BUSINESS AND INDUSTRIAL ECONOMICS

A.Y. 2020/2021
BIE classroom exam – June 29th, 2021

NAME _____________________________________ SURNAME ____________________________________

STUDENT ID_(matricula)___________________________________________________________________

MULTIPLE-CHOICE QUESTIONS [10 points]

You do not need to provide explanations for your answers. However, if you want to add a note to an answer
(e.g., an assumption, a clarification, an explanation), please write it in the paper sheets that you will upload
as a unique .pdf file.

1. The analysis of market shares is less informative of the possible impact of a merger on competition in a market
where:
a. Firms sell differentiated products, compared to a market where firms sell homogenous products.
b. There are barriers to entry, compared to a market where there are no barriers to entry.
c. Firms have similar market shares, compared to a market where firms have very different market
shares.
d. The market is static, compared to a highly innovative market.
Reference: Module G

2. Which of the following statements on competition among firms is FALSE?

a. Entry of new firms in an industry can be temporally deterred by incumbents because of the ownership
of a patent, which is essential for developing the product. This is a strategic entry barrier that
incumbents use to set price higher than their marginal costs in the short run.
b. If firms undertake a predatory pricing strategy, they set the price higher than their marginal costs in
the short run to deter entry of new firms and earn extra profits in the long run.
c. Collusion among firms is more likely when an industry is less concentrated and there are many new
entrants.
d. All the other answers are false.
Reference: Module E

3. Which of the following statements on network goods is TRUE? The costs of switching from one network good
A to another network good B:
a. Decreases when a user spends just limited time in learning how to use A.
b. Decreases with the strength of indirect network externalities.
c. Decreases as the price of A increases.
d. All the other answers are false.
Reference: Module E (slides 77-78)

1
4. Fill in the blanks with the economic theory, which is the most suitable to explain the case.
a. In startups, members of the entrepreneurial team and employees likely share the same space and, thus,
monitoring is easy. This case can be explained by ___________ (0.25 points). Agency theory
b. Firms usually choose market transactions over vertical integration when asset specificity is low. This case
can be explained by ___________ (0.25 points) Transaction cost theory
c. Two firms, I and J, engage in a transaction using a certain asset. Firm I has greater incentive than firm J
to undertake relational-specific investments on the asset to maximize the surplus of transaction if it owns
the asset. This case can be explained by ___________ (0.25 points) Incomplete contract theory
d. Affiliations of a biotech startup with prestigious universities and venture capitalists are particularly useful
when the startup is going through an initial public offering (IPO). This case can be explained by
___________ (0.25 points). Signaling theory
Reference:
a) Module C (slides 33-40)
b) Module D (slides 8-12)
c) Module C (slides 46-50)
d) Module B (slides 79-82)

5. Firm A and B are active in six industries. The table reports firms A and B’s shares of sales in each industry j
(pij, with j = 1,…,6). Which of the following statements is TRUE?
It is possible that more than one answer is correct.

Industry pij (A) pij (B)

1 0.80 0.05
2 0.10 0.15
3 0.025 0.10
4 0.025 0.10
5 0.025 0.25
6 0.025 0.35

a. According to Rumelt’s approach, firm A is an unrelated-business firm, while firm B is a related-

business firm.
b. According to Rumelt’s approach, firm A is a dominant-business firm, while firm B is an
unrelated-business firm.
c. Berry’s indexes (DB) for firm A and firm B are 0.65 and 0.23, respectively.
d. Berry’s indexes (DB) for firm A and firm B are 0.35 and 0.77, respectively.

2
Solution:
Industry pij (A) pij (B)
1 0,8 0,05
2 0,1 0,15
3 0,025 0,1
4 0,025 0,1
5 0,025 0,25
6 0,025 0,35
DB 0,35 0,77
Reference: Module D (slides 46- 49)

6. Which of the following statements on internationalization and foreign direct investment (FDI) is FALSE?
a. A Chinese firm producing furniture acquires an Italian retail firm to sell its products on the Italian
market. This is a case of greenfield FDI.
b. A firm internationalizes by exporting its products abroad. This is a case of FDI.
c. The Scandinavian School argues that internationalization occurs progressively. Firms enter foreign
markets by establishing firstly production subsidiaries and, then, developing sales subsidiaries.
d. All the other answers are false.
Reference: Module D (slides 59-61; 77)

7. Which of the following statements on the free riding problem is TRUE?

a. The free-riding problem is not a case of market failure.
b. The free riding problem is more likely when agents involved in the private provision of a public good
can easily coordinate.
c. All firms producing cornflakes do some advertising to cornflakes without reference to any brand
name; this practice increases the market demand for cornflakes. In this market, there is no free
riding.
d. All the other answers are false.
Reference: Module B (slide 38)

8. A coal-fired power plant jointly produces electricity and air pollution. Air pollution adversely affects a nearby
farm producing an agricultural product. Assume that: pe = 10 is the price of the electricity, pf = 8 is the price
of the agricultural product (both firms are price-takers), ce (e, x) = e2 + (x2 – 5x) is the cost for the coal-power
plant of producing electricity e jointly with x units of pollution (pollution is a production externality), and cf
(f, x) = f2 + fx is the cost for the farm of producing f units of agricultural products when the coal-fired plant
emits x units of pollution. The two firms merge to internalize the production externality, calculate the produced
amount of electricity (e*), agricultural product (f*), and pollution (x*).
a. e*= 10; f*=11/3, x*=2/3.
b. e*= 5; f*=2/3; x*=11/3.
c. e*= 10; f*=2/3; x*=11/3.
d. None of the other answer is correct.

