BUSINESS AND INDUSTRIAL ECONOMICS

A.Y. 2020/2021
BIE classroom exam – September 9th, 2021

NAME _____________________________________ SURNAME ____________________________________

STUDENT ID_(matricula)___________________________________________________________________

MULTIPLE-CHOICE QUESTIONS [10 points]

You do not need to provide explanations for your answers. However, if something is not clear in the text
and 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 definition of a “relevant market” is mainly based on

a. Companies’ marketing strategies
b. The technology of production
c. Demand-side substitutability
d. Supply-side complementarity
Reference: Module G

2. Which of the following statements on firm’s boundaries is FALSE?

a. The horizontal boundaries of a firm are also determined by cost considerations (e.g., economies of
scale and scope)
b. The vertical boundaries of a firm result from the decisions at each stage of the value chain on how to
produce inputs (distribute outputs). According to the transaction cost theory, a firm has wide vertical
boundaries (i.e., it is highly vertical integrated), when it requires highly-specific assets to produce
inputs (distribute output) at different stages
c. A vertically integrated firm, which owns essential inputs in the upstream market is always less
efficient than another firm in the same industry, which relies on market transactions to obtain
these inputs
d. Tapered integration and franchising contracts are alternative strategies between vertical integration
and market transactions
Reference: Module D (all module)

3. According to Vernon model,

a. Internationalization is worth in the introductory phase of a product life-cycle
b. Locating production in a foreign country is worth if the cost of producing abroad is lower than the
cost of producing domestically, especially in the mature phase of a product life-cycle
c. Internationalization is less likely in the growth phase of a product life-cycle as new firms imitate
competitors’ new products
d. All the other statements are WRONG

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Reference: Module D (slides 69-72)

4. Which of the following statements on the relationship between market structure and innovation is TRUE?
a. Some scholars concur that innovation rates are higher in large concentrated industries than in
competitive markets as large oligopolistic firms have many resources to invest in innovation
b. Some scholars agree that competition incentivizes innovation, because firms in a competitive market
have abundant resources to innovate and protect their innovations. In addition, leveraging on their
position in the market (price-makers), they can set the price of the products, thus being able to repay
their innovation investments
c. The public benefits of innovation are always lower than the private benefits, independently of the
market structure
d. High competition among firms triggered by process innovation characterizes industries at the early
stage of their life
Reference: Module F (all module)

5. In the market, there are four large firms engaging in a collusive agreement. It follows that
a. If the firms play the trigger strategy and the discount factor of future profits is δ, each firm has
incentive to deviate from the collusive agreement if δ > 0.75
b. If the firms play the trigger strategy and the discount factor of future profits is δ, each firm has
incentive to deviate from the collusive agreement if δ < 0.25
c. A firm has less incentive to deviate from the collusive agreement if demand sharply increases
d. All the other statements are WRONG
Reference: Module E (slides 38-47)

6. Fairphone is a high-grow start-up producing innovative smartphones, which it sells at reasonable prices.
Fairphone is located in the Netherlands; it produces and assembles all the components of its smartphones in
house, except for their unbreakable screens. These screens are a crucial source of competitive advantage over
competitors, whose screens usually crash when the phones fall. Fairphone’s supplier of screens is Dolpha
Technology. Dolpha Technology is a medium-size firm (more than 100 employees). It is highly specialized
(the production of smart phone screens account for the 90% of its revenues) and located (headquarter and
production plants) in China. Basing on the description above, we conclude that Fairphone has incentive to
continue to buy the screens from Dolpha Technology. However, there might be risks of opportunistic
behaviours because
a. Geographical proximity between Fairphone and Dolpha Technology favours monitoring
b. If Fairphone cannot rely on other suppliers, Dolpha Technology might have incentive to renege
the terms of its supply contract with Fairphone
c. Specialization, which generates economies of scale, makes Dolpha Technology an efficient producer,
which has incentive to behave opportunistically independently from the downstream market structure
d. All the other statements are CORRECT
Reference: Module C (slides 11-20)

