Answers to Chapter 12 Exercises

Review and practice exercises

12.1. Store clustering. “Tourists traipsing along a half-mile stretch of 23rd Street in
New York pass five Starbucks outlets. In Tokyo, 7-Eleven boasts 15 stores within a similar
distance of Shinjuku station.”25 Does it make any sense for stores to be clustered in this
way?

12.2. LC and CS burgers. LC Burgers is currently the sole fast-food chain in Linear
city, a city that is one mile long and consists of one street, with one thousand consumers
distributed uniformly along the street. The price for the BigLC, the only product sold by
the LC Burger chain, is set nationally at $4, so that the local Linear city manager’s decision
is limited to choosing the number and location of its stores.
Each store costs $600,000 to open and lasts indefinitely. Each consumer buys one burger
per week at the current price of $4. However, no consumer will walk for more than a quarter
of a mile to buy a burger. Operating costs are $1 per burger. The interest rates is 0.1% per
week. The market conditions are unchanging, so present discounted profits can be regarded
as level perpetuities.
(a) Suppose that LC Burgers faces no competition and no threat of entry.
How many stores should LC Burgers open, and at what locations?
Answer: If LC Burgers opens a single store, it can capture at most 500 consumers (the
ones living a quarter mile to the left and a quarter mile to the right of the store). In such
a case, the profits would be
(4 1) ⇥ 500
600, 000 = 900, 000
0.001
Since only half of the market is covered, LC Burgers can open another store, again hoping
to capture at most 500 customers. To cover the entire market, the optimal location is at 14
and 34 , case in which there is no overlap between the ”markets” of each store. By opening
two stores, LC’s total profit is given by 1,800,000.
CS Burgers is contemplating entering Linear city. CS Burgers’ costs and price are the same
as those of LC Burgers. Moreover, consumers regard the products at both chains as equally
good, so, if both brands are in town, each consumers buys from the closest store.
(b) At what locations should CS Burgers open stores, given that LC Burg-
ers has opened the locations found to be optimal in part (a)?
Answer: Note that a store is profitable if covers 250 customers. In fact, profit is then
given by
3 ⇥ 250
600, 000 = 150, 000
0.001
Therefore, CS Burgers can open sores in 4 locations, namely at a very small distance to the
left and right of each LC Burgers store. In this case CS Burgers will have the whole market
and will make profits of $600.000 = 4 ⇥ $150, 000.
(c) Recognizing the threat of entry by CS Burgers, at what locations
should LC Burgers open stores?
Answer: A store becomes profitable if it covers more than 200 customers. To see this,
solve the equation
3⇥x
600, 000 = 0
0.001
with respect to x. Given this, if the distance between to stores is less than 0.4 miles, no
firm locating in between is viable (locating in the middle or right next to a store brings at
most 200 customers). Therefore, in order to avoid entry LC Burgers can open 3 stores, one
located at 0.2, the other at 0.6 and the last at 1. In such a case CS Burgers cannot find a
profitable position to open a store.

12.3. German telecommunications. In less than one year after the deregulation of the
German telecommunications market at the start of 1998, domestic long-distance rates fell by
more than 70%. Deutsche Telekom, the former monopolist, accompanied some of these rate
drops by increases in monthly fees and local calls. MobilCom, one of the main competitors,
feared it might be unable to match the price reductions. Following the announcement of
a price reduction by Deutche Telekom at the end of 1998, shares of MobilCom fell by 7%.
Two other competitors, O.tel.o and Mannesmann Arcor, said they would match the price
cuts. VIAG Interkom, however, accused Telekom of “competition-distorting behavior,”
claiming the company is exploiting its (still remaining) monopoly power in the local market
to subsidize its long-distance business.26
Is this a case of predatory pricing? Present arguments in favor and against such asser-
tion.
Answer: One could indeed argue that this is a case of predatory pricing. If Deutsche
Telekon has monopoly in local markets it has strong financial resources and can a↵ord to
loose money in the long distance market by pricing below marginal cost. However, since
there are 2 other competitors that matched Deutsche Telekom’s prices, one can argue that
there exists technology with marginal cost less than the low price charged. Evidently,
the other explanations can also be used, namely, low-cost signaling and reputation for
toughness.

Challenging exercises

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 12.4. Exclusive contracts as a barrier to entry. Suppose that there is one buyer who
is willing to pay up to one unit of a given good for the price of 1. There is an incumbent
seller with production cost 12 (a value that is publicly known). Suppose there is a potential
competitor to the seller. Unlike the incumbent seller, the potential entrant’s cost is unknown
to buyer and incumbent. Both expect it to be a value uniformly distributed in the [0, 1]
interval. The potential entrant, by contrast, is able to observe its cost and make an entry
decision conditional on the observed value. If entry takes place, then the sellers play a
price-setting game (with homogeneous product), whereby the low-cost firm sets a price just
below the high-cost firm’s cost.
(a) Show that the incumbent and the consumer’s ex-ante expected payo↵s
are both given by 14 .
Answer: If the entrant’s cost is greater than 12 , then no entry takes place and the incumbent
sets the monopoly price 1. If the entrant’s cost is less than 12 , then the entrant enters and
sets price equal to the incumbent’s cost, 12 . The buyer’s expected payo↵ is 12 times zero (no
entry) plus 12 times (1 12 ) (entry takes place), that is, 14 . The incumbent, in turn, receives
an expected payo↵ of 12 (no entry) times (1 12 ), or 14 .

Now suppose that incumbent and consumer agree to an exclusive contract before the po-
tential entrant makes its entry decision. The contract stipulates that the consumer buys
the product from the incumbent (and only from the incumbent) at a price of 34 . Moreover,
if the consumer were to buy from the entrant then it would pay the incumbent a penalty
of 12 for breach of contract.
(b) Show that both consumer and incumbent are better o↵ with this ex-
clusive contract.
Answer: Notice that, despite the contract, entry still takes place when the entrant is very
efficient. In fact, if the entrant’s cost is less than 14 , then the entrant enters and sets price
equal to 14 — or just a little less than that. Given this price, the buyer switches seller: it now
pays 14 (price) plus 12 (penalty from breach of contract), a total of 34 (the price required by
the incumbent). Following this reasoning, we conclude that entry occurs with probability
1 1 1
4 , the probability that the entrant’s cost is lower than 4 . The buyer’s expected utility is 4
times (1 14 12 ) (entry takes place) plus 34 times (1 34 ) (entry does not take place), or
simply 14 (the same value as before). The incumbent, in turn, now gets 14 times 12 (entry
takes place and the entrant receives the damage payment) plus 34 times 34 12 (entry does
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not take place), or 16 , which is strictly greater than 14 , the previous payo↵.
Not surprisingly, the loser in this process is the entrant. Without contracts, the entrant
sells at a price 12 , whereas with the above contract the maximum the entrant can charge is
1 1 1
4 . Notice that, if the entrant’s cost lies in the interval [ 4 , 2 ], then entry does not take place
even though the entrant is more efficient than the incumbent.
Note that the buyer is indi↵erent between no contract and the above exclusive contract.
However, to the extent that the incumbent seller is strictly better o↵ with an exclusive
contract, there exist contracts (with a slightly lower price) such that both incumbent and
buyer are strictly better o↵.

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 Applied exercises

12.5. Bundling. Find examples of firm bundling strategies. Determine whether bundling
is pro-competitive, anti-competitive, or relatively neutral with respect to competition.