MANAGERIAL ECONOMICS

HOMEWORK - 4
Study Group - E7
Krupa Bhulani 62210792
Sai Harika Padmanabhuni 62210973
Saichand Lakkakula 62210280
Tuhin Kumar Sen 62210756
Ashish Goel 62210290

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?

U(I) = √I , where I = Monetary payoff

U(I not investing) = √(6,00,625) = 775

U(I investing) = 0.6 x U(10,00,000) + 0.4 x (2,50,000)
= 0.6 x (√(10,00,000)) + 0.4 x (√(2,50,000))
= 0.6 x (1000) + 0.4 x (500)
= 600 + 200
= 800
 Since, the utility of investing is greater than the utility of not investing, Arnab should
invest in the factory.

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
expectancy is 80 years. Assume a 5% interest rate.

When looked at the problem from a returns perspective, the break even deposit would come
at a point when the future value of all the payments combined would be equal to the present
value of the deposit.

Following are the variables given –

Annual Payment = Rs. 5000

Average Age = 60 years (1)
Average population-wide life expectancy = 80 years (2)
Thus, tentative period of payment would be (2)-(1) = 20 years

Present Value (P) = PMT * [1 – [ (1 / 1+r)^n] / r]

Hence Present Value (P) = 5000*[1 – [ (1 / 1+0.05)^20] / 0.05] = Rs. 62,311 = Deposit amount

For LEICO to break even, the present value of the deposit would have to be equal to
the future value of all the payments, and thus the breakeven deposit would be Rs.
62,311. So, essentially, if a consumer at age 60 pays Rs. 62,311, they would receive an
annual payment of Rs. 5000 for the next 20 years [as the average life expectancy is 80
years).

(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?

Those whose life expectancy is more than the average population-wide life expectancy is
80 years would be the keenest to purchase the annuity. The greater number of years they
live beyond the average life expectancy, the more return on their deposit they would
receive.
 (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?

Since, people whose life expectancy is below 80 years, will not take the insurance,
the new range of customers will be between 80 years and 100 years of life
expectancy. Knowing this information, LEICO should consider a new average age
within this range where they break even. Since we know that the population is evenly
distributed, we can conclude that the new average life expectancy in this range would
be 90 years and the payment period would be for 30 years.

Hence New Present Value (P) = 5000*[1 – [ (1 / 1+0.05)^30] / 0.05] = Rs. 76,862.25

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?

CC
200 300 400 500 600
FC 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

The best responses for each of the manufacturers are marked in bold. And the
 strategy profile where both of them have their best responses is when FC
manufactures a quantity of 300 with a payoff of 2, and CC manufacturers a quantity
of 400 with a payoff of 5.

Thus, the Nash equilibrium when both choose their production simultaneously is
when CC’s quantity is 400 and FC’s quantity is 300

(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.

CC FC CC FC
200 -1 63
300 1 32
200 400 1 54
500 -33 1
600 0 -22

200 -1 28
300 2 2
300 400 -1 95
500 43 -3
600 -13 1

200 0 -2
300 5 2
400 400 2 0
500 39 -1
600 88 -1

200 45 -2
300 0 3
500 400 -1 4
500 -12 1
600 -57 -2

200 19 -3
300 3 2
600 400 4 0
500 17 -1
600 72 -3

Using the backward induction technique, we first identified the outputs favorable
to FC for each option CC chooses. They are marked in bold in the last column.

Based on those values, the payoffs for CC are marked in bold in the second last
column. Among those values, the most favorable option for CC will be choosing the
quantity of 400, giving it a payoff of 5. The corresponding payoff for FC is 2 and its
 quantity is 300.

Thus, the equilibrium in this scenario when CC chooses first is CC’s quantity of 400
and FC’s quantity of 300.

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 C B(qB) = 3qB, respectively.

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

P = 15 – Q = 15 – ( qa + qb)
Ca = 6qa & MCa = 6
Cb = 3qb & MCb = 3

TRa = qa x (15 - ( qa + qb)) = 15 qa – qa2 – qa qb

MRa = 15 – 2qa – qb
At the best response, profit of A is maximized for a given B’s response,

Thus, we can equation MRa = MCa = 6

Best response function (BRa) => qa = (9 - qb)/2

(b) What is the best response (or reaction) function of firm B?

