EC3099 Commentaries 2015

Examiners’ commentaries 2015

EC3099 Industrial economics
Important note
This commentary reflects the examination and assessment arrangements

for this course in the academic year 2014–15. 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 (2015). 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 unit, 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 unit 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.
In general, problem-type questions are quite specific as to what you
are supposed to do, and a good answer generally involves some use
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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 essay-
type 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 recommended
reading for that particular topic, then come back to the 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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Examination revision strategy
Many candidates are disappointed to find that their examination

performance is poorer than they expected. This may be due to a
number of reasons. The Examiners’ commentaries suggest ways of
addressing common problems and improving your performance. One
particular failing is ‘question spotting’, that is, confining your
examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have 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 each course. You should read the
syllabus 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. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be
helpful during your 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. We strongly advise you not to adopt this
strategy.
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EC3099 Industrial economics – Zone A
Important note


references
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
Answer both parts of this question.
a. A survey has found that small UK firms that produce customised components
for UK manufacturers often do not rely on formal contracts for their
relationship. Furthermore, over half of the firms claim that the technology
used to support the relationship should be upgraded but this investment
is not being made. Using the theory of transaction costs, describe why
underinvestment often occurs in these relationships. (10 marks)
Reading for this question
Subject guide, Chapter 1; Tirole (1988) introductory chapter; Church and
Ware (2000) Chapter 3.
Approaching the question
The relationships studied in the survey would tend to generate ‘hold up’
problems of the sort that reduce investment in relationships: they involve
customised components, so that producers are making investments
to adapt to the specific needs of buyers. As the buyers and sellers are
separate, one would expect some opportunism in the relationship. There
are few formal contracts in this sector, making it difficult to commit to
payments that will be upheld ex post. It could be difficult to anticipate
contingencies in any contract, even informal, that guides the relationship;
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so even if contracts exist, they are unlikely to be complete. Indeed, for

relatively small orders, one would expect that the costs of attempting to
write a relatively complete contract would not be justified by the size of
the contract. A very good answer would also describe a specific theoretical
model to illustrate these arguments.
b. A recent report by McKinsey states that vertical integration is notoriously
difficult to implement successfully and – when it turns out to be the wrong
strategy – is costly to fix. As a result, the report recommends ‘don’t vertically
integrate unless it is absolutely necessary to create or protect value.’
Describe how vertical integration can create or protect value and, given this,
in which circumstances it might be a desirable strategy to follow for a firm.
(15 marks)
Subject guide, Chapters 1, 7 and 8; Tirole (1988) introductory chapter and
Chapters 3 and 4; Church and Ware (2000) Chapters 3, 5 and 22.
The basic premise of the McKinsey report seems to be that it is best, as
a default, not to vertically integrate. While markets often work well and
competition in the buyer and seller market assures efficient exchange,
one could give a more nuanced answer to this question from various
perspectives.
First, the answer could describe double marginalisation where the number
of buyers and sellers is not large on both sides of the market (typically,
and in the subject guide, we look at a single buyer and a single seller).
This basic externality would argue for vertical integration so as to prevent
price rising too far, but in fact there are a number of vertical contracts
that can at least partially resolve this problem, including two part tariffs
and vertical restraints (such as quantity forcing or pricing constraints).
This can be extended to the case of service provision, where again some
kind of vertical restraint (including two part tariffs, but also including
service contracts and other types of restraints) could be used to correct
the externality that tends to result in underprovision of services. This is
not a given, however, as the downstream market structure (e.g. a large
number of competing retailers) can tend to control this sort of externality.
If vertical restraints can go a long way towards resolving these vertical
externalities, why integrate?
One reason might be transaction costs – see the answer to part (a) above.
Candidates could outline the transaction cost argument for when markets
fail, and could also include some kind of summary intuition for this
relying on small numbers bargaining, high asset specificity or some kind of
information failure in the contracting.
Vertical integration can also make sense for price discrimination reasons
and market power reasons. Price discrimination may require control of
resale, which can sometimes be facilitated by vertical integration into
certain customer segments. It can also be used to promote barriers to
entry, for example by forcing entrants to set up their own distribution
network if they wish to enter. These points are developed in the subject
guide.
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Question 2
a. Explain why cartels tend to be unstable. How might the members of a cartel
try to increase its stability? (10 marks)
Subject guide, Chapter 4; Tirole (1988) Chapter 6; Church and Ware
(2000) Chapter 10.
The answer to this question should begin by analysing the incentives to
collude as opposed to the incentives to defect from a cartel agreement
in the context of a formal model of collusion as well as more generally.
Factors that hinder or facilitate cartel stability should be discussed, and
this could then provide a basis for assessing the ways cartel stability can be
increased by firms. The emphasis should be on factors that can be affected
by cartel members and not on exogenous industry characteristics.
b. Price wars imply losses for all the firms involved. Nevertheless price wars
occur. Does this mean that firms behave irrationally? Discuss with reference
to economic theories of price wars and any relevant empirical evidence.
(15 marks)
(2000) Chapter 10.
There are several theories that predict that price wars will occur between
rational firms. A starting point for the discussion, including some empirical
evidence, is provided in Chapter 4 of the subject guide.
Three theories are put forward. One is the Green-Porter model, where
there is uncertainty about the level of demand when firms choose prices in
each period. A firm cannot tell when it does badly in a period whether this
is because demand was low or because some other firm cheated on a price
agreement. Hence, even if firms collude (as they do in the subgame perfect
equilibrium of the model), there are cases where a demand shock triggers
a price war that lasts for several periods. This sort of ‘accidental’ price war
is necessary to discipline behaviour. Without such occasional reversions,
the equilibrium of (tacit) collusion could not be sustained because there
would be too much of an incentive to cheat under the cover of uncertainty
about the cause of the low prices. Also, the firms cannot collude on the full
monopoly price: this increases the ‘temptation’ to cheat too much when
there is imperfect observability of cheating. Green and Porter tested their
model on late 19th century railroad price wars and found some empirical
evidence to support it.
Rotemberg and Saloner postulate that demand fluctuates randomly but it
is observable in each period before the price is set. Firms can also observe
the past actions of their rivals. In such a case, the gain from cheating is
bigger when demand is high than when it is low because the payoff from
cheating increases with high demand. This means that firms must adjust
the collusive agreement: they decrease the collusive price in booms so that
the payoff from cheating shrinks and the incentive to cheat is reduced. No
price wars occur in equilibrium but prices do move countercyclically. This
is the opposite of Green and Porter’s result. Some evidence consistent with
the model was provided by Rotemberg and Saloner.
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Finally, Slade proposes that firms have imperfect information about either
demand or cost of rivals – but firms may have information of their own
that can be inferred from their actions. Hence, a price cut can be a signal
of the true cost of the firm or of demand. Firms, then, periodically cut
prices, but these are the reflection of firms’ updating their knowledge
about the underlying competitive conditions of the industry and so reflect
a move to a new collusive equilibrium. Levenstein and Levenstein and
Suslow provide some support for this theory and Slade also provides
evidence of price wars in downturns which could be consistent with this
theory (as well as Green and Porter’s theory).
Question 3
Answer all parts of this question.
a. Two firms, A and B, produce a differentiated product and compete in
the same market. Discuss, illustrating your argument with appropriate
diagrams, the concepts of ‘strategic substitutes’ and ‘strategic complements’
in the context of this competition. What do these concepts mean, and
which underlying models of competition are consistent with each of
these concepts? You may support your answer with formal expressions as
appropriate. (8 marks)
b. Firms A and B play a three-stage game. In the third stage, the firms are
Cournot competitors if both are active in the industry, with fixed cost of
production K and marginal costs cA and cB, respectively. The marginal cost of
firm A depends on its choice of innovation investment, F, in stage 1, with cA
decreasing in F. Firm B can observe F and must decide, in stage 2, whether
to enter the industry or not. In such a case, does firm A have an incentive to
‘overinvest’ in innovation? Explain, using formal modelling or diagrams as
appropriate. Make sure to define what you mean by ‘overinvestment’.
(10 marks)
c. Does it matter to your answer in (b) whether the firms are Bertrand or
Cournot competitors in the final stage of the game? Explain, including formal
modelling or diagrams as appropriate to illustrate your argument. (7 marks)
(2000) Chapters 13–16.
a. Strategic substitutes refer to the case where reaction functions slope
downwards: an aggressive action by one firm induces a passive
reaction by the other. Example: the Cournot model. Strategic
complements refer to the case of a positive slope of reaction functions:
an aggressive action by one firm induces an aggressive reaction by the
other. Example: the Bertrand model with differentiated products. A
good answer would link the slope of reaction functions with properties
of the profit functions, using formal expressions to illustrate.
b. In the case of strategic substitutes (Cournot), we have downward
sloping reaction functions. There are two possible courses of action for
firm A. Firm A may want to accommodate the entry of firm B. In such
a case, if we compare with the behaviour when firms cannot influence
their rivals (i.e. when F is not observable), we see an increased
incentive to shift out the reaction function of firm A by investing to
reduce marginal cost. The reason is that, as the reaction function shifts
out, the stage 3 equilibrium moves to a point where firm A produces
more and firm B produces less. This is to the benefit of firm A and is
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the result of the downward sloping reaction functions. Alternatively,

