Microeconomics–Final Solution.

October 4, 2011

1. (a) Given the demand and supply curves, equilibrium is given by 10 − P = 5 which implies
P ∗ = 5 and Q∗ = 5. Both consumer surplus and producer surplus are 5×5
2 = 12.5.
(b) With import, equilibrium price is 3. From the demand curve, domestic consumption at
a price of 3 is 7. Domestic supply at a price of 3 is 3. Import = 7 − 3 = 4
7×7 3×3
(c) With import, consumer surplus is 2 = 24.5. Producer surplus is 2 = 4.5. Clearly,
consumers gain and producers lose. Aggregate surplus is 24.5 + 4.5 = 29 which is higher
than the surplus in (a).
(d) With a per unit import tariff of 1, domestic price is 4. Domestic consumption is 6 and
6×6
domestic production is 4. Import is 2. Consumer surplus is 2 = 18 and producer
4×4
surplus is 2 = 8. Government revenue is Import × per unit tariff = 2 × 1 = 2. Total
surplus is 18 + 8 + 2 = 28. Total surplus is lower compared to (c).

2. (a) Combining the two markets, we obtain the aggregate demand curve Q = Q1 + Q2 =
dT R(Q)
150−2P or P = 75− Q2 . The marginal revenue function is therefore M R(Q) = dQ =
dP (Q)Q dT C(Q)
dQ = 75 − Q. The marginal cost curve is M C(Q) = dQ = 10. Equating
M R(Q) = M C(Q), we obtain Q∗ = 65 and P∗ = 42.5. Profit = P Q − 10Q∗
∗ ∗ = 2112.5.
(b) The monopolist now prices the high quality version by considering the demand for that
version by group 1 consumers. For the low quality version, he considers the demand for
that version by group 2 consumers.
Hence, to price the high quality version, he considers the demand curve Q1 = 100 − P .
The marginal revenue is M R(Q1 ) = 100 − 2Q1 and the marginal cost is M C(Q1 ) = 10.
From M R(Q1 ) = M C(Q1 ), the equilibrium quantity is Q∗1 = 45 and the equilibrium
price is 55. Profit from the high quality version is therefore π1 = 55×45−10×45 = 2025.
To price the low quality version, the monopolist considers the demand curve Q2 = 40−P .
Note that the cost of producing the low quality version is 12Q. M R(Q2 ) = M C(Q2 )
implies 40 − 2Q2 = 12 which implies Q∗2 = 14. The equilibrium price is 26. Profit from
the low quality version is therefore π2 = 26 × 14 − 12 × 14 = 196.
Total profit is therefore π1 + π2 = 2025 + 196 = 2221. Clearly, profit from the damaged
goods strategy is higher.

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3. (a) The Nash equilibria are (T,L) and (B,R).
(b) Draw game tree, use backward induction induction and find subgame perfect equilibrium
(T,L).
(c) Suppose player 2 makes threat to always play R. From game tree, it can be seen that
if player 1 actually plays T, then player 2 has to choose between getting payoff 4 (by
playing L) or payoff 2 (by playing R). Clearly, player 2 would choose L. Hence, the threat
of playing R is not credible.
(d) Player 2 can force the outcome (B,R) by removing the option of playing L, for example
by doing something that destroys that option.

4. (a) i. For both firms, H is the dominant strategy. Hence, both firms engage in high
advertising.
ii. The dominant strategy equilibrium is (H,H). The outcome is not socially efficient.
The socially efficient outcome is (L,L).
(b) i. The Nash equilibria are (L1,L2) and (L2,L1).
ii. Firm 1’s rationale behind the advertising campaign is to signal its commitment to
location L1. Firm 2 then would respond by playing its best response to L1, which
is L2. Hence, Firm 1 manages to force the equilibrium (L1,L2) which gives it higher
payoff.

5. (a) First, we find each firms reaction function. To find Firm 1’s profit function is

π1 = P Q1 − T C1
= (30 − (Q1 + Q2 ))Q1 ,

since T C1 = 0. The profit maximization condition is given by

∂π1
= 30 − 2Q1 − Q2 = 0
∂Q1

30−Q2
which implies Q1 = 2 . Hence, firm 1’s reaction function is

30 − Q2
R1 (Q2 ) = .
2

This is firm 1’s best response function. Firm 2’s profit function is

π2 = (30 − (Q1 + Q2 ))Q2 .

Differentiating with respect to Q2 and setting it equal to zero, we obtain firm 2’s reaction
function
30 − Q1
R2 (Q1 ) = .
2

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 We now solve Q1 = R1 (Q2 ) and Q2 = R2 (Q1 ). This gives Q∗1 = Q∗2 = 10. Since total
output is 20, price is 10. So, the profit of each firm is 100.
(b) Under collusion, the two firms maximize the joint profit

πm = P (Q1 + Q2 )(Q1 + Q2 )
= (30 − Q1 − Q2 )(Q1 + Q2 )
= 30Q1 + 30Q2 − Q21 − 2Q1 Q2 − Q22 .

We obtain

∂πm
= 30 − 2Q1 − 2Q2
∂Q1
∂πm
= 30 − 2Q1 − 2Q2 .
∂Q2

Setting these equations to zero and solving, we obtain Qm m

1 = Q2 = 7.5. Hence, total
monopoly output is Qm m
1 + Q2 = 15 and the monopoly price is 15. Monopoly profit is
πm = 225.
(c) If the two firms interact only once, collusion cannot be sustained. Each firm will deviate
from the monopoly output. To see this, note that

30 − Qm
R1 (Qm
2 )=
2
= 11.25 > Qm
1
2

and
30 − Qm
R2 (Qm
1 )=
1
= 11.25 > Qm
2 .
2
Therefore, both firms end up producing more than its share of monopoly output. As a
result total output is greater than the monopoly output of 15.
(d) If the two firms interact repeatedly, then collusion can be sustained by the threat of
future punishment. If any firm deviate from the monopoly output, then the two firms
would revert to the Cournot-Nash equilibrium. Hence, if the firms sustain collusion, they
can each earn half the monopoly profit ( 225
2 = 112.5) for ever. But if any one deviates,
the deviator would get a momentary high profit but the lower Cournot profit of 100 from
the next period. If both players are sufficiently patient, then they would find sustaining
collusion better.

6. (a) The total returns from using x boats is given by

√
πs = x − x,

where x is the total cost of using x boats (note that the price of a boat is 1). To find

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 the socially optimum number of boats, we maximize πs .

dπs 1
= √ − 1.
dx 2 x

Setting the derivative equal to zero, we find the optimal number of boats x∗ = 14 .
(b) The actual number of boats is
√
obtained by equation the average output to the price of
x
the boat. Average output is x . So the actual number of boats is given by
√
x
= 1,
x

which implies x = 1.
(c) Since the river is a common resource, the output obtained by a villager is only that that
is produced by his own boats. Hence, a particular villager is not concerned about the
socially optimal number of boats that should be used in the river. Instead, his focus is
on whether given the existing number of boats in the river, would the output obtained
from an additional boat be sufficient to cover the cost
√
of the extra boat. But the output
x
obtained from the new boat is the average output x . So, the villagers would continue
to add new boats till this average output is equal to the price of a boat. This leads to
overfishing in the river.