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Why would the second half of problem 3 (What is IC's optimal level of investment?) found on page 2 be equal to 1.

I am getting the result of 2/3 (two-thirds).



Econ 444 (Corporate Economics), Fall 2017 Problem Set #3
Due in class Wednesday, October 11 Problem 1. Bill’s is the only booth selling used records at the Coachella music festival.
As the monopoly seller of used records at the festival, Bill earns $700 in profit. This year,
Ted is considering setting up a competing booth at the festival. It would cost him $150
do so. However, Bill tells Ted that if he set up a booth, he would face a record price war.
After some research, Ted learns that if Bill follows through on his threat Bill would earn
$100 in profit while he himself would earn $25 (before accounting for the $100 set up cost).
Nevertheless, if Bill does not start a record price war, he would earn $300 while Ted would
earn $120.
1. Draw this game in extensive form. Be sure to fully label the game tree.
Stay out
(0,700) B
(-125,100) (-30,300) 2. What is the subgame perfect equilibrium outcome?
Solution. In the subgame starting from Bill, Bill will accommodate. Suppose that
Bill accommodates, in the original game, Ted will stay out. Therefore the SPNE is
(Stay out, Accommodate if Enter). The outcome is that Ted stay out of the market,
so that Ted gets $0 and Bill gets $700. Econ 444: Problem Set #3 2 3. Would you advise Ted to set up his booth?
Solution. Observe that If Ted enters the market, Bill will accommodate and Ted earns
$-30.It is not profitable for him to do so due to the very high entry cost. He would be
advised to stay home.
4. Doing some more research, Ted learns that his setup cost will actually be $75, not
$150. How would your advice to Ted change given these lower costs?
Solution. Once Ted enters the market, Bill will accommodate, which gives Ted a
payoff of 45, even though he has threatened to start to a record price war. The new
SPNE is (Enter, Accommodate if Enter). Therefore, Ted would be advised to enter
due to the lower entry cost. Problem 2. Suppose Incumbent Coal (IC) invests in capital equipment KIC to mine coal.
Once IC makes its capital investment decision, it is committed to a certain level of production.
A potential entrant, Entrant Coal (EC), observes KIC and chooses how much capital KEC
it would like to invest in, which subsequently commits EC to a set level of production as
well. No other firms can enter the market. Each firm’s total revenue, in millions of dollars,
accruing from its respective capital investment is given by
T RIC = (4 − KIC − KEC )KIC T REC = (4 − KEC − KIC )KEC and the total cost of capital, in millions of dollars, for each firm is
T CIC = 2KIC T CEC = 2KEC 1. Write down the profit function for EC. What is EC maximizing over?
Solution. Given KIC , EC’s problem:
max(4 − KEC − KIC )KEC − 2KEC
KEC 2. Suppose IC’s level of capital investment is KIC . What EC’s is optimal level of capital
expenditure given IC’s choice? Econ 444: Problem Set #3 3 Solution. Take the first order condition of EC’s problem with respect to KEC to get

(KIC ) = 2 − KIC
2 3. Write down IC’s profit function. What is IC’s optimal level of investment?

Solution. Given KEC
(KIC ) = 2−KIC
2 IC’s problem: ∗
max(4 − KEC
(KIC ) − KIC )KIC − 2KIC
KIC Take the first order condition of IC’s problem with respect to KIC to get

KIC 4. Characterize the Subgame Perfect Nash Equilibrium (SPNE) strategy profile in market? What is the equilibrium level of investment in the market?

