Examiners’ commentaries 2014
Examiners’ commentaries 2014
EC3099 Industrial economics
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2013–14. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.
General remarks
Learning outcomes
At the end of this course, and having completed the Essential reading and
activities, you should be able to:
• describe and explain the determinants of the size and structure of firms
and the implications of the separation of ownership and control
• describe and explain the pricing behaviour by firms with market power
and its welfare implications
• apply analytical models of firm behaviour and strategic interaction
to evaluate various business practices, including tacit collusion, entry
deterrence, product differentiation, price discrimination and vertical
restraints
• recognise and explain the basic determinants of market structure and
the key issues in competition policy and regulation.
Format of the examination
This course is assessed by a three-hour examination. The examination
consists of eight questions divided into two sections, each of four
questions. Section A includes essay-type questions, while Section B
includes problem-type questions. You will be required to answer four
questions, two from each section.
What are the Examiners looking for?
Some examination questions will be problem-type questions, while others
will be essay-type questions.
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EC3099 Industrial economics
In general, problem-type questions are quite specific as to what you
are supposed to do, and a good answer generally involves some use
of mathematics. When you answer problem-type questions in an
examination, all the necessary steps must be shown. Moreover, you should
take care to explain what the mathematics show – do not simply list
equations.
Essay-type questions can be more or less specific, although a good answer
to an essay-type question must include some rigorous economic analysis,
usually with reference to some economic model or models.
Reading and preparation for the examination
It is important to read more widely than just the subject guide. In essaytype questions in particular, you get a higher mark by including relevant
material not in the subject guide. And whatever the question, exposure
to a wider set of readings is usually necessary to understand in depth the
economics involved and be able to provide correct and comprehensive
answers in the examination.
While there is no single best way to organise your study, it may be useful,
for each topic in the syllabus, to start with the relevant chapter of the
subject guide, then do the Essential and some of the Further reading for
that particular topic, then come back to the subject guide and attempt the
various learning activities and sample examination questions.
Planning your time in the examination
Use your time efficiently bearing in mind that all questions carry
equal weight in the final mark. Your answers must be as detailed and
comprehensive as possible given the time constraints (unless you are
specifically asked to discuss something briefly), but you should not include
material which is not relevant to the question.
Steps to improvement
• Your answers to problem-type questions should not simply list
mathematical results but they should also explain what the
mathematics mean.
• Your answers to essay-type questions must be focused, not too
descriptive and must contain rigorous economic analysis.
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Examiners’ commentaries 2014
Question spotting
Many candidates are disappointed to find that their examination
performance is poorer than they expected. This can be due to a number
of different reasons and the Examiners’ commentaries suggest ways
of addressing common problems and improving your performance.
We want to draw your attention to one particular failing – ‘question
spotting’, that is, confining your examination preparation to a few
question topics which have come up in past papers for the course. This
can have very serious consequences.
We recognise that candidates may not cover all topics in the syllabus in
the same depth, but you need to be aware that Examiners are free to
set questions on any aspect of the syllabus. This means that you need
to study enough of the syllabus to enable you to answer the required
number of examination questions.
The syllabus can be found in the Course information sheet in the
section of the VLE dedicated to this course. You should read the
syllabus very carefully and ensure that you cover sufficient material in
preparation for the examination.
Examiners will vary the topics and questions from year to year and
may well set questions that have not appeared in past papers – every
topic on the syllabus is a legitimate examination target. So although
past papers can be helpful in revision, you cannot assume that topics
or specific questions that have come up in past examinations will occur
again.
If you rely on a question spotting strategy, it is likely
you will find yourself in difficulties when you sit the
examination paper. We strongly advise you not to adopt
this strategy.
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EC3099 Industrial economics
Examiners’ commentaries 2014
EC3099 Industrial economics – Zone A
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2013–14. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.
Comments on specific questions
Candidates should answer FOUR of the following EIGHT questions: TWO from
Section A, and TWO from Section B. All questions carry equal marks.
Section A
Answer TWO questions from this section.
Question 1
‘An optimal incentive scheme offered by the owners of a firm to the firm’s
manager should reward the manager when profits are high and penalise him
when profits are low.’ Discuss this statement with reference to an economic
analysis of the relationship between the owners and the manager that takes into
account the fact that the manager’s effort level may not be observable by the
owners.
Reading for this question
Chapter 2 of the subject guide.
Church, J.R. and R. Ware Industrial Organization: A Strategic Approach.
(Maidenhead: McGraw-Hill, 2000) [ISBN 9780256205718] Chapter 3.
Tirole, J. The Theory of Industrial Organization. (Cambridge, MA: MIT Press, 1988)
[ISBN 9780262200714] Introductory chapter.
Approaching the question
A good answer should describe a model of the relationship between the
owners of a firm and its manager, and examine the optimal incentive
scheme that should be given to the manager. Such a model is described,
for instance, in Chapter 2 of the subject guide. In that model, the gross
profit of the firm depends on the manager’s effort as well as on the
firm’s environment, which is uncertain: the higher the manager’s effort,
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Examiners’ commentaries 2014
the higher the probability of high gross profit. On the other hand, the
manager’s utility increases in her wage but decreases in the amount of
effort she exerts. For simplicity, there are two possible levels of effort, high
and zero. The owners’ objective is to maximise the firm’s expected net
profit (i.e. gross profit minus the manager’s wage). What level of effort the
owners will prefer depends on whether the firm’s maximised net profit is
higher under high effort or under no effort.
Two cases should be considered. When the owners can observe the
manager’s effort level, the higher the effort that the owners want the
manager to exert, the higher the wage they must offer – irrespective of
what the profit of the firm turns out to be.
What if the effort level of the manager cannot be observed by the
owners? If the owners want the manager to exert high effort, they must
compensate her with a higher wage the higher the profit of the firm. More
specifically, the owners must design an incentive scheme for the manager
that maximises the firm’s expected net profit subject to ensuring that the
manager accepts the job and chooses to exert high effort, i.e. subject to a
‘participation constraint’ and an ‘incentive-compatibility constraint’. Note
that if the owners want the manager to exert no effort, they do not need
to make the wage a function of the firm’s profit. A good answer should
describe the details of the model, distinguishing between the various cases,
and provide intuition for the main results.
Question 2
Answer both parts of this question.
a. In some industries, manufacturers operate their own distribution networks,
marketing their products directly to retail outlets. In others, manufacturers
use independently-owned wholesalers or manufacturing representatives
to market their products. What factors are likely to influence the choice of
distribution method for a particular product? Explain. (10 marks)
Reading for this question
Chapters 1 and 8 of the subject guide.
Church and Ware (2000) Chapters 3 and 22.
Tirole (1988) Introductory chapter and Chapter 4.
Approaching the question
This question required a discussion of vertical relationships and incentives
for vertical integration: what determines which activities are brought
inside the firm and which are maintained outside the firm through some
form of vertical relationship.
A good answer should describe how, once a relation-specific investment
has been made by one party to a relationship, there is the potential for
opportunistic behaviour by the other party. These incentive problems may
influence the decision of a firm to vertically integrate. The answer should
clarify why integration may solve or reduce the problem of potential
opportunistic behaviour. For example, high-frequency transactions with
significant relationship-specific investment are likely to be brought inside
the firm. Thus, firms with dense distribution activities (so they can fully
employ a sales force on their own products) in which significant expertise
distributing the firm’s product generates value are more likely to use
company employees (e.g. turbine manufacturers use their own sales force
to market turbines). Those with relatively sparse distribution activities (in
which an employee could not be fully employed if limited to the firm’s
products) in which there is little firm-specific expertise or human capital
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EC3099 Industrial economics
are more likely to contract with independent wholesalers or manufacturing
representatives (e.g. paper clip manufacturers use independent office
supply wholesalers to market their product to retail stores).
