Product Di¤erentiation - Part II

1. Two hairdressers (denoted 1 and 2) are located at each end of a 4 km

long street. The street is uniformly populated by 200 potential customers
who would like to have a haircut at one of the hairdressers. The cost of
travelling along the street is 5 euros per kilometer and each hairdresser has
a constant marginal cost of 2 euros per haircut.

(a) Let p1 and p2 be the price of a haircut at Hairdresser 1 and 2, respec-

tively. Given these prices, …nd the location of the indi¤erent consumer
and derive the demand function for each hairdresser.
b , is
Solution: The location of the indi¤erent consumer, denoted x
implicitly given by
b = p2 + 5 (4
p 1 + 5x b)
x
 and explicitly given by
p2 p1
b =2+
x :
10
(b) Find the Nash equilibrium of a game where the two hairdressers simul-
taneously choose the price of a haircut. Calculate also the demand and
pro…ts of each hairdresser.
Solution: The demand function of Hairdresser 1 is
b = 100 + 5 (p2
q1 = 50x p1 ) ;
so the pro…t function is

1 = (p1 2) (100 + 5 (p2 p1)) :

The …rst-order condition for pro…t maximisation is
@ 1
= 100 + 5 (p2 p1 ) 5 (p 1 2) = 0:
@p1
 Since the game is symmetric, the Nash equilibrium will be symmetric,
so we can set p1 = p2 and solve, yielding

p1 = p2 = 22:
This yields demand equal to 100 for each hairdresser, and pro…ts equal
to

1 = 2 = (22 2) 100 = 2000:

(c) Suppose that a third hairdresser (denoted 3) enters the market and
locates half way between the two hairdressers and charges a price p3
for a haircut. This hairdresser has the same costs as the two others.
Find the Nash equilibrium of a game where all three hairdressers choose
price simultaneously. Calculate demand and pro…ts of each hairdresser
in equilibrium.
Solution: Let x b denote the location of the consumer who is indif-
ferent between Hairdresser 1 and Hairdresser 3, and let yb denote the
location of the consumer who is indi¤erent between Hairdresser 3 and
Hairdresser 2. xb is implicitly given by

b = p3 + 5 (2
p 1 + 5x b)
x
and explicitly given by
p3 p1
b =1+
x ;
10
while yb is implicitly given by

p3 + 5 (yb 2) = p2 + 5 (4 yb)
and explicitly given by
p p3
yb = 3 + 2 :
10
Thus, the demand functions of the three hairdressers are
b = 50 + 5 (p3
q1 = 50x p1 ) ;

q2 = 50 (4 yb) = 50 + 5 (p3 p2 ) ;

q3 = 50 (yb b ) = 100 + 5 (p1 + p2

x 2p3) :
This game is partly symmetric, in the sense that Hairdresser 1 and 2
are symmetric and will therefore choose the same price in equilibrium.
We can therefore solve the problem for Hairdresser 1 and 3, then apply
symmetry by setting p2 = p1, and solve for p1 and p3.
The pro…t-maximisation problems of Hairdressers 1 and 3 are
max 1 = (p1 2) (50 + 5 (p3 p1))
p1
and
max 3 = (p3 2) (100 + 5 (p1 + p2 2p3)) :
p3
The …rst-order conditions are
@ 1
= 50 + 5 (p3 p1) 5 (p1 2) = 0
@p1
and
@ 3
= 100 + 5 (p1 + p2 2p3) 10 (p3 2) = 0:
@p3
Setting p2 = p1 and solving yields
p1 = p2 = p3 = 12:
Thus, it turns out that all three hairdressers set the same price in
equilibrium (even if the game is not symmetric). Demands are given
by
q1 = q2 = 50
and
q3 = 100:
 Pro…ts are given by

1 = 2 = (12 2) 50 = 500
and

3 = (12 2) 100 = 1000:

Notice that Hairdresser 3 has higher demand and higher pro…ts because
it has a locational advantage relative to the other two hairdressers.

2. Two fast-food restaurants are located in University Street, which is char-

acterised as the interval [0; 1]. Restaurant 1 is located at the point
x1 = 0:25, while Restaurant 2 is located at the point x2 = 0:75. A total
of 100 consumers are uniformly distributed on the interval [0; 1]. Each
consumer buys one meal from the most preferred restaurant – where the
price plus the transportation cost is lowest. When travelling to a restau-
rant consumers have to pay a transportation cost of 2 euros per unit of
distance travelled. The prices charged by the two restaurants are p1 and
p2, respectively.

