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INDUSTRIAL ORGANIZATION

SPRING QUARTER 2009

PROFESSOR REQUENA

PROBLEM SET 3

Problem 1

Zak and Gabriella are two students who met by chance in a party of a common friend the

day before the spring term starts. Both students have a lot in common and liked each

other very much. Unfortunately, they forgot to exchange addresses. Fortunately, each

remembered that they spoke of attending a campus party the next week. Unfortunately,

two such parties were being held. One party is small. If each attends this party, they will

certainly meet. The other party is huge. If each attends this one, there is a chance they will

not meet because of the crowd. Of course, they will certainly not meet if they attend

separate parties. Payoffs of each depending on the combined choice of parties follow, with

Zak ‘s list payoffs listed first.

Gabriella

Go to small Go to large party

party

Zak Go to small 1000,1000 0,0

party

Go to large 0,0 500,500

party

1.2. Identify the Pareto optima; outcome for this “two party” problem.

1.1. The easiest way to find the Nash equilibria is to first eliminate the dominated

strategies for each player. Doing so, we find two Nash Equilibria (S, S) and (L,

L).

Gabriella

Go to small Go to large party

party

Zak Go to small 1000 , 1000 0,0

party

Go to large 0,0 500 , , 500

party

1.2 The Pareto optimal outcome is (1000, 1000), which results from the strategy pair

(S,S). At this point there is no way to make either party better off.

Problem 2

Solve the typical “Chicken” game. Two players each drive their car down the center of a

road in opposite directions. Each chooses either STAY or SWERVE. Staying wins

admiration and a big payoff if the opponent chooses SWERVE. Swerving loses face and

has a low payoff when the other player stays. Bad as that is, it is still better than the payoff

when both players choose STAY in which case they each die. These outcomes follow.

Player A

STAY SWERVE

Player B STAY -6,-6 2,-2

SWERVE -2,2 1,1

2.2. This is a good game to introduce mixed strategies. If Player A adopts the strategy,

STAY one-fifth of the time, and SWERVE four-fifths of the time, show that Player B

will be indifferent between the strategies, STAY and SWERVE.

2.3. If both players use this probability mix, what is the chance that they will both die?

(Hint: The easiest way to see this is to add the probabilities to the border of the

game matrix and then compute the joint probabilities in each cell).

2.1. The Nash equilibria are (Stay, Swerve) and (Swerve, Stay)

Player A

STAY SWERVE

Player B STAY -6, -6 2 , -2

SWERVE -2, 2 1, 1

E(profit player B / STAY)= (0.2)*(-6)+(0.8)*(2)=0.4

E(profit player B / SWERVE)= (0.2)*(-2)+(0.8)*(1)=0.4

2.3 The easiest way to see this is to add the probabilities to the border of the game

matrix and then compute the joint probabilities in each cell.

Player A

STAY 1/5 SWERVE 4/5

Player B STAY -6,-6 2,-2

1/5 1/25 4/25

SWERVE -2,2 1,1

4/5 4/25 16/25

Problem 3

The inverse demand curve of product “small widgets” is p(Q)=400-2Q. There are two firms

and each firm has a unit cost of production equal to 40, and they compete in the markets

in quantities. That is, they can choose any quantity to produce, and they make their

quantity choices simultaneously.

3.1. Show how to derive the Cournot-Nash equilibrium to this game. What are the firms’

profits in equilibrium?

q1

1

q1 = 90 − q 2

2

By symmetry

1

q 2 = 90 − q1

2

* *

q1 = q 2 = 60

Q* = 120

P* = 160

Π 1 = Π 2 = 7200

3.2. Suppose that firm 1 has a cost advantage. Its units cost is constant and equal to 25

whereas the firm 2 has the higher unit cost of 40. What is the Cournot outcome now?

q1

1

q1 = 93 − q 2

2

Max Π 2 = (400 − 2(q1 + q 2 ))q 2 − 40q 2

q1

1

q1 = 90 − q 2

2

q1* = 64

q 2* = 68

Q* = 122

P* = 158

Π 1 = 8512

Π 2 = 8024

Problem 4

Suppose that an industry has two firms, L and F, producing a homogenous good. Firm L is

a well-know leader in the industry adn both firms behave according to the Stackelberg

model. The inverse demand function is p=1-qL-qS, where qL and qS are the quantities

produced by firm L and firm F, respectively, and p is the market price. The cost function is

C(qi)=qi/2, i=L,S.

