Recitation 7 Krzysztof Makarski Auction 1. At Toivos auction house in Ishpemming, Michigan, a beautiful stued moosehead is being sold by auction.

There are 5 bidders in attendance: Aino, Erkki, Hannu, Juha, and Matti. The moosehead is worth $100 to Aino, $20 to Erkki, and $5 to each of the others. The bidders do not collude and they dont know each others valuations. (a) If the auctioneer sells it in an English auction, who would get the moosehead and approximately how much would the buyer pay? Answer: Aino would get it for $20. (b) If the auctioneer sells it in a sealed-bid, second-price auction and if no bidder knows the others values for the moosehead, how much should everyone bid, who would get the moosehead and how much would he pay? Answer: Aino $100, Erkki $20, and the others $5.Aino would get it for $20. 2. Charlie Plopp sells used construction equipment in a quiet Oklahoma town. He has run short of cash and needs to raise money quickly by selling an old bulldozer. If he doesnt sell his bulldozer to a customer today, he will have to sell it to a wholesaler for $1,000. Two kinds of people are interested in buying bulldozers. These are professional bulldozer operators and people who use bulldozers only for recreational purposes on weekends. Charlie knows that a professional bulldozer operator would be willing to pay $6, 000 for his bulldozer but no more, while a weekend recreational user would be willing to pay $4, 500 but no more. Charlie puts a sign in his window. Bulldozer Sale Today. Charlie is disappointed to discover that only two potential buyers have come to his auction. These two buyers evidently dont know each other. Charlie believes that the probability that either is a professional bulldozer operator is independent of the others type and he believes that each of them has a probability of 1/2 of being a professional bulldozer operator and a probability of 1/2 of being a recreational user. Charlie considers the following three ways of selling the bulldozer: Method 1. Post a price of $6,000, and if nobody takes the bulldozer at that price, sell it to the wholesaler. 1

 Method 2. Post a price equal to a recreational bulldozer users buyer value and sell it to anyone who oers that price. Method 3. Run a sealed-bid auction and sell the bulldozer to the high bidder at the second highest bid (if there is a tie, choose one of the high bidders at random and sell the bulldozer to this bidder at the price bid by both bidders.) (a) What is the probability that both potential buyers are professional bulldozer operators? What is the probability that both are recreational bulldozer users? What is the probability that one of them is of each type? Answer. 1/4, 1/4 and 1/2. (b) If Charlie sells by method 1, what is the probability that he will be able to sell the bulldozer to one of the two buyers? What is the probability that he will have to sell the bulldozer to the wholesaler? What is his expected revenue? Answer.
3 1 3 , , 4 4 4

$6, 000 + 1 $1, 000 = $4, 750. 4

(c) If Charlie sells by method 2, how much will he receive for his bulldozer? Answer. $4,500. (d) Suppose that Charlie sells by method 3 and that both potential buyers bid rationally. What will be Charlies expected revenue from selling the bulldozer by method 3? Answer.
1 4

$6, 000 + 3 $4, 500 = $4, 750. 4

(e) Which of the three methods will give Charlie the highest expected revenue? Answer. Method 3. (f) Suppose that a weekend recreational user would be willing to pay $3, 500 (comparing to $4, 500 before). How would your answer to (d) and (e) change? 3. Late in the day at an antique rug auction there are only two bidders left, April and Bart. The last rug is brought out and each bidder takes a look at it. The seller says that she will accept sealed bids from each bidder and will sell the rug to the highest 2

bidder at the highest bidders bid. Each bidder believes that the other is equally likely to value the rug at any amount between 0 and $1,000. Therefore for any number x between 0 and 1,000, each bidder believes that the probability that the other bidder values the rug at less than x is x/1, 000. The rug is actually worth $800 to April. If she gets the rug, her prot will be the dierence between $800 and what she pays for it, and if she doesnt get the rug, her prot will be zero. She wants to make her bid in such a way as to maximize her expected prot. (a) Suppose that Bart will bid exactly what the rug is worth to him. If April bids $x for the rug, what is the probability that she will get the rug? What is her prot if she gets the rug for $x? What is her expected prot if she bids $x? Answer.
x , 1000

$(800 x), $(800 x)

x 1000

(b) Find the bid x that maximizes her expected prot. (Hint: Take a derivative.) Answer. x = 400. (c) Now let us go a little further toward nding a general answer. Suppose that the value of the rug to April is $V and she believes that Bart will bid exactly what the rug is worth to him. Write a formula that expresses her expected prot in terms of the variables V and x if she bids $x. Answer.
x $(V x)( 1000 )

