P13.6 A.

SOLUTION Because MCA = 0, Firm As profit-maximizing output level is found by setting MRA = MCA: MRA $1,250 - $2QA - QB $2QA QA = = = = MCA 50 $1,200 - QB 600 - 0.5QB

Notice that the profit-maximizing level of output for Firm A depends upon the level of output produced by itself and Firm B. Similarly, the profit-maximizing level of output for Firm B depends upon the level of output produced by itself and Firm A. These relationships are each competitors output-reaction curve Firm A output-reaction curve: Firm B output-reaction curve: B. QA = 600 - 0.5QB QB = 600 - 0.5QA

The Cournot market equilibrium level of output is found by simultaneously solving the output-reaction curves for both competitors. To find the amount of output produced by Firm A, simply insert the amount of output produced by competitor Firm B into Firm As output-reaction curve and solve for QA. To find the amount of output produced by Firm B, simply insert the amount of output produced by competitor Firm A into Firm Bs output-reaction curve and solve for QB. For example, from the Firm A output-reaction curve QA QA QA 0.75QA QA = = = = = 600 - 0.5QB 600 - 0.5(600 - 0.5QA) 600 - 300 + 0.25QA 300 400 (000) units

Similarly, from the Firm B output-reaction curve, the profit-maximizing level of output for Firm B is QB = 400. With just two competitors, the market equilibrium level of output is Cournot equilibrium output = QA + QB = 400 + 400 = 800 (000) units

The Cournot market equilibrium price is $1,250 Q = $1,250 - $1(800) = $450

P13.7 A.

SOLUTION To illustrate Stackelberg first-mover advantages, reconsider the Cournot model but now assume that Firm A, as a leading firm, correctly anticipates the output reaction of Firm B, the following firm. With prior knowledge of Firm Bs output-reaction curve, QB = 600 - 0.5QA, Firm As total revenue curve becomes TRA = $1,250QA 2 - QA - QAQB = $1,250QA - QA2 - QA(600 - 0.5QA) = $650QA - 0.5QA2 With prior knowledge of Firm Bs output-reaction curve, marginal revenue for Firm A is MRA = TRA/QA = $650 - $1QA Because MCA = $50, Firm As profit-maximizing output level with prior knowledge of Firm Bs output-reaction curve is found by setting MRA = MCA = $50: MRA $650 - $1QA QA = MCA = $50 = 600

After Firm A has determined its level of output, the amount produced by Firm B is calculated from Firm Bs output-reaction curve QB = 600 - 0.5QA = 600 - 0.5(600) = 300

With just two competitors, the Stackelberg market equilibrium level of output is 900 and price is $350. Notice that market output is greater in Stackelberg equilibrium than in Cournot equilibrium because the first mover, Firm A, produces more output while the follower, Firm B, produces less output. Stackelberg equilibrium also results in a lower market price than that observed in Cournot equilibrium. In this example, Firm A enjoys a significant first-mover advantage. Firm A will produce twice as much output and earn twice as much profit as Firm B so long as Firm B accepts the output decisions of Firm A as given and does not initiate a price war. If Firm A and Firm B cannot agree on which firm is the leader and which firm is the follower, a price war can break out with the potential to severely undermine the profitability of both leading and following firms. If neither duopoly firm is willing to allow its competitor to exercise a market leadership position, vigorous price competition and a competitive market price/output solution can result. Obviously, participants in oligopoly markets have strong incentives to resolve the uncertainty surrounding the likely competitor response to leading-firm output decisions.

P13.8 A.

SOLUTION To derive Cokes optimal price-response curve, set C/PC = 0 15 - 5PC + 1.25PP +2.5X = 0 5PC = 15 + 1.25PP + 2.5X PC = $3 + $0.25PP + $0.5X Cokes optimal price-response curve shows that Coke should increase its own price by 25 with each $1 increase in the price of Pepsi, and increase its own price by 50 with every $1 increase in the marginal cost of production.

B.

If Pepsi charges $5 and marginal costs are $2 per 24-pack, Cokes optimal priceresponse curve shows that Coke should charge $5.25 per 24-pack: PC = $3 + $0.25PP + $0.5X = $3 + $0.25($5) + $0.5($2) = $5.25

P14.3 A.

