ECON 20005: Competition and Strategy

Assignment Three Solutions

Question 1: Marketing in the Linear City
Suppose there is a linear city with 100 inhabitants, spread evenly along a 1km long street and
there are two stores who sell identical products and are located at either end of the beach at
locations 0 and 1 (respectively labeled firm 0 and firm 1). Under the baseline model, for
both firms marginal costs are c = 10 and consumers travel costs are t = 20 per km travelled
to a given firm. Firms compete on prices as Simultaneous Bertrand Nash competitors.
Firm 0 has an opportunity to invest in marketing. Should it invest in marketing, consumers
will be relatively less willing to travel to firm 1 as the marketing investment results in an
increase in consumers per-km travel cost to t1 = 30 for firm 1. Assume that firm 0s travel
cost remains the same under marketing (t0 = 20).
Note: except for the marketing part, the set-up of the model is the same as that from the
class notes. Where necessary, you may use the results from the class notes to characterise the
NE and NE outcomes in a world without marketing.
1.1 Derive the firms demand functions and profit functions if firm 0 invests in marketing.
The indifferent consumer is defined where
p0 + 20x = p1 + 30(1 x) x =

3 p1 p0
+
5
50

p0
p1
Hence consumer demand for firm 0 is x = 53 + p150
and for firm 1 is 1 x = 52 + p050
.
The corresponding profit functions for firm 0 and firm 1 are:

3 p p 
1
0
0 = (p0 10)
+
5
50

2 p p 
0
1
1 = (p1 10)
+
5
50

1.2 Sketch the demand functions of firm 0 in (x, p0 ) space with and without marketing. Fix
p1 = 30 (its NE level without marketing) in sketching firm 0s demand functions. In your
sketch, highlight the impact marketing has on firm 0 demand at p1 = 30. Fixing p1 = 30,
6 p0
1 30p0

0
firm 0s demand function is x = 53 + 30p
50 = 5 50 with marketing and x = 2 + 40 =
p0
5
4 40 without marketing. Sketching firm 0s demand functions with and without mar-

Firm 0 Demand Curves

(at p1=30)

x
5/4
6/5

keting
3/5 we have:
(impact of marketing)

x(p0) (demand curve with marketing)

1/2
x(p0) (demand curve without marketing)
30

10

p0

NOTE: It is also ok (and perhaps more correct) to scale up these curves by the number
of people on the Linear City M = 100.
1.3 Derive the firms best response functions, Nash Equilibrium prices and corresponding
profits if firm 0 invests in marketing. Where is the indifferent consumer located at the
NE prices? Provide intuition for the impact of marketing on equilibrium outcomes relative to the baseline no-marketing case (i.e., solved for in class).
The first-order conditions and corresponding best-response functions for firm 0 and
1 are:
0
p0
1
p1

1
p0 +
25
1
= p1 +
25
=

1
p1 +
50
1
p0 +
50

4
= 0 p0 = 20 +
5
3
= 0 p1 = 15 +
5

p1
2
p0
2

100
Solving for the NE prices yields (p0 , p1 ) = ( 110
3 36.67, 3 33.33). The correspond12800
9800

ing profits are (0 , 1 ) = ( 9 1422.22, 9 1, 088.89).

Intuitively, marketing further differentiates firm 0 from firm 1 in such a way that both
firms have relatively more local market power, however consumers are relatively more
attracted to firm 0. As a result, firm 0 can charge a higher price for its product and
earn more profits relative to firm 1 even though both firms sell intrinsically the same
product. In fact, we see that firm 1 has a higher price under marketing in the Bertrand
NE (p1 = 33.33 under marketing and recall p0 = 30 without marketing)! Again, this is a
result of firm 1 having more local market power as firm 0s marketing efforts creates further differentiation through the higher travel costs t1 , although firm 1 ultimately earns
lower profits under marketing than without marketing because of the loss in demand.
1.4 Suppose the lump-sum marketing cost for firm 0 is M = 100. Characterize the SPNE
and equilibrium path of a two-period game where firm 0 decides to invest in marketing
in the first period, and the two firms then compete as Simultaneous Bertrand Nash
2

competitors on prices (according to the Linear city model) in the second period.
As derived in class, firm 0s Bertrand NE profits are 1000 in the symmetric Hotelling
model. Weve seen from 1.1 and 1.2 that firm 0 stands to earn 1422.22 if it invests
in marketing and further differentiates itself from firm 1. Thus the profit differential,
1422.22-1000=422.22 is larger than the M = 100 lump-sum marketing cost. Hence in a
SPNE, firm 0 would optimally choose to invest in marketing. The SPNE strategies are:
Firm 0: {Invest in Marketing, p0 = 110
3 }
Firm 1: {p1 = 30 if firm 0 does not invest in marketing, p0 =
invest in marketing }