firm A may want to deter the entry of firm B. Again it will overinvest,
as this reduces the potential third stage profit of firm B and makes its
entry less likely.
c. Yes, it does. For entry accommodation, the result is reversed when
the game is one of strategic complements and reaction functions
are upward sloping (Bertrand with differentiated products). Firm
A’s investment in cost-reducing innovation would shift its reaction
function back: it would price lower for any given price by firm B. This
would hurt firm A, so A tends to underinvest compared to the case
where it cannot influence B’s actions. However, for entry deterrence,
overinvestment is appropriate in order to reduce the potential stage 3
profit of firm B and therefore the likelihood of entry by firm B.
Question 4
‘The equilibrium number of firms in a homogeneous goods industry is lower
the more intense is price competition among firms in the industry.’ Discuss this
statement, with reference to a theoretical model and the empirical evidence.
Subject guide, Chapter 9; Sutton (1991).
The core of the answer should include a discussion of the relationship
between short-run competition and market structure with reference to
a theoretical framework for the analysis of the determinants of market
structure, such as the one outlined in Chapter 9 of the subject guide.
In an exogenous sunk cost industry, the key result of a positive effect of the
intensity of short-run competition on market structure can be illustrated
using a simple two-stage game: at stage 1 firms decide whether or not to
enter at a certain sunk cost, while at stage 2 they are faced with various
possible competition regimes, namely Bertrand competition, Cournot
competition, and perfect collusion. Using a linear demand function and
a constant marginal cost (the same for all firms), one can show that the
number of firms that enter is lowest under Bertrand competition and
highest under collusion. In other words, market concentration is higher
the more intense the competition. The intuition for this result should
be clearly explained. Some discussion of whether the result extends to
endogenous sunk cost industries is also required.
The final part of the question asks for a brief discussion of empirical
evidence. Some evidence provided by Symeonidis is discussed in the
subject guide: a major shift in UK competition policy in the late 1950s
has made it possible to compare a group of previously collusive industries
(which experienced an increase in the intensity of price competition) with
a ‘control’ group of non-collusive industries (which were not affected by
the change in policy). Any other available evidence may also be discussed.
A very good answer might also indicate the main policy implications of
these results. One such implication is that competition policy authorities
should perhaps be less concerned with concentration than with ensuring
that competition remains effective, i.e. firms do not collude and there are
no barriers to entry.
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Section B
Question 5
The profit of a firm can take one of two values, Π1 and Π2, where Π2 − Π1 > 10.
The firm is run by a manager who chooses between two levels of effort, e = 1
(high) and e = 0 (low). The manager’s utility function is U = w1/2 − e, where w is
her wage. Whether the firm makes Π1 or Π2 depends on the manager’s effort
and on the firm’s environment, which is uncertain. In particular, if the manager’s
effort is high, the profit is Π2 with probability 0.8 and Π1 with probability 0.2.
If the manager’s effort is low, the profit is Π2 with probability 0.3 and Π1 with
probability 0.7. Before the manager decides on the level of effort, the owners
of the firm choose a contract for the manager which specifies the value of w
for each of the two possible values of Π. The owners’ objective is to maximise
expected net profit E(Π − w). Given the incentive scheme chosen by the owners,
the manager decides whether to take the job and, if she accepts, chooses e to
maximise her expected utility E(U). Her reservation wage is w0 = 4. After the
manager has made her choice, the profit is observed and the manager gets paid.
a. What is the optimal contract if the owners can observe the manager’s effort?
(9 marks)
b. What is the optimal contract if the owners cannot observe the manager’s
effort? (12 marks)
c. Show that the net profit of the owners is lower if the manager’s effort is
unobservable than if it is observable. (4 marks)
a. If the effort is observable, the owners can impose the level of effort
they prefer. If they want no effort (e = 0), then they should give the
reservation wage w0 = 4 (note that in this case the manager obtains a
reservation utility of U0 = w01/2 − 0 = 2. Net expected profit will then
be 0.3Π2 + 0.7Π1 − 4. If the owners want high effort (e = 1), they
should pay the manager a wage sufficient to guarantee him or her a
utility of U0 = 2. So the wage must be at least 9 (so that U = 91/2 − 1
= 2 = U0). Net expected profit will be 0.8Π2 + 0.2Π1 − 9.
Clearly, the owners will choose to impose high effort if and only if
0.8Π2 + 0.2Π1 − 9 > 0.3Π2 + 0.7Π1 − 4 ⇔ Π2 − Π1 > 10. Since the
question has specified that Π2 − Π1 > 10, we conclude that the owners
will choose to impose high effort in the case where effort is observable.
b. If the effort is unobservable, the owners cannot simply impose a level
of effort. Instead they may want to design an incentive scheme for
the manager. Of course, if they want e = 0, all they need to do is give
again the reservation wage w0 = 4. Net expected profit will then be
0.3Π2 + 0.7Π1 − 4. If they want e = 1, however, they will choose an
incentive scheme such that to each realised level of profit corresponds
a wage level. Formally, the owners must design a wage structure
wi(Πi), i = 1, 2, that maximises their expected net profit
0.8(Π2 – w2) + 0.2(Π1 – w1)
subject to a ‘participation constraint’
0.8(w21/2 – 1) + 0.2(w11/2 – 1) ≥ 2
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and an ‘incentive-compatibility constraint’

0.8(w21/2 – 1) + 0.2(w11/2 – 1) ≥ 0.3w21/2 + 0.7 w11/2) .
This maximisation problem is easy to solve because both constraints
are satisfied with equality. We get a system of two equations in w1
and w2. Solving we obtain w1 = 1.96 and w2 = 11.56. These are the
wage levels that maximise the owners’ expected net profit, which is
therefore equal to 0.8Π2 + 0.2Π1 − 9.64. Clearly, the owners will
choose to impose high effort if and only if 0.8Π2 + 0.2Π1 − 9.64 >
0.3Π2 + 0.7Π1 − 4 ⇔ Π2 − Π1 > 11.28, which may or may not hold.
If Π2 − Π1 > 11.28, the owners will implement the incentive scheme
and induce high effort (e = 1), but if 10 < Π2 − Π1 < 11.28, they will
prefer e = 0 and will therefore just give a flat wage equal to 4.
c. There are two cases, depending on whether e = 1 or e = 0 is the
optimal contract for the owners under part (b). In both cases it is easy
to show that the statement under part (c) holds.
Question 6
A monopolist produces a good with constant marginal cost equal to c, c < 1. Assume
for now that all consumers have the demand D(p) = 1 – p. The population is of
size 1.
a. Suppose that the monopolist cannot discriminate in any way among the
consumers and has to charge a uniform price, pU. Calculate the profit
maximising price and the corresponding profit. (5 marks)
b. Suppose now that the monopolist can charge a two-part tariff, T = AT + pT q,
where AT is the fixed fee, pT is the price per unit, and q is the quantity bought.
Calculate the profit maximising two-part tariff and the corresponding profit.
Compare pU and pT and comment. (5 marks)
c. Compare the welfare implications of the uniform price under (a) and the two-
part tariff under (b). (5 marks)
Assume now that there are two types of consumers. Type 1 consumers have
demand D1(p) = 1 – p, and type 2 consumers have demand D2(p) = 1 – p/2. The
population is of size 1 and there are equally many consumers of the two types.
Finally, assume that c = 1/2.
d. Calculate the two-part tariff that maximises the profit of the monopolist in
this new situation. Compare the two-part tariffs found in parts (b) and (d) for
c = 1/2 and comment. (10 marks)
(2000) Chapter 5.
a. The monopolist chooses p to maximise π = (p − c)(1 − p). The
first-order condition is 1 − 2p − c = 0. Hence pU = (1 + c)/2 and
therefore πU = (1 − c)2/4.
b. The monopolist sets the price per unit equal to marginal cost and
extracts all consumer surplus through the fixed fee. Hence pT = c
< pU and πT = AT = (1 − c)2/2. In a situation with only one type of
consumers, the optimal solution is to set price equal to marginal cost
in order to induce the efficient level of consumption and maximise
total surplus. The surplus is then extracted through the fixed fee.
Under a uniform price the monopolist is forced to use the price per
unit to make profit, so the price is set above marginal cost.
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c. Welfare is defined as profit plus consumer surplus. Welfare is

