Final exam preparation file

1. Firm i sells cereal and is active in a market characterized by spatial competition. The total
market area (normalized to 1) is approximately circular and each firm competes with its direct
neighbors, as consumers don’t want to consume cereals that are very far from their optimal
choice. As such, the willingness to pay of each consumer decreases by 100 Euro per year for
each unit of deviation of the product from what would have been their optimal choice. The
maximum willingness to pay of each consumer (if the provider is located where they live) is 600
Euro per year. For the present example assume that marginal costs are equal to 1. Fixed costs
are equal to 4.

Summary: t=100, F=4, v=600, c=1.

a) Derive the demand level of Firm 𝑖 if the company competes with Firm 𝑗 charging a price of 𝑝𝑗
on the left and with Firm ℎ, charging a price of 𝑝ℎ on the right. (0.5 points)
Since the firms are symmetric, they will locate at equal distance from each other. This means
1
that Firm 𝑗 is located 𝑛
kilometres away from Firm 𝑖. As the consumers are distributed
1
uniformly, this means that 𝑛% of the consumers are located between the two firms. When
determining the demand for Firm 𝑖, we need to calculate how many of those consumers will
buy from Firm 𝑖. To do this, we need to find the indifferent consumer 𝑥̅ , for whom buying from
Firm 𝑖 results in the same level of utility as buying from Firm 𝑗.
𝑈𝑥̅ 𝑖 (𝑝𝑖 , 𝑝𝑗 , 𝑡) = 𝑈𝑥̅ 𝑗 (𝑝𝑖 , 𝑝𝑗 , 𝑡)
To find the value of 𝑥̅ , we therefore derive the utility of buying from Firm 𝑖 for a customer
located 𝑥 kilometres away from Firm 𝑖:
𝑈𝑥̅ 𝑖 (𝑝𝑖 , 𝑝𝑗 , 𝑡) = 𝑣 − 𝑝𝑖 − 𝑡𝑥 = 600 − 𝑝𝑖 − 100𝑥
Since we are now concerned with the section of the market between Firm 𝑖 and Firm 𝑗, we
know that if a customer is located 𝑥 units of distance away from Firm 𝑖, then their location is
1/𝑛 − 𝑥 units of distance away from Firm 𝑗. This makes the utility from buying from Firm 𝑗
equal to:
1
𝑈𝑥̅ 𝑗 (𝑝𝑖 , 𝑝𝑗 , 𝑡) = 𝑣 − 𝑝𝑗 − 𝑡𝑥 = 600 − 𝑝𝑗 − 100( − 𝑥)
𝑛
Setting the two utilities equal, yields the distance from Firm 𝑖 of the switching/indifferent
consumer:
1
600 − 𝑝𝑖 − 100𝑥̅ = 600 − 𝑝𝑗 − 100( − 𝑥̅ )
𝑛
100
𝑝𝑗 − 𝑝𝑖 + 𝑛 𝑝𝑗 − 𝑝𝑖 5
𝑥̅𝑗 = = +
20 20 𝑛
A similar process occurs with regard to competition with Firm ℎ:
𝑝ℎ − 𝑝𝑖 5
𝑥
̅̅̅ℎ = +
20 𝑛

The total demand for Firm 𝑖 is given by all consumers up to the indifferent consumer on both
sides of the market:
 𝑝𝑗 + 𝑝ℎ − 2𝑝𝑖 10
𝐷𝑖 = 𝑥̅𝑗 + ̅̅̅
𝑥ℎ = +
20 𝑛

b) Assuming that all firms will charge the same equilibrium price, derive how high that price will
be as a function of the number of firms. (0.5 points)
To derive the optimal price, we must optimize the profit function of a representative firm:
𝑝𝑗 + 𝑝ℎ − 2𝑝𝑖 10 𝑝𝑗 + 𝑝ℎ − 2𝑝𝑖 10
𝜋𝑖 = 𝑝𝑖 ( + )−( + )−4
20 𝑛 20 𝑛
𝑝𝑗 + 𝑝ℎ 𝑝𝑖2 10𝑝𝑖 𝑝𝑗 + 𝑝ℎ 𝑝𝑖 10
= 𝑝𝑖 − + − + − −4
20 10 𝑛 20 10 𝑛

