ECON 511 - Intermediate Economics I

2018 Exam III -Solution

Exercise 1: Consumers
(a) Suppose Ann has demand
(
640 − 20p if p < 32
DA (p) =
0 if p > 32

and Bob has demand

(
300 − 15p if p < 20
DB (p) = .
0 if p > 20

Ann and Bob are the only individuals who are interested in good x.
There are Q̄ = 275 units of the good available. Suppose QA = 150 units are given
to Ann and QB = 125 units are given to Bob.
• Decide whether the proposed allocation of the good, (QA , QB ), is efficient. If
it is efficient, justify your conclusion. If it is not efficient, derive the efficient
allocation.

Solution Aggregate demand from Ann and Bob is:


940 − 35p
 if p < 20
D(p) = 640 − 20p if 20 6 p < 32 .


0 if p > 32
Hence, the inverse aggregate demand is:

0
 if Q > 940
Q
P (Q) = 1887
− 35 if 240 6 Q < 940 .

 Q
32 − 20 if 0 6 Q < 240

188 275 940 − 275 665

Q̄ = 275 =⇒ P (Q̄) = − = = = 19
7 35 35 35
=⇒ DA (19) = 640 − 20 · 19 = 640 − 380 = 260
DB (19) = 300 − 15 · 19 = 300 − 285 = 15

=⇒ The proposed allocation is not efficient. The efficient allocation of Q̄ is

QA ∗ = 260 units to Ann and QB ∗ = 15 units to Bob.

1
(b) Consider the allocation of two goods to two individuals, consumers A and B. The
total amount available to divide is (x̄, ȳ). An allocation consists of a bundle (xA , yA )
for consumer A and a bundle (xB , yB ) for consumer B such that

(xA , yA ) + (xB , yB ) = (x̄, ȳ).

• What would it mean for an allocation to be economically efficient?

Solution An allocation (xA ∗ , yA ∗ ), (xB ∗ , yB ∗ ) is efficient if no other allocation

exists that makes at least one individual better off without making anyone worse
off.
• In each remaining part of this question, an allocation is proposed and the
marginal rates of substitution for each individual evaluated at the proposed
allocation are given.
For each proposed allocation, decide whether it is efficient. If it is efficient,
justify your conclusion. If it is not efficient, indicate an improving trade.
(i) (x̄, ȳ) = (3, 3), (xA , yA ) = (1, 2), (xB , yB ) = (2, 1),
MRSA (1, 2) = 9, MRSB (2, 1) = 9
(ii) (x̄, ȳ) = (4, 6), (xA , yA ) = (4, 4), (xB , yB ) = (0, 2),
MRSA (4, 4) = 4, MRSB (0, 2) = 2

Solution
(i) This is an interior allocation at which the MRS of both individuals is the
same. Therefore, we know that it is efficient.
(ii) This is a corner allocation with xB = 0, it is efficient if MRSA > MRSB
at the allocation. This holds (4 > 2). The only improvement would be a
transfer of a small amount of good 1 from B to A in exchange for a small
amount of good 2 from A to B. xB = 0, therefore such a transfer is not
possible. Hence, the proposed allocation is efficient.

ECON 511 2018 Exam III - Solutions Page 2 of 18

Exercise 2: Producers
(a) Consider two firms that each use the same factors, labor and capital, to produce the
1 2
same good, Widgets. Firm 1 has production functionQ1 (L1 , K1 ) = (L1 ) 5 (K1 ) 5 . Firm
1 1
2 has production functionQ2 (L2 , K2 ) = (L1 ) 2 (K1 ) 10 . Total resources of (L̄, K̄) = (3, 6)
are available to allocate between the two firms in a socially efficient manner.

• The resources are allocated such that (L1 , K1 ) = (1, 5) and (L2 , K2 ) = (2, 1).
Decide whether this allocation is efficient. If it is efficient, justify your conclu-
sion. If it is not efficient, indicate an improving adjustment.

