Problem Set 3 Solutions

1. (i.)
The equilibrium (market clearing) production level, Q, is found
by setting M C = M R:
0.728Q = 120 2Q
Q = 43.98 44

The equilibrium price, P where M C = M R:

P (Q) = 120 2Q
P = 120 2(43.98)
P = $32.02

Total revenue is the product of the optimal price and quantity:

P Q = 32.02 43.98 = $1, 408.66

Total cost is found by plugging the optimal quantity into the cost
function:
T C(Q ) = 0.364(43.98)2
T C = $704.33

We can also derive consumer, producer, and social surplus (for

section iii):

Producer Surplus:
Consumer surplus:

1
2 (43.98)

1
2 (43.98)

32.02 = $704.33

(120 32.02) = $1934.97

Total social surplus: T SS = CS + P S = $2, 639.30

Graphically:

P
120

100

80

CS
60

MC
40

32.02

PS

20

P(Q)
0
0

10

20

30

40 44

50

60

(ii.)
Marginal damage (MD) is increase in damage from producing one
extra unit of output:
4D(Q)/ 4 Q = 0.2Q

70

Total social cost (TSC) is the sum of total cost and total damage:
0.364Q2 + 0.1Q2 = 0.464Q2

The marginal social cost (MSC) is the sum of marginal cost and
marginal damage:

M C + M D = 0.728Q + 0.2Q = 0.928Q

(iii.)
The Pigouvian tax is the difference between marginal social cost
(MSC) and marginal cost at Q where M SC = Demand:
0.928Q = 120 2Q
Q = 40.39836 41

When Q = 41, M C = 0.728(41) = $29.84, and M SC = 0.928(41) =

$38.04 the Pigouvian tax is :
38.04 29.84 = $8.20

Market clearing quantity is Q where M SC = Demand, so Q =

41. The market clearing price is P where M SC = Demand, so
P = $38.04.
This graph shows the total social surplus is greater with the tax
than without:

P
120

100

80

60

MC + tax

MC
38.04
40

32.02

tax

GH

20

MD

P(Q)

0
0

10

20

30

4240 44

50

Before the tax:

CS = A + B + G + H
PS = C + D + J
Damage = F + L, where L = I + H + J
Total Social Surplus
=A+B+G+H +C +D+J F I H J
=A+B+G+C +DI F

After the tax:

CS = A

60

70

PS = B + C
Tax Revenue = D + G
Damage = F
Total Social Surplus = A + B + C + D + G F
By comparing the total social surplus before tax with the one after
tax, we find that the net gain with a tax is I.
(iv.)
This example illustrates the theory of the second best. Note that
the monopolists production lies below the socially optimal level.
So taxing the monopolist would reduce welfare! We should not
recommend a pollution tax given the structure of this market. If
anything, we should subsidize production so as to improve social
welfare. However, it is unlikely that a regulatory agency in charge
of regulating pollution would subsidize an industry to correct a
distortion associated with the exercise of market power. But you
could calculate the optimal subsidy taking into account the monopolists profit maximization problem and the marginal damage
function.
2. (i)
(i) The two firms are identical, so we can solve the optimization
problem for one firm and then use symmetry to find the solution:
maxq1 = p1 (q1 , q2 )q1 c1 (q1 ) = q1 q12 + zq1 q2
Giving the FOC (interior solution):
1 2q1 + zq2 = 0
q1 =

1+zq2
2

This is firm 1s best response function (BRF). By symmetry, firm

2s BRF is:

1+zq1
2

q2 =

You can now plug one BRF into the other to solve. Or, you can use
this often-quicker symmetry strategy: using the fact that q1 = q2 ,
so you can change the q2 in firm 1s BRF to a q1 and quickly solve
for the optimal quantities (note that you can only do this after
taking the first-order conditions).
1+zq1
2

q1 =

2q1 = 1 + zq1
q1 =

= q2

1
2z

Now plug these quantities into the inverse demand functions to

find equilibrium prices:
p1 = 1

1
2z

z
2z

p1 =

1
2z

2z
2z

1
2z

z
2z

= p2

[Note: whenever you use any shortcut, just make sure you have
provided everything the question asked for. In this case, you could
have solved for equilibrium quantities and prices without ever writing down firm 2s best response function, but the question explicitly asks for this.]
Convert the two inverse demand functions into demand functions.
Rearrange each equation and then plug one into the other:
q1 = 1 + zq2 p1 and q2 = 1 + zq1 p2
q1 = 1 + z(1 + zq1 p2 ) p1
q1 = 1 + z + z 2 q1 zp2 p1
(1 z 2 )q1 = 1 + z zp2 p1
q1 (p1 , p2 ) =

