HE3001 Tutorial 9 Solutions

1) Sol Microsystems has recently invented a new language, Guava, which runs on a proprietary chip, the
Guavachip. The chip can only be used to run Guava, and Guava can only run on the Guavachip. Sol
estimates that if it sells the chip for a price pc and the language for a price p g, the demand for the chip-
language system will be

x=120−( p c + p ¿ ¿ g)¿
(a) Sol initially sets up two independent subsidiaries, one to produce the chip and one to produce the
language. Each of the subsidiaries will price its product so as to maximize its profits, while assuming that
a change in its own price will not affect the pricing decision of the other subsidiary. Assume that marginal
costs are negligible for each company. If the price of the language is set at p g, what is the chip company’s
profit function (neglecting fixed costs)?

(120−p c − p ¿ ¿ g) pc ¿

(b) Calculate the optimal choice of pc as a function of p g.

Differentiate the profit function with respect to pc and set the result equal to zero.

120−2 pc − p g=0

pc =60− pg /2

(c) Now consider the language subsidiary’s pricing decision. What is the optimal choice of p g as a
function of pc .

p g=60−p c /2

(d) Solving these two equations in two unknowns, what are the values of pc and p g.

pc = p g=40 so that pc + pg =80

(e) Sol Microsystems decides that the independent subsidiary system is cumbersome, so it sets up Guava
Computing which sells a bundled system consisting of the chip and the language. Let p be the price of the
bundle. What is Guava Computing’s profit function?

(120 – p) p

(f) What is the optimal choice of p?

Differentiate the profit function with respect to p and set the result equal to zero.

p=60
(g) Compare the prices charged by the integrated system and the separate subsidiaries. Which is lower?
Which is better for consumers? Which makes more profit?

Integrated system has a lower price and is better for consumers.

Profit ( integrated )=( 120−60 )∗60=3600

Profit ( separate )=2∗(120−40−40 )∗40=3200
Integrated system makes more profit.

2) Microsystems Henrietta Fowler publishes Metropolitan Chicken magazine which obtains revenue from
both readers and advertisers.

The number of subscribers to Metropolitan Chicken is determined by the demand equation

QS =4000−PS where PS is the subscription price measured in cents. The cost of printing, handling, and
mailing a copy of Metropolitan Chicken is 400 cents per subscriber.

If she charges advertisers a rate of P A cents per-subscriber for each ad, she could attract Q A =80−P A
advertisements. Suppose that the cost of printing and distributing an advertisement is negligible.

(a) Write an expression for Metropolitan Chicken’s total revenue from advertising as a function of the
variables Q A and Q S . (Remember that total revenue is revenue per reader times the number of readers.)
Solve for the number of ads Q A and the price charged per-subscriber P A that maximizes her advertising
revenue.

Revenue ¿ advertising=revenue per reader ×the number of readers

¿(80−Q A )Q A ×Q S

Differentiate the revenue function with respect to Q A and set the result equal to zero.

QS (80−2Q A )=0
P A =40 , Q A =40

(b) Does this answer depend on the number of subscriptions sold? How much extra advertising revenue
(in cents) would Henrietta get if she added one more subscriber?

No, as long as there are a positive number of subscriptions, the optimal price to charge advertisers is 40 .

Revenue per reader ¿ 40 × 40=1600 cents.

(c) Write an expression for Metropolitan Chicken’s profits from subscriptions (total subscription revenue
minus costs of printing, handling, and mailing to subscribers) as a function of Q S . If Henrietta were to
choose Q S to maximize subscription profits, how many subscriptions would she sell and at what price?
2
Profits from subscriptions = ( 4000−Q S ) Q S−400 Q S =3600 Q S−Q S

Differentiate profit function with respect to Q S and set the result equal to zero.

3600−2Q S=0

QS =1800 , P S=2200

(d) Suppose Henrietta considers total profit from advertising and subscriptions. Write an expression for
Henrietta’s total profit as a function of the two variables Q A and Q S . What quantities Q A and Q S should
she choose in order to maximize profits and how do these differ from parts b) and c)? Can you explain the
intuition behind this?
2
Total profit= (80−Q A )Q A × Q S +3600 Q S−Q S

Differentiate the profit function with respect to Q A and set the result equal to zero.

Q A =40 , P A =40

Differentiate the profit function with respect to Q S and set the result equal to zero.

( 80−Q A ) Q A + 3600−2 QS =0
1600+3600−2Q S=0

QS =2600 , PS=1400
As you can see, there is now a lower price for subscriptions and higher number of subscriptions. This is
because subscriptions are complementary with advertisements, and when taking this into account, this
means that more are desired.

3) A group of 13 consumers are considering whether to connect to a new computer network. Consumer 1
has an initial value of $1 for hooking up to the network, consumer 2 has an initial value of $2, consumer 3
has an initial value of $3, and so on up to consumer 13.

