Industrial Organization: Problem Set (Chapters #1 to #3)

Raúl Bajo ([email protected])

1. Returns to scale

(a) Consider the following production function with n + m inputs:

 
y = (α1 x1 + α2 x2 + · · · + αn xn ) + xβn+1
1
· xβn+2
2
· · · xβn+m
m

Find the values of α1 , α2 , · · · , αn , β1 , β2 , · · · , βm , such that the previous production

function exhibits constant returns to scale.
(b) Consider a production function with 3 inputs, namely labor (L), capital (K), and energy
(E):
ε
y = [αK ρ + βLρ + γE ρ ] ρ
where y is the output level and α, β, γ > 0. Find the values of ρ and ε such that the
previous production function exhibits constant returns to scale.
ε
(c) Consider again the previous production function. i.e., y = [αK ρ + βLρ + γE ρ ] ρ . Find
and interpret the marginal product of energy (E).

2. Show (using an example) whether the following statements are true or false.

(a) A production function can exhibit constant returns to scale while having constant
marginal products of its inputs.
(b) If a production function exhibits decreasing returns to scale then the marginal products
of the inputs cannot be decreasing.

3. Pepa Inc. is a succesful company founded by a former UNAV student. The company produces
manufactured goods. All the production takes place in a big factory. The factory uses three
inputs to produce its output –capital (K), labor (L) and energy (E). The production function
of the company is as follows: y = K 0.25 L0.5 E 0.20 , where y is the amount of production
(manufactured goods). Furthermore, we know that the cost of labor is w = 4, the cost of
capital is r = 2 and the cost of energy is p = 8.
In the long-run capital is flexible. Therefore, the company can choose K. If the goal of the
company is also to produce y = 500 in the long-run, what is the amount of capital, labor and
energy that minimize the cost of the firm?

4. Italian Catsup, Ltd. is a factory located in the Allegheny County. The factory uses Italian
tomatoes
√ (T ) to produce ketchup. We know that the production function of this factory is
ε
y = γ T , where γ > 0 and ε > 1. We assume that the cost of Italian tomatoes is c. The
firm sells ketchup at price p > c > 0.

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 (a) Formulate the profit-maximization problem and find the amount of Italian tomatoes (as
a function of p, c, γ and ε) employed by Italian Catsup, Ltd. if the goal of this company
is to maximize profit. Plot your solution.
(b) What is the marginal product of Italian tomatoes? Show that (at the optimum) the
value of the marginal product of Italian tomatoes is equal to the cost of Italian tomatoes
(or, as shown in class, that the marginal revenue of Italian tomatoes is equal to the
marginal cost of Italian tomatoes). Explain your result.

5. Consider the following production function:

y ≡ f (x1 , x2 , x3 , x4 ) = min{2x1 , 4x2 } + min{x3 , 2x4 }, where x1 , x2 , x3 , and x4 are different
inputs. The cost of all these inputs is the same and equal to 1; that is wi = 1 for all
i ∈ {1, 2, 3, 4}. Provide the expression of the Total Cost as a function of y.

6. Consider the following production function: y ≡ f (x1 , x2 , x3 , x4 ) = min{x1 + x20.5 , x0.5

3 + x4 },
where x1 , x2 , x3 , and x4 are different inputs. Let us denote by wi the cost of input i ∈
{1, 2, 3, 4}. Find the expression of the Total Cost as a function of w1 , w2 , w3 , w4 and y.

7. This exercise discusses the “fuel-switching” effect that typically occurs in the power plants in
New England during winter when, due to pipeline capacity constraints, natural gas becomes
scarce and power plants find it cheaper to produce electricity out of oil. For more information,
see http://goo.gl/jCvsu1.
First Choice, Inc. is a power plant that operates in Wellfleet (MA). The plant uses two fuels
to produce electricity: natural gas (G) and oil (O). Normally, the plant uses natural gas.
However, when electricity demand peaks (usually in Winter), the plant also uses oil.
The production function of the power plant can be written y = log G + O. The cost of natural
gas is pG and the cost of oil is pO . The goal of the firm is to minimize cost.1

(a) Find the optimal amount of natural gas (G∗ ) and oil (O∗ ) (as a function of pG , pO , and
y) that minimize the cost of First Choice, Inc..
(b) Find the threshold value of pG (as a function of ȳ) at which the firm is willing to “switch
fuels”.

In Barnstable (MA), there is another power plant that uses either natural gas or oil to produce
electricity. The production function of the power plant can be written as y = log (4G + 2O).

(c) Plot the isoquants associated to the production levels y = 3 and y = 4.

(d) Assume that the price of electricity is 4, pG = 2 y pO = 3. What is the optimal amount
of Gand O that maximizes the profit of the firm? Find the relative prices of the inputs

pG
pO such that the firm is indifferent between using G and O to produce.

