Industrial Organization: Markets and Strategies

Paul Belleflamme and Martin Peitz
published by Cambridge University Press

Part III. Sources of Market Power
Exercise 1 Competition on the Salop circle
Consider a market in which firms 1, ..., N are equidistantly distributed on a
circle with circumference 1. Firms have constant marginal costs of production
c, which are the same for all firms. Consumers are uniformly distributed on the
circle (and have mass 1). A consumer x incurs a transportation τ |x − li | when
buying from firm i. Here the distance between consumer and firm is the arc
distance on the circle (that is consumers move on the circle). Suppose that all
consumers are active in the market.
1. Determine the demand function of firm i as a function of all prices. [Be
2. Determine equilibrium prices in the game in which all firms set prices
3. How do transport costs affect profits?
4. Argue informally whether or not you think that an equilibrium exists for
all location configurations.

Exercise 2 Quality-augmented Hotelling model
Consider the Hotelling model in which consumers are uniformly distributed
on the [0, 1]-interval and firms A and B are located at the extreme points.
Firms produce a product of quality si . Consumer x ∈ [0, 1] obtains utility uA =
(r−tx)sA −pA if she buys one unit of product A and uB = (r−t(1−x))sB −pB if
she buys one unit of product B. Each consumer buys either one unit of product
A or one unit of product B.
1. Describe the property of the utility function with respect to quality in two
or three sentences.
2. Determine the demand for products A and B at given prices and given
3. Suppose that qualities sA and sB are given and that marginal costs of
production are zero. Determine the Nash equilibrium in prices under the
assumption that qualities are not too asymmetric implying that both firms
have a strictly positive market share in equilibrium.

Compare this finding to the standard quality-augmented Hotelling-model in which consumer x obtains utility uA = r + sA − tx − pA if she buys product A and uB = r + sB − t(1 − x) − pB if she buys product B. one or none of the owners support the project? Explain. Do the grocery owners support this connection? Is it possible that both. 1. Suppose that initially connection are bad so that all inhabitants of A do their shopping in A and all inhabitants of B do their shopping in B. Suppose that qualities are symmetric and that the cost of quality C(si ) is increasing and strictly convex in si . 2. How does the equilibrium profit depend on quality? 5. Each village has its grocery store which sells a particular brand. What is the likely position the two city councils will take? 3. Some villagers propose a better connection between A and B. Exercise 3 Market integration Somewhere far away there exist two villages Applecastle (A) and Orangevillage (B).4. How may the opinion of the city council be different if there is a local sales tax? 2 .

Consumers buy either one unit of any of the two goods or they do not purchase in the market. l2 ) ∈ < × <? Do there exist location pairs for which no price equilibrium exists (instability in competition)? 2. Consumers incur a transport cost τ (x− li )2 when buying product i at location li . and that firms face constant marginal costs of production c. What are equilibrium prices for any location pair (l1 . Is there too much or too little product differentiation from a social point of view? Exercise 5 A model of vertical product differentiation Suppose there are 2 firms in a vertically differentiated market. s]. [Hint: this is not the same model as the one presented in the book.] 2. If they do not purchase in the market their indirect utility is 0.Exercise 4 A location-then-price game Consider a market in which consumers are uniformly distributed on the unit interval. Assume that there exist consumers of mass 1 whose preference parameter is uniformly distributed on [0. where θ is the preference parameter of a consumer. What are locations in subgame perfect equilibrium? [Recall that firms locate anywhere on the real line] 4. If they purchase good i their indirect utility is θsi − pi . s1 < s2 . 1. 1]. Suppose that firms have zero marginal costs of production. Determine the demand function of each firm depending on prices and qualities. Suppose firms set qualities from an interval [0. 1. 1]. How do profits change as the distance between the two firms increases (consider only symmetric locations)? 3. Suppose that qualities are given. where a consumer is described by x ∈ [0. Suppose firms set prices simultaneously and that the willingness to pay is sufficiently large such that all consumers are active. Suppose that firms set locations simultaneously before setting prices. which are independent of quality. 3. Which qualities will result in subgame perfect equilibrium in the game in which firms set qualities simultaneously at stage 1 and set prices simultaneously at stage 2? 3 . si is the quality of good i and pi is the price of good i. Determine equilibrium prices and profits in the game in which firms simultaneously set prices.

