Oz Shy - Industrial Organization: Theory and Applications - Instructor's Manual

Instructors Manual for
Industrial Organization
Theory and Applications
by Oz Shy
The MIT Press
Cambridge, Massachusetts
London, England
Copyright c 19952004 Oz Shy. All rights reserved.
The manual was typeset by the author using the L
A
T
E
X2
document preparation software by

Leslie Lamport (a special version of Donald Knuths T
E
X program) during the months from
September 1995 to November 1995 while I was visiting the Economics Department of the
University of Michigan. All the gures are also drawn in L
A
T
E
X using software called T
E
Xcad
developed by Georg Horn, which can be downloaded from various mainframes.
Version 1.0 [Draft 20], (1995): Prepared for the rst printing of the rst edition
bkman21.tex rst draft to be posted on the Web (2000/07/07)
(parallel to the 5th Printing of the book)
v.24 (2004/04/14): 6.1.d, 6.1.e
This version: bkman24.tex 2004/04/14 17:36
Contents
To the Instructor v
2 Basic Concepts in Noncooperative Game Theory 1
3 Technology, Production Cost, and Demand 7
4 Perfect Competition 9
5 The Monopoly 11
6 Markets for Homogeneous Products 17
7 Markets for Dierentiated Products 25
8 Concentration, Mergers, and Entry Barriers 29
9 Research and Development 33
10 The Economics of Compatibility and Standards 35
11 Advertising 37
12 Quality, Durability, and Warranties 39
13 Pricing Tactics: Two-Part Tari and Peak-Load Pricing 43
14 Marketing Tactics: Bundling, Upgrading, and Dealerships 45
15 Management, Compensation, and Regulation 49
16 Price Dispersion and Search Theory 51
17 Miscellaneous Industries 53
To the Instructor
Before planning the course, I urge the instructor to read carefully the Preface of the book that
suggests dierent ways of organizing courses for dierent levels of students and also provides a
list of calculus-free topics.
The goals of this manual are:
To provide the instructor with my solutions for all the problems listed at the end of each
chapter;
to convey to the instructor my views of what the important concepts in each topic are;
to suggest which topics to choose for dierent types of classes and levels of students.
Finally, please alert me to any errors or incorrect presentations that you detect in the book
and in this manual. (e-mail addresses are given below). Note that the errata les (according
to the printing sequence) are posted on the Web in PDF format. Before reporting errors and
typos, please view the errata les to see whether the error you found was already identied and
corrected.
Haifa, Israel, (April 14, 2004)
E-mail : ozshy@ozshy.com
Backup : OzBackup@yahoo.com
Web-page : www.ozshy.com
Catalog-page : http://mitpress.mit.edu/book-home.tcl?isbn=0262691795
This draft : bkman24.tex 2004/04/14 17:36
Chapter 2
Basic Concepts in Noncooperative Game Theory
An instructor of a short course should limit the discussion of game theory to the four most
important concepts in this chapter that are essential for the understanding most of the analyses
presented in this book:
1. The denition of a game (Denition 2.1): It is important that the student will understand
that a game is not properly dened unless the list of players, the action set of each player,
and the payo functions are clearly stated. It is important that the student will understand
the meaning of the term outcome as a list of the specic actions chosen by each player
(and not a list of payos as commonly assumed by students).
2. Nash equilibrium (Denition 2.4).
3. Welfare comparisons among outcomes (Denition 2.6).
4. Extensive form games, strategies (compare with actions), subgames, and the SPE (De-
nition 2.10).
I urge the instructor to discuss the issues of existence, uniqueness, and multiple equilibria in
class. More precisely, it is important that the student will know that in order to prove existence,
it is sucient to nd only one NE outcome; however, to prove nonexistence, the student must
go over all outcomes and show that at least one player benets from unilateral deviation.
I believe that the above can be covered in 2 lectures, or in three hours of instruction. If
you wish to devote more time to game theory, you can introduce the equilibrium in dominant
actions (Denition 2.3) before teaching the NE equilibrium concept. If you wish to emphasis
more game theory, I advise covering repeated games (section 2.3).
Answers to Exercises
1. (a) It is straightforward to conclude that
R
1
(a
2
) =
_
WAR if a
2
= WAR
WAR if a
2
= PEACE
and R
2
(a
1
) =
_
WAR if a
1
= WAR
WAR if a
2
= PEACE.
That is, WAR is each players best response to each action taken by the other player
(hence, WAR is a dominant action for each player). Now, ( a
1
, a
2
) = (WAR, WAR)
is a (unique) NE since this outcome is on the best-response function of each player.
(b)
R
J
(a
R
) =
_
if a
R
=
if a
R
=
and R
R
(a
J
) =
_
if a
J
=
if a
J
= .
There does not exist a NE for this game since there does not exist an outcome the
is on both best-response functions. That is, R
J
() = , but R
R
() = , but
R
J
() = , but R
R
() = , so R
J
() = , and so on.
2 Basic Concepts in Noncooperative Game Theory
(c)
R
(a
) =
_
B if a
= L
T if a
= R
and R
(a
) =
_
L if a
= T
R if a
= B.
A NE does not exist for this game since R
(L) = B, but R
(B) = R, but R
(R) =
T, so R
(T) = L, and so on.

2. (a) If (T, L) is a NE, then
(T, L) = a e =
(B, L), and
(T, L) = b d =
(T, R).
(b) If (T, L) is an equilibrium in dominant actions, then T has to be a dominant action
for player , that is
(T, L) = a e =
(B, L) and
(T, R) = c g =
(B, R);
and L is a dominant action for player , that is
(T, L) = b d =
(T, R), and
(B, L) = f h =
(T, R).
Let us observe that the parameter restrictions given in part (a) are also included in
part (b) conrming Proposition 2.1 which states that an equilibrium in dominant
actions is also a NE.
(c) i. (T, L) Pareto dominates (T, R) if (a c and b > d) or (a > c and b d);
ii. (T, L) Pareto dominates (B, R) if (a g and b > h) or (a > g and b h);
iii. (T, L) Pareto dominates (B, L) if (a e and b > f) or (a > e and b f).
(d) Loosely speaking, the outcomes are Pareto noncomparable if one player prefers (T, L)
over (B, R), whereas the other player prefers (B, R) over the outcome (T, L). For-
mally, either
(T, L) = a > g =
(B, R) but
(T, L) = b < h =
(B, R),
or
(T, L) = a < g =
(B, R) but
(T, L) = b > h =
(B, R).
3. (a) There are three Pareto optimal outcomes:
i. (n
1
, n
2
) = (100, 100), where
1
(100, 100) =
2
(100, 100) = 100;
ii. (n
1
, n
2
) = (100, 99), where
1
(100, 99) = 98 and
2
(100, 99) = 101;
iii. (n
1
, n
2
) = (99, 100), where
1
(99, 100) = 101 and
2
(99, 100) = 98;
(b) There is no NE for this game.
1
To prove this, we have to show that for every outcome
(n
1
, n
2
), one of the players will benet from changing his or her declared value. Let
us look at the following outcomes:
1
A typo in the question (rst printing) leads to this undesirable result (see Basu, K. 1994. The Travelers
Dilemma: Paradoxes of Rationality in Game Theory. American Economic Review 84: 391395; for a mechanism
that generates (2, 2) as a unique NE outcome).
Basic Concepts in Noncooperative Game Theory 3
i. If (n
1
, n
2
) = (100, 100), then player 1 can increase his or her payo to
1
= 101
by declaring n
1
= 99.
ii. If (n
1
, n
2
) = (99, 100), then player 2 can increase his or her payo from
2
= 98
to
2
= 99 by declaring n
2
= 99. Hence, players always benet from declaring
a value of one dollar lower than the other player, and so on.
iii. If (n
1
, n
2
) = (2, 2), then player 1 can increase his or her payo from
1
= 2 to
1
= 98 by declaring n
1
= 100.
4. (a) There are several NE outcomes for this game. For example, (LG, SM, SM) is a NE
outcome since
C
(LG, SM, SM) = =
C
(SM, SM, SM)
F
(LG, SM, SM) = = =
F
(LG, LG, SM)
G
(LG, SM, SM) = = =
G
(LG, SM, LG).
Hence, no rm nds it protable to unilaterally change the type of cars it produces.
(b) Again, there are several NE. The outcome (LG, SM, SM) is also a NE for this game,
and the proof is identical to the one given in part (a).
5. (a) There are three subgames: the game itself, and two proper subgames labeled JL
(for Jacob left) and JR (for Jacob right). The three subgames are illustrated in
Solution-Figure 2.1.
Rachel
Jacob
R
= 2
J
= 1

