PROBLEM SET 4 - SOLUTIONS

Question 1.
A price-discriminating monopolist sells in two separate markets such that goods sold in
one market are never resold in the other. It charges p1 = $2 in one market and p2 = $8
in the other market. At these prices, the price elasticity in the first market is −2.20 and
the price elasticity in the second market is −0.10. Which of the following actions is sure
to raise the monopolist’s profits?

1. lower p2

2. raise p2

3. raise both p1 and p2

4. raise p1 and lower p2

5. raise p2 and lower p1

Answer
Given prices and elasticities in the two markets, the monopolist is operating on the
inelastic part of the demand curve in market 2 and on the elastic part of the demand
curve in market 1. We know that when the monopolist is operating on the elastic part
of the demand curve (like he is in market 1), he is maximizing profits in that market,
so there will be no change in the price in market 1. However, because the elasticity of
demand in market 2 is inelastic, increasing p2 is going to increase the revenue of the
monopolist in market 2, since an increase in price reduces the quantity sold, but also
reduces total production costs, so profits will increase.
Correct Answer: B

Question 2.
A monopolist has a constant marginal cost of $2 per unit and no fixed costs. He faces
separate markets in the United States and England. He can set one price p1 for the U.S.
market and another price p2 for the English market. If demand in the United States is
given by Q1 = 7, 000 − 700p1 and demand in England is given by Q2 = 1, 200 − 200p2 ,
then the price in the United States will

1. equal the price in England

2. be smaller than the price in England by $2

3. be larger than the price in England by $4

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 4. be larger than the price in England by $2

5. be smaller than the price in England by $4

Answer
The monolopist maximizes:
maxy1 ,y2 p1 (y1 )y1 + p2 (y2 )y2 − M C(y1 + y2 )
maxy1 ,y2 y1 (10 − y1 /700) + y2 (6 − y2 /200) − 2(y1 + y2 )

F OC1 : 10 − y1 /700 + y1 (−1/700) = 2 ⇔ y1 = 2800 ⇒ p1 = 6 (US)

F OC2 : 6 − y2 /200 + y2 (−1/200) = 2 ⇔ y2 = 400 ⇒ p2 = 4 (England)
Correct Answer: D

Question 3.
Suppose that the price elasticity of demand for airline flights between two cities is con-
stant and equal to −1.5. If 4 airlines with equal costs are in Cournot equilibrium for
this industry, then the ratio of price to marginal cost in the industry is

1. 8/7

2. 9/8

3. 7/6

4. 3/2

5. None of the above.

NOTE: assume constant marginal cost, such that: M C(y1 ) = M C(y2 ) = M C(y3 ) =
M C(y4 ) = M C(Y ).

Answer
h i
1
For n firms in the market: p(Y ) 1 − |ǫ(Y )|/si
= M Ci (∗), i = 1, ..., n and si = yi /Y .

The equality of the cost functions of the fours firms implies that in equilibrium all
four firms will produce equal amounts of output (will have equal market shares), so it
follows that y1 = y2 = y3 = y4 = Y /4, and s1 = s2 = s3 = s4 = 1/4.

If marginal costs of the four firms are constant, this means that M C(y1 ) = M C(y2 ) =

2
M C(y3 ) = M C(y4 ) = M C(Y )

So theh ratio of P (Yi )/M C(Y ) can be found by adding the ∗ equations for all four firms:
1
p(Y ) 1 − |ǫ(Y )|/s1 = M C1
h i
1
p(Y ) 1 − |ǫ(Y )|/s2 = M C2
h i
p(Y ) 1 − |ǫ(Y 1)|/s3 = M C3
h i
p(Y ) 1 − |ǫ(Y 1)|/s4 = M C4
⇒ 4p(Y ) − p(Y ) |ǫ(Y1 )| y1 +y2 Y+y3 +y4 = M C(y1 ) + M C(y2 ) + M C(y3 ) + M C(y4 )
h i
⇔ p(Y ) 4 − |ǫ(Y1 )| YY = 4M C(Y )
h i
1
⇔ p(Y ) 4 − 3/2 = 4M C(Y )
p(Y ) 4 4 6
⇒ M C(Y )
= 4− 23
= 3 = 5
10

Alternatively, you can look at any of the (∗) equations and solve for p(Y )/M C(Y ) =
1 1
1−si /ǫ
= 5/6 = 6/5 since M C(yi ) = M C(Y ) for all i.
Correct Answer: E

Question 4.
A duopoly faces the inverse demand curve p = 160 − 2q. Firm 1’s total cost function is
given by C1 (q1 ) = 8q1 and firm 2’s total cost function is given by C2 (q2 ) = 10q2 . In a
Cournot equilibrium,

1. the firm with the lower marginal cost produces more

2. both firms will produce the same amount

3. the firm with the higher marginal cost produces more to cover the higher costs

4. the reaction function for both firms is the same since both firms have a constant
marginal cost

5. more than one of the above is correct.