we assume now that the marginal cost of production depends on quality. How does an increase in c affect the profits of the two firms? Provide the economic intuition behind this result. θ ⊂ R+ . Suppose that firm i has constant marginal cost equal to c · si . 8] with the density 1/6. Exercise 7 The quality-quantity trade-off under vertical differentiation Consider the vertical differentiation model presented in Section 5.3.Exercise 6 Vertical product differentiation and cost of quality A consumer with income m that consumes a product of quality si and pays pi obtains the utility si m/6 − pi . y. the cost of providing the other dimension increases and the amount of this other dimension is thus 4 . Firms 1 and 2 offer the qualities s1 and s2 . The total mass of consumers is equal to 1. We denote by C (qi . 2. the resulting utility is zero.3. firm 2. Derive the demand of firms 1 and 2. si ) the cost of firm i producing qi units at a quality si and we assume C (qi . 1. We assume that s1 ≤ s2 and s1 . if the firm increases one dimension (quality or quantity). That is. thus. Calculate the Nash Equilibrium in prices and find the equilibrium profits as a function of s1 and s2 . Consumers are distributed uniformly on θ. There are two firms in the market. which measures their prefer£ ¤ ence for quality. Suppose that the quality of the product can be£ described by some number si ∈ [s. si ) = aqi si . θ) = r − pi + θsi when consuming a unit of good i (where r is supposed to be sufficiently large. increases with quality. s] ⊂ ¤ R+ . It is. If instead the consumer decides not buy the good. respectively. We look for the subgame-perfect equilibria of the following two-stage game: firms first choose the quality of their product and then compete in prices. continues to earn higher profits than firm 1 as long as c < 5/6. 2]. What are the equilibrium quality choices of the two firms? 3. θ and are of mass M = θ − θ. and calculate the reaction functions of the two firms. Contrary to what was assumed in Section 5. s2 ∈ [1. Show that the high quality firm. this formulation introduces a trade-off between quality and quantity as the marginal cost of production. With a > 0. Consumers are identified by θ ∈ θ. asi . Two firms compete in the market. A consumer of type θ receives a utility of vi (p. Consumer income m is uniformly distributed on the interval [2. more expensive to produce higher quality. so that all consumers buy in the market).

reduced. 2. Suppose that 100. we can approximate the consumer distribution by a continuum on [0. (A1) 2 1. hilly terrain.000 inhabitants are uniformly distributed along the street. To make travelling up the slope easier for pedestrians. (a) Show that (s1 .shtml for some pictures of the escalators and the stairs of this area).. One famous example can be found in the Western District. this has led the city authorities to imagine rather unusual methods of transport. with the convention that s1 < s2 .12hk.. s2 ) = (s. imagine the following story. 5 . the cost for the instructor of providing a high-quality teaching increases (given the time available. For the sake of this problem set. we assume ½ ¾ θ+a θ > max 2θ − a. we redefine all quantities by dividing them by 100. of a larger value of parameter a)? Firm 1 produces quality s1 and firm 2 produces quality s2 . as well as hot and humid weather. An example of such an inverse relationship between quality and quantity can be found in the way an instructor teaches a course: as the number of students enrolled (i. the Mid-Levels escalators were opened to the public in October 1993. Consider the second stage of the game where firms set prices simultaneously. the instructor’s ability to meet students outside of class. Derive the Nash equilibrium in prices and express the equilibrium quantities and profits of the two firms at stage 2. s) are the equilibrium quality choices of the game. (b) What is the effect of a stronger quality—quantity trade-off (i. Because the street is so steep.000).e. or to provide students with feedback on their assignments.e. To guarantee interior solutions in the pricing game.. . Travelling up and down the slopes therefore causes problems. where one of the busiest commercial area of Hong Kong can be found. Without loss of generality. 1] with a mass set equal to 1 (i. Suppose that the street is one kilometre long (kilometre 0 is down at the crossroad with Des Voeux Road and kilometre one is up at the crossroad with Conduit Road). (See http://www. Exercise 8 Product differentiation in Hong-Kong Hong Kong Island features steep. Consider now the first stage of the game where firms simultaneously choose the quality of their product. s) or (s. inevitably decreases with the number of students enrolled). sidewalks are made of stairs. This area stretches from Des Voeux Road in Central (which is at sea level) up to Conduit Road in the Mid-Levels (which is the mid section of the hill of Hong Kong Island). taking the qualities as given. quantity) increases.e.

