MICROECONOMICS II

PROBLEM SET IV: Oligopoly

EJERCISE 1
Firstly, recall the inverse demand function depends on the quantities produced by the 2
producers, such that:
2000 2
,
.
a) To do so, solve the problem of both producers. The general problem of any
producer i, is given by:
,
= 2000 2
80000 560
Take the first order condition with respect to and obtain:
2000 4
2
560 0
For i different than j. Isolate to obtain the reaction function of producer i.
0.5
360
Due to the fact that both producers are symmetric and we are taking into account
any producer, the reaction function of producer j is symmetric and is given by:
0.5
360
Now, plot both reaction functions. To do so, simply compute the points in which
the functions cross the axes:

b) To compute the Cournot equilibrium, we need to solve the system of equations

given by both reaction functions. The result is:
240
Now, if we introduce the Cournot equilibrium quantities in the profit function of
any producer, we obtain that:
= 2000 2 240 240 240 80000 560 240 35200
Then, each producer gets profits of: 35200.
Then, both producers obtain jointly 70400.
Finally, compute the consumer surplus as always. This is given by:
2000 1040 480
230400
2
Therefore, the CS plus profits plus fix costs are: TS=460800.
c) In case that both producers form a cartel and behave like a monopolist, its
problem would be:
= 2000 2
80000 560
Solving the basic problem of the monopoly, we get that
360 and
179200.
The consumer surplus is given by:

2000

1280 360
2

129600

Then, the consumer surplus plus profits plus fix costs are given by: TS=388800.
We see that the total surplus is higher under duopoly than monopoly. This is due
to the fact that duopoly produces a quantity closer to perfect competition,
increasing the consumer surplus. It is worthy to say that when computing the
total surplus we excluded fix costs. Due to the fact that fix costs in this problem
are high, if we take them into account, monopoly would yield a higher total
surplus, due that only one firm would support them. In the duopoly, each firm
pays them separately.

EXERCISE 2
a) The profit function of any politician i is given by:
,
= 300 3
150 2
Recall that in order to write the profit function we need firstly to get the inverse
demand function, which will depend on the quantity of both politicians (recall
exercise 1).
b) In order to get the reaction function of each politician, as in exercise 1, take the first
order condition with respect to , and isolate , such that:
298
0.5
6
As both politicians are symmetric, the reaction function of politician j is:
298
0.5
6
c) If politician B makes
A:

20, introducing this quantity in the reaction function of

298
39,667.
6
d) In order to get the equilibrium of Cournot, solve the system given by the 2 reaction
functions. We get that:
.
e) In order to compute the total surplus, firstly compute the profit of each politician:
0.5 20

300

150

3139

The sum of profits of both politicians is: 2*

6278
To compute the producer surplus, sum profits and add fix costs, such that:
EP=6278+300=6578.
Finally, compute as always the consumer surplus:
298
300 101.33
2
9
6578.2
2
where 101.33 is the price that consumers pay. Therefore, the total surplus is
6578.2 6578=13156.
f) The proposition is false. If we take the quantity q as the quantity of corruption
offered by politicians, more competition implies more corruption, since with more
competition we get closer to the situation of perfect competition, in which quantity
is higher. Less competition implies that the price that consumers of corruption pay

is more expensive, since less quantity of corruption is offered. Therefore, according

to this model, bipartidism offers less corruption than the systems with more political
parties.
EXERCISE 3
Firstly, notice that we know the AC. Recall that TC=ACq. Such that TC1=2
TC2=
a) This is a Cournot problem. The problem of firm 1 is:
= 10
,
2
Taking the first order condition with respect to
reaction function of firm 1 is:
8
2
The problem of firm 2 is:
= 10
,

and

and isolating, we get that the

Taking the first order condition with respect to and isolating, we get that the
reaction function of firm 2 is:
9
2
Solving the system of equations, we get that
7/3 y
10/3. Introducing
the quantities in the inverse demand function, we get that p=13/3. Finally, the
profit of each firm would be:
49/9 and
100/9. The profits of the
industry are 149/9.
b) This is a Stackelberg problem. Firm 1 is the follower; then, since we are solving
using
backward
induction,
the
best
reply
of
1
is:
8
2
Now, firm 2 maximizes its profit subject to the best reply of firm 1. Then, its
problem consist in maximizing:
= 10
,
8