𝜕𝜋𝑖 𝑝𝑗 + 𝑝ℎ 𝑝𝑖 10 1
= − + + =0
𝜕𝑝𝑖 20 5 𝑛 10

We can thus calculate the optimal reaction of Firm 𝑖 to changes in the prices of its main
competitors:
𝑝𝑗 + 𝑝ℎ 50 1
𝑅𝐹𝑖 = 𝑝𝑖∗ = + +
4 𝑛 2
If the prices of all firms are equal, this yields the following optimal price:
∗ 𝑝𝑖∗ + 𝑝𝑖∗ 50 1
𝑝𝑖 = + +
4 𝑛 2
100
𝑝𝑖∗ = +1
𝑛

c) Calculate the equilibrium number of firms on the market. How high is the price of each firm?
(0.5 points)
We know that firms enter until profits are equal to zero:
1 100 1
𝜋𝑖 = 𝑞𝑖 𝑝𝑖 − 𝐹 = ( + 1) − − 4 = 0
𝑛 𝑛 𝑛

𝑛2 = 25 → 𝑛 = 5 𝑓𝑖𝑟𝑚𝑠
Plugging in the equilibrium number of firms, we can calculate the optimal price of the firms:
100
𝑝𝑖∗ = + 1 = 21 𝐸𝑢𝑟𝑜
𝑛
Each consumer will be charged a total of 21 Euro for their yearly consumption.

d) How would the equilibrium number of firms change if the fixed costs were to rise to 6,25 Euro?
What is the effect on the prices?
1 100 1
𝜋𝑖 = 𝑞𝑖 𝑝𝑖 − 𝐹 = ( + 1) − − 6,25 = 0
𝑛 𝑛 𝑛

𝑛2 = 16 → 𝑛 = 4 𝑓𝑖𝑟𝑚𝑠
100
𝑝𝑖∗ = + 1 = 26 𝐸𝑢𝑟𝑜
4

The number of firms decreases and prices rise to cover the extra cost.
2. A large number of firms is potentially competing in selling a homogeneous product. The inverse
demand for the product is equal to: 𝑝 = 400 − 2,5𝑄, where 𝑄 is the total demand on the
market. The firms have identical cost structures: 𝐶𝑖 = 40𝑞𝑖 + 3000, in other words (𝑀𝐶𝑖 = 40
and 𝐹𝑖 = 3000). The firms compete through output.
a) Given free entry, how many firms will be active on the market? When calculating the free entry
𝑎−𝑀𝐶
level, use the fact that each firm produces an output equal to: 𝑞𝑖 = 𝑏(𝑛+1)𝑖 , where the
parameters characterising the optimal quantity come from the following inverse demand
specification: 𝑝 = 𝑎 − 𝑏𝑄 . How high are the total industry profits in this case? How high are
the prices? (1 point)
Using the information given above, we can calculate the quantity produced under different
types of market structure, as well as the profits, given the number of firms.
400 − 40 144
𝑞𝑖 = =
2,5(𝑛 + 1) 𝑛 + 1
𝑝 = 400 − 2,5𝑛𝑞𝑖
𝜋𝑖 = 𝑝𝑞𝑖 − 40𝑞𝑖 + 3000
∑ 𝜋𝑖 = 𝑛𝜋𝑖
𝑖

Market Industry profit

Output per firm Price Profit
Structure ∑ 𝜋𝑖
𝑞𝑖 𝑝 𝜋𝑖
𝑛 𝑖

𝑛=1 72 220 9960 9960

𝑛=2 48 160 2760 5520
𝑛=3 36 130 240 720
𝑛=4 28.8 112 −926.4 −3705.6
The level of market demand is enough to accommodate 3 firms. If a fourth firm were to enter,
it would make losses. The total industry profits are 720 Euro. The profits per firm are equal to
240 Euro. Since 3 firms produce 36 units each, the total output is equal to 108 units. The price
is equal to 130 Euro.

b) What price level would a regulator set, if it were to restrict the entry to just one firm (𝑛 = 1)
and would practice a zero-profit regulation (i.e. price setting which ensures that the profit of
the firm is not negative)? How much would the firm produce at this new regulated price level?
(0.5 points)
The price is selected by setting firm profits equal to zero:
𝜋𝑖 = (400 − 2,5𝑄)𝑄 − 40𝑄 − 3000 = −2,5𝑄2 + 360𝑄 − 3000 = 0
Recall that a quadratic equation in the form of:
𝑎𝑥 2 + 𝑏𝑥 + 𝑐 = 0
has the following solution:
−𝑏 − √𝑏 2 − 4𝑎𝑐
𝑥=
2𝑎
In our case:
−360 − √3602 − 4. (−2,5). (−3000)
𝑄= = 135,11 ≈ 135 𝑢𝑛𝑖𝑡𝑠
−1
 The government reimburses the firm for its costs, hence setting the price equal to the average
costs of the company:
𝑃 = 62,50 𝐸𝑢𝑟𝑜

