Industrial Organization: Markets and Strategies

Paul Belle‡amme and Martin Peitz

published by Cambridge University Press

Part VI. Theory of competition policy

Exercises

Exercise 1 Industries with cartels

Brie‡y describe and analyze a case of your choice concerning a price- or

quantity-…xing cartel (please not OPEC). The following questions may be useful
to bear in mind: What are the relevant characteristics of the industry? What
was the scope of the cartel? How was the cartel enforced? What were the
e¤ects of the cartels? How did the competition authority or court argue and
what was the decision, if any? [suggested length: 1-2 pages, timesnewroman 12
pt, doublespaced]

Exercise 2 Collusion and pricing

Two (advertising-free) newspapers compete in prices for an in…nite number

of days. The monopoly pro…ts (per day) in the newspaper market are  M and
the discount rate (per day) is . If the newspapers compete in prices, they both
earn zero pro…ts in the static Nash equilibrium. Finally, if the …rms set the
same price, they split the market equally and earn the same pro…ts.
On Sundays, the newspapers may sell a weekly magazine (that can be bought
without buying the newspaper). The monopoly (competitive) pro…ts when sell-
ing the magazine are also  M (zero).

1. Suppose that the newspapers do not sell a weekly magazine. They like to
collude on the monopoly price. Write down the strategies that the news-
papers could follow to achieve this outcome. Find the discount rates for
which they are able to sustain the monopoly price using these strategies.

2. From now on suppose that the newspapers sell a weekly magazine. For
which discount rates can the monopoly price be sustained only in the
market for magazines? (Write down the equation that characterizes the
solution.) Compare the solution found in question 1 and 2 and comment
brie‡y.

3. For which discount rates can the monopoly price be sustained both in the
market for newspapers and in the market for magazines? (Write down the
equation that characterizes the solution.)

1
Exercise 3 Collusion and pricing II

Consider a homogeneous-product duopoly. The two …rms in the market

are assumed to have constant marginal costs of production equal to c. The
two …rms compete possibly over an in…nite time horizon. In each period they
simultaneously set price pi , i = 1; 2. After each period the market is closed
down with probability 1   .
Market demand Q(p) is decreasing, where p = minfp1 ; p2 g. Suppose, fur-
thermore, that the monopoly problem is well de…ned, i.e. there is a solution
pM = arg maxp pQ(p). If …rms set the same price, they share total demand
with weight  for …rm 1 and 1   for …rm 2. Suppose that  2 [1=2; 1).
Suppose that …rms use trigger strategies and Nash punishment.

1. Suppose that  = 0. Derive the equilibrium of the game.

2. Suppose that  > 0 and  = 1=2. Derive the condition according to which
…rm 1 and …rm 2 do not …nd it pro…table to deviate from the collusive
price pM .

3. Suppose that  > 0 and  > 1=2. Derive the condition according according
to which pM is played along the equilibrium path. Show that the condition
is the more stringent the higher .

4. Show that previous results in (3) also hold for any collusive price pC 2
(c; pM ).

5. Suppose that  > 0 and  > 1=2 and that …rm 1 can only adjust its
price every  periods. Derive the condition according to which pM is
played along the equilibrium path. How does the time span  in‡uence
the condition?

Exercise 4 Collusion and pricing III

Four …rms produce a homogeneous product at constant marginal costs ci =

1, i 2 f1; 2; 3; 4g. Market demand is given by 9  p, where p is the lowest price
set by the …rms. The price p is chosen from a discretized price set (where the
minimal price change " is arbitrarily small). When analyzing equilibria proceed
in two steps: Characterize the equilibrium for a given (small) " and then let "
turn to zero. If the lowest prices is set by more than one …rm, the demand at
that price is split evenly among …rms with the lowest price.

1. Determine Nash equilibrium price, quantity and pro…t of each …rm of the
game in which …rms simultaneously set price. Consider only symmetric
equilibria.

2. Suppose that …rms coordinate their pricing decisions and implement the
monopoly solution. What is each …rm’s pro…t if they jointly implement
the monopoly solution?

2
 3. Consider a model of repeated interaction in which each …rm sets its per-
period price in any discrete point in time t = 1; 2; ::: over an in…nite
time horizon. Firms discount future pro…ts by  < 1. The per-period
game is as described above. Characterize the subgame-perfect equilibrium
that implements the highest possible pro…t for the …rms in the industry.
Determine the critical discount factor below which tacit collusion on the
monopoly price cannot be sustained.

4. Suppose now that …rm 1 enjoys a marginal cost reduction to c1 = 1=2.

Determine Nash equilibrium price, quantity and pro…t of each …rm of the
one-shot game in which …rms simultaneously set price under the assump-
tion that …rms do not set prices below marginal costs.

5. Return to the in…nitely repeated game in which, di¤erent from part 3,

…rm 1 enjoys a cost advantage as speci…ed in part 4. Argue whether
there a critical discount factor below 1 such that tacit collusion on the
collusive outocome of part 2 of the exercise can be sustained. Compare
your …nding with the one obtained in part 3. Note: You are not expected
to derive an explicit solution for the critical discount factor; an implicit
characterization is su¢cient.

Exercise 5 Parallel pricing and evidence of collusion

A competition policy authority has noticed that the …rms in the Lysine
industry consistently charge very similar prices, and the suspicion is that they
are colluding. Do you think that parallel pricing is proof of collusion? If not,
what kind of evidence would you look for?

Exercise 6 Collusion and quantity competition

Consider the following market: Two …rms compete in quantities, i.e., they
are Cournot competitors. The …rms produce at constant marginal costs equal
to 20. The inverse demand curve in the market is given by P (q) = 260  q .