2
Introducing the constraint in the objective function:
= 10
Maximize with respect to and obtain that
5. Introducing the quantity in
the best reply of 1, we get that
. Introducing the quantities in the inverse
demand function, we get that
. Finally, compute the profits as we did in the
9/4 and
12.5. Total
previous exercises for each firm, and get that
profit is 59/4.
We see that the profit of the leader increases with respect to the previous section,
while the profit of the follower decreases. The production in the industry
increases and therefore, price falls.
This increase in production and reduction of price improves the situation of firm
2 since it knows how firm 1 is going to react. The follower then, maximizes with
respect to the residual demand that firm 2 lefts.

c) If profits in the industry wants to be maximized, only firm 2 should produce, since it
is the most efficient. Then, the problem would consist in a monopoly for firm 2. The
problem would be:
= 10
Solving the problem of the monopoly as usual, we get that q= =4.5,
0.
Introducing the quantity in the inverse demand function, p=5.5. Finally, we can
compute the profits of the monopolist, that would be
4.5 .
This profits can be shared such that
49/9 and
12.5 . Then, both
firms (independently on the different scenarios of competition in quantities)
would get higher profits.
EXERCISE 4
a) This is a Cournot problem. Since both firms are symmetric, the problem of any
firm i is:
,
= 40
Taking the first order condition with respect to and isolating, we get that the
reaction function of firm i is:
40
4
Since both firms are symmetric, the reaction function for firm j is:
40
4
Solving the system of equations, we get that
8. Introducing quantities
in the inverse demand function, we get that p=24. Finally, the profit of each firm
is given by:
=
8 24 8
128
b) This is a Stackelberg problem. The firm TU is the follower, therefore, since we
solve using backward induction, we know that the best reply for TU is :
40
4
Now, YO maximizes its profit subject to the best reply of TU. Then, the problem
consists in maximizing:
= 40
40

4
Introduce the constraint in the objective function such that:
= 40
Maximize with respect to

and obtain that

in the best reply of TU, we get that

. Introducing the quantity

. Introducing the quantities in the

inverse demand function, we get that

. Finally, compute profits as we
128.57 and
have done in the previous exercises for each firm, and get
123.47.
c) Firstly, fixing the total production (Y), solve which share of the production
minimizes costs. That is:




Y/2. Now we can solve the problem
Solving the problem, we get that
assuming that there is a monopolist that produces Y. Its problem would be:
= 40
2
Solving the problem of the monopolist as always, obtain that: Y=40/3.
40/6 . Introducing the quantity in the inverse demand
Therefore,
function, p=80/3. Finally, we can compute the profit for each firm, which
corresponds to half of the profits obtained by the monopolist:
0.75 40/3 .
The following table shows a comparison among aggregate variables in the
different scenarios.
Y
P

Cournot
16
24
256

Stackelberg
16.429
23.571
249.04

Monopoly
13.3
26.6
266.67

We see that the monopoly offers a lower quantity at a higher price than the rest
of the scenarios, obtaining higher profits. This is due to the fact that in Cournot
there are 2 competing firms, producing more quantity at a lower price, and
getting closer to the situation of perfect competition.

EXERCISE 5
a) This is a Stackelberg problem. Call the leader firm l and the follower f. Solving
using backward induction, the problem of firm f is:
,
= 1
0.4
and equate to 0. Isolate as we
Take the first order condition with respect to
did in the previous exercises, and obtain that the reaction function of f is:
1
2
2
Graphically, the reaction function of firm f is:

Now, firm l maximizes its profits subject to the reaction function of firm f:
,
= 1
0.4

