Seminar 4 - Solutions

Industrial Organisation (ES30044)
Seminar Four: Oligopoly (i)

Seminar Four:
Oligopoly (i)
1. Two firms, A and B, compete in two separate markets. In market 1, the inverse demand
function is given by p1 = 5 Q1 , where Q1 = q1A + q1B . is the total amount of output
supplied by firms A and B to market 1. In market 2, the inverse demand function is given
by p2 = 4 Q2 , where Q2 = q2A + q2B is the total amount of output supplied by firms A and
B to market 2. The firms compete by setting quantities and the marginal cost of
production for each firm is equal to 1.
(a) Suppose that firm A offers to withdraw entirely from market 2 in exchange for firm Bs agreement to
withdraw from market 1. Examine whether this offer will raise or lower the profits of firm B, ignoring
fixed costs.
(b) Supposing that firm B agrees to this proposal, is it likely that such an arrangement would be
sustainable? Justify your answer.
A = 5 Q1 q1A + 4 Q2 q2A q1A + q2A

B = 5 Q1 q1B + 4 Q2 q2B q1B + q2B
Where
Q1 = q1A + q1B
Q2 = q2A + q2B
Cournot situation
Firm A
A
= 5 2q1A q1B 1 = 0
A
q1
2q1A = 4 q1B
A
= 4 2q2A q2B 1 = 0
A
q2
2q2A = 3 q2B
Firm B
B
= 5 2q1B q1A 1 = 0
B
q1
2q1B = 4 q1A
B
= 4 2q2B q2A 1 = 0
B
q2
2q2B = 3 q2A
Thus:
2q1A = 4 q1B
2q2A = 3 q2B
2q1B = 4 q1A
2q2B = 3 q2A
Thus:
q
1
3
2q = 4 4 q1A 2q1A = 2 + 1 q1A = 2
2
2
2
4
q1A =
3
A
1
4
8
2 = 4 q1B q1B = 4
3
3
q1B =
4
3
A
1
3 q2
3
3
A
A
2q = 3 3 q2 2q2 = +
q2A =
2
2 2
2
2
A
2
q2A = 1
()
2 1 = 3 q2B q2B = 3 2
q2B = 1
2
Thus:
4 4 7
p1 = 5 Q1 = 5 q1A + q1B = 5 + =
3 3 3
p2 = 4 Q2 = 4 q2A + q2B = 4 1+ 1 = 2
4 4 8
+ =
3 3 3
Q2 = q2A + q2B = 1+ 1 = 2
Q1 = q1A + q1B =
Thus
A = 5 Q1 q1A + 4 Q2 q2A q1A + q2A
4 25
8 4
A = 5 + 4 2 1 + 1 =
3 3
3 9
B = 5 Q1 q1B + 4 Q2 q2B q1B + q2B
4 25
8 4
B = 5 + 4 2 1 + 1 =
= 2.78
3 3
3 9
Monopoly
A = 5 q1A q1A q1A

B = 4 q2B q2B q2B
Firm A
A
= 5 2q1A 1 = 0
q1A
q1A = 2
A = 5 2 2 2 = 4
Firm B
B
= 4 2q2B 1 = 0
B
q2
q2B = 1.5
B = 4 1.5 1.5 1.5 = 2.25

