ECO380 Managerial Economics I: Competitive Strategy, Fall 2013

Answer key for Problem Set #1

Due in class October 1, 2013 (Tuesday)

Please type your answers except figures and equations. On your cover sheet,
please write down your name, student ID number, people you worked with, as well as
websites, books and office hours you used. Please hand in your answers to Problems
1, 2, 3, 4 and 5. Each problem may contain several parts. Each part is worth 3 points,
there are 72 total points available.
Problem 1. Suppose that, in a large city, 200 identical street vendors compete in a
competitive market for hot dogs.
1. The vendors total costs to produce q hot dogs is, C(q) = 41 q + 18 q 2 . What is the
marginal cost function of each firm?
Answer. Follow the rules I gave you on taking derivatives,

M C(q) =

dC(q)
1 1
= + q.
dq
4 4

2. Given your answer from above, how many hot dogs will each vendor produce if
offered a price of $4 per hot dog?
Answer. Competitive firms are price takers, meaning they can act as though
they can sell as many items as they want for the given price. We know firms
will set q such that P = MC(q) to maximize profits, that is,
P =4=

1 1
+ q.
4 4

Solve this to get q = 15. Notice that we could have gotten the same formula from
writing the firms profit maximization problem and taking the first derivative.

ECO380: Problem Set #1

3. Using your answer from part 1, what is the competitive supply curve for this
market?
Answer. The 200 firms are identical so each produces an equal amount,
Qs = 200q,

(1)

the supply curve can be found by substituting this into the individual firm
supply curve derived from P = M C =

1
4

+ 14 q,

q = 4P 1.

(2)

From (1) and (2), we have Qs = 800P 200, or equivalently,

P =

Qs
1
+
800 4

4. Let demand for hot dogs be Q = 2500100P , what is the short run equilibrium
price?
Answer. Set supply equal to demand,
800P 200 = 2500 100P
Now solve for equilibrium price,
P =

2700
=3
900

5. What is the total quantity of hot dogs sold in short-run equilibrium?

Answer. We know P so we can get the total quantity by substituting it into
the demand curve. If you wanted to get the quantity for each firm, we can
simply divide by the total number of firms (200), since each is identical.
Q = 2200, q = 11
6. In the long run, would you expect this industry to experience entry or exit?
Explain your answer.

ECO380: Problem Set #1

Answer. Each firm makes 3 11 = $33 in revenue, while its costs are C(11) =
2
11
+ 118
4

= 17.875. Since firms are making a positive profit we would expect more

hot dog vendors to enter the industry. They will continue to enter until all firms
make zero profits, at which point the industry will be in long-run equilibrium.

Problem 2. Suppose Monolith Enterprises has gained exclusive rights to sell ball
point pens in Toronto. The demand for ball point pens is described by Q = 1500
10P , Monoliths total cost function for producing pens is C(Q) = 2Q.
1. What is the marginal cost function for Monolith?
Answer. The marginal cost function is M C(Q) = 2.
2. Write down the monopolists optimization problem where the monopolist chooses
quantities.
Answer. The monopolists problem is to choose a quantity to maximize his
profit given that price will be determined by the demand curve. In general this
problem is
maxQ QP (Q) C(Q)
Monolith choses Q, total quantity, because it is the only firm in the market.
We can solve the demand curve in terms of price instead of quantity to get,
1
P (Q) = 150 10
Q. If the marginal costs of each pin is 2 then the total cost for

producing Q pins is 2Q. Substituting these into the maximization problem, we

have
max Q(150
Q

1
Q) 2Q.
10

3. What quantity of pins should Monolith produce?

Answer. From the FOC (or MR - MC = 0), we have
1
150 Q 2 = 0
5

ECO380: Problem Set #1

If it helps you to see how this works, distribute the Q to see profits has the form
150Q

1
Q2
10

2Q. Then solve for Q:

Qm = 740

I denote this Qm since it is the monopolys optimal quantity.

