Industrial Organization

Problem Set 3
Exercise 1.
Four …rms produce a homogeneous product at constant marginal
costs ci = 1, i = 1; 2; 3; 4. Market demand is given by 9 p, where p is
the lowest price set by the …rms. The price p is chosen from a discretized
price set (where the minimal price change " is arbitrarily small). When
analyzing equilibria proceed in two steps: Characterize the equilibrium
for a given (small) " and then let " turn to zero. If the lowest prices
is set by more than one …rm, the demand at that price is split evenly
among …rms with the lowest price.

1. Determine Nash equilibrium price, quantity and pro…t of each …rm

of the game in which …rms simultaneously set price. Consider only
symmetric equilibria.

2. Suppose that …rms coordinate their pricing decisions and imple-

ment the monopoly solution. What is each …rm’s pro…t if they
jointly implement the monopoly solution?

3. Consider a model of repeated interaction in which each …rm sets

its per period price in any discrete point in time t = 1; 2; ::: over
an in…nite time horizon. Firms discount future pro…ts by <
1. The per-period game is as described above. Characterize the
subgame-perfect equilibrium that implements the highest possible
pro…t for the …rms in the industry. Determine the critical discount
factor below which tacit collusion on the monopoly price cannot
be sustained.

4. Suppose now that …rm 1 enjoys a marginal cost reduction to c1 =

1=2. Determine Nash equilibrium price, quantity and pro…t of each
…rm of the one-shot game in which …rms simultaneously set price
under the assumption that …rms do not set prices below marginal
costs.

5. Return to the in…nitely repeated game in which, di¤erent from

part 3, …rm 1 enjoys a cost advantage as speci…ed in part 4. Argue
whether there a critical discount factor below 1 such that tacit
collusion on the collusive outocome of part 2 of the exercise can be
sustained. Compare your …nding with the one obtained in part 3.
Note: You are not expected to derive an explicit solution for the
critical discount factor; an implicit characterization is su¢ cient.

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 Exercise 2.
Consider a homogeneous-product Cournot oligopoly with 4 …rms.
Suppose that the inverse demand function is P (q) = 64 q.

1. Suppose that …rms incur a constant marginal cost = 4. Charac-

terize the Nash equilibrium of the game in which all …rms simul-
taneously choose quantity.
2. Suppose that …rms 1 and 2 consider to merge and that there are
synergies leading to marginal costs cm < c. Characterize the Nash
equilibrium. At which level cm (you may want to give an approxi-
mate number) are the two …rms indi¤erent whether to merge?
3. Is such a merger that just makes the two …rms indi¤erent between
merging and non-merging consumer-welfare increasing?
4. At which level cm would the merger be consumer-welfare neutral?
5. Suppose that instead …rms 1, 2, and 3 consider to merge. The new
marginal cost of the merged …rms is cn < c. At which level cn are
the three …rms indi¤erent whether to merge?
6. Compare your …ndings in (5) and (2). What can you say about
incentives to merge in this case?

Exercise 3.
Suppose that an upstream monopolist has constant marginal costs
of production c and sells to symmetric Cournot duopolist in the down-
stream market at a two-part tari¤ (wi ; Fi ), where i 2 f1; 2g is the identity
of the downstream …rm. Here, wi refers to the linear wholesale price and
Fi the …xed fee to be paid by downstream …rm i. Downstream …rms
have zero marginal costs and face market demand P (q) = a q. Sup-
pose that a > c > 0. Consider the timing according to which, at the
…rst stage, the upstream …rms set tari¤s in the wholesale market and,
at the second stage, downstream …rms simultaneously set quantities in
the downstream market.

1. Suppose that the upstream monopolist has to set Fi = 0 and pub-

licly posts the wholesale prices wi. Calculate the subgame perfect
equilibrium and comment on your …ndings.
2. Suppose that the upstream monopolist publicly posts two-part
tari¤s (wi ; Fi ). Characterize the subgame perfect equilibria when
the upstream …rm is restricted to o¤er a non-discriminatory o¤er
(w; F ) to both downstream …rms.

