Imperfect Competition – Tutorial

1 Entry Deterrence – Solutions

1.1
a) Firm 2 gets profits (100 − x1 − x2 )x2 − 400. From FOC follows reaction
function R(x1 ) = 0.5(100 − x1 ). Profits are then (100 − x1 − R(x1 ))R(x1 ) − 400.
This is equal to 1/4(100 − x1 )2 − 400.
b) The solution xa1 = 60 is comes from solving 1/4(100 − x1 )2 = 400.
c) The Stackelberg leader firm 1 maximizes (100−x1 −R(x1 ))x1 = 0.5(100−
x1 )x1 . It follows that x1 = 50. Since x1 < xa1 firm 2 enters the market,
producing 25.
d) If firm 1 chooses 60 its profits are (100 − x1 )x1 = 2400. If it chooses 50
profits are (100 − xS1 − xS2 )xS1 = 1250. Hence the firm decides to block entry.
e) Cournot equilibrium is given by solving reaction functions x1 = 0.5(100 −
x2 ) and the same symmetrically, yielding x1 = x2 = 100/3. Since xC a
1 < x1 firm
2 will enter the market.

1.2
a) For q1 ≤ k1 , M C1 = 6. For q1 > k1 , M C1 = 12. Both comes from the
definition of a capacity in this example.
b) For q1 ≤ k1 , the problem is: max(60 − 4q1 − 4q2 )q1 − 6q1 . Then the
incumbent’s best response function is q1 = (1/4)(27 − 2q2 ). For q1 > k1 , the
problem is max(60 − 4q1 − 4q2 )q1 − 12q1 , and the incumbents best response
function is q1 = 1/2(12 − q2 ). The entrant’s best response function in this case
is symmetric to this second case.
c) Try out both possible cases (k1 ≥ q1 and k1 ≤ q1 ). By using the response
functions from above. Indeed with k1 ≥ q1 a solution is: k1 = 5, q1∗ = 5 and
q2∗ = 3.5.
For any k1 maximize separately for firm 1:
Assume k1 ≥ q1 : Then max(60 − 4q1 − 4q2 )q1 − 6q1 + λ(k1 − q1 ). The first
order condition with constraint not binding (λ = 0) gives the same response
function as above and q1∗ = 5 and q2∗ = 3.5.
For k1 ≤ q1 : Then max(60 − 4q1 − 4q2 )q1 − 12(q1 − k1 ) − 6k1 − λ(k1 − q1 ).
Then q1∗ = q2∗ = 4.
For 4 < k1 < 5 the constraint must be binding in both cases and q1 = k1
and q2∗ = (1/2)(12 − k1 ). This could also be argued not using the Kuhn Tucker,
by simply saying that between 4 and 5 it can be neither larger nor smaller, so
it must be equal.
d)

1
 The reaction function of firm 2 is still given by q2 = 6 − q1√/2. Given this
reaction function, the profits of firm 2 will be zero if q1 = 12 − f . Hence firm
2 will enter the market if firm 1 can credibly threat to produce more than i) 7
ii) 4 units. Seven is not credible (see c), 4 is credible. Hence firm 2 enters in
the second case only, and the solution is given from the reaction functions as:
i) f = 64: k1 = q1 = 6, q2 = 0.
ii) f = 25: k1 = q1 = 5 and q2 = 3.5.
e) Converts variable costs into sunk expenditures, making the threat to pro-
duce q1 > q1C credible in some situations.

1.3
a Residual demand is given by D(p) = 90 − p.
b When firms sell full capacity maximum price is 80. If both firms set price
equal to 80, no one has an incentive to deviate. Reducing price is not
optimal as both firms already sell at full capacity. Increasing price is not
optimal as this yield a profit of (90 − p)p, which is decreasing in p for
prices above 80.
c When both firms sell full capacity maximum price is 70 (= 100 − 20 − 10).
If both firms set price equal to 70, no one has an incentive to deviate.
Reducing price is not optimal as both firms already sell at full capacity.
Increasing price is not optimal as for firm 2 this yield a profit of (90 −
p)p and for firm 1 this yield a profit of (80 − p)p. both expressions are
decreasing in p for prices above 70.

d . There is no pure strategy equilibrium. To see this, note that if both firms
do not sell at full capacity, which happens when they charge a price larger
than 20, each firm has an incentive to undercut. Let us then consider
prices at or below 20. If a firm increase its price, then it receives a profit
of (60 − p)p which is maximal at p=30 and yields profit equal to 30. The
resulting profit equals 900 which is larger than the profit the firm makes
by selling full capacity at a prices smaller than 20 (maximal profit 800).