Workbook 5. Differentiation

Módulo 3.
Organización Industrial
Workbook #5. Product Differentiation
1. Consider the case of exogenous differentiation in a Bertrand Model. There are two firms (1 and 2) with
marginal cost equal to zero, and the following demands:
q1 = 1 – p1 + c p2, and q2 = 1 + c p1 – p2, where c is a positive constant.
1.1 Write the equation of the profit function for every firm.
1.2 Find the equation of the best response function of every firm
1.3 Find the Bertrand-Nash equilibrium.
1.4 How are the equilibrium prices with respect to marginal cost? Is there any difference with the
homogeneous Bertrand model?
Solutions.
1.1 1 = p1[1 – p1 + cp2], 2 = p2[1 + cp1 – p2].
1+𝑐 𝑝 1+𝑐 𝑝
1.2 𝑝1 = 2 2 , and 𝑝2 = 2 1
1
1.3 𝑝1 = 𝑝2 =
2−𝑐
1.4 Prices are above marginal cost. In the homogenous Bertrand model, equilibrium prices are equal to
marginal cost.
2. Consider the case of exogenous differentiation in a Cournot Model. There are two firms (1 and 2).
They have equal and constant marginal cost of $m, and face the following inverse demands:
p1 =  – 2q1 - q2, and p2 =  - 2q2 – q1, where  > m.
2.1 Write the equation of the profit function for every firm.
2.3 Find the Cournot-Nash equilibrium.
2.4 Find the prices and profit of every firm associated to the Cournot equilibrium
Solutions.
2.1 1 =( – 2q1 - q2)q1 – mq1 , 2 =( – 2q2 – q1)q2 – mq2.
𝛼−𝑚 𝑞 𝛼−𝑚 𝑞
2.2 𝑞1 = 4 − 42 , and 𝑞2 = 4 − 41
𝛼−𝑚
2.3 𝑞1 = 𝑞2 =
5
2𝛼+3𝑚 2(𝛼−𝑚)2
2.4 𝑝1 = 𝑝2 = $( 5 ), and 𝜋1 = 𝜋2 = $ 25
3. Consider a linear city of length 1 in which the consumers are uniformly distributed. There are two firms
located at the extremes of the linear city: firm 1 is located at the left-hand extreme, and firm 2 is located at
the right-hand extreme. Assume that every consumer buys one unit of the product, that transportation cost
are linear (d, where d is distance), and that production costs are zero.
Given their location, the firms engage in price competition: they set prices simultaneously as in the
Bertrand Model.
3.1 Derive the demands faced by every firm.
3.3 Find the Bertrand-Nash equilibrium set of prices.
3.4 How are the equilibrium prices with respect to marginal cost? Is there any difference with the
homogeneous Bertrand model?
Solutions.
Follow your notes. (Hint. Note that length is 1)
1
4. Assume that the market demand in an industry is: P(Q) = 1 – Q, and that the cost functions of the firms
are Ci(qi) = 0.5 qi + F, for all the firms i = 1, 2,…n, where m < 1, and F is the cost of entry into the
industry. Consider the free entry sequential game in which the firms decide whether to enter the market in
the first stage, and in the second stage they decide output simultaneously.
4.1 Find the best response function of every firm in the second stage of the game. This is a function that
relates the maximum profit output with the number of firms (n).
4.2 Find the Nash equilibrium of the second stage.
4.3 Find the number of firms and the output level of every firm that result from the perfect Nash
equilibrium.
4.4 Relate barriers to entry, as indicated by the entry cost, with market structure.
Solutions.
0.5 0.5 𝑛
4.1 𝑞 = , and 𝑄 =
𝑛+1 𝑛+1
0.5
4.2 𝑛 = − 1
√𝐹
0.5
4.3 𝑞 = √𝐹, 𝑛 = 𝐹 − 1
√
4.4 Relate F (barrier to entry) with n (market concentration)
5. Consider a circular city of length L in which the consumers are uniformly distributed, and firms decide
sequentially whether to enter the market in the first stage, and then decide simultaneously its price in the
second stage. Every consumer buys one unit to the firm with the lower integrated price: price per unit plus
transportation cost. Transportation costs are quadratic (d2, where d is distance). The profit function of
every firm (i=1,2,3…n) is: i(p) = pi Di(p) – F if the firm enters the market, and i = 0 if decides not to
enter, where pi is the price of firm i, p is a vector of the prices of all the firms, Di is the demand faced by
firm i, and F is the entry cost.
5.1 Find the demand faced by every firm
5.2 Find the best response function of every firm in the second stage of the game.
5.3 Find the Nash equilibrium of the second stage. This is a function that relates the maximum profit price
with the number of firms (n).
5.4 Find the number of firms and the price level of every firm that result from the perfect Nash
equilibrium
5.5 Relate barriers to entry (as represented by the entry cost F) with market structure (n).
5.6 Relate the size of the market (as represented by L) with market structure (n).
5.7 Relate the degree of differentiation (as represented by ) with the market structure (n).
Solutions.
𝑛(𝑝2 −𝑝1 ) 𝐿
5.1 𝑥1 = 𝜏 𝐿 +𝑛
𝜏 𝐿2 𝑝2
5.2 𝑝1 = 2 𝑛2 + 2
𝜏 𝐿2
5.3 𝑝 =
𝑛2
𝜏 1/3 𝜏
5.4 𝑛 = 𝐿 (𝐹) , 𝑝= 𝜏 2/3
( )
𝐹
5.5 Relate F with n
5.6 Relate L with n
5.7 Relate  with n

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Módulo 3.

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