1

De La Salle University
School of Economics
MICREC2
Solutions to Midterm Examination # 2
Professor: Dr. Angelo A. Unite Term 1, AY 2012-13
Point Distribution:

I. 13
1. 5
a. 3
b. 2
2. 3.5
3. 4.5

II. 4
1. 1.5
2. 2
3. 0.5

III. 5
1. 1.5
2. 1
3. 2.0
4. 0.5

IV. 10
1. 5
a. 3
b. 2
2. 5
a. 3
b. 2

Maximum Total Points = 28
Bonus Points = 4
 2

I. Market demand : p = 200 2Q , where Q = q1 + q2 . MC1 = 2q1 for Firm 1 and

MC2 = 2q2 for Firm 2.
1. Suppose the two firms act according to the Cournot model.
a. Find the output reaction function of each firm.

The ORF of firm i is obtained by solving the firms FOC for a maximum profit, MRi = MCi
( )
for its own output as a function of the other firms output: qi = qi q j

The residual demand function of either firm is given by p = 200 2Q = 200 2 ( q1 + q2 )

R1
Thus, R1 = p q1 = 200q1 2q12 2q1 q2 and MR1 = = 200 4q1 2q2
q1
R2
R2 = p q2 = 200q2 2q22 2q1 q2 and MR2 = = 200 4q2 2q1
q2

dC1 dC2
Given MC1 = = 2q1 and MC2 = = 2q2
dq1 dq2
Thus the FOCs of the two firms and corresponding ORFs are
100 1
Firm 1: MR1 = MC1 200 4q1 2q2 = 2q1 q1 = q2
3 3
100 1
Firm 2: MR2 = MC2 200 4q2 2q1 = 2q2 q2 = q1
3 3

b. Find the Cournot equilibrium quantity and price for each firm.

The Cournot equilibrium solution is obtained by substituting the output reaction function
of Firm 2 (Firm 1) in Firm 1s (Firm 2s) output reaction function.

Substituting Firm 2s ORF into Firm 1s, we get

100 1 100 1
q1 = q1 q1 = 25 and
3 3 3 3
100 1
q2 = ( 25 ) q2 = 25
3 3

Since the two firms products are identical, then at equilibrium they sell at the same price:

p = 200 2Q = 200 2 ( 25 + 25 ) p = 100

 3

2. What are the Stackelberg equilibrium quantity and price for each firm when Firm 1
acts as the quantity leader and Firm 2 acts as follower?

As leader, Firm 1 is assumed to know and can estimate the follower firms (Firm 2) output
100 1
reaction function q2 = q1 obtained in part 1.
3 3

Firm 1s residual demand curve is obtained by substituting Firm 2s output reaction

function in the demand curve faced by Firm 1, p = 200 2 ( q1 + q2 ) .
100 1 400 4
Thus, p = 200 2 q1 + q1 p = q1
3 3 3 3
Firm 2s profit-maximizing output is obtained by solving its FOC for a maximum profit
400 4
MR1 = MC1 . Since Firm 1s residual demand is p = q1 , then
3 3
400 4 2 dR 400 8
R1 = p q1 = p = q1 q1 MR1 = 1 = p = q1
3 3 dq1 3 3
and from part 1 we got MC1 = 2q1 , so MR1 = MC1
400 8
q1 = 2q1 q1 = 28.57
3 3
Firm 2 then sets its output after Firm 1 based on its output reaction function. Thus,
100 1
q2 = ( 28.57 ) q2 = 23.81
3 3

Since the two firms sell identical products, then at equilibrium, they sell at the same price.
This is obtained by substituting the total output of the two firms in the market demand
p = 200 2 ( q1 + q2 ) = 200 2 ( 28.57 + 23.81 ) p = 95.24
 4

3. Suppose the two firms form a cartel. Determine the optimal total output of the
cartel (Q), output for each member firm (q1 and q2), and the price (p) at which each
member firm should sell its output.