Furthermore, the choice of distribution method may be influenced by
whether or not the firm can easily use vertical restraints to mitigate the
various inefficiencies that arise in vertical relationships (such as double
marginalisation or the inefficient provision of services) and/or exercise
market power without the need to vertically integrate. For instance,
candidates could describe how vertical restraints such as exclusive dealing
or resale price maintenance can be used by manufacturers, and why
incentives for vertical integration may be greater when these restraints
cannot be used.
b. A competition authority has hired you to evaluate the market for rental cars.
A survey of customers of the top five car rental firms (which account for
approximately 80% of all rentals) at five large airports reveals substantial
variation in the rental rates charged to different customers of the same
firm. Rates vary considerably across a large number of dimensions: across
different airports, across days of the week (with weekend rates substantially
lower than Monday to Thursday rates), over rental periods (one-day versus
weekend, week or month), and across car models. In addition, there appear
to be a large number of promotional rates used by different customers (AAA
discounts, corporate discounts, advertised specials, advance reservation rates
etc.), so that rentals that appear to have identical characteristics (day of
week, location, length of rental, model of car) often entail different prices.
What are possible explanations for non-uniform pricing in a market? Assess
the plausibility of each explanation for the pattern of pricing observed in the
rental car market. Include in your assessment any preconditions that attach
to each explanation and whether they are likely to be satisfied in this market.
(15 marks)
Reading for this question
Chapters 3 and 7 of the subject guide.
Church and Ware (2000) Chapters 5 and 8.
Tirole (1988) Chapters 3 and 5.
Approaching the question
Prices may be nonuniform or nonlinear for a variety of reasons. These
include peak-load pricing (prices used to ration fluctuating demand
given fixed capacity), cost variations in providing service and price
discrimination based on consumer search behaviour and willingness to
pay.
Peak-load pricing: demand is likely to fluctuate, both predictably and
unpredictably, in this market. If rental fleets are likely to be fully rented
at particular times, the cost of these rentals should be higher. This would
tend to predict, for example, a higher price for weekday rentals (when
there is likely to be substantial business demand) and a lower price
for weekend rentals (when demand is likely to be lower and capacity
constraints less likely to be reached).
Cost variation: costs are likely to vary across rentals, leading to further
price variation. There are likely to be locational cost differences that may
raise the marginal and average rental cost (e.g. locational rents, wage
rates, etc.). Different car models have different capital costs, leading to
different implied rental rates. Finally, there may be some fixed cost of
transacting a rental, suggesting that the per day cost of multi-day rentals is
less than the per day cost of a one-day rental.
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Examiners’ commentaries 2014
Price discrimination: some of the price variation is almost certainly due to
price discrimination. Rental car firms would appear to have some market
power and an ability to prevent resale or arbitrage (rentals are legally
non-transferable). Price discrimination may exacerbate differentials based
on one of the other reasons. For example, business travellers, who rent
primarily on weekdays, are likely to value rental cars more and have a
lower demand elasticity. This will tend to imply a higher mark-up over
the higher weekday cost, implying an even greater price differential
weekday-weekend than implied by cost differentials. Promotional rates
can be understood as price discrimination based on market segmentation
and possibly on search costs (e.g. advertised specials). The nonlinear
prices (where quantity is days of the rental period) may also involve price
discrimination as well as simple cost differences.
Question 3
Answer both parts of this question.
a. ‘The more firms there are in an industry, the more competitive it is’. Do you
agree? Justify your answer with reference to specific economic models and
any relevant empirical evidence. (12 marks)
Reading for this question
Chapters 3, 4 and 9 of the subject guide.
Church and Ware (2000).
Sutton, J. Sunk Costs and Market Structure. (Cambridge, MA: MIT Press, 2007)
[ISBN 9780262693585] Chapters 8 and 10.
Tirole (1988) Chapters 5 and 6.
Approaching the question
Candidates would normally be expected to begin by explaining what they
mean by ‘competitive’. Answers could then include some selection of the
following arguments. First, and most straightforwardly, candidates could
describe how Cournot equilibrium profits fall as the number increases.
They could in fact link this to standard measures of market power and
concentration to show that this is reflected in these measures (they could
also mention that it is reflected in actual policy). On the other hand,
in other industries such as Bertrand, this would not hold. If candidates
wanted to go through a larger list of industry structures they could –
for example, look at dominant firms with a fringe or other asymmetric
structures and comment on whether adding more firms makes a difference
and how that changes as one adds different types of firm.
Next, a good answer would deal with the issue of tacit collusion or other
types of collusion and explain how this could get more difficult as the
number of firms increases. A very good answer could discuss how the
critical discount factor for tacit collusion to be sustained in a standard
collusion model increases with the number of firms.
Finally, although higher concentration is associated with less intense price
competition in many models when there is a fixed number of firms in
the market, the opposite may be the case when one allows for free entry.
With free entry, the causality also goes from intensity of competition to
concentration, and tougher price competition leads to fewer firms in an
industry. A good answer could include a simple comparison of Cournot
and Bertrand oligopoly with free entry and a very good answer would
describe the competition-concentration link in the context of the economic
theory and evidence on the determinants of market structure. Either way,
the point needs to be made that tougher price competition reduces the
profit margin, so it increases the output a firm must produce to cover fixed
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EC3099 Industrial economics
and entry costs, thereby reducing the number of firms that can survive in
long-run equilibrium.
b. ‘Since patents generate monopolies, and monopolies generate deadweight
loss, society would be better served by eliminating patent protection for
innovations’. Discuss this statement with reference to economic theory and
any relevant empirical evidence. (13 marks)
Reading for this question
Chapter 10 of the subject guide
Church and Ware (2000) Chapter 18.
Approaching the question
Candidates could discuss static deadweight loss and monopoly in the first
instance. They might wish to deviate to whether monopolies generate
loss at all, perhaps discussing alternative pricing strategies such as
price discrimination or cases where there are efficiency gains. This is a
detail, however. Second, they should discuss whether patents generate
monopolies or not: they generate potential for market power, but whether
that is realised is another thing. The subject guide mentions empirical
work suggesting that inventing around patents is common.
Nevertheless, patents often do generate some monopoly power and
monopoly power does generate deadweight loss. Dynamic welfare gains
should be discussed next in counterpoint to the static welfare losses. This
should be the core of a good answer. Patents may generate enormous
welfare gains by maintaining incentives for firms to undertake innovative
activity. If there were no protection for intellectual property rents, firms
might have little incentive to engage in R&D to develop new innovations,
leading to substantial productivity and welfare loss. In fact, the patent
system trades off gains from making innovative benefits appropriable with
losses from monopoly restriction of output – therefore patents are granted
only for a finite number of years.
On the other hand, a very good answer could also briefly discuss
alternatives to the patent system as ways to generate innovation
(e.g. subsidies – as discussed in the subject guide – or prizes could be
considered) without the static welfare losses.
Question 4
Describe the theory on the determinants of market structure in advertisingintensive industries. In what ways are the theoretical predictions different from
those for ‘exogenous sunk cost industries’? Then discuss briefly the empirical
evidence on the theory.
Reading for this question
Chapter 9 of the subject guide.
Sutton (2007).
Approaching the question
A good answer should include a brief review of some basic concepts in the
theoretical analysis of the determinants of market structure: the distinction
between short-run and long-run decisions, the distinction between
exogenous sunk cost industries and endogenous sunk cost industries,
and the bounds approach. The core of the answer should focus on the
determinants of market structure in advertising-intensive industries, and
include a discussion of the relationship between market size and the level
of concentration in these industries. A very good answer should provide
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Examiners’ commentaries 2014
details and emphasise the economic intuition behind the main results,
using a simple formal model if necessary.
You should then discuss in what ways the theoretical predictions for
advertising-intensive industries differ from those for exogenous sunk cost
industries. It is important to explain why the non-convergence result and
the non-monotonicity result apply to advertising-intensive industries but
not to exogenous sunk cost industries. Finally, you should briefly describe
any relevant empirical evidence.
