EF3442 – Homework 4

Not For Distribution Beyond the Class

Yunan Li
March 10, 2024

This homework will focus on imperfect competition. Each question is a mix of ‘drill variety’ and
using the techniques to analyze a novel economic setting. As always, start early as some of these
problems are challenging.

Two questions from this homework will be selected at random and graded for a total of 10 points.
Please check your work. I encourage the use of Wolfram Alpha or similar software to verify your
calculations.

Submissions must follow the following format: the answer to be clearly displayed first, demar-
cated, followed by a justification written in clear, concise English. Mangled telegrams and streams
of consciousness should be avoided, variables and functions should be defined. Marks are deducted
for submissions that don’t follow this format, are hard to read or incomprehensible.

Question 1
In class we examined a model of Bertrand competition in which all consumers had the same RP,
i.e. $3. This corresponds to a demand curve of the following form. D(p) = 100 for 0 ≤ p ≤ 3 and
D(p) = 0 for all p > 3. Here you will examine a model of Bertrand competition in which not all
consumers have the same RP.

Two firms selling the identical product compete in Bertrand fashion by setting their prices p1
and p2 simultaneously. Whichever firm sets the lower price will get the entire market, whereas the
other will sell zero units. If firms set the same price, then they will each get half of the market.
Each firm must satisfy all the demand they face, i.e., they cannot turn away customers prepared to
pay the price they have posted. The total demand at a unit price of p is given by D(p) = 25 − 0.5p.
So, if firm 1’s price p1 < p2 , firm 1’s demand will be 25 − 0.5p1 while firm 2’s demand will be
0. If p1 = p2 = p, then firm 1’s demand will be 0.5(25−0.5p) and firm 2’s demand will be the same.

Both firms face the same cost function, which is given by C(q) = 12 q 2 where q is the quantity
produced. Production is instantaneous, so each firm produces the exact amount needed to fulfill
its realized demand.

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 1. If firm 1 sets a price of $8 a unit and firm 2 sets a price of $9 a unit, what is each firm’s
profit?

2. Explain why the combination (p1 , p2 ) with p1 ̸= p2 can never be a Nash equilibrium.

3. Is p1 = p2 = 15 a Nash equilibrium?

4. Is p1 = p2 = 150/11 a Nash equilibrium?

5. If both firms could switch to the same production technology that exhibited constant returns
to scale, would their equilibrium profits increase?

Question 2
Royalty stacking occurs when multiple patent holders extract high licensing fees from downstream
firms that are developing a new product. This problem is especially prevalent in the tech sector.
Here we’ll examine wizard robes, which are sold by firms 1 and 2.1 Each firm has developed a
new design that integrates elements of other fashionistas’ work. In order to sell the new robes,
each firm must buy the patents for these design elements from the license holders—namely, Edna
Mode and Jacobim Mugatu.2 Mode and Mugatu bear no costs; they simply own patents, and sell
them. Each firm must buy both patents in order to produce; otherwise, it is out of the game and
receives a payoff of 0.
The market’s structure is as follows. First, the patent holders simultaneously set royalty fees.
Denote the per unit royalty fee set by Mode with rO ≥ 0 and the per-unit fee set by Mugatu with
rU ≥ 0. A firm that sells q units is obliged to pay rO q to Mode and rU q to Mugatu.
After rO and rU are chosen, firms 1 and 2 choose quantities q1 and q2 respectively. The inverse
demand function for the new robes is given by p = 100 − q1 − q2 . The marginal cost of production,
not including royalty fees, that firms 1 and 2 each face is a constant $5 a unit.

(a) Fix rO and rU . Give the expression for firm 1’s profit, as a function of q1 , q2 , and the
royalties. Denote the profit by Π1 (q1 , q2 ).

(b) Fix rO and rU . Give the expression for firm 2’s profit, as a function of q1 , q2 , and the
royalties. Denote the profit by Π2 (q1 , q2 ).

(c) Derive firm 1’s best response function to firm 2’s choice of quantity—that is, BR1 (q2 )—by
maximizing its profit with respect to its own quantity, taking 2’s quantity as given (as well
as the royalties).

(d) Derive firm 2’s best response function to firm 1’s choice of quantity—that is, BR2 (q1 )—by
maximizing its profit with respect to its own quantity, taking 1’s quantity as given (as well
as the royalties).
1
Due to Gamp’s Law of Elemental Transfiguration, the wizard robe is a perfectly divisible good.
2
He invented the piano-key necktie.

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 (e) Determine the equilibrium values of q1 and q2 in terms of rO and rU .

(f) Write down an expression for Mode’s profit as a function of rO and rU .

(g) Write down an expression for Mugatu’s profit as a function of rO and rU .

(h) Determine the equilibrium royalty choices of Mode and Mugatu.

(i) Solve for the market demand, q1 + q2 , and price p in equilibrium.

(j) The Ministry of Magic decides that patent holders are getting away with robbery here, and
that they should be forced to discount their royalty fees from their equilibrium values by
a fraction d—that is, to set fees equal to dri , where ri is the fee obtained in part (8), and
0 < d < 1. What is the effect on Mode and Mugatu’s profits—that is, do they go up or
down? If this depends on the value of d, say how. (Hint: WolframAlpha is your friend.)

Question 3
Consider two firms (think Microsoft and Intel) who produce perfect complements of a single good:
the good is worthless unless the two complements are used together (think that consumers only
buy PC with an Intel chip and a Microsoft OS together). Given the market demand for the bundle
and the cost function of each firm, we want to explore the profit margins for each firm. Assume
firms choose prices simultaneously.

