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MSc IBE - SS2010

Problemset 2

Perfect and Imperfect Competition: Basic Concepts

May, 11 2010

This problem set is designed to give you the opportunity to review rm behavior in
all
perfect and imperfect competition frameworks. You are asked to solve exercises
listed below. Be prepared to present your solutions in class either on the blackboard
or the overhead projector.
We encourage you to team up to groups. However, in order to obtain points in
class, you musthand in your solution individually and be prepared to
present it and defend it on your own . Please hand in your solution with our
Monday May 10, 2010
secretary (Schloss, Museumsügel, 019) no later than
11 a.m. . Please do not forget to note your name and matriculation number on
your solution sketch.
Jehle, Georey A., and Philip J. Reny (2000). Advanced Microeconomic Theory.
Addison Wesley, Chapter 4.
Exercise 1: Short-run Equilibrium
Consider a competitive industry composed of J identical rms. Firms produce
output according to the Cobb-Douglas technology, q = xα k1−α , where x is some
variable input such as labor, k is some input such as plant size, which is xed
in the short run, and 0 < α < 1. Let wx and wk denote the price of labor and
capital, respectively. p is the price of the nal good. Suppose α = 1/2, wx = 2,
and wk = 1/2, and k = 1. Market demand is given by q d = 240/p.
1. Set up the cost function and the short-run prot maximization problem of
the rm.
2. Show that the rm's short-run maximum prots are
α
(1)
1 α
π j = p 1−α wxα−1 α 1−α (1 − α)k − wk k.
MSc IBE - SS2010
Jung & Gröschl

3. Derive an expression for output supply per rm in the short-run equilibrium
as a function of the nal good price p.
4. What will the short-run market supply function with J = 60 rms be?
5. Solve for the short-run equilibrium price p, market quantity q , output per
rm q j , and rm prots π j .
6. Illustrate the short-run equilibrium at the market level in a price - quantity
gure. Explain.
7. Use the cost function to derive expressions for short-run marginal costs and
the short-run average costs as a function of q . Depict the short-run marginal
cost curve and the short-run average cost curve in a price - quantity gure.
Use the gure to show whether a rm makes negative, zero, or positive
prots.

Exercise 2: Long-run Equilibrium and Constant-Returns to Scale

In the long run, rms may enter in response to positive prots and incumbent
rms are free to choose their plant size optimally.
1. Explain the concept of constant-returns to scale.
2. Explain the conditions that must hold in the long-run equilibrium.
3. Use the prot function given in Exercise 1 and α = 1/2, wx = 2, and wk = 1.
Determine the optimal long-run equilibrium market price p̂ assuming that
plant size k > 0.
4. Solve for the long-run equilibrium (number of rms, total quantity produced,
quantity produced by each rm, prots of rm j ) using the market demand
function given in exercise 1. Assume that plant size is k = 1. Explain the
mechanisms at work.
5. Show that in the long-run equilibrium the number of rms is indeterminate
when all rms in the industry share the same constant returns-to-scale tech-
nology and face the same factor prices.
MSc IBE - SS2010
Jung & Gröschl

Exercise 3: Cournot Duopoly

In a Cournot duopoly in a market for a homogeneous good, there are J = 2
rms. Entry by additional rms is eectively blocked. Each duopolist has constant
average and marginal costs,

C 1 (q 1 ) = c1 q 1 , C 2 (q 2 ) = c2 q 2 , and 0 ≤ c1 ≤ c2 (2)

J
(3)
X
p=a−b qj ,
j=1

where a > 0, b > 0, and a > c.

1. Write down the prot functions for rm 1 and rm 2.
2. Show that rm 1 will have greater prots and produce a greater share of
market output than rm 2 in the Nash equilibrium.

Exercise 4: Cournot Price Competition/ Bertrand Competition

Duopolists producing substitute goods q1 and q2 face inverse demand schedules:
1
p1 = 20 + p2 − q1 (4)
2
and
1
p2 = 20 + p1 − q2 , (5)
2
respectively. Each rm has constant marginal costs of 20 and no xed costs. Each
rm is a Cournot competitor in price, not quantity.
1. Compute the Cournot equilibrium in this market, giving the equilibrium
price and output for each good.
2. Explain the Bertrand paradox and compute the result that would follow if
the rms were Bertrand competitors.
MSc IBE - SS2010
Jung & Gröschl

Exercise 5: Total Welfare Maximization and Pareto Eciency

Consider market demand to be p = a − bq for total market output q . Firms are
identical, with marginal cost c ≥ 0.
1. Give a denition for consumer and producer surplus.
2. When each rm produces the same output q/J , what will total surplus W =
CS + P S , as a function of total output be?

3. At which quantity will total surplus be maximized?

4. Use a gure to argue whether the price-quantity pair on the demand curve
in this competitive case is a Pareto ecient outcome. Explain.

Exercise 6: Price Setting and Social Performance under a Pure Monopoly

A monopolist faces linear demand p = a − bq and has a cost C(q) = cq + f .
1. Explain how a monopolist sets the price.
2. Derive the equilibrium price and quantity.
3. Illustrate the monopoly equilibrium in a price,cost-quantity gure.
4. Derive the price elasticity of demand ε. Show how the monopoly markup
depends on the elasticity of demand.
5. Derive the dead weight loss (DWL) due to the monopoly. Show how this
depends on ε.