Advanced Industrial Organization: Problem Set 2

CRN 25965 - ECON 485 B Pascal Courty University of Victoria

There is no need to write long answers. I provide suggested length in word
count to help you practice making clear and concise answers.
Exercise 1 Damaged-good strategy (25%, 40 words per answer on average)
A firm sells a product in a market where there are two types of consumers,
high and low-valuation consumers. There are equally many of the two types of
consumers, and the total number of consumers is normalized to 1. The product
has value 3 to the high-valuation consumers and value 1 to the low-valuation
consumers. All consumers have unit demand, i.e., they buy either one unit or
do not participate. The product is produced at constant marginal cost equal to
0.
1. Find the profit maximizing price and calculate the firms profit.
2. The firm considers introducing a damaged version of the product. The
damaged version is produced at constant marginal cost equal to 1/10. It
results in a utility of 5/10 to the low-valuation consumers and of 6/10
to the high valuation consumers. Find the optimal price of the normal
and of the damaged version of the product. Should the firm introduce the
damaged version? What are the welfare consequences of the introduction
of the damaged version?

Exercise 2 Bundling (25%, 30 words per answer on average)

Suppose that a monopolist produces two products, product 1 and product
2. There is a mass 1 of consumers. A share of consumers are heterogeneous
among each other and are described by their type . This type is distributed
uniformly on the unit interval. The willingness-to-pay for product 1 is assumed
to be r1 = and r2 = 1 . A share (1 )/2 of consumers has willingness
to pay r1 = 2/3 and r2 = 0. The remaining share (1 )/2 of consumers
has willingness to pay r1 = 0 and r2 = 2/3. Firms can sell products 1 and 2
independently at prices p1 and p2 , respectively. Alternatively, it may only sell
a bundle at price p. This is a situation referred to as pure bundling. A third
possibility is that the firm sells the bundle and the independent products, a
situation referred to as mixed bundling.
1. Suppose = 1. Determine whether independent selling, pure or mixed
bundling are profit maximizing. Calculate associated prices and profits.
2. Suppose that > 0 and characterize the solution under independent selling for all > 0.
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3. Suppose that = 4/5. Characterize the profit-maximizing solution under

independent selling, pure bundling, and mixed bundling. Show which of
the selling strategies is profit-maximizing. Discuss your result.
4. Suppose that = 2/3. Characterize the profit-maximizing solution under
independent selling, pure bundling, and mixed bundling. Show which of
the selling strategies is profit-maximizing. Discuss your result.

Exercise 3 Research Article (50%, 40 words per answer on average)

Timothy Bresnahan and Peter Reiss. Entry and Competition in Concentrated
Markets. Journal of Political Economy, 1991. You should read sections I and
II and only what is necessary to understand Figures 3 and 4 in section III (you
can skip IIIC and IV).
A local market is populated by S consumers. Each consumer has demand
d(p) = 100 p for a homogenous product (such as dental care, plumbing).
Firms have to invest fixed cost F to enter the market and then pay c(q) = q 2
to produce q units.
1. (a) Compute the inverse demand curve p(Q) in a local market. (b) Plot
p(Q) for S = 1, S = 2 and S = 100. What happens to p(Q) when the
number of consumers in the market increases?
2. (a) What is the smallest population size S such that a monopolist earns
non-negative profits? Denote that value sM . (b) What is the smallest
population size such each member of a cartel formed of n firms earns
non-negative profits?
3. Consider a large local market (S large) with many firms who are price
taker and earn zero profits. How many consumers does each firm serve?
Denote that value s .
4. (a) Show that sM and s are positive if and only if F < 502 . (b) Assume
this condition holds and show that sM < s . Interpret.
5. Consider a local market where there are n identical firms. Define firm
size sn as the observed number of consumers served by each firm. Provide
informal arguments: (a) Why would you expect firm size to increase with
the number of firms in a market (sn+1 > sn )? (b) Why should the ratio
sn+1 /sn converge to one as n increases?
6. How would you derive sM , s2 and s from Figure 3?
7. From looking at Figure 4, which markets would you think are the least
competitive? What could explain differences in plots across markets?
8. Would the approach presented in the paper work for other markets such
as retailing, food industry, restaurants?