INDUSTRIAL ORGANISATION (ECON 305 W1)

MAIN EXAMINATION MAY 2019

SCHOOL OF ACCOUNTING, ECONOMICS AND FINANCE

MAIN EXAMINATION: MAY 2019
INDUSTRIAL ORGANISATION 305 (ECON305 W1)
________________________________________________________
INTERNAL EXAMINER: MS. N. DAMOYI
INTERNAL MODERATOR: DR. P. NYATANGA
EXTERNAL EXAMINER: DR. P. BAUR (UNIVERSITY OF JOHANNESBURG)

TOTAL: 300 MARKS DURATION: 3 HOURS

___________________________________________________________________________
INSTRUCTIONS TO CANDIDATES:

This question paper consists of sixteen (16) pages including the cover page.

1. SECTION A: WRITTEN QUESTIONS MARKS: 200

• Answer any FOUR questions out of six questions from this section.
• Suggested time allocation for this section is 30 minutes per question.

2. SECTION B: MULTIPLE-CHOICE QUESTIONS MARKS: 100

• Candidates are required to attempt all 25 MCQ questions.
• Record all your answers on the separate MCQ answer sheet (pink form) provided.
• Only HB pencil may be used on the MCQ answer sheet.
• Make sure all your details (student number, seat number) are correctly recorded on the
MCQ answer sheet.
• +4 marks are awarded for each correct answer. Unanswered questions score zero.
• Suggested time allocation for this section is 1 hour.

3. WRITE NEATLY AND LEGIBLY. WRITE WRITTEN QUESTIONS IN PEN

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

SECTION A: WRITTEN QUESTIONS [100 MARKS]

Answer any FOUR of the following SIX questions.
Suggested time allocation for section A: 30 minutes per question
Note: Credit will only be given to students who show ALL their workings.
QUESTION ONE [50 MARKS]
Government grants Firm A an exclusive license to operate as a monopolist. Firm A faces an
inverse demand curve of 𝑃𝑃 = 400 − 4𝑄𝑄, and incurs marginal cost of production of 32.
a) Derive Firm A’s marginal revenue and calculate the amount of output it will produce, as
well as the price it will charge for its output. [10 marks]

b) If the elasticity of demand for the monopolist’s product is 0,45,

i. what is the Lerner index? [3 marks]

ii. What does this (Lerner index) imply about market power? [2 marks]
iii. Briefly explain the relationship between the elasticity of demand and the Lerner
index. [3 marks]

c) List three reasons why the elasticity of demand is likely to be large in the long-run.
[6 marks]
Assume a second firm is able to enter the market due to the expiration of Firm A’s
exclusive license. The two firms compete as Bertrand firms and produce differentiated
products. The demand functions for products of these two firms are:

Firm A: 𝑞𝑞𝐴𝐴 = 12 − 2𝑝𝑝𝐴𝐴 + 𝑝𝑝𝐵𝐵

Firm B: 𝑞𝑞𝐵𝐵 = 18 − 6𝑝𝑝𝐵𝐵 + 2𝑝𝑝𝐴𝐴

Firm A’s marginal cost is 2, and Firm B’s marginal cost is 3.

d) List the assumptions behind the Bertrand model with homogeneous products, and explain
the Bertrand paradox. [10 marks]

e) Calculate Firm A’s and Firm B’s best response functions, and their equilibrium prices 𝑝𝑝𝐴𝐴∗
and 𝑝𝑝𝐵𝐵∗ (round off prices to two decimal places) [16 marks]

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

QUESTION TWO [50 MARKS]

Note: Credit will only be given to students who show ALL their workings.
1
Consider a Cournot duopoly in which the inverse demand curve is 𝑃𝑃 = 80 − 2 𝑄𝑄 where
𝑄𝑄 = 𝑞𝑞1 + 𝑞𝑞2 . Each firm has a constant marginal cost of production, mc = 20, and there are
no fixed costs.

