THE OHIO STATE UNIVERSITY ECON 5700

INDUSTRIAL ORGANIZATION

Problem Set 3

Due by

NAME

I worked with:

Instructions: Please complete your work and attach it to the print out. No credit will be given for
answers without work shown. Submit all pages of the homework on the due date. Do not write on the
back of pages.

You can collaborate on this problem set with up to three of your classmates on this problem set, but it is in
your interest to understand each solution as the exams are very much individual and will be comprised of
similar problems.

Grading: Grading is done for completion

Material covered: This problem set covers lectures 11-14. You will be able to do the first question after
lecture 11, the second after lecture 12, and so on.
1. CPU. Intel and AMD will both be releasing new CPUs in the spring. Some market research revealed
two types of customers in the market: there is 1 “Intel Fanatic” for every 2 normal customers. Normal
customers buy from whoever is cheapest (or split evenly if prices are equal), whereas Intel fanatics
always buy from Intel. Based on market research, both companies are considering two prices for their
new watches —$350 and $300. The manufacturing cost of each is a constant $220.

a. Fill out the below table with total profit from each set of 3 customers, depending on pricing
decisions. Remember, normal customers buy from whoever is cheapest (if the price is the
same, they split evenly) and Intel fanatics always buy from Intel.

Intel
$300 $350

$300
AMD

$350

What is the one-shot competitive equilibrium? _____________________________

b. AMD doesn’t like the above outcome and wants to change the game. The company is
considering making a public announcement 1 prior to launch that the its new CPU will be sold
at $350, hoping Intel will follow suit. If Intel doesn’t follow along and prices at $300 instead,
AMD will need to reverse their price announcement, and sell for $300 as well, or they will
not sell any units. Importantly, AMD feels reversing its announced pricing decision is costly
no matter what Intel does, as it would harm the company’s reputation going forward. If this
reputational cost is $100 in terms of the payoffs above, write a revised game board assuming
AMD has made the public price announcement, and solve for the new one-shot equilibrium.

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 Intel
$300 $350

$300
AMD

$350

Equilibrium: _____________________________

Is AMD’s price announcement a good thing for AMD? □ Yes □ No

Is AMD’s price announcement a good thing for Intel? □ Yes □ No

2. Recruiting Season Game Theory. BCG and McKinsey are trying to plan OSU recruiting for the new
school year. The firm that is first to interview, fly out candidates, and make offers generally gets their
pick of candidates. Firms that come to campus later don’t get as many quality applicants and,
ultimately, employees. Firms would otherwise prefer to interview later, however, as they generally
know their hiring needs better later in the year.

a. Assume that whichever firm recruits first gets all of the best candidates, which is valued at
400. The firm that recruits second gets nothing. If both firms recruit at the same time, they
each get half the good candidates, valued at 200. But, recruiting early poses a cost of 100 to
each firm, due to the uncertainty in hiring. Fill out the payoff table below.

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 BCG
Late timeline Early timeline

Late timeline
McKinsey

Early timeline

b. Are there any strictly dominant strategies?

For BCG: ___________________

For McKinsey: ___________________

c. What is the one-shot Nash equilibrium of this game? ________________

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To avoid the ever-forward-creeping recruiting dates, some schools set strict dates on which firms can
come to campus. On the West Coast, Stanford and Berkeley have scheduled the official consulting
information session date for the exact same day. BCG and McKinsey only have enough local partners to
go to one of the schools. The recruiters realize that if they can correctly predict which meeting their rival
is going to, and go to the other one, they’ll get all the students from that school. However, if they guess
incorrectly and both show up at the same school, they’ll split the students from that school while still
losing out on the students from the other school. Therefore, the payoffs they face in their choice are:

BCG
Stanford Berkeley

40 80
Stanford
McKinsey

40 80

80 40
Berkeley
80 40

d. Are there any strictly dominant strategies? □ Yes □ No

List any and all Nash equilibrium to this game. If there are none, explain why.

____________________________________________________________

If the firms can communicate with each other beforehand, will they easily reach an agreement
on who should go where?
□ Yes □ No

Why? _________________________________________________________________

Would either firm have any reason to lie during the conversation?

□ Yes □ No

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e. If we’re being honest, both firms would prefer Stanford students to Berkeley students (even
though both are poor substitutes for OSU students), such that they really face a payoff of:

BCG
Stanford Berkeley

40 60
Stanford
McKinsey

40 80

80 30
Berkeley
60 30

List any and all Nash equilibrium to this game. If there are none, explain why.

