Industrial Organization: Markets and Strategies

Paul Belle‡amme and Martin Peitz

published by Cambridge University Press
Part II. Market power
Exercises

Exercise 1 Monopoly with quality choice

Consider a monopolist who sells batteries. Each battery works for h hours
and then needs to be replaced. Therefore, if a consumer buys q batteries, he
gets H = qh hours of operation. Assume that the demand for batteries can be
derived from the preferences of a representative consumer whose indirect utility
function is v = u(H) pq, where p is the price of a battery. Suppose that u
is strictly increasing and strictly concave. The cost of producing batteries is
C(q) = qc(h), where c is strictly increasing and strictly convex.
1. Derive the inverse demand function for batteries and denote it by P (q).
2. Suppose that the monopolist chooses q and h to maximize his pro…t. Write
down the …rst-order conditions for pro…t maximization assuming that the
problem has an interior solution, and explain the meaning of these condi-
tions.
3. Write down the total surplus in the market for batteries (i.e., the sum
of consumer surplus and pro…ts) as a function of H and h. Derive the
…rst-order conditions for the socially optimal q and h assuming that there
is an interior solution. Explain in words the economic meaning of these
conditions.
4. Compare the solution that the monopolists arrives at with the social op-
timum. Prove that the monopolist provides the socially optimal level of
h. Give an intuition for this result.

Exercise 2 Monopoly versus Duopoly

Consider a market in which consumer type x is uniformly distributed on
the unit interval. Consumers demand 0 or 1 unit (they buy at most one unit
overall in the market). Firm A is located at 0 and …rm B at 1. Firms incur
constant marginal costs of production c = 1=2. There is mass 1 of consumers.
A consumer located at x 2 [0; 1] obtains utility ux = r x pA if she buys from
…rm A; ux = r (1 x) pB if she buys from …rm B; and 0 if she does not
buy. If more than one …rm is present, …rms simultaneously set prices.
1. Consider the monopoly problem in which only …rm A is present and sets
its prices to maximize pro…ts. Calculate the monopoly solution depending
on r where r 2 [0; 4].

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 2. Consider the duopoly problem in which …rms compete in prices. Solve for
Nash equilibrium depending on r. [Note: Be careful, make sure that you
characterize the equilibrium for any parameter r 2 [0; 4]:]
3. Compare the price level in duopoly to the price level under monopoly.
Are duopoly pricing necessarily lower than monopoly prices? Explain
your …ndings.
4. Suppose that …rm A is the incumbent and, thus, has already entered the
market. Suppose at a stage prior to the price-setting stage, …rm B decides
whether to enter. To enter the …rm has to pay an entry cost K which is
sunk. Depending on r calculate the critical sunk cost K ^ above which …rm
B would not be willing to enter the market.

Exercise 3 Price competition

Consider a duopoly in which homogeneous consumers of mass 1 have unit

demand. Their valuation for good i = 1; 2 is v(fig) = vi with v1 > v2 . Marginal
cost of production is assumed to be zero. Suppose that …rms compete in prices.

1. Suppose that consumers make a discrete choice between the two products.
Characterize the Nash equilibrium.
2. Suppose that consumers can now also decide to buy both products. If
they do so they are assumed to have a valuation v(f1; 2g) = v12 with
v1 + v2 > v12 > v1 . Firms still compete in prices (each …rm sets the price
for its product— there is no additional price for the bundle) Characterize
the Nash equilibrium.
3. Compare regimes (1) and (2) with respect to consumer surplus. Comment
on your results.

Exercise 4 Price competition with asymmetric marginal costs

Consider a market with three …rms o¤ering a homogenous product at con-

stant marginal costs ci , i 2 f1; 2; 3g. Firms simultaneously set prices pi . Con-
sumers have unit demand. Consumers’willingness to pay v are distributed over
[0; 1) according to a cumulative distribution function which takes values G(v).

1. Assume that ci = c for all i. Assume that (1 G(p))(p c) is single-peaked

and has a unique maximizer. Characterize all Nash equilibria. What are
equilibrium pices? What are equilibrium quantities?
2. Suppose that c1 < c2 < c3 . Assume that (1 G(p))(p ci ), i = 1; 2; 3; is
single-peaked and has a unique maximizer. Characterize all Nash equilib-
ria. What are equilibrium pices? What are equilibrium quantities?

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 3. Which of the equilibria in (2) is typically chosen? Explain why.