1. Find the equilibrium quantities under Cournot competition as well as the

quantity that a monopolist would produce. Calculate the equilibrium prof-
its in Cournot duopoly and the monopoly pro…ts. Suppose that the …rms
compete in this market for an in…nite number of periods. The discount
factor (per period) is ,  2 (0; 1).

2. The …rms would like to collude in order to restrict the total quantity
produced to the monopoly quantity. Write down strategies that the …rms
could use to achieve this outcome.

3. For which values of  is collusion sustainable using the strategies of ques-

tion (b)? [Hint: Think carefully about what the optimal deviation is.]

3
Exercise 7 The European air cargo cartel

Read the following press release of the European Commission (Brussels,

March 28, 2012): http://europa.eu/rapid/press-release_IP-12-314_en.htm. For
the sake of the exercise, we model the European air cargo market during the 72
months of the cartel existence as follows. First, only the 14 …rms associated in
the cartel were active on the market; second, these …rms were symmetric; they
all had the same constant marginal cost, c, for supplying airfreight services;
third, these …rms competed à la Cournot (i.e., by choosing the quantity of air-
freight services); …nally, the inverse demand for airfreight services (per month)
was given by p = a  2q, where q denotes the total quantity of airfreight services
supplied by the 14 …rms.
As written in the text, the Commission …ned the cartel members a total
of e169 million. Given that the cartel lasted for 72 months, this is roughly
equivalent to a …ne of e2.35 million per month. This …ne is meant to compensate
the European consumers for the surplus reduction that they su¤ered because of
the existence of the cartel.

1. Show that (a  c) had to be equal to e3.89 million (per month) to justify

the …ne of e2.35 million per month imposed by the Commission.

2. Set (a  c) to e3.89 million. Assuming that the cartel pro…ts were equally
shared among the 14 cartel members, show that any of these …rms would
have been better o¤ by unilaterally leaving the cartel (which would have
then counted only 13 members) and by acting independently. What does
this tell you about the stability of cartels? Discuss.

3. Continue to set (a  c) to e3.89 million. Take now a tacit collusion per-

spective. Suppose that the 14 …rms were following a grim trigger strategy
and were expecting to continue to compete inde…nitely on that market.
Compute the minimum discount factor that allowed the 14 …rms to sustain
full collusion (i.e., to behave as a cartel).

Exercise 8 Cournot mergers: pro…tability and welfare properties

Consider a homogeneous good duopoly with linear demand P (q) = 12  q ,

where q is the total industry output, and constant marginal costs c = 3.

1. Suppose that …rms simultaneously set quantities. Determine the equilib-

rium (price, quantities, pro…t, welfare).

2. The …rms consider to merge although their production costs are not af-
fected. Determine the solution to this problem. Is such a merger prof-
itable? What are the welfare e¤ects of such a merger?

3. Suppose that the merger is e¢ciency enhancing, leading to marginal costs

cm < c. What are the welfare e¤ects of such a merger. Do you possibly
have to qualify your answer in (2)?

4
 4. Consider the possibility of …rm entry after the merger (the entrant pro-
duces at marginal costs c = 3 and has entry cost e). Suppose …rst that the
merger is not e¢ciency-enhancing. Analyze such a market and comment
on your result (depending on the entry cost e). Suppose next that the
merger is e¢ciency-enhancing, i.e. cm < 3. Depending on cm and e, when
is a merger pro…table? [Hint: Calculate pro…ts for cm = 1=2.]

5. Many countries scrutinize merger and sometimes block them (or impose
remedies)? Discuss which factors should make the courts or the competi-
tion authority more inclined to block a merger.

Exercise 9 Cournot mergers and synergies

Consider a homogeneous-product Cournot oligopoly with 4 …rms. Suppose

that the inverse demand function is P (q) = 64  q .

1. Suppose that …rms incur a constant marginal cost c = 4. Characterize

the Nash equilibrium of the game in which all …rms simultaneously choose
quantity.

2. Suppose that …rms 1 and 2 consider to merge and that there are synergies
leading to marginal costs cm < c. Characterize the Nash equilibrium. At
which level cm (you may want to give an approximate number) are the
two …rms indi¤erent whether to merge?

3. Is such a merger that just makes the two …rms indi¤erent between merging
and non-merging consumer-welfare increasing?

4. At which level cm would the merger be consumer-welfare neutral?

5. Suppose that instead …rms 1, 2, and 3 consider to merge. The new mar-
ginal cost of the merged …rms is cn < c. At which level cn are the three
…rms indi¤erent whether to merge?

6. Compare your …ndings in (5) and (2). What can you say about incentives
to merge in this case?

Exercise 10 Cournot mergers with di¤erentiated products

Consider an n-…rm Cournot oligopoly in which each …rm i faces inverse

P
demand Pi (q1 ; q2 ; :::; qn ) = 1  qi  
q , where  2 (0; 1). Suppose that
j6=i j
all …rms have constant marginal costs of production c = 0.

1. Determine equilibrium quantities, prices and pro…ts.

2. Suppose that n = 4 and  = 1=2. Determine equilibrium quantities, prices

and pro…ts in the case of a two-…rm merger.

5
 3. Suppose that n = 4 and  = 1=2. Determine whether a two-…rm merger
is pro…table?

4. Describe the forces at play when considering the pro…tability of the merger.
What is the role of  ?

5. Discuss the welfare e¤ects of the merger.

Exercise 11 Cournot mergers and demand

Consider the following Cournot merger game. The inverse demand function
is of the form

P (q ) = a  q

where  > 0 and there are n …rms with constant marginal costs of production
c.

