Industrial Organization

ECNS 406
Fall 2015

Homework #: 5

Due by the beginning of class on: Thursday October 22, 2015

Name:

Instructions:
There are 4 questions worth a total of 100 points. Answer each question clearly and
concisely. You must show your work to receive credit. You are allowed to work with others,
but all work must be your own.
Clearly print your name above and in the space provided on the next page. You must
turn in both sides of this cover sheet along with your responses. You do not need to turn
in the questions, only your responses with the cover sheet. All pages must be stapled to be
graded.
ECNS 406 Homework #: 5 Due: 10/22/2015

Product Differentiation
1. Consider a linear city Hotelling model. There are two firms, A and B, located at the (30)
ends of the product space. The length of the product space is 3 and transportation costs
are 1 times the distance traveled. Each consumer has a baseline valuation of 9 and each
firm has a constant marginal cost of 4. The indirect utility function for each consumer
is uA (x) = 9 − pA − 1(x) and uB (x) = 9 − pB − 1(3 − x) depending on whether you buy
from firm A or firm B. Answer the following questions for the competitive equilibrium
if it exists.
(a) What is each firm’s best response function?

Solution: Start with the consumer’s utility maximization problem. uA (x) and
uB (x) are defined above. A consumer located at x in the preference space buys
from whatever firm provides greater utility.
Now think about the indifferent consumer(s). For a competitive equilibrium,
the indifferent consumer is located at x and is indifferent to buying from A or
B where

uA (x) = uB (x)
9 − pA − 1(x) = 9 − pB − 1(3 − x)
2x = pB − pA + 3
(pB − pA ) 3
x= +
2 2

If firm A is a local monopolist, then the relevant indifferent consumer is located

at y and is indifferent to buying from firm A or not buying at all where

uA (y) = 0
9 − pA − 1(y) = 0
y = 9 − pA

If firm B is a local monopolist, then the relevant indifferent consumer is located

at z and is indifferent to buying from firm B or not buying at all where

uB (z) = 0
9 − pB − 1(3 − z) = 0
z = pB − 6

With the indifferent consumers we define the demand for each firm. The demand
each firm faces depends on whether their at a competitive equilibrium or their
a local monopolist. Firm A is a local monopolist if x > y and at a competitive
equilibrium if x < y. Firm B is a local monopolist if x < z and at a competitive

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ECNS 406 Homework #: 5 Due: 10/22/2015

equilibrium if x > z. We reduce each of these conditions as follows.

x<y for firm A to be in a competitive equilibrium

(pB − pA ) 3
+ < 9 − pA substitute in the values of x and y
2 2
pB − pA + 3 < 18 − 2pA multiply by 2
pA < 15 − pB by rearranging
x>z for firm B to be in a competitive equilibrium
(pB − pA ) 3
+ > pB − 6 substitute in the values of x and z
2 2
pB − pA + 3 > 2pB − 12 multiply by 2
pB < 15 − pA by rearranging

Each firm’s demand is defined piecewise as follows based on whether their in

a competitive equilibrium or have a local monopoly (We could also add the
cases where demand is zero or where the firm operates at a touching/kinked
equilibrium.).
(
(pB −pA ) 3
2
+ 2
if pA < 15 − pB
qA =
9 − pA if pA > 15 − pB
(  
3 − (pB −p
2
A)
+ 23 if pB < 15 − pA
qB =
3 − (pB − 6) if pB > 15 − pA

Each firm’s profits are πi = pi qi − 4qi = (pi − 4)qi for i = {A, B} and after
substitution and rearranging we get the following.
(  
(pB −pA ) 3
(pA − 4) 2
+2 if pA < 15 − pB
πA =
(pA − 4) (9 − pA ) if pA > 15 − pB
(  
(pB − 4) (pA −p2
B)
+ 32 if pB < 15 − pA
πB =
(pB − 4) (9 − pB ) if pB > 15 − pA