Thus Firm A (B) would have higher (lower) profits under the offer. Despite this, firm B may
accept the offer of firm A, if it faces significant fixed costs in market 1, as in this case its net
profit (i.e. after taking fixed costs into account) might increase under the offer. To analyse
whether such an arrangement would be sustainable, one needs to analyse competition
between the two firms as a repeated game (using a model similar to that outlined in chapter 4
of the Subject Guide), and examine the incentives of the firms to cheat on their agreement.
2. Two firms, A and B, compete in two separate markets. In market 1, the inverse demand
function is given by p1 = a1 b1Q1 , where Q1 = q1A + q1B is the total amount of output
supplied by firms A and B to market 1. In market 2, the inverse demand function is given
by p2 = a2 b2Q2 , where Q2 = q2A + q2B is the total amount of output supplied by firms A
and B to market 2. The firms compete by setting quantities and the marginal cost of
production for each firm is equal to 1.
(a) Suppose that firm A offers to withdraw entirely from market 2 in exchange for firm Bs agreement to
withdraw from market 1. Examine whether this offer will raise or lower the profits of firm B, ignoring
fixed costs.
(b) Supposing that firm B agrees to this proposal, is it likely that such an arrangement would be
sustainable? Justify your answer.
Note: Firms A, B, Markets 1, 2
p1 = a1 b1Q1
p2 = a2 b2Q2
Q1 = q1A + q1B
Q2 = q2A + q2B
Thus:
1A = p1 1 q1A
1A = a1 b1 q1A + q1B 1 q1A
1A
= a1 1 2b1q1A b1q1B = 0
A
1
1 a 1 B
q1A = 1
q1
2 b1
1
qB
2 1 1
q1A =
where:
1 = a1 1 b1
Now:
1B = p1 1 q1B
1B = a1 b1 q1A + q1B 1 q1B
1B
q
B
1
= a1 1 2b1q1B b1q1A = 0
1 a 1
q1B = 1
q1A
2 b1
q1B =
1
1 q1A
2
)
)
where 1 = a1 1 b1 . Thus:
q1A = q1B =
1
3
And by symmetry:
q2A = q2B =
2
3
where 2 = a2 1 b2 . Thus:
a1 1
2
21
b1 3a1 2 a1 1 a1 + 2
p1 = a1 b1
=
= a1 b1
=
3
3
3
3
a2 1
2
2 2
b2 3a2 2 a2 1 a2 + 2
p2 = a2 b2
=
= a2 b2
=
3
3
3
3
Profits:
a 1 1
1A = p1 1 q1A = 1 1 = b112
3 3 9
a 1
1
2A = p2 1 q2A = 2 2 = b2 22
3 3 9
a 1 1
1B = p1 1 q1B = 1 1 = b112
3 3 9
a 1
1
2B = p2 1 q2B = 2 2 = b2 22
3 3 9
Thus:
A = 1A + 2A =
1
b 2 + b2 22
9 1 1
B = 1B + 2B =
1
b 2 + b2 22
9 1 1
(a) Suppose that firm A offers to withdraw entirely from market 2 in exchange for firm Bs
agreement to withdraw from market 1. Examine whether this offer will raise or lower the
profits of firm B, ignoring fixed costs.
Now:
6
p1 = a1 b1q A
p2 = a2 b2 q B
A = a1 b1q A q A q A
A
= a1 1 2b1q A = 0
q A
a 1 1
qA = 1
=
2b1
2
Thus:
A = p1 1 q A
a1 1
1
b1 2a1 a1 1 a1 + 1
A
p1 = a1 b1q = a1 b1 = a1 b1
=
=
2
2
2
2
a + 1 1 a1 1 1 1 2
A = 1
1 =
= b11
2
2 2 2 4
a + 1 2 1 2
B = 2
1 = b2 2
2
2 4
Thus:
2
2
2
2
2
1
1 2 4b11 + 4b2 2 9b2 2 4b11 5b2 2
2
2
= b11 + b2 2 b2 2 =
=
9
4
36
36
B
Comment?
(b) Supposing that firm B agrees to this proposal, is it likely that such an arrangement would
be sustainable? Justify your answer.
Comment?
3. Two firms (Firm 1 and Firm 2) produce differentiated products and compete over prices.
Their respective demand curves are given by:
q1 =
1
(120 4 p1 + 2 p2 )
2
q2 =
1
120 2 p2 + p1
4
Both firms have constant average costs of 10. Calculate the Nash equilibrium (prices,
quantities and profits), illustrate it in a diagram, and explain your results.
1
1 = p1 c q1 = p1 10 (120 4 p1 + 2 p2 ) = 80 p1 2 p12 + p1 p2 10 p2 600

