HE3001 Tutorial 9

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)?

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

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

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

(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?

(f) What is the optimal choice of p?

(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?
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.

(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?

(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?

(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?
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
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.

(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?

(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?

(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. (Hint: Show that given that consumers 10 – 13 are
connected, other consumers will not consider entering the market.)

(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?
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?

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

(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 .

(d) 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.

Conceptual Question

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

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.