T. R). L) Pareto dominates (T. one of the players will beneﬁt from changing his or her declared value. (T. or π α (T.1 which states that an equilibrium in dominant actions is also a NE. where π 1 (100. L) = b ≥ d = π β (T. (b) There is no NE for this game. n2 ) = (100. 1994. R) but π β (T. and L is a dominant action for player β. but Rβ (B) = R. so Rβ (T ) = L. R) but π β (T. Let us observe that the parameter restrictions given in part (a) are also included in part (b) conﬁrming Proposition 2. iii. Let us look at the following outcomes: 1 A typo in the question (ﬁrst printing) leads to this undesirable result (see Basu. then T has to be a dominant action for player α. R).1 To prove this. 100). 100) = 100. 100) = 101 and π 2 (99. n2 ) = (99. L) Pareto dominates (B. L). 3. (a) If (T. and π β (T.” American Economic Review 84: 391–395. L) = b > h = π β (B. (n1 . (T. where π 1 (100. ii. A NE does not exist for this game since Rα (L) = B. (T. R) if (a ≥ c and b > d) or (a > c and b ≥ d). ii. L) is a NE. L) = a < g = π α (B. 100). . (d) Loosely speaking. L) = b ≥ d = π β (T. whereas the other player prefers (B. (b) If (T. for a mechanism that generates (2. (n1 . L) Pareto dominates (B. where π 1 (99. 99). R). L) = a ≥ e = π α (B. Formally. (c) i. n2 ). L) = a > g = π α (B. L) over (B. (a) There are three Pareto optimal outcomes: i. then π α (T. 100) = 98. R). and so on. but Rα (R) = T . either π α (T. (n1 . L) = b < h = π β (B. 99) = 98 and π 2 (100. L) is an equilibrium in dominant actions. R) over the outcome (T. R). L) if (a ≥ e and b > f ) or (a > e and b ≥ f ). 100) = π 2 (100. R). the outcomes are Pareto noncomparable if one player prefers (T. “The Traveler’s Dilemma: Paradoxes of Rationality in Game Theory. R) = c ≥ g = π α (B. 99) = 101. iii. that is π α (T. 2) as a unique NE outcome). and π β (B. R). L).

no ﬁrm ﬁnds it proﬁtable to unilaterally change the type of cars it produces. SM. 100). This subquestion may confuse students who are already thinking in terms of backward induction. n2 ) = (99. and two proper subgames labeled JL (for Jacob left) and JR (for Jacob right). SM. an instructor teaching from the ﬁrst printing is urged to change this subquestion to ﬁnding the NE for the entire game only. iii.1: Three subgames of the dynamic Battle of the Sexes (b) One easy way to ﬁnd NE outcomes for an extensive form game is to construct a normal-form representation. Also. 2). ii. If (n1 . and so on.1) proves that the NE outcomes involve the two players going together either to football or to the opera. If (n1 . 100). SM. there are several NE. Hence. then player 1 can increase his or her payoﬀ to π 1 = 101 by declaring n1 = 99. SM ) is a NE outcome since π C (LG. where the NE of the subgames are used to ﬁnd the SPE. the normal-form representation is already given in Table 2. LG. φ πR = 2 πJ = 1 JL • ω πR = 0 πJ = 0 φ πR = 2 πJ = 1 φ • ω Rachel ◦ ω Jacob φ φ JR • ω πR = 1 πJ = 2 πR = 0 J • π =0 ω πR = 1 πJ = 2 πR = 0 πJ = 0 πR = 0 πJ = 0 Solution-Figure 2. players always beneﬁt from declaring a value of one dollar lower than the other player. SM. SM ) = α ≥ γ = π C (SM. The three subgames are illustrated in Solution-Figure 2. SM. SM ) π F (LG. and the proof is identical to the one given in part (a).1. The outcome (LG. SM ) π G (LG. SM ) = β = β = π F (LG. Since our analysis is based on SPE you may want to avoid assigning this subquestion (only). n2 ) = (100. SM ) is also a NE for this game.Basic Concepts in Noncooperative Game Theory 3 i. 4. SM. to postpone ﬁnding the NE for the subgames to the next subquestion. it is easy to verify that the following three outcomes constitute NE: sJ = 2 φ if sR = ω φ if sR = φ and sR = φ. (b) Again. n2 ) = (2. then player 2 can increase his or her payoﬀ from π 2 = 98 to π 2 = 99 by declaring n2 = 99. (a) There are three subgames: the game itself.2. SM ) = β = β = π G (LG. LG). (LG. Formally. Hence. 5. hence. then player 1 can increase his or her payoﬀ from π 1 = 2 to π 1 = 98 by declaring n1 = 100. For example. equation (2. SM. (a) There are several NE outcomes for this game. If (n1 . .2 However. Also.

Now. . Jacob’s announcement constitutes an incredible threat. In contrast. the strategies sR = aR = φ constitute a unique SPE. sR = φ. Looking at the proper subgames in Solution-Figure 2.4 sJ = sJ = Basic Concepts in Noncooperative Game Theory ω if sR = ω ω if sR = φ ω if sR = ω φ if sR = φ and and sR = ω.1) (c) Using backward induction. himself. who knows Jacob’s best-response function in the second stage. RJ (φ)) = 2 > 1. 0) and (1.2 demonstrates that (θ. 3 Instructors: Here is a good opportunity to discuss the concepts of credible and incredible threats. Altogether. (a) Jacob’s expected payoﬀ is given by: Eπ J (θ. 1/3) is a NE in mixed actions. we look for Rachel’s strategy (given Jacob’s best response). 1] if ρ = 1/3 RJ (ρ) = 1 if λ > 1/3 0 0 and RJ (aR ) = ω if aR = ω φ if aR = φ and RR (θ) = if θ < 2/3 [0.1. (2. 6. since Jacob. Thus. note that the outcomes (0.3 Clearly. (c) Solution-Figure 2. we ﬁrst construct Jacob’s strategy (which constitutes the Nash equilibria for the two proper subgames). we conclude that RJ (aR ) = ω if aR = ω (subgame JR) φ if aR = φ (subgame JL). 1] if θ = 2/3 1 if θ > 2/3. (b) The players’ best-response functions are given by if ρ < 1/3 [0. (d) No! Jacob’s best response is to play φ whenever Rachel plays φ. ρ) = θρ × 2 + θ(1 − ρ) × 0 + (1 − θ)ρ × 0 + (1 − θ)(1 − ρ) × 1 = 2 + 3θρ − ρ − θ. 1) are also NE outcomes in mixed actions and are the same as the pure NE outcomes. Rachel.2. If Rachel plays aR = ω. would ignore it if Rachel plays φ in the ﬁrst stage. ρ) = (2/3. The players’ best-response functions are drawn in Solution-Figure 2. Rachel’s expected payoﬀ is given by: Eπ R (θ. if Rachel plays aR = φ. ρ) = θρ × 1 + θ(1 − ρ) × 0 + (1 − θ)ρ × 0 + (1 − θ)(1 − ρ) × 2 = 2 + 3θρ − 2ρ − 2θ. then her utility is given by π R (φ. then her utility is given by π R (ω. should ignore Jacob’s announcement. RJ (ω)) = 1. Also.

there are two equilibria: the two pure NE outcomes and one NE in mixed actions. ρ) = (2/3.3 has only one intersection since in that game NE in pure strategies does not exist. at the NE in mixed actions. 1/3) = Eπ R (2/3.Basic Concepts in Noncooperative Game Theory θ 1 ✻ 5 θ 1 2 3 RJ (ρ) 1 ρ ✻ RR (θ) ✻ RJ (ρ) • • RR (θ) ✲ ρ ✲ ρ 1 3 1 2 3 1 ✲ θ • 1 3 1 Solution-Figure 2. 1/3) into the players’ payoﬀ functions (deﬁned above) yield 2 Eπ J (2/3. 3 (e) The best-response functions in Solution-Figure 2. and therefore the best-response functions intersect only once. meaning that in the mixed extension game. .2: Best-response functions for the Battle of the Sexes in mixed actions (d) Substituting (θ. Figure 2.2 intersect three times. In contrast. 1/3) = .

.

Using the same procedure and Deﬁnition 3. However. k) = αlα−1 . ∂Q = αlα−1 k β . I urge you to make a formal deﬁnition and refer the students to Deﬁnition 3. β > 0. by Deﬁnition 3. Therefore.Chapter 3 Technology. Hence. this technology exhibit CRS if α + β = 1.2. when you ﬁrst encounter a discussion of returns to scale. when addressing elasticity issues. and DRS if α + β < 1.2. (b) M PL (l. (a) AC(Q) = T C(Q) F ∂T C(Q) = c. and Demand This chapter summarizes the basic microeconomic tools the students need to know prior to taking this class. by Deﬁnition 3. and M C(Q) = Q Q ∂Q These functions are drawn in Figure 4. ∂l ∂M PL (l. (a) Let λ > 1. k)/∂k = 0. (λl)α + (λk)α = λα (lα + k α ) > λ(lα + k α ). the technology exhibits IRS if (λl)α (λk)β = λα+β lα k β > λlα k β . students should be referred to Deﬁnition 3. which holds when α + β > 1. and CRS if α = 1. ∂k which is greater than zero under the assumption that α.3. the factors are supporting since M PL (l. (b) In this technology. 4. the technology exhibits DRS if α < 1. 3. k) ≡ hence.2 in the book. . Let λ > 1. Then. k) = αβlα−1 k β−1 . the factors are neither substitutes nor complements. 2. Similarly. (a) Let λ > 1. For example.2. Answers to Exercises 1. Production Cost. ∂M PL (l. my advice is to return (or refer) to this chapter whenever deﬁnitions are needed. My advice for the instructor is not to spend time on this chapter but simply assign this chapter (with or without the exercises) as reading in the ﬁrst class.2. This (quasi-linear) technology exhibits DRS since √ √ √ λl + λk < λl + λ k = λ(l + k). Then. Similarly. = + c. the technology exhibits IRS if which holds if α > 1.

p =1 MR which is independent of Q. hence if −1 < ηp ≤ 0. Hence. (a) Using Deﬁnition 3. hence if 0 ≤ < 1. 5. ηp (Q) = −1 when Q = 99/2 = 49.5. (c) The demand is elastic if ηp < −1.8 Technology. (d) M R(Q) = 0 when Q = 49. Therefore.3. Hence. Hence. > 1. T R(Q) = p(Q)Q = (99 − Q)Q. the marginal revenue is zero at the output level where the demand elasticity is −1 (unit elasticity). ηp (Q) = −2 when Q = 33.5. 1+ 1 = − −1 . The demand is inelastic if (d) By Proposition 3. (a) p = (b) ηp = ∂Q(p) p = A(− )p− ∂Q Q −1 (99 − 33)66 = 2178. which is a special case of Figure 3. Hence.3. 2 and CS(66) = (99 − 66)33 = 544. ηp (Q) ≡ p 99 − Q ∂Q(p) p = (−1) = − .5. CS(33) = 6.5 2 A .3. and Demand (b) Clearly. the elasticity is constant in the sense that it does not vary with the quantity consumed. Q Ap− Thus. (c) The inverse demand function is given by p(Q) = 99 − Q. (b) From the above. M R = p[1 + 1/(− )]. M R(Q) ≡ dT R(Q)/dQ = 99 − 2Q. ∂Q Q Q Q Hence. AC(Q) is minimized when Q = +∞. That is. AC(Q) declines with Q. Q p = A Q− . (c) Declining average cost function reﬂects an increasing returns to scale technology. 1 1 A(− )p− p = =− . (e) Using Figure 3. Production Cost.