R
= 0
J
= 0

R
= 0
J
= 0

R
= 1
J
= 2
R
= 0
J
= 0

R
= 1
J
= 2
R
= 2
J
= 1

R
= 0
J
= 0
JL JR
Solution-Figure 2.1: Three subgames of the dynamic Battle of the Sexes
(b) One easy way to nd NE outcomes for an extensive form game is to construct a
normal-form representation.
2
However, the normal-form representation is already
given in Table 2.2. Also, equation (2.1) proves that the NE outcomes involve the
two players going together either to football or to the opera. Formally, it is easy to
verify that the following three outcomes constitute NE:
s
J
=
_
if s
R
=
if s
R
=
and s
R
= ,
2
This subquestion may confuse students who are already thinking in terms of backward induction. Since our
analysis is based on SPE you may want to avoid assigning this subquestion (only). Also, an instructor teaching
from the rst printing is urged to change this subquestion to nding the NE for the entire game only; hence, to
postpone nding the NE for the subgames to the next subquestion, where the NE of the subgames are used to
nd the SPE.
4 Basic Concepts in Noncooperative Game Theory
s
J
=
_
if s
R
=
if s
R
=
and s
R
= ,
s
J
=
_
if s
R
=
if s
R
=
and s
R
= .
(2.1)
(c) Using backward induction, we rst construct Jacobs strategy (which constitutes the
Nash equilibria for the two proper subgames). Looking at the proper subgames in
Solution-Figure 2.1, we conclude that
R
J
(a
R
) =
_
if a
R
= (subgame JR)
if a
R
= (subgame JL).
Now, we look for Rachels strategy (given Jacobs best response). If Rachel plays
a
R
= , then her utility is given by
R
(, R
J
()) = 1. In contrast, if Rachel plays
a
R
= , then her utility is given by
R
(, R
J
()) = 2 > 1. Altogether, the strategies
s
R
= a
R
= and R
J
(a
R
) =
_
if a
R
=
if a
R
=
constitute a unique SPE.
(d) No! Jacobs best response is to play whenever Rachel plays . Thus, Jacobs
announcement constitutes an incredible threat.
3
Clearly, Rachel, who knows Jacobs
best-response function in the second stage, should ignore Jacobs announcement,
since Jacob, himself, would ignore it if Rachel plays in the rst stage.
6. (a) Jacobs expected payo is given by:
E
J
(, ) = 2 +(1 ) 0 + (1 ) 0 + (1 )(1 ) 1
= 2 + 3 .
Rachels expected payo is given by:
E
R
(, ) = 1 +(1 ) 0 + (1 ) 0 + (1 )(1 ) 2
= 2 + 3 2 2.
(b) The players best-response functions are given by
R
J
() =
_
_
0 if < 1/3
[0, 1] if = 1/3
1 if > 1/3
and R
R
() =
_
_
0 if < 2/3
[0, 1] if = 2/3
1 if > 2/3.
The players best-response functions are drawn in Solution-Figure 2.2.
(c) Solution-Figure 2.2 demonstrates that (, ) = (2/3, 1/3) is a NE in mixed actions.
Also, note that the outcomes (0, 0) and (1, 1) are also NE outcomes in mixed actions
and are the same as the pure NE outcomes.
3
Instructors: Here is a good opportunity to discuss the concepts of credible and incredible threats.
Basic Concepts in Noncooperative Game Theory 5
1 1 1
1 1 1
1
3
R
R
() R
J
()
R
R
()
R
J
()
2
3
2
3
1
3
Solution-Figure 2.2: Best-response functions for the Battle of the Sexes in mixed actions
(d) Substituting (, ) = (2/3, 1/3) into the players payo functions (dened above)
yield
E
J
(2/3, 1/3) = E
R
(2/3, 1/3) =
2
3
.
(e) The best-response functions in Solution-Figure 2.2 intersect three times, meaning
that in the mixed extension game, there are two equilibria: the two pure NE outcomes
and one NE in mixed actions. In contrast, Figure 2.3 has only one intersection since
in that game NE in pure strategies does not exist, and therefore the best-response
functions intersect only once, at the NE in mixed actions.
Chapter 3
Technology, Production Cost, and Demand
This chapter summarizes the basic microeconomic tools the students need to know prior to
taking this class. My advice for the instructor is not to spend time on this chapter but simply
assign this chapter (with or without the exercises) as reading in the rst class. However, my
advice is to return (or refer) to this chapter whenever denitions are needed. For example, when
you rst encounter a discussion of returns to scale, I urge you to make a formal denition and
refer the students to Denition 3.2. Similarly, when addressing elasticity issues, students should
be referred to Denition 3.3.
1. (a) Let > 1. Then, by Denition 3.2, the technology exhibits IRS if
(l)
(k)
=
+
l
> l
,
which holds when + > 1. Using the same procedure and Denition 3.2, this
technology exhibit CRS if + = 1, and DRS if + < 1.
(b) In this technology, the factors are supporting since
MP
L
(l, k)
Q
l
= l
1
k
,
hence,
MP
L
(l, k)
k
= l
1
k
1
,
which is greater than zero under the assumption that , > 0.
2. (a) Let > 1. Then, by Denition 3.2, the technology exhibits IRS if
(l)
+ (k)
(l
+k
) > (l
+k
),
which holds if > 1. Similarly, the technology exhibits DRS if < 1, and CRS if
= 1.
(b) MP
L
(l, k) = l
1
. Hence, MP
L
(l, k)/k = 0. Therefore, the factors are neither
substitutes nor complements.
3. Let > 1. This (quasi-linear) technology exhibits DRS since
l +
k < l +
k = (l +
k).
4. (a)
AC(Q) =
TC(Q)
Q
=
F
Q
+c, and MC(Q) =
TC(Q)
Q
= c.
These functions are drawn in Figure 4.2 in the book.
8 Technology, Production Cost, and Demand
(b) Clearly, AC(Q) declines with Q. Hence, AC(Q) is minimized when Q = +.
(c) Declining average cost function reects an increasing returns to scale technology.
5. (a) Using Denition 3.3,
p
(Q)
Q(p)
Q
p
Q
= (1)
p
Q
=
99 Q
Q
.
Hence,
p
(Q) = 2 when Q = 33.
(b) From the above,
p
(Q) = 1 when Q = 99/2 = 49.5.
(c) The inverse demand function is given by p(Q) = 99 Q. Therefore, TR(Q) =
p(Q)Q = (99Q)Q. Hence, MR(Q) dTR(Q)/dQ = 992Q, which is a special
case of Figure 3.3.
(d) MR(Q) = 0 when Q = 49.5. That is, the marginal revenue is zero at the output
level where the demand elasticity is 1 (unit elasticity).
(e) Using Figure 3.5,
CS(33) =
(99 33)66
2
= 2178, and CS(66) =
(99 66)33
2
= 544.5
6. (a)
p
=
A
Q
. Hence, p = A
1
.
(b)
p
=
Q(p)
Q
p
Q
= A()p
1
p
Q
=
A()p
Ap
= .
Thus, the elasticity is constant in the sense that it does not vary with the quantity
consumed.
(c) The demand is elastic if
p
< 1, hence if > 1. The demand is inelastic if
1 <
p
0, hence if 0 < 1.
(d) By Proposition 3.3, MR = p[1 + 1/()]. Hence,
p
MR
= 1
_
1 +
1
=

1
which is independent of Q.
Chapter 4
Perfect Competition
A perfectly competitive market is characterized by nonstrategic rms, where rms take the
market price as given and decide how much to produce (and, whether to enter, if free entry is
allowed). Most students probably had some discussion of perfectly competitive markets in their
intermediate microeconomics class. However, given the importance of this market structure, I
urge the instructor to devote some time in order to make sure that the students understand
what price-taking behavior means.
It is now the right time to emphasize that, in economics, the term competitive refers to
price taking behavior of agents. For example, we generally assume that our consumers are
competitive, which means that they do not bargain over prices and take all prices and their
income as given. In a competitive market structure, we make a similar assumption about the
rms.
You may want to emphasize and discuss the following points:
1. The assumption of price taking behavior has nothing to do with the number of rms in the
industry. For example, one could solve for a competitive equilibrium even in the presence
of one rm (see an exercise at the end of this chapter). Note that this confusion often
arises since certain market structures yield market allocations similar to the competitive
allocation when the number of rms increases (see for example subsection 6.1.2 which
shows that the Cournot allocation may converge to the competitive allocation when the
number of rms increases to innity).
2. A major reason for studying and using alternative (noncompetitive) market structures
stems from the fact that the competitive market structure very often fails to explain
why concentrated industries are observed.
3. Another major reason for studying alternative market structures stems from the nonexis-
tence of a competitive equilibrium when rms technologies exhibit IRS.
Finally, note that this chapter does not solve for a competitive equilibrium under decreasing
returns to scale technologies for two reasons: (i) other market structures analyzed in this book
are also developed mainly for CRS (unit cost) technologies, and (ii) most students are familiar
with the DRS from their intermediate microeconomics class. However, the exercise at the end
of this chapter deals with a DRS technology.
1. Firm 1 takes p as given and chooses q
1
to
max
q
1
1
= pq
1
wL
1
= p
_
L
1
wL
1
.
10 Perfect Competition
The rst and second order conditions are given by
0 =
d
1
dL
1
=
p
2
L
1
w,
d
2
1
d(L
1
)
2
=
p
4L
3/2
1
< 0.
Hence, q
1
=
L
1
= p/(2w).
2. Given that there is only one rm, the supply equals demand equilibrium condition yields
that 120 p
e
= p
e
/2. Therefore, p
e
= 80; hence, q
e
1
= Q
e
= p
e
/2 = 40.
3. From the production function, we can nd the equilibrium employment level to be L
e
1
=
(q
e
1
)
2
= 1600. Hence,
1
= p
e
q
e
1
wL
e
1
= 80 40 1600 = 1600.
4. Given that the rms have the same technologies, they have the same supply functions.
Therefore, the supply equals demand condition becomes 120 p
e
= p
e
/2 + p
e
/2, which
yields p
e
= 60, Q
e
= 120 60 = 60, hence, q
e
1
= q
e
2
= 30.
5. Clearly, the competitive price is lower and the aggregate production is higher when the
industry consists of two rms.
6.
p p = 2q
1
q
1

p p = 2q
2
q
2

p p = q
1
+q
2
Q = q
1
+q
2
30 30 60
60

120
120
p = 120 Q
Solution-Figure 4.1: Competitive equilibrium with two rms
Chapter 5
The Monopoly
Most students encounter the monopoly problem in their intermediate microeconomics class.
However, the instructor would probably want to make sure that all students fully understand the
monopolys choice problem and the eect of price elasticity on the monopolys price, as well as
the arguments against monopoly (section 5.2). I also urge the instructor not to skip discussing
discriminating monopoly (section 5.3).
The remaining sections, the cartel (section 5.4), and the durable goods monopolies (sec-
tion 5.5) are more optional depending on the instructors tastes and students ability.
1. (a)
p

dQ
dp
p
Q
= ap
1
p
ap
= .
Hence, the exponential demand function has a constant price elasticity. By Propo-
sition 3.3,
MR(Q) = p
_
1 +
1
_
= p
_
1
_
.
(b) Equating marginal revenue to marginal cost yields
1
MR = p
M
_
1
_
= c = MC; hence, p
M
=
c
1
.
(c) As increases, the demand becomes more elastic, hence, the monopoly price must
fall. Formally,
dp
M
d
=
c( 1) c
( 1)
2
< 0.
(d) The rst edition (rst printing) contains a typo. The question asks what happens to
the monopolys price when +1. Clearly, p
M
+. The reason is, that when
= 1, the (entire) demand has a unit elasticity, implying that revenue does not vary
with price (or quantity produced). Hence, given that the revenue is constant (in
fact TR = a when = 1), then the prot maximization problem is reduced to cost
minimization which yields that the monopoly would attempt to produce as little
as possible (but still a strictly positive amount).
1
The instructor may want to emphasize to the students that in the case of constant-elasticity demand functions
(exponential demand functions) it is easier to solve for the monopolys price rst (using Proposition 3.3) and then
solve for the quantity produced by substituting the price into the demand function. This procedure becomes very
handy when solving monopolistic competition equilibria analyzed in section 7.2.
12 The Monopoly
(e) Inverting the demand function yields p(Q) = a
1/
Q
1/
. Thus,
TR(Q) p(Q)Q = a
1
Q
1
1
.
Hence,
MR(Q)
dTR(Q)
dQ
= a
1
_
1
1
_
.
(f) Equating marginal revenue to marginal cost yields
a
1
_
1
1
_
= c,
yielding that the monopolys prot maximizing output is
Q
M
= a
_
1
c
_
.
Note that the same result is achieved by substituting p
M
(calculated before) into the
demand function.
2. (a) Solution-Figure 5.1 illustrates an aggregate demand composed of the two groups of
consumers, where each group shares a common valuation for the product.
Q
p
V
H
V
L
n
H
n
H
+n
L
Solution-Figure 5.1: Aggregate demand composed of two consumer groups

