ECON 451 Exam Questions

1. Please define the following concepts:

a. Economies of scale/returns to scale
b. Nash equilibrium
c. Product diversification
d. Herfindahl index
e. Limit pricing

2. True or false (credit given for explanation and/or explicit calculation):

a) If a profit-maximizing competitive firm produces such a quantity q that MC(q) = AC(q), it must
be earning zero economic profit.
b) Consider a competitive industry with identical firms. In a short run industry equilibrium, a firm
will always supply the quantity that minimizes its average cost.
c) In a competitive industry with identical firms and increasing marginal costs, the higher is the
fixed cost, the higher is the long-run equilibrium price.
d) Consider a monopolist with a constant marginal cost. The higher is the elasticity of demand at
monopoly price, the higher is the profit to sales ratio for the monopolist.

3. A firm’s demand function is given by Q = 20 – 2P. Assume there is no cost. a) What is the
(monopolist) firm’s profit maximizing price and quantity? b) What is the price elasticity of
demand at this price and quantity? c) What is the value of the Lerner index at that point?

4. Assume that a monopolist supplies goods to consumers located in two regions of the country.
The demand functions for the good in each region are
Q1 = 1 − P1 and Q2 = 0.5 − P2
Assume that there is no production and transportation cost.
a) Assuming that the monopolist must charge a uniform (linear) price to the two regions, find the
profit-maximizing uniform price.
b) Assume that the monopolist can engage in third-degree price discrimination. Calculate the
profit-maximizing price for each region.
c) Does third-degree price discrimination increase or decrease welfare, as measured by the sum of
consumers’ plus producers’ surplus, in this case? Is this general result when one compares uniform
monopoly prices with third-degree price discrimination?

5. A monopolist produces a product whose demand price and production costs vary with quality s
and quantity Q according to
P = s(1 − Q) C = s2Q
a) Calculate the price and quality levels that a monopolist would choose, and the corresponding
quantity sold.
b) Derive the consumers’ surplus for any combination {s, Q}.
c) The social planner does care for both consumers and monopolist (consumers’ plus producers’
surplus). Find the optimum quantity and quality.

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 d) In which case (monopoly or social planner) the consumers’ surplus is higher?

6. The demand functions for markets H and L are gives as follows:

PH = 20 – QH PL = 10 – QL
The total cost function of the monopolist firm is as follows: C = 10 + 5Q
a) Assume that the monopolist firm applies a uniform price (same price for these two markets).
What is the optimum price?
b) Assume that the monopolist firm applies 3rd degree price discrimination. What are the optimum
prices?
c) Assume that the monopolist firm applies two part pricing in both markets. What are the
optimum prices?

7. Big C cable is a monopoly that can offer cable packages with different number of channels at
different monthly fees. The marginal cost of providing an additional TV channel is c = 0. Let p be
the customer’s willingness to pay (in cents per month) for an additional TV channel when he
already has q channels. There are two types of customers: high types whose demand for channels
is given by
pH = 120 − qH
and low types whose demand for channels is given by
pL = 60 − qL
a) Suppose all the high type customers live in Yuppieville and all the low type customers live in
Sticksfield. What number of channels and at what monthly fee will Big C offer in each of these
two areas?
b) Alternatively, assume that high types and low types live in the same area, and Big C cannot tell
its customers apart. Now it has to design a Basic package with 60 channels targeted at low types
and a Premium package with 120 channels targeted at high types. If Big C wants to sell to both
types, what is the profit-maximizing price for the Basic and Premium packages?
c) If 20% of Big C’s customers are high types and 80% are low types, will Big C benefit from
including just 40 (instead of 60) channels in its Basic Package? (Credit given for explicit
calculation of new prices for Basic and Premium packages)
d) Rate the packages in a), b) and c) in terms of their effects on social welfare. Explain.

8. A restaurant has three types of customers. A third of its customers, Type A, are willing to spend
$5 on an appetizer but only $2 on a dessert. Another third, Type B, are willing to spend $3.50 on
an appetizer and $3.50 on a dessert. The remaining third, Type C, are willing to spend only $2 on
an appetizer but $5 on a dessert. All three types are willing to spend $10 on the main course. It
costs the restaurant a constant $2 to prepare an appetizer or a dessert, and $7 to prepare the main
course. Which is optimal for the restaurant, to offer appetizers and desserts à la carte (with
separate prices on the menu), or to offer them only as a complete meal, tied in with the main
course?