____________________________________________________________

If the firms can communicate with each other beforehand, will they easily reach an agreement
on who should go where with this new payoff table?

□ Yes □ No

If McKinsey chooses to go to Stanford, what would BCG’s best response be?

□ Stanford □ Berkeley

Therefore, if the McKinsey partners could hop in an Uber to Stanford and send a text
message telling BCG their plans, and that they were throwing their phones out the window of
the car (don’t worry, the firm will replace them), would they choose to do it?

□ Yes □ No

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Consulting firms also recruit for summer intern positions. A major reason for having the summer
internship program is to get a pipeline for promising candidates earlier than rivals. Bain is considering
whether to make a summer offer to a certain candidate or not. If this candidate performs well, the firm
gets a large benefit. But, if the summer intern doesn’t perform well, the firm is in a pickle: not making an
offer to a summer intern lowers their “offer percentage,” which means next year other top candidates may
choose another firm where they are more likely to get an offer. This is what Bain and the intern’s decision
tree looks like, where F stands for firm and I stands for intern:

a) F: 11, I: 9

F No offer b) F: 3, I: 0

c) F: 6, I: 10
Get by
I F
d) F: 3, I: 0
Offer
F F e) F: 0, I: 11

f) F: 3, I: 0

g) F: 7, I: 0

f. What will be the equilibrium outcome in this game? _________________

(Write the letter corresponding to the branch, and show your work by crossing out the paths
that will not be taken by each actor at their decision node on the diagram above)

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 g. If all consulting firms were to sign a (enforceable) pledge saying they won’t hire an intern
who performs at or below the “get by” level, as evaluated by an independent firm, what
would be the equilibrium then? _________________

h. If instead of the pledge, you could provide a contract to the firm and the intern that would
legally bind the intern to work hard, how much would the intern be willing to pay for this
service (in “payoff points” from above payoffs)?

Intern would pay: _________________

If you wanted to charge the firm, too, how much would it be willing to pay?

Firm would pay: _________________

3. Console Wars. Microsoft and Sony are each trying to price their new gaming consoles. Microsoft is
pricing the Xbox Series X, and Sony is pricing the PS5.
a. As a warm-up, suppose the two consoles are identical from the consumer’s point of view. The
two firms have an identical, constant, cost of production, at $250 per unit, with no capacity
constraint. If Sony sets their price at $500, and prices must be listed in whole dollar amounts,
what is Microsoft’s optimal price in response?

Microsoft’s optimal price would be: ________________

What will be the equilibrium prices for each console in this setting?

Microsoft’s equilibrium price: ________________

Sony’s equilibrium price: ________________

b. In reality, there are loyalties to each brand and so customers do not choose strictly on price.
Each company’s sales depend on both their own and their competitor’s prices.

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 Microsoft’s sales quantity is:

𝑞𝑞𝑀𝑀 = 16 − 0.04𝑝𝑝𝑀𝑀 + 0.016𝑝𝑝𝑆𝑆 ,

while Sony’s is

𝑞𝑞𝑆𝑆 = 20 − 0.08𝑝𝑝𝑆𝑆 + 0.08𝑝𝑝𝑀𝑀 ,

where 𝑝𝑝𝑀𝑀 is Microsoft’s price, 𝑝𝑝𝑆𝑆 Sony’s price, and 𝑞𝑞𝑀𝑀 and 𝑞𝑞𝑆𝑆 Microsoft’s and Sony’s
annual console sales in millions, respectively. Each firm’s cost of producing a console is still
$250.

What are equilibrium prices going to be in the market? How many units does each of the
retailers sell? How high are profits?

Microsoft: Price: ___ Quantity: Profit:

Sony: Price: ___ Quantity: Profit:

c. Microsoft is worried about “network effects”, or the ability to attract developers, and will also
make significant revenue from game sales. Suppose that instead of simply maximizing profit,
they choose a price such that they are able to sell 8M units the first year. Hold Sony’s price
fixed at what you solved for in (b). What price should Microsoft set now?

Microsoft: Price: ___ Quantity: 8M Profit:

d. Sony hears of Microsoft’s plan, and is planning to adjust the PS5 price in order to maximize
profits. What will the equilibrium market outcome be, assuming Sony is maximizing profits
(e.g. using their reaction function from part b), but Microsoft’s reaction function is to choose
a price such that they sell 8M units?

