ECON 301

PROBLEM SET 10 SOLUTIONS

EXERCISE 1:

Consider the following duopoly. Demand is given by P = 10 Q, where Q = Q1 + Q2.

The firms cost functions are C1 = 4 + 2Q1 and C2 = 3 + 3Q2 respectively.
a)

What are marginal costs for firm 1 and firm 2? What is marginal revenue if they
collude? What is the joint profit-maximizing (i.e. collusive) output and how
much will each firm produce? What would happen if instead only firm 1 entered
(and so behaved like a monopolist)? What would happen if only firm 2 entered?

b)

What happens if the two firms are both in the market and dont collude? [Use
the Cournot model] First calculate MR for firm 1 holding quantity produced by
firm 2 as given. Using MR=MC find the reaction function of firm 1. Use the
same procedure to find firm 2s reaction function. Using reaction functions, find
Q1 an Q2 such that firms do not want to deviate. Find market price by plugging
the joint quantity in the demand curve. Calculate profits for firm 1 and firm 2.

c)

How much should firm 1 be willing to pay to purchase firm 2 if collusion is

illegal but the takeover is not? Use your results from (a) and (b).

1. (a) First note that MC1 = 2 and MC2 = 3. So if the two firms collude and act as a
single entity, they should only produce via firm 1 as it always has a lower marginal cost.
Together they see MR = 10 2Q, so set this equal to MC1 = 2 and we find Q* = 4 (at
firm 1 only), from which P = 6. Firm 1s profit is 6(4) [4 + 2(4)] = 12, while firm 2s
profit is -3 [presumably the two firms would in fact simply split the total profits of 9
somehow]. If firm 1 enters but firm 2 is not in the market, then the analysis is just as
above and firm 1 earns a profit of 12. If firm 2 enters but not firm 1, then MR = MC
becomes 10 2Q = 3 and so Q2* = 3.5, P = 6.5, and firm 2s profit is 6.5(3.5) [3 +
3(3.5)] = 9.25 only.
(b) Now firm 1 takes Q2 as fixed (cant be affected by 1), so MR1 = (10 Q2)
2Q1. Equating this to MC1 = 2 implies Q1* = 4 Q2/2 is the optimal choice. This is firm
1s reaction function. Similarly for firm 2 we have (10 Q1) 2Q2 = 3, and thus Q2* =
1

ECON 301

PROBLEM SET 10

3.5 Q1/2 is its best response. To solve for the Cournot equilibrium we plug this back
into firm 1s reaction curve, i.e. Q1 = 4 (3.5 Q1/2)/2. This yields Q1 = 3, and then Q2
= 3.5 3/2 = 2, and P = 10 (3 + 2) = 5. Profits are 5 and 1 respectively.
(c) From part a), firm 1 earns 12 as a monopolist; from part b), it earns 5 when
competing with firm 2. So it should be willing to pay up to 12 5 = 7 (perhaps
annualized over time) to buy firm 2, much higher than firm 2s profits.
EXERCISE 2:

Two computer firms, A and B, can choose to produce either a fast, high-quality system
(H) or a slow, low-quality system (L). Market research indicates that the resulting profits
are given by the following payoff matrix:
Firm B
H
Firm A

30,30 50,35

40,60 20,20

a)

What are the Nash equilibria of this game (assuming that the firms make their
decisions simultaneously)? (Nash equilibrium is a set of strategies that are a
mutual best response. Given what Firm A is doing, firm B doesnt want to
deviate and vice versa).

b)

If firm A has a head start on production and can commit first, what will the
outcome be? What if firm B has a head start instead? Is there a first-movers
advantage in this game?

(a) Listing the strategy of firm A first, the Nash equilibria here are (L,H) and (H,L)
[there is also a mixed strategy NE but we havent studied it]. You can check that in each
of these cases, each firm is best responding to the others actions.
(b) Knowing what firm Bs response will be, firm A would choose H if it could
commit first. Then B would choose L, leading to (50,35), which is the best possible
outcome for firm A. If B could commit first, it would choose H (leading to a choice of L
from A, and a payoff of 60 for B).

Economics 301

Problem Set 10

Spring 2009

Econ 301, Spring 2009

Professor Rosenblat
Exercise 3
Perloff Ch. 13
20. A duopoly faces a market demand of p = 120 Q . Firm 1 has a constant marginal cost of
MC1 = 20 . Firm 2s constant marginal cost is MC2 = 40 . Calculate the output of each firm,

market output, and price if there is (a) a collusive equilibrium or (b) a Cournot equilibrium.
a). a collusive equilibrium: the two firms collude and act as a single entity. This is equivalent to having one firm with 2 plants.
Since

MC1 = 20 < 40 = MC2 , production occurs only at plant 1.

Since the market demand is linear, one has that

To maximize profit, firms set

p = 120 Q MR = 120 2Q .

MR = MC1 120 2Q = 20 Q = 1202 20 = 50 = Q1 p = 120 50 = 70 .

b). a Cournot equilibrium:

Firm 1: the total revenue is
Given

TR1 = pQ1 = (120 Q1 Q2 )Q1 = 120Q1 Q12 Q2Q1 .

Q2 , the marginal revenue is MR1 =

To maximize profit, firm 1 sets

Firm 2: the total revenue is

Given

TR1
Q1

= 120 2Q1 Q2 .

MR1 = MC1 120 2Q1 Q2 = 20 Q1 = 50 0.5Q2 .

TR2 = pQ2 = (120 Q1 Q2 )Q2 = 120Q2 Q1Q2 Q22 .

Q1 , the marginal revenue is MR2 =

To maximize profit, firm 2 sets

TR2
Q2

= 120 Q1 2Q2 .

MR2 = MC2 120 Q1 2Q2 = 40 Q2 = 40 0.5Q1 .

Using the two reaction functions, one has

Q1 = 50 0.5(40 0.5Q1 ) = 30 0.25Q1 Q1 =

Q2 = 40 0.5(40) = 20 . Q = Q1 + Q2 = 40 + 20 = 60 p = 120 Q = 120 60 = 60.

30
0.75

= 40

and