lOMoAR cPSD| 15981206

Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Economics of Strategy

Tutorial 1 - Answers

Economies of Scale and Scope

1. Let the cost function be C = 100 + 4q + 4q2.

a) Derive the average cost and marginal cost functions.
b) Is there any range of production characterized by economies of scale?
c) At what production level are economies of scale exhausted?

a) AC = TC/q = 100/q + 4 + 4q
MC = dTC/dq = 4 + 8q

b) Yes. To find the range of production characterized by scale economies, equate AC with MC.
100/q + 4 + 4q = 4 + 8q
100/q = 4q
100 = 4q2
25 = q2
q=5
For q between 0 and 5 production is characterized by economies of scale.
c) At q = 5 economies of scale are exhausted.

2. Suppose the cost function of firm A, which produces two goods, is given by
C (Q1 , Q2) = 100 – 0.5Q1Q2 + (Q1)2 + (Q2)2
The firm wishes to produce 5 units of good 1 and 4 units of good 2. Does the cost function
exhibit economies of scope?

The total cost of producing 5 units of good 1 and 4 units of 2 is

C (5 , 4) = 100 – 0.5 x 5 x 4 + (5)2 + (4)2 = 131 We
also calculate C (5 , 0) = 125 and C (0 , 4) = 116.
Made separately, the total cost of making 5 units of good 1 and 4 units of good 2 is £241. The
cost of making 5 units of good 1 and 4 units of good 2 together is £131. Therefore this technology
does display economies of scope in the production of goods 1 and 2.
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Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

3. Economies of scale are usually associated with the spreading of fixed costs, such as when a
manufacturer builds a factory. But the spreading of fixed costs is also important for
economies of scale associated with marketing, R&D, and purchasing. Explain.

Fixed costs are those costs that do not vary directly with output. Fixed costs must be expended in
order to initiate production, but also for activities such as selling the output or developing
improvements to the output. As the firm’s scale of operation increases in terms of volume of
output and number of products produced, functions related to marketing, R&D, and purchasing
are spread over more units—hence reducing the cost of each of these activities per unit sold. For
example, once a firm invests in developing a new product, those R&D costs are fixed regardless
of the scale of that product.

4. You are the manager of the “New Products” division of a firm considering a group of
investment projects for the upcoming fiscal year. The CEO is interested in maximizing
profits and wants to pursue the project or set of projects that return the highest expected
profits to the firm. Three potential alternatives have been proposed, including the
following estimated financial projections:

Alpha Project Upfront Costs £60 million

Expected Revenues £85 million

Beta Project Upfront Costs £20 million

Expected Revenues £16 million

Gamma Project Upfront Costs £30 million

Expected Revenues £60 million

Which set of projects would you recommend if your firm could only spend £70 million
in upfront costs on investments and if the investment in Alpha project decreased the
upfront costs required for each of the remaining projects by half?

The CEO wants the projects or set of projects that returns the highest possible profits within the
limitation of investing no more than £70 million in upfront costs. Given this challenge, the
initially obvious answer is to pursue Alpha Project since its expected revenues are the greatest
(£85 million). However, because an investment in Alpha Project reduces the upfront costs of the
remaining projects by half, investing in Alpha would also then allow an investment in Beta
Project since the total upfront costs would then be at the limit of £70 million and would produce
even greater combined revenues of £101 million.

5. What is the difference between economies of scale and learning economies? If a larger
firm has lower average costs, can you conclude that it benefits from economies of scale?
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Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Would a small firm necessarily enjoy the same cost position if it were to duplicate the size
of its larger rival?

Economies of scale are said to exist if average costs decrease as output increases. Learning
economies, a source of economies of scale, refer to a reduction in average costs due the
accumulation of experience and know-how. Lower costs may be due to the fact that the firm is
farther down the learning curve or that the firm enjoys economies of scale. A small firm, if it
becomes large, can replicate the cost position if the lower costs are due to economies of scale.
However if the lower costs are due to learning curve effects the firm has wait until the cumulative
output results in lower costs.

6. During the 1990s, firms in the Silicon Valley of Northern California experienced high rates
of turnover as top employees moved from one firm to another. What effect do you think
this turnover had on learning-by-doing at individual firms? What effect do you think it
had on learning by the industry as a whole?

Employees may be viewed as assets of the firm. However, unlike other firm assets (e.g. capital
equipment, buildings, etc.) human assets walk out the door on a daily basis and may take with
them the knowledge that they acquired while at the firm. Both employer and employee are
exposed to risks within their relationship. While firms must invest both time and dollars to
provide employees with formal and experiential training in order to maximize productive
efficiency, firms are exposed to the risk of their assets going elsewhere. Conversely, employees
must invest time in learning firm-specific skills and forgo alternate employment opportunities to
remain at the firm.

As turnover increases, firms are less inclined to invest in extensive training, as they cannot retain
the benefit of learning over time. This is compounded by the adverse consequences of sharing
valuable information with employees that can be passed on to competitors. Productive efficiency
is further hampered as there are fewer experienced employees available to provide on-the-job
training for new employees. Additionally, firms have little incentive to incur the substantial cost
of training more individuals. Finally, high turnover can serve as an indicator to employees that
the firm is a short-term career option. Consequently, employees may be less inclined to make a
relationship-specific
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Economics of Strategy

Tutorial 2 - Answers

Games and Strategy

1. What is a Nash Equilibrium? Find the Nash Equilibrium of the

following game

Left Right
Up 7 5
4 9
Down 6 2
5 10

Why would strategies that do not constitute a Nash Equilibrium be an

unlikely outcome of the game?

A Nash equilibrium in a game occurs when each player chooses a strategy that
gives it the highest payoff, given the strategies chosen by the other players in the
game.

Left Right
Up 7 5
4 9
Down 6 2
5 10

Nash Equilibrium: (Down, Left)

If players chose strategies that did not constitute a Nash equilibrium, then the
players could choose another strategy that increased their payoff given the
strategies chosen by the other players.

For example, if Player 2 plays Left, Player 1 will lose 1 by changing from Down to
Up. Therefore, she does not change her strategy.

If Player 1 plays Up, Player 2 will lose 2 by changing from Left to Right.
Therefore, he does not change his strategy.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

As no player has any incentive to change its strategy from (Down, Left), (Down,
Left) is a Nash Equilibrium.

Alternatively, we can start from any other cell (excluding (Down, Left)) and show
that at least one player can improve her/his payoff by changing her/his strategy.

2. The classic toy game called Chicken derives from the James Dean
movie Rebel without a Cause, in which two teenage boys drive cars
towards a cliff edge to see who chickens out first. The same game is
played by middle-aged drivers who approach each other in streets too
narrow for them to pass without someone slowing down.

