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Industrial Organization: Markets and Strategies

Paul Belle‡amme and Martin Peitz
published by Cambridge University Press
Part II. Market power
Exercises & Solutions

Exercise 1 Monopoly with quality choice

Consider a monopolist who sells batteries. Each battery works for h hours
and then needs to be replaced. Therefore, if a consumer buys q batteries, he
gets H = qh hours of operation. Assume that the demand for batteries can be
derived from the preferences of a representative consumer whose indirect utility
function is v = u(H) pq, where p is the price of a battery. Suppose that u
is strictly increasing and strictly concave. The cost of producing batteries is
C(q) = qc(h), where c is strictly increasing and strictly convex.

1. Derive the inverse demand function for batteries and denote it by P (q).
2. Suppose that the monopolist chooses q and h to maximize his pro…t. Write
down the …rst-order conditions for pro…t maximization assuming that the
problem has an interior solution, and explain the meaning of these condi-
tions.
3. Write down the total surplus in the market for batteries (i.e., the sum
of consumer surplus and pro…ts) as a function of H and h. Derive the
…rst-order conditions for the socially optimal q and h assuming that there
is an interior solution. Explain in words the economic meaning of these
conditions.
4. Compare the solution that the monopolists arrives at with the social op-
timum. Prove that the monopolist provides the socially optimal level of
h. Give an intuition for this result.

Solutions to Exercise 1
1. The inverse demand for batteries is obtained by solving the following problem:

max u(qh) pq:

q

The …rst-order conditions for this problem can be written as

P (q) = hu0 (qh)

which is the inverse demand function for batteries.

2. The monopolist’s maximization problem is given by

max qP (q) qc(h);

q;h

1
where P (q) is given in part 1. The …rst-order conditions for an interior solution are:

h(u0 (H) + Hu00 (H)) = c(h) and

q(u0 (H) + Hu00 (H)) = qc0 (h)
where h(u0 (H) + Hu00 (H)) is the marginal revenue from selling an extra battery.
First, let us interpret the expressions inside the brackets: u0(H) is the revenue from
selling an extra hour of operation, while u00 (H) is the discount in the price per hour
of operation that the monopolist must give in order to induce consumers to buy an
extra unit. This discount has to be multiplied by H since the discount is given to all
inframarginal units. Hence, u0 (H) + Hu00 (H) is the marginal revenue from selling
an extra hour of operation. Since the monopolist sells hours of operation in packets
of h units each (a battery provides h hours of operation), u0 (H) + Hu00 (H) has to
be multiplied by h to give the marginal revenue from selling an extra battery. c(h) is
the marginal cost of batteries. Therefore the …rst equation is the familiar monopoly
pricing condition that says that at the optimum, the monopolist produces up to the
point where his marginal revenue equals his marginal cost. Similarly, the second
equation indicates that at the optimum, the marginal revenue from extending the life
of each battery by one hour must equal to marginal cost (note that the marginal cost
has to be multiplied by the number of batteries that the monopolist produces since
the cost of each one of them increases by c0 (h)).
3. The total surplus in the market for batteries is given by u(H) qc(h). The
…rst-order conditions for the social optimum (assuming that an interior solution to
this problem exists) are

hu0 (H) = c(h) and

qu0 (H) = qc0 (h)
where hu0 (H) is the marginal utility of consumers from having an extra battery. It
equals the consumers’ willingness-to-pay for an extra hour of operation multiplied
by h which is the number of hours of operation they get when they buy an extra
battery. The right-hand side of the …rst equation is the marginal cost of producing
an extra battery; the …rst equation states that, at the social optimum, the marginal
utility of consumers has to be equal to the marginal cost of production. The second
equation says that, at the social optimum, the marginal utility of consumers from
having batteries which provide one more hour each, has to be equal to the marginal
cost of extending the life of each battery by one hour.
4. To compare the solutions in parts 2 and 3, we divide the …rst-order conditions
for the monopoly problem by one another:
h c(h) c(h)
= 0 , c0 (h) = :
q qc (h) h
This equation shows that the monopolist produces h by equating the marginal cost of
h with the average cost of h. This implies in turn that h is produced at the minimum
average cost.
By dividing the …rst-order conditions for social optimum by one another we get the
same condition which implies that the monopolist chooses the socially optimal level

2
of h. Moreover, since the condition that determines h is independent of q , it follows
that this result is true even though the monopolist provides too little quantity.

Exercise 2 Price competition [included in the 2nd edition of the book]

Consider a duopoly in which homogeneous consumers of mass 1 have unit

demand. Their valuation for good i = 1; 2 is v(fig) = vi with v1 > v2 . Marginal
cost of production is assumed to be zero. Suppose that …rms compete in prices.

1. Suppose that consumers make a discrete choice between the two products.
Characterize the Nash equilibrium.
2. Suppose that consumers can now also decide to buy both products. If
they do so they are assumed to have a valuation v(f1; 2g) = v12 with
v1 + v2 > v12 > v1 . Firms still compete in prices (each …rm sets the price
for its product— there is no additional price for the bundle) Characterize
the Nash equilibrium.
3. Compare regimes from parts (1) and (2) with respect to consumer surplus.
Comment on your results.

Solutions to Exercise 2
1. Nash equilibrium given by p1 = v1 v2 , p2 = 0, 1 = v1 v2 and 2 = 0.
2. Nash equilibrium given by p1 = v12 v2 , p2 = v12 v1 , 1 = v12 v2 and
2 = v12 v1 .
3. Consumer surplus in 1) is CSa = v2 , whereas it is given by CSb = v1 +v2 v12
in 2). As v12 > v1 by assumption, consumer welfare is strictly greater in 1) than in
2). In 2) the nature of competition changes because consumers have positive valuation
to buy both products; this relaxes competition.

Exercise 3 Cournot competition

Two …rms (…rm 1 and …rm 2) compete in a market for a homogenous good
by setting quantities. The demand is given by Q(p) = 2 p. The …rms have
constant marginal cost c = 1.

1. Draw the two …rms’ reaction function. Find the equilibrium quantities
and calculate equilibrium pro…ts.
2. Suppose now that there are n …rms where n 2. Calculate equilibrium
quantities and pro…ts.

Solutions to Exercise 3
This is the standard Cournot model, just in case students have forgotten about their
intermediate micro class.