that is if τ increases (e. Nash equilibrium in the post-1993 situation (a) Derive the identity of the consumer who is indifferent between the two shops. ⎨ r − τ 1 (x) − p1 r − τ 2 (1 − x) − p2 if consumer buys at Too-Chow ⎩ 0 if consumer does not buy.. the Mid-Levels escalators made going up and down equally painful for consumers. 6 . each inhabitant of the street may consume at most one bowl of shark fin soup. This is translated by the following assumptions: τ 1 (x) = tx and τ 2 (1 − x) = (t + τ ) (1 − x) . (c) Show that Two-Chow’s profits increase if walking up the street becomes more costly for consumers.e. • After 1993. Everyday. The price per bowl of the two shops are respectively denoted by p1 and p2 . consumers had to pay a fixed fee f (independent of distance) to use the escalators. This is translated by the following assumptions: τ 1 (x) = tx and τ 2 (1 − x) = t (1 − x) + f . (c) Express the condition (in terms of f and t) under which the previous answers are valid (i. 1] is given by ⎧ if consumer buys at Won-Ton. However.g. 1.. Explain the intuition behind this result. where it is assumed that r is large enough so that every consumer buys one bowl of soup. • Before 1993 and the installation of the Mid-Levels escalators. As it happens. (b) Compute the equilibrium prices and profits of the two shops. with f > 0. We want to contrast the pre. because the temperature has risen). The net utility for a consumer located at x on the interval [0. Nash equilibrium in the pre-1993 situation (a) Derive the identity of the consumer who is indifferent between the two shops. one shop (named ‘Won-Ton’ and indexed by 1) is located at point 0. while the other shop (named ‘Too-Chow’ and indexed by 2) is located at point 1. we set their marginal cost of production to zero. with t. τ > 0. walking up the street was much more painful than walking down. bought either from Won-Ton or from Too-Chow. For simplicity.There are only two shops selling shark fin soup in this area.and post-1993 situations. 2. (b) Compute the equilibrium prices and profits of the two shops. the condition for Too-Chow to set a price above its zero marginal cost).

τ ) is too large.(d) Show that Two-Chow’s profits increase if taking the escalator becomes less expensive. 3. i. for f = 0 ).2 0. (b) Won-Ton benefits from the installation of the escalators. 7 .0 Tobacco products 0. that is if f decreases. The easiest way to think about the advertising elasticities is the following: Total demand consists of demand today and tomorrow. f = 3 and compare Won-Ton’s profits for τ = 2 and τ = 4).3 0.e.4 0. establish and explain intuitively the following results.2 0.8 0. set t = 2.4 Drugs 0.3 Books 2.. (a) Too-Chow suffers from the installation of the escalators (even when its access is free.1 0. In which industries do you expect advertising intensity to be high? Distinguish between short run and long run.0 1. unless the extra transportation cost of climbing the stairs (i. Exercise 9 Examples of product differentiation Give five examples of product markets in which product differentiation is likely to be a determining factor for competition in the market place.7 1. Comparing your answers for (1) and (2).7 1. Short-run Long-run Income Price advertising advertising elasticity elasticity elasticity elasticity Bakery products 0. Can such advertising be total surplus increasing? Explain.3 0. Give five examples in which the imperfections in competition are likely to be the result of factors different from product differentiation.8 0.e.. Explain the intuition behind this result and contrast with your answer at (1c). The short-run elasticity is the effect that advertising today has on demand today whereas the long-run elasticity is the effect that advertising today has on demand tomorrow.6 Exercise 11 Wasteful advertising Suppose that advertising expenditures are wasteful in the sense that they only redirect existing demand and do not increase consumer utility. (To show this. Exercise 10 Advertising intensity Consider the elasticities reported in the table below.7 0.