Each firm chooses their price to maximize profits. The first order conditions are
as follows.
(   
(pB −pA ) 3 (pA −4)
dπA 2
+ 2
− 2
if pA < 15 − pB
=
dpA (9 − pA ) − (pA − 4) if pA > 15 − pB
(   
(pA −pB ) 3 (pB −4)
dπB 2
+ 2
− 2
if pB < 15 − pA
=
dpB (9 − pB ) − (pB − 4) if pB > 15 − pA

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ECNS 406 Homework #: 5 Due: 10/22/2015

dπi
Setting dpi
= 0 and solving for that price we get the following. For firm A:
   
(pB − pA ) 3 (pA − 4)
0= + − if pA < 15 − pB
2 2 2
pB 7
pA = + if pA < 15 − pB
2 2
0 = (9 − pA ) − (pA − 4) if pA > 15 − pB
13
pA = if pA > 15 − pB
2
For firm B:
   
(pA − pB ) 3 (pB − 4)
0= + − if pB < 15 − pA
2 2 2
pA 7
pB = + if pB < 15 − pA
2 2
0 = (9 − pB ) − (pB − 4) if pB > 15 − pA
13
pB = if pB > 15 − pA
2
These are the firms best response functions.
(
pB
+ 27 if pB < 15 − pA
pA = 132
2
if pA > 15 − pB
(
pA
+ 72 if pA < 15 − pB
pB = 132
2
if pB > 15 − pA

(b) Are the two goods strategic complements or strategic substitutes?

Solution: The two goods are strategic complements if pB + pA < 15 and they
are neither strategic complements or strategic substitutes if pB + pA > 15. This
is because both firms have a local monopoly and are not in direct competition
with each other.

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ECNS 406 Homework #: 5 Due: 10/22/2015

(c) What are the equilibrium prices and quantities?

Solution: The equilibrium will be a symmetric equilibrium. Imposing the sym-

metric equilibrium conditions of pA = pB = p∗ we get the following.
( ∗
p
+ 27 if p∗ < 15
p∗ = 13 2
∗
2
15
2
if p > 2
(
3
if p∗ < 15
q∗ = 2 ∗ ∗
2
15
9−p if p > 2

Solving for p∗ and substituting in p∗ to the above equations yields the following.
(
7 if 7 < 15
p∗ = 13 13
2
15
2
if 2
> 2
(
3
if 7 < 15
q ∗ = 25 13
2
15
2
if 2
> 2

Examining the conditions show that it must be that p∗ = 7 and q ∗ = 23 .

(d) Find the profits of each firm and represent profits graphically in the preference
space.

Solution: Each firm’s profits are (p∗ − 4) 3

= 29 .


2

(e) Find the consumer surplus and represent this measure graphically in the preference
space.

Solution: 3
3
x2 2
Z 
2 15
CS = 2 (9 − 7 − x)dx = 2 2x − =
0 2 0 4

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ECNS 406 Homework #: 5 Due: 10/22/2015

2. How do profits change as the length of the product space increases for any horizontal (10)
product differentiation model? This includes both the Hotelling linear city model and
the Salop circle model.

Solution: From a competitive equilibrium, Firm profits increase as the length of the
product space increases. As the length of the product space increases the equilibrium
changes from a competitive one, to a touching equilibrium, and finally to a local
monopoly equilibrium. Firm profits increase until a local monopoly equilibrium is
achieved and then firm profits do not change as the length of the product space
increases.

3. Consider a Salop circular model of product differentiation with one firm. The circum- (30)
ference of the circle is 6. Each consumer has transportation costs of 1 times the distance
traveled and a baseline valuation of 9. The firm has a constant marginal cost of 4. The
indirect utility function for each consumer is uA (x) = 9 − pA − 1(x).
(a) Find the equilibrium price and quantity.

