Microeconomics I

Assignment 5
Due on: November 18, 2014 (At 11:30 AM)

1. [This was the Home Task] Suppose that there are two firms, firm 1 and firm 2,
producing differentiated products. Each firms marginal (average) cost of production
is constant c. The utility function of the representative consumer is given by.
U (x1 , x2 ) =(x1 + x2 )

x21 + 2x1 x2 + x22

+ m,
2

where xi denotes the good produced by firm i and m denotes the quantity of all
other goods measured in terms of money. Income of the representative consumer is
assumed to be sufficiently large.
(a) First consider that these two firms are engaged in sequential move quantity
competition, such that firm 1 is the leader and firm 2 is the follower. Derive
the equilibrium quantity of each firm, price of each firm, profit of each firm,
consumers surplus and social welfare. Compare the equilibrium output, price
and profit of the leader with those of the follower. Will each firm earn more
profit in the equilibrium compared to that in the case of simultaneous move
quantity competition?Illustrate your answer both algebraically and diagrammatically. How do the equilibrium output of the leader and the follower change
due to change in the degree of product differentiation?
(b) Next, consider that these two firms are engaged in sequential move price competition, such that firm 1 is the leader and firm 2 is the follower. Derive the
equilibrium quantity of each firm, price of each firm, profit of each firm, consumers surplus and social welfare. Compare the equilibrium output, price and

IGIDR

2014

Microeconomics I, Assignment 5

profit of the leader with those of the follower. Will the leader earn more profit
in the equilibrium compared to that in the case of simultaneous move price competition? Illustrate your answer both algebraically and diagrammatically. How
do the equilibrium output of the leader and the follower change due to change
in the degree of product differentiation?
20+20=40

2. Consider the following. There are two firms, firm 1 and firm 2. There are two markets,
market 1 and market 2. Firm 1 is the monopolist in market 1 and a duopolist with
firm 2 in market 2. Let x, y1 and y2 denote, respectively, output of firm 1 in market
1, output of firm 1 in market 2 and output of firm 2 in market 2. The demand
is infinitely elastic in market 1 at p1 = 50 and the inverse demand in market 2 is
p2 = 200 y1 y2 .
Cost functions of firm 1 and firm 2 are given by C1 =

(x+y1 )2
2

+ F and C2 =

y22
2

+ F,

respectively, where F is sufficiently large so that no firm has any incentive to setup
multiple plants.
Suppose that firms compete in terms of quantity in market 2 and both markets clear
simultaneously. That is, Firm 1 decides x and y1 and firm 2 decides y2 , simultaneously
and independently.
(a) Calculate the equilibrium outputs and profits of firm 1 and firm 2.
(b) Now suppose that government intervenes in market 1, which raises the price in
market 1 to 55. Will firm 1 like such intervention? What happens to firm 2s
profit due to the intervention?
(c) Now, suppose that the market 1 clears before market 2. That is, firm 1 chooses
x before it engages in Cournot competition in market 2. Will your answer to
(a) and (b) change? Why or why not?
10+10+15=35
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