Answer Key for Chapter 12

Exercises:
3. A monopolist can produce at a constant average (and marginal) cost of AC = MC = $5. It faces a market demand curve given b ! = 53 " #. a. Calculate t$e profit%ma&imi'ing price and (uantit for t$is

monopolist. Also calculate its profits. First solve for the inverse demand curve, P = 53 Q. Then the

marginal revenue curve has the same intercept and twice the slope: MR = 53 2Q. Marginal cost is a constant "uantit#: 53 2Q = 5, or Q = 2$. !u%stitute Q = 2$ into the demand function to find price: P = 53 2$ = 2&. 'ssuming fi(ed costs are )ero, profits are e"ual to = TR TC = *2&+*2$+ *5+*2$+ = 5,-. b. )uppose a second firm enters t$e market. *et !+ be t$e output of t$e first firm and !, be t$e output of t$e second. Market demand is no- given b !+ . !, = 53 " #. Assuming t$at t$is second firm $as t$e same costs as t$e first/ -rite t$e profits of eac$ firm as functions of !+ and !,. .hen the second firm enters, price can %e written as a function of the output of %oth firms: P = 53 Q/ Q2. .e ma# write the profit functions for the two firms:
2 1 = PQ1 C (Q1 ) = (53 Q1 Q2 )Q1 5Q1 , or 1 = 48Q1 Q1 Q1Q2

5. !etting MR = MC, find the optimal

and
2 2 = PQ2 C(Q2 ) = (53 Q1 Q2 )Q2 5Q2 , or 2 = 48Q2 Q2 Q1Q2 .

c. )uppose (as in t$e Cournot model) t$at eac$ firm c$ooses its profit% ma&imi'ing level of output on t$e assumption t$at its competitor0s output is fi&ed. 1ind eac$ firm0s 2reaction curve3 (i.e./ t$e rule t$at gives its desired output in terms of its competitor0s output). 0nder the 1ournot assumption, each firm treats the output of the other firm as a constant in its ma(imi)ation calculations. Therefore, Firm / chooses Q/ to ma(imi)e / in part *%+ with Q2 %eing treated as a constant. The change in / with respect to a change in Q/ is

1 = 48 2Q1 Q2 = 0 , or Q1 = 24 Q2 . Q1 2
This e"uation is the reaction function for Firm /, which generates the profit2 ma(imi)ing level of output, given the output of Firm 2. 3ecause the pro%lem is s#mmetric, the reaction function for Firm 2 is

Q2 = 24

Q1 . 2

d. Calculate t$e Cournot e(uilibrium (i.e./ t$e values of ! + and !, for -$ic$ eac$ firm is doing as -ell as it can given its competitor0s output). firm5 !olve for the values of Q/ and Q2 that satisf# %oth reaction functions %# su%stituting Firm 24s reaction function into the function for Firm /: 4$at are t$e resulting market price and profits of eac$

1 Q1 Q1 = 24 24 , or Q1 = 16. 2 2
3# s#mmetr#, Q2 = /-. To determine the price, su%stitute Q/ and Q2 into the demand e"uation: P = 53 /- /- = 2/. 5rofit for Firm / is therefore

i = PQi C*Qi+ = i = *2/+*/-+ *5+*/-+ = 25-.

Firm 24s profit is the same, so total industr# profit is / 6 2 = 25- 6 25- = 5/2.

6. 7$is e&ercise is a continuation of 8&ercise 3. 4e return to t-o firms -it$ t$e same constant average and marginal cost/ AC = MC = 5/ facing t$e market demand curve Q+ . Q, = 53 " P. its output decision before t$e ot$er. a. )uppose 1irm + is t$e )tackelberg leader (i.e./ makes its output decisions before 1irm ,). 1ind t$e reaction curves t$at tell eac$ firm $o- muc$ to produce in terms of t$e output of its competitor. Firm 24s reaction curve is the same as determined in part *c+ of 7(ercise 3: Q2 = 24 Q1 2 . 9o- -e -ill use t$e )tackelberg model to anal 'e -$at -ill $appen if one of t$e firms makes

Firm / does not have a reaction function %ecause it ma8es its output decision %efore Firm 2, so there is nothing to react to. 9nstead, Firm / uses its 8nowledge of Firm 24s reaction function when determining its optimal output as shown in part *%+ %elow. b. :o- muc$ -ill eac$ firm produce/ and -$at -ill its profit be5 Firm /, the !tac8el%erg leader, will choose its output, Q/, to ma(imi)e its profits, su%:ect to the reaction function of Firm 2: ma( / = PQ/ C*Q/+, su%:ect to Q2 = 24 Q1 2 .

!u%stitute for Q2 in the demand function and, after solving for P, su%stitute for P in the profit function:

max 1 = 53 Q1 24

Q1 2

(Q1 ) 5Q1 .