Solution The allocation is efficient if and only if MP L1 = MP L2 and MP K1 =

MP K2 at the allocation.
2
1 4 2 K1 5
MP L1 (L1 , K1 ) = L1 − 5 K1 5 = 4
5 5L1 5
1
2 1 −3 2L1 5
MP K1 (L1 , K1 ) = L1 5 K1 5 = 3
5 5K1 5
1
1 1 1 K2 10
MP L2 (L2 , K2 ) = L2 − 2 K2 10 = 1
2 2L2 2
1
1 1 9 L2 2
MP K2 (L2 , K2 ) = L2 2 K2 10 =
−
9
10 10K2 10
1 2 1 1
=⇒ MP L1 (1, 5) = · (5) 5 < · √ = MP L2 (2, 1)
5 2 2
√
2 1 2
MP K1 (1, 5) = · 3 > = MP K2 (2, 1)
5 (5) 5 10

The allocation is not efficient. At the current allocation firm 1 has a higher
marginal product of labor than firm 2 and firm 2 has a higher marginal product
of capital than firm 1. Output would increase if labor was moved from 1 to 2
and/or capital was moved from 2 to 1.
• Would√your answer to the first part change if firm 2 were required to produce
Q2 = 2?

Solution In this case, an optimal allocation is characterized by the following

two equations.
√
MRT S1 (K1 , L1 ) = MRT S2 (K2 , L2 ) and Q2 (K2 , L2 ) = 2

ECON 511 2018 Exam III - Solutions Page 3 of 18

 √
Q2 (2, 1) = 2 so the target output is reached.

MP L1 (L1 , K1 )
MRT S1 (K1 , L1 ) =
MP K1 (L1 , K1 )
2 3
K1 5 5 K1 5
= 4 · ·
5L1 5 2 L1 15
1 K1
= ·
2 L1
5
=⇒ MRT S1 (1, 5) =
2
MP L2 (L2 , K2 )
MRT S2 (K2 , L2 ) =
MP K2 (L2 , K2 )
1 9
1 K2 10 K2 10
= 1 · 10 1
2 L2 2 L2 2
K2
=5 ·
L2
1 5
=⇒ MRT S2 (2, 1) =5 · =
2 2
Therefore, the allocation would be efficient under this circumstance.

(a) There are two producers in the market, firm A and firm B. Firm A’s cost function is
1
CA (QA ) = 16 QA and firm B’s cost function is CB (QB ) = 10 QB . Total output quantity
traded in this market is Q = 400 units.

• How should this output be allocated between the two firms such that it is pro-
duced efficiently?

Solution An interior allocation QA > 0, QB > 0 is optimal if and only if MCA (QA ) =
MCB (QB ).
1
MCA (QA ) =for all QA > 0
6
1
MCB (QB ) = for all QB > 0
10
=⇒ MCB < MCA ∀ QA , QB > 0

=⇒ The optimal allocation is a corner solution. QB ∗ = 400 should be produced by

firm B and QA ∗ = 0 should be produced by firm A.

ECON 511 2018 Exam III - Solutions Page 4 of 18

Exercise 3: Market Interventions
Widgets are produced both inside and outside Freedonia and consumed both inside and
outside Freedonia. The market is competitive within Freedonia and outside Freedonia.
The demand and supply functions in Freedonia (subscript F) and outside Freedonia (sub-
script O) are

0 for pF > 100
DF (pF ) = ,
100 − pF for 0 6 pF 6 100

0 for pO > 100
DO (pO ) = ,
100 − pO for 0 6 pO 6 100
SF (pF ) = 3pF for all pF > 0,
SO (pO ) = 5pO for all pO > 0,

respectively, where pF is the price in Freedonia and pO is the price outside Freedonia
(both measured in Freedonian currency for convenience).
Transportation costs between Freedonia and other countries are negligible and will be
ignored for simplicity.

(a) With free trade (i.e. there is only one world market open to Freedonia and the rest
of the world and no barriers to trade such as quotas, tariffs, etc...) what is the
equilibrium price and quantity?

Solution Aggregate demand is

(
0 if p > 100
D(p) = DF (p) + DO (p) =
200 − 2p if 0 6 p < 100

And aggregate supply is

S(p) = SF (P ) + SO (p) = 8p ∀ p > 0.

In equilibrium,

D(P ) = S(p)
⇐⇒ 200 − 2p = 8p
⇐⇒ p∗ = 20
=⇒ Q∗ = D(20) = S(20) = 160.

(b) Freedonia imposes a tariff of T = 5 Freedonian dollars.

• What are the competitive equilibrium prices, pF and pO and quantities traded,
QF and QO , in each market? Explain.