2
1
2 = p2 c q2 = p2 10 (120 2 p2 + p1 ) = 70 p2 p22 + p1 p2 5p1 600
2
4
Thus:
1
1
= 80 4 p1 + p2 = 0 p1 = 20 + p2
p1
4
2
1
1
= 70 2 p2 + p1 = 0 p2 = 35 + p1
p2
2
4
Thus:
1
1
1 15
460 92
p1 = 20 + 35 + p1 4 p1 = 80 + 35 + p1 p1 = 115 p1 =
=
4
4
4
4
15
3
1 92 420 + 92 512 128 2

p2 = 35 + =
=
=
42
4 3
12
12
3
3
Check:
1 128 240 + 128 368 92

2
p1 = 20 +
=
=
=
= 30
4 3
12
12
3
3
Thus:
2 92
p1n = 30 =
3 3
2 128
p2n = 42 =
3
3
Thus:
q1 =
q1 =
1
120 4 ( 92 3 ) + 2 (128 3 )
2
1 3120 4 92 + 2 128
2
3
q1 =
1 360 368 + 256
2
3
q1 =
248 124
=
6
3
And:
q2 =
1
120 2
4
( )+
128
92
1 3120 2 128 + 92
q2 =
4
3
1 360 256 + 92
q2 =
4
3
q2 =
196 49
=
12
3
Thus:
1 = p1 c q1
92
124
1 = 10
3
3
1 =
62 124 7688
=
3 3
9
And:
9
2 = p2 c q2
128
49
2 =
10
3
3
2 =
98 49 4802
=
3 3
9
p2
R1 : p1 = 20 +
1
p
4 2
R2 : p2 = 35 +
1
p
4 1
pb
128/3
35
-140
20
p1
92/3
-80
Figure 1
Note: If firms reaction functions are upward (downward) sloping, then we say that their
strategies are strategic complements (substitutes) for one another.
4. Consider a 3-firm oligopoly in which firms 1 and 2 make output in the morning, and are
followed in the afternoon by firm 3, which makes its output choice given the choice of
output by firms 1 and 2. Market demand is given by p = 100 20q, where
q = q1 + q2 + q3 and each firm faces an identical cost function ci = 10qi ,i = 1,2,3 .
Calculate the Stackelberg level of outputs and profits for each firm.
Use backward induction to calculate first the profit of firm 3. Firm 3 will maximise profits
taking the other firms output as given
3 = 100 20 q1 + q2 + q3 q3 10q3
Thus:
10
3
= 100 20q1 40q3* 20q2 10 = 0
q3
q3* =
1
90 20 q1 + q2
40
Firms 1 and 2 will both maximise the constrained profit functions:
Max 1 = 100 20 q1 + q2 + q3 q1 10q1

