Econ 106P: Solutions to Problem Set 1

Yingju Ma
Aug 20, 2015
(Due on Thursday, Aug 20, 10:45am.)
No Late Submission Accepted.
You are encouraged to work as teams with 2-3 members, but please submit your own solution.
On the top of your answer sheet please show your name, UID, and whom you work with.

1. Two-Part Tari
Consider a monopoly firm and two consumers 1 and 2. The consumers demand functions are
P1 = 12

q1 and P2 = 10

q2 and the monopolys cost function is C(q) = 2q. Assume that the

monopoly uses a two-part tari pricing scheme.

A. What is the monopolys profit-maximizing quantity if it only faces consumer 1? What is the
resulting profit?
B. Assume that the monopoly faces both consumers. What is its profit-maximizing two-part tari
scheme if it needs to ensure participation (i.e. both consumers will buy something)? What is
the resulting profit?
C. Assume now that the monopoly faces 5 consumers with the same demand function as consumer
1, and one consumer with the same demand function as consumer 2. Would the monopoly
rather exclude the second type of consumer (i.e. set a pricing scheme such that the second
type would not buy anything)?
Solution:
A. The monopoly is essentially conducting perfect price discrimination in this case. Therefore,
apply the condition P = M C, we know that q = 10 and = 50.
B. The monopolys problem is
1
max 2 (10
P
2
FOC:

2(10

P ) + 22

P )(10

P ) + P (12

P + 10

P)

2(12

P + 10

4P + 4 = 0, which implies that P = 3 and F =

= 65.
1

49
2 .

P)
The profit is

C. If the monopoly excludes the second type, its profit would be 50 5 = 250. If it doesnt, its
problem is

1
max 6 (10
P
2
FOC:

6(10

is = 6

P ) + 70
361
18

( 11
3

P )(10

P ) + P (5(12

P ) + 10

P)

2(5(12

12P + 12 = 0, which implies that P =

11
3 )

2) (5(12

+ 10

11
3 )

200 13

11
3

P ) + 10

and F =

361
18 .

P)
The profit

< 250. Therefore, the monopoly

would rather exclude the second type.

2. Joint Cost Production

Suppose a monopoly firm produce two final products with same raw materials, the same as the
example showed in Lecture 2. Lets assume product 1 becomes more popular due to a change of
consumers taste. Then the demand for product 1 is lager than before, say P1 = 300
demand of product 2 does not change, P2 = 100

q1 . The

q2 . Firm has the same cost function: C0 = 30q0 ,

C1 = 10q1 , C2 = 4q2 .
A. Solve for firms optimal production plan.
B. Find the production plan that maximize the social welfare.
C. Compare the firms solution you find in Part A with the solution we have in the slides, try to
interpret the dierence of these two results, with economic intuition.
Solution:
A. We have
N M R1 =

N M R2 =

2q1 , if q1 145

290

0, otherwise

2q2 , if q2 48

96

0, otherwise

Therefore, the sum of the NMRs is

N M R1 + N M R2 =

8
>
<
>
:

386
290

4q, if q 48

2q, if 48 < q 145

0, otherwise

Let the net marginal profit from 1 additional unit of raw materials equate the marginal cost of
raw materials:
N M R1 + N M R2 = M C0 = 30
has only one solution: q = 130. Note that at q = 130, N M R2 = 0, which means production of
product 2 has stopped (at q2 = 48). Therefore q0 = q1 = 130, q2 = 48.
2

B. To maximize social welfare, we use the idea of NMU=MC. That is the marginal benefit from 1
additional unit of raw materials equate the marginal cost of raw materials.
(
290 q1 , if q1 290
N M U1 =
0, otherwise
N M U2 =

q2 , if q2 96

96

0, otherwise

Therefore, the sum of the NMUs is

N M U1 + N M U2 =

8
>
<
>
:

386
290

2q, if q 96

q, if 96 < q 290

0, otherwise

N M U1 + N M U2 = M C0 = 30 gives q = 260. That means q0e = q1e = 260, q2e = 96.

C. After a positive demand shock for product 2, the firm simply increase the quantity supplied of
product 2, without changing the production of product 2. Therefore firm wastes more raw
materials than before, in terms of not using them to produce product 2. This happens when
there is significant dierence in the demand for two final products. Monopoly firm usually
wants to keep the quantity low, to maintain a relative high price.

3. Vertical Market Separation with Competitive Manufacturer

Consider a vertically separated market with the distributor as a monopoly in the retail market, but
with the manufacturer as a competitive firm. The demand function of the retail market is P = 20 q,
and the manufacturers cost function is C(q) = 4q.
A. What is the demand function faced by the manufacturer?
B. What is the wholesale price?
C. How many units would the distributor purchase from the manufacturer?
Solution:
A. It is the same as the MR of the retail market: Pw = 20

2q.

B. Since the manufacturer is competitive, Pw = M C = 4.

C. By the condition M R = Pw = M C, we have q = 8.

4. Pirates of the Caribbean

100 pirates need to divide 5 gold coins among themselves. They agree to the following rule:
Starting with pirate 1, each pirate proposes a plan, then the 100 pirates take a vote (for/against)
3

 If at least half of the (remaining) pirates vote for the plan, then the gold coins are divided
accordingly; otherwise, the proposer is executed

We assume that
Each pirate values his life most.
Being alive, he prefers more gold coins than less.
Being alive and having the same number of gold coins, he prefers to watch others die.
A. If it were pirate 100s turn to propose, what is his best action? Given this, what is pirate 99s
best proposal? How about pirate?
B. Which pirate is the first such that, if it were his turn to propose, there is no way of staying alive?
C. Let n be the answer of question 2. Is there a way such that pirate n

1 can stay alive?