given the importance of this market structure. A major reason for studying and using alternative (noncompetitive) market structures stems from the fact that the competitive market structure very often “fails” to explain why concentrated industries are observed. the term competitive refers to price taking behavior of agents. Answers to Exercises 1.Chapter 4 Perfect Competition A perfectly competitive market is characterized by nonstrategic ﬁrms. I urge the instructor to devote some time in order to make sure that the students understand what price-taking behavior means. note that this chapter does not solve for a competitive equilibrium under decreasing returns to scale technologies for two reasons: (i) other market structures analyzed in this book are also developed mainly for CRS (unit cost) technologies. we generally assume that our consumers are competitive. where ﬁrms take the market price as given and decide how much to produce (and. and (ii) most students are familiar with the DRS from their intermediate microeconomics class. You may want to emphasize and discuss the following points: 1. whether to enter. Finally. the exercise at the end of this chapter deals with a DRS technology. one could solve for a competitive equilibrium even in the presence of one ﬁrm (see an exercise at the end of this chapter).1. However. if free entry is allowed). It is now the right time to emphasize that. 3. For example. Another major reason for studying alternative market structures stems from the nonexistence of a competitive equilibrium when ﬁrms’ technologies exhibit IRS. q1 . The assumption of price taking behavior has nothing to do with the number of ﬁrms in the industry. Most students probably had some discussion of perfectly competitive markets in their intermediate microeconomics class. in economics. which means that they do not bargain over prices and take all prices and their income as given. Note that this confusion often arises since certain market structures yield market allocations similar to the competitive allocation when the number of ﬁrms increases (see for example subsection 6. 2. In a competitive market structure.2 which shows that the Cournot allocation may converge to the competitive allocation when the number of ﬁrms increases to inﬁnity). Firm 1 takes p as given and chooses q1 to max π1 = pq1 − wL1 = p L1 − wL1 . we make a similar assumption about the ﬁrms. For example. However.

1 4. 2 d(L1 ) 4L 1 L1 = p/(2w).10 The ﬁrst and second order conditions are given by 0= Hence. From the production function. Hence. q1 = q2 = 30. 2.1: Competitive equilibrium with two ﬁrms . Clearly. Qe = 120 − 60 = 60. q1 = Qe = pe /2 = 40. Given that the ﬁrms have the same technologies. which e e yields pe = 60. 3. Given that there is only one ﬁrm. e π1 = pe q1 − wLe = 80 × 40 − 1600 = 1600. Therefore. the supply equals demand equilibrium condition yields e that 120 − pe = pe /2. hence. Therefore. we can ﬁnd the equilibrium employment level to be Le = 1 e (q1 )2 = 1600. q1 = √ dπ1 p = √ − w. 5. the competitive price is lower and the aggregate production is higher when the industry consists of two ﬁrms. hence. p ✻ p = 2q1 p ✻ p = 2q2 120 • p ✻ p = q1 + q2 60 • 30 ✲ q1 • ✲ q2 p = 120 − Q 120 ✲ Q = q1 + q2 30 60 6. dL1 2 L1 Perfect Competition d2 π1 p = − 3/2 < 0. the supply equals demand condition becomes 120 − pe = pe /2 + pe /2. pe = 80. Solution-Figure 4. they have the same supply functions.

**Chapter 5 The Monopoly
**

Most students encounter the monopoly problem in their intermediate microeconomics class. However, the instructor would probably want to make sure that all students fully understand the monopoly’s choice problem and the eﬀect of price elasticity on the monopoly’s price, as well as the arguments against monopoly (section 5.2). I also urge the instructor not to skip discussing discriminating monopoly (section 5.3). The remaining sections, the cartel (section 5.4), and the durable goods monopolies (section 5.5) are more optional depending on the instructor’s tastes and students’ ability. Answers to Exercises 1. (a) ηp ≡ dQ p = a p− dp Q

−1

p =− . ap−

Hence, the exponential demand function has a constant price elasticity. By Proposition 3.3, −1 1 =p . M R(Q) = p 1 + − (b) Equating marginal revenue to marginal cost yields1 M R = pM −1 = c = M C; hence, pM = c . −1

(c) As increases, the demand becomes more elastic, hence, the monopoly price must fall. Formally, dpM c( − 1) − c < 0. = d ( − 1)2 (d) The ﬁrst edition (ﬁrst printing) contains a typo. The question asks what happens to the monopoly’s price when → +1. Clearly, pM → +∞. The reason is, that when = 1, the (entire) demand has a unit elasticity, implying that revenue does not vary with price (or quantity produced). Hence, given that the revenue is constant (in fact T R = a when = 1), then the proﬁt maximization problem is reduced to cost minimization which yields that the monopoly would “attempt” to produce as little as possible (but still a strictly positive amount).

The instructor may want to emphasize to the students that in the case of constant-elasticity demand functions (exponential demand functions) it is easier to solve for the monopoly’s price ﬁrst (using Proposition 3.3) and then solve for the quantity produced by substituting the price into the demand function. This procedure becomes very handy when solving monopolistic competition equilibria analyzed in section 7.2.

1

**12 (e) Inverting the demand function yields p(Q) = a1/ Q−1/ . Thus, T R(Q) ≡ p(Q)Q = a Q1− . Hence, M R(Q) ≡
**

1 1 dT R(Q) 1 = a Q− 1 − . dQ 1 1

The Monopoly

**(f) Equating marginal revenue to marginal cost yields a Q−
**

1 1

1−

1

= c,

yielding that the monopoly’s proﬁt maximizing output is QM = a −1 c .

Note that the same result is achieved by substituting pM (calculated before) into the demand function. 2. (a) Solution-Figure 5.1 illustrates an aggregate demand composed of the two groups of consumers, where each group shares a common valuation for the product. p VH

✻

VL nH nH + nL

✲Q

Solution-Figure 5.1: Aggregate demand composed of two consumer groups (b) The monopoly has two options2 : setting a high price, p = V H , or a low price, p = V L . Solution-Figure 5.1 reveals that the proﬁt levels (revenue since production is costless3 ) are given by π|p=V H = nH V H , and π|p=V L = (nH + nL )V L .

**Comparing the two proﬁt levels yields the monopoly’s proﬁt maximizing price. Hence, pM =
**

2

VH VL

if V H > (nH + nL )V L /nH otherwise.

Instructors are urged to assign or discuss this exercise, since it provides a good opportunity to introduce the student to a discrete (logic based) analysis which is used later in a wide variety of topics (see for example the section on tying [section 14.1]). 3 The ﬁrst printing of the ﬁrst edition neglects to assume that production of G-Jeans is costless.

The Monopoly

13

Thus, the monopoly sets a high price if either there are many high valuation consumers (nH is large) and/or these consumers are willing to pay a very high price (V H is high). 3. (a) In market 1, p1 = 2 − q1 . Hence, by Proposition 3.2, M R1 (q1 ) = 2 − 2q1 . Equating M R1 (q1 ) = c = 1 yields q1 = 0.5. Hence, p1 = 1.5. In market 2, p2 = 4 − q2 . Hence, by Proposition 3.2, M R2 (q2 ) = 4 − 2q2 . Equating M R2 (q2 ) = c = 1 yields q2 = 1.5. Hence, p2 = 2.5. (b) π1 = (p1 − c)q1 = (0.5)2 = 0.25, and π2 = (p2 − c)q2 = (1.5)2 = 2.25. Summing up, the monopoly’s proﬁt under price discrimination is π = 2.5. (c) There are two cases to be considered: (i) The monopoly sets a uniform price p ≥ 2 thereby selling only in market 2, or (ii) setting p < 2, thereby selling a strictly positive amount in both markets. Let us consider these two cases: i. If p ≥ 2, then q1 = 0. Therefore, in this case the monopoly will set q2 maximize its proﬁt in market 2 only. By subquestion 3a above, π = π2 = 2.25. ii. Here, if p < 2, q1 > 0 and q2 > 0. Therefore, aggregate demand is given by Q(p) = q1 +q2 = 2−p+4−p = 6−2p, or p(Q) = 3−0.5Q. By Proposition 3.2, M R(Q) = 3 − Q. Equating M R(Q) = c = 1 yields Q = 2, hence, p = 2. Hence, in this case π = (p − c)2 = 2 < 2.25. Altogether, the monopoly will set a uniform price of p = 2.5 and will sell Q = 1.5 units in market 2 only.4 4. (a) π(q1 , q2 ) = (100 − q1 /2)q1 + (100 − q2 )q2 − (q1 + q2 )2 . (b) The two ﬁrst order conditions are given by 0= ∂π ∂q1 ∂π 0= ∂q2 = 100 − q1 − 2(q1 + q2 ) = 100 − 2q2 − 2(q1 + q2 ).

M M M M Solving for q1 and q2 yields that q1 = 25 and q2 = 12.5. (c) Substituting the proﬁt maximizing sales into the market demand functions yield pM = pM = 87.5. Hence, 1 2 M M π(q1 , q2 ) = 87.5 × 12.5 + 87.5 × 25 − (12.5 + 25)2 = 1875.

(d) Now, that each plant sells only in one market, the two ﬁrst order conditions become 0= ∂π ∂q1 ∂π 0= ∂q2 = 100 − q1 − 2q1 = 100 − 2q2 − 2q2 .

Note that consumers in market 1 are better oﬀ under price discrimination than without it, since under no discrimination no output is purchased in market 1. Given that the price in market 2 is the same under price discrimination and without it, we can conclude that in this example, price discrimination is Pareto superior to nonprice discrimination, since both consumer surplus and the monopoly proﬁt are higher under price discrimination.