q1
s.t
q3 = q3 =
1
90 20 q1 + q2
40
And:
Max 2 = 100 20 q1 + q2 + q3 q2 10q2

q2
s.t
q3 = q3 =
1
90 20 q1 + q2
40
Thus:
d 1 1 1 dq3
=
+
dq1 q1 q3 dq1
s.t
q3 = q3 =
1
90 20 q1 + q2
40
d 1
= 100 40q1s 20q2 20q3 10 + 10q1s = 0
dq1
d 1
= 90 30q1s 20 q2 + q3 = 0
dq1
q1s = 3
2
q +q
3 2 3
2
q +q
3 1 3
q2s = 3
Thus:
11
q1s = 3
2
q +q
3 2 3
2
1
q1s = 3 q2 + 90 20 q1 + q2
3
40
1
3q1s = 9 2 q2 + 90 20 q1 + q2
40
2
3q1s = 9 2q2 90 20 q1 + q2
40
9
3q1s = 9 2q2 + q1 + q2
2
3q1s =
9
+q q
2 1 2
2q1s =
9
q
2 2
q1s =
9 1
q
4 2 2
9 1
q
4 2 2
9 1
q2s = q1
4 2
q1s =
q1s =
9 1 9 1
q
4 2 4 2 1
q1s =
9 9 1
+ q
4 8 4 1
3 s 9
q =
4 1 8
36 3
q1s =
=
24 2
12
And:
q2s =
9 1
q
4 2 1
q2s =
9 1 3
4 2 2
q1s =
9 3
4 4
q1s =
6 3
=
4 2
Thus:
q3 =
1
90 20
40
q3 =
1
90 60
40
q3 =
1
30
40
( )
q3 =
3
4
Thus:
1s = 2s = p c q sj = 100 20 q1s + q2s + q3s 10 q sj
1s = 2s = 100 20
1s = 2s = 100 20
1s = 2s = 90 75
( ) 10
15
) 10
1s = 2s = 22.5
And:
13
j = 1,2
3s = p c q3s = 100 20 q1s + q2s + q3s 10 q3s
3s = 100 20
3s = 100 20
3s = 90 75
( ) 10
15
) 10
3s = 11.25
Note:
We could have used symmetry to make things easier. We have:
2
q +q
3 2 3
2
q2 = 3 q1 + q3
3
1
90 20 q1 + q2
q3 =
40
q1 = 3
And we know that, in equalibrium, q1s = q2s : Thus, we could write:
q1s = 3
2 s
q1 + q3s
3
3q1s = 9 2q1s 2q3s
5q1s = 9 2q3s
q1s =
9 2 s
q
5 5 3
And:
q3s =
1
90 40q1s
40
q3s =
9
qs
4 1
14
Thus:
q1s =
9 2 9
q1s
5 5 4
q1s =
9 18 2 s
+ q
5 20 5 1
3 s 18
q =
5 1 20
5 18 1 6 3
q1s = = = = q2s
3 20 1 4 2
And:
q3s =
9 3 96 3
=
=
4 2
4
4
5. Consider a situation in which firm 1 makes output in the morning, and is followed in the
afternoon by firms 2, 3, and 4, who make their output choices simultaneously, given the
choice of output by firm 1. Market demand is given by p = 1 q , where
q = q1 + q2 + q3 + q4 , and all four firms face an identical cost function ci = 0 ,
i = 1,2,3,4 .
(a) Calculate equilibrium outputs, price, and profits for the four firms;
(b) What would happen to the profits of the four firms if more firms began making output in the
afternoon?
(a) Calculate equilibrium outputs, price, and profits for the four firms;
Use backward induction to calculate first the profits of firms 2, 3, 4. Consider Firm 2. Firm 2
will maximise profits taking the other firms output as given
2 = 1 q1 + q2 + q3 + q4 q4
Thus
2
= 1 q1 2q2* q3 q4 = 0
q2
q2* =
1
1 q1 q3 + q4
Firms 3 and 4 will have analogous reaction functions:

15
1
1 q1 q2 + q4
2
1
q4* = 1 q1 q2 + q3
2
q3* =
And since Firms 2, 3, and 4 are identical in all respects it must be the case that three
equilibrium Stakelberg outputs will be identical vis. q2s = q3s = q4s . Thus:
q2s =
1
1 q1 2q2s
2
q2s =
1
1 q1
4
Firm 1 will thus maximise the constrained profit function:
Max 1 = 1 q1 + q2 + q3 + q4 q1
q1
s.t
qi =
1
1 q1
4
i = 2,3,4
d 1 1 1 dq2 1 dq3 1 dq4