Section B
Answer TWO questions from this section.
Question 5
Two firms, A and B, produce a homogeneous product at constant marginal (and
average) cost c and compete by simultaneously setting prices. There are N
consumers in the market, each with a reservation price of R for one unit of the
good. Before the start of the game, a fraction α of the consumers is purchasing
at firm A and fraction 1 – α is purchasing at firm B. If a consumer purchases
again at his current supplier, he pays only the purchase price, pi, for the good,
where pi is the price charged by firm i (i = A, B). If a consumer switches to the
other firm, however, he must pay the purchase price at the new supplier plus a
constant cost of switching, s.
a. Assuming that s = 0, what is the Nash equilibrium price in this market? If the
two firms merged to form a monopoly, what would be the equilibrium price
charged and the profit per firm? Explain. (6 marks)
b. Now suppose that s > 0 and firm B charges R for the good. State a condition
under which the best response of firm A is to charge R as well. Explain. (6 marks)
c. Let α = ½. Under the assumption that s > 0.5(R – c), show that the Nash
equilibrium price is R. Explain the intuition for your result and contrast it with
your results in part (a). (6 marks)
Now suppose that the firms play a two-stage game in two periods. The second
stage is as already described. In the first stage/period the firms simultaneously
set prices to attract consumers (and they sell the good at those prices). In other
words, consumers buy the good in the first stage without incurring any switching
costs. Let α = ½ and s > 0.5(R – c), so that the firms anticipate that the price they
will both charge in the second stage will be R. Since the firms make sales in both
periods, the relevant profit is the present discounted value of their profits over
the two periods.
d. Discuss how much the firms will be willing to drop their price in the first
stage in order to attract consumers. Given this, do you think that consumers
are hurt by the existence of switching costs in this market? Why or why not? (7 marks)
Reading for this question
Chapter 3 of the subject guide.
Church and Ware (2000) Chapter 8.
Tirole (1988) Chapter 5.
Approaching the question
a. In this case we have a standard Bertrand model with homogeneous
product, so price equals marginal cost. If the two firms merged, they
could charge the full reservation price of R and split the resulting
profits, so each firm would obtain N(R – c)/2.
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EC3099 Industrial economics
b. If B charges R for the good, then if A charges R as well it earns αN(R –
c). If it charges less, then to make any difference to its market share it
would have to drop price to R – s. If it does this, then it can earn
N(R – s – c). For αN(R – c) to be larger than N(R – s – c), we need
(R – c)(1 – α) < s.
c. We see that the condition derived in part (b) is satisfied, therefore the
best response to R by firm B is R by firm A. Similarly, the best response
to R by firm A is R by firm B. The best response functions look as
follows with the Nash equilibrium at (R, R).
The intuition is that the switching cost implies that there is no gain at
all in market share by dropping price a little bit below the competitor.
Instead, the only possibility is to drop it a lot (enough to overcome
the consumers’ aversion to switching). When doing this, however, the
increase in market share is offset by a large decrease in revenue per
head. For a large enough switching cost, the price cut must be drastic
and so the revenue per head drops so much that the price cutting
strategy never pays. If s is large enough that this does not pay for R,
then it does not pay for anything less than R.
d. In the first stage firms anticipate that they will both charge R in the
second period and that there will be no switching of consumers. Each
firm will know that its second period market share and therefore profit
can increase by attracting more consumers in the first period. Each firm
will therefore be willing to drop its price in the first stage sufficiently
so that its total discounted profit over the two periods is zero. This will
result in setting price below marginal cost in the first period, which is,
of course, beneficial to consumers.
Whether consumers gain or lose overall compared to the case without
switching costs (where p = c in every period) depends on how their
welfare over the two periods is weighted and the precise shape of
utility. The result is ambiguous.
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Examiners’ commentaries 2014
Question 6
Two identical firms produce a homogeneous product and compete on prices. The
capacity of each firm is 3. The firms have constant marginal cost equal to zero up
to their capacity constraint. Market demand is given by D(p) = 9 − p. If the firms
set the same price, they split the demand equally. If the firms set a different
price, the demand of each firm is calculated according to the efficient rationing
rule, i.e. the consumers with the highest willingness to pay are served by the
firm with the lowest price. Suppose first that the firms compete for one period
only.
a. Show that p1 = p2 = 3 can be sustained as a Nash equilibrium. Calculate the
equilibrium profits.
From now on assume that the firms compete for an infinite number of
periods. The firms’ discount factor is δ∈(0,1). Each firm plays the following
‘trigger’ strategy: Charge the monopoly price pM in the first period. In period
t, t > 1, charge pM if p1 = p2 = pM was the outcome in all previous periods;
otherwise, charge the price 3. (6 marks)
b. Compute the monopoly price. Calculate the present discounted value of the
profits that each firm obtains if they collude forever. (5 marks)
c. Suppose now that one of the firms considers deviating from collusion.
Calculate the present discounted value of the profits that the firm
(maximally) earns if it deviates. (5 marks)
d. For which values of δ can collusion on the monopoly price be sustained as a
subgame perfect equilibrium? (4 marks)
e. More generally, do you expect collusion to be easier to sustain when firms
are capacity constrained or not? Explain. (5 marks)
Reading for this question
Chapters 3 and 4 of the subject guide.
Church and Ware (2000) Chapters 8 and 10.
Tirole (1988) Chapters 5 and 6.
Approaching the question
a. The answer to this part is based on the model of price competition
under capacity constraints. At the prices p1 = p2 = 3, both firms
produce at full capacity. Neither of the firms has an incentive to deviate
to a lower price as this would result in the same number of sales but
at a lower price, and would therefore reduce profit. Moreover, the
efficient rationing rule implies that a firm that deviates to a higher
price faces a demand of D(p) = 6 − p. Its profits would be (6 − p)
p, which is decreasing in p for all p > 3. This implies that deviating
to a price above 3 is not profitable. Hence, p1 = p2 = 3 is a Nash
equilibrium. The equilibrium profits are π1 = π2 = 3(9 − 3)/2 = 9.
b. The monopoly price is the value of p that maximises (9 − p)p, or pM =
9/2. The corresponding quantity is 9/2 and the monopoly profit is PM
= 81/4. Each firm produces 9/4 and obtains profit per period PM/2 =
81/8 if it plays the trigger strategy. The present discounted value of the
profits is PM/[2(1 – δ)] = 81/[8(1 − δ)].
c. The optimal deviation is pM − ε (ε very small), which allows the firm to
sell its entire capacity at (almost) the monopoly price. The profit in the
period of the deviation is: (9/2)3 = 27/2 (ignoring ε). The deviation
triggers a reversal to the static Nash equilibrium in all future periods.
The present discounted value of the profits of the maximal profits from
deviating is 27/2 + 9(δ + δ2 + δ3 +…) = 27/2 + 9δ/(1 – δ).
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EC3099 Industrial economics
d. Collusion can be sustained as a SPE if 81/[8(1 − δ)] ≥ 27/2 + 9δ/(1 –
δ), or δ ≥ 3/4.
e. When firms are capacity constrained, the incentive to defect is weaker
because the defection profit is lower compared to the case of no
capacity constraints. This makes collusion easier to sustain. On the
other hand, the punishment of defection is less harsh because firms
make some profit even at the one-shot Nash equilibrium. This makes
collusion harder to sustain. The overall effect of capacity constraints on
the sustainability of collusion is therefore ambiguous.
Question 7
An industry consists of three firms. Each firm has the cost function C(qi) = 5 +
2qi. The inverse demand function of the industry is given by P(Q) = 18 – Q, where
Q is aggregate output. The timing of production is as follows. Firm 1 produces
its output first. Knowing firm 1’s output, firm 2 produces. Then knowing firm 1
and 2’s outputs, firm 3 produces its output. The industry demand, cost functions,
and production sequence are common knowledge. Find the equilibrium values
of production for each firm, taking into account the fact that firms that move
earlier in the sequence may use ‘production deterrence’ strategies against their
rivals.
