Examination Papers

Examiners’ Reports

ME
E XT

M
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E
AL PROG RA

Examination papers and

Examiners’ reports

Industrial economics
Economics, Management, Finance
and the Social Sciences

2001, 2002, 2003 2790099

 Examination papers and Examiners’ reports 2003

Examiner’s report 2003

Zone B
General comments
Our examinations are designed to cover the whole of the syllabus. Candidates had a
choice of eight questions from which four were to be attempted. Some of these were
problem-type questions, while others were essay-type questions. In general, problem-
type questions were quite specific as to what students are supposed to do, and a good
answer generally involved some use of mathematics. For these questions, brief
outlines of suggested answers are given below. Some of the calculations are omitted
in the answers below to save space; when candidates answer problem-type questions
in an examination, all the necessary steps must be shown. Moreover, they 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. For these questions, the comments
below should be seen as providing guidelines, and are not intended as model answers.
Specific comments on questions
Question 1
This question required students to describe a model of the relationship between the
owners of a firm and its manager, and examine the optimal incentive scheme that
should be given to the manager. Such a model is described, for instance, in Chapter 2
of the Subject Guide. In that model, the gross profit of the firm depends on the
manager’s effort as well as on the firm’s environment, which is uncertain: the higher
the manager’s effort, the higher the probability of high gross profit. On the other hand,
the manager’s utility increases in her wage but decreases in the amount of effort she
exerts. For simplicity, there are two possible levels of effort, high and zero. The
owners’ objective is to maximise the firm’s expected net profit (i.e. gross profit minus
the manager’s wage). What level of effort the owners will prefer depends on whether
the firm’s maximised net profit is higher under high effort or under no effort.
Two cases should be considered. When the owners can observe the manager’s effort
level, the higher the effort that the owners want the manager to exert, the higher the
wage they must offer – irrespective of what the profit of the firm turns out to be.
What if the effort level of the manager cannot be observed by the owners? If the
owners want the manager to exert high effort, they must compensate her with a higher
wage the higher the profit of the firm. More specifically, the owners must design an
incentive scheme for the manager that maximises the firm’s expected net profit
subject to ensuring that the manager accepts the job and chooses to exert high effort,
i.e. subject to a ‘participation constraint’ and an ‘incentive-compatibility constraint’.
Note that if the owners want the manager to exert no effort, they do not need to make
the wage a function of the firm’s profit. A good answer should describe the details of
the model, distinguishing between the various cases, and provide intuition for the key
results.

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99 Industrial economics

Question 2
A good answer should start with a brief description of the ‘Bertrand paradox’. Take
the simple case of two firms producing a homogeneous product at the same constant
marginal cost c. The two firms meet only once and they simultaneously set prices p
1
and p2, respectively. The Nash equilibrium outcome of this game is p1* = p2* = c, so
firms make zero profit.
The answer should then go on to explain how the existence of capacity constraints
can allow firms to set price above marginal cost and make positive profits in the
above context. The basic argument can be easily stated. Assume that both firms have
production capacity smaller than D(c), i.e. no firm can cover the entire demand at a
price equal to the common marginal cost. Then p1 = p2 = c is no longer a Nash
equilibrium. If firm i raises its price slightly above c, given that
pj = c, then all consumers will want to buy from firm j; however, firm j will not be
able to satisfy the whole demand, so some consumers will end up bying from firm i.
Hence firm i will make positive profit instead of zero. Since p = c is not a profit-
i
maximising response to pj = c, p1 = p2 = c is not a Nash equilibrium.
A good answer should then make the above ideas more specific in the context of a
particular model, such as the one described in Section 3 of the Subject Guide.
Question 3
a. This is a symmetric Cournot duopoly. Standard calculations give equilibrium
values q1 = q2 = 20, P = 80, Π = Π = 400.
1 2

b. This is an asymmetric Cournot duopoly: firm 1 has marginal cost 30, while firm 2
has marginal cost 60. We obtain: q1 = 40, q2 = 10, P = 70, Π = 1600, Π = 100.
1 2