maximised under a two-part tariff because the efficient level of
consumption is induced. However, the consumers are better off under
a uniform price, because the monopolist cannot extract all their
surplus in that case. A detailed discussion of the welfare effects of
price discrimination can be found in Chapter 7 of the subject guide.
d. Suppose first that the monopolist serves both types of consumers.
For a given price p, the monopolist will set the fixed fee equal to the
consumer surplus of the low demand consumers (type 1), i.e. A = (1
− p)2/2. The monopolist chooses p to maximise overall profit (p − c)
(1 − p) + (p − c)(1 – p/2) + 2(1 − p)2/2. It turns out that p = 3/4
and A = 1/32. The profit is π = 9/64.
The monopolist could instead serve only the high demand consumers
(type 2). The price is then p = c = 1/2 and the optimal fixed fee
is equal to the consumer surplus of type 2 consumers, i.e. A = (1
– p/2)2/2 = 9/32. The resulting profit is π = 9/32 because only
consumers of type 2 accept the contract and all profit comes from the
fixed fee. Comparing profits, it is optimal for the monopolist to serve
only the high demand consumers.
Comparing the two-part tariffs in parts (b) and (d), the price per unit
is the same and equal to c. However, the fixed fee is higher in part (d),
because the consumers served have a higher demand.
Question 7
a. Let two bars, A and B, sell the same beer at zero marginal cost in Smalltown.
Smalltown consists of a single straight road of length 1, the Avenue, on
which the bars must locate. There is a continuum of consumers living in the
Avenue and each consumer wishes to buy one pint of beer. Consumers have
a reservation value v. A consumer located at x, who buys the beer at a bar
located at y, has to pay additionally to the price of the beer a travel cost t =
(x − y)2. Suppose that the price of beer is fixed by the government at p* per
pint, where p* < v. Describe where the two bars would choose to locate, and
explain your answer. How and why would your answer change if there were
three bars in Smalltown? (12 marks)
(2000) Chapter 11.
When the price is fixed the two bars both locate at the centre (this can be
shown by considering cases). This is the only Nash equilibrium, since in
all other cases one of the bars can increase its market share (and therefore
its profit) by deviating. In other words, in this case there is only a demand
effect: each firm wants to move towards its rival because in this way it
increases its market share, and therefore its profit.
With a fixed price and three bars, this Nash equilibrium breaks down:
either bar can increase profit by moving slightly away from the centre
since it captures almost half the demand rather than a third. In fact in this
case, there is no Nash equilibrium in pure strategies (again, this can be
shown by considering cases).
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b. A natural monopolist has total cost C(Q) = 300 + 15Q and faces market
demand Q = 200 – 2P. Derive the monopolist’s output and profit and the
consumer surplus when: (i) price is set equal to marginal cost; (ii) price is
set equal to average cost; (iii) there is two-part pricing and the monopolist
chooses the tariff to maximise profit; (iv) there is two-part pricing and a
regulator chooses the tariff to maximise consumer surplus, subject to the
monopolist breaking even. For parts (iii) and (iv), you may assume that there
are N identical consumers. (13 marks)
Subject guide, Chapters 8 and 11; Tirole (1988) Chapters 1 and 4; Church
and Ware (2000) Chapters 4 and 25.
i. When P = MC = 15, we have Q = 170, π = –300, CS = 0.5×85×170
= 7225.
ii. In this case P = AC ⇔ 100 – 0.5Q = 300/Q + 15 ⇔ 100Q – 0.5Q2
= 300 + 15Q ⇔ Q2 – 170Q + 600 = 0 ⇔ Q = 166.4. We take the
largest of the two solutions to the quadratic equation because it results
in higher welfare. It follows that P = 16.8, CS = 0.5×83.2×166.4 =
6922, π = 0.
iii. The per unit price will be P = MC = 15. The fixed fee will be equal to
CS in part (a) divided by N: 7225/N. Also, Q = 170, π = 7225 – 300
= 6925, CS = 0.
iv. The per unit price will be P = MC = 15 to maximise consumer surplus.
The fixed fee will be the fixed cost (300) divided by N: 300/N. Then Q
= 170, π = 0, CS = 6925.
Question 8
A profit maximising firm has the chance to research the cure for the common
cold (CCC). If it spends Z > 1 on R&D, then it has probability p(Z) = 1 – 1/Z of
discovering the CCC (and zero probability otherwise). Assume that the firm has
no other costs besides research costs and no other revenues other than those
from selling the CCC if it discovers it. The present value of revenue from the CCC
once discovered is Π. Units for research costs and CCC profits are millions of
pounds.
a. Assume that Π is sufficiently high that the firm finds it profitable to do
research. How much will it spend on research as a function of Π? (7 marks)
b. What is the expected present value of profits in terms of Π if the firm
optimally chooses Z? What would happen if Π < 4? Explain. (7 marks)
c. Assuming no discounting, so that the present value of profits is just the sum
of all future profits, and an annual profit of 0.15 from monopoly exploitation
of CCC, what is the minimum patent length that will induce the company to
do any research? (7 marks)
d. Assume the patent is the length you worked out in part (c). What is the
maximum fixed license fee the company could charge for the CCC? (4 marks)
Subject guide, Chapters 5 and 10; Tirole (1988) Chapters 1 and 10;
Church and Ware (2000), Chapters 4 and 18.
a. The firm will maximise its expected profits by choosing the level of
R&D spending Z. It will then get a present value of revenue Π with
probability p(Z). The expected present value of profits is therefore
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V(Z) = p(Z)Π – Z. Differentiation with respect to Z leads to the first

order condition:
p′(Z)Π – 1 = 0 ⇔ Π/(Z2) – 1 = 0.
The solution Z* = Π1/2 is the optimal level of R&D spending.
b. At the optimal level of spending, Z*, expected profits are:
V* = p(Z*)Π – Z* = (1 – 1/Π1/2) Π – Π1/2 = Π1/2 (Π1/2 − 2).
This expression is increasing in Π for Π > 1. When Π = 4, V* = 0. This
means that if Π < 4, then the present value of doing research must be
negative, and the firm would spend nothing on researching the CCC.
c. After the patent expires anyone can produce the drug and there are
no more profits to be made. This means that for n years the firm earns
0.15 per year, where n is the patent length. The total present value
of revenue from the CCC is 0.15n. We saw in part (b) that the profits
must be at least 4 for the company to break even, so the shortest
patent length which lets the company break even solves 0.15n = 4 ⇔
n = 26.667.
d. Once the firm has discovered the CCC, the net present value of profits
is 0.15n = 4. This is the maximum value of a license, since it is the
maximum the firm buying the license could earn from selling the CCC.
13

EC3099 Industrial economics – Zone B
Important note


references
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
Question 1
a. A survey has found that small UK firms that produce customised components
for UK manufacturers often do not rely on formal contracts for their
relationship. Furthermore, over half of the firms claim that the technology
used to support the relationship should be upgraded but this investment
is not being made. Using the theory of transaction costs, describe why
underinvestment often occurs in these relationships. (10 marks)
The relationships studied in the survey would tend to generate ‘hold up’
problems of the sort that reduce investment in relationships: they involve
customised components, so that producers are making investments
to adapt to the specific needs of buyers. As the buyers and sellers are
separate, one would expect some opportunism in the relationship. There
are few formal contracts in this sector, making it difficult to commit to
payments that will be upheld ex post. It could be difficult to anticipate
contingencies in any contract, even informal, that guides the relationship;
so even if contracts exist, they are unlikely to be complete. Indeed, for
14
relatively small orders, one would expect that the costs of attempting to
write a relatively complete contract would not be justified by the size of
the contract. A very good answer would also describe a specific theoretical
model to illustrate these arguments.
b. A recent report by McKinsey states that vertical integration is notoriously
difficult to implement successfully and – when it turns out to be the wrong
strategy – is costly to fix. As a result, the report recommends ‘don’t vertically
integrate unless it is absolutely necessary to create or protect value.’
Describe how vertical integration can create or protect value and, given this,
in which circumstances it might be a desirable strategy to follow for a firm.
(15 marks)
Subject guide, Chapters 1, 7 and 8; Tirole (1988) introductory Chapter
and Chapters 3 and 4; Church and Ware (2000) Chapters 3, 5 and 22.
The basic premise of the McKinsey report seems to be that it is best, as
a default, not to vertically integrate. While markets often work well and
competition in the buyer and seller market assures efficient exchange,
one could give a more nuanced answer to this question from various
perspectives.
First, the answer could describe double marginalisation where the number
of buyers and sellers is not large on both sides of the market (typically,
and in the subject guide, we look at a single buyer and a single seller).
This basic externality would argue for vertical integration so as to prevent
price rising too far, but in fact there are a number of vertical contracts
that can at least partially resolve this problem, including two part tariffs
and vertical restraints (such as quantity forcing or pricing constraints).
This can be extended to the case of service provision, where again some
kind of vertical restraint (including two part tariffs, but also including
service contracts and other types of restraints) could be used to correct
the externality that tends to result in underprovision of services. This is
not a given, however, as the downstream market structure (e.g. a large
number of competing retailers) can tend to control this sort of externality.
If vertical restraints can go a long way towards resolving these vertical
externalities, why integrate?
One reason might be transaction costs – see the answer to part (a) above.
Candidates could outline the transaction cost argument for when markets
fail, and could also include some kind of summary intuition for this relying
on small numbers bargaining, high asset specificity, or some kind of
information failure in the contracting.
Vertical integration can also make sense for price discrimination reasons
and market power reasons. Price discrimination may require control of
resale, which can sometimes be facilitated by vertical integration into
certain customer segments. It can also be used to promote barriers to
entry, for example by forcing entrants to set up their own distribution
network if they wish to enter. These points are developed in the subject
guide.
15
Question 2
a. Explain why cartels tend to be unstable. How might the members of a cartel
try to increase its stability? (10 marks)
(2000) Chapter 10.
The answer to this question should begin by analysing the incentives to
collude as opposed to the incentives to defect from a cartel agreement
in the context of a formal model of collusion as well as more generally.
Factors that hinder or facilitate cartel stability should be discussed, and
this could then provide a basis for assessing the ways cartel stability can be
increased by firms. The emphasis should be on factors that can be affected
by cartel members and not on exogenous industry characteristics.
b. How and why do price wars occur? Answer with reference to three different
theories of price wars and discuss the evidence that exists supporting each
as a good explanation of price wars. Is any one of these models a “better”
description of price wars? Explain. (15 marks)
(2000) Chapter 10.
There are several theories that predict that price wars will occur between
rational firms. A starting point for the discussion, including some empirical
evidence, is provided in Chapter 4 of the subject guide.
Three theories are put forward. One is the Green-Porter model, where
there is uncertainty about the level of demand when firms choose prices in
each period. A firm cannot tell when it does badly in a period whether this
is because demand was low or because some other firm cheated on a price
agreement. Hence, even if firms collude (as they do in the subgame perfect
equilibrium of the model), there are cases where a demand shock triggers
a price war that lasts for several periods. This sort of ‘accidental’ price war
is necessary to discipline behaviour. Without such occasional reversions,
the equilibrium of (tacit) collusion could not be sustained because there
would be too much of an incentive to cheat under the cover of uncertainty
about the cause of the low prices. Also, the firms cannot collude on the full
monopoly price: this increases the ‘temptation’ to cheat too much when
there is imperfect observability of cheating. Green and Porter tested their
model on late 19th century railroad price wars and found some empirical
evidence to support it.
Rotemberg and Saloner postulate that demand fluctuates randomly but it
is observable in each period before the price is set. Firms can also observe
the past actions of their rivals. In such a case, the gain from cheating is
bigger when demand is high than when it is low because the payoff from
cheating increases with high demand. This means that firms must adjust
the collusive agreement: they decrease the collusive price in booms so that
the payoff from cheating shrinks and the incentive to cheat is reduced. No
price wars occur in equilibrium but prices do move countercyclically. This
is the opposite of Green and Porter’s result. Some evidence consistent with
the model was provided by Rotemberg and Saloner.
16
Finally, Slade proposes that firms have imperfect information about either
demand or cost of rivals – but firms may have information of their own
that can be inferred from their actions. Hence, a price cut can be a signal
of the true cost of the firm or of demand. Firms, then, periodically cut
prices, but these are the reflection of firms’ updating their knowledge
about the underlying competitive conditions of the industry and so reflect
a move to a new collusive equilibrium. Levenstein and Levenstein and
Suslow provide some support for this theory and Slade also provides
evidence of price wars in downturns which could be consistent with this
theory (as well as Green and Porter’s theory).
Question 3
Using any suitable economic models, describe at least two different ways in
which incumbent firms can deter the entry of rivals in a market.
Subject guide, Chapters 5 and 6; Tirole (1988) Chapter 8; Church and
Ware (2000) Chapters 13–16.
Various examples of entry deterrence are described in detail in the subject
guide: capacity expansion and ‘overinvestment’ (Chapter 5), and product
proliferation (Chapter 6). Bundling is also briefly mentioned. Candidates
should outline the models, examine critically the key assumptions
necessary for entry deterrence to work, summarise the results and explain
the intuition.
Question 4
‘A major difficulty with the implementation of competition policy stems from
the fact that many business practices which unambiguously reduce welfare are
difficult to detect, while many business practices which are easy to detect have
ambiguous welfare implications.’ Discuss.
Subject guide, Chapter 10; Tirole (1988) Chapters 3, 4, 6 and 9; Church
and Ware (2000) various chapters.
A good answer should begin by discussing business practices which
unambiguously reduce welfare but are difficult to detect, such as collusion
and predatory pricing, focusing on why these practices have adverse
welfare effects and why they are difficult to detect. Circumstances where
the welfare effects are not necessarily unambiguously negative could also
be discussed. Next, the answer should examine business practices which
are relatively easy to detect but have ambiguous welfare implications,
such as vertical restraints and price discrimination, again focusing on the
reasons why such practices are relatively easy to detect and why their
welfare effects are ambiguous.
A very good answer would provide details, complement the theoretical
arguments with relevant empirical evidence and may also briefly mention
how competition authorities in various parts of the world are tackling
these problems in practice.
17
Section B
Question 4
The profit of a firm can take one of two values, Π1 and Π2, where Π2 − Π1 > 10.
The firm is run by a manager who chooses between two levels of effort, e = 1
(high) and e = 0 (low). The manager’s utility function is U = w1/2 − e, where w is
her wage. Whether the firm makes Π1 or Π2 depends on the manager’s effort
and on the firm’s environment, which is uncertain. In particular, if the manager’s
effort is high, the profit is Π2 with probability 0.8 and Π1 with probability 0.2.
If the manager’s effort is low, the profit is Π2 with probability 0.3 and Π1 with
probability 0.7. Before the manager decides on the level of effort, the owners
of the firm choose a contract for the manager which specifies the value of w
for each of the two possible values of Π. The owners’ objective is to maximise
expected net profit E(Π − w). Given the incentive scheme chosen by the owners,
the manager decides whether to take the job and, if she accepts, chooses e to
maximise her expected utility E(U). Her reservation wage is w0 = 4. After the
manager has made her choice, the profit is observed and the manager gets paid.
a. What is the optimal contract if the owners can observe the manager’s effort?
(9 marks)
b. What is the optimal contract if the owners cannot observe the manager’s
effort? (12 marks)
c. Show that the net profit of the owners is lower if the manager’s effort is
unobservable than if it is observable. (4 marks)
a. If the effort is observable, the owners can impose the level of effort
they prefer. If they want no effort (e = 0), then they should give the
reservation wage w0 = 4 (note that in this case the manager obtains a
reservation utility of U0 = w01/2 − 0 = 2. Net expected profit will then
be 0.3Π2 + 0.7Π1 − 4. If the owners want high effort (e = 1), they
should pay the manager a wage sufficient to guarantee him or her a
utility of U0 = 2. So the wage must be at least 9 (so that U = 91/2 − 1
= 2 = U0). Net expected profit will be 0.8Π2 + 0.2Π1 − 9.
Clearly, the owners will choose to impose high effort if and only if
0.8Π2 + 0.2Π1 − 9 > 0.3Π2 + 0.7Π1 − 4 ⇔ Π2 − Π1 > 10. Since the
question has specified that Π2 − Π1 > 10, we conclude that the owners
will choose to impose high effort in the case where effort is observable.
b. If the effort is unobservable, the owners cannot simply impose a level
of effort. Instead they may want to design an incentive scheme for
the manager. Of course, if they want e = 0, all they need to do is give
again the reservation wage w0 = 4. Net expected profit will then be
0.3Π2 + 0.7Π1 − 4. If they want e = 1, however, they will choose an
incentive scheme such that to each realised level of profit corresponds
a wage level. Formally, the owners must design a wage structure
wi(Πi), i = 1, 2, that maximises their expected net profit
0.8(Π2 – w2) + 0.2(Π1 – w1)
subject to a ‘participation constraint’
0.8(w21/2 – 1) + 0.2(w11/2 – 1) ≥ 2
18
and an ‘incentive-compatibility constraint’

