ECON401: Problem Set 7 Solutions

© 2023 Noriko Ozawa

ECON401: Applied Microeconomic Analysis

Problem Set 7 Solutions

1. a) There is no point charging P < 20 because all consumers are willing to pay 20 or more for the plan.
There is no point charging 20 < P < 25, because in this price range only regular users will purchase,
but they are willing to pay 25. So, the optimal price should be either P = 20 or P = 25.

At P = 20, all of the potential customers will purchase. So, the profit per purchase is $20 – 10 =
$10, which is also the expected profit per potential customer.

At P = 25, only 50% of the potential customers will purchase. The profit per purchase is $25 – 10
= $15 and the expected profit per potential customer is 0.5(15) = $7.50.

The optimal price for the 300-minute plan (when offered alone) is therefore P = $20

b) By an argument similar to that given in part a), the optimal price should be either P = 30 or P = 70.

At P = 30, all of the potential customers will purchase. So, the profit per purchase is $30 – 10 =
$20, which is also the expected profit per potential customer.

At P = 70, only 50% of the potential customers will purchase. The profit per purchase is $70 – 10
= $60 and the expected profit per potential customer is 0.5(60) = $30.

The optimal price for the 300-minute plan (when offered alone) is therefore P = $70

c) The truth-telling constraint (or incentive-compatibility constraint) for light users says that the net
benefit should be equal to or greater for the light user when purchasing the 300-minute plan than
the 600-minute plan. Or,
TTCL  : 20  P300  30  p600
The truth-telling constraint (or incentive-compatibility constraint) for regular users says that the net
benefit should be equal to or greater for the regular user when purchasing the 600-minute plan than
the 300-minute plan. Or,
TTCR  : 70  P600  25  p300
e) To maximize profits, GWL should charge as much as it can while still making sure (TTCL) and
(TTCR) are satisfied. In addition, it should make sure that each type of consumer is willing to
purchase a plan rather than no plan at all. In other words, the following participation constraints
must be satisfied:
PCL  : 20  P300  0  P300  20
PCR  : 70  P600  0  P600  70
First, (TTCL) can be written as: P600  P300  10 . This is automatically satisfied so far as (PCL) and
(PCR) are satisfied. Next, rewrite (TTCR) as: P600  P300  45  P600  P300  45 . This, along with
(PCL), implies that the optimal prices are P 300  $20 and P600  20  45  $65 . At these prices,
(PCR) is also satisfied.

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 ECON401: Problem Set 7 Solutions
© 2023 Noriko Ozawa

2. a)
Price, T
slope = c

V q, H   THEff  0
THEff

V q , L   TLEff  0

TLEff

q LEff qHEff Quantity, q

b) When consumers’ types are observable, the monopolist’s problem is to choose two bundles
q L , TL , q H , TH  so as to maximize its profits subject to the two participation constraints, one for
the low demand type and the other for the high demand type.
max TL  TH  cqL  qH 
q L , L
q H , H

subject to:
1
2
 
 L 1 1  qL 2  TL  0 (PCL)

1
2

 H 1 1  qH 2  TH  0  (PCH)

Both constraints are binding at the optimal solution. So, we can substitute for TL and TH from
(PCL) and (PCH) into the objective function to obtain the following unconstrained optimization
problem.
max
qL ,qH ,
1
2
 
1
 
 L 1  1  qL 2   H 1  1  qH 2  cqL  qH 
2
The first-order conditions are:
w.r.t. qL:  
 L 1  qLEff  c  0  qLEff  1 
c
L

w.r.t. qH:  
 H 1  qHEff  c  0  qHEff  1 
c
H

The optimal (first-best) bundles are:

 2   2  
 Eff 1   c   1   c 
 Eff  
c c

 qL  1  , TL   L 1     ,
   H 1   
Eff Eff
 q  1  , T 
2    H   
H H
 L 2   L    H 
      

c) When consumer’s type are unobservable, the monopolist’s problem is to choose two bundles
choose two bundles q L , TL , qH , TH  so as to maximize its profits subject to the participation
constraint and truth-telling constraint of each type.

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 ECON401: Problem Set 7 Solutions
© 2023 Noriko Ozawa

max TL  TH  cqL  qH 
q L ,TL
q H ,TH

subject to:
1
2

 L 1 1  qL 2  TL  0  (PCL)

1
2

 H 1 1  qH 2  TH  0  (PCH)

1
2
 1

 L 1  1  qL 2  TL   L 1  1  qH 2  TH
2
  (TTCL)

1
2
 1

 H 1  1  qH 2  TH   H 1  1  qL 2  TL
2
  (TTCH)

Note first that from the diagram a) we know that type-H has an incentive to pretend to be type-L.
This implies that (PCL) and (TTCH) are binding at the optimal. We ignore (PCH) and (TTCL) at this
stage and check whether the solution satisfies both (PCH) and (TTCL) later.
PCL  1
 TL   L 1  1  qL 2
2
  (1)

 
TTCH   TH  1  H 1  1  qH 2  1  H 1  1  qL 2  1  L 1  1  qL 2
2 2 2
   
1
2
1

  H 1  1  qH    H   L 1  1  qL 2
2
2
   (2)

Substituting for TL and TH in the objective function from (1) and (2) yields the following
unconstrained optimization problem:
1
 1
 1
 
max  L 1  1  qL 2   H 1  1  qH 2   L   H 1  1  qL 2  cqL  qH 
qL ,qH 2 2 2
 
F.O.C’s:
w.r.t. qL: 2 L   H 1  q*L  c  0  q*L  1 
c
 qLEff
2 L   H

w.r.t. qH:
H
 
 H 1  q*H  c  0  q*H  1 
c
 qHEff

The optimal (second-best) bundles when consumer’s type is private information:

 2
1  

q*L , TL*  
 1 
c
,  L 1  
c
 2 L   H 2   2 L   H




 
   
 2
c 1   c
2  

q*H , TH*  
 1  ,  H 1  
  H 2    H


  2
1
   H   L 1  

c
  2 L   H




 
      

= information rent
Check yourself that both (PCH) and (TTCL) are satisfied.