=
+
dq1 q1 q2 dq1 q3 dq1 q4 dq1
d 1
3
= 1 q1s q2 q3 q4 + q1s = 0
dq1
4
q1s =
4
1 q2 q3 q4
5
q1s =
4 3
1 1 q1
5 4
q1s =
1
2
Thus:
1 1 1
qis = 1 =
4 2 8
i = 2,3,4
Thus:
16
q s = qis =
i=1
1 3 7
+ =
2 8 8
Thus:
p s = 1 q s = 1
7 1
=
8 8
1 1 1
1s = p s q1s = =
8 2 16
1 1 1
sj = p s q sj = =
8 8 64
j = 2,3,4
(b) What would happen to the profits of the four firms if more firms began making output in
the afternoon?
Firm 1 would continue to produce monopoly output of 1/2. The remaining firms would
compete in a larger Cournot oligopoly over the remaining output. Assume Firms 2, 3, ..., N
compete in the afternoon: Consider Firm 2:
N

2 = 1 q q2 = 1 q1 + q2 + qi q2

i=3
N
2
= 1 q1 2q2 qi = 0
q2
i=3
1
q2* = 1 q1 qi
2
i=3
q2s =
1
1 q1 N 2 q2s
qis =
1
1 q1
N
i = 2,3,..., N
Max 1 = 1 q q1
q1
s.t
qis =
1
1 q1
N
i = 2,3,..., N
17
d 1 1 1 dqi
=
+
dq1 q1 qi dq1
i = 2,3,..., N
d 1
N 1 s
= 1 2q1s q2 + q3 + ... + qN +
q =0
dq1
N 1
d 1
N 1 s
= 1 2q1s N 1 qi +
q =0
dq1
N 1
i = 2,3,..., N
d 1
N 1
N 1 s
= 1 2q1s
1 q1s +
q =0
dq1
N
N 1
q1s =
1
2
And so:
qis =
1 1
1
1 =
N 2 2N
i = 2,3,..., N
Thus:
N
q s = qis =
i=1
1
1
2N 1
+ N 1
=
2
2N
2N
Thus:
p s = 1 q s = 1
2N 1
1
=
2N
2N
1s = p s q1s =
1 1
1
=
2N 2 4N
is = p s qis =
1
1
1
=
2N 2N 4N 2
i = 2,3,..., N
18
6. Consider a Cournot duopoly with industry demand p = q , where q = q1 + q2 . The

two firms cost functions are c1 = cq1 and c2 = cq2 , where c, > 0 .
(a) Calculate the Cournot-Nash equilibrium level of outputs, prices, and profits.
(b) Examine the responsiveness of equilibrium outputs, prices, and profits, to variations in
(a) Calculate the Cournot-Nash equilibrium level of outputs, prices, and profits.
Consider first Firm 1:
1 = q1 + q2 q1 cq1
1
= c 2 q1i q2 = 0
q1
q1i =
1 c
q2
Now Firm 2:
2 = q1 + q2 q2 cq2
2
= c 2 q2i q1 = 0
q2
q2i =
1 c
2 1
Thus:
1 (2 )c
q1n =
.
.
1
c
(
)
1
q2n =
And:
1 2 (1 + )c
q n = q1n + q2n =
Thus:
19
1 2 (1 + )c
pn = qn =
pn =
+ (1 + )c
3
1n = (p n c )q1n =
2
1
(2 )c
9
2n = (p n c )q2n =
2
1
(2 1)c
9
Thus:
q1n
c
=
>0
3b
q2n
2c
= <0
3b
q n
c
= >0
3b
p n c
= >0
3
1n 2c
= (2 )c > 0
9b
2n
2c
= (2 1)c < 0
9b
20
7. Consider a duopoly situation where market demand is p = 100 5q , q = q1 + q2 , and