4. What is the price at this level of output?
Answer. Substitute Qm from the previous part into the demand curve.
P m = 150

1 m
Q = $76
10

5. Is this outcome efficient? If so, why? If not, what is the efficient level of output?
Answer. This outcome is far from efficient, at the efficient level of output price
is equal to marginal cost, that is, P = M C = 2, because then every person who
values a pin for more than it costs to produce a pin will purchase one. The
efficient level of quantity is just the number of pins sold when they are priced
at marginal cost:
Qe = 1500 10 2 = 1480
Some of you argued that the outcome was efficient because Monolith was maximizing profits. However efficiency is about how much total surplus the market
is producing, not just firm profits. Monolith is intentionally reducing its production to benefit itself by getting higher prices. In doing so it is distorting the
market from its efficient outcome.
6. What is the Lerner Index for Monolith?
Answer. Here you just need to know the formula for the Lerner Index, youve
already solved for the price:
LI =

P MC
76 2
=
= .974
P
76

ECO380: Problem Set #1

7. Suppose Monoliths cost function changed to C(Q) = 10 + 2Q. Would Monoliths optimal quantity of pins be different? Explain why or why not.
Answer. The optimal quantity of pins stays the same. When Monolith maximizes its profit, the optimal condition is M R = M C. Notice that the marginal
cost function M C(Q) = 2 stays the same under the new cost function. Therefore, the optimal quantity of pins does not change.
Problem 3. The following firms compete within the same industry:
Name
Sales (millions)
ACME Industries
35
Beta Inc.
10
Caltech
15
Douglass Ltd.
4
Gramen Inc.
12
Houghton Enterprises
22
Jenentech
7
1. Use this information to calculate CR3 and CR5 for the industry?
Answer. The concentration ratios are just the shares of the N largest firms,
they can be calculated this way:
72
35 + 22 + 15
=
= 68.6% and
35 + 22 + 15 + 12 + 10 + 7 + 4
105
35 + 22 + 15 + 12 + 10
94
=
=
= 89.5%.
35 + 22 + 15 + 12 + 10 + 7 + 4
105

CR3 =
CR5

2. What is the HHI for the industry?

Answer. This table calculates the share of each firm and the share squared,
the HHI is just the sum of the shares squared.
Name
Sales (millions)
ACME Industries
35
Beta Inc.
10
Caltech
15
Douglass Ltd.
4
Gramen Inc.
12
Houghton Enterprises
22
Jenentech
7
Sum
105

si (%)
33.33
9.52
14.28
3.81
11.42
20.95
6.67
100.00

s2i
1111
91
204
15
131
439
44
2034

ECO380: Problem Set #1

Therefore, HHI =

6
P7

i=1

s2i = 2035. The HHI commonly uses the share in

percents, so it runs from 0 to 10000 if you used the share as a decimal, the
HHI runs from 0 to 1, either is fine for our purposes.

Problem 4. Alice and Barbara sell used CDs at music festivals. Each is deciding
whether or not to set up their booth at the last festival of the summer. The festival
is scheduled to take place in Alton, very near where Alice lives. It will cost her only
$30 to travel the festival. Barbara is farther away, and it will cost her $100 to travel
to Alton. Both Alice and Barbara would prefer to be only CD sellers at the festival,
since they would avoid competition. If only one seller is at the festival, she will make
$150 during the day (not counting travel costs). If both Barbara and Alice sell CDs
at the festival, they will lower their prices and each make $50 during the day. Both
Alice and Barbara receive $0 for not attending the festival.
1. Draw the Normal Form of the game Alice and Bob are playing, be sure to label
the game completely.
Answer. I set the problem up with Alice as the row player and Barbara as
the column player. If a player goes to the festival, their payoff is calculated by
considering how much they make based on whether the other player was present,
and then deducting the travel cost they must pay to attend the festival. If they
do not attend the festival, their payoff is 0.
Alice \ Barbara
Set up
NOT

