Markets and Strategy

ECMMS 2010-2011
Stephanie Rosenkranz and Kris de Jaegher

Problem set 1
1. Nash Equilibrium In each of the following games, find the set of possible
Nash equilibria in pure strategies:

Game (a):

y1 y2

x (2,1) (1,2)
1
x (1,5) (2,1)
2

Game (c): Game (b):

y1 y2 y1 y2 y3

x (3,7) (6,6) x (0,4) (5,6) (8,7)

1 1
x (2,2) (7,3) x (2,9) (6,5) (5,1)
2 2

Game (d):

y1 y2 y3

x (0,0) (5,4) (4,5)

1
x (4,5) (0,0) (5,4)
2
x (5,4) (4,5) (0,0)
3
2. Game Theory Consider the game in the following figure:

C1 C2 C3
R1 3, 2, 1,
2 1 a a) Given a condition on
R2 2, b, 0, b such that R2 is
2 4 2 strictly dominated
R3 c, 3, e, by R1.
d 2 4 b) Given that a) holds,
find a condition on d
such that C1 strictly dominates C2.
c) Given that a) and b) hold, find conditions on a and c such that (R1, C1)
is a Nash equilibrium.
d) Given that a)-c) hold, find conditions on d, e such that (R1, C1) is the
unique Nash equilibrium.

2. (Part II, Exercise 3) Cournot competition

Two firms (firm 1 and firm 2) compete in a market for a homogenous good
by setting quantities. The demand is given by
D(p) = 2 - p. The firms have constant marginal cost c
= 1.

1. Draw the two firms’ reaction function. Find the equilibrium quantities
and calculate equilibrium profits.
2. Suppose now that there are n firms where n ³ 2. Calculate equilibrium
quantities and profits.

Hint: This is the standard Cournot model, just in case students have
forgotten about their intermediate micro class.

3. (Part II, Exercise 8) Asymmetric duopoly

Consider two quantity-setting firms that produce a homogenous good and
choose their quantities simultaneously. The inverse demand function for the
good is given by P =  - x1 − x2, where x1 and x2 are the outputs of firms 1
and 2 respectively. The cost functions of the two firms are C1(x1) = c1x1 and
C2(x2) =c2x2, where c1 
and c2 (+ c1)/2.

1. Compute the Nash equilibrium of the game. What are the market
shares of the two firms?
2. Given your answer to (1), compute the equilibrium profits, consumer
surplus, and social welfare.
 3. Prove that if c2 decreases slightly, then social welfare increases if the
market share of firm 2 exceeds 1/6, but decreases if the market share
of firm 2 is less than 1/6. Give an economic interpretation of this
finding.

4. Capacity choice and price competition

Consider the following two-stage game: In stage 1, two firms set capacities
x1 and x2 simultaneously. In stage 2 firms set prices pi simultaneously for a
homogeneous product. Assume that the marginal cost for one unit of
capacity is k and is incurred in the first stage. Once capacity is installed,
marginal production costs at the second stage are zero. Assume efficient
rationing if capacity is not enough to serve all consumers at a given price
(consumers with the highest willingness-to-pay are served first). The demand
function for the good is given by Q(p) = a – p and k < a < (4/3)k.

1. What would be the maximum capacity, a firm would never find optimal
to exceed?
2. Suppose at the second stage, firm 1 choose a price p1 < p2 such that
Q(p1) > x1. What is firm 2’s residual demand?
3. What are the firms’ profits for p1 < p2?
4. Argue that p1 = p2 = p* = a - x1 - x2 is an equilibrium outcome at the
second stage. (Hint: show first that p2 < p1 cannot be an equilibrium
outcome. Then argue that given p1 = p*, p2 > p1 can neither be an
equilibrium.)
5. Given these second stage prices, what capacities will the firms choose
at the first stage?

HAND-INASSIGNMENT 1

Bertrand competition
An industry consists of two firms. The demand function for the product of
firm i is
qi(pi ,pj). Suppose firms set prices.

1. Derive the first-order condition for profit maximization for firm i.

2. Now suppose and qi = 24 - 5pi + 2pj. The marginal cost of production
for each firm is zero. Find the price best-response function for firm i
3. Assume the firms compete over prices once; find the Nash equilibrium
in prices.
4. Assume firms coordinate their strategies. Compare the first-order
condition for the coordinated strategies to those derived in 1) for the
independent strategies.
5. Find the optimal collusive prices.
6. Draw a diagram that illustrates parts (1) through (5).
7. What are collusive profits? Bertrand profits?
8. What is the optimal defection from the collusive agreement?