Industrial Organization: Markets and Strategies

Paul Belleflamme and Martin Peitz

published by Cambridge University Press

Part III. Sources of Market Power

Exercises
Exercise 1 Competition on the Salop circle
Consider a market in which firms 1, ..., N are equidistantly distributed on a
circle with circumference 1. Firms have constant marginal costs of production
c, which are the same for all firms. Consumers are uniformly distributed on the
circle (and have mass 1). A consumer x incurs a transportation |x li | when
buying from firm i. Here the distance between consumer and firm is the arc
distance on the circle (that is consumers move on the circle). Suppose that all
consumers are active in the market.
1. Determine the demand function of firm i as a function of all prices. [Be
careful!]
2. Determine equilibrium prices in the game in which all firms set prices
simultaneously.
3. How do transport costs aect profits?
4. Argue informally whether or not you think that an equilibrium exists for
all location configurations.

Exercise 2 Quality-augmented Hotelling model

Consider the Hotelling model in which consumers are uniformly distributed
on the [0, 1]-interval and firms A and B are located at the extreme points.
Firms produce a product of quality si . Consumer x [0, 1] obtains utility uA =
(rtx)sA pA if she buys one unit of product A and uB = (rt(1x))sB pB if
she buys one unit of product B. Each consumer buys either one unit of product
A or one unit of product B.
1. Describe the property of the utility function with respect to quality in two
or three sentences.
2. Determine the demand for products A and B at given prices and given
qualities.
3. Suppose that qualities sA and sB are given and that marginal costs of
production are zero. Determine the Nash equilibrium in prices under the
assumption that qualities are not too asymmetric implying that both firms
have a strictly positive market share in equilibrium.
1

4. Suppose that qualities are symmetric and that the cost of quality C(si )
is increasing and strictly convex in si . How does the equilibrium profit
depend on quality?
5. Compare this finding to the standard quality-augmented Hotelling-model
in which consumer x obtains utility uA = r + sA tx pA if she buys
product A and uB = r + sB t(1 x) pB if she buys product B.

Exercise 3 Market integration

Somewhere far away there exist two villages Applecastle (A) and Orangevillage (B). Each village has its grocery store which sells a particular brand. Suppose that initially connection are bad so that all inhabitants of A do their
shopping in A and all inhabitants of B do their shopping in B. Some villagers
propose a better connection between A and B.
1. Do the grocery owners support this connection? Is it possible that both,
one or none of the owners support the project? Explain.
2. What is the likely position the two city councils will take?
3. How may the opinion of the city council be dierent if there is a local sales
tax?

Exercise 4 A location-then-price game

Consider a market in which consumers are uniformly distributed on the
unit interval, where a consumer is described by x [0, 1]. Consumers incur a
transport cost (x li )2 when buying product i at location li . Suppose firms set
prices simultaneously and that the willingness to pay is suciently large such
that all consumers are active. Suppose that firms have zero marginal costs of
production.
1. What are equilibrium prices for any location pair (l1 , l2 ) < <? Do
there exist location pairs for which no price equilibrium exists (instability
in competition)?
2. How do profits change as the distance between the two firms increases
(consider only symmetric locations)?
3. Suppose that firms set locations simultaneously before setting prices. What
are locations in subgame perfect equilibrium? [Recall that firms locate
anywhere on the real line]
4. Is there too much or too little product dierentiation from a social point
of view?

Exercise 5 A model of vertical product dierentiation

Suppose there are 2 firms in a vertically dierentiated market. Consumers
buy either one unit of any of the two goods or they do not purchase in the
market. If they do not purchase in the market their indirect utility is 0. If
they purchase good i their indirect utility is si pi , where is the preference
parameter of a consumer, si is the quality of good i and pi is the price of good
i. Assume that there exist consumers of mass 1 whose preference parameter is
uniformly distributed on [0, 1].
1. Determine the demand function of each firm depending on prices and
qualities. [Hint: this is not the same model as the one presented in the
book.]
2. Suppose that qualities are given, s1 < s2 , and that firms face constant marginal costs of production c, which are independent of quality. Determine
equilibrium prices and profits in the game in which firms simultaneously
set prices.
3. Suppose firms set qualities from an interval [0, s]. Which qualities will result in subgame perfect equilibrium in the game in which firms set qualities
simultaneously at stage 1 and set prices simultaneously at stage 2?