1+z
1z 2

1
p
1z 2 1

z
p
1z 2 2

And of course, by symmetry:

q2 (p1 , p2 ) =

1+z
1z 2

1
p
1z 2 2

z
p
1z 2 1

(ii.)
The strategy looks very similar to part (a), except now we will
write profits as q(p)p instead of p(q)q, and we will maximize with
respect to p. Consider firm 1:

maxp1 = q1 (p1 , p2 )p1 =

1+z
p
1z 2 1

1
p2
1z 2 1

z
p p
1z 2 2 1

The FOC (interior solution) is:

1+z
1z 2

2
p
1z 2 1

z
p
1z 2 2

=0

This gives firm 1s best response function.

p1 =

1+zzp2
2

By symmetry, firm 2s BRF is:

p2 =

1+zzp1
2

Now lets use the fact that p1 = p2 in equilibrium (again by symmetry) to solve firm 1s BRF for p1 :
p1 =

1+zzp1
2

2p1 = 1 + z zp1
p1 =

1+z
1z

= p2

Now substitute in to the demand functions to find equilibrium

quantities. Before doing that, lets simplify the demand functions
by recognizing that p1 = p2 :
q1 (p1 ) =

1+z
1z 2

1+z
p
1z 2 1

1
(1z)(2+z)

1+z
1z 2

1+z
p
1z 2 1

1
(1z)(2+z)

And by symmetry:
q1 (p1 ) =
(iii.)
First lets compare prices. Prices under quantity competition will
be higher than prices under price competition if:
1
2z

>

1+z
2+z

2 + z > 2 + 2z z z 2
0 > z 2
This will always be true for values of z between -1 and 1 (Note: if
you do not restrict the values of z, you have to be careful. If z > 2
or 2 < z < 1, then when you try to cross multiply, the sign flips.
(But also note, if z > 1, then you will get a negative quantity under
quantity competition, which does not make sense.) If z = 0, ie the
two goods are completely unrelated or heterogenous, then both
sides of this equation are equal. If z = 1, we get the Cournot
and Bertrand results for the case where the firms produce the same
exact product.
Now lets compare quantities. Quantities under quantity competition will be lower than quantities under price competition if:
1
2z

<

1
1z 2

+z

2 z z2 < 2 z

z 2 < 0

This will always be true for values of z between 0 and 1. If z=0,

ie the two goods are completely unrelated or heterogenous, then
both sides of this equation are equal. If z = -1, we get the Cournot
and Bertrand results for the case where the firms produce the same
exact product.
When we considered the Cournot and Bertrand models of duopoly
(with two perfectly homogenous i.e. identical products), we saw
that under the Bertrand model, in which firms compete on price,
firms end up producing the fully competitive quantities and prices
are driven down to the efficient level p = M C. Under Cournot
competition, in which firms compete on quantity, quantities are
lower and prices higher than the optimal level. This problem shows
that similar results hold when we consider two goods that are
partially, but not perfectly homogenous: price competition gives a
solution closer to the Pareto optimal solution than does quantity
competition. The more complementary or substitutable the two
goods are, the more the Bertrand and Cournot models diverge.
When goods are very heterogenous, the differences between the
Bertrand and Cournot models become small (and if we consider
two completely unrelated goods, both models provide exactly the
same result, which corresponds to each firm having a monopoly in
its product market).
3. (i.)
If firms are behaving competitively, all producers are willing to
produce up to the point where price equals marginal cost. The
total quantity demanded in this hour is exogenously set at 40000
MW. To determine who produces, construct a dispatch schedule
by ordering producers from least to greatest marginal cost.
To do this, see what happens at different costs:
For less than $20, see if the fringe supplies. Set 0.01Qf = 20 which
yields Qf = 2000. So, yes it supplies.
At a cost of $20, firm 1 will supply 15000 MW.