0.8(w21/2 – 1) + 0.2(w11/2 – 1) ≥ 0.3w21/2 + 0.7w11/2) .
This maximisation
subject to problem is easy to solve because both constraints
subject
subject toaaa‘participation
to ‘participation
‘participation constraint’
constraint’
constraint’
are satisfied with equality. We get a system of two equations in w1
11//22 11//22
and w
000..8.88(((w
w 111)))00we
w22221./ 2Solving w
0..2.22(((ww1111/ 2 1w
obtain 11)))1 =1.96
222 and w2 = 11.56. These are the
wage levels that maximise the owners’ expected net profit, which is
and
andan
and
therefore
an ‘incentive-compatibility
an‘incentive-compatibility
‘incentive-compatibility
equal to 0.8Π2 + 0.2Πconstraint’
constraint’
constraint’
− 9.64. Clearly, the owners will
1
choose w
11/to
/2/22 impose high111/effort
ww111 111)))  000.only
/2/22 if and w2221if
w
11//2/220.8Π +111/0.2Π
w111 2 ... 1 − 9.64 >
w
//22
000..8.88(((ww222 111)))000..2.22(((w .3.33w 000..7.727w
1
0.3Π2 + 0.7Π1 − 4 ⇔ Π2 − Π1 > 11.28, which may or may not hold.

This
This
If
This maximisation
maximisation
Π2 maximisation
− Π1 > 11.28,problem problem
problem
the owners is
is easy
iseasy
easy to
willtoto solve
solvebecause
implement
solve because
because both constraints
bothconstraints
the incentive
both constraints
schemeareare satisfied
aresatisfied with
satisfiedwith equality.
withequality.
equality.
We
Weget
We
and get
getaaasystem
induce system
system
high of of
oftwo
effort two
two(e equations
equations
equations
= 1), butin in
inifw ww
10
11
1 and
andand
< w
Πw
w22
−
2.
2 . . Solving
Solving
Solving
Π 1
< we
we
we
11.28,obtain
obtain
obtain
they w
ww
will
1
11==
= 1.96
1.96
1.96 and
and
and w
ww 2
22==
= 11.56.
11.56.
11.56.
These
Theseare
These
prefer eare
are =thethe
the
0 and wage
wage
wage will levels
levels
levels
therefore that
that maximise
thatmaximise
maximise
just give athe the
the
flatowners’
owners’
owners’
wage equal expected
expected
expected net profit,
netprofit,
to 4.net which
profit,which
whichisis therefore
istherefore equal
thereforeequal
equal
to 0.8
to0.8
0.8 ++0.2
0.2 9.64.
0.21119.64.
9.64. Clearly,
Clearly,onthe
the owners
ownersewill will
will choose
choose to
to impose
impose high
high effort
effort ifif and
and only
only ifif 0.8
0.82
c. to
There 222+
are two cases, Clearly,
depending the owners
whether = 1choose
or e =to 0 impose
is the high effort if and only if 0.822
+ 0.2
+0.2
0.2111 9.64 >
9.64>>for0.3
0.3 + 0.7
+0.7 
0.7111 4
44     > 11.28,
>>11.28, which
11.28,cases
which may or may not hold. If   111>>>

+optimal 9.64
contract 0.3 222+owners
the under part
222(b).
111In both which ismay
it may ormay
or
easy maynot
nothold.
hold.IfIf222
11.28, the
11.28,the
11.28, owners
theowners
ownerswillwill implement
willimplement
implementthe the
the incentive scheme
incentivescheme and
schemeand induce
andinduce high
inducehigh effort
higheffort (e
(e===1),
effort(e 1), but
butififif10
1),but 10
10<<<
to show that the statement under partincentive
(c) holds.
 111<<<11.28,
222
  11.28, they
11.28,they will
theywill prefer
prefereee===000and
willprefer and will
andwill therefore
willtherefore just
thereforejust give
giveaaaflat
justgive flat wage
flatwage equal
wageequal to
equalto 4.
to4.
4.
Question 6
(c) There
(c) There
(c) are
Thereare two
aretwo cases,
twocases, depending
cases,depending on
dependingon whether
whethereee===111or
onwhether or
oreee===000is
is the
isthe optimal
theoptimal contract
optimalcontract for
contractfor the
forthe owners
theowners
owners
Considerunder
a market
part where
(b). In N firms
both produce
cases a homogeneous thatproduct and compete
under
under part(b).
part (b).InInboth
both cases
cases itititis
is easy
iseasy
easy to show
toshow
to that
showthat the statement
thestatement
the statement under part
underpart
under (c)
part(c) holds.
(c)holds.
holds.
by simultaneously setting quantities. The inverse demand function has the
general form P = P(Q) = P(q1 + q2 + q3 + … + qN), where qi is the quantity
6. produced
6.
6. Considerby afirm
Consider
Consider i andwhere
aamarket
market
market P is the
where
where NNmarket
N firms price. The
produce
firmsproduce
firms produce demand curve product
aaahomogeneous
homogeneous
homogeneous is downward
product
product and compete
andcompete
and competeby by simultaneously
bysimultaneously
simultaneously
setting
sloping, so quantities.
P′(Q) <
settingquantities.
setting 0. The
The
quantities.The inverse
total cost
Theinverse demand
of
inversedemand firm i
demandfunctionfunction
is given has
by
functionhas C the
(q
hasithe
the). general form
formPPP===P(Q)
generalform
i general P(Q)
P(Q)===P(q
P(q
P(q111+++qqq222+++qqq333+++…
…
…+++
qqNNN),),),where
a. qShow where
where qqqiii–is
that (P is
isMCthe
the quantity
the)/P
quantity
quantity produced
produced
produced
= si/ε, where by firm
byfirm
by iiand
firmithe
MC denotes and
and PPPis
is the
isthe
marginal market
thecost,
market
market price.
price.
si isprice.
the The The demand
Thedemand curve
demandcurve is
curveis
is
i
downward
downward
downward
market share sloping,
sloping,
sloping, so
so P(Q)
of firmsoi andP(Q)
P(Q) << 0.
0.
ε is<the The
The
0. The total
total cost
cost
total value
absolute of
of firm
firm
cost ofoffirm i
i is
is given
given
i is given
the price by
by C
C
by Ciof
elasticity (q
i (q
(q
i i).
ii).
).
demand. (7 marks)
(a) [7
(a) [7
(a) marks]
[7marks] Show
marks]Show that
Showthat (P
(P–––MC
that(P MC i)/P
)/P===sssi/,
MCi)/P i i/, where
/,where
i MC
whereMC denotes
MCdenotes the
denotesthe marginal
themarginal cost,
cost,sssiiis
marginalcost, is the
isthe market
themarket
i share
marketshare
share
b. Derive a ‘weighted Lerner index’ for the industry as a whole that is directly
of firm
firmiiiand
offirm
of and is
andis the
isthe absolute
theabsolute value
absolutevalue of
valueof the
ofthe price
theprice elasticity
priceelasticity of
elasticityof demand.
ofdemand.
demand.
related to the Herfindahl index of market concentration, H = ∑i si2.
(b) [6 marks] Derive a ‘weighted Lerner index’ for the industry as (6 marks)
a whole that is directly related to the
(b) [6
(b) [6marks]
marks]Derive
Deriveaa‘weighted
‘weightedLerner
Lernerindex’
index’for
forthe
theindustry
industryas
asaawhole
wholethat
thatisisdirectly
directlyrelated
relatedtotothe
the
c. From Herfindahl
Herfindahl
your answer
Herfindahl index
index
index of market
ofmarket
to part
of market concentration,
concentration,
(b), canconcentration,
you thereforeH H
H===iiisssii2i22.that