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7. Which of the following statements on managerial firms is TRUE?
a. Managers and owners have necessarily conflicting goals, managers are more informed than owners
on how to run the firm, and managers are risk neutral, while owners are risk adverse
b. Because of their risk attitude, managers tend to undertake diversification moves. Indeed,
diversification implies high uncertainty and risks; this especially occurs when managerial firms enter
unrelated industries where they lack industry-specific knowledge
c. In line with managerial theories, empirical evidence shows that managerial firms always perform
better (i.e., gain higher profits) than owner-controlled firms. Indeed, owner-controlled firms suffer
from information asymmetries as owners have less firm- and industry-specific knowledge than
managers
d. All the other statements are FALSE.
Reference: Module C (slides 30-39), module D (slides 55-56)

8. Which of the following statements is TRUE? In platform businesses,

a. Key technological challenges deal with designing the interface through which participants
interact
b. The exchange of products requires the ownership of these products by the firm running the platform
c. Platform owners can leverage only on their private knowledge; therefore they have no incentive to
facilitate the creation of complementary innovations by third parties
d. All of the other statements are TRUE
Reference: Module E (slides 80-84)

9. Which of the following statements is FALSE?

a. Open-source software (OSS) is an example of a public good, in which individual programmers’
willingness to signal their talent to employers does not mitigate free-riding problems.
b. The production process of a chemical firm pollutes the land that a farm uses to grow its crops. A
solution to this negative production externality is that the farm owns the land and sells pollution rights
to the chemical firm
c. Firms’ R&D investments generate knowledge spillovers, which benefit other firms in the industry.
Therefore, firms have incentives to sign R&D agreements with other firms to alleviate free-riding
problems in R&D investments
d. Public goods, information asymmetries, externalities, and natural monopolies are among the causes
of market failures
Reference: Module B (all module)

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10. Firms 1-6 are active in industries A-F. The table reports firms’ shares of sales in each industry (a blank cell
means that a firm does not operate in an industry, e.g., firm 1 does not operate in industry D). Industries A, B
and C are related industries; the same holds for industries D, E, F. Which of the following statements is
FALSE?
Of note, more than one statement can be false
Firm Industry A Industry B Industry C Industry D Industry E Industry F
1 0.65 0.125 0.225
2 0.14 0.16 0.025 0.675
3 0.2 0.7 0.1
4 0.705 0.025 0.17 0.1
5 0.01 0.01 0.005 0.975
6 0.725 0.125 0.025 0.125

a. Basing on the Herfindahl index (HI), the industries D and F are more concentrated than
industries A and C
b. Firms 2 and 4 have a higher Gort index (D2) than firms 1 and 5
c. According to the Rumelt approach, firms 1 and 2 are related-business firms. Instead, firm 6 is a
dominant-business firm
d. Basing on the Herfindahl index, industry E is the most concentrated one as firm 5 dominates it.
Basing on the Specialization index (SI), firm 5 is the most diversified firm
Reference: Module D (slides 46-49), Module E (slides 34-35)
For the calculation of indexes, see Excel file “Results_Indexes”

EXERCISE 1 [4 points]
A coal-fired power plant jointly produces electricity and air pollution. Air pollution adversely affects a nearby
farm producing agricultural products. Assume that pe = 20 is the price of electricity, pf = 10 is the price of the
agricultural products (both firms are price-takers), Ce (e, x) = e2 + (x2 – 8x) 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.
a.) Suppose there are no property rights on air pollution and thus there is no market for pollution (the price of
pollution is 0). Calculate the produced amount of electricity (e*), agricultural products (f*), pollution (x*)
and the profits (π*), separately for the two firms. [1 point]

b.) Suppose that the two firms merge to internalize the negative externality. Calculate the produced amount of
electricity (e*), agricultural products (f*), pollution (x*) and the overall profit of the merged firm (π*). [1
point]

c.) Suppose that property rights on the air are created and assigned to the farmer who can now sell pollution
rights at price px. Calculate the optimal amount of electricity (e*), the optimal number of agricultural products
(f*), the traded property rights (x*) and the profits (π*) for the two firms. [1.5 points]

d.) Suppose the property rights on air would have, instead, been assigned to the coal-fired power plant. Would
the results you found in point c.) of the exercise be different? [0.25 points] Explain your reasoning. [0.25
points]