Set up
20, -50
0, 50

NOT
120, 0
0, 0

2. Does either player have a dominant strategy? If so, what is it?

Answer. For Alice,Set up is a dominant strategy. When Barbara sets up,
if Alice choosesSet up, she gets 50, which is greater than 0, the outcome of
NOT. When Barbara does not set up, if Alice chooses Set up, she gets
150, which is greater than 0, the outcome ofNOT. So Set Up is Alices best

ECO380: Problem Set #1

response whatever Barbara chooses to do. This is the definition of a dominant

strategy.
In contrast, Barbaras best response depends on whether Alice attends or not,
so she has no dominant strategy.
3. List all pure strategy Nash equilibria for this game. Remember that a Nash
equilibrium is a strategy profile.
Answer. There is only one Nash equilibrium, that is, Alice sets up and Barbra does not set up. You can find it by checking to see what strategy profiles
are mutual best responses. Alternatively, since Alice has a dominant strategy,
you could eliminate her dominated strategy, NOT, and then see what Barbara
should do.
In this game, notice how the difference in travel costs are decisive in the outcome.
Consumers at the festival would view Alice and Barbara equally, but Alice
wins a very high payoff simply because of the difference in travel costs.

Problem 5. Let market demand in the cement industry be given by Q(P ) = 200P .
There are only two firms in the industry and the total cost function for each firm is
C(qi ) = 20qi + 400, where i = 1, 2.
1. What is the marginal cost for both firms?
Answer. For each firm,
MC =

C(qi )
= 20.
qi

2. Represent the market price as a function of each firms output, q1 and q2 .

Answer. Since total quantity Q = q1 + q2 ,
P (Q) = 200 Q = 200 q1 q2 .
3. Find the best-response function of each firm.

ECO380: Problem Set #1

Answer. For given q2 , firm 1s problem is choosing q1 to maximize its profit,

that is,
max 1 (q1 , q2 ) = max P (Q)q1 C(q1 )
q1

q1

= max(200 q1 q2 )q1 (20q1 + 400).

q1

From FOC, we have

200 2q1 q2 |{z}
20 = 0
|
{z
}
MR

MC

Solve for q1 to find firm 1s best-response function,

2q1 = 180 q2 .
1
q1 (q2 ) = 90 q2 .
2

(3)

Since two firms are symmetric, firm 2s best-response function is,

1
q2 (q1 ) = 90 q1 .
2

(4)

4. Suppose firm 2 produces nothing, that is, q2 = 0. What is firm 1s output level?
Compare the quantity with the monopoly output level.
Answer. From (3), putting q2 = 0, we have q1 (0) = 90, which is firm 1s output
level when firm 2 produces nothing.
Considering the monopoly case, the monopolys problem is
max M (q) = max(200 q)q (20q + 400).
q

Notice that this profit function is identical to firm 1s problem in the Cournot
model with q1 = q and q2 = 0. We can solve this problem, to find have q M = 90,
which is equivalent q1 (q2 = 0).
5. Using the Cournot model, find each firms output, profit, and price in equilibrium.

ECO380: Problem Set #1

Answer. Solving the simultaneous equations, we can substitute (4) into (3),
we have
1
q1 = 90
2



1
90 q1
2

Solve this for q1C = 60, then substitute this into (4) to find q2C = 60.1 Since
Q = q1C + q2C = 120, the equilibrium price P (Q = 120) = 80 and each firms
C C
C
profit is C
1 = 2 = 1 (q1 , q2 ) = 3200.