Exercise 5 Cournot competition

Two …rms (…rm 1 and …rm 2) compete in a market for a homogenous good
by setting quantities. The demand is given by Q(p) = 2 p. The …rms have
constant marginal cost c = 1.

1. Draw the two …rms’ reaction function. Find the equilibrium quantities
and calculate equilibrium pro…ts.

2. Suppose now that there are n …rms where n 2. Calculate equilibrium

quantities and pro…ts.

Exercise 6 Equilibrium uniqueness in the Cournot model

Consider an oligopoly with n …rms that produce homogeneous goods and

compete à la Cournot. Inverse demand is given by P (Q) with P 0 (Q) < 0, and
0 00
each …rm
P i has a cost function of Ci (qi ) with Ci (qi ) > 0 and Ci (qi ) 0. Denote
q i = j6=i qj .

1. Compute the …rst- and second order condition of …rm i. Under which
conditions is the pro…t function of …rm i, i , strictly concave?
dqi
2. Compute the slope of the best-reply function of …rm i, dq i . In which
interval is this slope?

A su¢ cient condition for uniqueness of a Cournot equilibrium is (see, e.g.,

Tirole (1999), page 226)

@2 i @2 i
+ (n 1) < 0;
@qi2 @qi @q i

3. Suppose that demand is concave and that marginal costs are constant.
For which number of n is the condition above satis…ed?
Pn
4. Suppose that P (Q) = a b i=1 qi and Ci (qi ) = cqi , for all i 2 f1; :::; ng.
Is there a unique equilibrium for any n?

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Exercise 7 Competition and cost changes

Consider a homogeneous-product n …rm oligopoly where demand is given

by some downward-sloping, well-behaved log-concave inverse demand function
P (q). Firms compete in capacities q i and prices then adjust to clear the market;
i.e. if …rms have chosen (q 1 ; :::; q n ) the market price will be p = P (q 1 ; :::; q n ).
Firms have constant marginal costs of production ci 0.

1. Are capacities in such a market typically strategic substitutes or strategic

complements? Explain.
2. Use …rst-order conditions of pro…t maximization to obtain an oligopoly
pricing formula that provides a relationship between markup and price
elasticity of demand.
3. Suppose that …rm i experiences an increase in marginal costs. What hap-
pens to the equilibrium capacity of this …rm i? What happens to the
equilibrium capacity of its competitors? What happens to industry ca-
pacity in equilibrium? Explain your answers (no formal analysis needed;
you can assume standard properties about the …rms’objective function).

Exercise 8 Industries with price or quantity competition

Which model, the Cournot or the Bertrand model, would you think provides
a better …rst approximation to each of the following industries/markets: the oil
re…ning industry, farmer markets, cleaning services. Discuss!

Exercise 9 An investment game

Consider a duopoly market with a continuum of homogeneous consumers

of mass 1. Consumers derive utility vi 2 fv H ; v L g for product i depending
on whether the product is of high or low quality. Firms play the following 2-
stage game: At stage 1, …rms simultaneously invest in quality: The more a …rm
invests the higher is its probability i of obtaining a high-quality product. The
associated investment cost is denoted by I( i ) and satis…es standard properties
that ensure an interior solution: I( i ) is continuous for i 2 [0; 1), I 0 ( i ) > 0 and
I 00 ( i ) > 0 for i 2 (0; 1), and lim #0 I 0 ( i ) = 0; lim "1 I 0 ( i ) = 1. Before the
beginning of stage 2 qualities become publicly observable— i.e., all uncertainty
is resolved. At stage 2, …rms simultaneously set prices.

1. For any given ( 1 ; 2 ), what are the expected equilibrium pro…ts? In

case of multiple equilibria select the (from the view point of the …rms)
Pareto-dominant equilibrium.
2. Are investments strategic complements or substitutes? Explain your …nd-
ing.

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 3. Provide the equilibrium condition at the investment stage.
4. How do equilibrium investments change as v H vL is increased?

Exercise 10 Hotelling model

Reconsider the simple Hotelling model in which consumers are uniformly
distributed on the unit interval and …rms are located at the extremes of this
interval. Now take consumers’participation constraint explicitly into account.
Derive the equilibrium depending on the parameter . [Be careful to distinguish
between di¤erent regimes with respect to competition between …rms!]