Solution: The monopolist will either sell to the entire market or to part of
the market. If the monopolist sells to the entire market, the firm wants to set
the price as high as possible such that the consumer located the farthest away
(x = 3) will still buy. uA (x = 3) = 9 − pA − 3 and the highest price the firm
can charge and sell to the entire market is pA = 6. Consider this a minimum
price because whether or not the firm sold to the entire market or part of the
market, the firm would never want to set a lower price.
Now if the monopolist sells to part of the market, there is an indifferent consumer
indifferent to buying from firm a and not buying at all. Set uA (x) = 0 to find
that indifferent consumer and solving for x gives x = 9 − pA . The monopolist
faces demand from both sides of the market so qA = 18 − 2pA . Firm A’s profits
are as follows.

πA = (pA − 4)(18 − 2pA )

dπA
= 18 − 2pA − 2(pA − 4)
dpA
13 dπA
pA = after setting =0
2 dpA
13 13
Since pA = 2
> 6, the firm will charge a price of 2
. qA = 18−2pA = 18−13 = 5.

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ECNS 406 Homework #: 5 Due: 10/22/2015

(b) Find the profits of the firm and represent profits graphically in the preference space.

Solution: Profits are given above by the following equation. πA = (pA −4)(18−
2pA ) = ( 13
2
− 4)(18 − 13) = 25
2
.

(c) Find the consumer surplus and represent this measure graphically in the preference
space.

Solution:
Z 5
2 13
CS = 2 (9 − − x)dx
0 2
 5
2 2
5 x
=2 x−
2 2 0
 
25 25
=2 =
8 4

(d) How does this model compare to the Hotelling model?

Solution: Note that there are twice as many consumers here as the length of
the product space is 6 instead of 3, but there is only one firm instead of two.
With the monopoly circle model, the price is lower, quantity is higher profits
are higher and consumer welfare is greater than the Hotelling duopoly.

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ECNS 406 Homework #: 5 Due: 10/22/2015

4. Consider a Salop circular model of product differentiation with two equally spaced firms. (30)
The circumference of the circle is 6. Each consumer has transportation costs of 1 times
the distance traveled and a baseline valuation of 9. Both firms have a constant marginal
cost of 4. The indirect utility function for each consumer is uA (x) = 9 − pA − 1(x) and
uB (x) = 9 − pB − 1 (3 − x) depending on whether you buy from firm A or firm B. Answer
the following questions for the competitive equilibrium if it exists.
(a) What is each firm’s best response function?

Solution: As discussed in class there are three possible types of equilibrium:

competitive, touching, or local monopoly. The local monopoly case (with one
firm) was explored in the question above. The outcome had each firm (there was
only one) supplying over half of the market. With two firms the local monopoly
outcome is not an equilibrium because both firms can’t supply over half the
market each. Thus, we can rule out the possibility of a local monopoly.
To determine the competitive and touching outcome, we start by finding the
locations of the indifferent consumers. First there is the consumer located at x
who is indifferent from buying from firm A or from firm B. Set uA (x) = uB (x)
and solve for x to get the location of the indifferent consumer.

uA (x) = uB (x)
9 − pA − x = 9 − pB − (3 − x)
2x = pB − pA + 3
pB − pA 3
x= +
2 2
Next, there’s the indifferent consumer located at y who is indifferent to pur-
chasing from firm A and not purchasing at all.

uA (y) = 0
9 − pA − 1(y) = 0
y = 9 − pA

Finally, there’s the indifferent consumer located at z who is indifferent to pur-

chasing from firm B and not purchasing at all.

uB (z) = 0
9 − pB − 1 (3 − z) = 0
z = pB − 6

With the indifferent consumers we define the demand for each firm. The demand
each firm faces depends on whether their at a competitive equilibrium or the
touching equilibrium. Firm A is at a competitive equilibrium if x < y and a
touching equilibrium if x = y. Firm B is at a competitive equilibrium if x > z

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ECNS 406 Homework #: 5 Due: 10/22/2015

and a touching equilibrium if x = z. We reduce each of these conditions as

follows.

