Problem Set 4 (Solution)

Managerial Economics - MGEB-23-1)

XLRI - Xavier School of Management

1. Find all pure strategy Nash equilibria of the following two-player normal-form games
of complete information. Come up with your own description of a game between firms
that you can imagine to motivate each normal form: i.e., describe who the players are,
the actions they can choose, and why the payoffs look (qualitatively) like they do.

(a) Solution: (D,R).

Player 2
L R
U (100, 100) (25 , 150)
Player 1
D (150, 25) (75, 75)

(b) Solution: (U, L) and (D, R).

Player 2
L R
U (5, 11) (0 , 0)
Player 1
D (0, 0) (11, 5)

(c) Solution: (U, R) and (D, L).

Player 2
L M R
U (0, 0) (5, 6) (10, 10)
Player 1 M (6, 5) (1, 1) (6, 5)
D (10, 10) (6, 5) (0, 0)

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 Player 2
L R
(d)
U (-5, -5) (10 , 0)
Player 1
D (0, 10) (0, 0)

2. Consider a market with inverse demand p = a − 2Q. Firms have no fixed cost and
constant marginal cost c.

(a) Derive expressions for industry price, quantity, profit, and the Lerner index (price-
cost margin) if this market is served by a monopolist.
Solution:
a−c a+c (a − c)2
M R = a − 4Q = M C = c =⇒ Qm = pm = , πm =
4 2 8
p−c a−c
Lerner index = p
= a+c
.
(b) Derive expressions for the Nash equilibrium industry price, quantity, profit, and
the Lerner index if the market is served by Cournot duopolists. Compare these
to your answers in part (a).
Solution: The profit functions of firms 1 and 2 are:

π1 (q1 , q2 ) = (a − 2(q1 + q2 ) − c)q1

π2 (q1 , q2 ) = (a − 2(q1 + q2 ) − c)q2

FOCs imply the following best response functions of firms 1 and 2:

a − c − q2 a − c − q1
q1 = q2 =
4 4
Simultaneously solving them, we get Nash equilibrium quantities:

a−c a + 2c (a − c)2
q1∗ = q2∗ = , p∗ = , π1∗ = π2∗ = .
6 3 18
(c) Do the same thing for the case in which the market is served by Bertrand duopolists.
Solution:
In the Bertrand equilibrium p∗1 = p∗2 = c, π1∗ = π2∗ = 0.
(d) If the duopolists could choose whether to compete by choosing prices simultane-
ously or by choosing quantities simultaneously, which would they prefer? Which
would consumers prefer? Which is more efficient?
Solution:

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 The firms will choose the Cournot model. The consumer will choose the Bertrand
model because it is yielding a perfectly competitive outcome. Please check calcu-
lating the consumers’ surpluses in both cases.
(e) What will firm profits be in Nash equilibrium if there are n identical Cournot
competitors?

3. Consider a Dominant Firm-Competitive Fringe model with the following assumptions.

There are 100 firms that behave in a competitive manner and have identical cost
functions given by ci (qf ) = 12 qf2 . The dominant firm has zero marginal costs. Total
demand is given by Qm (p) = 1000 − 50p.

(a) What is the supply curve of one of the competitive firms?

Solution: The marginal cost of a competitive fringe i is qf . Therefore, the supply
curve of a ith firm is qis = p.
(b) What is the total supply curve of the competitive fringe firms?
Solution: The supply function for all competitive frings is S f = 100p.
(c) Compute the dominant firm’s profit-maximizing price?
Solution: The residual demand for the dominant firm is Qd = 1000−50p−100p =
Q
1000−150p. The marginal revenue for the dominant firm is M Rd = 20
3
− 75 . Since
20 Q d f
M C = 0 for the dominant firm, 3 − 75 = 0. Thus, q = 500 and S = 5000,
p = 10
3
.

4. Consider two firms facing the demand curve p = 50 − 5Q, where Q = Q1 + Q2 . The
firms’ cost functions are C1 (Q1 ) = 20 + 10Q1 and C2 (Q2 ) = 10 + 12Q2 .