1. Discuss the shape of the inverse demand function depending on  .

2. Determine the Cournot equilibrium pro…ts in this set-up.Determine the

Cournot equilibrium pro…ts in this set-up. [You can simply use the …rst-
order conditions without checking whether the solution is a maximizer.]

3. Consider a merger among x …rms in an n-…rm industry. Write down the

condition for the merger to be pro…table. Check whether a 3-…rm merger
is pro…table in an industry with initially 4 …rms for parameter values
 2 f1; 2; 3g.

Exercise 12 Cournot mergers and asset complementarity

Consider an n …rm symmetric homogeneous product Cournot oligopoly.

Each …rm i has physical assets Ki = K normalized to 1. Its cost function
1 1
is Ci (qi ) = q2 .
The demand side of the market is given by an inverse
i +
Ki 32 P
demand curve P (q) = 1  q where q = q .
i i

1. Determine equilibrium price, quantity, and pro…t of the n …rm Cournot

model speci…ed above. What is the upper bound on n for all …rms in the
industry to make non-negative pro…ts?

2. Consider now a merger between the two …rms n and n  1. Suppose

…rst that physical assets cannot be sold and that the assets of one of the
merging partners are liquidated, i.e. the cost function of the merged …rm
1
is Ci (qi ; Ki ) = qi2 + 32
. Determine equilibrium price, quantity, and pro…t
of the …rm Cournot model after the merger. For which n are mergers
pro…table? For which n are mergers consumer surplus increasing?

6
 3. Consider again a two-…rm merger, but suppose now that the merged …rm’s
1
assets can be combined giving rise to the cost function Ci (qi ; Ki ) = Ki i
q2 ,
1 2 1
i.e. the merged …rm n  1 has cost function Cn1 (qi ; 2) = q + . De-
2 i 16
termine equilibrium price, quantity, and pro…t of the …rm Cournot model
after the merger. For which n are mergers pro…table? For which n are
mergers consumer surplus increasing? [Hint: you may want to solve parts
3 and 4 together]

4. Consider once again a two-…rm merger, but suppose now that the merged
…rm’s assets are complementary. More speci…cally, suppose that the merged
1 2 1
…rm n  1 has cost function Cn1 (qi ; 2) = q + 16 . Determine equilibrium
4 i
price, quantity, and pro…t of the …rm Cournot model after the merger. For
which n are mergers pro…table? For which n are mergers consumer surplus
increasing? What happens when the complementary is even stronger?

5. Based on your …ndings in parts 2-4 what are the policy conclusions for an
antitrust authority?

Exercise 13 Mergers with price-setting …rms

Consider a homogeneous product industry with three …rms A; B; and C .

Firms have constant marginal costs of production cA > cB > cC and no …xed
costs. There is a unit mass of consumers with willingness to pay r > cA . Firms
simultaneously set prices to maximize pro…ts. Suppose that, in parts 2 to 4 of
this problem, …rms do not choose weakly dominated strategies. In case of a
merger, the merged entity has the lowest cost of the two …rms consuming the
merger.

1. Characterize the full set of Nash equilibria—in particular, characterize

  
equilibrium demand and equilibrium prices (pA ; pB ; pC ). What is the
Nash equilibrium outcome if all …rms do not choose weakly dominated
strategies?

2. Is a merger between …rms A and B pro…table? What would be the con-

sumer surplus e¤ect of such a merger?

3. Is a merger between …rms A and C pro…table? What would be the con-

sumer surplus e¤ect of such a merger?

4. Is a merger between …rms B and C pro…table? What would be the con-

sumer surplus e¤ect of such a merger?

Exercise 14 Mergers and free entry

7
 Consider a homogeneous product market with in…nitely many quantity-
setting …rms. The inverse demand function is given by P (q) = a  q where
q is industry quantity. The cost function of each …rm is Cs (qi ) = cs qi + Fs for
qi > 0 and Cs (0) = 0. Suppose that parameters are such that, in any equi-
librium, more than one …rm is active (Note: In the analysis below it is NOT
required to derive the parameter restriction which guarantees that this property
is satis…ed.) For simplicity, the analysis below should be carried out under the
assumption that the number of …rms is a real number.

1. Characterize the set of pure-strategy free-entry equilibria of the game in

which all …rms simultaneously quantities. Determine equilibrium quantity
of each active …rm, equilibrium price, industry quantity, number of …rms,
and consumer welfare in equilibrium.

2. Consider a single merger between two …rms. Suppose that the merged
…rm has cost function Cm (qi ) = cm qi + Fm for qi > 0 and Cm (0) = 0 and
that cm = cs , while Fm  2Fs . Derive the exact condition when a merger
is pro…table when there is free entry before and after the merger.

3. In the setting of (2) is a pro…table merger welfare-increasing? Or is a

pro…table merger welfare-decreasing? Explain your …ndings.

4. Consider now a single merger after which the merged …rm has costs with
cm  cs and Fm = Fs . Derive the exact condition when a merger is
pro…table when there is free entry before and after the merger. [2 points]

5. In the setting of (4) is a pro…able merger welfare-increasing? Or is a

pro…table merger welfare-decreasing? Explain your …ndings.

Exercise 15 Burning ships

Hernan Cortéz, the Spanish conqueror (”conquistador”), is said to have

burned his ships upon the arrival to Mexico. Why would he do such a thing?