Reading for this question
Chapter 5 of the subject guide.
Church and Ware (2000) Chapters 13–16.
Tirole (1988) Chapter 8.
Approaching the question
The sequence of moves and the possible actions of each firm are as
follows. Firm 1 can either:
i. blockade production by firms 2 and 3 simply by producing the
monopoly output, or
ii. deter production by firms 2 and 3 by producing some level of output
higher than the monopoly output, or
iii.accommodate production by one or both rival firms.
Firm 2 can either:
i. produce zero given q1, or
ii. blockade production by firm 3 by producing the optimal (positive) q2
given q1, or
iii.deter production by firm 3, or
iv. accommodate production by firm 3.
Finally, firm 3 chooses q3 given q1 and q2. Note that deterring production
by a rival firm is possible in this industry because of the fixed cost of
production (equal to 5).
The monopoly output for firm 1 is given by the level of q1 that maximises
(18 – q1)q1 – (5 + 2q1) ® q1* = 8. However, given q1* = 8, firm 2 would
find it optimal to produce q2* = 4. Therefore production by firm 2 cannot
be blockaded.
Firm 1 could deter production by firms 2 and 3 by producing some level
of output higher than the monopoly output. Let us call this q1d. To find
q1d, we need first to turn to firm 2. Taking q1d as given, firm 2 would
choose the level of q2 that maximises (18 – q1d – q2)q2 – (5 + 2q2) ® q2*
= (16 – q1d)/2 (firm 3 would not find it profitable to produce under entry
deterrence by firm 1). Firm 1 would anticipate this reaction by firm 2 and
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Examiners’ commentaries 2014
would set q1d so that firm 2’s profit from choosing q2* is negative or zero.
Calculations yield q1dÎ[16 – 2Ö5, 16 + 2Ö5]. Moreover, firm 1 would
choose the level of output in this range that maximises its profit, and
this is q1d = 16 – 2Ö5 (the lowest level). The corresponding profit would
be 32Ö5 – 25. This would be the (maximised) profit of firm 1 if firm 1
deterred production by firm 2 (and firm 3).
Alternatively, firm 1 might choose to accommodate firm 2. Taking q1 as
given, firm 2 would then choose the level of q2 that maximises its profit.
Now its profit function would depend on whether firm 3 would choose
to produce a positive level of output. If firm 3 did not find it profitable to
produce, then the profit of firm 2 would be (18 – q1 – q2)q2 – (5 + 2q2)
Þ q2* = (16 – q1)/2. If firm 3 found it profitable to produce a positive
output, given q1 and q2, its best reply would be the output that maximises
(18 – q1 – q2 – q3)q3 – (5 + 2q3) ⇒ q3* = (16 – q1– q2)/2. In this case, firm
2 would choose q2 to maximise its profit (18 – q1 – q2 – q3)q2 – (5 + 2q2)
taking q1 as given and anticipating the best reply function of firm 3. It
turns out that again q2* = (16 – q1)/2.
Firm 1 would anticipate this reaction function by firm 2 and would set q1
so as to maximise its profit subject to q2* = (16 – q1)/2. This maximisation
problem yields q1* = 8, which in turn implies q2* = 4. The corresponding
profit for firm 1 would be 27.
We therefore compare firm 1’s profits under deterrence and
accommodation. Since 32√5 – 25 > 27, firm 1 will produce q1d = 16 –
2√5. Firms 2 and 3 will produce zero.
Question 8
Consider a market with an upstream manufacturer of wheels and a downstream
manufacturer of skates. Both firms are monopolists. Every skate requires four
wheels, and the marginal cost to the upstream firm to produce a set of four
wheels is c. Let w denote the price the upstream firm charges for a set of wheels.
Let the cost of all other inputs involved in skate production be zero, so that w
is the marginal cost for the downstream firm. The inverse demand for skates is
given by P(Q) = a – bQ.
a. Derive the downstream firm’s demand for wheels (or ‘sets of four wheels’) as
a function of w. (5 marks)
b. What profits will the two firms make when each maximises its own profit?
How does the sum of their profits compare to what they could obtain if they
were vertically integrated? How does consumer welfare compare in the two
cases? Offer some economic intuition. (13 marks)
c. Now suppose that instead of using linear pricing, the upstream firm uses
an optimal two-part tariff. What profit does each firm make and how is
consumer surplus affected? Does the ability to use a two-part tariff reduce
the incentive to vertically integrate? Explain. (7 marks)
Reading for this question
Chapter 8 of the subject guide.
Church and Ware (2000) Chapter 22.
Tirole (1988) Chapter 4.
Approaching the question
a. The downstream firm chooses Q to maximise its profit pD = (a – bQ –
w)Q, where w is the per-unit cost of a ‘set of four wheels’, which the
downstream firm takes as given. Solving the FOC with respect to Q we
obtain Q(w) = (a – w)/2b. This is the downstream firm’s demand for
‘sets of four wheels’ as a function of w.
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EC3099 Industrial economics
b. When the ownership of the downstream firm is separate from the
ownership of the upstream firm, each firm maximises its own profit
independently. We start from the downstream firm. Applying the
results from part (a), the downstream firm’s demand for ‘sets of
four wheels’ as a function of w is given by Q(w) = (a – w)/2b. Now
consider the upstream firm: it anticipates that Q(w) = (a – w)/2b
will be the downstream firm’s optimal response to any level of w. The
upstream firm, then, chooses w to maximise its profit pU = (w – c)(a –
w)/2b. Solving the FOC of this maximisation problem with respect to
w we obtain w = (a + c)/2. Plugging this back into Q(w) we get Q =
(a – c)/4b.
We can also compute the price charged by the downstream monopolist
and the profits that each firm earns in this decentralised equilibrium:
On the other hand, a vertically integrated structure would choose Q to
maximise pJ = (a – bQ – c)Q. Solving the FOC with respect to Q we
obtain QJ = (a – c)/2b. Plugging this back into the inverse demand
function and the profit function of the vertically integrated firm we get
the price of each set of skates and the level of profits:
Comparing the two outcomes, we can easily see that the total profits of
the industry are lower under decentralisation:
The reason for this is the double marginalisation problem, and a good
answer should explain what this is and why it creates an inefficiency
beyond that created under a single monopoly. This not only reduces
total industry profits but also causes the price paid by consumers to be
higher, thus reducing consumer welfare:
c. The upstream firm can now use a two-part tariff. Suppose for simplicity
that if the downstream firm refuses to buy the sets of wheels from
the upstream monopolist, it gets zero profits – i.e. the outside option
of the downstream firm is zero. Assuming the upstream firm can
costlessly replace the downstream firm with another downstream firm,
the upstream firm’s outside option will be the profits it gets in the
decentralised equilibrium. In this case, the upstream monopolist can
offer a two-part tariff T = A + wQ to the downstream firm, where w
= c and A = (a – c)2/4b. In this way, the negative externality that the
downstream firm exerted to the upstream firm disappears: with w = c,
the downstream firm maximises the profit of the vertically integrated
firm, pJ. This profit is all extracted by the upstream firm. Profit, price
and consumer surplus are the same as under vertical integration. Note
that if the downstream firm has an outside option value V > 0, then
A = (a – c)2/4b – V. So the distribution of the total surplus (but not its
size) will depend on the firms’ outside options.
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Examiners’ commentaries 2014
Examiners’ commentaries 2014
EC3099 Industrial economics – Zone B
Important note
This commentary reflects the examination and assessment arrangements
for this course in the academic year 2013–14. The format and structure
of the examination may change in future years, and any such changes
will be publicised on the virtual learning environment (VLE).
