Industrial Organization, Answers Working group week 5

Entry deterrence
November 27, 2014

Question 1- Stackelberg leadership

(a) To deter entry firm 2 must make zero profits or less from participating in this market:
2 = q2 (P c) F = q2 (2520 50(q1 + q2 ) 120) 5000
= q2 (2400 50q1 50q2 ) 5000
In order to make this a function only of firm 1s chosen output, lets find the best response
function of firm 2 to firm 1 output choice:
d2
=0
dq2
= 2400 50q1 100q2 = 0
q1
q2 = 24
2
Plug this into the profit function of firm 2 to find out at what minimum level of firm 1 production,
q1 , firm 2 would not benefit from entering the market.
q1
q1
)(2400 50q1 50(24 )) 5000 = 0
2
2
q1
q1
0 = (24 )(1200 50 ) 5000
2
2
q1 2
5000 = 50(24 )
2
q1
10 = 24
2
q1 = 28

2 (q1 ) = (24

The profit of the Stackelberg leader is then given by:

1 = q1 (P c) = q1 (2520 50q1 120)

= 28(2400 50 28) = 28000
(b) In case of entry accomodation, firm 1 will produce its optimal quantity given the best response
function of firm 2.
1 = q1 (P c) = q1 (2520 50(q1 + q2 ) 120)
q1
= q1 (2400 50(q1 + 24 ))
2
= q1 (1200 25q1 )

Take a first order condition to find firm 1s optimal output:

d1
=0
dq1
1200 50q1 = 0
q1 = 24
q2 = 24

q1
= 12
2

Profits are then given by:

1 = q1 (P c) = 24(2520 50(24 + 12) 120) = 14400
2 = q2 (P c) 5000 = 12(2520 50(24 + 12) 120) 5000 = 2200

(c) Firm 1 earns higher profits when it deters the entry of firm 2.

Question 2-Entry deterrence

(a) Sequential competition can be solved through backward induction. Lets see what firm 2s best
response is for a given choice of q1 in the first round.

T R2 = p q2 = (110 q1 q2 )q2
M R2 = 110 q1 2q2 = M C2 = 10
q1
q2 = 50
2
Knowing that this will be the response of firm 2, firm 1 equates his marginal revenue to marginal
costs:

T R1 = p q1 = (110 q1 q2 )q1
q1
= (110 q1 (50 ))q1
2
q1
= (60 )q1
2
M R1 = 60 q1 = M C1 = 20
q1 = 40
q2 = 50

q1
= 30
2

These output levels give rise to a market price of p = 40 so that profits are:
1 = q1 (p AC1 ) = 40(40 20) = 800
2 = q2 (p AC2 ) = 30(40 10) = 900
(b) We must find out the level q1 which given the reaction function we found under (a) leads to non
positive profits for firm 2 if it decides to enter the market. We know firm 2 will react to a choice
of q1 by: q2 = 50 q21 . With this we can write firm 2s profit as a function of e and the output

choice of firm 1:
2 = q2 (p M C2 ) e
q1
= (50 )(110 q1 q2 10) e
2
q1
q1
= (50 )(50 ) e
2
2
q1 2
= (50 ) e
2
Now that we have firm 2s profits as a function of firm 1s output choice lets find out what firm
1 must do to deter firm 2 from entering:
q1
2 = (50 )2 e 0
2

q1
e
50
2
100 2 e q1

So any q1 100 2 e will ensure that firm 2 does not enter the market. Given that as a
monopolist firm 1 would act:
T R1 = p q1 = (110 q1 )q1
M R1 = 110 2q1 = M C1 = 20
q1M = 45

For any e 27.52 , the restriction q1 100 2 e will be binding strictly. Firm 1 would rathest
produce 45 as a monopolist,
but in order to become a monopolist he will need to produce more,

namely: q1 = 100 2 e. Assuming this is the case, firm 1s profits will be:

1 = q1 (p AC1 )

= (100 2 e) (110 (100 2 e) 20)

= (100 2 e) (2 e 10)
(c) Firm 1 would find it profitable to deter entry if its profits in this case are higher than in the
case of accomodation. From (a) and (b) we have the two profit levels, so that its beneficial to
deter entry if e is such that:

(100 2 e) (2 e 10) > 800

Question 3- Subgame perfect NE

(a) A strategy is a list of actions that the agent plans to play one action for each possible situation
where he or she could be required to make a decision.
Player 1 has two possible actions at a single action point in the game so strategies: S1 = {M, C}.
Player 2 has two possible actions at two possible action points (one following each of player 1s
choices) so his total number of strategies to choose from is 22 = 4: S2 = {SS, SC, CS, CC}.
The order denotes that player 2 plays the first action in response to player 1 choosing M, and
the second action in response to player 1 choosing C.
(b) A starting version of the game tree would incorporate the two sequential decisions of the firms.
Figure 1 is a preliminary tree and denotes the order and possibilities of the game, but lacks the
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Figure 1: Game Tree

Game Tree.png
payoffs resulting from different outcomes. Calculate those:
Ac
20 8
=
=6
2B
2
Ac
20 8
qC =
=
=4
3B
3
Ac
20 8
qS =
=
=3
4B
4

qM =

If firm 1 plays M and 2 plays S we get bottom left of the game tree. Then: P c = 20q1 q2 c =
3 so that: 1 = q1 (p c) = 6 3 = 18, and 2 = q2 (p c) = 3 3 = 9.
If firm 1 plays M and 2 plays C we get to the second from the left bottom outcome. Then:
P c = 20 q1 q2 c = 2 so that: 1 = q1 (p c) = 6 2 = 12, and 2 = q2 (p c) = 4 2 = 8.
If firm 1 plays C and 2 plays S we get to the second from the right bottom outcome. Then:
P c = 20 q1 q2 c = 5 so that: 1 = q1 (p c) = 4 5 = 20, and 2 = q2 (p c) = 3 5 = 15.
If firm 1 plays C and 2 plays C we get to the bottom right outcome. Then: P c = 20q1 q2 c =
4 so that: 1 = q1 (p c) = 4 4 = 16, and 2 = q2 (p c) = 4 4 = 16.
The full game tree then becomes figure 2.
Two write down the payoff matrix put all strategy possibilities of one player on the horizontal
axis and all those of the other on the vertical axis. Put in each cell of the matrix the outcome
resulting from these strategies being played against each other.

M
C

SS
[18,9]
[20,15]

SC
[18,9]
[16,16]

CS
[12,8]
[20,15]

Table 1: Payoff matrix

CC
[12,8]
[16,16]

(c) To find the subgame perfect NE of this game the game tree representation is most useful because
it shows the sequential nature of the game and allows for backward induction. The most efficient
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Figure 2: Game Tree

Game Tree.png
way of identifying SPNE is to apply this. Look at the choice of player 2 if player 1 chose M,
then S is the preferred strategy. Similarly, look at the choice of player 2 if player 1 chose C, then
C is the preferred strategy. Knowing that this is how player 2 will choose, player 1 in choosing
between M and C is effectively choosing between outcomes [18,9] and [16,16] respectively. He
prefers to choose M then so that the SPNE is strategy combination: {M, SC}.
(d) To find all the NE the payoff matrix is most useful. For each column of the matrix, strategy of
firm 2, underline the outcome of firm 1 corresponding to its best response for this column:

M
C

SS
[18,9]
[20,15]

SC
[18,9]
[16,16]

Table 2: Payoff matrix best responses firm 1

CS
CC
[12,8]
[12,8]
[20,15] [16,16]

Now do the same on a row basis for player 2. So identify through underlining for each row,
strategy of firm 1, the outcome corresponding to the best response of firm 2 for this row. Then
we get:

M
C

SS
[18,9]
[20,15]

SC
[18,9]
[16,16]

Table 3: Payoff matrix best responses both

CS
CC
[12,8]
[12,8]
[20,15] [16,16]

Those cells where both players are playing best responses to each others strategies are NE:
{M, SC} and {C, CC}.
The more believable of these two is the first: {M, SC}, because this NE is also subgame perfect
whilst the other is not. The strategies being used in this NE are NE in every subgame which does
not hold for {C, CC}. Consider the latter strategy. In the subgame consisting of the lefthand
side decision node of player 2 followed to the end, promising to play C is not a best response
at all. It serves as a threat to convince player 1 not to choose M, but this is incredible. The
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NE solution concept allows you to promise whatever in parts of the game tree that you do not
reach. Subgame perfectness strengthens this by requiring that what you promise to do there is
in your own best interest assuming the game did get there.