Examiner's report 2005 Zone B ‘General remarks ‘To prepare for taking this paper, candidates should make surethey read and digest the Tntredvetion to this examiners’ report, Also, candidates shoud remember that ‘Microcconomics isan economics paper It requires candidate tobe thoroughly familiar with ‘economic terms like “etums to scale” and ‘monopolistic competition" (0 terms that were ‘often misunderstood inthis paper) and tobe abe to use econemic explanations rather then ‘merely geometric descriptions in composing their answers something that was lacking generally but particularly in answers to Question 9). ‘Specific comments on quest Question 1 © Increasing Land i bya for of 2 iseases @ bythe sane fate: a2any* AP =2°2"87%G219%°)e A. Ths there are constant uns scale ) ‘tr mininies cont by coosing th quantities of our capital oth he marginal Tae of tecnica subation ofl for capital equal hao of te prise oa wit of labour tothe price ofa unit of capita: MRTS,_ «%. The MTS, is equal tthe ratio of MP, Ss ean an ee ad MRM ye = MEE, mp, = = o2sqam x" =: x0 fo gg Mees, FE. seting MRS "99 7K 3L irre won? Altematve (ji best completes the statement. Using appropiate diagrams, candidates should hhave explained that both market models predict that, in the long ran, with freedom of entry and exit, entry (or exit) will only stop when profits (lo sses)are driven to zero, In both ‘models, price equals average cost in long -run equilibrium but, because individual firms face downwatd-sloping demand curves in monopolistic competion rather than horizontal {demand curves asin perfect competition, in mo nopolistic competition, price exceeds margin cost( > MR= MC) while in perfect competion, pie ual mail cost 2%Question (Candidates needed to explain that, in a pure exchange economy, the consumption contract ‘curve isa curve showing all eficient allocations of goods between two consumers: one consumer eannot be made better off, by reallocating goods between them, without making the other worte off. These efficient allocations involve different balances of goods in ‘consumption between pairs of consumers. Ifa society cares only about efficiency and not euity, however, then all points on the consumption contrac (cive yield the same level of social welfare, as society is not concerned with the distribution of wilt between individuals. Inthe way just described , the statement canbe said to be true. Good candidates also explained that, in another sense, the statement canbe said tobe false. ‘The reason is that, for overall Pareto efficiency in a production -and-exchange economy, not ‘only must here be consumption efficiency nd production efficiency but also thee mst be ‘efficiency in the product -mix. This occurs when goods that are produced efficiently (onthe ‘production contact curve) are allocated among consumers so that they are not only onthe ‘Consumption contract curve but also the marginal rat of substitution between any pir of ‘goods is equal to th e marginal rate of transformation between them (given by the slope ofthe {tensformation curve). If this condition isnot met itis always possible to make atleast one ‘person beter off without making anyone worse off by changing the product -mix. Thus, for tach efficiently produced product -mix (represented by a point on the transformation curve) {here isa consumption contract curve but only parts of these consumption contact curves satify the condition for efficiency in the product -mix. In this seme, then, the statement an be sid tobe false. Question 4 ‘A.consumer’s intertemporal allocation of consumption optimum can be represented by a point of tangency between an indifference curve ad the intertemporal budget constant. The absolute value ofthe slope ofthe indifference curve describes the consumer's marginal rat ‘of substitution of present for future consumption and equals 1+ p, where p isthe rte of time preference. The absolute value ofthe slope of the consumer's budget line desribes the ‘opportunity cost of £1 of present consumption in terms of future consumption and equals ihr where is de Hottest te, defied de premium om the welaive valuc Cease et one prog in-the-fue consumption eins. Ths th onsumptin optima, ‘Th eaowe to te fist qustion is "Yes" ‘The rate of time preference propeisthe vale of ‘p when consumption levels are eqval in each period (i.e slong the 45° line). A positive ‘value means tha the individual is willing to forego more_ that one £1 of fature consumption {for £1 more of present consumption and implies tht the individual is “impatient”. Thus, if ‘r= 0 and assuming the individual has a diminishing marginal rat of substition of present for future consumption (convex -o-e-otgi indifference curves), he would optimise his intertemporal allocation of consumption by consuming more