Exercise 16 Quantity commitment

Up to two …rms are in a market in which quantities are the strategic variable.
There are two periods; in the …rst period …rm 1 is a protected monopolist.
In each of the two periods t = 1; 2 the inverse demand function P t is given
by P t (xt ) = 20  xt . In each period the cost function of …rm i is given by
t t
Cit (xi ) = 9 + 4xi . Pro…ts of a …rm are the sum of its pro…ts in each period (no
discounting). Firms maximize pro…ts by setting quantities.

1. Determine the monopoly solution.

8
 2. Because of technological restrictions …rm 1 has to choose the same quantity
in each period (x11 = x1
2
). Observing x11 , …rm 2 is considering to enter in
2
period 2. Determine the pro…t maximizing x2 given x11.

3. Assume that …rm 2 will enter in period 2. What quantity will …rm 1
produce? Determine equilibrium prices, quantities, and pro…ts.

4. Firm 2 only enters in period 2 if it can make positive pro…ts. Determine

the subgame perfect equilibrium of the two-period model.

Exercise 17 Strategic quantity choice

Consider a market with two …rms, A and B . The …rms produce homogenous
goods, compete in quantities, and face a constant marginal cost equal to 1/4.
The timing is the following: First, …rm A chooses its quantity qA . Then, after
observing qA , …rm B chooses its quantity qB . The price in the market is given
by the inverse demand function P (q) = 1  q, where q = qA + qB .

1. Find the subgame perfect Nash equilibrium.

2. Assume from now that there is an entry cost of e. Firm A is already

established in the market, and …rm B is considering whether to establish
itself in the market or not. The timing is the following: First, …rm A
chooses its quantity qA . Then, after observing qA , …rm B decides whether
to enter the market and, in case of entry, how much to produce.

3. Write down …rm B’s pro…t function.

4. Assume for now that e = 1=10. Illustrate …rm A’s pro…t as a function of
qA when the reaction of …rm B is taken into account.

5. Find the subgame perfect Nash equilibrium for all values of e > 0.

Exercise 18 Taxonomy of entry-related strategies I

Consider a market with di¤erentiated products. In the …rst stage …rm 1 is

the incumbent …rm and can invest an amount K1  0 in reducing its marginal
costs, c(K1 ) = c  K1 =10. In stage two …rm 2 can decides about entering the
market with constant marginal costs of c and entry costs of e. In stage three if
entry takes place …rms engage in price competition and face symmetric demand
functions given by Di (pi ; pj ) = A  api + bpj (A > a > b > 0). If no entry takes
place, …rm 1 acts as a monopolist with demand, D1 (p1 ) = A  ap1 .

1. Calculate the best response functions for both …rms. Draw a graph.

Argue graphically from now on:

9
 2. Does an increase in K1 increase or decrease the pro…t of the entering …rm?
Does an increase in K1 make the incumbent tough or soft?

3. Does a marginal investment K1 increase or decrease the pro…t of the in-

cumbent? (Assume that e is su¢ciently low such that entry takes place
for K1 close to zero. Moreover, assume A  10)

4. Use your answer of (2): Is entry deterrence via cost reduction possible in
this setting? If your answer is YES, which numbers would you have to
compare to decide whether entry deterrence is optimal? If your answer is
NO, what do we have change in this model to induce entry deterrence?

5. Use your answer of (3): If entry accommodation is optimal how much

should …rm 1 invest in cost reduction?

6. How would you answer to (4) change if we consider a Cournot game in-
stead?

7. How would you answer to (5) change if we consider a Cournot game in-
stead?

Exercise 19 Taxonomy of entry-related strategies II

Consider the market from the previous exercise again.

1. Use the best-response functions from the previous exercise to calculate

equilibrium prices for c1 6= c2 in the Nash equilibrium in which …rms set
prises.

2. Use your result from (1) to show that p

i
= (A + ac)=(2a  b), for i = 1; 2,
if c1 = c2 = c.

Now, use again that c1 (K1 ) = c  (K1 =10) and c2 = c.

Set c = 4, a = 2, b = 1, A = 10, and F = 7:95.

3. Show that the critical level of K1D to deter entry is below 0:5.

4. Suppose that investment in cost reduction is restricted to half units, i.e.

K1 2 f0; 0:5; 1; 1:5; : : :g. Will …rm 1 deter entry in a subgame perfect Nash
equilibrium? State …rm 1’s optimal business strategy.

5. Reconsider your answer to (4) if …rm 1 as a monopolist faces a demand

of D1 (p1 ) = A  ap1 + bp1 = A  (a  b)p1 .

10
Exercise 20 Sequential quantity choice and entry

Consider a market for a homogenous good with one incumbent …rm (…rm
1) and one potential entrant (…rm 2). The interaction between the two …rms
evolves in two stages. In stage 1, …rm 1 chooses its quantity q1 . In stage 2, after
observing q1 , …rm 2 decides whether or not to enter the market. If it enters,
it incurs an entry cost e and chooses its own quantity, q2 . If …rm 2 does not
enter then q2 = 0 and …rm 2 does not pay the entry cost e (…rm 1 then is a
monopoly). Assume that the inverse demand for the good is P = a  (q1 + q2 ),
and that the cost of production of each …rm i is C(qi ) = qi2=2.

1. Compute the range of e for which entry is blockaded. That is, compute
…rm 1’s output when it operates as a monopolist, then given this quantity,
compute the highest pro…t that …rm 2 can earn if it decides to enter, and
…nally, compute the range of e for which entry is blockaded.

2. Now, suppose that e is su¢ciently low to ensure that entry is not block-
aded. Compute the quantities and pro…ts of each …rm when entry is
accommodated. That is, compute the outputs that will be selected in
a Stackelberg equilibrium and the resulting pro…ts. (Instruction: …rst,
compute …rm 2’s best response function, br2 (q1 ). Second, substitute for
br2 (q1 ) into …rm 1’s pro…t function and compute …rm 1’s pro…t-maximizing
quantity q1. Third, …nd …rm 2’s best response against q 1 , using …rm 2’s
best response function. Finally, given the pair of quantities you found,
compute the equilibrium pro…ts).