Information about the subject guide and the Essential reading
references
Unless otherwise stated, all cross-references will be to the latest version
of the subject guide (2011). You should always attempt to use the most
recent edition of any Essential reading textbook, even if the commentary
and/or online reading list and/or subject guide refers to an earlier
edition. If different editions of Essential reading are listed, please check
the VLE for reading supplements – if none are available, please use the
contents list and index of the new edition to find the relevant section.
Comments on specific questions
Candidates should answer FOUR of the following EIGHT questions: TWO from
Section A, and TWO from Section B. All questions carry equal marks.
Section A
Answer TWO questions from this section.
Question 1
‘An optimal incentive scheme offered by the owners of a firm to the firm’s
manager should reward the manager when profits are high and penalise him
when profits are low’. Discuss this statement with reference to an economic
analysis of the relationship between the owners and the manager that takes into
account the fact that the manager’s effort level may not be observable by the
owners.
Reading for this question
Chapter 2 of the subject guide.
Church, J.R. and R. Ware Industrial Organization: A Strategic Approach.
(Maidenhead: McGraw-Hill, 2000) [ISBN 9780256205718] Chapter 3.
Tirole, J. The Theory of Industrial Organization. (Cambridge, MA: MIT Press, 1988)
[ISBN 9780262200714] Introductory chapter.
Approaching the question
A good answer should describe a model of the relationship between the
owners of a firm and its manager, and examine the optimal incentive
scheme that should be given to the manager. Such a model is described,
for instance, in Chapter 2 of the subject guide. In that model, the gross
profit of the firm depends on the manager’s effort as well as on the
firm’s environment, which is uncertain: the higher the manager’s effort,
the higher the probability of high gross profit. On the other hand, the
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EC3099 Industrial economics
manager’s utility increases in her wage but decreases in the amount of
effort she exerts. For simplicity, there are two possible levels of effort, high
and zero. The owners’ objective is to maximise the firm’s expected net
profit (i.e. gross profit minus the manager’s wage). What level of effort the
owners will prefer depends on whether the firm’s maximised net profit is
higher under high effort or under no effort.
Two cases should be considered. When the owners can observe the
manager’s effort level, the higher the effort that the owners want the
manager to exert, the higher the wage they must offer – irrespective of
what the profit of the firm turns out to be.
What if the effort level of the manager cannot be observed by the
owners? If the owners want the manager to exert high effort, they must
compensate her with a higher wage the higher the profit of the firm. More
specifically, the owners must design an incentive scheme for the manager
that maximises the firm’s expected net profit subject to ensuring that the
manager accepts the job and chooses to exert high effort, i.e. subject to a
‘participation constraint’ and an ‘incentive-compatibility constraint’. Note
that if the owners want the manager to exert no effort, they do not need
to make the wage a function of the firm’s profit. A good answer should
describe the details of the model, distinguishing between the various cases,
and provide intuition for the main results.
Question 2
Answer both parts of this question.
a. In some industries, manufacturers operate their own distribution networks,
marketing their products directly to retail outlets. In others, manufacturers
use independently-owned wholesalers or manufacturing representatives
to market their products. What factors are likely to influence the choice of
distribution method for a particular product? Explain. (10 marks)
Reading for this question
Chapters 1 and 8 of the subject guide.
Church and Ware (2000) Chapters 3 and 22.
Tirole (1988) Introductory chapter and Chapter 4.
Approaching the question
This question required a discussion of vertical relationships and incentives
for vertical integration: what determines which activities are brought
inside the firm and which are maintained outside the firm through some
form of vertical relationship.
A good answer should describe how, once a relation-specific investment
has been made by one party to a relationship, there is the potential for
opportunistic behaviour by the other party. These incentive problems may
influence the decision of a firm to vertically integrate. The answer should
clarify why integration may solve or reduce the problem of potential
opportunistic behaviour. For example, high-frequency transactions with
significant relationship-specific investment are likely to be brought inside
the firm. Thus, firms with dense distribution activities (so they can fully
employ a sales force on their own products) in which significant expertise
distributing the firm’s product generates value are more likely to use
company employees (e.g. turbine manufacturers use their own sales force
to market turbines). Those with relatively sparse distribution activities (in
which an employee could not be fully employed if limited to the firm’s
products) in which there is little firm-specific expertise or human capital
are more likely to contract with independent wholesalers or manufacturing
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Examiners’ commentaries 2014
representatives (e.g. paper clip manufacturers use independent office
supply wholesalers to market their product to retail stores).
Furthermore, the choice of distribution method may be influenced by
whether or not the firm can easily use vertical restraints to mitigate the
various inefficiencies that arise in vertical relationships (such as double
marginalisation or the inefficient provision of services) and/or exercise
market power without the need to vertically integrate. For instance,
candidates could describe how vertical restraints such as exclusive dealing
or resale price maintenance can be used by manufacturers, and why
incentives for vertical integration may be greater when these restraints
cannot be used.
b. A competition authority has hired you to evaluate the market for rental cars.
A survey of customers of the top five car rental firms (which account for
approximately 80% of all rentals) at five large airports reveals substantial
variation in the rental rates charged to different customers of the same
firm. Rates vary considerably across a large number of dimensions: across
different airports, across days of the week (with weekend rates substantially
lower than Monday to Thursday rates), over rental periods (one-day versus
weekend, week or month), and across car models. In addition, there appear
to be a large number of promotional rates used by different customers (AAA
discounts, corporate discounts, advertised specials, advance reservation rates
etc.), so that rentals that appear to have identical characteristics (day of
week, location, length of rental, model of car) often entail different prices.
What are possible explanations for non-uniform pricing in a market? Assess
the plausibility of each explanation for the pattern of pricing observed in the
rental car market. Include in your assessment any preconditions that attach
to each explanation and whether they are likely to be satisfied in this market.
(15 marks)
Reading for this question
Chapters 3 and 7 of the subject guide.
Church and Ware (2000) Chapters 5 and 8.
Tirole (1988) Chapters 3 and 5.
Approaching the question
Prices may be non-uniform or nonlinear for a variety of reasons. These
include peak-load pricing (prices used to ration fluctuating demand
given fixed capacity), cost variations in providing service, and price
discrimination based on consumer search behaviour and willingness to
pay.
Peak-load pricing: demand is likely to fluctuate, both predictably and
unpredictably, in this market. If rental fleets are likely to be fully rented
at particular times, the cost of these rentals should be higher. This would
tend to predict, for example, a higher price for weekday rentals (when
there is likely to be substantial business demand) and a lower price
for weekend rentals (when demand is likely to be lower and capacity
constraints less likely to be reached).
Cost variation: costs are likely to vary across rentals, leading to further
price variation. There are likely to be locational cost differences that may
raise the marginal and average rental cost (e.g. locational rents, wage
rates, etc.). Different car models have different capital costs, leading to
different implied rental rates. Finally, there may be some fixed cost of
transacting a rental, suggesting that the per day cost of multi-day rentals is
less than the per day cost of a one-day rental.
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EC3099 Industrial economics
Price discrimination: some of the price variation is almost certainly due to
price discrimination. Rental car firms would appear to have some market
power and an ability to prevent resale or arbitrage (rentals are legally
non-transferable). Price discrimination may exacerbate differentials based
on one of the other reasons. For example, business travellers, who rent
primarily on weekdays, are likely to value rental cars more and have a
lower demand elasticity. This will tend to imply a higher mark-up over
the higher weekday cost, implying an even greater price differential
weekday-weekend than implied by cost differentials. Promotional rates
can be understood as price discrimination based on market segmentation
and possibly on search costs (e.g. advertised specials). The nonlinear
prices (where quantity is days of the rental period) may also involve price
discrimination as well as simple cost differences.
Question 3
Answer both parts of this question.
a. ‘Even though consumers prefer higher quality to lower quality, firms might
still find it profitable to offer low quality products’. Discuss this statement
with reference to economic theory and any relevant empirical evidence. (12 marks)
Reading for this question
Chapter 6 of the subject guide.
