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Problem Set 3

The document outlines a problem set focusing on various economic models, including Hotelling's model with vertical differentiation and asymmetric marginal costs, collusion in competitive markets, and the effects of market structure on collusion sustainability. It presents questions related to demand functions, equilibrium prices, and the impact of marginal cost changes on profits, as well as statements for evaluation regarding collusion dynamics in different market conditions. The problems require analytical solutions and discussions on strategic interactions among firms in both Cournot and Bertrand competition frameworks.

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Шерхан Алишер
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3 views

Problem Set 3

The document outlines a problem set focusing on various economic models, including Hotelling's model with vertical differentiation and asymmetric marginal costs, collusion in competitive markets, and the effects of market structure on collusion sustainability. It presents questions related to demand functions, equilibrium prices, and the impact of marginal cost changes on profits, as well as statements for evaluation regarding collusion dynamics in different market conditions. The problems require analytical solutions and discussions on strategic interactions among firms in both Cournot and Bertrand competition frameworks.

Uploaded by

Шерхан Алишер
Copyright
© © All Rights Reserved
Available Formats
Download as PDF, TXT or read online on Scribd
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Problem set # 3

1. Hotelling Model with vertical differentiation


Consider a differentiated duopoly where the two firms are respectively located in l1 = 0 and
l2 = 1. Consumers are uniformly distributed according to the variety they prefer x ∈ [0, 1].
Moreover, the two products are characterized by qualities s1 and s2 . A consumer at x pur-
chasing art price pi one unit of good i = 1, 2 characterized by location li and quality si has
preferences described by the following expression:

U (li , si , x) = si − pi − |li − x|

Hence, when consumers receive for free (pi = 0) a product of the variety they prefer li = x, their
maximum willingness to pay coincides with the evaluation of the quality si of that product.
Both firms have null marginal costs of production.

(a) Derive the expressions of the demand function for each of the two products
for given varieties l1 = 0 and l2 = 1 and given qualities s1 and s2 with s1 > s2 .
(b) Compute the optimal prices in the Nash equilibrium. Which firm sets the highest price?
How do prices vary as qualities s1 and s2 vary?
(c) Derive the demand for each of the two goods corresponding to equilibrium prices. Which
of the two firms has the largest market share? How does the demand for each of the two
goods vary as qualities s1 and s2 vary?

2. Hotelling Model with asymmetric marginal costs


Carlo (C) and Gianni (G) work as masseurs in the city of Malluvallis, which is linear and
of unitary length [0,1]. Carlo’s shop is located in 0 at the western extreme of the city while
Gianni’s shop is located at the eastern border in 1. The marginal costs of the two masseurs are
identical and correspond to cC = cG = 20. There are N = 120 potential costumers uniformly
distributed along the city. Each consumer is willing to pay at most a sum v = 60 in order to
get a home massage. If instead he decides to go to the shop, he has to pay a cost t = 5 for each
unit of travelled distance. Carlo and Gianni compete on prices.

ˆ Determine the demand function of each of the two masseurs.


ˆ Calculate the equilibrium prices that Carlo and Gianni will apply, specifying their best
reply functions.
ˆ Suppose now that Carlo’s marginal cost increases to cC = 30, while Gianni’s marginal
cost remains the same. How do the demand functions of the two masseurs change?
ˆ Determine the equilibrium prices, compare them to the previous ones and explain why
they are different.
ˆ What is the sign of the direct effect of a change in Carlo’s marginal cost (cC ) on Carlo’s
profits? Explain briefly.
ˆ What is the sign of the strategic effect of a change in Carlo’s marginal cost (cC ) on Carlo’s
profits? Explain briefly.

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3. Collusion: barriers to entry
Industry X, in the current period (t = 1), is populated by n firms that compete on prices,
produce a perfectly homogeneous good, are all characterized by the same cost function C(qi ) =
cqi and by absence of capacity constraints. Market demand is defined by Q = D(p). Denote the
price that maximizes total market profits by pm and the related maximum profits by π m . In
each period following the first one (t ≥ 2) a new competitor enters the market with probability
φ ∈ [0, 1]. This competitor will set a price equal to the marginal cost c and is active for one
period only. With probability 1 − φ entry does not take place.

