ME Problem Set X

PGP 2016-18
1. There are only two firms producing newgelly (a new substance used in the
manufacturing of ice-cream substitutes). Each can produce either 1 or 2 or 3 tons of
newgelly. The demand function is given by
Total Quantity
(measured in tons)
2
3
4
5
6

Price
20
18
10
8
4

Firm 1s total cost function is given by: TC = 1 + 4q

Firm 2s total cost function is given by: TC = 4 + 2q
(i)In each cell of the following table enter a pair of numbers (x, y), x is the profit of firm 1
and y is the profit of firm 2.
Firm 2
1

1
Firm 1

2
3

(ii) Which outcomes are Nash Equilibria?

(iii) Is there a Nash equilibrium that both firms prefer to all the other Nash equilibria?

2. Sony Electronics produces a home video game that has become very popular with
children. Sony's managers have reason to believe that Bonny Electronics is
considering entering the market with a competing product. Sony must decide whether
to set a high price to accommodate entry or a low, entry-deterring price. The payoff
matrix below shows the profit outcome for each company under the alternative price
and entry strategies. Sony's profit is entered before the comma, and Bonny's is after
the comma.

Bonny

Sony

(i)
(ii)

Enter

Dont enter

High
price

60 , 25

85 , 0

Low
Price

30 , - 20

60, 0

Does Sony have a dominant strategy?

Sonys managers have vaguely suggested a willingness to lower price in order
to deter entry. Is this threat credible in light of the payoff matrix above?

3. Two spiders find a dead insect at the same time, each spider will make menacing
gestures to scare off the other. If one spider backs down, that spider gets nothing and
the other spider gets the insect to itself. If both spiders back down, they can share the
insect. If neither backs down, the spiders will fight. The payoffs resulting from the
fight depend on the sizes of the spiders and are described below.
Spider 2

Spider 1

Back Down

Fight

Back
Down

5,5

0 , 10

Fight

10 , 0

x, y

(i) Suppose the spiders are the same size so that x = y. For what values of x, will each spider
have a dominant strategy?
(ii) Again, suppose the spiders are the same size. For what values of x, will this game be a
Prisoners Dilemma?
(iii) Suppose when spider 1 is smaller than spider 2 that x < 0 < y. Find the unique solution of
this game.

4. A competitive refining industry produces one unit of waste for each unit of refined product.
The industry disposes of the waste by releasing it into the atmosphere. The inverse demand
curve for the refined product (which is also the marginal benefit curve) is Pd = 24 - Q, where
Q is the quantity consumed when the price consumers pay is Pd. The inverse supply curve
(also the marginal private cost curve) for refining is MPC = 2 + Q, where MPC is the
marginal private cost when the industry produces Q units. The marginal external cost curve is
MEC = 0.5Q, where MEC is the marginal external cost when the industry releases Q units of
waste.
a) What are the equilibrium price and quantity for the refined product when there is no
correction for the externality?
b) How much of the chemical should the market supply at the social optimum?
c) How large is the deadweight loss from the externality?
d) Suppose the government imposes an emissions fee of $T per unit of emissions. How large
should the emissions fee be if the market is to produce the economically efficient amount of
the refined product?
5. Consider a manufactured good whose production process generates pollution. The annual
demand for the good is given by Qd = 100 - 3P. The annual market supply is given by Qs = P.
In both equations, P is the price in dollars per unit. For every unit of output produced, the
industry emits one unit of pollution. The marginal damage from each unit of pollution is given
by 2Q.
a) Find the equilibrium price and quantity in a market with no government intervention.
b) At the equilibrium you computed, calculate: (i) consumer surplus; (ii) producer surplus;
(iii) total dollars of pollution damage. What are the overall social benefits in the market?
c) Find the socially optimal quantity of the good. What is the socially optimal market price?
d) At the social optimum you computed, calculate: (i) consumer surplus; (ii) producer surplus;
and (iii) total dollars of pollution damage. What are the overall social benefits in the market?
e) Suppose an emissions fee is imposed on producers. What emissions fee would induce the
socially optimal quantity of the good?
6. The demand for widgets is given by P = 60 - Q. Widgets are competitively supplied according
to the inverse supply curve (and marginal private cost) MPC = c. However, the production of
widgets releases a toxic gas into the atmosphere, creating a marginal external cost of MEC =
Q.
a) Suppose the government is considering imposing a tax of $T per unit. Find the level of the
tax, T, that ensures the socially optimal amount of widgets will be produced in a competitive
equilibrium.
b) Suppose a breakthrough in widget technology lowers the marginal private cost, c, by $1.
How will this affect the optimal tax you found in part (a)?