1 Introduction

1.1. Competition and performance.Empirical evidence from a sample of more than 600
UK firms indicates that, controlling for the quantity of inputs (that is, taking into account
the quantity of inputs), firm output is increasing in the number of competitors and
decreasing in market share and industry concentration.1 How do these results relate to the
ideas presented in this chapter?
Answer: In Section ??, I argued that one of the implications of market power is the
decline of productive efficiency. Controlling for input levels, the level of output is a
measure of productive efficiency. The number of competitors and the degree of
concentration are measures of the degree of competition (concentration is an inverse
indicator). The empirical evidence from UK firms is therefore consistent with the view
presented in the text.

1 . Nickell, Stephen J. (1996), “Competition and Corporate Performance,” Journal of Political Economy
104, 724–746.
2 Consumers

2.1. Fruit salad. Adam and Barbara are big fruit salad fans (and both agree that the
more the better). However, their tastes differ regarding the way the salad is made. For
Adam, for each apple you throw in, there should be one and only one banana (if you give
him more than one banana, he will throw it way). For Barbara, as long at it’s fruit, it
doesn’t matter; in other words, all that counts is the number of pieces of fruit.
(a) Show what Adam’s and Barbara’s indifference curves look like.
Answer: Figure 2.1 depicts Adam’s and Barbara’s indifference curves (left and right
panels, respectively).
(b) Are apples and bananas substitutes or complements?
Answer: For Adam, apples and bananas are perfect complements; for Barbara, perfect
substitutes.

2.2. Village microbrew. Village microbrew raised its price from $10 to $12 a case
(wholesale). As a result, sales dropped from 10,500 to 8,100 (in units). Based on your
estimate of the demand elasticity, what percent change in sales would you predict if price
were cut from $10 to $9? What demand level would this correspond to?

Figure 2.1
Indifference curves: Adam and Barbara
bananas bananas

3 U =1 U =2 3

2 ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ......
...
...
2 U =3
...
...
...
...
...
...

1 ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ........
.
...
...
...
...
1
... ..
... .
... ...
... ...
..
... .
...
..
.
.. ... apples apples
1 2 3 1 2 3

3
Answer: We can approximate it by the “change formula,”
  
∆q p 10, 500 − 8, 100 12
≈ = = −1.77
∆p q 10 − 12 8, 100
This is approximate, since we’re using discrete changes. If we assume that the elasticity of
demand is constant then we could get an exact solution by using the log formula:
∆ log q log 10500 − log 8100
= = = −1.42
∆ log p log 10 − log 12
Did revenue rise or fall? Since  < −1, the increase in prices led to an overall fall in
revenue. (If you want to make sure, then calculate the revenues before and after the price
change.) If the elasticity is constant, what is the demand at $9? If the elasticity is constant
then the log formula calculates the elasticity exactly and in addition we know that:
log 10500 − log q9
= −1.42
log 10 − log 9
where q9 is the demand when the price is $9 per case, so (after a little bit of algebraic
manipulation)  
10
q9 = exp log 10500 + 1.42 log = 12195
9
With constant demand elasticity, the percent variation method only gives an
approximation of the value of demand elasticity. Moreover, estimating demand for a
different price level will give a different value than the log formula. Specifically, the
demand estimate when price is $9 is given by
 
q9 = 10500 1 + (−1.77) × (−10%) = 12358

since the drop in price from 10 to 9 corresponds to a −10% variation

2.3. Demand elasticity. Based on the values in Table 2.1, provide an estimate of the
impact on sales revenues of a 10% increase in each product’s price.
Answer: Revenue is given by R = p × q. Differentiating, we get
dR = dp q + p dq
Dividing by R,
dR q p
= dp + dq
R R R
Since R = p q and  = dq /dp p/q, we have
dR q p
= dp + dq
R R R
q p
= dp + dq
pq pq
dp dp p dq
= +
p p q dp
dp dp
= + 
p p
dp

= 1+
p

4
Given that d p/p = 10%, we have

Product dR/R
Norwegian salmon in Spain (1 − 0.8) × 10% = 2%
Norwegian salmon in Italy 1%
Coffee in the Netherlands 8%
Natural gas in Europe (short-run) 8%
Natural gas in Europe (long-run) −5%
US luxury cars in US −9%
Foreign luxury cars in US −18%
Basic cable TV in US −31%
Satellite TV in US −44%
Ocean shipping services (worldwide) −34%

2.4. Smartphones. The following pairs of price and quantity demanded for smartphones
have been observed: (100, 600); (105, 590); (110, 575); (115, 550); and (120, 510).
(a) Calculate the approximate elasticity of demand when price is $105.
Answer: Using the percent variation method, an increase in price to 110 leads to an
estimate of elasticity of (575 − 590)/(110 − 105)105/590 = −.53. A decrease in price to
100 leads to an estimate of elasticity of (600 − 590)/(100 − 105)105/590 = −.36. We
conclude that the value of the demand elasticity is somewhere between −.36 and −.53.
Alternatively, we can approach this problem by using logs. The elasticity estimates would
then be (log(575) − log(590))/(log(110) − log(105)) = −.55 for a price increase and
(log(600) − log(590))/(log(100) − log(105)) = −.34 for a price decrease. (Notice that,
while the estimates at each point are quite different, the resulting range is similar.)
(b) Is the demand elasticity constant at all prices?
Answer: Generally speaking, the value of demand elasticity does not need to be constant
at all price levels. In this particular case, it can be shown that it is not. In fact, if the
demand elasticity is constant, then the estimate obtained by using the log formula gives
the exact value of elasticity. As shown in part (a), the estimates obtained with the logs
formula applied to two different pairs of points are different. It follows that the value of 
varies for different price levels. This is consistent with the rather wide range of estimates
we obtained in the previous question.
(c) How does the value of demand elasticity vary as price increases?
Answer: Using logs and computing the elasticity at each point based on a $5 price
increase, we obtain the following estimates, starting at $100 : −.35, −.55, −1.00, −1.77.
This pattern is not infrequent: as we increase price, demand elasticity increases (in
absolute value).

5
 (d) If the monthly subscription fee for Internet access from a cell phone
falls from $10 to $2, what would you expect to happen to the quantity
of cell phones demanded at any given price? What effect would this
Internet access price change have on the mobile phones’ elasticity of
demand?
Answer: We would expect the quantity of phones demanded to increase at all price levels
when the price of Internet access, a complementary product, decreases. However, it would
be difficult to determine what the change in demand elasticity would be at any given price
point.

2.5. Cars. Table ?? gives the “own” and cross-price elasticities for selected automobile
models.2 Specifically, each cell corresponds to the demand elasticity of the car model
listed in the row with respect to changes in the price of the car model listed in column.
(a) Why are the “own” elasticities so high?
Answer: These are models for which many substitute models are available. Thus, even if
the demand for cars is not very elastic, the demand for a particular model is.
(b) Are the Accord and Taurus complements or substitutes?
Answer: The cross-price elasticity of the Accord with respect to the price of the Taurus is
given by 0.1, a positive value. The two models are therefore substitutes. In fact, no two
models in this sample are complements.
(c) What are the Taurus’s closest competitors?
Answer: Looking at the Taurus row, we see that the cross-price elasticity is highest for
the Accord. In other words, a 1% change in the price of the Accord would have a greater
impact on the demand for the Taurus, than a 1% change in the price of any other model
(other than the Taurus).
(d) If GM lowers the price of its Chevy Cavalier, does it “cannibalize” its
Buick Century sales?
Answer: Yes. However, the cross price elasticity of the Century with respect to the price
of the Cavalier is fairly small. Therefore, a decrease in the price of the Cavalier will reduce
the demand for the Century by only a small amount.
(e) Why is the direct elasticity for the Mazda not lower than the elasticity
for more expensive models (as the rule of thumb would suggest)?
Answer: As suggested by the qualitative analysis of demand elasticity, luxuries tend to
have higher elasticity than non-luxuries. However, another rule of thumb to keep in mind
is that the elasticity for a particular product is always higher than the elasticity for the
group of products it belongs to. As it happens, there are many more compact car models
than there are luxury car models. Therefore, even though the elasticity for luxury cars is
higher than the elasticity for compact cars, the elasticity for a particular luxury model
2 . Source: Berry, Steven, James Levinson, and Ariel Pakes (1995), “Automobile Prices in Market Equi-
librium,” Econometrica 63, 841–890.

6
may not be much greater than the elasticity for a particular compact car.
(f) Suppose Honda sold 300k Accords in 2001. In 2002, the price of the
Accord decreased by 2%, whereas the price of the Taurus decreased
by 3%. What is the likely change in Accord sales?
Answer: The percent change in demand is approximately given by
(−2%) × (−4.8) + (−3%) × (0.1) = 9.3%. We would expect an increase in Accord sales of
approximately 9.3%, or .093 × 300k = 27.9 k units.

2.6. Netflix and Hulu. Suppose the demand for Netflix is given by

qN = a − bN pN + bB pB

where qN is the number of Netflix subscriptions, pN the price of a Netflix plan, and pH the
price of a Hulu plan.
(a) What is the price elasticity of Netflix subscriptions?
Answer: The price elasticity is
d qN pN pN
= = −bN
d pN qN qN

Note the demand is elastic for high values of pN /qN and inelastic for low values of pN /qN .
(b) Suppose a = 500, bN = 10, bH = 5, and pH = pN = 50. What
are N ’s elasticity and cross-price elasticity? Are products N and H
substitutes or complements?
Answer: The cross-elasticity of Netflix with respect to Hulu’s price is given by
d qN pH pH
NH = = bH
d pH qN qN
Substituting the values in the above expressions, we get  = −2, and NH = 1. The positive
sign of the cross-elasticity means the products are substitutes. (You might have guessed
it.)
(c) How much do consumers get in surplus at these prices?
Answer: Consumer surplus is the area under the demand curve but above the price. First
we compute the choke price, that is the highest value of willingness to pay. Since

qN = a − bN pN + bH pH

when a = 500, bN = 10, bH = 5, and pH = pN = 50 we get

qN = 500 − 10 pN + 5 × 50

If qN = 0, then pN = (500 + 250)/10 = 75. This means the choke price is given by 75.
Next we compute total output at the prevailing prices. This is given by

qN = 500 − 10 × 50 + 5 × 50 = 250

7
Since demand and cost are linear, consumer surplus is a triangle where the height is the
difference between the demand choke price (75) and price (50), whereas the base is output
(250). This implies
1
CS = × 250 × (75 − 50) = 3125
2

2.7. Lamborghini. The current US demand for the Lamborghini Gallardo SE is elastic;
specifically, it is estimated that demand elasticity is given by  = −3. The current price is
p = $120k. Annual sales at this price amount to q = 160 (number of cars).
(a) What do you estimate would be the impact of an increase in price to
$140k?
Answer: From the definition of elasticity, we have
q2 − q1 p2 − p1
≈
q1 p1

An increase to 140k represents a 16.6% shift in price. We should thus expect a change in
sales of −3 × 16.6 = −50%. The new level of sales is therefore

q2 = 160 × (1 − 50%) = 80

If instead we use logs, then we solve the equation

log q1 − log q2
=
log p1 − log p2

which in this case becomes (price in thousands of dollars)

log 160 − log q2

−3 =
log 120 − log 140

log q2 = log 160 + 3 (log 120 − log 140) = 4.613

Finally
q2 = exp(4.613) = 100.76
that is, between 100 and 101 cars.
Suppose the cross price elasticity of the demand for Lamborghinis with respect to the price
of the Maserati MC12 is LM = .05; and with respect to the price of gasoline, LG = −.1.
(b) What are the definitions of a substitute and of a complement? Are
Maserati MC12 and gasoline substitutes or complements with respect
to Lamborghinis? Can you think of other substitutes and comple-
ments to the Lamborghini Gallardo SE?
Answer: Product A is a substitute with respect to B if the cross-price elasticity is
positive; and a complement if the cross-price elasticity is negative. Given these definitions,
the Lamborghini and the Maserati are substitute products, whereas the Lamborghini and
gasoline are complements. Additional substitutes might include other luxury models, e.g.,
the Porsche Carrera. Additional complements might include Lamborghini merchandise;

8
see http://www.lamborghini.co.uk/merchandising/index.php (Question: could this
conceivably be a substitute instead of a complement?)
(c) Suppose that, in addition to the price increase considered in (a), there
is also an increase in the price of the Maserati MC12 (from $110k
to $115k); and an increase in the price of gasoline (from $2 to $2.8
per gallon). What do you estimate will be the new demand for the
Lamborghini Gallardo SE?
Answer: The price of the Maserati MC12 increases from $110k to $115k. That’s a 4.545%
increase in price. Since the cross-price elasticity is LM = .05, we get a percent increase in
demand of (.05) × 4.545% = .227%. Finally, new demand is

q2 = 160 × (1 + .227%) = 160.3632

(We thus have a very small impact, at most one extra car sold.) As to the price of
gasoline, we would have
 
2.8 − 2
q2 = 160 × 1 + (−.1) × = 153.6
2

If we want to consider the compound effect of all three changes, then we add the three
effects:
     !
140 − 120 115 − 110 2.8 − 2
q2 = 160× 1 + (−3) × + (.05) × + (−.1) × = 73.96
120 110 2

Let us now consider the solution with logarithms. From the definition of elasticity, we have

log q2 − log q1 =  (log p2 − log p1 )

This expression is valid both for a change in the own price (in which case  is the own
elasticity) and for the change in the price of a different product (in which case  is the
cross-price elasticity). And when there are several price changes, we simply add the
various elasticity-times-difference-in-log-price terms. Specifically, in this case we have

log q2 −log 160 = −3×(log 140−log 120)+(.05)×(log 115−log 110)−(.1)×(log 2.8−log 2.0)

which implies
log q2 = 4.581
or simply
q2 = exp(4.581) = 97.612
that is, between 97 and 98 cars.