TRb = qb x (15 - ( qa + qb)) = 15 qb – qb2 – qa qb

MRa = 15 – qa – 2qb
At the best response, profit of B is maximized for a given A’s response,

Thus, we can equation MRb = MCb = 3

Best response function (BRb) => qb = (12 - qa)/2

(c) What are the equilibrium quantities produced by each firm?

At equilibrium, we can equate the best response linear equations for A and B,

2qa = 9 - qb & 2qb = 12 - qa

On equating, we get :-

qa = 2 & q b = 5

(d) What is the market price?

Market price (P) = 15 – Q, where Q = qa + qb. Therefore, P = 8.

What are the profits of each firm?

Profits of A = TRa – Ca = (30 – 4 – 10) – 12 = 4

Profits of B = TRb – Cb = (75 – 25 – 10) – 15 = 25

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.

Fight
In -5,-5
A
B 5,5
0,10 Not fight
Out

The figure represents the payoffs of B(new entrant) and A(monopoly) at each level. Let’s
start from the right of the figure. If B enters the market, in this case, if A fights it will result
in a payoff of -5, but if it doesn’t it will have a payoff of 5. So, A doesn’t have an incentive to
fight. So we can eliminate the A fight scenario overall.

Whether to enter the market or not is B’s decision. If B doesn’t enter it will have a payoff of
0, but if it enters it will have a payoff of 5 since A won’t fight B. Thus it is beneficial for B to
enter the market.

Hence we can conclude that the outcome will be B will enter the market and A will not
fight B, resulting in a profit of $5 million for each of the firms.

(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.
 Leave
Fight -1,10
In B
A -5,-5
B 5,5 Not leave
0,10 Not fight
Out

The figure represents the payoffs of B(new entrant) and A(monopoly) at each level. Let’s
start from the right of the figure.
Step 1 :
Leave
Fight -1,10
In B
A -5,-5
B 5,5 Not leave
0,10 Not fight
Out
If B enters the market and A fights, upon leaving B will have a payoff of -1 and if B stays it
will have a payoff of -5. Thus, if A fights, it’s better for B to leave resulting in a lower loss.
Now let’s understand if A has an incentive to fight or not.

Step 2 :
Leave
Fight -1,10
In B
A -5,-5
B 5,5 Not leave
0,10 Not fight
Out
Looking at the two yellow coloured cells above, if A fights, it will have a payoff of 10, and if
doesn’t fight, it will have a payoff of 5. Thus A will have an incentive to fight, rendering the
scenario of A “Not fighting” useless.

Step 3 :
Leave
Fight -1,10
In B
A -5,-5
B 5,5 Not leave
0,10 Not fight
Out
The remaining cases at this moment are one in which B enters the market and the other in
which it doesn’t. A has the same payoff in both cases, but B has a better payoff if it doesn’t
enter the market.
 Leave
Fight -1,10
In B
A -5,-5
B 5,5 Not leave
0,10 Not fight
Out
Thus, the outcome will be B not entering the market and A having its original profit of
$10 million.

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

We know that, P = 1000 – Q

Let Qp = Qty produced by Pratt and Whitney and Qr = Qty produced by Rolls Royce
In case of Monopoly,
P = 1000 – Qp
TRp = (1000- Qp)* Qp
MRp = 1000 – 2Qp
Mcp = 120
In case of a monopoly, MR = MC
1000 – 2Qp = 120
Qp = 440
P = 1000 – 440 = 560

Customer Surplus – ½ *(1000 – 560) * (440) = 96,800

In case of duopoly where Pratt and Whitney is the Stackelberg leader

P = 1000 – Q
P = 1000 – Qp – Qr
TRp = (1000 – Qp – Qr)*Qp
MCp = 120

For GE & Rolls Royce, the Stackelberg follower

Since MR = MC, Best response of Qr is
1000 – 2Qr – Qp = 160
Qr = (840 – Qp)/2

For Pratt and Whitney, the Stackelberg leader, substituting Qr = (840 – Qp)/2
TR = (1000 – Qp – (840 – Qp)/2)Qp
MR = 580 – Qp
580 – Qp = 120
Qp = 460
Qr = 190
P = 1000 – 480 – 180 = 350

Customer Surplus – ½ *(1000 – 350) * (190+460) = 2,11,250

Secretary Gates should agree to the second production line as in the case of duopoly
where Pratt and Whitney is the Stackelberg leader, they are paying a lower price and their
consumer surplus is increasing.