Econ 101A — Problem Set 5 Solutions Due in class on Tu 26 November. No late Problem Sets accepted, sorry! This Problem set tests the knowledge that you accumulated mainly in lectures 20 to 24. Some of the material will only be covered on Lecture 24, but you should be able to do most of the problem set already [as of Tu 17 November]. The problem set is focused on monopoly, oligopoly, and static game theory. General rules for problem sets: show your work, write down the steps that you use to get a solution (no credit for right solutions without explanation), write legibly. If you cannot solve a problem fully, write down a partial solution. We give partial credit for partial solutions that are correct. Do not forget to write your name on the problem set! Problem 1. Monopoly, Oligopoly, and Perfect Competition (46 points) In this problem you are asked to compare the outcomes of monopoly, oligopoly, and perfect competition in one market. We are going to assume very simple functional forms in order to simplify the algebra. We assume that the Þrm has a very simple cost function: c (y) = cy, with c > 0. The marginal cost of production therefore is constant. As for the market demand, we assume that it takes the simple linear form p (Y ) = a − bY, with a > c > 0 and b > 0, where Y is the total production on the industry. 1. Consider Þrst the case of perfect competition. Derive the marginal and average cost curves. How does the supply curve look like for each Þrm? What about in the industry? (aggregate the individual supply curve over J Þrms). (4 points) 2. Equate supply and demand to obtain the industry-level production under perfect competition YP∗C , as well as the price level under perfect competition p∗P C . (3 points) 3. How do perfect competition price and quantity vary as the cost of production c increases? How do they vary if there is a positive demand shock (a increases)? (3 points) 4. We consider now the monopoly case. Write down the proÞt maximization problem and the Þrst order conditions with respect to y. [In the case of monopoly, y = Y ] (2 points) ∗ and p∗M . How does p∗M vary as a increases? Why is this comparative statics diﬀerent from 5. Solve for yM the one under perfect competition? (2 points) 6. Compare the total output and prices of perfect competition and monopoly. Compute the monopoly proÞts and conpare them to the proÞts under perfect competition. (3 points) 7. Consider now the case of duopoly, that is, an oligopoly with two Þrms, i = 1, 2. Write down the proÞt maximization problem of Þrm i as a function of the quantity produced by Þrm −i, y−i . (3 points) 8. We are now looking for Nash equilibria (in pure strategies) in the quantity produced y1 , y2 . Each Þrm ∗ , maximizes proÞts with respect to yi . i, holding Þxed the qantity produce by the other Þrm at y−i Write down the Þrst order conditions for Þrms 1 and 2. (3 points) 9. In a Nash equilibrium each Þrm must choose the optimal quantity produced given the production choice of the other Þrm. Combine the two Þrst order conditions in point 5 to obtain the Nash equilibrium quantity produced by Þrm 1, y1∗ , and by Þrm 2, y2∗ . Derive also the industry production YD∗ = y1∗ + y2∗ , the price p∗D , the proÞt level of each Þrm π∗i,D , and the aggregate proÞt level Π∗D = π∗1,D + π ∗2,D (6 points) ∗ Π∗M , and p∗M . (3 points) 10. Compare YD∗ , Π∗D , and p∗D with YP∗C Π∗P C , and p∗P C and YM 11. Finally, the general case of oligopoly. Assume that there are I Þrms, all identical, with production costs as above. Write down the proÞt maximization problem and the Þrst order condition of a Þrm. (2 points) 1 12. We now solve for the oligopoly production using a trick. We look for a symmetric solution,Pthat is, a ∗ == j6=i yj∗ = solution where each Þrm produces the same. In particular, impose the condition y−i ∗ ∗ (I − 1) yO . Find the solution for the Nash