Industrial Organization: Markets and Strategies

Paul Belle‡amme and Martin Peitz

published by Cambridge University Press

Part IV. Pricing strategies and market segmentation

Exercises

"Purple Dream" has the monopoly on the production of purple light-emitting

diodes (LEDs). It faces geographically separated markets, market 1 and 2. The
demands are qA = 1  pA and qB = 1=2  pB , respectively. The transport and
production costs are set to zero.

1. Assume that the …rm chooses to set a uniform price across the two markets.
What is the pro…t maximizing uniform price? What are the quantities sold
on the two markets at this price?

2. Assume that the …rm uses third-degree price discrimination. What are
the pro…t maximizing prices and quantities on the two markets?

3. Calculate consumer surplus and pro…t under a uniform price and under
third-degree price discrimination. Compare the two situations and com-
ment on the result.

4. Does the result from question 3 hold generally? How would the results
change if qB = 1=3  pB ?

Exercise 2 Price discrimination and pharmaceuticals

Do you think that price discrimination between rich and poor countries is a
feasible solution for giving poor developing countries better access to patented
pharmaceuticals? In the answer you should draw upon the theory covered in
the book.

Exercise 3 Muli-product monopoly

A monopoly faces a continuum of consumers who are distributed uniformly

on the unit interval. The total mass of consumers is 1. Each consumer is
interested in buying at most one unit. Consumers di¤er in the way they perceive
the monopoly’s output. Assuming for simplicity that the monopoly is located at
point 0, the utility of a consumer who is located at some point x between 0 and
1 if he buys from the monopoly is r  p  tx2 , where p is the monopoly’s price,
r > 0, and t > 0 is the transportation cost per-unit of distance. If a consumer
does not buy, his utility is 0. The monopoly’s per-unit cost of production is c.

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 1. Given p, …nd the location (i.e., "address") of the consumer who is just
indi¤erent between buying and not buying. Show this consumer on a
graph.

2. How high can p be such that the market will be still covered (i.e., every
consumer will buy)?

3. Write the monopoly pro…t as a function of p (hint: distinguish the case

where the market is covered from the case where the market is uncovered).

4. Show that if t < (r  c)=3, then at the pro…t maximum, the monopoly will
choose a price that ensures that the market is covered. (Hint: this part
might be a little di¢cult: essentially you need to show that if t < (r c)=3,
then raising p slightly above the point at which the market is just covered
leads to a lower pro…t).

5. Suppose that the monopoly incurs a …xed cost F whenever it opens a plant.
Compute the monopoly’s maximal pro…t given the assumption that the
market is exactly covered and that the monopoly has a single plant at
point 0.

6. Now suppose that the monopoly opens a second plant at point 1. The
utility for the consumer who buys at this plant is r  p2  t(1  x)2 ,
where p2 is the price of the product at the second plant. Compute the
monopoly’s maximal pro…t in this case under the assumption that the
market is covered (note that now the monopoly bears a …xed cost of 2F
since it operates two plants).

7. Based on your answers in (5) and (6), compute the range of F for which
the monopoly will operate two plants, one plant, or no plants (i.e., will
exit the market altogether).

8. Explain the intuition for your result in (7). In particular, explain why the
monopoly might bene…t from opening a second plant at point 1.

Consider a country that can be divided into two distinct markets of di¤erent
sizes: market 1 is small (in the sense that it can only accommodate one …rm),
while market 2 is larger (in the sense that it can accommodate two …rms). Two
…rms are active in the country: …rm A is a national company that is active
on both markets; …rm B is a local company and is only active on market 2.
Demand conditions on the two markets are as follows. On market 1 (where only
…rm A is active), inverse demand is given by

qA1 = a  pA1 :

2
On market 2 (where both …rms are active and their products are seen as imper-
fect substitutes by the consumers), the system of inverse demands is

2
qA2 = 3
(1620  2pA2 + pB2 )
2
qB2 = 3
(1620  2pB2 + pA2 ) ;

where qKi (resp. pK i ) is the quantity demanded to (resp. the price set by) …rm
K in market i (K = A; B and i = 1; 2). To translate the fact that market 2
is larger than market 1, it is assumed that a < 1620. Both …rms produce at a
constant marginal cost, which is assumed to be equal to zero for simplicity.

1. Local pricing. Suppose that the national …rm (…rm A) chooses to adapt its
prices to the local market conditions. Firm A has thus two choice variables:
pA1 and pA2 . As for the local …rm (…rm B), it has, by de…nition only one
choice variable: pB2 . Find the equilibrium prices of the two …rms and
then compute their equilibrium pro…ts.

