Intermediate Microeconomics EC202

Lekima Nalaukai Semester II, 2020

Tutorial 11 Suggested Solutions

Chapter 13

Part A: Multiple Choices

1. All of the following statements are true except:
A. Perfect competition can only exist in industries with a large number of firms.
B. A monopoly market structure cannot exist in an industry with an undifferentiated
product.
C. Monopolistic competition implies that each firm has some ability to differentiate
its product.
D. Oligopoly can exist in industries with differentiated and undifferentiated products.

2. Suppose that firms A and B are Cournot duopolists in the salt industry. The market demand
curve can be specified as P  200  QA  QB . The marginal cost to each firm is $40. What
is firm B’s profit-maximizing quantity when firm A produces an arbitrary output QA ?
A. QB  160  QA .
B. QB  160  2QA .
C. QB  80  QA .
D. QB  80  1 2 QA .

Ans: D
3. Suppose in a Cournot duopoly that two firms, Firm 1 and Firm 2, face market demand
P  50  Q and both have marginal cost, MC  $20 . The equilibrium output for each firm
will be
A. Q1  Q2  7.5
B. Q1  Q2  10
C. Q1  Q2  15
D. Q1  Q2  20

Ans: B
4. Suppose that firms A and B are Cournot duopolists in the salt industry. The market demand
curve can be specified as P  200  QA  QB . The marginal cost to each firm is $40.
Suppose that firm A is producing 100 units. What is firm B’s profit-maximizing quantity?
A. 100.
B. 60.
C. 30.
D. 20.

Ans: C
Intermediate Microeconomics EC202
Lekima Nalaukai Semester II, 2020

Tutorial 11 Suggested Solutions

Chapter 13

5. Bertrand duopolists, Firm 1 and Firm 2, face inverse market demand P  50  Q and both
have marginal cost, MC  $20 . The equilibrium output this market will be
A. 15
B. 20
C. 30
D. 40

Ans: C
6. Stackelberg duopolists, Firm 1 and Firm 2, face inverse market demand P  50  Q . Both
have marginal cost, MC  $20 . If the follower takes the leader’s output as fixed at Q1,
what is the equation of its reaction function?
A. 30  Q1  Q2
B. 15  Q1  Q2
C. 15  2Q1  Q2
D. 15  Q1 / 2  Q2

Ans: D
7. Let firm A face demand curve QA = 100 – PA + .5PB and firm B face demand curve QB =
100 – PB + .5PA. Products A and B both have constant marginal cost of production of 10
per unit (and no fixed cost). Each firm acts as a Bertrand competitor. What is firm B’s
profit-maximizing price when firm A sets a price of $70 for its good?
A. $70
B. $72.5
C. $74
D. $76.5

Ans: B
Intermediate Microeconomics EC202
Lekima Nalaukai Semester II, 2020

Tutorial 11 Suggested Solutions

Chapter 13

Part B: Conceptual Questions

1. Explain why, at a Cournot equilibrium with two firms, neither firm would have any regret
about its output choice after it observes the output choice of its rival.
In a Cournot setting, each firm chooses a level of output that maximizes its own profit given the
output choice of the other firm. In equilibrium each firm is choosing the profit-maximizing level
of output given the other firm’s output choice. Thus, neither firm will have any regret since it is
doing the best it can given the other firm’s choice.

2. Explain the difference between the Bertrand model of oligopoly and the Cournot model of
oligopoly. In a homogeneous products oligopoly, what predictions do these models make
about the equilibrium price relative to marginal cost?

In the Cournot model of oligopoly, firms choose a level of output given the output choices of rival
firms. In the Bertrand model of oligopoly, firms choose a price given the prices set by rival firms.
In the Bertrand model it is assumed that the firm with the lowest price will achieve 100% market
share. Therefore, firms will undercut the prices of rival firms until price is driven down to the
firm’s marginal cost.
In a homogenous products oligopoly, Cournot firms exhibit market power and set a price above
the perfectly competitive price and provide a level of output below the perfectly competitive level.
Bertrand firms, by undercutting prices of rival firms, drive the price down to the level of marginal
cost, achieving the perfectly competitive solution. Thus, in the Cournot model price is above the
perfectly competitive price and in the Bertrand model price is equal to the perfectly competitive
price.
3. What are the characteristics of a monopolistically competitive industry? Provide an
example of a monopolistically competitive industry.

A monopolistically competitive market has three key features. First, the market is fragmented,
meaning it consists of many buyers and many sellers. Second, there is free entry and exit into the
market. Third, firms produce horizontally differentiated products.
The restaurants in a city might represent a monopolistically competitive market. There are likely
many restaurants, and many consumers who want to eat at a restaurant; entrepreneurs can easily
enter the restaurant market; and consumers likely view the restaurants as imperfect substitutes.
Clothing retailers might represent another monopolistically competitive market.
Intermediate Microeconomics EC202
Lekima Nalaukai Semester II, 2020

Tutorial 11 Suggested Solutions

Chapter 13

Part C: Calculations
1. In the following, let the market demand curve be P = 70 - 2Q, and assume all sellers can
produce at a constant marginal cost of c = 10, with zero fixed costs.
A. If the market is perfectly competitive, what is the equilibrium price and quantity?