(a) For given prices, …nd the location of the consumer who is indi¤erent
between the two restaurants.
b , is
Solution: The location of the indi¤erent consumer, denoted by x
implicitly given by

b
p1 + 2 ( x 0:25) = p2 + 2 (0:75 b)
x
and explicitly given by
p2 p1
b = 0 :5 +
x :
4
(b) Assume that both restaurants can serve meals for a constant marginal
cost of 1 euro. Calculate the Nash equilibrium when the restaurant set
prices simultaneously.
Solution: Demand for Restaurant 1 is

b = 50 + 25 (p2
q1 = 100x p1 ) ;
so the pro…t function is

1 = (p1 1) (50 + 25 (p2 p1)) :

The …rst-order condition for a pro…t-maximising price is
@ 1
= 50 + 25 (p2 p1) 25 (p1 1) = 0:
@p1
Since the game is symmetric, we can set p1 = p2 and solve, yielding

p1 = p 2 = 3 :
(c) Assume that marginal costs increase from 1 to 2 euros for both restau-
rants? What happens to prices and pro…ts in the new equilibrium?
Solution: In this case, the pro…t function of Restaurant 1 is

1 = ( p1 2) (50 + 25 (p2 p1)) ;

so the …rst-order condition changes to
@ 1
= 50 + 25 (p2 p1) 25 (p1 2) = 0:
@p1
Applying symmetry and solving yields

p1 = p 2 = 4 :
Equilibrium demand is 50 for each restaurant before and after the cost
increase. Before the cost increase, equilibrium pro…ts were

1 = 2 = (3 1) 50 = 100:
 After the cost increase, pro…ts are

1 = 2 = (4 2) 50 = 100:
Thus, the cost increase does not a¤ect pro…ts. The cost increase is
entirely passed on to consumers in the form of a higher price. The
reason is that total demand is …xed, which means that prices can be
increased without a loss in total demand.

(d) Assume that the owner of Restaurant 1 can relocate her restaurant (by
a small distance) before the restaurants set prices. In which direction
does she want to relocate? Prove your answer!
Solution: Let the location of Restaurant 1 be given by 0:25 + a. The
indi¤erent consumer is then located at
p2 p1
b
x = 0:5 (1 + a) + ;
4
and demand for the two restaurants are given by

b = 50 (1 + a) + 25 (p2
q1 = 100x p1 )
and
q2 = 100 (1 b ) = 50 (1
x a) 25 (p2 p1 ) :
Notice that we recover the previous demand functions if a = 0.
Simultaneously solving the pro…t-maximising problems of the two restau-
rants (assuming marginal cost equal to 1) yields the following equilib-
rium prices:
2
p1 = 3 + a;
3
2
p2 = 3 a:
3
The equilibrium pro…ts of Restaurant 1 are
100
1= (3 + a)2 :
9
We see that these pro…ts are increasing in a. Thus, Restaurant 1 would
increase its pro…ts by relocating in the direction of Restaurant 2 (notice
that a positive value of a implies a location to the right of 0:25).
Notice here the di¤erence between this result and the result derived in
the lecture (see the slides), where the subgame perfect Nash equilibrium
of a game with endogenous locations was locations at the endpoints,
i.e., maximum di¤erentiation. The explanation for the results derived
in the lecture is that the price competition e¤ect is stronger than the
market share e¤ect, so that each …rm has an incentive to locate away
from the rival …rm in order to dampen price competition. In this exer-
cise it is the opposite: each …rm has an incentive to relocate towards
the rival …rm. So in this exercise, the price competition e¤ect is weaker
 than the market share e¤ect. But notice the di¤erence in assumptions
between the two games. In the game derived in the lecture, we assume
that travelling costs are quadratic in distance, while in this exercise we
assume that travelling costs are linear in distance. Such a small di¤er-
ence in the model assumptions can lead to very di¤erent outcomes!

3. Two stores are located at each endpoint of a line of length 1: Store 1 is

located at 0 and Store 2 is located at 1. The two stores o¤er the same good
at prices p1 and p2, respectively. Each store has a constant marginal cost
of 2 euros for the good. Suppose that there are 90 consumers uniformly
distributed on the line. Each consumer wants to buy one unit of the good
from the most preferred store, and the choice of store is made to minimise
total consumption expenditures (price + transportation costs). Because of
heavy wind, it is more costly for the consumers to travel to Store 1 than to
Store 2. Travelling to Store 1 implies a transportation cost of 6 euros per
unit of distance, while travelling to Store 2 implies a transportation cost
of only 3 euros per unit of distance.

(a) Calculate the demand function for each store.

b , is
Solution: The location of the indi¤erent consumer, denoted by x
implicitly given by
b = p2 + 3 (1
p 1 + 6x b) ;
x
and explicitly given by
1 p 2 p1
b=
x + :
3 9
The demand functions are given by
b = 30 + 10 (p2
q1 = 90x p1 ) ;

q2 = 90 (1 b ) = 60
x 10 (p2 p1 ) :
(b) Suppose that the two stores choose prices simultaneously. Find the
Nash equilibrium.
Solution: The pro…t-maximisation problems of the two stores are given
by
max 1 = (p1 2) (30 + 10 (p2 p1))
p1
and
max 2 = (p2 2) (60 10 (p2 p1)) :
p2
The …rst-order conditions are
@ 1
= 30 + 10 (p2 p1 ) 10 (p1 2) = 0
@p1
and
@ 2
= 60 10 (p2 p1 ) 10 (p2 2) = 0:
@p2
 Simultaneously solving the two …rst-order conditions yields

p1 = 6 and p2 = 7:

(c) In equilibrium, how many consumers buy from each of the stores? What
are the pro…ts of each store?
Solution: Plugging the equilibrium prices into the demand functions
yields
q1 = 40 and q2 = 50:
The pro…ts are

1 = (6 2) 40 = 160
and

2 = (7 2) 50 = 250:
4. Two hairdressers (denoted 1 and 2) are located at each end of a 3 km
long street. The street is uniformly populated by 120 potential customers
who would like to have a haircut at one of the hairdressers. The cost of
travelling along the street is 2 euros per kilometer and each hairdresser has
a constant marginal cost of 3 euros per haircut.

(a) Let p1 and p2 be the price of a haircut at Hairdresser 1 and 2, respec-

tively. Given these prices, …nd the location of the indi¤erent consumer
and derive the demand function for each hairdresser.
b , is
Solution: The location of the indi¤erent consumer, denoted by x
implicitly given by
b = p2 + 2 (3
p 1 + 2x b) ;
x
and explicitly given by
p2 p1
b = 1 :5 +
x :
4
(b) Find the Nash equilibrium of a game where the two hairdressers simul-
taneously choose the price of a haircut. Calculate also the demand and
pro…ts of each hairdresser.
Solution: We start out by deriving the demand functions, which are
given by
b = 60 + 10 (p2
q1 = 40x p1 )
and
q2 = 40 (3 b ) = 60
x 10 (p2 p1 ) :
The game is symmetric, so we only need to solve the problem for one
of the hairdressers. Consider Hairdresser 1, who solves the following
problem:
max 1 = (p1 3) (60 + 10 (p2 p1)) :
p1
 The …rst-order condition is
@ 1
= 60 + 10 (p2 p1) 10 (p1 3) = 0:
@p1
Applying symmetry and solving yields
p1 = p 2 = 9 :
This yields the following demand and pro…ts:
q1 = q2 = 60;

1 = 2 = (9 3) 60 = 360:

(c) Suppose that a third hairdresser (denoted 3) enters the market and
locates in the same building as Hairdresser 1, at the endpoint of the
street. Find the Nash equilibrium of a game where all three hairdressers
choose price simultaneously. Calculate demand and pro…ts of each
hairdresser in equilibrium.
Solution: The two hairdressers that are co-located are homogeneous
in the eyes of the consumers, so competition between them will drive
their prices down to marginal cost. Thus, in equilibrium:
p1 = p 3 = 3 :
Hairdresser 2 solves the following problem:
max 1 = (p2 3) (60 10 (p2 p1)) ;
p2
where p1 = p3 = 3 in equilibrium. The …rst-order condition is
@ 2
= 60 10 (p2 p1) 10 (p2 3) = 0:
@p2
Setting p1 = 3 and solving for p2 yields
p2 = 6 :
Equilibrium demand is therefore
q1 + q3 = 60 + 10 (6 3) = 90
 and
q2 = 120 90 = 30:
Equilibrium pro…ts are given by

1 = 3=0
and

2 = (6 3) 30 = 90:

5. Suppose that there are two stores located at each end of a 6 kilometer long
street. The two stores o¤er the same good and have the same constant
marginal cost of 8 euros for selling the good. Suppose that there are 240
consumers uniformly distributed along the street. Each consumer wants
to buy one unit of the good from the most preferred store, and the choice
of store is made to minimise total consumption expenditures (price +
transportation costs). The cost of travelling along the street is 4 euros per
kilometer.

(a) Calculate the demand function for each store.

b , is
Solution: The location of the indi¤erent consumer, denoted by x
implicitly given by

b = p2 + 4 (6
p 1 + 4x b) ;
x
and explicitly given by
p2 p1
b =3+
x :
8
The demand functions are given by

b = 120 + 5 (p2
q1 = 40x p1 )
 and
q2 = 40 (6 b ) = 120
x 5 (p2 p1 ) :

(b) Suppose that the two stores choose prices simultaneously. Find the
Nash equilibrium.
Solution: The problem of Store 1 is

max 1 = (p1 8) (120 + 5 (p2 p1)) :

p1
The …rst-order condition is
@ 1
= 120 + 5 (p2 p1) 5 (p 1 8) = 0:
@p1
Applying symmetry and solving yields

p1 = p2 = 32:
(c) Calculate the demand and pro…ts for each store in equilibrium.
Solution: Plugging the equilibrium prices into the demand functions
yields
q1 = q2 = 120:
The pro…ts are

1 = 2 = (32 8) 120 = 2880:

(d) Suppose that a third store, o¤ering the same good, enters the market
and locates at the exact same location as one of the two existing
stores. Find the Nash equilibrium of a game where the three stores
choose prices simultaneously.
Solution: Suppose that Store 3 locates in the same point as Store
2. In this case, competition between these two stores will drive their
 prices to marginal cost, so that p2 = p3 = 8 in equilibrium. Plugging
p2 = 8 into the …rst-order condition of Store 1 (derived under (b)),
and solving for p1, yields
p1 = 20:

(e) Suppose that the third store does not co-locate with one of the existing
stores, but locates instead at the mid-point of the street. What is the
Nash equilibrium in this case? Calculate also demand and pro…ts in
equilibrium.
Solution: In this case there will be two types of indi¤erent consumers,
those that are indi¤erent between Store 1 and Store 3, and those that
are indi¤erent between Store 3 and Store 2. The location of the former
type, denoted by xb , is implicitly given by

b = p3 + 4 (3
p 1 + 4x b)
x
and implicitly given by
p3 p1
b = 1 :5 +
x ;
8
while the location of the latter type, denoted by yb, is implicitly given
by
p3 + 4 (yb 3) = p2 + 4 (6 yb)
and explicitly given by
p2 p3
yb = 4:5 + :
8
Demand for the three stores is then given by

b = 60 + 5 (p3
q1 = 40x p1 ) ;

q2 = 40 (6 yb) = 60 + 5 (p3 p2 ) ;
 q3 = 40 (yb b ) = 120 + 5 (p1 + p2
x 2p3) :

The pro…t-maximisation problem of Store 1 is

max 1 = (p1 8) (60 + 5 (p3 p1)) ;

p1
and the equivalent problem of Store 3 is

max 3 = (p3 8) (120 + 5 (p1 + p2 2p3)) :

p3
The …rst-order conditions are
@ 1
= 60 + 5 (p3 p1) 5 (p1 8) = 0
@p1
and
@ 2
= 120 + 5 (p1 + p2 2p3) 10 (p3 8) = 0:
@p2
Since Store 1 and Store 2 are symmetric, they will choose the same
price in equilibrium. We can therefore set p2 = p1 and solve the
…rst-order conditions for Store 1 and Store 3 for p1 and p3. This yields

p1 = p2 = p3 = 20:
Thus, all three stores set the same price in equilibrium (even if Stores
1/2 and Store 3 are asymmetrically located). Equilibrium demand is
given by
q1 = q2 = 60
and
q3 = 120:
Pro…ts are

1 = 2 = (20 8) 60 = 720
 and
3 = (20 8) 120 = 1440:
Notice that Store 3 has higher demand, and therefore higher pro…ts,
because it has a better location than the two other stores.

6. Two hairdressers are located at the endpoints of a 4 kilometer long street:

Hairdresser 1 is located at the West end while Hairdresser 2 is located at
the East end. There are 1000 potential customers uniformly distributed
along the street. Each of them would like to go to one of the hairdressers to
have a haircut. The two hairdressers charge prices p1 and p2, respectively,
and the cost of travelling along the street is 3 euros per kilometer. Each
consumer chooses a hairdresser based on price and transportation costs.
However, if the price plus transportation cost is higher than 40 euros,
consumers prefer to let their hair grow. Each hairdresser has a constant
marginal cost of 10 euros.
(a) With the assumption that all consumers prefer to go to a hairdresser
rather than letting their hair grow, …nd the location (as a function of
prices) of the consumer who is indi¤erent between the two hairdressers.
b , is
Solution: The location of the indi¤erent consumer, denoted by x
implicitly given by

b = p2 + 3 (4
p 1 + 3x b)
x
and explicitly given by
p2 p1
b =2+
x :
6
(b) Calculate the demand function for each hairdresser.
Solution: The demand functions are given by
250
b = 500 +
q1 = 250x (p2 p1 )
3
 and
250
q2 = 250 (4 b ) = 500
x (p2 p1 ) :
3
(c) Suppose that the two hairdressers choose prices simultaneously. Find
the Nash equilibrium and calculate the pro…ts of each hairdresser. Ver-
ify that, in equilibrium, every potential customer prefers to go to a
hairdresser rather than letting the hair grow.
Solution: The pro…t-maximisation problem of Hairdresser 1 is
250
max 1 = (p1 10) 500 + (p2 p1 ) :
p1 3
The …rst-order condition is
@ 1 250 250
= 500 + (p2 p1 ) (p1 10) = 0:
@p1 3 3
 Because of symmetry, we can set p2 = p1 and solve for p1, which
yields
p1 = p2 = 16:
This gives a demand of 500 for each hairdresser, and pro…ts are given
by
1 = 2 = (16 10) 500 = 3000:
With equal prices, the customer with the highest cost of going to a
hairdresser is one of the customers located at the middle of the street.
Such a customer has travelling costs of 2 3 = 6 and a therefore a
total cost of 16+6 = 22 < 40. Thus, every potential customer prefers
going to a hairdresser.