4

(ii) charging p2 = 50. and selling only to the second period consumers. the second period proﬁt maximizing price is p2 = 50. The two cases are illustrated in Solution-Figure 5. (a) Equating marginal revenue to the tax inclusive unit cost yields a − 2Q = c + t. thereby earning a second-period proﬁt of π2 = 2 × 50 = 100. pM = (a + c + t)/2. (f) This decomposition increases the monopoly’s proﬁt since the technology exhibits DRS. Hence. yielding a proﬁt level of π2 = 2 × 50 = 100. First-period consumer buys in period 1: In this case the second period proﬁt maximizing price is again p2 = 50. or. the second period price is independent of the actions of the ﬁrst-period buyer. as illustrated in Solution-Figure 5.14 M M yielding q1 = 100/3 and q2 = 25. 1 2 π = π1 (q1 ) + π2 (q2 ) = 250 100 × − 3 3 100 3 2 + 75 × 25 − 252 = 2917. Now.3. (a) We solve for the monopoly’s proﬁt maximizing prices starting from the second period. By section 5. Therefore. the monopoly has two choices: (i) charging p2 = 20. Altogether. yielding a proﬁt level of π2 = 3 × 50 = 150. the maximum price the monopoly can charge the ﬁrst-period buyer in the ﬁrst period is p1 = 150. an increase in t raises the monopoly price by less than t. Altogether. thereby earning a second period proﬁt of π2 = 3 × 20 = 60. in this case. thereby extracting all surplus from all consumers. and sell to all three consumers. by Proposition 3. yielding a proﬁt level of π2 = 2 × 50 = 100. The Monopoly (e) pM = 100 − 100/6 = 250/3 and pM = 100 − 25 = 75. (b) The second period outcome may depend on two cases: First-period consumer does not buy in period 1: In this case. the second-period price is independent of the action of the ﬁrst-period buyer in the ﬁrst period. 1 2 1 −2 = pM 1 + 2 1 −4 = M R2 (q2 ). or QM = (a − c − t)/2. checking the eﬀect of a tax rate change on the monopoly’s price yields that dpM /dt = 1/2 < 1. Now. . 7.2 (left). The second period outcome may depend on two cases: First-period consumer does not buy in period 1: Clearly. the monopoly should set p1 = 40. in order to attract the ﬁrst-period buyer to purchase in period 1. Hence. M 5.5pM . Hence. 6. the discriminating monopoly will set quantities to satisfy M R1 (q1 ) = M ). pM = 1. Hence. First-period consumer buys in period 1: In this case the second period proﬁt maximizing price is again p2 = 50.2.3 M R2 (q2 M R1 (q1 ) = pM 1 + 1 Thus.

as illustrated in Solution-Figure 5.The Monopoly p ✻ 15 p pM (c + t) ✻ • • • a pM (c + t) pM (c) c+t pM (c) • c MR ✲Q c+t c D ✲ Q M R(Q) D Solution-Figure 5. Now. Hence. M R = pM 1 + 1 −2 = c + t.2: How the monopoly price varies with a speciﬁc tax (b) Using Proposition 3.3. an increase in t raises the monopoly price by more than t.2 (right). . checking the eﬀect of a tax rate change on the monopoly’s price yields that dpM /dt = 2 > 1. yielding pM = 2(c + t).

.

subsection 6. and therefore provides self-discipline which restricts the gains from deviation from the cooperative actions.1. since c2 > c1 . Market structures are assumed by the researcher rather than solved for. this topic is written in a way that enables the instructor to teach self-enforcing collusion even without formally teaching repeated games. if pe < c1 then both ﬁrms produce zero output. i = j. where under the Cournot game ﬁrms’ actions are the quantity produced. Hence. (a) By Lemma 4. However. j = 1. Cournot and Bertrand market structures select Nash equilibrium outcomes. The important issues to discuss and emphasize are: 1. Answers to Exercises 1. qj . ∂q1 and 0 = ∂π2 = α − q1 − 2q2 − c2 . (b) Each ﬁrm i takes the output of its opponent. 2. by showing that a partial removal of trade barriers need not be welfare improving. i. but at these prices demand exceeds zero (since Q(c1 ) = α − c1 > 0). 2. including the player’s own earlier actions.2 (preferential trade agreements) provides a good example to the law of (no) second best.6. and in the Bertrand game ﬁrms’ actions are prices. 3. if a competitive equilibrium exists then it must be that pe ≤ c1 . Specifying a market structure is the same as specifying the rules of the game before predictions (e. if a competitive e e equilibrium exists. Hence.g. Self-enforcing collusion (section 6. Finally. q1 = Qe = α − c1 and q2 = 0. qi yielding ﬁrst order conditions given by 0= ∂π1 = α − 2q1 − q2 − c1 . Instructors who choose to teach this topic may want to emphasize that a trigger strategy is a function of the entire history of what each player has played in earlier periods.5) is suited for more advanced students. as given and solves max πi = (α − qi − qj )qi − ci qi .Chapter 6 Markets for Homogeneous Products The Cournot. ∂q2 . then pe = c1 .3) before covering self-enforcing collusion. Instructors may want to go over repeated games (section 2. Free entry versus a ﬁxed number of ﬁrms. both ﬁrms produce a ﬁnite amount of output only if p ≤ c1 and p ≤ c2 . however. equilibrium outcomes) are sought.. and sequential moves market structures are essential for a further study of industrial organization. Therefore. Bertrand.

(e) In a Bertrand equilibrium. Hence. Thus. . thereby ensuring that ﬁrm 2 will not ﬁnd it proﬁtable to produce any amount. the more eﬃcient ﬁrm (ﬁrm 1) completely undercuts the price set by ﬁrm 2. (ii) price is higher when ﬁrm 2 moves ﬁrst. s q1 = α − c2 ∂π1 + q1 − c1 . the Bertrand equilibrium price exceeds the competitive equilibrium price. Comparing the two sequential-moves equilibria we see that (i) aggregate output decreases when the less eﬃcient ﬁrm (ﬁrm 2) moves before ﬁrm 1. 3 3 3 c c Then. ﬁrm 1 sets its price to equal the unit cost of ﬁrm 2. q1 = Qb = α − c2 + and q2 = 0. pc = α − q1 − q2 = (α + c1 + c2 )/3. 2 4 4 Hence. q1 and q2 yields c q1 = 2α − c1 − c2 α − 2c1 + c2 α − 2c2 + c1 . Hence.18 Markets for Homogeneous Products Solving the two equations for the two variables. we can approximate the Bertrand equilibrium by b b pb = c2 − and pb = c2 . q2 = . 2 4 4 Hence. (iii) the market share of the less eﬃcient ﬁrm increases when it moves before ﬁrm 1. Assuming that money is continuous. ps = (α + c2 + 2c1 )/4. = α − 2q1 − 2 ∂q1 α + c2 − 2c1 s α − 3c2 + 2c1 3α − c2 − 2c1 . instructors should point out to the students that this is not really a Nash-Bertrand equilibrium since the proﬁt of ﬁrm 1 increases as decreases. (d) When ﬁrm 2 is the leader. and Q = . R2 (q1 ) = α − c2 q1 − . yielding the ﬁrst order condition 0= Therefore. and (v) the market share of the more-eﬃcient ﬁrm increases when it moves ﬁrst. Notice that 1 2 when the unit costs are not equal (the present case). q2 = . and Qs = . ﬁrm 1 (the leader) takes ﬁrm 2’s best-response function as given and chooses q1 to max π1 = α − q1 − q1 α − c2 q1 − 2 2 q1 − c1 q1 . Also. (iv) the production of the more-eﬃcient ﬁrm increases when it moves ﬁrst. 2 2 In a sequential-moves equilibrium. ps = (α + c1 + 2c2 )/4. by symmetry (replacing c1 by c2 and vice versa in the previous subquestion) we can conclude that s q2 = α + c1 − 2c2 s α − 3c1 + 2c2 3α − c1 − 2c2 . and Qs = . (c) From the ﬁrst order conditions of the previous subquestion we can immediately solve for ﬁrm 2’s best-best response function. q1 = .

0 = πi = − F. the best-response function of ﬁrm 1 is given by q1 = R1 (q2 . q2 )]q2 − cq2 . . q2 The ﬁrst-order condition is given by 0 = dπ2 /dq2 = 60 − q1 /2 − q2 − c/2. Given that all ﬁrms have identical technologies (identical cost functions). Hence. Therefore. Thus. 2 2 In the second period. the (endogenously determined) number of ﬁrms in this industry declines with the ﬁxed cost parameter F . q2 ) which is given in (6. pc = 100 − 100N 20.8) we have it that R3 (q1 . 4 N +3 N +3 (b) Under free entry. we can attempt to search for a Cournot equilibrium where all ﬁrms produce the same output c c c levels. q3 . hence. . the ¯ best-response function of ﬁrm 2 is given by R2 (q1 ) = 120 − q1 − c . or N = 2 (N + 3) F Thus. and πi = pc q c − F − (q c )2 = N +3 N +3 (N + 3)2 100 100N (N − 1)q c .Markets for Homogeneous Products 19 2. under free entry all existing ﬁrms make zero proﬁt. . 20. ﬁrms enter as long as they make above normal proﬁts. Hence. 2 . 000 300 − F. . 000 − 3. or q = . ﬁrm 1 takes q2 . (a) We ﬁrst focus on the problem faced by ﬁrm 1. 3. 000 20. . ∂q1 100 − 4 N j=2 qj Therefore. . qN ) = . ﬁrm 3 takes q1 and q2 as given and chooses q3 to maximize its proﬁt. That is. Q = . In a Cournot market structure. by a real number. qN as given and chooses q1 that solves max π1 = (100 − q1 − q2 − · · · − qN )q1 − F − (q1 )2 . q2 ) as given and chooses q2 that solves ¯ q ¯ q max π2 = [120 − q1 − q2 − R3 (¯1 . q1 The ﬁrst order condition is given by 0= ∂π1 = 100 − 2q1 − q2 − · · · − qN − 2q1 . N . using (6. In this case. . Entry stops when a further entry generates a loss to ﬁrms. if we approximate the number of ﬁrms. = .8). In the third period. ﬁrm 2 takes q1 and R3 (¯1 . The solution to this problem yields ﬁrm 3’s best-response function R3 (q1 . q2 ) = 120 − c q1 + q2 − . q c ≡ q1 = q2 = · · · = qN . q c = 25 − Therefore. .