To determine the profit2ma(imi)ing "uantit#, we find the change in the profit function with respect to a change in Q/: d / = 53 2 Q/ 2$ + Q/ 5. dQ / !et this e(pression e"ual to ; to determine the profit2ma(imi)ing "uantit#:

53 2Q/ 2$ 6 Q/ 5 = ;, or Q/ = 2$. !u%stituting Q/ = 2$ into Firm 24s reaction function gives Q2: Q2 = 2$ 2$ = /2. 2

!u%stitute Q/ and Q2 into the demand e"uation to find the price: P = 53 2$ /2 = /,.

5rofits for each firm are e"ual to total revenue minus total costs, or / = */,+*2$+ *5+*2$+ = 2<<, and 2 = */,+*/2+ *5+*/2+ = /$$. Total industr# profit, T = / 6 2 = 2<< 6 /$$ = $32. 1ompared to the 1ournot e"uili%rium, total output has increased from 32 to 3-, price has fallen from 2/ to /,, and total profits have fallen from 5/2 to $32. 5rofits for Firm / have risen from 25- to 2<<, while the profits of Firm 2 have declined sharpl# from 25- to /$$.

;.

)uppose t$at t-o identical firms produce -idgets and t$at t$e firms in t$e market. 7$eir costs are given b

are

t$e onl

C+ = ;<!+ and C, =

;<!,/ -$ere !+ is t$e output of 1irm + and !, t$e output of 1irm ,. #rice is determined b t$e follo-ing demand curve= # = 3<< " ! -$ere ! = !+ . !,. a. 1ind t$e Cournot%9as$ e(uilibrium. firm at t$is e(uilibrium. 5rofit for Firm /, TR/ 2 TC/, is e"ual to
1 2 2 = 3 0 0 Q Q Q Q 6 0 Q = 2 4 0 Q Q Q Q . 1 1 1 2 1 1 1 1 2

Calculate t$e profit of eac$

Therefore,

1 = 2 4 0 2 Q Q . 1 2 Q 1
4

!etting this e"ual to )ero and solving for Q/ in terms of Q2: Q/ = /2; ;.5Q2. This is Firm /4s reaction function. 3ecause Firm 2 has the same cost structure, Firm 24s reaction function is Q2 = /2; ;.5Q/ . !u%stituting for Q2 in the reaction function for Firm /, and solving for Q/, we find Q/ = /2; *;.5+*/2; ;.5Q/+, or Q/ = <;. 3# s#mmetr#, Q2 = <;. !u%stituting Q/ and Q2 into the demand

e"uation to determine the e"uili%rium price: P = 3;; <; <; = /$;. !u%stituting the values for price and "uantit# into the profit functions, / = */$;+*<;+ *-;+*<;+ = -$;;, and 2 = */$;+*<;+ *-;+*<;+ = -$;;. Therefore, profit is e"uili%rium. -$;; for %oth firms in the 1ournot2=ash

b. Suppose the two firms form a cartel to maximize joint profits. How many wi !ets will be pro uce " #alculate each firm$s profit.
>iven the demand curve is 5 = 3;; ?, the marginal revenue curve is M@ = 3;; 2?. 5rofit will %e ma(imi)ed %# finding the level of output such that marginal revenue is e"ual to marginal cost: 3;; 2? = -;, or ? = /2;. .hen total output is /2;, price will %e /<;, %ased on the demand

curve. !ince %oth firms have the same marginal cost, the# will split the total output e"uall#, so the# each produce -; units. 5rofit for each firm is: = /<;*-;+ -;*-;+ = ,2;;.

c. )uppose 1irm + -ere t$e onl above5

firm in t$e industr .

:o- -ould

market output and 1irm +0s profit differ from t$at found in part (b)

9f Firm / were the onl# firm, it would produce where marginal revenue is e"ual to marginal cost, as found in part *%+. 9n this case Firm / would produce the entire /2; units of output and earn a profit of /$,$;;. d. >eturning to t$e duopol of part (b)/ suppose 1irm + abides b t$e

agreement/ but 1irm , c$eats b

increasing production. :o- man

-idgets -ill 1irm , produce5 4$at -ill be eac$ firm0s profits5 'ssuming their agreement is to split the mar8et e"uall#, Firm / produces -; widgets. reaction function: Firm 2 cheats %# producing its profit2 ma(imi)ing level, given Q/ = -;. !u%stituting Q/ = -; into Firm 24s

6 0 Q = 1 2 0 = 9 0 . 2 2
Total industr# output, QT, is e"ual to Q/ plus Q2: QT = -; 6 &; = /5;. !u%stituting QT into the demand e"uation to determine price: P = 3;; /5; = /5;. !u%stituting Q/, Q2, and P into the profit functions: / = */5;+*-;+ *-;+*-;+ = 5$;;, and 2 = */5;+*&;+ *-;+*&;+ = </;;. Firm 2 increases its profits at the e(pense of Firm / %# cheating on the agreement.

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