The FOC to maximize the cartel profit requires that the cartel allocate production between
the two member firms so that marginal costs are equal and the common marginal cost
equals the cartel marginal revenue: i.e., MRC(Q) = MC1(q1)= MC2(q2) = MCC(Q)

To arrive at the profit-maximizing solution, the FOC for a maximum profit for the cartel
can be written as MRC(Q) = MCC(Q), where Q = q1 + q2 . Now, since the cartel faces the
market demand curve p = 200 2Q
dR
RC = p Q = 200Q 2Q 2 MRC = C = 200 4Q
dQ
To get MCC which is the horizontal sum of the marginal costs of the two member firms, we
need to invert the marginal cost of each member firm and let MC1 = MC2 = MCC
1
Then, MC1 = 2q1 MCC = 2q1 q1 = MCC
2
1
and MC2 = 2q2 MCC = 2q2 q2 = MCC
2
1 1
Then the horizontal sum of MC1(q1) and MC2(q2) is q1 + q2 = MCC + MCC
2 2
Q = MCC MCC = Q

Since the optimal total cartel output Q* satisfies MRC(Q*) = MCC(Q*), then
200 4Q = Q Q = 40

To find the optimal allocation of output between the member firms, first calculate the
cartels marginal cost at the optimal Q*, MCC = 40

then substitute this into the inverted marginal cost function of each member firm:
1
q1 = ( 40 ) q1 = 20
2
1
q2 = ( 40 ) q2 = 20
2

The optimal price at which each member firm should sell their output is obtained by
substituting the optimal total cartel output in the market demand curve faced by the cartel:

p = 200 2 ( 40 ) p = 120
 5

II. Firm 1 is the low-cost price leader: MC1 = 20 , market demand: Q = 4,000 40 p ,
Q = q1 + q2 , market share agreement 60:40, with firm 1 taking 60% of the market.
1. Find Firm 2s output reaction function.

The market-share agreement of the two firms imply that k1 = 0.6 and k2 = 0.4 . Firm 2 acts
as follower and produces its output according to the agreed-upon market shares:
k 0.4 2
q2 = 2 q1 q2 = q1 q2 = q1
k1 0.6 3

2. Determine the profit-maximizing output that Firm 1 will produce. What price will
it set in the market?

The relevant demand curve for Firm 1 is its residual demand, i.e., the market demand for
2
which q2 = q1 .
3
Q = 4,000 40 p p = 100 0.025Q
2
Therefore, p = 100 0.025Q = 100 0.025 ( q1 + q2 ) = 100 0.025 q1 + q1
3
0.125
p = 100 q1
3
Firm 1, as leader, chooses its output that maximizes profit based on Firm 1s residual
25
demand p = 700 q1 .
3
The profit-maximizing output is obtained from Firm 1s FOC for a maximum profit
MR1 = MC1 .
0.125 2 dR 0.25
Since R1 = pq1 = 100q1 q1 MR1 = 1 = 100 q1
3 dq1 3
and since MC1 = 20
0.25
then, MR1 = MC1 100 q1 = 20 q1 = 960
3
Based on Firm 1s relevant demand curve, the price it will set is
0.125
p = 700 (160 ) p = 60
3

3. How much output will Firm 2 produce?

As follower, Firm 2 sells according to their market share agreement.
2
Therefore, q2 = ( 960 ) q2 = 640
3
 6

III. Dominant firm: MCL = 10 , 100 fringe firms: MCi = 10 + 5qi . The total industry
demand is given by Q = 400 8 p .
1. What is the total supply function of the fringe firms?

Each fringe firm i act like a perfectly competitive firm and chooses output such that
p = MCi , where p is the price set by the dominant firm. Since the 4 fringe firms have
identical marginal cost functions given by MCi = 10 + 5qi , then the supply function of a
typical fringe firm i is
p = 10 + 5qi qi = 0.2 p 2 for i = 1, 2, , 100

The total output supplied by the follower firms is

100 4
QF = qi = ( 0.2 p 2 ) = 100 ( 0.2 p 2 ) QF = 20 p 200
i=1 f =1

2. Find the dominant firms residual inverse demand curve function.

The dominant firms residual demand is qL = Q QF . Since the direct market demand is
Q = 400 8 p and since QF = 20 p 200 from part 1, then
qL = ( 400 8 p ) ( 20 p 200 ) qL = 600 28 p
600 1
p= qL
28 28

3. Find the profit-maximizing quantity produced and the price set by the dominant
firm, and the quantity produced by each fringe firm.