Exercise 11 Price and quantity competition

Reconsider the duopoly model with linear individual demand and di¤eren-
tiated products. Show that pro…ts under quantity competition are higher than
under price competition if products are substitutes and that the reverse holds
if products are complements.

Exercise 12 Asymmetric duopoly

Consider two quantity-setting …rms that produce a homogenous good and
choose their quantities simultaneously. The inverse demand function for the
good is given by P = a q1 q2 , where q1 and q2 are the outputs of …rms 1
and 2 respectively. The cost functions of the two …rms are C1 (q1 ) = c1 q1 and
C2 (q2 ) = c2 q2 , where c1 < a and c2 < (a + c1 )=2.
1. Compute the Nash equilibrium of the game. What are the market shares
of the two …rms?
2. Given your answer to (1), compute the equilibrium pro…ts, consumer sur-
plus, and social welfare.
3. Prove that if c2 decreases slightly, then social welfare increases if the mar-
ket share of …rm 2 exceeds 1=6, but decreases if the market share of …rm
2 is less than 1=6. Give an economic interpretation of this …nding.

Exercise 13 Selling independent products to budget-constrained consumers

Consider two sellers 1 and 2 and a continuum of buyers. Seller i o¤ers
product i at price pi and incurs zero marginal cost of production. Buyers are
identical and derive utility ui from one unit of each product. Thus their utility
is ui if they buy one unit of product i and zero units of product j, j 6= i; it is
u1 + u2 if they buy one unit of each product. Additional units do not give any
extra utility. Each buyer has a budget y, which she cannot exceed. Each seller
is assumed to prefer not to sell a unit rather than setting a zero price. Suppose
that u1 > u2 .

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 1. Derive the demand function of each buyer.
2. Consider the game in which sellers simultaneously set price. Characterize
the Nash equilibrium of the game.
3. Determine consumer surplus and total surplus that realize in equilibrium.
How does consumer surplus depend on income? Is the equilibrium neces-
sarily e¢ cient or are there ine¢ ciencies? Explain.

Exercise 14 Di¤ erentiated duopoly with uncertain demand

1. Consider a monopolist facing an uncertain inverse demand curve

p=a bq + :

When setting its price or quantity the monopolist does not know but
knows that E[ ] = 0 and E[ 2 ] = 2 . The cost function of the monopolist
is given by
c2 q 2
C(q) = c1 q + ;
2
with a > c1 > 0 and c2 > 2b.
Show that the monopolist prefers to set a quantity if the marginal cost
curve is increasing and a price if the marginal cost curve is decreasing.
Provide a short intuition for the result.
2. Now consider a di¤erentiated duopoly facing the uncertain inverse demand
system
p1 = a bq1 dq2 +
and
p2 = a bq2 dq1 + ;
2
with 0 < d < b, E[ ] = 0 and E[ ] = 2 . Again, the cost functions are
2
similar for both …rms and are given by C(q) = c1 q + c22q , with a > c1 > 0
2 2
and c2 > 2(b b d ) .
Both …rms play a one-shot game in which they choose the strategy variable
and the value of this variable simultaneously.
Argue by the same line of reasoning as in (1) that

(a) if c2 > 0 in the unique Nash equilibrium both …rms choose quantities
(b) if c2 < 0 in the unique Nash equilibrium both …rms choose prices
(c) if c2 = 0 there exist four Nash equilibria in pure strategies.

Exercise 15 Cournot duopoly and cost information

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 Consider a dupopoly market for a homogeneous product in which …rms set
quantity. Inverse demand is P (q) = 1 q with q = q1 + q2 . Firm 1 has marginal
costs equal to 0.7. Firm 2 has marginal cost 0.65 with probability 1=2 and 1
with probability 1=2.
1. Suppose that the cost type is publicly observed by both …rms prior to the
quantity setting. Characterize the equilibrium outcome of this game.
2. Suppose from now on that …rm 2 privately observes its cost type before
setting its quantity. Determine the equilibrium of this game. What is the
appropriate equilibrium concept? In particular, determine equilibrium
quantities and pro…ts.
3. Would …rm 2 have an incentive to reveal its cost type to …rm 1 if it could
do so at zero cost?
4. Would …rm 1 have an incentive to …nd out about …rm 2’s costs? Would
it like to do so privately (assuming that …rm 2 does not know the cost of
…rm 1 has when investigating) or publicly?
5. Are consumers better o¤ if …rm 2’s cost type remains private information?
Discuss.