SOLUTION Yes, the dominant strategy for firm A is up. Notice that if firm B chooses left, the highest payoff of $5 million can be achieved if Firm A chooses up. On the other hand, if firm B chooses right, the highest payoff of $7.5 million can be achieved if firm A again chooses up. No matter what firm B chooses, the highest payoff results for firm A occurs if A chooses up. Therefore, up is a dominant strategy for firm A. No, there is no dominant strategy for firm B. If firm A chooses up, the highest payoff of $10 million can be achieved if firm B chooses left. On the other hand, if firm A chooses down the highest payoff of $5 million can be achieved if firm B chooses right. Therefore, there is no dominant strategy for firm B. The profitmaximizing choice by firm B depends upon the choice made by firm A.

B.

P14.4 A.

SOLUTION Yes, the secure strategy for The Home Depot is to offer 90-day free financing. Irrespective of the choice made by the Lowes Companies, in its secure strategy The Home Depot can insure that it avoids the worst-possible outcome of earning only $15 million by choosing to offer 90-day free financing. Yes, the secure strategy for the Lowes Companies is to offer 90-day free financing. Irrespective of the choice made by The Home Depot, Lowes secure strategy insures that it avoids the worst-possible outcome of earning only $10 million by choosing to offer 90-day free financing.

B.

P14.5 A.

SOLUTION A set of strategies constitutes a Nash equilibrium if no player can improve their payoff through a unilateral change in strategy. The concept of Nash equilibrium is important because it represents a stable situation in which no player can improve their situation given the strategies adopted by other players. Yes. The Nash equilibrium strategy is for both Kellogg and General Mills to advertise. Given that Kellogg chooses to advertise, General Mills makes the most profit by also choosing to advertise. Similarly, given that General Mills has chosen to advertise, the best Kellogg can do is to advertise as well. Given the dual decision to advertise, neither competitor can improve profits by changing its advertising decision.

B.

P14.6 A.

SOLUTION In this problem, the low-price strategy is a dominant strategy for both firms. If firm B charged low prices, firm A will also choose to charge low prices because the $5 million profit then earned is more than the $10 million loss that would be suffered by firm A if it pursued a high-price strategy. If firm B charged high prices, firm A would still choose to charge low prices because the $40 million profit then earned is more than the $25 million profit that would be earned if firm A pursued a high-price strategy. If firm A charged low prices, firm B will also choose to charge low prices because the $5 million profit then earned is more than the $10 million loss that would be suffered by firm B if it pursued a high-price strategy. If firm A charged high prices, firm B would still choose to charge low prices because the $40 million profit then earned is more than the $25 million profit that would be earned if firm B pursued a high-price strategy. In this case, if both firms pursue a low-price strategy a Nash equilibrium also results. A set of strategies constitutes a Nash equilibrium if no player can improve their payoff through a unilateral change in strategy. The concept of Nash equilibrium is important because it represents a stable situation in which no player can improve their situation given the strategies adopted by other players. If the firms agreed to collude and charge high prices, both would earn $25 million and joint profits of $50 million would be maximized. However, the joint high-price strategy is not a stable equilibrium. To see the instability of having both firms choose high-price strategies, see how each firm has strong incentives to cheat on any covert or overt agreement to collude. If firm B chose a high-price strategy, firm A could see profits jump from $25 million to $40 million by switching from a highprice to a low-price strategy. Similarly, if firm A chose a high-price strategy, firm B could see profits jump from $25 million to $40 million by switching from a highprice to a low-price strategy. Both firms have strong incentives to cheat on any covert or overt agreement for both of them to charge high prices. Such situations are common and help explain the difficulty of maintaining cartel-like agreements.

B.

P15.3 SOLUTION A. P =
Percentage change in output Percentage change in price
0.15 - 0.03

= -5 B. Given the solution to part (a), and using the optimal mark-up on cost formula (Hirschey, p. 588), the optimal mark-up is 25%. Given a marginal cost of $120, and using the optimal pricing formula (Hirscheys Pricing Rule-of-Thumb, p. 586), the optimal price is $150.

P15.4 A.

SOLUTION EP

Q P2 + P1 P Q2 + Q1 750 - 250 $12 + $16 = $12 - $16 750 + 250 = -3.5

=

B.

Given P = EP = -3.5, the optimal markup on cost for Saturday brunch at the Bristol during this time frame is: Optimal Markup = - 1 on Cost P +1 =
-1 - 3.5 + 1

= 0.4 or 40% Given MC = $8.56, the optimal price is: Optimal Markup = P - MC on Cost MC P - $8.56 0.4 = $8.56 $3.424 = P - $8.56 P = $11.99

P15.5 A.