(d) Now calculate the bid $x that will maximize her expected prot. (Same hint: Take a derivative.) Answer. x = V/2. 4. If you did the previous problem correctly, you found that if April believes that Bart will bid exactly as much as the rug is worth to him, then she will bid only half as much as the rug is worth to her. If this is the case, it doesnt seem reasonable for April to believe that Bart will bid his full value. Lets see what would the best thing for April to do if she believed that Bart would bid only half as much as the rug is worth to him (a) If Bart always bids half of what the rug is worth to him, what is the highest amount that Bart would ever bid? 3

Answer. $500. (b) Suppose that the rug is worth $800 to April and she bids $x for it. April will only get the rug if the value of the rug to Bart is less than $2x. What is the probability that she will get the rug if she bids $x for it? What is her expected prot if she bids $x? What should she bid? Answer.
2x , 1000 2x $(800 x) 1000 , $400

(c) Suppose that April values the rug at $V and she believes that Bart will bid half of his true value. What should April bid? Answer.
2x Maximize (V x) 1000 , to get x = V /2.

(d) Suppose that April believes that Bart will bid half of his actual value and Bart believes that April will bid half of her actual value. Suppose also that they both act to maximize their expected prot given these beliefs. Will these beliefs be self-conrming in the sense that given these beliefs, each will take the action that the other expects? Answer. Yes. Monopoly 1. Professor Bong has just written the rst textbook in Punk Economics. It is called Up Your Isoquant. Market research suggests that the demand curve for this book will be Q = 2, 000 100P , where P is its price. It will cost $1, 000 to set the book in type. This setup cost is necessary before any copies can be printed. In addition to the setup cost, there is a marginal cost of $4 per book for every book printed. Find his optimal output, price and prots. Use two dierent methods (prot maximization and MR = MC approach). Show his prots on a graph. Answer. Q = 800. 2. A monopolist has an inverse demand curve given by p(y) = 12 y and a cost curve given by c(y) = y 2 . 4

(a) What will be its prot-maximizing level of output? Answer. 3 (b) What will be the Pareto optimal level of output? Answer. 4 (c) Compute and draw the deadweight loss. Answer.
3 2

(d) Suppose this monopolist could operate as a perfectly discriminating monopolist and sell each unit of output at the highest price it would fetch. What would the output and the deadweight loss be in this case? Answer. 4 and 0 (e) Suppose the government decides to put a tax on this monopolist so that for each unit it sells it has to pay the government $2. What will be its output under this form of taxation? Answer. 2.5. (f) If you wanted to choose a price ceiling for this monopolist so as to maximize consumer plus producer surplus, what price ceiling should you choose? How much output will the monopolist produce at this price ceiling? Answer. 8, 4. (g) Suppose now that the government puts a lump sum tax of $10 on the prots of the monopolist. What will be its output? Answer. 3.

Monopoly behavior

1. Ferdinand Sludge has just written a disgusting new book, Orgy in the Piggery. His publisher, Graw McSwill, estimates that the demand for this book in the United States is Q1 = 50, 000 2, 000P1 , where P1 is the price in the U.S. measured in U.S. dollars. The demand for Sludges opus in England is Q2 = 10, 000 500P2 , where P2 is its price in England measured in US dollars. His publisher has a cost function C(Q) = $50, 000 + $2Q, where Q is the total number of copies of Orgy that it produces. (a) If McSwill must charge the same price in both countries, how many copies should it sell? What price should it charge to maximize its prots? How much will those prots be? 27, 500, $13, $252, 500. (b) If McSwill can charge a dierent price in each country and wants to maximize prots, how many copies should it sell in the United States? What price should it charge in the United States? How many copies should it sell in England? What price should it charge in England? How much will its total prots be? Answer. US: 23, 000, $13.5. England: 4, 500, $11 Total prots = $255, 000. 2. Consider a monopoly producing two goods A and B. The monopoly has the following cost structure: C(yA ) = 0 and C(yB ) = 0. There are two types of consumers called 1 and 2 with unit demand functions for each good. For simplicity each type consists only of one consumer. The following are reservations prices (or valuations) of goods A 1 1 2 2 and B by consumers: vA = 80 and vB = 80, vA = 120 and vB = 10. (a) What are the optimal prices of both goods, pA and pB without any bundling? Compute prots a associated with this pricing strategy. Answer. pA = 80 and pB = 80, which implies prots = 3 80 = 240 (b) What is optimal price of the bundle pbundle using pure bundling pricing (i.e. only bundles are sold). Compute prots b associated with this pricing strategy. Answer. pbundle = 130, which implies prots = 2 130 = 260 6