Derive the equilibrium if firms cannot inform consumers that their product contains the undesirable ingredient. As it happens. Should attack ads be allowed in this setting? Exercise 13 Informative advertising It is not difficult to navigate in Lonely-Line City: a single street runs from kilometer 0 to kilometer 1 along which 100 inhabitants are equidistantly distributed. 1. Suppose that each shop i sells one liter at price pi at the shop and that all inhabitants get up each morning and walk to one of the two shops to get the milk. Suppose that. at an initial stage. firms can simultaneously launch costly attack ads in which they reveal that their competitor’s product contains an undesirable ingredient. If a consumer learns that product i has the undesirable ingredient utility is decreased by d. Suppose that parameter values are such that in the equilibria to be characterized below the market is fully covered. absent advertising. 2. 1] with a mass of 100.] To keep the place residential the local government has decided that no shops are allowed within the city limits. In this case a consumer of type x derives utility r − tx − p1 if she purchases product 1 and utility r − (1 − t)x − p2 if she purchases product 2. Firms set prices simultaneously. [Approximate the consumer distribution by a continuum on [0. Suppose now that. Are consumers better off in this equilibrium compared to the solutions in (1) and (2). 1. at an initial stage. What is the price set by each of the two shops. each shop pays a wholesale price of c cents per liter. Each morning each inhabitant drinks one liter of fresh milk. there exists one shop at each boundary of the city [one at point 0 and one at point 1]. firm i simultaneously decide whether to inform consumers that its product contains an undesirable ingredient (suppose that such informative advertising is possibly costless). 4. what are the shops’ profits? [Characterize the Nash equilibrium of the corresponding game!] 8 . consumers are not aware of this ingredient. Assume that transporting one liter of milk costs t cents per kilometer (this is the disutility incurred by an inhabitant if he walks or the cost for the shop for delivery). 3. Characterize the equilibrium of the two-stage game.Exercise 12 Negative advertising and information disclosure Consider the linear Hotelling duopoly in which each firm produces a product with a firm-specific undesirable ingredient at zero marginal costs. Characterize the equilibrium of the two-stage game depending on the advertising cost A. Suppose that. Explain your result.

Each inhabitant listens to ad 1 with a 50% chance and to ad 2 also with a 50 % chance. Assume furthermore that for each inhabitant the probability to listen to ad 2 is independent of whether he or she has listened to ad 1. Consider a day at which both shops have milk available. Determine the equilibrium in each of the two cases (the advertising costs are assumed to be the same in each case). you can assume that parameter constellations are such that first-order conditions of profits maximization characterize the equilibrium. and a 25% chance that an inhabitant listens to none of the ads. Return to the situation in (1) but suppose that shops sometimes do not have fresh milk available and that inhabitants only make the walk if they know that they get the milk for sure. i. The price of the two products is given and equal to 1. A consumer located at x ∈ [0.. 4. ad 2 contains information on shop 2. consumers do not observe the qualities. a 25% chance that an inhabitant listens to ads 1 and 2. Which option do shops prefer? [Characterize the equilibrium for options 1 and 2. p1 = p2 = 1 (e. 3]. The quality of each product is drawn independently from the uniform distribution on this interval [2.g. There is time for two ads. The quality of product i is denoted by si ∈ [2. there is a 25% chance that an inhabitant listens to ad 1 only. each shop can buy the right to use the city’s public speakers to advertise the availability of the milk. 9 . Both firms observe the two qualities of the product. 3. The inhabitants of Lonely-Line City. however. both ads contain information on both shops. what are the shops’ profits? [Characterize the Nash equilibrium of the corresponding game in which shops simultaneously set prices pi ! Illustrate your analysis by a figure!] Compare your findings to those in (1). a 25% chance that an inhabitant listens to ad 2 only. Exercise 14 Comparative advertising Consider a Hotelling duopoly in which firms are located at the extreme points of the unit interval and consumers of mass 1 are uniformly distributed on the unit interval.] Provide an intuition for your result. 3]. Therefore.2. both shops have a delivery service and that shops set a price that depends on the address of the inhabitant who buys. In each case. Consequently. Shops have the following two options: (a) they jointly announce the availability of milk in each ad. production costs are zero. 1] derives utility Es1 −x−p1 from product 1 and Es2 −(1−x)−p2 from product 2. where Esi is the expected quality of product i given the information available to consumers. What are the prices charged by the shops.e. Suppose that instead of consumers walking to one of the shops. do not always pay attention to the ads. because the price is fixed upstream). (b) ad 1 contains information on shop 1.