ECON 511 2018 Exam III - Solutions Page 5 of 18

 Solution

pO = pF − T =pF − 5
SO (pF − 5) + SF (pF ) = DO (pF − 5) + DF (pF )
⇐⇒ 5(pF − 5) + 3pf = 100 − (pF − 5) + 100 − pF
⇐⇒ 10pF = 230
⇐⇒ pF = 23
=⇒ pO = 23 − 5 = 18
=⇒ DF (23) = 100 − 23 = 77, SF (23) = 3 · 23 = 69
DO (18) = 100 − 18 = 82, SO (18) = 5 · 18 = 90

Freedonia imports 77 − 69 = 8 units from outside producers.Note that there is

still trade despite of the tariff. Without trade the solution would be:
In Freedonia,

DF (pF ) = SF (pF )
⇐⇒ 100 − pF = 3pF
⇐⇒ pF = 25
=⇒ QF = 75

Outside Freedonia,

DO (pO ) = SO (pO )
⇐⇒ 100 − pO = 5pF
100 50 2
⇐⇒ pO = = = 16 ≈ 16.67
6 3 3
50 250
=⇒ QO = 5 · = ≈ 83.33
3 3
That is, pO < pF − 5 = 20 and there are potential gains from trade.
• List all sources of deadweight loss at this equilibrium and explain.

Solution There are 3 sources of deadweight loss present here:

(1) The quantity traded is too low

QF + QO = 77 + 82 = 159 < 160 = Q∗

(2) The quantity is not allocated efficiently to consumers.

Because of the different prices in Freedonia(pF = 23) and the rest of the
world(pO = 18), there exist consumers in Freedonia who cannot purchase
the good in equilibrium despite having a greater valuation for for it than
some consumers outside Freedonia who obtain the good in equilibrium.
(3) The output produced is not allocated efficiently among the firms,
because producers face different prices.
• For each source, what is the size of the corresponding deadweight loss? Explain.

ECON 511 2018 Exam III - Solutions Page 6 of 18

 Solution Inverse aggregate demand is

D 100 − 12 Q if Q < 20
P (Q) =
0 otherwise
and inverse aggregate supply is
1
P S (Q) = Q for all Q > 0.
8
(1) The size of DWL due to the low quantity traded is:
1
DW L1 = · (pD (159) − pS (159)) · (160 − 159)
2  
1 41 159
= · − ·1
2 2 8
1 164 − 159
= ·
2 8
5
=
16
= 0.3125
(2) The size of DWL due to inefficient allocation among consumers can
be found as follows.
159 41
Using inverse aggregate demand, we find P D (159) = 100 − = . The
2 2
efficient allocation of 159 units is
 
41 41 159
QF = DF = 100 − = = 79.5 > 77
2 2 2
 
41 159
QO = DO = = 79.5 < 82.
2 2
Therefore, the corresponding deadweight loss is
1 1 D
DW L2 = (pD D D
F (79.5) + pF (77)) · (79.5 − 77) − (pO (79.5) + pO (82)) · (82 − 79.5)
2
| {z } |2 {z }
Loss of Social Value in Freedonia Gain Outside Freedonia
1 5
= · · (pD D
F (77) − pO (82))
2 2
(Because inverse demand is the same in Freedonia and outside Freedonia)
5 25
= · (23 − 18) = = 6.25
4 4
(3) The size of DWL due to inefficient allocation to producers is found
similarly.
159
Using the inverse aggregate supply, we find P S (159) = . The efficient
8
allocation of 159 units is
 
159 159 477 5
QF = SF =3· = = 59 < 69
8 8 8 8
 
159 159 795 3
QO = SO =5· = = 99 > 90.
8 8 8 8

ECON 511 2018 Exam III - Solutions Page 7 of 18

 Therefore, the corresponding deadweight loss is
         
1 S S 5 5 1 S 3 S 3
DW L3 = p (69) + pF 59 69 − 59 − p 99 + pO (90) 99 − 90
2 F 8 8 2 O 8 8
| {z } | {z }
Additional Cost in Freedonia Cost Savings Outside Freedonia
   
1 159 75 1 159 75
= · 23 + · − · + 18 ·
2 8 8 2 8 8
1 75
= · · (23 − 18)
2 8
375 7
= = 23
16 16
=⇒ The total deadweight loss is

DW L = DW L1 + DW L2 + DW L3
5 25 375
= + + = 30
16 4 16

ECON 511 2018 Exam III - Solutions Page 8 of 18

Exercise 4: Monopoly
Consider a market with 20 consumers and a single firm. The consumers are of two types,
A and B. All 10 consumers of type A have identical demand functions

55 − 21 p for p 6 110
dA (p) = ,
0 for p > 110

550 − 5p for p 6 110
thus, aggregate demand from type A consumers is DA (p) = .
0 for p > 110
All 10 consumers of type B have identical demand functions

45 − 12 p for p 6 90
dB (p) = ,
0 for p > 90

450 − 5p for p 6 90
thus, aggregate demand from type B consumers is DB (p) = .
0 for p > 90
Aggregate demand in the market is D(p) = DA (p) + DB (p), i.e.

