**Question:**

**Answer:**

(1) Levi’s Clothing is a Fashion Clothing Industry. In the fashion clothing industries, the degree of a negative externality is likely to be much lower. Still, the incentives to invest may not high enough, since the retailer’s benefit from investing in effort sales depends on the margin it receives. Specifically, if the margin is low, then the retailer will invest a small amount. Using an RPM policy, the manufacturer (Levi’s Clothing) can create a larger margin for the retailer, thus inducing the optimal level of investment. An RPM policy induces investment in sales effort (which increases demand); instead of competing in price (which is now the minimum price required by the manufacturer), the retailers compete in investments in sales effort to attract customers. The final beneficiaries of this policy are, obviously, the retailers and the manufacturer. Nevertheless, consumers also benefit from better services at the point of sale.

(2)

(a) Microsoft’s best response to any given price *pi* by Intel.

Given Demand for Computers: Q = 100, 000, 000 – 50, 000(500 + *pm* + *pi*)

Thus, Demand for Windows: Q = 100, 000, 000 – 50, 000(500 + *pm* + *pi*)

For a given value of *pi*, the demand for Windows is Q = 75, 000, 000 – 50, 000 *pi* – 50, 000 *pm*.

The corresponding marginal revenue for Microsoft is MRM = 1500 – *pi* – Q/25, 000.

Setting this equal to Microsoft’s marginal cost of zero gives q*M = 37, 500, 000 – 25, 000 *pi*, and the corresponding optimal price of p*M = 750 – *pi* /2.

For Intel’s best response to any given price *pm* by Microsoft, all equations would be the same. The only difference is that Intel has a marginal cost of $300.

MRI = 1500 – *pm –* Q/25, 000

Setting this equal to Intel’s marginal cost of $300 gives with the corresponding optimal price of

P*I = 900 – *pm* /2

By solving these two equations together to get the Nash Equilibrium prices,

p*M = 750 – *pi* /2

2p*M = 1500 – *pi*

2p*M = 1500 – (900 – *pm* /2)

2p*M = 1500 – 900 + *pm* /2

p*M = $400 (Nash equilibrium price for pi)

P*I = 900 – *pm* /2

2 P*I = 900 – *pm*

2 P*I = 1,800 – *pm*

2 P*I = 1,800 – (750 – *pi* /2)

2 P*I = 1,800 – 750 + *pi* /2

P*I = $700 (Nash equilibrium price for pi)

Price of a computer is

P=500 + *pm* + *pi*

P=500+400+700 = $1600

So, total computer sales are 20 million.

(b) If they set a package price of PMI, the price of a computer system will be 500 + PMI. The number of computers sold will be Q = 100, 000, 000 – 50, 000(500 + PMI). The marginal revenue corresponding to this demand curve is MRMI = 1500 – Q/25, 000. Setting this equal to the (combined) marginal cost of $300 gives a quantity of Q*MI = 30, 000, 000 and a corresponding package price of p*MI :

Q = 100, 000, 000 – 50, 000(500 + PMI)

30, 000, 000 =100, 000, 000 – 50, 000(500 + PMI)

PMI = $900

At this price, the contribution to Microsoft’s and Intel’s combined profits is $600 ($900 – $300) per computer times 30 million machines, or $18 billion. In comparison, the Nash Equilibrium in part (a) involved a contribution of $800 ($400+$700-$300) per computer times 20 million machines, or $16 billion. Cutting a deal is worth $2 billion to Microsoft and Intel together.