P = MC implies 70 – 2Q = 10, or Q = 30 and P = 10.

B. If the market is controlled by a monopolist, what is the equilibrium price and quantity?
How much profit does the monopolist earn?
A monopolist produces until MR = MC yielding 70 – 4Q = 10 so Qm = 15 and Pm = 40.
Thus πm = (40 – 10)*15 = 450.

C. Now suppose that Amy and Beau compete as Cournot duopolists. What is the Cournot
equilibrium price? What is total market output, and how much profit does each seller
earn?

For Amy, MRA = MC implies 70 – 4qA – 2qB = 10. We could either calculate Beau’s profit-
maximization condition (and solve two equations in two unknowns), or, inferring that the
equilibrium will be symmetric since each seller has identical costs, we can exploit the fact
that qA = qB in equilibrium. (Note: You can only do this after calculating marginal revenue
for one Cournot firm, not before.) Thus 70 – 6qA = 10 or qA = 10. Similarly, qB = 10.
Total market output under Cournot duopoly is Qd = qA + qB = 20, and the market price is
Pd = 70 – 2*20 = 30. Each duopolist earns πd = (30 – 10)*10 = 200.

2. The market demand curve in a commodity chemical industry is given by Q = 600 - 3P, where Q is
the quantity demanded per month and P is the market price in dollars. Firms in this industry supply
quantities every month, and the resulting market price occurs at the point at which the quantity
demanded equals the total quantity supplied. Suppose there are two firms in this industry, Firm
1 and Firm 2. Each firm has an identical constant marginal cost of $80 per unit.

A. Find the Cournot equilibrium quantities for each firm. What is the Cournot equilibrium market
price?

Begin by inverting the market demand curve: Q = 600 – 3P  P = 200 – (1/3)Q. The marketing-
clearing price if firm 1 produces Q1 and firm 2 produces Q2 is:
Intermediate Microeconomics EC202
Lekima Nalaukai Semester II, 2020

Tutorial 11 Suggested Solutions

Chapter 13

 P = 200 – (1/3)(Q1 + Q2).

 Let’s focus on firm 1 first.
 Firm 1’s residual demand curve has the equation
 P = [200 – (1/3)Q2] – (1/3)Q1.
 TR1=200Q1-1/3Q2Q1-1/3Q12
 The corresponding marginal revenue curve is thus:
 MR1 = [200 – (1/3)Q2] – (2/3)Q1.
 Equating firm 1’s marginal revenue to marginal cost and solving for Q 1 gives us:
 [200 – (1/3)Q2] – (2/3)Q1 = 80, or
 Q1 = 180 – 1/2Q2.
o This is Firm 1’s reaction function.
 Similar logic gives us Firm 2’s reaction function:
 Q2 = 180–1/2Q1.
 Now, we have two equations (the two reaction functions) in two unknowns (Q1 and Q2).
 Solving this system of linear equations gives us:
 Q1 = Q2 = 120.
 The resulting market price is:
 P = 200 – (1/3)(120+120) = 120.
 Each firm’s profit is (P – M)Qi,
 for i = 1,2, or (120 – 80)(120) = $4,800 per month.
 Industry profit is thus: $9,600 per month.

B. Assuming that Firm 1 is the Stackelberg leader, find the Stackelberg equilibrium quantities for
each firm. What is the Stackelberg equilibrium price?

 To find the Stackelberg equilibrium, we begin by substituting Firm 2’s reaction function into
the expression for the market-clearing price to get Firm 1’s residual demand curve.
 This gives us: P = 200 – (1/3)(Q1 + 180 – ½ Q1)  P = 140 – (1/6)Q1.
 The corresponding marginal revenue curve is: MR1 = 140 – (1/3)Q1.
 Equating marginal revenue to marginal cost gives us: 140 – (1/3)Q1 = 80,
o or Q1 = 180.
 This is the Stackelberg leader’s quantity.
 The Stackelberg follower’s quantity is found by substituting the leader’s quantity into the
follower’s reaction function:
o Q2 = 180 – ½ (180) = 90.
 The resulting market price is:
o P = 200 – (1/3)(180 + 90) = 110.
Intermediate Microeconomics EC202
Lekima Nalaukai Semester II, 2020

Tutorial 11 Suggested Solutions

Chapter 13

 Notice that this is lower than the Cournot equilibrium price.

C. Calculate and compare the profit of each firm under the Cournot and Stackelberg equilibria. Under
which equilibrium is overall industry profit the greatest, and why?

 Let’s now compute the profit of each firm under Stackelberg leadership and compare
to the profit under Cournot.
 The leader’s profit is:
o (110 – 80)(180) = $5,400 per month.
 The follower’s profit is:
o (110 – 80)(90) = $2,700 per month.
 Notice that the leader earns higher profit than under the Cournot equilibrium, while
the follower earns lower profit.
 Overall industry profit under Stackelberg leadership --- $5,400 + $2,700 = $8,100 ---
is less than it is in the Cournot model.