~~EC3099_ZA_2016_d0

This paper is not to be removed from the Examination Hall

UNIVERSITY OF LONDON EC3099 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance

and the Social Sciences, the Diplomas in Economics and Social Sciences

Industrial Economics

Wednesday, 02 May 2018: 10:00 to 13:00

Candidates should answer FOUR of the following EIGHT questions: TWO from
Section A, and TWO from Section B. All questions carry equal marks.

If more questions are answered than requested, only the first answers attempted will
be counted.

PLEASE TURN OVER

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SECTION A

Answer TWO questions from this section.

1. Answer BOTH PARTS of this question.

(a) Consider two markets, A and B. There are seven firms in market A with the
following market shares: (15 marks)

Market A Market shares

firm A1 7%
firm A2 18%
firm A3 15%
firm A4 24%
firm A5 20%
firm A6 14%
firm A7 2%

There are five firms in market B with the following market shares:

Market B Market shares

firm B1 5%
firm B2 10%
firm B3 35%
firm B4 45%
firm B5 5%

(i) Which of the two markets is more concentrated? Explain your answer.

(ii) What can you say about the firms’ average market power in each of the
two markets? Is this higher in market A or in market B? Explain.

(b) There are many markets in which firms compete in prices but still manage to
set prices above their marginal costs of production and obtain high profits.
This contrasts with the prediction of the basic oligopoly model of Bertrand
price competition that when firms have constant and identical marginal cost of
production, they will set their prices equal to marginal cost and obtain zero
profits. Specify three implicit assumptions of this model that are essential to
the result that firms will obtain zero profits in equilibrium. Explain, for each
assumption, how relaxing it may lead firms to charge prices above marginal
cost and obtain positive profits in equilibrium. (10 marks)

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2. Discuss the view that incumbent firms in an industry can use a strategy of product
proliferation to deter entry. Present the basic argument using a model of horizontal
product differentiation, examine critically the key assumptions necessary for this
strategy to work, and briefly discuss any relevant empirical evidence.
(25 marks)

3. Describe the difficulties faced by competition authorities in the design and

implementation of merger policy. Include in your answer a discussion of the
possible economic causes and consequences of mergers. (25 marks)

4. Analyse how investment specificity affects the ex-ante incentives for investment
when there is ex-post bargaining over the surplus. Then explain how investment
specificity and the incompleteness of contracts may affect the decision of a firm to
vertically integrate and discuss briefly any relevant empirical evidence.
(25 marks)

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SECTION B

Answer TWO questions from this section.

5. A monopolist can supply its product in two distinct markets. Demands in the two
markets are given, respectively, by Q1 = 200 – P1 and Q2 = 100 – P2, where Q1
and Q2 are quantities sold in markets 1 and 2, respectively, and P1 and P2 are
prices charged in markets 1 and 2, respectively. The marginal cost of production is
zero and there are no fixed costs.

(a) Suppose that the monopolist is constrained to charge a uniform price across
the two markets. Calculate the profit maximising price, total quantity supplied,
the monopolist’s total profits and consumer surplus.
(8 marks)

(b) Now suppose that the firm can price discriminate between the two markets.
For each market, calculate the profit-maximising price, output, profit and
consumer surplus. What is total output and how does it compare with your
answer in part (i)? (10 marks)

(c) A regulator for this market has objective function W = Π + CS, where Π is the
monopolist’s profit and CS is consumer surplus. How would the regulator
regard price discrimination? Explain your answer in light of your results in
parts (i) and (ii). (7 marks)

6. Consider a market with two firms, A and B, producing a differentiated product. The
demand for the products of firms A and B are, respectively, QA = ½ + (pB – pA)/2t
and QA = ½ + (pA – pB)/2t, where pA is the price of firm A, pB is the price of firm B
and t > 0 is a parameter. Each firm has a constant marginal cost of production
which is equal to c > 0. The firms choose prices only once and do so
simultaneously.

