TUTORIALS - SOLUTIONS

Tutorial Problem Set 5

Problem 1
(a) The incumbent solves

max P (q)q C(q) = (130 q)q 10q

q

The first order condition is 120 2q = 0 and the monopoly quantity is q m = 60, the price
is pm = 70 and monopoly profits are

⇧m = (120 60)60 = 3600.

(b) Each firm i 2 {I, E} solves

max ⇧i = (130 qi qj 10)qi

qi

which yields as reaction function

120 qj
qi =
2
Solving for the symmetric equilibrium we get

qI = qE = 40

which yields a market price of pd = 50 and duopoly profits of

⇧d = (120 80)40 = 1600.

(c) In order to meet his debt repayment the entrant’s profits in period 1 need to satisfy

⇧E (qI , qE ) = (120 qI qE )qE D = 400

(120 qE )qE 400 + qI qE

(120 qE )qE 400

qI  = q̄I (qE )
qE

(d) If the entrant stays in the market in period 2, firms earn duopoly profits in period 2,
no matter what they do in period 1. Hence, in period 1, they maximise their short run
profits, that is they behave as in subquestion (b) above and produce qI = qE = 40. Their
equilibrium profits for the whole game are thus ⇧d + ⇧d . In this equilibrium the entrant
is able to cover D with his equilibrium profit of ⇧d = 1600 in period 1. The entrant has
no incentive to deviate as he operates on his best response function. The incumbent could

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 TUTORIALS - SOLUTIONS

deviate by increasing his quantity which lowers market price and profits of the entrant such
that the condition in c) is no longer satisfied. This requires
(120 40)40 400
qI > q̄I (qE = 40) = = 70.
40
Deviating from qI = 40 to qI = 70 gives the incumbent a period 1 profit of

⇧dev
I = (120 40 70)70 = 700

and induces E’s exit at the end of period 1. Hence, this equilibrium exists if there is no
incentive for I to predate or

⇧d + ⇧d ⇧dev
I + ⇧m

(⇧m ⇧d )  (⇧d ⇧dev

I )

⇧d ⇧dev
I 1600 700 9
 m d
= = = 0.45
⇧ ⇧ 3600 1600 20
The subgame perfect equilibrium holds if the weight of future profits is sufficiently low.
This is necessary to weaken the incentive to deviate and predate in order to get future
monopoly instead of duopoly profits.
(e) Taking the derivative of q̄I (qE ) with respect to qE yields

@ q̄I (qE ) (120 2qE ) (120 qE )qE + 400 400 qE2 400
= = 2
= 2 1
@qE (qE )2 qE qE
and also check the second order condition for a maximum which is
@ q̄I (qE ) 800
= < 0.
@qE qE3

Hence the maximiser solves 400

2
qE
= 1 which gives

qE = 20.

and
(120
20)20 400
q̄I (qE = 20) = = 80.
20
The incumbent needs to sell at least 80 units to make sure that the best response of E is
not enough to guarantee a profit of 400. This means the incumbent makes period 1 profits
of
⇧pred
I = (120 80 20)80 = 1600

and total profits of ⇧pred

I + ⇧m . The optimal deviation for I given E produces qE = 20 is
to produce less and allow E sufficient profits to stay in the market. Using the best response

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function we can calculate the deviation quantity as (120 20)/2 = 50 which gives period
1 profits of
⇧dev
I = (120 50 20)50 = 2500.

Thus, this SPE exists if

⇧pred
I + ⇧m ⇧dev
I + ⇧d

(⇧m ⇧d ) (⇧dev
I ⇧pred
I )

⇧dev
I ⇧pred
I 2500 1600 9
m d
= = = 0.45
⇧ ⇧ 3600 1600 20
I has more incentives to predate if the future gain is higher. Therefore, this SPE exists if
the weight of future profits, , is sufficiently high.
(f) The Areeda-Turner test presumes unlawful any price below short run MC or AVC (if
short-run MC not available). In our example the MC is 10. The period 1 market price in
the equilibrium in e) is
ppred = 130 80 20 = 30.

Hence, the Areeda-Turner test would not pick up predation in this example and consider
the low prices as competitive.
(g) Consumer surplus is
1
CS(p) = (130 p)2 .
2
Consumer surplus in the competition equilibrium of d) is lower since

CS(pd = 50)+CS(pd = 50) = 6400 < CS(ppred = 30)+CS(pm = 70) = 5000+1800 = 6800.

With equal weights for current and future payoffs, the predation equilibrium in e) creates
more consumer surplus. The low prices during predation more than compensate for the
increase in market power in the future. Obviously, this conclusion hinges on the parameter
which captures the expected length of the price predation and the recoupment period.

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