Solution. Given KIC
= 1, KEC
)= ∗
2 = 12 . Hence, the SPNE strategy profile ∗

(KIC )}, that is, {1, 2−K
is {KIC
}. The equilibrium total level of investment in
2 the market is K ∗ = 1 + 1
2 = 32 . 5. Calculate each firm’s equilibrium profit. Does this market exhibit a first or second
mover advantage?
Solution. In terms of IC:

πIC = (4 − KEC
− 2KIC
= $ M illion
In terms of EC:

πEC = (4 − KEC
− 2KEC
= $ M illion
Note πIC > πEC , so there exists a first mover advantage.
6. Suppose now that IC can easily adjust its level of capital at any moment (e.g. it is not
committed to its investment ex-post). How would this effect equilibrium firm profits? Econ 444: Problem Set #3 4 Solution. If IC cannot commit to its investment ex-post, then this become a simultaneous game where EC’s best response function is
KEC (KIC ) = 2 − KIC
2 and IC’s best response function is
KIC (KEC ) = 2 − KEC
2 Solve these two equations simultaneously to get equilibrium output such as

= 2
3 and individual firm’s equilibrium profits as

= πIC
= 4− 2
2 2 2
− ) − 2 · = $ M illion
3 3 3
9 Hence, EC’s profit increases; while IC’s profit decreases.
7. How much would the incumbent IC be willing to pay for the ability to commit to a
level of capital. In other words, what is the value of commitment?
Solution. The value of commitment is the difference of profits with and without the
first mover’s advantage, that is,
1 4
− = $ M illion
2 9
Problem 3. Suppose there are two stores in state college that sell Windbreakers and compete on prices. University Windbreakers (UW) is located on the corner of College and
University. Atherton Windbreakers (AW) is located on the corner of College and Atherton.
The street is 1 mile long. Both stores buy their merchandise from the same distributor,
so their marginal cost for windbreakers is $10 a piece. However, there is one strange thing
about State College. The wind always blows to the East. That means it is easier for the
town’s 100 customers, who are uniformly located along the street, to walk in that direction.
As a result, a customer located at point x along the street receives the following utility when
purchasing from UW and UA, respectively
ux,U W = V − PU W − 2x
ux,AW = V − PAW − 8(1 − x)
where V = $100. Econ 444: Problem Set #3 5 1. At what point x along the street are customers indifferent between purchasing from
UW or AW given prices PU W and PAW ?
Solution. Solve
V − PU W − 2x∗ = V − PAW − 8(1 − x∗ )
to get
x∗ = 
8 + PAW − PU W
10 2. What is each firm’s demand function?
DU W = x∗ · 100 = 80 + 10PAW − 10PU W
DAW = (1 − x∗ ) · 100 = 20 + 10PU W − 10PAW
3. Write down each firm’s profit function. What is each firm maximizing over?
Solution. In terms of UW,
max DU W · (PU W − 10)
PU W equivalently,

max 80 + 10PAW − 10PU W · (PU W − 10)
PU W In terms of AW,
max DAW · (PAW − 10)
PAW equivalently,

max 20 + 10PU W − 10PAW · (PAW − 10)
PAW 4. Write down each firm’s best response function. How does each firm’s optimal price
respond to a rise in its rival’s price? Are prices strategic complements or substitutes
in this case?
Solution. Take the first order condition of UW’s profit-maximization problem with
respect to PU W to get UW’s best response function:
PU W = 18 + PAW
2 Econ 444: Problem Set #3 6 Similarly, take the first order condition of AW’s profit-maximization problem with
respect to PAW to get AW’s best response function:
PAW = 12 + PU W
2 Hence, prices are strategic complements since a firm’s price is increasing in its rival’s
5. Characterize the equilibrium strategy profile in this market. What are the equilibrium
prices? Which firm sets a higher price?
Solution. Solving two best response functions together to find the equilibrium strategy
profits, that is,

{PU∗ W , PAW
} = {16, 14} So UW sets a higher price in the equilibrium.
6. Write down each firm’s equilibrium profits and market shares. How would these change
if customers found it equally costly to travel in each direction (e.g. if the wind no longer
blew only to the east)?