c. This is again an asymmetric Cournot duopoly: firm 1 has marginal cost 30, while
firm 2 has marginal cost 30 + r. We obtain: q1 = 30 + r/3, q2 = 30 – 2r/3,
Π1 = (30 + r/3)2 + q r, Π2 = (30 – 2r/3)2. Note that the profit of firm 1 consists
2
now of the profit from its own sales plus the royalties obtained from firm 2. Firm
1 would like to raise r as much as possible, but firm 2’s outside option is not to
accept the license and get a profit equal to 100, as calculated under part (b). To
find the largest value of r that gives firm 2 an incentive to buy the license, we
2
solve (30 – 2r/3) = 100, and obtain r = 30. The profit of firm 2 and the quantities
produced are the same as under part (b). However, the profit of firm 1 is 1900:
firm 1 appropriates the extra surplus generated by the lower physical cost of
firm 2.
d. This is a symmetric Cournot duopoly, where both firms have marginal cost equal to
30 (L is a fixed cost). At equilibrium, q = q = 30, P = 60, Π1 = 900 + L,
1 2

Π2 = 900 – L. L is then set in order to make firm 2 indifferent between accepting

and not accepting. Recall that firm 2 can always not accept the license and get a
profit equal to 100. Hence L = 800. The profit of firm 1 is 1700.
e. Firm 1 would prefer a unit license fee to a fixed licence fee: simply compare its
profit under parts (c) and (d). On the other hand, consumers would prefer a fixed
licence fee to a unit license fee: with a unit fee of 30 total quantity is 50, while under
a fixed license fee total quantity is 60 and consumers also benefit from the lower
physical cost of firm 2.

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 Examination papers and Examiners’ reports 2003

Question 4
One source of considerable net profits in the long run under conditions of free entry is
the presence of vertical differentiation. Chapter 6 of the Subject Guide describes a
model of vertical differentiation in which free entry does not lead to zero net profits at
equilibrium. You should outline this model (or a related one), summarise the results,
and explain the intuition.
A second source of considerable net profits in the long run under conditions of free
entry is the presence of first-mover advantages. A model that illustrates this in the
context of a horizontally differentiated industry is the model of entry deterrence
through product proliferation by incumbent firms described in the Subject Guide.
Again you should present the model, examine critically the key assumptions
necessary for the product proliferation strategy to work, derive the results, and explain
the intuition.
Question 5
a. A good answer should describe a simple model of a vertical relation between a
manufacturer and a retailer. Suppose demand by consumers is given by
q = D(p), with D′(p) = ∂q/∂p < 0. The efficient outcome (from the point of view of
the firms) is the one which maximises the aggregate profit (i.e. manufacturer’s
plus retailer’s): (p – c)D(p). The first-order condition is
(w – c)D′(p) + (p – w)D′(p) + D(p) = 0. Denote by pm the value of p that
maximises the aggregate profit.
When the two firms make separate decisions, first the manufacturer chooses w, then
the retailer chooses p. The profit of the retailer is (p – w)D(p). The retailer chooses
p to maximise this profit, which gives first-order condition (p – w)D′(p) + D(p) = 0.
Now compare the two first-order conditions. The term (w – c)D′(p) < 0 is missing
in the second one. In other words, when choosing p the retailer does not take into
account the effect of this choice on the manufacturer’s profit. In particular, the
retailer sets p > pm. There is a ‘vertical externality’ which creates an inefficiency for
the firms because aggregate profit is not maximised. It also creates an inefficiency
m
for the consumers because the price consumers face is higher than p .
One solution is for the manufacturer to set w = c, and extract the retailer’s profit
through a franchise fee A = (pm – c)D(pm). Your answer should explain why this (or
any other) solution would internalise the vertical externality.
b. A key point to discuss is under what circumstances it is profitable for a firm to
reduce its marginal cost. By reducing its marginal cost, a firm reduces the profit of
rival firms in future periods. If there is a fixed cost that these firms must incur in
future periods, reducing one’s marginal cost makes it more likely for rivals to decide
not to produce in future periods. On the other hand, if deterring rival production is
not feasible or is very costly, the effect of reducing one’s marginal cost on one’s own
profit will largely depend on whether firms compete by setting prices or quantities.
If competition is in quantities, the firm that reduces its marginal cost increases its
market share and also its profit (at least up to a certain point) in future periods. But
if competition is in prices, the firm that reduces its marginal cost triggers a more
aggressive response (i.e., a lower price) by its rivals, which reduces the profit of all
firms in future periods. A good answer should discuss these issues, preferably with
the help of appropriate diagrams.