Explain why the payoff table below fits both stories. Enclose the
payoffs that correspond to best replies in a circle or a square. Explain
why neither player has a dominant strategy. Why are (slow, speed)
and (speed, slow) Nash Equilibria?

Slow Speed
Slow 2 3

2 0
Speed 0 -1

3 -1

Slow Speed
Slow 2 3

2 0

Speed 0 -1

3 -1

(slow, speed) and (speed, slow) are Nash Equilibria as neither player can
improve their payoff by unilaterally changing her/his strategy.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

3. In the payoff table below, rank the payoffs so that this game is
equivalent to the Prisoners’ Dilemma game. Explain your reasoning.

Not Confess
Confess
Not b a
Confess b d
Confess d c
a c

For this game to be equivalent to the Prisoners’ Dilemma we need: i) confess to

be a strongly dominant strategy for both players and ii) the joint payoffs from
cooperation are higher than the joint payoffs from noncooperation.

So for both Players: a > b and c > d. This ensures that confess is a strongly
dominant strategy for both players.

For the joint benefits from cooperation to dominate the ones from
noncooperation, we need b > c.

Therefore, a > b > c > d.

4. How can cooperation emerge in an infinitely repeated prisoners’

dilemma game even though in a single-shot prisoners’ dilemma,
noncooperation is a dominant strategy?

In the repeated prisoners’ dilemma game, the players might, in equilibrium, play
cooperatively. This could occur if one player chose to cooperate with the other
player as long as the other player chose to cooperate and to resort to non-
cooperation when the other player cheated. For this to work, the short-term
benefit of cheating must be lower than the long-term benefit of not cheating. This
would require the player to place a sufficiently strong weight on future payoffs
relative to current payoffs.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

5. In the mid-1990s, Value Jet wanted to enter the market serving routes
that would compete head to head with Delta Airlines in Atlanta. Value
Jet knew that Delta might respond in one of two ways: Delta could
fight or it could be “accommodating”, keeping the price at a high level.
Value Jet had to decide whether it would enter on a small scale or on a
large scale. The annual profits (in millions of dollars) associated with
each strategy are summarized in the following table (where player 1 is
Value Jet and player 2 is Delta):

Accommodate Fight
(Price High) (Price Low)
Enter on a 30 24
Small Scale
6 1
Enter on a 15 18
Large Scale
12 3

a. If Value Jet and Delta choose their strategies simultaneously, what

strategies would firms choose at the Nash Equilibrium and what
would be the payoff for Value Jet? Explain.
b. Now assume that the two airlines choose their strategies
sequentially. Analyze the sequential game in which Value Jet
chooses either “small” or “large” in the first stage and then Delta
accommodates or starts a price war in the second stage. Did Value
Jet enhance its profits by moving first? If so, how much more did it
earn? (Hint: Draw a game tree)

a.

Accommodate Fight
(Price High) (Price Low)
Enter on a 30 24
Small Scale
6 1
Enter on a 15 18
Large Scale
12 3

Nash Equilibrium: (Enter on a Large Scale, Fight)

Value Jet’s payoff is $3m.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

b.

The game tree above models the two stages of the game. The payoffs are the
same as in the matrix in (a).

If VJ (Value Jet) builds small, D (Delta) will accommodate (preferring 30 over

24).
Thus, VJ will get 6 if it enters small.
If VJ (Value Jet) builds large, D (Delta) will fight (preferring 18 over 15). Thus,
VJ will get 3 if it enters large.
Value Jet’s optimal strategy is to build small and for Delta to accommodate.
Value Jet will then receive $6 million. Value Jet has increased its profit from
$3 million in (a) to $6 million in (b), so by moving first, gains an extra $3
million in profit.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Economics of Strategy

Tutorial 3 - Answers

Competitors and Competition – Part I

1) The following table gives US market share data in percentages for three paper
product markets in 1994.
Facial Tissues Toilet Paper Paper Towels
Company % Share Company % Share Company % Share
Kimberly- 48 Proctor & 30 Proctor & 37
Clark Gamble Gamble
Proctor & 30 Scott 20 Scott 18
Gamble
Scott 7 James River 16 James River 12
Georgia 6 Georgia 12 Georgia 11
Pacific Pacific Pacific
Other 9 Kimberly- 5 Kimberly- 4
Clark Clark
Other 16 Other 18

a) Calculate the four-firm concentration ratio for each industry.

b) Calculate each industry’s H Index.

HFT = 0.482 + 0.32 + 0.072 + 0.062 = 0.3289

HTP = 0.32 + 0.22 + 0.162 + 0.122 + 0.052 = 0.1725
HPT = 0.372 + 0.182 + 0.122 + 0.112 + 0.042 = 0.1974

c) Which industry do you think exhibits the most concentration?

Given the highest four-firm concentration ratio and a very high Herfindahl index,
facial tissue is the most concentrated with 2 firms controlling 78% of the market.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

2) Why are the concepts of own and cross-price elasticities of demand essential to
competitor identification and market definition?

The magnitude of consumer responses to changes in a product market’s (or industry’s) price
is measured by the own-price elasticity of demand, which equals the percentage change in a
product market’s sales that results from a 1 percent change in price. If an industry raises
price and consequently loses most of its customers to another industry (or industries), we
conclude that the market under consideration faces close substitute products (or the product
market competes with other product markets). Measuring the own-price elasticity of demand
tells us whether a product faces close substitutes, but it does not identify what those
substitutes might be. We can identify substitutes by measuring the cross-price elasticity of
demand between two products. The cross-price elasticity measures the percentage change in
demand for good Y that results from a 1-percent change in good X. The higher the cross-
price elasticity, the more readily consumers substitute between two goods when the price of
one good is increased.

3) The sugar industry is a duopoly. The two firms, Sweet and Sour, compete through
Cournot quantity-setting competition. The inverse market demand is given by P = 400
– 2Q, where Q is the total quantity produced by Sweet and Sour. Each firm has a
marginal cost of £40 and no fixed cost.

a. Derive Sweet’s best response function and illustrate it on a graph.

The inverse market demand:

P = 400 − 2Q = 400 − 2 (q1 + q2), (1)

where q1 is the quantity of output sold by Sweet and q2 is the quantity of output sold by
Sour.
For any choice of output q2, Sweet faces the inverse demand and marginal revenue
curves:
P = (400 − 2q2) − 2q1 (2)
MR1 = (400 − 2q2) − 4q1 (3)

The marginal cost of both firms is £40. To maximize profit, Sweet chooses output, q1,
where the following condition holds.