The dominant firm chooses the output that maximizes its profit given its residual demand
curve. It is the solution to the leaders FOC for a maximum profit MRL = MCL .
600 1
Since dominant firms relevant demand curve is p= qL
28 28
600 1 dR 600 2
RL = p qL = qL qL2 MRL = L = qL
28 28 dqL 28 28

and since MCL = 10

600 2
therefore, MRL = MCL qL = 10 qL = 160
28 28
Based on the dominant firms relevant demand curve, the price it will set is
600 1
p= (160 ) p = 15.71
28 28

4. How much output will each of the 100 fringe firms produce?

The quantity produced by each firm i is based on its individual firm supply function from
part 1 qi = 0.2 (15.71) 2 qi = 1.14
 7

IV. Firm 1: q1 = 75 p1 + 0.5 p2 , Firm 2: q2 = 75 p2 + 0.5 p1 , C1 = 30q1 and C2 = 20q2 .

1. Suppose each firm acts according to the Bertrand model.

a. Find the price reaction function of each firm.

The price reaction function of firm i is obtained by solving the firms FOC for a maximum
profit, MRi = MCi for its own price as a function of the other firms price pi = pi p j : ( )
R1
R1 = p1 q1 = 75 p1 p12 + 0.5 p1 p2 and MR1 = = 75 2 p1 + 0.5 p2
p1
R
R2 = p2 q2 = 75 p2 p22 + 0.5 p1 p2 and MR2 = 2 = 75 2 p2 + p1
p2

Given C1 = 30q1 for Firm 1 and C2 = 20q2 for Firm 2.

dC q dC q
Then, MC1 = 1 1 = 30 ( 1) = 30 and MC2 = 2 2 = 20 ( 1) = 20
dq1 p1 dq2 p2

Thus the FOCs of the two firms and corresponding PRFs are

Firm 1: MR1 = MC1 75 2 p1 + 0.5 p2 = 30 p1 = 52.5 + 0.25 p2

Firm 2: MR2 = MC2 75 2 p2 + 0.5 p1 = 20 p2 = 47.5 + 0.25 p1

b. Find the Bertrand equilibrium price and output of each firm.

The Bertrand equilibrium prices obtained by simultaneously solving the price reaction
functions of the two firms for the unknown prices:

p1 = 52.5 + 0.25 ( 47.5 + 0.25 p1 ) p1 = 68.67

p2 = 47.5 + 0.25 ( 68.67 ) p2 = 64.67

The Bertrand equilibrium outputs are obtained by substituting the Bertrand equilibrium
prices in the two firms direct demand functions:

q1 = 75 68.67 + 0.5 ( 64.67 ) q1 = 38.66

q2 = 75 64.67 + 0.5 ( 68.67 ) q2 = 44.66

 8

2. Suppose instead that the two firms compete by setting quantities simultaneously
rather than prices, as in the Cournot model with differentiated products.
a. Find the output reaction function of each firm. [Hint: First, you need to find the
two firms inverse demand functions.]
In this case, we need to find the two firms inverse demand functions first which are
obtained by simultaneously solving the two firms direct demand functions for
pi = pi ( qi , q j ) .
4 2 2 4
p1 = 150 q1 q2 p2 = 150 q1 q2
3 3 3 3

The ORF of each Cournot competitor is then obtained by solving the firms FOC for a
maximum profit, MRi = MCi for its own output as a function of the other firms output,
qi = qi ( q j )
4 2 R1 8 2
R1 = p1 q1 = 150q1 q12 q1 q2 MR1 = = 150 q1 q2
3 3 q1 3 3
4 2 R 8 2
R2 = p2 q2 = 150q2 q22 q1 q2 MR2 = 2 = 150 q2 q1
3 3 q2 3 3

Given C1 = 30q1 for Firm 1 and C2 = 20q2 for Firm 2.

dC dC
Then, MC1 = 1 = 30 and MC2 = 2 = 20
dq1 dq2
Therefore, the ORF of the two firms are
8 2
MR1 = MC1 150 q1 q2 = 30 q1 = 45 0.25q2
3 3
8 2
MR2 = MC2 150 q2 q1 = 20 q2 = 48.75 0.25q1
3 3

b. Find the Cournot equilibrium output and price for each firm.

The Cournot equilibrium outputs are determined by simultaneously solving the two firms
ORFs for the unknown quantities:

q1 = 45 0.25 ( 48.75 0.25q1 ) q1 = 35

q2 = 48.75 0.25 ( 35 ) q2 = 40

The Cournot equilibrium prices are determined by substituting the Cournot equilibrium
outputs in the two firms inverse demand functions:

4 2
p1 = 150 ( 35 ) ( 40 ) p1 = 76.67
3 3
2 4
p2 = 150 ( 35 ) ( 40 ) p2 = 73.33
3 3