Answer
Firm 1 solves:
maxq1 [160 − 2(q1 + q2 )] q1 − 8q1
FOC: 160 − 4q1 − 2q2 = 8 ⇒ q1 = (76 − q2 )/2 (1)

Similarly, firm 2 solves:

maxq2 [160 − 2(q1 + q2 )] q2 − 10q1

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FOC: 160 − 2q1 − 4q2 = 10 ⇒ q2 = (75 − q1 )/2 (2)

Plug (2) into (1) to get:

q1 = 76−q22 (q1 ) = 152−75+q
2
1
⇒ q1 = 77/3 and q2 = 74/3

So the firm with the lower marginal cost produces more.

Correct Answer: A

Question 5.
In the game matrix below, the first payoff in each pair goes to player A who chooses the
row, and the second payoff goes to player B, who chooses the column. Let a, b, c, and
d be positive constants.

Player B
Left Right
Player A Top a, 1 b, 1
Bottom 1, c 1, d
If player A chooses Bottom and player B chooses Right in a Nash equilibrium, then
we know that:
1. b > 1 and d < 1

2. c < 1 and b < 1

3. b < 1 and c < d

4. b < c and d < 1

5. a < 1 and b < d

Answer
If (Bottom, Right) is a Nash Equilibrium, it means that Bottom has to be a best
response for player 1, when player 2 chooses Right, which means that 1 > b. Similarly,
Right has to be a best response of player 2, when player 1 chooses Bottom, which means
that d > c.
Correct Answer: C

Question 6.
Alec and Kim used to be much better friends than they are now. The problem is what
to do about Christmas gifts? If they wait until Christmas morning and move simulta-
neously, their payoff matrix is:

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 Kim
Gift No Gift
Alec Gift 3, 3 1, 3
No Gift 4, 2 5, 5
If Alec commits at Thanksgiving time not to buy a gift for Kim, Kim will find it in
her best interest:

1. to buy a gift for Alec to spite him

2. not to buy a gift for Alec

3. to buy a gift for Alec with probability 2/7

4. to buy a gift for Alec with probability 4/9

5. to buy a gift for Alec with probability 4/6

Answer
If Alec decides to buy a gift for Kim, Kim is indifferent between buying a gift back to
Alec, and not buying him one (Kim gets the same payoff of 3 in both cases). However,
if Alec decides not to buy a gift for Kim, it is in Kim’s best interest not to buy a gift for
Alec, in which case she will get a payoff of 5. You have to think how credible is Alec’s
commitment at Thanksgivig of not buying a Christmas gift for Kim: regardless what
Kim does, Alec is always better of by not buying a gift for Kim (No Gift is a dominant
strategy for Alec). So his commitment of not buying a gift is credible, and it is in Kim’s
best interest not to buy a gift as well.

Another way to think about this game is to make it a sequential game in which Alec
moves first (at Thanksgiving), and Alec moves second (at Christmas), after having ob-
served Alec’s choice. The equilibrium of the sequential game is again (No Gift, No
Gift).

NOTE: if you want to look for a mixed strategy NE, you will find: p = 0 and q = 0.
Correct Answer: B

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Question 7.
Suppose AMD is considering cloning Intel’s latest CPU chip. If AMD enters Intel’s mar-
ket, Intel can play Mean, expand its output, drop prices, and try to make AMD’s profit
as small as possible or play Nice by cutting back its output and sharing the market.
AMD and Intel both know that after all moves are complete, the time-discounted profits
of future chip production in billions of dollars are:

Intel
Mean Nice
AMD In 3, 5 5, 4
Out 0, 9 0, 14
Assuming AMD moves first, which of the following is the Nash equilibrium for sequential
play?

1. (In, Nice)

2. (In, Mean)

3. (Out, Nice)

4. (Out, Mean)

Answer
Write down the tree of the sequential game, with AMD moving first (decide to enter or
not), and Intel moving second (play nice or mean). Start at the end of the game: in the
second period, Intel will choose to play mean if AMD enters (5 > 4), and will choose
to play nice if AMD does not enter the market (14 > 9). Move the analysis one period
forward: if AMD enters, Intel will play mean, and AMD will end up with a payoff of
3. If AMD does not enter, Intel will play nice, and AMD will end up with a payoff of
0. Since 3 > 0, AMD will choose to enter the market in the first period, and Intel will
respon by playing mean in the second period. So the equilibrum if the sequential game
is: (In, Mean).
Correct Answer: B

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Question 8.
If an upstream monopolist sells to a downstream monopolist, the price to consumers
will be higher than the competitive price but not so high as it would be if the down-
stream monopolist took control of the upstream monopolist’s business and ran both the
upstream and downstream markets to maximize total profits.

