Indian School Of Business

Microeconomics A, 2012
Solutions to Assignment 3.
Instructor: Parikshit Ghosh.
There may be errors or typos (hopefully very few), so please read critically.
1. The monopolist can adopt one of two strategies: set a price of
H
and sell only to H-type consumers,
or set a price of
L
and sell to a mix of H and 1-types. If
L
is the optimum price, the optimum
quantity is given by the MR = MC rule, i.e.,
2a =
L
) =

L
2a
However, there is always the option of keeping the price at
H
and selling only to H-type consumers.
The above output level is optimal only as long as it yields higher prots, i.e., if

L
_

L
2a
_
a
_

L
2a
_
2
0
H
a0
2
Let a be the value of a for which the above inequality is binding (it is the solution to a quadratic
equation). Then, the monopolist will serve some 1-type consumers if and only if a a. When it is
optimal to sell only to H-types (but not all of them), the MR = MC rule implies
2a =
H
) =

H
2a
This is the true optimum as long as its value is less than the number of H consumers, 0. In other
words, for
a

H
20
= a
Therefore, the optimum price-output pair is as follows:
(j

) =
_
_
_
_

H
,
v
H
2a
_
if a a
(
H
, 0) if a < a < a
_

L
,
v
L
2a
_
if a a
2. This is the same linear cost, linear demand duopoly model we did in class, except that the rms have
dierent marginal costs..
(a) Firm is reaction function is given by

i
(
j
) = arg max
qi
(a c
i
/
i
/
j
)
i
=
a c
i
/
j
2/
This gives you two equations in two unknowns. Solving, the equilibrium quantities are

1
=
a + c
2
2c
1
3/

2
=
a + c
1
2c
2
3/
Substituting in the demand function, the equilibrium price is
j =
a + c
1
+ c
2
3
and the equilibrium prots are

1
=
(a 2c
1
+ c
2
)
2
9/

2
=
(a 2c
2
+ c
1
)
2
9/
1
(b) The solution to this is in the lecture slides.
3. Let r
i
=

i6=j
r
j
. Agent is payo is given by
n
i
= r

i

1
:
.j(r
i
+ r
i
)
Since from is perspective, r
i
is a constant, her f.o.c for optimum choice is
cr
1
i
=
j
:
Hence, the NE choices are symmetric and given by
r =
_
c:
j
_ 1
1
On the other hand, the symmetric Pareto ecient choice is
r

= arg max
x
r

jr
=
_
c
j
_ 1
1
Comparing, we nd r r

for : 1, i.e., there is over-ordering in the NE outcome. The reason is

that when each person orders an extra unit of ice cream, she imposes a cost on others which is
n1
n
th
of the price of that unit. This is a negative externality which selsh maximizing agents will not factor
into their calculations. There are no externalities when each person pays the part of the bill she is
responsible for (the Dutch treat).
4. This question illustrates, in a stylized way, the economic ineciency arising from rent seeking activities
like lobbying or bribery. Rent seeking is any activity which generates private returns to the agent but
does not contribute to increasing the size of the pie..
(a) Agent i solves
max
ai
_
1 r
i
1 r
i
+

j6=i
(1 r
j
)
_
r
i

j6=i
r
j
This yields the rst order condition
(2r
i
1)

j6=i
(1 r
j
) = (1 r
i
)
2
(b) Put r
i
= r

for all i above and solve to get

r

=
:
2: 1
; a

=
: 1
2: 1
It is easy to check that n

= r

.
(c) In any symmetric allocation, every agent gets 1,: share of total output. Therefore the allocation
which maximizes total output is the best allocation. Clearly, this involves r = 1, a = 0 In the
Nash equilibrium, there is ineciently little investment in production activity (r) and ineciently
excessive investment in unproductive rent seeking (a). In equilibrium, nobody is able to get ahead
of others, but they bring down total output through their unproductive investments, i.e., their
eorts to capture a bigger share of the pie.
(d) Since ^ n = 1,
n n

= 1 r

=
: 1
2: 1
This is decreasing in : and approaches
1
2
as : ! 1. The intuition is that as there are more
people, total (as opposed to per capita) output is higher. This increases the marginal product of
rent seeking and encourages more rent seeking activity.
2
5. This is the standard Cournot model with asymmetric and quadratic cost functions.
(a) Firm 1s reaction function is

1
(
2
) = arg max
q1
(23
1

2
)
1

2
1
=
1
4
(23
2
)
Firm 2s reaction function is

2
(
1
) = arg max
q2
(23
1

2
)
2
2
2
2
=
1
6
(23
1
)
Solving simultaneously, the equilibrium quantities are

1
= 5

2
= 3
Using these quantities in the demand function, we nd the equilibrium price:
j = 15
and also prot levels:

1
= 50

2
= 27
(b) Suppose rm 1 has bought up rm 2. Then it becomes a multi-plant monopolist who solves
max
q1q2
(23
1

2
)(
1
+
2
)
2
1
2
2
2
The optimal quantity choices are

1
= 4.6

2
= 2.3
which yields combined prots from the two plants

= 79.35
So rm 1 will experience an increase in prots of 29.5 if it can buy up rm 2, and will be willing
to pay up to that amount for the purchase. Firm 2 will experience foregone prots of 27, and
should be willing to make the sale at any price higher than that. Obviously, there is room for a
deal between the two parties. If rm 1 can make a take-it-or-leave-it oer to rm 2, it will make
the minimum acceptable oer, i.e., a price of 27.
6. This question is about monopoly and regulation. i forgot to specify the cost of production in the
question. Take it to be zero.
(a) First, nd the supply from the competitive fringe at any price j set by the dominant rm. Using
the rule j = 'C, each rm supplies j(j) = j, and so the competitive fringe as a whole supplies
1 (j) = 50j. Subtracting this from total demand, we get the dominant rms residual demand
function
Q = 1000 100j
The rm then solves
max
p
j(1000 100j) )j

= 5
Its optimum quantity is 500, and its maximized prot is 2,500. Note that the competitive fringe
produces an additional quantity of 250 at this price, so the total quantity consumed by buyers is
750. Also the prot of each rm in the fringe is jj(j)
1
2
j(j)
2
=
25
2
.
3
(b) (i) In a perfectly competitive market (removing the dominant rm), equilibrium implies demand
and supply are equal, i.e.,
1000 50j = 50j )j
c
= 10,
c
= 500
(ii) Under pure monopoly (no competitive fringe), the rm solves
max
p
j(1000 50j) )j
m
= 10,
m
= 500
It may seem curious that the outcome is the same under pure monopoly and pure competition,
but the puzzle is easily resolved if you observe that the monopolist has a cost advantage over the
competitive fringe. The usual monopolistic distortion is exactly cancelled by this cost advantage.
(c) Comparing, we can see that the competitive fringe softens the impact of monopolyit produces
lower prices, more output and higher consumers surplus. Calculation should show that it also
produces higher social surplus.
(d) First, the government should only allow the most cost ecient rm to produce, i.e., allow the
dominant rm and ban all the fringe rms. However, this will lead to the usual monopolistic
distortion, so to prevent that, the government needs to introduce price regulation and force the
dominant rm to sell at its marginal cost, i.e., 0. To keep the rms (both dominant and fringe)
at the same level of prots as in part (a), they have to be paid 2,500 and 25/2 respectively. Since
there are 50 fringe rms, the total compensation payments amount to 2, 500 + 50
_
25
2
_
= 3, 125.
When j = 5, consumers surplus was
1
2
(205) 750 = 5, 625. When j = 0, consumers surplus
is
1
2
20 1000 = 10, 000. The increase in consumers surplus is 4,375. Even after paying o the
rms to the tune of 3,125 by taxing consumers, they are still left with a gain of 4,375 - 3,125 =
1,250. This illustrates how suitable regulation can bring about a Pareto improvement
7. This is a weaker form of Bertrand competition. The goods are not perfect substitutes, so when a rm
undercuts its rival, it starts stealing customers slowly rather than drastically.
(a) The reaction functions are
j
m
(j
c
) = arg max
pm
(20 j
m
+ j
c
) j
m
= 20 2j
m
+ j
c
j
c
(j
m
) = arg max
pc
(10 2j
c
+ j
m
) j
c
= 10 4j
c
+ j
m
Solving these simultaneous equations, we get equilibrium prices:
j
m
= 12
6
7
j
c
= 5
5
7
Solve for quantities and prots by substitution.
(b) The merged rm solves
max
pm;pc
(j
m
, j
c
) (20 j
m
+ j
c
) j
m
+ (10 2j
c
+ j
m
) j
c
The rst order conditions are
0
0j
m
= 20 2j
m
+ 2j
c
= 0
0
0j
c
= 10 4j
c
+ 2j
m
= 0
The optimum prices are obtained by solving these two equations:
j

m
= 25
j

c
= 15
Ill leave it to you to calculate the quantities and prots.
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(c) The Consumers Forum is correct in this case. The goods are substitutes, though not perfect
substitutes, as evidenced by the fact that a higher price for a good increases the demand for the
other. When the rms are separate, they exert a negative eternality on each other when they
cut their own prices (because they steal some audience from the other). After the merger, this
negative externality will be corrected and the rm will maintain higher ticket prices for both
concerts and movies. As a result, consumers will be worse o. Had the merger been between two
rms which sold complementary goods (a higher price of one hurts rather than helps the sales of
the other), the merger would have been benecial for consumers, as we discussed in class.
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