3. Compute the lowest q1 for which entry is deterred. Compute …rm 1’s
pro…ts at this output level.

4. Given your answer in (3), show …rm 2’s best response function graphically
in the quantities space (recall that …rm 2 may wish to stay out of the mar-
ket when q1 is relatively high). Show on the same graph the Stackelberg
equilibrium you found in Section (3) and the lowest q1 for which entry is
deterred.

5. Given your answers in (2) and (3), …nd the range of e for which entry
is accommodated, and the range of e for which it is deterred. Explain
in no more than 3 sentences the intuition for the result (i.e., why is it
natural to expect that entry is accommodated/deterred when e is relatively
low/high).

Exercise 21 Capacity choice and entry

Consider an industry for a homogenous product with a single …rm (…rm 1)

that can produce at zero cost. The demand function in the industry is given by
Q = a  p. Now suppose that a second …rm (…rm 2) considers entry into the

11
industry. Firm 2 can also produce at zero cost. If …rm 2 enters, …rms 1 and 2
compete by setting prices. Consumers buy from the …rm that sets the lowest
price. If both …rms charge the same prices, consumers buy from …rm 1.

1. Solve for the Nash equilibrium if …rm 2 chooses to enter the industry.
Would …rm 2 wish to enter if entry required some initial investment?

2. Now suppose that before it enters, …rm 2 can choose a capacity, x2 , and a
price p2 (the capacity x2 means that …rm 2 can produce no more than q2 =
x2 units). Given q2 and p2 , …rm 1 chooses its price and then consumers
decide who to buy from. Compute the Nash equilibrium in the product
market if …rm 1 chooses to …ght …rm 2. What is …rm 1’s pro…t in this
case? Show …rm 1’s pro…t in a graph that has quantity on the horizontal
axis and price on the vertical axis. Would …rm 2 choose to produce in
that case?

3. Now suppose that …rm 1 decides to accommodate the entry of …rm 2.

Compute the residual demand that …rm 1 faces after …rm 2 sells q2 units,
and then write the maximization problem of …rm 1 and solve it for p1 .
What is …rm 1’s pro…t if it decides to accommodate …rm 2’s entry? Draw
…rm 1’s pro…t in a graph that has quantity on the horizontal axis and price
on the vertical axis. Would …rm 2 wish to enter in this case?

4. Given your answers to (2) and (3), compute for each p2 the largest capacity
that …rm 2 can choose without inducing …rm 1 to …ght it. (Hint: to answer
the question you need to solve a quadratic equation. The solution is given
by the small root).

5. Show that the capacity you computed in (4) is decreasing with p2 . Explain
the intuition for your answer. Given your answer, explain how …rm 2 will
choose its price. Computing p2 is too complicated; you are just asked to
explain in words how …rm 2 chooses p2 .)

Exercise 22 Investment and incumbency

Consider a di¤erentiated product market. At the …rst stage …rm 1 is the

incumbent …rm and can invest an amount I1  0 in reducing its marginal
costs, c(I1 ) = c  I1 =10. At stage two …rm 2 decides whether to enter the
market with constant marginal costs of c and entry costs of e, which is sunk
at this stage. At stage three, if entry has taken place, …rms engage in quantity
competition and face inverse demand functions given by Pi (qi ; qj ) = a  bqi  dqj
(a > b > d > 0). If no entry takes place, …rm 1 acts as a monopolist with inverse
demand, P m (q1 ) = a  bq1 .

1. Calculate the best response functions for both …rms. Draw a graph.

12
 2. Does an increase in I1 increase or decrease the pro…t of the entering …rm?
Does an increase in I1 make the incumbent tough or soft?

3. Does a marginal investment I1 > 0 increase or decrease the pro…t of the

incumbent? (Assume that e is su¢ciently low such that entry takes place
for I1 close to zero.)

4. If entry accommodation is optimal how much should …rm 1 invest in cost

reduction? (Use your answer of (3).)

5. Is entry deterrence via cost reduction possible and pro…table in this set-
ting? Discuss your results in the light of the taxonomy developed in the
book.

Exercise 23 Competition and entry

Consider a homogeneous good duopoly with linear demand P (q) = 1  q ,

where q is the total industry output. Suppose that …rms are quantity setters
and …rms incur constant marginal costs of production ci .

1. Suppose that …rms have constant marginal costs of production c. Deter-

mine the Nash equilibrium in quantities (report prices, quantities, pro…t,
welfare)

2. Reconsider your answer in (1) because of the following: A tabloid runs a

series on consumers paying “excessive” prices. The government considers
introducing a non-negative special sales tax t  0 per unit on this prod-
uct (and plans to use the revenues for some project from which nobody
bene…ts). Determine the welfare-maximizing tax rate (the government is
assumed to be able to commit to the tax; welfare is total surplus which in-
cludes tax revenues). Discuss your result. What would be your conclusion
if the government was considering subsidizing the …rm?

3. Return to the case without taxes. Consider now the duopoly with c1 = 0
and c2 = c 2 [0; 1]. Determine the equilibrium (price, quantities, pro…t,
welfare).