 0 for p > 110
D(p) = 550 − 5p for 90 6 p 6 110 ,

1000 − 10p for 0 6 p < 90

with corresponding inverse aggregate demand


 0 if Q > 1000
1
P (Q) = 100 − 10 Q if 100 6 Q 6 1000 .

110 − 15 Q if 0 6 Q < 100
1
The monopolist’s cost function is C(Q) = 40
Q2 for all Q > 0.

(a) Suppose the firm acts as a regular monopolist setting one price. What are the optimal
price for the regular monopolist, pM , and corresponding quantity sold, QM ?

Solution Revenue of the monopolist is


 0 if Q > 1000
1 2
R(Q) = P (Q) · Q = 100Q − 10 Q if 100 6 Q < 1000 .

110Q − 51 Q2 if 0 6 Q < 100

The corresponding marginal revenue is


 0 if Q > 1000
1
MR(Q) = 100 − 5 Q if 100 < Q < 1000 .

110 − 52 Q if 0 6 Q < 100

Note, MR is not defined at Q = 100.

1
MC(Q) = Q.
20

ECON 511 2018 Exam III - Solutions Page 9 of 18

 Assume QM ∈ (100, 1000),

=⇒ MC(Q) = MR(Q)
1 1
⇐⇒ Q = 100 − Q
20 5
1
⇐⇒ Q = 100
4
⇐⇒ Q = 400 ∈ (100, 1000)X
=⇒ QM = 400
1
=⇒ pM = P (QM ) = 100 − · 400 = 60
10

(b) Suppose the firm perfectly (first-order) price discriminates, by proposing individu-
alized take-it-or-leave-it offers. What is the optimal quantity, Q1 , for the perfectly
price-discriminating monopolist?

Solution With perfect price discrimination the monopolist extracts all surplus from
the consumer. Therefore, MR(Q) = P (Q).

=⇒ MR(Q) = MC(Q)
1 1
⇐⇒ 100 − Q = Q
10 20
3
⇐⇒ 100 = Q
20
2000 2
⇐⇒ Q = = 666 ∈ (100, 1000)X
3 3
2
=⇒ Q1 = 666
3

(c) Suppose the firm uses a two-part tariff with individualized per-unit prices and lump-
sum fees to (second-order) price discriminate. What are the monopolist’s optimal
per-unit prices and lump-sum fees?

Solution The monopolist sets the same per-unit price for all consumers and uses
the lump-sum fee to extract surplus from the consumers. Therefore, MR(Q) = P (Q)
and the monopolist produces the surplus maximizing quantity.
2000
MR(Q) = MC(Q) ⇐⇒ Q =
3
(compare to part b)
 
2000 1 2000 300 − 200 100 1
=⇒ p = P
∗
= 100 − · = = = 33 ≈ 33.33.
3 10 3 3 3 3

The fee will differ for consumers of types A and B.

ECON 511 2018 Exam III - Solutions Page 10 of 18

 Without a fee, the surplus for a type-A consumer is
1
SRA = (pA (0) − p∗ ) · dA (p∗ )
2   
1 100 1 100
= 110 − · 55 − ·
2 3 2 3
 2
1 230 115 115
= · · = ≈ 1469.4
2 3 3 3
 2
115
=⇒ FA =
∗
is the optimal lump-sum fee for type-A consumers
3

Without a fee, the surplus for a type-B consumer is

1
CSB = (pB (0) − p∗ ) · dB (p∗ )
2   
1 100 1 100
= 90 − · 45 − ·
2 3 2 3
 2
1 170 135 − 50 85
= · · = ≈ 802.8
2 3 3 3
 2
85
=⇒ FB =
∗
is the optimal lump-sum fee for type-B consumers
3

(d) Suppose the monopolist splits the market into two segments, A and B (according to
consumer types), and (third-degree) price discriminates by setting different per-unit
prices, pA and pB , in segments A and B, respectively. What are the optimal prices
and corresponding quantities sold for each of the two market segments?

