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EC 313: Industrial Economics

Lent Term 2011


Professor Mark Schankerman

Problem Set 4

1. Consider a two-goods monopoly with costs of production Ci (qi ) = fi + ci qi for each


good, where fi is the fixed and ci is the marginal cost for good i. Assume that the demand
for good i is given as qi (pi ) = pi−i , where i ≥ 1 (note that the demands for the two
goods are independent). You are asked to regulate this monopoly and choose the two prices
p = (p1 , p2 ) in order to maximise V (p) + Π(p) where V is net consumer surplus satisfying
∂V (p)/∂pi = −qi (pi ) and Π(p) is total monopoly profits (remember they have to pay out
the fixed costs).
(a) First Best: Suppose that any loss by the monopoly will be covered by a transfer
from the treasury (do not worry about the treasury’s finances). What are the optimal prices
in this case?
(b) Second Best, Product By Product: Now suppose that you are going to require that
the monopoly has to cover its fixed costs itself, and that it must not make losses on either
of the two products. Derive the expressions that determine the optimal prices (there is no
simple closed-form solution).
(c) Second Best, Ramsey Prices: Now suppose you only require that the monopoly
does not make any losses overall (adding the two products together) and assume that this
constraint is binding (so it actually makes zero profits). Assume that the Lagrange multiplier
associated with this constraint takes the value µ = 1/2 (remember, this is the ”shadow cost”
of raising another $1 of fixed cost). Moreover, in the demand functions let 1 = 6 and 2 = 4.
How does the optimal relative price p1 /p2 change if the relative cost c1 /c2 increases by one
unit?

2. Consider a market with inverse demand P = a − 2Q. Firms have no fixed cost and
constant marginal cost c.
(a) Derive expressions for industry price, quantity , profit, and the Lerner index if this
market is served by a monopoly.
(b) Derive expressions for the Nash equilibrium industry price, quantity, profit, and the
Lerner index if the market is served by Cournot duopolists. Compare these to your answers
in part (a).
(c) Do the same thing for the case in which the market is served by Bertrand duopolists.
(d) If the duopolists could choose whether to compete by choosing prices simultaneously
or by choosing quantities simultaneously, which would they prefer? Which would consumers
prefer? Which is more efficient?

3. Consider a market with inverse demand P = 11 − Q, where Q is the sum of output


produced by all firms in the market. Firms have identical cost functions c(q) = 2 + q.
(a) Suppose there is a single firm in this market. What price and quantity will the firm
choose? What will be the consumer surplus? What will be the firm’s profit?

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(b) Suppose there are n firms in the market that compete by simultaneously choosing
quantities. What quantities, q c (n), will they choose in equilibrium? How do these quantities
change with the number of firms? What is the total quantity Qc (n) produced in equilibrium
and how does it change with the number of firms in the market? What is the profit π c (n)
and how does it change with n ? What is the consumer surplus and how does it change with
n?