100
3

if firm 0 does

100
The SPNE path is (1) firm 0 invests in marketing and (2) (p0 , p1 ) = ( 110
3 , 3 ).

Question 2: Tourists at Federation Square

The management at Federation Square (Fed Square) believes more and more tourists are
visiting Melbourne each year, and that it would be helpful to identify tourists from Australians to improve their tourism offerings. Estimates from a recent survey suggests that
30% of the people at Fed Square are Tourists and 70% are Australians. Suppose a new bar
opens called Australia-Mania at Fed Square, and that Fed Square management runs both
Australia Mania and Transport bar. Both Australians and Tourists get $50 of happiness if
they go to Transport, whereas Australians get $75 of happiness if they go to Australia-Mania
(as they are relatively annoyed) while Tourists get $150 of happiness (as they are relatively
overjoyed). The current cover charges for entering Australia Mania and Transport are $5 and
$10, respectively.
Fed Square management attempts to screen the two types by allowing patrons into AustraliaMania only if they purchase sufficiently many toy kangaroos from a local souvenir shop. That
is, Tourists and Australians are able to signal their types using receipts from buying toy
kangaroos. Australians find toy kangaroos useless, so their cost of buying n kangaroos is
cA = n2 . Tourists absolutely love buying toy kangaroos, so their cost of buying n kangaroos is only cT = n2 /4. These costs are measured in dollars ($) as well and Australia-Mania
requires that n be a positive, non-zero integer. Assume all patrons in Fed Square must go to
a bar, and that the bar is either Australia-Mania or Transport.
2.1 Given the current cover charge scheme, what integer values of n support a separating
equilibrium where Australians go to Transport and Tourists go to Australia-Mania?
To characterise the separating equilibrium, we state the incentive compatibility constraints that induce Australians and Tourists to go to Transport and Australia-Mania,
respectively:

ICA : 75 n2 5 $50 10 n2 30 n 30 5.477

p
n2
n2
5 $50 10
40 n (4 105) 20.494
ICT : $150
4
4
That is, for any integer value of n that satisfies 6 n 20, there will be separation
where only Australians go to Transport and Tourists go to Australia-Mania.
3

2.2 Suppose Fed Square management removes the cover charge scheme and toy kangaroo
signalling policy from 2.1. Assume there is sufficient competition for bar patrons from
other bars in Melbourne such that cover charge to enter Australia-Mania or Transport
bar is set to the expected happiness value (in $) from a given patron in a given bar.
Characterise the corresponding equilibrium. In particular, what are the cover charges
and which type of patrons will go into which bar?
The cover charge at Australia-Mania is CA = 0.30 150 + 0.7 75 = 97.5 and at Transport is CT = 0.30 50 + 0.7 50 = 50. Thus, Australians realize $75 $97.5 = $22.5
of happiness from going to Australia-Mania and $50 $50 = $0 from going to Transport, implying they will go to Transport in this equilibrium. Similarly, Tourists realize
$150 $97.5 = $52.5 of happiness from going to Australia-Mania and $50 $50 = $0
from going to Transport, implying they will go to Australia-Mania in this equilibrium.
We still get separation in this equilibrium.
2.3 For what values of n that induce separation under the original cover charges and toykangaroo signalling device from 2.1 are Australians better off under the equilibrium
from 2.2 than the separating equilibrium in 2.1?
Under the equilibrium from 2.2, Australians realize $0 of happiness from going to Transport bar. Under the separating equilibrium from 2.1, Australians realize $40 of happiness
from going to Transport bar for any integer value of n that induces separation. Hence,
Australians are better off under the separating equilibrium from 4.1 for all values of
6 n 20 that induce separation.
2.4 For what values of n that induce separation under the original cover charges and toykangaroo signalling device from 2.1 are Tourists better off under the equilibrium from
2.2 than the separating equilibrium in 2.1?
Under the equilibrium from 2.2, Tourists realize $52.5 of happiness from going to
Australia-Mania. For a given value of n toy kangaroos from 2.1 under separation,
2
Tourists realize $150 n4 5 happiness. Comparing this equal to the happiness level
under the 2.2 equilibrium we obtain:
150

n2
5 52.5 n 4 92.5 19.235
4

That is, if n 19 then Tourists are better off under the separating equilibrium from 2.1,
while if n 20 then Tourists are better off under the equilibrium from 2.2. Recalling
that separation in 2.1 is supported only for 6 n 20, we conclude if 6 n 19,
then Tourists are better off under the separating equilibrium 2.1, while if n = 20 then
Tourists are better off under the equilibrium in 2.2.
Question 3: Monitoring students
A professor hires a student to work for her for a summer to do a project. If the student works
hard, there is a 50% chance the project is successful, while if the student does not work hard
there is a 10% chance the project is successful. It costs the student $50 of happiness to work
hard and $10 of happiness to not work hard. If the project is successful the professor gets a
4