2.8. Constant elasticity demand. Linear demand curves have constant slope, that is,
constant derivative dq /dp. Consider now a demand curve with constant elasticity.
(a) Show that such demand curve has the form q = α pβ (that is, show
that, if the demand curve has this form, then demand elasticity is
constant).

9
Answer: As shown in the text, demand elasticity may be written as
d log q
=
d log p
If the value of  is independent of p and q, then it must be that log q is liner in log p, that
is,
log q = a + b log p
Applying the exponential function to both sides of the equation, we get

q = ea pb

which is the desired expression, where β = b and α = ea .

(b) Consider two points from the demand curve, (q1 , p1 ) and (q2 , p2 ).
Show that the expression ∆ log q/∆ log p gives the exact value of the
demand elasticity.
Answer: Since
log q = a + b log p
we have
log q1 = a + b log p1
log q2 = a + b log p2

Taking differences, we get

log q1 − log q2 ∆ log q
=b= =
log p1 − log p2 ∆ log p
3 Firms

3.1. DRAM factory. You own and operate a facility located in Taiwan that
manufactures 64-megabit dynamic random-access memory chips (DRAMs) for personal
computers (PCs). One year ago you acquired the land for this facility for $2 million, and
used $3 million of your own money to finance the plant and equipment needed for DRAM
manufacturing. Your facility has a maximum capacity of 10 million chips per year. Your
cost of funds is 10% per year for either borrowing and investing. You could sell the land,
plant and equipment today for $8 million; you estimate that the land, plant, and
equipment will gain 6% in value over the coming year. (Use a one-year planning horizon
for this problem.)
In addition to the cost of land, plant, and equipment, you incur various operating
expenses associated with DRAM production, such as energy, labor, raw materials, and
packaging. Experience shows that these costs are $4 per chip, regardless of the number of
chips produced during the year. In addition, producing DRAMs will cause you to incur
fixed costs of $500k per year for items such as security, legal, and utilities.
(a) What is your cost function, C(q), where q is the number of chips
produced during the year?
Answer: The $5 million you originally spent for the land, plant, and equipment is a sunk
expenditure and thus not an economic cost. However, there is a “user cost of capital”
associated with the land, plant and equipment, based on its current market value of $8
million and your cost of funds and the rate of depreciation or appreciation of the asset
over the planning horizon. Your (opportunity) cost of investing $8 million for one year is
$800k, but these assets will appreciate by $480k over the year, giving a (net) user cost of
capital of $320k. (The depreciation rate of capital is 6%.) This is a fixed cost of making
DRAM’s, to which we must add the other fixed costs of $500k to get a combined fixed
cost of $820k for the year. The variable costs are a constant $4 per chip, so the cost
function is C(Q) = 820k + 4 Q, in the range of 0 < Q < 1m. (One could also report that
C(0) = 0, by definition, and that C(Q) is infinite for Q > 1m, since your maximum
capacity is one million chips per year. Of course, in practice there would likely be a way to
push production beyond “rated capacity,” at some cost penalty, but that is beyond the
scope of this problem.)
Assume now that you can sell as many chips as you make at the going market price per

11
chip of p.
(b) What is the minimum price, p, at which you would find it profitable
to produce DRAMs during the coming year?
Answer: The average cost function is AC (Q) = 820k/Q + 4, again up to one million chips
per year. This declines with Q, so the minimum AC is achieved at full capacity
utilization. At one million chips per year, the fixed costs come to $0.82 per chip, so
average costs are $4.82 per chip. This is your minimum average cost, and thus the
minimum price at which is makes sense to stay open for the year.

3.2. mp34u. Music Ventures sells a very popular mp3 player, the mp34u. The firm
currently sells one million units for a price of $100 each. Marginal cost is estimated to be
constant at $40, whereas average cost (at the output level of one million units) is $90. The
firm estimates that its demand elasticity (at the current price level) is approximately -2.
Should the firm raise price, lower price, or leave price unchanged? Explain.
1
Answer: Optimal pricing implies m = || . In this problem, we have

p − MC 100 − 40
m= = = 0.6,
p 100

which is greater than 1/| − 2| = .5. This tells us that the price/cost margin is too high, so
a lower price would be optimal. Note that the margin depends on MC , not AC .

3.3. KindOfBlue jeans. Two years ago, KindOfBlue jeans were priced at $72 and
121,000 units were sold. Last year, the price was lowered to $68 and sales increased to
132,000.
(a) Estimate the value of the demand elasticity.
Answer: Using the percent variation method (and measuring q in thousands), we have
132−121
121
= 68−72 ≈ −1.64
72

Using the logarithm method, we have

ln 132 − ln 121
= ≈ −1.52
ln 68 − ln 72

(b) Based on your estimate of the demand elasticity, how many units
would you expect to be sold if price were lowered by an additional
$1?
Answer: Let q be the new value of q. Continuing with the first method, I would estimate
q − 132 67 − 68
= −1.636 ×
132
 68
67 − 68
q = 132000 × 1 − 1.636 × ≈ 135, 177
68

12
Using the logarithm method,


ln(q) − ln(132) = −1.522 × ln(67) − ln(68)


q = exp ln(132) − 1.522 × ln(67) − ln(68) ≈ 135, 011

(c) In order to increase profits, should price be lowered below $68? If

your answer begins — as it should! — with “it depends,” indicate as
clearly as possible what additional information you would need and
how you would base your answer on such additional information.
Answer: It depends on what the value of marginal cost is. To be more precise, if marginal
cost is lower than marginal revenue, then we should further increase output, that is,
decrease price. Marginal revenue is given by
 
1
MR = p 1 +


Depending on which value of elasticity we use, we get MR ≈ 26.5 or MR ≈ 23.3 (when

p = $68). So, if marginal cost is lower than 23.3 we should further decrease price. If
marginal cost is greater than 26.5, we should instead increase price. Otherwise, it is not
clear.

3.4. EZjoint. After spending 10 years and $1.5 billion, you have finally gotten Food and
Drug Administration (FDA) approval to sell your new patented wonder drug, which
reduces the aches and pains associated with aging joints. You will market this drug under
the brand name of EZjoint. Market research indicates that the demand elasticity for
EZjoint is -1.25 (at all points on the demand curve). You estimate the marginal cost of
manufacturing and selling one more dose of EZjoint is $1.
(a) What is the profit-maximizing price per dose of EZjoint?
Answer: The optimal pricing rule (one version of it) states that
MC
p= 1
1+ 

where  is the price elasticity of demand. We thus have

1
p= 1 =5
1 − 1.25

Note that R&D expenditures are a sunk cost and thus do not enter into the pricing
decision.
(b) Would you expect the elasticity of demand you face for EZjoint to rise
or fall when your patent expires?
Answer: The level of demand for EZJoint must fall now that there are many very close
substitutes in the form of generic versions. Hopefully, your brand will still allow you to
command a premium price, but surely at any given price you will sell less as a result of
the presence of the generic competition.

13
 The elasticity of demand for EZjoint will very likely rise now that closer substitutes
are available. Customers will presumably be more price sensitive, which in turn induces
you to set a lower price. However, to the extent that the price elasticity is lower at higher
price levels of the demand curve; and to the extent that competitions from generics forces
the branded drug firm to specialize on the high-valuation segment; then it is possible that
the elasticity faced by the former monopolist now be less elastic.
Suppose that, after patent expiry, a generic version of EZjoint was introduced in the
market (under the chemical name clorophospartane). Reacting to entry, EZjoint decided
to increase price.
(c) Can this behavior be consistent with rational profit maximizing?
Answer: One possible explanation is that the market is divided into two segments, one
more price sensitive than the other. While a monopolist, EZjoint was setting a price that
balanced the goal of achieving both market segments. Once entry by a generic
manufacturer has taken place, EZjoint decided to “give up” on the price-sensitive segment
and target exclusively the segment with more inelastic demand — thus the price increase.

3.5. Las-O-Vision. Las-O-Vision is the sole producer of holographic TVs, 3DTVs. The
weekly demand for 3DTVs is D(p) = 10200 − 100 p. The cost of producing q 3DTVs per
week is q 2 /2 (note this implies that MC = q).
(a) What is Las-O-Vision’s total revenue schedule?
Answer: Total Revenue is given by p(q) q, that is, the revenue that Las-O-Vision receives
when it sells q units. To get p(q), we invert the demand function q = 10.2k − 100 p by
solving for p in terms of q, or p(q) = 102 − q/100. Substituting this into our total revenue
equation, we obtain TR (q) = (102 − q/100) q = 102 q − q 2 /100.
(b) What is Las-O-Vision’s marginal revenue schedule?
Answer: Marginal revenue is the derivative of Total Revenue with respect to q, so
MR (q) = 102 − q/50; or, since our demand equation is linear in q, we can obtain it by
recalling that the marginal revenue curve is twice as steep as the inverse demand curve
and starts at the same point on the vertical axis.
(c) What is the profit-maximizing number of 3DTVs for Las-O-Vision to
produce each day? What price does Las-O-Vision charge per 3DTV?
What is its daily profit?
Answer: The profit maximizing quantity, q ∗ , is that quantity at which marginal cost and
marginal revenue are equal. Setting MR (q) = MC , we have 102 − q ∗ /50 = q ∗ , or q ∗ = 100.
The profit maximizing price is that which generates q ∗ = 100 in sales or, substituting into
the inverse demand function calculated in (a), p(100) = 102 − (100/100) = 101. When
selling 100 units, Las-O-Vision generates total revenues equal to
TR (100) = 102 × 100 − 1002/100 = $10.1k. Its total cost is 1002 /2 = 5k. Therefore its
total profit when it sells 100 units is 10.1k − 5k = $5.1k.

14
Table 3.1
Monsanto’s Roundup: price, sales, revenue and profit
Year Price Quantity Revenue Profit
1995 45 13 599 400
1996 44 16 718 473
1997 40 20 823 517
1998 35 28 1003 578
1999 33 33 1092 592
2000 28 40 1105 509
2001 25 45 1139 464

3.6. Monsanto. With reference to the discussion in Box ??:

(a) How do you know that cutting the price of Roundup was a good idea
for Monsanto?
Answer: The key issue here is elasticity: Does a lower price produce greater revenue and
profit? The case suggests it does. In order to estimate whether profit increased when price
fell, you can guesstimate revenue (take price and quantity from the figures) and cost (the
international price is an upper bound). Almost any estimate will show profit going up.
Table 3.1 is based on a marginal cost of 15, which is probably on the high side (and thus
understates the increase in profit). A more specific, quantitative answer is given in the
next answer
(b) How might you estimate the elasticity of demand and the profit-
maximizing price for 1995. Do you think Monsanto set the right
price?
Answer: The first issue to address is that the price drop is not a controlled experiment:
other things might have been changing at the same time. Did the market for herbicides
overall grow? We don’t know. Once you’ve made this point, you can think about
estimating the value of elasticity by applying the ratio of variations method for
year-on-year variations. Some estimates can be found in Table 3.2.
If you take 2.5 as a ballpark estimate, the ratio of price to marginal cost should be
1.67, so with a cost of 15 the price should be about 25, that is, lower than what Monsanto
chose. There is an important qualification to this estimate of optimal price: One
possibility is that there is some form of price discrimination going on here. At the time
this case takes place, Monsanto was also selling Roundup Ready seeds, which is a
complementary product to Roundup. If seed buyers were willing to pay more than other
users of Roundup, Monsanto could target both markets by charging less for Roundup and
more for the seeds. Some observers suggest this is precisely what Monsanto did. More on
this in Chapter ??.
(c) If cutting price was a good idea, why didn’t Monsanto do it earlier?
Answer: While we have data looking at the real effect of the price cut, Monsanto was

15
Table 3.2
Monsanto’s Roundup: demand elasticity
Year Elasticity
1996 -7.13
1997 -2.59
1998 -2.51
1999 -2.11
2000 -1.07
2001 -1.32

working off estimates, which may have suggested that what they were doing was optimal
given the information available. Even if Monsanto had an estimate of demand elasticity
similar to the ones we computed, there are several considerations to take into account.
First, it may have been the case that Monsanto’s executives had never thought about
changing prices (this possibility is not very appealing to an economist, who always
assumes that firms maximize profits). Second, we know that success breeds laziness: while
their product was successful and profits high Monsanto’s executives had little incentive to
work harder. Finally, one plausible explanation for waiting until the mid-1990s is risk:
experimenting with different prices might be costly. Early on during the Roundup patent
life, there is a lot at risk. When the patent is about the expire, the costs of making a
mistake are lower. In other words, “If it ain’t broke don’t fix it; and if it’s about to break,
try fixing it now.”