4. Consider now an extended model in which only …rm 1 is necessarily

present. At stage 1, …rm 1 can make an investment I after which …rm
2’s marginal costs is c2 = 1=2 instead of c2 = 0. Afterwards, …rm 2 ob-
serves the investment decision of …rm 1 and, at stage 2, decides whether
to enter at a negligible entry cost e > 0. At stage 3, active …rms set
quantities simultaneously. Determine the subgame perfect equilibrium of
this game. Discuss your result in the light of what you have learnt reading
about entry-related strategies (max 3 sentences).

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 5. Consider now a di¤erent entry model. Both …rms have zero marginal costs
of production but consumers have become accustomed to product 1 (even
if they did not consume it themselves). Therefore, consumers are willing
to pay 1=2 money units less for product 2 than for product 1. The inverse
demand function P (q) = 1  q gives demand for product 1. At stage 1,
the potential entrant, …rm 2, considers to enter the market at an entry
cost e > 0. (There is no investment stage in this game.) At stage 2,
…rms set quantities simultaneously. Report the pro…t function for each
…rm. Determine the equilibrium in case …rm 2 has entered (report prices,
quantities, pro…t, welfare). Determine the subgame perfect equilibrium
and comment on your result. You may want to reuse some of the results
derived above.

Exercise 24 Deterrence under price competition

Consider a Hotelling market in which consumers are uniformly distributed

on the [0; 1]-interval (i.e., x  U [0; 1]) and have unit demand. When buying one
unit from …rm A consumer x obtains utility rA  x  pA , while buying one unit
from …rm B gives rB  (1  x)  pB . In those expressions ri is the stand-alone
utility provided by product i and pi is the price set by …rm i. Firms have zero
marginal costs of production. Suppose that r is su¢ciently large such that the
outside option is never a relevant option.

1. Determine the price equilibrium (please report prices and quantities) un-
der parameter constellations such that each …rm has strictly positive de-
mand in equibrium.

2. Suppose that …rm A has an additional instrument and can invest in rA .

Both …rms o¤er a base utility r, but …rm A can increase its stand-alone
utility by r at cost C(r) = (c=4)(r )2 . Thus, rA = r + r and
rB = r. Consider the simultaneous-move game in which …rm A sets
(r; pA ) and …rm B sets pB . Determine the Nash equilibrium under the
parameter restriction on c such that each …rm has strictly positive demand
in equibrium (i.e., you can assume that c is su¢ciently large such that the
equilibrium is interior).

3. Consider the same setting as in part 3, but suppose that …rm A sets
r at a prior stage. This choice becomes common knowledge and, at a
subsequent stage, …rms compete in prices. Determine the subgame-perfect
Nash equilibrium under the parameter restriction on c such that each …rm
has strictly positive demand in equibrium.

4. Compare your results in parts 3 and 4. Explain your …ndings.

5. Consider the same timing as in part 4, but assume that, di¤erent from
what was the choice variable in this part, …rm A can decrease the stand-
alone utility of its competitor by r at cost C(r) = (c=4)(r )2 . (The

14
 stand-alone utility of …rm A is here always r.) Determine the subgame-
perfect Nash equilibrium under the parameter restriction on c such that
each …rm has strictly positive demand in equibrium.

6. Provide two real-world interpretations about how a …rm may be able to

reduce a competitor’s stand-alone utility (up to half a page of text).

7. Discuss how your …ndings in parts 4 and 6 can become relevant in the
context of entry deterrence.

8. Consider the same timing as in part 4, but assume that, in addition to

increasing its own stand-alone utility from r to r + rA at cost C(rA ) =
(c=4)(rA )2 , …rm A can decrease the stand-alone utility of its competitor
by rB at cost C(rB ) = (c=4)(rB )2 . Determine the subgame-perfect
Nash equilibrium under the parameter restriction on c such that each …rm
has strictly positive demand in equibrium. Comment on your …ndings
compared to those in parts 4 and 6 regarding the equilibrium di¤erence
r A  rB .

Exercise 25 Upstream merger

Consider an industry with two symmetric upstream …rms A and B and one
downstream …rm D. The downstream …rm may sell the product of none, one,
or both upstream …rms. Total industry pro…ts are a function of the number
of upstream …rms selling through D, denoted by V (n), n 2 f0; 1; 2g, which is
assumed to be increasing in n. The outside option for each …rm of not selling
is zero. Thus, V (0) = 0.
Rents are the outcome of Nash bargaining between any pair of one upstream
…rm and the downstream …rm (equal sharing of the surplus within the pair above
the pro…ts that would occur if this pair did not agree).

1. What will be the pro…ts of …rms A, B and D if D sells both products?

2. Suppose that the two upstream …rms merge (and become a two-product
…rm) and that function V continues to apply—an interpretation of the
latter property is that prices are set by independent pro…t centers within
the merged …rm. Then, Nash bargaining takes place between the merged
upstream …rm and the downstream …rm. What will be the pro…ts of the
merged upstream …rm AB and the downstream …rm D ?

3. Provide the exact condition for the merger to be pro…table.

4. Explain your …ndings.

Exercise 26 Non-linear pricing in the supply chain

15
 A monopolist produces a good with constant marginal cost equal to c, c <
1. Assume for now that all consumers have the demand Q(p) = 1  p. The
population is of size 1.

1. Suppose that the monopolist cannot discriminate in any way among the
consumers and has to charge a uniform price, pU . Calculate both the price
that maximizes pro…ts and the pro…ts that correspond to this price.

2. Suppose now that the monopolist can charge a two-part tari¤ (m; p) where
m is the …xed fee and p is the price per unit. Expenditure then is m + pq.
Calculate the two-part tari¤ that maximizes pro…ts and the pro…ts that
correspond to this tari¤. Compare pU and p and comment brie‡y.