Exercise 4 Equilibrium uniqueness in the Cournot model

3
 Consider an oligopoly with n …rms that produce homogeneous goods and
compete à la Cournot. Inverse demand is given by P (Q) with P 0 (Q) < 0, and
0 00
each …rm
P i has a cost function of Ci (qi ) with Ci (qi ) > 0 and Ci (qi ) 0. Denote
q i = j6=i qj .

1. Compute the …rst- and second order condition of …rm i. Under which
conditions is the pro…t function of …rm i, i , strictly concave?
dqi
2. Compute the slope of the best-reply function of …rm i, dq i . In which
interval is this slope?

A su¢ cient condition for uniqueness of a Cournot equilibrium is (see, e.g.,

Tirole (1999), page 226)

@2 i @2 i
+ (n 1) < 0;
@qi2 @qi @q i

3. Suppose that demand is concave and that marginal costs are constant.
For which number of n is the condition above satis…ed?
Pn
4. Suppose that P (Q) = a b i=1 qi and Ci (qi ) = cqi , for all i 2 f1; :::; ng.
Is there a unique equilibrium for any n?

Solutions to Exercise 4
see the 1999-book by Vives

Exercise 5 Industries with price or quantity competition

Which model, the Cournot or the Bertrand model, would you think provides
a better …rst approximation to each of the following industries/markets: the oil
re…ning industry, farmer markets, cleaning services. Discuss!

Exercise 6 An investment game

Consider a duopoly market with a continuum of homogeneous consumers

of mass 1. Consumers derive utility vi 2 fv H ; v L g for product i depending
on whether the product is of high or low quality. Firms play the following 2-
stage game: At stage 1, …rms simultaneously invest in quality: The more a …rm
invests the higher is its probability i of obtaining a high-quality product. The
associated investment cost is denoted by I( i ) and satis…es standard properties
that ensure an interior solution: I( i ) is continuous for i 2 [0; 1), I 0 ( i ) > 0 and
I 00 ( i ) > 0 for i 2 (0; 1), and lim #0 I 0 ( i ) = 0; lim "1 I 0 ( i ) = 1. Before the
beginning of stage 2 qualities become publicly observable— i.e., all uncertainty
is resolved. At stage 2, …rms simultaneously set prices.

1. For any given ( 1 ; 2 ), what are the expected equilibrium pro…ts? In

case of multiple equilibria select the (from the view point of the …rms)
Pareto-dominant equilibrium.

4
 2. Are investments strategic complements or substitutes? Explain your …nd-
ing.
3. Provide the equilibrium condition at the investment stage.
4. How do equilibrium investments change as v H vL is increased?

Solutions to Exercise 6

1. Bertrand competition: If v1 = v2 , 1 = 2 = 0. If vi > vj , i = and

j = 0, i 6= j . The expected equilibrium pro…t is E i = i (1 j) .

2. At stage 1, each …rm solves max i i (1 j) I( i ). First-order condition

of pro…t maximization is

(1 j) = I 0( i)

Since I( i) is strictly convex I 0 ( i) is monotone and thus invertible.

i = (I 0 ) 1
[(1 j) ]

Since I 0 ( i ) is increasing the best response of …rm i is decreasing in j and

investment decisions are strategic substitutes.

3. The equilibrium investment decisions 1 = 2 are characterized by

(1 ) = I 0( ):

There is a unique solution to this equation.

4. Rewriting the above equation as

I 0( )
=
1
we see that the numerator on the right-hand side is increasing in while the
denominator on that side is decreasing in . Thus, an increase in implies a
larger . Due to the nature of Bertrand competition only the quality di¤erence
but not the absolute levels of qualities a¤ect investment incentives.

Exercise 7 Hotelling model

Reconsider the simple Hotelling model in which consumers are uniformly

distributed on the unit interval and …rms are located at the extremes of this
interval. Now take consumers’participation constraint explicitly into account.
Derive the equilibrium depending on the parameter . [Be careful to distinguish
between di¤erent regimes with respect to competition between …rms!]

Exercise 8 Price and quantity competition

5
 Reconsider the duopoly model with linear individual demand and di¤eren-
tiated products. Show that pro…ts under quantity competition are higher than
under price competition if products are substitutes and that the reverse holds
if products are complements.

Exercise 9 Asymmetric duopoly [included in the 2nd edition of the book]

Consider two quantity-setting …rms that produce a homogenous good and

choose their quantities simultaneously. The inverse demand function for the
good is given by P = a q1 q2 , where q1 and q2 are the outputs of …rms 1
and 2 respectively. The cost functions of the two …rms are C1 (q1 ) = c1 q1 and
C2 (q2 ) = c2 q2 , where c1 < a and c2 < (a + c1 )=2.

1. Compute the Nash equilibrium of the game. What are the market shares
of the two …rms?
2. Given your answer to (1), compute the equilibrium pro…ts, consumer sur-
plus, and social welfare.
3. Prove that if c2 decreases slightly, then social welfare increases if the mar-
ket share of …rm 2 exceeds 1=6, but decreases if the market share of …rm
2 is less than 1=6. Give an economic interpretation of this …nding.

Solutions to Exercise 9

1. The Nash equilibrium of the game is obtained by solving the following system
of equations:

@ 1
= (a q1 q2 ) q1 c1 = 0;
@q1
@ 1
= (a q1 q2 ) q2 c2 = 0:
@q2
The equilibrium is given by the pair

a 2c1 + c2 a 2c2 + c1
q1 = ; q2 = :
3 3
Given q1 and q2 , the equilibrium market share are:

q1 a 2c1 + c2
1 = = ;
q1 + q2 2a c1 c2
q2 a 2c2 + c1
a2 = = :
q1 + q2 2a c1 c2

6
 2. The equilibrium pro…ts are given by

1 = (a q1 q2 )q1 c1 q1 = (q1 )2
(a 2c1 + c2 )2
= ;
9
(a 2c2 + c1 )2
2 = :
9
and the consumer surplus is given by
Z q1 +q2
CS = (a q)dq (a q1 q2 )(q1 + q2 )
0
(q1 + q2 )2 (2a c1 c2 )2
= = :
2 18
Adding the three together, social welfare is given by

W = CS + 1 + 2
(q1 + q2 )2
= + (q1 )2 + (q2 )2 :
2

3. Di¤erentiating W with respect to c2 yields

@W @(q1 + q2 ) @q1 @q2
= (q1 + q2 ) + 2q1 + 2q2
@c2 @c2 @c2 @c2
q1 + q2 6(q2 )2 1
= = 2(q1 + q2 )( 2 ):
3 6
Hence, a small reduction in c2 increases W if 2 > 1=6 and deceases W is
2 < 1=6.