(b) The monopoly has two options
2
: setting a high price, p = V
H
, or a low price,
p = V
L
. Solution-Figure 5.1 reveals that the prot levels (revenue since production
is costless
3
) are given by
|
p=V
H = n
H
V
H
, and |
p=V
L = (n
H
+n
L
)V
L
.
Comparing the two prot levels yields the monopolys prot maximizing price. Hence,
p
M
=
_
V
H
if V
H
> (n
H
+n
L
)V
L
/n
H
V
L
otherwise.
2
Instructors are urged to assign or discuss this exercise, since it provides a good opportunity to introduce the
student to a discrete (logic based) analysis which is used later in a wide variety of topics (see for example the
section on tying [section 14.1]).
3
The rst printing of the rst edition neglects to assume that production of G-Jeans is costless.
The Monopoly 13
Thus, the monopoly sets a high price if either there are many high valuation con-
sumers (n
H
is large) and/or these consumers are willing to pay a very high price
(V
H
is high).
3. (a) In market 1, p
1
= 2 q
1
. Hence, by Proposition 3.2, MR
1
(q
1
) = 2 2q
1
. Equating
MR
1
(q
1
) = c = 1 yields q
1
= 0.5. Hence, p
1
= 1.5.
In market 2, p
2
= 4 q
2
. Hence, by Proposition 3.2, MR
2
(q
2
) = 4 2q
2
. Equating
MR
2
(q
2
) = c = 1 yields q
2
= 1.5. Hence, p
2
= 2.5.
(b)
1
= (p
1
c)q
1
= (0.5)
2
= 0.25, and
2
= (p
2
c)q
2
= (1.5)
2
= 2.25. Summing
up, the monopolys prot under price discrimination is = 2.5.
(c) There are two cases to be considered: (i) The monopoly sets a uniform price p 2
thereby selling only in market 2, or (ii) setting p < 2, thereby selling a strictly positive
amount in both markets. Let us consider these two cases:
i. If p 2, then q
1
= 0. Therefore, in this case the monopoly will set q
2
maximize
its prot in market 2 only. By subquestion 3a above, =
2
= 2.25.
ii. Here, if p < 2, q
1
> 0 and q
2
> 0. Therefore, aggregate demand is given by
Q(p) = q
1
+q
2
= 2p+4p = 62p, or p(Q) = 30.5Q. By Proposition 3.2,
MR(Q) = 3 Q. Equating MR(Q) = c = 1 yields Q = 2, hence, p = 2.
Hence, in this case = (p c)2 = 2 < 2.25.
Altogether, the monopoly will set a uniform price of p = 2.5 and will sell Q = 1.5
units in market 2 only.
4
4. (a)
(q
1
, q
2
) = (100 q
1
/2)q
1
+ (100 q
2
)q
2
(q
1
+q
2
)
2
.
(b) The two rst order conditions are given by
0 =

q
1
= 100 q
1
2(q
1
+q
2
)
0 =

q
2
= 100 2q
2
2(q
1
+q
2
).
Solving for q
M
1
and q
M
2
yields that q
M
1
= 25 and q
M
2
= 12.5.
(c) Substituting the prot maximizing sales into the market demand functions yield
p
M
1
= p
M
2
= 87.5. Hence,
(q
M
1
, q
M
2
) = 87.5 12.5 + 87.5 25 (12.5 + 25)
2
= 1875.
(d) Now, that each plant sells only in one market, the two rst order conditions become
0 =

q
1
= 100 q
1
2q
1
0 =

q
2
= 100 2q
2
2q
2
.
4
Note that consumers in market 1 are better o under price discrimination than without it, since under no
discrimination no output is purchased in market 1. Given that the price in market 2 is the same under price
discrimination and without it, we can conclude that in this example, price discrimination is Pareto superior to
nonprice discrimination, since both consumer surplus and the monopoly prot are higher under price discrimination.
14 The Monopoly
yielding q
M
1
= 100/3 and q
M
2
= 25.
(e) p
M
1
= 100 100/6 = 250/3 and p
M
2
= 100 25 = 75. Hence,
=
1
(q
1
) +
2
(q
2
) =
250
3

100
3

_
100
3
_
2
+ 75 25 25
2
= 2917.
(f) This decomposition increases the monopolys prot since the technology exhibits
DRS.
5. By section 5.3, the discriminating monopoly will set quantities to satisfy MR
1
(q
M
1
) =
MR
2
(q
M
2
). Hence, by Proposition 3.3
MR
1
(q
1
) = p
M
1
_
1 +
1
2
_
= p
M
2
_
1 +
1
4
_
= MR
2
(q
2
).
Thus, p
M
1
= 1.5p
M
2
.
6. (a) We solve for the monopolys prot maximizing prices starting from the second period.
The second period outcome may depend on two cases:
First-period consumer does not buy in period 1: Clearly, in this case, the sec-
ond period prot maximizing price is p
2
= 50, yielding a prot level of
2
=
3 50 = 150.
First-period consumer buys in period 1: In this case the second period prot max-
imizing price is again p
2
2
= 2 50 = 100.
Altogether, the second-period price is independent of the action of the rst-period
buyer in the rst period. Therefore, the maximum price the monopoly can charge
the rst-period buyer in the rst period is p
1
= 150.
(b) The second period outcome may depend on two cases:
First-period consumer does not buy in period 1: In this case, the monopoly has
two choices: (i) charging p
2
= 20, and sell to all three consumers, thereby
earning a second period prot of
2
= 3 20 = 60; or, (ii) charging p
2
= 50,
and selling only to the second period consumers, thereby earning a second-period
prot of
2
= 2 50 = 100.
First-period consumer buys in period 1: In this case the second period prot max-
imizing price is again p
2
2
= 2 50 = 100.
Altogether, the second period price is independent of the actions of the rst-period
buyer. Now, in order to attract the rst-period buyer to purchase in period 1, the
monopoly should set p
1
= 40, thereby extracting all surplus from all consumers.
7. The two cases are illustrated in Solution-Figure 5.2.
(a) Equating marginal revenue to the tax inclusive unit cost yields a 2Q = c + t, or
Q
M
= (a c t)/2. Hence, p
M
= (a + c + t)/2. Now, checking the eect of a
tax rate change on the monopolys price yields that dp
M
/dt = 1/2 < 1. Hence, as
illustrated in Solution-Figure 5.2 (left), an increase in t raises the monopoly price by
less than t.
The Monopoly 15
Q
p
c
c +t
MR(Q)
a
Q
p
c
c +t
p
M
(c)
p
M
(c +t)
MR
D
D
p
M
(c +t)
p
M
(c)

Solution-Figure 5.2: How the monopoly price varies with a specic tax
(b) Using Proposition 3.3,
MR = p
M
_
1 +
1
2
_
= c +t, yielding p
M
= 2(c +t).
Now, checking the eect of a tax rate change on the monopolys price yields that
dp
M
/dt = 2 > 1. Hence, as illustrated in Solution-Figure 5.2 (right), an increase in
t raises the monopoly price by more than t.
Chapter 6
Markets for Homogeneous Products
The Cournot, Bertrand, and sequential moves market structures are essential for a further study
of industrial organization.
The important issues to discuss and emphasize are:
1. Market structures are assumed by the researcher rather than solved for. Specifying a
market structure is the same as specifying the rules of the game before predictions (e.g.,
equilibrium outcomes) are sought.
2. Cournot and Bertrand market structures select Nash equilibrium outcomes, where under
the Cournot game rms actions are the quantity produced, and in the Bertrand game
rms actions are prices.
3. Free entry versus a xed number of rms.
Self-enforcing collusion (section 6.5) is suited for more advanced students. Instructors may
want to go over repeated games (section 2.3) before covering self-enforcing collusion, however,
this topic is written in a way that enables the instructor to teach self-enforcing collusion even
without formally teaching repeated games. Instructors who choose to teach this topic may
want to emphasize that a trigger strategy is a function of the entire history of what each player
has played in earlier periods, including the players own earlier actions, and therefore provides
self-discipline which restricts the gains from deviation from the cooperative actions.
Finally, subsection 6.6.2 (preferential trade agreements) provides a good example to the law
of (no) second best, by showing that a partial removal of trade barriers need not be welfare
improving.
1. (a) By Lemma 4.1, both rms produce a nite amount of output only if p c
1
and
p c
2
. Hence, since c
2
> c
1
, if a competitive equilibrium exists then it must be
that p
e
c
1
. However, if p
e
< c
1
then both rms produce zero output, but at these
prices demand exceeds zero (since Q(c
1
) = c
1
> 0). Hence, if a competitive
equilibrium exists, then p
e
= c
1
. Therefore, q
e
1
= Q
e
= c
1
and q
e
2
= 0.
(b) Each rm i takes the output of its opponent, q
j
, as given and solves
max
q
i
i
= ( q
i
q
j
)q
i
c
i
q
i
, i, j = 1, 2, i = j,
yielding rst order conditions given by
0 =

1
q
1
= 2q
1
q
2
c
1
, and 0 =

2
q
2
= q
1
2q
2
c
2
.
18 Markets for Homogeneous Products
Solving the two equations for the two variables, q
1
and q
2
yields
q
c
1
=
2c
1
+c
2
3
, q
2
=
2c
2
+c
1
3
, and Q =
2 c
1
c
2
3
.
Then, p
c
= q
c
1
q
c
2
= ( +c
1
+c
2
)/3.
(c) From the rst order conditions of the previous subquestion we can immediately solve
for rm 2s best-best response function. Hence,
R
2
(q
1
) =
c
2
2

q
1
2
.
In a sequential-moves equilibrium, rm 1 (the leader) takes rm 2s best-response
function as given and chooses q
1
to
max
q
1
1
=
_
q
1
_
c
2
2

q
1
2
__
q
1
c
1
q
1
,
yielding the rst order condition
0 =

1
q
1
= 2q
1
c
2
2
+q
1
c
1
.
Therefore,
q
s
1
=
+c
2
2c
1
2
, q
s
2
=
3c
2
+ 2c
1
4
, and Q
s
=
3 c
2
2c
1
4
.
Hence, p
s
= ( +c
2
+ 2c
1
)/4.
(d) When rm 2 is the leader, by symmetry (replacing c
1
by c
2
and vice versa in the
previous subquestion) we can conclude that
q
s
2
=
+c
1
2c
2
2
, q
s
1
=
3c
1
+ 2c
2
4
, and Q
s
=
3 c
1
2c
2
4
.
Hence, p
s
= ( +c
1
+ 2c
2
)/4.
Comparing the two sequential-moves equilibria we see that (i) aggregate output
decreases when the less ecient rm (rm 2) moves before rm 1; (ii) price is higher
when rm 2 moves rst; (iii) the market share of the less ecient rm increases
when it moves before rm 1; (iv) the production of the more-ecient rm increases
when it moves rst; and (v) the market share of the more-ecient rm increases
when it moves rst.
(e) In a Bertrand equilibrium, the more ecient rm (rm 1) completely undercuts the
price set by rm 2. Assuming that money is continuous, rm 1 sets its price to
equal the unit cost of rm 2, thereby ensuring that rm 2 will not nd it protable
to produce any amount. Hence, we can approximate the Bertrand equilibrium by
p
b
1
= c
2
and p
b
2
= c
2
. Thus, q
b
1
= Q
b
= c
2
+ and q
b
2
= 0. Notice that
when the unit costs are not equal (the present case), the Bertrand equilibrium price
exceeds the competitive equilibrium price. Also, instructors should point out to the
students that this is not really a Nash-Bertrand equilibrium since the prot of rm 1
increases as decreases.
Markets for Homogeneous Products 19
2. (a) We rst focus on the problem faced by rm 1. In a Cournot market structure, rm 1
takes q
2
, q
3
, . . . , q
N
as given and chooses q
1
that solves
max
q
1
1
= (100 q
1
q
2
q
N
)q
1
F (q
1
)
2
.
The rst order condition is given by
0 =