x<y for firm A to be in a competitive equilibrium

(pB − pA ) 3
+ < 9 − pA substitute in the values of x and y
2 2
pB − pA + 3 < 18 − 2pA multiply by 2
pA < 15 − pB by rearranging
x>z for firm B to be in a competitive equilibrium
(pB − pA ) 3
+ > pB − 6 substitute in the values of x and z
2 2
pB − pA + 3 > 2pB − 12 multiply by 2
pB < 15 − pA by rearranging

For a touching equilibrium, the relevant conditions are as follows.

x=y
pA = 15 − pB from above
x=z
pB = 15 − pA from above

Note that these are best response functions for the touching equilibrium.
Now just focus on the potential competitive equilibrium. Throughout this part
we assume that pA + pB < 15 as required for a competitive equilibrium. Firm
A’s demand comes from both sides of the circle, so qA = 2x = pB − pA + 3. Firm
A’s profits are πA = (pA − 4)(pB − pA + 3). For Firm B, we get qB = 2(3 − x) =
pA − pB + 3. Firm B’s profits are πB = (pB − 4)(pA − pB + 3). Differentiating
profits with respect to that firm’s price we get

dπA
= pB − pA + 3 − (pA − 4)
dpA
dπB
= pA − pB + 3 − (pB − 4)
dpB

Setting each first order condition equal to zero and solving for that firms price
gives best response functions of

pB 7
pA = +
2 2
pA 7
pB = +
2 2

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ECNS 406 Homework #: 5 Due: 10/22/2015

Combining both best response functions we get the following.

(
pB
+ 72 if pA + pB < 15
pA = 2
15 − pB if pA + pB = 15
(
pA
+ 72 if pA + pB < 15
pB = 2
15 − pA if pA + pB = 15

(b) Are the two goods strategic substitutes or strategic complements?

Solution: For a competitive equilibrium, the two goods are strategic comple-
ments. For a touching equilibrium, the two goods are strategic substitutes.

(c) Find the equilibrium prices and quantities.

Solution: We could either impose symmetry conditions of pA = pB = p∗ or

substitute pB into the equation for pA . Either way, we get the following prices.
(
∗ 7 if p∗ < 152
p = 15 ∗ 15
2
if p = 2
(
15
7 if 7 < 2
p∗ = 15
2
if 15
2
= 15
2

It must be that p∗ = 7, q ∗ = 3 and we have a competitive equilibrium (read

below to find out why).
Why a competitive equilibrium and not a touching equilibrium? Both seem
to satisfy the conditions above. Note that if both firms choose the touching
equilibrium price of 15
2
, they would split the market and their profits would be
higher than under the competitive equilibrium. To figure out which price is
relevant, construct a 2x2 strategic form game where each firm can either choose
a price of 7 or a price of 15
2
. The payoffs are the firms’ profits. You’ll find that
a price of 7 is a best response and that when both firms charge a price of 15 2
,
each firm has an incentive to deviate from that price. This is another example
of the prisoner’s dilemma from the perspective of the firms.

(d) Find the profits of each firm and represent profits graphically in the preference
space.

Solution: Firm profits are πi = (p∗ − 4) (3) = (7 − 4) (3) = 9

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(e) Find the consumer surplus and represent this measure graphically in the preference
space.

Solution: Consumer surplus is as follows.

Z 3
2
CS = 4 (9 − 7 − x) dx
0
 23
x2

CS = 4 2x −
2 0
 
9
CS = 4 3 −
8
15
CS =
2

(f) How does this model compare to the Hotelling model?

Solution: In this version of the circle model, there are twice as many consumers
as in the Hotelling model (length of 6 compared to 3). The prices are the same,
but everything else is doubled in the circle model. Each firm produces more in
the circle model, firm profits are higher and consumer welfare is greater.

(g) How does this model compare to the monopoly version of the Salop circular model?

Solution: The price is higher - 7 versus 6.5 and each firm produces less - 3
versus 5. As expected, firm profits are lower - 9 compared to 25/2, and consumer
welfare is higher - 15/2 compared to 25/4.

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