AP/ECON 3200 Industrial Organization Monopolistic competition: Practice problem set Problem 1.

In a monopolistically competitive market with the market demand func3 tion given by p = 25 2 Q there are 10 rms. Each rm has total cost 1 2 function T C = 2 q + 2q + 8 (i) Find the short run equilibrium in this market. (ii) How will the number of rm in this market change in the long run? (iii) Find the long-run equilibrium price, output per rm and the number of rms. Illustrate it on a diagram. 3 (iv) Suppose the marker demand increased to p = 125 2 Q: How does it aect the long-run equilibrium? (v) Suppose instead the xed costs of production increased to 32, while the 3 market demand is still p = 25 2 Q. How does the new long-run equilibrium compare to that in parts (iii) and (iv)? Problem 2. Consider a Cournot duopoly with two rms. Demand function for rm i s output is pi = ai bi qi rqj where j is another rms and r < bi , r < bj (i) Write down the inverse demand function for rm i (ii) Calculate demand elasticity for rm i with respect to its own price and to the price of its competitor. Show that rm i s demand is more sensitive to own price changes than to price changes of the other rm (i.e. that two rms produce dierentiated products)

Answers: Problem 1. (i) Prot function of rm i: = 25 3X qj 2 j =1

10

qi

1 2 q + 2qi + 8 2 i

Taking the derivative with respect to qi and rearranging we obtain the protmaximizing output level (the best response function): qi = 5:75 3X qj 8 j 6=i

Using the symmetry condition and its implication for rm-level outputs (qi = qj for any pair of rms i and j ), in equilibrium each rm will produce approximately 1.3 units of output. Total industry output is then 3 Q = 10 1:3 = 13 and price is p = 25 2 13 = 5:5 (ii) With the equilibrium price and rm-level output from part (i), the rm-level revenue is 7.15 and total cost of production is 11.5. Since rms are making losses in the short-run, the number of rms will decrease in the long-run. (iii) Taking the derivative of the prot function, we obtain a protmaximizing condition which must hold for every rm i operating in the market: 3 qi qi 2 = 0 p 2 In the long-run, free entry will ensure that rm-level prots are equal to zero. Setting rm-level prot to zero, we obtain the second equilibrium condition (zero-prot condition): pqi 1 2 q + 2qi + 8 2 i =0

Solving this system of equation for p and qi , we obtain the long-run equilibrium price and output per rm: p = 7 qi = 2 for all rms 2

From, the market demand we obtain total demand (and total supply) Q = 12, and the number of rms is N = Q =6 q (iv) With the new market demand both equilibrium condition remain unaected so p = 7 and qi = 2 continue to be the equilibrium values. Only the number of rms will increase to N = Q = 118 = 59 q 2 (v) With higher xed costs, q = 4; p = 12; N = 3:25: With higher xed costs some rms will exit and the remaining will operate at larger scale. Problem 2. (i) qi = (ii) @qi pi bj p i = <0 @pi qi bj (ai pi ) r (aj pj ) @qi pj rpj >0 = @pj qi bj (ai pi ) r (aj pj ) Increase in own price will decrease rm i s demand while increase in the competitor s price will increase it. Given that r < bj , the second elasticity is always smaller than the rst one in absolute terms for the any pi = pj , thus variation in the price for the competitor s good has less impact on demand for rm i s product. bj (ai pi ) r (aj b1 b2 r 2 pj )