Industrial Organization

Fall 2004

Exam 2

Please respond to question #1 and then choose 3 of the following questions, in your exam book. Problem #1 is worth 40 points and each of the other 3 responses is worth 20 points. Clearly label each response. Ask questions if something is unclear.

You must respond to the following problem.

1. Suppose there is a potential entrant with ACe=MCe=$30 and a dominant incumbent firm with ACi=MCi=$15. The market demand for this product is P = 100 – Q.

a. Find the profit maximizing price, quantity and profit earned by the incumbent if they act as a monopolist. A diagram might be useful, but is not necessary in your response.

b. Explain the concept of limit pricing and how the incumbent firm could use it in this case. Specifically, where should the limit price be set, how much output would be produced and how much profit would be lost by the incumbent if they pursued this strategy?

c. How do game theorists feel about the usefulness of the traditional model of limit pricing? Use a game tree to show how a game theorist views this sequential game where the potential entrant moves first and the incumbent chooses between the profit maximizing strategy (from part a) and the limit pricing strategy (from part b).

d. Explain the important role that the discount rate plays in an incumbent’s decision to limit price to deter entry.

Choose any 3 of the following.

2. Suppose a Cournot duopoly exists in the soft drink industry between Coke and Pepsi. Industry demand is: P=60 – 2Q and AC=MC=$10 for both firms.

a. Solve for the Cournot equilibrium quantities and price. Calculate profit for each firm.

b. If the soft drink industry operated according to the Bertrand model, what are the price, quantity and profits of our two firms?

c. From society’s point of view, is the Cournot outcome more desirable than the Bertrand outcome? Explain.

d. Now suppose that Coke acts as a Stackelberg leader and Pepsi is the follower. The firms now have different costs: ACcoke=MCcoke = $10 and ACpepsi=MCpepsi=$20. Solve for the Stackelberg equilibrium quantities and price. Calculate profit for each firm.

3. In the following game, Coke and Pepsi are simultaneously selecting a pricing strategy for a case of their product. Payoffs are in millions of dollars (Pepsi, Coke).

a. Identify any dominant and/or dominated strategies.

b. Find any pure Nash equilibria.

c. Is this game an example of the Prisoner’s Dilemma? Explain why or why not. Use a specific example to make your point.

d. We discussed several cases where firms have made the decision to engage in predatory pricing. What exactly is “predatory pricing”? How does a firm’s reputation factor into the decision? Use one of the cases from Chapter 10 to make your point.

Coke Pricing
Strategies
$10.50 / $11.50 / $12.50 / $13.50
$6.25 / 66, 190 / 68, 199 / 70, 198 / 73, 191
Pepsi Pricing / $7.25 / 79, 201 / 82, 211 / 85, 214 / 89, 208
Strategies / $8.25 / 82, 212 / 86, 224 / 90, 229 / 95, 225
$9.25 / 75, 223 / 80, 237 / 85, 244 / 91, 245


4. There is an incumbent Senator Gray and a potential challenger Green. Gray decides first whether to advertise or not, then Green decides whether to enter the race or not. Payoffs are measured as utility each politician receives from the outcome so larger #’s are better.

a. Is there a Nash equilibrium in this extensive game? Explain.

b. If Green is able to move first, will the outcome of the new game change? Assume the utility payoffs are the same. Briefly explain.

c. Following the process described in Chapter 10, put this extensive game into the Normal Form, finding all possible Nash equilibria in the Normal Form.

d. Determine which, if any, are “subgame perfect”. Explain.

5. Potpourri.

a. Describe both the “tit-for-tat” and the “trigger price” strategy for maintaining collusion. What are the similarities and differences between them?

b. Describe the conditions that foster collusion and explain why they make collusion more or less likely to succeed.

c. What is the difference between a game of “chicken” and the prisoners’ dilemma? Create an example of both to help make your point.

d. Explain the Areeda-Turner standard and why it is controversial amongst economists.