Discuss. Suppose that firms can simultaneously disclose their own quality si at zero cost. Consider now a model in which firms can choose not to advertise. firms can only engage in comparative advertising. Exercise 15 Price dispersion A study by Brynjolfsson and Smith on retail price for books and CDs finds that price dispersion (weighted by market shares) is lower for internet retailers than for conventional retailers. 3. 10 . Suppose that instead of advertising their own quality. have prohibitively high search costs). Discuss verbally the welfare properties of the equilibria determined in (2) and (3). Characterize the equilibrium of this game. i.e. Note that firms know the cost a and make their disclosure decisions simultaneously.e. Provide verbally an intuition about the properties of the equilibrium of this game. 3}. 4. The number of 15 consumers know the prices charged by all the stores in the market (i. 2. Prove that it is the unique equilibrium.e. consider an alternative setting in which there are only two discrete types si ∈ {2. Suppose now that disclosure is costly. a firm has to spend a given advertising cost a ∈ (0..e. 1/4]. Characterize the equilibrium in which both firms simultaneously decide whether to disclose the quality difference at cost a ∈ (0. Exercise 16 Another model of sales Consider a market for a homogenous product with n identical price-setting stores. where q is the number of customers the store serves. while M consumers do not know the prices at all (i. In the last two cases the same advertising cost a applies. Characterize the equilibrium of the game in which firms first decide whether to advertise their own quality truthfully or not to disclose any information and then consumers make their choices. To simplify the argument. Each store has a cost function √ C(q) = q. to use non-comparative advertising or to use comparative advertising. 5.1. each of whom wishes to buy up to one unit and is willing to pay for it up to r = 1. firms can costly advertise only the quality difference s1 − s2 . Consumers then decide which product to buy. where n is determined by free entry. There are M + 15 consumers in the market. Suppose that firm i conditions its action on si only. 1/4] to disclose its own quality. have zero search costs). i..

F ∗ (p). increases? Explain the intuition for this result. Firms set prices and then consumers make their consumption decisions. n∗ . 6. 4. write the support of the equilibrium mixed strategy of prices. What happens to the distribution of price paid by informed consumers when the number of uninformed consumers. M . Show that there does not exist a symmetric Nash equilibrium in pure strategies. How do prices change if α is increased. Using these expressions. increases? What does this result mean for the uninformed consumers? Explain the intuition for this. All consumers have unit demand and a willingness-to-pay r. 3. Compute the profits of a store when it happens to be charging the lowest price in the market and when it does not. A share α of consumers is informed about the prices in the market. 5. Suppose that all the stores in the market use the same mixed strategy. What happens to the distribution of prices when the number of uninformed consumers. (Calculate ∂π ∗ /∂α. Given n∗ . Prove that this profit is zero. 4. Prove that there cannot exist a symmetric pure-strategy equilibrium in this market. 2.) 11 . Use the zero profit condition to compute the equilibrium number of firms. The share (1 − α)/2 goes to firm i = 1. 1. What is the support of the mixed strategy as a function of n? 3. Characterize equilibrium prices in the unique mixed-strategy Nash equilibrium. Exercise 17 Yet another model of sales Suppose that two firms with constant marginal costs compete in prices in a homogeneous product market. 2 and decides whether to buy (these consumers do not know that a product from firm j 6= i exists). M . How do equilibrium profits changes as α increases. Write the profit of a store when it charges p = 1 (hint: what is the probability that when a store charges p = 1 it will have the lowest price in the market?).1. compute the equilibrium distribution of prices at each store. 2.

