COURSE 801: INDUSTRIAL ECONOMICS

MIDTERM EXAM, 14.9.16

Time: 70 minutes 30 Marks

Answer ​any two​ questions. Keep your answers short and precise, taking care to
explain in words​ the crucial steps of each derivation.

1. Two firms 1 and 2 with zero marginal costs produce a homogeneous product for
a market where demand is given by D (p) = 1 − p .
a) If the firms simultaneously choose their outputs, find the Cournot-Nash
equilibrium quantities ​q​1​ ​and ​q​2.​
b) Instead, suppose the same firms play the following two-stage game. In the
first stage, they simultaneously choose their capacities ​K1​ ​ a​ nd ​K​2.​ These
capacities are irreversibly committed and observable. In the second stage
they simultaneously choose prices ​p​1​ a​ nd ​p2​ .​ Marginal cost of capacity is ​c​ per
unit, with ¾ ​<​ ​c ​<​ 1. If firms choose the same price, demand is equally shared.
If they choose unequal prices, the firm with the lower price sells its full
capacity output according to the efficient rationing rule, and the residual
demand goes to the other firm. Prove that in the second stage, equilibrium
prices are p1 = p2 = p* = 1 − K 1 − K 2 .
(5, 10)

2. A good is demanded by a unit mass of identical consumers who are uniformly

distributed along a line segment of unit length. Each consumer has inelastic unit
demand with willingness to pay of ​v​, which is high enough to ensure that the
market is covered in equilibrium. The good is produced at zero marginal cost by
two identical firms ​i ​and ​j​ located at ​li​ ​ ​and ​l​j​ ​on the line segment, where
0 ≤l i ≤lj ≤1 . In order to buy the good from a firm located at ​l​i​ , a consumer at
location ​x​ incurs transport costs that is a ​quadratic​ function t(x − li )2 of the
distance. The firms simultaneously choose prices, given their locations.
a) Derive reaction functions of the firms and determine whether prices are strategic
substitutes or strategic complements. Make sure to bring out the relevance of the
various assumptions of the model at the appropriate stage of your derivation.
b) Determine the Bertrand-Nash equilibrium prices, and show that the Bertrand
Paradox holds for the case of homogeneous products.
(7 ½, 7 ½)
3. Two firms play an infinitely repeated game, with discount factor δ. In any
period, they can either collude, earning π ​ ​c​ each, or compete, earning the Nash
equilibrium profit π ​ ​n​ ​each.​ ​Deviation from collusion earns ​πd​ ​ for the deviating
firm, but it is punished by a grim trigger strategy with Nash reversion from the
very next period. Collusion requires communication, which creates evidence that
lasts for that period only. There is an antitrust agency that audits the industry
and finds the evidence with probability ​ρ​ < 1. This results in a fine ​F​ on each
firm, including a deviating firm. However, π ​ ​c​ – ​ρF > π​n​, so auditing by itself is
not sufficient to deter collusion. The firms resume colluding again from the next
period even after a successful audit, but evidence is generated again for that
period, which can be discovered by audit with the same probability.
a) Set up and explain the relevant incentive compatibility condition and derive
the critical minimum value of the discount factor that will sustain collusion in
equilibrium.
b) Suppose the antitrust agency offers a reduced fine ​f < ρF ​to a firm that
reports the evidence, but it cannot offer a positive reward. The firms use
Nash reversion to deter such reporting. Derive the new minimum value of the
discount factor and compare it with the answer you obtained in part (a).
What does this tell you about the usefulness of leniency programmes?
(7 ½, 7 ½)