inthe current period then inthe ‘iature period. ‘The answer tothe second question is “Yes”. Just bocause an impatient person will want to spend more in the frst pesiod than inthe second ifthe interest rae is zero doesnot imply that |e will necessarily be a borrower (rst -period consumption in excess of frst -peried income) rather than a lender (First -period consumption less than first -ptid income). Whether 2 person isa lender or not depends on whet his consumer optimum is relative to is 2‘endowment point (epreseting his consumption in cach period if he neither lends nor Sorrows), An impatient person could be alenderifhis fst -period income (which, together ‘ith his second -period income, determines his endowment pint) exceeds his des red first- Datiodconsumpon (hich, together wit his second -period consumption, represent his eemsumer optimum). Candidates needed to explain these points with reference to appropiate diagrams. . Question 5 Candidates should have used a diagram to ex plain that, although George will nt be abe to ‘ay as moch ¥ when he buys units of X under the two-unts fie scheme compared with the £1-per-anit subsidy scheme (72 units of Y (= 100~ 4x 7) rather than 73 (= 100—3% 9)), be need not necessrily be worse off under the two -umits fee scheme. If George has a strong far Tit is possible that under the later scheme be would consume less than 8 Umits of X and more than 76 units of Y and, asa result, be better off reach a i gher indifference curve) than under the subsidy scheme, The digram below depict the (wo ‘optima. (The diagram is not drvn to scale to make it clear) rex = RY wee, nx ex 9x “The El-per-init subsidy scheme is represented by line CD andhas the equation y~=100~ 3. ‘The owo-units fee scheme is tepresented by line AB andhas the equation y=100~ 4 6-—2). “The values of >and y given above canbe derived from these equations. isthe optim consumption bundle under the subsidy scheme. is the opionum ‘consumption bundle under the transfer scheme, As drawn, {ison higher indifference fcurve tian s, s0 George is beter off. [Drawing a different diagram, itis posible, of course, for CD to li¢wholly below 1, in which cage the optimum under the in “kind transfer scheme ‘would be ona lower indifference curve than.)‘rama pope Came pts 005 Question 6 (Candidates should have recognised that, inthe context ofthe questior, eat seeking refers to activity by special interest groups intended to influence goverment olices in ways that allow the ‘yous to obain or keep economic profits or ren ts. These rents are obitned al the expense ofthe ‘est of society. Morover,bocanse rent seeking consumes rsoures (eg. costs of lobbying) an also distorts the allocation of resources, the res of society loses more than the special interests ‘in, Thus, rent seeking activity reves economic efficiency. Abou, in principe, pote losers could collectively ouspend the gainers in campaigning for thex view and in influencing politicians by contains to party funds, et, they ay not do. so because: + individually, each gniner i ikely to gain more from a policy that is being poshed than ‘cach Loser slike to lose; bing fewer in number, special interests can more easily overcome free rides problems in ‘pressing fora policy (which to them isa public good) than olhe citizens ean in opposing, ‘the policy (which to them isa public bad. Question 7 @. Candidates needed to explain thatthe question is about hidden -actions (not hidden- characteristics) aspecis of asymmetric information an d needed to explain the moral bazard ‘problems tht may arse with reference to examples in markets for insurance, drable goods, snd managers. 1m insurance markets, moral hazard oocurs wha the party tht is insured can ae the probability or magnitude of the event that triggers payment. Using a diagram showing the ‘uilibrium amount of ‘care’, candidates should explain that insarance reduces incentives to take care, Thus, although this results in fewer costs of taking care (es care is reduced), the re isan increase in the price of insurance (a increased damage coas ae borne by insurance ‘companies) so that, overall, insureds are worse of (there isan eiiciency loss) beeause ofthe moral buzard problem. ‘When suppliers know the quality oftheir products but consumers do not at least prior ‘making purchase, asin many durable yoods rks, we havea situation of asyemmetic information about an action, the firm's choice of product quality. Ther isa potential moral hazard problem because a firm caa reduce its costs by lowering its product” s quality, which Towers consumer welfare, ceteris paribus. However, given that firms have the ability to cheat ‘consumers means that rational coasumers will expect firms to produce low ~quaiy products ‘50 that, in equilibrium, the market for high -qualiy products is destroyed and poteatial ‘consumer and producer surplus wil be foregone. ‘The moral bazard problem arises in the employment of managers because their work effort is ‘not directly observable so thatthe manager may not choose the level of effort which ‘maximises the total surplus ofthe principals (the firm's owners) andthe agents (managers). Using a diagram wo show the mantger’s optimal choice of remuneration apd shitking, ‘candidates should have shown why flat salary induces an ineTicent level of efor. O) (Candidates should have shown that, by encouraging insureds te shoulder some ofthe risk of Toss by means of coinsurance, insurance companies can reduce disincentives to take care and 31involve insurance contracts providing peril insurance (eg tough the use of deductibles or ‘o-insurance) ~ rather than either fll insurance or zero insurance. In markets for durable goods, a possible market response to moral hazard problems isthe evelopment of firms "reputations or brand names. Inthe absence ofa valuable reputation or brand name, afm is better off cheating than being honest. fa fm cheats - by charging high price but delivering a lower -quality product thn itelaims ~ it may eventually lose ‘custom and go out of business but, in the meantime, it es eamed a ate of retam greater than the return to being honest. If frm develops a epuatoa or brand name, however, it willbe ‘aid a premium for producing high quality, The area hat reputation and the premium stream willbe lost if the frm is discovered cheating is then an effective deterent to cheating ‘As long asthe present value of the anticipated premium steam from being hones is greater than the one-time gain from cheating, firms will be hones, and high quality goods can exist ‘in equilibrium. To create the premium stream a firm mast make sunk expenditures on things like advertising so that economic profits are zero andthe premium sresm is converted int 0 ‘quasi rent. In effect, the sunk expenditures incurred in establishing a reputation act as a bond ‘ora guarantee of quality: if the firm cheats it loses its sunk expenditures. However, moral __bazard problems are reduced only at the cost of misallocating resources (given thatthe creation of reputations involves raising price above marginal cos). Again, tere is ate off a trade off between the inefficiencies associated with P> MC and incentives to supply high-quality products: the latter can be increased only atthe expense of increasing the former ‘Again, a compromise seems likely ‘Candidates should bave used an appropriate diagram to show that a manager canbe induced to choose an eicient level of effort by m_ aking her a residual claimant. Again, however, ‘theres a trade off ~ between the costs of isk bearing and effort raising incentives: the later ‘an be increased only atthe expense of increasing the former. The optimal point on this trade-off is likely to involve management compensation contacts which donot make ‘managers the sole residval claimants but, instead, provide them with some fat salary ‘component as well asa prfit-related element of remuneration, Question 8 @ ‘Candidates should have g ven clear explanations ofthe fllowing propositions: (1) The ‘demand fora facto is less elastic the lower the elasticity of domand forthe product which the factor helps to produce. The reason i elated tothe fc that, to derive the industry demand curve for a factor, we cannot simply take the horizontal summation of individual firms ‘marginal revenue product curves (which assume a fixed product price). Instead, we mast allow fr the reduction inthe product price which occurs a all fms respond o a reduction inthe price ofa factor by employing more of the factor and increasing ther output. (2) The ‘demand fora factors es elastic wien factors a fixed than when oer factors can be ‘varied in response to a change in the price ofthe factor in question. Candidates should have ‘explained why this is tue whether factors are complementary o anticomplementary. (3) The ‘demand fora factor is ess elastic the less elastic is the apply of other factors. ‘Good candidates explained thatthe analysis of fuctor demand indicates tha, unlike the snalyss of prodct demand, the factor demand curve is always negatively sloped. That is, there is no such thing asa “Giffen factor”. As well as changing its mix of inputs by substituting towards the relat ely cheaper input — the substitution effect (as usual, always negative) ~ te firm can alter it total output ~the outpt effect. The output effect als tends to produce a downward -sloping, long-run input demand curve. When the wage rate rises, heaan popes nf ie pe 208 costof producing any level of ouspu increases and tbe firm. 