2. National pricing. Suppose now that …rm A commits to set the same price
in the two local markets. Denote this price by pA . As for …rm B, nothing
changes: it still sets its single price pB2 . Find the equilibrium prices of
the two …rms and then compute their equilibrium pro…ts.

3. Compare your answers to questions 1 and 2 by taking three speci…c values

for the parameter a, namely a = 540, a = 1188, and a = 1260. In which
scenario(s) does …rm A prefer national pricing over local pricing? Explain
the intuition behind your results. In which scenario(s) does …rm B prefer
that …rm A sets the same price in the two markets (national pricing)?
Explain the intuition behind your results.

Consider a horizontally di¤erentiated product market in which two …rms are

located at points l1 = 0 and l2 = 1 on the line. Firms produce at marginal costs
c. There is a continuum of consumers of mass 1 who are uniformly distributed
on the unit interval. They have unit demand and have an outside utility of 1.
A consumer located at x 2 [0; 1] obtains indirect utility v1 = r   (x)2  p1 if
she buys one unit from …rm 1 and v2 = r   (1  x)2  p2 if she buys from …rm
2. Firms have marginal costs equal to c.

1. Suppose that …rms simultaneously set a uniform price for all consumers.
Characterize the equilibrium of the game. Determine equilibrium pro…ts.

2. Suppose now that …rms can price-discriminate between consumers located

on [0; 1=2] (segment A) and [1=2; 1] (segment B). Determine the pro…t
function of each …rm. Characterize the pure-strategy Nash equilibrium of
the game in which …rms simultaneously set prices. Note: You are allowed
to restrict attention to the part of the demand function, which is relevant
for the equilibrium analysis.

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 3. Compare your result in (2) to the game in which …rms cannot discriminate.
In which environment obtain …rms larger pro…ts? Explain your …ndings.

4. Suppose now that …rm 1 can discriminate between the two consumer seg-
ments and that …rm 2 cannot. Characterize the Nash equilibrium of the
price game in which …rm 1 sets a possibly di¤erent price for each consumer
segment, while …rm 2 sets the same price to all consumers.

5. Compare the …rms’ pro…ts in situation (4) to those in situation (2).

6. Consider the possibility for …rms to “invest” (non-negative number) into

the possibility to price discriminate between consumers in segments A
and B at investment cost I . Characterize the equilibrium of the two-stage
game in which …rms simultaneously decide whether to invest in stage 1
and simultaneously set prices in stage 2 depending on the level of the
investment cost I . Comment on your result.

Exercise 6 Price discrimination in duopoly

Consider a duopoly market with two …rms and a continuum of consumers.

Each …rm i 2 f1; 2g sells its product at price pi and incurs marginal costs equal
to zero. Consumers are of measure 1 and have unit demand. When buying one
unit of product i a consumer of type (t; x) obtains utility r  tjx  li j  pi where
li is the location of …rm i and pi is its price; if she does not buy her utility is
set equal to 1. Half of consumers belong to the group with type tA and half
of consumers to the other group with type tB ; tA  tB . Within each group,
consumers are uniformly distributed on the unit interval, x 2 [0; 1]. Firms are
located at 0 and 1, respectively.

1. Suppose that tA = tB . Determine the demand function faced by the two

…rms. Determine the equilibrium in the simultaneous-move price game.
Report equilibrium prices, outputs, and pro…ts.

2. Suppose that tA > tB . Determine the demand function faced by the two
…rms. Determine the equilibrium in the simultaneous-move price game.
Report equilibrium prices, outputs, and pro…ts.

3. Suppose that tA > tB . Suppose furthermore that both …rms observe

consumer type t and that they can condition their price on this type;
i.e., …rm i set pi (t). (Consumers are assumed not to be able to trade
among each other). Determine the demand function faced by the two
…rms. Determine the equilibrium in the simultaneous-move price game.
Compare your result to the previous setting. Discuss whether …rms bene…t
from regulation that requires them to set uniform prices.

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 4. Suppose that tA > tB . Suppose now that only …rm 1 observes consumer
type t and that it can condition its price on this type – i.e., …rm 1 set p1 (t) –
whereas …rm 2 has to charge the same price to all consumers. (Consumers
are assumed not to be able to trade among each other). Determine the
demand function faced by the two …rms. Determine the equilibrium in
the simultaneous-move price game.