Not that the result that a cost reduction may be socially undesirable was …rst
demonstrated in Lahiri and Ono (1988), "Helping Minor Firms Reduces Welfare,"
Economic Journal.

Exercise 10 Selling independent products to budget-constrained consumers1

Consider two sellers 1 and 2 and a continuum of buyers. Seller i o¤ers

product i at price pi and incurs zero marginal cost of production. Buyers are
identical and derive utility ui from one unit of each product. Thus their utility
is ui if they buy one unit of product i and zero units of product j, j 6= i; it is
u1 + u2 if they buy one unit of each product. Additional units do not give any
extra utility. Each buyer has a budget y, which she cannot exceed. Each seller
is assumed to prefer not to sell a unit rather than setting a zero price. Suppose
that u1 > u2 .
1 This exercise is inspired by Jeon, D.-S. and D. Menicucci (2006). Bundling Electronic

Journals and Competition among Publishers. Journal of the European Economic Association
4: 1038-1083.

7
 1. Derive the demand function of each buyer.
2. Consider the game in which sellers simultaneously set price. Characterize
the Nash equilibrium of the game.
3. Determine consumer surplus and total surplus that realize in equilibrium.
Is the equilibrium necessarily e¢ cient or are there ine¢ ciencies? Explain.

Solutions to Exercise 10
1. For p1 u1 , p2 u2 and p1 + p2 y , Q1 (p1 ; p2 ) = 1 and Q2 (p1 ; p2 ) = 1.
For p1 u 1 , p2 u2 and p1 + p2 > y , Q1 (p1 ; p2 ) = 1 and Q2 (p1 ; p2 ) = 0
if u1 p1 > u 2 p2 and Q1 (p1 ; p2 ) = 0 and Q2 (p1 ; p2 ) = 1 if the reverse
inequality holds. For pi maxfui ; yg and pj > uj , Qi (pi ; pj ) = 1 and
Qj (pi ; pj ) = 0. For all other prices, Q1 (p1 ; p2 ) = 0 and Q2 (p1 ; p2 ) = 0.
2. For u1 u2 y , p1 = y and seller 2 does not sell. Thus, the buyer only buys
product 1. Consider next the case u1 + u2 > y > u1 u2 . Note that when
both products are bought under this inequality, we must have in equilibrium
that p1 + p2 = y . Suppose that prices satisfy that u1 p1 = u2 p2 . Then,
buyers are indi¤erent between product 1 and product 2 if they were to make
a discrete choice. In this case, if …rm i slightly increases the price, the buyer
can no longer a¤ord to buy both products. However, the buyer than buys
product j and, therefore, …rm i does not have an incentive to deviate. Whenever
u1 p1 6= u2 p2 and p1 + p2 = y , the …rm which o¤ers a larger net surplus
has an incentive to increase its price. Hence, in equilibrium, u1 p1 = u2 p2 .
Solving u1 p1 = u2 p2 and p1 + p2 = y gives pi = (y + ui uj )=2. Clearly,
for u1 + u2 y , each seller charges p1 = u1 and p2 = u2 .
3. Consumers make strictly positive surplus if u1 + u2 > y > u1 u2 . Here, …rms
compete for the limited budget of the buyer. For a smaller as well as for a larger
budget, consumer surplus is zero. Thus, consumer surplus in non-monotone in
y . For u1 u2 y , there is a total surplus loss compared to the social optimum
because in the social optimum each buyer obtains one unit of each product.

Exercise 11 Di¤ erentiated duopoly with uncertain demand

1. Consider a monopolist facing an uncertain inverse demand curve
p=a bq + :
When setting its price or quantity the monopolist does not know but
knows that E[ ] = 0 and E[ 2 ] = 2 . The cost function of the monopolist
is given by
c2 q 2
C(q) = c1 q + ;
2
with a > c1 > 0 and c2 > 2b.
Show that the monopolist prefers to set a quantity if the marginal cost
curve is increasing and a price if the marginal cost curve is decreasing.
Provide a short intuition for the result.

8
 2. Now consider a di¤erentiated duopoly facing the uncertain inverse demand
system
p1 = a bq1 dq2 +
and
p2 = a bq2 dq1 + ;
with 0 < d < b, E[ ] = 0 and E[ 2 ] = 2 . Again, the cost functions are
2
similar for both …rms and are given by C(q) = c1 q + c22q , with a > c1 > 0
2 2
and c2 > 2(b b d ) .
Both …rms play a one-shot game in which they choose the strategy variable
and the value of this variable simultaneously.
Argue by the same line of reasoning as in (1) that

(a) if c2 > 0 in the unique Nash equilibrium both …rms choose quantities
(b) if c2 < 0 in the unique Nash equilibrium both …rms choose prices
(c) if c2 = 0 there exist four Nash equilibria in pure strategies.

Solutions to Exercise 112

Price vs. quantity setting

quantity setting:

c2 q 2
E( ) = pq C(q) = (a bq)q c1 q
2
@E( )
= a 2bq c1 c2 q = 0
@q
a c1 ab + ac2 + bc1
! E(q ) = p = +
2b + c2 2b + c2
(a c1 )2
E( q) =
2(2b + c2 )

price setting:

a p a p c2 a p 2
E( ) = pq C(q) = p c1
b b b b 2 b b
@E( )
= 0
@p
b(a c1 ) (a c1 )
! E(p ) = a q = +
2b + c2 2b + c2 b
(a c21 ) c2 2
E( p) =
2(2b + c2 ) 2b2
2 This exercise is based on Klemperer&Meyer (1986).