equilibrium quantity yO . Derive also the industry production ∗ , the price p∗O , the proÞt level of each Þrm π∗O , and the aggregate proÞt level Π∗O = Iπ∗O . (4 YO∗ = IyO points) 13. What is nice about this general oligopoly solution is that embeds the previous cases: for I = 1 we go back to monopoly, for I = 2 we get the duopoly solution. Most interestingly, show that for I → ∞, the prices, the total quantity produced, and the total industry proÞts converge to the perfect competition ones. Compare this to Bertrand competition. How many companies did we need there to get the same outcomes as perfect competition? (8 points) Solution to Problem 1. 1. The marginal cost and average cost both equal c. It follows that the supply curve is as follows: ∞ if p > c yi∗ (p) = any y ∈ [0, ∞] if p = c 0 if p < c The aggregate supply curve coincides with the individual supply curve (this is the case since supply is horizontal, perfectly elastic). 2. From point 1, it is clear that in perfect competition the price p∗P C must equal c (remember, price must equal marginal cost). Given this, it is easy to Þnd yP∗ C : p∗P C = a − byP∗ C or a−c b 3. An increase in the cost of production c induces an increase in the perfect competition price and a decrease in the quantity produced. An exogenous increase in demand (increase in a) increases the quantity produced, but it does not vary the price. yP∗ C = 4. A monopolistic Þrm maximizes proÞts: max (a − by) y − cy. y and the Þrst order condition is ∗ − c = 0. a − 2byM 5. It follows that ∗ = yM a−c 2b and a+c a−c = . 2b 2 In this case, as demand increases, (a increases), the monopoly price goes up. While under perfect competition an increase in demand does not increase prices, it does so under monopoly. The monopolistic Þrm takes advantage of the increased demand in a way that a perfectly competitive Þrm cannot do. ∗ p∗M = a − byM =a−b ∗ equals yP∗ C /2 and the price p∗M is higher than p∗P C = c. Under 6. The total output under monopoly yM monopoly the Þrm produces less output than under perfect competition in order to raise prices. The proÞts equal ¶ µ a−c (a − c)2 a+c ∗ ∗ −c = >0 (pM − c) yM = 2 2b 4b These proÞts are large than the proÞts under perfect competition, which are zero. 2 7. A duopolistic Þrm maximizes proÞts: max (a − b (yi + y−i )) yi − cyi . yi (1) 8. The Þrst order condition of problem (1) is ∗ − c = 0. a − 2byi∗ − by−i It follows that the Þrst order conditions for the two Þrms are a − 2by1∗ − by2∗ − c = 0. (2) a − 2by2∗ − by1∗ − c = 0. (3) and 9. From the Þrst order condition (2), we get y2∗ = (a − c) /b − 2y1∗ . We substitute this expression into (3) to get a − 2 (a − c) + 4by1∗ − by1∗ − c = 0 or 3by1∗ = a − c, so y1∗ = a−c 3b and a−c a−c a−c a−c − 2y1∗ = −2 = . b b 3b 3b Not surprisingly, the quantities produced by Þrms 1 and 2 are equal. The total quantity produced is y2∗ = YD∗ = y1∗ + y2∗ = 2 The duopoly price is a−c 3b µ ¶ 2 a−c 1 p∗D = a − bYD∗ = a − b 2 = a + c. 3b 3 3 The Þrm proÞts equal ∗ = π∗D = (p∗D − c) yD µ ¶ 2 (a − c)2 a−c 1 a+ c−c = >0 3 3 3b 9b and the aggregate proÞts equal Π∗D = 2π ∗D = 2 (a − c)2 9b 10. When we compare prices across monopoly, duopoly and perfect competition, we Þnd c = p∗P C < p∗D < p∗M . As for the total quantity produced, we obtain ∗ . YP∗C > YD∗ > YM Finally, for proÞts, we have 0 = Π∗P C < Π∗D < Π∗M . A monopolistic Þrm extracts most proÞts by charging a higher price, and therefore selling less. Firms in a duopoly would like to collude and do the same, but collusion is not sustainable. They end up producing too much (relative to the proÞt maximizing level) and as a consequence the price and the industry proÞts decline. Still, those proÞts are higher than under perfect cmpetition. 