8. XYZ, Ltd. is an upstream firm that extracts oil in Williston (ND). The costs for this company
are c(q) = 2q 2 + 50 and c(0) = 0 if q = 0 (i.e. 50 is the avoidable fixed cost or quasi-fixed
cost), where q denotes a barrel of oil produced by the company. Denote p as the market price
of a barrel.
1
Hint: Recall that if y = log(x) then ey = x, where e is the Euler’s number (2.71828...).

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 (a) Find the supply function of the firm. Plot the solution.
(b) Find the price of a barrel of oil at which the firm is willing to produce a positive amount.
(c) If the price of a barrel of oil is 25, how many barrels will XYZ, Ltd. be willing to
produce?

9. In the industry of chairs with reclining back (which is perfectly competitive) there are two
production technologies, with the following total cost functions, C1 (y) = 200+190y−30y 2 +y 3
and C2 (y) = 1000 + 600y + y 3 (respectively), where y is the amount of chairs produced.
Due to the Swedish competence, the market price of a chair has decreased, and is currently 190
euros. In the short-run, should the firms with costs C1 (y) produce or should they shut-down?
Should the firms with costs C2 (y) produce or should they shut-down?

10. Assume that the inverse demand function in the market is given by p(Q) = −α(Q)2 + β,
where Q is the total quantity and α, β > 0. Let us denote n the total number of firms in the
market. Firms have the following cost function: c(qn ) = qn2 , where qn is the production of
each firm, given that there are n firms in the market. Finally, let us assume that ∂qn
∂n < 0,
and that firms that produce in the market incur in a positive entry cost F .
∂qn
(a) Briefly, discuss, why is it reasonable to assume that ∂n < 0?
(b) Set up the welfare equation. Then take the First Order Condition that maximizes welfare
by choosing the number of firms in the market n.
(c) Show that the number of firms in part (b) is equal to the number of firms assuming that
the market is perfectly-competitive (i.e. assuming that there is free-entry).

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 Industrial Organization 2023-24
Problem Set 2

1. A monopolist can produce at a constant average (and marginal) cost of AC = M C = $5. It

faces a market demand curve given by q = 53 − p.

(a) Calculate the profit-maximizing price and quantity for this monopolist. Also calculate
its profits.
(b) Suppose a second firm enters the market. Let q1 be the output of the first firm and
q2 be the output of the second. Market demand is now given by q1 + q2 = 53 − p.
Assuming that this second firm has the same costs as the first, write the profits of each
firm as functions of q1 and q2 .
(c) Suppose (as in the Cournot model) that each firm chooses its profit-maximizing level
of output on the assumption that its competitor’s output is fixed. Find each firm’s
reaction function.
(d) Calculate the Cournot equilibrium. What are the resulting market price and profits of
each firm?
(e) Suppose there are N firms in the industry, all with the same constant marginal cost,
M C = $5. Find the Cournot equilibrium. How much will each firm produce, what will
be the market price, and how much profit will each firm earn? Also, show that as N
becomes large, the market price approaches the price that would prevail under perfect
competition.

2. Two quantity-setting firms in a market face a linear inverse demand function p = 1 − Q,

where Q is industry output. Both firms have identical costs of production

q2
C(q) =
2

Firm 1 can sell the same good as a monopolist in another market as well as in the market
that we are considering, whereas firm 2 can not do so. The demand function in the second
market is D(p) = a − p. Determine firm 1’s optimal production level in each of the two
markets as a function of the parameter a (i.e. how many units should firm 1 sell in each
market for any value of a > 0).

3. Consider a homogeneous product industry with inverse demand given by p = 100 − Q.

Variable costs are zero. There is currently one incumbent firm and one potential competitor.
Entry into the industry implies a sunk cost of F .

(a) Determine the incumbent’s optimal output in the absence of potential competition.
(b) Suppose the entrant takes the incumbent’s output as given. What output should the
incumbent firm set to deter entry?
(c) Calculate the Stackelberg equilibrium, assuming no fixed costs of entry. Is the entrant
willing to enter the market?

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4. In a market with annual demand Q = 100 − p, there are two firms, A and B, that make
identical products. Because their products are identical, if one charges a lower price than
the other, all consumers will want to buy from the lower-priced firm. If they charge the same
price, consumers are indifferent and end up splitting their purchases about evenly between
the firms. Marginal cost is constant and there are no capacity constraints.

(a) What are the single-period Nash equilibrium prices, pA and pB ?

(b) What prices would maximize the two firms’ joint profits?
Assume that one firm cannot observe the other’s price until after it has set its own price
for the year. Assume further that both firms know that if one undercuts the other, they
will revert forever to the non-cooperative behavior you described in (a).
(c) If the interest rate is 10%, is one repeated-game Nash equilibrium for both firms to
charge the price you found in part (b)? What if the interest rate is 110%? What is the
highest interest rate at which the joint profit-maximizing price is sustainable?