Solution Revenue in segment A is


0 if QA > 550
RA (QA ) = pA (QA ) · QA = 1 2 .
110QA − 5 QA if 0 6 QA < 550

0 if QA > 550
=⇒ MRA (QA ) = .
110 − 52 QA if 0 6 QA < 550
Revenue in segment B is

0 if QB > 450
RB (QB ) = pB (QB ) · QB = 1 2 .
90QB − 5 QB if 0 6 QB < 450

0 if QB > 450
=⇒ MRB (QA ) = .
90 − 52 QB if 0 6 QB < 450
At the monopolist’s optimal quantities Q∗A , Q∗B , we must have

• MRA (Q∗A ) = MRB (Q∗B ) = MC(Q∗A + Q∗B ) if there exists an interior solution
Q∗A > 0, Q∗B > 0

ECON 511 2018 Exam III - Solutions Page 11 of 18

 • MRi (Q∗i = 0) < MRj (Q∗j > 0) = MC(Q∗j ) at a corner solution with Q∗i =
0, Q∗j > 0.

If there exists an interior solution,


110 − 25 QA = 20 1
(QA + QB ) 2 2
2 1 =⇒ 20 + QB = QA ⇐⇒ 50 + QB = QA
90 − 5 QB = 20 (QA + QB ) 5 5

2 1 1 5 1
90 − QB = (QA + QB ) = (50 + QB + QB ) = + QB
5 20 20 2 10
175 1
⇐⇒ = QB
2 2
⇐⇒ Q∗B = 175 > 0
=⇒ Q∗A= 175 + 50 = 225 > 0
1
=⇒ PA∗ = PA (225) = 110 − · 225 = 110 − 45 = 65
5
1
PB∗ = PB (175) = 90 − · 175 = 90 − 35 = 55
5

(e) Based on your answers to questions (a) through (d) and your knowledge about each
of the four types of monopoly, rank the different types of monopoly both in terms
of deadweight loss (from smallest to largest) and producer’s surplus (from largest to
smallest). Explain. If a ranking is ambiguous, explain why.

Solution There is no DWL with perfect price discrimination or a 2-part tariff. The
monopolist extracts all surplus and therefore produces the surplus maximizing quantity.
The quantity produced in the other two types is too low. In this case, the total quanti-
ties in parts a and d coincide,QM = QA +QB so the DWL from this source is the same
for both kinds of monopoly.
However, in the segmented market consumers face two different prices. Therefore the
good is allocated inefficiently.
Altogether, DW L(d) > DW L(a) > DW L(b) = DW L(c) = 0, producer’s surplus is
the same for parts (b) and (c) and it is maximized there.
With the segmented market(d) the monopolist always does at least as well as in the
regular monopoly as he is free to choose identical prices in both segments.
P S(b) = P S(c) > P S(d) > P S(a)

ECON 511 2018 Exam III - Solutions Page 12 of 18

Exercise 5: Oligopoly
Consider a market with aggregate demand function

440 − 21 p for p 6 880
D(p) =
0 for p > 880
and two firms. The two firms differ in their cost functions.
The first firm’s cost function is
c1 (q1 ) = (q1 )2 for all q1 > 0
and the second firm’s cost function is
c2 (q2 ) = 2(q2 )2 for all q2 > 0,
where qi is the output of firm i ∈ {1, 2}.
(a) Suppose both firms act as price-takers. What is the short-run (without entry or exit,
i.e. only these two firms are in the market) equilibrium?

Solution Firm 1’s supply function is found from

1
MC1 (q1 ) = 2q1 = p ⇐⇒ q1 = p
2
1
=⇒ S1 (p) = p (∀p > 0)
2
Note that there is no avoidable fixed cost and MC1 (q1 ) = 2q1 > q1 = AC(q1 )∀q1 > 0.
Similarly, firm 2’s supply is
1
MC2 (q2 ) = 4q2 = p ⇐⇒ q2 = p
4
1
=⇒ S2 (p) = p (∀p > 0)
4

3
Aggregate supply is S(p) = S1 (p) + S2 (p) = p (∀p > 0)
4
=⇒ S(p) = D(p)
3 1
⇐⇒ p = 440 − p
4 2
5
⇐⇒ p = 440
4
4 1760
⇐⇒ p∗ = · 440 = = 352
5 5
3 3
=⇒ Q∗ = S(p∗ ) = p∗ = · 352 = 264
4 4
(b) Suppose the firms act as Cournot-Nash duopolists, that is, they simultaneously and
independently choose their output quantities once.
• Given q1 , what is firm 2’s best-response? Given q2 , what is firm 1’s best-
response?