Solution. Given {PU∗ W , PAW
} = {16, 14}, we could solve equilibrium output and prof∗
its such that DU∗ W = 60 and DAW
= 40, that is, the market share of UW is 60% and

= 160.
the market share of AW is 40%. Besides, πU∗ W = 360 and πAW If consumers find it equally costly to travel in each direction, then two firms should
split the market equally. As a result, the profit and market shares of UW decrease;
while the profit and market share of AW increase instead.
7. Calculate consumer’s surplus in this market. How does it compare to the competitive
case? Can you say something about dead weight loss in this model?
CS H = 100 · (82.8 + (84 − 82.8) · 0.6 + (86 − 82.8) · 0.4) = $8380
In a competitive equilibrium, PU W = PAW = 10. At these prices, market shares are then
x∗ = 0.8 1 − x∗ = 0.2 Econ 444: Problem Set #3 7 consumer surplus is now higher at
CS C = 100 · (88.4 + (90 − 88.4) · 0.8 + (90 − 88.4) · 0.2) = $8920
and firm profits are zero. Dead weight loss is then the difference in total surplus between
the competitive case and the duopoly case. We can write that as
DW L = CS C − CS H − ΠH = 8920 − 8380 − 520 = $20
So in this case, the DWL is a small relative to consumer surplus, or even firm profits. In
other words, the market is quite close to efficient.
Problem 4. Two ice cream shop owners, IScream Left (IL) and IScream Right (IR) are
considering setting up ice cream stands along the Ocean City board walk, which is exactly
one mile long. To do so, they need to make two decisions: (1) Where do they want to
locate their stands along the boardwalk (2) How much do they want to charge for an ice
cream. They know that there are 1,000 potential customers uniformly distributed along the
boardwalk and that each will buy at most one ice cream. They also know that the utility
a customer located at point 0 ≤ x ≤ 1 along the boardwalk gets when she buys ice cream
from IL or IR, respectively, is
ux,IL = V − pIL − t(a − x)2
ux,IR = V − pIR − t(1 − a − x)2
where a and 1 − a are the respective locations of IL and IR along the boardwalk (assume
0 ≤ a ≤ 21 ). (Note this means that we are forcing IL and IR to locate symmetrically along
the boardwalk. This is a simplification. The assumption that a ≤ 1
2 is without loss of generality.) Let V = 110 and t = 2, and suppose both IL and IR face a unit cost of c = $2
for each ice cream.
1. Suppose IL locates at a and sells at price pIL while IR locates at 1 − a and sells at
price pIR . What is the location x of a consumer that is indifferent between buying
from either stand?
Solution. The indifferent consumer is one that has an equal utility of buying from
either stand (ux,IL = ux,IR ). Write
V − pIL − t(a − x)2 = V − pIR − t(1 − a − x)2 Econ 444: Problem Set #3 8
x∗ = pIR − pIL
2(1 − 2a)t 2 2. At these prices and locations, what is the demand for each stand?
Solution. At these prices and locations, all consumers to the left of x∗ buy from IL,
and all consumers to the right of x∗ buy from IR. Then
p −p
p − p
DIL = x∗ · N =
· N = 1000
2(1 − 2a)t 2
4(1 − 2a) 2
p − p
p −p
· N = 1000
DIR = (1 − x∗ ) · N =
2(1 − 2a)t 2
4(1 − 2a) 2
3. If IL and IR locate at a and 1 − a, respectively, and IR sets its price at pIR , what
should IL charge for Ice cream?
Solution. IL’s optimal price conditional on IR’s price, and each stand’s location, is
determined by IL’s best response function. To find IL’s best response function, we first
maximize IL’s profit with respect to price, holding constant its rival’s price and both
stands’ locations.
max πIL = maxpIL (pIL − c)DIL
pIL IL’s first order condition is then
pIR − 2pIL + c 1
+ =0
(1 − 2a)2t
and its best response function (solving for pIL ) is then
pIL = 1
· (pIR + c + (1 − 2a)t) = · (pIR + 2 + 2(1 − 2a))
2 4. Similarly, what is IL’s optimal price if IR sets its price at pIR ?
Solution. Just like IL, IR will also be maximizing its profit with respect to its own
price. Solving IR’s problem
max (pIR − c)DIR
pIR we get that
pIR = 1
· (pIL + c + (1 − 2a)t) = · (pIL + 2 + 2(1 − 2a))
