THE UNIVERSITY OF ZAMBIA

SCHOOL OF HUMANITIES AND SOCIAL SCIENCES

DEPARTMENT OF ECONOMICS
TEST 2 27th May, 2018

ECN 9125: INDUSTRIAL ORGANISATION

TIME: 1 hour 20 Minutes
INSTRUCTIONS:
ANSWER QUESTION ONE AND ANY OTHER TWO QUESTIONS IN SECTION B.
______________________________________________________________________________
SECTION A (Compulsory)

QUESTION ONE [20 Marks]

Consider the following kinked demand curve for an oligopolistic firm and answer the questions
which follow:
𝟐𝟎 − 𝟎. 𝟒𝑸 𝒇𝒐𝒓 𝑸 < 𝒌
𝑷={
𝟐𝟔 − 𝑸 𝒇𝒐𝒓 𝑸 > 𝒌
(a) Calculate the value of 𝒌 and draw the kinked demand curve. [4 Marks]
𝒌 is the output level where the kink occurs. This is where the two demand curves are
equal.
20 − 0.4𝑄 = 26 − 𝑄
𝑄 − 0.4𝑄 = 26 − 20
26 − 20
𝑄=𝑘= = 10
0.6
26
Price 6

20

P=16

k =10 26 Output 50
 The kink happens at P =16 and Q = 10 as shown in the diagram above.
(b) Calculate the MR function corresponding to this demand curve. [3 Marks]
Before Q = 10

𝑇𝑅 = (20 − 0.4𝑄)𝑄 = 20𝑄 − 0.4𝑄 2

𝑀𝑅 = 20 − 0.8𝑄
After Q = 10
𝑇𝑅 = (26 − 𝑄)𝑄 = 26𝑄 − 𝑄 2
𝑀𝑅 = 26 − 2𝑄
Hence the Marginal Revenue function is:

20 − 0.8𝑄 𝑓𝑜𝑟 𝑄 < 10

𝑀𝑅 = {
26 − 2𝑄 𝑓𝑜𝑟 𝑄 > 10

(c) Draw the MR curve on the same graph as the kinked demand curve. [2 Marks]

Price

20

P=16

12

k =10 26 50

Output

The marginal revenue as a break at Q = 10, from the MR = 12 to MR = 6.

(d) If the marginal costs is constant at K15, find the optimal output and price. [3 Marks]
If Marginal costs is constant at 15, optimization will occur before the break in Marginal
revenue. Hence we have:

𝑀𝑅 = 20 − 0.8𝑄 = 15
 20 − 15
𝑄∗ = = 6.25
0.8

𝑃∗ = 20 − 0.4(6.25) = 17.5
(e) Find the optimal price and output given that the marginal cost is K5. [3 Marks]
If Marginal costs is constant at 5, optimization will occur after the break in Marginal
revenue. Hence we have:

𝑀𝑅 = 26 − 2𝑄 = 5

26 − 5
𝑄∗ = = 10.5
2

𝑃 ∗ = 26 − (10.5) = 15.5

(f) Explain why the firm may opt to maintain the price if the marginal costs increases from
K8 to K10. [5 Marks]
If the marginal cost increases from K8 to K10, Output will remain constant at Q = 10,
price will remain P = 16.

This is because when optimization occurs on the MR section with a break, the firm will
not be able to pass on the cost to consumers via higher prices.

This is due to strategic behavior of rival firms who will not follow suit in increasing the
price. This firm will opt to maintain the price in order to maintain its market share.

SECTION B

QUESTION TWO [10 Marks]

Consider two firms operating in a vertically differentiated market. The best response functions
for each firm are given as:

𝑷𝟐 − 𝟐𝑷𝟏 + 𝟐𝟎 = 𝟓𝒀𝑳 for firm 1

𝟐𝑷𝟐 − 𝑷𝟏 − 𝟐𝟎 = 𝟓𝒀𝑯 for firm 2

Where 𝑃1 and 𝑃2 are the prices of the two firms and 𝑌𝐻 and 𝑌𝐿 are highest and lowest incomes of
the consumers of the two products respectively.

(a) Find the Nash equilibrium prices for each firm [3 Marks]

5 (𝑌𝐻 − 2𝑌𝐿 )
𝑃∗1 = 20 +
3
 5 (𝑌𝐿 − 2𝑌𝐻 )
𝑃∗ 2 = 20 +
3
(Derivations are required)

(b) What is the quality gap between the two products? [1 Marks]
The quality gap is the coefficient of the incomes in the best response function. Therefore, the
quality gap is 5 units.