9
 ! compare pro…ts of the two settings (Note that E( 2 ) = 2
> 0):

c2 2
p > q , > 0 if c2 < 0
2b2
! …rm chooses price competition if MC are decreasing

c2 2
p < q , < 0 if c2 > 0
2b2
! …rm chooses quantity competition if MC are increasing

Calculate best responses given the strategic choice of the other …rm (by symmetry
we only have to look at …rm 1):

Suppose that …rm 2 has decided to set quantity q2

! optimal quantity reaction by …rm 1:

q12
1 = (a bq1 dq2 + )q1 c1 q1 c2
2
@ 1
= 0
@q1
a c1 dq2
E(q1 ) =
2b + c2

(a c1 dq2 )2
best response payo¤: E( 1) =
2(2b + c2 )

! optimal price reaction by …rm 1:

2
p1 (a p1 dq2 + ) a p1 dq2 + c2 a p1 dq2 +
1 = c1
b b 2 b
@ 1
= 0
@p1
b(a dq2 c1 )
E(p1 ) = a dq2
2b + c2

(a dq2 c1 )2 c2 2
best response payo¤: E( 1) =
2(2b + c2 ) 2b2
! optimal reaction to quantity setting by the competitor is to also set quantities
if c2 > 0, i.e. if MC are increasing!

suppose …rm 2 has decided to set price p2

10
 ! optimal quantity reaction by …rm 1:

a p2 dq1 +
plug in q2 = into p1 = a bq1 dq2 +
b
(b d) (b2 d2 ) d (b d)
! p1 = a q 1 + p2 +
b b b b

rename:
(b d) (b2 d2 ) d b (b d)
a ; ; ;
b b b b

c2 q12
1 = ( q1 + p2 + b)q1 c1 q1
2
@ 1
= 0
@q1
c1 + p2
E(q1 ) =
2b + c2
(a c1 + p2 )2
E( 1) =
2(2 + c2 )
! optimal price reaction by …rm 1:

p1 + p 2 + b
q1 =
@ 1
= 0
@q1
( + p2 c1 )
E(p1 ) = + p2
2 + c2
2
( + p2 c1 )2 c2b
E( 1) =
2(2 + c2 ) 2b2
! optimal reaction to price setting by …rm 2 is to set quantities if c2 > 0, i.e.,
if MC are increasing
Summary:

if c2 > 0, then it is a dominant strategy for both …rms to set quantities !

unique Cournot equilibrium

if c2 < 0, it is a dominant strategy for both …rms to set prices ! unique

Bertrand equilibrium

if c2 = 0, …rms are indi¤erent between choosing prices and quantities ! there

are four NE: {price, quantity}, {quantity, price}, {quantity, quantity}, {price,
price}

11
Exercise 12 Cournot duopoly and cost information
Consider a duopoly market for a homogeneous product in which …rms set
quantity. Inverse demand is P (q) = 1 q with q = q1 + q2 . Firm 1 has marginal
costs equal to 0.7. Firm 2 has marginal cost 0.65 with probability 1=2 and 1
with probability 1=2.
1. Suppose that the cost type is publicly observed by both …rms prior to the
quantity setting. Characterize the equilibrium outcome of this game.
2. Suppose from now on that …rm 2 privately observes its cost type before
setting its quantity. Determine the equilibrium of this game. What is the
appropriate equilibrium concept? In particular, determine equilibrium
quantities and pro…ts.
3. Would …rm 2 have an incentive to reveal its cost type to …rm 1 if it could
do so at zero cost?
4. Would …rm 1 have an incentive to …nd out about …rm 2’s costs? Would
it like to do so privately (assuming that …rm 2 does not know the cost of
…rm 1 has when investigating) or publicly?
5. Are consumers better o¤ if …rm 2’s cost type remains private information?
Discuss.

Solutions to Exercise 12

1. …rms share information:

high costs:

…rm 1:

1 = (1 q1 q2 0:7)q1
@ 1
= 0:3 q2 2q1 = 0
@q1
0:3 q2
q1 =
2

…rm 2:

2 = (1 q2 q1 1)q2 = ( q2 q1)q2
H
! will not produce ! ! =02
0:3
q1 = = 0:15
2
1 = (1 0:15 0:7)0:15 = (0:15)2 = 0:0225

12
low costs:

…rm 2:

2 = (0:35 q1 q2 )q2
@ 2
= 0:35 q1 2q2 = 0
@q2
0:35 q1
q2 =
2
…rm 1:
0:3 0:35 q1
q1 = +
2 4 4
4 1 1
q1 = = 0:0083
3 16 12
2
q2 = 0:13
15
1 2 1 1
1 = (0:3 ) = 0:0069
12 15 12 144
1 2 2 4
2 = (0:35 ) = 0:018
12 15 15 225
) the lower cost …rm makes higher pro…ts

2. Firm 2 privately observes its cost type:

! Solve for a Bayesian NE since its a static game with imperfect info

…rm 2:

2 = (1 q1
q2 c2 )q2
1 c2 q1
! max 2 , q2 (c2 ) =
q 2
0:35 q1
q2L =
2
q2H = 0

13
 …rm 1:
1 1 1 1
1 = (0:3 q1 q2L )q1 + (0:3 q1 q2H )q1 = (0:3 q1 )q1 ( q2L + q2L )q1
2 2 2
| {z 2 }
E(q2 )

0:3
E(q2 )
q1 =
2
0:35 q1
E(q2 ) =
4
0:3 0:35 q1 17
q1 = = 0:121
2 8 140
L 4
q2 = 0:114
35
q2H = 0

17 4
NE strategies: fq1 = 140 ; q2L = 35 ; q2H = 0g

pro…ts:
1 17 4 17 1 17 17 289
E( 1) = (0:3 ) + (0:3 ) = 0:015
2 140 35 140 2 140 140 19600
L 17 4 4 4 16
2 = (0:35 ) = = 0:0131
140 35 35 35 1225
H
2 = 0
3. yes, because if he is of high cost, he makes zero pro…ts in both cases, but if he
has lower costs, then his pro…t is higher if costs are revealed!

4.
If …rm 1 …nds out costs publicly:
1 1 1 53
E( 1) = (0:15)2 + = 0:01472
2 2 144 3600
If costs are not revealed:
289
E( 1) = 0:01474
19600
If …rm 1 …nds out the costs privately:
4
It knows that …rm 2 thinks …rm 1 does not know and will therefore play q2L = 35
H
and q2 = 0. Hence, …rm 1 will take this into account when maximizing pro…ts.
high costs:

1 = (0:3 q1 )q1 , q1 = 0:15

3 9
1 = ( )2 =
20 400

14
 low costs:
4 13
1 = (0:3 q1
)q1 , q1 =
35 140
13 2 169
1 = ( ) =
140 19600
1 9 1 169 61
E( 1 ) = + = 0:01556
2 400 2 19600 3920

) …rm 1 has an incentive to …nd out costs privately, whereas it does not want to
…nd out publicly!