conclude .. an increase
in industry concentration will cause an increase in the industry price-cost
(c)
(c) [12
(c) [12
margin? marks]
[12marks]
marks] From
From
ExplainFrom your
your
your
why or whyanswer
answer
answer to part
topart
not. to (b),
part(b), can
(b),can you
canyou therefore
youtherefore conclude
thereforeconclude
conclude that an
thatan
that
(12 marks) increase
anincrease in
increasein industry
inindustry
industry
concentration will cause an increase in the industry price-cost margin? Explain why or why not.
concentration
concentration will
will causean
cause anincrease
increaseininthe
theindustry
industryprice-cost
price-costmargin?
margin?Explain
Explainwhy
whyor
orwhy
whynot.
not.
Subject
Reading:
Reading:
Reading: guide, Chapters
Chapters
Chapters
Chapters 333 and
and3 99and
and of9;
of
9 of theTirole
the
the (1988)
Subject
Subject
Subject Chapter
Guide,
Guide,
Guide, 5;(1988),
Tirole
Tirole
Tirole Churchchapter
(1988),
(1988), and 5,
chapter
chapter 5, Church
5, Church and
Church and Ware
and Ware (2000),
Ware (2000),
(2000),
chapter
Ware
chapter 8
8 and
(2000)
and 12.
Chapter
12.
chapter 8 and 12. 8 and 12.
ANSWER
ANSWER
ANSWER
a. Firm i chooses qi to maximise its profit Πi = qiP(qi + Q– i) – Ci(qi),
(a) where
(a) Firm i chooses q to maximise its profit iii = q P(q + Q ) – C (q ), where
(a) Firm
Firmiichooses choosesqqiiitotomaximise
maximiseits itsprofit
profit ==qqiiP(q iP(qiii++Q Q–––ii)i)––CCii(q
i(qii),
i),where
where
Q
Q
Q ===qqq1111++
Q––––iiii= ++qqq2222+++…
+……++++qqqiq
… +++qqqiiqi+++i 1+11+1+++
ii––i–1–111+ ……
……++++
qqqNNNqis
is
is
N
taken
taken
is taken
taken as
as
as given.
asgiven.
given.
given.


i i
i
dP
dP(((qqqiii Q
dP Q
Qiii))) dC
dCi(((qqqi)))
dC
The FOC is: qqqiii PPP(((qqqiii Q
Q
Qiii))) i i i i 000.
q dq dq
The FOC
TheFOC
The is: qqiii
is:
FOCis: dqdqiii dqiii
dq ...
P  MC qqqii dP
dP qqqii Q
Q dP sssiii .
dP
This can be written as: PPMC
MCiii
 i
dP
 i
Q dP

This can
Thiscan
This be
canbe written
bewritten as:
writtenas:
as: PPP PPP dQ
dQ
dQ Q
Q PPP dQ
Q dQ
dQ  ...
(b)
(b)
b. The
(b) The
The weighted
Theweighted
weighted Lerner
weightedLerner
Lerner index
Lernerindex
index for
indexfor
for the
forthe industry
theindustry
the can
industrycan
industry be
canbe
can defined
bedefined
be as
definedas
defined as
as
22
 PPPMC
MC
MCiii sssi2ii  H
H
H
i ssiii PP 
 s    i   
ii  P  i i   ,,,
555
19
where H 
where i si2 isisthe Herfindahl index, a measure of industry
the Herfindahl index, a measure of industry concentration: H takes values
between 0 and 1, with H = 1 being monopoly.
concentration: H takes values between 0 and 1, with H = 1 being
(c) monopoly.
In a Cournot oligopoly, an exogenous increase in H – because of a horizontal merger, say – will
cause
c. In an increase
a Cournot in thean
oligopoly, weighted Lerner
exogenous indexin(aHmeasure
increase of market
– because of a power).
horizontal merger, say – will cause an increase in the weighted Lerner
However,
index concentration
(a measure is ultimately
of market power). an endogenous variable, driven by fundamental economic
factors like technology, demand and the industry competitive regime. Therefore when we observe
However, concentration is ultimately an endogenous variable, driven
both a high H and a high price-cost margin in an industry, we cannot conclude that the former
by fundamental economic factors like technology, demand and the
necessarily causes the latter, since both may be driven by a third variable (one candidate is
industry competitive
efficiency differencesregime.
among Therefore
firms). when we observe both a high
H and a high price-cost margin in an industry, we cannot conclude that
the former high
Moreover, necessarily causes the
concentration needlatter,
not besince both may
associated be adriven
with by a
high price-cost margin at all, as when
third variable (one candidate is efficiency differences among firms).
tougher competition because of deregulation or trade liberalisation, say, causes firm exit and
mergers – high
Moreover, and therefore a rise need
concentration in concentration – and at
not be associated theasame
with high time a decline in the price-cost
margin.
price-cost margin at all, as when tougher competition because of
deregulation or trade liberalisation, say, causes firm exit and mergers –
and therefore a rise in concentration – and at the same time a decline
7. Answer
in theboth parts ofmargin.
price-cost this question.
(a)7 [12 marks] Let two bars, A and B, sell the same beer at zero marginal cost in Smalltown.
Question
Smalltown consists of a single straight road of length 1, the Avenue, on which the bars must
locate. There is a continuum of consumers living in the Avenue and each consumer wishes to buy
one bars,
a. Let two pint of beer.
A and B, Consumers
sell the same have
beera at
reservation valuecost
zero marginal v. Ain consumer
Smalltown.located at x, who buys the
beer atconsists
Smalltown a bar located at y, has
of a single to pay
straight additionally
road tothe
of length 1, theAvenue,
price ofon the beer a travel cost t = (x − y)2.
whichSuppose
the barsthat thelocate.
must price of beerisisa fixed
There by theofgovernment
continuum at p* in
consumers living perthe
pint, where p* < v. Describe
where
Avenue andthe twoconsumer
each bars would choose
wishes to buyto locate,
one pintand
of explain your answer.
beer. Consumers have How and why would your
answer change
a reservation if Athe
value v. two barslocated
consumer were allowed
at x, whotobuys
set the
theprice
beer ofat beer?
a bar
located at y, has to pay additionally to the price of the beer a travel cost t =
Reading:
(x Chapterthat
− y)2. Suppose 6 of
thethe Subject
price Guide,
of beer Tirole
is fixed (1988),
by the chapterat7,p*Church
government per and Ware (2000), chapter
11.
pint, where p* < v. Describe where the two bars would choose to locate, and
explain your answer. How and why would your answer change if the two bars
ANSWER
were allowed to set the price of beer? (12 marks)
Reading
When the for
pricethis question
is fixed the two bars both locate at the centre (this can be shown by considering cases).
This is the
Subject onlyChapter
guide, Nash equilibrium, sinceChapter
6; Tirole (1988) in all other cases one
7; Church andofWare
the bars can increase its market share
(and therefore
(2000) Chapterits11.
profit) by deviating. In other words, in this case there is only a demand effect: each
firm wants to move towards its rival because in this way it increases its market share, and therefore its
Approaching
profit. the question
When the price is fixed the two bars both locate at the centre (this can be
If the price
shown is not fixed,
by considering then in
cases). addition
This is the to theNash
only demand effect, there
equilibrium, is in
since a strategic effect: each firm
wants
all to cases
other moveoneaway of from its rival
the bars because its
can increase in this wayshare
market products
(andbecome
thereforemore differentiated, price
its profit) by deviating. In other words, in this case there is only a demandeffects can lead to some
competition is less intense, and profits increase. The interplay of the two
differentiation
effect: each firmorwants
even maximal differentiation
to move towards its rival(location
because at
inthe
thisends
wayof it the line).
increases its market share, and therefore its profit.
(b) [13 marks] A natural monopolist has total cost C(Q) = 300 + 15Q and faces market demand Q =
If the price
200 is not
– 2P. fixed,
Derive thethen in additionoutput
monopolist’s to theand
demand
profit effect,
and thethere is a surplus when: (i) price is set
consumer
strategic
equaleffect: each firm
to marginal cost;wants to move
(ii) price is setaway
equalfrom its rivalcost;
to average because in is two-part pricing and the
(iii) there
this monopolist
way products become more differentiated, price competition is less
chooses the tariff to maximize profit; (iv) there is two-part pricing and a regulator
intense, and the
chooses profits increase.
tariff The interplay
to maximize consumerofsurplus,
the twosubject
effects to
canthe
lead to
monopolist breaking even. For
someparts
differentiation or even maximal differentiation (location at the
(iii) and (iv), you may assume that there are N identical consumers. ends
of the line).
b. A natural monopolist has total cost C(Q) = 300 + 15Q and faces market
demand Q = 200 – 2P. Derive the monopolist’s output 6 and profit and the
consumer surplus when: (i) price is set equal to marginal cost; (ii) price is
set equal to average cost; (iii) there is two-part pricing and the monopolist
chooses the tariff to maximise profit; (iv) there is two-part pricing and a
20
regulator chooses the tariff to maximise consumer surplus, subject to the

