University of California, Davis Department of Economics Industrial Organization 121A Spring 2009 Professor Requena MID TERM EXAM 11 MAY Name Total points: 80 (40 short answer, 40 derivative questions). Be careful with the time — ONLY 50 minutes! Short answer section (10 points each) (25 sentences) The game box below describes the “Battle of Sexes” game. fm? sigh toe =| @A |} 0.0 5 fF] 0.0 | OA (A) Define a Nash Equilibrium (10 pts). Find the Nash Equilibrium the “Battle of Sexes” game. Answer: Its @ solution concept of a game involving two or more players, in which each player is assumed to know the equilibrium strategies of the other players, and no player has anything to gain by changing only his or her own strategy unilaterally. If each player has chosen a strategy and no player can benefit by changing his or her strategy while the other players keep theirs unchanged, then the current set of strategy choices and the corresponding payolfs constitute a Nash equilibrium. There are two Nash Equilibria, (High, High) and (Low, Low) (B) _ Define a Dominant Strategy. Do Firm 1 and/or Firm 2 have any Dominant Strategy in the “Battle of Sexes” game? (10 pts) ‘Answer: When one strategy is better than another strategy for one player, no matter how that player's opponents may play. There are no dominant strategies in that type of game.Derivation Section 1, (20 points) Suppose two firms compete in an industry with an inverse demand function given by P=300-Q. Firm | has a marginal cost of $30, while firm 2 has a marginal cost of $40, there are no fixed costs. (A) Solve for the Cournot-Nash Equilibrium. State the quantities and profits for each firm and the market price. (5 points) P=300-, ~&, > Firm! 's reaotion curve. MR = MC, > 300-3, -2§, =30 2 b=t0h4) | Firm's reactton curve ; MRs=MC2 > 300-$,-24, = 40 > $224(2h0-4,) @ Nash Eguil brian . f? 240-4) wy $= 20b-f) ey solve Pe System of oguation. $= ae = 93,33 $2 = MP = 93.33 Market prite : Pe 200- 22-2 — Ho 2123.3 profit for firm i. 1, = (P-30) #, = ag HH1I Ts = P-4) G2 = Bega = 9999.78 (B) Would the introduction of fixed costs change the equilibrium? If so, how? If not, why not? (5 Pom) Woe Fie cose dace nob on tes Firms? profit yam aatinn problem ; heme the reactiin curves and Nach Bauilrbrium will NeT change. The Introduction of fixed costs will affect the profits ofthe firms sHnugl.(©) What do we mean when we say that the strategies are “strategic complements”? Suppose that two firms compete in prices in a product differentiated market. Draw their reaction curves and identify the Nash Equilibrium? (10pts) In economics and game theory, the decisions of two or more players are called strategic complements if they mutually reinforce one another (they are called strategic substitutes if they mutually offset one another). Diagram (p1, p2) with two reaction curves upward sloping ‘The intersection of the reaction curves is the Nash Equlibrium hk yeaction curve for firm | ® yeaction cune for firm 2 K nash bquibbrinm Reattion curves -for berttand competittin, (D) What are three reasons collusion is difficult to sustain. You should explain each of the three reason taking into account the conditions required to successfully collude (10pts) Tn order to sustain tacit collusion you need to succeed in 1. Reaching agreement ~ Reaching agreement is difficult if firms are not identical, mix marketing variables (price. quality, delivery, post-sale service, advertising), multidimensional pricing, dynamic uncertainty, limited communication opportun 2. Achieving coordination ~ How they achieve coordination if they cannot interact 3. Detection and enforcement ~ Cost and likelihood of detection increase with number of competitors and volatility of market conditions; Cost of enforcement rises with number of competitors, extent of product differentiation, difficulty to access cost data. 4. Limiting entry ~ existence of effective batriers to entry (natural bacriers, intimidation practices, predation strategies) spune { (C) Suppose instead of choosing quantities, the firms chose prices. What would be the Nash Equilibrium? (5 points) The monopoly Prive for firm | & ( Pr") given by MR=2MG > 3200-20230 . 