ˆ Compute the critical discount factor for the sustainability of a collusive agreement in the
industry.
ˆ Verify that the critical discount factor is increasing in φ and briefly explain the intuition
for this result.

4. Collusion: frequency of interaction


Industry X is populated by n firms that compete on prices, produce a perfectly homogeneous
good and are all characterized by the same cost function C(qi ) = cqi . Market demand is defined
by Q = D(p), firms face no capacity constraints and interact in every period t = 1, 2, ..... Denote
the price that maximizes total market profits by pm and the related maximum profits by π m .

ˆ Compute the critical discount factor for the sustainability of a collusive agreement in the
industry.
ˆ Now assume that, differently from the previous question, market demand does not mate-
rialize each period, but every T periods. Whenever market demand materializes, it turns
out to be Q = T D(p). Compute the critical discount factor for the sustainability of a col-
lusive agreement in the industry and prove that such critical discount factor is increasing
in T .
ˆ Briefly explain the intuition for the fact that the critical discount factor is increasing in
T.

5. Collusion: Bertrand vs Cournot


Consider the following demand function p(Q) = 15 − Q, in a market where two firms compete
with total cost function T Ci (qi ) = 3qi with i = 1, 2, and Q = q1 + q2 . Suppose that the two
firms compete à la Cournot.

ˆ Compute quantities, prices and profits of the two firms in equilibrium.

ˆ Compute quantities, prices and profits of the two firms if they collude.

ˆ Which condition on the discount factor δ should hold in order for collusion to be sustain-
able?

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Suppose now that the two firms compete á la Bertrand.

ˆ Compute quantities, prices and profits of the two firms in equilibrium.

ˆ Compute quantities, prices and profits of the two firms if they collude.

ˆ Which condition on the discount factor δ should hold in order for collusion to be sustain-
able?
ˆ Is it easier to sustain a collusive agreement if firms compete à la Cournot or á la Bertrand?
Comment the results obtained at the previous points giving the economic intuition.

6. Collusion: Lags in detection of deviations


Consider a market in which three firms (A,B and C) produce homogeneous products and
compete à la Cournot. The three firms have constant marginal cost equal to 40. Market
demand is given by p = 160 − Q where Q = qA + qB + qC .

ˆ Compute the critical discount factor such that collusion is sustainable in the market.
ˆ Suppose now that it takes two period for rivals to detect that a deviation has occurred.
Compute the critical discount factor. How does it compare to the one found above.
Explain.

Establish whether the following statements are True, False, or Uncertain explaining
briefly why.

Statement 1
In a market in which firms offer homogeneous products it is easier to sustain a collusive agreement
as opposed to a market in which firms offer differentiated products.

Statement 2
Consider the market of mineral water, in which water is extracted from springs, bottled and then
distributed to final consumers. Three firms operate in this market in country A, having identical
marginal costs, identical number of brands and each holding 1/3 of total capacity. (Capacity is
measured by the amount of water that can be extracted in a given interval of time.) Three firms
operate also in country B, having identical marginal costs and identical number of brands. However
in country B one firm holds 60% of total capacity and each of the remaining firms holds 20% of total
capacity. STATEMENT TO DISCUSS: It is more likely that a collusive agreement is sustainable
in market A than in market B.

Statement 3
In country X there exist four companies that compete in the distribution of gasoline to final con-
sumers. Each company has a network of petrol stations. The companies have agreed NOT to publish

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their prices on the big screens located along the highways. These screens report the prices set in the
petrol stations that the driver can find within 100 kilometers. DISCUSS: Such an agreement exerts
anti-competitive effects by allowing firms to sustain higher prices.

Statement 4
In a given sector with differentiated products, prices are set by a regulatory authority and are con-
stant over time. The strategic effect induces firms to locate as far as possible from each other.

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