or ρ > 1/2. and q3 = 4 8 2 s s s Hence. . 4 4 The ﬁrst-order condition is given by 0 = dπ1 /dq1 = 30 − c/4 − q1 /2. Now. if no ﬁrm deviates. let ﬁrm i’s price strategy. ﬁrm 1 takes the best-response functions of ﬁrms 2 and 3 as given and chooses q1 that solves max π1 = {120 − q1 − R2 (q1 ) − R3 [q1 . deviation is not proﬁtable to either ﬁrm if 5N/(1 − ρ) > 10N . . 1 2 (d) We can reconstruct ﬁrms’ trigger strategies where we assume that the punishment point is now pb = 4 and pb = 4. the sum of discounted proﬁts is π1 = 5N/(1 − ρ). be given by 2 pi (τ ) = 10 as long as p1 (t) = p2 (t) = 10 for all t = 1.20 Markets for Homogeneous Products In the ﬁrst period. Qs = q1 + q2 + q3 = 7(120 − c)/8 and ps = (120 + 7c)/8. B C and the government earns a revenue of $10 per unit. solving s s s s for q1 . Hence. (a) Let pA denote the (tariﬀ inclusive) price consumers in country A pay for a unit of k import from country k. (a) Under zero production cost. pA = 70 and pA = 50. 1 2 (b) We’ll construct an equilibrium in trigger strategies where ﬁrms’ threat point is pb = 0 1 and pb = 0. respectively. Firm 2: If no ﬁrm deviates. then π1 = (10 − )N + 0 ≈ 10N (since eﬀective period τ + 1 all ﬁrms revert to pi = 0). k = B. (e) Collusion is less likely to be sustained when one ﬁrm has a cost advantage over the other because deviation by ﬁrm 1 (low cost) will leave it with a positive stream of proﬁt compared with a zero proﬁt generated by deviation when the two ﬁrms have an identical cost structure. if no ﬁrm deviates in any period. 4. τ − 1 0 otherwise. all Bertrand equilibrium outcomes yield zero proﬁts to both ﬁrms. the sum of discounted proﬁt is π2 = (N/2)(10−4)/(1− ρ). If ﬁrm 1 deviates in period τ . If ﬁrm 1 deviates in period τ . Comparing the two proﬁt levels reveals that deviation is not proﬁtable if ρ > 1/2. A’s consumers still purchase from country C B B C implying that this FTA is ineﬀective and therefore does not alter A’s welfare. 5. under a uniform speciﬁc tariﬀ of $10 per unit of import. R2 (q1 )]}q1 − cq1 = {30 + q1 3c q1 − }q1 − cq1 . and then into R3 [q1 . Hence. and then substituting into R2 (q1 ). (c) All Bertrand equilibria are of the form pb = 4 − ≈ 4 and pb = 4. Since now ﬁrms have diﬀerent proﬁt functions. Thus the Bertrand outcome is pb = 0 and pb = 0. 2. Firm 1: In each period τ . we 1 2 need to check proﬁtability from deviation by each ﬁrm separately. If it deviates. A FTA with country B reduces pA to pA = 60 > 50 = pA . the present value of the sum of discounted proﬁt to each ﬁrm i is πi = 5N/(1 − ρ). Formally. s q1 = 120 − c s 120 − c 120 − c s . . Therefore. R2 (q1 )] yields. i = 1. . Clearly consumers buy from country C. Therefore. . C. then its sum of discounted proﬁt is π1 = 10N + ρ4N/(1 − ρ). then the sum of discounted proﬁt is π2 = (10 − 4)N + 0. q2 = . Comparing the two proﬁt levels shows that deviation is not proﬁtable for ﬁrm 1 if ρ > 5/6.

it must yield that both ﬁrms charge pL . I provide a formal solution for this problem. with the exception of highly elastic demand. (a) Clearly pL is a dominant action for each ﬁrm in the static one-shot game. (I. 6. Therefore. Altogether.01 to pA = 60 (a reduction C B of 1 cent per unit of import). by Proposition 2. the FTA hardly changes consumer surplus. p2 = pL if p1 = pL (b) We now add a third stage to the game.1: Sequential price game: Meet the competition clause From the ﬁgure. it is straightforward to conclude that the following prices constitute a SPE: pL if p1 = pH and p1 = pL .1. Hence. Note that in this case the consumer price falls from pA = 60. Note that the answer for exercise 3 provides a solution for N = 3 ﬁrms. Hence. implying that the ﬁrms charge the industry’s proﬁt maximizing price and earn a proﬁt of 100 each.:) pL π1 = 70 π2 = 70 (III. However.Markets for Homogeneous Products 21 (b) Now.:) (II.2. Hence.:) pL • Firm 1 ◦ Firm 2 pH pL pH • pH π1 = 100 π2 = 100 π1 = 120 π2 = 0 pL π1 = 0 π2 = 120 • Firm 1 π1 = 70 π2 = 70 Solution-Figure 6. In this case. in this case the government faces a large reduction in tariﬀ revenues due to the elimination of a $10 tariﬀ per unit of import. country A loses from the FTA. . in what follows.01 = pA . the SPE if given by p2 = pH pL if p1 = pH if p1 = pL and p1 = pH . In addition. where ﬁrm 1 commits to reduce its price to ﬁrm 2’s price whenever ﬁrm 2 charges pL . We can derive the SPE directly by formulating the extensive form game which is illustrated in Solution-Figure 6. if a SPE exists. 7. (pL . which intuitively can be generalized to the N > 3 case. This third stage is (partly) illustrated at the bottom of Figure 6. a FTA with country B reduces pA to pA = 60 < 60. A’s B B C consumers switch to buying from country B and no tariﬀ revenues are collected. pL ) is a unique NE for the one-shot game.1 (consider the ﬁrst two stages only).

let us deﬁne aN ≡ a − Qs . recall that s + qs qN N −1 = (1/2 + 1/4)(aN −1 − c). 4 (aN −2 − qN −2 ) − s s s The solution is qN −2 = (aN −2 − c)/2. . 2 for all N. Thus. s In particular. . . qN −1 = (aN −1 − c)/2. Deﬁne Qs ≡ N qi and Qs = N −1 qi . 2 we have it that 1 N −1 s 1 a−c a−c s qN = q1 = N −1 = N . Firm N solves max πN = (a − Qs − qN − c)qN . there is no limit on the number of ﬁrms that will enter if free entry is allowed. . since 1 k s s qN = qN −k . s qN = (aN − c)/2 = (aN −1 − c)/4. s s Also. Therefore. s We now analyze ﬁrm N − 2. the N -ﬁrm sequential moves equilibrium output levels are s qi = a−c . . Hence. Firm N − 1 knows what ﬁrm N will be producing and solves max πN −1 = qN −1 s (a − Qs −1) − qN −1 ) − −(N = [aN − c]qN −1 2 aN − c − c qN −1 2 [aN −1 − qN −1 − c]qN −1 = . We therefore look at how the N th ﬁrm decides on how much to produce. it −N can be veriﬁed that s aN −1 = aN + qN −1 for allN. 2 2 2 2 Altogether. . . −1 Since there is no ﬁxed cost. 2i for all i = 1. N . qN −1 = (aN −2 − c)/4 and qN = (aN −2 − c)/8. ﬁrm 2 solves max πN −2 = qN −2 = 3(aN −2 − qN −2 − c) − c qN −2 4 [aN −2 − qN −2 − c]qN −2 . for N = 1. s qN = aN − c . N. . a1 = a − Qs = a − 0 = a. −N Before we proceed to analyzing ﬁrm N − 1. . 2 s Hence. . for i = 1. −1 Finally. Recall that aN −2 − qN −2 = aN −1 . Therefore.22 Markets for Homogeneous Products s (a) Let qi denote the sequential-moves equilibrium output level produced by ﬁrm i. Hence. since aN = aN −1 − qN −1 and aN = aN −1 − qN −1 = (aN −1 + c)/2. . for all 0 < k < N. −N qN s yielding qN = (a − Qs − c)/2. . q1 = (a − c)/2. Also. . s s i = 1. N where i=1 −N i=1 Qs ≡ 0 for i = 1.

ps → c (the competitive price level). Qs → a − c (competitive output level). . Hence. we can show that1 Qs = (a − c) 1 − 1 2N .9). section 9.Markets for Homogeneous Products (b) Aggregate output is given by Qs = i=1 s N qi = (a − c) 23 1 1 1 + + ··· + N 2 4 2 . (c) As the number of ﬁrms increases. 1 The ﬁrst printing of the ﬁrst edition contains a typo in the speciﬁcation of Qs in the question.2 (see mathematical appendix. Using the same arguments as in the proof of Lemma 9.

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1 and are derived as follows: 3 max π1 ⇒ R1 (α2 ) = 2 + α2 . for example. are important for a further study of industrial organization. Section 7. Answers to Exercises 1. Location models (section 7.3). (a) The best-response functions are drawn in Figure 7. α1 2 1 max π2 ⇒ R2 (α1 ) = 1 + α1 .3. Instructors should cover at least the Hotelling linear city model which students always ﬁnd very intuitive and therefore very appealing. in particular the Hotelling model (subsection 7. section 7.1).Chapter 7 Markets for Diﬀerentiated Products The ﬁrst section extends the market structures deﬁned in Chapter 6 to markets with diﬀerentiated products. The instructor can demonstrate the parameter restrictions needed to ensure existence by imposing symmetric locations (a = b) into the conditions of Proposition 7.1: Advertising best-response functions . to distinguish between vertically and horizontally diﬀerentiated products (see section 12. The linear city model is used several times in the manuscript.2). α2 2 α2 ✻ 4 2 or. and its application to the theory of international trade.5) can be skipped. and to deﬁne and contrast the concepts of strategically substitutes and strategically complements best-response functions.2 (somewhat more advanced) introduces the student to the endogenous determination of the variety of brands. The existence proof (Appendix. 3 3 R1 (α2 ) 8 1 0 −4 3 14 ✲ α1 • R2 (α1 ) Solution-Figure 7.6. α2 = − + R1 (α2 ). Using the two-brand environment enables us to analyze the diﬀerence in market outcomes generated by the Cournot and the Bertrand market structures.

one on each side of the ﬁrm.26 Markets for Diﬀerentiated Products (b) The two best-response functions are upward sloping. denoted by x. (a) Given a low reservation price (a low B). the monopoly will pick the highest possible price subject to having the consumers living at the edges of town purchase the product. ˆ Hence. that is. The indiﬀerent consumer (on ✛ 2a 1 2 ✲ 1 2 0 1 2 −a +a 1 Solution-Figure 7. Figure 7. 2 a= B . the monopoly chooses p that solves max π = p2a = 2p(B − p).2: Single-ﬁrm location model each side) is determined by the reservation utility. 1 pM = B − .2 illustrates the location of the two indiﬀerent consumers. 2 1 a= . set p to satisfy B − 1/2 − p = 0. hence strategically complements. B − a − p = 0. we get that the indiﬀerent consumers lie “outside” the city. (a) The indiﬀerent consumer. hence. This implies that for B > 1. π1 = 14 2 2. a = B − p. we’ll attempt to ﬁnd a monopoly equilibrium where not all the market is served. or. Hence. 2 3. 2 and π M = 2pa = B2 . x= ˆ R + p2 − p 1 . 2 Now. not all the market is served. 1+R R = 1. Formally. 1+R ˆ (b) Substituting p1 = p2 yields x = R/(1 + R). the monopoly can increase the price and still having the entire street purchase the product. Thus. N N (c) Solving for a NE yields α1 = 14 and α2 = 8. Hence. (b) When substituting B > 1 into the solution for ‘a’ found in the previous subquestion. The ﬁrms’ proﬁt levels in a NE are: 2 and π = 82 . R→∞ lim x = lim ˆ R→∞ . 2 1 and π M = B − . it is easy to verify that 0 < B < 1 implies that 0 < a < 1/2. p The solution is given by pM = B . Hence. must satisfy ˆ ˆ x × 1 + p1 = (1 − x) × R + p2 .