(a) Compute the Nash equilibrium prices and profits. How do the equilibrium
prices and profits change with t? Explain the intuition for this result.
(10 marks)

Suppose now that the manufacturers sell their products to retailers who then resell
those products to the final consumers. The precise sequence of events is as follows.
In the first stage, the manufacturers simultaneously choose the wholesale prices wA
and wB that they charge to their retailers. In the second stage, the retailers observe
the wholesale prices and simultaneously choose the retail prices pA and pB that they
charge to consumers. No retailer sells the products of both manufacturers. The only
cost to a retailer is the wholesale price that it pays to the manufacturer.

(b) Derive the subgame perfect equilibrium retail prices, wholesale prices,
retailers' profits and manufacturers' profits if both manufacturer A and
manufacturer B use many retailers to distribute their products to final
consumers. Compare the market outcome with that obtained in part (a).
(5 marks)
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 (c) Alternatively, assume that before the choice of wholesale prices manufacturer
A can write a contract with one retailer granting this retailer exclusivity in the
distribution of A’s product and also manufacturer B can write a contract with a
different retailer granting that retailer exclusivity in the distribution of B’s
product. Compute the subgame perfect equilibrium retail prices, wholesale
prices, retailers' profits and manufacturers' profits. Will the manufacturers
prefer to distribute through a single retailer each? Explain the intuition for your
results. (10 marks)

7. Consider a market with two firms, A and B, producing a differentiated product. The
demand for the products of firms A and B are, respectively, QA = 60 – 2pA + pB and
QB = 60 – 2pB + pA, where pA is the price of firm A and pB is the price of firm B.
Each firm has a constant marginal cost of production which is equal to 30. The
firms choose prices only once and do so simultaneously.

(a) Write down the reaction functions of the two firms and illustrate them on a
graph. Why is it the case that the optimal price of a given firm increases with
the price of the other firm? (5 marks)

(b) Compute the Nash equilibrium prices and profits. (5 marks)

Suppose now that before choosing prices firm A has the opportunity to invest in a
new technology that reduces its marginal cost of production to 15. This investment
costs 300 to firm A.

(c) Compute the Nash equilibrium prices and profits if firm A invests in the new
technology. Should firm A invest in this technology? Explain. (5 marks)

Finally, suppose that before choosing prices both firms have the opportunity to invest
in a new technology that costs 300 and reduces their marginal cost of production to
15.

(d) Derive the Nash equilibrium prices and profits if both firms invest in the
technology. Are the firms better off or worse off than in the case in which none
invests in the new technology? Explain the intuition for your results.
(5 marks)

(e) Is an implicit agreement between the two firms not to invest in the new
technology sustainable? Explain why or why not. (5 marks)

8. Suppose there are three types of cars, lemons, melons, and peaches. There is a
large number of potential buyers and sellers. Potential buyers value lemons at
£1,400, melons at £2,800, and peaches at £4,200. Potential sellers have no use
for lemons (they value them at £0). They value melons at £2,000 and peaches at
£4,000. Everybody knows that 1/3 of the cars are lemons, 1/3 of the cars are
melons, and 1/3 of cars are peaches. Buyers and sellers are risk neutral. The price
p of used cars is given exogenously.

(a) Explain why, from an efficiency perspective, all cars should be traded.
(6 marks)
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(b) Suppose that neither buyers nor sellers observe the quality of a car. Show that
for any price p in the interval [2000, 2800] all cars will be traded. (6 marks)

(c) Now suppose that sellers are partially informed: they can distinguish a really
bad car, a lemon, from melons and peaches, but they cannot distinguish a
melon from a peach. Buyers still do not observe the quality of a car. Show that
there are no prices at which melons or peaches will be traded. (5 marks)

(d) Finally, suppose that sellers are fully informed: they know the true type of a
car. Buyers still do not observe the quality of a car. Are there prices at which
both lemons and melons are traded? Are there prices at which peaches are
traded? If so, determine the price ranges. (5 marks)

(e) Given your answers in parts (b), (c), and (d), how does the volume of trade
change as the degree of informational asymmetry changes? Is the relationship
monotonic? Explain. (3 marks)

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