𝜋𝑖 = 62,50.135 − 40.135 − 3000 = 37,5 𝐸𝑢𝑟𝑜

This is the lowest non-negative profit that a firm with this demand and cost structure could
earn.

c) Suppose that the government were to decide to regulate prices to equal marginal costs. How
much would the monopolist produce at this price (assume that the firm cannot choose to exit
the market)? How high are firm profits?
𝑃 = 𝑀𝐶 = 40 𝐸𝑢𝑟𝑜
𝑝 = 400 − 2,5𝑄 → 𝑄 = 160 − 0,4𝑝 = 144 𝑢𝑛𝑖𝑡𝑠
𝜋𝑖 = 40.144 − 40.144 − 3000 = −3000 𝐸𝑢𝑟𝑜
d) Assume that the government wants to maximize the sum of the consumer surplus and profits.
Would it prefer to regulate the price to the level of the average costs or the marginal costs?
To answer this question, we need to calculate the consumer surplus in each case. If prices are
(𝑎−𝑃)𝑄
given by: 𝑝 = 𝑎 − 𝑏𝑄, then the consumer surplus is equal to: 𝐶𝑆 = 2
.
The consumer surplus under average-cost pricing is thus:
(400 − 62,5)135
𝐶𝑆 = = 22781.25 𝐸𝑢𝑟𝑜
2
The profits of the producer are:
𝜋𝑖 = 62,50.135 − 40.135 − 3000 = 37,5 𝐸𝑢𝑟𝑜
The total welfare under average-cost pricing is thus:
𝑊 = 𝐶𝑆 + 𝜋𝑖 = 22818.75 𝐸𝑢𝑟𝑜

The consumer surplus under marginal-cost pricing is:

(400 − 40)144
𝐶𝑆 = = 25920 𝐸𝑢𝑟𝑜
2
The profits of the producer are:
𝜋𝑖 = 40.144 − 40.144 − 3000 = −3000 𝐸𝑢𝑟𝑜
The total welfare under marginal-cost pricing is thus:
𝑊 = 𝐶𝑆 + 𝜋𝑖 = 22920 𝐸𝑢𝑟𝑜
The welfare under marginal cost pricing is 101,25 Euro higher than when prices are set to equal
average costs. This means that it is possible for the government to transfer money to offset
the losses of the monopolist and there would still be an extra 101,25 Euro of suprplus.
e) Imagine that the government has decided to deregulate prices on the market. However, it
retains the right to control the total number of firms. What number of firms would it allow to
enter if it has the goal of maximizing the sum of the consumer surplus and profits?
Consumer Total
Market Output per Industry profit
Price Profit surplus welfare
Structure firm ∑ 𝜋𝑖
𝑝 𝜋𝑖 (𝑎 − 𝑃)𝑛𝑞𝑖
𝑛 𝑞𝑖 𝑖
2
𝑛=1 72 220 9960 9960 6480 16440
𝒏=𝟐 𝟒𝟖 𝟏𝟔𝟎 𝟐𝟕𝟔𝟎 𝟓𝟓𝟐𝟎 𝟏𝟏𝟓𝟐𝟎 𝟏𝟕𝟎𝟒𝟎
 𝑛=3 36 130 240 720 14580 15300
𝑛=4 28.8 112 −926.4 −3705.6 16588,8 12883,2
We can see that any entry beyond the 2nd firm leads to a decrease in total welfare. As such the
government should limit the number of entrants to two firms if it aims to maximize the sum
of consumer surplus and firm profits. Note, however, that without restrictions on pricing, the
total welfare is smaller. It falls by 26% compared to regulation where prices are set to equal
marginal costs and the number of firms is limited to 1.

