ECONOMICS 121A

INDUSTRIAL ORGANIZATION
SPRING QUARTER 2009
PROFESSOR REQUENA

PROBLEM SET 3

DUE: MAY 6TH

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

1.1. Find the Nash Equilibria for this problem.

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

2.1. Find the Nash Equilibria in this game.

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

2.2. We use expected values:

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

The probability to (STAY, STAY) is 1/25

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?

Max Π 1 = (400 − 2(q1 + q 2 ))q1 − 40q1

q1

360 − 4q1 − 2q1 = 0

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?

Max Π 1 = (400 − 2(q1 + q 2 ))q1 − 25q1

q1

375 − 4q1 − 2q1 = 0

1
q1 = 93 − q 2
2
Max Π 2 = (400 − 2(q1 + q 2 ))q 2 − 40q 2
q1

360 − 4q1 − 2q1 = 0

1
q1 = 90 − q 2
2

Solving the two equation- 2 unknow parameters system,

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 )

Max Π1 = p (Q )q 1 − cq1 = 100 − 2(q1 + q 2 )  q1 − 4q1

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

ΠC1 = pq 1 − cq 1 = 36(16) − 4(16) = 512

ΠC2 = pq 2 − cq 2 = 36(16) − 4(16) = 512

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?

Max ΠT = p (Q )Q − cQ = [100 − 2(Q )]Q − 4Q

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

p COL = 100 − 2(24) = 52

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

Π1 = pq 1 − cq 1 = 40(18) − 4(18) = 648 > 576

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

7.1. Find the Nash equilibria.

Firm 2
C NC
Firm 1 C 8, 8 2, 10

NC 10, 2 3, 3

Equilibria (NC, NC) with payoffd (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.