9. Suppose there are 100 residents uniformly-spaced living on a 10-km long street. Each resident
has a willingness to pay for pizza of $30 and would buy 1 pizza per week. It costs a resident $1 to
travel one km. The marginal cost for each pizza shop is $5 per pizza and there is no fixed cost.
Assume price setting behavior.

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 a) Assume that those two shops are located just in the middle of the street. What will be the
equilibrium price? What will be the profits of these two shops?
b) Assume that pizza shops are located on opposite ends of the street. Derive the demand
functions (as a function of other firms’ price) and find the prices charged by each firm. Find the
profits of the shops.
c) Assume that there is a potential entrant. What is the best location for the entrant? Why?

10. Suppose there are 800 residents uniformly-spaced living on a 8-km long circular street. Each
resident has a willingness to pay for pizza of $10 and would buy 1 pizza per week. It costs a
resident $1 to travel one km. There are 4 shops located uniformly, i.e., the distance between two
neighboring shops is 2 km. Each shop is owned by independent firms. The marginal cost is $2 per
pizza and there is no fixed cost. Assume price setting behavior.
a) Derive the demand function for Shop 2 (in terms of prices of shops 1 and 3).
Hint: Q2 = 100*(x+y)

b) Find optimum prices for all shops.

c) Assume that the firms that own shops 2 and 3 merge together. Find the optimum price for the
merged firm that now owns shops 2 and 3.

11. A cable company has two services, the Basic Service and the Movie Channel. The demands for
the two services are completely unrelated for each and every consumer. Each buyer is
characterized by a pair of reservation prices as shown in the following table:
Basic Service (TL) Movie Channel (TL)
Students 5 15
Families 11 9
Hotels 14 6
Schools 4 16
Young Adults 0 17
Pensioners 17 0
The marginal cost of each service is 3 TL. Assume there are equal number of consumers in each
category.
a) If the services are sold separately, what price should the cable operator set for each service?
b) Suppose that the operator decides to pursue a mixed bundling strategy. What price should be set
for the bundled service? What price should be set for each service if purchased individually?
c) Assume that a new firm enters the market and provides only the Basic Service. The marginal
cost of the new firm is 3 TL. Can the incumbent cable operator apply the mixed bundling
strategy? (Assume price setting behavior.)

12. DayQui ice cream parlor is a monopoly. It sells to two types of customers: H and L. Consumer
H enjoys ice cream more than consumer L. In particular, the net utility (measured in TL) of
customer of type i (i is either H or L) is the consumer surplus from having q kg of ice cream
minus the price p paid for it:

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 Ui = [vi – (q/200)]q - p
where vH = 0.28 and vL = 0.20.
Assume that DayQui does not know which customer is which type and would like to offer two
different ice cream serving sizes sold at different prices (pH, qH) and (pL, qL) intended for different
customer types.
a) Suppose that 10 kg ice cream is offered at the price of 1.5 TL and 16 kg ice cream is offered at
the price of 3.2 TL. Will it work? Why or why not?
b) Suppose that DayQui decides to offer a 10 kg portion for 1.5 TL and it is intended for the L
type. What is the profit maximizing price for the 16 kg portion?
c) Assume that DayQui’s marginal cost is zero. If it were to serve only customers H, what
optimal size portion would it choose and at what price?

13. Define the concept of “consistent conjectural variations” and show how its value can be
derived.

14. Two firms produce digital cameras. Demand for these digital cameras is given by P = 100 – Q.
Firm 1 has developed a proprietary technology that enables it to produce digital cameras at a
constant marginal and average cost of $10 each. Firm 2 has an older technology that enables it to
produce digital cameras at a constant marginal and average cost of $15 each.
a) Assume the two firms compete in quantities (Cournot).
(i) What are the equilibrium quantities, market price, and profits for each firm?
(ii) Suppose firm 2 could develop a “copycat” technology with identical costs to firm 1 (MC =
AC = 10). How much, if anything, should it be willing to spend to develop that technology?
(iii) What is the social value of developing this “copycat” technology given Cournot
competition? (Value = ΣΔπ + ΔConsumer Surplus)
b) Now assume the two firms compete in prices (undifferentiated Bertrand).
(i) What are the equilibrium price, quantities, and firm profits if firm 1 uses its proprietary
technology and firm 2 uses its old technology?
(ii) Suppose firm 2 could develop a “copycat” technology with identical costs to firm 1 (MC =
AC = 10). How much, if anything, should it be willing to spend to develop that technology?
(iii) What is the social value of developing this “copycat” technology given Bertrand
competition? (Value = ΔΣπ + ΔConsumer Surplus)
(c) Both the social value and the incentives for firm 1 to develop its proprietary technology
(MC=10), given that both firms were initially using the public technology (MC = 15), are
larger under Bertrand competition than under Cournot competition. (Take this as a fact; you
could derive the result if you had time!) How does this compare to your findings for the
social value and firm 2’s incentives to develop the “copycat”.