5. Are consumers better o¤ if …rm 2’s costs stay private information?

1. costs are publicly observed:

1 2 13
low cost: q = + = 0:216
12 15 60
1 13 2 169
CS = ( ) = 0:0235
2 60 7200

high cost: q0:15 =

1 9
CS = (0:15)2 = 0:01125
2 800
5
! E(CS) = 0:01736
288
2. costs are private info:

17 289
high cost: q = ! CS = 0:00737
140 39200
17 4 1089
low cost: q = + ! CS = 0:02778
140 35 39200
689
! E(CS) = 0:01758 (1)
39200
3. …rm 1 observes costs without …rm 2 knowing it:

9
high cost: q = 0:15 ! CS =
800
4 13 29 841
low cost: q = + = ! CS =
35 140 140 39200
641
! E(CS) = 0:01635
39200
! Consumers are better o¤ if costs stay private info. They are worst o¤ when
…rm 1 can …nd out the costs privately.

15
Exercise 13 Strategic capacity choice

Consider a market in which …rms 1; :::; N set simultaneously capacities for

a homogeneous product and afterwards a third party, which observes market
demand and the capacity choice of each …rm sets the market clearing price.
Suppose that inverse demand is linear and of the form P (q) = a q, where
PN
p is the price, a a positive constant, and q aggregate output, q = i=1 qi ;
qi is the quantity sold by …rm i. Suppose that …rm i has constant marginal
costs of production ci (…rms have di¤erent marginal costs!). Suppose that a >
maxfc1 ; :::; cN g. Suppose furthermore that the parameters of the model are
such that each …rm produces positive output. Solve for the Nash equilibrium
where capacity is the strategic choice of the …rms. Determine aggregate output
and price level in equilibrium. Determine the output of each …rm i.

Exercise 14 Price setting in a market with limited capacity [included in the

2nd edition of the book]

Suppose that two identical …rms in a homogeneous-product market compete

in prices. The capacity of each …rm is 3. The …rms have constant marginal
cost equal to 0 up to the capacity constraint. The demand in the market is
given by Q(p) = 9 p. If the …rms set the same price, they split the demand
equally. If the …rms set a di¤erent price, the demand of each one of the …rms
is calculated according to the E¢ cient Rationing Rule. Show that p1 = p2 = 3
can be sustained as an equilibrium. Calculate the equilibrium pro…ts.

Solutions to Exercise 14
At the prices p1 = p2 = 3, both …rms produce at full capacity. We conclude that
the …rms have no incentives to deviate to a lower price. This would result in the same
amount of sales but at a lower price. The e¢ cient rationing rule implies that a …rm
that deviates upwards faces a demand of D(p) = 6 p. Thus, the pro…ts are (6 p)p
when deviating to some p > 3. It is easy to show that (6 p)p is decreasing in p for all
p > 3. This, in turn, implies that deviating to a price above 3 is not pro…table. Hence,
p1 = p2 = 3 is an equilibrium. The equilibrium pro…ts are: N E = 3(9 3)=2 = 9.

Exercise 15 Capacity-constrained imperfect competition

Suppose two …rms in an industry face linear inverse demand curves Pi (qi ; qj ) =
7 qi qj , i = 1; 2, i 6= j. Firms compete in a two-stage game; …rst they set ca-
pacity and then they set price or output. At the …rst stage …rms set capacities,
at this stage the marginal costs of capacity is 6. Suppose that …rms have zero
marginal costs of production up until installed capacity and that production
above capacity is not feasible. In case of rationing, rationing is assumed to be
e¢ cient.

1. Suppose each …rm has a capacity of 7. Analyze competition at stage 2.

Determine the Nash equilibrium if both …rms set prices.

16
 2. Consider the same situation as in (1) but suppose that …rms choose quan-
tities, not prices at stage 2. Determine the Nash equilibrium.
3. Consider the same situation as in (1) but suppose that consumers do not
observe price and incur a cost of 1=2 if, after visiting one …rm, they decide
to visit the other …rm. [You can think of identical consumers with the
demand function as given above]. Characterize the equilibrium if both
…rms set prices. (What is the appropriate equilibrium concept here?).
Give an explanation (at most 2 sentences).
4. Suppose that …rms have given capacities q 1 and q 2 , respectively. If …rm 1
is the high-price …rm, what is its demand function? Determine the Nash
equilibrium in prices (provided that q i 49=24, i = 1; 2). Show that
equilibrium prices satisfy p1 = p2 = a q 1 q 2 .
5. Determine the subgame perfect equilibrium of the two-stage game in which
…rms …rst set capacities and then prices. Give an explanation (at most 3
sentences).
6. Suppose that …rms collude at the stage at which they set capacity. What
should they do?
7. Suppose that …rms are able to use a less costly technology (e.g., the mar-
ginal cost of capacity falls from 6 to 11=2). What are the competitive
e¤ects of this reduction in capacity costs? What would happen if those
costs fell to zero? Discuss your results.

Solutions to Exercise 15

1. Suppose that capacity is 7

! NE in prices
! products are homogenous ! prices equal to MC
! pB B
i = 0, qi = 3:5 and
B
i = 0 (i = 1; 2)

2. Suppose that capacity is 7

! NE in quantities:

i = (7 qi qj )qi
@ i
= 7 2qi qj = 0
@qi
7 q2
qi = with i = 1; 2; i 6= j
2

! q1C = q2C = 37 , pC C
1 = p2 =
7
3 and C
1 = C
2 = 49
9

17
 3. Consumers do not observe prices before consumption
The appropriate equilibrium concept is a Perfect Bayesian Equilibrium (PBE)
since consumers’decision which …rm to choose depends on their beliefs. There
are multiple PBE which can be supported by di¤erent belief systems. Focus will
be on the PBE that yields highest pro…ts for the …rms.
Assume that consumers believe that both …rms set identical prices.
! Consumers are indi¤erent between visiting either …rm 1 or …rm 2 at …rst.
Therefore, they visit …rm i (i = 1; 2) with probability 1=2 and will never con-
sider a second o¤er given that switching cost are larger than zero (they are equal
to 1=2 in this exercise). In consequence, …rms will set their prices equal to the
monopoly level. (We can therefore specify consumers’ beliefs even more pre-
cisely stating that consumers believe that …rms will both set monopoly prices.)
Do …rms have an incentive to deviate from setting monopoly prices given this
belief system? No, since the probability of a consumer switching to check the
o¤er of the second …rm is zero given the beliefs and consumers choose a …rm
randomly in the …rst place.
Hence, consumers believing that …rms set monopoly prices and …rms actually
choosing prices equal to monopoly level is a PBE.