1
q
1
= 100 2q
1
q
2
q
N
2q
1
.
Therefore, the best-response function of rm 1 is given by
q
1
= R
1
(q
2
, . . . , q
N
) =
100
N
j=2
q
j
4
.
Given that all rms have identical technologies (identical cost functions), we can
attempt to search for a Cournot equilibrium where all rms produce the same output
levels. That is, q
c
q
c
1
= q
c
2
= = q
c
N
. In this case,
q
c
= 25
(N 1)q
c
4
, or q =
100
N + 3
, hence, Q =
100N
N + 3
.
Therefore,
p
c
= 100
100N
N + 3
=
300
N + 3
, and
i
= p
c
q
c
F (q
c
)
2
=
20, 000
(N + 3)
2
F.
(b) Under free entry, rms enter as long as they make above normal prots. Entry stops
when a further entry generates a loss to rms. Hence, if we approximate the number
of rms, N, by a real number, under free entry all existing rms make zero prot.
Thus,
0 =
i
=
20, 000
(N + 3)
2
F, or N =
_
20, 000
F
3.
Thus, the (endogenously determined) number of rms in this industry declines with
the xed cost parameter F.
3. In the third period, rm 3 takes q
1
and q
2
as given and chooses q
3
to maximize its prot.
The solution to this problem yields rm 3s best-response function R
3
(q
1
, q
2
) which is
given in (6.8). Hence, using (6.8) we have it that
R
3
(q
1
, q
2
) =
120 c
2

q
1
+q
2
2
.
In the second period, rm 2 takes q
1
and R
3
( q
1
, q
2
) as given and chooses q
2
that solves
max
q
2
2
= [120 q
1
q
2
R
3
( q
1
, q
2
)]q
2
cq
2
.
The rst-order condition is given by 0 = d
2
/dq
2
= 60 q
1
/2 q
2
c/2. Therefore, the
best-response function of rm 2 is given by
R
2
(q
1
) =
120 q
1
c
2
.
In the rst period, rm 1 takes the best-response functions of rms 2 and 3 as given and
chooses q
1
that solves
max
q
1
1
= {120 q
1
R
2
(q
1
) R
3
[q
1
, R
2
(q
1
)]}q
1
cq
1
= {30 +
3c
4

q
1
4
}q
1
cq
1
.
The rst-order condition is given by 0 = d
1
/dq
1
= 30 c/4 q
1
/2. Therefore, solving
for q
s
1
, and then substituting into R
2
(q
s
1
), and then into R
3
[q
s
1
, R
2
(q
s
1
)] yields,
q
s
1
=
120 c
2
, q
s
2
=
120 c
4
, and q
s
3
=
120 c
8
.
Hence, Q
s
= q
s
1
+q
s
2
+q
s
3
= 7(120 c)/8 and p
s
= (120 + 7c)/8.
4. (a) Under zero production cost, all Bertrand equilibrium outcomes yield zero prots to
both rms. Thus the Bertrand outcome is p
b
1
= 0 and p
b
2
= 0.
(b) Well construct an equilibrium in trigger strategies where rms threat point is p
b
1
= 0
and p
b
2
= 0, respectively. Formally, let rm is price strategy, i = 1, 2, be given by
p
i
() =
_
10 as long as p
1
(t) = p
2
(t) = 10 for all t = 1, . . . 1
0 otherwise.
Now, if no rm deviates in any period, the present value of the sum of discounted
prot to each rm i is
i
= 5N/(1 ). If rm 1 deviates in period , then
1
= (10 )N + 0 10N (since eective period + 1 all rms revert to p
i
= 0).
Hence, deviation is not protable to either rm if 5N/(1 ) > 10N, or > 1/2.
(c) All Bertrand equilibria are of the form p
b
1
= 4 4 and p
b
2
= 4.
(d) We can reconstruct rms trigger strategies where we assume that the punishment
point is now p
b
1
= 4 and p
b
2
= 4. Since now rms have dierent prot functions, we
need to check protability from deviation by each rm separately.
Firm 1: In each period , if no rm deviates, the sum of discounted prots is
1
=
5N/(1 ). If rm 1 deviates in period , then its sum of discounted prot is
1
= 10N +4N/(1 ). Comparing the two prot levels shows that deviation
is not protable for rm 1 if > 5/6.
Firm 2: If no rm deviates, the sum of discounted prot is
2
= (N/2)(104)/(1
). If it deviates, then the sum of discounted prot is
2
= (10 4)N + 0.
Comparing the two prot levels reveals that deviation is not protable if > 1/2.
(e) Collusion is less likely to be sustained when one rm has a cost advantage over the
other because deviation by rm 1 (low cost) will leave it with a positive stream of
prot compared with a zero prot generated by deviation when the two rms have
an identical cost structure.
5. (a) Let p
A
k
denote the (tari inclusive) price consumers in country A pay for a unit of
import from country k, k = B, C. Therefore, under a uniform specic tari of $10
per unit of import, p
A
B
= 70 and p
A
C
= 50. Clearly consumers buy from country C,
and the government earns a revenue of $10 per unit. A FTA with country B reduces
p
A
B
to p
A
B
= 60 > 50 = p
A
C
. Hence, As consumers still purchase from country C
implying that this FTA is ineective and therefore does not alter As welfare.
(b) Now, a FTA with country B reduces p
A
B
to p
A
B
= 60 < 60.01 = p
A
C
. Hence, As
consumers switch to buying from country B and no tari revenues are collected. Note
that in this case the consumer price falls from p
A
C
= 60.01 to p
A
B
= 60 (a reduction
of 1 cent per unit of import). Hence, the FTA hardly changes consumer surplus.
However, in this case the government faces a large reduction in tari revenues due
to the elimination of a $10 tari per unit of import. Altogether, with the exception
of highly elastic demand, country A loses from the FTA.
6. (a) Clearly p
L
is a dominant action for each rm in the static one-shot game. Hence,
by Proposition 2.2, (p
L
, p
L
) is a unique NE for the one-shot game. Therefore, if a
SPE exists, it must yield that both rms charge p
L
.
We can derive the SPE directly by formulating the extensive form game which is
illustrated in Solution-Figure 6.1 (consider the rst two stages only).
p
L
p
H
p
H
p
L
p
L
p
H
Firm 1
Firm 2
1
= 70
2
= 70

1
= 120
2
= 0

1
= 0
2
= 120

1
= 100
2
= 100
p
L
1
= 70
2
= 70
Firm 1
(II.:)
(I.:)
(III.:)
Solution-Figure 6.1: Sequential price game: Meet the competition clause
From the gure, it is straightforward to conclude that the following prices constitute
a SPE:
p
2
=
_
p
L
if p
1
= p
H
p
L
if p
1
= p
L
and p
1
= p
L
.
(b) We now add a third stage to the game, where rm 1 commits to reduce its price to
rm 2s price whenever rm 2 charges p
L
. This third stage is (partly) illustrated at
the bottom of Figure 6.1. In this case, the SPE if given by
p
2
=
_
p
H
if p
1
= p
H
p
L
if p
1
= p
L
and p
1
= p
H
,
implying that the rms charge the industrys prot maximizing price and earn a prot
of 100 each.
7. Note that the answer for exercise 3 provides a solution for N = 3 rms, which intuitively
can be generalized to the N > 3 case. In addition, in what follows, I provide a formal
solution for this problem.
(a) Let q
s
i
denote the sequential-moves equilibrium output level produced by rm i,
i = 1, . . . , N. Dene Q
s

N
i=1
q
s
i
and Q
s
N
=

N1
i=1
q
s
i
, for i = 1, . . . , N where
Q
s
1
0 for i = 1.
Since there is no xed cost, there is no limit on the number of rms that will enter if
free entry is allowed. We therefore look at how the Nth rm decides on how much
to produce. Firm N solves
max
q
N
N
= (a Q
s
N
q
N
c)q
N
,
yielding q
s
N
= (a Q
s
N
c)/2.
Before we proceed to analyzing rm N 1, let us dene a
N
a Q
s
N
. Hence, it
can be veried that
a
N1
= a
N
+q
s
N1
for allN.
Firm N 1 knows what rm N will be producing and solves
max
q
N1
N1
=
_
(a Q
s
(N1)
q
s
N1
)
a
N
c
2
c
_
q
N1
=
[a
N
c]q
N1
2
=
[a
N1
q
N1
c]q
N1
2
.
Hence, q
s
N1
= (a
N1
c)/2.
Also, since a
N
= a
N1
q
s
N1
and a
N
= a
N1
q
s
N1
= (a
N1
+c)/2,
q
s
N
= (a
N
c)/2 = (a
N1
c)/4.
We now analyze rm N 2. Recall that a
N2
q
s
N2
= a
N1
. Also, recall that
q
s
N
+q
s
N1
= (1/2 + 1/4)(a
N1
c). Therefore, rm 2 solves
max
q
N2
N2
=
_
(a
N2
q
N2
)
3(a
N2
q
N2
c)
4
c
_
q
N2
=
[a
N2
q
N2
c]q
N2
4
.
The solution is q
s
N2
= (a
N2
c)/2. Hence, q
s
N1
= (a
N2
c)/4 and q
s
N
=
(a
N2
c)/8. Therefore,
q
s
N
=
a
N
c
2
, for all N.
In particular, for N = 1, a
1
= a Q
s
1
= a 0 = a. Thus, q
s
1
= (a c)/2.
Finally, since
q
s
N
=
_
1
2
_
k
q
s
Nk
, for all 0 < k < N,
we have it that
q
s
N
=
_
1
2
_
N1
q
s
1
=
1
2
N1
a c
2
=
a c
2
N
.
Altogether, the N-rm sequential moves equilibrium output levels are
q
s
i
=
a c
2
i
, for all i = 1, . . . , N.
(b) Aggregate output is given by
Q
s
=
i=1
Nq
s
i
= (a c)
_
1
2
+
1
4
+ +
1
2
N
_
.
Using the same arguments as in the proof of Lemma 9.2 (see mathematical appendix,
section 9.9), we can show that
1
Q
s
= (a c)
_
1
1
2
N
_
.
(c) As the number of rms increases, Q
s
a c (competitive output level). Hence,
p
s
c (the competitive price level).
1
The rst printing of the rst edition contains a typo in the specication of Q
s
in the question.
Chapter 7
Markets for Dierentiated Products
The rst section extends the market structures dened in Chapter 6 to markets with dierentiated
products. Using the two-brand environment enables us to analyze the dierence in market
outcomes generated by the Cournot and the Bertrand market structures, and to dene and
contrast the concepts of strategically substitutes and strategically complements best-response
functions.
Section 7.2 (somewhat more advanced) introduces the student to the endogenous determi-
nation of the variety of brands, and its application to the theory of international trade.
Location models (section 7.3), in particular the Hotelling model (subsection 7.3.1), are im-
portant for a further study of industrial organization. The linear city model is used several times
in the manuscript, for example, to distinguish between vertically and horizontally dierentiated
products (see section 12.2). Instructors should cover at least the Hotelling linear city model
which students always nd very intuitive and therefore very appealing. The existence proof
(Appendix, section 7.5) can be skipped. The instructor can demonstrate the parameter restric-
tions needed to ensure existence by imposing symmetric locations (a = b) into the conditions
of Proposition 7.6.
1. (a) The best-response functions are drawn in Figure 7.1 and are derived as follows:
max
1
R
1
(
2
) = 2 +
3
2
2
, or,
2
=
4
3
+
2
3
R
1
(
2
);
max
2
R
2
(
1
) = 1 +
1
2
1
.
1
R
1
(
2
)
R
2
(
1
)
8
1
0
4
3
14
Solution-Figure 7.1: Advertising best-response functions

26 Markets for Dierentiated Products
(b) The two best-response functions are upward sloping, hence strategically comple-
ments.
(c) Solving for a NE yields
N
1
= 14 and
N
2
= 8. The rms prot levels in a NE are:
1
= 14
2
and
2
= 8
2
.
2. (a) Given a low reservation price (a low B), well attempt to nd a monopoly equilibrium
where not all the market is served. Figure 7.2 illustrates the location of the two
indierent consumers, one on each side of the rm. The indierent consumer (on
0 1
1
2
1
2
+a
1
2
a
2a

