# Industrial Organization: Markets and Strategies

Paul Belleflamme and Martin Peitz

Part III. Sources of Market Power
Exercises
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
careful!]
2. Determine equilibrium prices in the game in which all firms set prices
simultaneously.
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
qualities.
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.
1

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)? Discuss.com/area/Central/MidLevelEscalators. 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).