6. Now suppose technical innovation makes each firms fixed cost is zero, that
is, C(qi ) = 20qi , where i = 1, 2. Find each firms output, profit, and price.
Compare with them before the innovation.
Answer. The new profit maximization problem for firm 1 is,
max(200 q1 q2 )q1 20q1
q1

Notice that fixed cost do not affect the first order condition. Therefore, firms
strategic choices (q1 and q2 ) are not changed and the equilibrium price is also
same. However, each firms profit is increase by the decrease in fixed cost. Thus,
each firms new profit will be 3600.
Problem 6 (This problem is NOT to be handed in.). The market for a new carbohydratefree strand of rice is served by three firms, AsiaRice, Bens Rice, and CountryRice (or
A, B, and C). These firms are engaged in (simultaneous) Cournot competition. Total
demand for a ton of carb-free rice is described by P = 4000 Q, where Q is the total
quantity produced by all firms in the market. The three firms have an identical total
cost function Ci (qi ) = 400qi for i = {a, b, c}.
1. Write AsiaRices profit as a function of the quantities produced by each firm
qa , qb , and qc ?
1

Alternatively, when firms are symmetric. One can solve FOC by using the symmetry condition,
that is, q1 = q2 . It yields,
2q1 = 180 q1 ,
which yields q1 = 60 directly. This ONLY works when firms are symmetric.

ECO380: Problem Set #1

10

Answer.
a (qa , qb , qc ) = (4000 (qa + qb + qc )) qa 400qa
{z
}
|
P

qa2

+ (3600 qb qc ) qa

(5)

2. What is the best response function of AsiaRice?

Answer. From the first order condition

a
qa

= 2qa + 3600 qb qc = 0,

AsiaRices best response function qa (qb , qc ) is

1
qa (qb , qc ) = 1800 (qb + qc ).
2

(6)

3. Suppose (for this part only) that Bens Rice faces a lower marginal cost of 200.
So its total cost function is Cb (qb ) = 200qb . Would your answer to part 2
change? Why or why not?
Answer. No, because AsiaRices best response function is a function of Bens
quantity, not Bens marginal cost. While the equilibrium quantities would
change, AsiaRices best responses functions would not.
4. What is the equilibrium strategy profile for this game (Hint: note that firms
are symmetric)?
Answer. Since the three firms are symmetric, they will choose the same strategy. Thus, the equilibrium condition says that, from (6),
1
q = 1800 (q + q ),
2
which implies that qa = qb = qc = 900.
5. What is the equilibrium price of a ton of carb-free rice?
Answer. From the above part, each firm produces 900 tons, so the total quantity is Q=2700. The equilibrium price is then obtained by the demand P =
4000 Q = 1300.

ECO380: Problem Set #1

11

6. How much profit does each firm earn in equilibrium?

Answer. Putting qa = qb = qc = 900 into (5), we have a (900, 900, 900) =
810, 000. Thus, each firm earns 810 thousands dollars.
7. Suppose Bens and CountryRice propose a mergerreducing the number of
firms in the industry to two. Would you expect the total quantity produced
in the industry to rise or fall following the merger? Explain your answer and
calculate the post-merger quantity produced.
Answer. The total quantity decreases due to the merger. The market becomes
the duopoly which is less competitive. As a result, quantities decrease and
prices increase. More specifically:
a (qa , qb ) = qa2 + (3600 qb ) qa
qa (qb ) = 1800 12 qb
qa = qb = 1200
Q = 2400

Problem 7 (This problem is NOT to be handed in.). Answer the following questions as best you can based on what you have learned from the course. Partial
answers will receive partial credit.
1. In a perfectly competitive market, we found that firms make zero profits in
long-run equilibrium. Why?
Answer. Because of the free entry condition. If firms are making positive
profits, more will enter, which will shift out the aggregate supply curve and
cause a drop in market prices.
2. Other things equal, the Department of Justice is more likely to sue to block
mergers that would result in a large increase in the Herfindahl-Hirschman Index
(HHI) of an industry. What is the HHI and why is this true?

ECO380: Problem Set #1

12

Answer.
HHI =

s2i

Where si is the market share of firm i. It is a measure of industry concentration.

The Justice department is concerned when concentration is high because more
concentrated markets frequently have higher prices and less efficient outcomes.
We saw this when studying the Cournot model.