Problem Set 2

Economics of Business and Markets

Fall 2019

Ana Rita Gomes – 152119xxx

Joana Mariano – 152119xxx

João Oliveira - 152119104

Rita Novais - 152119214

Simon Ulriksson – 152119xxx

1. In a linear city represented by the interval [0, 1], there are two firms that sell wine: firm L is
located at point 0 and firm R is located at point 0.6. Both firms produce wine at zero marginal
cost. Consumers are uniformly distributed in the linear city. Each consumer is willing to pay v
for a bottle of wine. A consumer located at x who purchases a bottle of wine from a firm
located at z at price p derives utility v − 10(z − x) 2 − p. Consumers also have the option not to
purchase, in which case they derive zero utility. However, assume that v is very large, so that
all consumers will purchase a bottle of wine.

(a) Find the equilibrium prices.

We will use the Hotelling Model two stage game, where firms choose prices.

To start solving this exercise, we need to find x, which is the consumer that is indifferent
between purchasing from firm L or firm R. Consumers to the left of x will consume from firm L
and consumers to the right of x will consume from firm R. To start, we will use both firms utility
functions.

𝑣 − 10(0 − 𝑥)2 − 𝑝𝐿 = 𝑣 − 10(0.6 − 𝑥)2 − 𝑝𝑅

↔ 𝑣 − 10𝑥 2 − 𝑝𝐿 = 𝑣 − 10(0.36 − 1.2𝑥 + 𝑥 2 ) − 𝑝𝑅

↔ 𝑣 − 10𝑥 2 − 𝑝𝐿 = 𝑣 − 3.6 + 12𝑥 − 10𝑥 2 − 𝑝𝑅

𝑝𝑅 − 𝑝𝐿
↔ −𝑝𝐿 = −3.6 + 12𝑥 − 𝑝𝑅 ↔ + 0.3 = 𝑥
12

The fraction of consumers to the left of x is x, so now we will compute the profit function of firm
L, which is:

𝑝𝑅𝑝𝐿 𝑝𝐿2
𝜋𝐿 = 𝑥𝑝𝐿 ↔ 𝜋𝐿 = − + 0.3𝑝𝐿
12 12

For firm R, the fraction of consumers is (1-x), so the profit function of firm R is:

𝑝𝑅𝑝𝐿 𝑝𝑅 2
𝜋𝑅 = (1 − 𝑥)𝑝𝑅 ↔ 𝜋𝑅 = − + 0.7𝑝𝑅
12 12

Each firm chooses prices to maximize their profit, so now we find the reaction functions of both
firms:
𝜕𝜋𝐿 𝑝𝑅 2𝑝𝐿
=0 ↔ − + 0.3 = 0
𝜕𝑝𝐿 12 12
2𝑝𝐿 𝑝𝑅
↔ = 0.3 + ↔ 𝑝𝐿 = 1.8 + 0.5𝑝𝑅
12 12
So we found the reaction function of firm L, now we move on to firm R:
𝜕𝜋𝑅 𝑝𝐿 2𝑝𝑅
=0 ↔ − + 0.7 = 0
𝜕𝑝𝑅 12 12
 2𝑝𝑅 𝑝𝐿
↔ = + 0.7 ↔ 𝑝𝑅 = 4.2 + 0.5𝑝𝐿
12 12
We now have the reaction functions of both firms, so we will just do the interception of the
reaction functions of both firms:

𝑝𝑅 = 0.5(1.8 + 0.5𝑝𝑅) + 4.2 ↔ 𝑝𝑅 = 0.9 + 0.25𝑝𝑅 + 4.2

↔ 0.75𝑝𝑅 = 5.1 ↔ 𝑝𝑅 = 6.8
We found that pR is 6.8, so now we use that number to discover pL:

𝑝𝐿 = 1.8 + 0.5 ∗ 6.8 ↔ 𝑝𝐿 = 5.2

In conclusion, we found that the equilibrium prices of both firms are as follows:

pR = 6.8

pL = 5.2

(b) The wine sold by firm L is of better quality, and consumers are willing to pay v + 1 for a
bottle from firm L (they are still willing to pay v for a bottle from firm R). Find the
equilibrium prices.