a) Derive each firms best response functions and calculate the quantity that each firm will
produce in equilibrium. [20 marks]

b) Illustrate the best-response (reaction) curves of each firm on a diagram. Label your
diagram fully and clearly indicate the Cournot equilibrium. Be sure to show the values
where the curves intercept the axes. [10 marks]

c) If the firms agree to collude and form a symmetric cartel, calculate each firms collusion
output. Illustrate the collusion outputs in your diagram in question (b) and label the
collusion equilibrium as J. [10 marks]

d) Calculate the output that either firm would produce if it deviated from the collusive
outcome whilst the other firm kept producing the collusive output. Add these deviation
outputs on your diagram in question (b) and label them as D. [10 marks]

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

QUESTION THREE [50 MARKS]

Note: Credit will only be given to students who show ALL their workings.
In this question firm 1 is a Stackelberg leader and firm 2 is a Stackelberg follower.
There is a fixed cost of production for firm 2 which means that it is not profitable for
firm 2 to operate at a very low scale. Therefore firm 1 can deter entry by firm 2 if it
produces a sufficiently large output: this is called the limit output and it depends on
firm 2’s fixed cost of production.

Suppose industry demand is 𝑃𝑃 = 60 − (𝑞𝑞1 +𝑞𝑞2 )

The total cost functions for Firm 1 and Firm 2 are:

𝐶𝐶1 (𝑞𝑞1 ) = 12𝑞𝑞1 + 𝐹𝐹 and 𝐶𝐶2 (𝑞𝑞2 ) = 12𝑞𝑞2 + 𝐹𝐹

where F is the fixed cost of production.

a) Derive Firm 2’s best-response function and calculate both firms’ Stackelberg equilibrium
output. [15 marks]

b) The limit output function for Firm 1 is 𝑞𝑞1𝐿𝐿 = 48 − 2√𝐹𝐹. If F =16, should Firm 1
accommodate or deter entry by Firm 2? [15 marks]

Suppose some industry barriers to entry are eliminated allowing 11 more firms to enter the
industry. Total firms in this industry is now 13. However, Firm 1 becomes the dominant firm,
making the rest of the 12 firms a competitive fringe. Industry demand is now 𝑄𝑄 = 600 − 6𝑃𝑃.
The total cost function for each of the identical fringe firms is given by 𝑇𝑇𝑇𝑇 = 2𝑞𝑞 2 + 10𝑞𝑞,
whilst the marginal cost and average cost of the dominant firm is constant and equal to
MC=4.
Use the above information to answer questions (c) to (e).
c) Show that the total supply function of the competitive fringe is 𝑄𝑄 𝑓𝑓 (𝑝𝑝) = 3𝑃𝑃 − 30.
[6 marks]
d) Calculate the residual demand function of the dominant firm. [4 marks]

e) Calculate the equilibrium output and price of the dominant firm. [10 marks]

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

QUESTION FOUR [50 MARKS]

Note: Credit will only be given to students who show ALL their workings.
A monopolist firm is considering investing in research and development, in an attempt to
innovate its production process. You are hired as their economist to analyse its situation
before and after the said innovation.

The firm’s demand function is 𝑃𝑃 = 1000 − 4𝑄𝑄.

a) If pre-innovation cost is 𝐶𝐶 ℎ = 800, calculate the firm’s pre-innovation output 𝑄𝑄𝑀𝑀

0 , price
P0 , and profit 𝜋𝜋0 .
M 𝑀𝑀
[12 marks]

b) Illustrate you answers in question (a) on a clearly, labelled diagram (axes, intercepts,
labelled curves). [10 marks]

c) You advise the firm to invest in non-drastic innovation, should it wish to retain its
monopoly position. The firm’s CEO is not clear on what it is. Briefly explain what is
meant by “non-drastic” innovation. [5 marks]