monopolist breaking even. For parts (iii) and (iv), you may assume that there
are N identical consumers. (13 marks)
Subject guide, Chapters 8 and 11; Tirole (1988) Chapters 1 and 4; Church
and Ware (2000) Chapters 4 and 25.
i. When P = MC = 15, we have Q = 170, π = –300, CS = 0.5×85×170
= 7225.
ii. In this case P = AC ⇔ 100 – 0.5Q = 300/Q + 15 ⇔ 100Q – 0.5Q2
= 300 + 15Q ⇔ Q2 – 170Q + 600 = 0 ⇔ Q = 166.4. We take the
largest of the two solutions to the quadratic equation because it results
in higher welfare. It follows that P = 16.8, CS = 0.5×83.2×166.4 =
6922, π = 0.
iii. The per unit price will be P = MC = 15. The fixed fee will be equal to
CS in part (a) divided by N: 7225/N. Also, Q = 170, π = 7225 – 300
= 6925, CS = 0.
iv. The per unit price will be P = MC = 15 to maximise consumer surplus.
The fixed fee will be the fixed cost (300) divided by N: 300/N. Then Q
= 170, π = 0, CS = 6925.
Question 8
A monopoly manufactures a good at zero cost. There is a monopoly retailer
downstream who purchases this product from the manufacturer at price w and
sells it to consumers at price p. In addition, the retailer undertakes advertising (a
fixed cost) that affects the final demand for the good. In particular, final demand
depends on both price p and advertising A and is given by Q = 1 – p + βA, where
0 < β < √2. The cost of advertising to the retailer is C(A)=A²/2. The retailer has
zero cost of production (apart from what he pays to the manufacturer). The two
firms play a two-stage game: at stage 1, the manufacturer sets his wholesale
price w; then, at stage 2, the retailer sets his retail price p and advertising level
A (the latter two at the same time).
a. Compute the subgame perfect equilibrium prices and advertising levels, and
the profits for manufacturer and retailer. (5 marks)
b. Now suppose that the manufacturer owns the retailer and sets the retail
price and advertising himself. Compute the optimal levels of retail price and
advertising, and profit, and explain how and why they differ from those in
part (a). (5 marks)
c. Going back to the case where the manufacturer and the retailer are separate,
describe how the manufacturer could design a vertical contract to restore the
joint profit maximising solution. (5 marks)
Now suppose that instead of a single retailer there are two retailers of
this product who compete in prices. Demand depends on the total amount
of advertising, A, set by the two retailers: Q = 1 – p + βA. The retailers
simultaneously set advertising first, and then they simultaneously set prices
(hence the retailers’ subgame has two stages and the overall game has three
stages).
d. Derive the subgame perfect equilibrium prices and advertising levels for the
retailers and the profit earned by the manufacturer in this case. (5 marks)
e. In the absence of vertical restraints or integration, is the manufacturer better
off with a monopoly retailer as in part (a) or with two competing retailers as
in part (d)? Explain. (5 marks)
21

(2000) Chapter 22.
a. We proceed by backward induction. Taking the wholesale price, w,
(a) We proceed by backward as given, the induction.
retailer chooses Takingthe theretail wholesale price and price,advertising w, as given, levels inthe retailer chooses
the retail price and orderadvertising to solve: levels in order to solve:
(a) We proceed by backward induction. Taking the wholesale price, 2 w, as given, the retailer chooses
(a) We proceed (a) We byproceedbackward byinduction.
backward Taking
induction. the Taking wholesale Athe price,
wholesale w, asprice, given,w,the as retailer
given, the chooses retailer chooses
the retailthe price andprice advertising levels in levels max order to ( p  w )(
solve: 1  p   A ) 
retail and advertising
the retail price and advertising levels in order p, A in order to solve: 2 to solve:
Thisproceed
(a)wholesale
We problem byhas w, two
backward first-order induction. conditions. Taking Using
the them
wholesale A2 andprice, A2 w,we
solving as get given,
king the price, as given, the (retailer
max p max w)(1chooses
( p p w 
)( A
1 )
  p   A )  A2 the retailer chooses
(a)
order to solve: We proceed
the retail price andThis by backwardadvertising
problem induction.
1 has p w
, levels
A
twoand Taking
in
first-order the
p , Aorder toconditions. max
wholesale
solve: ( p  w )( 1
price,
1 2w Using 2them and solving p  w, Aas )  given,
1  w the retailer chooses
p ( w )  w  A ( w )  p ,A , so Q ( w )  2 2.
This the problem retail
This A price
has2
problem two andfirst-order
has
we advertising
two first-order
get 2 conditions.
has levels
2 in Using
order to
conditions. them solve:
Using 2and solving
them
wholesale 2
andwe
2
AUsing solving get we 2as given, we
get
solving
 w)(1  p  A)  (a) We proceed This by
(a) We problem
backward proceed two
induction.
bymax first-order Taking
( p  w)(1induction.
backward conditions.
1 p w the A) Taking them
price,
the and
w,
wholesale price, thew, get
retailer
as given, chooses the retailer cho
2 1  w 1  w 1  Aw2
2
1  w 1  w
the retail p( w)price  wpand w) 
(the advertising
w  and max p , A
A
levels( (p w
and) 1 in
w  )(w
order
1A ( w p ) to
  ,
solve:
A ) so
 Q (,w )
so  1 
Q w
( w )  . . 1  w
This
themproblem hasTakingtwo 2get retail
the2 wholesale
first-order
price
p2this and
(wconditions. advertising
,2Aw price,
)pdemand Using asand
22chooses
levels
2
them Ainw
(
and
order
)2solving  to solve:
retailer
2wholesale  2get
2 price ,2 to Q
so2 maximize (2w)  his profit, .
ons.
d byUsingbackward The and solving
manufacturer
induction. we
anticipates
2  w,
and given, 2his the A2 2 we chooses A

2 2   2
This
rice and advertisingwQ 1 (w problem
w) , which levels hasyields
intwo order first-order
the 1 to  w conditions.
1wsolve:
solution max ( pUsing  w)(1them 1max p wand (Ap) solving
w)(1  we p) get 1A) w .
A( w)   , so p
Q ( (w w ) )   w  . and p , A A( w)   , so 2 Q ( w
The manufacturer anticipates 2this w2 anticipates
1first-order
21demand and
A12 Achooses his p ,w
21wholesale
A2
price
(his to 1 w2to
maximize 2 maximizehis profit,
2 The  2 manufacturer
This problem max ( w(The
pThe )has
p Thismanufacturer
wtwo
manufacturer
 w w )( a2
anticipates
1 
problem p   
this
A p
has ) and
 
demand
anticipates
a conditions.
two  ( wthis)and
this
first-order 1demand
 chooses
Using
demand ,
them
A
and
conditions.
a ,his
and 
chooses
soand wholesale
chooses Q
Using w) his
solving them
.
2we
price
wholesale
 get
wholesale
and .solving pricewetoget his profit, his profit,
maximize
wQ(w) , which wQ(w) , which yields the
price solution
yields to 2
maximize 
the 2solution  2
his profit, wQ(w), 2
which
2(2   ) 1  w2(2   )
2   2
yields the solution2 2   2
p, A
wQ(w ) , which 1  w the22solution
yields 1(ww w 1  w a. 1 w
emand
nd haschooses
two The first-order
manufacturer
his wholesaleconditions. p ( w
anticipates
price ) 1
Usingto w  athis
maximize them
a 1 demand 1
p 2and
( w his
) and
solving
w 21 A
1
and
profit, we
chooses ) 1get  his and a2A(, wso
wholesale )   Q (1w) 
price to22maximize
,isso 2 Q( whis ) a.profit,2 .
The profit of the retailer w  is
a

w this a p 
2 1

 1 demand /[
 8 (
 2
 p a and
a  1)] and , the
A a
profit

1 2  of
, A 2 . , price1the manufacturer     2 
r
2 2 22chooses  a 2
2a  . m r
2
The
wQ(w
p( w)  w  , which
manufacturer
)1,which w yields
and
anticipates
A
the
(
2 solution
w )   2 2w w,2(so 2 Q ( 2)w(p)2122his .
(
  2)2(2  A
)2w(22wholesale
2   )  2 )to2(maximize 2   2 .
)
his profit,
1 wQ(wof
1 profit 2) aprofit
 2vertically yields
theisretailer theaa solution aa )]
1/[82(2monopolist 22
1 and 2 1 profit 2use of2aprofit
2
the manufacturer isbut mainstead 2is ra.chooses
 The (b) TheThe , single
The A the
 retailer
manufacturerof w r 1is
integrated
anticipates  
pthis 1 /[
 demand
8 ( 2   adoes
 the and
)] not
and chooses
,the A athe  manufacturer
wholesale
his wholesale
of price price maximize
tomanufacturer a
 2his a
.pprofit,
TheThe The
2profit . manufacturer
profit of of the
1 the retailer
rretailer anticipates
is
1is   1 1 /[ this
8 ( 2 demand
 )] and
and and the

the chooses
profit
profit . ofofhis
thethe wholesale m price risto maximize
m  2 r . his p
a a
2 2(2  and 2
) AwQ (w)2,(which
directly 2by  solving: ) w the2 solution
yields a
 p a
 2  2(2   ) , A  2(2   )
r 2 a 2
wQ(w) , 2which yields the solution 2 .
facturer
(b)2 Theanticipates
)] andsingle
The
the profit
profit this
verticallyofof demand
the
the integrated
retailer
manufacturer and is chooses
monopolist
a
is 1 1 /[ 8 
( 2 2 
2
a his wholesale
does a 2 2not
1
)] (2and use price
2
the )1a profitto A
wholesale 2 2(2 
maximize
of the pricehis ) but
manufacturer profit, instead is chooses
a
 2 rbut a
p.
(b) The single (b) The vertically singleintegrated
manufacturer vertically ra is m monopolist
integrated ar . does
1 A
monopolist nota use 1Aaa wholesale
does not 1use a price
wholesale but instead

mprice chooses
instead p chooses p
hich and yields The the solution
profit of the retailer is w a   p
max   2p (1
w a  
and p 
the p) 
profit  , of  the manufacturer , A. a
 is  a
 2  a
A directlyand A directly by solving:  1 2/[ 8 ( 2  )]2 22(2   ) 22 2(22(2 ) ) 2 2 ..
andby solving:by solving: r p , A m r
1order A1 directly 1 instead monopolist 2
2
2(2   ) 2
list does (b) not The

