MANAGERIAL ECONOMICS

Indian School of Business

Homework 4

Instructions.
1. There are 6 questions of 10 marks each. Some questions may have sub-questions. The
part markings for the sub-questions are equal. There is no part of part marking.

2. You have to show your workings. Although rough work will not be evaluated.
3. Write the final answer in a box to highlight it.
4. Be brief and to the point.

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Problem 1:
√
Arnab is a risk-averse decision maker whose utility function is given by U (I) = I , where I
denotes Arnab’s monetary payoff. Arnab has Rs. 6,00,625. He can either keep this, or he can
invest all this money in a machine tools factory. If he invests, then he may end up with Rs.
10,00,000 with probability 0.6, or Rs. 250,000 with probability 0.4. Should Arnab invest in
this factory?

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Problem 2:
An annuity provides insurance against out-living one’s financial resources. LEICO, a life
insurance company, takes a deposit from customers at age 60 years, and returns an annual
payment of Rs. 5000 till their death.

(a) Calculate the break-even deposit for LEICO if average population-wide life ex-
pectancy is 80 years. Assume a 5% interest rate.

(b) If potential customers have a sense of their life expectancy, based on factors such as the
longevity of their parents, who will purchase the annuity with the deposit you have
calculated above?

(c) If life expectancy is uniformly distributed in the population (up to a maximum of 100
years) and potential customers have a sense of their life expectancy, what is the deposit
that LEICO will ultimately end up charging? Who will finally buy this annuity?

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Problem 3:
Find the Cournot-Nash Equilibrium in a game with two French fry manufacturers, Fred- die’s
Fries and Charlie’s Chips. There are five levels of production: produce 200, 300, 400, 500 or
600 thousands tons of output. The numbers in the table below represent as (FF,CC) the
profits for Freddie’s Fries and Charlie’s Chips corresponding to the quantities they produce.

200 300 400 500 600

200 63,-1 28,-1 -2,0 -2,45 -3,19
300 32,1 2,2 2,5 3,0 2,3
400 54,1 95,-1 0,2 4,-1 0,4
500 1,-33 -3,43 -1,39 1,-12 -1,17
600 -22,0 1,-13 -1,88 -2,-57 -3,72

(a) What is the Nash Equilibrium output for this game assuming that the two firms choose
their production quantities simultaneously?

(b) What would be the equilibrium if Charlie’s Chips could choose its output first and
Freddie’s Fries chose second, taking Charlie’s decision as given.

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Problem 4:
Consider a Cournot duopoly in which the two firms have different marginal costs. The
inverse demand in the market is P (Q) = 15 − Q. The costs of firm A and firm B are
CA(qA) = 6qA and CB(qB) = 3qB, respectively.

(a) What is the best response (or reaction) function of firm A?

(b) What is the best response (or reaction) function of firm B?
(c) What are the equilibrium quantities produced by each firm?
(d) What is the market price?
(e) What are the profits of each firm?

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Problem 5:
(a) Firm A currently monopolizes its market and earns profits of $10 million1. Firm B is a
potential entrant that is thinking about entering the market. If B does not enter the
market, it earns profits of $0, while A continues to earn profits of $10 million. If B
enters, then A must choose between accommodating entry, or fighting it. If A
accommodates, then A earns $5 million and B earns $5 million. If A fights, then both
firms lose $5 million. Draw the game inextensive form and predict the outcome.

(b) Again, consider the above game. Now, suppose the decision of B to enter is re- versible
in the following way. After B enters the market, and A has decided to either fight or
accommodate, B can choose to remain in the market or exit. All payoffs from the above
game remain the same. However, if B decides to exit the market, then B suffers a loss
of $1 million, while A regains its old profits of $10 million. Draw the game in
extensive form and predict the outcome.

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This is Problem 6, Chapter 11 from Allen et al’s Managerial Economics.

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Problem 6:
The accompanying article presents a decision facing Robert Gates, the US Secretary of
Defense, who is trying to reduce costs for the US Air Force’s F-35 fighter program. The
engines for the plane are currently produced by Pratt and Whitney in Connecticut. Some
lawmakers want to start a second production line for the engines in Ohio, run by GE and
Rolls Royce. Mr. Gates argues that a single production line will save costs for the military,
while Ohio lawmakers (who value the jobs the second line will create) say that competition
will lower engine prices and increase the welfare accruing to the sole consumer – the US
military.
As a budget analyst at the Pentagon, you have been asked to analyze two possible
scenarios and advise Secretary Gates on production strategy. You determine that the
military’s demand curve for F-35 engines is given by P = 1000 − Q. The marginal cost of
production (revealed in Congressional filings) is $120 mm per plane for Pratt and
Whitney (the original incumbent) and $160 mm per plane for GE-Rolls Royce (the
potential entrant).

(a) What is the quantity of engines produced if Pratt and Whitney is the monopolist
supplier in the market? What is the price that the government has to pay for the
engines? What is the consumer surplus for the military in this case?

(b) Now consider the duopoly case where Pratt and Whitney is the Stackelberg leader and
GE-Rolls Royce is the Stackelberg follower. What is the price that the govern- ment
has to pay for the engines? How many engines are produced and what is the consumer
surplus for the military in this case?

(c) Should Secretary Gates agree to the second production line? Explain briefly.