Your advice in (c) is taken. The firm invests in non-drastic innovation. Cost of production is
reduced to 𝐶𝐶 𝑙𝑙 = 520 .
Use this information to answer questions (d) to (f).
d) If the firm decides to innovate as per your advice, calculate its post-innovation output 𝑄𝑄𝑀𝑀
1,
price 𝑃𝑃1 , and profit 𝜋𝜋1 .
𝑀𝑀 𝑀𝑀
[10 marks]

e) Is this really a non-drastic innovation? Explain. [3 marks]

f) Suppose the firm was in a competitive market prior to innovation (i.e. not a monopolist
initially), calculate the quantity and profit it would make post-innovation. Comparing
innovation if the firm was initially in a competitive market versus if it was initially a
monopolist, is there a replacement effect in this case? Explain. [15 marks]

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

QUESTION FIVE [50 MARKS]

Note: Credit will only be given to students who show ALL their workings.
A nightclub owner realises that demand for drinks is lower among females than among men.
Management estimates that the demand functions for the two groups are:
Females: 𝑞𝑞1 = 40 − 5𝑝𝑝
Males: 𝑞𝑞2 = 60 − 2𝑝𝑝
Assume that it costs the nightclub R2 to provide one drink i.e. 𝑀𝑀𝑀𝑀=2. Each drink is priced at
R2.
a) On two separate, clearly labelled diagrams (label axis, curves and intercepts), draw the
demand curves for Females and Males, and show the horizontal line at the price.
Calculate the quantity of drinks each type of consumer demands at a price of R2 per
drink. Show these quantities on your diagrams. [10 marks]

b) The owner wants to ensure that both consumers come to his nightclub. Calculate the fixed
fee, T, which the owner will charge. [5 marks]

c) Calculate the total profit the nightclub earns from supplying both types of consumers.
[5 marks]
d) With the aid of a new clearly labelled diagram (label axis, curves and intercepts),
illustrate the change in profits when the nightclub raises the price above marginal cost
to R4 per drink and reduces the fixed fee, T, correspondingly.
i. Calculate the change in quantity and show these on your diagram.
ii. Calculate the new fixed fee.
iii. Calculate the change in profit from both consumers.
iv. Calculate the gain and loss in profits and explain why the gain in profits from
Males (high demand consumer) is greater than the loss in profits from Females
(low demand consumer). [30 marks]

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

QUESTION SIX [50 MARKS]

Note: Credit will only be given to students who show ALL their workings.
Suppose a monopoly wholesaler sells an input good to a monopoly retailer. The retailer faces
1
the following demand for the final product 𝑃𝑃 = 70 − 2 𝑄𝑄.

The retailer’s marginal costs has two components: the cost of buying inputs from the
wholesaler, and other costs equal to MC = 50.
The wholesaler has a constant marginal cost equal to 10 and no other costs.
The wholesaler sets a unit price W for the input and the retailer sets a unit price P for the final
good.
a) Assuming that the Wholesaler and Retailer operate as independent monopolists (vertical
separation) in their respective industries, calculate the prices and quantities in the market,
and profits of each firm. [23 marks]

b) Should the two firms vertically integrate, calculate the new prices and quantities in the
market, and new profits. [7 marks]

c) Compare the answers in (b) with the answers in (a). What do you conclude about vertical
integration and vertical separation? Explain your conclusion by referring to and
explaining the double marginalisation phenomenon. Does vertical integration solve
double marginalisation? [20 marks]

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

SECTION B: [100 MARKS]

MULTIPLE-CHOICE QUESTIONS
Suggested time allocation for this section is 1 hour.

1) Which of the following statements is incorrect regarding perfect competition?

A) Perfectly competitive firms have small economies of scale relative to the size of the
market.
B) Each firm makes an economic profit, which is the reason why there are many firms in
the industry.
C) Firms produce homogeneous products.
D) Barriers to entry or exit do not exist.
E) All firms take price as given and charge the same price for their products.

2) Which of the following statements is/are correct?

A) Consumer surplus is not an exact monetary measure of consumer welfare.

B) Demand and supply curves are able to capture social costs and benefits in addition to
private costs and benefits.
C) Distribution of the gains from trade is explicitly taken into account when changes in
total surplus are used to rank outcomes.
D) Both (A) and (C) are correct.
E) Both (B) and (C) are correct.