The use
w Thefirst
asingle a
 profit wholesale
 pofthe 
b. conditions
vertically
a
The integrated
price
single are:
but vertically monopolist
, A achooses

integrated does p2 )]anot Ause doesaprofit
wholesale
A
not 2
use price
a wholesale 2 but instead chooses ap
m  2 r .
a
retailer is 
2 max
a
 1 /[ 8
p(1 2max( 2 
p2is 
p Ar2 .
and
))p1/[8 the of the manufacturer
Aprofit of theismanufacturer
p is  m  2 r .
a a
(b) The single 2 vertically 2 The 2
integrated profit
( 2   of ) the
r
monopolist retailer ( does  (1 not max use  (A 2a)  
wholesale
p(1 2p  A) 
2
)] and the
price but instead chooses
and A directly by solving: price but instead chooses
p , A  p , A
p Jand A directly 2 by solving:
and The A directly by solving:  1  A p2, Ap  02 2
of theThe first
retailer
(b)
order
is
The  A
a2
firstconditions

single 1 /[
order8 ( 2  are:
conditions
vertically
2
)] and
integrated the
are: profit of
monopolist p the manufacturer
does not Ause is a mwholesale
a
 2 ra . price but instead chooses p
ax p(1  p  A) 
r
The first order
(b) The single vertically conditions are:
max p(J1J p  monopolist A)  2
A
and 2A directly by solving:  J p , Aintegrated p(1Ap2pA)0J A2

does not use a wholesale price but instead choos
and A directly max
by solving:  1  AA but
verticallyThe integrated
first order monopolist
conditionsdoes are:not use p ap wholesale
,A
Ap
 p1price 022 pinstead
102 A chooses 2p  0 p
 p A A2
ctly
 by solving:
J The
Thisfirst order conditions
is identical
The first order
to the retailer's are: conditions problem   J in are:Jmax(a) pJ (1the
for  pcase  A max )  p(1w=p0,
where   A
which )  we can simply use
 1  A  2 p  0
A  2 J p
 A1 AAp02pAJp0, A0 2
p ,
2
p in the The abovefirst expressions
order max conditions p ( 1 to  obtain
p  are:
 A )the   p  1AThe
solution.
A  A price
 2 p under
 0   A  0 is p J  1 /( 2   2 ) , the
 pintegration
The first order conditions are: A
 J This is identical
advertising
This is identical to
levelthe is retailer's
p, A J
A
to the  problem

2 and the
retailer's in (a)
problem 2pfor
total  
J the
profit

in J case where w = 0, which we can simply use
(a) offor the the integrated
case Jwhere firm w is = given
0, which by we0,can simply use

rder conditionsp   A 
are: 0 This is identical 2  to the retailer's J  problem
p
  1 
 A Ain
  0(a)2 p for 0 the case where w= 2 which we can simply use
A in the abovein the expressions
above expressionsto obtain to the obtainsolution. the  The
solution.
Apthe price The under price integration
under  1   is
A
integration p
 J
2 p
 1 0
/(
is 2 J  ) , the 2
 1 /( 2ispJ 
p retailer's ) ,1the
  1 /[ 2(2  
J
inJthe
2
)]  above
4J r . This
a
expressions profit exceeds to obtain sum
pthe solution.
Aof The price under
 0thepmanufacturer's and integration
the /( 2   2 ) , the
in (a)advertisingThiscase
for the islevelidentical
where is A w to=the 0,is retailer's
which Jandwe
1level 2the A problem
can
total simplyprofit
2Apmonopolies, A(a)
intotal offor
use the J the ofcase
integrated where
a firm wis=given 0, which by we can by issimply use
profits
This
advertising
is when they
identical
level
to act
advertising
the p
2 as  2Asuccessive
retailer's
2 and
is
J  problem 02in
J the
2  (a) 2 andwhich
profit

for thethe
 ptotal

caseisthe
 A
integrated
where
3profitr.0  Theof
J the
w reason
=
firm
0, integrated
which
is given
for this
J firm
we difference
can given
simply 2 isuse by
lution. The inpricethe Jabove under 2 expressions
integration to pobtain
is  1 /(the 2 solution.
 the ) , theThe price under integration  p   A is p0  1 /( 2   ) , the
 J  that1 /[ 2the(2   )]
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setup suffers exceedsfrom a the sum
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asp Jwell as
r 1)]J/[ 42obtain . This profit exceeds sum offor the manufacturer's and 2by
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above isgiven(to r  the 4solution.
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 1 /(  2and ) , thethe retailer's
2
al profit advertising
of the level is
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total profit problem of the inaintegrated
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act ofas to
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This the is retailer's
2 identical by
pmonopolies,
 the
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retailer.
to0 the which in
retailer's (a) is for 3 
problem the . case
The in where
reason
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for
the = 0,
this
case which
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where we w can
=is 0,simply
which use
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advertising level they
0, A whichact
J as wesuccessive
can act simply monopolies,
use in the above which expressions is 3which a
r .to The obtain reason the. The for this difference is we can simply u
2 is  2 and the total profit of the integrated firm is given
 by
a
J in the above profits
expressions whenA they
 to obtain as successive
the solution. monopolies, r
is 3 reason for this 2 difference is
isThe =price under integration isthe  1 /( 2  is)p, Jthe
J
ceedsthat the the decentralised
sum of1 /[the   setup
2(2manufacturer's )] in4
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a
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This
and
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from
priceprofit theexceeds
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under double
integration to the sum
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1/(2 manufacturer's
–problem
β2),The the as
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well
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under p integration
by retailer's  1 /( 2   2 ) ,
ntical to (c)theThe that
Jretailer's
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can in (a) r setup
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tariff: the
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good can at simply problem
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opolies,  underprovision
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ve expressions to 3
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is
under A is
retailer. 
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by the and retailer.the
is p3 total  profit
/( 2   of the
) , the integrated firm is given by
retailer, which obviously results in the integrated-monopolist
r
2  2
a price and advertising levels, and also
r
the doubleprofitsthat the Jwhen
marginalisation
  1 /[ they
decentralised2 ( 2  act
problem
 2as setup
)]J 4
successive
as  suffers
awell as
. This monopolies,
fromby how
2profit theexceeds double which the is 3of
marginalisation
sum r .the Themanufacturer's
reason
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and asthe byretailer's is
g level
(c) Theis A charges
J

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2 and can the feetotal
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 1
two-part determines
/[ 2
r of( 2 the
 