MR1 = MC
(400 – 2q2) – 4q1 = 40
4q1 = 360 – 2q2
q*1 = 90 – ½q2 (4)
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Equation (4) is Sweet’s best response function which is illustrated in Figure 1 as R1.

b. Derive Sour’s best response function and illustrate it on the graph which you drew
in part (a).

For any choice of output q1, Sour faces the inverse demand and marginal revenue
curves:
P = (400 − 2q1) − 2q2 (5)
MR2 = (400 − 2q1) − 4q2 (6)

To maximize profit, Sour chooses output q2, where the following condition holds.

MR2 = MC
(400 – 2q1) – 4q2 = 40
4q2 = 360 – 2q1
q*2 = 90 – ½q1 (7)

Equation (7) is Sour’s best response function which is illustrated in Figure 1 as R2.

c. Derive the Cournot-Nash equilibrium to this game and illustrate the equilibrium on
the graph which you drew in part (b). What are the profits for each firm in the
equilibrium?

Best response function for Sweet: q*1 = 90 – ½q2 (4)

Best response function for Sour: q*2 = 90 – ½q1 (7)

Substituting (4) into (7):

q*2 = 90 – ½(90 – ½ q*2)

q*2 = 90 – 45 + ¼q*2
q*2 = 45 + ¼q*2
q*2 - ¼ q*2 = 45
¾q*2 = 45
q*2 = 60

Substituting q2* = 60 into (4) gives us q*1 = 60.

Therefore, (q*1 = 60, q*2 = 60) is the Cournot-Nash equilibrium to this game,
which is illustrated by point C in Figure 1.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Now, set q1 = q2 = 60 in Equation (1) to solve for the market equilibrium price, P*.
P* = 400 – 2(q1 + q2)
P* = 400 – 2(60 + 60)
P* = 400 – 120
P* = 160

Sweet’s profits are

π*1 = (P* - c ) q*1
π*1 = (160 - 40 )60
π*1 = 7200

Similarly, Sour’s profits, π*2, are equal to £7200

d. Derive the monopoly output, i.e., the one that maximizes total industry profit?

The monopolist faces the inverse market demand curve:

P = 400 − 2Q, (1)
So, the monopolist’s marginal revenue curve is:
MRM = 400 – 4Q, (8)

To maximize profit, the monopolist chooses output, Q, where the following

condition holds.

MRM = MC
400 – 4Q = 40
4Q = 360
Q = 90

Therefore, the profit maximizing monopoly output, Q*M = 90

e. Why isn’t producing one half the monopoly output a Nash equilibrium outcome (the
solution to part (b))?

One half of the monopoly output is Q*M / 2 = 90/2 = 45.

Now, use Equation (4) to find Sweet’s best response when Sour produces 45
units.

q*1 = 90 – ½q2
q*1 = 90 – ½(45)
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

q*1 = 67.5

Similarly, use Equation (7) to find Sour’s best response when Sweet produces 45
units.

q*2 = 90 – ½q1
q*2 = 90 – ½(45)
q*2 = 67.5

It is now clear that (q1 = 45, q2 =45) is not a mutually best response quantity
choices by the two firms. If one firm produces 45 units, then the other firm wants
to deviate from that level of output and produce 67.5 units to maximize profit.
Therefore, producing one half the monopoly output by each firm is not a Nash
equilibrium outcome.

q2

180

Sweet’s best response function (R1)

90
C
60 Sour’s best response function (R2)

q1
60 90 180

f. Now assume that the marginal cost for each firm increases to £60. Draw the best
response functions for both firms. How does your answer differ from part (c)?
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

We derived MR1 and MR2 earlier (equations (3) and (6)). So Sweet’s best
response function is now

MR1 = MC
(400 − 2q2) − 4q1 = 60
340 – 2q2 − 4q1 = 0
4q1 = 340 – 2q2
q*1 = 85 – ½q2

MR2 = MC
(400 – 2q1) – 4q2 = 60
4q2 = 340 – 2q1
q*2 = 85 – ½q1

The new equilibrium is (q*1 = 56.67, q*2 = 56.67)

q2

180
170
Sweet’s best response function (R1)

90
85 C
Sour’s best response function (R2)
56.67
D

q1
56.67 85 90 170 180

4) Numerous studies have shown that there is usually a systematic relationship between
concentration and price. What is this relationship? Offer two brief explanations for
this relationship.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Leonard Weiss summarized the results of price and concentration studies in over 20
industries, including cement, railroad freight, supermarkets, and gasoline retailing. He finds
that with few exceptions, prices tend to be higher in concentrated markets. Consider an
industry with a high concentration ratio because there are a small number of Cournot
competitors. If each firm’s share of industry sales is large, the divergence between a firm’s
private gain and the revenue destruction effect from output expansion is small. Hence, total
industry output and price are closer to the levels that would be chosen by a profit-maximizing
monopolist. Alternatively, an industry with a high concentration ratio that has a small
number of sellers is able to engage more successfully in tacit collusion.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Economics of Strategy

Tutorial 4 - Answers

Competitors and Competition – Part II

1) Consider again question 3 from last week’s tutorial but now assume that the two firms
move sequentially. Find the Stackelberg output levels and price, assuming Sweet moves first
(you can assume that each firm has a marginal cost of £40 and no fixed cost).

We substitute for q2 (given by firm 2’s (sour) best response function and is equal to
q*2 = 90 – ½q1) in the demand function faced by firm 1 (sweet) so that its inverse demand
function may be written as:
P = (400 - 2q1) - 2q2
P = 220 – q1
Total revenue is equal to
TR1 = Pq1 = (220 – 2q1)q1
The relevant MR is then equal to
MR1 = 220 – 2q1
MR1 = MC
220 – 2q1 = 40
q*1 = 90
Given this output choice by firm 1, firm 2 selects its best response as given by its best response
function, which is equal to
q*2 = 45
Price is equal to
P = 400 – 2(90 + 45) = 130

2) According to Bertrand's theory, price competition drives firm’s profits down to zero even
if there are only two competitors in the market. Why don't we observe this in practice very
often?

There are two possible explanations: (a) product differentiation (b) capacity constraints
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

3) Consider a Bertrand oligopoly consisting of four firms that produce an identical product at
a marginal cost of £100. The inverse market demand for this product is P=500-2Q.

a) Determine the equilibrium level of output in the market.

Set P = MC to get 500 – 2Q = 100. Solving yields Q = 200 units.

b) Determine the equilibrium market price.

P = MC = $100.

c) Determine the profits of each firm.

Each firm earns zero economic profits.

4) Which model (Cournot, Bertrand) would you think provides a better approximation to each
of the following industries: oil refining, insurance. Why?