(d) Suppose that instead of there being two independent hairdressers, there
is a monopolist who owns and operates both hairdressing salons. Which
price should the monopolist choose in order to maximise total pro…ts?
Solution: A monopolist would set prices as high as possible while still
inducing all customers to demand a haircut from one of the salons.
Because of symmetry, this implies equal prices at both salons, and the
highest price that induces a demand of 1000 is a price that makes a
consumer located at the middle of the street (i.e., the consumer with
the longest travelling distance to any of the salons) indi¤erent between
going or not. Such a consumer has a travelling cost of 6 to any of the
salons, so this price is implicitly given by

p + 6 = 40;
yielding
p1 = p2 = 34:
Total pro…ts would then be given by

1 + 2 = (34 10) 1000 = 24000:

7. Two restaurants (denoted 1 and 2) are located at each end of a 10km
long street. Both restaurants o¤er exactly the same menu with the same
quality of food. There are 800 potential customers who are uniformly
located along the street. Each potential customer wants to buy one meal
and will choose the restaurant that minimizes the consumer’s total costs. In
addition to the price charged by the restaurant, each consumer also has to
pay transportation costs equal to 2 euros per kilometer. Both restaurants
have the same costs per meal they serve: 5 euros.

(a) Suppose that the two restaurants choose prices (p1 and p2) simulta-
neously. Find the Nash equilibrium. How much does each restaurant
earn in equilibrium.
Solution: We start out by …nding the location of the indi¤erent con-
b , which is implicitly given by
sumer, denoted by x
b = p2 + 2 (10
p 1 + 2x b)
x
and explicitly given by
p2 p1
b =5+
x :
4
Demand for the two restaurants are then given by

b = 400 + 20 (p2
q1 = 80x p1 )
and
q2 = 80 (10 b ) = 400
x 20 (p2 p1 ) :
The pro…t-maximisation problem of Restaurant 1 is

max 1 = (p1 5) (400 + 20 (p2 p1)) :

p1
The …rst-order condition is
@ 1
= 400 + 20 (p2 p1 ) 20 (p1 5) = 0:
@p1
 Because of symmetry, we can set p2 = p1 and solve for p1, yielding

p1 = p2 = 25:
Thus, in equilibrium each restaurant has 400 customers and earn a
pro…t of

1 = 2 = (25 5) 400 = 8000:

(b) Suppose that a third restaurant (denoted 3) enters the market and
locates half way between the two existing restaurants. If all restau-
rants choose prices simultaneously, what is the new Nash equilibrium?
Calculate also the market shares and pro…ts of each restaurant.
Solution: In this case there will be two types of indi¤erent consumers,
those that are indi¤erent between Restaurant 1 and Restaurant 3, and
those that are indi¤erent between Restaurant 3 and Restaurant 2. The
 b , is implicitly given by
location of the former type, denoted by x

b = p3 + 2 (5
p 1 + 2x b)
x
and implicitly given by
p3 p1
b = 2 :5 +
x ;
4
while the location of the latter type, denoted by yb, is implicitly given
by
p3 + 2 (yb 5) = p2 + 2 (10 yb)
and explicitly given by
p2 p3
yb = 7:5 + :
4
Demand for the three restaurants is then given by

b = 200 + 20 (p3
q1 = 80x p1 ) ;
 q2 = 80 (10 yb) = 200 + 20 (p3 p2 ) ;

q3 = 80 (yb b ) = 400 + 20 (p1 + p2

x 2p3) :

The pro…t-maximisation problem of Restaurant 1 is

max 1 = (p1 5) (200 + 20 (p3 p1)) ;

p1
and the equivalent problem of Restaurant 3 is

max 3 = (p3 5) (400 + 20 (p1 + p2 2p3)) :

p3
The …rst-order conditions are
@ 1
= 200 + 20 (p3 p1) 20 (p1 5) = 0
@p1
and
@ 2
= 400 + 20 (p1 + p2 2p3) 40 (p3 5) = 0:
@p2
Since Restaurant 1 and Restaurant 2 are symmetric, they will choose
the same price in equilibrium. We can therefore set p2 = p1 and solve
the …rst-order conditions for Restaurant 1 and Restaurant 3 for p1 and
p3. This yields
p1 = p2 = p3 = 15:
Thus, all three restaurants set the same price in equilibrium (even if
Restaurant 1/2 and Restaurant 3 are asymmetrically located). Equi-
librium demand is given by

q1 = q2 = 200
and
q3 = 400:
Pro…ts are

1 = 2 = (15 5) 200 = 2000

 and

3 = (15 5) 400 = 4000:

Notice that Restaurant 3 has higher demand, and therefore higher prof-
its, because it has a better location than the two other restaurants.