SOLUTION The $3 price increase to $39 represents a moderate 7.7 percent rise in price. Using the arc price elasticity formula, the implied arc price elasticity of demand for Betty's blouses is: Q 2 - Q1 P 2 + P1 EP = P 2 - P1 Q 2 + Q1
= 46 - 54 $39 + $36 $39 - $36 46 + 54

B.

= - 2. If it can be assumed that this arc price elasticity of demand EP = -2 is the best available estimate of the current point price elasticity of demand, the optimal markup on cost is:
Optimal Markup = - 1 on Cost P +1 = -1 - 2 +1

= 1 or 100%.

Betty's standard cost per blouse includes the $12 purchase cost, plus $6 allocated variable costs, plus $6 fixed overhead charges. However, for pricing purposes, only the $12 purchase cost plus the allocated variable overhead charge of $6 are relevant. Thus, the relevant marginal cost for pricing purposes is $18 per blouse. The allocated fixed overhead charge of $6 is irrelevant for pricing purposes because fixed overhead costs are unaffected by blouse sales. At the $36 price, Betty's actual markup on relevant marginal costs per blouse is an optimal 100 percent, because Markup on Cost
$36 - $18 $18 = 1 (or 100 percent).

Therefore, Betty's initial $36 price on blouses is optimal, and the subsequent $3 price increase should be rescinded.

P15.7 A.

SOLUTION The incremental net income from these offers can be determined as follows:
Offer 1 Offer 2 $14.60 $6.00 4.00 2.00 1.20 13.20 1.40 80,000 $112,000 $20.00 - 13.20 6.80 $6.00 4.00 2.00 0.00 12.00 2.00 120,000 $240,000 $14.00

Unit price Unit variable costs: Materials Direct labor Variable indirect labor Variable warranty expense Unit incremental profit Units to be sold Total variable profit on units sold at special price Less variable profit lost on regular sales: Regular price Regular variable costs Regular variable profit Units that cannot be sold at regular price if Offer 2 is accepted Opportunity cost of lost regular sales Incremental profit

20,000 $0 $112,000 $136,000 $104,000

Both offers involve a substantial incremental profit, but offer 1 appears to be the more attractive on a simple dollar basis. But wait Doesnt this mean they will sell below cost once we factor in the $3 for fixed overhead? To understand the fault of this logic ask yourself this: Is that $3 AFC still an operative assumption once output expands to 480,000 or 500,000? What are total fixed costs anyway? B. (i) The image of GEs quality may be affected by sales of the appliance in the department store chain with a private label. Other buyers may demand the reduced price if GE accepts offer 1 and the department store undercuts them at the retail price level. The sales lost if GE accepts offer 2 may affect future orders from regular customers.

(ii)

(iii)

C.

It depends upon how you evaluate the factors discussed in part B. The incremental profits of offer 1 exceed those of offer 2, but other long-run concerns might well dictate that it not be accepted.

P15.8 A.

SOLUTION With price discrimination, profits are maximized by setting MR = MC in each market, where MC = $10,000. Wholesale = MC = $10,000 = 500 units = $12,500. Retail = MC = $10,000 = 1,000 units = $30,000

MRW $15,000 - $10QW QW PW MRR $50,000 - $40QR QR PR

The profit contribution earned by the company is: = PWQW + PRQR - AVC(QW + QR) = $12,500(500) + $30,000(1,000) - $10,000(500 + 1,000) = $21,250,000

B.

Yes, the point price elasticity of demand for each customer class is: Wholesale QW = 3,000 - 0.2PW P = QW/PW PW/QW = -0.2 ($12,500/500) = -5 Retail QR = 2,500 - 0.05PR P = QR/PR PR/QR = -0.05 ($30,000/1,000) = -1.5 A higher price for retail customers is consistent with the lower degree or price elasticity observed in that market.

P15.10 A.

