Gerard

Gimnez Adsuar
IO ADE EUS

Problem Set 3

Problem 1

The assumptions well use to solve this model are the following ones: there are two
firms which produce the same type of product, but these are of different
characteristics (product differentiation) and compete a la Bertrand in prices.
Moreover, we consider that consumers have different preferences (horizontal
differentiation). As a consequence of this, each firm faces a different inverse demand
function, which well use in order to model their behaviour.
Both firms will try to maximize profits:

max ( , * = ( , * , ( (( )

$%

6789:;
( , *
( , * , (
(
=

=0
= (. . . )
(
(
(
( *
1 = 500
2
4 6789:;
16
( *
1 =
(375 + )
15
2
8
* (
2 = 500
2
4
Now that weve expressed the quantity produced by firm 1 as a function of P1 and P2,
we can calculate the reaction functions of each firm, by applying the first order
condition that marginal revenue equals marginal cost at the point of profit
maximization:

( , * = ( ( 150(
16
( *
16
( *
( , * = ( (
375 +
150(
375 +
)
15
2
8
15
2
8
( , *
16 1
16
( *
= ( 150
+ 1
375 +
= 0
(
15 2
15
2
8
So the reaction functions are:
*
(
( = 450 + * = 450 +
8
8

Solving this system of two linear equations, we obtain the equilibrium price:
64 4050
(8 =

= 514,29 = *8
63
8

Knowing this, we proceed by finding the equilibrium quantity that each firm will sell in
the market, that is, to their own residual demand:
16
( *
1 =
375 +
(8 = *8 = 194,28
15
2
8
So that the total quantity traded in the market is:
T = 2(8 = 2*8 = 388,56

Profits can be calculated easily since we know the price and quantity sold:
( ( , * = * ( , * = (8 (8 150(8 = 70774,26

Gerard Gimnez Adsuar

IO ADE EUS

We can see how under product differentiation, the type of Bertrand competition in
prices doesnt yield an equilibrium equal to that we would find under Perfect
Competition or with a duopoly without product differentiation.
In addition, we can calculate the firms markup cost with the Lerner index:

=
= 2,42 242% ( )

Graph of the two reaction functions and the equilibrium
700

600

Equilibrium
P1=450+(P2/8)

500

400

300

200

P2=450+(P1/8)

100

100

200

300

400

500

600

Problem 2

Were faced with an oligopoly competing a la Cournot in quantities, with product
differentiation. This is so given that the market has been liberalised, that is, there has
been a removal of the barriers of entry that the government was maintaining.
Since we depart from a situation of monopoly, we will estimate how many companies
will enter in the market, assuming each is producing the same product with different
characteristics (N firms). We know that firms will enter insofar as they can obtain nonnegative profits (participation constraint).
Thus, we start by modelling the ith firm which maximizes its profits, according to its
residual demand and its technology (represented by its total cost function):

3
7 7 , ^ , = 1000 1.57 1.5 1 ^
4

7 7 = 1507 + 500

7 7 , ^ , = 7 7 , ^ , 7 7 7

Gerard Gimnez Adsuar

IO ADE EUS

7 7 , ^ ,
9
= 1000 37 1 ^ 150 = 0 (. . . )
7
8

In this point, we assume that all firms, either old or incumbent, or new will
produce the same in equilibrium, that is,
78 = ^8
Thus,

9
850
378 + 1 78 = 850 78 =

9
8
3 + ( 1)
8
With this expression, given a n of firms in the industry, represented by N, each one
will produce an amount 78 .

Hence, the price will also be a function of N, and using the residual demand of firm i:

9
3
7 = 1000 1 78 78
8
2

In the same way, using the residual demand of firm i, we can find the Consumer
Surplus:
1,57*
=

2

And the Producer Surplus will simply be individual profits times N, which is the number
of firms:
7 7 , ^ , = 7 7 , ^ , 7 7 7

() = T () = 7




We can proceed by constructing a table with Excel, and given that all these variables
are now a function of N, we can calculate the values of each by assigning values of N:

Qei
1
2
3
4
5
6
7
8
9
10
11
12
13
14
15
16
17
18
19
20
21
22
23
24
25
26
27
28
29
30
31
32
33
34
35
36
37
38
39
40

Qe
283,33
206,06
161,90
133,33
113,33
98,55
87,18
78,16
70,83
64,76
59,65
55,28
51,52
48,23
45,33
42,77
40,48
38,42
36,56
34,87
33,33
31,92
30,63
29,44
28,33
27,31
26,36
25,47
24,64
23,86
23,13
22,44
21,79
21,18
20,61
20,06
19,54
19,05
18,58
18,13

pei
283,33
412,12
485,71
533,33
566,67
591,30
610,26
625,29
637,50
647,62
656,14
663,41
669,70
675,18
680,00
684,28
688,10
691,53
694,62
697,44
700,00
702,35
704,50
706,49
708,33
710,04
711,63
713,11
714,49
715,79
717,01
718,15
719,23
720,25
721,21
722,12
722,99
723,81
724,59
725,33

575,00
459,09
392,86
350,00
320,00
297,83
280,77
267,24
256,25
247,14
239,47
232,93
227,27
222,34
218,00
214,15
210,71
207,63
204,84
202,31
200,00
197,89
195,95
194,16
192,50
190,96
189,53
188,20
186,96
185,79
184,69
183,66
182,69
181,78
180,91
180,09
179,31
178,57
177,87
177,20

profitsie
PS
119916,67
63191,46
38819,73
26166,67
18766,67
14068,37
10900,39
8663,69
7026,04
5791,16
4837,03
4084,57
3480,72
2988,76
2582,67
2243,56
1957,48
1713,92
1504,86
1324,06
1166,67
1028,80
907,35
799,83
704,17
618,69
542,00
472,94
410,52
353,92
302,44
255,48
212,52
173,13
136,91
103,55
72,73
44,22
17,78
-6,77

