BUSINESS

AND INDUSTRIAL ECONOMICS

2015-2016

Boris Mrkajic, PhD


Analysis of oligopolistic markets Exercises solutions
Exercise 1 solution
As firms compete in quantities simultaneously, we solve a Cournot model.3
As both cost functions are linear, fixed costs of both firms are null ( = 0).
Both firms want to maximize their profits.
Firm 1 solves the following profit function:
max ! = ! + ! ! ! !
!!

max ! = (10 2 ! + ! ) ! 5!
!!

max ! = 10! 2!! 2! ! 5!

!!

Firm 2 solves the following profit function:

max ! = ! + ! ! ! !
!!

max ! = (10 2 ! + ! ) ! 2!
!!

max ! = 10! 2!! 2! ! 2!

!!

First order-condition for profit maximisation are:

!
!
= 0 &
= 0.
!
!
In particular,
!
= 10 4! 2! 5 = 0
!
!
= 10 4! 2! 2 = 0
!
Implying that:

! =

5 2! 5 !
=
4
4 2

! =

8 2!
!
=2
4
2

Solving this system of linear equations we get:

5 !

! = 2 4 2
2
5 2!
4

2! = 4

8! = 16 5 + 2!
=

And
=

! !!

Making the Cournot-equailbrium: ! , ! = (! , ! ).

Total quantity provided by the market is: =
!

Profits of the firms are: ! = !, ! =

!"!
!"

!"
!

, for the price of =

!"
!

Exercise 2 solution
As the firms compete in quantities simultaneously, we solve a Cournot model. Both firms want to maximize
their profits.
a) If Firm 1 decides not to invest, it pays nothing (! = 0), while it incurs cost of 1 for each unit
produced, meaning that its average and marginal costs are the same and they equal: ! = ! = 1. At
the same time, the total costs are: ! = ! .
Firm 2s total costs are: ! = 0, ! = ! = 1. At the same time, the total costs are: ! = ! .
In this case, both firms solve the following profit function
max ! = ! + ! ! ! !
!!

First order conditions yield:

!
= 3 2! ! 1 = 0
!

!
= 3 2! ! 1 = 0
!
! !

Solving this system of linear equations we get the Cournout-equalibrium: ! , ! = (! , !).

!

Total quantity provided by the market is: = !, for the price of = !.

!

Profits of the firms are: ! = !, ! = !.

b) If Firm 1 decides to invest, it pays initial investment (! = > 0), while it incurs no costs of each unit
produced, meaning that its average and marginal costs are the same and they equal: ! = ! = 0. At
the same time, the total costs are: ! = .
Firm 2s total costs are still: ! = 0, ! = ! = 1. At the same time, the total costs are: ! = ! .
In this case, Firm 1 solves the following profit function
max ! = ! + ! ! ! !
!!

max ! = (3 ! + ! ) !
!!

While Firm 2 solves the same profit function as in the previous case
max ! = ! + ! ! ! !
!!

max ! = (3 ! + ! ) ! !
!!

First order conditions yield:

!
= 3 2! ! = 0
!
!
= 3 2! ! 1 = 0
!
! !

Solving this system of linear equations we get the new Cournout-equalibrium: ! , ! = (! , !).
!

Total quantity provided by the market is: = !, for the price of = !.

Profits of the firms are: ! =

!"
!

, ! = !.

c) Based on the profits of Firm 1 with and without invest made, we can state that Firm 1 will find appealing
!"
!"
to invests iif the investment is lower than ! (!!"#$%& > !!"#!$%&' only if < ! ).
In the case of initial investmest, Firm 1 reduces its product costs (AC! = MC! = 0, after the investment),
and hence also benefits from increaseing its production (!!"#$%& > !!"#!$%&' ). As the reaction function of
!
Firm 2 in Cournot model is down-sloping (! = 1 ! ! , in this case), Firm 2 will have to decraese its
production. This is a consequence of the fact that quantities are strategic complements in Cournot model.

Exercise 3 solution
As the game is sequential, we solve a Stackelberg model, and one firm makes the decision first. We assume
Firm 1 is the first mover (leader), and Firm 2 is the second mover (follower). Both firms want to maximize
their profits.
We first derive the reaction function of the follower with respect to the assumed choice of the leader:
max ! = ! + ! ! ! !
!!

max ! = (100 ! ! ) ! 40!

!!

First order condition yields:

!
= 100 ! 2! 40 = 0
!
Firm 2 reaction function is:
1
! (! ) = 30 !
2
The total market demand is now:
1
= 70 !
2
Then, we derive the reaction function of the leader with respect to the reaction of the follower:
max ! = ! + ! ! ! !
!!

1
max ! = 70 ! ! 40!
!!
2
First order condition yields:
!
= 70 ! 40 = 0
!
=
=
The Stackelberg-equalibrium is: ! , ! = (30,15).
Total quantity provided by the market is: = 45, for the price of = 55.
Profits of the firms are: ! = 450, ! = 225.

Exercise 4 solution
As the firms compete in prices simultaneously, we solve a Bertrand model. Both firms want to maximize
their profits.

a) The firms solve the following profit function

max ! = ! ! !
!!

First order conditions yield:

!
= 12 12! + 5! = 0
!
!
= 10 + 2 12! + 5! = 0
!
Firm 1 reaction function is:
! ! = 1 +

12 !

Firm 2 reaction function is:

! ! =

5+ 5
+ !
6
12

b) Given = 1, rection function of Firm 2 is:

! ! = 1 +

12 !
!" !"

Solving this system of linear equations we get the Bertrand-equalibrium: ! , ! = ( ! , ! ).

!

Total quantity provided by each firm is: ! = ! = !.

!"

Profits of the firms are: ! = ! = !".

c) If the firms are symmetric (in the case of = 1, they indeed are), the prices are set equal to marginal
costs. This result is known as the Bertrand paradox, when the two firms charge a price equal to
marginal cost and hence incur zero extra-profits, while in other oligopolistic models (e.g. Cournot) the
price is higher than the Marginal Cost and guarantees to earn positive extra profits.