5. Suppose that tA = 2 > tB = 1. Consider the two-stage game in which,

in the …rst stage, …rms acquire the ability to identify a consumer’s type
t at cost C and, in the second stage, they compete in prices. Using your
insights from parts 2 to 4, characterize the subgame-perfect equilibria as
a function of C .

6. Discuss your …ndings.

Exercise 7 Price discrimination in duopoly with product returns

Consider a duopoly market with two …rms and a continuum of consumers.

Each …rm i 2 f1; 2g sells its product at price pi and incurs marginal costs of
production equal to zero. Consumers are of measure 1 and have unit demand.
With the purchase of one unit of product i a consumer of type x obtains utility
r  tjx  li j  pi where li is the location of …rm i and pi is its price; if she does
not buy her utility is set equal to 1. Half of consumers belong to the group
that never returns a product—we call them “easy” consumers—and the other
half ask for the replacement of the product with some probability, which …rms
have to provide—we call those consumers the “di¢cult” ones. The expected
cost of selling to a consumer in this second group is c > 0. It is assumed to be
independent of type x. Within each group, consumers are uniformly distributed
on the unit interval, x 2 [0; 1]. Firms are located at 0 and 1, respectively.

1. Determine the equilibrium in the simultaneous-move price game in which

…rms have to set a uniform price to all consumers. Report equilibrium
prices, outputs, and pro…ts.

2. Suppose that …rms have access to consumer data that allows them to
perfectly infer whether a consumer is easy or di¢cult; no information on
x is available. Determine the equilibrium in the simultaneous-move price
game in which each …rm i sets a price pE
i
to easy consumers and piD to
di¢cult consumers. Report equilibrium prices, outputs, and pro…ts.

3. Suppose that only …rm 1 has access to consumer data that allows it to
perfectly infer whether a consumer is easy or di¢cult—this is common
knowledge among …rms. Determine the equilibrium in the simultaneous-
E
move price game in which …rm 1 sets prices (pD
1
; p1 ) and …rm 2 a uniform
price p2 . Report equilibrium prices and pro…ts.

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 4. Consider the two-stage game in which …rms, in the …rst stage, …rms can
acquire the ability to identify whether consumers are easy or di¢cult at
cost C and in which, in the second stage, …rms compete in prices. Using
your insights from parts 1 to 3, characterize the subgame-perfect equilibria
as a function of C .

5. Suppose that a third party controls the personal data about whether a
consumer is easy or di¢cult. What access price to those data would it set
at a prior stage? In the corresponding three-stage game, will one or both
…rms acquire information? Discuss your …ndings.

Exercise 8 Personalized pricing

Consider a monopoly internet retailer who sells a single (digital) product at

zero marginal costs. Consumers have unit demand and heterogeneous valuations
u for this product; the value of the outside option is equal to zero. Valuations u
are distributed on the interval [0; 1], according to some continuous cumulative
distribution function. Unless a consumer protects her personal data at cost
" > 0, the monopoly internet retailer can infer the consumer valuation perfectly
and o¤er a personalized price; by assumption, arbitrage among consumers is
not possible. If a consumer protects her personal data, the monopolist does not
learn the valuation of this consumer.
Consider the following timing: First, each consumer decides whether to
protect her personal data; second, the monopolist sets a uniform price to all
consumers who protect their personal data and a personalized price for each
consumer whose valuation is known to the monopolist; third, consumers make
purchase decisions.

1. Characterize the subgame-perfect equilibrium in this setting. In partic-

ular, what are the privacy choices of consumers (their decision whether
to protect their data) and what are the prices set by the monopolist? Is
there a unique equilibrium? [You may want to start with the uniform
distribution and then extend your analysis to non-uniform distributions.]

2. Suppose that u is uniformly distributed on [0; 1]. Suppose, furthermore,

that, at stage 1, consumers think that the monopolist will charge the
unconditional monopoly price; i.e., pm = 1=2. For " negligibly small,
what is the outcome when consumers hold these possibly irrational beliefs
at stage 1 about price in case they hide their valuation, but are otherwise
rational (in particular, regarding the personalized price they receive if they
do not protect their personal data)? In particular, what are the privacy
choices of consumers and what are the prices set by the monopolist?

3. Suppose that u is uniformly distributed on [0; 1]. Calculate consumer

surplus and monopoly pro…t in the two cases above. Comment on your
…ndings concerning the comparison of pro…ts and the comparison of con-
sumer surplus.