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99 Industrial economics

Question 6
a The firm acts as a monopolist in each market. This is a case of third-degree price
discrimination. In particular, the firm chooses a price for the North, p , and a price
1
for the South, p2, to maximise its total profit Π = p1Q1 + p2Q2 – (5 + 3Q1 + 3Q2).
We obtain p1* = 9, Q1* = 6, p2* = 14, Q2* = 5.5. The deadweight loss is
DWL1* = 18 in the North and DWL2* = 30.25 in the South (a diagram might help
with calculating deadweight loss). Total profit is Π* = 91.5.
b Since the firm cannot discriminate, it must set a single price for all regions that it
serves. Total demand is:
Q = 0 when p ≥ 25 (since sales are zero in both regions),
Q = 12.5 – p/2 when 15 ≤ p < 25 (since sales are positive only in the South), and
Q = 15 – p + 12.5 – p/2 when 0 ≤ p < 15 (since sales are positive in both regions).
(Note that it is wrong to simply add up the demand functions for the two groups and
argue that total demand is always Q = 15 – p + 12.5 – p/2.)
If the firm serves both regions, it chooses a price, p, to maximise its total profit
Π = p(Q1 + Q2) – (5 + 3Q1 + 3Q2). We obtain p** = 32/3, Q1** = 13/3 < 6,
Q2** = 43/6 > 5.5. Confirm that p** < 15. Total profit is Π** = 499/6 The
deadweight loss is DWL1** = 529/18 and DWL2** = 529/36.

Alternatively, the firm might choose to serve only the larger market, i.e., the South.
In this case it would choose a price, p2, to maximise Π = p2Q2 – (5 + 3Q2). It would
obtain Π*** = 333/6, which is less than 499/6. So the firm will serve both regions.
c Total output is the same under parts (a) and (b), but it is ‘better’ allocated when
price discrimination is not allowed (since output is greater in the larger market).
Total profit will fall when discrimination is not allowed. On the other hand,
welfare is increased since the negative change in profits is more than compensated
by an increase in overall consumer surplus (not calculated above, but easy to
show). In fact the deadweight loss without price discrimination is smaller than
with price discrimination.
A ban on discrimination would improve welfare in this particular example. In this
case it is not be profitable for the monopolist to shut down the smaller market.
However, this result is not general. If the monopolist finds it profitable to serve
only the larger market when price discrimination is banned, then discrimination
would increase the quantity supplied overall and enhance welfare. A very good
answer would elaborate on this point.
Question 7
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.

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 Examination papers and Examiners’ reports 2003

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.
Question 8
The answer to this question should start by describing the rationale for merger policy.
This should include a discussion of the causes and consequences of mergers. The
answer should then focus on merger policy implementation. An important step in
implementing merger policy in any particular case is to determine the likely effects on
competition. This involves assessing the market power of the firms involved as well
as changes in market power brought about by the merger. You must explain why
assessing the effect of a merger on competition is often not straightforward, and point
out that it is not always easy to identify the degree of market power which is
acceptable in a particular industry, given the technological and other constraints faced
by firms in the industry.
For mergers that are thought to involve market power issues, the competition
authorities must examine whether the merger should be allowed despite its effect on
competition. This can be justified on efficiency grounds or because the merger is
made necessary by exogenous market forces. Your answer should elaborate on this
and also explain why assessing the balance of benefits and costs is often not easy.
You may want to discuss these issues in the context of a particular antitrust case that
you are familiar with, if you think that this can clarify your arguments. A good answer
would also briefly discuss how competition authorities in various parts of the world
are tackling these problems in practice.
Examination paper for 2004
The structure of the exam in 2004 will be the same as in 2003.

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