3) Which of the following statements is true regarding the deadweight loss?

A) The deadweight loss directly depends on the change in consumer surplus when a firm
switches from being a Stackelberg leader to being a monopolist .
B) The deadweight loss is responsible for increasing the price charged by the monopolist.
C) The deadweight loss is responsible for increasing producer surplus and reducing
consumer surplus.
D) The deadweight loss occurs when society switches from one consumer good to
another.
E) The deadweight loss depends on the quantity distortion between socially optimal
output and monopoly output.

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

4) Using the graph below, which statement is correct regarding the price 𝑃𝑃𝑚𝑚𝑚𝑚𝑚𝑚 ?

A) When price is equal to 𝑃𝑃𝑚𝑚𝑚𝑚𝑚𝑚 , a profit-maximising firm is able to avoid variable costs
but cannot avoid quasi-fixed costs.
B) When price is equal to 𝑃𝑃𝑚𝑚𝑚𝑚𝑚𝑚 , a profit-maximising firm will choose to shut down
permanently.
C) When price is less than 𝑃𝑃𝑚𝑚𝑚𝑚𝑚𝑚 , a profit-maximising firm will choose to temporarily shut
down to avoid quasi-fixed costs and fixed costs.
D) When price is less than 𝑃𝑃𝑚𝑚𝑚𝑚𝑚𝑚 , a profit-maximising firm will choose to temporarily shut
down to avoid quasi-fixed costs and variable costs.
E) When price is less than 𝑃𝑃𝑚𝑚𝑚𝑚𝑚𝑚 , a profit-maximising firm will choose to permanently
shut down to avoid variable costs and fixed costs.

𝑑𝑑 𝑃𝑃(𝑄𝑄)
5) What does a monopolist’s marginal revenue function 𝑀𝑀𝑀𝑀(𝑄𝑄) = 𝑃𝑃(𝑄𝑄) + 𝑑𝑑 𝑄𝑄
𝑄𝑄 imply?

A) The direct effect of a change in quantity on marginal revenue requires a change in

price.
B) The indirect effect of a change in quantity on marginal revenue requires a change in
sales volume.
C) Due to the indirect effects in marginal revenue, when the monopolist increases
quantity, its revenues will decrease, because the price the firm receives for the infra-
marginal units declines.
D) Due to the indirect effects in marginal revenue, when the monopolist decreases
quantity, its revenues will decrease, because the price the firm receives for the infra-
marginal units declines
E) Due to the direct effects in marginal revenue, when the monopolist increases
quantity, its revenues will decrease, because the price the firm receives for the infra-
marginal units declines

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

6) Market power of the dominant firm is determined by:

A) bribing government officials for an exclusive license.

B) paying “hush” money to the competitive fringe.
C) its elasticity of supply.
D) the elasticity supply of the competitive fringe.
E) Both (C) and (D) are correct.

7) Which of the following is a structural characteristic thought to be an entry barrier?

A) Sunk expenditures of the incumbent firm.

B) Comparative cost advantages.
C) Government exclusive license rights.
D) Sunk expenditures by consumers and product differentiation.
E) Large elasticity of demand.

8) Which of the following statements is true?

A) A dominant firm profit maximizes according to the residual demand curve, which is a
portion of market demand not supplied by fringe firms.
B) A dominant firm has 100 percent of market share in the industry, and serves the
majority of the market.
C) A dominant firm has market share, but less than 100 percent in the industry, and
serves 50 percent of the market.
D) A dominant firm does not take into account the reaction of its fringe competitors
when deciding how much quantity to produce.
E) Marginal revenue of the dominant firm is derived from the supply function of its
fringe competitors.

9) If the size of the competitive fringe were to expand then:

A) the elasticity of demand of the competitive fringe will be large, and the incumbent
firm’s market power will increase.
B) the elasticity of demand of the incumbent firm will be large, and its market power will
decrease.
C) the elasticity of demand of the competitive fringe will be small, and the incumbent
firm’s market power will increase.
D) the elasticity of demand of the incumbent firm will be small, and its market power
will increase.
E) The expansion of the size of the competitive fringe has no effect on the incumbent
firm.