Bertrand model is appropriate for a homogeneous good where production is not constrained by
capacity. Cournot is more appropriate when output cannot be increased quickly due to capacity
constraints.

Capacity constraints seem relatively more important in oil refining and relatively less important in
insurance. One would be inclined to select the Cournot model for oil refining and the Bertrand
model for insurance.

5) Jerry and Teddy are the only two producers of chewing gum, which consumers view as
differentiated products. The demand functions facing each producer are:

QJ = 150 – 10PJ + 9PT

QT = 150 – 10PT + 9PJ

Each producer has a constant marginal cost of £7 per unit.

a) Find the best response function for each producer.

We will first derive Jerry’s best response function. Jerry’s profit function is equal to

ΠJ = (PJ – c)(150 – 10PJ + 9PT)

We first expand the brackets to obtain

ΠJ = 150PJ – 10(PJ)2+ 9PT PJ – 150c + 10PJc - 9PTc

Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

To derive the best response function, we differentiate ΠJ with respect to PJ, equate the derivative to
zero and solve for PJ.

dΠJ/dPJ = 150 – 20PJ+ 9PT + 10c

150 – 20PJ + 9PT + 10c = 0
150 + 10c + 9PT = 20PJ
PJ = (150 + 10c + 9PT)/20

Substitute for c = 7 gives us

PJ = (150 + 10(7) + 9PT)/20

PJ = (220 + 9PT)/20

P*J = 11 + 0.45PT

For Teddy, his profit function is given by

ΠT = (PT – c)(150 – 10PT + 9PJ)

and his best response function is given by

dΠT/dPT = (150 – 10PT + 9PJ) – 10(PT – c)

(150 – 10PT + 9PJ) – 10(PT – c) = 0

150 + 10c – 20PT + 9PJ = 0
150 + 10c + 9PJ = 20PT
PT = (150 + 10c + 9PJ)/20

Substitute for c = 7 gives us

PT = (150 + 10(7) + 9PJ)/20

PT = (220 + 9PJ)/20

P*T = 11 + 0.45PJ

b) Find the Bertrand equilibrium price of each producer.

We have the best response functions for both firms. Substituting P*T into P*J gives us

P*J = 11 + 0.45PT
P*J = 11 + 0.45(11 + 0.45P*J)
P*J = 11 + 4.95 + 0.2025P*J
P*J – 0.2025P*J = 15.95
0.7975P*J = 15.95
P*J = 20
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Substituting P*J = 20 into Teddy’s best response function gives us

P*T = 11 + 0.45(20)
P*T = 20

So Bertrand Equilibrium is (P*J = 20, P*T = 20)

c) Draw the best response functions derived in part (a) and illustrate the Bertrand equilibrium
derived in part (b) on a graph

PT

RJ

RT
20
B

11

PJ
11 20
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

d) Sketch the effect of a decrease in Jerry’s marginal cost (with Teddy’s marginal cost
remaining the same).

PT

RJ - New
RJ - Old

RT
20
B

11

PJ
11 20
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Economics of Strategy

Tutorial 5 - Answers

Entry and Exit

1. Repeat the limit pricing example covered in the lecture assuming

that the
• demand function is P = 100 – Q
• fixed costs are equal to £850
• marginal cost is equal to £10
• limit price is equal to £34

Draw a game tree and show that limit pricing is not sub-game
perfect when the entrant is certain about post-entry competition
and price.

We first derive the profits when the incumbent is a monopolist.

TR = PQ = (100 – Q)Q
MR = dTR/dQ = 100 – 2Q

For profit maximization, MC = MR

10 = 100 – 2Q
2Q = 90
QM = 45

Substitute into the demand function to obtain PM = 55. Lastly the profits
are given by

πM = TR – TC
πM = (100 – Q)Q – (850 + 10Q)
πM = (100 – 45)45 – (850 + 10(45))
πM = 2475 – 1300
πM = 1175

Suppose that entry leads to Cournot competition. We need to obtain the

equilibrium output, price and profit per firm.

TRE = PQ = (100 – qE – qN)qE

Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

MRE = dTRE/dqE = 100 – 2qE – qN

MRE = MC
100 – 2qE – qN = 10
90– qN = 2qE
qE = 45– ½qN

TRN = PQ = (100 – qE – qN)qN

MRN = dTRN/dqN = 100 – qE – 2qN

MRN = MC
100 – qE – 2qN = 10
90– qN = 2qN
qN = 45– ½qE

Solving for qN

qN = 45– ½qE
qN = 45– ½(45– ½qN)
qN = 45/2 + ¼qN
qN = 30

And qE is equal to

qE = 45– ½qN
qE = 45– ½(30)
qE = 45 – 15
qE = 30

The price is equal to

P = 100 - qE - qN
P = 100 – 30 – 30
P = 40

And the profits are given by

πE = TR – TC
πE = (100 – qE – qN)qE – (850 + 10qE)
πE = (100 – 30 – 30) (30) – (850 + 10(30))
πE = 40 (30) – 1150
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

πE = 1200 - 1150
πE = 50

and πN = 50

Finally, the limit pricing scenario of PL = 34. If no entry occurs, quantity is

equal to 66 and profits

π = PQ – (850 + 10Q)
π = 34(66) – (850 + 10(66))
π = 2244 – 1510
π = 734

and if entry occurs, each firm produces 33 units and the profit per firm is

π = PQ – (850 + 10Q)
π = 34(33) – (850 + 10(33))
π = 1122 – 1180
π = -58
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

1
50
Accommodate
784
N
In -58
Limit Pricing
E 676
Limit Price 0
Out N
1909
N Monopoly Price
0
Out N
Monopoly Price 2350
Monopoly Price E
50
Accommodate
In N 1225
-58
Limit Pricing 1117
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

2. “How a firm behaves toward existing competitors is a major

determinant of whether it will face entry by new competitors.”
Explain.
If a firm is “tough” toward existing competitors (e.g., the firm is
involved in price or non-price competition), the firm will face less entry
because entrants will expect lower profits than if the incumbent were more
tolerant of entry. However, if the incumbent has a “soft” stance
toward the existing competitors, the entrant may take this as a signal for
some accommodation of entry and thus the entry rate could be higher. The
incumbent signals what post-entry competition will be like through its current
behavior
toward other firms in the industry.

3. “All else equal, an incumbent would prefer blockaded entry to

deterable entry.” Comment.
Entry is blockaded if the incumbent need not undertake any entry-deterring
strategies to deter entry. Blockaded entry may result when there are structural
entry barriers. Blockaded entry may also result if the entrant expects
unfavorable post-entry competition, perhaps because the entrant’s
product is undifferentiated from those of the incumbents.