Exercise 16 Strategic capacity choice

Consider a market in which …rms 1; :::; N set simultaneously capacities for
a homogeneous product and afterwards a third party, which observes market
demand and the capacity choice of each …rm sets the market clearing price.
Suppose that inverse demand is linear and of the form P (q) = a q, where
PN
p is the price, a a positive constant, and q aggregate output, q = i=1 qi ;
qi is the quantity sold by …rm i. Suppose that …rm i has constant marginal
costs of production ci (…rms have di¤erent marginal costs!). Suppose that a >
maxfc1 ; :::; cN g. Suppose furthermore that the parameters of the model are
such that each …rm produces positive output. Solve for the Nash equilibrium
where capacity is the strategic choice of the …rms. Determine aggregate output
and price level in equilibrium. Determine the output of each …rm i.

Exercise 17 Price setting in a market with limited capacity

Suppose that two identical …rms in a homogeneous-product market compete
in prices. The capacity of each …rm is 3. The …rms have constant marginal
cost equal to 0 up to the capacity constraint. The demand in the market is
given by Q(p) = 9 p. If the …rms set the same price, they split the demand
equally. If the …rms set a di¤erent price, the demand of each one of the …rms
is calculated according to the E¢ cient Rationing Rule. Show that p1 = p2 = 3
can be sustained as an equilibrium. Calculate the equilibrium pro…ts.

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Exercise 18 Capacity-constrained imperfect competition

Suppose two …rms in an industry face linear inverse demand curves Pi (qi ; qj ) =
7 qi qj , i = 1; 2, i 6= j. Firms compete in a two-stage game; …rst they set ca-
pacity and then they set price or output. At the …rst stage …rms set capacities,
at this stage the marginal costs of capacity is 6. Suppose that …rms have zero
marginal costs of production up until installed capacity and that production
above capacity is not feasible. In case of rationing, rationing is assumed to be
e¢ cient.

1. Suppose each …rm has a capacity of 7. Analyze competition at stage 2.

Determine the Nash equilibrium if both …rms set prices.
2. Consider the same situation as in (1) but suppose that …rms choose quan-
tities, not prices at stage 2. Determine the Nash equilibrium.
3. Consider the same situation as in (1) but suppose that consumers do not
observe price and incur a cost of 1=2 if, after visiting one …rm, they decide
to visit the other …rm. [You can think of identical consumers with the
demand function as given above]. Characterize the equilibrium if both
…rms set prices. (What is the appropriate equilibrium concept here?).
Give an explanation (at most 2 sentences).
4. Suppose that …rms have given capacities q 1 and q 2 , respectively. If …rm 1
is the high-price …rm, what is its demand function? Determine the Nash
equilibrium in prices (provided that q i 49=24, i = 1; 2). Show that
equilibrium prices satisfy p1 = p2 = a q 1 q 2 .
5. Determine the subgame perfect equilibrium of the two-stage game in which
…rms …rst set capacities and then prices. Give an explanation (at most 3
sentences).
6. Suppose that …rms collude at the stage at which they set capacity. What
should they do?
7. Suppose that …rms are able to use a less costly technology (e.g., the mar-
ginal cost of capacity falls from 6 to 11=2). What are the competitive
e¤ects of this reduction in capacity costs? What would happen if those
costs fell to zero? Discuss your results.

Exercise 19 Competition, installed capacity, and demand uncertainty

Suppose two …rms, …rm 1 and …rm 2, operate in a homogeneous good market.
The supply of …rm i, denoted by qi , is constrained by installed capacity ki ,
i.e., 0 qi ki for i = 1; 2. Firms have zero marginal costs of production
for quantities weakly below their capacity. They cannot increase production
beyond capacity.

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 There is a group of consumers of size e who all have unit demand with
the same willingness-to-pay r. Demand e is uncertain. The size of demand is
determined by the value a random variable takes. Suppose that this random
variable is uniformly distributed on the unit interval (i.e., on the interval [0; 1]).
Due to regulatory intervention there is a price ceiling P r that …rms are
allowed to charge (lower prices are admissible).
Consider the following two-stage game. At stage 1, before observing the
demand realization e …rms make investment decisions simultaneously. The con-
stant cost per unit of capacity is c. After the investment stage, information
about capacities become public knowledge. Next, demand is realized and pub-
licly observed. At stage 2, …rms compete in prices. Each …rm simultaneously
and independently sets its price pi . Firms maximize expected pro…ts.