(a) Suppose both firms have entered the industry. What is the joint profit-maximizing
level of output? How much will each firm produce? How would your answer
change if the firms have not yet entered the industry?
Solution: In case of collusion: p = 50−5(Q+Q) = 50−10Q and M R = 50−20Q.
The marginal costs of firms 1 and 2 are 10 and 12, respectively. Now take M C =
10, the cheaper one, so that both firms operate.
50 − 20Q = 10 =⇒ Q = 4, pm = 30.

(b) What is each firm’s equilibrium output and profit if they behave noncooperatively?
Use the Cournot model. Draw the firms’ best response curves and show the
equilibrium.
Solution: The profit functions of firms 1 and 2 are:
π1 = (50 − 5(Q1 + Q2 ))Q1 − (20 + 10Q1 )
π1 = (50 − 5(Q1 + Q2 ))Q2 − (10 + 12Q1 )

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 FOCs imply the following best response functions of firms 1 and 2:
40 − 5Q2 38 − 5Q1
Q1 = Q2 =
10 10
Simultaneously solving them, we get Nash equilibrium quantities:
14
Q∗1 = = 2.8, Q∗2 = 2.4, p∗ = 24, π1 = 19.2, π2∗ = 18.8.
5

(c) How much should Firm 1 be willing to pay to purchase Firm 2 if collusion is illegal
but a takeover is not?

5. You own a small bookstore. You hired a marketing firm to calculate your own price
elasticity of demand and your advertising elasticity of demand. Assume the firm has
provided you with the relevant numbers regardless of minor adjustments in price or
advertising budget. Your own price elasticity of demand is around −1.7, and your
advertising elasticity of demand is around 0.05. How much should you mark-up your
price over your marginal cost for your books? What should your advertising-to-sales
ratio be?

6. Suppose that demand for cruise ship vacations is given by P = 1200 − 5Q, where Q is
the total number of passengers when the market price is P .

(a) The market initially consists of only three sellers, Alpha Travel, Beta Worldwide,
and Chi Cruiseline. Each seller has the same marginal cost of $300 per passenger.
Find the symmetric Cournot equilibrium price and output for each seller.
(b) Now, suppose that Beta Worldwide and Chi Cruiseline announce their intention
to merge into a single firm. They claim that their merger will allow them to
achieve cost savings so that their marginal cost is less than $300 per passenger.
Supposing that the merged firm, BetaChi, has a marginal cost of c < $300, while
Alpha Travel’s marginal cost remains $300, for what values of c would the merger
raise consumer surplus relative to part (a).

7. Apple’s iPod has been the portable MP3 player of choice among many gadget enthu-
siasts. Suppose that Apple has a constant marginal cost of 4 and that market demand
is given by Q = 200 − 2P .

(a) If Apple is a monopolist, find its optimal price and output. What are its profits?
Solution:
M R = M C implies that 100 − Q = 4. Thus, Qm = 96, pm = 52 and π m = 2304.

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(b) Now, suppose there is a competitive fringe of 12 price-taking firms, each of whom
has a total cost function T C(q) = 3q 2 + 20q. Find the supply function of the
fringe.
Solution: Marginal cost for the fringe firm is 6q + 20 and AV C = 3q + 20.
M C = AV C implies q = 0. Thus, min AV C = 20 and a firm supply curve is
p = 6q + 20 implies q s = p−20
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if p ≥ 20 and 0 otherwise.
p−20
This implies that S f = 6
× 12 = 2(p − 20).
(c) ) If Apple operates as the dominant firm facing competition from the fringe in this
market, now what is its optimal output? How many units will fringe providers
sell? What is the market price, and how much profit does Apple earn?
Solution: The residual demand for the dominant firm is Qd = 200−2p−2(p−20) =
220−4p. M Rd = 55− 21 Q = 4 implies Qd = 102, p = 29.5 and S f = 2(29.5−20) =
19.
(d) Graph your answer from part c.