4
SOLUTIONS EXERCISE 1

a.) Suppose there are no property rights on air pollution and, thus, there is no market for pollution (the price of
pollution is 0). Calculate the produced amount of electricity (e*), agricultural products (f*), pollution (x*)
and the overall profit (π*), separately for the two firms. [1 point]
The two firms set the level of e*, f* and x* independently from each other. There are no property rights on
air thus the farmer has no control on x*.
We compute the profits of the two firms separately. For the coal-fired power plant we would have that:
𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 2 – 8𝑥)
The coal-fired power plant produces the level of electricity for which the price of electricity equals its
marginal cost:
𝜕𝐶𝑒 (e,x)
𝑝𝑒 = → 20 = 2e → 𝒆∗ = 𝟏𝟎
𝜕𝑒

The coal-fired power plant produces the level of pollution for which the price of pollution equals its marginal
cost (no property rights on air exist and thus there is no market for pollution implying that the price of
pollution is 0):
𝜕𝐶𝑒 (e,x)
0 = 𝜕𝑥
→ −2x + 8 = 0 = 2e → 𝒙∗ = 𝟒

𝛱𝑒 (𝑒, 𝑥) = (20 ∗ 10) − 102 − (42 – 8 ∗ 4) = 𝟏𝟏𝟔$

For the farmer we would have that:

𝛱𝑓 (𝑓, 𝑥) = 10𝑓 − 𝑓 2 − 𝑓𝑥
𝜕𝐶𝑓 (f,x) 𝑥
𝑝𝑓 = → 10 = 2f + x → 𝑓 = 5 −
𝜕𝑓 2
4
As 𝒙∗ = 𝟒, 𝒇∗ = 5 − 2
=𝟑
The external costs for the farmer are f*x= 12$
𝛱𝑓 (𝑓, 𝑥) = (10 ∗ 3) − 32 − 12 = 𝟗$
The total profits are 116$+9$= 125$

b.) Suppose that the two firms merge to internalize the negative externality. Calculate the produced amount of
electricity (e*), agricultural products (f*), pollution (x*) and the overall profit of the merged firm (π*). [1
point]

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) = 20𝑒 + 10𝑓 − 𝑒 2 − (𝑥 2 – 8𝑥) − 𝑓 2 − 𝑓𝑥
Starting from the first-order profit-maximization conditions, we obtain:
𝜕Π(e, f, x)
= 20 − 2𝑒 = 0 → 𝒆∗ = 𝟏𝟎
𝜕𝑒
𝜕Π(e, f, x) 𝑥
= 10 − 2𝑓 − 𝑥 = 0 → 𝑓 = 5 −
𝜕𝑓 2
𝜕Π(e, f, x) 8−𝑓
= −2𝑥 + 8 − 𝑓 = 0 → 𝑥 =
𝜕𝑥 2
5
 8−𝑓
𝑓 =5− → 𝒇∗ = 𝟒
4
8−4
𝑥= → 𝒙∗ = 𝟐
2
𝛱 𝑀 (𝑒, 𝑓, 𝑥) = (20 ∗ 10) + (10 ∗ 4) − 102 − (22 − 16) − 42 − (2 ∗ 4) = 𝟏𝟐𝟖$

e.) Suppose that property rights on the air are created and assigned to the farmer who can now sell pollution
rights at price px. Calculate the optimal amount of electricity (e*), the optimal amount of agricultural products
(f*), the traded property rights (x*) and the profits (π*) for the two firms. [1.5 points]

In this case, the farmer can choose x and its profit function becomes:
𝛱𝑓 (𝑓, 𝑥) = 10𝑓 − 𝑓 2 − 𝑓𝑥 + 𝑝𝑥 𝑥
Starting from the first-order profit-maximization conditions, we obtain:
𝜕Π(f,x)
= −𝑓 + 𝑝𝑥 = 0 → 𝒇∗ = 𝑝𝑥 Supply of farms’ products
𝜕𝑥

𝜕Π(f,x)
= 10 − 2𝑓 − 𝑥 = 0 → 𝒙𝑺 ∗ = 10 − 2𝑝𝑥 Supply of pollution rights
𝜕𝑓

The coal-fired power plant profit function would be:

𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 2 – 8𝑥) − 𝑝𝑥 𝑥
𝜕Π(e,x)
𝜕𝑒
= 20 − 2𝑒 → 𝒆∗ = 10 Supply of electricity