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 ECON401: Problem Set 7 Solutions
© 2023 Noriko Ozawa

d)
Price, T
slope = c

V q, H   THEff  0
THEff

V q, H   TH*  0
TH* V q , L   TLEff  0

TLEff

TL*

q*L q LEff q*H  qHEff Quantity, q

CSH > 0

e) I have discussed this in the class.

3. a) There is no information asymmetry between the inventor and the firm. So, we will obtain the first-
best here (the quantities should be those that maximize the joint profit regardless of the realization
of , but efficient risk-sharing is irrelevant here for both parties are risk neutral). We also know the
participation constraints in both states are binding at the optimal.
The inventor’s (principal’s) problem:
1
max a  bqH qH  t H   1 a  bqL qL  t L 
t H ,qH 2 2
tL ,qL

subject to: t H   H qH  F  0 (PCH)

t L   L qL  F  0 (PCL)

As the payment ti (i = H, L) increases, the inventor’s expected profit falls. So, the participation
constraints should bind at the solution. Substituting for ti from (PCi) to the objective function
yields the following unconstrained optimization problem.
1
max a  bqH qH   H qH  F   1 a  bqL qL   L qL  F 
qH ,qL 2 2
F.O.C’s:
w.r.t. qH:
1
a  2bqH   H   0  qHEff  a   H
2 2b

w.r.t. qL:
1
a  2bqL   L   0  qLEff  a   L
2 2b
Substituting qiEff into the corresponding participation constraint to obtain the payment ti as:
(PCi): tiEff   i qiEff  F

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 ECON401: Problem Set 7 Solutions
© 2023 Noriko Ozawa

 a   H Eff  a   L Eff 
The optimal (first-best) contract:  qHEff  , t H   H qHEff  F ;  qLEff  , t L   L q LEff  F 
 2b  2b 
b)
TR, TC, t

B TR

t H   H q H  F = 0

t L   L qL  F =
0

t HEff a
t LEff
b

0 qHEff qLEff Quantity

Under this contract, the marginal revenue is equal to marginal cost in both states and therefore, the
expected joint profits are maximized. Moreover, the firm receives the payment that is exactly equal
to the total cost of production. Hence, this contract guarantees the innovator the largest expected
profits.

c) The inventor must design an incentive contract in which the firm truthfully reveal the realized value
of marginal cost. Note that the firm has an incentive to misreport that the realized marginal cost is
high (i.e., H) when it is in fact low. This suggests that (TTCL) is binding at the optimal. Also,
the quantity in state L should be at the efficient level, whereas the quantity in state H should be
distorted downward. Moreover, the firm will earn information rents in state L, but zero profit in
state H (so, PCH is binding at the optimal).

The inventor’s problem:

1
max a  bqH qH  t H   1 a  bqL qL  t L 
t H ,qH 2 2
tL ,qL

subject to: t H   H qH  F  0 (PCH)

t L   L qL  F  0 (PCL)
t H   H qH  F  t L   H qL  F (TTCH)
t L   L qL  F  t H   L qH  F (TTCL)

As mentioned above, (PCH) and (TTCL) are binding. So, we have:

(PCH): t H   H qH  F (1)
(TTCL): t L   L qL   H   L qH  F (2)

Substituting (1) and (2) into the objective function yields the following unconstrained optimization
problem:

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 ECON401: Problem Set 7 Solutions
© 2023 Noriko Ozawa

1
max a  bqH qH   H qH  F   1 a  bqL qL   L qL   H   L qH  F 
qH ,qL 2 2
F.O.C’s:
w.r.t. qH:
1
a  2bqH   H   H   L   0  q*H  a   H   H   L  qHEff
2 2b 2b
1 a  
w.r.t. qL: a  2bqL   L   0  q*L  L
 qLEff
2 2b
Substituting q*H into (1) and q*L into (2) to get:
t H*   H q*H  F
t L*   L q*L  F   H   L q*H

I will leave it to you to show (PCL) and (TTCH) are satisfied at the optimal solution.

The optimal (second-best) contract:

 * a   H  H   L *  a L * 
 qH   , t H   H q*H  F ;  q*L  , t L   L q*L  F   H   L q*H 
 2b 2b  2b 
Information rent
d) TR, TC, t

B TR

t H   H q H  F = 0

tL* – LqL*– F > 0

t L   L qL  F =
0

t L*
a

t H* b

Information rent
0 q *H qHEff q*L  qLEff Quantity

Study the diagram above carefully and make sure you can explain i) why the innovator has to leave
the information rent when L and ii) why H is distorted downward when only the firm can
observe the realized value of .

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