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Summer School 2017 Final Examination: Answer Key

EC341
Industrial Organization & Introduction
to Competition Policy

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Question 1
Consider a market where cars are produced by a single monopolist and con-
sumed by a continuum of consumers with total mass normalized to µ = 1.
Each consumer demands at most one car. The producer can choose to pro-
duce either high quality or low quality cars (but not both at the same time).
It costs the monopolist cL = $10, 000 to produce a low quality car and
cH = $25, 000 to produce a high quality car. The value of a low quality
car to a consumer is uL = $12, 000 and the value of a high quality car is
uH = $30, 000. Consumers strictly prefer getting a car at a price equal to its
full value to not getting a car at all.

(a) Is it more efficient (from the perspective of the whole market) to produce
high or low quality cars?
Answer:
It is more efficient to produce high quality cars, as they generate a higher
surplus:
uH − cH = 30, 000 − 25, 000 > 12, 000 − 10, 000 = uL − cL

(b) Suppose that none of the buyers can observe the quality of the car.

i. Is there an equilibrium in which the monopolist chooses to produce


high quality cars? Explain.
Answer:
No, high quality cars will not be produced, because doing so would be
costly to the firm, but there would be no reward for the firm, as the
consumers will not be able to identify the quality.
ii. What price does the monopolist charge in equilibrium?
Answer:
In equilibrium, all consumers rationally expect the cars to be low
quality and are therefore willing to pay up to $12, 000. Because the
producer is a monopolist, it can extract this full surplus, so p =
$12, 000.

(c) Now, suppose that the fraction α of the buyers (the “informed buyers”)
can observe the quality of the car, while the remaining 1 − α (the “un-
informed buyers”) cannot. Let p∗ be the equilibrium price.

i. If only informed buyers were buying in an equilibrium, what quality


level and price would the monopolist choose in that equilibrium?

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Answer:
The only sequentially rational strategy for the informed buyers is to
buy a car of quality q if and only if pq ≤ uq . Given this, the mo-
nopolist would choose pH = uH = $30, 000 and pL = uL = $12, 000.
It follows that the monopolist gets profit (pH − cH )α = $5, 000α
if the quality is high and (pL − cL )α = $2, 000α if the quality is
low. Therefore, the monopolist produces high quality cars at the price
pH = $30, 000.
ii. Show that the uninformed buyers are buying in equilibrium, i.e., at
price p∗ . (Hint: Suppose not. What quality level will the monop-
olist then choose (by part i.)? Would it then be optimal for the
uninformed buyers not to buy?)
Answer:
If the uninformed buyers do not buy, the monopolist produces high
quality cars at the price pH = $30, 000, as computed above. But
then the uninformed buyers should also buy, as the cars are offered
at their true value and we have assumed that “Consumers strictly
prefer getting a car at a price equal to its full value to not getting a
car at all.” Contradiction.
iii. For what values of α does there exist an equilibrium in which the
monopolist produces high quality cars at price p∗ = $30, 000? Your
answer should be a number, not just a formula. (Hint: In this
equilibrium, the monopolist must not have an incentive to deviate
to low quality.)
Answer:
If the producer deviated to low quality, the value to informed con-
sumers would be uL − p∗ < 0, so that they would not buy. The pro-
ducer’s profit would be (1 − α)(p∗ − cL ). Thus, to prevent deviation
to low quality, we must have
cH − cL
p∗ − cH ≥ (1 − α)(p∗ − cL ) ⇒ α≥ .
p∗ − cL

Inserting p∗ = 30, 000, cL = $10, 000 and cH = $25, 000 into the
equation yields
25, 000 − 10, 000 3
α≥ =
30, 000 − 10, 000 4

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Question 2
Suppose that two firms produce a pair of imperfectly substitutable goods at
the same constant marginal cost c = 16 and compete à la Bertrand (firm 1
chooses p1 and firm 2 chooses p2 ). There are no fixed costs. The market
demands that the firms face each period (q1 for firm 1 and q2 for firm 2) are
given by
q1 = 24 − 3p1 + 2p2 ;
q2 = 24 − 3p2 + 2p1 .

The horizon is infinite (T = ∞), and all firms discount the future by
the same discount factor δ ∈ (0, 1). If these firms compete repeatedly, they
may be able to earn higher profits by engaging in tacit collusion. Let δ ∗ be
the minimum discount factor that sustains collusion. Answer the following
questions.