3. Compare the situation with a uniform price and a two-part tari¤ in terms
of welfare (a verbal argument is su¢cient).

4. Assume now instead that there are two types of consumers. The consumers
of type 1 have the demand Q1 (p) = 1  p, and the consumers of type 2
have the demand Q2 (p) = 1  p=2. The population is of size 1 and there
are equally many consumers of the two types. Finally, it is assumed in
this question that c = 1=2. Calculate the two-part tari¤ that maximizes
the pro…ts of the monopolist. Compare, for c = 1=2, the two-part tari¤
found found here with the one in question (2) and comment brie‡y.

Exercise 27 Two-part tari¤s with downstream competition

Suppose that an upstream monopolist has constant marginal costs of pro-

duction c and sells to symmetric Cournot duopolist in the downstream market
at a two-part tari¤ (wi ; Fi ), where i 2 f1; 2g is the identity of the downstream
…rm. Here, wi refers to the linear wholesale price and Fi the …xed fee to be
paid by downstream …rm i. Downstream …rms have zero marginal costs and
face market demand P (q) = a  q. Suppose that a > c > 0. Consider the tim-
ing according to which, at the …rst stage, the upstream …rms set tari¤s in the
wholesale market and, at the second stage, downstream …rms simultaneously
set quantities in the downstream market.

1. Suppose that the upstream monopolist has to set Fi = 0 and publicly

posts the wholesale prices wi . Calculate the subgame perfect equilibrium
and comment on your …ndings.

2. Suppose that the upstream monopolist publicly posts two-part tari¤s

(wi ; Fi ). Characterize the subgame perfect equilibria when the upstream
…rm is restricted to o¤er a non-discriminatory o¤er (w; F ) to both down-
stream …rms.

16
 3. Suppose that the upstream monopolist cannot publicly post two-part
tari¤s—i.e., the two-part tari¤ that applies to …rm i is private informa-
tion in the duopoly game at stage 2. Furthermore, suppose that down-
stream …rms hold passive beliefs—i.e., no matter which contract is o¤ered,
a downstream …rm expects its competitor to be o¤ered the equilibrium
tari¤. Is the equilibrium outcome obtained under (2) also an equilibrium
outcome in this case? Explain your …nding.

Exercise 28 RPM

RPM was common in a number of industries. In particular, it could be

observed in the clothing, consumer electronics, and food industry. What is the
probable motivation for …rms to use RPM in these industries. Discuss the likely
welfare consequences in these industries.

Exercise 29 Vertical contracting

A buyer wants to buy one unit of a good from an incumbent seller. The
buyer’s valuation of the good is 1, while the seller’s cost of producing it is
1/2. Before the parties trade, a rival seller enters the market and his cost, c, is
distributed on the unit interval according to a distribution function with density
g(c). The two sellers then simultaneously make price o¤ers and the buyer trades
with the seller who o¤ers the lowest price. If the two sellers o¤er the same price
the buyer buys from the seller whose cost is lower.

1. Determine the price that the buyer pays in equilibrium, p , as a function

of c. Given p , write the payo¤s of the expected payo¤s of the buyer and
the two sellers.

2. Suppose that the distribution of c is uniform. Show p and the expected

payo¤s of the parties graphically (put c on the horizontal axis and the
equilibrium price function on the vertical axis and show the payo¤s by
pointing out the appropriate areas in the graph).

3. Now suppose that the incumbent seller o¤ers the buyer a contract before
the entrant shows up. The contract requires the buyer to pay the incum-
bent seller the amount m regardless of whether he buys from him or from
the entrant, and gives the buyer an option to buy from the incumbent at a
price of p (this is equivalent to giving the buyer an option to buy at a price
m + p and requiring him to pay liquidated damages of m if he switches to
the entrant). If the buyer rejects the contract things are as in part (1).
Given p and c, what is the price that the buyer will end up paying for the
good? Using your answer, write the expected payo¤s of the buyer and the
two sellers as a function of p and m.

17
 4. Explain why the incumbent seller will choose p by maximizing the sum of
his expected payo¤,  I , and the buyer’s expected payo¤s, UB .

5. Write the …rst-order condition for p and show that the pro…t-maximizing
price of the incumbent seller, p , is such that p < 1=2. Also show that
if g(0) > 0 then p > 0.

6. Explain why the contract is socially ine¢cient. Is the outcome in part (1)
socially e¢cient? Explain the intuition for your answer.

7. Compute p assuming that the distribution of c is uniform, and show the
expected payo¤s of the parties and the social loss graphically (again, put
c on the horizontal axis and the equilibrium price function on the vertical
axis).

8. Compute p under the assumption that G(c) = c , where  > 0. How
does p vary with ? Give an intuition for this result.

Exercise 30 Franchising

A monopolistic manufacturer produces a good that is sold to three retailers.

The manufacturer has constant marginal cost equal to c < 1=2. The retailers are
monopolists in three di¤erent cities. The marginal cost of the retailers is equal
to the wholesale price of the good. Each of the retailers faces a demand function
Qb = 1  b p where p is the retail and b is a variable characterizing the local
demand function. Each retailer knows the value of b in its city. Furthermore, it
is common knowledge that b = 1 in one city and b = z in two cities, z 2 (1; 2].
The manufacturer o¤ers each of the retailers a two-part tari¤ consisting of a
wholesale price w and a franchise fee f . Let us assume that the retailers accept
any contract that results in nonnegative pro…ts. The retailers choose the retail
price p in their market (i.e., there is no resale price maintenance).

1. Let w < 1=2 and take f as given. Find the price that a retailer sets as a
function of b. Who earns the highest pro…t, retailers with b = 1 or b = z ?