Solution-Figure 7.2: Single-rm location model
each side) is determined by the reservation utility, that is, B a p = 0, or,
a = B p. Hence, the monopoly chooses p that solves
max
p
= p2a = 2p(B p).
The solution is given by
p
M
=
B
2
, a =
B
2
, and
M
= 2pa =
B
2
2
.
Now, it is easy to verify that 0 < B < 1 implies that 0 < a < 1/2, hence, not all
the market is served.
(b) When substituting B > 1 into the solution for a found in the previous subquestion,
we get that the indierent consumers lie outside the city. This implies that for
B > 1, the monopoly can increase the price and still having the entire street purchase
the product. Thus, the monopoly will pick the highest possible price subject to having
the consumers living at the edges of town purchase the product. Formally, set p to
satisfy B 1/2 p = 0. Hence,
p
M
= B
1
2
, a =
1
2
, and
M
= B
1
2
.
3. (a) The indierent consumer, denoted by x, must satisfy
x 1 +p
1
= (1 x) R +p
2
.
Hence,
x =
R +p
2
p
1
1 +R
.
(b) Substituting p
1
= p
2
yields x = R/(1 +R). Hence,
lim
R
x = lim
R
R
1 +R
= 1.
Markets for Dierentiated Products 27
Therefore, all the consumers will eat in restaurant 1 (i.e., x = 1) only if the trans-
portation cost for traveling to the east is innite. Otherwise, some consumers will
always eat at restaurant 2.
4. From (7.24), we can dene the location of the indierent consumer, x, by the implicit
function:
F(p
A
, p
B
) p
A
p
B
+( x a)
2
( x L +b)
2
= 0.
Firm A chooses p
A
that solves max
p
A

A
= p
A
x subject to x satisfying F(p
A
, p
B
) = 0.
The rst-order condition is given by
0 =
d
A
dp
A
= x +p
A
x
p
A
= x +p
A
_
F
p
A
F
x
_
= x
p
A
2(L a b)
.
Similarly, rm B chooses p
B
that solves max
p
B

B
= p
B
(L x), yielding a rst-order
condition given by
0 =
d
B
dp
B
= L x p
B
x
p
B
= x +p
B
_
F
p
B
F
x
_
= L x
p
B
2(L a b)
.
(a) Under a = b, we search for a symmetric solution. Substituting a = b and x = L/2
into rm As rst-order condition (or Bs rst-order condition) yields that
p
A
= p
B
= L(L 2a).
Note that p
A
= p
B
0 when a 1/2, reecting the fact that prices drop to zero
when the two brands become homogeneous.
(b) We now investigate the total eect of varying the location of rm A (varying a) on
the prot of rm A.
1
Using the two rst-order conditions, we have it that p
A
= 2(L a b) x and
p
B
= 2(L a b)(L x). Substituting into the function F(, ) = 0 yields
F(, ) = 2(L a b)(2 x L) +( x a)
2
( x L +b)
2
= 0.
Using the implicit function theorem, we have it that
x
a
=
(2 x L) 2( x a)
2(L a b) + 2( x a) 2( x L +b)
=
x=1/2
a=b
1
4
.
Now, using As rst-order condition, we can express As prot by
A
= p
A
x =
2(L a b)( x)
2
. Therefore,
d
A
da
< 0 whenever ( x)
2
+ (L a b)2 x
1
4
< 0,
which always hold since L 2a < L. Hence, rm A increases its prot by moving
toward point 0. Similarly, rm B increases its prot by moving toward point L.
1
This problem may be too dicult for most undergraduate students since it involves deviating from the
symmetric solution.
Chapter 8
Concentration, Mergers, and Entry Barriers
This chapter contains four major topics: How to measure concentration; merger and merger
guidelines; entry barriers; and entry deterrence. I urge the instructor not to skip the discussion
of concentration measures (section 8.1) and the appendix on merger regulations and guidelines
(section 8.6).
Regarding all other topics, the instructor will nd a wide variety of models to choose from.
Most of the topics are logical and require minimum calculations and very little calculus (if
any).
1
Finally, note that you can combine the topic of double monopoly markup, analyzed
under the topic of dealership (subsection 14.3.1), with the analysis of vertical integration given
in subsection 8.2.2.
1. (a) I
4
= 20 + 20 + 20 + 10 = 70.
(b) I
HH
= 4 10
2
+ 3 20
2
= 1, 600.
(c) i. After the merger of rms 1 and 2, I
HH
= 20
2
+ 10
2
+ 10
2
+ 3 20
2
= 1, 800.
ii. I
HH
= 1, 800 1, 600 = 200.
iii. The merger may be challenged by the FTC or the Justice Department since the
postmerger I
HH
exceeds 1, 000 and I
HH
= 200 > 100.
2. (a) The solution for a Cournot equilibrium with N rms is given in (6.9) and (6.10).
Substituting c = 0 (zero production cost) and N = 3 yields q
c
i
= 25 and
c
i
= 625,
i = 1, 2, 3.
(b) Substituting N = 2 into (6.10) yields
1
=
4
= 1111.111 . . ..
(c) Since rms 2 and 3 split the prot from the merged rm,
2
=
3
=
4
/2 = 555 <
625. Hence, rms 2 and 3 lose from this merger whereas rm 1 gains.
(d) A merger into a monopoly cannot reduce aggregate prot, simply because a monopoly
can always mimic the same production pattern of any oligopoly. To see this, sub-
stituting N = 1 into (6.10) yields a monopoly prot of
M
= 2500. Hence,
i
= 2500/3 = 833
1
3
> 625 > 555. Thus, the prot per rm is the highest
under the monopoly market structure (cartel).
(e) The dierence between the two mergers is as follows: When two out three rms
merge, competition is reduced to a duopoly; however, the extra aggregate industry
prot generated from the change in the number of rms is equally divided between
1
Subsection 8.4.2 can be presented using diagrams only. However, the rst printing of the rst edition lacks a
justication why rm 1s (high and low) best-response functions do not shift with a change in

k. In the second
printing I intend to add an appendix at the end of this chapter which derives both best-response functions. Also,
note that the equilibrium rst-period capital level in Figure 8.7 is

k
3
and not

k
2
as wrongly stated in the rst
printing.
30 Concentration, Mergers, and Entry Barriers
the two unmerged groups of rms. Thus, this share of the change in aggregate
industry prot is lower than the prot each rm makes under the triopoly.
In contrast, merging into a monopoly can only increase prot since a monopoly can
always produce like a duopoly, and under monopoly, all industry prot is equally
divided between the three rms.
3. (a) We look for a Nash equilibrium in prices.
2
The X-seller takes p
Y
as given and solves
max
p
X
X
= p
X
Q = p
X
( p
X
2p
Y
), yielding p
X
=

2
p
Y
.
The Y -seller takes p
X
as given and solves
max
p
Y
Y
= p
Y
2Q = 2p
Y
( p
X
2p
Y
), yielding p
Y
=
p
X
4
.
Hence,
p
N
X
=

3
, p
N
Y
=

6
, p
N
S
=
2
3
, Q
N
=

3
,
N
X
=
N
Y
=

2
9
.
(b) We dene a system as one unit of X bundled with two units of Y . Then, the merged
rm chooses a system price p
S
that solves
max
p
S
S
= p
S
( p
S
) yielding p
S
= Q
S
=

2
, and
S
=

2
4
.
(c) To make a welfare judgment on the gains from this merger it is sucient to compare
prices and prot levels. Before the merger, the price of one system is p
0
S
= p
X
+
2p
Y
= 2/3 > /2 = p
1
S
which is the price after the merger. Also, before the
merger, aggregate prot is
X
+
Y
= 2
2
/9 <
2
/4 =
1
S
which is the prot after
the merger takes place. Since the system price falls and industry prot increases, the
merger is welfare improving.
4. In view of Denition 8.1, Figure 8.1 shows that the pair (p
I
, q
I
) = (20, 10) constitutes a
contestable-market equilibrium.
Formally, the (incumbents) industry conguration (p
I
, q
I
) = (20, 10) is feasible since
demand equals supply and the incumbent makes a nonnegative prot. It is also sustainable
since no potential entrant can undercut the incumbents price while making a positive
prot.
2
A typo in the rst printing of the rst edition: the question should state that Q = x = y/2.
Concentration, Mergers, and Entry Barriers 31
q
I
p
I
20
10
p = 60 4Q
AC(q
I
) =
100
q
+q
Solution-Figure 8.1: Contestable-markets equilibrium

Chapter 9
Research and Development
Most of the topics in this chapter are not technically demanding (and less tedious in terms
of technical derivations). The classications of process innovation (section 9.1) uses only de-
mand and supply diagrams. Innovation race (section 9.2) relies on simple discrete probability
calculations. Cooperation in R&D (section 9.3) relies on a Cournot market structure in the
second stage and a Nash equilibrium in R&D in the rst stage. The calculation of the optimal
patent life (section 9.4) does not reach a closed-form solution. However Figure 9.3 enables the
instructor to explain the cost and benet of the patent system without performing any calcu-
lations. Then, the instructor can simply reproduce the government-innovation two stage game
and demonstrate how to build the social welfare function for calculating the optimal patent
life. Licensing of innovation (section 9.5) uses supply and demand analysis. The international
analysis (section 9.6) is divided into a simple matrix game of product innovation and a two stage
subsidy Cournot game of process innovation. Finally, the appendix sections discuss patent law
and R&D joint ventures (sections 9.7 and 9.8) and can be assigned as homework reading.
1. Using Denition 9.1, innovation is major if the monopoly price is below the initial unit
cost; that is if p
M
< c
0
. Innovation is minor if p
M
> c
0
. To nd p
M
, the monopoly solves
MR(Q
M
) = a 2Q
M
= c
1
= 2c
0
a. Therefore, the monopolys prot maximizing
output is Q
M
= a c
0
. Hence, p
M
= c
0
. Therefore, according to Denition 9.1 the
present innovation is neither major nor minor.
2. (a) The expected prot of a rm engaged in R&D, given that the other two rms are
also engaged in R&D, is the prize times the sum of the probability that the rm
discovers while the other two do not, plus twice the probability that it discovers
while one competing rm discovers and one does not, plus the probability that all
the three discover simultaneously, minus innovation cost. Formally, for each rm i,
i = 1, 2, 3,
E
i
=
1
2
1
2
1
2
V +
1
2
1
2
1
2
V
2
(2) +
1
2
1
2
1
2
V
3
I =
7V
24
I.
Thus, all the three rms nd it protable to engage in R&D if V > 24I/7 = 24/7
(since I = 1).
(b) The now single rm can operate zero, one, or two labs.
Operating a single lab: In this case, E|
1 lab
= V/2 I.
Operating two labs: In this case, the probability of discovery is one minus the
probability that none of the labs discovers. Thus,
E|
2 labs
=
_
1
1
2
1
2
_
V 2I =
3V
4
2I.
34 Research and Development
Now, E|
2 labs
> E|
1 lab
if V > 4I, which constitutes a sucient condition for
having the rm choosing to operate two labs.
3. (a) The probability that a rm does not discover is (1 ). Hence, the probability that
none of the n rms discovers at a particular date is (1 )
n
.
(b) Clearly, one minus the probability that none discovers. Hence, 1 (1 )
n
.
(c) Similar to the derivation given in (9.5),
ET(n) = [1 (1 )
n
] 1 + (1 )
n
[1 (1 )
n
] 2
+ (1 )
2
n[1 (1 )
n
] 3 + (1 )
3
n[1 (1 )
n
] 4 +
Therefore,
ET(n) = [1 (1 )
n
]
t=1
[(1 )
n
]
t1
t
(Lem 9.1)
=
1 (1 )
n
[1 (1 )
n
]
2
=
1
(2 )
.
4. (a) If the EC provides Airbus with a subsidy of 10 (contingent on developing the megacar-
rier, then Airbus dominant action is to develop.
(b) If the U.S. government provides Boeing with a subsidy of 10 (contingent on devel-
oping the megacarrier, then Boeings dominant action is to develop. Note that this
U.S. subsidy is independent whether the EC provides Airbus with a subsidy of 10 or
15.
(c) None! After the EC subsidy to Airbus is implemented, Airbus dominant action is to
develop (hence, independent of the U.S. subsidy to Boeing).
(d) Like any other welfare argument in economics, there are pros and cons to having
both governments subsidizing the development of the new megacarrier. Arguments
against the subsidies include (i) duplication of R&D which require twice the amount
of resources needed to develop and test the plane, (ii) the government may not
possess the means to determine whether the benets from the development to their
own economy dominate the cost, (i.e., economists generally believe that the private
sector can collect more accurate information), and (iii) income distribution eects;
that is, some economists claim that the development of the Concord by some EC
countries constitute a net transfer from poor to rich people, since most poor and
middle-class people do not get to y in the Concord.
Arguments for the subsidy include the introduction of more competition between
aircraft manufacturers that would reduce aircraft prices, boost the airline industry,
and may therefore increase the amount of travel.
Chapter 10
The Economics of Compatibility and Standards
The introduction to this chapter provides some basic terminology and a simple Battle of the
Sexes game of product standardization, which can be taught to the less technically procient
students. The behavior of a monopoly telephone company under network externalities (Sub-
section 10.1.1) uses very simple calculus (basically one rst-order condition). The remainder of
section 10.1 is devoted to a simple discrete (noncalculus) standardization-variety tradeo model.
The remaining two sections, the supporting services approach (section 10.2) and the compo-
nents approach (section 10.3) are somewhat more dicult despite the fact that no calculus is
used. In particular, whereas the components approach model is very simple, some students may
get confused because of the existence of multiple equilibria under incompatibility, in which case,
the instructor may want to construct only one equilibrium and compare it to the equilibrium
under compatible systems.
The important points to emphasize are:
A network externality is a particular type of a consumption externality, where a consumers
utility is aected by the number of consumers purchasing the same brand. Thus, network
externalities constitute an assumption about consumer preferences.
The supporting services and the components approaches do not assume any externality.
The network eects, where the utility of a consumer is aected by the brand choices of
other consumers is an equilibrium result (rather than an assumption).
1
Thus, the network
eects are generated by having hardware and software (or other types of hardware) treated
as perfect complements.
Unfortunately, the two exercises cover only the supporting services and the components ap-
proaches. In future printings/editions, I intend to add two exercises covering the two topics
analyzed in the network externalities section.
1. (a) Firm A gains control over the entire market when