3.7. Windows. Microsoft is the dominant player in the market for desktop operating
systems. Suppose each copy of Windows is sold for $50. Suppose moreover that the
marginal cost of production and shipping is $5. What value of the demand elasticity is
consistent with this price? Does it make sense? What elements of the OS market may be
missing from the elasticity rule?
Answer: In order for the price of $50 to be consistent with the simple formula for optimal
pricing, the price elasticity of demand, , would need to be such that
50 − 5 1
=
50 −
which implies  ≈ −1.11. This means that, if the price of Windows were to go up by 10%,
more than 10% would stop buying Windows. But 10% of $50 is $5, which is a very small
fraction of the overall price tag a consumer pays for a computer. It seems unreasonable
that so many users would move away from Windows (to a Mac? Linux?) because of such
a small price increase.
To put it differently: if Microsoft were to apply the optimal price formula with the
true value of elasticity, it would probably set a higher price for Windows. Why then such
a “small” price for the Windows operating system? One possible answer is that, by selling
more units of Windows, Microsoft is able to sell more of other products (Office?), so that
there is some cross-subsidization going on. Another possibility is that, although the short

16
run elasticity is small, in the long run setting a higher price risks “tipping” the industry
towards a different operating system. More on this in Chapter ??.

3.8. Profit maximization. Explain why the assumption of profit maximization is or is

not reasonable?
Answer: The answer to this question may be found in Section ??. The main reason we
might think that the assumption of profit maximization is not reasonable is that firm
managers are frequently not the firm owners; and the goals of managers frequently differ
from those of the owners. However, it can be argued that the discipline imposed by
shareholders, the labor market, the product market and the capital market are sufficient
to enforce profit maximization. In particular, the threat of a takeover has been found to
have a significant effect on value maximization.

3.9. Car parts. Two parts in an automobile taillight are the plastic exterior cover and
the light bulb. Which of these parts is a car company more likely to manufacture
in-house? Why?
Answer: Light bulbs are generally a homogeneous good. External suppliers enjoy
economies of scale and specialization; and supply the entire industry. In contrast, the
plastic exterior cover must be custom-designed and manufactured for each make and
model. Because it requires more Relationship Specific Investment (RSI), it is more likely
to be made in-house.

3.10. Jet engines. There are three main suppliers of commercial jet engines, Pratt &
Whitney, General Electric, and Rolls-Royce. All three maintain extensive support staff at
major (and many minor) airports throughout the world. Why doesn’t one firm service
each airport? Why do all three feel they need to provide service and support operations
worldwide themselves? Why don’t they subcontract this work? Why don’t they leave it
entirely to the airlines?
Answer: Jet engines are marvelously idiosyncratic. The knowledge, tools and parts
needed to service one family (brand) of engines do not transfer fully across brands. One
firm does not typically service each airport because the economies of scale (across brands)
are small and the economies of specialization (within brand) are large. The only thing
worse for an airline than an AOG (an aircraft sitting on the ground with a broken engine)
is an aircraft flying with a broken engine or two. To ensure their reputation and revenues
and to avoid ex post hold up, airlines demand before purchasing an aircraft that engine
makers pre-commit capital to ensure that parts and service are available at major stations
world-wide. Because the skills to do this are RSIs, and because the engine owner’s
reputation is at stake, to sell engines and credibly commit to keeping them running, each
manufacturer must provide service and support at major stations.
Subcontracting would be difficult because of the RSI required (the subcontractor
would fear hold-up) and because a poor subcontractor would impose a negative
externality on the manufacturer. When the jet goes down, the manufacturer’s reputation
will suffer on a scale beyond any contractual penalty a subcontractor could likely be held
to, so the work is not usually subcontracted. In addition, the manufacturers benefit
directly from direct feedback within the firm on the performance of the engines they

17
produce. This information may flow more readily within the firm than across firms.
Some airlines with sufficient scale do perform their own routine engine maintenance
at their own maintenance bases. However, the airlines cannot efficiently do emergency
engine repairs away from an airline’s main bases. While there are enough GE engines
going through Karachi International Airport to justify an on-site GE technical support
staff, most airlines do not have enough flights through Karachi to justify the investment.
The economies of scale in non-routine work are site and engine specific, not generally
airline specific.

3.11. Smart car. The Smart car was created as a joint venture between Daimler-Benz
AG and Swatch Group AG. Although Micro Compact Car AG (the name of the joint
venture) was originally jointly owned, in November of 1998 Daimler-Benz AG took
complete control by buying Swatch’s share.3 The deal put an end to a very stressed
relationship between Daimler and Swatch. What does Section ?? suggest as to what the
sources of strain might have been?
Answer: Section ?? suggests that, when two parties invest in specific assets and contracts
are incomplete, the equilibrium solution is inefficient in every situation short of vertical
integration. It is likely that some of this happened in the “stressed relationship” between
Daimler and Swatch. Since none of the parties was in complete control (and ownership) of
the future developments in the joint venture, the incentives for each party to invest were
less than efficient.

3.12. Franchise retailing. Empirical evidence from franchise retailing suggests that,
even when stores have similar characteristics, the mother company resorts to a mix
between company-owned stores and franchised ones.4 How can this be justified?
Answer: Franchisers face a problem in judging the performance of their franchisees.
Keeping some retail locations in-house provides the parent company with a baseline of
more readily accessible and less biased information against which the performance of the
franchises can be measured. This information then helps to set standards in negotiating
and administering future franchise contracts. Franchising the majority of retail locations
limits the parent’s direct financial outlay and exposure. Franchisers might also have an
interest in direct control of locations that could have a particularly strong impact on its
brand or reputation.

3.13. Body Shop. The U.K. Body Shop franchise network consists of three types of
stores: franchised, company owned and partnership stores. All stores that are distant from
headquarters by more than 300 miles are franchised. More than half of the
company-owned stores are within 100 miles of headquarters.5 How can you explain these
facts?
Answer: Owning a store has the advantages of vertical integration discussed in Section
3 . The Wall Street Journal Europe, November 5, 1998.
4 . See, for example, Affuso, Luisa (1998), “An Empirical Study on Contractual Heterogeneity Within
the Firm: The “Vertical Integration-Franchise Contracts” Mix,” University of Cambridge.
5 . Source: Watts, Christophe F (1995), “The Determinants of Organisational Choice: Franchising and
Vertical Integration,” M.Sc. dissertation, University of Southampton.

18
3.2. However, it also has the problem that it requires increased monitoring by the store
owner. We would expect the costs from monitoring to be lower the closer the store is to
headquarters. Consequently, we would expect vertical integration to be more likely when
the store is located closer to headquarters. The empirical evidence seems consistent with
this hypothesis.

3.14. Intel. Explain why Intel has maintained, if not increased, its competitive
advantage with respect to rivals. Indicate the explanatory power of the different causes
considered in the text (impediments to imitation, causal ambiguity, strategy, history).
Answer: This is a complex question. In fact, as argued in this chapter, this is the question
in strategy. A good source for the particular case of Intel is the HBS case “Intel
Corporation: 1968–1997,” No. 9–797–137 (Rev. October 21, 1998).

3.15. Input shares. Consider a firm with production function (Cobb-Douglas)

q = ξ K α Lβ

Suppose that output price p and input prices r, w are given. Show that a profit
maximizing firm chooses inputs levels such that the ratio between labor costs and total
revenue w L/p q is equal to β.
Answer: Firm profit is equal to

p ξ K α Lβ −(r K + w L)

The first-order condition for maximization with respect to L is given by

β p ξ K α Lβ−1 − w = 0

Noting that
ξ K α Lβ−1 = q/L
the first-order condition may be re-written as

β p q/L − w = 0

or simply
wL
β=
pq

3.16. Cost minimizing input mix. Consider a firm with production function
(Cobb-Douglas)
1 1
q = K 2 L2
Suppose that one unit of capital costs r = 12.5, whereas one unit of labor costs w = 8.
(a) Determine the optimal input mix that leads to an output of q = 2.
Answer: The firm’s problem is
min r K + w L
K,L

19
subject to
1 1
q = K 2 L2
Solving the constraint for K I get
q2
K= (3.1)
L
Substituting this for K in the objective function, the problem becomes
q2
min r +wL (3.2)
L L
The first-order condition for this minimization problem is given by
q2
−r +w =0
L2
Solving for L, I get r
r
L=q (3.3)
w
Substituting 2, 12.5 and 8 for q, r and w I get L = 2.5. Substituting 2.5 for L in (3.1), I
finally get K = 1.6
(b) Determine the firm’s cost function, that is, the minimum cost required
to produce output q.
Answer: From (3.3) for L in (3.2) and simplifying I get
√

C = 2 rw q

Substituting 12.5 and 8 for r and w, respectively, we get C = 20 q.

3.17. Pricing with capacity constraints. Consider again the case of a monopoly facing
linear demand and constant marginal cost. Demand is

q = a − b p,

and marginal cost is MC = c. Suppose moreover that the monopolist has a limited
capacity of K. In other words, it must be q ≤ K. What is the optimal price?
Answer: The easiest way to solve this problem is to first derive the optimal output level
under the assumption that there are no capacity constraints; and then compare the
candidate output level to the capacity constraint. Solving the demand curve for p, we have
a 1
p= − q
b b
This leads to a profit function
 
a 1
π(q) = p q − c q = − q q−cq
b b
The first-order condition for profit maximization (ignoring capacity constraints) is given by
1 a 1
− q + − q − c = 0,
b b b

20
or simply
a−bc
q=
2
Now we have two possibilities. If a−b
2
c
≤ K, then q = a−b c
2 is the optimal output level.
The optimal price is then given by
 
a 1 a−bc a+bc
p= − =
b b 2 2b
If however a−b
2
c
> K, then the optimal output level is q = K. The reason is that marginal
revenue is greater than marginal cost up to q = a−b c
2 , and so, if q <
a−b c
2 then we want q
as high as possible. Finally, in this case optimal price is given by
a 1 a−K
p= − K=
b b b

3.18. Optimal bidding. You are one of two companies bidding to try to win a large
construction project. Call your bid b. You estimate that your costs of actually performing
the work required will be $800k. You are risk neutral.6 You will win if and only if your
bid is lower than that of the other bidder. You are not sure what bid your rival will
submit, but you estimate that the rival’s bid is uniformly distributed between $1m and
$2m.7 What bid should you submit?
Answer: A risk-neutral bidder will use a bidding strategy that maximizes the expected
value of its bid b. This entails picking a bid value b that balances two offsetting effects:
changes in the value of winning due to changes in the bid (the larger your bid is the more
valuable the contract is) and changes in the chances of winning due to changes in b (the
larger your bid is the less likely you will win). Formally, the expected value of from
placing a bid b can be expressed
E[b] = (b − 800k) × P(b < br )
where br is the rival bidder’s bid and P(b < br ) is the probability that its bid, b, is less
than its rival’s bid, br . The first term in this equation is simply the payoff when a bidder
wins. The second term is its chances of winning (which requires that b < br ).
In this problem, the focal bidder believes that its rival’s bid can be anywhere between
$1m and $2m so
P(b < br ) = 1 − (b − 1m)/1m
for all bids between $1m and $2m. (Note that P(b < br ) = 1 for all bids less than $1m
since the focal bidder believes that the rival never bids below $1m; and P(b < br ) = 0 for
all bids greater than $2m since the focal bidder believes that the rival never bids above
$2m.) Substituting this expression into the expected value from placing a bid b we obtain
 
b − 1m
E[b] = (b − 800k) 1 −
1m
6 . We say that an agent is risk neutral if he or she is indifferent between receiving 100 for sure and
receiving 0 or 200 with probability 50% each. More generally, a risk-neutral agent only cares about
the expected value of each outcome.
7 . By “uniformly distributed between a and b” we mean that all values between a and b are equally
likely.

