MSci 607: Applied economics for management

Managerial Economics and Strategy (2017) by Perloff and Brander

Topic 6 (Oligopoly and monopolistic competition)

Chapter 11 Solutions
1.1. Given MC and AC in the figure, the cartel price is pm, at which each member produces qm
units of output to maximize cartel profits. A single OPEC member can increase production
without substantially changing the cartel price. At the cartel price, pm, each cartel member has an
incentive to increase output from qm to that level where price (pm) equals the marginal cost of
production. This will increase profit by an amount equal to the area under the price (pm) and
above the marginal cost curve for additional units purchased (for units between qm and the profit-
maximizing quantity, qpm). Thus, firms have incentive to cheat.

2.2. You first need to convert the demand curve into the inverse demand curve. The inverse
demand curve is p = 1 – 0.001Q. Firm 1’s profit is
π1 = [1 – 0.001(q1 + q2)]q1 – 0.28q1.
From the first-order condition,
dπ1/dq1 = 1 – 0.001(2q1 + q2) – 0.28 = 0  q1 = 360 – q2/2
Similarly, the firm 2’s best-response function is q2 = 360 – q1/2. The Cournot-Nash equilibrium
is
q1 = q1 = 240 and p = 0.52

2.3. Firm 1’s problem is

max π1 = (150 – q1 – q2)q1 – 60q1.
From the first-order condition,
dπ1/dq1 = 150 – 2q1 – q2 – 60 = 0  q1 = 45 – q2/2
Similarly, the firm 2’s best-response function is q2 = 45 – q1/2. The Cournot-Nash equilibrium is
q1 = q1 = 30 and p = 90

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2.4. The monopoly will make more profit than the duopoly will, so the monopoly is willing to
pay the college more rent. Although granting monopoly rights may be attractive to the college in
terms of higher rent, students will suffer (lose consumer surplus) because of the higher textbook
prices.

2.10. a. The profit for firm 1 is: π1 = (120 – q1 – q2)q1 – 20q1.

From the first order condition,
π1/q1 = 120 – 2q1 – q2 – 20 = 0  q1 = 50 – q2/2
The profit for firm 2 is: π2 = (120 – q1 – q2)q2 – 30q2.
From the first order condition,
π1/q1 = 120 – q1 – 2q2 – 30 = 0  q2 = 45 – q1/2
Solving the two best response functions,
q1 = 110/3 q1 = 80/3 Q = 190/3 p = 170/3

b. When considering the collusive monopoly equilibrium, only firm 1 will produce because its
marginal cost is lower ($20 versus $30 per unit). The monopoly’s profit function will be
π = (120 – Q)Q – 20Q.
Setting marginal revenue equal to marginal cost,
120 – 2Q = 20  Q = 50 units,
All of outputs are produced by firm 1. Price is p = 120 – 50 = $70.

2.13. Firm 1’s best-response function is q1 = 60 – 0.25q2. Symmetrically, Firm 2’s best-response
function is q2 = 60 – 0.25q1. Substituting the best response function for Firm 2 into the best-
response function for Firm 1 and solving for q1, the equilibrium quantity for Firm 1 is 48 units.
Symmetrically, the equilibrium quantity for Firm 2 is 48 units.

2.14. a. Cournot-Nash equilibrium

π1 = (15 – q1 – q2)q1 – q1 π1/q1 = 15 – 2q1 – q2 – 1 = 0  q1 = 7 – q2/2
π2 = (15 – q1 – q2)q2 – 2q2 π1/q1 = 15 – 2q2 – q1 – 2 = 0  q2 = 13/2 – q1/2
 q1 = 5 q2 = 4 p = 6 CS = (9  9)/2 π1 = 25 π2 = 16 DWL = 25/2

b. Merger to be a monopoly
π = (15 – Q)Q – Q π/Q = 15 – 2Q – 1 = 0  Q = 7 and p = 8
 Q=7 p=8 π = 49 CS = (7  7)/2 DWL = 49/2

c. The average cost of production for the duopoly is [(5  1)  (4  2)]/(5  4) = 1.44, whereas
the average cost of production for the monopoly is 1. The increase in market power effect
swamps the efficiency gain, so consumer surplus falls while deadweight loss nearly doubles.

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3.3. Assume the figure illustrates the best-response curves for two firms with differentiated
products. These best-response curves initially intersect at e1. Then, suppose the demand curve for
Firm 1 shifts to the right. The best-response curves show the price each firm picks to maximize
its profit, given its belief about its rival’s price. As demand for Firm 1’s product increases, Firm
1’s best-response curve shifts to the right. The Nash-Bertrand equilibrium occurs at the
intersection of the best-response curves (at e2). At this point, the new equilibrium price for Firm
1 is higher, and the new equilibrium price for Firm 2 is higher.