Each consumer’s willingness to pay to connect to the network depends on the total number of persons n
who are connected to it. In fact, for each i , consumer i ’s willingness to pay to connect to the network is i
times the total number of persons connected. Thus if 5 people are connected to the network, consumer
1’s willingness to pay is $5, consumer 2’s willingness to pay is $10 and so on.

Assume the following about the dynamics of entry:

Whether a consumer enters or not is determined by a two-step procedure.

 1. Consumers will first consider connecting only if the current marginal consumer in the network
has a (weakly) positive surplus at the market price. (*)
2. They will then decide to connect only if their willingness to pay (including themself in the
market) is at least equal to the price they are charged. (**)

Whether a consumer exits is determined by the following:

1. They will decide to exit if their willingness to pay (including themself in the market) is not at least
equal to the price they are charged. (***)

For this question, pay attention to which rule above (*), (**) and (***) is being used.

(a) What is the highest price at which 8 customers could hook up to the network and all of them either
have a surplus or break even?

Suppose j is the marginal consumer in the network, valuing the good at

p=v j n

Then all consumers i> j value the good more, and so also connect to the network.

1 2 3 4 5 6 7 8 9 10 11 12 13

Assuming that n=8, thus v j=6 . (Count bolded numbers above)

The minimum price needed for consumer 6 to stay connected is:

p=6× 8=48

(b) Suppose that the industry that supplies the computer network is competitive and that the cost of
hooking up each consumer to the network is $48 (i.e. this will be the market price). Will 8 customers be a
(locally) stable market equilibrium?

1 2 3 4 5 6 7 8 9 10 11 12 13

If n=9, marginal consumer 5 will have a value of 45 <48 , hence he will want to exit and the network
shrinks to n=8 (***). Other consumers >5 will have a value higher than 48, hence they will not exit (***).
Other consumers <5 will not consider entering because the marginal consumer does not have a weakly
positive surplus (*).

1 2 3 4 5 6 7 8 9 10 11 12 13

If n=7, the marginal consumer 7 in the market will have a value of 49> 48 , which is a strict surplus,
hence other consumers will consider entering the market (*). In particular only consumer 6 will choose to
enter because his willingness to pay when entering is 8 ×6=48≥ market price (**).

Note that none of the consumers 7 to 13 will exit the market as their willingness to pay are ≥ 48 (***).

The market will hence expand to n=8.

Thus, any small shift away from n=8 will result in a move back to n=8. The market equilibrium is thus
stable.
(c) Suppose that the government offers to subsidize 4 pioneer users with the highest 4 valuations. Non-
pioneer users have to pay the full cost of $48. Show that with this subsidy in place, the number of
consumers who sign up will be less than 8.

1 2 3 4 5 6 7 8 9 10 11 12 13

The top 4 consumers (10, 11 ,12, 13) are the pioneer users in the market who are subsidised.

The marginal consumer, consumer 10, is not earning a surplus at the given market price
(4 ×10−48=−8), hence other consumers will not consider entering the market (*). Thus, given the
market dynamics, only the 4 subsidised pioneer users will stay connected and we will not reach 8
consumers.

Note: other consumers (1 to 9) consider the surplus of consumer 10 at the market price of 48 because
they will not be receiving the subsidy themselves.

(d) Suppose that the government offers to subsidize N pioneer users with the highest N valuations. Non-
pioneer users have to pay the full cost of $48. What is the minimum number of N required for it to reach
8 consumers who sign up?

1 2 3 4 5 6 7 8 9 10 11 12 13

We know that N=4 is not enough, so let us first try N=5 to encourage a total of 5 consumers to sign
up. Suppose the top 5 consumers (9, 10, 11 ,12, 13) have already entered the market. Marginal consumer
9 is not earning a surplus at the market price (9 ×5−48=−3), hence other consumers will not consider
to enter the market (***). Similar to c) , we are unable to reach 8 consumers who sign up.

1 2 3 4 5 6 7 8 9 10 11 12 13

Let us now try N=6 to encourage a total of 6 consumers to sign up. Suppose the top 6 consumers (8, 9,
10, 11 ,12, 13) have already entered the market. Marginal consumer 8 is earning a weakly positive surplus
(6 × 8−48=0), hence other consumers will now consider entering the market (*).
When considering whether to enter, consumers compare their willingness to pay of $ v i ×(6+1)
(Counting themselves) to the cost of $48 (**).

Values: (7,14,21,28,35,42,49,56,63,70,77,84,91)

The next marginal consumer, consumer 7 with a willingness to pay of 49 will hence enter.

With 7 people in the market, we know that from part b), that the market will expand to 8 and stay stable
at 8 consumers.