Entry is deterred if the incumbent can keep the entrant out by employing
entry-deterring strategies, such as limit pricing and predatory pricing.
Moreover, the cost of the entry-deterring strategy is more than offset by the
additional profits that the incumbent enjoys in the less competitive
environment. However, entry-deterring strategies are generally met with
various degrees of success.

The firm who is able to use one or a combination of structural entry barriers
to blockade entry does not have to actively guard itself against entry and so
can focus on other activities. If entry is deterred rather than blockaded, the
incumbent must actively engage in predatory acts to discourage entry. A
threat of entry will most definitely constrain the incumbent. Given that the
incumbent might prefer to be passive rather than active about discouraging
entry, blockaded entry would be preferable to deterable entry.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

4. In most models of entry deterrence, the incumbent engages in

predatory practices that harm a potential entrant. Can these
models be reversed, so that the entrant engages in predatory
practices? If so then what are the practical differences between
incumbents and entrants?

Entrants and incumbents roles can be switched in the theoretical models and
the results will hold true. If the entrant has deep pockets then it can engage in
predatory practices to drive incumbent out. Incumbents have an advantage in
that they in most cases would have created brand loyalty or reputation,
network externalities, and lower costs due to learning curve. Taking all the
above factors into account, it is less likely that entrant will pursue predatory
practices.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Economics of Strategy

Tutorial 6 - Answers

Dynamics of Pricing Rivalry

1. Firms operating at or near capacity are unlikely to instigate price

wars. Briefly explain.

Firms who lower price earn less on every unit they sell up to the quantity they
sold before the price reduction. However, this loss can be offset by an increase in
units sold due to the now lower price. If a firm is at or near capacity, its ability to
expand quantity sold is constrained and hence the firm cannot recover the
forgone profits from selling each unit at a lower margin. The capacity-
constrained firm has little incentive to initiate a price reduction.

Firms are more likely to instigate price wars when excess capacity exists. For
example, if a firm is experiencing excess capacity, and a new firm enters the
market, the new entry will induce even greater excess capacity on the part of the
incumbent. If there are economies of scale in production, the costs of idle
capacity may rise with the degree of idleness. This suggests that the incumbent
will fight harder to retain market share under excess capacity conditions, and
that prices are likely to drop with entry. The firm with excess capacity may
lower its price in order to retain or steal market share

2. Suppose that you were an industry analyst trying to determine

whether the leading firms in the automobile manufacturing industry
are playing a tit-for-tat pricing game. What real world data would
you want to examine? What would you consider to be evidence of
tit-for-tat pricing?

Circumstantial evidence of tit-for-tat pricing is relatively easy to find. Public

pricing behavior, like the advance announcement of price changes and the use
of commitments to meet the lowest available price, support price coordination
and stability, as does simplified pricing behavior such as having annual pricing
reviews. However, hard evidence of tit-for-tat pricing is much harder to come
by, unless firms are foolish enough to put a collusive agreement in writing. You
would want detailed data on historical prices and firm profits in an attempt to
discern pricing patterns that support above-average industry profitability. One
such telltale pattern is a punishment strategy, where all firms lower price to
“punish” a renegade firm that reduces its price unilaterally. Then, after a
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

period, all firms raise their price back to the previous, higher level. However,
firms can always argue that external circumstances are responsible for the price
moves. Furthermore, if collusion is extremely effective, you would not observe
punishment behavior at all.

3. After several years of severe price competition that damaged

Boeing's and Airbus' profits, the two companies pledged that they
will not sink into another price war. However, in June 1999, Boeing
made an unusual offer to sell 100 small aircraft to a leasing
corporation at special discount prices. (Although customers never
pay list prices, it was felt that this deal was particularly attractive.)
Boeing's move follows a similar one by Airbus. Why do you think it
is so difficult for aircraft manufacturers to collude and avoid price
wars?
Orders in the aircraft manufacturing industry are lumpy in nature and
infrequent. Moreover, the terms of each sale are seldom made public. For these
reasons, it is very difficult for them to collude. The incentive to cheat on
cooperative pricing is relatively high as

(i) Lumpiness reduces the frequency of competitive interactions, lengthen the

time required for competitors to react to price reductions, and thus make price
cutting more attractive
(ii) Sale terms are not made public and so it may be difficult for an aircraft
manufacturer to learn whether a competitor has cut its price (price cutting is
more attractive when prices are kept secret)
(iii) In the aircraft manufacturing industry, product attributes are frequently
customized to individual buyers. When the product is tailor-made, the aircraft
manufacturer may be able to increase its market share by altering the design of
the product or by throwing in “extras” (e.g. spare parts). These are difficult to
observe, thus complicating the ability of an individual firm to monitor the
competitor’s behavior
(iv) Probably the number of buyers is limited thus limiting the likelihood that
secret price cuts will be detected
4. In 1918, the U.S. Congress passed a law allowing American firms to
form export cartels. Empirical evidence suggests that cartels were
more likely to be formed in industries where American exporters
had a large market share and in industries selling standardized
goods. Discuss.

The effect of standardization may correspond to the fact that it is easier to

monitor collusion with a standardized product. The effect of market share is
consistent with the idea that concentration facilitates collusion.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

5. The structure of the ready-mixed concrete industry in Denmark can

roughly be described as a collection of fairly tight regional oligopolies
with a few firms active in most submarkets and most firms active in
only one or two submarkets. Until 1993, list prices were frequently
subject to individual, confidential discounts of considerable amount.
This situation led industry observers and competition policy
authorities to suggest that pricing behavior in the industry was far
from the perfectly competitive ideal.

In response, the Danish Competition Council decided, in October

1993, to gather and regularly publish actual transaction prices set by
individual firms in three regional markets for two particular grades
of ready-mixed concrete. Presumably, the purpose of such
publications was to improve information on the buyer side (i.e.
among building contractors), whereby seller competition would be
stimulated and average transaction prices would fall.

In the Aarhus market, prices evolved as shown in the following figure.

What has been the effect on the market of publishing the prices
charged by individual firms?

This example shows that making information public is not a panacea to the
collusion problem. Although the market becomes more transparent, and collusive
agreements are easier to monitor, this may come at a cost: It gives firms the
opportunity to coordinate on a collusive equilibrium.

From the figure it is obvious that price dispersion between firms decreased
dramatically (compare January 1994 to November 1995) and the average price
level increased significantly. The data suggests that making all prices public
information helped firms coordinate on a collusive equilibrium. The requirement
to publish price ceased soon after the period reported.
 Economics of Strategy

Tutorial 7

Networks:
Blu-ray vs. HD DVD battle

Read the case study “Blu-ray Disc vs. HD DVD format war” (on KEATS) and
answer the following questions.

