Econ 461 - Industrial Organization
Stafford, Spring 2001
Problem Set 4
  1. Firm Aay operates a pool hall in Boom Town. Business has been very profitable. However, there are dark clouds on the horizon. Firm Bee is considering entering the pool hall market in Boom Town. The profits of Aay are 15 if it is a monopoly; if Bee enters and Aay accommodates and shares the market the duopoly profits are 5 for each firm; is Bee enters and Aay launches a price war, both firms earn -1.
    1. Draw the game tree for this scenario and determine the SPE.
    2. What if launching a price war involves not only charging a low price, but printing flyers to inform the public of the great deals available? If there is a price war, both firms print flyers, and the net result of the price war is -1 for each firm (that is, the -1 takes into account the cost of printing the flyers.) Assume that Aay can have flyers printed up prior to Bee's entry decision and that the printing cost is $8. Draw the game tree for this scenario and determine the SPE.
    3. What does your answer to (b) imply about the relationship between sunk costs, first-mover advantages, and entry deterrence?

      4.  
  2. The competitive fringe's supply curve is Q = P/5. Demand is given by P = 120 - Q. The dominant firms total costs are TC = 5q.
    1. Find the equilibrium quantity and profit for the dominant firm. (Hint: follow the example on slide 10 from 3/23.)
    2. Suppose that the dominant firm can improve the quality of its product through a one-time investment in capital equipment. The competitive fringe can offer a similar quality product, although in doing so, its costs increase and thus the fringe supply curve decreases to Q = P/5 - 20. What is the change in the dominant firm's profit and thus, how much would the dominant firm be willing to invest to improve its quality? (Note: You should get a relatively "clean" number for the dominant firm's quantity. However the price will be a rather "dirty" decimal, as will be the change in profit.)
From the book:
Exercise 15.6, parts a-c only
Exercise 16.3