4. Suppose that …rms have given capacities q1 and q2 :

e¢ cient rationing rule implies the following demand for …rm 1 (residual demand
for those not served by …rm 2):
(
b 1) = 0 if q2 Q1 (p1 )
Q(p
Q(p1 ) q2 if q2 < Q(p1 )

maximum capacity chosen is such that its revenues minus costs are non-negative
independent of its competitor:
! maximum revenue in period 2:

M
M @ 7
= p(7 p) ! =7 2p = 0 , pM = = 3:5
@p 2
M
= 3:52
M 49
pro…t maximizing capacity must satisfy: > 6qi , qi < 24 ! this condi-
tion is ful…lled by assumption

pro…ts:

2 = (p2 6)q2
1
b 1 ) 6q1 = p1 (Q=p1 )
= p1 Q(p q2 ) 6q1

Show that pN = p1 = p2 = 7 q1 q2 is the NE price, i.e., show that …rm

i has no incentive to deviate by setting a price above or below pN ! [Note that pN

18
 b 1 ) = (7
implies market clearing: Q(p p1 q2 ) = (7 7 + q1 + q2 q2 ) = q1 and
Q(p2 ) = q2 ]

Suppose pi < p :
! at p …rm i sells all its capacity
! lowering pi would increase demand above capacity
! still sell qi , but at lower price ! i #

Suppose pi > p :
! due to capacity limit of …rm j , …rm i obtains positive demand for pi > p
! in order to show that it is not optimal to raise prices, prove that the rev-
enue maximizing price lies to the left of p (Note: costs of capacity are already
incurred in period 1)
! if pi > p , then revenue is given as
(
b i) = pi (7 pi qj ) if 7 pi > q j
pi Q(p
0 else
7 qj
! revenue maximizing price: pbi = 2
! this price must be smaller than p
7 qj
pbi < p , <7 qi qj , 7 > qj + 2qi
2
49 49
! we know that qi by assumption. Hence, 7 >
24 24 + 49
12 ,
168
24 > 147
24 !
it is not optimal to set a price pi > p

!p =7 q1 q2 is the NE price

5. SPNE of the two-stage game

! second stage: see 4)
! …rst stage: plug in NE prices in the pro…t function:

1 q2
1 = (7 q1 q2 )q1 6q1 , FOC: 1 2q1 q2 = 0 , q1 =
2
1 q1
2 = (7 q2 q1 )q2 6q2 , FOC: 1 2q2 q1 = 0 , q2 =
2
1 2 1 1 1
) q1 = q2 = and 1 = 2 = (7 ) 6 =
3 3 3 3 9
! NE: …rms set quantities equal to qi = 31 and choose prices according to
p = 7 q1 q2
! chosen capacities are equal to the quantities that would result in a standard
Cournot game with MC equal to 6

19
 6. If …rms collude at the capacity setting stage, they maximize joint pro…ts:

M
M @ 1
= (7 q)q 6q ! =1 2q = 0 , q =
@q 2
M
q 1 1
) q1 M = q2 M = = and M
1 = M
2 = =
2 4 2 8

11
7. Reduction in MC to c = 2 changes the results of the …rst stage:

11 3 qj 1
i = (7 qi qj )qi qi , qi = ) q1 = q2 =
2 4 2 2
! As costs of capacity fall, q1 and q2 increase. Furthermore, pro…ts increase
to 1 = 2 = 14

As c ! 0, we arrive at capacities equal to Cournot quantities given zero marginal

production costs (see question 1). In general, the …rst-stage game corresponds to
solving a Cournot game with MC equal to the capacity costs and the unique second
stage game NE corresponding to p1 = p2 = p = 7 q1 q2 .

Exercise 16 Competition, installed capacity, and demand uncertainty

Suppose two …rms, …rm 1 and …rm 2, operate in a homogeneous good market.
The supply of …rm i, denoted by qi , is constrained by installed capacity ki ,
i.e., 0 qi ki for i = 1; 2. Firms have zero marginal costs of production
for quantities weakly below their capacity. They cannot increase production
beyond capacity.
There is a group of consumers of size e who all have unit demand with
the same willingness-to-pay r. Demand e is uncertain. The size of demand is
determined by the value a random variable takes. Suppose that this random
variable is uniformly distributed on the unit interval (i.e., on the interval [0; 1]).
Due to regulatory intervention there is a price ceiling P r that …rms are
allowed to charge (lower prices are admissible).
Consider the following two-stage game. At stage 1, before observing the
demand realization e …rms make investment decisions simultaneously. The con-
stant cost per unit of capacity is c. After the investment stage, information
about capacities become public knowledge. Next, demand is realized and pub-
licly observed. At stage 2, …rms compete in prices. Each …rm simultaneously
and independently sets its price pi . Firms maximize expected pro…ts.

1. Determine the allocation at stage 2 for given capacity choice.

2. Determine the Nash equilibrium at stage 2 for given capacities. Here you
have to distinguish between four di¤erent parameter regions. Note that

20
 in two regions pure-strategy equilibria do no exist and you have to solve
for mixed-strategy equilibria. Also note that since all consumer have the
same willingness-to-pay you can be agnostic about the rationing rule that
is applied. If prices are equal, demand is assumed to be equally split
between …rms.

3. Analyze the 2-stage game and solve for subgame perfect Nash equilib-
ria (HINTS: Do not treat …rms as symmetric. Consider capacity as a
pure strategy). What is the expected pro…t at this stage? Draw the best-
response functions of the two …rms in a diagram. Determine the aggregate
equilibrium capacity K = k1 + k2 in this game. Implicitly characterize
equilibrium capacities k1 and k2 . Can you say anything about equilibrium
pro…ts (e.g., whether they are the same for the two …rms or which …rm
enjoys higher pro…t)?

Exercise 17 Cournot equilibrium and competitive limit

Suppose there are N …rms in a homogeneous good market which set their
output sequentially (…rm i in period i). Suppose that …rms have identical con-
stant marginal costs of P
production c. The industry faces an inverse demand
N
P (q) = a q where q = i=1 qi is aggregate demand. Suppose that a > c.

1. What is the output level of …rm i in the subgame perfect equilibrium?

2. What is the aggregate output for N …rms?
3. Describe the equilibrium outcome when the number of …rms increases
without bounds (N ! 1).