21
From this expression it is clear that the bidder’s payoff, conditional on winning the bid,
goes up with b; but that its chance of winning declines with b. Picking the optimal b
entails finding the maximum of E[b], which we can easily obtain by taking the derivative
of E[b], setting it equal to zero and solving for b. This bid will be the point at which the
two effects of changing b just offset each other. Working in millions as units, we have
∂

E[b] = 1 − (b − 1) − (b − .8) = 0
∂b
b − .8 = 1 − b + 1
b = 1.4m
An alternative approach to this problem is to construct a demand function from the
information we have about the market. You can then solve the problem in the same way
as you would with more straightforward problems in which you are given an explicit
demand function (i.e., set MR = MC and solve for optimal q, then solve for optimal b). To
see how this approach works, note that the bid the firm submits is just like a price. The
higher its bid, the lower its expected demand will be. In this case, demand falls as the
price goes up because the firm’s chance of winning is falling. Formally, expected demand,
q, at any level b is equal to
q = 1 − P(b < br ) = 1 − (b − 1m)/1m = 2 − b/1m
As this equation indicates, when the firm’s bid is equal to 1m, “demand” comes to 1 unit.
That is, the firm is sure to win the contract. As the bid (the price) increases, demand falls
to some fraction of a unit until at 2m “demand” is zero. Since the contract is a
winner-take-all item, the idea of fractional units is not really correct, but if there were,
say, N consumers instead of a single consumer, and the firm was bidding against other
firms for the business of each consumer, the aggregate demand function would then be
 
b bN
qN = N 2 − = 2N −
1m 1m
This is like a simple linear demand function.
To continue with this approach, we need to invert the demand function and solve for
b to get
b = 2m − 1m × q
The bidder’s total revenue is then
b q = (2m − 1m × q) q
Taking the derivative of this total revenue function, we find that the marginal revenue of
the firm is
2m − 2 × 1m × q
As we would expect, the marginal revenue curve has twice the slope of the inverse demand
curve. We can then set this marginal revenue equal to the marginal cost of 800,000 to get
optimal q:
800k = 2m − 2 × 1m × q
2 × 1m × q = 1.2m
q = 1.2/2 = .6

22
Substituting this value into our inverse demand function, we obtain the optimal bid of

b = 2m − .6 × 1m = 1.4m

3.19. Competitive pressure. Suppose that a firm’s profits are given by

π = α + φ(e) + , where α denotes (the inverse of) the intensity of product market
competition, e effort by the manager, and  a random shock. The function φ(e) is
increasing and concave, that is, dφ/de > 0 and d2 φ/de2 < 0.
In order for the firm to survive, profits must be greater than π. The manager’s payoff
is β > 0 if the firm survives and zero if it is liquidated, that is, if profits fall short of the
minimum target. The idea is that if the firm is liquidated, then the manager loses his or
her job and the rents associated with it.
Suppose that  is normally distributed with mean µ and variance σ 2 , and that µ > π.
Show that increased product market competition (lower α) induces greater effort by the
manager, that is, de/dα < 0.
Answer: The manager’s payoff is given by
 
P = β P α + φ(e) +  > π − e
  
= β 1 − F π − α − φ(e) −e

where P(x > y) is the probability that x > y and F () is the probability that  is less than
x (cumulative distribution function). Taking the derivative with respect to e, the
manager’s choice of effort level, we get

dP   dφ(e)
= β f π − α − φ(e) −1
de de

density function of . Since µ > π, we have µ > π − α − φ(e). Therefore

where f () is the
f π − α − φ(e) is in the increasing

portion of f . It follows that an increase in α leads to
a decrease in f π − α − φ(e) ; and this, in turn, implies a lower dP /de. Finally, a lower
dP /de implies a lower value of e. In words, a decrease in the degree of competition
(higher α) decreases the marginal benefit from managerial effort (dP /de), and ultimately
leads to a lower effort of managerial effort (e).
4 Competition

4.1. Vitamin C. Vitamin C is a generic vitamin that is produced by many companies:

brand names are not very important, entry is easy. A good friend — a world-renowned
orthopedic surgeon from New Jersey — tells you that he is about to publish in The New
England Journal of Medicine (a highly respected and widely quoted medical journal) a
study indicating that daily doses of 500 mg of vitamin C tends to improve the muscle tone
and increase the physical stamina of adults, with no adverse side effects. Though a very
good doctor, he is woefully ignorant about the basic workings of markets and wants to
know what is likely to happen, and why — in the short run and in the long run — to the
price of vitamin C, to the quantity sold, to the profits of the producers, and to the number
of firms that produce it. Summarize what you would tell him.
Answer: One would expect demand to increase as a result of the NEJM article. In the
short-run, supply is fixed. We would therefore observe a move along the supply curve,
with both price and output going up. The extent of the price hike would depend on the
steepness of the supply curve: the steeper the short-run supply curve is, the greater the
price increase.
In the long-run, one would expect the supply function to expand, as new producers
enter the market and existing producers expand their capacity. Assuming that demand is
kept at the same level, this would correspond to a movement along the demand curve,
with output going up and price going down.
To summarize: We would expect price to go up in the short-run, then back down in
the long-run, possibly to almost the same level as the initial level. As to output, we would
expect it to go up, with a greater increase in the long-run than in the short run.

4.2. Comparative statics: aspartame, oil. For each of the following, use a supply and
demand diagram to deduce the impact of the event on the stated market. Would you
expect the impact to be primarily on price or quantity? Feel free to mention issues that
you don’t think are captured by a traditional supply and demand analysis.
(a) Event: The FDA announces that aspartame may cause cancer. Mar-
ket: Saccharin. (Note: aspartame and saccharin are low-calorie sweet-
eners.)
Answer: Saccharin and aspartame are substitutes. We would expect demand for saccharin
to increase (demand curve shifts up/right). This would lead to an increase in the price of

24
saccharin and the quantity produced. The supply is likely to be fairly elastic (flat) as
there are several producers. Thus we would expect the main impact to be on quantity.
The supply curve is expected to be flat particularly in the long-run. For example,
suppliers of other related products can convert their production capacity to saccharin if
the price were to remain at high levels for very long.
(b) Event: Oil price increases. Market: California electricity.
Answer: Oil is an input to some of the generating plants. This implies an upward shift in
marginal cost of some plants (those that use oil). If the plants are the marginal ones
(those determining the price) then price will rise. Since demand is inelastic, the primary
impact will be on price. Otherwise, there’s no impact: these plants simply make less
money. Some of you may have also noticed that oil and electricity are substitutes (in the
long run). This implies that you can also have a shift of the demand to the right. This
increases the price even further, and makes the overall effect on quantity ambiguous.

4.3. Comparative statics: price and quantity effects. Consider following events and
markets:

• OPEC reduces oil output [market: oil]

• Unusually rainy winter in New York City [market: umbrellas in NYC]
• Soccer Champions League final in Madrid [market: Madrid hotels]
• Unusually low catch of sole fish [market: sole fish]

Which of the four corresponds to the four cases considered in Figure ???
Answer:

• Top left: umbrellas

• Top right: Madrid hotels
• Bottom left: sole fish
• Bottom right: oil

4.4. Kidney transplants. Suppose that in a given state — let’s call it state X — a few
recent kidney transplant malpractice suits have led to punitive damage awards of
unprecedented levels. What impact do you expect this to have in the market for kidney
transplant services in state X? To the extent that you can, and making the necessary
assumptions as you go along, indicate the expected effects on price and quantity; the
relative magnitude of these effects; and any possible differences between short-run and
long-run effects.
Answer: The possibility of expensive lawsuits will lead doctors to take on more insurance,
and premiums for such insurance will increase. This implies an upward shift in the supply
curve as each doctor now charges more per unit of service. Given a demand curve, this
immediately leads to an increase in price and a decrease in quantity. Depending on the
nature of demand, the demand elasticity may be greater or smaller in absolute value. As a
general rule, demand for medicines and medical services tends to be relatively inelastic.

25
However, while demand for kidney transplants is relatively inelastic, the demand for
kidney transplants in state X is probably fairly elastic: one can always travel to a
neighboring state. I would thus expect the main effect to be on quantity: state X will
likely become a state with very few kidney transplants.
In the longer run, two things will happen. First, to the extent that demand is
downward sloping, doctors are now receiving a lower net price per unit of medical services
(the rest is insurance premiums). In the long run, doctors will be more flexible regarding
their location and it is expected that some will move out of state. This implies a further
shift in the supply curve, this time to the left. Second, buyers are also likely to be more
flexible, which implies a shift in the demand curve to the left. Both movements imply a
decrease in quantity. The effect on price is unclear: the shift in supply leads to an increase
in price, whereas the shift in demand leads to a decrease in price.

4.5. Book publishing. The technology of book publishing is characterized by a high

fixed cost (typesetting the book) and a very low marginal cost (printing). Prices are set at
much higher levels than marginal cost. However, book publishing yields a normal rate of
return. Are these facts consistent with profit maximizing behavior by publishers? Which
model do you think describes this industry best?
Answer: The model of monopolistic competition is probably the best approximation to
describing this industry. The model of monopolistic competition shows that price-making,
profit-maximizing behavior is consistent with a zero-profit long-run equilibrium. The
strong scale economies in book publishing imply that the gap between price and marginal
cost is particularly high.

4.6. Laundry detergent. The market for laundry detergent is monopolistically

competitive. Each firm owns one brand, and each brand has effectively differentiated itself
so that it has some market power (i.e., faces a downward sloping demand curve). Still, no
brand earns economic profits, because entry causes the demand for each brand to shift in
until the seller can just break even. All firms have identical cost functions, which are
U-shaped.
Suppose that the government does a study on detergents and finds out they are all
alike. The public is notified of these findings and suddenly drops allegiance to any brand.
What happens to price when this product that was brand-differentiated becomes a
commodity? What happens to total sales? What happens to the number of firms in the
market?
Answer: Based on the information provided, it seems that the initial situation in this
market is like the long-run equilibrium of the monopolistic competition model; see Figure
4.7. The government’s announcement has turned a differentiated product into a
homogeneous one. In terms of the graph in Figure 6.3, this implies a flattening of the
demand curve faced by each firm and a new long-run equilibrium where d (now
horizontal) is tangent to the AC curve. At this new long-run equilibrium, price is given by
p0LR and each firm’s output is given by qLR
0 .

Clearly, the new equilibrium implies a lower price and a higher output per firm:
p0LR < pLR and qLR0 >q .
LR
Suppose that price were to drop from pLR to p0LR without changing the degree of

26
product differentiation or the number of firms. This would imply an output per firm equal
0 , where q 0
to qSR 0 . If we take into account the
is greater than qLR but lower than qLR
SR
disappearance of product differentiation (and continue with the same number of firms),
then the output per firm would be less than qSR 0 . Whatever the exact value is, each firm

would be losing money (p0LR < AC). Therefore, in the post-announcement long-run
equilibrium, some firms will need to exit the market.
Finally, it is not clear what will happen to total output. On the one hand, each firm’s
output goes up. On the other hand, the number of firms goes down. Which effect
dominates depends on how consumers value product differentiation and how the demand
curve shifts as a result of the government announcement.

4.7. T-shirt printing. The custom T-shirt printing business has many competitors, so
that the perfect competition model may be considered a good approximation. Currently
the market demand curve is given by Q = 120 − 1.5 p, whereas the market supply is given
by Q = −20 + 2 p.
(a) Determine the market equilibrium
Answer: Equilibrium price is given by the equality
120 − 1.5 p = −20 + 2 p
which implies p = 40. Substituting into the demand curve (or the supply curve, it doesn’t
matter), we get Q = 60.
Suppose there is a T-shirt craze that increases demand by 10% (that is, for each price,
demand is now 10% greater than it was before the price increase).
(b) Determine the new demand curve.
Answer: The new demand curve is obtained by multiplying the initial one by 1.1=1+10%:
Q = 1.1 ×(120 − 1.5 p) = 132 − 1.65 p

(c) Determine the change in equilibrium quantity.

Answer: Equilibrium price is given by the equality
132 − 1.65 p = −20 + 2 p
which implies p = 41.64. Substituting for p in the demand curve we get Q = 63.29. Note
that the initial value of Q was 60. We thus have an increase of 3.29/60, or 5.48%
(d) If your answer to the previous question is different from 10%, explain
the difference in values.
Answer: The shift of the demand curve is partly reflected in an increase in Q and partly
in an increase in p. If the supply curve were flat, then the increase in equilibrium Q would
be exactly 10%. Since the supply curve is upward sloping, the increase is less than 10%
Now go back to the initial demand curve and suppose there is an increase in the cost of
blank T-shirts, an essential input into the business of selling custom T-shirts. Specifically,
for each unit by each supplier, the production cost goes up by 10%.
(e) Determine the new supply curve.

27
Answer: Since we have a proportional vertical increase in the supply curve (that is, when
the supply curve is expressed in the inverse form with price units as a function of quantity
units), we must first find the inverse supply curve, then multiply it by 1.1, then invert it
back again to obtain the (direct) supply curve. From Q = −20 + 2 p we get
p = 10 + .5 Q
The new inverse supply curve is thus given by


p = 1.1 × 10 + .5 Q = 11 + .55 Q
which can be inverted into
Q = −20 + 1.82 p

(f) Determine the change in equilibrium price.

