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Unformatted text preview: Economics 467 Spring 2010 Karl Dunz Problem Set 3 Answers 1. Consider a market with an incumbent monopoly and one potential entrant. Suppose that the market demand curve is given by u1D443 = 100 u1D444 and the marginal cost of production is zero for both firms. The monopoly has a current capacity of production equal to 30 units and has the possibility of expanding that capacity to 40 at a cost of $400. The potential entrant has the choice between not entering the market, in which case its profits are zero, and entering the market with a capacity of 20 at a cost of $900. Suppose that the monopoly makes its decision about whether or not to expand its capacity before the potential entrant decides whether or not to enter and the monopolists decision is observed by the potential entrant. If entry occurs then the two firms play a Bertrand game with the appropriate capacity constraints. (a) If capacity is 30 then the monopoly will produce that amount, charge a price of $70 and have profits equal to $2100. If capacity was 40 then the monopoly would produce that amount at a price of $60 for a profit of $2400, excluding the cost of expanding capacity. Since expanding capacity costs $400, which is more than the increase in profits, the monopoly will not expand capacity if it remains a monopoly....
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