ECO380 Markets, Competition, and Strategy

Problem Set #2
Due on Tuesday, Oct 26th 2021, by 10 am

Please use Crowdmark and submit your answers to Problems 1, 2, 3 and 4. If you work in a
group (note that you can only form a group in the same section), make sure that: 1) form a group on
Crowdmark – please use “help” on the website if you don’t know how; 2) submit one copy per group
– otherwise, the TAs will see multiple identical copies, which doesn’t look good. Also, please submit
your answer to each problem, one at a time. Again, it is your responsibility to submit it correctly
and on time. Otherwise, this creates difficulties for our graders. Read each problem carefully and
answer each part as best as you can. Partial credit will be given, so please show your work. Each
problem may contain several parts. Each part is worth 3 points. Number each part of your answers.

Problem 1 (Stackelberg). Two independent ice cream vendors own stands at either
end of a 2 mile long beach. Everyday there are 200 beach-goers who come to the
beach and distribute themselves uniformly along the water. Every beach-goer one
wants exactly one ice cream during the day, and values the ice cream from both
stands at $5. All of the beach-goers would rather be sunbathing or in the water, so
they have a disutility to walking on the beach of $1 per mile. Early’s Ice Cream, the
firm at location 0, is an early riser and always posts his price first. Cali Creamery,
at location 2, is more laid back and posts her price just before the beach opens (the
beach requires all prices be posted by the time the beach opens). Both firms have a
marginal cost of zero.

1. Each individual is also referenced by a location x on the beach between 0 and

2. What are the utilities of purchasing from Early’s and Cali for the person at
location .75, given that Early’s names price pe and Cali names price pc ? What
are the utilities for each individual as a function of their location on the beach,
x?

2. What is the demand for Early’s Ice Cream and Cali Creamery given the firms
name prices pe and pc ?
ECO380: Problem Set #2 2

3. What is Cali Creamery’s best response function when Early’s posts a price of
pe ?

4. What is the Stackleberg equilibrium outcome for this market? Report prices,
quantities, and profits for each firm.

5. Early’s owner feels that his hard work is not paying off, he hires you as a
business consultant. He’s annoyed that Cali is always undercutting his price
and is considering waiting to post so that Cali will not learn his price before
naming her own. He wants you to predict how waiting to post his price will
affect his profits. What will Early’s profits be under this new regime? What
advice do you give him?

Problem 2. Suppose there are two emergency hospitals in Townville, State ER and
University ER. Overall demand (patients) for ER visits in Townville is P = 120 − 2Q
per day, where Q = qs + qu . Marginal cost at the State ER is cs = 84 per patient.
University has access to better equipment so their marginal cost is cu = 70. Suppose
University ER is the Stackelberg leader and is able to choose their quantity before
State ER. State ER then responds to the choice by University.

1. Write down the profit function for State ER as a function of their quantity of
patients (qs ) and the choice of University’s quantity of patients (qu ).

2. Solve for State’s optimal strategy in the Stackelberg game.

3. Write down the profit function for University ER as a function of their quantity
of patients (qu ) only.

4. Solve for university’s optimal strategy.

5. Solve for both hospitals quantity of patients served, the equilibrium price, and
profit for both firms when the SPNE is played.

6. What is total surplus (Consumer surplus+Profit)?

ECO380: Problem Set #2 3

7. Suppose after State makes their choice of quantity of patients, University is able
to react and easily expand or contract their service. What is the outcome of
this model and why is it different from above? (No need to solve the model,
just intuitively explain what will happen and why).

Problem 3 (Repeated Games). Suppose two firms compete in micro-chip industry.

Each period firm 1 produces q1 chips and firm two produces q2 chips and the firms
face a demand curve of P = 1000 − 20Q, where Q = q1 + q2 . Both firms have a
constant marginal cost of $40 per chip, C(qi ) = 40qi .

1. What are the static Nash equilibrium strategies for this market? What are
equilibrium profits when the market operates for a single period?

2. Suppose the two firms agree to maximize joint profits rather than individual
profits and share the proceeds equally. How many chips does each firm agree
to make? What are firms profits for a single period?

3. Suppose the firms have agreed to maximize joint profits, but while firm 2 pro-
duces according to the agreement, firm 1 decides to cheat and maximize indi-
vidual profits instead. How many chips does firm 1 decide to produce? What
are profits for each firm?

4. Suppose the discount rate is δ = .9, and the industry lasts for only 10 periods.
Describe all of the equilibrium strategy profiles for this game.

Problem 4 (Repeated Games). Continue to consider the market described in the

last problem, however make the following change: Suppose the same industry exists
for an infinite number of periods, the discount factor for profits is still δ = .9. Firms
are considering the following strategy:

ˆ As long as no firm has cheated, play according to the agreement to optimize

joint profits and split the proceeds.

ˆ If either firm has cheated in any earlier period, play the static Nash equilibrium
in every period from now on.
ECO380: Problem Set #2 4

1. If both firms follow the proposed strategy, what is the present discounted value
of each firm’s profits?

2. If one firm decides it will cheat on the agreement and violate the strategy, what
is the highest profit that firm can achieve?

3. Based on your previous answers in this question, is the proposed strategy an

equilibrium? Why or why not?