ECON 511 2018 Exam III - Solutions Page 13 of 18

 Solution Inverse market demand is

D 880 − 2Q if Q < 440
P (Q) = .
0 otherwise
If q1 > 440, π2 < 0 ∀q2 > 0, firm 2’s profit is negative for any strictly positive
amount of output and it is optimal for firm 2 to shut down. Therefore, B2 (q1 ) = 0
if q1 > 440.
Given q1 ∈ [0, 440), firm 2’s profit from choosing q2 > 0 is

π2 (q1 , q2 ) = P D (q1 + q2 ) · q2 − C(q2 )

= (880 − 2(q1 + q2 )) q2 − 2(q2 )2
= (880 − 2q1 − 4q2 ) q2

The profit-maximizing quantity satisfies the first-order condition

∂π2 (q1 , q2 )
= 880 − 2q1 − 8q2 = 0
∂q2
1
⇐⇒ q2∗ = 110 − q1 > 0
4
∂ 2 π2 (q1 , q2 )
The second-order condition holds: = −8 < 0
∂q22
Therefore, firm 2’s best-response is
(
0 if q1 > 440
B2 (q1 ) = 1
110 − q1 if q1 < 440
4
Note that q1 + B2 (q1 ) = 110 + 43 q1 < 440 for all q1 < 440.
Similarly, for firm 1 profit from choosing q1 > 0 for given q2 is

π1 (q1 , q2 ) = P D (q1 + q2 ) · q1 − C(q1 )

= (880 − 2(q1 + q2 )) q1 − (q1 )2
= (880 − 3q1 − 2q2 ) q1

The profit-maximizing quantity satisfies the first-order condition

∂π1 (q1 , q2 )
= 880 − 6q1 − 2q2 = 0
∂q1
440 1
⇐⇒ q1∗ = − q2 > 0 if q2 < 440.
3 3
∂ 2 π1 (q1 , q2 )
The second-order condition holds: = −6 < 0 Note that q2 +B1 (q2 ) =
∂q12
440 2
+ q2 < 440 for all q2 < 440. Therefore, firm 1’s best-response is
3 3
(
0 if q2 > 440
B1 (q2 ) = 440 1
− q2 if q2 < 440
3 3
• What is the Nash equilibrium in outputs for this market?

ECON 511 2018 Exam III - Solutions Page 14 of 18

 Solution At any Nash equilibrium (q1∗ , q2∗ ), q1∗ = B1 (q2∗ ) and q2∗ = B2 (q1∗ ).
If q1 = 0

=⇒ q2 = B2 (0) = 110
440 110
=⇒ B1 (110) = − = 110 6= 0
3 3
If q2 = 0
440
=⇒ q1 = B1 (0) =
  3
440 1 440 2
=⇒ B2 = 110 − · = 110 6= 0
3 4 3 3

If one firm i ∈ {1, 2} chooses qi > 440, the other firm’s best-response is qj =
Bj (qi ) = 0. By the argument above, this cannot happen in equilibrium.
Thus, in any Nash Equilibrium qi ∈ (0, 440) for both firms i ∈ {1, 2} and

q1∗ = B1 (q2∗ ) = B1 (B2 (q1∗ ))

 
440 1 1 ∗
q1 =
∗
− 110 − q1
3 3 4
1
= 110 + q1∗
12
12
⇐⇒ q1∗ = · 110 = 120
11
=⇒ q2∗ = B2 (q1∗ )
1
= 110 − · 120
4
= 80

=⇒ the unique Nash Equilibrium is (q1∗ , q2∗ ) = (120, 80)

• What are the sources of deadweight loss at the equilibrium and what is the size
of the deadweight loss associated with each source? Explain.