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
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10) Using the graph below, if the dominant firm’s marginal cost is 𝑀𝑀𝑀𝑀1𝐷𝐷 then:

A) the fringe firms will produce half of the dominant firm’s output.
B) the dominant firm will produce 𝑄𝑄 𝐷𝐷 (𝑝𝑝0 ).
C) the dominant firm is considerably more efficient than the fringe firms; the fringe
cannot profitably produce and the dominant firm can ignore it.
D) Both (B) and (C) are correct.
E) None of the above.

Use the following information to answer questions 11 and 12.

A monopolist with a constant marginal cost of 8 is facing the demand function P=50-3Q.
11) The monopolist produces ___ units of output and the profit maximising price is ___.

A) 7; 29
B) 7; 50
C) 50; 0
D) 14; 8
E) 3; 41

12) What is the Lerner Index at the profit maximising price?

A) 1,00
B) 0,00
C) 0,84
D) 7,13
E) 0,72

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

13) Which of the following statements is false regarding the competitive fringe?
I. The existence of the competitive fringe dampen, and in the long-run eliminates the
dominant firm’s control over price.
II. The competitive fringe takes the price set by the dominant firm as given.
III. The competitive fringe’s total supply correspond to their horizontally summed
marginal cost curves.

A) I and III only.

B) I only.
C) III only.
D) I, II, and III.
E) II only.

Use the following information to answer questions 14, and 15.

An industry faces demand 𝑄𝑄=400−4𝑃𝑃. There are 25 firms in the industry, 24 of which are
part of a competitive fringe. The total cost function for each of the identical fringe firms is
given by 𝑇𝑇𝑇𝑇=6𝑞𝑞2+40𝑞𝑞, whilst the marginal cost and average cost of the dominant firm is
constant and equal to R8.
14) The total supply function of the competitive fringe is:

A) 𝑄𝑄 𝑓𝑓 = 2𝑃𝑃 − 40
B) 𝑄𝑄 𝑓𝑓 = 2𝑃𝑃 − 80
C) 𝑄𝑄 𝑓𝑓 = 2𝑃𝑃 + 40
D) 𝑄𝑄 𝑓𝑓 = 2𝑃𝑃 + 80
E) 𝑄𝑄 𝑓𝑓 = 24𝑃𝑃 − 40

15) The residual demand function of the dominant firm is:

A) 𝑄𝑄 𝐷𝐷 = 320 − 6𝑃𝑃
B) 𝑄𝑄 𝐷𝐷 = 480 − 6𝑃𝑃
C) 𝑄𝑄 𝐷𝐷 = 320 + 6𝑃𝑃
D) 𝑄𝑄 𝐷𝐷 = 480 + 6𝑃𝑃
E) 𝑄𝑄 𝐷𝐷 = 400 − 4𝑃𝑃

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 INDUSTRIAL ORGANISATION (ECON 305 W1)
MAIN EXAMINATION MAY 2019

16) Consider the equation below which depicts equilibrium in a Cournot duopoly:

Given this equation, which of the following statements is incorrect?

A) Firms with lower marginal costs will have greater market shares.
B) The more elastic is market demand, the higher is the mark-up of price over marginal
cost.
C) The greater the number of competitors, the smaller each firm’s market share and the
less its market power.
D) Cournot duopolists will always have market power.
E) Monopoly mark-ups are more than Cournot mark-ups.

Use the following information to answer questions 17 and 18.

