Advanced Industrial Organisation

Solution set week 2

Problem 1. The monopolist has incentives to lower prices over time, to sell to more
consumers. If consumers have to wait for some time for a price adjustment, they might be
willing to pay more to get it sooner. However, if the price adjustment will happen very fast,
it pays off to wait. The monopolist will always want to lower prices quickly after selling
to other consumers, however, instead of waiting (so it can sell to remain consumers faster,
increasing the consumers’ willingness to pay). Anticipating this, consumers will want to
wait. The monopolist must therefore lower prices immediately.

Problem 2.

(a) If the price is the same in each period, there is no reason for consumers to wait. The
marginal consumer is indifferent between buying in period 1 and not buying in period
1. If that consumer has value r̂, it follows that (1 + δ)r̂ − p = 0, so r̂ = p/(1 + δ). The
demand is then q1 = 1 − r̂ = 1 − p/(1 + δ). Rewrite this to get the inverse demand
function p = 1 − q1 + δ(1 − q1 ). The monopolist maximizes profits, which are equal to
q1 (1 − q1 + δ(1 − q1 )). This gives q1∗ = 1
2
and p∗ = 1+δ
2
. Profits are 1
4
+ δ 14 . (We show in
part c) that this yields higher profits than lowering the price over time.)

(b) If the seller leases the good, it will set the monopoly rental price in each period. The
1 1
price is p = 2
each period and the quantity is q = 2
each period. Discounted profits are
1
4
+ δ 41 .
(2+δ)2
(c) From the lecture slides (slides 12-15 of week 2) we know that p1 = 2(4+δ)
. Using the result
2 (2+δ)
for q1 = 4+δ
, we find that p2 = 2(4+δ)
.
It is easy to verify that p1 > p2 . Substitute q1 in
 2  2
(2+δ) 2+δ 2
+δ 14 (2+δ) 1


the profit function (see slides) to get profits Π = (4+δ) (4+δ)
= (1+ 4
δ) 4+δ
.
These profits are lower than the profits under leasing if
 2
1 2+δ 1
(1 + δ) < (1 + δ) ⇔
4 4+δ 4
 2
2+δ
(4 + δ) < (1 + δ) ⇔
4+δ
(2 + δ)2
< (1 + δ) ⇔
4+δ

1
 (2 + δ)2 < (4 + δ)(1 + δ).

This inequality is always satisfied for 0 < δ < 1.

Problem 3.

(a) If the quality is high, then low value consumers are willing to pay at most 1 and high
value consumers at most 2. Profits are higher by selling to only high types (profits are
30
24
, sell to 5/12 of consumers in both periods at p = 2 and c1 = 0.5) compared to selling
to both types of consumers (profits are 1, sell to all consumers in both periods at p = 1
and c1 = 0.5).

(b) If the quality is low, then low value consumers are willing to pay at most 1/2 and high
value consumers at most 1. Profits are higher by selling to all types (profits are 1, sell
to all consumers in both periods at p = .5 and c0 = 0) compared to selling to high types
only (profits are 10/12, sell to 5/12 of consumers in both periods at p = 1 and c0 = 0).

(c) To show that these pricing strategies can be part an equilibrium, we must show that there
exists a set of strategies and beliefs, such that the firm or consumers cannot be better
off by changing their strategies (given the strategies of others). Beliefs must be rational
in the sense that Bayes’ rules applies wherever possible (any beliefs are admisseable for
zero probability events, in which case Bayes’ rule cannot be applied).
Assume that consumers believe that any p 6= 1 indicates that the monopolist has low
quality, and that only high types of consumers buy the good if p = 1. We now show that
under these assumptions, the proposed pricing strategies are equilibrium strategies.
If the quality is low, and the monopolist sets p < 1, the consumer can infer the quality
is low. The monopolist then prefers to sell to all types at p = 0.5, and profits are 1. If
the monopolist would imitate a high quality firm, and set p = 1, then only high type
5
consumers buy (they pay at most 1 for low quality) and profits are 12
(1 − 0) in each
period, so lower than the profits with p = 0.5.
If the quality is high, and the monopolist sets p = 1, the consumer can infer the quality
is high. The monopolist then prefers to sell to high types only. In period 2 they know
5
the quality and they are willing to pay p = 2. So profits are 12
(1 − 12 ) + 5
12
(2 − 12 ) = 20
24
.
If the monopolist would imitate a low quality firm, and set p ≤ 1/2, then profits are
(p1 − 21 ) + 5
12
(2 − 12 ), which is lower than for p = 1 (all consumers buy in period 1, they
learn that quality is high, and only high types buy in period 2). Setting a price between