(c) What are optimal prices of the bundle pbundle and goods pA and pB using mixed bundling pricing (i.e. bundles as well as separate goods are sold). Compute prots c associated with this pricing strategy. Answer. pbundle = 160, pA = 120 and pB > 40, which implies prots = 1 160 + 1 120 = 280 3. A phone company ABC monopolized the telecommunications market in the country X. It is not an usual market, as there are only two types of customers in this market: type 1 (residential customer with low demand - low type) and 2 (business customer with high demand). More, there is only one customer of each type. After extensive market research the monopolist ABC estimated that demands of dierent types of customers are: D1 (P1 ) = 5 P1 for type 1, and D2 (P2 ) = 10 2P2 for type 2. Lets assume for simplicity that cost of ABC are zero, i.e. C(Q) = 0. (a) Consider a monopolist that doesnt engage in price discrimination by any means (in other words, it uses linear pricing). What are monopolists prots in this case Answer. Problem maxP (15 3P ) gives P = 2.5 and = 18.75
P

(b) Consider a monopolist that wants to charge 2 dierent two-part taris: T1 (Q1 ) = f1 + P1 Q1 customized to type 1 consumers and T2 (Q2 ) = f2 + P2 Q2 customized to type 2 customers. Formulate now the problem of prot maximizing monopolist ABC subject to participation and incentive compatibility (self selection) constraints for each type. Denote a net surplus of type 1 at two part tari T (Q) = f + P Q as CS1 (P ) f, and by analogy a net surplus of type 2 at two part tari T (Q) = f + P Q as CS2 (P ) f. Answer.

Problem max f1 + f2 + P1 D1 (P1 ) + P2 D2 (P2 ) sb. to CS1 (P1 ) f1 0 CS2 (P2 ) f2 0 CS1 (P1 ) f1 CS1 (P2 ) f2 CS2 (P2 ) f2 CS2 (P1 ) f1 (c) At optimal solution the participation constraint for type 1 (low type) and incentive compatibility constraint for type 2 (high type) holds with equality. The other constraints are unimportant and can be neglected at optimal solution (check at the end if they are satised). Using this info rewrite the prot maximization problem of ABC from b) to get unconstrained problem with only P1 and P2 as decision variables. Solve rst the for optimal P1 , P2 , and then for associated f1 , f2 and prots . Answer. max CS1 (P1 ) + CS2 (P2 ) CS2 (P1 ) + CS1 (P1 ) + P1 D1 (P1 ) + P2 D2 (P2 )
P1 ,P2

f1 ,f2 ,P1 ,P2

or max2CS1 (P1 ) + CS2 (P2 ) CS2 (P1 ) + P1 D1 (P1 ) + P2 D2 (P2 )

P1 ,P2

Note that CS1 (P ) = 0.5(5 P )2 and CS2 (P ) = 0.5(5 P )(10 2P ) = (5 P )2 (recall consumer surplus is the area below demand curve and above the price). Now plugging all function of prices into objective problem we get: max(5 P2 )2 + P1 (5 P1 ) + P2 (10 2P2 )
P1 ,P2

FOCs: With respect to P1 : 5 P1 P1 = 0

P1 = 2.5

With respect to P2 : 2(5 P2 )(1) + 10 2P2 2P2 = 0

P2 = 0

Now we can compute f1 and f2 : f1 = CS1 (5) = 0.5(5 2.5)2 = 3.125

f2 = CS2 (0) CS2 (2.5) + CS1 (2.5) = (5 0)2 (5 2.5)2 + 0.5(5 2.5)2 = 4 2.52 2.52 + 0.5 2.52 = 3.5 2.52 = 21.875

and prots = 3.125 + 21.875 + 0(10 2 0) + 2.5(5 2.5) = 25 + 6.25 = 31.25 (d) What is a percentage increase in prots of a monopolist in point c) as compared to point a)? Answer. Percentage increase in prots = ( 31.25 1) 100 = 66.667% 18.75