(c) Assuming that there is a 1 unit difference between the highest and lowest incomes,
Show that the higher quality producer makes greater profits. [4 Marks]

To do this, you need to find the profits:

The profits confirm to the following general function:
1
𝜋1∗ = (𝑌𝐻 − 2𝑌𝐿 )2 (𝑠2 − 𝑠1 ) ( )
9

1
𝜋2∗ = (2𝑌𝐻 − 𝑌𝐿 )2 (𝑠2 − 𝑠1 ) ( )
9
Therefore, in this case the profits functions are:

5
𝜋1∗ = (𝑌𝐻 − 2𝑌𝐿 )2 ( )
9

5
𝜋2∗ = (2𝑌𝐻 − 2)2 ( )
9

Since |𝑌𝐻 − 2𝑌𝐿 | is less than |2𝑌𝐻 − 𝑌𝐿 |, 𝜋1∗ is less than 𝜋2∗ , Hence Shown.

(d) State and explain the principle of Maximal differentiation. [2 Marks]

If firms are operating under a vertically differentiated market, equilibrium profits will be
increasing in quality gap and if there is no gap in quality, the firms will earn normal profits (Zero
economic profits.

This simply means that a firm’s profits will depend on its level of product differentiation in terms
of quality and that the market can sustain both firms making normal profits and those making
supernormal profits in the long-run.

QUESTION THREE [10 Marks]

Consider the following market demand facing duopolistic power generating firms:

𝑷(𝑸) = 𝟏𝟎𝟎 − 𝟎. 𝟒𝑸

Given that both firms have a constant marginal cost of K10, find the following:
(a) The Market equilibrium price under sequential output setting. Assume firm 1 is the leader.
[3 Marks]
100 + 3(10)
𝑃∗ = = 32.5
4
(Working required)
(b) The Market equilibrium price under simultaneous output setting. [3 Marks]

100 + 2(10)
𝑃∗ = = 40
3

(Working required)
(c) The Market equilibrium price under output collusion [3 Marks]

100 + 10
𝑃∗ = = 55
2
(Working required)

(d) With respect to consumer surplus, would you recommend output collusion over sequential
output setting or simultaneous output setting?
[1 Marks]
No, consumer surplus is lower under output collusion due to higher prices and lower output as
compared to sequential output setting and simultaneous output setting.

QUESTION FOUR
A Competition expert at the University of Zambia has used STATA to estimate the following
market performance regression model following the SCP approach:

̂ 𝒊 = 𝟔. 𝟐𝟑 − 𝟎. 𝟑𝟔𝑪𝑶𝑵𝒊 + 𝟏. 𝟗𝟔𝑩𝑬𝟏𝒊 − 𝟐. 𝟖𝟔𝟓 𝑩𝑬𝟐𝒊

𝝅

Where 𝝅̂ 𝒊 is an estimate of the measure of market performance, 𝑪𝑶𝑵𝒊 is a measure of market

concentration, 𝑩𝑬𝟏𝒊 is the first barrier to entry and 𝑩𝑬𝟐𝒊 is the second barrier to entry.
(a) What is the difference between market power and market performance? [2 Marks]

Market power is the ability of the firm to profitably charge a price greater than the marginal
costs. This therefore refers to the ability of the firm to charge higher prices by controlling output.

Market performance refers to markets equilibrium outcomes in terms of prices, output, and
welfare as compared to a perfectly competitive case. A market is said to have better market
performance if its outcomes are closer to that of perfect competition.

The higher the market power of firms in any market the poorer the market performance.
Therefore measuring market power is inversely measuring market performance.

(b) Do you think the estimated coefficients in the regression model have appropriate signs?
[2 Marks]
Not all of them,
 Negative relationship between market performance and concentration is correct.
Positive relationship between the first barrier to entry and market performance is wrong.
Negative relationship between the second barrier to entry and market performance is correct.

(c) Given that the standard error for the concentration estimate is 0.04, is market
concentration significant in influencing the market performance? (Hint: Use the Rule of
Thumb) [ 3 Marks]
𝑏0
Based on the rule of Thumb, if 𝑡 = 𝑠𝑒 is greater than 2, the coefficient is significant. In
0.36
this case, 𝑡 = 0.04 = 9. This means market concentration significantly influences market
performance.

(d) State and explain the SCP approach profitability measures of market power.
[ 3 marks]
The profitability measures include:
Rates of return, the Lerner Index, and Tobin’s q. (please explain what these are)

All the Best

Chizonde B.