Exercise 6 Vertical product dierentiation and cost of quality

A consumer with income m that consumes a product of quality si and pays
pi obtains the utility si m/6 pi . If instead the consumer decides not buy the
good, the resulting utility is zero. Consumer income m is uniformly distributed
on the interval [2, 8] with the density 1/6. The total mass of consumers is equal
to 1. There are two firms in the market. Firms 1 and 2 oer the qualities s1
and s2 , respectively. We assume that s1 s2 and s1 , s2 [1, 2]. Suppose that
firm i has constant marginal cost equal to c si . It is, thus, more expensive to
produce higher quality.
1. Derive the demand of firms 1 and 2, and calculate the reaction functions
of the two firms.
2. Calculate the Nash Equilibrium in prices and find the equilibrium profits
as a function of s1 and s2 . What are the equilibrium quality choices of
the two firms?
3. How does an increase in c aect the profits of the two firms? Provide the
economic intuition behind this result. Show that the high quality firm,
firm 2, continues to earn higher profits than firm 1 as long as c < 5/6.

Exercise 7 The quality-quantity trade-o under vertical dierentiation

Consider the vertical dierentiation model presented in Section 5.3. Suppose
that the quality of the product can be described
by some number si [s, s]

R+ . Consumers are identified by , R+ , which measures their prefer

ence for quality. Consumers are distributed uniformly on , and are of mass
M = . A consumer of type receives a utility of
vi (p, y; ) = r pi + si
when consuming a unit of good i (where r is supposed to be suciently large,
so that all consumers buy in the market).
Two firms compete in the market. We look for the subgame-perfect equilibria
of the following two-stage game: firms first choose the quality of their product
and then compete in prices. Contrary to what was assumed in Section 5.3, we
assume now that the marginal cost of production depends on quality. We denote
by C (qi , si ) the cost of firm i producing qi units at a quality si and we assume
C (qi , si ) = aqi si .
With a > 0, this formulation introduces a trade-o between quality and quantity as the marginal cost of production, asi , increases with quality. That is,
if the firm increases one dimension (quality or quantity), the cost of providing
the other dimension increases and the amount of this other dimension is thus
4

reduced. An example of such an inverse relationship between quality and quantity can be found in the way an instructor teaches a course: as the number of
students enrolled (i.e., quantity) increases, the cost for the instructor of providing a high-quality teaching increases (given the time available, the instructors
ability to meet students outside of class, or to provide students with feedback on
their assignments, inevitably decreases with the number of students enrolled).
To guarantee interior solutions in the pricing game, we assume

+a
> max 2 a,
.
(A1)
2
1. Consider the second stage of the game where firms set prices simultaneously, taking the qualities as given. Firm 1 produces quality s1 and firm
2 produces quality s2 , with the convention that s1 < s2 . Derive the Nash
equilibrium in prices and express the equilibrium quantities and profits of
the two firms at stage 2.
2. Consider now the first stage of the game where firms simultaneously choose
the quality of their product.
(a) Show that (s1 , s2 ) = (s, s) or (s, s) are the equilibrium quality choices
of the game.
(b) What is the eect of a stronger qualityquantity trade-o (i.e., of a
larger value of parameter a)? Discuss.

Exercise 8 Product dierentiation in Hong-Kong

Hong Kong Island features steep, hilly terrain, as well as hot and humid
weather. Travelling up and down the slopes therefore causes problems; this has
led the city authorities to imagine rather unusual methods of transport.
One famous example can be found in the Western District, where one of the
busiest commercial area of Hong Kong can be found. This area stretches from
Des Voeux Road in Central (which is at sea level) up to Conduit Road in the
Mid-Levels (which is the mid section of the hill of Hong Kong Island). Because
the street is so steep, sidewalks are made of stairs. To make travelling up the
slope easier for pedestrians, the Mid-Levels escalators were opened to the public
in October 1993. (See http://www.12hk.com/area/Central/MidLevelEscalators.shtml
for some pictures of the escalators and the stairs of this area).
For the sake of this problem set, imagine the following story. Suppose that
the street is one kilometre long (kilometre 0 is down at the crossroad with Des
Voeux Road and kilometre one is up at the crossroad with Conduit Road).
Suppose that 100,000 inhabitants are uniformly distributed along the street.
Without loss of generality, we can approximate the consumer distribution by a
continuum on [0, 1] with a mass set equal to 1 (i.e., we redefine all quantities by
dividing them by 100,000).
5