Church and Ware (2000) Chapter 11.
Tirole (1988) Chapter 7.
Approaching the question
A good answer should describe an equilibrium in a standard vertical
differentiation model where the optimal configuration involves not a set of
high quality products, but a range of products. Consumers may all prefer
high to low quality if these are offered at the same price, but they differ
in their willingness to pay for quality – which could be partly driven by
income differences. Therefore some consumers purchase the low quality
and others purchase the high quality products because the low quality
carries a low price and the high quality carries a high price.
Candidates could show, as an illustration, the case from the subject guide
where for an intermediate degree of consumer heterogeneity, two firms
enter and choose different qualities but both make positive profits. The
intuition is that product differentiation still relaxes competition in the
vertical case: if the two firms decided to offer high quality, they would
compete head to head. By differentiating, firms can make positive profit.
As an aside, these positive profits remain even in the long run under free
entry and irrespective of market size due to the ‘finiteness property’ of
vertical differentiation models in which the cost of quality is primarily
a fixed cost, such as advertising or R&D. Empirical evidence can be
described to support these ideas.
b. ‘Competition policy raises special issues in innovative industries: monopoly
power may need to be tolerated and horizontal agreements among firms
in such industries should receive special treatment.’ Do you agree? Justify
your answer with reference to economic theory and any relevant empirical
evidence. (13 marks)
Reading for this question
Chapter 10 of the subject guide.
Church and Ware (2000) Chapter 18.
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Examiners’ commentaries 2014
Approaching the question
Research and development has a special status due to the sunk cost of
investment, high uncertainty, asymmetric information, and expense.
Patents, as a response to R&D’s structure, are contrary to competition
policy’s goals in some sense – but to the extent that patents potentially
grant monopoly power but do not grant the right to abuse that power,
competition policy and patent policy are in concert.
Research joint ventures are agreements among firms that normally would
raise concerns in competition circles, but they are beneficial to welfare
to the extent that they reduce duplicative expenditure, allow for pooling
of resources (to overcome financial constraints or obtain economies) and
improve R&D incentives by facilitating appropriability of returns. Subsidies
can be used to generate socially optimal amounts of research (normally,
the externalities in research would indicate that the market level would be
set too low), but could also be viewed as state aid, which again would be
viewed unfavourably by competition authorities. The empirical evidence
on the effectiveness of subsidies and policies towards research joint
ventures, as pointed out in the subject guide, is mixed.
A good answer could also briefly discuss whether merger policy might be
any different in innovative industries to the extent that some mergers may
result in improved R&D capabilities; or whether policy towards dominant
firms should be more lenient to the extent that market power may
increase incentives for R&D.
Question 4
A monopolist supplies a ‘basic’ good (printers) consumed in fixed quantity (one
unit) and a ‘complementary’ good (ink cartridges) consumed in variable amounts
and supplied also by a competitive industry at a price equal to marginal cost.
The unit cost of printers is c0 and the unit cost of ink cartridges is c. There are
two types of customer, high users and low users. The monopolist cannot observe
the customer’s type directly.
a. Describe how a tying arrangement can increase the monopolist’s profit
above the level obtainable in the absence of tying. What are the welfare
implications of such tying? (15 marks)
b. Discuss, more generally, possible reasons for tying and its welfare
implications. What does your discussion suggest about the appropriate
public policy towards tying arrangements? Explain briefly with reference to
economic theory as well as any relevant empirical evidence. (10 marks)
Reading for this question
Chapter 7 of the subject guide.
Church and Ware (2000) Chapter 5.
Tirole (1988) Chapter 3.
Approaching the question
a. The answer could make use of the model described in Chapter 7
of the subject guide to analyse second-degree price discrimination.
In that model tying is analysed as an application of two-part
pricing. The general problem of the monopolist under tying is to
choose the price p of the complementary good so as to maximise
Π = NS1 ( p ) + ( p − c) D( p ) − Nc 0 , where N is the number of
consumers, D(p) is total demand of the complementary good at price p,
and S1 is the consumer surplus of the low-demand type (which is equal
to the fee the monopolist charges for the basic good).
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EC3099 Industrial economics
This leads to an optimal price p* > c. A good answer should give a
formal proof or some intuitive explanation of this point. Now in the
absence of tying the monopolist is constrained to set p = c and derives
all his profit from the basic good, whose price is A = S1(c). Thus, in the
absence of tying, everything is as if the monopolist is faced with the
problem of maximising the above profit function but does not in fact do
so, since he chooses p = c instead of p* > c. So profit must be higher
under tying.
The fact that p* > c implies that, if both consumer types are served,
welfare is unambiguously lower under tie-in sales because the level
of consumption of the complementary good is lower than the socially
efficient level. The level of consumption of the basic good is the same
with or without tying. On the other hand, if tie-in sales are not allowed,
the chances increase that the firm will choose to serve the high users
only, so welfare could in fact increase under tie-in sales.
b. A good answer should describe various reasons for tying, in addition
to price discrimination. It should point out that tying can be used
to restrict competition, but it can also be used in ways that increase
efficiency and social welfare. It could also briefly discuss current
competition law towards tying. One possible conclusion is that a
rule of reason approach may be the best public policy towards tying
arrangements, but other conclusions are possible – it’s the arguments
that count. Empirical evidence from antitrust cases can be used to
support any arguments on the welfare implications of tie-in sales and
on appropriate policies.
Section B
Answer TWO questions from this section.
Question 5
There are two types of consumers for the rides at the ‘Disneyland Experience’,
10 of the high type and 20 of the low type. The demand of a high type is given
by qH = 20 – p and the demand of the low type is given by qL = 10 – ½ p, where p
is the price of a ride. The marginal cost of a ride is zero.
a. Suppose the Disneyland monopoly decides to set a two-part tariff. Find the
optimal two-part tariff assuming that the firm decides to ensure that both
types come to Disneyland. Derive the levels of consumer surplus for each
type and the profit for Disneyland. (7 marks)
b. Suppose instead that Disneyland chooses to cut out the low types. Find the
new optimal two-part tariff. What is the new surplus of the high types, and
profit for Disneyland? (7 marks)
c. Now suppose that Disneyland decides to offer two different packages
(each package containing some number of tickets for rides). Derive the
optimal package sizes and the prices at which the packages will be sold.
Compute how much consumer surplus each type earns, and how much profit
Disneyland makes from this scheme. (7 marks)
d. Comparing the results in parts (a–c), which is the preferred pricing scheme
for Disneyland? Which scheme is most efficient from a welfare perspective?
Provide economic intuition for your answer. (4 marks)
Reading for this question
Chapter 7 of the subject guide.
Church and Ware (2000) Chapter 5.
Tirole (1988) Chapter 3.
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Examiners’ commentaries 2014
Approaching the question
a. Disneyland will offer a two-part tariff T = F + pq, where F is the
access fee (independent of quantity), p is the price per ride and q is the
number of rides demanded by a specific consumer. Disneyland chooses
p and F to maximise its total profit from the two types:
p = 30F + (p – 0)(20qL + 10qH).
Let’s start with the choice of the access fee. Disneyland will set F such
that the consumer surplus of the type with low willingness to pay is
fully extracted: F = CSL(p) = ½(20 – p)(10 – ½p). Hence Disneyland’s
profit can be written as:
p = 30[½(20 – p)(10 – ½p)] + p[20(10 – ½p) + 10(20 – p)].
The value of p that maximises profit is p* = 4. The access fee will be
F* = ½(20 – p*)(10 – ½p*) = 64. The surplus of the low type will
be CSL(p*)] = 0, while the surplus of the high type will be CSH(p*) =
½(20 – p*)(20 – p*) – F* = 64.
Disneyland’s profit will be p* = 3200 and total welfare W* =
20[CSL(p*)] + 10[CSH(p*)] + π* = 3840.
b. Since S2(p) > S1(p), Disneyland charges an access fee equal to the
surplus of the high type and cuts out the low types (who are not
prepared to pay this access fee). Profit can now be written as:
p = 10[½(20 – p)(20 – p)] + p[10(20 – p)].