's cost faction therefor sits ‘pwards. If labour is @ noma input (labour demand falls as output falls), marginal cost also Jncreases asthe wage rate increases, o the frm will produce less ourpt. Thus, when labour ‘2 normal input, the ouput effect reinforces the substttion effet. Interestingly, thisis also ‘tue if labour is an inferior input (labour demand falls as output rises) Tn tis e255, an increase in the wage rate causes the marginal cst fancton to shift downwards. Asa result, the firm produces more output and, because labours an inferior input, it wll demand less of {he inferior input sits output increases © ‘Candidates needed to explain that the elasticity of supply of labour to particular industry depends on the degree of specificity of units of Iabour to tha use and on the length of ine Slowed fr labour tobe re -allocated to or sway from that use. Some unit of labour are said tobe more specifi to a particular indastry than other unis i the are prepared to work in that industry at a lower rate than others. This may occur because of differences in subjective preferenoss for employment in that industry or beemse of differences in objective abilities to ‘work productively elsewhere. The greater these diflerences theless elastic ithe supply of labour tothe particalar inusty, Labour tends to be more mobile and more elastic in supply the tonges the time allowed fr is reallocation to ar away ffoman industry. One factor that ‘ediuees mobility in te shor run is the ime i takes fr labour to aoquie the industry. -speciic ‘Skills that are used in the production processes of particular industries. In response to the lst par ofthe question © andidates should have distinguished between transfer ‘eamings (hich are the amount hat my unit of factor must cam in order to prevent from transferring to another use) and economic reat (which isthe excess over ransfer eamings that tit actually ems), Cmdidaes then needed to demenstat, with he ad of agar, hat ‘workers already employed in an industry. would benefit more from: an increase in demand forthe ‘utput produced by the industry the greater the proportion of tei camings ¢ omposed of economic ‘eat —that sth steper isthe slope ofthe labour suply curve to hat inst. Question 9 ‘Good candidates examined both gambling and insurance decisions and flly explained ‘Mlowant concepts Eke aetaraly fe gambles and i newrnee a se -averse and risk loving behaviour “The answer tothe first question is “No". Candidates needed to show thata risk -averse person may accept a risky prospect ifthe expected payoff is suficealy greater than the payofT that ‘would result from not accepting the risk. Candidates should have shown that, facing a risky ‘prospec, a risk-averse person may reduce (shed) risk by buying insurance. “The answer tothe second question is “Yes” ~ excep in the (pethaps) special circumstances described in the last sentence of his paragraph. Candidates needed to show that risk loving person will prefer a risky prospect over a curtain one a lng asthe expected value of the Former is equal to or higher thn that ofthe later and wil prefer some isky prospects over a ‘certain one even when the expected value ofthe former is es than that of the later. ‘Candidates needed to show tht a risk -loving person would not want to reduce risk such a person could only replace a risky prospect bya less. risky one that was no greater in expected Wale and therefore less desirable toa is lover, The latter situation would occur if the person could buy only ctuailly fir insurance or insurance that was actuarially6 manesmens less risky prospect with a higher expected value thats, ‘the person was able to buy insurance that was actuarially favourable to hirwher (but prevented from over insuring) then it is possible thatthe person would opto reduce risk by accepting th les risky prospect. Note: Budget lines need to be drawn from the endowanen point. The tatteris om the certainty line when analysing acceptance or rejection of a gamble bat off the certainty ine ‘when analysing the reduction of risk by means of insu rance. For comparative purposes, fir ‘odds lines should also be drawn through endowment points, not through points of intersection of budget ines with the axis. Question 10 o (Candidates should have demonstrated that, ina competitive equilibrium, ex traction volumes willbe adjusted so that he net pice (or royalty), the diffrence betweon rice and por unit extraction cost, wil risa the rat of intzest ~ thats, Fay ~~ @—) 0-1). Tisis “Hoteling’srule'. They should show why firms can increase the present value of thi profits by lterng their extraction paths if is condition doesnot hold. ‘Thus, when c= 0, the price musts se athe ate of interest —thatis, 2, = (+2), oF ‘Assuming cis positive and constant, price wil rise overtime at arate whic his ess than the rat ofinerest~thatis, 788—Fe