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Exercise 9 Markets with damaged goods

Some …rms incur costs to o¤er a lower quality: i) Intel dismantled the math-
ematical coprocessor in some versions of the 486 CPU, ii) IBM has developed
software to make some of their printers slower, and iii) Sony deliberately limited
the capacity of some MiniDiscs to 74 instead of 80 minutes. Why do you think
that the …rms do this? What do you think that the welfare consequences are?

A …rm sells a product in a market where there are two types of consumers,
high and low-valuation consumers. There are equally many of the two types of
consumers, and the total number of consumers is normalized to 1. The product
has value 3 to the high-valuation consumers and value 1 to the low-valuation
consumers. All consumers have unit demand, i.e., they buy either one unit or
do not participate. The product is produced at constant marginal cost equal
to 0. The …rm considers introducing a damaged version of the product. The
damaged version is produced at constant marginal cost equal to 1/10. It results
in a utility of 5/10 to the low-valuation consumers and of 6/10 to the high
valuation consumers.

1. Find the pro…t maximizing price in the absence of a damaged version.

Calculate the …rm’s pro…t.

2. Find the optimal price of the normal and of the damaged version of the
product when the two versions are o¤ered. Calculate the …rm’s pro…t.

3. Should the …rm introduce the damaged version? What are the welfare
consequences of the introduction of the damaged version?

Exercise 11 Non-linear pricing

A monopolist produces a good with constant marginal cost equal to c, c <

1. Assume for now that all consumers have the demand Q(p) = 1  p. The
population is of size 1.

1. Suppose that the monopolist cannot discriminate in any way among the
consumers and has to charge a uniform price, pU . Calculate both the price
that maximizes pro…ts and the pro…ts that correspond to this price.

2. Suppose now that the monopolist can charge a two-part tari¤ (m; p) where
m is the …xed fee and p is the price per unit. Expenditure then is m +
pq. Calculate the two-part tari¤ that maximizes pro…ts and the pro…ts
that correspond to this tari¤. Compare pU and p and comment brie‡y.
Compare the situation with a uniform price and a two-part tari¤ in terms
of welfare (a verbal argument is su¢cient).

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 3. Assume now instead that there are two types of consumers. The consumers
of type 1 have the demand Q1 (p) = 1  p, and the consumers of type 2
have the demand Q2 (p) = 1  p=2. The population is of size 1 and there
are equally many consumers of the two types. Finally, it is assumed in this
question that c = 1=2. Calculate the two-part tari¤ that maximizes the
pro…ts of the monopolist. Compare the two-part tari¤s found in questions
(2) and (3) for c = 1=2 and comment brie‡y.

Exercise 12 Multi-stop shopping

Suppose that a supermarket o¤ers a product selection consisting of of prod-

ucts A and B. Consumers are willing to pay 10 Euro for one unit of product
A and 10 Euro for product B. Consumers have heterogeneous shopping cost z .
This shopping cost is uniformly distributed over the interval [0; 10]. Consumers
are of mass 10. The …rm has marginal cost of 6 for product A and 0 for product
B.

1. Calculate the pro…t-maximizing prices pA and pB . How much pro…t can

the supermarket make.

2. Suppose that a discounter has entered the market who sells product A
at its (lower) marginal costs of 4 Euro. Now consumers can opt for one-
stop shopping at the supermarket, two-stop shopping at the supermarket
and the discounter, or not to shop at all. The shopping cost z applies
to each stop. Determine the pro…t maximizing prices of the supermarket.
Determine the supermarket’s pro…t.

3. Compare your results in (2) to those in (1). Interpret your …ndings.

Exercise 13 Ticket sales

Consider a monopoly which can sell up to 50 concert tickets in a small

town (at zero marginal costs); i.e., it may sell fewer tickets but cannot exceed
the capacity of 50. Consumers have unit demand. The inverse demand of all
consumers in this town is either 100  q or 160  q. Each of the corresponding
states of the world occurs with probability 1=2. Consumers know the state of
the world when making purchasing decisions.

1. Suppose that the …rm knows the local demand conditions (i.e., the state
of the world) when it chooses its selling strategy. Determine the optimal
strategy to sell tickets at a uniform price. Calculate pro…t-maximizing
price and pro…ts.

8
 2. Suppose that the …rm does not know local demand conditions (i.e., the
state of the world) when it chooses its selling strategy. Determine the opti-
mal strategy to sell tickets at a uniform price. Calculate pro…t-maximizing
price and pro…ts.