There are only two shops selling shark fin soup in this area. For simplicity,
we set their marginal cost of production to zero. As it happens, one shop (named
Won-Ton and indexed by 1) is located at point 0, while the other shop (named
Too-Chow and indexed by 2) is located at point 1. Everyday, each inhabitant
of the street may consume at most one bowl of shark fin soup, bought either
from Won-Ton or from Too-Chow. The price per bowl of the two shops are
respectively denoted by p1 and p2 . The net utility for a consumer located at x
on the interval [0, 1] is given by

if consumer buys at Won-Ton,

r 1 (x) p1
r 2 (1 x) p2 if consumer buys at Too-Chow

0
if consumer does not buy.
where it is assumed that r is large enough so that every consumer buys one
bowl of soup.
We want to contrast the pre- and post-1993 situations.

Before 1993 and the installation of the Mid-Levels escalators, walking up

the street was much more painful than walking down. This is translated
by the following assumptions:
1 (x) = tx and 2 (1 x) = (t + ) (1 x) , with t, > 0.
After 1993, the Mid-Levels escalators made going up and down equally
painful for consumers. However, consumers had to pay a fixed fee f (independent of distance) to use the escalators. This is translated by the
following assumptions:
1 (x) = tx and 2 (1 x) = t (1 x) + f , with f > 0.
1. Nash equilibrium in the pre-1993 situation
(a) Derive the identity of the consumer who is indierent between the
two shops.
(b) Compute the equilibrium prices and profits of the two shops.
(c) Show that Two-Chows profits increase if walking up the street becomes more costly for consumers, that is if increases (e.g., because
the temperature has risen). Explain the intuition behind this result.
2. Nash equilibrium in the post-1993 situation
(a) Derive the identity of the consumer who is indierent between the
two shops.
(b) Compute the equilibrium prices and profits of the two shops.
(c) Express the condition (in terms of f and t) under which the previous
answers are valid (i.e., the condition for Too-Chow to set a price
above its zero marginal cost).
6

(d) Show that Two-Chows profits increase if taking the escalator becomes less expensive, that is if f decreases. Explain the intuition
behind this result and contrast with your answer at (1c).
3. Comparing your answers for (1) and (2), establish and explain intuitively
the following results.
(a) Too-Chow suers from the installation of the escalators (even when
its access is free, i.e., for f = 0 ).
(b) Won-Ton benefits from the installation of the escalators, unless the
extra transportation cost of climbing the stairs (i.e., ) is too large.
(To show this, set t = 2, f = 3 and compare Won-Tons profits for
= 2 and = 4).

Exercise 9 Examples of product dierentiation

Give five examples of product markets in which product dierentiation is
likely to be a determining factor for competition in the market place. Give five
examples in which the imperfections in competition are likely to be the result
of factors dierent from product dierentiation.
Exercise 10 Advertising intensity
Consider the elasticities reported in the table below. The easiest way to
think about the advertising elasticities is the following: Total demand consists
of demand today and tomorrow. The short-run elasticity is the eect that
advertising today has on demand today whereas the long-run elasticity is the
eect that advertising today has on demand tomorrow. In which industries do
you expect advertising intensity to be high? Distinguish between short run and
long run.
Short-run
Long-run
Income
Price
advertising
advertising
elasticity
elasticity
elasticity
elasticity
Bakery products
0.7
0.3
0.2
0.3
Books
2.2
0.8
0.3
0.4
Drugs
0.7
1.1
0.7
1.0
Tobacco products 0.0
1.8
0.4
0.6
Exercise 11 Wasteful advertising
Suppose that advertising expenditures are wasteful in the sense that they
only redirect existing demand and do not increase consumer utility. Can such
advertising be total surplus increasing? Explain.