As background material read NYU-Stern Mini-Case on Betamax and VHS (on

KEATS) and answer question 1. But the main focus is on Blu-ray and HD
DVD.

1. What factors led to the dominance of VHS over Betamax in the VCR
market?

2. What are the main features of Blu-ray and HD DVD? What are their
main differences?

3. Explain the nature of network externalities in this market. How did

they affect consumers’ choices during the battle?

4. What attempts were made to compatibility?

5. Why did Blu-ray win? Evaluate Sony’s strategy.

6. What happened to this market after Toshiba withdrew HD DVD?

No model answer will be posted on KEATS.

Tutorial 7 (Networks) answers
What factors led to the dominance of VHS over Betamax in the VCR market?
The VHS versus Betamax format war in the 1980s is an example of how marketing, technical
specifications, and market timing can affect the success or failure of a product. Here are
some of the factors that led to VHS's dominance in the VCR market:

• Marketing and Distribution: JVC the creator of the VHS format made licensing deals
with multiple electronics manufacturers to produce VHS machines whereas Sony the
creator of the Betamax format kept tighter control over the manufacturing process.
This allowed VHS to be more widely available and marketed to a larger audience.
• Recording Capacity: VHS tapes could record longer programs than Betamax tapes. In
the early days of the format war this was a significant advantage that made VHS
more appealing to consumers who wanted to record full-length movies or sports
events.
• Price: VHS machines and tapes were generally cheaper than their Betamax
counterparts which made them more attractive to price-sensitive consumers.
• Adult Content: The adult film industry adopted the VHS format, which helped to
popularise it among consumers who were interested in that type of content.
Betamax on the other hand did not allow adult content to be released on its tapes.
• Studio Support: Movie studios and other content providers started releasing their
movies on VHS tapes which gave consumers more reason to choose VHS over
Betamax.
Overall, the combination of marketing, technical specifications and market timing all played
a role in VHS's dominance over Betamax. By the late 1980s, VHS had become the dominant
format in the VCR market and Betamax had largely faded into obscurity.
What are the main features of Blu-ray and HD DVD? What are their main differences?
Blu-ray and HD DVD were two competing high-definition video disc formats that emerged in
the mid-2000s. While both formats offered high-quality video and audio they had several
key differences in their technical specifications and features:
Blu-ray:

• Disc capacity: Blu-ray discs had a higher capacity than HD DVD with a maximum
capacity of 50GB for dual-layer discs compared to 30GB for HD DVD.
• Data transfer rate: Blu-ray discs had a faster data transfer rate than HD DVD with a
maximum transfer rate of 54Mbps compared to 36.55Mbps for HD DVD.
• Compression: Blu-ray used a more advanced video compression format called
MPEG-4 AVC which allowed for higher-quality video with less data than HD DVD's
compression format.
• Interactive features: Blu-ray discs offered more advanced interactive features such
as picture-in-picture video and online connectivity.
 • Studio support: Many major movie studios supported the Blu-ray format including
Sony Pictures, Disney and 20th Century Fox.
HD DVD:

• Disc structure: HD DVD discs had a more simplistic structure than Blu-ray discs,
which made them easier and cheaper to manufacture.
• Backward compatibility: HD DVD players could play standard DVD discs while Blu-
ray players required separate hardware to play standard DVDs.
• Interactive features: HD DVD discs had basic interactive features such as picture-in-
picture video and online connectivity but not as advanced as those offered by Blu-
ray.
• Studio support: HD DVD had less support from major movie studios than Blu-ray
with only Universal Studios and Warner Bros fully supporting the format.
In the end, the greater capacity, faster data transfer rate and more advanced compression
format of Blu-ray combined with greater studio support helped it to win the format war and
become the dominant high-definition video disc format. Today, Blu-ray remains a popular
format for high-definition video content while HD DVD has largely faded from the market.
Explain the nature of network externalities in the “Blu-ray Disc vs. HD DVD format market.
How did they affect consumers’ choices during the battle?
Network externalities occur when the value of a product or service to a consumer is
influenced by the number of other users of that product or service. In the case of the Blu-ray
Disc vs. HD DVD format market network externalities played a significant role in shaping
consumers' choices during the battle.
As the two formats competed for market share, consumers had to decide which format to
adopt. One of the key factors that influenced this decision was the availability of content in
each format. Consumers were more likely to choose the format that had more movies and
other content available as this made the format more valuable to them. This created a
positive feedback loop. As more consumers adopted a particular format more content was
released in that format making it even more attractive to consumers.
This positive feedback loop is an example of network externalities. As the number of users
of a particular format grows, the value of that format increases for all users. This can create
a "winner-takes-all" dynamic, where the dominant format becomes entrenched and it
becomes difficult for competitors to gain a foothold in the market.
In the case of the Blu-ray Disc vs. HD DVD format battle, network externalities worked in
favour of Blu-ray. As more consumers adopted Blu-ray more movies and other content were
released in that format, making it even more attractive to new consumers. This created a
snowball effect that eventually led to Blu-ray becoming the dominant format.
Overall, network externalities played a significant role in shaping consumers' choices during
the Blu-ray Disc vs. HD DVD format market battle. As consumers weighed the relative merits
of each format the availability of content in each format influenced their decisions and the
positive feedback loop created by network externalities worked to entrench the dominant
format.
What attempts were made to compatibility in the Blu-ray Disc vs. HD DVD format war
During the Blu-ray Disc vs. HD DVD format war there were several attempts to improve
compatibility between the two formats in order to make it easier for consumers to use both
formats. Some of the key attempts at compatibility included:

• Dual-format players: Several companies including LG and Samsung introduced dual-

format players that could play both Blu-ray Discs and HD DVDs. This gave consumers
the flexibility to choose which format to use for each movie or other content they
wanted to watch.
• Discs with both formats: Some studios released discs that contained both Blu-ray
and HD DVD versions of a movie or other content. This allowed consumers to choose
which format to use for playback regardless of which type of player they owned.
• Digital copies: Some studios included digital copies of movies with their Blu-ray Discs
and HD DVDs. This allowed consumers to watch the movie on a variety of devices
including smartphones and tablets regardless of which format the physical disc was
in.
While these attempts at compatibility were helpful for consumers who wanted to use both
formats they ultimately did not resolve the format war.
Why did Blu-ray win over HD DVD? Evaluate Sony’s strategy.
Blu-ray Disc ultimately won over HD DVD in the high-definition video disc format war largely
due to a combination of technical advantages and strategic decisions made by Sony and its
partners. Here are some of the key factors that contributed to Blu-ray's victory and Sony's
strategy:

• Greater capacity and faster data transfer rate: Blu-ray Discs could hold more data
and transfer data at a faster rate than HD DVDs giving them a technical advantage in
terms of picture and sound quality.
• More studio support: Sony was able to secure support from a number of major
movie studios including Disney, Fox and Warner Bros. This gave Blu-ray access to a
wider range of content making it more attractive to consumers.
• More advanced compression format: Blu-ray Discs used a more advanced
compression format known as MPEG-4 AVC which allowed for better video quality at
lower bitrates.
• Strategic partnerships: Sony formed partnerships with a number of other companies
including Panasonic and Philips to promote the Blu-ray Disc format and develop new
technologies to support it.
• Timing: Sony was able to launch its PlayStation 3 gaming console with a built-in Blu-
ray player giving it a significant market advantage over HD DVD players.
Overall, Sony's strategy played a significant role in the success of the Blu-ray Disc format. By
securing support from major studios and developing a technical advantage, Sony was able
to make Blu-ray a more attractive option for consumers. The company's partnerships and
investment in the format also helped to drive its adoption and success. While the format
war was closely contested Sony's strategic decisions ultimately helped Blu-ray to emerge as
the dominant high-definition video disc format and it remains a popular option for
consumers today.
What happened to the Blu-ray Disc market after Toshiba withdrew HD DVD?
After Toshiba withdrew HD DVD from the market in 2008, the Blu-ray Disc market
experienced a significant boost in sales and adoption. The withdrawal of HD DVD effectively
ended the format war eliminating the uncertainty that had surrounded the high-definition
video disc market for several years. With HD DVD out of the picture consumers no longer
had to choose between competing formats making it easier for them to adopt Blu-ray as
their preferred format.
In the months following Toshiba's announcement sales of Blu-ray players and discs surged.
According to the Digital Entertainment Group Blu-ray player sales rose by 72% in the first
quarter of 2008 while Blu-ray disc sales increased by 123%. These figures continued to grow
throughout the year with Blu-ray player sales reaching 10.7 million units in 2008 up from 4.5
million in 2007.
The removal of HD DVD from the market also had an impact on movie studio many of which
had previously released titles in both formats. With HD DVD no longer a factor studios could
focus their efforts on Blu-ray releases leading to an increase in the number of titles available
in the format.
Overall, the withdrawal of HD DVD was a major turning point for the Blu-ray Disc market. It
helped to remove the uncertainty that had surrounded the format war and gave consumers
a clear path forward for adopting high-definition video discs. The removal of HD DVD also
allowed the Blu-ray format to consolidate its position as the dominant high-definition video
disc format which it remains to this day.
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

Economics of Strategy

Tutorial 8 - Answers

Linear Pricing

1. A nearby pizza parlor offers pizzas in three sizes: small, medium, and
large. Its corresponding price schedule is: £6, £8, and £10. Do these data
indicate that the firm is price discriminating? Why or why not?

We cannot definitely say that the pizza parlor is price discriminating since we don’t
have enough data about cost or size of pizza.
However, suppose that the marginal cost of pizza per 100g is the same regardless of
size. And suppose further than the size of medium pizza is 33% greater than small
pizza but 25% smaller than large pizza. Then, since the markups across the size are
the same (e.g. a medium sized pizza is 33% bigger but costs 2/6 = 33% more), this is
not the case of price discriminating.

2. Discounts to students and senior citizens can often be explained by

third-degree price discrimination, since students and seniors often have
a different elasticity of demand than other age groups. Do students and
seniors have a higher or lower elasticity of demand than other groups?
Why?

Students and seniors often have a higher elasticity of demand. This is because they
normally have below-average incomes and they have a low value of time, so they are
more likely to shop for the lowest price

3. A market consists of two population segments, A and B. An individual in

segment A has demand for your product QA = 50 – P. An individual in
segment B has demand for your product QB = 120 – 2P. Segment A has
1000 people in it. Segment B has 1200 people in it. The monopolist has a
constant marginal cost of 20.
a. Write down your total market demand if the two segments are
treated as one and carefully explain how you obtained it.
b. Assume that you must charge the same price to both segments.
What is the profit-maximizing price? What are your profits?
c. Suppose that you can separate the two segments and charge
separate profit-maximizing prices to each. What will these prices
be? What are your total profits?
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

a. Segment A: QA = 50 – P for P ≤ 50 as for any P > 50 segment A people buy

zero units. As there are 1000 type A consumers, the total demand from
segment A is QA = 1000(50 – P) = 50000 – 1000P (for P ≤ 50).

Segment B: QB = 120 – 2P for P ≤ 60 as for any P > 60 segment B people buy

zero units. As there are 1200 type B consumers, the total demand from
segment B is QB = 1200(120 – 2P) = 144000 – 2400P (for P ≤ 60).

Therefore total demand is:

Q = QB = 144000 – 2400P for 50 ≤ P ≤ 60 (only segment B is active)

Q = QA + QB = 144000 – 2400P + 50000 – 1000P = 194000 – 3400P for P <
50 (both segments are active)

b. For 50 ≤ P < 60 the only consumers in the market are segment B consumers.
We proceed by first deriving total revenue TR and then marginal revenue MR.
But first, we need to rewrite the demand function in its inverse form

Q = 144000 – 2400P
P = 60 – Q/2400
TR = PQ = 60Q – Q2/2400
MR = dTR/dQ = 60 – Q/1200

We need to calculate the MR at the break point (that is when segment A

customers begin to enter the market) P = 50, Q = 24000. Why? Remember
that profit maximization requires MR = MC. If the MR at P = 50, Q = 24000
is above 20 then MR > MC and it is optimal to further reduce the price. In
other words, the relevant part of the MR is when both segments are active (Q
= 194000 – 3400P).