Solution
(1) The quantity is too low. Total output is q1∗ + q2∗ = 120 + 80 = 200 < 264.
1
DW L1 = (pD (200) − pS (200)) · (264 − 200)
2 
1 800
= 480 − · 64
2 3
640 20480
= 32 · =
3 3
(2) Production is not efficiently allocated among firms. The efficient way of

ECON 511 2018 Exam III - Solutions Page 15 of 18

 producing 200 units of output is found using inverse market supply.
4 800
P S (200) = · 200 =
3   3
800 1 800 400
⇒ q1 = S1 = · = > 120
3 2 3 3
 
800 1 800 200
q2 = S2 = · = < 80
3 4 3 3
The deadweight loss is computed as the additional cost from producing too
much at firm 2 minus the cost savings from producing too little at firm 1.
     
220 400
DW L2 = C2 (80) − C2 − C1 − C1 (120)
3 3
 2 !  2
2 200 400
= 2 · (80) − − + (120)2
3 3
40000 160000
= 2 · 6400 − 2 − + 14400
9 9
240000
= 27200 −
9
48000 16000 1
= = = 5333
9 3 3
All consumers face the same price, therefore, the allocation of the good to
consumers is efficient. Not a source of deadweight loss here.
In total,
20480 16000 36480
DW L = DW L1 + DW L2 = + = = 12160.
3 3 3
(c) Suppose the firms move sequentially according to the Stackelberg leader-follower
model. That is, firm 1 chooses its output first. Firm 2 observes firm 1’s choice and
then chooses its own output conditional on its observation.
• What is the subgame perfect Nash equilibrium that can be found via Backward
Induction?

Solution After observing q1 , firm 2 will use the strategy found as its best-
response in part b.
(
0 if q1 > 440
q2 ∗ (q1 ) = 1
110 − q1 if q1 < 440
4
Firm 1 anticipates firm 2’s strategy and maximizes π1 (q1 , q2 ∗ (q1 )). π1 (q1 , q2 ∗ (q1 )) <
0 if q1 > 440. If q1 < 440 ⇒ q1 + q2∗ (q1 ) < 440.
π1 (q1 , q2 ∗ (q1 )) = P D (q1 + q2 ∗ (q1 )) · q1 − C(q1 )
  
1
= 880 − 2 q1 + 110 − q1 · q1 − (q1 )2
4
5
= 660q1 − (q1 )2
2

ECON 511 2018 Exam III - Solutions Page 16 of 18

 q1∗ ∈ (0, 440) must satisfy the first-order condition

∂π1 (q1 , q2 ∗ (q1 ))

= 660 − 5q1 = 0
∂q1
660
⇐⇒ q1∗ = = 132
5
∂ 2 π1 (q1 , q2 ∗ (q1 ))
The second-order condition holds: = −5 < 0.
∂q12
∗
The unique ( Nash Equilibrium is the strategy profile (q1 , q2 ) with q1 = 132 and
∗ ∗

0 if q1 > 440
q2 ∗ (q1 ) = 1 .
110 − q1 if q1 < 440
4
• What are the sources of deadweight loss at the Nash equilibrium? For each
source, what is the size of the loss? Explain.

Solution
(1) There is one price and the good is allocated to consumers efficiently =⇒
no source of DWL from the consumer side
(2) In equilibrium the firms produce q1 = 132 and q2 = 77 units. Total output
is Q = 132 + 77 = 209 < 264 = Q∗ (from part(a))
=⇒ The quantity traded is too low, this is a source of DWL
1
DW L1 = (pD (209) − pS (209))(264 − 209)
2
1 836
= (462 − ) · 55
2 3
1386 − 836
= · 55
6
1
= 550 · 55
6
5 15215
= (55)2 =
3 3
(3) The efficient way of producing 209 units of output can be identitfied via the
inverse market supply.
4 2
pS (209) = 209 = 279
 3 3
2 2
S1 279 = 139 > 132
3 3
 
2 2
S2 279 = 69 < 77
3 3

ECON 511 2018 Exam III - Solutions Page 17 of 18

 =⇒ The output is not allocated efficiently among producers.
 2 !  2 !
2 2
DW L2 = 2 772 − 69 − 139 − (132)2
3 3
| {z } | {z }
additional cost to 2 cost savings by 1
87362 175561
= 11858 − − + 17424
9 9
262923
= 29282 −
9
615 205
= =
9 3
15215 + 205
In total, DW L = DW L1 + DW L2 = = 5110.
3

ECON 511 2018 Exam III - Solutions Page 18 of 18