The value of p that maximises profit now is p** = 0 (same as the
marginal cost of a ride). The access fee will be F** = ½(20 – p**)
(20 – p**) = 200. The surplus of the low type will be zero, since they
do not buy any rides, and that of the high type will also be zero, since it
is all extracted through the access fee.
Disneyland’s profit will be p** = 10F** = 2000 and total welfare W**
= π** = 2000.
c. Disneyland’s problem now is to design two packages, one for the low
types and one for the high types, in a way that will provide incentives
to its customers to buy the package designed for them rather than not
buy or buy the other package. Let’s denote the packages as (q1, T1)
and (q2, T2), where q1, q2 are the number of rides and T1, T2 the prices
charged for the packages. Disneyland maximises its profit π =20T1 +
10T2 under two constraints. First, a participation constraint for the low
type: CS1(q1) – T1 ≥ 0. This says that the low type will buy only if the
benefit he gets from buying is at least as big as the access fee. Second,
an incentive compatibility constraint for the high type: CS2(q2) – T2
≥ CS2 (q1) – T1. This says that the high type will have no incentive to
pretend he is the low type.
Both constraints must hold with equality at equilibrium since the firm
just gives the minimum required for both types. This implies
T1 = CS1 (q1)
and
T2 = T1 + CS2 (q2) – CS2 (q1)
The monopolist’s problem therefore becomes choosing q1 and q2 to
maximise:
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EC3099 Industrial economics
The first order conditions are:
and
with solutions (q1) = 8 and (q2) = 20. The package prices are T1 = 96
and T2 = 168. Profit will be equal to 3,600. The surplus of the low type
is zero, and the surplus of the high type is 32. Total welfare is W = 20 ×
0 + 10 × 32 + 3,600 = 3,920.
d. Disneyland prefers the scheme under part (c) to that under part (a)
because with two different packages it is able to extract more surplus
from high type consumers. This is a general result: the firm is worse off
under a two-part tariff because in this situation it loses some flexibility
relative to offering different packages. Moreover, Disneyland prefers
serving both types under a two-part tariff than serving only the high
types. This is not a general result and it is obtained in this case because
the number of low type consumers is relatively large and their demand
not very low. The result might be reversed if the number of low type
consumers were relatively small or their demand very low.
Consumers are worse off under (c) than under (a): the increased
flexibility of the firm makes price discrimination more effective, so
more consumer surplus is redistributed to the owners of the firm in the
form of profits.
Total welfare is higher under (c) than under (a) because the scheme
under (c) reduces the price distortions in the market: each low type
consumer buys the same quantity in both cases, but each high type
consumer buys a larger quantity.
Question 6
Two firms, A and B, produce a homogeneous product at constant marginal (and
average) cost c and compete by simultaneously setting prices. There are N
consumers in the market, each with a reservation price of R for one unit of the
good. Before the start of the game, a fraction α of the consumers is purchasing
at firm A and fraction 1 – α is purchasing at firm B. If a consumer purchases
again at his current supplier, he pays only the purchase price, pi, for the good,
where pi is the price charged by firm i (i = A, B). If a consumer switches to the
other firm, however, he must pay the purchase price at the new supplier plus a
constant cost of switching, s.
a. Assuming that s = 0, what is the Nash equilibrium price in this market? If the
two firms merged to form a monopoly, what would be the equilibrium price
charged and the profit per firm? Explain. (7 marks)
b. Now suppose that s > 0 and firm B charges R for the good. State a condition
under which the best response of firm A is to charge R as well. Explain.
(7 marks)
c. Let α = ½. Under the assumption that s > 0.5(R – c), show that the Nash
equilibrium price is R. Explain the intuition for your result and contrast it with
your results in part (a). (4 marks)
Now suppose that the firms play a two-stage game in two periods. The second
stage is as already described. In the first stage/period the firms simultaneously
set prices to attract consumers (and they sell the good at those prices). In other
words, consumers buy the good in the first stage without incurring any switching
costs. Let α = ½ and s > 0.5(R – c), so that the firms anticipate that the price they
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Examiners’ commentaries 2014
will both charge in the second stage will be R. Since the firms make sales in both
periods, the relevant profit is the present discounted value of their profits over
the two periods.
d. Discuss how much the firms will be willing to drop their price in the first
stage in order to attract consumers. Given this, do you think that consumers
are hurt by the existence of switching costs in this market? Why or why not? (7 marks)
Reading for this question
Chapter 3 of the subject guide.
Church and Ware (2000) Chapter 8.
Tirole (1988) Chapter 5.
Approaching the question
a. In this case we have a standard Bertrand model with homogeneous
product, so price equals marginal cost. If the two firms merged, they
could charge the full reservation price of R and split the resulting
profits, so each firm would obtain N(R – c)/2.
b. If B charges R for the good, then if A charges R as well it earns αN(R –
c). If it charges less, then to make any difference to its market share it
would have to drop price to R – s. If it does this, then it can earn N(R – s
– c). For αN(R – c) to be larger than N(R – s – c), we need (R – c)(1 – α)
< s.
c. We see that the condition derived in part (b) is satisfied, therefore the
best response to R by firm B is R by firm A. The best response functions
look as follows with the Nash equilibrium at (R, R).
The intuition is that the switching cost implies that there is no gain at
all in market share by dropping price a little bit below the competitor.
Instead, the only possibility is to drop it a lot (enough to overcome
the consumers’ aversion to switching). When doing this, however, the
increase in market share is offset by a large decrease in revenue per
head. For a large enough switching cost, the price cut must be drastic
and so the revenue per head drops so much that the price cutting
strategy never pays. If s is large enough that this does not pay for R,
then it does not pay for anything less than R.
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EC3099 Industrial economics
d. In the first stage firms anticipate that they will both charge R in the
second period and that there will be no switching of consumers. Each
firm will know that its second period market share and therefore profit
can increase by attracting more consumers in the first period. Each firm
will therefore be willing to drop its price in the first stage sufficiently
so that its total discounted profit over the two periods is zero. This will
result in setting price below marginal cost in the first period, which is,
of course, beneficial to consumers.
Whether consumers gain or lose overall compared to the case without
switching costs (where p = c in every period) depends on how their
welfare over the two periods is weighted and the precise shape of
utility. The result is ambiguous.
Question 7
Answer both parts of this question.
a. Consider the linear model of spatial differentiation where identical
consumers are uniformly distributed on the interval [0, 1]. Each consumer
consumes exactly one unit of a homogeneous good. There are three firms
that can produce the good at the same constant marginal cost. The price of
the good is fixed (at a level higher than the marginal cost and lower than the
reservation price of the consumers). Consumers incur a linear transportation
cost, that is a consumer situated at distance x away from the location of a
firm incurs a cost tx to go to that firm and return, and t is the same for all
consumers. The firms must simultaneously choose a location on the interval
[0, 1]. Derive the pure strategy Nash equilibrium or equilibria in location
choice, if there are any. Explain your reasoning. (10 marks)
Reading for this question
Chapter 6 of the subject guide.
Church and Ware (2000) Chapter 11.
Tirole (1988) Chapter 7.
Approaching the question
The derivation proceeds by considering cases. Let si (in [0, 1]) be firm i’s
position along the line, or more precisely the distance between point 0 on
the line and the firm i’s location. There are three possible configurations.
Case 1: si ≠ sj ≠ sk, i.e. the 3 firms are located at different points on the
line. This is not a NE. To see this, suppose without loss of generality that
s1 < s2 < s3. Then firm 1 can increase its market share and therefore profit
by moving to the right (away from point 0), and firm 3 can increase its
market share and therefore profit by moving to the left (away from point
1). In other words, some of the firms have a profitable deviation.