Gerard Gimnez Adsuar

IO ADE EUS
CS
119916,67
126382,92
116459,18
104666,67
93833,33
84410,21
76302,76
69309,55
63234,38
57911,56
53207,29
49014,87
45249,31
41842,61
38740,00
35897,00
33277,21
30850,62
28592,27
26481,26
24500,00
22633,54
20869,13
19195,82
17604,17
16085,98
14634,13
13242,35
11905,17
10617,73
9375,75
8175,41
7013,31
5886,42
4792,01
3727,62
2691,04
1680,27
693,50
-270,93

SW
60208,33
63691,46
58979,59
53333,33
48166,67
43705,10
39901,38
36654,78
33867,19
31455,78
29353,65
27507,44
25874,66
24421,31
23120,00
21948,50
20888,61
19925,31
19046,13
18240,63
17500,00
16816,77
16184,56
15597,91
15052,08
14542,99
14067,06
13621,18
13202,58
12808,86
12437,87
12087,70
11756,66
11443,21
11146,01
10863,81
10595,52
10340,14
10096,75
9864,53

ATC
180125,00
190074,38
175438,78
158000,00
142000,00
128115,31
116204,14
105964,33
97101,56
89367,35
82560,94
76522,31
71123,97
66263,92
61860,00
57845,50
54165,82
50775,93
47638,40
44721,89
42000,00
39450,31
37053,69
34793,73
32656,25
30628,97
28701,19
26863,53
25107,75
23426,59
21813,62
20263,11
18769,97
17329,64
15938,02
14591,43
13286,56
12020,41
10790,24
9593,60

151,76
152,43
153,09
153,75
154,41
155,07
155,74
156,40
157,06
157,72
158,38
159,04
159,71
160,37
161,03
161,69
162,35
163,01
163,68
164,34
165,00
165,66
166,32
166,99
167,65
168,31
168,97
169,63
170,29
170,96
171,62
172,28
172,94
173,60
174,26
174,93
175,59
176,25
176,91
177,57

The yellow line represents the value of N, (N=2), where Consumer Surplus and
Producer Surplus is maximized, and hence, Social Welfare is maximized as well.
The blue line represents N=10, which would be the maximum number of firms allowed
by the government. And finally, the green line represents N=39, which would be the
number of firms that would enter the market with free entry, given that were a 40th
firm to enter, each firm would become unprofitable and one would leave, as it
wouldnt be sustainable.
Note that the free entry equilibrium (green line) is not the one maximizing welfare at
all, in fact, Social Welfare is less than 20 times what we find when its maximized
(N=2). This is so since there are duplications of fixed costs, given that each firm must
make a large investment regardless of the output that they make (fixed and sunk
costs). This duplication of costs can be fully appreciated by the last column, which
shows the average total cost per unit of production. The more firms enter the market,
the higher the average costs per unit, since each firm produces less and less, and
facing diseconomies of scale.
Moreover, if we only considered welfare, we could reach the conclusion that free
entry is only detrimental but notice how the total number of people benefiting from
this service increases with the number of firms in the market. In the optimum, 412

Gerard Gimnez Adsuar

IO ADE EUS

thousand people benefit, while in the equilibrium with free entry more than 724
thousand enjoy the service.




The results are extracted from the table:
1 18,58 units per firm is the equilibrium quantity per firm with free entry
2 724,59 thousands of subscribers with free entry
3 177,87 per unit is the equilibrium price with free entry
4 N=39 the number of firms in this equilibrium with free entry
5 206,06 units per firm is the quantity that each firm should produce to maximize
welfare, which happens when N=2
6 412,12 thousands of subscribers is the total quantity that maximizes social
welfare, when N=2
7 459,09 per unit is the optimum price that maximizes welfare, when N=2
8 N=2 in the social optimum
9 459,09 per unit is the price that maximizes consumer surplus (as well as SW)
10 N=2 is the number of firms that maximizes consumer surplus (as well as SW)

Graphs:

This one below shows the situation with N=2, where Social Welfare is maximized given
that Producer Surplus and Consumer Surplus are maximum:

1000

CASE OF N=2

Consumer Surplus generated from firm i

800

600

400

Profits firm i

ATC(q)

D1

200

Residual Demand

Total Demand

MC
MR1

100

200

300

400

500

600

Gerard Gimnez Adsuar

IO ADE EUS

The graph below shows the situation in which there are 39 firms in the market (N=39),
as shown, the residual demand curve touches the ATC curve, and its precisely at this
point where firms are producing, so that their profit is 0.
300

250

Consumer surplus generated by ith firm

Profits = 0

200

ATC

150
MC

100
D39
MR39

50

20

40

60

80

100

120

140

Note how the total demand curve doesnt appear on the graph, due to the scale. We
have to imagine that the area of the green triangle multiplied by 39 times will equal to
the total Consumer Surplus, and given that profits are (almost) 0, also equal to the
Social Welfare.

Appendix

I have proved using Mathematica, that the Consumer Surplus as a function of N has a
maximum exactly in N= 5/3, but since we only care of discrete numbers, N=2.
The graph below depicts the function of CS (y-axis) and N (x-axis):
100 000

80 000

dCS(N) dN
Maximum CS(2)

60 000

40 000

CS(N)

20 000
Maximum CS'(N)=0