where the two firms face cost functions ci = 40qi , i = 1, 2 .
(a) Calculate the critical rate of interest to sustain collusion under a trigger strategy based on: (i) Cournot
Reversion; and (ii) Bertrand Reversion.
(b) Which trigger strategy is more likely to sustain collusion? Why?
(a) Calculate the critical rate of interest to sustain collusion under a trigger strategy based on:
(i) Cournot Reversion; and (ii) Bertrand Reversion.
(i) Cournot Reversion
Nash-Cournot Profit
1 = 100 5 (q1 + q2 ) q1 40q1
1
= 60 10q1 5q2 = 0
q1
q1 = 6
q2
2
By symmetry:
q2 = 6
q1
2
Thus:
q1n = 6
q1n
= 4 = q2n
2
q n = q1n + q2n = 8
Thus:
p n = 100 5q n = 100 5 8 = 60
1n = (60 40 )4 = 80
21
Monopoly Profit
m = (100 5q )q 40q
= 60 10q m = 0
q
qm = 6
q1m = 3
Thus:
p m = 100 5q m = 100 5 6 = 70
1m = (70 40 )3 = 90
Renege Profit
q1r = 6
q1m
3
= 6 = 4.5
2
2
Thus:
p r = 100 5 (q1r + q2m )= 100 5 (4.5 + 3) = 62.5
1r = (62.5 40 )4.5 = 101.25

Thus:
r r Cournot =
1m 1n
90 80
10
40 8
=
=
=
=
r
m
1 1 101.25 90 11.25 45 9
N.B.
r r Cournot
1 2 1 2
9
8

1 64 8
9
=
= 8
= 72 72 = =
9
1
9
8

72 1 9
2 2
64
8
64 64
m
1
r
1
n
1
m
1
Note: The values of , , and c, are irrelevant.

Bertrand Reversion
22
r r Bertrand =
1m 1b
1m 0
90 0
90
=
=
=
=1
r
m
m
m
1 1 1 180 90 90
Or:
r r Bertrand
1 2
1
0

0
=
=
= 8
= 8 =1
m
1
1
1

1
2 2
4
8
8
m
1
r
1
b
1
m
1
m
1
m
i.e. Under Bertrand Reversion 1r = m and 1b = 0 . Note that again the values of , , and
c, are irrelevant. Also note that r Cournot < r Bertrand - collusion is more likely to be sustained
under Bertrand Reversion because the punishment from reneging is so much greater.
8. Consider a market in which there are two similar, but not identical, goods with inverse
demand:
pi = qi q j i
where i, j = 1, 2 , > 0 and > > 0 . The cost of producing good i is given by Ci = cqi ,
i = 1, 2 .
(a) Assume that the goods are produced by two different firms (e.g. Firm 1 and Firm 2) who set their
outputs simultaneously. Compute the Nash equilibrium in quantities.
(b) Assume now that the goods are produced by a single monopolist. Compute and comment upon the
outputs set by the monopolist. How do these compare to those set by the competing firms in (a) above?
(c) How would your answer to (a) change if outputs were set simultaneously, but Firm 1 had the option of
credibly committing to a particular output. Would Firm 1 always exercise such an option? Why or why
not?
(d) Using your analysis in (a)-(c) above, in what sense is it true to assert that product differentiation
alleviates competition?
(a) Assume that the goods are produced by two different firms (e.g. Firm 1 and Firm 2) who
set their prices simultaneously. Compute the Nash equilibrium in quantities.
Firm 1 chooses q1 to maximise:
1 = ( q1 q2 )q1 cq1
taking q2 as given, while Firm 2 chooses q2 to to maximise:
2 = ( q2 q1 )q2 cq2
taking q1 as given.
Thus:
23
1
= c 2 q1* q2 = 0
q1
q1* =
1

2

q2

And:
2
= c 2 q2* q1 = 0
q2
q2* =
1

2

q1

where = ( c ) . Thus:
2q1* =
1 *
q1
2
q1* 2
=
2
2
2

q 2 2 = 1
2 2
*
1
4 2 2 2
q
=
2
2
2
*
1
2
2 2
q1n =
(2 + )(2 ) 2
q1n =
2 +
=
2 +
c
2 +
And so:
q2n =
c
2 +
24
(b) Assume now that the goods are produced by a single monopolist. Compute and comment
upon the outputs set by the monopolist. How do these compare to those set by the
competing firms in (a) above?
The monopoly will choose q1 and q2 to maximise:
= p1q1 + p2 q2 c (q1 + q2 )
= ( q1 q2 )q1 + ( q2 q1 )q2 c (q1 + q2 )
= ( c )(q1 + q2 ) (q12 + q22 ) 2 q1q2