3
Results:
e*=5
f*= 11/3
x*=2/3

Solution:
If the two firms merge, the merged entity produces both electricity and agricultural products (it can choose e, f and
x) and its profit is:
𝛱 𝑀 (𝑒, 𝑓, 𝑥) = 10𝑒 + 8𝑓 − 𝑒 2 − (𝑥 2 – 5𝑥) − 𝑓 2 − 𝑓𝑥
Starting from the first-order profit-maximization conditions, we obtain:
𝜕Π(e, f, x)
= 10 − 2𝑒 = 0 → 𝒆∗ = 𝟓
𝜕𝑒
𝜕Π(e, f, x) 𝑥
= 8 − 2𝑓 − 𝑥 = 0 → 𝑓 = 4 −
𝜕𝑓 2
𝜕Π(e, f, x) 5−𝑓
= −2𝑥 + 5 − 𝑓 = 0 → 𝑥 =
𝜕𝑥 2
5−𝑓 𝟏𝟏
𝑓 =4− → 𝒇∗ =
4 𝟑
11
5−
𝑥= 3 → 𝒙∗ = 𝟐
2 𝟑
Reference: Module B (slides 59-70)

9. Which of the following statements on the relevance of policymakers’ intervention is FALSE?

a. In highly competitive industries, the establishment of intellectual property rights (IPRs) by
policymakers actually causes negative effects on innovation. Indeed, obtaining IPRs increases
the costs of innovating firms, which, thus, are forced to increase their prices; this has negative
repercussions on their survival.
b. Policymakers can directly provide public goods, thus solving the free riding problem, which hampers
the private provision of public goods.
c. In highly competitive industries, policymakers can stimulate innovation by providing non-financial
support to firms engaging in innovation and by setting up institutional entry barriers.
d. All the other answers are false.
Reference: for the correct answer, Module F (slide 25)

10. Assume that two firms produce homogeneous goods using the same technology. In a Cournot competition,
firms
a. Choose the quantities they produce. The choice of each firm is simultaneous and independent.
In equilibrium, firms’ profits are normally higher than profits in a Bertrand competition.
b. Choose the quantities they produce. The choice of each firm is simultaneous and independent. In
equilibrium, firms’ profits are normally lower than profits in a Bertrand competition.

4
 c. Choose the quantities they produce. The choice of each firm is independent, but one firm (the leader)
chooses before the other one (the follower). In equilibrium, leader’s profits are higher than follower’s
profits.
d. Choose the price at which they sell their goods. The choice of each firm is simultaneous and
independent. In equilibrium, firms’ profits are normally higher than profits in a Bertrand competition.

Reference: Module E (slide 11-27)

EXERCISE 1 [7 points]
Consider a duopoly situation with two firms (firm 1 and firm 2) facing the demand curve Q = 53 - P, where Q =
q1 + q2. Both firms have the following cost function Ci(qi) = 5qi, i=1,2
a.) Find the Cournot equilibrium (quantities, prices, profits). [1.5 points]
b.) Find the von Stackelberg equilibrium (quantities, prices, profits). [1.5 points]
c.) Find the price, quantities, and profits under collusion. [1.5 points]
d.) If you were firm 2 (the follower in case of b.), which competition regime would you choose? [0.5 points]
e.) Calculate the total consumer surplus, total producer surplus, and the total welfare in the market in each of the
three cases above (under Cournot, von Stackelberg, and collusion). If you were the policymaker, which
solution would you prefer? [2 points]

EXERCISE 1 [7 points]: SOLUTION

a.) Starting from the inverse demand function P = 53 - (Q1 + Q2), firm 1 chooses the quantity Q1 that maximizes
its profit function:
π1(Q1) = (53 - (q1 + q2))q1 – 5q1=53q1-q12-q1q2-5q1=48q1-q12-q1q2=0
From the first order condition, we get firm 1’s best reply function: q1 = 24 - q2/2
Similarly, firm 2 chooses the quantity Q2 that maximizes its profit function in a symmetrical way:
From the first order condition, we get firm 2’s best reply function: q2= 24 - q1/2
By solving the system with the two best reply functions:
q1=24-(24-q1/2)/2
we find the Cournot equilibrium quantities: qC1 = 16 and qC2 = 16
Hence, the quantity Q = 32 is sold at the price pC = 53 - 32 = 21, which is the same for both firms, and the two
firms get the profits:
πc1=P*q1-C1= 21*16 – 5*16=256
πC2=P*q2-C2= 21*16 – 5*16=256

b.) Find the von Stackelberg equilibrium (quantities, prices, profits).