SOLUTION It is appropriate to begin analysis of this problem by examining the optimal activity level, assuming the firm mines and sells equal quantities of silver and lead. For profit maximization where Q = QS = QL, set: MC = MRS + MRL = MR $10 = $11 - $0.00006Q + $0.4 - $0.00001Q $0.00007Q = 1.4 Q = 20,000 Profit maximization with equal sales of each product requires that the firm mine Q = 20,000 tons of ore. Under this assumption, marginal revenues for the two products are: MRS = $11 - $0.00006(20,000) = $9.80 MRL = $0.4 - $0.00001(20,000) = $0.20 Because each product is making a positive contribution to marginal costs of $10 per ton, Q = 20,000 is an optimal activity level. Relevant prices are: PS = $11 - $0.00003(20,000) = $10.40 PL = $0.4 - $0.000005(20,000) = $0.30

B.

A five-fold (or 500%) increase in silver demand means that a given quantity could be sold at 5 times the original price. Alternatively, 5 times the original quantity demanded could be sold at a given price. Therefore, the new silver demand and marginal revenue curves can be written: PS = = MRS = = 5($11 - $0.00003QS) $55 - $0.00015QS 5($11 - $0.00006QS) $55 - $0.0003QS

Now, assuming all output is sold, MC = MRS + MRL = MR $10 = $55 - $0.0003Q + $0.4 - $0.00001Q 0.00031Q = 45.4 Q = 146,452 Thus, profit maximization with equal sales of each product requires that the firm mine Q = 146,452 tons of ore. Under this assumption, marginal revenues for the two products are:

MRS MRL

= $55 - $0.0003(146,452) = $11.06 = $0.4 - $0.00001(146,452) = -$1.06

Even though MRS + MRL = MC = $10, the above Q = 146,452 solution is suboptimal. MRS = $11.06 > $10 = MC implies that a $1.06 profit contribution was earned on each marginal ton of ore mined when just considering S sales. This means that the firm would like to expand production beyond Q = 146,452 just to sell more S. The negative marginal revenue for L implies that the firm had to reduce price so much in order to sell all 146,452 pounds of L (indeed offer a negative price or subsidy of 33 per pound) that total revenues fell by $1.06 on the last pound sold. Rather than sell L under such unfavorable conditions, the firm would like to reduce L sales below 146,452 pounds. The firm would sell L only up to the point where MRL = 0 because, given additional production to sell S, the marginal cost of L is zero. Set, MRL $0.4 - $0.00001Q $0.00001Q QL PL = = = = MCL 0 0.4 40,000

= $0.4 - $0.000005(40,000) = $0.20

The optimal production and sales level of S is found by setting MRS = MC, because S is the only product sold from the marginal ton of ore being mined. MRS $55 - $0.0003QS 0.0003QS QS = MC = MCS = $10 = 45 = 150,000 and PS = $55 - $0.00015(150,000) = $32.50

Therefore, the firm should mine 150,000 tons of ore, and sell all 150,000 ounces of S produced at a price of $32.50. Only 40,000 pounds of lead should be sold at a price of 20 per pound, with the remaining 110,000 pounds produced being held off the market. (Note: Despite a five-fold increase in demand, prices increase by less than five-fold given the firms expansion in output.)

Extra Problems 1. a. Firm 1s reaction function is q1 = 60 0.5q2. b. The competitive output is 120. By applying known relationships among the outcomes of the various market structures, the rest of the table may quickly be filled in. For example, the monopoly output will be of the competitive output, and so forth. 2. a. No. b. The Nash Equilibrium {6,6} is a prisoners dilemma. c. The relevant portion of the game matrix is symmetric. Thus the same critical discount factor will apply to both players. It is (20 15)/(21 20) = 5. d. Equilibrium is {8,4}. Notice that this outcome incorporates the notion of a first mover advantage and that the outcome mirrors that of a Stackelberg equilibrium. 3. a. =-3

b. Optimal markup on cost is 50%. (Use the optimal markup formula, Hirschey, p. 588.) Optimal price is $45. (Use Hirscheys Rule-of-Thumb from p. 586.) 4. a. With price discrimination, profits are maximized by setting MR = MC in each market, where MC
= AVC = $20 (because AVC is constant). Locals = MC = $20 = 20 = 20,000 and PL = $30 Tourists = MC = $20 = 30 = 37,500 and PT = $35

$40

MRL $0.001QL 0.001QL QL

$50

MRT $0.0008QT 0.0008QT QT

The profit contribution earned by the Fun-Land Amusement Park is $762,500. b. Yes, a higher price for Tourist customers is consistent with the lower degree of price elasticity observed in that market. Evaluating at equilibrium outputs and prices, elasticity of demand for locals is 3, and elasticity of demand for tourists is -2.33.