ECONOMICS 121A

INDUSTRIAL ORGANIZATION
SPRING QUARTER 2009
PROFESSOR REQUENA

PROBLEM SET 5

DUE: JUN 3RD

Problem 1. [Predatory conduct]

Consider the following game with three stages between an incumbent and a potential
entrant. The incumbent firm may incur in a sunk cost and may use it as a “threat” for price
predation in case the potential entrant decides to enter the market (i.e. the incumbent will
announce that she can incur in a sunk cost). The sequence of the game is as follows. In
stage one the incumbent has to decide whether invest or not, with F=5, which is a sunk
cost for the incumbent. In stage two, the potential entrant has to decide whether to enter or
to remain outside the market. In stage three, and in the case of entry, the incumbent has to
decide whether to accomodate to the entry (with profits πD=3 for both firms in the last
stage) or to compete in prices, that is to “predate” (with loses of πG=-1, for both firms). In
the stage three , if entrant does not enter the market, the incumben acts as a monopoly
and obtain πM= 10.

(A) Draw the extensive game (tree representation) and determine the Nash perfect
equilibrium. Is the threat of price predation credible by the entrant?
EQUILIBRIUM:
INCUMBENT Perfect
equilibrium:
(F>0, NE)
F=0 F=5

ENTRANT ENTRANT

Enter Enter No Enter

No Enter

INCUMBENT INCUMBENT

Accomodate Fight
Accomodate Fight

3 -1 10 -2 -1 5
3 -1 0 3 -1 0
(B) How does the equilibrium change if F=3? Is the threat credible now?

EQUILIBRIUM:
INCUMBENT

F=0 F=3

ENTRANT ENTRANT

Enter Enter No Enter

No Enter

INCUMBENT INCUMBENT

Accomodate Fight Accomodate Fight

3 -1 10 -1 7
0 0
3 -1 0 -1
3

(C) Discuss alternative ways that the incumbent may use to provide credibility to the
announcement of price predation..

1. To build capacity
2. To build reputation based on past actions
3. To write down a contract “I will pay X if I do not fight”
Problem 2. [Horizontal mergers and vertical relations]
Norman International has a monopoly in the manufacture of whatsits. Each whatsit
requires exactly one richet as an input and incurs other variable costs of $5 per unit.
Richets are made by PepRich Inc., which is also a monopoly. The variable costs of
manufacturing richets are $5 per unit. Assume that the inverse demand for whatsits
p = 50 − qw p q
is w , where w is the price of whatsits in dollars per unit and w is the quantity of
whatsits offered for sale by Norman International.

(A) Assume that the two monopolists act as independent profit-maximizing companies,
with Norman International setting a price pw for whatsits and PepRich setting a price pr
for richets. Hence, derive the profit-maximizing price for whatsits as a function of the
price of richets, and use this function to obtain the derived demand for richets.

(B) Use your answer in (A) to write down the profit function for PepRich. Hence, derive
the profit-maximizing price of richets. Use this to derive the profit-maximizing price of
whatsits. Calculate the sales of whatsits (and so of richets) and calculate the profits of
the two firms.

( C) Now assume that these two firms merge to form NPR International. Write down
the profit function for NPR given that it sets a price pw for whatsits. Hence, calculate
the postmerger profit-maximizing price for whatsits, sales of whatsits, and the profits of
NPR

(D) Verify that this merger has increased the joint profits of the two firms while reducing
the price charged to consumers. By how much has consumer surplus been increased
by the merger in the market for whatsits?

Answer:

(A) Assume that the two monopolists act as independent profit-maximizing companies, with Norman
International setting a price pw for whatsits and PepRich setting a price pr for richets. Hence, derive
the profit-maximizing price for whatsits as a function of the price of richets, and use this function to
obtain the derived demand for richets

Profits for Norman International are given by revenue minus the cost of richets and other variable costs. If
a richet costs pr per unit we obtain

Taking the derivative with respect to qw and solving for the optimal level of output (qw) will yield
The price of whatsits is then

We can then write the price of richets in inverse demand or price dependent form

(B) Use your answer in (A) to write down the profit function for PepRich. Hence, derive the profit-
maximizing price of richets. Use this to derive the profit-maximizing price of whatsits. Calculate the
sales of whatsits (and so of richets) and calculate the profits of the two firms.

The profits of PepRich are given by revenue from the sales of richets minus their cost. Revenue is
given by

Profits are given by

If we take the derivative of profit with respect to qr and set equal to zero we obtain
The price of richets is then given by

p r = 45 − 2 qr = 45 − 20 = 25

The price of whatsits is given by

Sales of whatsits are

Profits of Norman International are given by revenue minus the cost of the richets minus the other
variable costs or

Profits of PepRich are given by

( C) Now assume that these two firms merge to form NPR International. Write down the profit
function for NPR given that it sets a price pw for whatsits. Hence, calculate the postmerger profit-
maximizing price for whatsits, sales of whatsits, and the profits of NPR.

Profits for NPR are given by revenue minus the cost of richets (5) and other variable costs. Profits are

Taking the derivative with respect to qw and solving for the optimal level of output (qw) will yield the
optimal sales of whatsits.
The price of whatsits is then

p w = 50 − qw = 50 − 20 = 30

Profits for the combined firm are given by

(D) Confirm that this merger has increased the joint profits of the two firms while reducing the
price charged to consumers. By how much has consumer surplus been increased by the merger
in the market for whatsits?

The joint profits are 400. The profits of NI alone were 100 and the profits of PepRich alone were 200
for a total of 300. Thus, the profits as a merged firm are larger. The price to consumers of 30 is
lower than in the case of separate firms when the price of whatsits was 40.

We can compute consumers surplus most easily by finding the area of the rectangle bounded by the
two prices and the original quantity and then adding the area of the triangle with height equal to the
change in price and base equal to the change in quantity. If we let (p1, q1) be the initial price
quantity pair for whatsits and (p2, q2) be the subsequent pair we obtain
Thus consumers are better off with the merger.