Suppose the airline industry consists of two firms, A and B. These two firms engage in Cournot competition with each other over a certain route for which inverse demand is

ECN121A (INDUSTRIAL ORGANIZATION) PROBLEM SET 2 DUE BEGINNING OF CLASS: Question 1: [50 points] Suppose the airline industry consists of two firms, A and B. These two firms engage in Cournot competition with each other over a certain route for which inverse demand is P(Q) = 1000 ! Q with Q = qA + qB. The main component of each airline’s marginal cost is fuel which is assumed to cost 400 per flight (regardless of the number of passengers). (a) [10 points] Solve for the Cournot equilibrium price. Suppose the airlines figure out a way to collude with each other and still have the same fuel cost of 400 per flight. (b) [10 points] Solve for the market price when the two firms collude Suppose for whatever reason the world price of oil falls (as it has), and fuel costs for the airlines fall with it so that their marginal cost is now 100 per flight. (c) [10 points] Solve for the new Cournot equilibrium price assuming the firms are not colluding. (d) [10 points] Solve for the new market price assuming the firms are colluding. As of July 1, 2015, the Department of Justice has begun investigating the major U.S. carriers for collusion because they have noted that fuel costs have fallen recently, yet airfares have not. (e) [5 points] In the example I have given, what do you note about how fares change when costs fall? As an economist for the Department of Justice, does the direction of the change in fares in response to a change in marginal costs provide any evidence of whether or not the airlines are colluding? (f) [5 points] In a single line, give one possible reason for why the fares charged by the airlines may not have changed despite their costs falling. Question 2: [40 points] Consider Bertrand competition with homogeneous products. Two firms, 1 and 2, produce an identical product and compete by choosing price. Consumers buy from the firm with the lower price. If the prices are identical, however, assume all consumers buy from firm 1. Inverse demand for the product is given by Q = 80 ! P and each firm has a marginal cost of 10. Assume that the firms can only set integer prices, so if one wants to undercut the other by the smallest amount possible, the undercut must be at least a dollar. (a) [10 points] Write out the best response function of firm 1 for any price that firm 2 could choose. 1 (b) [10 points] Write out the best response function of firm 2 for any price that firm 1 could choose. (c) [20 points] What is/are the Nash equilibrium/equilibria of this game? Question 3: [20 points] Consider Bertrand competition but with differentiated products. The products are Mishka’s coffee and Temple coffee. The demand for Mishka’s coffee is given by qM = 12 ! 2pM + pT where pM is the own price of coffee and pT is Temple’s price of coffee. Demand for Temple’s coffee is qT = 12 ! 2pT + pM. Note that because the products are differentiated, if one coffee shop sets a lower price it does not capture the entire coffee market. Assume the marginal cost of each coffee shop is 3. (a) [10 points] Find the best response functions of each coffee shop. (b) [10 points] Solve for the equilibrium prices of each coffee shop. Question 4: [40 points] Consider two maple syrup producers that engage in Cournot competition. Inverse demand for maple syrup is given by P(Q) = 16 ! Q and the marginal cost of each producer is 4. The two producers compete with each other each period by choosing an amount of maple syrup to produce, q1 and q2, respectively. (a) [10 points] If the producers do not collude, what is the Cournot equilibrium amount of syrup produced by each firm every period and what are the lifetime profits of each producer? (b) [10 points] If the discount factor of each producer is d = 0.2, will the firms be able to sustain collusion using the grim punishment strategy? (c) [10 points] How much would the producers together be willing to pay to lobby the government to implement a maple syrup quota system that limits each producer to producing 3 units of maple syrup a month? (d) [10 points] Do you expect jam producers to support, be indifferent to, or be against the maple syrup cartel? Explain your answer. 2