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)]  he 4  the
a
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This (now
This the is maximal)
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good
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exceeds
at
exceeds marginaljoint
the the sum profit
sumcost
of of
the isthe
(zero distributed
manufacturer's
here) to between
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iler. (c)
that The
the
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2  decentralised
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The
and can use
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can from retailer. the tariff:
usemonopolies,
fee can double
r
a two-part
be he to
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marginalisation
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a problem marginal
parties good as at
agree cost
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on the here)
by contract.
cost (zero to the here) to the
profits when they act as successive which is 3  . The reason for this difference is
2  retailer, which obviously resultsthe inresults
thethe integrated-monopolist price and advertising levels,
 and also and
a
2
4  retailer,
)] underprovision
a
. This which
profit of profits
obviously
advertising
exceeds
retailer, which when by
sum
obviously they of in actthe
retailer.
the as successive
integrated-monopolist
manufacturer's
results indouble
the when monopolies,
and the
r price
retailer's which and is 3
advertising
price . The
and reason
levels,
advertising for this
also difference is
charges This r vertical contract
a that
fixed the fee whichmanufacturer’s
decentralised increases
determines setup and efficiency
suffers
how the retailer’s
from
the unambiguously
(now the profits
maximal) as both
they
marginalisation
joint act as consumer
profit successive
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is distributed surplus
r
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riff:
en they he(c) actThe
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and
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of The
aandwhich
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be set
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the
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at marginal
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maximal) isprofit
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is todistributed
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(c) Theretailer,
ntegrated-monopolist manufacturer
manufacturer
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and
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the
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and also
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can ensure
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andboth
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here)
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centralised
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This suffers
contract
vertical from contractthe
increases double efficiency
increases marginalisation unambiguously
efficiency problem
unambiguously as both
as well by
consumer
as both surplus
consumer (through
surplus a also a
(through
ow the retailer,
charges
(now maximal) which
a fixed obviously
jointfee which
profit results
is determines
distributed in the integrated-monopolist
how between the (now maximal) price joint and advertising
profit is levels,
distributed and
between
sion lower Note
of advertising
(c) The thatmanufacturer
by theThis
resale price vertical
decentralised
retailer. maintenance
can use contract
setup suffers
a on two-partbyincreases
itself from
tariff:fails theefficiency
he to
doublemaximise unambiguously
marginalisation joint profit problem as both
because as of consumer
the presence surplus (through a
can be consumer
setcharges lower
manufacturer
to ensure price)
a consumer
fixed
that and (c)
fee
both
lower
and price)
The
which
retailer.
well parties joint
consumer
as by and
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manufacturer
determines
agree joint
fixed
price)
underprovision
increase.
profit
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how can increase.
contract.
of use
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the
advertising (now
set toprices
two-part maximal)
ensure
increase.
p J , advertising
by the
the
tariff:that
retailer.
goodhe
joint
both atprofit
prices marginal
parties the is good cost
distributed
agree onat (zero
marginal
the here)
between
contract. to the
cost (zero here) to
cy retailer,
of advertising:
manufacturer
This
unambiguously vertical as which
and even
contract
both obviously
retailer. if increases
retailer,
consumer theThe retail
which results
fixed
surplus price
efficiency in
obviously
fee the
were can
(through integrated-monopolist
fixed
be results
set
unambiguously
a to
to in
ensure the integrated-monopolist
that
as both
both pricewould andbe
parties
consumer advertising
distorted
agree price
surpluson the levels,
downward
and contract.
(through anda also levels, and
advertising
facturer Note can that use
whenever chargesa two-part
resale price
the c.
aresale
fixed tariff:
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maintenance
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manufacturerwhich prices by the
can ause
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itself good fails attomarginal
a two-part
how theprice
maximise tariff:
(now cost
he (zero
prices
maximal)
joint profit here)
the good
joint
becauseto at the(which
profit is
thedistributed
ofsurplus presence between
crease. This
lower Notevertical
consumerthat contract
Noteprice) price
charges
that increases
and resale acharged
maintenance
joint fixed efficiency
profit
price fee wholesale
by which
increase.
maintenance itself
unambiguouslyfails
determines
by to
itself
above
maximisehowas marginal
fails the
both
to joint
(now
consumer
maximise
cost
profitmaximal) because
joint
he
joint
profit
would
of(through
the
profit
because
in
presence
isaofdistributed
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hich obviously order results
manufacturer
to make in the
profit). integrated-monopolist
marginal
and retailer. cost (zero
The here)
fixed price
to
fee the can and
retailer,
p be advertising
set which
to ensure obviouslylevels,
that and
results
both also
in
parties the agree on the contract.
lower consumer even ifprice) manufacturer
and joint andprice
profit retailer.
increase. toThe J ,fixed pfee canwould be set tocharges
ensure bethat both parties agree on the cont
fixedoffeeadvertising:
which ofThis advertising:
determines
vertical of
the
even
how retail
contract
advertising: if the
the price
(now
increases retail
even
were
maximal)
if
fixed
price
efficiency
the were
and
retail joint fixedprofit
advertising advertising
unambiguously
price to is
were
J , advertising
distributed
levels,
fixed and as
to palso be
J ,between
both
distorted
would
consumer
advertising
downward
distorted
surplus
would be downward
(through
distorted adownward
selfand fails
wheneverNote
to that
maximise
the
whenever resale joint
manufacturer
the price
profitThis
manufacturer vertical
maintenance
because
charged contract
by
theitself
ofwholesale
aensure
charged presence
a increases
fails
priceparties
wholesale toabove efficiency
maximise
price marginal
above unambiguously
joint profit
cost
marginal because
(which cost as he both
ofwould
(which the heconsumer
inwould surplus
presence in (throu
rer retailer.
(d) Note
Given The
lower a fixed
consumer
wholesale fee
whenever canprice)
price, be the w, set
and andto joint
manufacturer startingprofit that with both
increase.
charged the pricing
a agree
wholesale subgame on the
price contract.
(after above advertising
marginal levels
cost have
(which he would in
that to resale price lower maintenance consumerby price)
itselfand fails joint to profit
maximise increase. joint profit because of the presence
cal orderof
ere contract
fixed toto22
been
pincreases
make
order
advertising: profit).
chosenmake
J , advertising efficiency
andeven
order profit).
would if make
observed),
to unambiguously
the beretail distorted
it is
profit). price clear wereasthat
downward both
fixedforconsumer to p Jadvertising
any surpluslevels
, advertising (through
would there bea distorted
is price downward
(Bertrand)
umer price) of and joint
advertising: profit even increase.
if the retail price were fixed to p J , advertising would be distorted downward
wholesale whenever
price Note above the
that manufacturer
marginal
resale price cost charged
(which
maintenance heapricing,
wholesale
would
by itself in fails price to above marginal cost (which heofwould in
(d) Given
competition
(d) a wholesale
Given a
leading
price,
wholesale
to
Notew,
marginal
and
price, thatstarting resale
w,
cost
and price
with
starting maintenance
the
i.e.
pricing
with
both
the bymaximise
retailers'
subgame
pricing itselfsubgame price
fails
(after
jointwill
to profit
equal
maximise
advertising
(after
because
w in any
joint
levels
advertising
the presence
case
profit
havelevels
and
because of the pres
whenever
order
both will to make the manufacturer
(d) profit).
make zero aprofit
Given wholesale charged
at this price, a
stage w, wholesale
(any andcosts price
starting above
of advertising p J the pricing
with marginal are already cost
subgame (which
sunk(after he would stage).havelevels have
at thisadvertising in
a fixed fee which determines how the (now maximal) joint profit is
distributed between manufacturer and retailer. The fixed fee can be set
to ensure that both parties agree on the contract. This vertical contract
increases efficiency unambiguously as both consumer surplus (through
a lower consumer price) and joint profit increase.
Note that resale price maintenance by itself fails to maximise joint
profit because of the presence of advertising: even if the retail price
were fixed to pJ , advertising would be distorted downward whenever
the manufacturer charged a wholesale price above marginal cost
(which he would in order to make profit).
d. Given a wholesale price, w, and starting with the pricing subgame
(after advertising levels have been chosen and observed), it is clear
that for any advertising levels there is price (Bertrand) competition
leading to marginal cost pricing, i.e. both retailers’ price will equal w
in any case and both will make zero profit at this stage (any costs of
advertising are already sunk at this stage). Knowing this, neither firm
will advertise, because advertising is costly and price competition does
not allow them to recoup these costs. The problem here is that
although advertising increases demand, it does so for both firms (an
externality) and does not yield any returns due to subsequent price
demand, it does so
demand, it does so for both firms for(an
bothexternality)
firms
competition. (an externality)
and this
Anticipating and
not does
doesresult – thatnot
yield anyyield any returns
returns
competitive due todue
retailers willto subsequent
subsequent
price competition.notAnticipating
advertise this result – that competitive retailers will not advertise
demand 1 –– w – in the
price competition. Anticipating this result ––inthat
the first stage, theretailers
competitive manufacturer
will faces
not advertise in the
first stage, the manufacturer faces demand 1  w and maximises profits
and maximises profits w(1 – w) with optimal wholesale price w(1  w) with optimal
first stage, the manufacturer faces demand 1  w and maximises profits w(1  w) with optimal
wholesale price w d d
w  1
= / 2
1/2,
, leading
leadingto
toprofits
profits  d
m  1 / 4 .
wholesale price w d  1 / 2 , leading to profits  md  1 / 4 .
(e) We compare manufacturer profits
e. We compare in parts (a)profits
manufacturer and (d). Having
in parts (a)aand
monopolist retailer
(d). Having a is better than
We compare manufacturer profits
Bertrand-competing in parts
retailers
monopolist (a) and
whenever
retailer is (d).
better Having
m  than
a d
m , which
a ismonopolist
equivalent toretailer
Bertrand-competing the is better
condition
retailers  than
1 . What
Bertrand-competing retailers whenever
is the economic whenever  m this
intuition for
a
 m ,result?
d
, which is
which isThe equivalent
equivalent to the condition
to the condition
manufacturer faces a trade-off . What
β > 1.  1between two
externalities: (perfect) competition among retailers solves
s the economic intuition for this result? The manufacturer faces a trade-off between the double marginalization problem,
two but
externalities: (perfect) competition among retailers solves the double marginalization problem, but the
at the cost of having
Whatno advertising.
is the economic A monopoly
intuition retailer,
for this on the
result? other
The hand, fully
manufacturer internalises
faces
advertising externality, but at between
a trade-off the cost oftwoanexternalities:
inefficient extra price competition
mark-up. The latter arrangement
at the cost of having no advertising. A monopoly retailer, on the(perfect)
other hand, among
fully internalises the
is better for the manufacturer
retailers solves the double marginalization problem, but at the cost ofdemand (as
when advertising is sufficiently important in increasing
advertising externality, but at the
captured by a highhaving
cost of an inefficient extra price mark-up. The
 ). no advertising. A monopoly retailer, on the other hand, fully
latter arrangement
s better for the manufacturer when advertising is sufficiently important in increasing demand (as
internalises the advertising externality, but at the cost of an inefficient
captured by a high  ). extra price mark-up. The latter arrangement is better for the
manufacturer when advertising is sufficiently important in increasing
ENDby
demand (as captured OF PAPER
a high β).
END OF PAPER
23

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Examiners’ commentaries 2015

Examiners’ commentaries 2015

This commentary reflects the examination and assessment arrangements

Information about the Subject guide and the Essential reading

Format of the examination

What are the examiners looking for?

of mathematics. When you answer problem-type questions in an

Reading and preparation for the examination

Planning your time in the examination

Examination revision strategy

Many candidates are disappointed to find that their examination

Examiners’ commentaries 2015

This commentary reflects the examination and assessment arrangements

Information about the Subject guide and the Essential reading

Comments on specific questions

so even if contracts exist, they are unlikely to be complete. Indeed, for

the result of the downward sloping reaction functions. Alternatively,

and an ‘incentive-compatibility constraint’

c. Welfare is defined as profit plus consumer surplus. Welfare is

V(Z) = p(Z)Π – Z. Differentiation with respect to Z leads to the first

Examiners’ commentaries 2015

This commentary reflects the examination and assessment arrangements

Information about the Subject guide and the Essential reading

Comments on specific questions

and an ‘incentive-compatibility constraint’

0.3Π2 + 0.7Π1 − 4 ⇔ Π2 − Π1 > 11.28, which may or may not hold.

regulator chooses the tariff to maximise consumer surplus, subject to the

Reading for this question

list does (b) not The

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