4. What is the lowest discount factor, δ that the firms could have for the proposed
strategy to be an equilibrium?

Problem 5 (Bertrand, This problem is NOT to be handed in.). There are two com-
panies who offer tax return services in College Springs: H & R Block and Bill’s
Financial Service. Marginal cost for doing a tax return is c = $10 and demand in
College Springs for tax returns is Q = 100 − P per day (in the first half of April).
Assume first that both H & R Block and Bill’s have unlimited capacity to complete
tax returns. Also assume both firms are choosing price simultaneously. (In other
words, this a Bertrand game with homogeneous goods.)

1. Suppose (for this part only) Bill was a monopolist, what price would he set?
What would be Bill’s profits?

2. What is the Nash Equilibrium for this duopoly game? What is profit for the
two firms?

3. Show that there is no profitable deviation from the NE you found above (i.e.,
verify that both firms are playing a best response).

4. Now assume that H & R Block is a bigger outfit and can complete 100 tax
returns a day maximum, while Bill’s has fewer employes and can complete 40
tax returns per day maximum. Is the Nash equilibrium you found in 1 still a
Nash Equilibrium? If not, show a profitable deviation. If so, show there is no
profitable deviation.
ECO380: Problem Set #2 5

5. Now suppose there is a shortage of trained tax accountants because of the advent
of Turbo tax. This has caused H & R to only be able to complete 30 tax returns
per day maximum and Bill’s to only be able to complete 20 tax returns per day
maximum. Is the Nash equilibrium you found in 1 still a Nash Equilibrium? If
not, show a profitable deviation. If so, show there is no profitable deviation.

6. Now suppose that the capacity constraints are as in the previous part and each
firm sets a price of $50. Is this a Nash Equilibrium? If not, show a profitable
deviation. If so, show there is no profitable deviation.

Problem 6 (Hoteling, This problem is NOT to be handed in.). Suppose there are
two beer companies. One produces a beer that has a high alcohol content (ABV
10%), while the other company produces a light beer that has a low ABV (5%).
Assume there are 50 consumers whose preferences for alcohol content (ABV) are
uniformly distributed between 5% and 10%. Consumers all value drinking a beer
their ideal beer at $10 but dislike a beer with a different ABV than their ideal ABV
by $1 per percentage point. That is, if I prefer a beer with 6% ABV and I drink the
light beer, my utility will be $1 lower. If I prefer a beer with 5.5% and I drink the
light beer my utility will be $0.50 lower. Marginal cost is the same for both companies
and is equal to $1. The two companies compete by choosing prices simultaneously.

1. What is the utility of purchasing the low ABV beer for a consumer whose
preferred beer contains x ABV?

2. What is the utility of purchasing the high ABV beer for a consumer whose
preferred beer contains x ABV?

3. Find an expression for the “location” of marginal consumer given pl and ph .

In other words, given prices, what is the ABV preference for a consumer who
is indifferent between consuming the light beer and the heavy beer. Call this
function xm (pl , ph ).

4. What happens to the “location” of the marginal consumer as the price of the
heavy beer increases?
ECO380: Problem Set #2 6

5. Using this expression, what is the demand curve for the two beers?

6. What is the profit function for each firm?

7. What is the best response function of each firm?

8. Solve for the pure strategy Nash Equilibrium in prices. What are profits in this
equilibrium?

Problem 7 (This problem is NOT to be handed in.). Incor is currently the only sup-
plier of widgets and earns monopoly rents of $700k. Enterprise is considering entering
the market. It would cost Enterprise $100k to set up a factory. However, Incor has
threatened to start a price war if Enterprise enters. Your research shows that if Incor
follows though on its threat, Incor would earn only $100k from producing widgets,
while Enterprise would earn only $25k (before accounting for building costs). How-
ever, if Incor does not start the price war, it would make $300k, while Enterprise
would earn $200k.

1. Draw this game in extensive form. Be sure to fully label the game tree.

2. What is the subgame perfect equilibrium outcome?

3. Would you advise Enterprise to build the widget factory?

Problem 8 (This problem is NOT to be handed in.). Assume two firms compete in
Cournot competition, but compete for an infinite amount of time. The one-shot
payoffs are listed below and the discount rate is δ = .8. We’ll focus on three different
choices for quantities to produce. Call the “collusive quantity” for firm i qic and
the “competitive” quantity qicm . The competitive quantity strategies are a Nash
equilibrium of the stage-game. A deviation occurs when a firm agrees to produce qic
but instead produces qid , which is i’s best response to q−i
c
in the stage game. Call the
collusive profits πic , and the competitive profits πicm . If one firm deviates, it receives,
πid for this period, while its opponent receives πind .
Collusive payoffs:
π1c = π2c = 600
ECO380: Problem Set #2 7

Firm 1 deviates:
π1d = 800

π2nd = 400

Firm 2 deviates:
π2d = 800

π1nd = 400

Competitive payoffs:
π1cm = π2cm = 500

1. State the grim trigger strategy that could be used to facilitate collusion.

2. Will these firms be able to collude given the assumptions of the model and the
discount rate? Why or why not?

3. Suppose the discount factor δ = .6 instead of .8? Would the firms be able to
collude? Why or why not?

4. What is the minimum value of δ that would facilitate collusion?

5. Intuitively explain why collusion would not be an equilibrium outcome if δ is

very small.