Sketches of Solutions for Assignment #5

Managerial Economics, Fall 2015

Due: Monday November 30

Readings: Three Baye chapters. Managing in Competitive, Monopolistic, and

Monopolistically Competitive Markets. Basic Oligopoly Models. Game Theory:
Inside Oligopoly.
A. Questions from intermediate microeconomics.
1. A firm sells its product in a perfectly competitive market where other firms
charge a price of $80 per unit. The firms total costs are C(Q) = 40+8Q+2Q2 .
a. How much output should the firm produce in the short run?
Ans. Π(Q) = 80Q − (40 + 8Q + 2Q2 ). Since this is a quadratic opening
downwards, this is maximized with Π0 (Q) = 0, that is, when price, P =
80, is equal to marginal cost, 8 + 4Q, that is Q∗ = 18.
b. What price should the firm charge in the short run?
Ans. It has no choice in the matter, P = 80 — a higher price would
result in 0 sales, a lower price would push demand higher than the firm
can profitably meet.
c. What are the firms short-run profits?
Ans. Π∗ = 80 · 18 − (40 + 8 · 18 + 2 · 182 ) = 248.
d. What adjustments should be anticipated in the long run?
Ans. If all of the firms have access to the same technology as this firm
and that is in fact the best technology, then we expect to see entry until
AC(Q) = (40 + 8Q + 2Q2 )/Q is minimized and price is√equal to that
lowest average cost. AC(·)√ reaches a minimum at Q = 20, at which
point, average cost is 6 · 5 + 8 ' 21.4.
2. You are the manager of a firm that produces a product according to the
cost function C(qi ) = 100 + 50qi − 4qi2 + qi3 . Determine the short-run supply
function if:
a. You operate a perfectly competitive business.
Ans. π(qi ) = pqi − C(qi ), the FOCs are π 0 (qi ) = 0 or p − C 0 (qi ) = 0, the
usual “price equals marginal cost” equation, but here it is important to
check the SOCs as well, π 00 (qi ) < 0 (or else you will be at a local minimum
for profits). The two expressions are
3qi2 − 8qi + (50 − p) = 0, and − (6qi − 8) < 0.
√
8± 64−12(50−p)
The first yields qi = 6 , the second yields qi > 86 . Combining
the short run supply function is
p
8 ± 64 − 12(50 − p) 2
qi∗ (p) = for p > 44 .
6 3
The fixed cost, 100, is large enough that profits are negative until p >
74.5 (approximately), so the long-run supply function is the short-run for
higher p and 0 for lower.
b. You operate a monopoly.
Ans. In this case, there is no supply function, you set either quantity or
price.

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 c. You operate a monopolistically competitive business.
Ans. In this case, there is no supply function, you set either quantity or
price.
3. The CEO of a major automaker overheard one of its division managers make
the following statement regarding the firms production plans: “In order to
maximize profits, it is essential that we operate at the minimum point of our
average total cost curve.” If you were the CEO of the automaker, would you
praise or chastise the manager? Explain.
Ans. Chastise. Having some market power means that short run profits are
maximized when marginal revenue is equal to marginal cost. This in turn
may not be a good recommendation for the longer term, e.g. if it prices the
division’s products out of the market segment, re-design and its consequent
change of cost function may be a best response.
4. The second largest public utility in the nation is the sole provider of elec-
tricity in 32 counties of southern Florida. To meet the monthly demand for
electricity in these counties, which is given by the inverse demand func-
tion P = 1, 000 − 5Q, the utility company has set up two electric gen-
erating facilities: Q1 kilowatts are produced at facility 1, and Q2 kilo-
watts are produced at facility 2 (so Q = Q1 + Q2 ). The costs of produc-
ing electricity at each facility are given by C1 (Q1 ) = 10, 050 + 5Q21 and
C2 (Q2 ) = 5, 000 + 2Q22 , respectively. Determine the cost function for the
utility, C(Q) = minQ1 ,Q2 C1 (Q1 ) + C2 (Q2 ) subject to Q = Q1 + Q2 . With
this, determine the profit-maximizing amounts of electricity to produce at
the two facilities, the optimal price, and the utility companys profits.
Setting Q2 = Q − Q1 turns this into a one variable problem,
min 10, 050 + 5, 000 + 5Q21 + 2(Q − Q1 )2 .
Q1

The solution happens where the two marginal costs are equal, that is, when
4
10Q1 = 4(Q − Q1 ), that is, Q1 = 14 Q and Q2 = 10
14 Q. This means that the
cost function is
4 10 280 2
C(Q) = (10, 050 + 5, 000) + 5( Q)2 + 2( Q)2 = 15, 050 + Q .
14 14 196
The profit maximization problem is
280 2
max Q(1, 000 − 5Q) − (15, 050 + Q ),
Q 196
∗
which has Q = 77 97 as its solution, with a price of 1, 000 − 388 98 = 611 91 .
B. Oligopoly questions.
1. The inverse market demand in a homogeneous-product Cournot duopoly is
P = 100 − 2(Q1 + Q2 ) and costs are C1 (Q1 ) = 12Q1 and C2 (Q2 ) = 20Q2 .
a. Determine the reaction function for each firm.
b. Calculate each firms equilibrium output.
c. Calculate the equilibrium market price.
d. Calculate the profit each firm earns in equilibrium.
Ans. The previous were done in lecture.
e. Calculate the quantity and profit that maximize the sum of consumer and
producer surplus. Use this to calculate the social inefficiency due to the
oligopolistic structure of the industry.