𝜕Π(e,x) 𝑝𝑥
𝜕𝑥
= −2𝑥 + 8 − 𝑝𝑥 = 0 → 𝒙𝑫 ∗ = 4 − 2
Demand of pollution rights

In equilibrium 𝑝𝑥 is such that 𝒙𝑫 ∗ = 𝒙𝑺 ∗

𝑝𝑥
𝒙𝑫 ∗ = 4 − = 10 − 2𝑝𝑥 = 𝒙𝑺 ∗
2

Solving for 𝑝𝑥 we obtain that 𝒑𝒙 = 𝟒

By substitution we obtain that 𝒙𝑫 ∗ = 𝟐
Therefore the profit functions for the two firms are:

𝛱𝑒 (𝑒, 𝑥) = 20𝑒 − 𝑒 2 − (𝑥 2 – 8𝑥) − 𝑝𝑥 𝑥 = (20 ∗ 10) − 102 − (22 − 16) − (4 ∗ 2) = 𝟏𝟎𝟒$

𝛱𝑓 (𝑓, 𝑥) = 10𝑓 − 𝑓 2 − 𝑓𝑥 + 𝑝𝑥 𝑥 = (10 ∗ 4) − 42 − 8 + 8 = 𝟐𝟒$

Total profits is 104$ + 24$ = 128$

f.) Suppose the property rights on air would had instead been assigned to the coal-fired power plant. Would the
results you found in point c. of the exercise be different? [0.25 points] Explain your reasoning. [0.25 points]

No, the results would not change. According to the Coase’s theorem, the same outcome is achieved
independently of which firms was assigned the property rights.

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EXERCISE 2 [3.5 points]
Consider a duopoly situation with two firms (1 and 2) facing the demand curve P = 70 - 5Q, where Q = q1 + q2.
The firms’ cost functions are C1(q1) = 20 + 10q1 for firm 1, and C2(q2) = 10 + 12q2 for firm 2. Please, round off all
calculations to the second decimal and round up where necessary.

a.) Suppose that products are homogeneous and that the two firms (1 and 2) set their quantity level at the same
time. Find the resulting Nash’s equilibrium (quantities, prices, profits). [1.5 points]

b.) Suppose that products are homogeneous and that firm 1 sets its quantity before firm 2. Find the resulting
Nash’s equilibrium (quantities, prices, profits). [1.5 points]

c.) Suppose you are the CEO of firm 2 (the follower in case of b.), which competition regime would you choose?
[0.25 points] Explain why. [0.25 points]

SOLUTIONS EXERCISE 2

a.) Suppose that products are homogeneous and that the two firms (1 and 2) set their quantity level at the same
time. Find the resulting Nash’s equilibrium (quantities, prices, profits). [1.5 points]

Starting from the inverse demand function P = 70 - 5(q1 + q2), firm 1 chooses the quantity q1 that maximizes
its profit function:

𝛱1 (𝑞1 , 𝑞2 ) = ((70 − 5( 𝑞1 + 𝑞2 ))𝑞1 − 20 − 10𝑞1 = 60𝑞1 − 52𝑞1 − 5𝑞1 𝑞2 − 20

From the first order condition, we get firm 1’s best reply function:

∂𝛱1 (𝑞1 , 𝑞2 ) 1
= 60 − 10𝑞1 − 5𝑞2 = 0 → 𝑞1 = 6 − 𝑞2
∂𝑞1 2

Similarly, firm 2 chooses the quantity q2 that maximizes its profit function:

𝛱2 (𝑞1 , 𝑞2 ) = ((70 − 5( 𝑞1 + 𝑞2 ))𝑞2 − 10 − 12𝑞2 = 58𝑞2 − 52𝑞2 − 5𝑞1 𝑞2 − 10

From the first order condition, we get firm 2’s best reply function:

∂𝛱2 (𝑞1 ,𝑞2 ) 1

∂𝑞2
= 58 − 5𝑞1 − 10𝑞2 = 0 → 𝑞2 = 5.8 − 2
𝑞1

By solving the system with the two best reply functions, we obtain:
3.1
𝑞1 = 6 − 0.5 (5.8 − 0.5𝑞1 ) → 𝑞1 = 0.75 = 4.13
𝑞2 = 5.8 − 0.5 ∗ 4.13 = 3.73

The Cournot equilibrium quantities are 𝑞1 = 4.13 and 𝑞2 = 3.73

Hence, the quantity Q = 4.13 + 3.73 = 7.86 is sold at the price pC = 30.7 , which is the same for both firms,
and the two firms get the profits:

𝛱1𝐶 =P*q1-C1= 126.79 − 20 − 41.3 = 65.49 $

𝛱2𝐶 =P*q2-C2= 114.51 − 10 − 44.76 = 59.75 $

7
b.) Suppose that products are homogeneous and that firm 1 sets its quantity before firm 2. Find the resulting
Nash’s equilibrium (quantities, prices, profits). [1.5 points]

The game is solved via backward induction, that is, starting from the second stage:

q2= 5.8 - 0.5*q1. (see the first order condition of firm 2 in point a.)