3. Suppose that the …rm does not know local demand conditions (i.e., the
state of the world), but consumers do and that the …rm can sell tickes over
two periods. It can o¤er a certain number of tickets at price p1 period
1 and all unsold tickets at price p2 . It commits to prices and an upper
limit of tickets for sale in period 1, q 1 , prior to starting the ticket sales.
Determine the pro…ts-maximizing …rm strategy in a setting with random
rationing. (Choose the equilibrium that maximizes …rm pro…ts.)

4. Consider the same setting as in part 3 except that there is e¢cient ra-
tioning. What is the optimal …rm strategy in this setting? (Choose the
equilibrium that maximizes …rm pro…ts.)

5. Comment on your …ndings in parts 1 to 4.

6. Consider the same setting as in part 4 with the only di¤erence that the …rm
cannot commit to p2 prior to period 2. Determine the pro…t-maximizing
strategy of the …rm and comment on your …nding. (Choose the equilibrium
that maximizes …rm pro…ts.)

Exercise 14 Price discrimination among sequentially arriving consumers and

…xed supply

Suppose that a monopoly retailer has exactly 2 units of a perishable product

available. It cannot increase its stock in the relevant period. Customers have
unit demand and either a high or a low willingness to pay: 1 consumer is willing
to pay r = 10 and 2 consumers are willing to pay r = 6. Customers arrive in
random order at the shop. The retailer has to set a price for each of the 2 units.
The retailer’s opportunity cost of selling is zero.

1. What is the optimal pricing of the 2 units of the product if the retailer
has to set the same price for all units?

2. What is the optimal pricing of the 2 units of the product if the retailer is
allowed to set di¤erent prices for these units? What are the monopolist’s
expected pro…ts?

3. Provide a pro…t comparison. Discuss your result. Is welfare larger or

smaller in (2) than in (1)?

Exercise 15 Dynamic pricing and consumer storage

9
 Consider a monopolist providing a product over several periods. The monop-
olist has constant marginal costs of production of c in each period. Consumers
consider to consume one unit of a good in each period. The consumer popula-
tion is of mass 1. Half of all consumers have a high valuation rH for the product,
which is the same in each period. The other consumers have a low valuation rL
with rH > rL > c. While high-type consumers have to buy the product in the
period in which they consume it, low-type consumers are assumed to be able
to store one unit for one period at no cost. The common discount factor is  .
We assume that even a product which is consumed one period later generates
a value larger than production costs, rL > c.

1. Suppose that there is an in…nite time horizon and that the monopolist
commits to a price path fpt gt=1;2;::: before the market opens. Determine
the pro…t-maximizing price path under the constraint that the price has
to be the same in all periods. Determine the monopolist’s pro…ts.

2. Consider the same setting as in (1) without the restriction that the prices
have to be constant over time. What is the pro…t-maximizing price path?
Under which conditions does the monopolist prefer non-constant prices
over constant prices? Determine the maximal pro…ts of the monopolist?
Explain your result.

3. Consider now a two-period setting. Suppose that the monopolist cannot

commit to a price path. In particular, the monopolist sets p1 and, after
selling in the …rst period, he sets p2 at the beginning of the second period.
Are there parameter constellations such that the monopolist sets di¤erent
prices in the two periods? If your answer is negative provide a proof why
non-constant prices cannot be a subgame perfect Nash equilibrium. Oth-
erwise, characterize the set of parameters under which a subgame perfect
Nash equilibrium with non-constant prices is supported.

Exercise 16 Behavior-based price discrimination

Consider a market with network e¤ects (i.e., a consumer’s utility depends

on the number of users of a product) in which each consumer has a willingness
to pay equal to xi where xi is the number of consumers buying product i =
1; 2. The products are functionally identical and thus consumers are indi¤erent
between any products in the market, given equal numbers of units sold. Suppose
that the incumbent …rm has served mass 2=3 of consumers in the previous
period. These old consumers already have experienced product 1 and are not
willing to consider product 2. There is mass 1=3 of new consumers, who have
not previously experienced product 1. All costs are assumed to be equal to zero.
In (1) to (3) …rms …rst set prices and after observing prices, consumers make
their purchasing decisions.

10
 1. Suppose that the incumbent …rm cannot distinguish between new and old
consumers and that …rm 2 sets its price before …rm 1. What is a subgame-
perfect Nash equilibrium that gives the highest pro…t for the incumbent
…rm among all equilibria? Characterize this equilibrium.