2 Econ 444: Problem Set #3 9 5. Holding their locations on the boardwalk fixed at a and 1 − a, respectively, what is the
equilibrium price of ice cream?
Solution. In any equilibrium, both firms best response conditions must be satisfied.
To find the pair of prices for which this is true, we must solve this two equations
system. We do this by substituting one best response function into the other. When
we do this we get that
pIL = pIR = c + (1 − 2a)t = 2 + 2(1 − 2a)
Alternatively, note that in this case, because we assume symmetry in both costs and
location, both stands’ best response functions are identical. When this is true, there
will be a symmetric solution and both stands will set the same price. When we do
this, we can simplify the problem by solving just one equation:
p = (p + c + (1 − 2a)t) ⇒ pIL = pIR = c + (1 − 2a)t = 2 + 2(1 − 2a)
6. Given your solution from above, where on the board walk would IL and IR set up their
Solution. We now know what the price of ice cream in the market for each 0 ≤ a ≤ 1
2 . Now we have to solve for the locations a, 1 − a that maximize both firms’ profits. Note
that, in contrast to the pricing problem above, IL and IR now choose their location a
to maximize profit. Let’s start with IL’s problem:
max πIL = (pIL − c)DIL = (c + (1 − 2a)t − c)500 = (c + 2(1 − 2a) − c)500
a We know that at each a the price of ice cream will be the same at both stands.
Consequently, each stand will collect one half of the demand.
Observe that as a increase, IL moves toward the center of the boardwalk, IL’s profit
decreases. Consequently, it is optimal for IL to set a = 0. This is also true for IR
(try it!). Consequently, IL and IR will set up their stands at opposite ends of the
boardwalk, as far apart as possible.
Importantly, this is a dominant strategy. Regardless of IR’s location, IL will always
locate at the far end of the boardwalk a = 0, and vice versa. As a result, this is a Nash
Equilibrium. Econ 444: Problem Set #3 10 7. How much ice cream does each stand sell? How much does each stand make in profit?
Solution. We know from above that each stand will sell 500 units - half the total
demand. We also know that each shop will locate its stand at each respective edge of
the boardwalk. AT a = 0 the market price for ice cream will be:
p = c + t = 2 + 2 = $4
and each shop’s profit will subsequently be
π = (4 − 2) ∗ 500 = $1000 8. Do these equilibrium prices and locations constitute a Subgame Perfect Nash Equilibrium (SPNE)? Explain why or why not.
Solution. The prices and locations we have solved for thus far do constitute an SPNE
outcome. This is because in each stage (subgame) of this two stage game both firms
are playing a Nash equilibrium. We were able to get this solution by using backward
induction. First we solved for the Nash equilibrium prices conditional on locations (the
second stage of the game). Then, stepping back, we solved for the Nash equilibrium
in location choice. Problem 5. (True/False). For each statement, assert whether it is true or false and
explain your answer.
1. In a quantity game, e.g. Cournot, quantities are strategic substitutes.
Solution. True. Just as in the simultaneous Cournot game, a firm optimally responds
to an increase in its rival’s production by reducing its quantity produced. This follows
from firms’ best response functions. 2. Firms playing a Subgame Perfect Nash equilibrium (SPNE) in a finitely repeated Betrand game must play a Nash equilibrium in each sub-games.
Solution. True. By definition, a Sub-game perfect Nash equilibrium (SPNE) of a
dynamic game necessitates a Nash equilibrium in each sub-game. Econ 444: Problem Set #3 11 3. Two Betrand competitors on a linear city will choose to locate as far away from each
other as possible.
Solution. True. Notice how in problem 4 the firms will choose to locate as far from
each other as possible to reduce price competition pressure. This is called the principle
of maximal differentiation.

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