Answer: The new equilibrium price is given by the equality
120 − 1.5 p = −20 + 1.82 p
which implies p = 42.17. This corresponds to an increase of 2.17/40 = 5.42%.
(g) If your answer to the previous question is different from 10%, explain
the difference in values.
Answer: The answer is similar to that of question (d). If the demand curve were perfectly
inelastic, then the shift in the supply curve would imply a change in equilibrium price of
exactly 10%. Since the demand curve is downward sloping, the upward shift in the supply
curve implies an increase in prices as well as a decrease in equilibrium quantity. For this
reason, the increase in equilibrium price is lower than the shift in the supply curve.

4.8. Sales tax. Consider an industry with market demand Q = 550 − 20 p and market
supply Q = 100 + 10 p. Determine the equilibrium price and quantity. Suppose the
government imposes a tax of $6 per unit to be paid by consumers. What is the impact on
equilibrium price and quantity? What if the sales tax is paid by the seller instead of the
buyer?
Answer: We derive equilibrium p and Q by solving the supply and demand system of
equations. Since both are written in terms of Q, this is a relatively easy task:
550 − 20 p = 100 + 10 p
or simply
550 − 100
p= = 15
20 + 10
Substituting for p in the supply equation, we get
Q = 100 + 10 × 15 = 250
Suppose each consumer must pay a $6 tax. This means each consumer is willing to pay 6
dollars less for each unit then before. Consumer gross willingness to pay is given by the
inverse demand curve. From Q = 550 − 20 p, we get
550 1 1
p= − Q = 27.5 − Q
20 20 20

28
It follows that, with the sales tax, willingness to pay is now given by
 
1 1
p = 27.5 − Q − 6 = 21.5 − Q
20 20
or, to put in the same form as initially,

Q = 430 − 20 p

The new equilibrium is determined by the intersection of the demand and the new supply
curve:
430 − 20 p = 100 + 10 p
or simply
430 − 100
p= = 11
20 + 10
Substituting for p in the supply equation, we get

Q = 100 + 10 × 11 = 210

Notice that the price effectively paid by consumers is 11 + 6 = 17. This represents an
increase of 2 with respect to the initial price, which is considerably less than 6. Why?
because some of the tax’s burden is taken by sellers, who now receive a price of 11, a drop
of 4. (Note that, as expected, 2 + 4 = 6, the value of the tax.)
Suppose instead that sellers must pay the $6 tax. This means that if a seller was
willing to sell for a price p, it is now willing to sell for p + 6, so that the net price is the
same p as before. What is then the new supply function? It helps to solve it in terms of p
as a function of Q:
100 1
p=− + Q
10 10
The new supply curve is therefore given by
 
1 1
p = −10 + Q + 6 = −4 + Q
10 10
or, to put in the same form as initially,

Q = 40 + 10 p

The new equilibrium is determined by the intersection of the demand and the new supply
curve:
550 − 20 p = 40 + 10 p
or simply
550 − 40
p= = 17
20 + 10
Substituting for p in the supply equation, we get

Q = 40 + 10 × 17 = 210

As we compare this equilibrium to the case when the tax is paid by the buyer, we realize
that: (a) total output is the same; (b) the price effectively paid by the buyer is the same;

29
(c) the price effectively received by the seller is the same. We have just stumbled into an
important result from the economic theory of taxation: the burden of a sales tax does not
depend on who actually pays the tax!
Extra credit: What then determines the relative burden of a sales tax that falls on
buyers and on sellers?

4.9. Sales tax with steeper demand. Consider again Exercise 4.8. Suppose that
demand is instead given by Q = 280 − 2 p.
(a) Show that the equilibrium levels of p and q are the same as in the
initial equilibrium of Exercise 4.8.
Answer: Equilibrium price is determined by

280 − 2 p = 100 + 10 p

or simply
280 − 100
p= = 15
2 + 10
Substituting for p in the supply equation, we get

Q = 100 + 10 × 15 = 250

the same values as in the initial equilibrium in Exercise 4.8.

(b) Determine the impact of a $6 sales tax in terms of the price effectively
paid by buyers and sellers.
Answer: As shown in Exercise 4.8, it does not matter whether the tax is paid by seller or
buyer. Suppose that sellers must pay the $6 tax. As shown in Exercise 4.8, the new
supply function is given by
Q = 40 + 10 p
The new equilibrium is determined by the intersection of the demand and the new supply
curve:
280 − 2 p = 40 + 10 p
or simply
280 − 40
p= = 20
2 + 10
Substituting for p in the supply equation, we get

Q = 40 + 10 × 20 = 240

(c) Compare the results in (b) to those in Exercise 4.8. Explain the
economic intuition.
Answer: In Exercise 4.8, a $6 tax lead to an equilibrium price of 17. As a result, the $6
tax is borne by consumers ($2) and firms ($4). By contrast, in the present exercise price is
given by 20. As a result, the burden of the $6 tax falls primarily on consumers, who pay
$5, whereas firms pay only $1.

30
 The difference between Exercise 4.8 and the present exercise is that demand is now
steeper. A steeper demand means that consumers are less sensitive to price changes,
which in turn implies that sellers are able to pass through a greater portion of the tax.
More generally, the lower the demand elasticity, the greater the incidence of a sales tax on
consumers.

4.10. Car prices in Europe. Sales taxes on car purchases in Europe vary from 0% to
more than 200%.8 The UK is one of the countries with lowest taxes, whereas Denmark is
one of the countries with highest taxes.
(a) In which countries do you expect consumer prices to be the highest?
Answer: The countries with the highest sales tax.
(b) In which countries do you expect pre-tax consumer prices to be the
highest?
Answer: The countries with the lowest sales tax.
By law, if a consumer buys a car in country x and then registers the car in country y, the
consumer receives a refund from the tax paid in country x and then pays the
corresponding tax in country y.
(c) What is the optimal car buying strategy for a European who does not
mind to purchase abroad?
Answer: Purchase the car in the country with the highest sales tax.

4.11. Electricity supply. Consider an electricity market where there are three suppliers,
each with constant marginal cost (a reasonable approximation in electricity generation).
Firm 1 has a capacity of 200 and MC = 5. Firm 2 has a capacity of 100 and MC = 8.
Firm 3 has a capacity of 100 and MC = 10. Suppose that suppliers act as price takers.
(a) Determine the industry supply curve.
Answer: See Figure 4.2. Each firm supplies zero if price is below its marginal cost; if price
is greater than marginal cost, then the firm supplies all the way to capacity. It follows that
the supply curve is zero for p up to 5, 200 for p in the [5, 8) interval, 300 (= 200 + 100) for
p in the [8, 10) interval; and 400 (= 200 + 100 + 100) for p greater than 10.
(b) Suppose that market demand is given by Q = 540 − 20 p. Determine
the market equilibrium. Is this equilibrium a long-run equilibrium?
Answer: At p = 10, demand is Q = 540 − 200 = 340. Then Firm 1 produces q = 200,
Firm 2 produces q = 100, and Firm 3 produces q = 40. Since the supply curve is such that
price equals 10 for any output level between 300 and 400, we confirm that market
equilibrium is given by p = 10 and Q = 340. If the technology available to potential
entrants is like firm 3’s, then the answer is yes, this is a long-run equilibrium: an
additional entrant would not be able to make positive profits. Notice that, in this
equilibrium, while firm 3 earns zero profit (it is the marginal firm), both firms 1 and 2
earn positive profits (rents from a better cost function).
8 . Source: European Parliament, “Car taxes: the less I pollute, the less I pay,” 27-06-2006.

31
Figure 4.2
Electricity supply
p

D2 D1

10 ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...
...
...
...
...
8 ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ..
.
...
...
...
... ...
... ...
... ...
... ...
... ...
5 ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ...... ..
.
.
..
.
...
...
...
...
.. ... ...
.
.. ... ...
.
.. ... ...
.
.. ... ...
.
.. ... ...
.
.. ... ...
.
.. ... ...
.
.. ... ...
.
..
...
...
..
... q
0
0 100 200 300 400

(c) Suppose that (i) demand falls to D(p) = 400−20 p; (ii) Firm 3 reduces
its MC to 8; (iii) Firm 2 reduces its MC to 7. What happens to
equilibrium profits in each case?
Answer: See Figure 4.2. (i) If demand falls, then so do profits. (ii) If Firm 3 reduces its
MC to 8, the price drops to 8, and so do profits. (iii) If Firm 2 reduces its MC to 7, then
Firm 2’s profits increase, whereas Firm 1 and Firm 3’s profits remain constant.

4.12. Average and marginal cost. Show that, in a long-run equilibrium with free entry
and equal access to the best available technologies, the comparison of price to the
minimum of average cost or the comparison of price to marginal cost are equivalent tests
of allocative efficiency. In other words, price is greater than the minimum of average costs
if and only if price is greater than marginal cost.
Show, by example, that the same is not true in general (hint: consider a monopolist
with constant average and marginal cost c).
Answer: We first show the following fact: marginal cost is greater than average cost if
and only if average cost is increasing. To see this, notice that Average Cost is given by
the ratio Cost / Output. Taking the derivative with respect to Output q, we get
dC
d AC d C dq q−C 1

= = = MC − AC
dq dq q q2 q
which shows the fact.
In the long-run equilibrium of an industry with equal access, each firm will be
producing at a point in the left-hand portion of its Average Cost curve. Given the above
fact, it follows that marginal cost is lower than or equal to average cost. Since there is free
entry, price is equal to average cost. Specifically, either price is equal to the minimum of
average cost and equal to marginal cost; or price is greater than the minimum of average
cost and greater than marginal cost.

32
 The same is not true, for example, in a short-run equilibrium. Consider the case of
perfect competition and suppose that price is greater than the minimum of average cost.
Since firms are price takers, price is equal to marginal cost. So, price is greater than the
minimum of average cost, whereas price is equal to marginal cost.
5 Market Failure

5.1. Front yards. Front yards, if well tended, generate positive externalities for a
house’s neighbors. Do you think this is an important externality? Is the market solution
inefficient?
Answer: The externality is likely to be important: one of the characteristics that make a
neighborhood attractive is precisely how well tended the front yards are. If each household
were to choose gardening effort solely based on his or her benefits, it’s likely that the
equilibrium level of gardening effort would be lower than optimal. However, it’s also likely
that neighborhood social pressure induces residents to put a little more effort than they
would like: if they don’t, they risk being shunned by their neighbors. If the social norm
regarding acceptable gardening levels is at the socially optimal level, then it is possible
that the market solution be efficient.

5.2. AT&T. The long-run demand elasticity of AT&T in the period 1988–1991 was
estimated to be around -10.9 Assuming the estimate is correct, what does this imply in
terms of AT&T’s market power at the time?
Answer: A demand elasticity of 10 implies that AT&T’s demand is very elastic. In fact,
the author of the study that produced this estimate computes the welfare loss due to
AT&T’s market power to be less than 1% of sales volume.

5.3. Monopoly power. “The degree of monopoly power is limited by the elasticity of
demand.” Comment.
Answer: Optimal monopoly pricing leads to the following relation between the price-cost
margin and demand elasticity: (p − MC )/p = 1/||, where p is price, MC marginal cost,
and e demand elasticity. It follows that the greater the value of  the lower the value of
(p − MC ) and the lower monopoly profits. A monopolist facing a very elastic demand
curve makes profits at the level of a competitive firm.

5.4. Windows. Is the Windows operating system an essential facility? What about the
Intel Pentium microprocessor? To what extent does the discussion in Section ?? on
9 . Ward, Michael R. (1995), “Measurements of Market Power in Long Distance Telecommunications,”
Federal Trade Commission, Bureau of Economics Staff Report.

34
essential facilities (vertical integration, access pricing) apply to the above examples?
Answer: By means of preface: this is a very controversial question; not all economists
agree on a single answer. Having said that, both Microsoft (the producer of the Windows
operating system) and Intel (the producer of the Intel Pentium microprocessor) provide
computer makers with essential components, without which the machines could not
function. Nevertheless, strictly speaking, we cannot say that their output represents an
essential facility. The discussion in Section ?? applies to monopolists. The crucial
difference from the examples presented in the section is the fact that Microsoft and Intel
are not monopolists: computer makers always have the option of switching to another
provider of components.
However, the widespread use of the Windows operating system, and the fact that
Windows is only supplied by Microsoft, implies that the latter’s position is much closer to
the one of a monopolist than is Intel’s. Even though Intel’s chip design is very close to
being an industry standard, Intel is not the only company supplying microprocessors with
that design. Hence, the Windows operating system is closer to what is called an essential
facility than Intel’s Pentium processor.