MR = 60 – Q/1200
MR = 60 – 24000/1200
MR = 40

So MR > MC at Q = 24000. It is optimal to reduce price. We now derive the

TR and MR for P < 50. First, express the demand function it its inverse form

Q = 194000 – 3400P
P = 57.06 – Q/3400
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

TR = PQ = 57.06Q – Q2/3400
MR = 57.06 – Q/1700

MR = MC
57.06 – Q/1700 = 20
Q/1700 = 37.06
Q = 63002

And the corresponding price is

P = 57.06 – 63002/3400
P = 38.53

Finally the profits

π = (P – c)Q
π = (38.53 – 20)63002
π = 1167426.06

c. The problem can now be solved as two separate markets. In each, you pick the
profit maximizing quantity to sell to the segment by setting marginal cost
equal to the marginal revenue

Segment A:
QA = 50000 – 1000P
P = 50 – QA/1000
TR = PQ = 50Q – Q2/1000
MR = 50 – Q/500

MR = MC
50 – Q/500 = 20
Q/500 = 30
QA = 15000

And the price from the demand function

P = 50 – QA/1000
P = 50 – 15000/1000
PA = 35

Segment B:
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

QB = 144000 – 2400P
P = 60 – QB/2400
TR = PQ = 60Q – Q2/2400
MR = 60 – Q/1200

MR = MC
60 – Q/1200 = 20
Q/1200 = 40
QB = 48000

And the price from the demand function

P = 60 – QB/2400
P = 60 – 48000/2400
PB = 40

Finally the profits

π = (PA – c)QA + (PB – c)QB

π = (35 – 20)15000 + (40 – 20)48000
π = 225000 + 960000 = 1185000

An increase of £17573.94 compared to the no price discrimination case

4. Suppose that Coca-Cola uses a new type of vending machine that charges
a price according to the outside temperature. On “hot days” - defined as
days in which the outside temperature is 25 Celsius or higher – demand
for vending machine soft drinks is QH = 300 – 2P. On “cool” days – when
the outside temperature is below 25 Celsius - demand is QC = 200 – 2p.
The marginal cost of a soft drink is 20p.
a. What price should the machine charge for a soft drink on “hot”
days? What price should it charge on “cool” days?
b. Suppose that half of the days are “hot” and the other half are
“cold”. If Coca-Cola uses a traditional machine that is simply
programmed to charge the same price regardless of the weather,
what price should it set? (Hint: when both markets are active,
aggregate demand, QA, is QA = 0.5QH + 0.5QC)
c. Compare Coca-Cola’s profit from a weather-sensitive machine to a
traditional, uniform pricing machine. (Hint: total profits when
both markets are active are given by 0.5πH + 0.5πC)
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

a. On a hot day Q = 0.5QH = 0.5(300 – 2P) = 150 – P or in the inverse form P =

150 – Q.

TR = PQ = 150Q – Q2
MR = dTR/dQ = 150 – 2Q

MR = MC
150 – 2Q = 20
QH = 65

P = 150 – QH
P = 150 – 65
PH = 85

On a cold date Q = 0.5QC = 0.5(200 – 2P) = 100 – P or P = 100 – Q

TR = PQ = 100Q – Q2
MR = 100 – 2Q

MR = MC
100 – 2Q = 20
QC = 40

P = 100 – Q
P = 100 – 40
PC = 60

b. Hot day: QH = 300 – 2P for P ≤ 150.

Cold day: QC = 200 – 2P for P ≤ 100.

Therefore aggregate demand is:

Q = 0.5QH = 150 – P for 100 ≤ P ≤ 150 (market active only on hot days)
Q = QA = 0.5QH + 0.5QC = 0.5(300 – 2P) + 0.5(200 – 2P) = 250 – 2P for P <
100 (market active both on hot and cold days – we multiply QH and QC by 0.5
to take into account that half of days are hot and half cold).

For 100 ≤ P ≤ 150 the market is active only on hot days. The relevant total
revenue is

TR = PQ = 150Q – Q2
Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

MR = 150 – 2Q

Calculating MR at P = 100, Q = 50 gives us

MR = 150 – 100
MR = 50

So MR > MC at Q = 50. It is optimal to reduce price. We now derive the TR

and MR for P < 100. First, express the demand function it its inverse form

Q = 250 – 2P
P = 125 – Q/2

TR = PQ = 125Q – Q2/2
MR = 125 – Q

MR = MC
125 – Q = 20
QA = 105

And from the demand function the price is

P = 125 – QA/2
P = 125 – 105/2
PA = 72.5

c. Under price discrimination (part a), profits on a hot day are

πH = (PH – c)QH
πH = (85 – 20)130
πH = 8450p or £84.50

On a cold day profits are

πC = (PC – c)QC
πC = (60 – 20)80
πH = 3200p or £32

So total profits are equal to

Economics of Strategy: Answers to tutorial questions (Evagelos Pafilis)

0.5πH + 0.5πC = 0.5(84.50) + 0.5(32) = £58.25

Under no price discrimination (part b), expected profits are equal to

πA = (PA – c)QA
πA = (72.5 – 20)105
πA = 5512.5p or £55.13
 Economics of Strategy
Tutorial 9 - Questions
Non-linear Pricing

1. First-time subscribers to the Economist pay a lower rate than repeat

subscribers. Is this price discrimination? Of what type?

2. Passengers travelling on Japanese Airlines flights have the option to buy Wi-Fi
access in various packages. A 1-hour plan currently goes for a price of $10.15, a
3-hour plan sells for $14.40 and a 24-hour plan for $18.89. Briefly describe
the pricing tactics reflected in these options.

3. A study of the New York fish market (when it was the Fulton fish market)
suggests that the average price paid for whiting by Asian buyers is significantly
lower than the price paid by White buyers.1 What type of price discrimination
does this correspond to, if any? What additional information would you need
to answer the question?

4. RawDeal is the only sushi bar in the neighbourhood. Their estimated marginal
cost is £0.1 per sushi unit. RawDeal estimates that each consumer has a
demand for sushi given by 𝑞 = 20 − 10𝑝, where 𝑞 is number of sushi units and
𝑝 is price in pounds per unit.
a. Determine the optimal price per sushi unit.
b. RawDeal is considering switching to an all-you-can-eat-sushi policy.
Determine the optimal price per customer. How does profit compare to
pricing per unit?
c. Discuss other advantages and disadvantages of each pricing option.
d. Ignoring implementation costs, what is the optimal two-part tariff for
sushi (i.e., a fee at the door plus a price per sushi piece).

1
Graddy, Kathryn (1995), “Testing for Imperfect Competition at the Fulton Fish Market,“ Rand Journal of
Economics 26, 75-92.
5. A local bar owner has a constant marginal cost of £2 per drink. He determines
that the demand for drinks is different for under 25 than it is for those age 25
and over, with each group comprising of an equal number of individuals.
Specifically, he discovers that the demand for drinks is:

Age 18-24: 𝑞 𝑢 = 18 − 3𝑝

Age 25 and over: 𝑞 𝑜 = 10 − 2𝑝

a. If the local bar owner could separate the groups and practice third-
degree price discrimination, what price per drink would be charged to
members of each group? What would be the bar owner's profit in this
case?

b. Now suppose that the bar owner can implement two part-pricing (i.e.
entry fee plus number of drink tokens) by checking ids at entry

i. What will the entry charge and number of drink token be for
each group?

ii. What would be the bar owner’s profit under this regime?