Managerial Economics

Indian School of Business

Term 1

HOMEWORK 4
GROUP ASSIGNMENT, CODE 2N-b

Problem 1 (4+4=8 points)

An old lady is looking for help crossing the street.1 Only one person is needed to help her; more
are okay but no better that one. Sunny and Simran are the two people in the vicinity who can
help; each has to choose simultaneously whether to do so. Each of the two will get utility worth 3
from the old lady’s success (no matter who helps her). But each one who goes to help will bear a
cost of 1, this being the utility value of the person’s time taken up in helping. Set this up as a
game. Write the payoff table, and find all pure-strategy Nash equilibria.

The payoff matrix is below. Best-response analysis shows there are two pure-strategy Nash equilibria: (Help,
Not Help) with payoffs (2, 3) to (Sunny, Simran) and (Not Help, Help) with payoffs (3, 2).

Simran

Help Not

Help 2, 2 2, 3

Sunny Not 3, 2 0, 0

Problem 2 (10 points)

Having muscled out the other bhelpuri vendors on Chowpatty Beach in Bombay, the proprietors
of Royal Bhelpuri and Modern Bhelpuri have to decide where to locate their stalls. Customers
are situated uniformly along the beach, and will purchase 1 bhel from the vendor closest to them.
a. (5 points) If the beach is 1 km long, what are the Nash equilibrium locations for Royal
and Modern?
b. (5 points) If a new entrant, Tasty Bhelpuri, enters the market, what are the equilibrium
locations?

a. Note, if they set up stalls at distance l1 and l2 from one end, the indifferent consumer is at
point (l1+l2)/2. If Royal sets up the stall at one end, the other player has an incentive to
set up stall very short distance away, say e (very small) so that it would cater to as much
of the market as possible i.e., 1- e/2 of the total market (giving Royal a small market of

1
This problem is from Dixit and Skeath’s Games of Strategy.
 e/2). Then Royal, taking Modern’s location as given, has an incentive to move e distance
beyond Modern (i.e. to location 2e from the starting point) and get 1-(3e/2), as long as
(l1+l2)/2 is less than ½. So, by this logic, each will continue to locate until they reach
distance (1/2, ½). Beyond that, there is no reason to change. Analogously, suppose they
start at the other end then they have an incentive to shift closer to the first end until they
reach (½, ½). So this is the NE.
b. Suppose they all start at (1/2, ½, ½) and get 1/3 of the mkt each. So each has an incentive
to deviate and try to get a larger market share since the slightest move away gives her
access to the complete market at one end. But then each player has the same incentive.
Suppose they each are at (1/3, 2/3,1) away from one end. Then, say the first player has an
incentive to move a little closer to the second player and so does the third player. There
is NO NE.

Problem 3 (5 points)
Find the Cournot-Nash Equilibrium in a game with two French fry manufacturers, Freddie’s
Fries and Charlie’s Chips. There are five levels of production: produce 6,8, or 12 million tons of
output. The numbers in the table below represent as (FF,CC) the profits for Freddie’s Fries and
Charlie’s Chips corresponding to the quantities they produce.

6 8 12

6 18, 18 15, 20 9, 18

8 20, 15 16, 16 8, 12

12 18, 9 12, 8 0, 0

For each player, producing 12 million tons of output is a dominated strategy. Therefore, neither
player will play that. The remaining game reduces to a prisoner’s dilemma. The Cournot solution
is to produce 8 million tons each, which gives a payout of 16 to each.

Problem 4 (13 points)

Consider a Cournot duopoly in which the two firms have different marginal costs. The inverse
demand in the market is P(Q) = 15 – Q. The costs of firm A and firm B are CA(qA) = 6qA and
CB(qB) = 3qB, respectively.
a. (3 points) What is the best response (or reaction) function of firm A?
b. (3 points) What is the best response (or reaction) function of firm B?
c. (3 points) What are the equilibrium quantities produced by each firm?
d. (2 points) What is the market price?
e. (2 points) What are the profits of each firm?

For firm A, reaction function is 9 = 2qA + qB

For firm B, reaction function is 12 - 2qB = qA
Solve to obtain
qA = 2 and qB=5
P* = 8
ProfitsA = 8*2 -12 =4
ProfitsB = 8*5 – 15 = 25

Problem 5 (8 points)
The accompanying article presents a decision facing Robert Gates, the US Secretary of Defense,
who is trying to reduce costs for the US Air Force’s F-35 fighter program. The engines for the
plane are currently produced by Pratt and Whitney in Connecticut. Some lawmakers want to start
a second production line for the engines in Ohio, run by GE and Rolls Royce. Mr. Gates argues
that a single production line will save costs for the military, while Ohio lawmakers (who value
the jobs the second line will create) say that competition will lower engine prices and increase
the welfare accruing to the sole consumer – the US military.

As a budget analyst at the Pentagon, you have been asked to analyze two possible scenarios and
advise Secretary Gates on production strategy. You determine that the military’s demand curve
for F-35 engines is given by P=1000-Q. The marginal cost of production (revealed in
Congressional filings) is $120 mm per additional plane for Pratt and Whitney (the original
incumbent) and $160 mm per additional plane for GE-Rolls Royce (the potential entrant).

a. (1+1+1 = 3 points) What is the quantity of engines produced if Pratt and Whitney is the
monopolist supplier in the market? What is the price that the government has to pay for
the engines? What is the consumer surplus for the military in this case?
b. (2+1+2 = 3 points) Now consider the duopoly case where Pratt and Whitney is the
Stackelberg leader and GE-Rolls Royce is the Stackelberg follower. What is the price that
the government has to pay for the engines? How many engines are produced and what is
the consumer surplus for the military in this case?
c. (2 points) Should Secretary Gates agree to the second production line? Explain briefly.
In the monopoly case, q(PW)= 440, P =560 and CS = 96800
In the Stackelberg case, q(PW)= 460, q(GE)=190, P =350 and CS = 211250
Secretary Gates should agree. Price is lower and CS is higher.