Economics 406

Spring 2015

Problem Set 4

Due Tuesday, February 24, by the end of class.

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1. Consider a Cournot game between two firms. The firms face an inverse demand function
described by the equation P (Q) = α − Q if Q ≤ α, P (Q) = 0 if Q > α, where P is the
price of output and Q is the total output produced by the two firms. Firm 1 produces its

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output q1 at a constant unit cost c1 (i.e, the total cost to firm 1 of producing q1 units of
output is c1 q1 ). Firm 2 produces output q2 at a constant unit cost c2 .

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(a) Solve for the Nash equilibrium output choices of each firm, (q1∗ , q2∗ ), as a function of α,
c1 , and c2 . You may assume that both firms choose a positive quantity of output in
the Nash equilibrium (this will be true as long as c1 and c2 are not too big, or not too

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far apart). Solve also for each firm’s profit, total output, and the Nash equilibrium

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price, also as functions of α, c1 and c2 .

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(b) Suppose firm 2 has an innovation that reduces its cost (that is, makes c2 smaller).
What is the directional effect (up or down) on the Nash equilibrium outputs and
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profits of the firms, and on the Nash equilibrium price?
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2. Consider the following Bertrand game between two firms, firm 1 and firm 2. As in the
standard Bertrand game, each firm’s action is a choice of price (that is, some nonnegative
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real number). However, the firms produce goods that are not identical, and thus consumers
do not use the rule of buying only from the firm that charges a lower price. Instead,
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the demand for each firm’s good is a continuous function of the prices they choose. In
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particular, demand for firm 1’s good as a function of p1 and p2 is 1 + p2 − p1 , and demand
for firm 2’s good as a function of p1 and p2 is 1 + p1 − p2 . Each firm has a constant unit
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cost of production c.
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(a) Write down each firm’s profit as functions of c, p1 , and p2 .

(b) Solve for each firm’s best response function.
(c) Find the Nash equilibrium of the game (as a function of c).
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(d) Are there any outcomes that yield both firms a higher payoff than the Nash equilib-
rium? If not, prove your answer. If so, give one example.
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3.
(a) Suppose that there are four firms in the standard Hotelling game, in which each firm
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wishes to locate in a place that maximizes its market share. Find a Nash equilibrium
in which each firm sells to 1/4 of the market. Demonstrate that each firm is using a
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best response in your Nash equilibrium.

(b) Consider the Hotelling game with three firms. Write down firm 1’s best response as a
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function of firm 2’s and firm 3’s choices of location, x2 and x3 . A best response will
not exist for some values of x2 and x3 , but for others it will. Given your answer, can
there be a Nash equilibrium in pure strategies of the Hotelling game with three firms?
Explain.

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