x = 1) only if the transˆ portation cost for traveling to the east is inﬁnite. Substituting a = b and x = L/2 ˆ into ﬁrm A’s ﬁrst-order condition (or B’s ﬁrst-order condition) yields that pA = pB = τ L(L − 2a). we have it that pA = 2τ (L − a − b)ˆ and x pB = 2τ (L − a − b)(L − x). we search for a symmetric solution. reﬂecting the fact that prices drop to zero when the two brands become homogeneous. From (7. Therefore. all the consumers will eat in restaurant 1 (i. 2τ (L − a − b) Similarly. using A’s ﬁrst-order condition. ﬁrm B increases its proﬁt by moving toward point L. Substituting into the function F (. we have it that −(2ˆ − L) − 2(ˆ − a) x x ∂x ˆ =− = ∂a 2(L − a − b) + 2(ˆ − a) − 2(ˆ − L + b) x x x=1/2 a=b 1 .24). Similarly. yielding a ﬁrst-order ˆ condition given by 0= ∂x ˆ dπB = L − x − pB ˆ = x + pB ˆ dpB ∂pB ∂F ∂pB ∂F ∂x ˆ =L−x− ˆ pB . x x x Using the implicit function theorem. x dπA <0 da whenever 1 − (ˆ)2 + (L − a − b)2ˆ < 0. we can deﬁne the location of the indiﬀerent consumer.1 Using the two ﬁrst-order conditions. 1 This problem may be too diﬃcult for most undergraduate students since it involves deviating from the symmetric solution.Markets for Diﬀerentiated Products 27 Therefore. 4. 4 Now. ) = 2τ (L − a − b)(2ˆ − L) + τ (ˆ − a)2 − τ (ˆ − L + b)2 = 0. we can express A’s proﬁt by πA = pA x = ˆ 2τ (L − a − b)(ˆ)2 . Otherwise. Hence. ﬁrm B chooses pB that solves maxpB πB = pB (L − x). The ﬁrst-order condition is given by 0= dπA ∂x ˆ ∂pA = x + pA − ∂F ˆ = x + pA ˆ dpA ∂pA ∂x ˆ ∂F =x− ˆ pA . 2τ (L − a − b) (a) Under a = b. . x x ˆ ˆ Firm A chooses pA that solves maxpA πA = pA x subject to x satisfying F (pA . ﬁrm A increases its proﬁt by moving toward point 0. Note that pA = pB → 0 when a → 1/2. some consumers will always eat at restaurant 2.e. x.. ) = 0 yields ˆ F (. x x 4 which always hold since L − 2a < L. (b) We now investigate the total eﬀect of varying the location of ﬁrm A (varying a) on the proﬁt of ﬁrm A. pB ) ≡ pA − pB + τ (ˆ − a)2 − τ (ˆ − L + b)2 = 0. pB ) = 0. by the implicit ˆ function: F (pA .

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1 Finally. simply because a monopoly can always mimic the same production pattern of any oligopoly. ˆ ˆ note that the equilibrium ﬁrst-period capital level in Figure 8.1). however.10) yields π1 = π4 = 1111. (a) I4 = 20 + 20 + 20 + 10 = 70.Chapter 8 Concentration.10) yields a monopoly proﬁt of π M = 2500. However. IHH = 202 + 102 + 102 + 3 × 202 = 1. (a) The solution for a Cournot equilibrium with N ﬁrms is given in (6.. The merger may be challenged by the FTC or the Justice Department since the postmerger IHH exceeds 1. Regarding all other topics. with the analysis of vertical integration given in subsection 8.7 is k3 and not k2 as wrongly stated in the ﬁrst printing. πi = 2500/3 = 833 1 > 625 > 555. 600. ﬁrms 2 and 3 lose from this merger whereas ﬁrm 1 gains. i = 1. the instructor will ﬁnd a wide variety of models to choose from. After the merger of ﬁrms 1 and 2.111 . iii. ∆IHH = 1. 000 and ∆IHH = 200 > 100. 2. note that you can combine the topic of double monopoly markup. Thus. . (b) Substituting N = 2 into (6. analyzed under the topic of dealership (subsection 14. 600 = 200. Most of the topics are logical and require minimum calculations and very little calculus (if any). (d) A merger into a monopoly cannot reduce aggregate proﬁt. π2 = π3 = π4 /2 = 555 < 625. Also. 800 − 1.9) and (6. . (c) i. In the second printing I intend to add an appendix at the end of this chapter which derives both best-response functions. Mergers.2. 3. To see this.6). entry barriers. and Entry Barriers This chapter contains four major topics: How to measure concentration. substituting N = 1 into (6.4. the proﬁt per ﬁrm is the highest 3 under the monopoly market structure (cartel). (c) Since ﬁrms 2 and 3 split the proﬁt from the merged ﬁrm. 2. 800.2 can be presented using diagrams only. and entry deterrence. the ﬁrst printing of the ﬁrst edition lacks a ˆ justiﬁcation why ﬁrm 1’s (high and low) best-response functions do not shift with a change in k. (e) The diﬀerence between the two mergers is as follows: When two out three ﬁrms merge.3.1) and the appendix on merger regulations and guidelines (section 8. (b) IHH = 4 × 102 + 3 × 202 = 1.10). the extra aggregate industry proﬁt generated from the change in the number of ﬁrms is equally divided between Subsection 8. competition is reduced to a duopoly. Hence. Answers to Exercises 1. I urge the instructor not to skip the discussion of concentration measures (section 8.2. Hence. merger and merger guidelines. 1 . ii. c c Substituting c = 0 (zero production cost) and N = 3 yields qi = 25 and πi = 625.

4 The Y -seller takes pX as given and solves max πY = pY 2Q = 2pY (α − pX − 2pY ). merging into a monopoly can only increase proﬁt since a monopoly can always produce like a duopoly. q I ) = (20. Y S 3 6 3 3 9 (b) We deﬁne a system as one unit of X bundled with two units of Y . 2 A typo in the ﬁrst printing of the ﬁrst edition: the question should state that Q = x = y/2. πX = πY = . before the S 1 merger. 3. and Entry Barriers the two unmerged groups of ﬁrms. In view of Deﬁnition 8. (a) We look for a Nash equilibrium in prices. and πS = . the merger is welfare improving. Thus. It is also sustainable since no potential entrant can undercut the incumbent’s price while making a positive proﬁt. Before the merger. pY yielding pY = Hence. Mergers. . Also.1. the merged ﬁrm chooses a system price pS that solves max πS = pS (α − pS ) yielding pS = QS = pS α α2 . pN = X α α 2α α α2 N N . this share of the change in aggregate industry proﬁt is lower than the proﬁt each ﬁrm makes under the triopoly. Then. and under monopoly. 2 α − pX . Formally. q I ) = (20. In contrast. all industry proﬁt is equally divided between the three ﬁrms. 4. pN = . QN = .1 shows that the pair (pI . pN = . Figure 8.30 Concentration.2 The X-seller takes pY as given and solves max πX = pX Q = pX (α − pX − 2pY ). the price of one system is p0 = pX + S 2pY = 2α/3 > α/2 = p1 which is the price after the merger. 10) constitutes a contestable-market equilibrium. 10) is feasible since demand equals supply and the incumbent makes a nonnegative proﬁt. aggregate proﬁt is πX + πY = 2α2 /9 < α2 /4 = πS which is the proﬁt after the merger takes place. the (incumbent’s) industry conﬁguration (pI . Since the system price falls and industry proﬁt increases. pX yielding pX = α − pY . 2 4 (c) To make a welfare judgment on the gains from this merger it is suﬃcient to compare prices and proﬁt levels.

1: Contestable-markets equilibrium . and Entry Barriers 31 pI ✻ p = 60 − 4Q ✒ AC(q I ) = 20 • 100 q +q 10 ✲ qI Solution-Figure 8.Concentration. Mergers.

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plus twice the probability that it discovers while one competing ﬁrm discovers and one does not. However Figure 9. 11 3V − 2I. Eπ|1 lab = V /2 − I.4) does not reach a closed-form solution. (b) The now single ﬁrm can operate zero. Hence. Therefore.1) uses only demand and supply diagrams. the monopoly solves M R(QM ) = a − 2QM = c1 = 2c0 − a. 2.3 enables the instructor to explain the cost and beneﬁt of the patent system without performing any calculations. Finally. innovation is major if the monopoly price is below the initial unit cost. Operating two labs: In this case. the appendix sections discuss patent law and R&D joint ventures (sections 9.8) and can be assigned as homework reading. 3. all the three ﬁrms ﬁnd it proﬁtable to engage in R&D if V > 24I/7 = 24/7 (since I = 1). i = 1.5) uses supply and demand analysis. Answers to Exercises 1. The international analysis (section 9.2) relies on simple discrete probability calculations. To ﬁnd pM . Cooperation in R&D (section 9. given that the other two ﬁrms are also engaged in R&D. Eπi = 111 111V 111V 7V V + (×2) + −I = − I. for each ﬁrm i.Chapter 9 Research and Development Most of the topics in this chapter are not technically demanding (and less tedious in terms of technical derivations). Thus. the instructor can simply reproduce the government-innovation two stage game and demonstrate how to build the social welfare function for calculating the optimal patent life. 2. Innovation race (section 9. the monopoly’s proﬁt maximizing output is QM = a − c0 .3) relies on a Cournot market structure in the second stage and a Nash equilibrium in R&D in the ﬁrst stage. The calculation of the optimal patent life (section 9. pM = c0 .1 the present innovation is neither major nor minor. Licensing of innovation (section 9. minus innovation cost. Then. plus the probability that all the three discover simultaneously. the probability of discovery is one minus the probability that none of the labs discovers. Therefore. that is if pM < c0 .1. or two labs. The classiﬁcations of process innovation (section 9. V − 2I = Eπ|2 labs = 1 − 22 4 .7 and 9. is the prize times the sum of the probability that the ﬁrm discovers while the other two do not. Operating a single lab: In this case. (a) The expected proﬁt of a ﬁrm engaged in R&D. 222 222 2 222 3 24 Thus. Using Deﬁnition 9. Formally. Innovation is minor if pM > c0 . one. according to Deﬁnition 9.6) is divided into a simple matrix game of product innovation and a two stage subsidy Cournot game of process innovation.

since most poor and middle-class people do not get to ﬂy in the Concord. the probability that none of the n ﬁrms discovers at a particular date is (1 − α)n . Arguments against the subsidies include (i) duplication of R&D which require twice the amount of resources needed to develop and test the plane. then Airbus’ dominant action is to develop. Hence. 1 − (1 − α)n . (ii) the government may not possess the means to determine whether the beneﬁts from the development to their own economy dominate the cost.5). then Boeing’s dominant action is to develop. Arguments for the subsidy include the introduction of more competition between aircraft manufacturers that would reduce aircraft prices. (c) None! After the EC subsidy to Airbus is implemented. n ]2 [1 − (1 − α) α(2 − α) 4.34 Research and Development Now. (i. economists generally believe that the private sector can collect more accurate information). ET (n) = [1 − (1 − α)n ] ∞ t=1 [(1 − α)n ]t−1 × t (Lem 9. (c) Similar to the derivation given in (9. which constitutes a suﬃcient condition for having the ﬁrm choosing to operate two labs. subsidy to Boeing).1) = 1 − (1 − α)n 1 = .S. . one minus the probability that none discovers. (b) Clearly. that is. and may therefore increase the amount of travel. 3.S. independent of the U. some economists claim that the development of the Concord by some EC countries constitute a net transfer from poor to rich people.S. ET (n) = [1 − (1 − α)n ] × 1 + (1 − α)n [1 − (1 − α)n ] × 2 + (1 − α)2 n [1 − (1 − α)n ] × 3 + (1 − α)3 n [1 − (1 − α)n ] × 4 + · · · Therefore. Eπ|2 labs > Eπ|1 lab if V > 4I. government provides Boeing with a subsidy of 10 (contingent on developing the megacarrier. Note that this U. and (iii) income distribution eﬀects. there are pros and cons to having both governments subsidizing the development of the new megacarrier. subsidy is independent whether the EC provides Airbus with a subsidy of 10 or 15..e. (d) Like any other welfare argument in economics. Airbus’ dominant action is to develop (hence. Hence. (b) If the U. (a) The probability that a ﬁrm does not discover is (1 − α). (a) If the EC provides Airbus with a subsidy of 10 (contingent on developing the megacarrier. boost the airline industry.

