Practice Midterm

Question 1
Suppose there are two beer companies: LowCo and HighCo. LowCo produces a beer that has a
low alcohol content (ABV 3%), while the other company HighCo produces a beer that has a high
ABV (11%). Their marginal costs are 𝑐𝑙 and 𝑐ℎ, respectively. Note that 𝑐𝑙 and 𝑐ℎ might differ.
Assume there are 100 consumers whose preferences for alcohol content (ABV) are uniformly
distributed between 3% and 11%. Consumers all value drinking their ideal beer at $𝑉 but dislike
a beer with a different ABV than their ideal ABV by $1 per percentage point. That is, if I prefer a
beer with 4% ABV and I drink the light beer, my utility will be $1 lower. If I prefer a beer with
3.5% and I drink the light beer my utility will be $0.5 lower. Assume 𝑉 is high enough so that all
consumers buy a beer. The two companies compete by choosing prices simultaneously. We
observe that the prices are 𝑝𝑙=55/6 and 𝑝ℎ=28/3, respectively.

(a) (4 pts) Find an expression for the location of marginal consumer given 𝑝𝑙 and 𝑝ℎ. In other
words, given prices, what is the ABV preference for a consumer who is indifferent between
consuming the light beer and the heavy beer. Call this function 𝑥𝑚(𝑝𝑙,𝑝ℎ).
(b) (5 pts) Using this expression, what is the demand curve for the two beers? (c) (5 pts) What is
the best response function of each firm?
(d) (6 pts) Estimate cost parameters 𝑐𝑙 and 𝑐ℎ.
(e) (5 pts) Calculate the marginal consumer 𝑥𝑚's surplus if 𝑉=20.
(f) (5 pts) If 𝑉 is small enough, some consumers would find it not worthwhile to buy a beer.
What is the minimum value of 𝑉 such that all consumers buy a beer in equilibrium?

Question 2
Suppose there are two health insurance companies in Canada, AlphaCo and BetaCo. Overall
demand for health insurance in Canada is described by a linear demand curve 𝑃=60−𝑄, where
𝑄=𝑞𝑎+𝑞𝑏. Marginal cost is 𝑐𝑎 at AlphaCo and 𝑐𝑏 at BetaCo. Note that 𝑐𝑎 and 𝑐𝑏 might differ.
Suppose AlphaCo is the Stackelberg leader and is able to choose their quantity before BetaCo.
BetaCo then responds to the choice by AlphaCo. We observe that 𝑞𝑎=25,𝑞𝑏=12.5.

(a) (6 pts) Solve for BetaCo's optimal strategy in the Stackelberg game.
(b) (3 pts) Estimate BetaCo's marginal cost 𝑐𝑏.
(c) (8 pts) Estimate AlphaCo's marginal cost 𝑐𝑎.
(d) (9 pts) Suppose BetaCo's marginal cost reduces by 1/2 so its new marginal cost is 12𝑐𝑏.
AlphaCo's marginal cost remains the same 𝑐𝑎. Predict the sales of each firm in the Stackelberg
game with the new set of marginal costs.

Question 3
Toronto and Vancouver are two separate markets. In Toronto, the market for house cleaning
service is served by three firms, Arya Cleaning, Bran Cleaning, and Cersei Cleaning (or A, B, and
C). These firms are engaged in (simultaneous) Cournot competition. In Vancouver, the market
for house cleaning service is served by a monopolist Drogo Cleaning (or D). Total demand for
house cleaning service is similar in the two cities, and can be described by 𝑃𝑚=𝛼−𝛽𝑄𝑚, where
𝑄𝑚 is the total quantity provided by all firms in market 𝑚=𝑇𝑜𝑟𝑜𝑛𝑡𝑜,𝑉𝑎𝑛𝑐𝑜𝑢𝑣𝑒𝑟. All four firms
have a linear total cost function described by 𝐶𝑖(𝑞𝑖)=𝑐𝑖×𝑞𝑖, where 𝑞𝑖 is the quantity produced by
firm 𝑖 and 𝑖∈{𝐴,𝐵,𝐶,𝐷}. Note that the marginal cost parameters 𝑐𝐴,𝑐𝐵,𝑐𝐶,𝑐𝐷 may differ. A
consulting firm in Toronto collected data on firms A, B and C: 𝑃𝑇𝑜𝑟𝑜𝑛𝑡𝑜=14, 𝑞𝐴=13/2, 𝑞𝐵=6,
𝑞𝐶=11/2. A consulting firm in Vancouver collected data on firm D: 𝑃𝑉𝑎𝑛𝑐𝑜𝑢𝑣𝑒𝑟=51/2,
𝑞𝐷=49/4.

(a) (4 pts) Estimate demand parameters 𝛼 and 𝛽 using sales and price data.
(b) (5 pts) What is the best response function of Arya Cleaning? (Hint: 𝑞𝐴 as a function of 𝑞𝐵,
𝑞𝐶 and the cost parameters.)
(c) (7 pts) Estimate the cost parameters 𝑐𝐴,𝑐𝐵,𝑐𝐶,𝑐𝐷. (Hint: Use the analogous of Arya's best
response to get B and C's best responses.)
(d) (6 pts) Suppose Arya Cleaning and Bran Cleaning propose a merger --- reducing the number
of firms in Toronto to two. The merged firm produce with the minimum marginal cost
(𝑐=min{𝑐𝐴,𝑐𝐵}). Calculate the post-merger quantity produced by firm C.
(e) (Hard, 10 pts) Assume 𝑁 identical firms with marginal cost 𝑐𝑁=2 enter the market of
Vancouver. Therefore, now there are 𝑁+1 firms in total in the market of Vancouver. These 𝑁+1
firms are engaged in (simultaneous) Cournot competition. What is the new equilibrium quantity
produced by Drogo Cleaning (firm D)? (Hint: 𝑞𝐷 as a function of 𝑁.)

Question 4
Suppose LuluApple Enterprise has gained exclusive rights to sell cloth face masks in Toronto.
The demand for cloth face masks (of the representative consumer) is described by 𝑄=40−𝑃,
where 𝑃 is the price per cloth face mask. LuluApple's total cost function for producing cloth face
mask is 𝐶(𝑄)=10×𝑄. Suppose LuluApple chooses the price to maximize its profit.

(a) (5 pts) Write down the monopolist's optimization problem where the monopolist chooses
prices. Derive the equilibrium price and the Lerner Index for LuluApple.

(b) (7 pts) Suppose that the monopolist finds out a new technology that could produce output
at a cost of 𝐶(𝑄)=6×𝑄+9. However, to make this change, LuluApple would have to restructure
the factory. Does LuluApple want to make this change, and if so, what is the most LuluApple
would be willing to pay to make this change?