2
 0.5 and 1 is clearly worse because then still only high types buy in period 1. Setting a
price above 1 also lowers profits, because no consumer will buy.
The last step is to show that consumers cannot be better off. At p = 1, we assumed
that only high types buy. Low types are not better off by buying (they are indifferent).
All other cases are clear.

Problem 4.

28
(a) If r̂ = 48
, then the monopolist knows that people that bought in period 1 have a value
28
between 28/48 and 1. The profit-maximizing price for this group is p2 = 48
.

(b) The monopolist knows that people that did not buy in period 1 have a value between 0
28
and 28/48. The inverse demand function for this group is given by p = 48
− q and the
14
profit-maximizing price for this group is p̃2 = 48
.

28
(c) In period 1, all people with a value of at least 28/48 buy, so demand is 1 − 48 . In period
2, all existing consumers buy again (since for everyone the value is at least as high as
28 14
the price) and the demand by new consumers is 48
− 48
.

(d) Buying in period 1 at p1 and then in period 2 at price p2 gives utility: r̂ −p1 +δ(r̂ −p2 ) =
28 8 14
48
− p1 . Buying in period 2 at price p̃2 gives utility δ(r̂ − p̃2 ) = 10 48
. So this consumer
is indifferent if p1 = 0.35

(e) This has to be true, since those consumers value the good even more.

(f) See p. 260 of the textbook for a detailed derivation. Start by assuming that r̂ ≥ 1/2.
You can then derive the second period price for each group (it will be p2 = r̂ for the
group that already purchased the product in period 1 since the unconstrained monopoly
price is 1/2 but you know that all these consumers are willing to pay at least r̂, and it is
p̃2 = r̂/2 for the consumers who did not purchase the group in period 1 since the demand
function for that group is q2 = r̂ − p˜2 and r̂/2 is then the monopoly price). Note also
that the consumer with value r̂ is indifferent between buying in period 1 (giving utility
of r̂ − p1 + δ(r̂ − p2 )) and waiting and buying in period 2 (giving utility of δ(r̂ − p̃2 )).
The firms’ profits are equal to

π = (p1 + δp2 )(1 − r̂) + δ p̃2 (r̂ − p̃2 ).

3
 Substitute for what you know about r̂ and the prices in period 2 (notice that they depend
on p1 ), to get:

2δ 2 − δ − 2p1 p1 p1
π = (p1 + p1 )( )+δ ( ).
2−δ 2−δ 2−δ 2−δ
Take the derivative with respect to p1 and set equal to zero to find the optimal price in
4−δ 2
period 1: p∗1 = 2δ+8
. The second period prices are then p2 = 4+2δ
2δ+8
and p˜2 = 2+δ
2δ+8
.
2+δ
Notice that we then have r̂ = 4+δ
, so that indeed r̂ ≥ 1/2 as we assumed to be the case.
28
For δ = 0.8,we have r̂ = 48
, which is the threshold value we worked with under (a)-(e)
so the prices found earlier are the profit-maximizing prices. .

(g) Comparing prices, you can see that p̃2 < p1 < p2 . Compared to the price in the first
period, the monopolist will increase prices for existing consumers, since the monopolist
now knows they are willing to pay more than p1 , and decrease the price for new consumers
since they are not willing to pay p1 .