1. Determine the allocation at stage 2 for given capacity choice.

2. Determine the Nash equilibrium at stage 2 for given capacities. Here you
have to distinguish between four di¤erent parameter regions. Note that
in two regions pure-strategy equilibria do no exist and you have to solve
for mixed-strategy equilibria. Also note that since all consumers have
the same willingness-to-pay you can be agnostic about the rationing rule
that is applied. If prices are equal, demand is assumed to be equally split
between …rms.
3. Analyze the 2-stage game and solve for subgame perfect Nash equilib-
ria (HINTS: Do not treat …rms as symmetric. Consider capacity as a
pure strategy). What is the expected pro…t at this stage? Draw the best-
response functions of the two …rms in a diagram. Determine the aggregate
equilibrium capacity K = k1 + k2 in this game. Implicitly characterize
equilibrium capacities k1 and k2 . Can you say anything about equilibrium
pro…ts (e.g., whether they are the same for the two …rms or which …rm
enjoys higher pro…t)?

Exercise 20 Cournot equilibrium and competitive limit

Suppose there are N …rms in a homogeneous good market which set their
output sequentially (…rm i in period i). Suppose that …rms have identical con-
stant marginal costs of P
production c. The industry faces an inverse demand
N
P (q) = a q where q = i=1 qi is aggregate demand. Suppose that a > c.

1. What is the output level of …rm i in subgame perfect equilibrium?

2. What is aggregate output for N …rms?
3. Describe the equilibrium outcome when the number of …rms increases
without bounds (N ! 1).

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Exercise 21 Competing in price-quantity pairs
Consider a duopoly for a homogeneous product. Firms i = 1; 2 set price-
quantity pairs (pi ; qi ) simultaneously. If at these pairs some consumers are
rationed, rationing is assumed to be e¢ cient. Suppose …rms are constrained
by capacities ki > 0 and inverse market demand is P (q) = q 1 . Does a Nash
equilibrium in pure strategies exist? Is it unique? Characterize all Nash equilibria
of this game.

Exercise 22 Sequential price setting with di¤ erentiated products

Consider a market with two horizontally di¤erentiated products and inverse
demands given by Pi (qi ; qj ) = a bqi dqj . Set b = 2=3 and d = 1=3. The
system of demands is then given by Qi (pi ; pj ) = a 2pi + pj . Suppose …rm
1 has cost c1 = 0 and …rm 2 has cost c2 = c (with 7c < 5a). The two …rms
compete in prices. Compute the …rms’pro…ts:
1. at the Nash equilibrium of the simultaneous Bertrand game,
2. at the subgame perfect equilibrium of the sequential game

(a) with …rm 1 being the leader, and

(b) with …rm 2 being the leader.

3. Show that …rm 2 always has a second-mover advantage, whereas …rm 1

has a …rst-mover advantage if c is large enough.

Exercise 23 Timing game

Use the results of the previous exercise to solve for the Nash equilibria of
the endogenous timing game in which …rms simultaneously choose whether to
play ‘early’or to play ‘late’. If they both make the same choice (either ‘early’or
‘late’), the simultaneous Bertrand game follows; if they make di¤erent choices,
a sequential game follows with the …rm having chosen ‘early’being the leader.
Discuss the economic intuition behind your result.

Exercise 24 Information sharing in Cournot duopoly

Consider the Cournot duopoly with linear demand P (q) = 1 q with q =
q1 + q2 and constant marginal cost. Firm one has marginal cost of zero. This is
commonly known. The marginal cost of …rm 2 is privately known to …rm 2; …rm
1 only knows that they are prohibitively high or zero and that both events are
equally likely (this is commonly known). High marginal costs are assumed to be
prohibitively high such that …rm 2 does not produce. Consider the three-stage
game in which, at stage 1, …rm 2 draws its marginal costs, then, at stage 2, it
decides whether to share its information with its competitor and, at stage 3, in
which both …rms compete in quantity.

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 1. Characterize the equilibrium of this game. Does …rm 2 have an incentive
to share its private information?
2. Would …rm 1 be better o¤ under information sharing?

Exercise 25 Price competition and information sharing

Consider the same setting except that …rms face a di¤erent demand function
and that …rms set prices at stage 3. Let demand be Qi = 1 pi dpj with
d > 0 so that products are substitutes and d < 1. Characterize the equilibrium
of this game. Does …rm 2 have an incentive to share its private information?

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