D. How many pirates would die in the end?

Solution:
A. If it were pirate 100s turn to propose, it must be the case that all previous 99 have been executed.
Thus pirate 100 will take all 5 gold coins for himself.
Knowing this, pirate 99 has no way of making pirate 100 agree to his proposal. However, he
only needs at least half of the votes among the remaining 2 pirates. Therefore he would also
take all 5 gold coins for himself.
Pirate 98 needs 2 votes to survive, one of which comes from himself. Clearly, he has no way of
getting pirate 99s vote, but if his proposal does not get approved, pirate 1 would get nothing
at all. Therefore, pirate 98 would give pirate 100 a gold coin and keep the remaining 4 for
himself.
B. Following the previous argument, we have:
When there are 1-2 pirates left, the proposing pirate keeps all the gold coins.

When there are 3-4 pirates left, the proposing pirate gives out 1 gold coin and keeps the
rest.

When there are 5-6 pirates left, the proposing pirate gives out 2 gold coins and keeps the
rest.

...

When there are 9-10 pirates left, the proposing pirate gives out 4 gold coins and keeps
the rest.

Hence, when there are 11-12 pirates left, the proposing pirate needs to give out all the gold
coins to stay alive. Then for pirate 88, there is no way to get 6 votes from the rest of the
remaining pirates, and hence he would surely die when its his turn to propose.
4

C. Yes. He could give 1 gold coin each to pirates 99, 97, 95, 93, 91. Note that pirate 88 would vote
for this proposal even though getting nothing, because otherwise he would die when it comes
to his turn. Thus pirate 87 gets 7 votes in total (including his own) which is exactly half the
vote among the remaining 14 pirates.
D. Notice the following:
If it were pirate 88s turn, he cannot stay alive; for pirate 87, he can stay alive by securing
88s vote and paying 1 gold coin each to pirates 99, 97, 95, 93, 91.

Pirates 86-84 cannot stay alive if it were their turn. Note that they cannot get 88s vote

since 88 can stay alive when its 87s turn anyway, and by assumption pirates prefer to
watch others die. But pirate 83 can stay alive by securing 86-84s vote and paying 1 gold
coin each to pirates 99, 97, 95, 93, 91.

This pattern goes on

Pirate 89 can stay alive;

Pirate 88 cannot stay alive, but 87 can stay alive; (89-87=2, Pirate 87 needs these 2
votes to pass, against 89 and 90)
Pirates 86-74 cannot stay alive, but 83 can stay alive; (87-83=4, Pirate 83 needs these
4 votes to pass, against 87-90)
Pirates 82-76 cannot stay alive, but 75 can stay alive; (83-75=8)
Pirates 74-60 cannot stay alive, but 59 can stay alive; (75-59=16)
Pirates 58-28 cannot stay alive, but 27 can stay alive. (59-27=32)
Pirates 26-1 cannot stay alive. (Needs get 64 votes to pass, against 27-90)

Therefore, 26 pirates would die in the end.

5. Cournot Competition with Entry Cost

Consider a market with demand function P = 20

Q. There are 30 potential competing firms with

identical cost functions C(q) = q, but to enter the market they each need to pay an entry cost of 2.
In particular, each firm first decides whether it will pay the cost to enter the market; no firm can
see others decisions in this phase. Then the firms who enter the market play Cournot competition.
A. If there are two firms in the market, what are their profits after taking into account the entry
cost?
B. Would it be profitable for a third firm to pay the cost to enter the market?
C. How many firms would be in the market in the SPNE?
Solution:
A. Without loss of generality, consider firm 1. It solves maxq1 (20
FOC 20

q2

2q1

and thus q1 = q2 =

q1

q2 )q1

q1 , which yields the

1 = 0. By symmetry of the problem, we know that q1 = q2 in equilibrium,

19
3 .

Profits are 1 = 2 =
5

343
9 .

B. If a third firm, denoted 3, pays the cost to enter the market, it solves maxq3 (20 q1 q2 q3 )q3 q3 ,
which yields the FOC 20

q1

q2

2q3

1 = 0. By symmetry of the problem, we know that

q1 = q2 = q3 in equilibrium, and thus q1 = q2 = q3 =

19
4 .

Profits are 1 = 2 = 3 =

329
16

> 0.

Hence it is profitable for a third firm to pay the cost to enter the market.
P
C. Suppose that there are n firms in the market, each firm i solves maxqi (20 qi
qi ,
j6=i qj )qi
P
which yields the FOC 20
2qi 1 = 0. By symmetry of the problem, we know that
j6=i qj
q1 = = qn in equilibrium, and thus q1 = = qn =

19
n+1 .

The equilibrium number of firms n must satisfy

361
(n + 1)2
361
((n + 1) + 1)2

20

The only integer satisfying the above two inequalities is 12.

Each firms profit is

361
(n+1)2

2.