8. Two restaurants are located one a street that is 2 kilometers long. Restau-
rant 1 is located 200 meters from one end of the street, while Restaurant
2 is located 200 meters from the other end. There are 400 consumers
uniformly distributed along the entire street. Both restaurants o¤er only
one type of meal and each consumer wants to buy a meal in one of the
restaurants if the price plus travelling costs do not exceed 20 euros. Trav-
elling costs are 4 euros per kilometer. Both restaurants have the same
production costs; it costs 5 euros to make and serve one meal.
(a) Find the location of the consumer who is indi¤erent between the two
restaurants.
b , is implicitly given by
Solution: This location, denoted by x

b
p1 + 4 (x 0:2) = p2 + 4 (1:8 b)
x
and explicitly given by
p2 p1
b =1+
x :
8
(b) Find the demand for each restaurant as a function of prices.
Solution: The demand functions are

b = 200 + 25 (p2
q1 = 200x p1 )
and
q2 = 200 (2 b ) = 200
x 25 (p2 p1 ) :
(c) Assume that the two restaurants simultaneously and independently
choose the price of a meal. Find the Nash equilibrium prices.
Solution: Restaurant 1 solves the following problem:

max 1 = (p1 5) (200 + 25 (p2 p1)) :

p1
The …rst-order condition is
@ 1
= 200 + 25 (p2 p1) 25 (p1 5) = 0:
@p1
Because of symmetry, we can set p2 = p1 and solve for p1, yielding

p1 = p2 = 13:

(d) Suppose that the owner of Restaurant 1 can relocate her restaurant (by
a small distance) before the restaurants set prices. In which direction
does she want to relocate? Prove your answer!
Solution: Let the location of Restaurant 1 be given by 0:2 + a. The
indi¤erent consumer is then located at
a p 2 p1
b =1+ +
x ;
2 8
and demand for the two restaurants are given by

b = 200 + 100a + 25 (p2

q1 = 200x p1 )
and
q2 = 200 (2 b ) = 200
x 100a 25 (p2 p1 ) :
Notice that we recover the previous demand functions if a = 0.

200 + 100a + 25 (p2 p1 ) 25 (p1 5) = 0

200 100a 25 (p2 p1 ) 25 (p2 5) = 0
Simultaneously solving the pro…t-maximising problems of the two restau-
rants yields the following equilibrium prices:
4
p1 = 13 + a;
3
4
p2 = 13 a:
3
The equilibrium pro…ts of Restaurant 1 are
400
1= (6 + a)2 :
9
We see that these pro…ts are increasing in a. Thus, Restaurant 1 would
increase its pro…ts by relocating in the direction of Restaurant 2 (notice
that a positive value of a implies a location to the right of 0:2).
Notice here the di¤erence between this result and the result derived in
the lecture (see the slides), where the subgame perfect Nash equilibrium
of a game with endogenous locations was locations at the endpoints,
 i.e., maximum di¤erentiation. For a further explanation, see the solu-
tion to Exercise 2 (d), which is similar.

(e) Assume now that instead of being two independent restaurants, there
is a monopolist who owns and operates both restaurants. Which price
should the monopolist choose in order to maximise total pro…ts?
Solution: A monopoly owner would maximise pro…ts by choosing the
same price for both restaurants, and this price should be the highest
possible price that still guarantees demand from all potential customers
in the market. This must be a price that makes the customer with the
highest travelling costs indi¤erent between attending a restaurant or
not. Such a customer is located at the midpoint of the street and has
travelling costs (to either of the restaurants) equal to 4. Since the
maximum willingness to pay is 20, the highest price that would make
this customer want to attend a restaurant is 20 4 = 16.
9. Consider the market for air travel between City A and City B. There are
three airline companies (1, 2 and 3) each o¤ering one daily ‡ight from
Porto to Paris: Airline 1’s ‡ight departs at 8am, Airline 2’s ‡ight departs
at 2pm and Airline 3’s ‡ight departs at 8pm. There are 6000 potential
daily customers. Each airline company has a constant cost of 100 euros
per passenger. The consumers are heterogeneous with respect to their
preferences for departure times, where each consumer is characterised by
a "most preferred departure time". Suppose that, for each consumer, the
disutility of departing at a time which di¤ers from his/her most preferred
departure time is 5 euros per hour di¤erence. Each consumer’s maximum
willingness to pay for a ‡ight (price plus "transportation costs") is 250
euros.

(a) Consider two di¤erent distributions of consumer preferences. For each

of these two cases, determine which model is the most appropriate:
Hotelling or Salop.
 i. Consumers’ most preferred departure time is uniformly distributed
over the 12-hour interval between 8am and 8pm.
Solution: Hotelling, since the distribution of consumers has a start-
ing point and an endpoint.

ii. Consumers’ most preferred departure time is uniformly distributed

over the entire 24-hour interval.
Solution: Salop, since there is no starting point or endpoint to the
distribution.