Jn both cases (and i, assuming the demand curve is constan_tover time, the extraction path ectnes as price rises overtime. i a+ Je x, given that c< Pp * © . ‘The effect ofa higher interest rate can best be demonstrated by using a diagram of extraction ‘over two-periods. Present price falls, as more extraction is undertaken m the pres ent perio, and fature price rises, as lest extraction is undertaken inthe future period, unl the rate of increase in net price is equal to the higher rate of imteret. Thus, the price path rises more steeply and the extraction path fills more steeply. Tn monopoly, the equilibrium condition is given by MR.,—e= BIR,—cltL+ 2). As the ‘marginal revenue curve i steeper than the demand curve this implies that, forgiven (Gaocluding c= 0) price mut rise more slowly under mosopoly than under conditions of | competition, so that, while price starts higher under monopoly, it eventually falls below the competitive price. Under monopoly, the extraction path deckines at a slower rte than under ‘competition andthe period over which extraction takes place before the resources exhausted is longerifthe demand fr the resource is expected to grow faster tere is n upward presi ot Drees 2 atthe bot the current price and future prices rise, bu he rate of ineease in Pees being determined by the interest rat, remains unchanged. This is possible becuse Te choke" price rises overtime Lessis extracted in ealierpesiods and more is extracted in Inter prods than if demand was constant or gowing nore slowly over ime. ‘The post-tax royalty becomes (1~ a(R, <) if cis the royaltytax rate, Hotaling ’s ule impli that he post-iax royalty rst rise atthe ale, ifthe eoure ito bs exploited Miciendy, That's, (Ry, cKt—a) = G+ 2 Y~ a), or (Fs —e)= C4 HP, 9) “Tins, Hotellng’s ule continues to operate unchanged in the presence ofa royalty tx, ad 0 ange occurs othe optimal price an extraction pt. Question 11 @ ‘ist, candidates should have defined the concept of Pareto -efficiency and briefly explained the fist (Kundameatal) theorem of welfie exonomies. Although the activity of one entity (8 Drson ora frm) may affect the welfare of another, and some ray becom ¢ worse off a long Rs thone effects are transmitted through competitively determined market prices the outcome js sconomicaly efficient. As long as consumers maximise uit, prodocers maxiise ‘profits and al individuals and firms are price takes, the new equilibrium, jus s the od is ‘Pareto efficient. There will be efecs the distribution of ral income, bat the problem (ir there is one) is about equity rather than efficiency. Next, candidates should have defined an ‘extomality a situation in which one economic agents action direst confers a benefit or {imposes a cost on some ober agent without that consequence bring reflected in marke prices ftnd exchange transactions — to emphasise that the interaction moog people when there are externalities are ofa direct kind (atlty or production possibiltis arediecly affected). ‘Diagrams should heve been wsed to show that an externality results in an inefficient allocation of resources because the pursuit of narrow self interest (decisions based on private ‘barginal costs and benefits) causes a divergence between soci marginal benefits and social ‘marginal costs. Ffficiency les areas areas between the socia| marginal costs and soci ‘marginal benefits) needed to be correctly ident fied (often they were nt). © (Candidates needed to discuss merger'mnitisation, social conventions and bargaining as private to avoid the inefficiencies of extemalitis. Factors timiting the ffsetivenses of these private responses (spec ill in relation to bargaining) are: (8) ‘negotiation costs, 2) fee -riderfhold-out problems, (3) dfilties in identifying sources and recipients of extemal effects, and (3) small -mumnbers bargaining problems associated with ‘symmetric information. Question 12 @ {Using a simple supply -and-demand diagram, candidates should have defined (oet) consumer ‘supls and (ne!) producer surpus and explain why their sum otal surplus, is lower at any ‘ther output than the competitive equilibrium level, 3Mises o Candies should ave used 2 diagram st ‘consumer end producer surpluses. arto the one bel ow to show changes in ‘Atte inital equilibrium, 7,09 the consumer suplus is A-+.+C and producer surplus is ‘J+ 1+ and total surplus and total welfare i the sum of ese amounts thats, REBHCHI+IFK, Bow Bee, where = isthe subsidy per unit. P, is the effective prive (Le nehang the srfosily they rveive) of producers “id P, is he price paidby consumers. 