3.4. Firm 1 wants to maximize its profit by choosing p1:

π1 = (p1 – 10)q1 = (p1 – 10)(100 – 2p1 + p2).
From the first order condition,
π1/p1 = 100 – 4p1 + p2 + 20 = 0  p1 = 30 + p2/4
Similarly, firm 2’s best-response function is p2 = 30 + p1/4. The Nash-Bertrand equilibrium
prices are p1 = p2 = 40, and each firm produces 60 units.

3.5. Each firm’s profit maximizing problems lead to

π1 = (p1 – 30)(100 – 2p1 + p2) π1/p1 = 100 – 4p1 + p2 + 60 = 0  p1 = 40 + p2/4
π2 = (p2 – 10)(100 – 2p2 + p1) π2/p2 = 100 – 4p2 + p1 + 20 = 0  p2 = 30 + p1/4
The Nash-Bertrand equilibrium are
p1 = 152/3 p2 = 128/3 q1 = 124/3 q2 = 196/3

3.6. The degree of profitability in a Bertrand market is directly related to the degree of product
differentiation (more differentiation = more profit). This differentiation can be real or imaginary.
In this instance if both Coke and Pepsi are bottling tap water, the differentiation would fall into
the imaginary category created by advertising. Nonetheless, the effect on profits is the same (and
may make the advertising expenditures pay off).

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4.2. The government subsidy reduces the fixed cost of production, pivoting each firm’s average
cost curve down. The market returns to a long-run equilibrium where firms again earn zero
profit. This occurs after new firms enter the industry, shifting individual firm demand curves to
the left until they are tangent to the new average cost curve with the subsidy. At the new long-
run equilibrium, individual firm prices are lower (because the tangency point between the new
demand and new average cost curves is lower).

4.4. If firms have identical costs and produce a homogeneous good, all firms earn zero profits.
However, even with free entry, firms face downward-sloping demand curves and are therefore
able to charge prices that exceed marginal costs. One important reason why demand curves slope
downward is that firms may sell differentiated products. However, it is possible that, even with
homogeneous products, the number of firms is small enough that firms face downward-sloping
firm-specific demand curves. As a result, in the long-run equilibrium, a monopolistically
competitive firm operates where its downward-sloping demand curve is tangent to its average
cost curve. Because its demand curve is downward sloping, its average cost curve must also be
downward sloping in the equilibrium.

5.1. a. The Cournot equilibrium in the absence of a government intervention is q1 = 30, q2 = 40, p
= 50, π1 = 900, and π2 = 1,600.
b. The Cournot equilibrium is now q1 = 33.3, q2 = 33.3, p = 53.3, π1 = 1,108.9, and π2 = 1,108.9.

5.2. As Firm 2’s profit was 1,600 in Question 5.1, a fixed cost slightly greater than 1,600 will
prevent entry.

Chapter 13 Solutions

2.2. Refer to 2.2 of Chapter 11. We found that q1 = q2 = 240 and p = 0.52. In Stackelberg
equilibrium, the reaction function of the follower (firm 2) is the same as that of Cournot
equilibrium. Firm 1’s profit function by substituting firm 2’s reaction function, is
π1 = [1 – 0.001(q1 + (360 – ½ q1)]q1 – 0.28q1.
First order condition is
dπ1/dq1 = 0.36 – 0.001q1 = 0
We get q1 = 360, and q2 = 360 – ½ (360) = 180.
The total Stackelberg output is 360 + 180 = 540, which exceeds the Cournot output of 480. The
Stackelberg price is 1 – 0.001(540) = $0.46 or 46¢, which is lower than the Cournot price.
Relative to the Cournot case, profit is higher for the leader and lower for the follower and
aggregate profits are lower in the Stackelberg case.

2.3. Inverse demand in this case is given by p=40−0.1 ( q A + qB ) where q A and q B denote the
output for firm A and B respectively. Firm B’s profit is: π B =( 40−0.1 q A −0.1 q B ) q B−20 qB
which can be simplified to π B =20 q B−0.1 q A q B−0.1 q 2B. The first order condition for Firm B’s

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 ∂π
optimization is =20−0.1 q A−0.2q B =0 which can be solved for Firm B’s best-response
∂ qB
function q B =100−0.5 q A. Firm A has a symmetric best-response function of q A=100−0.5 q B.
Solving these two best-response functions simultaneously gives us the Nash-Cournot solution of
66.7 units for each firm. To solve for the Stackelberg outcome substitute Firm B’s best-response
function into Firm A’s profit function and maximize. This gives Firm A’s optimal output as 100
and Firm B’s response as 50. Finally, if the two firms collude they each produce half of the
monopoly outcome (which is 100), so they each produce 50 units.
Here is a diagram for Firm B’s best-response function showing these outcomes.