bonus of $1000, while if the project is not successful the professor earns $0. If the student
elects not to work for the professor, she gets an outside-option payoff of $30. Assume the
student exerts high effort when indifferent between exerting high effort and not exerting high
effort, and works when indifferent between working and not working. Finally assume the
student wants to maximise her total expected income (i.e., she is risk neutral).
3.1. Suppose the professor can observe the students effort level. Find the optimal higheffort inducing incentive contract.
The professor would pay the student $80 if the student works hard and $40 if the student
does not work hard (so the students net-utility is equal to the outside option of $30).
This would induce the student to work hard. The expected profits for the professor
would be 0.5 $1000 $80 = $420.
3.2. Suppose the professor cannot observe the students effort level. Find the optimal higheffort inducing incentive contract in terms of a base salary for the student s and a bonus
b if the project is successful.
The incentive compatibility and participation constraints are:
IC : s + 0.5b 50 = s + 0.1b 10

P C : s + 0.5b 50 = 30
Solving yields b = 100 and s = 30.

3.3. Find the incentive contract that maximises the professors expected income. That is,
determine whether the profit-maximizing high-effort inducing contract, or the profitmaximizing low-effort inducing contract delivers higher expected profits to the professor.
The professors expected profit under the high-effort inducing contract is: 0.5(1000
100) 30 = $420. Alternatively the professor could simply pay the student $40 for
minimal effort and get expected profit 0.1(1000)-40=$60 which is less than $420. Thus,
the high-effort inducing contract is the profit-maximising one.
3.4. Suppose the professor could perfectly monitor the student by installing cameras in
the students office (assume the student knows the camera is in the office). Such an
investment would cost the professor $200. Should the professor install the cameras and
pay the student with an appropriate incentive contract, or should the professor continue
to offer the expected income maximising contract from 3.3.?
The professors net expected profits from the investment is $420-200=$220. We saw from
part 3.3. that the professors expected profits from the high-effort inducing contract is
strictly greater than $420 > $220, so the professor should not buy the camera, and
should simply offer the high-effort inducing contract.
Question 4: Gone fishin
A group of 100 fishermen are currently deciding whether to fish at their nearby lake, or drive
a distance to fish in the ocean. Each fisherman would prefer to fish in the lake since it is close.
However, as more people fish at the lake, the payoff/yield from doing so falls. Specifically if
n of the 100 fisherman fish at the lake, then they each get a payoff of 100 2n. Fisherman
who fish at the ocean each get a payoff of 8 no matter how many people fish at the ocean.

4.1. Assume for the moment that there are n = 40 fishermen fishing at the lake, and the
remaining 60 fishermen are fishing at the ocean. Compute the marginal private gain
and the marginal social gain if one of the fishermen switches from fishing at the lake to
fishing at the ocean. Is society better off as a whole from this switch?
Marginal private gain= S(n+1)-P(n)=8-(100-2(40))=-12
Marginal social gain=marginal private gain + marginal spillover
effect=12 + 39


P (75) P (74) = 12 + 39 (100 2(75)) (100 2(74)) = 12 + 78 = 66
Yes, society is better off as a whole from the switch as the marginal social gain is
positive.
4.2. Suppose fishermen are free to choose whether to fish at the lake or the ocean. Find the
Nash Equilibrium number of fisherman who would fish at the lake, nne .
NE found where P (n + 1) = S(n), or:
100 2(n + 1) = 8 2n = 90 nne = 45
Theres a second NE at n = 46, ok if the students work with this one too.
4.3. Suppose that the government could choose the number of fishermen who fish at the lake
and the ocean. What would be the socially optimal number of fisherman at the lake, n ?
Total welfare function is T (n) = n(100 2n) + (100 n)8 = 100n 2n2 + 800 8n =
2n2 + 800 + 92n. First order condition for welfare maximization:
T (n)
= 4n + 92 = 0 n = 23
n

4.4. The government wants to leave the fishermen free to make their own lake/ocean choices.
However, it wants to use a fish-at-the-lake tax t to affect their incentives to ensure n
fishermen will fish at the lake in a Nash Equilibrium. Suppose that under the tax the
fishermen who fish at the lake get a net-of-tax payoff of 100 2n t. Find the value of
t that will ensure that the nne value under the tax scheme will correspond to the value
of n that you found in part c.
The tax is set so the NE condition yields the socially optimal number of fisherman:
P (n + 1) t = S(n ) 100 2(23 + 1) t = 8 t = 100 46 2 8 = 44.