5.5. Carbon tax. Consider an industry with demand q = 1 − p and supply q = p.

Suppose that each unit of output implies one unit of CO2 added to the atmosphere and a
marginal social cost of e, where e is the total level of emmissions.
(a) What is the level of CO2 emission at the market equilibrium?
Answer: Equating supply and demand, we get 1 − p = p, or simply p = 12 . Substituting in
the supply curve (or the demand curve) we get q = 21 . Since one unit of output
corresponds to one unit of emissions, we conclude that the emissions level is 12 .
(b) What is the socially optimal level of CO2 emissions?
Answer: Since e = q, The total social marginal cost is given by q + q = 2 q, where the first
term corresponds to production cost and the second to cost from emissions. The inverse
demand is given by p = 1 − q. Equating the two, we get
2q = 1 − q
or simply q ∗ = 13 .
(c) Determine the Pigou tax that achieves the social optimum.
Answer: Equilibrium output (supply = demand) is given by
q+t=1−q
Since the goal is q = 31 , it follows that t∗ = 1 − 2 q ∗ = 13 .

5.6. Common facility. Different divisions within a firm frequently compete for a
common resource. Suppose that divisions 1 and 2 of a given firm share a common facility
F . Let yi be the service level used by division i (i = 1, 2). Division i’s gross benefit in
terms of improved divisional earnings is given by yi − 0.25 yi2 − 0.1 (y1 + y2 ).
(a) What are the equilibrium levels of yi if the various divisions act sep-
arately?

35
Answer: Each division maximizes

yi − 0.25 yi2 − 0.1 (y1 + y2 )

Let us consider division 1. Since it cannot control the other division, the optimal solution
corresponds to maximizing

y1 − 0.25 y12 − 0.1 y1 = 0.9 y1 − 0.25 y12

The solution is y1 = 1.8. By symmetry, the same is true for the other division, so y2 = 1.8.
(b) What are the optimal levels of yi from an overall firm point of view?
Answer: The firm maximizes total benefit, that is

y1 − 0.25 y12 − 0.1 (y1 + y2 ) + y2 − 0.25 y22 − 0.1 (y1 + y2 ) =

= 0.8 (y1 + y2 ) − 0.25 (y12 + y22 )

Maximizing with respect to y1 we get y1 = 1.6, and similarly y2 = 1.6.

(c) Explain the difference between the results in (a) and (b).
Answer: The equilibrium value is greater than the optimal value. The reason is that there
is a negative externality: when division 1 uses the facility more intensely, it does not take
into account that this costs division 2 lower divisional earnings. In other words, part of
division 1’s gain is not a gain for a firm as a whole.
(d) How can equilibrium and optimality be reconciled?
Answer: One possibility is to create a system of transfer pricing whereby each division
pays for the use of the common facility F . If the fee is set at .1 (the cost imposed on the
other facility), then the equilibrium solution will be optimal.
6 Price Discrimination

6.1. Perfect price discrimination. Consider a monopolist with demand D = 120 − 2 p

and marginal cost MC = 40. Determine profit, consumer surplus, and social welfare in the
following two cases: (a) single-price monopolist; (b) perfect price discrimination.

Solution: As we have seen before, in these problems it is useful to work with the inverse
demand curve. In the present case, this is given by p = 60 − .5 q. Marginal revenue is
given by MR = 60 − q. Equating to marginal cost and solving with respect to q, we get
60 − q = 40, or q = 20. This implies p = 60 − 20/2 = 50. Monopoly profits are
(50 − 40) × 20 = 200, whereas consumer surplus is 12 (60 − 50) × 20 = 100. It follows that
social surplus is equal to 300.
Consider now the case of a perfect discriminating monopolist. Price for the qth unit
is now given p = 60 − .5 q, so long as the resulting price is greater than marginal cost. If
follows that the monopolist’s optimal output is given by solving p = MC , or 60 − .5 q = 40,
which yields q = 40. Under perfect discrimination, consumer surplus is zero (each
consumer pays a price equal to its willingness to pay, or else it doesn’t buy). Seller’s profit
is given by the integral of the difference between price and marginal cost. Since demand is
linear, this is the area of the triangle formed by the demand curve and the MC curve, from
0 to optimal q: 12 (60 − 40) × 40 = 400.

6.2. The Economist. First-time subscribers to the Economist pay a lower rate than
repeat subscribers. Is this price discrimination? Of what type?
Answer: This is an example of price discrimination by indicators (also known as
third-degree price discrimination). The market is segmented into new subscribers and
repeat subscribers. New subscribers, know the product less well and are thus likely to be
more price sensitive. Moreover, the fact that they have not subscribed in the past
indicates that they are likely to be willing to pay less than current subscribers. It is
therefore optimal to set a lower price for new subscribers.

6.3. Cement. Cement in Belgium is sold at a uniform delivered price throughout the
country, that is, the same price is set for each customer, including transportation costs,
regardless of where the customer is located. The same practice is also found in the sale of

37
plasterboard in the United Kingdom.10 Are these cases of price discrimination?
Answer: Yes, these are cases of price discrimination. Consider the total price being paid
by each customer, P , as being composed of the price actually charged and the
transportation cost; P = pi + ti . Since locations are different, transportation costs are
different, thus, each consumer is charged a price pi that depends on his or her location.
This is a clear example of geographic price discrimination, one instance of discrimination
by indicators.

6.4. Fulton fish market. A study of the New York fish market (when it was the Fulton
fish market) suggests that the average price paid for whiting by Asian buyers is
significantly lower than the price paid by White buyers.11 What type of price
discrimination does this correspond to, if any? What additional information would you
need in order to answer the question?
Answer: This appears to be a case of price discrimination by indicators (also known as
third-degree price discrimination), whereby a group of buyers (a market segment) pays a
different price than another group. Theory predicts that in a non-competitive market
(monopoly, oligopoly) buyers with higher price elasticity should be charged a lower price;
as a result, we can conclude that Asian buyers have higher price elasticity than white
buyers.
In order to have a more accurate picture, however, more information is needed.
Different prices could could simply result from quantity discounts and the possible fact
that different quantities are bought by the different groups. If that were the case, we
would have price discrimination by self-selection, not by indicators. In other words, it may
be that Asian buyers pay a lower price not because they are Asian but because they
purchase larger quantities. Similarly, the time of purchase (e.g., before 5am or after 5am)
could be correlated with race, so that it is not race that determines the price difference.
A similar reasoning applies to the type of establishment the buyer represents (store,
fry shop, etc.). Finally, it could also be the case that different groups use different types of
payment type (cash or credit), so that different prices reflect different costs.
For a more complete discussion, see the cited reference.

6.5. Coupons. Supermarkets frequently issue coupons that entitle consumers to a

discount in selected products. Is this a promotional strategy, or simply a form of price
discrimination? Empirical evidence suggests that paper towels are significantly more
expensive in markets offering coupons than in markets without coupons.12 Is this
consistent with your interpretation?
Answer: This may be interpreted as a case of price discrimination by self selection. By
offering coupons (hence a lower price), supermarkets can serve the buyers with a higher
price elasticity at a different price. In order for this strategy to improve revenues with
10 . Phlips, Louis (1983), The Economics of Price Discrimination, Cambridge: Cambridge University
Press, pp. 23–30.
11 . Graddy, Kathryn (1995), “Testing for Imperfect Competition at the Fulton Fish Market,” Rand
Journal of Economics 26, 75–92.
12 . Levedahl, J.W. (1986), “Profit-Maximizing Pricing of Cents-Off Coupons: Promotion or Price Dis-
crimination?,” Quarterly Journal of Business and Economics 25, 56–70

38
respect to single price, supermarkets should then set a higher regular price. Hence,
empirical evidence is consistent with the explanation that this is a form of price
discrimination.

6.6. GetGoing.com. In 2013, the travel booking site GetGoing was offering a “Pick
Two, Get One” deal: customers would select two flights — to different cities — and make
a purchase before finding out where they would be heading. GetGoing would then select
one of the destinations. Explain how this can be a profitable strategy for GetGoing.
Answer: The idea is that business travelers are less flexible: they have specific
appointments at specific locations. They would never accept a deal that would take them
to Istanbul or Beijing. Leisure travelers, by contrast, are more flexible: they want to go to
a fun destination, but it does not have to be exactly a particular destination.
Given this, the “Pick Two, Get One” provides a good vehicle for price discrimination.
It is effectively a form of damaged good: at no savings for itself, the seller makes the
service strictly worse (nobody likes the uncertainty about their final destination). The
point is that the utility loss from product damaging is much greater for high-valuation
buyers (business travelers) than for low-valuation travelers.

6.7. Coca-Cola. In 1999, Coca-Cola announced that it was developing a “smart”

vending machine. Such machines are able to change prices according to the outside
temperature.13 Suppose, for the purposes of this problem, that the temperature can be
either “High” or “Low.” On days of “High” temperature, demand is given by
Q = 280 − 2 p, where Q is number of cans of Coke sold during the day and p is the price
per can measured in cents. On days of “Low” temperature, demand is only Q = 160 − 2 p.
There is an equal number days with “High” and “Low” temperature. The marginal cost of
a can of Coke is 20 cents.
(a) Suppose that Coca-Cola indeed installs a “smart” vending machine,
and thus is able to charge different prices for Coke on “Hot” and
“Cold” days. What price should Coca-Cola charge on a “Hot” day?
What price should Coca-Cola charge on a “Cold” day?
Answer: On a Hot day, Q = 280 − 2 p, or p = 140 − Q/2. Marginal revenue is
MR = 140 − Q. Equating to marginal cost (20) and solving, we get Q∗ = 120 and p∗ = 80.
On a Cold day, Q = 160 − 2 p, or p = 80 − Q/2. Marginal revenue is MR = 80 − Q.
Equating to marginal cost (20) and solving, we get Q∗ = 60 and p∗ = 50.
(b) Alternatively, suppose that Coca-Cola continues to use its normal
vending machines, which must be programmed with a fixed price,
independent of the weather. Assuming that Coca-Cola is risk neutral,
what is the optimal price for a can of Coke?
Answer: Observe from part (a) that even on a Hot day the optimal price is no greater
than 80 cents. So, we can restrict our attention to prices of 80 cents or less. In this price
range, the expected demand is given by Q = 12 (280 − 2p) + 12 (160 − 2 p) = 220 − 2 p.14
13 . Financial Times, October 28, 1999.
14 . If p > 80, then we must consider the possibility of zero consumption by at least one of the market
segments.

39
Solving for p gives p = 110 − Q/2. The marginal revenue associated with this expected
demand curve is given by MR = 110 − Q. Equating this marginal revenue to marginal
cost, we get Q∗ = 90 and p∗ = 65.
(c) What are Coca-Cola’s profits under constant and weather-variable
prices? How much would Coca-Cola be willing to pay to enable
its vending machine to vary prices with the weather, i.e., to have
a “smart” vending machine?
Answer: Under price discrimination, from part (a), profits on a Hot day are
(80 − 20) × 120 = $72, and profits on a Cold day are (50 − 20) × 60 = $18. Expected
profits per day are therefore ($72 + $18)/2 = $45. Under uniform pricing, expected profits
per day are (65 − 20) × 90 = $40.50. It follows that Coca-Cola should be willing to pay up
to an extra $4.50 per day for a “smart” vending machine.
However, one might add that there are other important considerations. The fact that
Coca-Cola did not pursue the idea of a “smart” vending machine is probably less due to
the economics of it as it is due to the consumer backlash that the idea created.

6.8. Sal’s satellite. Sal’s satellite company broadcasts TV to subscribers in LA and

NY. The demand functions are given by
1
QNY = 50 − 3 PNY
2
QLA = 80 − 3 PLA
where Q is in thousands of subscriptions per year and P is the subscription price per year.
The cost of providing Q units of service is given by
TC = 1, 000 + 30 Q

where Q = QNY + QLA .

(a) What are the profit-maximizing prices and quantities for the NY and
LA markets?
Answer: Note that, from the cost function, we get MC = 30. It follows that PNY = 90,
QNY = 20, PLA = 75 and QLA = 30.
(b) As a consequence of a new satellite that the Pentagon developed,
subscribers in LA are now able to get the NY broadcast and vice
versa, so Sal can charge only a single price. What price should he
charge?
Answer: Note that demand in NY is positive if and only if price is lower than 150;
whereas demand in LA is positive if and only if price is lower than 120. It follows that
total demand is given by

 QNY + QLA = 130 − P
 if P < 120
Q= 1
QNY = 50 − 3 P if 120 < P < 150

0 if P > 150


Suppose that P < 120, so that the first formula applies. Then the inverse demand curve is
given by P = 130 − Q. Optimal price is P = (130 + 30)/2 = 80, which confirms the
hypothesis that P < 120. Quantity is given by Q = 130 − P = 50.

40
 (c) In which situation is Sal better off? In terms of consumers’ surplus,
which situation do people in LA prefer? What about people in NY?
Why?
Answer: Sal is better off without the new satellite (that is, when he can price
discriminate). People in NY prefer the new satellite, since they pay a lower price. People
in LA preferred the situation before the introduction of the satellite, because the price
increased for them. As often is the case, price discrimination makes some people better
off, some people worse off.