2
2
Solving the problem as we did in the previous exercises, we obtain that:
1
2 2
And introducing the quantity of the leader in the reaction function of f we get
that:
1 3
4
4
2
Now introduce both quantities in the inverse demand function in order to get the
price:
1
2
4 4
In order to know if firm l allows firm f to participate in the market, simply we
must check when profits of f are positive. They will be positive if:
(
)(
)>0.4
Which can be rewritten as:

>0.4
Then, if this condition is satisfied, firm f will participate in the market producing
a positive amount of the good. We see that the higher the marginal cost of the
leader is, the more likely that the follower participates is; while the higher the
marginal cost of f, the less likely that f participates is.
. Moreover, the residual demand is
b) Notice that in this case,
. The residual demand curve
given by
1
shows all possible combinations of quantity demanded of f and prices given an
offered quantity by l. In such a case, this quantity would be the one that l has
chosen to maximize profits. Graphically:

Firm f is maximizing its profits as a monopolist over the residual demand left by
l.
EXERCISE 6

a) Notice that the problem is exactly the same that the one done in the previous
0. Then, introducing the values of
exercise, with the exception that
the marginal cost in the production functions and inverse demand of exercise
5.a), we obtain that:
0.5,
0.25,
0.25.
We can compute profits of both firms as usual:

b) Firstly, obtain the best reply of firm f. This is given by:

1
2
Introduce the best reply in the profit function of firm f, and obtain the profits of
such a firm, which depend on the production of firm l.
= 1
Then, we see that the firm f will get negative profits when

. In

1 2 (simply, isolate the quantity of l

particular, it will happen when
in the previous inequality). In order to understand the result, suppose F=1/20.
Then, profits of f will be negative if
0.55279. Suppose that
0.6. As
you can see, firm f will not participate in the market since it has negative profits.
Computing the profits of firm l, we get that
1 0.6 0.6
0.19,
which is greater than the profits in the basic Stackelberg case with F=1/20,
which would be 0.075.
Moreover, firm l will not produce more than necessary to kick out firm f from
the market if F 1/16. This is due to the fact that firm f will have costs
sufficiently high so as to produce in the Stackelberg case. Then, the interval is
given by
, 1/16 for
1/2.
It does not happen in the basic Cournot due to the fact that firms take decisions
simultaneously, being not capable of ensuring the monopoly position due to the
lack of advantage of being the leader.

EJERCISE 7
a) In the Bertrand model, firms compete in prices and not quantities. Since both
firms are homogenous, the profit function of a representative firm i is given by:
Where the super index 1 and 2 denote the timing of the game. The profit for each
of the periods (for
1,2) is given by:
0

,j
,j
,j

The profit function of each period says: in case the price set by firm i is lower
than the one set by j, firm i gets a profit of its price minus its marginal cost. In
case both firms set the same price, both of them get a half of its price minus its
marginal cost. In case firm i sets a price higher than j, firm I gets 0 profits.
Recall that:
0

,j

,j
,j

That is, the demand of i is 0 if it sets a price higher than j. In case both firms set
the same price, they get the same demand, 0.5. In case firm i sets a lower price
than j, it gets the whole demand 1.
b) A vector of prices ( , ) such that

for
1,2, is the unique
Bertrand equilibrium. Proof.
1) Firstly, notice that this is a game with finite periods (2 periods). In this kind
of games, there is only a posible equilibrium for each period, and is the one
corresponding to the static game.
2) If
,
,
0 and
0. Firm j can improve profits setting

. Therefore
is not a Bertrand equilibrium.
3) If
,
,
0 and
0. Firm I can improve profits setting

. Therefore
is not a Bertrand equilibrium.
4) Then, in equilibrium

. Consider that

. Then,
,
,
0.5 and
,
,
.
But

. The same happens with firm j.