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 Ans. Because the cost and marginal cost for firm 1 is always lower, it
is inefficient to have firm 2 produce anything. To find the social opti-
mum, set price equal to 12, the lower marginal cost, and calculate the
consumer surplus (area under the demand curve above the price p = 12.
The producer surplus will be equal to 0 at that point.
2. The inverse demand for a homogeneous-product Stackelberg duopoly is P =
20, 000−5Q. The cost structures for the leader and the follower, respectively,
are CL (QL ) = 3, 000QL and CF (QF ) = 4, 000QF .
a. What is the followers reaction function?
b. Determine the equilibrium output level for both the leader and the fol-
lower.
c. Determine the equilibrium market price and the profits of the leader and
the follower.
d. Calculate the quantity and profit that maximize the sum of consumer and
producer surplus. Use this to calculate the social inefficiency due to the
oligopolistic structure of the industry.
Ans. Except for the last part, this was done in lecture, the last part mirrors
the previous problem.
3. Two firms compete in a market to sell a homogeneous product with inverse
demand function P = 400 − 2Q. Each firm produces at a constant marginal
cost of $50 and has no fixed costs. Use this information to compare the
output levels and profits in settings characterized by Cournot, Stackelberg,
Bertrand, and collusive behavior.
Ans. This is a good review problem.
4. You are the manager of BlackSpot Computers, which competes directly with
Condensed Computers to sell high-powered computers to businesses. From
the two businesses perspectives, the two products are indistinguishable. The
large investment required to build production facilities prohibits other firms
from entering this market, and existing firms operate under the assumption
that the rival will hold output constant. The inverse market demand for
computers is P = 5, 100 − 0.5Q and both firms produce at a marginal cost of
$750 per computer. Currently, BlackSpot earns revenues of $6.38 million and
profits (net of investment, R&D, and other fixed costs) of $1 million. The
engineering department at BlackSpot has been steadily working on develop-
ing an assembly method that would dramatically reduce the marginal cost
of producing these high-powered computers and has found a process that
allows it to manufacture each computer at a marginal cost of $500. How will
this technological advance impact your production and pricing plans? How
will it impact BlackSpots bottom line?
Ans. This is a Cournot competition problem, find the Cournot equilib-
rium quantities, the profits being $1 million means that fixed costs are
$5.38 million. When BlackSpot’s marginal cost decreases, their best response
curve shifts outward, they produce more, their competitor produces less, and
Blackspot’s profits increase. You should be able to put numbers on these.
5. The market for a standard-sized cardboard container consists of two firms:
CompositeBox and Fiberboard. As the manager of CompositeBox, you enjoy
a patented technology that permits your company to produce boxes faster
and at a lower cost than Fiberboard. You use this advantage to be the

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 first to choose its profit-maximizing output level in the market. The in-
verse demand function for boxes is P = 800 − 4Q, CompositeBoxs costs are
CC (QC ) = 40QC , and Fiberboard’s costs are CF (QF ) = 80QF . Ignoring
antitrust considerations, would it be profitable for your firm to merge with
Fiberboard? If not, explain why not; if so, put together an offer that would
permit you to profitably complete the merger.
Ans. Here is one (of many) easy ways to get to the profitability of merging
— if you merge, you can mothball Fiberboard’s technology and produce the
same quantities using the lower CC (·), and this yields a higher profit. To
put it another way, you at least make 40 · QSF where QSF is Fiberboard’s
Stackelberg quantity. Any offer to buy out Fiberboard that does not exceed
the increase in profits from the resulting monopoly is feasible here. Again,
you should be able to put numbers on these.
6. During the 1980s, most of the worlds supply of lysine was produced by a
Japanese company named Ajinomoto. Lysine is an essential amino acid that
is an important livestock feed component. At this time, the United States
imported most of the worlds supply of lysine — more than 30,000 tons — to
use in livestock feed at a price of $1.65 per pound. The worldwide market
for lysine, however, fundamentally changed in 1991 when U.S.-based Archer
Daniels Midland (ADM) began producing lysine — a move that doubled
worldwide production capacity. Experts conjectured that Ajinomoto and
ADM had similar cost structures and that the marginal cost of producing and
distributing lysine was approximately $0.70 per pound. Despite ADMs entry
into the lysine market, suppose demand remained constant at Q = 208−80P
(in millions of pounds). Shortly after ADM began producing lysine, the
worldwide price dropped to $0.70. By 1993, however, the price of lysine shot
back up to $1.65. Use the theories discussed in the Baye chapter on Basic
Oligopoly Models to provide a potential explanation for what happened in
the lysine market.1 Support your answer with appropriate calculations.
Ans. Price dropped to marginal cost, a Bertrand result, and then went back
up to the price that prevailed when there was just one firm, the monopoly
price, collusion. One could understand the initial drop as ADM proving to
Ajinomoto that they could and would deliver enough lysine to drive prices
down to marginal cost.
C. Games.
1. While there is a degree of differentiation among general merchandise retailers
like Target and Kmart, weekly newspaper circulars announcing sales provide
evidence that these firms engage in price competition. This suggests that
Target and Kmart simultaneously choose to announce one of two prices for
a given product: a regular price or a sale price. Suppose that when one
firm announces the sale price and the other announces the regular price for
a particular product, the firm announcing the sale price attracts 50 million
extra customers to earn a profit of $5 billion, compared to the $3 billion
earned by the firm announcing the regular price. When both firms announce
the sale price, the two firms split the market equally (each getting an extra
25 million customers) to earn profits of $1 billion each. When both firms