6.9. Stadium pricing. Stanford Stadium has a capacity of 50k and is used for exactly
seven football games a year. Three of these are OK games, with a demand for tickets
given by D = 150k − 3 p per game, where p is ticket price. (For simplicity, assume there is
only one type of ticket.) Three of the season games are not so important, the demand
being D = 90k − 3 p per game. Finally, one of the games is really big, the demand being
D = 240k − 3 p. The costs of operating the Stadium are essentially independent of the
number of tickets sold.
(a) Determine the optimal ticket price for each game, assuming the ob-
jective of profit maximization.
Answer: Demand for OK games is given by D = 150 − 3 p, where number of tickets is
measured in thousands. Inverse demand is p = 50 − Q/3. Marginal revenue is
MR = 50 − 23 Q. Marginal cost is zero, since costs do not depend on the number of tickets
sold. Equating marginal cost to marginal revenue, we get Q = 75. This is greater than
capacity. Therefore, the optimal solution is simply to set price such that demand equals
capacity: 150 − 3 p = 50, which implies p = $33.3
Demand for not-so-important games is given by D = 90 − 3 p. Inverse demand is
p = 30 − Q/3. Marginal revenue is MR = 30 − 32 Q. Equating marginal revenue to marginal
cost, we get Q = 45. Substituting back in the inverse demand curve we get p = $15.
Since demand for the Big Game is greater than for the OK games, it will surely be
the case that MR = MC implies a demand level greater than capacity. The optimal price is
therefore determined by equating demand to capacity: 240 − 3 p = 50, or simply p = $63.3
Given that the Stadium is frequently full, the idea of expanding the Stadium has arisen.15
A preliminary study suggests that the cost of capacity expansion would be $100 per seat
per year.
(b) Would you recommend that Stanford go ahead with the project of
capacity expansion?
Answer: The marginal gross profit of an additional seat is the sum of the difference
between marginal revenue and marginal cost for all games where capacity was a
constraint. For OK games, marginal revenue is given by MR = 50 − 23 50 = 16.7. For the
Big Game, MR = 80 − 32 50 = 46.7. Adding these up (three times the first plus the second)
we get $96.7. Since this is less than the marginal cost of capacity expansion, it is not
worth it to pursue the project. (Note that during OK games there is excess capacity, so
15 . Ignore the fact that Stanford Stadium used to hold 90,000 seats and was thought to be too big.

41
these do not benefit from the project.)

6.10. Spoken Word. Your software company has just completed the first version of
SpokenWord, a voice-activated word processor. As marketing manager, you have to decide
on the pricing of the new software. You commissioned a study to determine the potential
demand for SpokenWord. From this study, you know that there are essentially two market
segments of equal size, professionals and students (one million each). Professionals would
be willing to pay up to $400 and students up to $100 for the full version of the software. A
substantially scaled-down version of the software would be worth $50 to students and
worthless to professionals. It is equally costly to sell any version. In fact, other than the
initial development costs, production costs are zero. Although you know there are two
market segments, you cannot directly identify a consumer as belonging to a specific
market segment.
(a) What are the optimal prices for each version of the software?
Answer: It is optimal to price the full version at 400 and the scaled-down version at 50.
Total profits are 450.
Suppose that, instead of the scaled-down version, the firm sells an intermediate version
that is valued at $200 by professionals and $75 by students.
(b) What are the optimal prices for each version of the software? Is
the firm better off by selling the intermediate version instead of the
scaled-down version?
Answer: One first possibility would be to price the intermediate version at 75 and the full
version at 400. However, this would lead professionals to choose the intermediate version
since the difference between willingness to pay and price is greater for the intermediate
version. In order to induce professionals to buy the full version, the full version’s price
would need to be 75 + (400 − 200) = 275, where the value in parentheses is the
professionals’ difference in willingness to pay between the two versions. (This is the same
as saying professionals need to get a minimum surplus of 200-75=125.) This would lead to
a total profit of 275 + 75 = 350, which is lower than initially. Still another possibility
would be to price the full version at 400 and the intermediate version at
400 − (400 − 200) = 200. In this case, professionals would buy the full version but students
would not buy the intermediate version. Profits would then be 400: better than 350 but
still less than the 450 the firm would get with the truly scaled-down version.

6.11. SoS. SoS (Sounds of Silence, Inc) prepares to launch a revolutionary system of
bluetooth-enabled noise-cancellation headphones. It is estimated that about 800,000
consumers would be willing to pay $450 for the headphones; an additional 1,500,000
consumers would be willing to pay $250 for the headphones. Though SoS knows this
marketing information, it cannot identify a consumer as belonging to one group or the
other.
SoS is considering the launch of a stripped-down version of the headphones (the
stripped-down version uses wires instead of bluetooth). The 800,000 high-valuation
consumers would only be willing to pay $325 for the stripped-down version. The
remaining 1,500,000 consumers don’t particularly care about bluetooth vs. wire

42
connections; they are willing to pay the same $250 for either version.
Both the bluetooth version and the stripped-down version cost the same to produce:
$100 per unit.
(a) Determine the optimal pricing policy assuming that SoS only sells
bluetooth-enabled headphones.
Answer: There are two candidate price levels: 450 and 250. At 450, profit is given by
(450 − 100) × 800, 000 = $280m. At 250, profit is given by
(250 − 100) × (800, 000 + 1, 500, 000) = $345m. It follows the optimal price is $250.
(b) Determine the optimal pricing policy assuming that SoS offers the two
versions.
Answer: The new alternative to consider is offering the stripped-down version at a lower
price and the full version at a higher price. The relevant constraint is that high-end users
have no incentive to choose the stripped down version. This implies that
450 − pH ≥ 325 − pL
Since low-valuation buyers will not have an incentive to buy the more expensive version (a
fact that we can confirm later on), the best we can do is to charge their valuation: 250. It
follows from the above inequality that the highest price we can charge the full version is
pH = 450 − 325 + 250 = 375. Under this strategy, total profit is given by
π = (375 − 100) × 800, 000 + (250 − 100) × 1, 500, 000 = $445m
Since this is better than $345m, the optimal solution determined in (a), versioning is the
optimal strategy.
(c) Suppose that SoS finds out that the estimate regarding the number of
low-valuation users is overly optimistic. In fact, there are only 300,000
consumers who would be willing to pay $250. How would you change
your answer to (a) and (b)?
Answer: Given a different number of low-valuation consumers, we must recompute both
the values in (a) and the values in (b). As to (a), we still have $280m from targeting
high-end users only. A price of $250 now leads to a profit of
(250 − 100) × (800, 000 + 300, 000) = $165m. It follows that, if the seller were to sell one
version only, then the optimal price is now $450.
Consider now the case of versioning. The no-deviation constraint is still the same and
so pH would still be equal to $375. Total profit is now given by
π = (375 − 100) × 800, 000 + (250 − 100) × 300, 000 = $265m
This is less than $280m. It follows that the overall optimal policy is now to forget about
versioning and simply target high-end users with a price of $450.

6.12. RawDeal. RawDeal is the new sushi bar in the neighborhood. Their estimated
marginal cost is 10 cents per sushi unit. RawDeal estimates that each consumer has a
demand for sushi given by q = 20 − 10 p, where q is number of sushi units and p is price in
dollars per unit.
(a) Determine the optimal price per sushi unit.

43
Answer: Inverse demand is given by

p = 2 − 0.1 q

If demand is linear and given by p = a − b Q, then optimal price is given by

a+c
p=
2
It follows that, in the present case,
2 + .1
p= = 1.05
2
(that is, one dollar and 5 cents).
(b) RawDeal is considering switching to an all-you-can-eat-sushi policy.
Determine the optimal price per customer. How does profit compare
to pricing per unit?
Answer: All you can eat means the price per unit is zero. It follows that each consumer
will eat 20 units of sushi. The consumer surplus from 20 units at zero price is given by
1
CS = 2 × 20 = 20
2
It follows that revenue per customer is $20. Since each customer will eat 20 units, cost per
customer will be 20 × .1 = $2. It follows that profit per customer is given by $18. By
contrast, charging 1.05 per piece leads to a demand of

q = 20 − 10 p = 20 − 10 × 1.05 = 9.5

and a profit of
π = (1.05 − .10) × 9.5 = .95 × 9.5 = 9.025
It follows that switching to all you can eat nearly doubles RawDeal’s profit.
(c) Discuss other advantages and disadvantages of each pricing option.
Answer: Implementation costs play an important role here. One of the advantages of
all-you-can eat is that you don’t need to monitor how much each patron eats: all you need
to do is to charge the entrance fee. One potential problem is that all patrons are not
equal: if you get stuck with people who eat a lot, then the deal may be better for the
customers than for the seller. In fact, one problem when you have all-you-can eat
restaurants competing against “conventional” ones is that consumers naturally self select,
with the big eaters disproportionately visiting the all-you-can-eat venues more often.
(d) Ignoring implementation costs, what is the optimal two-part tariff for
sushi (i.e., a fee at the door plus a price per sushi piece).
Answer: The optimal two-part tariff is to set price equal to marginal cost and charge a
fixed fee equal to the consumer surplus at that price. If unit price is 10 cents, then each
consumer will order
q = 20 − 10 p = 19

44
units of sushi. This implies that consumer surplus is given by the area of the triangle
between the demand curve and price level, that is,
1
× (2 − .1) × 19 = 18.05
2
Profit per consumer is then given by

π = F + pq − cq

where F is the fixed fee, p is price per unit, c is cost per unit, and q quantity consumed.
However, since we set p = c, we simply get π = F . In other words, under the optimal
two-part tariff profit per consumer is given by 18.05. As expected, this is better than all
you can eat (18 per consumer), though by very little (less than 1%). In fact, given the
transactions costs of charging on a per unit basis, all-you-can eat may well be the overall
optimal solution.

6.13. Pricing with limited capacity. Consider the model of a monopolist with two
markets presented earlier in the chapter. Suppose that the seller has a limited capacity
and low marginal cost up to capacity. An example of this would be an airline with two
types of passengers or a football stadium with two types of attendees.
Derive the conditions for optimal pricing. How do they relate to the case when there
are no capacity constraints?
Answer: Let K denote capacity and p1 (q1 ), p2 (q2 ) the inverse demand functions. The
monopolist’s problem becomes:

max q1 p1 (q1 ) + q2 p2 (q2 ) − c (q1 + q2 )

q1 ,q2

subject to
q1 + q2 ≤ K
Suppose that the constraint q1 + q2 ≤ K is not binding. Then the elasticity rule applies
and we have
MR 1 = MR 2 = c

Suppose that the constraint q1 + q2 ≤ K is binding. Then the cost term in the objective
function is simply c K, a constant; and the constraint can be solve to yield q2 = K − q1 .
Since cost is constant, the objective is to maximize the revenue in market 1 plus the
revenue in market 2. Since q2 = K − q1 , each time we increase q1 by one unit we must
decrease q2 by 1 unit as well, and vice-versa. This implies that the derivative of the
objective function with respect to q1 is given by

MR 1 + (−1) MR 2

Since this must equal zero (first-order condition) we again obtain MR 1 = MR 2 .

The same result can be obtained intuitively. Suppose that the seller is capacity
constrained. Is the current set of prices optimal? One alternative is to take one unit from
one market and sell in the other market, changing prices accordingly. Would the seller
want to do this? By taking one unit away from Market 1, the seller would lose MR 1 . By

45
selling it in Market 2, the seller would get MR 2 . Optimality then requires that
MR 1 = MR 2 .
The difference with respect to the case when capacity is not a constraint is that, if
before MR 1 = MR 2 = c, now MR 1 = MR 2 takes on a higher value, whichever value solves
q1 + q2 = K.

For math aficionados. From a mathematical point of view, the best way to solve a
maximization problem with constraints is to write down the Lagrangean for this problem.
In this case we have


L = q1 p1 (q1 ) + q2 p2 (q2 ) − c (q1 + q2 ) + λ K − q1 − q2

The first-order conditions are:

MR 1 = MC + λ
MR 2 = MC + λ

Depending on whether capacity constraints are binding or not, we will have λ positive or
zero. Whichever is the case, the above equations show that optimality implies that
marginal revenue be equated across markets. Notice that, if demand elasticity differs
across markets, then this implies different prices for the different markets.

6.14. BlackInk. Printing Solutions, the maker of the printer BlackInk, faces an
important product design dilemma: deciding the speed of its popular laser printer. There
are two market segments: Professionals are willing to pay up to $800 (a − .5) for the
printer, where a is printer speed. Students, in turn, are willing to pay up to $100 a.
Maximum printer speed corresponds to a = 1, whereas a = 0 corresponds to a worthless
printer. There are one million professionals and one million students. It is equally costly
to produce a printer with any level of a. In fact, other than the initial development costs,
production costs are zero.
How many versions of the BlackInk should Printing Solutions sell? Which versions?
What are the optimal prices of each version?
Answer: Suppose first that the firm sells one version only. If that is the case, then it
might as well choose a = 1. There are then two candidates for optimal price: $400 and
$100. Profits are given by $400m in the first case and $200m in the second case (recall
that there are one million professionals and one million students). It follows that
a = 1, p = 400 is the optimal solution (conditional on there being only one version).
Since there are only two types of consumers, it will not be necessary to offer more
than two different versions. Since it is equally costly to produce any version and
willingness to pay is increasing in a, it follows that one of the versions should have
maximum speed (a = 1).
If there is to be self-selection between two different versions, it will be the case that
professionals choose the faster printer and students the slower one. We thus have four
possible constraints: incentive and participation; for type H and for type L (professionals
and students, respectively). I next argue that, if the value of a is optimally chosen, then
all constraints except the low type incentive constraint must be binding:

46
 1. The type H incentive constraint must be binding. If that were not the case, then we
could increase the value of a a little bit without violating the incentive constraint.
This would imply a higher value for the L type, which would then allow me to
charge a higher price.