3. You are the manager of a manufacturer of parts. Your firm has a monopoly but so do the
distributors of your product (you do not sell your good directly but rather through an
intermediary). You know that the demand faced by your intermediary is equal to 𝑝 = 400 −
2,5𝑄. Your intermediary has no cost of selling the product aside from the price it has to pay to
purchase it from you (𝑟). Your company, on the other hand, faces substantial costs: 𝐶𝑃 =
40𝑞𝑃 + 3000.
a) What price would you change your intermediary? What would be the price that the
intermediary charges the final consumers? How high are your profits? What about the profits
of the intermediary? (1 point)
In order to choose the optimal price, you need to understand the market for the final product
and in particular how the intermediary will set its prices.
The demand that the intermediary faces is given by:
𝑝 = 400 − 2,5𝑄 → 𝑄 = 160 − 0,4𝑝
The intermediary (retailer) maximizes its profits (𝜋𝑅 ):
𝜋𝑅 = (160 − 0,4𝑝)𝑝 − (160 − 0,4𝑝)𝑟 = 160𝑝 − 0,4𝑝2 − 160𝑟 + 0,4𝑝𝑟
𝜕𝜋𝑅
= 160 − 0,8𝑝 + 0,4𝑟 = 0
𝜕𝑝
𝑝 = 200 + 0,5𝑟
𝑄 = 160 − 0,4(200 + 0,5𝑟) = 80 − 0,2𝑟
Now you know how the intermediary will respond in terms of sales and pricing to your
decisions regarding the wholesale price of the product, you can choose a price level which
maximizes your profitability:
𝜋𝑃 = (80 − 0,2𝑟)𝑟 − 40(80 − 0,2𝑟) − 3000 = 88𝑟 − 0,2𝑟 2 − 3200
𝜕𝜋𝑅
= 88 − 0,4𝑟 = 0
𝜕𝑝
𝑟 = 220 𝐸𝑢𝑟𝑜
𝑝 = 200 + 0,5.220 = 310 𝐸𝑢𝑟𝑜
𝑄 = 80 − 0,2.220 = 36 𝑢𝑛𝑖𝑡𝑠
𝜋𝑅 = 310.36 − 220.36 = 3240 𝐸𝑢𝑟𝑜
𝜋𝑃 = 220.36 − 40.36 − 3000 = 3480 𝐸𝑢𝑟𝑜

b) Imagine that the two firms would merge. How high would the price be then? How high would
the profits be? Is the decision to merge mutually beneficial? (0.5 points)
This would turn the problem into a simple profit maximization for a monopolist:
𝜋𝐼 = (400 − 2,5𝑄)𝑄 − 40𝑄 − 3000 = 360𝑄 − 2,5𝑄 2 − 3000
𝜕𝜋𝐼
= 360 − 5𝑄 = 0
𝜕𝑄
𝑄 = 72 𝑢𝑛𝑖𝑡𝑠
 𝑝 = 400 − 2,5.72 = 220 𝐸𝑢𝑟𝑜

𝜋𝑅 = 220 .72 − 40.72 − 3000 = 9960 𝐸𝑢𝑟𝑜

In order to assess whether the merger could be mutually beneficial we can compare the profits
if the firms are integrated to the sum of profits when the firms are not integrated:
𝜋𝑁𝐼 = 3240 + 3480 = 6720 𝐸𝑢𝑟𝑜
The benefits of the merger are equal to the difference in profits:
𝜋𝐼 − 𝜋𝑁𝐼 = 3240 𝐸𝑢𝑟𝑜

c) Suppose that a potential merger has been forbidden by the Competition Agency but you have
been allowed to set a maximum retail price for your product. How would you select the retail
price? What would be the maximum wholesale price you could charge in order to make sure
that the intermediary prefers to sign a contract with maximum prices as opposed to one where
it is free to select prices on its own? (0.5 points)
Ideally, the firm would like to pick a level of output which corresponds to the monopoly
optimal output:
𝑄 = 72 𝑢𝑛𝑖𝑡𝑠
𝑝 = 400 − 2,5.72 = 220 𝐸𝑢𝑟𝑜
This means that the maximum price would be 𝑝̅ = 220 𝐸𝑢𝑟𝑜.
If this is the maximum price that it can charge, the intermediary’s profits are equal to:
𝜋𝑅 = 220.72 − 𝑟. 72
In order to make this contract more attractive to the intermediary, the firm needs to make
sure that its retailer earns more than it would if it were to price independently of the
manufacturer:
𝜋𝑅 = 220.72 − 𝑟. 72 ≥ 3240 𝐸𝑢𝑟𝑜
𝑟 ≤ 175 𝐸𝑢𝑟𝑜
We can imagine the firm choosing to set a wholesale price equal to 175 Euro. This yields the
following profit structure for each company:
𝜋𝑅 = 220.72 − 175 .72 = 3240 𝐸𝑢𝑟𝑜
𝜋𝑃 = 175 .72 − 40.72 − 3000 = 6720 𝐸𝑢𝑟𝑜
Compared to profits without any price coordination (𝜋𝑃 = 3480 𝐸𝑢𝑟𝑜), your company now
earns 3240 Euro more, which represents a 93% increase in profitability.