The utility of the consumer “x” who purchases a product from firm L is, in this case:

𝑣 + 1 − 10 ∗ (𝑥 − 0)2 − 𝑝𝐿
To find the indifferent consumer:
𝑝𝑅 − 𝑝𝐿 23
𝑣 + 1 − 10 ∗ (𝑥 − 0)2 − 𝑝𝐿 = 𝑣 − 10 ∗ (0.6 − 𝑥)2 − 𝑝𝑅 ⇔ 𝑥 = +
12 60
As firm L is in the extreme, point 0, it can be stated:
𝑝𝑅−𝑝𝐿 23
Demand for firm L = 𝑥 = +
12 60
𝑝𝑅−𝑝𝐿 23 𝑝𝐿−𝑝𝑅 37
Demand for firm R = 1 − 𝑥 = 1 − 12
+ 60 = 12
+ 60

Thus, thus the profits are:

𝑝𝑅 − 𝑝𝐿 23 𝑝𝐿2 − 𝑝𝑅 ∗ 𝑝𝐿 23 ∗ 𝑝𝐿
𝜋𝐿 = 𝑝𝐿 ∗ 𝑥 = 𝑝𝐿 ∗ ( + )= − +
12 60 12 60
𝑝𝐿 − 𝑝𝑅 37 𝑝𝑅 2 − 𝑝𝑅 ∗ 𝑝𝐿 37 ∗ 𝑝𝑅
𝜋𝑅 = 𝑝𝑅 ∗ (1 − 𝑥) = 𝑝𝑅 ∗ ( + )= − +
12 60 12 60
As both firms want to maximize their profits:
𝜕𝜋𝐿 2𝑝𝐿 − 𝑝𝑅 23 𝑝𝑅 23
=0⇔− + = 0 ⇔ 𝑝𝐿 = +
𝜕𝑝𝐿 12 60 2 10
𝜕𝜋𝑅 2𝑝𝑅 − 𝑝𝐿 37 𝑝𝐿 37
=0⇔− + = 0 ⇔ 𝑝𝑅 = +
𝜕𝑝𝑅 12 60 2 10
Solving the system of equations to find the prices:

𝑝𝑅 23 83 83
𝑝𝐿 = + 𝑝𝐿 37 𝑝𝐿 = 𝑝𝐿 =
2 10 ⇔ { ( + ) 23 15 15
{
𝑝𝐿 37 𝑝𝐿 = 2 10 + ⇔ 83 ⇔{
97
2 10 ( )
𝑝𝑅 = + − 𝑝𝑅 = 15 + 37 𝑝𝑅 =
2 10 { 2 10 15
83 97
Solution: The equilibrium prices are 15 for firm L and 15 for firm R.

(c) Firm L is the price leader, i.e., firm L sets its price first, whereas firm R sets its price only
after observing the price chosen by firm L. Find the equilibrium prices (for this part, assume
that the wine sold by both firms is of the same quality, so that consumers are willing to pay v
for a bottle of wine, regardless of which firm they buy from).

𝑃𝑅 = 0.5𝑃𝐿 + 4.2
Since Firm L is the price leader to maximize its profit take:

𝑃𝐿2 𝑃𝑅 𝑃𝐿
𝛱𝐿 = − + + 0.3𝑃𝐿
12 12
And substitute 𝑃𝑅 to obtain 𝑃𝐿 :

𝑃𝐿2 1 𝑃𝐿2 𝑃𝐿2 4.2 3.6 𝑃𝐿2 78

𝜋𝐿 = − + (0.5𝑃𝐿 + 4.2)𝑃𝐿 + 0.3𝑃𝐿 = − + + 𝑃+ 𝑃𝐿 = − + 𝑃𝐿
12 12 12 24 12 12 24 12
𝜕𝛱𝐿 𝑃𝐿 7.8
=0⇔−− + = 0 ⇔ 𝑃𝐿 = 7.8
𝜕𝑃𝐿 12 12
Finally, substitute 𝑃𝐿 = 7.8 in 𝑃𝑅 = 0.5𝑃𝐿 + 4.2 to obtain 𝑃𝑅 :

𝑃𝑅 = 0.5𝑃𝐿 + 4.2 = 0.5 ∗ 7.8 + 4.2 = 8.1

(d) Compute the HHI in the markets of parts a) and b). Is the HHI higher when products are
vertically differentiated - as in part b) - or when products are identical - as in part a)? Provide
the intuition behind this finding.