ECONOMICS 121A

INDUSTRIAL ORGANIZATION
SPRING QUARTER 2009
PROFESSOR REQUENA

PROBLEM SET 5

DUE: JUN 3RD

Problem 1. [Predatory conduct]

Consider the following game with three stages between an incumbent and a potential
entrant. The incumbent firm may incur in a sunk cost and may use it as a “threat” for price
predation in case the potential entrant decides to enter the market (i.e. the incumbent will
announce that she can incur in a sunk cost). The sequence of the game is as follows. In
stage one the incumbent has to decide whether invest or not, with F=5, which is a sunk
cost for the incumbent. In stage two, the potential entrant has to decide whether to enter or
to remain outside the market. In stage three, and in the case of entry, the incumbent has to
decide whether to accomodate to the entry (with profits πD=3 for both firms in the last
stage) or to compete in prices, that is to “predate” (with loses of πG=-1, for both firms). In
the stage three , if entrant does not enter the market, the incumben acts as a monopoly
and obtain πM= 10.

(A) Draw the extensive game (tree representation) and determine the Nash perfect
equilibrium. Is the threat of price predation credible by the entrant?
(B) How does the equilibrium change if F=3? Is the threat credible now?
(C) Discuss alternative ways that the incumbent may use to provide credibility to the
announcement of price predation..

Problem 2. [Horizontal mergers and vertical relations]

Norman International has a monopoly in the manufacture of whatsits. Each whatsit
requires exactly one richet as an input and incurs other variable costs of $5 per unit.
Richets are made by PepRich Inc., which is also a monopoly. The variable costs of
manufacturing richets are $5 per unit. Assume that the inverse demand for whatsits
is pw = 50 − qw , where pw is the price of whatsits in dollars per unit and qw is the quantity of
whatsits offered for sale by Norman International.

(A) Assume that the two monopolists act as independent profit-maximizing companies,
with Norman International setting a price pw for whatsits and PepRich setting a
price pr for richets. Hence, derive the profit-maximizing price for whatsits as a
function of the price of richets, and use this function to obtain the derived demand
for richets.
(B) Use your answer in (A) to write down the profit function for PepRich. Hence, derive
the profit-maximizing price of richets. Use this to derive the profit-maximizing price of
whatsits. Calculate the sales of whatsits (and so of richets) and calculate the profits of
the two firms.

( C) Now assume that these two firms merge to form NPR International. Write down
the profit function for NPR given that it sets a price pw for whatsits. Hence, calculate
the postmerger profit-maximizing price for whatsits, sales of whatsits, and the profits of
NPR

(D) Verify that this merger has increased the joint profits of the two firms while reducing
the price charged to consumers. By how much has consumer surplus been increased
by the merger in the market for whatsits?