Exercise 12 Negative advertising and information disclosure

Consider the linear Hotelling duopoly in which each firm produces a product
with a firm-specific undesirable ingredient at zero marginal costs. Suppose that,
absent advertising, consumers are not aware of this ingredient. In this case a
consumer of type x derives utility r tx p1 if she purchases product 1 and
utility r (1 t)x p2 if she purchases product 2. If a consumer learns that
product i has the undesirable ingredient utility is decreased by d. Suppose that
parameter values are such that in the equilibria to be characterized below the
market is fully covered. Firms set prices simultaneously.
1. Derive the equilibrium if firms cannot inform consumers that their product
contains the undesirable ingredient.
2. Suppose that, at an initial stage, firm i simultaneously decide whether to
inform consumers that its product contains an undesirable ingredient (suppose that such informative advertising is possibly costless). Characterize
the equilibrium of the two-stage game.
3. Suppose now that, at an initial stage, firms can simultaneously launch
costly attack ads in which they reveal that their competitors product
contains an undesirable ingredient. Characterize the equilibrium of the
two-stage game depending on the advertising cost A. Are consumers better
o in this equilibrium compared to the solutions in (1) and (2). Explain
your result.
4. Should attack ads be allowed in this setting?

Exercise 13 Informative advertising

It is not dicult to navigate in Lonely-Line City: a single street runs from
kilometer 0 to kilometer 1 along which 100 inhabitants are equidistantly distributed. [Approximate the consumer distribution by a continuum on [0, 1] with a
mass of 100.] To keep the place residential the local government has decided
that no shops are allowed within the city limits. As it happens, there exists one
shop at each boundary of the city [one at point 0 and one at point 1].
Each morning each inhabitant drinks one liter of fresh milk. Assume that
transporting one liter of milk costs t cents per kilometer (this is the disutility
incurred by an inhabitant if he walks or the cost for the shop for delivery), each
shop pays a wholesale price of c cents per liter.
1. Suppose that each shop i sells one liter at price pi at the shop and that
all inhabitants get up each morning and walk to one of the two shops to
get the milk. What is the price set by each of the two shops, what are the
shops profits? [Characterize the Nash equilibrium of the corresponding
game!]
8

2. Suppose that instead of consumers walking to one of the shops, both shops
have a delivery service and that shops set a price that depends on the
address of the inhabitant who buys. What are the prices charged by the
shops, what are the shops profits? [Characterize the Nash equilibrium
of the corresponding game in which shops simultaneously set prices pi !
Illustrate your analysis by a figure!] Compare your findings to those in
(1).
3. Return to the situation in (1) but suppose that shops sometimes do not
have fresh milk available and that inhabitants only make the walk if they
know that they get the milk for sure. Therefore, each shop can buy the
right to use the citys public speakers to advertise the availability of the
milk. There is time for two ads. The inhabitants of Lonely-Line City,
however, do not always pay attention to the ads. Each inhabitant listens
to ad 1 with a 50% chance and to ad 2 also with a 50 % chance. Assume
furthermore that for each inhabitant the probability to listen to ad 2 is
independent of whether he or she has listened to ad 1. Consequently, there
is a 25% chance that an inhabitant listens to ad 1 only, a 25% chance that
an inhabitant listens to ad 2 only, a 25% chance that an inhabitant listens
to ads 1 and 2, and a 25% chance that an inhabitant listens to none of the
ads.
4. Consider a day at which both shops have milk available. Shops have
the following two options: (a) they jointly announce the availability of
milk in each ad, i.e., both ads contain information on both shops, (b) ad
1 contains information on shop 1, ad 2 contains information on shop 2.
Determine the equilibrium in each of the two cases (the advertising costs
are assumed to be the same in each case). Which option do shops prefer?
[Characterize the equilibrium for options 1 and 2. In each case, you can
assume that parameter constellations are such that first-order conditions
of profits maximization characterize the equilibrium.] Provide an intuition
for your result.