The game is solved via backward induction, that is, starting from the second stage. In this stage, firm 2
chooses its quantity as in the simultaneous game (Cournot), so its best reply function is:
q2= 24 - q1/2 (see the first order condition of firm 2 in point a.)

5
Going to the first stage of the game, we find the optimal price for firm 1 by plugging the best reply function of
firm 2 in the profit function of firm 1: π1(q1, q2) = (53 - (q1 + q2))q1 – 5q1
π1(Q1,Q2)=(53-q1-24 - q1/2)q1 – 5q1)=(20-q1/2)q1-5q1 = 24q1 – q12 /2=0,
From the first order condition, we get the optimal level of 24-q1=0, q1= 24, from which it is possible to derive the
optimal quantity for firm 2, q2= 24-24/2=12

In equilibrium, the overall quantity Q = Q1 + Q2 = 24+12 = 36 be sold at the price P = 53 – 36 = 17

πS1=P*Q1-C1= 17*24 – 5*24=288
πS2=P*Q2-C2= 17*12 –5*12=144

c.) Find the price, quantities, and profits under collusion.

P = 35 – Q, MR=53-2Q
MR=MC, 53-2Q=5, Q=24 (q1=q2=12)
P=53-24=29
Πcoll1 =πcoll2=P*q-c*q=29*12-5*12=288

d.) If you were firm 2 (the follower in case of b), which competition regime would you choose?
Q1 Q2 P π1 π2
Cournot 16 16 21 256 256
Von 24 12 17 288 144
Stackelberg
Collusion 12 12 29 288 288

e.)
CS PS TW
Cournot 512 512 1024
Von Stackelberg 648 432 1080
Collusion 288 576 864

EXERCISE 2 [3 points]
Suppose that two thirds of drivers drive carefully and get into a car accident with probability 0.1. The remaining
one third is not as careful and faces the probability of a car accident of 0.8. Assume every driver has the same
income of $825 per year. Having a car accident results into damages of $350. Drivers are risk-averse and have
utility function U = √𝑤, where w is the income per year. There is a risk-neutral insurance firm in the city.

6
a.) For now, assume that information is perfect and symmetric. What happens if the firm offers full insurance at
actuarially fair rates (such that the premium for each dollar insured is equal to the expected payment by the
insurance firm)?
What will be the total premium for each type of drivers? [0.75 points]
Which type of drivers will choose to buy the insurance? [0.75 points]
b.) Now assume: each driver knows her/his type, but this information is not available to the insurance firm. If all
drivers decide to purchase the insurance, at what total premium would the insurance firm break-even (have
zero profit)? [0.5 point]
c.) Suppose the insurance firm does charge the premium you calculated in part (b.), which type of drivers will
decide to buy the insurance? [0.5 point]
d.) What type of problems the insurance company may face according to the results you find in part (c.) of the
exercise? [0.5 point]

EXERCISE 2: SOLUTION
a.) Expected cost (EC) of covering high-risk driver is 0.8*350 = 280
Expected cost (EC) of covering low-risk driver is 0.1*350 = 35

The expected utility (EU) of the two types of drivers are:

High-risk drivers: EU (uninsured) = 0.2∗ √825 + 0.8∗ √475 (825-350) = 23.17 < EU (insured) = √825 − 280 =
23.34
Low-risk drivers: EU (uninsured) = 0.9 ∗ √825+0.1 ∗ √475 = 28.02 < EU (insured) = √825 − 35= 28.10
➔ Both types of drivers will buy the insurance

b.) The insurance firm cannot distinguish a high-risk driver from a low-risk driver.
If all drivers purchase the insurance, the firm’s expected cost (EC) per customer would be:
EC: 0.33 * 280 + 0.67 * 35 = 92.4+ 23.45= 115.85

c.) For high-risk drivers, the expected utility with the new premium is now:
EU (insured) =√825 − 115.85=26.63
High-risk driver would buy insurance, because they have higher utility when they are insured compared to when
they are not.
EU (insured) = 26.63 > EU (uninsured) =23.17
Moreover, high-risk drivers pay a lower premium relative to the one computed in part (a.) of the exercise (115.85
vs. 280) which further increases their incentives to buy the insurance.

For low-risk drivers, the expected utility with the new premium is now:
EU (insured) =√825 − 115.85 = 26.63, which is lower than their expected utility without insurance (28.02), so
they will choose to stay uninsured.
Moreover, low-risk drivers pay a higher premium relative to the one computed in part (a.) which decrease their
incentives to buy the insurance.

7
d.) What type of problems the insurance company may face according to the results you find in part (c.) of the
exercise? In part (c.) of the exercise, only high-risk drivers have incentives to buy the insurance at the premium of
115.85. Therefore, the insurance firm gets a biased selection of customers facing a problem of adverse selection.