Case 2: si = sj ≠ sk, i.e. two of the 3 firms are at the same location. This
is not a NE either. Suppose without loss of generality that s1 = s2 ≠ s3.
Then firm 3 can increase its market share and therefore profit by moving
towards the other firms: again, some firm has a profitable deviation.
Finally, case 3: si = sj = sk, i.e. all the firms are at the same location. Then
any firm can increase its market share and therefore profit by moving to
the long side of the line (or in any direction, if it is located between 1/3
and 2/3). Since there is a profitable deviation, si = sj = sk is not a NE.
We conclude that there is no Nash equilibrium in pure strategies.
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Examiners’ commentaries 2014
b. Two firms produce a homogeneous good and compete in prices over an
infinite number of periods. The demand is given by Q = 1 – p, where p is
the price of the good. Unit costs are c1 for firm 1 and c2 > c1 for firm 2. The
discount factors that the firms apply to future profits are, respectively, δ1
and δ2. Assume that under collusion the low-cost firm does all the production
and the firms share the profit, with 1/3 going to firm 2 and 2/3 going to
firm 1. Compute the gains from tacit collusion for each firm and derive the
relevant conditions under which tacit collusion can be sustained with trigger
strategies. Which firm do you think may be more likely to deviate from
collusion? Provide some economic intuition. (15 marks)
Reading for this question
Chapter 4 of the subject guide.
Church and Ware (2000) Chapter 10.
Tirole (1988) Chapter 6.
Approaching the question
Candidates should begin by describing the trigger strategies used by the
firms. They should then calculate each firm’s collusive profit, deviation
profit and punishment profit. When the firms collude, production takes
place with marginal cost c1. The monopoly profit is (1 – c1)2/4, therefore
collusive profits each period are P1C = 2/3 (1 – c1)2/4 and P2C = 1/3 (1 –
c1)2/4. If a firm deviates, it does so optimally, so it reduces its price slightly
below the collusive price, serves the whole demand at that price and
makes monopoly profit minus e for one period. Ignoring e, the deviation
profits are given by P1D = (1 – c1)2/4 and P2D = (1 – c2)2/4. Finally, if
collusion breaks down, the firms play a one-shot Bertrand game every
period forever. The Nash equilibrium of this Bertrand game is for firm 1
(the low-cost firm) to set price slightly below c2, the high-cost firm’s unit
cost. Profits are given by P1P = (c2 – c1)(1 – c2) and P2P = 0.
Collusion can be sustained if for each firm the present discounted value
of its profits is higher when adopting the trigger strategy than when
deviating. In particular the critical discount factor for collusion to be
sustainable with trigger strategies is generally given by δ* = (PD –
PC)/(PD – PP). Plugging into this expression the profit values derived
previously, we obtain δ1* and δ2*. Collusion is sustainable if δ1 > δ1* and δ2
> δ2*.
Which firm is more likely to deviate from collusion? This depends on
several things. First, it depends on the firms’ discount factors δ1 and δ2.
Given δ1* and δ2*, a firm is more likely to deviate the lower its discount
factor. Second, it depends on the critical discount factors δ1* and δ2*.
Given δ1 and δ2, a firm is more likely to deviate the higher its critical
discount factor. In our example, δ1* and δ2* depend on the firms’ unit costs
and the fraction of the monopoly profit each firm gets under collusion.
Firm 2 gets only 1/3 of the joint collusive profit, so in a way it has less
to lose if collusion breaks down. But in another way, it has more to lose
since its profit is zero in the punishment phase, while firm 1 can still make
a positive profit. Furthermore, firm 2 has less to gain from deviating (its
deviation profit is lower than that of firm 1). On the whole, then, it is not
clear which firm has a higher critical discount factor, but this will clearly
depend on the difference between c1 and c2. For instance, if c1 and c2 are
close, then P1P will not differ much from P2P, P1D will not differ much from
P2D, but P1C will be much higher than P2C, and therefore δ1* will be lower
than δ2*.
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EC3099 Industrial economics
Question 8
An industry consists of three firms. Each firm has the cost function C(qi) = 5 +
2qi. The inverse demand function of the industry is given by P(Q) = 18 – Q, where
Q is aggregate output. The timing of production is as follows. Firm 1 produces
its output first. Knowing firm 1’s output, firm 2 produces. Then knowing firm 1
and 2’s outputs, firm 3 produces its output. The industry demand, cost functions,
and production sequence are common knowledge. Find the equilibrium values
of production for each firm, taking into account the fact that firms that move
earlier in the sequence may use ‘production deterrence’ strategies against their
rivals.
Reading for this question
Chapter 5 of the subject guide.
Church and Ware (2000) Chapters 13–16.
Tirole (1988) Chapter 8.
Approaching the question
The sequence of moves and the possible actions of each firm are as
follows. Firm 1 can either:
i. blockade production by firms 2 and 3 simply by producing the
monopoly output, or
ii. deter production by firms 2 and 3 by producing some level of output
higher than the monopoly output, or
iii.accommodate production by one or both rival firms.
Firm 2 can either:
i. produce zero given q1, or
ii. blockade production by firm 3 by producing the optimal (positive) q2
given q1, or
iii.deter production by firm 3, or
iv. accommodate production by firm 3.
Finally, firm 3 chooses q3 given q1 and q2. Note that deterring production
by a rival firm is possible in this industry because of the fixed cost of
production (equal to 5).
The monopoly output for firm 1 is given by the level of q1 that maximises
(18 – q1)q1 – (5 + 2q1) ⇒ q1* = 8. However, given q1* = 8, firm 2 would
find it optimal to produce q2* = 4. Therefore production by firm 2 cannot
be blockaded.
Firm 1 could deter production by firms 2 and 3 by producing some level
of output higher than the monopoly output. Let us call this q1d. To find
q1d, we need first to turn to firm 2. Taking q1d as given, firm 2 would
choose the level of q2 that maximises (18 – q1d – q2)q2 – (5 + 2q2) → q2*
= (16 – q1d)/2 (firm 3 would not find it profitable to produce under entry
deterrence by firm 1). Firm 1 would anticipate this reaction by firm 2 and
would set q1d so that firm 2’s profit from choosing q2* is negative or zero.
Calculations yield q1d∈[16 – 2√5, 16 + 2√5]. Moreover, firm 1 would
choose the level of output in this range that maximises its profit, and
this is q1d = 16 – 2√5 (the lowest level). The corresponding profit would
be 32√5 – 25. This would be the (maximised) profit of firm 1 if firm 1
deterred production by firm 2 (and firm 3).
Alternatively, firm 1 might choose to accommodate firm 2. Taking q1 as
given, firm 2 would then choose the level of q2 that maximises its profit.
Now its profit function would depend on whether firm 3 would choose
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Examiners’ commentaries 2014
to produce a positive level of output. If firm 3 did not find it profitable to
produce, then the profit of firm 2 would be (18 – q1 – q2)q2 – (5 + 2q2)
⇒ q2* = (16 – q1)/2. If firm 3 found it profitable to produce a positive
output, given q1 and q2, its best reply would be the output that maximises
(18 – q1 – q2 – q3)q3 – (5 + 2q3) → q3* = (16 – q1– q2)/2. In this case, firm
2 would choose q2 to maximise its profit (18 – q1 – q2 – q3)q2 – (5 + 2q2)
taking q1 as given and anticipating the best reply function of firm 3. It
turns out that again q2* = (16 – q1)/2.
Firm 1 would anticipate this reaction function by firm 2 and would set q1
so as to maximise its profit subject to q2* = (16 – q1)/2. This maximisation
problem yields q1* = 8, which in turn implies q2* = 4. The corresponding
profit for firm 1 would be 27.
We therefore compare firm 1’s profits under deterrence and
accommodation. Since 32√5 – 25 > 27, firm 1 will produce q1d = 16 –
2√5. Firms 2 and 3 will produce zero.
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