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Consider a differentiated duopoly market in which firms compete by...

Consider a differentiated duopoly market in which firms compete by selecting prices and produce to fill orders. Let p1 be the price chosen
by firm 1 and let p2 be the price of firm 2. Let q1 and q2 denote the quantities demanded (and produced) by the two firms. Suppose that the
demand for firm 1 is given by q1 = 22 − 2p1 + p2 , and the demand for firm 2 is given by q2 = 22 − 2p2 + p1 . Firm 1 produces at a constant
marginal cost of 10 and no fixed cost. Firm 2 produces at a constant marginal cost of c and no fixed cost. The payoffs are the firms'
individual profits.
Now suppose that firm 1 does not know firm 2's marginal cost c. With probability 1/2 nature picks c = 14, and with probability 1/2 nature
picks c = 6. Firm 2 knows its own cost (that is, it observes nature's move), but firm 1 only knows that firm 2's marginal cost is either 6 or 14
(with equal probabilities). Calculate the best-response functions of player 1 and the two types (c = 6 and c = 14) of player 2 and calculate
the Bayesian Nash equilibrium quantities.

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Answer & Explanation Solved by verified expert 숨 Rated

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Answered by tsuneja

Under incomplete information, that is, when c=14 or c=6, the Bayesian Nash equilibrium of this Bertrand game is (14, 16, 12).

Step-by-step explanation

Step 1: Deriving the Profit functions for each firm.

For firm 1:
Given:
q1 = 22 − 2p1 + p2
M c1​= 10

Now, π1​= T R1​− T C1​

where, T R1​= p1​× q1​
T C1​= 10q1​
So, π1​= (p1​× q1​) − (10q1​)
π1​= q1​[(p1​− 10)]
On substituting the value of q1, we get:
π1​= (22 − 2p1 + p2)(p1​− 10)
∴ π1​= 42p1​+ p1​p2​− 2p12​− 10p2​− 220

For firm 2:
Given:
q2 = 22 − 2p2 + p1
M C2​= c  where c > 0

Now, π2​= T R2​− T C2​

where, T R2​= p2​× q2​
T C2​= cq2​
So, π2​= (p2​× q2​) − (cq2​)
π2​= q2​[(p2​− c)]
 On substituting the value of q2, we get:
π2​= (22 − 2p2 + p1)(p2​− c)
∴ π2​= (22 + 2c)p1​+ p1​p2​− 2p22​− 22c − cp1​

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Step 2: Deriving the Best-response function for each firm.

For firm 1:
On differentiating the profit function (π1​)with respect to p1, we get:
42 + p2​− 4p1​− − − − − (1)
Putting (1) equals to zero and solving for p1​, we get:
p1​= 442+p2​​

So, the best-response function of firm 1 is:

BR1​= 442+p2​​

For firm 2:
On differentiating the profit function (π2​)with respect to p2, we get:
22 + 2c + p1​− 4p2​− − − − − −(2)
On solving equation (2) for p2​, we get:
p2​= 422+2c+p1​​

So, the best-response function of firm 2 is:

BR2 = 422+2c+p1​​

Step 3: Determining the Nash Equilibrium when c=10.

It is known that p2​= 422+2c+p1​​

If c=10, p2​= 422+2(10)+p1​​

So, p2​= 442+p1​​------------(3)

Plugging the value of p1 in equation (3), we get:

p2​= 442+442+p2​​

On solving for p2:

p2​= 14

Thus, the equilibrium price (p2​∗ )is $14

Substituting the value of p2 in the best response function of firm 1, we get:

p1​= 442+14​

So, p1​= 14

Thus, the equilibrium price (p1​∗ )is $14

Hence, the Nash Equilibrium (p1​∗ , p2​∗ )is (14,14)

Step 4: Calculating the profit of firm 1.

It is known that, π1​= (22 − 2p1 + p2)(p1​− 10)

So, π1​= (22 − 2(14) + 14)(14 − 10)
∴ π1​= $32

Step 5: Determining the Nash equilibrium when c=6 or c=14.

When c=14, that is, there are high costs, the best response function of firm 2 will be:
p2​= 422+2(14)+p1​​
 So, p2​= 450+p1​​

When c=6, that is, there are low costs, the best response function of firm 2 will be:
p2​= 422+2(6)+p1​
Question ​
Answer & Explanation Related Questions Related Textbooks

So, p2​= 434+p1​​

Now, firm 1 is not informed regarding the cost that firm 2 will have.
So, firm 1 will choose a price that will maximize its profits.
2
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Since the probability is 1/2, the firm will choose a price such that:

21​(42p1​+ p1​p2h​− 2p12 − 10p2h​) + 21​(42p1​+ p1​p2l​− 2p12​− 10p2l)

where, p2h​represents the price of firm 2 if there are high costs and p2l​represents the price of firm 2 when there are low costs.

On differentiating with respect to p1, we get:

21​(42 + p2h​− 4p1​) + 21​(42 + p2l​− 4p1​) − − − − − (4)

Putting equation (4) equals to zero and on solving for p1:

p1​= 442+21​p2h​+21​p2l​​− − − − − (5)

Plugging the values of p2h​ and p2l​ in equation (5)

p1​= 442+21​450+p1​​+21​434+p1​​

On solving for p1​, we get:

p1​= 14

Thus, the equilibrium price (p1​∗ ) is $14.

For firm 2:
Plugging the value of p1* in the best response function of firm 2, we obtain:

When c=14,
p2h​= 450+14​= $16

When c=6,
p2l​= 434+14​= $12

Thus, the Bayesian Nash equilibrium of this Bertrand game is (14, 16, 12).

Step 6: Calculating the level of profit of each firm.

For firm 1:
π1​= 21​[(42)(14) + (14)(16) − (2)(142) − (10)(16)] + 21​[(42)(14) + (14)(12) − (2)(142) − (10)(12)]

∴ π1​= $252

Similarly, for firm 2:

When c=14 (high cost),
π2​= (16 − 14)(22 − 2 × 16 + 16) = $12

When c=6,
π2​= (12 − 6)(22 − 2 × 12 + 12) = $60


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