11. In the case of oligopoly, the maximization problem of Þrm i is max (a − b (yi + y−i )) yi − cyi yi with y−i = P j6=i yj . The Þrst order condition of problem (1) is ∗ − c = 0. a − 2byi∗ − by−i 3 (4) 12. Impose symmetry, we can write (4) as ∗ − c = 0. a − 2byi∗ − b (I − 1) yO We can then sum over the I such conditions to get a − 2b I X i=1 ∗ yi∗ − b (I − 1) yO −c =0 or ∗ ∗ − bI (I − 1) yO − Ic = 0. Ia − 2bIyO This implies ∗ yO = a−c (I + 1) b The total quantity produced is ∗ =I YO∗ = IyO a−c (I + 1) b The oligopoly price is p∗O =a − bYO∗ µ ¶ I a−c 1 a+ c. =a−b I = (I + 1) b I +1 I +1 The Þrm proÞts equal ∗ π∗O = (p∗O − c) yO = µ ¶ I a−c (a − c)2 1 a+ c−c = >0 I +1 I +1 (I + 1) b (I + 1)2 b and the aggregate proÞts equal Π∗O = Iπ∗O = I (a − c)2 (I + 1)2 b 13. For I → ∞, the total quantity produced YO∗ converges to (a − c) /b, wich is the production under perfect competition. Price p∗O converge to c, that is, to marginal cost pricing, Finally, industry-level proÞts Π∗O converge to zero, as in perfect competition. Therefore, when there are many Þrms, we converge to perfect competition. But it takes an awful lot of Þrms, not just 2 as in the Bertrand case! 4 Problem 2. Nash Equilibria in a simple game (19 points) Two Þrms are deciding simultaneously whether to enter a market. If neither enters, they make zero poÞts. If both enters, they make proÞts -1, since the market is too small for two Þrms. If only one enters, that Þrm makes high proÞts. This game is summarized in the following matrix: 1 \2 Enter Do not Enter Enter −1, −1 10, 0 Do not Enter 0, 5 0, 0 1. What are the pure-strategy Nash Equilibria of this game? (3 points) 2. Now assume that Þrm 1 can enter the market with probability p1 and Þrm 2 can enter the market with probability p2 . Write down the expected utlity of each Þrm as a function of the strategy of the other player, and Þnd the best response correspondence for Þrms 1 and 2. (8 points) 3. Graph these best response correspondences and Þnd the Nash equilibria in mixed strategies. (5 points) 4. Is there one equilibrium out of these that seems more plausible to you? (3 points) Solution to Problem 2. 1. The pure-strategy Nash Equilibria in this game are (Enter, Do Not Enter) and (Do Not Enter, Enter). That is, in the two equilibria only one Þrm will enter the market, but we cannot predict which one. 2. The expected utility for Þrm 1 is as follows: u1 (Enter, σ 2 ) = p2 u1 (Enter,Enter) + (1 − p2 ) u1 (Enter,Do Not Enter) = −p2 + 10 (1 − p2 ) = 10 − 11p2 and u1 (Do Not Enter, σ 2 ) = p2 u1 (Do Not Enter,Enter) + (1 − p2 ) u1 (Do Not Enter,Do Not Enter) = 0 Similarly, the expected utility for Þrm 2 is as follows: u2 (Enter, σ1 ) = p1 u2 (Enter,Enter) + (1 − p1 ) u2 (Enter,Do Not Enter) = −p1 + 5 (1 − p1 ) = 5 − 6p1 and u2 (Do Not Enter, σ1 ) = p1 u2 (Do Not Enter,Enter) + (1 − p1 ) u2 (Do Not Enter,Do Not Enter) = 0. It follows that the best response correspondence of Þrm p1 = 1 p1 ∈ [0, 1] BR1 (σ2 ) = p1 = 0 1 is if p2 < 10/11 if p2 = 10/11 if p2 > 10/11 and the best response correspondence of Þrm 2 is if p1 < 5/6 p2 = 1 p2 ∈ [0, 1] if p1 = 5/6 BR2 (σ1 ) = if p1 > 5/6. p2 = 0 3. See Þgure. The mixed-strategy equilibrium is (p∗1 , 1−p∗1 ); (p∗2 , 1−p∗2 ) = (5/6, 1/6); (10/11, 1/11). Notice that we also Þnd the two equillibria in pure strategies. 4. It is not obvious which one of the three equilibria is the best predictor of behavior. Between the pure strategy equilibria, the one where only Þrm 1 enters seems more likely since the payoﬀ from entering is higher for Þrm 1 (10) than for Þrm 2 (5). This is what Thomas Schelling has called a focal point. On the other hand, this is a game in which the potential gains from entering are very large, while the potential losses are not large. It is hard to imagine that Þrm 2 will accept to stay out. If I was to predict the outcome, I would probably predict that both Þrms enter, although this is not a Nash Equilibrium! (you do not have to agree with me:) 5

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