HE3001 Tutorial 10

1) Mighty Soft software company is about to introduce a new computer operating system called
DoorKnobs. As swapping files is easier with people who have the same operating system, the amount
people are willing to pay for DoorKnobs is greater the larger they believe DoorKnobs’s market share to
be.

The perceived market share for DoorKnobs is the fraction of all computers that the public believes is using
DoorKnobs. When the price of DoorKnobs is p, then its actual market share is the fraction of all
computer owners that would be willing to pay at least $ p to have DoorKnobs installed on their
computers.

Market researchers have discovered that if DoorKnobs’ perceived market share is s and the price of
DoorKnobs is $ p, then its actual market share will be x , where x is related to the price p and perceived
market share s by the formula

p=256 s (1−x ) (1)

In the short run, Mighty Soft can influence the perceived market share of DoorKnobs by marketing
strategies. In the long run, the truth will emerge, and DoorKnobs’ perceived market share s must equal
its actual market share x .

(a) If the perceived market share is s, then the demand curve for DoorKnobs is given by Equation (1).
Draw the demand curve relating price to actual market share in the case in which DoorKnobs’s perceived
market share is s=1/2. Label this curve s=1/2

(b) On the demand curve that you just drew with s=1/2, mark a dot on the point at which the actual
market share of DoorKnobs is 1/2. What is the price at which half of the computer owners actually want
to buy DoorKnobs, given that everybody believes that half of all computer owners want to buy
DoorKnobs?

(c) On the same graph, draw and label a separate demand curve for the case where DoorKnobs’s
perceived market share s takes on each of the following values: s=1/8 ,1 /4 , 3/4 ,7 /8 , 1. Just as in
part b), mark the points at which actual market share takes these values, showing the respective prices at
which the actual market share is s.

(d) Let us now draw the long-run demand curve for DoorKnobs, where we assume that computer owners’
perceived market shares s are the same as the actual market shares x . If this is the case, it must be that
s= x, so the inverse demand curve is given by p=256 x (1−x). On the graph above, plot a few points
on this curve and sketch in an approximation of the curve. (Hint: the curve you draw must go through all
the points that you have already plotted.)

(e) Suppose that Mighty Soft sets a price of $48 for DoorKnobs and sticks with that price. There are three
different perceived market shares such that the fraction of consumers who would actually want to buy
DoorKnobs for $48 is equal to the perceived market share. One such perceived market share is 0. What
are the other two possibilities?

(f) Suppose that by using its advertising and media influence, Mighty Soft can choose its perceived market
share x . Suppose that it sets a price that makes the actual market share equal to its chosen perceived
market share, p=256 x (1−x), what market share x should MightySoft choose in order to maximize its
revenue and what price should it charge in order to maintain this market share?
2) Suppose we have consumers who have to decide whether to subscribe and use the digital food-
delivery service FoodBear. The market is perfectly competitive such that Foodbear will charge a price
equal to its’ marginal cost. There are some peculiar network advantages from having more consumers in
the service such that marginal cost is decreasing initially and at very large scales. Consumers have a
perfectly elastic demand curve. This is drawn in the figure below.

Willingness
to pay

MC curve

Suppose that the market expands whenever willingness to pay exceeds the marginal costs.

(a) Indicate in the graph all possible equilibria in the market.

(b) Which of these are stable equilibria, and which of these are unstable equilibria? Explain.

Suppose that the MC curve now looks like the below.

MC curve

Willingness to
pay

n n1 n2
Being a recent startup, FoodBear is finding it hard to scale up its business. However, it has a loyal fanbase
of n< n1.

(c) Is its’ fanbase enough to help it expand to a large scale?

(d) Suppose it can raise consumer’s willingness to pay by some advertisements. Indicate in the diagram
the minimum amount that it has to be raised by to help it expand to a larger scale. Will the
advertisements need to be temporary or permanent?
(e) Discuss how the size of the needed advertisement to achieve a large scale changes with the size of
their initial fanbase.

3) Intoot produces checkwriting software. The program itself, Fasten, sells for $50 and includes a package
of checks. Check refill packets for Fasten cost $20 to produce and Intoot sells the checks at cost. Suppose
that a consumer purchases Fasten for $50 in period 1 and spends $20 on checks in each subsequent
period. Assume for simplicity that the consumer uses the program for an infinite number of periods.

(a) If the interest rate is r = .10 per period, what is the present value of the stream of payments made by
the consumer?

(b) Fasten’s competitor produces an equally effective product called Czechwriter. Czechwriter can do
everything Fasten can do and vice versa except that Fasten cannot use check refill packets that are sold
by anyone other than Fasten. Czechwriter also sells for $50 and sells its checks for $20 per period. A
Fasten customer can switch to Czechwriter simply by purchasing the program and then spending on
Czechwriter’s checks in the subsequent periods. What is the switching cost for a Fasten customer?