4.1 Obtain the quantities produced by firms L and S in equilibrium and the market price.

4.2. Compare the profits of the firms in that scenario with those obtained in the scenario

where firms compete a la Cournot.

4.1 Follower

1

Max Π S = pq S − C (q S ) = (1 − q L − q S )q S − q S

qS 2

∂Π S 1

C.P.O. = 1 − qL − qS − = 0

∂q S 2

1 qL

FR S → q S* (q L ) = −

4 2

Leader

1

Max ΠL = (1 − q L − q S ) − q L

qL 2

1 qL

s .a . q S* (q L ) = −

4 2

1 q L 1 3 qL 1 q L q L2

Max Π L = 1 − q L − − q L − q L = − q L − q L = −

qL

4 2 2 4 2 2 4 2

∂Π L 1 2q L 1

C.P.O. = − =0 q L* = = 0,25

∂q L 4 2 4

Follower

1

1 4 1

q S* = − = = 0,125 1

4 2 8 q S* = = 0,125

8

1 1 3

QS = + = = 0,375

4 8 8

1 1 5

pS = 1 − − = = 0,625

4 8 8

Profits

51 11 1

Π LS = − = = 0.03125

8 4 2 4 32

51 11 1

Π SS = − = = 0.015625

8 8 2 8 64

b) Cournot

1 qL

FR S → q S* (q L ) = − 1 1 1 qL

4 2 qL = − −

1 q 4 2 4 2

FRL → q L* (q S ) = − S

4 2

1 1 qL 3 1 1 ^

qL = − + qL = q LC = = 0,16

4 8 4 4 8 6

1 ^

q SC = = 0,16

1 1 2 ^

6

QC = + = = 0,3 3

6 6 6

1 1 2 ^

p S = 1 − − = = 0,6 6

6 6 3

21 11 1 ^

Π LS > ΠCL = ΠCS > Π SS

ΠCL = ΠCS = − = = 0.02 7

3 6 2 6 36

Problem 5

The inverse demand curve of product “square wheels” is p(Q)=100-2Q, and the cost

function for all firms operating in the industry is CT(Q)=4Q.

5.1.Under perfect competition, what is the industry production and price of a “square

wheel”?

CMg = 4 p =4

4 = 100 − 2Q

96 = 2Q

Q = 48

5.2. Suppose that there are only two firms operating in the industry, competing `a la

Cournot. Obtain the reaction curve of each firm. What is the production and price in

this scenario? What are the firms’ profits?

p (Q ) = 100 − 2(q 1 + q 2 )

q1

= 100q 1 − 2q 12 − 2q 1q 2 − 4q 1

= 96q 1 − 2q 12 − 2q 1q 2

∂Π1

C.P.O. = 96 − 4q 1 − 2q 2 = 0

∂q 1

4q 1 = 2q 2 − 96

96 − 2q 2

q1 =

4

q2

FR1 → q1 (q 2* ) = 24 −

2

q1

By symmetry FR 2 → q 2 (q1* ) = 24 −

2

1 1

q 1 = 24 − 24 − q 1

2 2

1

q 1 = 12 + q 1

4

1

q 1 1 − = 12

4

4

q 1 = 12

3

q1 = 16 Q = 32

q 2 = 16 p = 100 − 2(32) = 36

Q C = 32

p C = 100 − 2(32) = 36

5.3. Draw the reaction curves and identify the Cournot-Nash equilibrium.

q2

q2 FR1 → q 1 (q 2* ) = 24 −

2

48

q1* (q 2 )

q 2 = 0 → q 1 = 24

45º

q 1 = 0 → q 2 = 48

C

24 q1

FR 2 → q 2 (q 1* ) = 24 −

2

16

q 1 = 0 → q 2 = 24

q 2 = 0 → q 1 = 48

q 2* (q 1 )

16 24 48 q1

5.4. If the two firms decide to collude, what is the industry production and price in that

scenario? And what are the firms’ profits?