(a) Calculate the (per-period) prices, quantities, and profits in the one-shot
(non-collusive) Bertrand equilibrium and in the case when both firms
merge. [Hint: Note that the merged firm will need to produce both
goods and will thus need to optimally choose both prices.]
Answer:
The results are in the table below:

Bertrand Merged
Objectives maxpi (24 − 3pi + 2p−i )(pi − 16) maxp1 ,p2 (24 − 3p1 + 2p2 )(p1 − 16)+
(24 − 3p2 + 2p1 )(p2 − 16)
Best responses pi = (36 + p−i )/3
Prices pBi = 18 pMi = 20
Quantities qiB = 6 qiM = 4
Profits πiB = 12 π M = 32

(b) How can the two firms use tacit collusion in the repeated game to jointly
earn the same profit each period as the merged firm from part (a)? Write
down explicitly the grim trigger strategies that the firms follow to achieve
this. Do not yet attempt to verify whether these strategies form an
equilibrium or to compute δ ∗ .
Answer:

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Set the collusive prices so as to maximize total profit, i.e., pcol
i = 20, and
set the punishment prices equal to the Bertrand equilibrium, ppun i = pBi =
18. The firms can now follow the following grim trigger strategies:
(
pcol
i if t = 1 or (pjs = pcol
i for all s < t and both j ∈ {1, 2})
pit = pun
pi otherwise

(c) Given your answer to part (b), determine δ ∗ , the minimum discount
factor that sustains this collusive outcome.
Answer:
To find this, first find the optimal deviation. This is simply the individual
best response to the other firm setting the collusive price:
36 + 20 56
pdev
i = BRi (20) = = ≈ 18.67.
3 3
Thus, the deviating firm obtains profit
64
πidev = (24 − 3pdev
i + 2pcol dev
−i )(pi − 16) = ≈ 21.33.
3

Also recall that the profit when colluding is πicol = π M /2 = 16 and the
profit during mutual punishment is πipun = πiB = 12.
Now, collusion is sustainable if and only if even the optimal deviation is
not profitable:
πipun π col
dev
πi + ≤ i ,
1−δ 1−δ
i.e.,
πidev − πicol 64/3 − 16 4
δ ≥ δ ∗ = dev pun = = ≈ 0.57.
πi − πi 64/3 − 12 7

(d) Suppose that instead of updating quantities each period, the firms are
only allowed to update them in odd-numbered periods (the choice made
then persists for two periods). Find the new threshold discount factor,
δ ∗∗ . Is collusion now easier or harder to sustain than in the baseline case?
Answer:
The SPNE condition now becomes
r
π coll π pun π dev − π coll
≥ π dev (1 + δ) + δ 2 ⇒δ≥
1−δ 1−δ π dev − π pun

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r
This reduces to ∗∗ 4
δ≥δ = ≈ 0.756 > δ ∗ .
7
Collusion is now harder to sustain (because punishment is delayed and
the rewards to deviation are prolonged).

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Question 3
A good is produced by a single producer, Upstream Corporation. The pro-
duction technology exhibits constant returns to scale, at a marginal cost of
c = 4 per unit of the good. There are no fixed costs.
Upstream Corporation sells all of its production to two retailers, Down-
stream One and Downstream Two, who then sell it on to consumers. The
price that Upstream Corporation charges the retailers is pU per unit of the
good. Both retailers pay the same price.
The retailers sell only this particular good, and neither of the two has any
costs other than the cost of buying the good from the producer. Consumers’
indirect demand function is P (Q) = 16 − 2Q, where Q is total quantity
consumed. The retailers compete by simultaneously setting quantities.
Answer the following questions.

(a) Compute the equilibrium prices, quantities, and profits when all three
firms are independent.
Answer:
The retailers’ market has standard Cournot competition. Retailer i solves
qi = maxqi ((16 − 2qi − 2q−i ) − pU )qi . The equilibrium is q1 = q2 =
(16 − pU )/6.
Given this, Upstream Corporation solves pU = arg maxpU (1/3)(16−pU )(pU −
4). The solution is pU = 10. Substituting back into the downwstream so-
lution and into the consumer demand function yields q1 = q2 = 1 and
pD = 12. The profits are therefore π U = 12; π1 = π2 = 2. The total sup-
plier surplus is Π = π1 + π2 + π U = 16.