9. Suppose that z = 0. 7. once an uninformed consumer pays z. The remaining (1 − α)L consumers are uninformed and have to pay a cost z in order to learn the prices that different stores charge. 5. where n is determined by free entry. However. 6. compute the high price. she knows only the distribution of prices but not the actual prices charged by each store. Solve for the long-run competitive equilibrium in the market. Such a consumer then picks a store at random. and AP is the 12 . 4. each store must earn a zero profit). Each store has a cost function C(q) = 4 + q. each of whom wishes to buy up to 1 unit and is willing to pay for it up to r = 5. each store can sell up to 4 units and its cost of selling the first q units is 4 + q). 2. If an uninformed consumer does not pay z. Compute the average price on the market and the standard deviation of prices. There are L consumers in the market. Assume that there are two prices being charged in equilibrium. Now suppose that z > 0. pl ? Given your answer. 3. so each one of these store gets an equal share of the αL informed consumers). where SD is the standard deviation of prices. Solve the conditions you wrote in (6) for λ and n. 8.Exercise 18 Bargains and ripoffs Consider a market for a homogenous product with n identical stores. for q ≤ 4 and c(q) = ∞ for q > 4 (in other words. let P D = SD/AP be a measure of price dispersion. Compute the demand faced by low and high price stores (note that uninformed consumers pick stores at random so each stores gets an equal share of the (1 − α)L uninformed consumers. 1. How do the equilibrium values of λ and n vary with z? Explain the intuition for your result. informed customers are indifferent among all stores that charge low prices. she becomes completely informed and knows all prices charged by all stores. ph (hint: assume that a fraction λ of all stores charge pl and a fraction 1 − λ charge ph and use the condition that ensures that uninformed consumers do not find it worthwhile to search). Compute the marginal and average costs of stores and illustrate it in a figure. What is the low price. Prove that there can be at most 2 prices in a Nash equilibrium. Using these calculations. Suppose that a fraction of all the consumers is fully informed about the prices that the different stores charge. Use your answers in (4) and (5) to express the zero profit conditions for high and low price stores (recall that there is a free entry so in equilibrium.

Is this statement necessarily correct? Explain. Analyze the effects of such a policy on consumer surplus. Characterize equilibrium prices. Does an equilibrium (in pure strategies) always exist? Discuss. (If a group of consumers is indifferent suppose that half of them buys software COOL and the other half GREAT. 6. Suppose now that consumers who bought COOL will not consider buying GREAT2 in period 2 and that consumers who bought GREAT will not consider buying COOL2 in period 2. 13 . Characterize equilibrium prices. Does this affect its incentive in period 1? In particular. suppose that there is no discounting.) 4. Provide some real-world examples that have some similar features as the theoretical market described in part (4). Exercise 20 Switching costs and pricing strategy Suppose that two software companies launch a new software each.) 2. Both softwares are produced at zero marginal costs and consumers are willing to pay r for the software. Consider now the market environment in which the firm that produces COOL in period 1 and COOL 2 in period 2 is aware of the fact that it will launch COOL2 in period 2. however. Suppose. allocation and profit. 1.) 5.average price. There is a unit mass of consumers. All of them consider the two software offers as identical. profits. Suppose that firms set prices and compete only in one period. does it have an incentive to deviate from the price calculated in (1)? (NOTE: Suppose that there is no discounting. How is P D affected by s? How is P D affected by α? Are these results intuitive? Explain. Suppose that each firm sold to half of the consumers their software and that they launch new products COOL2 and GREAT2. (Again. 3. allocation and profit. Consumers are willing to pay r for the new products. Suppose firms set prices. Consider the market environment as described in (4). One of them is called COOL. Exercise 19 Switching costs and competition Switching costs relax competition and their presence are therefore profitenhancing. that consumers who buy the product from a different firm than in the first period incur a disutility γ. Explain in up to five sentences the general economic principles at work in markets such as the one describend in (4). Characterize the subgame perfect equilibrium in the two-period model. Suppose the courts rule that prices cannot be set below marginal costs. and welfare. the other GREAT.