Microsoft: Price: ___ Quantity: 8M Profit:

Sony: Price: ___ Quantity: Profit:

4. Wild, Wild Oats. Back to 2006, Whole Foods and Wild Oats (another “crunchy” grocer) each had
large market shares in the natural foods sector. They were both choosing how many stores to have in
the US. Each had the same annual total cost function of

𝑇𝑇𝑇𝑇(𝑞𝑞) = 24 + 2𝑞𝑞,

Where 𝑞𝑞 is the number of stores they operate, and costs are measured in millions of dollars. As the
number of stores increases, the revenue each store can generate per year falls, so we can think of the
demand for stores in the US as:

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 1
𝑃𝑃 = 4 − 𝑄𝑄
300

where “price” (price received per entire store) is measured in millions; 𝑞𝑞 is a single firm’s number of
stores while 𝑄𝑄 is the total market number of stores.

a. Calculate the Cournot-Nash equilibrium, assuming that each chooses the number of stores
that maximizes its profits when taking its rival’s output as given. First, write down the
residual demand each firm faces, and then their best response function. Lastly, find the
equilibrium quantity and profit.

Whole Foods’ Response Function 𝑞𝑞𝑊𝑊𝑊𝑊 (𝑞𝑞𝑊𝑊𝑊𝑊 ) =

∗
Whole Foods’ equilibrium number of stores: 𝑞𝑞𝑊𝑊𝑊𝑊 =

∗
Wild Oats’ equilibrium number of stores: 𝑞𝑞𝑊𝑊𝑊𝑊 =

Whole Foods’ equilibrium profit: 𝜋𝜋𝑊𝑊𝑊𝑊 =

b. In 2007, Whole Foods acquired Wild Oats for $565M. While this allowed Whole Foods to
save some costs (i.e. eliminate Wild Oats’ Fixed Costs), it also allowed Whole Foods to close
some Wild Oats stores, and convert the rest into being Whole Foods locations. Assume
Whole Foods’ cost function is unchanged. How many Wild Oats stores will it close?

Number of Wild Oats stores that will close:

(all other stores will become Whole Foods locations)

By what percent will market prices increase due to these closures?

(Note, this explains the phenomenon of companies buying rivals only to close their stores)

c. A few years later, as the economy improved, foreign entrants began to notice Whole Foods’
attractive market. The French chain Carrefour has investigated entering the US market. It
would compete directly against Whole Foods in the natural foods sector. However, it would
have a marginal cost function of
𝑀𝑀𝐶𝐶𝐶𝐶 (𝑞𝑞𝑐𝑐 ) = 2.1

Since Whole Foods is the “first mover” in the US market, they can now re-adjust the number
of stores they have anticipating Carrefour’s entry. What will be the equilibrium now?

∗
Whole Foods’ equilibrium number of stores: 𝑞𝑞𝑊𝑊𝑊𝑊 =

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 Carrefour’s equilibrium number of stores: 𝑞𝑞𝐶𝐶∗ =

Market Price (i.e. revenue per store): 𝑃𝑃 =

d. Of course, Carrefour would also incur fixed costs if they enter the US market. What is the
highest level of fixed costs such that Carrefour would be willing to enter, if Whole Foods is
choosing its store level anticipating Carrefour’s entry?

Fixed costs must be less than or equal to:

5. A recent class action lawsuit claimed a number of tech firms agreed not to hire workers from their
rivals, and that this depressed wages. Consider the payoff table below for two such firms.

Google
Poach from Rivals Don’t Poach

20 10
Poach from
Rivals
Apple

20 30

30 25
Don’t Poach

10 25

a. What is the equilibrium outcome:

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b. Suppose these firms wanted to sustain the “Don’t Poach” equilibrium with a grim trigger
strategy. Assuming an infinitely repeating game, for what range of discount factors 𝛿𝛿 would
such a strategy work?

Agreement works as long as 𝛿𝛿

c. Meta was not interested in joining the arrangement. Consider the table below, which shows
that as a newer firm that was growing quickly, Meta faced different incentives.

Meta
Poach from Rivals Don’t Poach

20 10
Poach from
Rivals
Others

15 15

25 15
Don’t Poach

5 10

Assuming a “grim trigger” strategy by other firms, over what range of 𝛿𝛿 would Meta be
willing to play “Don’t Poach”?

Agreement works as long as 𝛿𝛿

Given this, and what you know about finance, what will Meta do?

□ Poach □ Not Poach

(This highlights an obvious requirement of punishment strategies – the punishment must

actually be worse than what you’d like to sustain)

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