(c) Fasten is contemplating raising the price of checks to $30 per period. If so, will its customers switch to
Czechwriter? Explain.

(d) Fasten contemplates raising the price of checks to $22 per period. Will its customers switch?

(e) At what price for checks will Fasten’s customers just be indifferent to switching?

(f) If it charges the highest price that it can without making its customers switch, what profit does Fasten
make on checks from each of its customers per period? What is the present value of the profit per
customer that Fasten gets if it sets the price of checks equal to the number determined in the last
question? How does this compare to the customer switching cost?

(g) Suppose now that the cost of switching also involves several hours of data conversion that the
consumer values at $100. The total cost of switching is the cost of the new program plus the data
conversion cost. What is the total switching cost?

(h) Making allowances for the cost of data conversion, what is the highest price that Intoot can charge for
its checks? What is the present value of profit from this price? How does this compare to total switching
costs?

(i) Suppose that someone writes a computer program that eliminates the cost of converting data and
makes this program available for free. Suppose that Intoot continues to price its check refill packages at
$25. A new customer is contemplating buying Fasten at a price of $50 and paying $25 per period for
checks, versus paying $50 for Czechwriter and paying $20 for checks. If the functionality of the software is
identical, which will the consumer buy?

(j) Intoot decides to distribute a coupon that offers a discount of $ d off of the regular purchase price.
What would be the value of d to make consumers indifferent between purchasing Fasten and
Czechwriter?
4) Consider Software X version 1, published by ABC which will be sold for two years, until version 2 comes
out. The software is locked with encryption such that each copy bought can only be used by 1 user at any
time.

Let p1 be the price charged for copies sold in the first year and let p2 be the price charged for copies sold
in the second.

Everyone is aware that there will be an active market for used copies after one year and that used copies
of version 1 will have zero resale value when the new version is released after 2 years. At the end of the
first year, owners can resell their copies to the software store for 40% of the second-year price, p2. The
demand in the first year is thus a function of the net costs: q 1=D1 ( p1−0.4 p 2).

After the first year, owners may decide to keep their copies for future use. The number copies kept is
k
given by a keeper’s demand which depends on the resale price: D (0.4 p 2).

For simplicity, let us assume that new and used software cost the same in the software store in the
second year, and that students are indifferent between them. As copies bought in the second year have
zero resale value, the demand for software in the second year is thus only a function of the price,
q 2=D2 ( p2 ).
(a) Write an expression for the number of new copies that ABC can sell in the second year after
publication if it sets prices p1 in year 1 and p2 in year 2.

(b) Write an expression for the total number of new copies that ABC can sell over two years at prices p1
and p2 in years 1 and 2. Would the total number of copies sold change if p1 increases and p2 remains
constant?

(c) Suppose that marginal costs are fixed per unit at c . Write out an expression for the profits of ABC.

Let
D1 ( p1−0.4 p 2)=100 (90−p 1+ 0.4 p2); D2 ( p2 )=100(90− p2 ); Dk (0.4 p2)=100(90−0.8 p2) .
Marginal costs c=10 .

(d) What are the prices p1 and p2 that will maximise ABC’s total profits over the 2 years?

(e) Suppose that ABC now wants to charge the same price in both years. What is the price that will
maximise its total profits and what will be the quantities sold in each year?

(f) Suppose that ABC decides instead to release an intermediate version after the first year such that the
resale market is now eliminated (i.e. everyone who buys in the first year will keep their software). Hence,
D1 ( p1 )=100(90− p1 ), D2=100 (90− p 2). Suppose that ABC again charges the same price in both
years. What is the price that will maximise its total profits and what will be the quantities sold in each
year?

(g) If ABC wants to charge the same price in both years, would it be better for ABC to release an
intermediate version or not?
Practice

5) Suppose that demand for DoorKnobs is as given in question 1, and assume that the perceived market
share in any period is equal to the actual market share in the previous period. Then where x t is the actual
market share in period t , the equation p=256 x t −1 (1−x t ) is satisfied.

Rearranging this equation, we find that x t =1−( p /256 x t −1) whenever p/256 x t−1 <1. If
p/256 x t−1 ≥1, then x t = 0. With this formula, if we know the actual market share for any period, we can
calculate market share for the next period.

Let us assume that DoorKnobs sets the price at p=32 and never changes this price. (To answer the
following questions, you will find a calculator useful.)

(a) If the actual market share in the first period was 1/2, find the actual market share in the 2nd period,
the 3rd period, 4th period, 5th period.

(b) Do they seem to be approaching a limit? If so, what?

(c) Notice that when price is held constant at p, if DoorKnobs’s market share converges to a constant x , it
must be that x=1−( p/256 x ). Solve this equation for x in the case where p=$ 32. What do you say
about two solutions?