= 1. In this case, by (10.10),
p
B
has to be suciently high to satisfy
1 =

=
Y p
A
2Y p
A
p
B
, or p
B
= Y.
(b) i. Let

denote the market share for rm A after income has doubled from Y to
2Y . Then, by (10.10) we have that
=
2Y p
A
p
B
4Y p
A
p
B
>

=
Y p
A
p
B
2Y p
A
p
B
1
Some authors use the term indirect network externalities to describe the behavior generated by the supporting
services and the components approaches. I feel that this term was poorly chosen since externalities are either
assumed or not assumed at all, and therefore the term indirect cannot be used to describe models that do not
explicitly assume any externality.
36 The Economics of Compatibility and Standards
if p
A
> p
B
. This result can also be demonstrated by dierentiating

with
respect to Y , yielding
d
dY
=
p
A
p
B
(2Y p
A
p
B
)
2
> 0 if p
A
> p
B
.
Thus, the rm with the lower market share increases its market share when
consumer income rises.
ii. Since

increases, by (10.9) N
A
/N
B
must increase.
2. (a) Potential equilibria can be classied into two types: (i) Firm A sells to consumers AA,
and AB; and rm B sells to BB and BA (alternatively, Firm A sells to consumers
AA, and BA; and rm B sells to BB and AB). (ii) Firm A sells to AA, AB, and
BA; whereas rm B sells to BB only (alternatively, rm A sells to AA only, whereas
rm B sells to BB, AB, and BA).
In what follows we will demonstrate, by a way of contradiction, that both types of
equilibria do not exists.
i. Under this type, p
I
A
= p
I
B
since consumers AB and BA are indierent between
systems AA and BB as long as the prices are equal. However, this prices
cannot support a Bertrand-Nash equilibrium since rm A can increase its prot
by undercutting rm B by charging p
A
= p
I
B
which will cause consumer BA
to switch to system AA (this is the usual Bertrand undercutting argument).
ii. Under this type, we must have that p
I
B
= p
I
A
+ 2 (otherwise rm B is not
maximizing its prot). However, since consumers reservation utility is zero, see
equation (10.12), equilibrium prices must satisfy p
I
B
2, hence, p
I
A
= 0 and
I
A
= 0. However, rm A can always increase its prot by raising its price by
thereby making strictly positive prot.
(b) Following the proof of Proposition 10.14, it can be established that there exists an
equilibrium in which each consumer buys his or her ideal system. In this equilibrium,
p
x
A
= p
y
A
= p
x
B
= p
y
B
= , and
c
A
=
c
B
= 4.
Chapter 11
Advertising
From a technical point of view, the analyses given in this chapter are pretty much straight
forward, perhaps, with the exception of the calculation of the socially optimal level of persuasive
advertising given in equation 11.13, where an integral is computed. The appendix describing
advertising regulations can be assigned as a home reading.
1. (a) Since
A
=
%Q
%A
= 0.05, and
p
=
%Q
%p
= 0.2,
then by the Dorfman-Steiner condition (Proposition 11.1), we have that the prot
maximizing ratio of advertising to revenue is
A
M
pQ
M
=

A
p
=
1
4
.
Hence, A
M
= $2.5 mil..
(b) Now,
p
= 0.5. Therefore A
M
= 10 0.05/0.5 = $1 mil..
(c) When the demand becomes more price elastic, the monopoly reduces the ratio of
advertising expenditure to revenue.
2. (a) A
= A
= 1 implies that n
= n
= 3, hence,
=
b
= 30 1 = 29.
When A
= A
= 2, we have it that n
= n
= 3, hence,
=
b
= 30 2 = 28.
Conclusion: if both rms spend the same amount on advertising, then industry prot
is maximized at A
= A
0. That is, advertising in this city serves as a mean by

which each rm attracts consumers from the competing rm, but cannot increase
industry sales beyond the level determined by zero advertising.
(b) Fortune teller takes A
as given and chooses A
to maximize his or her prot.

The rst-order condition is given by
0 =

=
30A
(A
)
2
1.
The second-order condition can be easily veried. Hence, A
= R
(A
) =
30A
.
By symmetry, A
= R
(A
) =
_
30A
. The two best-response functions are drawn

in Solution-Figure 11.1.
(c) Solution-Figure 11.1 illustrates that the two best response functions intersect twice,
reecting the fact that there exist two Nash equilibria for this advertising game. For
the purpose of this question, we dene 0/0 (yes, zero divided by zero) as equal to 1.
38 Advertising
............................... .
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
.
A
0 30
30
R
(A
)
R
(A
Solution-Figure 11.1: Fortune tellers advertising best-response functions

Then, clearly A
= A
= 0 constitutes one NE. To obtain the other NE, substituting

R
(A
) into R
yields A
=
_
30
_
30A
. Hence, A
N
= A
N
= 30 which is also
illustrated in Solution-Figure 11.1.
(d) In the interior NE,
N
i
(30, 30) = 30 30 = 0, i = , , which is lower than
N
i
(1, 1) = 29. Thus, the industrys prot is not maximized at the interior NE. How-
ever, at the other NE, industrys prot is maximized and each rm earns
N
i
(0, 0) =
30.
(e) The interior NE (30, 30) is stable. The interior NE (0, 0) is unstable since any
unilateral deviation by one of the rm would trigger a sequential chain of responses
that would move the advertising equilibrium to (30, 30) (see Solution-Figure 11.1
for an illustration). Thus, in this example, the NE that maximizes industry prot is
unstable.
3. In order for (I, P) to constitute a NE outcome, we need to show that unilateral deviation
is not protable for each rm. That is, using Table 11.1,
2
(I, P) = N
1
(I, I) = (1 )E when 1 N/E;
1
(I, P) = E
1
(P, P) = N/2 when N/(2E).
Chapter 12
Quality, Durability, and Warranties
This is a long chapter with a wide variety of topics dealing with supply and demand for quality.
The analyses are pretty much straight forward and do not require any preparation with the
exception of section 12.2 that relies on the knowledge of location models developed in Chapter 7.
Other sections use only simple calculations of expected values. The appendix on the legal
approach to liability (section 12.8) may be assigned as a home reading.
An Alternative Model for Section 12.6
The model suggested below provides some improvement as it assumes that consumers are ex-
pected utility maximizers (similar to what is assumed in Section 12.5).
1
Suppose that consumers
believe that the monopoly is a high-quality producer with probability , and a low-quality pro-
ducer with probability 1 , where 0 < < 1. Then, without any additional information,
EU = H + (1 )L p. Therefore, the maximum price that consumers are willing to pay is
p = H +(1 )L. Then a low-quality producer could set the price at p, and make a prot of
( p c
L
) 1 = H + (1 )L c
L
= H + (1 )L c
L
> 0. ()
The price and quantity pair in Proposition 12.10 should be modied to
p
m
= H and q
m
=
H + (1 )L c
L
H c
L
.
Had the monopolist been a low-quality producer, he or she could have made the same prot by
setting p and selling to all consumers [as is indicated in (*)] rather than setting p = p
m
and
q = q
m
. Therefore, in choosing this price-quantity pair the monopolist could signal his or her
quality to the consumers. Finally, since H > L > c
H
> c
L
,
(H c
H
)
H + (1 )L c
L
H c
L
> H + (1 )L c
H
= ( p c
H
) 1.
Hence, the high-quality monopoly would indeed nd it protable to signal its high quality to the
consumers.
1
I thank Keiichi Koda for proposing this improvement.
40 Quality, Durability, and Warranties
1. (a) Using the utility function (12.2) and the zero reservation utility assumption, the
consumer who is indierent between purchasing from A and not purchasing at all
must satisfy U
z
(A) = az p
A
= 0, yielding z = p
A
/a.
(b) Follows directly from (12.4).
(c) For a given p
B
, rm A chooses p
A
to
max
p
A
A
= p
A
_
p
B
p
A
b a

p
A
a
_
, yielding 0 =
p
B
2p
A
b a

2p
A
a
.
For a given p
A
, rm B chooses p
B
to
max
p
B
B
= p
B
_
1
p
B
p
A
b a
_
, yielding 0 = 1
2p
B
p
A
b a
.
Second-order conditions are easily obtained. Solving the two rst-order conditions
yield the equilibrium prices. Substituting into the prot functions yield the equilibrium
prot levels.
(d) We rst verify that given b
e
= 1, the prot maximizing location of rm A is a
e
= 4/7.
Thus, given b
e
= 1, rm A chooses a
e
to
max
a
a
=
a(1 a)
(4 a)
2
, yielding a
e
=
4
7
.
We now verify that given a
e
= 4/7, rm B would choose to locate on the east edge
of the street.
2
For a given a
e
rm B chooses b
e
to maximize
B
which is given
above. We would like to show that for a
e
= 4/7,
0 <

