Problem set 1 (+ = easy, ++ = intermediate, +++ =difficult)

Exercises
1 (+) Monopolistic competition
Suppose firms are operating within a market in which there is monopolistic
competition. The demand curve for each firm i is the following Qi=S[(1/n)-
(1/b)*(Pi- )]. Qi is the quantity demanded to firm i, S is the market size, n is the
number of firms, P is the price of firm i and is the average price of other firms.
The cost function is the following: C = F + c*Qi. C represents total costs, F denotes
fixed costs and c marginal costs. Additionally, we assume that P = (1/bn) + c.

Suppose that the market size is 450000$, fixed costs are 375000000$, marginal costs
are 5000$ and 1/b is 67500. Firms operating in the market are symmetric.

a) Compute average cost and price when n = 6. Is this a short- or long- term scenario?
Comment.

b) Compute average cost and price when n = 10. Is this a short- or long- term scenario?
Comment.

c) Compute the number of firms in the equilibrium as well as price, average cost, Qi
and represent the three scenarios graphically.

2 (+) Iterated elimination of strictly dominated strategies

L M R
T 1,1 0,4 2,2
M 2,4 2,3 1,2
B 1,0 0,1 0,2

3 (+) Iterated elimination of strictly dominated strategies

A B C D
a 0,-1 4,4 4,2 2,0
b 0,3 0,0 3,4 2,0
c 5,2 2,0 1,3 1,3
d 4,4 1,0 0,1 0,5

1
4 (++)
Formulate a strategic game that models a situation in which two people work on a joint
project. Each individual can either work hard or goof off. If one individual works hard,
then the other individual prefers to work hard as well. If one individual goofs off, then
the other individual prefers to goof off as well.
a) Specify the strategy set of individuals.
b) Represent this static game of complete information using a matrix, in which you
specify the appropriate payoffs.
c) Find the outcome of the game. Can this game be considered a Prisoner’s Dilemma
situation?
d) Consider now the case in which preferences are the same as before except that each
person prefers to goof off when the other person works hard. Answer again to points
b) and c).
e) Can we say that a situation in which two people pursue a joint project necessarily
has the structure of the Prisoner’s Dilemma?

5 (+)
Determine whether each of the following games differs from the Prisoner’s Dilemma
only in the names of the players’ actions, or whether it differs also in one or both of
the players’ preferences.
For each game specify the best response functions of players and the Nash equilibria.

X Y
X 3,3 1,5
Y 5,1 0,0

X Y
X 2,1 0,5
Y 3,-2 1,-1

6 (++)

2
In a simple model of duopoly, two firms produce the same good, for which each firm
charges either a low price (15$) or a high price (20$). Each firms wants to achieve the
highest possible profit. Firms fixed costs are equal to 2000$, marginal costs are equal
to 10$.
If both firms choose ‘high’, then the market is split evenly - the quantity sold by each
firm is 1200 units. If one firm chooses ‘high’ and the other chooses ‘low’, then the firm
choosing ‘high’ obtains no customers, whereas the firm choosing ‘low’ sells 2500
units.
If both firms choose ‘low’, the market is split evenly (1250 units each).
a) Specify the strategy set of players (firms).
b) Represent this static game of complete information using a matrix.
c) Find the outcome of the game, comment the results.
7 (+++)
Each of the two players has two possible actions, Quiet or Fink. Each action pair results
in the players’ receiving amounts of money equal to the numbers corresponding to that
action pair in the figure below.
Quiet Fink
Quiet 2,2 0,3
Fink 3,0 1,1

The players are not selfish; rather the preferences of each player i are represented by
the payoff function mi(a) + αmj(a), where mi(a) is the amount of money received by
player i when the action profile is a, j is the other player, and α is a given non-negative
number.
- Formulate a strategic game that models this situation in the case α = 1. Is this
game the Prisoner’s Dilemma?
- Find the range of values for α for which the resulting game is the Prisoner’s
Dilemma. For values of α for which the game is not the Prisoner’s Dilemma,
find the Nash equilibria.
- Comment the results.
8 (++)
Consider a finite version of the Cournot duopoly model. Suppose each firm must
choose either half of the monopoly quantity qm/2 or the Cournot equilibrium quantity.
No other quantities are feasible. Firms have marginal costs equal to c and P(Q) = a –
Q where Q is the aggregate quantity. Show that this two-action game is equivalent to
the Prisoners’ Dilemma.
3
9 (+++)
Consider a market where two firms 1 and 2 compete à la Cournot. The demand curve
is P(Q)=20-Q. The two firms have the same costs function and marginal costs equal
to zero.
1. Do firms compete over prices or quantities?
2. Compute the firms’ best response functions
3. Compute the equilibrium quantities for both firms, the total quantity produced, the
price and firms’ profits.
4. Represent graphically firms’ best response functions and the equilibrium in the
market.
How do results change when the costs functions are respectively C(q1)= F + c*q1
and C(q2)= F + c*q2.
f. Compute the new firms’ best response functions
g. Compute the new equilibrium quantities for both firms, the new total quantity
produced, the new price and firms’ profits.
h. Represent graphically the new firms’ best response functions and the new
equilibrium in the market.