2, isthe price ceiling. ‘With tie subsidy, consumer surplus becomes A+B4C++ T+ H+G and producer Supls becomes’ Bi C-+ B+ d-+ 1+ K. Thus, consumer supls increases by + Tt HG and producer surplus increases by B+ C+ B. Summing these changes and subtracting the SRetot the subsidy, B+ C+ E+ F-+G +H ++ J, tis implies thatthe met cost to society is =F. “Wit the pice ceiing, vonsumer surpins becomes BF and prnducer surplus becomes K ‘Thus, consumer increases by JC (his may be a decrease if C > J) and produce surplus eerseaca by - JT. Summing these changes implies the: the net cost to society is —C = ‘Comparing the welfare changes resulting fom each scheme, the we Ifreof consumers and Glodvcershigher under inesubsidy scheme ~by C+2+H+G and B+ C+E+I+% respectively. ‘Assume tinear supply and demand curves. Then, ifthe absolute values ofthe demand and ‘ppl clasticites are equal tthe inital equilibrium (es dawn), the met costo society ofthe fre sehemes isthe same(—F =—C ~ 1), Witha demand carve thats relat ively incase ‘Semper to supply, the net ocial cost woul be larger inthe ease ofthe pice ceting, The reverse would bette if demand were relatively elastic compared to supply.einen pp Ele po > Candidates should have used a diagram similar to te following: poe suey Ss Z— pxim apt. vis Tess F x Deven s |x oa cuniy [Atthe inital equilibrium, 1,0; the consumer surphs is, A+B 4+C and producer spins is {E+ and total surplus and total welfare is the sum ofthese mounts tha i ASBECHESE ‘tte government supports the price at_P,, producers sell Q3, of which consumers buy 02 tnd te goverment buys Q;Q2. Consumer suplusfillsto 2, producer sup inesase ser cr D + i+ B+ P,aod government expenditureis -G =F C-D— B= 3-K. ‘Summing these amounts we ean see that ttl welfare isnow A+ B+ B-G— IK aanaae sumer ae worse off by BC, producer are better offby By C+D + 1 and Fehament inmees ave deeiorted by “C ~P—C—D=H-J~K., Somming thes Etnounts, the change in total welfare is -C~ P—G~K~J. Ifthe government sets a quota at Q, consumes surplus falls to, preducer sup changes Aa ee and (lewving wide adeninistration cote) there tno change in roverament ‘expenditure. Total welfareisnow A+B+ 5. Pe erriee consumes are wore offby —B~C , producers’ welfare changes by BoP (SY see erit B= F and worse off if B-< F),and, summing these changes the change i total welfare is ~C— F. ‘Carin good candidates remembered to make comparisons. Ths, under both schemes, aes ave worse offby —B— C.. Producers are better off undec seine i than scheme tyccep eH +P. Total welfare flls more under schene i thn scheme: By —G ~-¥ Question 13 o © pidates needed to give clear explanations ofthe assumptions and equilibrium outcomes spine various market models —and make comparisons. The basic numerical results ae as fallows: 3738 {9-=1,000-2,000P, so fim ls resdual demand curveis P=1~(0,+;) 000. Ths for firm 1, MR,=3--Q, /1000~0,/500 Also, C(Q)= 0280, 9 4 tnaximisaion HR =NC, 0 1~Q, /1000~Q, /500= 0.28 nd, therefore 0, 360-0, 2. Similarly, Q, = 250~Q, /2. Substutirg one equation (bestresponse function into another and saving saltancusly. 160-(360--, /2)/2=100-Q, /4= 240. And Q, = 360~ 240/ pei-(240+ 240) ,000= 0:52. 1 = m =240(0.52~€.28)= 57.0. Tn perfect collusion, the two fim behave like a monopoly n determining total output and price, dividing ouput and profits equally between them. MR=MC, 1—Q /500= 0.28, 0 Q = 360 and Q, y= m, = 180.64 028)= 6420. Inthe Stackelberg model, the fllower (eg fim 2) sets its output according, to its best~ respoase function, Qy = 360-0, /2. The leader (eg. firm 1) anticipates that reaction and so ‘chooses tat outpat which, wen combined wih te follower "s correctly predicted output tends tothe most profitable outeome for ise Thus, firm | 's residual demand equation is = (360-03 /2)/1,000—0, /2,000 = 0.640, /2,0005 ‘and Mj= 0.64~Q, /1,000. Setting MR=MC, 0.64~Q, /2,000: (60-360 /2=180. P= 1~(360+180) /1,000% 0.46. x, =360(0.46~ 0.26) = 64.20 and x= 180 9 46~ 0.28) 32.40. “Thus, ranking the models in order of industry price and profit (| ascending magnitude) and industry output (in descending rignitude) we find the collesiveis first, Cournot is second, land Stackelberg is third. Each fin produces half th industry output and ears half the industry profi in the collusive and Cournot m odels. Inthe Stackelberg model the leader Products larger output and ears a higher profit than the follower and the leader |°s ouput tnd profit is higher than a Cournot firm's, while the follower 's output and profit i ower than ‘8 Cournot firm's. 28, 90 0, = 360. “The ontenme of a Coumot duopoly is where each firm has chosen n output which aximises its profit given the outpat chosen by the otber frm. Tn other Words, each fm s ‘doing the bea it can give the choice of the other. tis therefore an example ofa Nash ‘equilibrium, The outputs set by perfectly collading finns maximise joint profits. However, {fis outcome is nota Nash equilibrium becanse each fim isnot maximising its profit given the choice