I feel that this term was poorly chosen since externalities are either assumed or not assumed at all. pB has to be suﬃciently high to satisfy ˆ 1=δ= (b) Y − pA . whereas the components approach model is very simple. some students may get confused because of the existence of multiple equilibria under incompatibility. In particular.1) uses very simple calculus (basically one ﬁrst-order condition). the instructor may want to construct only one equilibrium and compare it to the equilibrium under compatible systems. I intend to add two exercises covering the two topics analyzed in the network externalities section. In future printings/editions. (a) Firm A gains control over the entire market when δ = 1. where a consumer’s utility is aﬀected by the number of consumers purchasing the same brand. Then. • The supporting services and the components approaches do not assume any externality. Let δ denote the market share for ﬁrm A after income has doubled from Y to 2Y . The remainder of section 10. the two exercises cover only the supporting services and the components approaches.” where the utility of a consumer is aﬀected by the brand choices of other consumers is an equilibrium result (rather than an assumption).1 Thus. The behavior of a monopoly telephone company under network externalities (Subsection 10.1 is devoted to a simple discrete (noncalculus) standardization-variety tradeoﬀ model. the network eﬀects are generated by having hardware and software (or other types of hardware) treated as perfect complements.Chapter 10 The Economics of Compatibility and Standards The introduction to this chapter provides some basic terminology and a simple “Battle of the Sexes” game of product standardization.10). The important points to emphasize are: • A network externality is a particular type of a consumption externality. Thus. network externalities constitute an assumption about consumer preferences. 1 . ¯ i. The remaining two sections. by (10. Answers to Exercises Unfortunately. The “network eﬀects. the supporting services approach (section 10. and therefore the term indirect cannot be used to describe models that do not explicitly assume any externality.2) and the components approach (section 10.1. ˆ 1.10) we have that ˆ ¯ 2Y − pA − pB > δ = Y − pA − pB δ= 4Y − pA − pB 2Y − pA − pB Some authors use the term indirect network externalities to describe the behavior generated by the supporting services and the components approaches. in which case. In this case.3) are somewhat more diﬃcult despite the fact that no calculus is used. by (10. which can be taught to the less technically proﬁcient students. 2Y − pA − pB or pB = Y.

and BA. Under this type.9) NA /NB must increase. In what follows we will demonstrate.36 The Economics of Compatibility and Standards ˆ if pA > pB . since consumers’ reservation utility is zero. and BA. by (10. Under this type. pI = 0 and B A I πA = 0. Firm A sells to consumers AA. However. see equation (10. ii. px = py = px = py = λ. and BA). However. Thus. In this equilibrium. yielding ˆ dδ pA − pB >0 = dY (2Y − pA − pB )2 if pA > pB . and AB. AB. and ﬁrm B sells to BB and BA (alternatively. (a) Potential equilibria can be classiﬁed into two types: (i) Firm A sells to consumers AA. However. i. AB. Since δ increases. ﬁrm A can always increase its proﬁt by raising its price by thereby making strictly positive proﬁt. it can be established that there exists an equilibrium in which each consumer buys his or her ideal system. this prices cannot support a Bertrand-Nash equilibrium since ﬁrm A can increase its proﬁt by undercutting ﬁrm B by charging pA = pI − which will cause consumer BA B to switch to system AA (this is the usual Bertrand undercutting argument). whereas ﬁrm B sells to BB only (alternatively. (b) Following the proof of Proposition 10. pI = pI since consumers AB and BA are indiﬀerent between A B systems AA and BB as long as the prices are equal. whereas ﬁrm B sells to BB. ˆ ii. hence. that both types of equilibria do not exists. by a way of contradiction. 2. equilibrium prices must satisfy pI ≤ 2λ. This result can also be demonstrated by diﬀerentiating δ with respect to Y . the ﬁrm with the lower market share increases its market share when consumer income rises. .14. (ii) Firm A sells to AA.12). and ﬁrm B sells to BB and AB). ﬁrm A sells to AA only. we must have that pI = pI + 2λ (otherwise ﬁrm B is not B A maximizing its proﬁt). A B A B c c and πA = πB = 4λ.

hence.05/0. Hence. When Aα = Aβ = 2. advertising in this city serves as a mean by which each ﬁrm attracts consumers from the competing ﬁrm. we have that the proﬁt maximizing ratio of advertising to revenue is AM 1 A = = . (c) Solution-Figure 11.1). Therefore AM = 10 × 0.5 mil. 2. the monopoly reduces the ratio of advertising expenditure to revenue. (b) Fortune teller β takes Aα as given and chooses Aβ to maximize his or her proﬁt.05. ∂Aβ (Aβ )2 √ The second-order condition can be easily veriﬁed. Answers to Exercises 1. we have it that nα = nβ = 3. but cannot increase industry sales beyond the level determined by zero advertising.13. pQM − p 4 Hence.. For the purpose of this question. . %∆A and p = %∆Q = −0. AM = $2. (c) When the demand becomes more price elastic. πα = πb = 30 − 1 = 29. (a) Aα = Aβ = 1 implies that nα = nβ = 3. By symmetry. (b) Now. where an integral is computed. Aα = Rα (Aβ ) = 30Aβ . hence. Conclusion: if both ﬁrms spend the same amount on advertising. That is. perhaps. the analyses given in this chapter are pretty much straight forward. The appendix describing advertising regulations can be assigned as a home reading. (a) Since A = %∆Q = 0. reﬂecting the fact that there exist two Nash equilibria for this advertising game.1 illustrates that the two best response functions intersect twice. The ﬁrst-order condition is given by 0= ∂πβ 30Aα = − 1. then industry proﬁt is maximized at Aα = Aβ → 0.1. with the exception of the calculation of the socially optimal level of persuasive advertising given in equation 11. we deﬁne 0/0 (yes.Chapter 11 Advertising From a technical point of view. πα = πb = 30 − 2 = 28. p = −0. The two best-response functions are drawn in Solution-Figure 11.2. %∆p then by the Dorfman-Steiner condition (Proposition 11. Aβ = Rβ (Aα ) = 30Aα . zero divided by zero) as equal to 1.5 = $1 mil.5..

AN = AN = 30 which is also α β illustrated in Solution-Figure 11. P ) = θE ≥ π 1 (P.. 3. . we need to show that unilateral deviation is not proﬁtable for each ﬁrm. . 0) = 30. Thus. . Hence. substituting Rα (Aβ ) into Rβ yields Aβ = 30 30Aβ . ✻ . . .... . industry’s proﬁt is maximized and each ﬁrm earns πi (0. .. 30 . when θ ≥ N/(2E).. ✲ ... . in this example. . In order for (I. 30) = 30 − 30 = 0.. . . That is. .. i = α. which is lower than N (1. . .. I) = (1 − θ)E π 1 (I... N (d) In the interior NE.. at the other NE. . . P ) = N ≥ π 1 (I. 30) (see Solution-Figure 11.. π 2 (I. β. The interior NE (0. (e) The interior NE (30.1: Fortune tellers’ advertising best-response functions Then. . the NE that maximizes industry proﬁt is unstable. 0) is unstable since any unilateral deviation by one of the ﬁrm would trigger a sequential chain of responses that would move the advertising equilibrium to (30. . πi (30.38 Advertising Aα Rβ (Aα ) Rα (Aβ ) . the industry’s proﬁt is not maximized at the interior NE. .. . To obtain the other NE.. Thus. ✻. .. using Table 11. 0 30 ✲ Aβ Solution-Figure 11. .1.. .. 1) = 29..... . ✲ ...1. Howπi N ever.. P ) to constitute a NE outcome. .. P ) = N/2 when θ ≥ 1 − N/E.. .1 for an illustration). .. clearly Aα = Aβ = 0 constitutes one NE. 30) is stable.

p H − cL Hence.10 should be modiﬁed to pm = H and q m = αH + (1 − α)L − cL . Therefore.5). p The price and quantity pair in Proposition 12. Therefore. the high-quality monopoly would indeed ﬁnd it proﬁtable to signal its high quality to the consumers. Finally. and a low-quality producer with probability 1 − α. where 0 < α < 1. and Warranties This is a long chapter with a wide variety of topics dealing with supply and demand for quality.Chapter 12 Quality. Other sections use only simple calculations of expected values. .6 The model suggested below provides some improvement as it assumes that consumers are expected utility maximizers (similar to what is assumed in Section 12. and make a proﬁt of ¯ ¯ (¯ − cL ) · 1 = αH + (1 − α)L − cL = αH + (1 − α)L − cL > 0. H − cL (∗) Had the monopolist been a low-quality producer. Then. in choosing this price-quantity pair the monopolist could signal his or her q=q quality to the consumers. since H > L > cH > cL .8) may be assigned as a home reading. he or she could have made the same proﬁt by setting p and selling to all consumers [as is indicated in (*)] rather than setting p = pm and ¯ m . 1 I thank Keiichi Koda for proposing this improvement. The analyses are pretty much straight forward and do not require any preparation with the exception of section 12. Durability. An Alternative Model for Section 12. (H − cH ) αH + (1 − α)L − cL > αH + (1 − α)L − cH = (¯ − cH ) · 1. the maximum price that consumers are willing to pay is p = αH + (1 − α)L. The appendix on the legal approach to liability (section 12.2 that relies on the knowledge of location models developed in Chapter 7.1 Suppose that consumers believe that the monopoly is a high-quality producer with probability α. Then a low-quality producer could set the price at p. without any additional information. EU = αH + (1 − α)L − p.