(b) Suppose all three firms merge, forming a single entity, Monster Monopoly,
which manufactures the good and sells it directly to consumers. Compute
the new equilibrium prices, quantities, and profits. Relative to part (a),
was the merger beneficial to each of the following: (i) consumers, (ii)
firms, (iii) overall efficiency? Why?
Answer:
The monopolist solves maxQ ((16 − 2Q) − 4)Q. The solution is QM = 3.
The price is pM = 10. The monopolist’s profit is ΠM = 18.
First, notice that the producers’ surplus increased: from Π = 16 to
ΠM = 18, so that the merger was beneficial to the firms. Next, note that
it was also beneficial to the consumers, because prices decreased (and

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quantities increased). Therefore, the total surplus also increased: the
merger improved efficiency. The efficiency gain was due to the removal
of double marginalization.

(c) Suppose that instead of merging with Upstream Corporation, the retail-
ers can agree to divide the downstream market into two identical sub-
markets, one for each retailer. They can fully commit to not entering
each others’ market, so that each retailer now has complete monopoly
power over their half of the market. Compute the new equilibrium prices,
quantities, and profits. Relative to part (a), was the division of the mar-
ket beneficial to each of the following: (i) consumers, (ii) firms, (iii)
overall efficiency? Why?
Answer:
First, we must find the demand functions of the retailers. To this end,
first find the direct demand function of the whole market: P (Q) = 16 −
2Q ⇒ Q(P ) = 8 − (1/2)P . Because each retailer gets one half of the
market, its demand function is Qi (Pi ) = (1/2)Q(Pi ) = 4 − (1/4)Pi .
Now, each retailer solves maxQi (Pi −P U )(4−(1/4)Pi ), obtaining Pi = 8+
(1/2)P U . Each retailer’s output (and thus also demand from Upstream)
is therefore Qi = 4−(1/4)Pi = 2−(1/8)P U , so that the entire downstream
demand is Q = Q1 + Q2 = 4 − (1/4)P U .
Upstream now solves maxP U (P U −4)(4−(1/4)P U ), obtaining P U ;div = 10
and π U ;div = 9.
The downstream prices are P1;div = P2;div = 8 + (1/2)10 = 13 and the
quantities are Q1;div = Q2;div = 2 − (1/8) · 10 = 3/4 , so that the total
quantity is Qdiv = 1.5 and the retail profits are π1;div = π2;div = 9/4 = 2.25.
The total producer surplus is Πdiv = π U ;div + π1;div + π2;div = 13.5.
The consumers were hurt by the agreement: their price increased from
pD = 12 to P div = 13. The downstream firms benefited from the addi-
tional market power: their profits increased from π1 = 2 to π1;div = 2.25.
However, the upstream firm was hurt enough that the total supply-side
surplus decreased from Π = 16 to Πdiv = 13.5. Because both the supply-
side and the demand-side surpluses decreased, overall efficiency (total
surplus) decreased as well.
The increased downstream market power exacerbated the double marginal-
ization problem, hurting efficiency.

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Question 4
Consider the following homogeneous good industry. The market demand is
given by P (Q) = 80 − 5Q. Let there be a single incumbent and a single po-
tential entrant, both of which initially have the same production technology,
characterized by constant marginal cost c = 10 and no fixed costs.
The sequence of events is as follows:

1. First, the incumbent decides whether to make an investment in a cost-


reducing technology. We assume that to reduce the marginal cost by the
amount k1 , the incumbent must pay a cost of (k1 )2 . The incumbent’s
cost function is thus

C1 (k1 , q1 ) = (10 − k1 )q1 + k12 .

Note that the maximum possible investment is kmax = c = 10, because


costs cannot be negative.

2. Next, the entrant observes k1 and decides whether or not to enter. If


it enters, it must pay a sunk entry cost of F = 85. The entrant has no
opportunity to invest in technology, so that if it enters, its cost function
is C2 (q2 ) = 10q2 + 85. If the entrant does not enter, it gets a payoff of
zero.

3. Finally, the active firms simultaneously decide quantities. [That is, if


the entrant has chosen not to enter, only the incumbent sets a quantity
(i.e., solves a monopoly problem); if the entrant has chosen to enter,
Cournot competition ensues.]

4. The chosen quantities are produced and profits reaped, by which the
game ends.

Answer the following questions.