B
(4/7, b)
b
49b
2
21b + 8 (b).
To demonstrate this inequality, we need to prove that (b) > 0 for all b [0, 1].
Clearly
(b) = 98b 21, which is negative for 0 b < 21/98 and positive for
b > 21/98. Hence, the function hits a minimum at b = 21/98. Now, (21/98) =
5.75 > 0. Hence (b) =
B
/b > 0 for all b [0, 1] implying that rm B would
locate at b
e
= 1.
2. Let U
i
(k) denote the utility of consumer i when he buys the brand with quality k, k = H, L
and i = 1, 2. We want to show that
U
2
(L) = L(I
2
p
L
) > H(I
2
p
H
) = U
2
(H).
From (12.1), we have it that since consumer 1 buys the low-quality brand, then
U
1
(L) = L(I
1
p
L
) > H(I
1
p
H
) = U
1
(H).
Therefore,
(H L)I
1
< Hp
H
Lp
L
.
Now, since I
2
< I
1
by assumption, (HL)I
2
< Hp
H
Lp
L
, implying that H(I
2
p
H
) <
L(I
2
p
L
).
2
Many students will nd this part of the proof to be dicult.
Quality, Durability, and Warranties 41
3. Under these prices, we seek to characterize the demand and supply patterns of our agents.
3
New buyers (who do not yet own a car): Recalling our assumption that N
L
= U
L
=
0, if a new buyer buys a new car, then his or her expected utility is V
b
= 0.5N
G
+0.5N
L
p
N
= 0. In contrast, if a new buyer buys a used car then V
b
= 0.5U
G
+0.5U
L
p
U
> 0.
Hence, under the assumed prices, new buyers buy used cars.
Good-used-car sellers: The question simply assumes that good-used-car owners must
leave the country and therefore sell their good-used cars.
Lemon-used-car sellers: If a lemon-used-car seller sells his or her lemon and buys a new
car, then V
s,L
= 0.5N
G
p
N
+ p
U
= p
U
. In contrast, if she or he buys a used car then
V
s,L
= 0.5U
G
p
U
+ p
U
= 0.5U
G
. By assumption p
U
< 0.5U
G
, hence, lemon-used-car
sellers buy (and sell) used cars.
Altogether, under the assumed prices, nobody buys a new car.
4. (a) The monopolys production cost is the initial production cost plus the expected (as
most once) replacement cost, which is equal to c + (1 )c = (2 )c.
(b) The maximum monopoly price is the expected consumer surplus from purchasing
this product with this type of warranty. This surplus equals V if the product does
not fail at all and if the product fails only once (in which case it is replaced). The
probability of a double failure is (1 )
2
. Hence, the probability of no double failure
is 1 (1 )
2
= (2 ). Therefore, p
M
= (2 )V .
(c) If the monopoly provides this warranty, then
W
= (2 )V (2 )c = (2
)(V c). If the monopoly sells with no warranty, then
NW
= V c. Hence,
W
>
NW
since it is assumed that V > c. Thus, the monopoly will bundle the
product with this warranty.
3
The purpose of this question is demonstrate that used cars are traded when some good-used-car owners are
forced to sell their car, say, because they leave the country. Note: If you are using the rst printing of the rst
edition, change the last sentence in this question to . . . the four types of agents. . . .
Chapter 13
Pricing Tactics: Two-Part Tari and Peak-Load Pricing
The analyses given in this relatively short chapter rely mainly on logical arguments and therefore
do not require any special technical preparation. Section 13.4 presents an attempt to endogenize
the seasons in determining prot maximizing peak-load pricing, and therefore may be given a
lower priority in case the instructor is short of time.
1
1. (a) The two cost functions are drawn in Solution-Figure 13.1.

k (# copies)
$
TC(k) = 0.05k
TC(k) = 300 + 0.02k
k
300
Solution-Figure 13.1: The cost of photocopying with or without two-part tari
(b) The number of copies yielding identical cost under the two payment systems is found
by equating 0.05
k = 300 + 0.02
k. Therefore,

k = 10, 000 copies. Thus, for k >

k,
the two-part tari system is less costly, and for k <

k, the xed-per-unit price system
is less costly.
2. (a) By Proposition 13.4, to nd the prot maximizing pricing structure we need (i) to
equate the high-season marginal revenue to the cost of an aircraft seat plus the
per-passenger cost, and (ii) to equate the low-season marginal revenue to the
per-passenger cost only.
Given that the Summer demand curve lies completely below the Winter demand
curve, we can conclude that Winter is the high season. However, since the two
demand curves are relatively close, we need to be careful about the capacity con-
straint determined by the Winter condition.
In the Winter, capacity is determined by having the monopoly equating
MR
W
(q
W
) = 10 2q
W
= r +c = 2, and MR
S
(q
S
) = 5 q
S
= c = 1.
1
If you are using the rst printing of the rst edition note that the calculations of consumer surplus in
section 13.2 are wrong. Ask for the errata le by e-mail.
44 Pricing Tactics: Two-Part Tari and Peak-Load Pricing
The rst equality implies that q
W
= 4, hence, p
W
= 6. The second equality implies
that q
S
= 4, hence, p
S
= 3. Altogether,
I
= 6 4 + 3 4 2 4 1 4 = 24.
(b) Similar to the previous subquestion, the monopoly equates
MR
W
(q
W
) = 10 2q
W
= r +c = 4, and MR
S
(q
S
) = 5 q
S
= c = 1.
The rst equality implies that, q
W
= 3, hence, p
W
= 7. The second equality implies
q
S
= 4 > 3 = q
W
. Hence, due to the capacity constraint, the airline will y only
3 passengers during the Summer season. Thus, p
S
= 5 3/2 = 3.5. Altogether,
I
= 7 3 + 3.5 3 4 3 1 3 = 16.5.
Chapter 14
Marketing Tactics: Bundling, Upgrading, and Dealerships
This chapter introduces several topics related to prot enhancing marketing tools that were not
discussed (at least not in full) in earlier chapters.
1. (a) Under pure tying, we need to check two options: (i) Under p
T
= 4, all three con-
sumers buy the packages, hence,
T
(4) = 3 4 = 12. (ii) Under p
T
= 10, only
consumer 2 buys a package, hence,
T
(10) = 10. Clearly, the rst option maximizes
the prot under pure tying.
(b) The prot maximizing product and package prices are p
MT
X
= p
MT
Y
= 4 and p
MT
=
8. Under this price structure, consumer 1 buys one unit of X, consumer 3 buys one
unit of Y and consumer 2 buys the package (or one unit of each good). Altogether,
MT
= 4 + 4 + 8 = 16.
(c) Notice that mixed tying yields the same prot maximizing pricing structure as no
tying, since in the present example, the monopoly cannot charge consumer 2 more
than the sum of the prices of the two products sold separately. In fact, in the
present example, pure tying is prot reducing. Therefore, mixed tying (which yields
an identical allocation as no tying) generates a higher prot than pure tying.
2. (a) We need to compare the prot levels under the commitment of not introducing a
new edition, in which case the publisher can charge a higher price in the rst period
by adding the resale value to the price, to the prot level when no commitment is
made and the monopoly introduces a new edition.
By (14.17), the prot level under commitment is nV , and under no commitment is
2n(V c) F. Comparing the two prot levels reveals that commitment not to
introduce a new edition is more protable if F > nV 2c.
(b) Indeed, this condition in weaker (i.e., implied by) the condition given in (14.17) since
it compares in the case of commitment, in which rst-period students believe that
no new edition will be published, hence the monopoly can raise the books price
by its resale value, to the case where there is no commitment and a new edition is
introduced.
In contrast, the condition given in (14.16) and hence in (14.17) is derived by com-
paring the monopolys second period prot only and therefore yields the condition
under which a new edition will not be introduced in the second period. In other
words, the condition given in (14.16) and (14.17) does not take into account that
rst period price can be raised by the resale value when a commitment is made not
to introduce a new edition.
3. (a) When a new edition is not introduced in the second period, the monopoly competes
with period 1 students on selling the rst edition. First period students will undercut
46 Marketing Tactics: Bundling, Upgrading, and Dealerships
the monopoly (since rst-period students do not have any production cost) and for
a given p
N
2
will set p
U
2
so that
V p
N
2
V p
U
2
.
Now, in a Bertrand equilibrium, if used-book sellers can undercut the monopolist,
then the monopoly price is reduced to cost( p
N
2
= c). Hence, the maximum price
user-book sellers can charge is
p
U
2
=
_
c (1 )V if c (1 )V
0 otherwise
Notice that if c < (1 )V , or < 1 c/V , then the monopoly undercuts the
used-book sellers (since consumers do not value used books very much). Under this
condition, the monopoly would set p
N
2
= (1 )V , and therefore earn a prot of
N
2
= n[(1 )V c].
(b) There are two cases:
High value for used books ( > 1 c/V ): A new edition would yield a second-
period prot of
N
2
= n(V c) F. When a new edition is not introduced, then
2
= 0. Hence, a new edition is introduced if F n(V c), which is the same as
condition (14.16) when = 1.
Low value for used book ( < 1 c/V ): When is low, used book sellers
are undercut by the monopoly. In this case, if a new edition is not introduced in
the second period, then p
N
2
= (1 )V c (the monopoly undercuts used-book
sellers). Hence,
N
2
= n[(1 )V c]. Altogether, a new edition is introduced
if n(V c) F n[(1 )V c], or if F nN, which is dierent from
condition (14.16).
4. (a) Under this contract, the dealer chooses Q (sales) to
max
Q
d
= (1 )[p(Q)QcQ] = (1 )[(a Q)QcQ].
The rst-order condition yields Q
d
= (a c)/2, p
d
= (a + c)/2, and
d
= (1
)(a c)
2
/4. Thus, the dealers sales and price are independent of (1 ) (share
of the prot of the dealer). Under this contract, the industry prot is
M
+
d
=
(a c)
2
4
+ (1 )
(a c)
2
4
=
(a c)
2
4
,
which equals the industrys prot when the rms vertically integrate into a monopoly
given in (14.24).
(b) Under this contract, the dealer chooses Q that solves
max
Q
d
= (1 )p(Q)QcQ = (1 )(a Q)QcQ.
Marketing Tactics: Bundling, Upgrading, and Dealerships 47
The rst-order condition is (1 )(a 2Q) c = 0, hence,
Q
d
=
a
2

c
2(1 )
, and p
d
=
a
2
+
c
2(1 )
.
Now, industry prot is given by the sum
M
+
d
=
_
Q
d
p
d
_
+
_
(1 )Q
d
p
d
cQ
d
_
=
_
p
d
c
_
Q
d
=
_
a
2
+
c 2(1 )c
2(1 )
__
a
2