2 For a given ae ﬁrm B chooses be to maximize πB which is given above. 1] implying that ﬁrm B would locate at be = 1. 2. the consumer who is indiﬀerent between purchasing from A and not purchasing at all must satisfy Uz (A) = az − pA = 0.4). 7 We now verify that given ae = 4/7. φ(21/98) = 5. the proﬁt maximizing location of ﬁrm A is ae = 4/7. (H −L)I2 < HpH −LpL . which is negative for 0 ≤ b < 21/98 and positive for b > 21/98.2) and the zero reservation utility assumption. b−a For a given pA . we have it that since consumer 1 buys the low-quality brand. b−a a 2pB − pA . (b) Follows directly from (12. 1]. we need to prove that φ(b) > 0 for all b ∈ [0. b−a yielding 0 = pB − 2pA 2pA − . since I2 < I1 by assumption.1). Solving the two ﬁrst-order conditions yield the equilibrium prices. From (12. ﬁrm B would choose to locate on the east edge of the street. ∂b To demonstrate this inequality. given be = 1. b−a a pB − pA . yielding z = pA /a. (c) For a given pB .40 Answers to Exercises Quality. . Clearly φ (b) = 98b − 21. (H − L)I1 < HpH − LpL . then U1 (L) = L(I1 − pL ) > H(I1 − pH ) = U1 (H). Let Ui (k) denote the utility of consumer i when he buys the brand with quality k. Substituting into the proﬁt functions yield the equilibrium proﬁt levels. Thus. (4 − a)2 4 yielding ae = . Now. ﬁrm B chooses pB to max πB = pB 1 − pB yielding 0 = 1 − Second-order conditions are easily obtained. We want to show that U2 (L) = L(I2 − pL ) > H(I2 − pH ) = U2 (H). We would like to show that for ae = 4/7. Therefore. ﬁrm A chooses ae to max πa = a a(1 − a) .75 > 0. Hence φ(b) = ∂πB /∂b > 0 for all b ∈ [0. 2 Many students will ﬁnd this part of the proof to be diﬃcult. the function φ hits a minimum at b = 21/98. 0< 2. (d) We ﬁrst verify that given be = 1. ∂πB (4/7. implying that H(I2 −pH ) < L(I2 − pL ). ﬁrm A chooses pA to max πA = pA pA pB − pA p A − . b) ≈ 49b2 − 21b + 8 ≡ φ(b). (a) Using the utility function (12. Durability. L and i = 1. Hence. k = H. and Warranties 1. Now.

Therefore. then π N W = ρV − c.L = 0. . (a) The monopoly’s production cost is the initial production cost plus the expected (as most once) replacement cost. 3 The purpose of this question is demonstrate that used cars are traded when some good-used-car owners are “forced” to sell their car. change the last sentence in this question to “. Under these prices. because they leave the country. then V s.5N L − pN = 0. This surplus equals V if the product does not fail at all and if the product fails only once (in which case it is replaced). . the monopoly will bundle the product with this warranty. 4. In contrast. under the assumed prices. if she or he buys a used car then ¯ ¯ ¯ s. ¯ ¯ Hence. Thus. Altogether. then π W = ρ(2 − ρ)V − (2 − ρ)c = (2 − ρ)(ρV − c).5U L − pU > 0. nobody buys a new car. under the assumed prices. then his or her expected utility is V b = 0. The probability of a double failure is (1 − ρ)2 . if a new buyer buys a new car. Hence.5N G +0. Note: If you are using the ﬁrst printing of the ﬁrst edition. . Lemon-used-car sellers: If a lemon-used-car seller sells his or her lemon and buys a new car. the probability of no double failure is 1 − (1 − ρ)2 = ρ(2 − ρ). (b) The maximum monopoly price is the expected consumer surplus from purchasing this product with this type of warranty. if a new buyer buys a used car then V b = 0.5N G − pN + pU = pU . we seek to characterize the demand and supply patterns of our agents. In contrast. the four types of agents. . which is equal to c + (1 − ρ)c = (2 − ρ)c.Quality. By assumption pU < 0. say. Hence. If the monopoly sells with no warranty.” .5U G + 0.3 New buyers (who do not yet own a car): Recalling our assumption that N L = U L = 0. π W > π N W since it is assumed that ρV > c. and Warranties 41 3. Durability.L = 0. hence. new buyers buy used cars. pM = ρ(2 − ρ)V .5U G − pU + pU = 0. (c) If the monopoly provides this warranty.5U G .5U G . lemon-used-car ¯ V ¯ ¯ sellers buy (and sell) used cars. . Good-used-car sellers: The question simply assumes that good-used-car owners must leave the country and therefore sell their good-used cars.

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Therefore. and for k < k. In the Winter.1. Ask for the errata ﬁle by e-mail. and M RS (qS ) = 5 − qS = c = 1. 000 copies.1: The cost of photocopying with or without two-part tariﬀ (b) The number of copies yielding identical cost under the two payment systems is found ˆ ˆ ˆ ˆ by equating 0. .05k = 300 + 0. Section 13. 2. we can conclude that Winter is the high season. However. (a) The two cost functions are drawn in Solution-Figure 13.4 presents an attempt to endogenize the seasons in determining proﬁt maximizing peak-load pricing.1 Answers to Exercises 1.2 are wrong. k = 10. and (ii) to equate the “low-season” marginal revenue to the per-passenger cost only. capacity is determined by having the monopoly equating M RW (qW ) = 10 − 2qW = r + c = 2. for k > k.02k.” we need to be careful about the capacity constraint determined by the Winter condition.4. (a) By Proposition 13. ˆ the ﬁxed-per-unit price system the two-part tariﬀ system is less costly. to ﬁnd the proﬁt maximizing pricing structure we need (i) to equate the “high-season” marginal revenue to the cost of an aircraft seat plus the per-passenger cost. $ T C(k) = 0.Chapter 13 Pricing Tactics: Two-Part Tariﬀ and Peak-Load Pricing The analyses given in this relatively short chapter rely mainly on logical arguments and therefore do not require any special technical preparation. 1 If you are using the ﬁrst printing of the ﬁrst edition note that the calculations of consumer surplus in section 13. is less costly. Thus. and therefore may be given a lower priority in case the instructor is short of time.05k ✻ T C(k) = 300 + 0. since the two demand curves are “relatively close.02k • 300 ✲ k (# copies) ˜ ˜ k Solution-Figure 13. Given that the Summer demand curve lies completely below the Winter demand curve.

. pW = 6.5. pS = 3. hence. Altogether. π I = 6 × 4 + 3 × 4 − 2 × 4 − 1 × 4 = 24. hence. the airline will ﬂy only 3 passengers during the Summer season. The second equality implies that qS = 4. the monopoly equates M RW (qW ) = 10 − 2qW = r + c = 4. Altogether. qW = 3.5 × 3 − 4 × 3 − 1 × 3 = 16. Thus. and M RS (qS ) = 5 − qS = c = 1. (b) Similar to the previous subquestion. hence. π I = 7 × 3 + 3. Hence. due to the capacity constraint. The second equality implies qS = 4 > 3 = qW .5. The ﬁrst equality implies that. pS = 5 − 3/2 = 3.44 Pricing Tactics: Two-Part Tariﬀ and Peak-Load Pricing The ﬁrst equality implies that qW = 4. pW = 7.

Clearly. in which ﬁrst-period students believe that no new edition will be published. Answers to Exercises 1.17) is derived by comparing the monopoly’s second period proﬁt only and therefore yields the condition under which a new edition will not be introduced in the second period. First period students will undercut . mixed tying (which yields an identical allocation as no tying) generates a higher proﬁt than pure tying. in which case the publisher can charge a higher price in the ﬁrst period by adding the resale value to the price. By (14. (a) When a new edition is not introduced in the second period. (a) We need to compare the proﬁt levels under the commitment of not introducing a new edition. Therefore. to the case where there is no commitment and a new edition is introduced. the condition given in (14. (b) The proﬁt maximizing product and package prices are pM T = pM T = 4 and pM T = X Y 8. 2. Altogether. only consumer 2 buys a package.16) and hence in (14. the monopoly cannot charge consumer 2 more than the sum of the prices of the two products sold separately. all three consumers buy the packages. (a) Under pure tying. the condition given in (14. (b) Indeed. and Dealerships This chapter introduces several topics related to proﬁt enhancing marketing tools that were not discussed (at least not in full) in earlier chapters. π M T = 4 + 4 + 8 = 16.Chapter 14 Marketing Tactics: Bundling. hence. the monopoly competes with period 1 students on selling the ﬁrst edition. the proﬁt level under commitment is nV . implied by) the condition given in (14.. π T (10) = 10. π T (4) = 3 × 4 = 12. In contrast. hence the monopoly can raise the book’s price by its resale value. Comparing the two proﬁt levels reveals that commitment not to introduce a new edition is more proﬁtable if F > nV − 2c. this condition in weaker (i. Upgrading. consumer 1 buys one unit of X. to the proﬁt level when no commitment is made and the monopoly introduces a new edition.17).17) “does not take into account” that ﬁrst period price can be raised by the resale value when a commitment is made not to introduce a new edition. in the present example. (c) Notice that mixed tying yields the same proﬁt maximizing pricing structure as no tying. we need to check two options: (i) Under pT = 4. since in the present example. 3.16) and (14.e. In other words. the ﬁrst option maximizes the proﬁt under pure tying. and under no commitment is 2n(V − c) − F .17) since it compares in the case of commitment. In fact. (ii) Under pT = 10. hence. pure tying is proﬁt reducing. consumer 3 buys one unit of Y and consumer 2 buys the package (or one unit of each good). Under this price structure.

pd = (a + c)/2. Thus. the monopoly would set pN = (1 − α)V . and therefore earn a proﬁt of 2 N π2 = n[(1 − α)V − c]. used book sellers are undercut by the monopoly. the dealer chooses Q (sales) to max π d = (1 − φ)[p(Q)Q − cQ] = (1 − φ)[(a − Q)Q − cQ]. Hence. which is diﬀerent from condition (14. then the monopoly undercuts the used-book sellers (since consumers do not value used books very much). (b) Under this contract. then π2 = 0. Hence. the maximum price 2 user-book sellers can charge is pU = 2 c − (1 − α)V 0 if c ≥ (1 − α)V otherwise Notice that if c < (1 − α)V . a new edition is introduced if n(V − c) − F ≥ n[(1 − α)V − c]. Upgrading. then pN = (1 − α)V − c (the monopoly undercuts used-book 2 N sellers).16). Under this condition. (a) Under this contract. (b) There are two cases: High value for used books (α > 1 − c/V ): A new edition would yield a secondN period proﬁt of π2 = n(V − c) − F . Hence. or α < 1 − c/V .16) when α = 1. In this case. 4. a new edition is introduced if F ≤ n(V − c). Altogether. then the monopoly price is reduced to cost( pN = c). Low value for used book (α < 1 − c/V ): When α is low. if used-book sellers can undercut the monopolist. which is the same as condition (14. and Dealerships the monopoly (since ﬁrst-period students do not have any production cost) and for a given pN will set pU so that 2 2 V − pN ≤ αV − pU . or if F ≤ nαN . π2 = n[(1 − α)V − c]. the dealer chooses Q that solves max π d = (1 − φ)p(Q)Q − cQ = (1 − φ)(a − Q)Q − cQ. Under this contract. the industry proﬁt is πM + πd = φ (a − c)2 (a − c)2 (a − c)2 + (1 − φ) = . in a Bertrand equilibrium. Q . the dealer’s sales and price are independent of (1 − φ) (share of the proﬁt of the dealer). Q The ﬁrst-order condition yields Qd = (a − c)/2. and π d = (1 − φ)(a − c)2 /4. 2 2 Now.46 Marketing Tactics: Bundling. if a new edition is not introduced in the second period. When a new edition is not introduced. 4 4 4 which equals the industry’s proﬁt when the ﬁrms vertically integrate into a monopoly given in (14.24).