Firm A and Firm B are the only two producers in an industry with differentiated goods. The
marginal cost for both firms is c = 0.
The demand function for the good that Firm A produces is: 𝑞𝑞𝐴𝐴 = 40 − 2𝑝𝑝𝐴𝐴 + 𝑝𝑝𝐵𝐵
The demand function for the good that Firm B produces is: 𝑞𝑞𝐵𝐵 = 40 − 2𝑝𝑝𝐵𝐵 + 𝑝𝑝𝐴𝐴
17) Firm A’s best response function is given by:

1
A) 𝑝𝑝𝐴𝐴 = 10 − 4 𝑝𝑝𝐵𝐵
1
B) 𝑞𝑞𝐴𝐴 = 10 − 4 𝑞𝑞𝐵𝐵
1
C) 𝑝𝑝𝐴𝐴 = 10 + 4 𝑝𝑝𝐵𝐵
1
D) 𝑝𝑝𝐴𝐴 = 20 + 2 𝑝𝑝𝐵𝐵
1
E) 𝑞𝑞𝐴𝐴 = 20 + 2 𝑞𝑞𝐵𝐵

18) If both firms increase the degree of product differentiation, at the new Nash equilibrium:

A) both firms will produce more output.

B) consumers will be more responsive to price changes by each firm.
C) the firms’ profits will be in line with the Bertrand paradox.
D) both firms will charge lower prices.
E) both firms will earn greater economic profits.

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Use the following information and diagram to answer questions 19 and 20.

Consider the extensive form game below. Firm E is a potential entrant that is deciding
whether to enter a market or not, firm I is an existing incumbent in the market. The profits of
firm E are shown first in brackets with the profits of firm I shown second.

19) In the above game, if the incumbent acts passively, then the entrant would make a
profit/loss of ____.

A) –2
B) 3
C) 2
D) 0
E) 4

20) The final outcome in this game is that the incumbent acts________ , and entrant
_______the market.

A) Aggressively; stays out

B) Passively; enters
C) Passively; fighting
D) passively; stays out
E) Aggressively; enters

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21) Which of the following statements is true?

A) Drastic innovation results in zero economic profits due to the new monopoly price
being equal to price charged by a competitive firm.
B) Drastic innovation always results in an economic loss due to the new monopoly price
being lower than average costs.
C) Drastic innovation is one where the monopoly price corresponding to the new, higher
costs, is below the original level of marginal costs.
D) Both (A) and (C) are correct.
E) None of the above statements is correct.

22) Which of the following statements about the structure-conduct-performance (SCP)

approach and the new empirical industrial organization (NEIO) approaches is correct?

A) The NEIO approach considers a cross-section of industries, and the SCP approach
estimates marginal costs.
B) The SCP approach considers a cross-section of industries, and the NEIO approach
estimates marginal costs.
C) The SCP approach considers a cross-section of industries, and estimates marginal
costs.
D) The NEIO approach considers a cross-section of industries, and estimates marginal
costs.
E) The SCP approach considers individual industries, and estimates marginal costs.

23) Empirical research sometimes uses the following measure of firm performance

What is the name of this measure?

A) The price-cost margin (where cost equals average cost).

B) The profit-revenue ratio.
C) The price-cost margin (where cost equals marginal cost).
D) Tobin’s q.
E) The rate of return on capital.

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24) Where there is a problem of successive monopolies and double marginalization, the firms
can use various strategies to address the resulting problem of excessively high prices and
reduced profits. Which of the following does NOT work?

A) The upstream firm merging with the downstream firm.

B) The upstream firm choosing the downstream firm by use of a franchise.
C) The upstream firm setting a minimum sales target that the downstream firm must
achieve.
D) The upstream firm setting a maximum retail price that the downstream firm must
charge.
E) The upstream firm terminating the contract of the downstream firm.

25) Consider a natural monopoly that sells two products. Own-price elasticities of each
product are as follows (absolute values): 𝜀𝜀11 = 5 for product one and 𝜀𝜀22 = 2 for product
two. If the marginal cost for both products is MC=1, and product two is sold for a price of
𝑃𝑃2= 6, using the Ramsey pricing rule, what is the price set for product one?

A) 𝑃𝑃1 = 2,50
B) 𝑃𝑃1 = 1,50
C) 𝑃𝑃1 = 6
D) 𝑃𝑃1 = 1,67
E) Not enough information to calculate answer.

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