Dr. Barry Haworth
University of Louisville
Department of Economics
Economics 301
Summer 2000

### Exam #3

Your answers will be assessed in terms of both accuracy and completeness, but also upon your ability to clearly demonstrate that you understand the relevant concepts involved in each question. When math is needed to answer a question, you must show all relevant work to get full credit.

Section 1: Answer both questions 1-2 below
1. A monopolist faces a market demand (Q) and marginal revenue (MR) curve given by

Q = 70 - P
MR = 70 - 2Q

The monopolist produces at a constant short run average and marginal cost, whereby AC = MC = 20.

a. If this monopolist wants to maximize profits, how much output should the monopolist produce?

b. Calculate the profits, consumer surplus and deadweight loss associated with producing the output level you reported in part a.

c. Demonstrate how this monopolist can implement a two-part tariff to increase profits beyond those you reported in part b (this question requires actual numbers and an explanation for full credit, not discussion only).

2. Two firms (A and B) are engaged in an advertising game. Their strategies are: (i) to conduct a heavy advertising campaign, or (ii) conduct a light advertising campaign.

The payoffs relating to these strategies are as follows:

(a) if both firms choose heavy advertising, then firm A makes \$5 million in profit and firm B makes \$2 million in profit.

(b) if both firms choose light advertising, then firm A makes \$2 million in profit and firm B makes \$4 million in profit.

(c) if firm A chooses heavy advertising and firm B chooses light advertising, then firm A makes \$3 million in profit and firm B makes \$3 million in profit.

(d) if firm A chooses light advertising and firm B chooses heavy advertising, then firm A makes \$4 million in profit and firm B makes \$3 million in profit.

a. Construct a table (i.e. normal form game), similar to that in class, that illustrates the strategies and payoffs for each player.

b. Is this an example of the classic Prisoner's dilemma game discussed in lecture? Explain.

c. If it exists, then what is the (Nash) equilibrium of this game? Explain.

Section 2: Answer two of the three questions below.
1. Monopoly firms may choose linear or nonlinear pricing strategies. Linear pricing is said to distort the allocation of resources. During lecture, we discussed two "effects" relating to this misallocation (also including in the text): the allocation effect and the distribution effect.

a. Define/discuss each of these two effects and why they are problems?

b. Does switching from a linear pricing strategy to a nonlinear pricing strategy like price discrimination eliminate the concerns associated with these two effects? Explain.

2. The threat of potential entry in imperfectly competitive markets affects the behavior of existing firms. Discuss each of the following:

a. how the threat of entry affects the pricing behavior of (existing) firms

b. possible strategic actions by (existing) firms that are designed to deter entry

3. Solarmobile has a monopoly on the production of solar powered compact cars. Assume that the company is currently able to produce at zero cost but is capable of producing up to 25,000 of these cars per year.

The cars sell for either of two prices (Solarmobile decides which price).

If Solarmobile sets P = \$10,000, then market demand is 25,000 cars

If Solarmobile sets P = \$5,000, then market demand is 50,000 cars

A potential entrant is considering whether to enter this market, but to do so the firm must build a production facility. The fixed cost of the production facility would be the only costs incurred by the entrant. Depending on how much the firm needs to produce, the firm would choose one of two types of production facility:

• to produce 20,000 or fewer cars the entrant would spend \$100 million
• to produce 20,001 - 25,000 cars the entrant would spend \$120 million

(for simplicity, assume that these facilities can be built overnight) Furthermore, if the firm enters, then the entrant and Solarmobile will each serve half of the overall market demand.

a. If the entrant first decides whether to enter before Solarmobile chooses a market price, then draw this situation as a sequential game in extensive form (i.e. as a game tree) where the payoffs are the profits (for each firm) associated with each potential outcome.

b. If this game has a Nash equilibrium, then what is it? Explain.

c. Does the entrant have an incentive to "bribe" Solarmobile to choose a different price? Explain.