c
2(1 )
_
=
_
a c
2
__
a
2

c
2(1 )
_
<
(a c)
2
4
.
Thus, this contract yields a lower prot than the industrys prot when the rms
vertically integrate into a monopoly given in (14.24).
(c) Whereas the prot sharing contract analyzed in part (a) is optimal (i.e., maxi-
mizes industrys prot) it is rarely observed since it requires having the manufacturer
monitoring the prot made by the dealer. This monitoring may be too costly for the
manufacturer. In contrast, the per-unit contract analyzed in the text, despite being
not optimal, does not require any monitoring since the dealer pays up front for each
unit it acquires from the manufacturer.
5. We will demonstrate how a monopoly can benet from establishing a trade-in procedure
by constructing a simple model. Suppose that there are two consumers: one owns an old
refrigerator and one that is a new buyer. The utility from using an old refrigerator is V
U
whereas the utility from buying a new one is max{V
N
p
N
, 0}, where V
N
> V
U
> 0. We
further assume that V
N
< 2V
U
.
Single price policy: I will argue that the prot maximizing price is p
N
= V
N
, thereby
selling only to the rst-time buyer and earning a prot of
= V
N
. To see this, note that
the monopoly can set a lower price, p
L
= V
N
V
U
, thereby selling two units and earn a
prot of
L
= 2(V
N
V
U
). However, by assumption,
L
<
.
Trade-in price policy: We now show that by employing a trade-in price policy, the
monopoly can price discriminate between new buyers and old-model owners. Suppose
that the monopoly announces that current users can trade-in their old refrigerator for a
new one for a price of p
TI
= V
N
V
U
, whereas the price with no trade-in is p
N
= V
N
. Note
that under these prices, current users trade-in their old refrigerator for a new one, and also
a new buyer buys a new one. Altogether,
TI
= V
N
V
U
+V
N
= 2V
N
V
U
> V
N
=
.
Chapter 15
Management, Compensation, and Regulation
Instructors who choose to teach from this chapter are urged to go over the principal-agent
problem (section 15.1), which is developed three times in order to allow for a a gradual in-
crease in the degree of diculty. More precisely, the rst subsection illustrates the problem
with no uncertainty. A subsequent subsection introduces uncertainty with no risk aversion.
The third subsection of introduces risk aversion implicitly by assuming asymmetric information.
Altogether, these three subsections analyze the principal-agent problem in dierent degrees of
complexity, thereby enabling the instructor to stop at the level that exceeds the students ability.
Section 15.2 introduces a simple free-rider team eort problem. Section 15.3 introduces
Fershtman-Judd model, which is recommended only if the students are capable of solving
Cournot-type problems very easily. The remaining sections: executives compensation (sec-
tion 15.4) and the regulation of the rm (section 15.4) do t the more advanced students.
1. (a) Under collusion, the social planner chooses a common eort level for all scientists
e that solves
max
e
_
w e
2
_
=
V
N
e
2
=
Ne
N
= e e
2
,
yielding e
= 1/2.
(b) Each scientist i takes all other eort levels (e
j
, j = i) as given and solves
max
e
i
U
i
=
V
N
(e
i
)
2
=
j=i
e
j
+e
i
N
(e
i
)
2
,
yielding a NE where e
i
= 1/(2N) for all i = 1, 2 . . . N.
(c) Yes, since the optimal eort level is e
= 1/2 which is independent of the number of

scientists. In constrast, the NE eort levels decrease further below the optimal level
when the number of scientists increases, reecting a stronger free-rider eect.
2. (a) The manager of rm 1 chooses q
1
that solves
max
q
1
M
1
= 0.5[(a q
1
q
2
)q
1
+ (1 c)q
1
],
yielding a best-response function given by
q
1
= BR
1
(q
2
) =
a c + 1 q
2
2
.
The best response function of rm 2 (the rm that maximizes prot only) is given
by q
2
= BR
2
(q
1
) = 0.5(a c q
1
). Therefore, the equilibrium output levels are
given by
q
e
1
=
a c + 2
3
, and q
e
2
=
a c 1
3
.
50 Management, Compensation, and Regulation
Clearly, q
e
1
> q
e
2
conrming that the managerial compensating scheme of rm 1 is
output increasing at the expense of the rm that maximizes prot only (rm 2).
(b) The owner of rm 1 earns
O
1
=
1
M
1
. From the previous calculation we conclude
that p
e
= (a 2c 1)/3. Hence,
e
1
= (a c 1)(a c + 2)/9. We now set
1
suciently small (as in [15.29]), so that we approximate the owners prot by the
rms prot. Formally,
O
1
=
1
.
Finally, comparing the prot of the owner of rm 1 under the present managerial
compensation scheme to her prot when this manager maximizes prot only (the
simple Cournot prot given in (6.7)) yields that
O
1

c
1
if and only if a 2 + c.
That is, the present compensation scheme dominates a simply Cournot behavior
(given that the other rm behaves in a Cournot fashion) if the demand intercept is
suciently higher than the unit production cost.
Chapter 16
Price Dispersion and Search Theory
Price dispersion (section 16.1) demonstrates that a discount store and an expensive store can
coexist in a market where consumers have dierent search costs (resulting, say, from dierent
values of time). The analysis relies on a simple of location model. Thus, the students should
nd this section easy to follow. Search theory (section 16.2) is introduced with no calculus, so
the analysis relies on simple probability arguments.
1. (a) To see what happens, we look at the equilibrium prices when L 0. From (16.9)
we see that
lim
L
p
e
D
= lim
L
p
e
ND
= 2H and s
e
0.
Hence, when L becomes small (i.e., some consumers have a negligible search cost),
both stores charge the same price, implying that there is no discount store.
(b) When = 3/2, the consumer indierent between searching or buying at random is
located at L. Hence, when = 3/2 all consumers buy at random. When = 1,
s
e
< L implying that the discount store a negative market share (which is ruled out
by out assumption that > 3/2).
2. (a) Using (16.13), we have it that
s 0 1 2 3 4 5
p 1 4.77 6.52 7.86 9.00 10.0
Solution-Table 16.1: Reservation price as a function of the search cost parameter
(b) Solution-table 16.1 reveals that for s 4 the consumer reservation price is p = 9,
implying that the consumer will accept any price in the rst store visit.
(c) Solution-table 16.1 reveals that p = 1 when s = 0 (i.e., when search cost is zero).
(d) When s = 0,
1
the probability that the consumer nds the price higher than 1 (i.e.,
the reservation price) in a single store visit is = 8/9. The probability that prices
exceed 1 in two store visits is
2
= (8/9)
2
. Hence, the probability that this consumer
nds prices exceed 1 in all store visits is lim
T
(8/9)
T
= 0.
Note also that this result can be inferred from (16.16) where the calculated expected
number of stores visited is = 1/(1 ) = 9 < +.
1
The rst printing of the rst edition does not specify which search cost is assumed. This question should
read, under the search cost you found in the previous subquestion, calculate....
Chapter 17
Miscellaneous Industries
The purpose of this chapter is to demonstrate to the student that there is no general model
that can describe all industries; however, I also wish to demonstrate in this last chapter that
the tools developed in this book are indispensable to the analysis of most industries, and are,
therefore, worth learning.
This chapter discusses four types of industries that require special attention since (perhaps
like any other industry) they do not fall in any category and therefore cannot be analyzed by
simply picking one of the market structure analyzed earlier in the book. In future editions I
will attempt to expand this part of the book by introducing at least three more industries: the
health industry, the defense industry, and (you guessed, of course), the lawyers.
1. From the denition, this technology (cost function) exhibits economies of scope if
TC(n, n, n) = (n
+n
+n
< (n
+ (n
+ (n
= TC(n, 0, 0) +TC(0, n, 0) +TC(0, 0, n),

or,
(3n
< 3n
, therefore if 3
< 3, hence if < 1.

2. The main message here is that the introduction of a binding price cap by the regulator
will cause the monopoly airline to reduce ight frequency (or any other quality aspect of
the service).
(a) Under the FC network, each route can be analyzed separately. Now, from the utility
function of route 3 passengers (17.2), we see that the monopoly extracts maximum
surplus when p
3
= +
f
3
. Since the airfare is regulated (i.e., p
3
= p
3
) we have it
that the minimum frequency that the airline must provide on route 3 (at this airfare)
is

f
3
= ( p
3
)
2
. Clearly, as p
3
decreases, the corresponding frequency

f
3
decreases.
(b) Under the HS network, the ight frequency on route 3 is the (minimum) frequency
on routes 1 and 2.
1
Hence, similar to (17.5), but with a given p
3
, the monopoly
chooses

f

f
1
=

f
2
that solves
max
f
h
= n p
3
+ 2n + 2n
_
f 2cf,
1
The rst printing of the rst edition contains a typo: Replace ...charges an airfare

f
3
with airfare p
3
.
54 Miscellaneous Industries
yielding a rst order condition given by 0 = 2n/(2
_
f) 2c. Hence,
2
f =
_
n
2c
_
2
<
_
3n
4c
_
2
= f
h
.
Therefore, under the HS network, a price cap on route 3 will reduce the ight
frequency on all routes.
3. The analysis here follows the same stages as in section 17.4, but it uses a dierent driving
time function.
3
(a) If some people take the train and some drive a car, it must be that L
T
= L
C
. Thus,
v + = v(n
C
)
3
, implying that n
e
C
=
_
v +
v
_
1/3
.
(b) The social planner chooses n
s
C
that solves
minL
s
= (N n
c
)(v +) +n
C
V (n
C
)
3
,
yielding
n
s
C
=
_
v +
4v
_
1/3
< n
e
C
.
Thus, the social planner would recommend a policy that would result in a reduction
in the number of people who drive a car.
(c) Let denote the highway toll on this route. Then, to set the toll that would generate
the socially optimal number of highway users, the social planner sets
s
that solves
v + = v(n
s
C
)
3
+ = v
_
v +
4v
_
+,
yielding that
s
= 3(v +)/4.
2
One has also to check that, in this equilibrium, the airfare on route 3, p
3
, is lower than the sum of the airfares
on routes 1 and 2; that is, we need to verify that (or nd the conditions under which) p
3
p
1
+ p
2
. Otherwise,
route 3 passengers can purchase two separate tickets and reach their destination at a lower airfare.
3
The rst printing of the rst edition contains a typo. Simply set t
C
= (n
C
)
3
(the equation stated in this
question equals to the value of the driving time, L
C
and not t
C
).

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(T) = L, and so on.

(B, L), and

(T, R), and

Solution-Figure 5.1: Aggregate demand composed of two consumer groups

Solution-Figure 7.1: Advertising best-response functions

Solution-Figure 8.1: Contestable-markets equilibrium

0. That is, advertising in this city serves as a mean by

as given and chooses A

to maximize his or her prot.

. The two best-response functions are drawn

Solution-Figure 11.1: Fortune tellers advertising best-response functions

= 0 constitutes one NE. To obtain the other NE, substituting

= 1/2 which is independent of the number of

= TC(n, 0, 0) +TC(0, n, 0) +TC(0, 0, n),

< 3, hence if < 1.

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Oz Shy - Industrial Organization: Theory and Applications - Instructor&#39;s Manual

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Instructors Manual for

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(T) = L, and so on.

(B, L), and

(T, R), and

Solution-Figure 5.1: Aggregate demand composed of two consumer groups

Solution-Figure 7.1: Advertising best-response functions

Solution-Figure 8.1: Contestable-markets equilibrium

0. That is, advertising in this city serves as a mean by

as given and chooses A

to maximize his or her prot.

. The two best-response functions are drawn

Solution-Figure 11.1: Fortune tellers advertising best-response functions

= 0 constitutes one NE. To obtain the other NE, substituting

= 1/2 which is independent of the number of

= TC(n, 0, 0) +TC(0, n, 0) +TC(0, 0, n),

< 3, hence if < 1.

You might also like

Oz Shy - Industrial Organization: Theory and Applications - Instructor's Manual

Oz Shy - Industrial Organization: Theory and Applications - Instructor's Manual