1For fun, find business press coverage of the scandal. While under-prosecuted, white collar
crime is not completely un-prosecuted.

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 announce the regular price, each company attracts only its 50 million loyal
customers and the firms each earn $3 billion in profits.
a. If you were in charge of pricing at one of these firms, would you have a
clear-cut pricing strategy? If so, explain why. If not, explain why not.
Ans. The one-shot game has the following form,
Sale Regular
Sale (1, 1) (5, 3)
Regular (3, 5) (3, 3)
Clarity would be achieved if either firm had a dominant strategy and one
could work out the implications, but neither firm has a dominant strategy.
There are two pure strategy equilibria, but there is disagreement about
which of the possible pure strategy equilibria is best, payoffs of (5, 3)
versus (3, 5). The mixed strategy equilibrium gives payoffs (3, 3), which
is Pareto dominated by either pure strategy equilibrium. It is not clear,
from the little given here, what the firms will do.
b. Solve for the three equilibria for the one-shot game the describes a “one-
off” pricing decision.
Ans. The pure strategy equilibria are as just given, (Regular,Sale) and
(Sale,Regular), with payoffs (3, 5) and (5, 3), the mixed equilibrium has
both randomizing ( 12 , 12 ), with payoffs (3, 3).
c. Propose a mechanism that might solve your dilemma. (Hint: Unlike Wal-
mart, neither of these two firms guarantees “Everyday low prices.”)
Ans. If the two firms alternated week-ends for their sales, then on av-
erage the payoffs would be (4, 4). There are many many other possible
correlating devices.
2. Two firms, a supplier and a manufacturer can invest in expensive, comple-
mentary technologies, and if they both do this, they will achieve the high
quality output that will guarantee both high profits. The problem is that
if one of them has invested, the other firm would be better “free riding”
on their investment, it’s an expensive investment for both of them, and the
improvements on just one side will improve profits somewhat, at no cost to
the non-investor. Putting numbers on the payoffs, let us suppose they are
Don’t invest Invest
Don’t invest (5, 7) (32, 0)
Invest (0, 22) (28, 19)
a. Suppose that a vertical merger or acquisition is arranged and that the
joint firm receives the sum of the payoffs to the two firms. What is the
optimal investment pattern for the joint firm?
Ans. Both invest, profits are 28 + 19 = 47, which is greater than 0 + 22,
32 + 0, or 5 + 7.
b. Suppose that one of the firms hasn’t had the advantage of your experience
with the idea of solving dynamic interactions by “looking forward and
solving backwards.” Not knowing this cardinal principle, they decide
that they will move first, invest, and give the other firm every incentive
to invest. What will be the result?
Ans. If they try moral suasion, we rather expect the other firm to free-
ride. If firm 1 has invested and they can commit to paying firm 2 at least

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 x > 3 for investing, firm 2 will invest and profits will be (28 − x, 19 + x).
If firm 2 has invested and they can commit to paying firm 1 at least
y > 4 for investing, firm 1 will invest and profits will be (28 + y, 19 −
y). The commitment can take many forms, perhaps signing an exclusive
supply/demand agreement at a price that transfers the x or the y.
c. Consider contracts of the form: “I will invest, and if I do not invest while
you have invested, I owe you damages of x. You will invest, and if you do
not invest while I have invested, you owe me damages of x. Further, this
contract is not valid unless both of us have signed it.” For what values of
x will the contract have the property that signing the contract and then
investing becomes the dominant strategy?
Ans. Consider the game
Don’t invest Invest
Don’t invest (5, 7) (32 − z, z)
Invest (z, 22 − z) (28, 19)
We wish make Invest a dominant strategy for both, this requires z > 5,
28 > 32 − z, z > 7, and 19 > 22 − z. So any z > 7 satisfies all of
these requirements. Note the contrast between the payoffs (28, 19) and
(28 − x, 19 + x) for x > 3 or (28 + y, 19 − y) for y > 4.