2. Under the same circumstances as in (1), what is a subgame-perfect Nash

equilibrium that gives the highest pro…t for the entrant …rm among all
equilibria? Characterize this equilibrium.

3. Suppose now that the incumbent …rm can distinguish between new and
old consumers and that …rm 2 sets its price before …rm 1. What are the
highest pro…ts that the entrant can make in any subgame-perfect Nash
equilibrium? Provide a formal justi…cation of your answer.

4. Discuss the economics behind your results in (1) to (3).

Exercise 17 Software bundling

A software company sells two applications, noted A and B, that are totally
unrelated to one another. The marginal cost of production for each application
is constant and is equal to 10. The company faces four categories of potential
buyers, which are characterized by a pair of reservation prices as depicted in
the following table; it is assumed that each category counts the same mass of
consumers, which is set to 1.

Application A Application B
Category 1 100 30
Category 2 80 80
Category 3 60 60
Category 4 30 100

1. What price should the company set for each application if it decides to
sell them separately? What pro…ts will the company achieve in this case
and which categories of consumers will buy which application?

2. Suppose now that the company pursues a mixed bundling strategy. Which
price should it set for the bundle and for the separate applications? What
pro…ts will the company achieve in this case and which categories of con-
sumers will choose which option? Is mixed bundling more pro…table than
spearate selling? Discuss.

3. How would your answers to (1) and (2) change if the marginal cost of
production increased from 10 to 40?

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 Suppose that a monopolist produces two products, product 1 and product
2. There is a mass 1 of consumers. A share  of consumers are heterogeneous
among each other and are described by their type . This type is distributed
uniformly on the unit interval. The willingness-to-pay for product 1 is assumed
to be r1 =  and r2 = 1  . A share (1  )=2 of consumers has willingness
to pay r1 = 2=3 and r2 = 0. The remaining share (1  )=2 of consumers has
willingness to pay r1 = 0 and r2 = 2=3. The …rm can sell products 1 and 2
independently at prices p1 and p2 , respectively. Alternatively, it may only sell
a bundle at price p. This is a situation referred to as pure bundling. A third
possibility is that the …rm sells the bundle and the independent products, a
situation referred to as mixed bundling.

1. Suppose that  = 1. Determine whether independent selling, pure or

mixed bundling are pro…t maximizing. Calculate associated prices and
pro…ts.

2. Suppose that  > 0 and characterize the solution under independent sell-
ing for all  > 0.

3. Suppose that  = 4=5. Characterize the pro…t-maximizing solution under

independent selling, pure bundling, and mixed bundling. Show which of
the selling strategies is pro…t-maximizing. Discuss your result.

4. Repeat the previous question with  = 2=3.

Exercise 19 Competitive bundling

Suppose that, as in Section 11.3.2, each of two …rms 1 and 2 provides two
components A and B. The o¤erings of both …rms are horizontally di¤erentiated.
A consumer of type ( A ;  B ) 2 [0; 1]2 derives a net surplus r   A  (1   B ) 
1
pA  p2
B
1
if she buys component A from …rm 1 at price pA and component B from
…rm 2 at price p2
B
. Correspondingly, for other systems of A and B. The gross
surplus is assumed to be zero if the consumer does not buy a system. Consider
only values of r such that the market is fully covered in equilibrium. Consumers
of mass 1 are uniformly distributed on the unit square.

1. Suppose that …rm 1 incurs a constant marginal cost of zero for each com-
ponent and that …rm 2 incurs a marginal cost of c (with c < 3). Thus,
…rm 1 is more e¢cient. Determine the pro…t function of each …rm when
each …rms sells each component separately. Determine equilibrium prices
and equilibrium pro…ts in the setting in which …rms simultaenously set
prices for both components.

2. Consider the same setting as before when both …rms o¤er only a system
(pure bundling). Determine equilibrium prices and equilibrium pro…ts in
the setting in which …rms simultaneously set prices for their system.

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3. Compare your results in (1) and (2). When is it more pro…table for …rm
1 to sell components in a bundle? When is it more pro…table for …rm 2 to
sell components in a bundle?

4. Suppose now that …rm 1 is more e¢cient producing component A and …rm
2 is more e¢cient producing component B. In particular, suppose that,
for component A, …rm 1 incurs a constant marginal cost of zero and that
…rm 2 incurs a marginal cost of c, while the reverse holds for component B .
Determine equilibrium prices and equilibrium pro…ts under independent
selling and pure bundling. Discuss the pro…tability of pure bundling in
this setting.

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