Solutions to Exercise 17
N …rms, M C = 0, homogenous good, output is set sequentially
) Search for SPNE (backward induction starting in period N with …rm N )

…rm N :
N
X1
N = (p c)qN = (a q c)qN = (a qj qN c) qN
j=1
N
X1
@ N 1
! = 0 , qN = (a qj c)
@qN 2 j=1

21
 …rm N 1:
N
X2
N 1 = (a q c)qN 1 = (a qj qN 1 qN c) qN 1
|{z}
j=1
e x p e c t e d : ) p l u g i n qN

N
X2
1
= (a qj qN 1 c)qN 1
2 j=1
N
X2
@ N 1 1
! = 0 , qN 1 = (a qj c)
@qN 1 2 j=1

1
PN 3
...analogously for N 2: qN 2 = 2 (a j=1 qj c)

1
PN k 1 1
Pi 1
Hence, qN k = 2 (a j=1 qj c) or qi = 2 (a j=1 qj c).

) Compare qi with qi 1:

i 1
X i 2
X
1 1
qi qi 1 = (a qj c) (a qi c)
2 j=1
2 j=1
1
, qi = q (I)
2 i 1

) …rms always produce less (half) than the …rm before them!

What does the …rst …rm i = 1 do?

qi=1 = 12 (a c 0) = 12 (a c) (II)

) from (I) and (II) we …nd solutions for questions (1) to (3):
1. qi = 1i (a c)
2 PN PN 1 PN 1
2. aggregate output: q = i=1 qi = i=1 2i (a c) = (a c) i=1 2i =
(a c) (1 12 N )

3. For N ! 1: q ! (a c)
Note that for q ! (a c): P ! c, i.e. Bertrand competition (But …rms are asym-
metric in the sense of qi .)

Exercise 18 Competing in price-quantity pairs

Consider a duopoly for a homogeneous product. Firms i = 1; 2 set price-
quantity pairs (pi ; qi ) simultaneously. If at these pairs some consumers are
rationed, rationing is assumed to be e¢ cient. Suppose …rms are constrained
by capacities ki > 0 and inverse market demand is P (q) = q 1 . Does a Nash
equilibrium in pure strategies exist? Is it unique? Characterize all Nash equilibria
of this game

22
Exercise 19 Sequential price setting with di¤ erentiated products [included in
the 2nd edition of the book]

Consider a market with two horizontally di¤erentiated products and inverse

demands given by Pi (qi ; qj ) = a bqi dqj . Set b = 2=3 and d = 1=3. The
system of demands is then given by Qi (pi ; pj ) = a 2pi + pj . Suppose …rm
1 has cost c1 = 0 and …rm 2 has cost c2 = c (with 7c < 5a). The two …rms
compete in prices. Compute the …rms’pro…ts:

1. at the Nash equilibrium of the simultaneous Bertrand game,

2. at the subgame perfect equilibrium of the sequential game

(a) with …rm 1 being the leader, and

(b) with …rm 2 being the leader.

3. Show that …rm 2 always has a second-mover advantage, whereas …rm 1

has a …rst-mover advantage if c is large enough.
4. Solve for the Nash equilibria of the endogenous timing game in which
…rms simultaneously choose whether to play ‘early’ or to play ‘late’. If
they both make the same choice (either ‘early’or ‘late’), the simultaneous
Bertrand game follows; if they make di¤erent choices, a sequential game
follows with the …rm having chosen ‘early’being the leader.

Solutions to Exercise 19

1. Nash equilibrium of the simultaneous Bertrand game. Firm 1 chooses p1 to

maximize 1 = (a 2p1 + p2 )p1 . Solving the …rst-order condition for p1 , one
…nds …rm 1’s reaction function as p1 = (a + p2 ) =4. Firm 2 chooses p2 to
maximize 2 = (a 2p2 + p1 )(p2 c). Solving the …rst-order condition for
p2 , one …nds …rm 2’s reaction function as p2 = (a + 2c + p1 ) =4. The solution
to the system made of the two reaction functions is p1 = (5a + 2c) =15 and
p2 = (5a + 8c) =15. We can then compute the equilibrium pro…ts as B 1 =
2 2 B 2 2
225 (5a + 2c) and 2 = 225 (5a 7c) .

2. Sequential game

(a) If …rm 1 is the leader, it takes …rm 2’s price reaction into account when
maximizing pro…ts; that is, it chooses p1 to maximize 1 = (a 2p1 +
1
4 (a + 2c + p1 ))p1 . The optimal price is found as p1 = (5a + 2c) =14.
Firm 2 then reacts by setting p2 = (19a + 30c) =56. Plugging the prices
into the pro…t functions, one obtains L 2
1 = (5a + 2c) =112 and 2 =
F
2
(19a 26c) =1568.

23
 (b) If …rm 2 is the leader, it takes …rm 1’s price reaction into account when
maximizing pro…ts; that is, it chooses p2 to maximize 2 = (a 2p2 +
1
4 (a + p2 ))(p2 c). The optimal price is found as p1 = (5a + 7c) =14.
Firm 1 then reacts by setting p1 = (19a + 7c) =56. Plugging the prices
into the pro…t functions, one obtains L 2 = (5a 7c)2 =112 and F1 =
2
(19a + 7c) =1568.
F 2 L
3. Firm 2 always has a second-mover advantage: p 2 = (19a
p 26c) =1568 > 2 =
2
(5a 7c) =112 ispequivalent to (19 5 p 14)a + (7 14 26)c > 0, which is
satis…ed as 19 5 14 = 0:292 > 0 and 7 14 26 = 0:192 > 0. Firm 1 has a
…rst-mover advantage if L 2 F 2
1 = (5a+2c) =112 > 1 = (19a+7c) =1568, which
is equivalent to 7c2 + 14ac 11a2 > 0 or c > 0:604a. (Note: 0:604 < 5=7,
i.e., there is a positive interval of c where the above condition is ful…lled.)

Exercise 20 Timing game [included in the 2nd edition of the book]

Use the results of the previous exercise to solve for the Nash equilibria of
the endogenous timing game in which …rms simultaneously choose whether to
play ‘early’or to play ‘late’. If they both make the same choice (either ‘early’or
‘late’), the simultaneous Bertrand game follows; if they make di¤erent choices,
a sequential game follows with the …rm having chosen ‘early’being the leader.
Discuss the economic intuition behind your result.