Going to the first stage of the game, we find the optimal price for firm 1 by plugging in the best reply
function of firm 2 in the profit function of firm 1:

𝛱1 (𝑞1 , 𝑞2 ) = ((70 − 5( 𝑞1 + 𝑞2 ))𝑞1 − 20 − 10𝑞1 = ((70 − 5( 𝑞1 + 5.8 − 0.5𝑞1 ))𝑞1 − 20 − 10𝑞1

= 31𝑞1 − 2.52𝑞1 − 20

From the first order condition, we get the optimal level of q1:
∂𝛱1 (𝑞1 ,𝑞2 ) 31
∂𝑞1
= 31 − 5𝑞1 = 0 → 𝑞1 = 5
= 6.2

from which it is possible to derive the optimal quantity for firm 2:

𝑞2 = 5.8 − 0.5 ∗ 6.2 = 2.7

In equilibrium, the overall quantity Q = q1 + q2 = 6.2 + 27 = 8.9

The quantity will be sold at the price P= 70- 5q → P = 70 - 5*8.9 = 25.5.

𝛱1𝑉𝑆 =P*q1-C1= 158.1 − 20 − 62 = 76.1 $

𝛱2𝑉𝑆 =P*q2-C2= 68.85 − 10 − 32.4 = 26.45 $

c.) Suppose you are the CEO of firm 2 (the follower in case of b.), which competition regime would you choose?
[0.25 points] Explain why. [0.25 points]

q1 q2 Q P 𝛱1 𝛱2
Cournot 4.13 3.73 7.86 30.7 65.49 59.75
Von Stackelberg 6.2 2.7 8.9 25.5 76.1 26.45

Firm 2 would rather choose to play a Counot game. In the VS game firms 2 is the follower and can only respond
to the quantity set by firm1, the leader, benefiting from the first mover advantage. The CEO of firm 2 would
therefore prefer the Cournot’s regime that enables to gain a higher profit.

8
EXERCISE 3 [2.5 points]

Consider a second-hand market for motorbikes. There are high-quality motorbikes, which buyers value at most
15,000 $, and low-quality motorbikes, which buyers value at most 6,000$. High-quality sellers will accept 10,000
$, while low-quality sellers will accept 5,000 $. Assume that buyers cannot observe quality before purchasing.

a.) What is the maximum fraction of low-quality motorbikes up to which sellers will still have incentives to sell
high quality motorbikes? [1.5 point]
b.) Based on the fraction of low-quality motorbikes you computed in point a.) of the exercise, what is the
buyers’ expected value? [1 point]

SOLUTIONS EXERCISE 3
a.) What is the maximum fraction of low-quality motorbikes up to which sellers will still have incentives to sell
high quality motorbikes? [1.5 point]

Assume that q is the fraction of low quality cars and 1-q is the fraction of good quality cars.
The EV of buyers of any car is:

EV= $6,000q + $15,000(1-q) = $15,000 - $9,000q

EV= $15,000 - $9,000q= $10,000 ($10,000 is the minimum that sellers accept for high quality motorbikes)

Solving for q we obtain that q= 5/9 = 0.55

The fraction of bad quality car is 0.55 which implies that 1-q is the fraction of good quality cars, that is 0.45.

b.) Based on the fraction of low-quality motorbikes you computed in point a.) of the exercise, what is the
buyers’ expected value? [1 point]

Buyers’EV is:
EV= 0.45*$15,000 + 0.55 * $6,000 = 10,050$
The buyers’ EV is slightly higher than the minimum that sellers accept for high quality motorbikes and for low
quality motorbikes. This condition enables that both types of motorbikes are sold in the market.

Do you want your submitted exam to be corrected?

a. Yes, I want
b. No, I withdraw