(b) Suppose that the three airline companies choose prices simultaneously.
Find the Nash equilibrium for each of the two assumptions on consumer
preferences given in (a).
Solution: Case (i): Airline 1 is located at 0; Airline 2 at 6 and Airline
3 at 12. The consumer indi¤erent between 1 and 2 is located at x1,
implicitly given by
p p1
p1 + 5x1 = p2 + 5 (6 x1 ) , x1 = 3 + 2 :
10
The consumer indi¤erent bewteen 2 and 3 is located at x2, implicitly
given by
p3 p2
p2 + 5 (x2 6) = p3 + 5 (12 x2 ) , x2 = 9 + :
10
Since consumer density is constant and equal to 6000
12 = 500, demand
is given by

q1 = 500x1 = 1500 + 50 (p2 p1) ;

q2 = 500 (x2 x1) = 3000 100p2 + 50 (p1 + p3) ;
q3 = 500 (12 x2) = 1500 + 50 (p2 p3) :
The Nash equilibrium is given by the solution to

max 1 = (p1 100) (1500 + 50 (p2 p1)) ;

p1
max 2 = (p2 100) (3000 100p2 + 50 (p1 + p3)) ;
p2
max 3 = (p3 100) (1500 + 50 (p2 p3)) ;
p3
which yields
p1 = p2 = p3 = 130;
and

q1 = q3 = 1500;
q2 = 3000:
Case (ii): Let Airline 1 be located at 0 (and 24); Airline 2 at 6 and
Airline 3 at 12. The consumer indi¤erent between 1 and 2 is located
at x1, implicitly given by
p p1
p1 + 5x1 = p2 + 5 (6 x1 ) , x1 = 3 + 2 :
10
The consusmer indi¤erent between 2 and 3 is located at x2, implicitly
given by
p3 p2
p2 + 5 (x2 6) = p3 + 5 (12 x2 ) , x2 = 9 + :
10
The consusmer indi¤erent between 1 and 3 is located at x3, implicitly
given by
p1 p3
p 3 + 5 ( x3 12) = p1 + 5 (24 x3) , x3 = 18 + :
10
Since consumer density if constant and equal to 6000
24 = 250, demand
is
q1 = 250 (x1 + 24 x3) = 2250 + 25 (p2 + p3) 50p1;
q2 = 250 (x2 x1) = 1500 + 25 (p1 + p3) 50p2;
q3 = 250 (x3 x2) = 2250 + 25 (p1 + p2) 50p3:
The Nash equilibrium is given by the solution to
max 1 = (p1 100) (2250 + 25 (p2 + p3) 50p1) ;
p1
max 2 = (p2 100) (1500 + 25 (p1 + p3) 50p2) ;
p2
max 3 = (p3 100) (2250 + 25 (p1 + p2) 50p3) ;
p3
which yields
p1 = p3 = 142; p2 = 136;
and
q1 = q3 = 2100; q2 = 1800:
10. Assume that all …rms on the Hotelling line (with length 1) are required to
charge the same …xed price; location is their only strategic variable. The
…rms produce otherwise identical products and consumers are uniformly
distributed on the line.

(a) Suppose that there are three …rms choosing locations simultaneously.
Explain why there does not exist a (pure-strategy) Nash equilibrium in
this case.
Solution: For any triple of locations, where the …rms are located at
di¤erent points on the line, the …rm located to the left and the …rm
located to the right would each have an incentive to relocate towards
the …rm in the middle. But if all …rms are located at the same point, for
example at the midpoint, each …rm would have an incentive to relocate
slightly to the left or right in order to increase demand. Thus, no Nash
equilibrium in pure strategies exist.
 (b) Suppose instead that the …rms choose locations sequentially and that
Firm 1 is already located at 14 . Suppose that Firm 2 chooses location
before Firm 3. Find the subgame perfect Nash equilibrium in locations.
Solution: Firm 2 locates at 34 and Firm 3 locates at 12 . With these
locations, neither Firm 2 nor Firm 3 has any incentives to unilaterally
change their locations, given that Firm 1 is already located at 14 .

11. Two restaurants are located at each end of the Main Street, which is 10
kilometers long. Restaurant 1 is located at the west end while Restaurant 2
is located at the east end. There are 1000 potential customers living along
Main Street, and they are uniformly spread out along the entire distance
of the street. Each consumer is willing to pay at most 20 euros for a meal
in either of the restaurants. The choice of restaurant for each consumer is
made to minimise total expenditures (price + transportation costs). The
price of the meal in the two restaurants are p1 and p2, respectively, while
transportation costs are 1 euro per kilometer travelled. Both restaurants
have the same production costs: 4 euros per meal. Each restaurant chooses
its price to maximise the restaurant’s pro…t.