Exercise 14 Comparative advertising

Consider a Hotelling duopoly in which firms are located at the extreme
points of the unit interval and consumers of mass 1 are uniformly distributed
on the unit interval. The price of the two products is given and equal to 1,
p1 = p2 = 1 (e.g. because the price is fixed upstream); production costs are
zero. The quality of product i is denoted by si [2, 3]. The quality of each
product is drawn independently from the uniform distribution on this interval
[2, 3]. Both firms observe the two qualities of the product, consumers do not
observe the qualities. A consumer located at x [0, 1] derives utility Es1 xp1
from product 1 and Es2 (1x)p2 from product 2, where Esi is the expected
quality of product i given the information available to consumers.
9

1. Suppose that firms can simultaneously disclose their own quality si at

zero cost. Consumers then decide which product to buy. Characterize the
equilibrium of this game. Prove that it is the unique equilibrium.
2. Suppose now that disclosure is costly, i.e. a firm has to spend a given
advertising cost a (0, 1/4] to disclose its own quality. Suppose that
firm i conditions its action on si only. Characterize the equilibrium of the
game in which firms first decide whether to advertise their own quality
truthfully or not to disclose any information and then consumers make
their choices. Note that firms know the cost a and make their disclosure
decisions simultaneously.
3. Suppose that instead of advertising their own quality, firms can costly
advertise only the quality dierence s1 s2 , i.e. firms can only engage
in comparative advertising. Characterize the equilibrium in which both
firms simultaneously decide whether to disclose the quality dierence at
cost a (0, 1/4].
4. Discuss verbally the welfare properties of the equilibria determined in (2)
and (3).
5. Consider now a model in which firms can choose not to advertise, to use
non-comparative advertising or to use comparative advertising. In the
last two cases the same advertising cost a applies. Provide verbally an
intuition about the properties of the equilibrium of this game. To simplify
the argument, consider an alternative setting in which there are only two
discrete types si {2, 3}.

Exercise 15 Price dispersion

A study by Brynjolfsson and Smith on retail price for books and CDs finds
that price dispersion (weighted by market shares) is lower for internet retailers
than for conventional retailers. Discuss.
Exercise 16 Another model of sales
Consider a market for a homogenous product with n identical price-setting
stores, where n is determined by free entry. Each store has a cost function

C(q) = q, where q is the number of customers the store serves. There are
M + 15 consumers in the market, each of whom wishes to buy up to one unit
and is willing to pay for it up to r = 1. The number of 15 consumers know
the prices charged by all the stores in the market (i.e., have zero search costs),
while M consumers do not know the prices at all (i.e., have prohibitively high
search costs).

10

1. Prove that there cannot exist a symmetric pure-strategy equilibrium in

this market.
2. Suppose that all the stores in the market use the same mixed strategy.
What is the support of the mixed strategy as a function of n?
3. Write the profit of a store when it charges p = 1 (hint: what is the
probability that when a store charges p = 1 it will have the lowest price in
the market?). Prove that this profit is zero. Use the zero profit condition
to compute the equilibrium number of firms, n . Given n , write the
support of the equilibrium mixed strategy of prices.
4. Compute the profits of a store when it happens to be charging the lowest price in the market and when it does not. Using these expressions,
compute the equilibrium distribution of prices at each store, F (p).
5. What happens to the distribution of prices when the number of uninformed
consumers, M , increases? What does this result mean for the uninformed
consumers? Explain the intuition for this.
6. What happens to the distribution of price paid by informed consumers
when the number of uninformed consumers, M , increases? Explain the
intuition for this result.

Exercise 17 Yet another model of sales

Suppose that two firms with constant marginal costs compete in prices
in a homogeneous product market. All consumers have unit demand and a
willingness-to-pay r. A share of consumers is informed about the prices in the
market. The share (1 )/2 goes to firm i = 1, 2 and decides whether to buy
(these consumers do not know that a product from firm j 6= i exists). Firms set
prices and then consumers make their consumption decisions.
1. Show that there does not exist a symmetric Nash equilibrium in pure
strategies.
2. Characterize equilibrium prices in the unique mixed-strategy Nash equilibrium.
3. How do prices change if is increased.
4. How do equilibrium profits changes as increases. (Calculate /.)