2. Assume in the rest of the exercise that z = 2. Suppose …rst that the
manufacturer knows the value of b in all three cities and that z = 2. What
contract will the manufacturer o¤er to the retailers? Is the franchise fee
the same for all retailers? Is it possible for the retailer to extract all pro…ts
in the vertical chain? Assume from now on that the manufacturer does
not know the retailers’ individual b. However, the manufacturer knows
that two of the retailers have b = z = 2 and that one retailer has b = 1.
Assume also that the manufacturer wishes to serve all retailers.

3. Find the optimal franchise fee as a function of the wholesale price w .

4. Find the optimal wholesale price as a function of c. Is the wholesale price

greater or less than c?

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 5. Can the manufacturer extract all pro…ts by setting w and f optimally?

6. Assume now instead that c = 1=4. Show that it is optimal for the manu-
facturer only to sell to the retailer with b = 1. What happens if c ! 0?

Exercise 31 Exclusive dealing

Suppose that two …rms produce at constant marginal costs c. There are two
periods and m buyers. Each buyer has an inverse demand curve: P (qI + qE ) =
1  (qI + qE ) where qI is the quantity sold by the incumbent and qE is the
quantity sold by the entrant. In the …rst period, there is only the incumbent
in the market. Thus, the incumbent produces the monopoly quantity. The
incumbent has marginal cost equal to cI . In the second period, an entrant
with constant marginal cost equal to zero enters into the market. The entry is
foreseen by the buyers. After entry, the two …rms compete à la Cournot. In
the …rst period, the incumbent o¤ers the buyers a fee for an exclusive dealing
agreement (take-it-or-leave-it). If a buyer accepts the o¤er, she cannot buy from
the entrant in the second period.

1. Suppose that the incumbent and entrant are equally e¢cient, i.e. cI =
0. What is the maximal fee for an exclusive dealing agreement that the
incumbent is willing to o¤er to a buyer? What is the minimum fee that a
buyer is willing to accept for signing an exclusive dealing agreement? Will
there be exclusive dealing in equilibrium?

2. Consider a general marginal cost of the incumbent cI . For which values

of cI will exclusive dealing arise in equilibrium?

Exercise 32 Long-term contracts, upgrades, and exclusion

Consider a market for a base good that is sold over two periods. In period 2,
also an upgrade may become available. For simplicity, set the mass of consumers
equal to 1 and marginal costs equal to zero. Firm 1 can be active in periods
1 and 2, …rm 2 can only be active in period 2. At the beginning of period 2,
…rms decide simultaneously whether to upgrade. Suppose that …rms maximize
the sum of pro…ts in periods 1 and 2.
The willingness-to-pay without upgrades is V per consumer in each period.
An upgrade by …rm 1 leads to a surplus of r + 1 , while an upgrade by …rm
2 would lead to a surplus of r + 2 . Firm 2 is assumed to be more e¢cient,
2 > 1 . The upgrading cost is C. Suppose furthermore that 1 > C . This
assumption means that upgrading is socially superior to not upgrading even if
it is done by the less e¢cient …rm.

1. Characterize the equilibrium if …rms can only o¤er short-term contracts,

i.e., …rm 1, when selling to consumers in period 1, cannot make them sign
a contract that binds consumers to buy from it in period 2.

19
 2. Characterize the equilibrium if …rm 1 can o¤er a long-term contract that
does not allow consumers or prevents them from buying from …rm 2. Dis-
cuss your result.

Exercise 33 Vertical integration.

1. Suppose that two downstream retailers sell a homogeneous product in

a downstream market. They have to pay w < 1 for each unit of the
product that they sell on to …nal consumers and do not incur any further
variable costs. The inverse downsteam market demand P (q) = 1  q ,
where q = q1 + q2 . Determine the Nash equilibrium when both …rms set
quantities simultaneously.

2. Suppose that there are many such downstream markets (to be precise,
a continuum of mass 1) and that prior to the quantity setting in those
downstream markets two upstream …rms simultaneously set quantities xi .
For each unit they incur marginal costs c. Determine the subgame perfect
equilibrium of the two-stage game.

3. What would change if there is only one instead of a continuum of down-

stream markets? Is there any conceptual di¤erence between those two
settings? Explain in at most three sentences.

4. Suppose that upstream …rm 1 merges with downstream retailer 1 in each of

the many downstream markets. Suppose furthermore that …rm 1 commits
neither to sell to any downstream retailer 2 nor to buy any units from
upstream …rm 2. The timing of the game is that, at stage 1, upstream
…rms simultaneously set xi and that, at stage 2, retailers set qi . Determine
the subgame-perfect equilibrium of this two-stage game.

5. Compare your results in (2) and (4). Does the vertical merger increase
the input price for non-integrated downstream …rms? Does the vertical
merger make consumers better o¤? Explain in one or two sentences.

Exercise 34 Exclusive dealing and vertical integration.

Consider a vertical duopoly with exclusive dealing contracts in place, i.e.,

upstream …rm i only sells to downstream …rm 
{ , i = 1; 2. Suppose that, at
stage 1, upstream …rms and then, at stage 2, downstream …rms set prices.
Downstream demand is of the form Qi (pi ; pj ) = 1  bpi + dpj . Upstream …rms
have zero marginal costs of production and set their wholesale price. Consider
subgame perfect equilibria.

1. Characterize equilibrium upstream and downstream prices.

20
2. Suppose that b = d = 1. Characterize the equilibrium if …rms indexed by
1 have vertically integrated (so that the integrated …rm’s transfer price is
0).

3. Are there incentives for vertical integration (for b = d = 1)? Discuss your
results.

21