Thus:
= ( c ) 2 q1m 2 q2 = 0
q1
And:
= ( c ) 2 q2m 2 q1 = 0
q2
Thus:
q1m =
m
q2
2
And:
q2m =
m
q1
2
Thus:
25
q1m =
m
q2
2
q1m =
m
q1
2
q1m =

1
2
2 m
+ 2 q1

2
q1m 1 2 = 1

2 2
q1m
=
2

q1m =

( + )( )

q1m =
+
c
q1m =
+ 2
c
q1m =
2 ( + )
And:
26
q2m =
m
q1
2
q2m =

q2m = 1
+ 2
+
q2m =
+ 2

q2m =
+
c
q2m =
+ 2
c
q2m =
2 ( + )
By symmetry
(c) How would your answer to (a) change if outputs were set simultaneously, but Firm 1 had
the option of credibly committing to a particular output?
We are essentially assuming now that Firm 1 is the Stackelberg market leader and makes its
decision over output before Firm 2. Thus:
1 (q1 , q2 ) = p1q1 = q1 q12 q1q2 cq1

2 (q1 , q2 ) = p2 q2 = q2 q22 q1q2 cq2
As before, we solve the model recursively vis:
2 (q1 ; q2 )
= 2 q2 q1 c = 0
q2
1

q2 = q1
2

27
Firm 1s problem is thus:

max 1 (q1 , q2 ) = p1q1 = q1 q12 q1q2 cq1
q1
s.t.
1

q2 = q2 = q1
2

Thus:
d 1 (q1 ; q2 ) 1 (q1 ; q2 ) 1 (q1 ; q2 ) dq2

=
+
=0
dq1
q1
q2
dq1
(49)
( 2 q

q2 c )+
q1 = 0
2
2
Thus:
q1 = c q2
2
4 2 2 s
s
2 q1 = c 2 q1
(50)

2 c
2
q1s =
4 2 2 2
q1s =
( c )( 2 )
4 2 2 2
Note that:
lim q1 =
c
2
(51)
which equates to the Stackelberg leaders equilibrium level of output when output is
homogenous. Now:
28
1

q2s = q1
2

q2s =
)(
1
c 2

2
4 2 2 2
q2s =
)(
1 c c 2

2 4 2 2 2
)(
) (
)(
c 4 3 2 2 c 2
q =
8 4 4 2 2
s
2
s
2
s
2
s
2
( c )( 4
=
( c )( 4
=
2 2 2 2 + 2
8 4
4
2 2 2
8 4
4
( c )( 4
=
2 2
8 4
3
Note that:
lim q2s =
c
4
which equates to the Stackelberg followers equilibrium level of output when output is
homogenous.
6. N firms face an identical total cost function Ci = cqi , i , i = 1, 2, , N, and a market
demand curve p d = q , where q = i =1 qi .
N
(a)
Calculate the profits for each of the N firms if firm 1 makes its output in the morning
and the remaining firms make their output in the afternoon.
(b)
What happens to each firms profit if firms 2 and 3 drop out of the market?
(c)
What happens to each firms profit if firms 2 and 3 merge?
(35 marks)
29
(a) Calculate the profits for each of the N firms if firm 1 makes its output in the morning and
the remaining firms make their output in the afternoon.
Consider Firm 2:
N
2 = ( c ) q2 q1 + qi q2
i =3
N
2
= c q1 2 q2 qi = 0
q2
i =3
q2* =
N
1
qi
2
i =3
q2s =
1
q1 (N 2 ) q2s
2
q2s =
1
( q1 )
N
Where = ( c ) . And since q2s = q3s = ... = qNs by symmetry, we have:

qis =
1
( q1 )
N
i = 2,3,..., N

N
Max 1 = ( c ) q1 q1 + qi q1 = ( c ) q1 q12 (N 1) qi
q1
i =2
s.t
1
qi = qis = ( q1 ) i = 2,3,..., N
N
Thus:
d 1 1 1 dqi
=
+
i = 2,3,..., N
dq1 q1 qi dq1
Thus:
30
d 1
N 1 s
= c 2 q1s q2 + q3 + ... + qN +
q =0
dq1
N 1
d 1
N 1 s
= c 2 q1s N 1 qi +
q =0
dq1
N 1
i = 2,3,..., N
d 1
N 1
N 1 s
= c 2 q1s
q1s +
q =0
dq1
N
N 1
d 1
N 1
N 1 s
= c 2 q1s
+ 2
q =0
dq1
N
N 1
N 1
N 1
q1s 2 2
= c
N
N
2 N 2 N + 2
N 1
q1s
= c
q1s =
N c N N 1
2 2 N
N 1 N
q1s = 1
N 2
N N + 1 N
q1s =
2
N
q1s =
And so:
qis =
1 =
N 2 2N
i = 2,3,..., N
Thus:
N
q = qis =
s
i=1
N + N 1
2N 1
+ N 1
=
=
2
2N 2N
2N
31
Thus:
2N 1
ps = qs =
2N
2N 1 c
ps =
2N
2 N 2 N 2Nc c
ps =
2N
ps =
+ 2N 1 c
2N
Note:
+ 2N 1 c
ps c =
c
2N
+ 2Nc c 2Nc
ps c =
2N
c
ps c =
2N
Thus:
c
1
1s = p s c q1s =
=
2
2N 2 4N
c
1
is = p s c qis = p s c qis =
=
2
2
2N 2N 4N
(b)
1s =
is =
i = 2,3,..., N
What happens to each firms profit if firms 2 and 3 drop out of the market?
1
2
4 N 2
4 N 2
i = 4,5,..., N
32
(c)
1s =
is =
What happens to each firms profit if firms 2 and 3 merge?
1
2
4 N 1
4 N 1
i = 23,4,..., N
33

Seminar 4 - Solutions

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Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Industrial Organisation (ES30044)

A = 5 Q1 q1A + 4 Q2 q2A q1A + q2A

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

A = 5 Q1 q1A + 4 Q2 q2A q1A + q2A

B = 5 Q1 q1B + 4 Q2 q2B q1B + q2B

A = 5 q1A q1A q1A

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

B = 4 1.5 1.5 1.5 = 2.25

Note: Firms A, B, Markets 1, 2

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

1A = a1 b1 q1A + q1B 1 q1A

1B = a1 b1 q1A + q1B 1 q1B

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

1 = p1 c q1 = p1 10 (120 4 p1 + 2 p2 ) = 80 p1 2 p12 + p1 p2 10 p2 600

1 92 420 + 92 512 128 2

1 128 240 + 128 368 92

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

1 360 368 + 256

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Firms 1 and 2 will both maximise the constrained profit functions:

Max 1 = 100 20 q1 + q2 + q3 q1 10q1

Max 2 = 100 20 q1 + q2 + q3 q2 10q2

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

1s = 2s = p c q sj = 100 20 q1s + q2s + q3s 10 q sj

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

3s = p c q3s = 100 20 q1s + q2s + q3s 10 q3s

And we know that, in equalibrium, q1s = q2s : Thus, we could write:

3q1s = 9 2q1s 2q3s

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Firms 3 and 4 will have analogous reaction functions:

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Firm 1 will thus maximise the constrained profit function:

d 1 1 1 dq2 1 dq3 1 dq4

dq1 q1 q2 dq1 q3 dq1 q4 dq1

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Firm 1 will thus maximise the constrained profit function:

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

Industrial Organisation (ES30044)

Seminar Four: Oligopoly (i)

6. Consider a Cournot duopoly with industry demand p = q , where q = q1 + q2 . The