industry proﬁt is given by the sum πM + πd = = = < φQd pd + (1 − φ)Qd pd − cQd = pd − c Qd c a c − 2(1 − φ)c a + − 2 2(1 − φ) 2 2(1 − φ) c a−c a − 2 2 2(1 − φ) (a − c)2 .Marketing Tactics: Bundling. To see this. πT I = VN − VU + VN = 2VN − VU > VN = π ∗ . by assumption. where VN > VU > 0. current users trade-in their old refrigerator for a new one. Suppose that there are two consumers: one owns an old refrigerator and one that is a new buyer. The utility from using an old refrigerator is VU whereas the utility from buying a new one is max{VN − pN . Altogether. does not require any monitoring since the dealer pays up front for each unit it acquires from the manufacturer. 2 2(1 − φ) 47 Now. thereby selling two units and earn a proﬁt of π L = 2(VN − VU ). maximizes industry’s proﬁt) it is rarely observed since it requires having the manufacturer monitoring the proﬁt made by the dealer. 0}. the per-unit contract analyzed in the text. π L < π ∗ . hence.. and also a new buyer buys a new one. This monitoring may be too costly for the manufacturer. (c) Whereas the “proﬁt sharing” contract analyzed in part (a) is optimal (i. thereby N selling only to the ﬁrst-time buyer and earning a proﬁt of π ∗ = VN . . despite being not optimal. 5. Upgrading. Trade-in price policy: We now show that by employing a trade-in price policy.24). 4 Thus. note that the monopoly can set a lower price. Single price policy: I will argue that the proﬁt maximizing price is p∗ = VN . We further assume that VN < 2VU . In contrast. whereas the price with no trade-in is pN = VN .e. We will demonstrate how a monopoly can beneﬁt from establishing a trade-in procedure by constructing a simple model. 2 2(1 − φ) and pd = a c + . and Dealerships The ﬁrst-order condition is (1 − φ)(a − 2Q) − c = 0. However. Note that under these prices. pL = VN − VU . the monopoly can price discriminate between new buyers and old-model owners. Suppose that the monopoly announces that current users can trade-in their old refrigerator for a new one for a price of pT I = VN −VU . Qd = a c − . this contract yields a lower proﬁt than the industry’s proﬁt when the ﬁrms vertically integrate into a monopoly given in (14.

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which is recommended only if the students are capable of solving Cournot-type problems very easily. Answers to Exercises 1. and Regulation Instructors who choose to teach from this chapter are urged to go over the principal-agent problem (section 15. the NE eﬀort levels decrease further below the optimal level when the number of scientists increases. (c) Yes. these three subsections analyze the principal-agent problem in diﬀerent degrees of complexity. and q2 = .Chapter 15 Management. (b) Each scientist i takes all other eﬀort levels (ej . The third subsection of introduces risk aversion implicitly by assuming asymmetric information. 2. the “social planner” chooses a common eﬀort level for all scientists e that solves Ne V max w − e2 = = e − e2 . The remaining sections: executives’ compensation (section 15. Altogether. 2 The best response function of ﬁrm 2 (the ﬁrm that maximizes proﬁt only) is given by q2 = BR2 (q1 ) = 0.4) do ﬁt the more advanced students. In constrast. Therefore. since the optimal eﬀort level is e∗ = 1/2 which is independent of the number of scientists. reﬂecting a stronger free-rider eﬀect. (a) Under collusion. More precisely. thereby enabling the instructor to stop at the level that exceeds the students’ ability.2 introduces a simple free-rider team eﬀort problem. yielding a NE where ei = 1/(2N ) for all i = 1. Section 15.5(a − c − q1 ). (a) The manager of ﬁrm 1 chooses q1 that solves max M1 = 0.1). N . A subsequent subsection introduces uncertainty with no risk aversion. j = i) as given and solves max Ui = ei V − (ei )2 = N j=i ej + ei N − (ei )2 . 2 . q1 yielding a best-response function given by q1 = BR1 (q2 ) = a − c + 1 − q2 . Section 15.5[(a − q1 − q2 )q1 + (1 − c)q1 ]. − e2 = e N N yielding e∗ = 1/2.4) and the regulation of the ﬁrm (section 15. q1 = 3 3 . the equilibrium output levels are given by a−c+2 a−c−1 e e .3 introduces Fershtman-Judd model. the ﬁrst subsection illustrates the problem with no uncertainty. . Compensation. . which is developed three times in order to allow for a a gradual increase in the degree of diﬃculty.

O (b) The owner of ﬁrm 1 earns π1 = π1 −M1 . That is. Hence. π1 = π1 . and Regulation e e Clearly. q1 > q2 conﬁrming that the managerial compensating scheme of ﬁrm 1 is output increasing at the expense of the ﬁrm that maximizes proﬁt only (ﬁrm 2). Finally. so that we approximate the owner’s proﬁt by the O ﬁrm’s proﬁt. Formally. From the previous calculation we conclude e = (a − 2c − 1)/3. .29]).7)) yields that π1 ≥ π1 if and only if a ≥ 2 + c. π e = (a − c − 1)(a − c + 2)/9. the present compensation scheme dominates a simply Cournot behavior (given that the other ﬁrm behaves in a Cournot fashion) if the demand intercept is suﬃciently higher than the unit production cost. Compensation. We now set µ that p 1 1 suﬃciently small (as in [15. comparing the proﬁt of the owner of ﬁrm 1 under the present managerial compensation scheme to her proﬁt when this manager maximizes proﬁt only (the O c simple Cournot proﬁt given in (6.50 Management.

Search theory (section 16. the students should ﬁnd this section easy to follow. Hence.52 3 7..e.. From (16.1: Reservation price as a function of the search cost parameter (b) Solution-table 16.Chapter 16 Price Dispersion and Search Theory Price dispersion (section 16. (a) To see what happens. the consumer indiﬀerent between searching or buying at random is located at L.0 Solution-Table 16. from diﬀerent values of time). ˆ D N L→∞ L→∞ Hence. we look at the equilibrium prices when L → 0.. Hence.2) is introduced with no calculus. when search cost is zero). ¯ implying that the consumer will accept any price in the ﬁrst store visit. 2.00 5 10. we have it that s p ¯ 0 1 1 4. se < L implying that the discount store a negative market share (which is ruled out ˆ by out assumption that α > 3/2).86 4 9.1 reveals that p = 1 when s = 0 (i. Note also that this result can be inferred from (16.1 reveals that for s ≥ 4 the consumer reservation price is p = 9. calculate. This question should read. the probability that this consumer ﬁnds prices exceed 1 in all store visits is limT →∞ (8/9)T = 0. (b) When α = 3/2. Thus.77 2 6. so the analysis relies on simple probability arguments. The probability that prices exceed 1 in two store visits is σ 2 = (8/9)2 . (c) Solution-table 16. when α = 3/2 all consumers buy at random.9) we see that lim pe = lim pe D = 2αH and se → 0. some consumers have a negligible search cost). when L becomes small (i. say. under the search cost you found in the previous subquestion.e. both stores charge the same price. implying that there is no discount store. The analysis relies on a simple of location model.1 the probability that the consumer ﬁnds the price higher than 1 (i.16) where the calculated expected number of stores visited is µ = 1/(1 − σ) = 9 < +∞. Answers to Exercises 1. the reservation price) in a single store visit is σ = 8/9. .e. 1 The ﬁrst printing of the ﬁrst edition does not specify which search cost is assumed. ¯ (d) When s = 0... When α = 1.1) demonstrates that a discount store and an ‘expensive’ store can coexist in a market where consumers have diﬀerent search costs (resulting..13). (a) Using (16.

.

n. therefore if 3β < 3. 0. and (you guessed. however. Clearly. and are. of course). Answers to Exercises 1. this technology (cost function) exhibits economies of scope if T C(n. similar to (17. In future editions I will attempt to expand this part of the book by introducing at least three more industries: the health industry. from the utility function of route 3 passengers (17. n. the monopoly ˜ ˜ ˜ chooses f ≡ f1 = f2 that solves max π h = n¯3 + 2nδ + 2n f − 2cf. p3 = p3 ) we have it ¯ that the minimum frequency that the airline must provide on route 3 (at this airfare) ¯ ¯ is f3 = (¯3 − δ)2 . (a) Under the FC network.5). hence if β < 1. The main message here is that the introduction of a binding price cap by the regulator will cause the monopoly airline to reduce ﬂight frequency (or any other quality aspect of the service). (3nα )β < 3nαβ .e.2). 0) + T C(0. From the deﬁnition. n). Since the airfare is regulated (i.Chapter 17 Miscellaneous Industries The purpose of this chapter is to demonstrate to the student that there is no general model that can describe all industries. the corresponding frequency f3 decreases. I also wish to demonstrate in this last chapter that the tools developed in this book are indispensable to the analysis of most industries. n) = (nα + nα + nα )β < (nα )β + (nα )β + (nα )β = T C(n. p f 1 ¯ The ﬁrst printing of the ﬁrst edition contains a typo: Replace “. Now. the lawyers. or. 2.” ¯ . p ¯ (b) Under the HS network. the defense industry.. each route can be analyzed separately. the ﬂight frequency on route 3 is the (minimum) frequency ¯ on routes 1 and 2. worth learning. 0) + T C(0. but with a given p3 . 0. as p3 decreases. therefore..charges an airfare f3 ” with “airfare p3 .. This chapter discusses four types of industries that require special attention since (perhaps like any other industry) they do not fall in any category and therefore cannot be analyzed by simply picking one of the market structure analyzed earlier in the book.1 Hence. we see that the monopoly extracts maximum √ surplus when p3 = δ + f3 .

LC and not tC ). Then. yielding ns = C v+φ 4v 1/3 < ne .2 ˜ f= n 2c 2 < 3n 4c 2 = f h. is lower than the sum of the airfares ¯ on routes 1 and 2. v+φ 4v + τ. a price cap on route 3 will reduce the ﬂight frequency on all routes. implying that ne = C v+φ v 1/3 . but it uses a diﬀerent driving time function. the airfare on route 3. The analysis here follows the same stages as in section 17. (c) Let τ denote the highway toll on this route. the social planner sets τ s that solves v + φ = v(ns )3 + τ = v C yielding that τ s = 3(v + φ)/4. One has also to check that. Simply set tC = (nC )3 (the equation stated in this question equals to the value of the driving time. 3. v + φ = v(nC )3 . under the HS network. C Thus. Hence. we need to verify that (or ﬁnd the conditions under which) p3 ≤ p1 + p2 . 2 . 3 The ﬁrst printing of the ﬁrst edition contains a typo. the social planner would recommend a policy that would result in a reduction in the number of people who drive a car. (b) The social planner chooses ns that solves C min Ls = (N − nc )(v + φ) + nC V (nC )3 .4. Thus. that is. Otherwise. in this equilibrium.3 (a) If some people take the train and some drive a car. ¯ route 3 passengers can purchase two separate tickets and reach their destination at a lower airfare. to set the toll that would generate the socially optimal number of highway users. Therefore.54 Miscellaneous Industries ˜ yielding a ﬁrst order condition given by 0 = 2n/(2 f ) − 2c. p3 . it must be that LT = LC .

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