Therefore, since both firms have the same incentives in choosing a lower
price,,

is not an equilibrium.
5) Finally, consider that

. Then
,
,
0.5
and
,
,
0. This is a Bertand equilibrium since no
one has incentives to deviate. If a firm sets a higher price, it will get 0
profits. If a firm set a lower price, it will get negative profits.
c) The equilibrium would not vary in case there are more than 2 firms in the
industry. Notice that the profit function of each firm would become:
0

,j
,j
,j

The only change is in the case

, j , where the profit is shared among
the n firms that set the same price. Then, we can translate the results found in b,
omitting the proof. Then, the Bertran equilibria consist in the fact that at least 2
firms set the same price equal to the marginal cost and the rest set any price
comprised among the marginal cost and any higher price. Notice that no one has
incentives to deviate. On the one hand, firms that set the price equal to the
marginal cost have no incentives to deviate, since a higher price would yield 0
profits while a lower price would yield negative profits. On the other hand, for
the rest of the firms, moving to a price around the marginal cost and any higher
price would yield profits equal to 0 (the same that they get), while setting a price
lower than the marginal cost would yield losses.
EXERCISE 8
a) Firstly analyze that there is no equilibrium when n=3.Call the location of
bakery i in the interval [0,1]. Call the 3 bakeries i, j and k.
We analyze then, all possible cases.
1) Case
. This is not an equilibrium. Each of them would obtain
1/3 of the demand. There is more than 1/3 of the demand to the left or to the

right of the point where

profits deviating.

. Then, any bakery could obtain higher

2) Case
. This is not an equilibrium. There is more than 1/3 of the
and k would obtain the highest
demand to the left or to the right of
part of the demand deviating near i and j. Then, we approximate to case 1,
which is not an equilibrium.

3) Case
. This is not an equilibrium. Both i and k have incentives
to deviate towards j. We approximate to case 1, which is not an equilibrium.

o
. In the first case, k can increase its demand
4) Case
deviating to the left, while in the second case, i can increase its demand
deviating to the right. In both cases we approximate to case 1. Indeed, this cases
are generalizations of 2 and 3.
Then, none of the possible alternatives is an equilibrium.
=0.25 and
b) The only Hotelling equilibrium for n=4 consists in
=0.75, and all bakeries obtain a demand of 0.25. Notice that none of the
bakeries have incentives to deviate. Take bakery 1. If bakery 1 deviates to
0.25
(to the left), obtains a demand of 0.25
0.25. If it deviates
to
0.25
, being sufficiently small, obtains a demand of 0.25
0.25. Suppose that is sufficiently big, such that
0.40. It would get a
.
.
.
.
0.25 . The same would happen with close
demand of
values. Try with
0.5. In this case, the demand would be 0.25, and would be
the same that in the mentioned equilibrium, such that it does not have incentives
to deviate.
EXERCISE 9
a) The profit function is given by the following expression:
,
=
, for i .

b) Suppose n=2. The first order condition of the profit function with respect to
is:
0
Isolate and obtain that
1 for i=1,2. Then, we see that independently of
the quantity chosen by the rival firm, each firm is going to choose a quantity
equal to 1. The reaction functions are:

We see that the quantity chosen by each firm is independent on the quantity
chosen by the other firm.
c) For the general case, take the first order condition of the profit function and get
that:
0
Isolating, we get
1 for i=1n. Therefore, the total quantity produced is
.
. Introducing the equilibrium quantity in the price, we get that
Observe that as n increases, production increases and price falls. In the limit, the
production is infinite and price is 0.

EXERCISE 10
The Stackelberg leader will never obtain lower profits that in case it competes a
la Cournot. The possibility of being the leader in the competetition gives it
advantage, since its decision conditions the one of the follower. Then, the leader
behaves like a monopolist (of course, taking into account the reaction function of
the follower). The follower, will maximize its profits attending the residual
demand that the leader does not satisfy.
In Cournot, both firms compete simultaneously, eliminating any kind of
advantage for deciding first.
EXERCISE 11
The oligopoly does not yield an efficient level of production (perfect
competition). The case that yields the least efficient production is the monopoly,
in which only one firm decides production. This firm will produce a lower
quantity and will sell it at a higher price that the other market structures. In the
case of Cournot oligopoly, several firms compete among them with quantities,

which yields a higher production and a lower price than the monopoly. In the
oligopoly, firms get positive profits. However, the production in the oligopoly
keeps on being lower than in perfect competition. In such a case, the price will
be lower and firms get 0 profit.