ofthe other firm. A firm would have increased its profi ts if it had produced s higher ouput, ven th output et by the other firm. This discussion isin the context of one = period mods of duopoly. Good candidates also explained biel that in malti period games Pith paniahment stratgies, which are both severe enougi and credible, a collusive solution {an be a subgame perfect Nash equilibrium. ‘Suppose that firms move simultaneously but that fim 1 sinounces that it wil produce the ‘Stackelberg leader ouput to induce firm 2 to produce the Stackelberg foll ower output, Will this result in the Stackelberg equilibrium? The answer is * No’ because, when fms move Siultancously, frm 2 does not view frm I °s weming that it will produce a large quantity as ‘credible treat. Firm 2 does not believe the threa t because itis notin firm 1's best interest to produce that large quantity of output. It were to produce the leader level of output nd the other firm produced the Cournot level of output, its profit would be lower than ifi¢t00aR eatin apes 2 Eanes pas 25 pronced the Cournot level. Because frm 1 cannot be sur tha rm 2 will below its threat and rece its output, im 1 will actually produce the Courmot output evel. In contrast, ‘when one finn moves fis, its threat to produce a large quantity is credible Because it has slready committed to producing the larpe quanti, thereby cating out its heat. © six firms ot of seven merge (resulting in two Cournot competitors thir collective post — ‘merger profit would be 57.60 (as calculated in (a). There was no ned to drive this result again. To find the calletive profits of the six merging fms before the merger, ist calculate ‘the equilibrium profit of one frm (ay fim 1) among seven fins in Courot competion. Fim I's best-response function is now Q, = 360-(Q5 +-t..AQp). AS, in this symmetric situation, al fms wil have the same ouspat in Counot eqiibium, (= 360-3(6)0, = 360 /4= 90. Thus, P= 1- 7190) /1,000 = 037 and = 90037- 0.28) = 630. The collective profit of six Firms pre merger, therefore, 6€20)= 48.60. Thisis less than 57.60 post-merger: hence, he merger is profitable three out of seven fms merge (eauting inf ive Court competitor) ther collective post - merger profits derived as fellows: 0, = 360-3(4}2, =120, P=1-5020) A,c00= 0.40, and m, =120 0 40~ 028)=14.40. 1440s als the collective post-merger profit ofthe three merging firms. As this is ess than thir collective pre merge profit, 24.30 [-3(8.10)), the merger of dee firms would nat be profitable. Question 14 ‘This isa straight forward question, so candidates were expéctd to provide detailed and scourate analyses and cleat diagrams, o (Candidates need to provide a precise diagrammatic and verbal explanation of ind Good candidates expressed the profit -maximising condition fo ii. mathematically. Al three schemes enable a monopo listo extract more consumer surpls in the form of profits than if ists a uniform price er unt. Inthe limit, a two part tariff enables the monopolist to extract ‘the maximum possible level, thai, the same as perfect price diserimination (a which case ‘ach unit is sold ata different price, equa othe reservation price for that unt). For example, is wok ocur if dhe monopolist Sod each unit, at a price equal to marginal cst while meeting overall market demand, and charging a fixed feet o each consumer comesponding 0 the difference berween the value each consume places on the otal quantity be buys and the ‘evenve raised from th pico per unit equsl to marginal cost. Ifconsumers have non identical demands but the seers constrain ed to charge a common Bed fe teach ‘consumer the profit-maximising two-part trfT will usally involve a price per unit that ‘exceeds the level of marginal cost and profit will be lower thn inthe unconstrained case. ‘One reason forthe constraint jus t mentioned may be a lack of information about individual ‘consumer demands (se condition (2) below). Compared with single (uniform) price monopoly, market segmentation price discrimination ‘can resaltin higher profits because sales are reallocated from groups of consumers for whi ‘he marginal revenve from additonal sale is relatively low (demand is less elastic) 10 sroups 9sat egmeaion pre Snnnation aot nie rit am ES Ty ot genio esr lanl AY in sces ont However, he largr the munber of Ons NES ‘an be divided into, the larger profits canbe. © Candies ne an of te fs of IE 1) BO incees ccs an he wl ingness to pay Zor units of the prods "Snag it potentially posible © Sarees 0 near daca a a iene amon co dagen in wick her isa aya ti ee me ch on An Tag ihe: i ver te Be SN ramps ofthe methods firms can wse 10 teSvewe conditons (2) and). For example, xamp® 2) might be achieved by meas of se selection SONS ike aiine priging cron) mi gg uvaing pases oss Poses a DEY