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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.

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.

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:

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

costs cannot be negative.

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.

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.

(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

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

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

ΠA

1 = ≈ 119.51 and ΠA

2 = ≈ 13.52.

41 1681

Finally, noting that

1,

(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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