Between $20 and $35, the fringe will produce an additional 1500
MW (Qf = 1500). You find this by subtracting the amount the
fringe will produce at p = $20 (which is 2000) from the amount
the fringe would produce at p = $35 (which is 3500).
At a cost of $35, firm 2 supplies 15000.
Between $35 and $40, the fringe will produce an additional 500
MW (Qf = 500). You find this by subtracting the amount the
fringe will produce at p = $35 (which is 3500) from the amount
the fringe would produce at p = $40 (which is 4000).
During this whole process, you should keep in mind how much is
being produced in total since this market only demands 40000. At
this point, total production is 34000. Therefore firm 3 will supply
the remaining 6000 MW needed in this market and firm 4 is not
needed.
In summary, the dispatch schedule looks like this:
The fringe will supply the first 2000 MW at a cost less than
$20 per MW.
Firm 1 will supply 15000 MW at a cost of $20 per MW. This
gets us to 17000 MW total.
The fringe will supply an additional 1500 MW until marginal
costs are $35 per MW. This gets up to 18500 MW total.
Firm 2 will supply 15000 MW at a cost of $35 per. This gets
up to 33500 MW total.
The fringe will supply 500 MW until marginal costs are $40.
This gets up to 34000 MW total.
Firm 3 will supply the last 6000 MW at a cost of $40 per
MW. This gets up to 40000 MW, which is the total market
demand.
Note that firm 4 is not needed to supply this market.
Since firm 3 is the last producer needed to satisfy this demand, it

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sets the market price which is equal to its MC. Therefore, if these
firms were behaving competitively, we would expect to see a price
of $40 per MW.
(ii)
To compute the equilibrium quantities for the strategic firms (assuming that they are behaving like Cournot oligopolists, we first
need to derive the residual demand curve faced by these dominant players. To do this, we substract the fringe supply from the
perfectly inelastic market demand: Qd = QQf = 40000Qf .
To compute Qf , use the MC of the fringe M Cf = 0.01Qf and use
the fact that there is only one fringe. So P = 0.01Qf , and therefore
Qf = P/0.01. Now find that Qd = 40000 P/0.01. Solving for P,
this yields a linear residual inverse demand of P (Q) = 4000.01Q.
Call the intercept of this inverse residual demand a and the slope
b.
To find the four different quantities that each of the four dominant
firms would choose to supply if they were behaving as Cournot
oligopolists, use the equations given in the lecture notes IO Models Notes and look at the part on deriving equilibrium conditions
for the N-firm Cournot oligopoly. In equation (10) of page 6, you
will find a formula that allows you to compute the four different
quantities that each of the four dominant firms would supply if
they were behaving as Cournot oligopolists. You have almost all
the information you need to plug into the formula and get the
different q except 2 parameters. Those 2 missing parameters are
a and b.
By (10), we know that:

a+

qi =

N
P

cj nci

j6=i

(N +1)b

If we substitute the demand parameters a and b and the rest of

the information already provided into (10), we get the equilibrium
Cournot quantities for each firm.
For example, for firm 1:

11

q1 =

400+(35+40+42)4(20)
50.01

= 8740

If we do this for all four firms, we obtain the following quantities:

q1 = 8740
q2 = 7240
q3 = 6740
q4 = 6540
Total = 29260

Note that the capacity constraints do not bind for any of the strategic firms.
(iii.)
To answer this question, use equation (11) in page 6 of the same
handout. Notice that in this supposed Cournot oligopoly, firm 4
does participate and so does the fringe. Therefore now there
are 5 firms in this market.
By (11), we know that:
p =

a+N c
N +1

where c is the average of the MC of all the firms.

To find the MC of the fringe, first find the quantity it would produce under this scenario. Subtracting the production of the four
dominant firms found in (ii) from the total quantity demanded
leaves 40000 29260 = 10740 MW for the fringe. Therefore
M Cf = 0.01(10740) = 107.4.

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The average c of MC of all firms in this market is thus (20 + 35 +

40 + 42 + 107.4)/5 = 48.88.
Plugging in the numbers into equation (11) we obtain:
p =

400+5(48.88
5+1

= 107.4

The equilibrium price is thus $107.40, which is more than double

the competitive price.
(iv).
The observed price ($85) is below the price predicted by the Cournot
model ($107.4), but significantly above the competitive price ($40).
Firms do no appear to be behaving competitively. Other factors
that we have not accounted for here (threat of entry by new firms
if profits get large enough, threat of regulatory intervention, the
effect of forward contracts) could explain why the price is not as
high as the static Cournot model predicts.

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