Solutions to Exercise 20 The following matrix represents the normal form of

the game:

Firm 1 / Firm 2 Early Late

B B L F
Early 1 ; 2 1; 2
F L B B
Late 1; 2 1 ; 2 1
1

As far as …rm 2 is concerned, we already know from Exercise 4.1 that F L

2 > 2 . It
L 2 B 2
is also easy to see that 2 = 2(5a 7c) =224 is larger than 2 = 2(5a 7c) =225: We
have thus F L B L 2
2 > 2 > 2 . As for …rm 1, it is easy to see that 1 = 2(5a+2c) =224 >
B 2 F B
1 = 2(5a + 2c) =225. We can also show that 1 > 1 :

F B
1 1 = 1
1568 (19a + 7c)2 2252
(5a + 2c)2
1
= 352 800 (5a 7c) (565a + 217c) ;

which is positive as we assume that 7c < 5a. Hence, there are two pure-strategy NE:
(Early, Late) and (Late, Early). There also exist a mixed-strategy NE. To characterize
it, let …rm 1 choose , the probability with which it plays (Early), such that …rm 2 is
B
indi¤erent between (Early) and (Late); that is, 2 +(1 ) L2 =
F
2 +(1 ) B2 ,
L B F L B
which is equivalent to = ( 2 2 )=( 2 + 2 2 2 ). We proceed in the same way
for …rm 2, which chooses , the probability with which it chooses (Early), to make …rm
B
1 indi¤erent between (Early) and (Late); that is, 1 +(1 ) L1 =
F
1 +(1 ) B1 ;

24
which implies that = L 1
B F
1 =( 1 +
L
1 2 B
1 ). Replacing the various pro…t
level by their respective value, one …nds

14(5a 7c)2 14(5a+2c)2

= 3175a2 3760ac 878c2 and = 3175a2 2590ac 1463c2 :

Exercise 21 Information sharing in Cournot duopoly [included in the 2nd edi-

tion of the book]

Consider the Cournot duopoly with linear demand P (q) = 1 q with q =

q1 + q2 and constant marginal cost. Firm one has marginal cost of zero. This is
commonly known. The marginal cost of …rm 2 is privately known to …rm 2; …rm
1 only knows that they are prohibitively high or zero and that both events are
equally likely (this is commonly known). High marginal costs are assumed to be
prohibitively high such that …rm 2 does not produce. Consider the three-stage
game in which, at stage 1, …rm 2 draws its marginal costs, then, at stage 2, it
decides whether to share its information with its competitor and, at stage 3, in
which both …rms compete in quantity.

1. Characterize the equilibrium of this game. Does …rm 2 have an incentive

to share its private information?
2. Would …rm 1 be better o¤ under information sharing?

Solutions to Exercise 21
Suppose …rst that …rm 2 shares its information. In this case …rm 1 learns the cost
type of …rm 2. If …rm 2’s costs are high, …rm 1 knows that …rm 2 will produce zero;
thus, …rm 1 will produce the monopoly quantity q1m = 1=2; the monopoly pro…t is
= 1=4. If the costs of …rm 2 are zero, we have a symmetric Cournot duopoly.
Firms will produce duopoly quantities. q1d = q2d = 1=3; and pro…ts are di = 1=9.
Now suppose that …rm 2 does not share its information. Then …rm 1 produces a
quantity between q1d and q1m . Pro…ts of …rm 1 and the low-cost …rm 2 are

1 1
1 = (1 q1 q2 )q1 + (1 q1 )q1
2 2
2 = (1 q1 q2 )q2

First-order conditions of pro…t maximization at stage 2 can be written as:

1 1
q2 = q1 ;
2 2
1 1
q1 = q2 :
2 4
Solving this system we obtain q2 = 2=7 and q1 = 3=7. We note that q1m = 1=2 >
3=7 > 1=3 = q1d . Equilibrium at stage 2 under information sharing are

25
 s 1 3 2 3 1 3 3 9
1 = 1 + 1 =
2 7 7 7 2 7 7 49
sL 3 2 2 4
2 = 1 =
7 7 7 49
Because of strategic substitutes …rm 1’s pro…t is larger than …rm 2’s pro…t.
We now turn to the decision of …rm 2 at stage 1. If the costs of …rm 2 are high, it
obtains zero pro…t independent of whether it share information. If the costs of …rm 2
are low, then its pro…t will be higher if it shares information (1=9 rather than 4=49),
because then …rm 1 will produce less. Thus, …rm 2 wants to share its information.
Note this is certainly true ex ante (i.e., if …rm 2 has to decide before knowing its
cost). In the example, it is also true interim (after learning its cost), because the high
cost type is indi¤erent whether to share information.
What about …rm 1’s pro…t? If …rm 2 shares information, …rm 1’s expected pro…t
is: (1=2) m d
1 + (1=2) 1 = (1=2)(1=4) + (1=2)(1=9) = 13=72. If …rm 2 does not share
information, its pro…t has been calculated to be 9=49. Since 9=49 > 13=72, …rm 1
would be better o¤ if …rm 2 did share information.

Exercise 22 Price competition and information sharing

Consider the same setting except that …rms face a di¤erent demand function
and that …rms set prices at stage 3. Let demand be Qi = 1 pi dpj with
d > 0 so that products are substitutes and d < 1. Characterize the equilibrium
of this game. Does …rm 2 have an incentive to share its private information?

Solutions to Exercise 22
Suppose that …rm 2 decides to share its information at stage 2. If its costs are high,
…rm 1 knows that …rm 2 will produce zero. Thus, …rm 1 will set the monopoly price
pm
1 = arg maxp1 (1 p1 )p1 = 1=2. If the costs are symmetric, we have a symmetric
price competition model with linear demand. Each …rm i maximizes (1 pi dpj )pi
subject to pi . The …rst-order condition of pro…t maximization can be written as
pi = 1=2 (1=2)dpj . Using symmetry, we obtain that pdi = 1=(2 + d).
Now suppose that …rm 2 does not share information. Then …rm 1 sets an interme-
diate price that is between pd1 and pm
1 , as we will show next. Pro…ts are

1 1
1 = (1 p1 )p1 + (1 p1 dp2 )p1 ;
2 2
2 = (1 p2 dp1 )p2 :

First-order conditions of pro…t maximization can be written as

1 1
p1 = ap2 ;
2 4
1 1
p2 = ap1 :
2 2
With information sharing, the price of …rm 1 is

26
 higher if the cost of …rm 2 are high (monopoly vs. intermediate price)

lower if the cost of …rm 2 are high (duopoly vs. intermediate price)

Let’s compare the pro…ts of …rm 2: Suppose that the costs of …rm 2 are high. Then
it obtains zero pro…ts anyhow.
Suppose that the costs of …rm 2 are low. Then its pro…ts are lower if it has shared
information, because in this situation …rm 1 will produce less. Thus, …rm 2 does not
want to share information! Moral: it depends on Cournot vs. Betrand.

27