Industrial organization and regulation

Mid-term test, 2017

1. Monopoly Pricing (6 points)

Consider a monopoly firm. The market demand is given by D(p) = 1 − bp

where p is the price and b > 0 is a constant. The firm’s production cost is
given by C(q) = cq where q is the quantity and c ∈ (0, 1/b) is the constant
marginal cost. Initially, suppose the firm sets a uniform price to maximize
profits. The price elasticity of demand is defined as  = dD(p) p
dp D(p)
, which is
negative.

a. (0.5 point) Set up the firm’s profit maximization problem.

b. (0.5 point) Use first-order condition to derive optimal monopoly price

p∗ .

c. (1 point) Write the first-order condition in terms of Lerner index and

price elasticity of demand.

d. (1 point) How does p∗ change when b becomes larger?

e. (1 point) Use the price elasticity of demand to explain in words the

result you derived in [d.].

f. (1 point) Now suppose that the firm implements perfect price dis-
crimination using two-part tariff, which includes a fixed fee f and a
variable fee w for each unit of sales. From the lecture, we know that
w = c. Then what f does the firm set?

g. (1 point) Following [f.], are consumers better off under this two-part
tariff, compared to uniform pricing?

Solutions:

1
 a. The firm solves

max(p − c)D(p) = (p − c)(1 − bp).

p

b. The F.O.C. is
1 − 2bp∗ + bc = 0

c. The F.O.C. can be re-written as

p∗ − c 1 − bp∗
= .
p∗ bp∗
p∗ −c ∗
Remember that at optimum, p∗
= − bpbp−1
∗ = − 1 .

d. From [b.], it is clear that p∗ decreases if b increases. (This is because

1 − 2bp∗ + bc = 1 − b(2p∗ − c) = 0. To have the equality hold, an
increase in b must be followed by a decrease in p∗ ).
bp
e. When b increases, || = 1−bp increases and therefore the demand
becomes more elastic. Facing a more elastic demand, the firm has to
adjust its price downward.

f. Given that w = c covers the cost, the firm uses f to fully capture
1
consumer surplus. That is, f = CS = 2b (1 − bc)2 .

g. No, they get zero surplus.

2. Hotelling Model with Linear Transportation Cost (6

points)

A Hotelling line is of length equal to 1. Two firms are located at the two end
points of the Hotelling line respectively: firm 1 is at point 0 and firm 2 is
at point 1 (note here the firms’ locations are fixed, so the problem is easier
than the one in the lecture slides where the locations could be chosen). A
unit mass of consumers are uniformly located on the Hotelling line. Firm
i, i = 1, 2, charges price pi . For a consumer with location x, his utility of
buying from firm 1 is u1 = 1 − p1 − xt where t > 0 measures the degree of
product differentiation. The consumer gets utility u2 = 1 − p2 − (1 − x)t if
buying from firm 2. This is a one-stage game in which both firms set price
simultaneously. We assume that t is relatively small so that the market is
always fully covered.

2
 a. (0.5 point) Find the location x̂ so that the consumer at this location
is indifferent between buying from firm 1 and buying form firm 2.

b. (0.5 point) Write down the demand functions for firm 1 and firm 2,
i.e., D1 (p1 , p2 ) and D2 (p1 , p2 ).

c. (1 point) Write down the best response functions for firms 1 and 2.

d. (1 point) Solve for the symmetric equilibrium price p∗ = p∗1 = p∗2 .

e. (1 point) Write down each firm’s equilibrium profit π ∗ = π1∗ = π2∗ .

f. (1 point) How does p∗ change when t increases?

g. (1 point) When does Bertrand paradox emerge in this model? Explain

why.

Solutions:

a. The indifferent consumer is identified by setting

1 − p1 − x̂t = 1 − p2 − (1 − x̂)t,

or equivalently
1 p2 − p1
x̂ = + .
2 2t
b. The demand functions are

1 p2 − p1
D1 (p1 , p2 ) = x̂ = +
2 2t
1 p1 − p2
D2 (p1 , p2 ) = 1 − x̂ = +
2 2t

c. Each firm i solves max pi Di (pi , pj ). The F.O.C. is

pi

1 pj − pi pi
+ − = 0.
2 2t 2t

The best response is

t pj
pi = BRi (pj ) = + .
2 2

d. Solve for a symmetric equilibrium such that p∗1 = p∗2 = p∗ . We have

p∗ = BRi (p∗ ), which gives
p∗ = t.

3
 e. π1∗ = π2∗ = 2t .

f. p∗ increases as t increases.

g. When t = 0. Product becomes homogenous when t = 0 and firms

lose the market power created by product differentiation.

3. The Effect of Mergers on Collusion (8 points)

The inverse market demand is given by p = 1 − Q where Q is the total

output and p is the price. Three firms compete in quantity (Cournot com-
petition). The firms have zero production cost and they interact repeatedly
for indefinite times. The common discount factor is δ ∈ (0, 1).

a. (0.5 point) When the three firms compete, what is the Cournot profit
for each firm in a one-shot game?

b. (0.5 point) What is the monopoly profit in this industry?

c. (1 point) Suppose the three firms agree to collude to equally share

the monopoly outputs and profits. What is a firm’s optimal devi-
ating quantity when the other two firms comply with the collusive
agreement?

d. (1 point) Continue with [c.], what is the non-deviating condition if

any deviation will trigger reverting to Cournot competition?

e. (1 point) Calculate the critical discount factor δ 3 above which collu-

sion can be sustained.

Now suppose firms 2 and 3 merge to a new firm, called m (here we are
not concerned about the profitability of merger, simply assume they merge
for some exogenous reason). Firm m still has zero production cost.

f. (1 point) Only firm 1 and firm m remain, and they agree to col-
lude to equally share the monopoly outputs and profits. What is a
firm’s optimal deviating quantity when the other firm comply with
the collusive agreement?

g. (1 point) What is the non-deviating condition if any deviation will

trigger reverting to Cournot competition?

4
 h. (1 point) Calculate the critical discount factor δ 2 above which collu-
sion can be sustained.

I. (1 point) From the comparison between δ 3 and δ 2 , does merger face-

plate collusion?

Solutions:
1 2 1


a. With three firms, each firm make profit πc = 4
= 16
.

b. The monopoly profit is Πm = 14 , and each firm gets πm = 1

12
.
Qm
c. If the other two firms choose 3
= 16 , firm 1’s optimal deviation is
derived from solving
1
max(1 − q − )q,
q 3
which yields optimal deviation q 0 = 1
3
and the associated profit is 1/9.

d. The no-deviating condition is

1 1 1 1 1 1 1 δ 1
+δ +δ 2 +... ≤ + δ + δ 2 +... ⇔ + ≤ .
9 16 16 12 12 12 9 16(1 − δ) 12(1 − δ)

e. δ 3 = 47 .

f. If only two firms remain, the Cournot output and profits are qc = 1/3
and πc = 1/9. If firm 2 follows the collusive strategies, firm 1’s
optimal deviation strategy is given by solving

1
max(1 − q − )q,
q 4

which yields q 0 = 3/8 and the associated deviating profit 9/64.

g. The non-deviating condition is

9 1 1 1 1 1 9 δ 1
+δ +δ 2 +... ≤ + δ + δ 2 +... ⇔ + ≤ .
64 9 9 8 8 8 64 9(1 − δ) 8(1 − δ)

h. δ 2 = 9/17.

I. Merger facilitate collusion as δ 2 < δ 3 .