2 Q=135 > Mois The monopoly rite for firm 2 (72") given by MR=MCs = 300-29 =4 2 d= Be > pz 1Fo The Batrand compehion pres: |es-4 Pras rote iP Po lbs. Ri-e Rocket Ree 1 Dr (note 40 & firm 2's marginal Cost 40 ree 40-4 if hea Si saat pe me nts can he) ilebr fl - ‘vm 1h Therefore ,ths Mash Equi meet ot 4o- ¢ aud firm | hae the antive market des or firm! 2 (D) Now suppose -had a strict capacity constraint of 50 units. Show that, given the action of firm 1 in (C), firm 2 is not “doing the best that it can”. What is the best that firm 2 can do? (5 points) @ VP firms produces Q=%200-7 = 2boreif the ples set at ho~2) the residual demand for firm 2 1 ty Ps = 300-60+8)- $, = 40-€-% Hts smpossible for firm ato do beter thaw hot partibpate sme MCs (640, Ef Hes Question tracy Cs beth firms having capacity Coastradet of Co shou whan firm | charging Go-) and s“pply Souths, tho restdual demand for firm 2 & Pa=300- 60~$ = 280- BR the yonopoly Prittng under +a vestdual dumand . MRa = 40 => 210-2}. =40 ; DG. = WL and soma thd Guawtity & Greater than firm 2's capaety two, $> fivms com produ at fu copay lenat , so wirts, and charge 0 rile fs =200- cd-So= 200 O! if the question tndly & firm has capacty constraint, Then firm 2 best producs lof werk and olwuges P, = 300-$0 -1eh = (at2. (20 points) Suppose two firms compete in an industry with an inverse demand function given by P=400~Q. Each firm has a marginal cost of $40. The firms compete in quantities and 360 choose them simultaneously. The reaction function for firm 1 is given by q, = reaction function of firm 2 is given as q, = 02% FYI: The Cournot equilibrium for this industry is for each firm to produce 120 units. The ‘Cournot profits for each firm in this industry are $14400. If both firms were to collude at the monopoly output they would each produce 90 and each firm would earn $16200 in profits. (A) Suppose firm 2 produced ¥% of the joint profit maximizing output (j.c., 90) and firm 1 cheated. What would be firm 1's one-period profit maximizing output be? What is the resulting market price? What would firm 1's profits be under this scenario? Circle your answers. (5 points) Joint profit maximizatiin. MR= MC > 400-2Q = 40 > Q= 180 > P=400-@= 220 > each firm produce &= Fo im one period (Given absve) the Pref is (P-40) B = (220-40) Fo = [6200 Given firm's yeachin cunts 4,2 3B iP Gs= 40 05 dh the Colluding aggnonord, Gy = HM = jap Pado0- (904125) = 14 T= (148-40) $, = (Ex |r Tr = CIS 40) Jo = 36x40 =EFO (B) Suppose these firms compete in multiple periods. At the end of each year, the probability the firms will compete against each other again is given as 8 and they discount future profits at a rate of .7. What is the present discounted value of profitsf both firms collude in each period? (5 points) ‘ndividual fiym oY Combined 7 RP =08 xoF =0.56 e Indl fim, PV of colluding propit = cH (lap) (b200 x w@ (5200 x 3.243 36818,2 Combined ; (Correct cP use the market total profit ta work period (i200 2) x 2.093 = 73634.4 Srnte the question doe nok specify if vs’ one forms or two firms’ prefrts) p i it wwfor-firml 2 fivm22 ov combined 2 (©) What is the present discounted value of profits4f firm 1 cheats in the first year and firm 2 never trusts her again (thus, the firms adopt “grim trigger strategies” and, after cheating the firms stay at the Cournot equilibrium)? (5 points) firm, PVP cheating propit = ree 4 comm (BE ep = [8225 + 14400 x ( ot, = [3225 + 1832.29 = 3652.24 firma. pv if Firm! chents lgp+ quemnet x ( ff) “Pll 132. 3 30497}. Combined. Cedetprazrasss2.2F = YUBA y 20497. 6702 Sp (D) Can the firms sustain collusion? Show you work! (5 points) Yes . Beamuse for cack fim the Pv of colluding Props, brluids 1 368192 , Greater then the PY oP cheating profit, which i 36.662,2}.