To make it concrete let pi be the unit price of an Intel chip and pm the unit price of a Microsoft
OS. The demand for the bundle is given by the equation below:

D(pi , pm ) = 100 − 2(pi + pm )

Assume that Intel has a constant marginal cost of $10 and Microsoft has a constant marginal cost
of $5.

1. Scenario 1: Two Separate Monopolies

Suppose Intel and Microsoft do not cooperate which means the Intel chip and the Microsoft
OS are produced separately. Determine equilibrium prices for each firm.

(a) Fix the price of Intel chip at p∗i . Consider Microsoft. What is its profit-maximizing
price as a function of p∗i ?
(b) Fix the price of Microsoft OS at p∗m . Consider Intel. What is its profit-maximizing
price as a function of p∗m ?
(c) Having determined the best-response functions, identify the equilibrium prices.
(d) Which firm generates higher profit? Would you infer that the profit depends positively,
negatively or not at all on the marginal cost? Give some intuition for your choice.

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 2. Scenario 2: The two firms merge into one big company that makes both products.

Suppose Intel chips and Microsoft OS are produced by a single firm. They bundle the
product together and call it a PC. Let ppc be the unit price of a PC. Assume that the de-
mand curve for the PC is the same as before, D(ppc ) = 100 − 2ppc , and the cost of producing
1 PC is just the combined costs of producing the Intel chip and the Microsoft OS. What
price will the firm set to maximize its profit? Calculate the total profit. How does the profit
compare with the combined profits in scenario 1? Explain.

Question 4
You are the monopoly supplier of Soma to a pair of downstream retailers. The retailers are located
in two different parts of town which we will refer to as market 1 and 2 respectively. The number
of people in each market is M . The demand in each market for Soma as a function of the retail
price is M (1 − p). Buyers in market 1 never go to the retailer in market 2 to purchase and buyers
in market 2 never patronize the retailer in market 1.
There is a third market consisting of comparison shoppers. These individuals will buy only from
the retailer with the lowest price. In the case when the retailers charge the same price, these
comparison shoppers will divide equally between the two retailers. Let C be the number of
comparison shoppers. The demand for Soma as a function of the price amongst comparison
shoppers is C(1 − p).
Hence, each retailer is a monopolist in its own market but faces competition in selling to the
comparison shoppers. Retailers can price discriminate between buyers in their home market and
comparison shoppers without fear of arbitrage. So, they are free to charge different prices to each
market. The price charged in the market for comparison shoppers must form an equilibrium. Does
the ability of the retailers to price discriminate help or hurt the manufacturer’s profitability?
As the manufacturer you have zero production costs. Your sales contract to each retailer consists
of two parts. The first is a franchise fee, F independent of the quantity purchased. The second
is a wholesale price w, that must be paid on each unit acquired (by a retailer). For example, if
a retailer buyers 25 units of Soma from you, they pay you F + 25 × w. You will offer the same
contract to both retailers. Because of your monopoly position you can make a take it or leave it
offer and the retailers will accept provided the contract generates non-negative profits for them.
Under a contract with franchise fee F and wholesale price w, the price that a retailer would charge
in its home market will be 1+w
2
. This is its profit maximizing monopoly price in the home market.

1. Suppose the manufacturer sold directly to the three markets. What price would maximize
its revenue?

2. Suppose C = 0, i.e., there are no comparison shoppers. What values of F and w should the
manufacturer set to maximize its revenue?

3. Suppose M = 0, i.e., everyone is a comparison shopper. What values of F and w should the
manufacturer set to maximize its revenue?

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 4. Suppose half the population are comparison shoppers, i.e., C = 2M . What values of F and
w should the manufacturer set to maximize its revenue?

5. In the case when C = 2M , is there a contract, different in kind from the one considered, the
manufacturer could offer to improve its profit? Keep it simple!

Question 5
Two firms compete in a Bertrand-Hotelling fashion in the sale of Soma. 1000 customers are
uniformly distributed on the line between 0 and 1. Seller 1 is at the left endpoint, i.e. at 0 and
the seller 2 at the right endpoint, i.e. at 1. Travel costs for consumes are $1 a unit per mile.
Each firm has a constant marginal cost of 0.5 a unit. Hence, if firm i produces qi units it incurs
a production cost of 0.5qi . You have an invention that will lower the costs of producing Soma.
With your technology the cost of producing q units of Soma will be 0.1q.

1. If firm 1 adopts your technology (for free) but not firm 2, what will equilibrium profits for
each be?

2. If firm 1 and 2 adopt your technology (for free), what will equilibrium profits for each firm
be?

3. You will approach firm 1 and make a take-it-or-leave-it offer for the technology. If firm 1
accepts you will not offer the technology to firm 2. If firm 1 declines, you will destroy the
technology and never sell it to anyone. What is the largest amount that firm 1 should be
willing to pay?

4. You will approach firm 1 and make a take-it-or-leave-it offer for the technology. If firm 1
accepts you will not approach firm 2. If firm 1 declines, you will approach firm 2 and make
it a take-it-or-leave-it-offer. If firm 2 declines, you will destroy the technology and never sell
it to anyone. What is the largest amount that firm 1 should be willing to pay?

5. Suppose you offer the technology to both firms simultaneously for a price of F . What price
F should you charge to maximize revenue? To help your thinking, fill in the table below
with the profits that each firm will earn depending on whether they accept or reject your offer.

Firm 2 Accepts Firm 2 Rejects

Firm 1 Accepts
Firm 1 Rejects

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