Q

= 100Q − 2Q 2 − 4Q = 96Q − 2Q 2

∂ΠT

C.P.O. = 96 − 4Q = 0

∂Q

96 q 1COL = 12

Q COL = = 24

4

q 2COL = 12

Q COL = 24

ΠCOL

1 = pq 1 − cq 1 = 52(12) − 4(12) = 576

ΠCOL

2 = pq 2 − cq 2 = 52(12) − 4(12) = 576

5.5. Suppose that the two firms collude and produce the same amount of output. If firm 1

assumes that firm 2 will not react if she changes output, what is the optimal level of

production of firm 1 if firm 2 produces 12 square wheels? Does firm 1 have any

incentive to continue colluding with firm 2?

q 2COL = 12

q2

FR1 → q 1 (q 2* ) = 24 −

2

12

q 1 = 24 − = 24 − 6 = 18

2

Q = q 1 + q 2 = 18 + 12 = 30

p = 100 − 2(30) = 40

5.6. Suppose that the two firm compete `a la Stackelberg with firm 1 acting as a leader and

firm 2 acting as a follower. What is the industry production and price in this scenario?

How many units does firm 1 produce? And firm 2? What are each firm’s profits?

Firm 2: q1

FR 2 → q 2 (q1* ) = 24 −

2

Firm 1: Max Π1 = pq 1 − cq 1

q1

q1

s .a . q 2* (q 1 ) = 24 −

2

Π1 = [100 − 2(q 1 + q 2 )] q 1 − 4q 1

q1

s .a . q 2* (q 1 ) = 24 −

2

q

Π1 = 100 − 2 24 + 1 q 1 − 4q 1

2

= [100 − 48 − q 1 ] q 1 − 4q 1

= [52 − q 1 ] q 1 − 4q 1

= 52q 1 − q 12 − 4q 1

= 48q 1 − q 12

∂Π1

C.P.O.: = 48 − 2q 1 = 0 q 1L = 24

∂q 1

q1 24

FR2 → q 2 = 24 − = 24 − = 12 q 2S = 12

2 2

5.7. Draw and compare the equilibrium in the each scenario (Cournot, Collusion

and Stackelberg) using the isoprofit curves.

(The graph also illustrate the isoprofit function of firm 1 when she cheats in collusion)

Problem 6

Obtain the equilibrium price in Bertrand in an industry with two firms, A and B, whose

marginal costs are, respectively, cA and cB, and cA < cB. Show that there is only one

equilibrium. What are the quantities produced by firms A and B for the equilibrium price if

the demand function is D(p)? What are the firms’ profits?

P

A

0 si p A > p B AB

D(p)

D ( pA )

qA = si p A = p B BC

2

D ( p A ) si p A < p B DE

B D

PB

C

E

q

Problem 7

Examine this non-cooperative game between two firms in which they can choose between

collusion (C) or competition `a la Cournot (no-collusion, NC), obtaining the following

payoffs (firm’s profits):

Firm 2

C NC

Firm 1 C 8,8 2,10

NC 10,2 3,3

Firm 2

C NC

Firm 1 C 8, 8 2, 10

NC 10, 2 3, 3

7.2. Consider an infinity time horizon (firms play the same game an indeterminate number

of times). Describe the “trigger” strategies of this supergame (repeated game). Explain

how does the pair of strategies (C,C) become a Nash-equilibrium in a infinity-repeated

game.

Rρ

PV∞cheat = 10 + 3Rρ + 3R 2 ρ 2 + ... = 10 + 3

1 − Rρ

8

PV∞cooperate = 8 + 8 Rρ + 8 R 2 ρ 2 + ... =

1 − Rρ

Cooperation if

8 Rρ

> 10 + 3

1 − Rρ 1 − Rρ

2

Rρ > ≈ .28

7

7.3. With finite time repeated games the Nash equilibrium is solved by “backward

induction”. If the players know when the game is to finish, they will solve the subgame in

the last period and the Nash Equilibrium will be No-cooperate. Solving backwards, the

previous period will do the same and so on until the first period.

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