Answer
Please see the derivation we had in class (chapter 26): in the case of an upstream and
a downstream monopolist the final price charged to customers has a double markup,
while if the downstream monopolist controls the upstream monopolist, the integrated
monopolist produces twice as much output as the nonintegrated monopolist and charges
a price higher than the competitive price, but lower than the price of the nonintegrated
monopolist.

You can work this out with an example of a linear demand function: if p(y) = a − by
and M C = c, then yi = (a − c)/2b, yni = (a − c)/4b, and the corresponding prices are
pi = (a + c)/2 and pni = (3a + c)/4.
Correct Answer: False

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Question 9.
If a labor market is dominated by a monopolist, it is possible that the imposition of a
minimum wage law could increase the amount of employment in that market.

Answer
The firm is a monopolist in its output market. However, we are interested in its position
in the input market (the input here being the type of labour used). Since it is the only
producer of its output, it means it is also the only buyer of the certain type of labour
used to produce its output (think one restaurant in one small town, that needs waiters
to produce its final product, the meals it sells). This makes the firm a monopsonist in
the labour market.

The wage currently paid by the monopsonist, w∗ (determined by the intersection of

the vertical projection of the number of people employed, L∗ , and the W (L) curve) is
below the corresponding competitive wage (wc ) (determined where S = D). The im-
position of a minimum wage wm anywhere in between w∗ and w∗∗ (determined by the
intersection of the M C curve with the D curve), will increase the number of people
employed by the monopsonist compared to the original employment level L∗ , up to a
maximum of Lc . This is because the new minimum wage flattens out the otherwise
upward sloping M C curve, making it easier for the monopsonist to hire more people
that he normally would without the minimum wage.
Correct Answer: True

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Question 10.
The coach of the offensive football team has two options on the next play. He can run
the ball or he can pass. His rival can defend either against the run or against the pass.
Suppose that the offense passes. Then if the defense defends against the pass, the offense
will make zero yards, and if the defense defends against the run, the offense will make
25 yards. Suppose that the offense runs. If the defense defends against the pass, the
offense will make 10 yards, and if the defense defends against a run, the offense will gain
2 yards.
(a). Write down a payoff matrix for this game. (b). Is there a Nash equilibrium in pure
strategies for this game? If so, what is it? If not, demonstrate that there is none.

Answer
(a) This is an example of a zero sum game, in which one player’s gain is equal to the
other player’s loss. The payoff matrix of the game is:

Defense
Run Pass
Offense Run 2, −2 20, −20
Pass 25, −25 0, 0
(b) This game has no pure strategy NE. If the offense runs, it’s better for the de-
fense to defend against the run (−2 > −10), while if the offense passes, it’s better for
the defense to defend against the pass (0 > −25). Similarly, if the defense decides to

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defend against the run, the offense is better off by passing (25 > 2), and if the defense
decides to defend against the pass, the offense is better off by running (10 > 0).

However, there is a mixed strategy equilibrium in which the offense will run with prob-
ability p = 0.75 and the defense will defend against a run with probability q = 0.30.
(NOTE: You do not need to determine the MSNE for the full answer to this problem,
as it is not required by the question.)

If the offense runs with probability p, he will get an expected payoff of 2p + 25(1 − p),
when the defense defends against the run, and an expected payoff of 10p, when the
defense defends agains the pass. The offense wants to make this expected payoff as big
as possible, and the defense wants to make it as small as possible. The graph below
shows the expected payoff of the offense for different values of p. Since the defense’s goal
is to minimize the offense’s expected payoff, for any p, the best payoff that the offense
can hope for is the minimum of the payoffs given by the two strategies (coloured line
on graph). The maximum of these minimum payoffs occurs at p = 0.75, where the two
lines intersect:
2p + 25(1 − p) = 10p
25 = 33p
p = 0.75

Similarly, if the defense defends against a run with probability q, then the offense’s
expected payoff will be 2q + 10(1 − q) when the offense runs, and 25q, when the offense
passes. For each q, the the defense will want to minimize the offense’s payoff, and the
offense will want to maximize its payoff. The graph below shows the expected payoff of
the offense for different values of q. The minimum of these maxima occurs at q = 0.75,
where the two lines intersect:
2q + 10(1 − q) = 25q
10 = 33q
q = 0.30

The third graph shows you the best response functions of the two players - their in-
tersection at p = 0.75 and q = 0.30 defines the mixed strategy Nash equilibrium of the
game.

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