2. The type L participation constraint must be binding. Were that not the case, I
could increase the price of the slower printer and increase profit without violating
any constraint.

3. The type H participation constraint must be binding. If that were not the case, then
I could decrease the slow printer’s speed a bit, decrease the price of the slower
printer by the decline in valuation to type L buyers, and then increase the price of
the fast printer such that the type H incentive constraint remains valid. At the
margin, this would increase seller’s profit, thus contradicting the possibility that the
type H participation constraint is not binding.
Given the above binding constraints, it must be that p1 (the price of the full version)
equals $400 (type H participation constraint), whereas pa (the price of the slow version,
with speed a) equals 100 a (type L participation constraint). Finally, the type H incentive
constraint implies that type H gets zero surplus from buying a slow printer:

800 (a − .5) − pa = 0

which implies a = 4/7, which in turn implies and pa = 100 × (4/7) ≈ 57.14.
Profits under one version are $400m. Under two versions, profits are $457.14m, an
increase of $57.14m. Basically, the increase corresponds to student sales.
Note for aficionados: the fact that three of the four constraints are binding need not
always be the case (see the baby iMac example in the main text). Suppose for example
that students have no use for printers that are slower than a = .5 but otherwise are not
interested in speed (that is, they are willing to pay 50 for any printer with a ≥ .5). Then
it is optimal to offer a printer with a = .5 and none of the incentive constraints are
binding. Suppose instead that students have no use for printers that are slower than
a = .6 but otherwise are not interested in speed (that is, they are willing to pay 60 for any
printer with a ≥ .6). Then it is optimal to offer a printer with a = .6 and the type H
participation constraint is not binding, for the optimal p1 is then 380 = 400 − 80 + 60.

6.15. Multiple two-part tariffs. Consider the model of non-linear pricing introduced in
Section ??. Suppose there are two types of consumers, in equal number: type 1 have
demand D1 (p) = 1 − p, and type 2 have demand D2 (p) = 2 (1 − p). Marginal cost is zero.
(a) Show that if the seller is precluded from using non-linear pricing, then
the optimal price is p = 12 and profit (per consumer) 38 .
Answer: Total demand from a consumer of Type 1 and a consumer of Type 2 is given by
D(p) = D1 (p) + D2 (p) = 1 − p + 2 (1 − p) = 3 (1 − p). The monopolist’s problem is:

max 3 p (1 − p)
p

The solution to this problem is given by the first order condition, 1 − 2 p = 0, so that we
get p = 21 and the profit is 34 (assuming there is one consumer of each type — which could

47
be interpreted as 1 thousand or 1 million, it really does not matter for the purpose of
determining optimal price). Since there are two consumers, profit per consumer is 38 .
(b) Show that if the seller must set a single two-part tariff, then the
9
optimal values are f = 32 and p = 41 , for a profit of 16
9
.
Answer: The monopolist’s demand remains the same. However, now the monopolist now
can also charge a fixed fee, f , from both consumers, which adds to the previous expression
of variable profit. Against this added element we have the constraint that the fixed fee
cannot exceed the consumer’s surplus from buying at a variable price p. The problem
becomes:
max 3 p (1 − p) + 2 f
p

s.t. 1
2 (1 − p)2 ≥ f

where the constraint comes from the fact that the consumer of Type 1 must have a
positive surplus, otherwise it will not buy. Once the constraint for the Type 1 consumer is
satisfied, the constraint for Type 2 is also satisfied; we can therefore ignore it. The
monopolist is better off when it extracts as much surplus as possible from consumers.
Thus, its optimal policy requires that the fixed fee be equal to the Type 1 consumer
surplus, that is, the constraint should be binding: 1/2(1-p)^2 is derived by calculating the CS for consumer type 1

1
2 (1 − p)2 = f

The monopolist’s problem becomes:

max 3 p (1 − p) + (1 − p)2
p

The first-order condition is given by

3 (1 − p) − 3 p − 2 (1 − p) = 0

which implies p = 41 , f = 9
32 and a profit of 98 . As before, welfare is given by

W= 32 (1 − p2 ) Welfare for A is just 0.1(1-p)^2 but for the entire thing is

3p(1-p) + (1-p)^2 which is B + 0.1(1-p)^2 which is A

(Notice that fees f are transfers from buyer to seller, thus do not enter the welfare
calculation.) Since now p = 14 we have Wb = 23 × 15 45 9
16 = 32 > 8 = Wa .

(c) Show that if the seller can set multiple two-part tariffs, then the op-
timal values are f1 = 18 , p1 = 12 , f2 = 78 , p2 = 0, for a profit of
5
8.
Answer: In this case the monopolist’s problem is more complex:

max p1 (1 − p1 ) + f1 + 2 p2 (1 − p2 ) + f2
p1 ,p2
s.t. CS 1 (p1 ) ≥ f1 (PC1)
CS 2 (p2 ) ≥ f2 (PC2)
CS 1 (p2 ) − f2 ≤ CS 1 (p1 ) − f1 (IC1)
CS 2 (p1 ) − f1 ≤ CS 2 (p2 ) − f2 (IC2)

48
where the participation constraints assure that consumers prefer to consume rather than
not consuming and the incentive compatibility constraints assure that each plan is chosen
by the targeted type of consumers, that is, Type 1 consumers prefer plan 1 to plan 2 while
Type 2 consumers prefer plan 2 to plan 1.
One can show that PC1 and IC2 are binding, while PC2 and IC1 are not. Proof:
Suppose that PC1 and IC2 are satisfied. We have:
pay a fixed fee less than their willingness to pay which is CS2(p1)

CS 2 (p2 ) − f2 ≥ CS 2 (p1 ) − f1 ≥ CS 2 (p1 ) − CS 1 (p1 ) ≥ 0

where the last inequality comes from the fact that, at any price, the surplus of the Type 2
consumers is higher, since they consume more. Therefore, PC2 is automatically satisfied.
PC2 will not be binding unless consumers of Type 1 are not served. To see this, suppose
PC2 is binding. From IC2 and PC1 we get

CS 2 (p1 ) ≤ f1 ≤ CS 1 (p1 )

which is obviously impossible. In contrast, PC1 must be binding: if PC1 and PC2 would
not bind the monopolist could increase its profits by increasing both f1 and f2 with the
same small amount without violating the ICs. If IC2 is not binding then the monopolist
could increase f2 with a small amount and keep all other constraints satisfied, while
increasing her profits. This concludes the argument that PC1 and IC2 are binding, while
PC2 and IC1 are not. It follows that
f1 = CS 1 (p1 )
= 1
2 (1 − p1 )2 CS2(p2) - p1(CS2-CS1)

f2 = CS 2 (p2 ) − CS 2 (p1 ) + f1
= (1 − p2 )2 − 21 (1 − p1 )2

The monopolist’s problem becomes:

max p1 (1 − p1 ) + 12 (1 − p1 )2 + 2 p2 (1 − p2 ) + (1 − p2 )2 − 12 (1 − p1 )2


p1 ,p2

or simply
max p1 (1 − p1 ) + 2 p2 (1 − p2 ) + (1 − p2 )2
p1 ,p2

The first order conditions are: 1 − 2 p1 = 0 and 2 − 4 p2 − 2 + 2 p2 = 0, and the solutions

are: p1 = 21 , f1 = 81 , p2 = 0, f2 = 87 , and profit is equal to 45 (which is greater than 98 , the
maximum profit with one two-part tariff only. Finally, social welfare in segment i is given
by
Wi = pi qi + 21 (1 − pi ) qi
which implies total welfare is given by
1
1 − p21 + 1 − p22



W = 2

1 1 3 11
Since p1 = 2 and p2 = 0, we get Wc = 2 × 4 +1= 8 > Wb .
(d) In what case is profit highest? In what case in social welfare highest?

49
Answer: Social welfare is given by the sum of firm profit and consumer surplus. Note in
particular that fixed fees f are transfers from consumers to sellers, thus excluded from
social welfare calculations.
Suppose demand is given by q = b (1 − p) (and inverse demand is p = 1 − q/b). Then
profit is given by
π = p q = b p (1 − p)
whereas consumer surplus is given by

S= 1
2 (1 − p) q = 1
2 b (1 − p)2

It follows that social welfare is given by

W = b p (1 − p) + 12 b (1 − p)2
= b (1 − p) p + 12 (1 − p)


1
= 2 b (1 − p) (1 + p)
1
b 1 − p2


= 2

In parts (a) we get pa = 12 . In part (b), pb = 41 . Finally, in part (c) we get pc1 = 1
2 and
pc2 = 0. We thus get
   
2 2
Wa = 12 1 − 12 + 21 × 2 × 1 − 12 = 98
   
2 2
Wb = 21 1 − 14 + 21 × 2 × 1 − 14 = 32 × 16 15
= 45
32
 
2
Wc = 21 1 − 12 + 21 × 2 × 1 − 02 = 11


8

We conclude that profits are highest in case (c) but social welfare is highest in case (b).

6.16. Sales. Many retail stores set lower-than-usual prices during a fraction of the time
(sale). One interpretation of this practice is that it allows for price discrimination between
patient and impatient buyers.
Suppose that each buyer wants to purchase one unit per period. Each period is
divided into two subperiods, the first and the second part of the period. Suppose there are
two types of buyers, i = 1, 2. Each type of buyer is subdivided according to the part of the
period they would ideally like to make their purchase. One half the buyers would prefer to
purchase during the first part of the period, one half during the second part. A buyer of
type i is willing to pay v i for a purchase during his or her preferred part of the period; and
v i for a purchase at another time.
Buyers of type 1, which constitute a fraction α of the population, are high-valuation,
impatient buyers; that is, v h is very high and v h very low. High valuation implies that v h
is very high; impatience implies that v h is very low: buyers of type 1 are not willing to
buy at any time other than their preferred time. Buyers of type 2, by contrast, are very
patient: v l ≈ v l . Assume that α is relatively low; specifically, α < v l /v h . To summarize:
v h > v l ≈ v l > α v h > v h ≈ 0.
(a) Show that, under a constant-price strategy, the seller optimally sets
p = vl .

50
Answer: If p > v 1 , then there is no sale. If v 2 < p < v 1 , then the only purchasers are the
impatient, high-valuation buyers, and the seller’s profit is π = α p, with maximum value
α v 1 . If p < v 2 , then all buyers make a purchase and the seller’s profit is π = p, with
maximum value v 2 . Since α v 1 < v 2 , it is clear that the best constant-price strategy is to
set p = v 2 .
(b) Determine firm profits when it sets prices p = v h and p = v l in the
first and second parts of the period, respectively. Show that profits
are greater under the “sales” strategy.
Answer: Under this strategy the seller’s profit is
1 1 1

π= α v 1 + (1 − α) v 2 + α v 2 = v 2 + α v 1 − v 2 > v 2
2 2 2
where the last inequality is based on the fact that v 2 ≈ v 2 .

6.17. Optimal bidding strategy. Consider a first-price auction with two bidders.
Suppose Bidder 1 believes that Bidder 2’s bid is some number between 0 and 12 , with all
numbers equally likely. Show that Bidder 1’s optimal bid is given by b1 = v1 /2.
Answer: By bidding b1 , Bidder 1’s expected profit is given by

π1 = (v1 − b1 ) P(b1 > b2 )

where vi and bi is bidder i’s value and bid, respectively.

The higher b1 , the lower the net gain from winning the auction, v1 − b1 ; but the
higher the probability of winning the auction, P(b1 > b2 ). Specifically, if b1 = 0, then
P(b1 > b2 ) = 0; whereas, if b1 = 21 , then P(b1 > b2 ) = 1. More generally, for b1 ∈ [0, 21 ],

P(b1 > b2 ) = 2 b1

It follows that
π1 = (v1 − b1 ) 2 b1
Taking the derivative with respect to b1 and equating to zero, we get the first-order
condition for profit maximization (see Section ??):

2 ( − b1 + v1 − b1 ) = 0

which leads to the desired expression.

This exercise begs the question of what should we expect Bidder 1’s belief about
Bidder 2’s bid to be. This gets into the realm of game theory, which I introduce in
Chapter ??. See specifically Exercise 7.11.