15. Assume that there are two firms in a given market, X and Y. Let the inverse demand function
be given by P = 6 – 4Q. The pre-merger cost function for each firm is identical and is given by Ci
= 4Qi. After the merger, the new firm XY will be more efficient with the cost function
CXY = 4θQXY, where θ ≤ 1. Assume that before the merger, the companies behave as in the
Bertrand model (price setting), and after the merger there is only one firm, i.e., the standard
monopoly behavior prevails. The Competition Authority (CA) allows the merger only if the
consumer surplus increases. Find the value(s) of θ that the CA will allow for the merger.

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 16. Assume that the demand for Product A is given by P = 100 – Q. All firms in the market use the
same technology, and the total cost functions of all firms are identical, Ci = 20Qi, (subscript i
denotes the ith firm).
a) Assume the market is perfectly competitive. Find the equilibrium price and total quantity
supplied.
b) Assume that there is only one firm. Find the equilibrium price and the quantity supplied.
c) Assume that there are 4 firms in the market and they set the quantity (the Cournot model). Find
the equilibrium price and total quantity supplied.
d) Assume that there are 4 firms in the market, and 2 of these firms merge together. Is merger
profitable for those who will merge? (Assume the Cournot Model and no change in the cost
function.)
e) Assume that there are 4 firms in the market and they set the product price (the Bertrand model).
Find the equilibrium price and total quantity supplied.
f) Assume that there are 4 firms in the market and they set the quantity. One of the firms is the
leader, and all others are followers, i.e., the leader firms knows how the followers behave (the
Stackelberg model). Find the equilibrium price and the quantity supplied by each firm.
g) Find the values of the Lerner index for “c” and “f”. Which market is more competitive? Why?

17. The demand function is given as follows: P = 50 – Q, and the total cost function of the
monopolist firm is, C = 16 + 2Q. There is a firm that plans to enter to the same market. Assume
that the potential firm has the same cost function.
a) What is the limit output of the monopolist firm that can deter entry? (Assume that the potential
firm believes that the incumbent monopolist will not change its output after entry.)
b) Is this a profitable strategy for the incumbent firm?

18. Explain the following strategies that can be used by a monopolist firm to deter entry.
a) Limit pricing
b) Joint cost raising

19. Firm A is monopolist in x market, and it consumes one unit of y in order to produce one unit of
x. It costs 5 + py TL to produce one unit of x. (py is the price of product y.) y is produced by a
monopolist, B, and it costs 5 TL to produce one unitf of y. The demand for x is defined by
px = 50 – qx (px product price, qx quantity demanded).
a) Assume that px is set by Firm A and py is set by Firm B. What would be the equilibrium prices
for products x and y? Calculate Firm A and B’s profits.
b) Assume that Firms A and B merge together. What would be the equilibrium prices for products
x and y? Calculate the profits of the new firm.
c) Would the merger between A and B increase the consumer surplus? Why (not)?

20. Firm A is monopolist in x market, and it consumes one unit of y in order to produce one unit of
x. It costs 5 + py TL to produce one unit of x. (py is the price of product y.) y is produced by a
monopolist, B, and it costs 5 TL to produce one unitf of y. The demand for x is defined by
px = 50 – qx (px product price, qx quantity demanded).

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 a) Assume that px is set by Firm A and py is set by Firm B. What would be the equilibrium prices
for products x and y? Calculate Firm A and B’s profits.
b) Assume that Firms A and B merge together. What would be the equilibrium prices for products
x and y? Calculate the profits of the new firm.
c) Would the merger between A and B increase the consumer surplus? Why (not)?

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