(a) Solve for the equilibrium quantities, prices, investment level, and profits.
Does the incumbent choose to accommodate or to deter entry?
Answer:
We begin by solving for the Cournot equilibrium that occurs in the last
stage if the entrant enters:
Letting c1 = 10 − k1 and c2 = 10, each firm i solves

max πi (qi , q−i ) = (80 − 5qi − 5q−i − ci )qi .


qi

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The FOC yields the best-response functions qi = (80 − ci − 5q−i )/10.
Inserting the values of ci into this expression yields
70 + k1 − 5q2 14 − q1
q1 = and q2 = .
10 2

Solving the system of equations given by these best-response functions


yields the Cournot equilibrium

2(35 + k1 ) 70 − k1
q1C = and q2C = .
15 15

Inserting these values into the definition of the operating profit, πi (qi , q−i ) =
(80 − 5qi − 5q−i − ci )qi , yields

4(35 + k1 )2 (70 − k1 )2
π1C = and π2C = .
45 45

Given this, in the entry decision stage the entrant stays out if and only if
its operating profit does not exceed its cost of entry, i.e., π2C ≤ F . Thus,
entry is deterred if and only if

(70 − k1 )2 √
π2C ≤ F ⇒ ≤ 85 ⇒ k1 ≥ k1L = 70 − 15 17 ≈ 8.15.
45

If the incumbent chooses k1 = k1L , the entrant chooses to stay out of the
market, so the incumbent becomes a monopolist in the final stage and
therefore solves
max(80 − 5q1 − (10 − k1L ))q1 .
q1

The FOC with respect to q1 yields q1L = (70 + k1L )/10. Plugging in the
value of k1L from above and simplifying yields

q1L = 14 − (3/2) 17 ≈ 7.815.

Thus the total profit if the incumbent deters entry by making the
limit investment is ΠL1 = (80 − 5q1L − (10 − k1L ))q1L − (k1L )2 . Plugging
in the values of q1L and k1L from above yields the total profit

√ 30, 215
ΠL1 = 1890 17 − ≈ 238.92.
4

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We saw above that if the incumbent instead accommodates entry (i.e., en-
ters Cournot competition), its operating profit is π1C = [4(35 + k1 )2 ]/45.
Thus, when the incumbent expects to accommodate, its optimal invest-
ment problem is
4(35 + k1 )2
max − (k1 )2 .
k1 45
Taking the FOC w.r.t. k1 yields k1A = 140/41 ≈ 3.41.
Plugging k1A into the expressions for Cournot duopoly quantities yields

210 182
q1A = ≈ 5.12 and q2A = ≈ 4.44.
41 41
To obtain the total profits we note that the total profit for the incumbent
is the operating profit minus the investment cost (k1A )2 , whereas for the
entrant it is the operating profit minus the entry cost F = 85, i.e., ΠA
1 =
C A 2 A C C
π1 − (k1 ) and Π2 = π2 − 85, where the operating profits πi are as
derived above. Plugging in the value of k1A yields

4900 22, 735


ΠA
1 = ≈ 119.51 and ΠA
2 = ≈ 13.52.
41 1681
Finally, noting that

ΠL1 ≈ 238.92 > 119.51 ≈ ΠA


1,

we conclude that the incumbent prefers to deter entry.

(b) Now, solve for the equilibrium investment level if the sunk entry cost is
F ′ = 500. How is the incumbent’s problem now different from that in
part (a)? [Hint: Use your solutions from part (a) as much as possible.
Is it hard for the incumbent to keep the entrant out in this case?]
Answer:
Note that in this case the entry cost is so high that entry is blockaded:
the entrant will never find it optimal to enter. To see this, examine the
entrant’s profit from entering Cournot competition, as derived in part
(a):
(70 − k1 )2 702
π2C = ≤ ≈ 109 < 500 = F.
45 45
It follows that no matter what the incumbent does, the entrant will never
find entry profitable.

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The incumbent is effectively a monopolist—it can behave as if the other
company were not actually there. In the production stage, the incumbent
solves
max(80 − 5q1 − (10 − k1 ))q1 ,
q1

which is maximized at
k1
qM = 7 + ,
10
where it yields
1
πM = (70 + k1M )2 .
20
In the first stage, the monopolist simply chooses its investment level to
maximize its profit, which equals this monopoly operating profit minus
the cost of investment:
1
max (70 + k1 )2 − (k1 )2 ,
k1 20
which is maximized when

70
k1M = ≈ 3.68,
19

yielding
140 4900
qM = ≈ 7.37; ΠM = ≈ 257.90.
19 19

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