11

Exercise 18 Bargains and ripos

Consider a market for a homogenous product with n identical stores, where
n is determined by free entry. Each store has a cost function C(q) = 4 + q, for
q 4 and c(q) = for q > 4 (in other words, each store can sell up to 4 units
and its cost of selling the first q units is 4 + q). There are L consumers in the
market, each of whom wishes to buy up to 1 unit and is willing to pay for it up to
r = 5. Suppose that a fraction of all the consumers is fully informed about the
prices that the dierent stores charge. The remaining (1 )L consumers are
uninformed and have to pay a cost z in order to learn the prices that dierent
stores charge. If an uninformed consumer does not pay z, she knows only the
distribution of prices but not the actual prices charged by each store. Such a
consumer then picks a store at random. However, once an uninformed consumer
pays z, she becomes completely informed and knows all prices charged by all
stores.
1. Compute the marginal and average costs of stores and illustrate it in a
figure.
2. Suppose that z = 0. Solve for the long-run competitive equilibrium in the
market.
3. Now suppose that z > 0. Prove that there can be at most 2 prices in a
Nash equilibrium.
4. Assume that there are two prices being charged in equilibrium. What is
the low price, pl ? Given your answer, compute the high price, ph (hint:
assume that a fraction of all stores charge pl and a fraction 1 charge
ph and use the condition that ensures that uninformed consumers do not
find it worthwhile to search).
5. Compute the demand faced by low and high price stores (note that uninformed consumers pick stores at random so each stores gets an equal share
of the (1 )L uninformed consumers; informed customers are indierent
among all stores that charge low prices, so each one of these store gets an
equal share of the L informed consumers).
6. Use your answers in (4) and (5) to express the zero profit conditions for
high and low price stores (recall that there is a free entry so in equilibrium,
each store must earn a zero profit).
7. Solve the conditions you wrote in (6) for and n.
8. How do the equilibrium values of and n vary with z? Explain the
intuition for your result.
9. Compute the average price on the market and the standard deviation of
prices. Using these calculations, let P D = SD/AP be a measure of price
dispersion, where SD is the standard deviation of prices, and AP is the
12

average price. How is P D aected by s? How is P D aected by ? Are

these results intuitive? Explain.
Exercise 19 Switching costs and competition
Switching costs relax competition and their presence are therefore profitenhancing. Is this statement necessarily correct? Explain.
Exercise 20 Switching costs and pricing strategy
Suppose that two software companies launch a new software each. One of
them is called COOL, the other GREAT. There is a unit mass of consumers.
All of them consider the two software oers as identical. Both softwares are
produced at zero marginal costs and consumers are willing to pay r for the
software.
1. Suppose that firms set prices and compete only in one period. Characterize equilibrium prices, allocation and profit. (If a group of consumers is
indierent suppose that half of them buys software COOL and the other
half GREAT.)
2. Suppose that each firm sold to half of the consumers their software and
that they launch new products COOL2 and GREAT2. Consumers are
willing to pay r for the new products. Suppose, however, that consumers
who buy the product from a dierent firm than in the first period incur
a disutility . Suppose firms set prices. Characterize equilibrium prices,
allocation and profit. Does an equilibrium (in pure strategies) always
exist? Discuss.
3. Consider now the market environment in which the firm that produces
COOL in period 1 and COOL 2 in period 2 is aware of the fact that it will
launch COOL2 in period 2. Does this aect its incentive in period 1? In
particular, does it have an incentive to deviate from the price calculated
in (1)? (NOTE: Suppose that there is no discounting.)
4. Suppose now that consumers who bought COOL will not consider buying
GREAT2 in period 2 and that consumers who bought GREAT will not
consider buying COOL2 in period 2. Characterize the subgame perfect
equilibrium in the two-period model. (Again, suppose that there is no
discounting.)
5. Provide some real-world examples that have some similar features as the
theoretical market described in part (4). Explain in up to five sentences the
general economic principles at work in markets such as the one describend
in (4).
6. Consider the market environment as described in (4). Suppose the courts
rule that prices cannot be set below marginal costs. Analyze the eects
of such a policy on consumer surplus, profits, and welfare.

13