(a) Find an expression for the location of the consumer who is indi¤erent
between the two restaurants.
b , is implicitly given by
Solution: This location, denoted by x

b = p2 + 10
p1 + x b
x
and explicitly given by
p2 p1
b =5+
x :
2
(b) Calculate the demand function for each restaurant.
 Solution: The demand functions are given by

b = 500 + 50 (p2
q1 = 100x p1 )
and
q2 = 100 (10 b ) = 500
x 50 (p2 p1 ) :

(c) Find the Nash equilibrium prices when the two restaurants choose prices
simultaneously. Calculate the equilibrium pro…ts for each restaurant.
Solution: Restaurant 1 solves the following problem:

max 1 = (p1 4) (500 + 50 (p2 p1)) :

p1
The …rst-order condition is
@ 1
= 500 + 50 (p2 p1 ) 50 (p1 4) = 0:
@p1
 Because of symmetry, we can set p2 = p1 and solve for p1, yielding

p1 = p2 = 14:
This gives a demand of 500 for each restaurant, so equilibrium pro…ts
are

1 = 2 = (14 4) 500 = 5000:

(d) Suppose that Restaurant 1 has the opportunity to move 3 kilometers

up the street, in the direction of the other restaurant.

i. What would be the new equilibrium prices if Restaurant 1 made the

move?
Solution: After the move, the location of the indi¤erent consumer
would be implicitly given by

b
p1 + x 3 = p2 + 10 b
x
and explicitly given by
p2 p1
b = 6 :5 +
x :
2
Demand is then given by

b = 650 + 50 (p2
q1 = 100x p1 )
and
q2 = 100 (10 b ) = 350
x 50 (p2 p1 ) :
Simultaneously solving the pro…t-maximisation problems of the two
restaurants yields the following equilibrium prices:

p1 = 15 and p2 = 13:
This yields demand for each restaurant of

q1 = 550 and q2 = 450;

 so pro…ts are given by

1 = (15 4) 550 = 6050

and

2 = (13 4) 450 = 4050:

ii. How much would the owner of Restaurant 1 be willing to pay in

order to make the move?
Solution: By making the move, the pro…ts of Restaurant 1 increases
from 5000 to 6050, so the owner should be willing to pay at most
6050 5000 = 1050 to make the move.

12. Two stores are located at each end of a 4 kilometer long street, with Store
1 located at the Western endpoint and Store 2 located at the Eastern
endpoint. Both stores o¤er the same product and have a constant marginal
cost of 10. The products are sold at prices p1 and p2, respectively. A
total of 120 consumers are uniformly distributed along the street. Each
consumer wants to buy one unit of the product if the total purchasing cost
is not above 100. The street is very steep, so the cost of travelling per
kilometer is 2 when travelling eastwards and 6 when travelling westwards.

(a) Find an expression for the demand function of each store.

Solution: As usual, we start our by …nding the location of the indif-
b , which is implicitly given by
ferent consumer, denoted by x

b = p2 + 2 (4
p 1 + 6x b) ;
x
and explicitly given by
p2 p1
b =1+
x :
8
 The demand functions are then given by
15
b = 30 +
q1 = 30x (p2 p1 ) ;
4
15
q2 = 30 (4 b ) = 90
x (p2 p1 ) :
4
(b) Suppose that the two stores choose prices simultaneously and indepen-
dently. Find the Nash equilibrium and calculate the demand and pro…ts
for each store.
Solution: The pro…t-maximisation problems of the two stores are given
by
15
max 1 = (p1 10) 30 + (p2 p1)
p1 4
and
15
max 2 = (p2 10) 90 (p2 p1 ) :
p2 4
The …rst-order conditions are
@ 1 15 15
= 30 + ( p2 p1 ) (p1 10) = 0
@p1 4 4
and
@ 2 15 15
= 90 (p2 p1 ) (p2 10) = 0:
@p2 4 4

15 15
30 + (p2 p1 ) (p1 10) = 0
4 4
15 15
90 (p2 p1 ) (p2 10) = 0
4 4
 Simultaneously solving the two …rst-order conditions yields
70 86
p1 = and p2 = :
3 3
Demand is then given by

q1 = 50 and q2 = 70:
The pro…ts are
70 2000
1= 10 50 =
3 3
and
86 3920
2= 10 70 = :
3 3

13. Consider the Hotelling model that was presented in class (see lecture
notes). Suppose that the …rms can locate outside the Hotelling line. That
is, the …rms can locate anywhere on the real line (from 1 to +1) while
all the consumers are located (with uniform distribution) between 0 and
1. Find the equilibrium locations and prices in the two-stage game where
the …rms …rst choose locations and then choose prices.

Solution: Since the game is symmetric, we only need to consider the

problem of one of the …rms. The equilibrium pro…t of Firm 1 in the
second-stage game is (see the slides):
t
1= (b a) (2 + a + b)2 :
18
If we let Firm 1 choose a to maximise these pro…ts, the …rst-order condition
for an interior solution is given by
@ 1 t
= (2 + a + b) (2 + 3a b) = 0 :
@a 18
By symmetry, we can set b = 1 a and solve for a, yielding
1 5
a= and b = .
4 4
The equilibrium prices are then given by
3
p1 = p2 = c + t (b a) = c + t:
2