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 3. Suppose that the upstream monopolist cannot publicly post two-
part tari¤s - i.e., the two-part tari¤ that applies to …rm i is private
information in the duopoly game at stage 2. Furthermore, suppose
that downstream …rms hold passive beliefs - i.e., no matter which
contract is o¤ered, a downstream …rm expects its competitor to be
o¤ered the equilibrium tari¤. Is the equilibrium outcome obtained
under (2) also an equilibrium outcome in this case? Explain your
…nding.

Exercise 4.
Consider an innovative environment where independent or nearly si-
multaneous discoveries are possible. More speci…cally, we assume that
two …rms are engaged in R&D that results either in an innovation (with
probability ) or failure (with probability 1 ). It is assumed that the
probability of success ( ) is independent across …rms. Firms can protect
their innovation either by secrecy or by …ling for a patent.

If the innovation is protected by secrecy, it leaks out with proba-

bility 1 s , regardless of the number of successful …rms. When
this happens, the innovation is publicly available and production
is at the competitive level, driving the innovator’s pro…ts down to
zero.

Patent protection is measured by the probability that a patent

holder can exclude competitors from using the innovation, which
is denoted p . Hence, with probability 1 p , the innovation
becomes public, resulting

again in zero pro…ts for the innovator.

If only one …rm succeeds in R&D and the innovation does not become
public, the …rm earns monopoly pro…t m . If both …rms succeed and
their innovation does not become public, each …rm earns duopoly pro…t
d < m . In the case where both …rms are successful and …le for the
patent, each …rm obtains it with probability 1=2.
The two …rms have to decide whether to …le for a patent (strategy
noted P ) or resort to secrecy (strategy noted S). This decision has to
be made before learning whether the competitor has succeeded or not.

1. Using the above information, compute the …rms’expected pro…ts

for the four combinations of strategies. Denote (a1 ; a2 ) the ex-
pected pro…t for a …rm when it chooses strategy a1 and its oppo-
nent chooses strategy a2 , with a1 and a2 2 fP ; Sg. You are thus
asked to compute (P ; P ), (P ; S), (S; P ), and (S; S).

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 2. Suppose that p = s . That is, the innovation has the same
probability of becoming public whether it is protected by secrecy
or by a patent (in other words, patent and secrecy oxoer the same
level of protection).

(a) Show that patenting is a dominant strategy. That is, show

that both (P ; P ) (S; P ) and ((P ; S)) (S; S) are
true.
(b) Show also that successful …rms prefer the situation where they
both …le for a patent over the situation where they both keep
the innovation secret. That is, show that (P ; P ) (S; S)
is true.

3. Suppose now that p 6= s. To ease the computations, set m = 16,

d = 4, and = 1=2.

(a) Compute the values of (P ; P ) ; (S; P ) ; (P ; S) and (S; S)

under these assumptions.
(b) Characterize the Nash equilibrium (in pure strategies) of the
game for all p ; s 2 [0; 1]. Represent graphically the charac-
terization of the equilibrium in the plane ( p = s ).
(c) Show that both …rms may choose to protect the innovation via
a patent even though patents o¤er a weaker protection than
secrecy. Explain the economic intuition behind this result.

Exercise 5.
Consider a monopoly market in which consumers’opportunity cost x
is uniformly distributed on the unit interval; i.e., x 2 [0; 1]. A consumer’s
utility of consuming one unit of the good o¤ered by the monopolist
relative to the outside option is 1=4 + ne =2 p x, where p is the price
set by the monopolist and ne is the expected number of fellow buyers of
the good. There is mass one of consumers. The monopolist’s marginal
costs are zero.

1. Suppose that consumers believe that ne = 1. Determine the

monopoly solution under these consumer believes.

2. Suppose that consumers form beliefs ne before observing price p

and that these beliefs are con…rmed in equilibrium, i.e., ne = n .
Determine the monopoly solution under these consumer beliefs.

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3. Suppose that consumers …rst observe price and then form beliefs
ne (p) and that beliefs are self-ful…lling; i.e., they are con…rmed in
the monopoly solution. Determine the monopoly solution under
these consumer beliefs.

4. Compare your …ndings in parts 2 and 3. Explain what is going on.