Note that the rules of entry and exit given in the question will give an equivalent result to the simpler
dynamics given in the lecture where we assume that there will be entry when willingness to pay is higher
than the marginal costs. The reason we need more detailed rules is because here we have zoomed in
onto the individual decisions of each consumer at each point in time.
Following the lecture, you can look at the dynamics by plotting n ( 14−n ) and the line 48. (The
former is derived similar to the lecture where we got n(1001−n). The graph looks something like the
below:

p=n(14−n)

6 8 13

As you can see, 6 is the unstable equilibria, while 8 is the stable equilibria. 6 is also the threshold number
of highest value users, after which the market will expand to 8 on its own.
4) Sam owns the dance hall. He holds a dance every week. This dance hall is one of the few suitable
locations in the county for unattached men and women to meet each other. An admission fee of Pm and
Pw are charged for men and women respectively. At any price, individuals are more likely to come if they
expect to see more persons of the opposite sex. Sam has discovered that if he charges price Pm to men
and if they expect Q w women to be in attendance, then the number of men who will attend is

3
Qm =40−P m + Qw
4
If he charges Pw to women and if they expect Q m men to be present, the number of women who will
attend is

1
Qw =40−P w + Q m
4
(a) Suppose that Sam set the men’s admission fees and gets the revenue from it while Sam’s wife set’s
the women’s admission fees and gets the revenue from it. What will be the prices charged by each of
them and their total revenue in equilibrium?

3
Sam maximises Pm Q m=Pm (40−Pm + Q )
4 w
3
The first order conditions give 40−2 Pm + Q =0
4 w
3
Pm=20+ Qw
8
Substituting into the men’s demand function, this gives:

3
Qm =20+ Qw
8

1
Sam’s wife maximises Pw Q w =Pm (40−P w + Q )
4 m
 1
The first order conditions give 40−2 Pw + Q =0
4 m
1
Pw =20+ Qm
8
Substituting into the women’s demand function, this gives:

1
Qw =20+ Qm
8

60 3
Hence Q m =20+ + Q
8 64 m
220 64
Solving, Q m = × =28.852 … Qw =23.6066 …
8 61
Pm=28.8524 … PW =23.6066 . .

Total revenue is 832.3225 ..+557.272=1380.594

(b) Rearrange the two demand equations above to produce “inverse demand functions” in which prices
are expressed in terms of quantities.

3
Pm=40−Q m + Qw
4
1
Pw =40−Q w + Q m
4

(c) Suppose Sam set’s both the men’s and women’s admission fees. Hence, he chooses prices so as to
maximize his total revenue Pm Q m + Pw Q w . Using your answer to the previous question, write Sam’s
revenue simply as a function of the two variables Q m and Q w .

( 3
4 ) ( 1
Pm Q m + Pw Q w = 40−Q m + Q w Q m + 40−Qw + Qm Q w
4 )
2 2
¿ 40 ( Q m+ Qw )−Qm −Qw +Qm Qw

(a) Sam chooses admission prices so as to maximize his revenue. Please solve for these admission prices
by first finding the values of Q m and Q w that maximize revenue.

Differentiate the revenue function with respect to Q m and set the result equal to zero.

40−2 Qm +Qw =0

Differentiate the revenue function with respect to Q w and set the result equal to zero.
 40−2 Qw +Qw =0
Solve these two equations simultaneously, we get

Qm =Qw =40
Thus,

3
Pm=40−40+ ∗40=30
4
1
Pw =40−40+ ∗40=10
4

Total revenue is 1200+ 400=1600 .

Complementarities between their setting of fees in (a) mean that they do not take the externalities into
account when setting prices separately. In particular, female demand has a stronger complementarity
with male demand. This results in prices of females dropping (more) in d) compared to a) when these
externalities are accounted for.

Conceptual Questions

5) Explain why when there are complementarities, a monopoly can perform better than competing firms.

When there are complementarities, competing firms do not take into account that their choices are
creating benefits for the other firm. This means that both of them will tend to produce too little. Because
of the lower amount of complementarities, they also earn a lower profit. Consumers also benefit from
the lower prices and higher quantities.

6) Explain intuitively why the demand curve with network externalities in the lecture has an inverted U
shape. How can we model the dynamics in the market and what outcomes will we expect to see? Explain.

Network externalities can lead to three potential equilibria in a market: a low-level equilibrium with no
users, a middle equilibrium with a small user base, and a high-level equilibrium with a large user base. To
determine which equilibrium is likely, we introduce dynamic adjustments and consider changing costs
over time.

Geometrically this is saying that when the demand curve is above the supply curve, the quantity goes up
and, when it is beneath the supply curve, the quantity goes down . Therefore, the middle equilibrium is
unstable, so it's unlikely to be the final state. With decreasing costs, two stable equilibria emerge. When
we introduce random perturbations (e.g., discounts or promotions), the system is more likely to shift
toward the high-level equilibrium.

In summary, network externalities can lead to multiple equilibria, and changing costs and perturbations
can influence the market's dynamics, favoring equilibria with larger user bases.