Examination papers and

Examiners’ reports
Industrial economics
2790099
2002, 2003, 2004

Undergraduate study in
Economics, Management,
Finance and the Social Sciences
 Examination papers and Examiners’ reports 2004

Examiner’s report 2004

Zone A

General comments
The 2004 examination in Industrial economics was designed to cover the
whole of the syllabus. There was a choice of eight questions of which four
were to be attempted. Some of these were problem-type questions, while
others were essay-type questions.
In general, problem-type questions are 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. Please note that some of the calculations are omitted in the
answers below to save space. When you answer problem-type questions in an
examination, all the necessary steps must be shown. Moreover, you 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
A good answer to this question should start by explaining what the
transaction costs-property rights approach to the theory of the firm tries to
do: to provide an explanation for the size and structure of firms. The three
key elements of the transaction costs approach should then be mentioned
and discussed: investment specificity, opportunistic behaviour, and bounded
rationality. This discussion should lead to a statement of the key theoretical
prediction of the transaction costs approach: the more specific the
investments required for the production and sale of a product, the higher the
probability of integration (i.e. common ownership) as opposed to a
contractual relationship between separate firms. A very good answer might
also give an outline of an appropriate formal model, such as the one
presented in Chapter 1 of the subject guide, to illustrate these ideas.
The answer should also clarify why integration solves or reduces the problem
of potential opportunistic behaviour by a reference to the literature on
property rights. The final part of the question asks for a discussion of
empirical evidence on the transaction costs-property rights approach. Some
empirical evidence, which is consistent with the theory, is discussed in the
subject guide, and students are welcome to discuss other empirical work as
well.

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99 Industrial economics

Question 2
a. Each firm i chooses q to maximise Wi = q (P – c) = q (a – q – q – … –
i i i 1 2
q – c). The first-order condition for this maximisation problem is
N
,Wi
= a < 2qi < -q j <c= 0
, qi j &i

There are N such first-order conditions, one for each firm, and the Nash
equilibrium is the solution of the system of the N equations. Because the
firms are symmetric, the solution to this system must be a symmetric
solution, i.e. all firms will choose the same level of output, say q. Hence
the first-order condition for firm i can be written as a – (N + 1)q – c =0,
a<c
which gives the equilibrium quantities q* = .
N +1
To obtain the equilibrium price and profit, substitute q* into the
demand function and the profit function Wi = q (P < c). Then
i
differentiate the expressions you derived with respect to N and show
that the derivatives are negative.
b. According to the model in part (a), a decrease in the number of firms
(i.e. a rise in industry concentration) leads to higher profit for each firm
and higher industry profit. There are also at least two alternative
mechanisms that can generate a positive link between concentration
and profitability. First, an increase in concentration may facilitate
collusion between firms and, hence, in the absence of additional entry,
lead to an increase in profitability. Second, an increase in the degree of
cost asymmetry among firms in an industry could raise both
concentration and industry profit – but note that this would imply a
correlation between the two variables, not a causal link.
On the other hand, higher industry concentration is not always
associated with higher profitability. To see this, one needs to treat
concentration as an endogenous variable which is determined by a
number of exogenous variables such as the size of the market, the level
of sunk costs and the degree of competition in an industry. According to
this approach (outlined in Chapter 9 of the subject guide), the profit of
each firm is determined by a free-entry condition, so it depends largely
on the level of entry costs, not concentration. In fact, since
concentration may be the result of intense competitive pressure, it is
even possible for industry profitability to be lower when concentration
is higher – provided there is free entry.

Question 3
a. If both firms operate in both markets, standard calculations give
equilibrium profit of each firm in market 1 equal to 16/9 and equilibrium
profit of each firm in market 2 equal to 1. So the total profit of each firm
in the absence of collusion is equal to 25/9 (ignoring fixed costs).
Monopoly profit in market 1 is equal to 4 and monopoly profit in market
2 is equal to 9/4 (again ignoring fixed costs). So firm B would have
lower profits under the offer.
b. Despite this, firm B may accept the offer of firm A, if it faces significant
fixed costs in market 1, as in this case its net profit (i.e. after taking
fixed costs into account) might increase under the offer. To analyse
whether such an arrangement would be sustainable, one needs to
analyse competition between the two firms as a repeated game (using a
model similar to that outlined in Chapter 4 of the subject guide), and
examine the incentives of the firms to cheat on their agreement.

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 Examination papers and Examiners’ reports 2004

Question 4
The discussion of entry deterrence by product proliferation in Chapter 6 of
the subject guide provides the basic outline of the answer.

Question 5
a. Since demand in each period is independent of the other period, the
monopoly price in each period can be calculated independently, and
with the given specification it is the same in each period. The profit-
maximising monopoly price is (a + c)/2 = 4.
b. If the incumbent is committed to a fixed price, then by charging a
slightly lower price the entrant can attract the entire market. To deter
entry, therefore, the incumbent must set a price such that any slightly
lower price offered by the entrant will result in negative profits for the
entrant; in other words, we need to calculate the price such that
(p < c)qE < FE = 0.
Given the specification of the demand and cost functions, this implies
(6 < qE < 2) qE < 7/4 = 0, which is a quadratic equation with solutions
E
q = 1/2 and 7/2. It can be checked that it is the larger root which will
deter entry. For an output of 7/2 in each period, the price will be 5/2.
At any price lower than this, the entrant would make negative profit.
c. The incumbent has two plausible choices: (i) charge the monopoly price
and make the monopoly profit in period 1, and then lose the entire
market in period 2, or (ii) charge the entry-deterring price.
If the incumbent charges the monopoly price in period 1, its (gross)
profit will be 4, and the fixed cost is 3, so total profit will be 1. (Having
committed to that price and realising that there will be entry in period 2
and that the entrant will set a slightly lower price, the incumbent will
not produce anything in period 2.)
If the incumbent charges the entry-deterring price in period 1, there will
be no entry in period 2 and the incumbent will make a profit of 7/4 in
each period. The fixed cost is 3 in each period, so total profit will be 1/2.
Thus it is more profitable to charge the monopoly price in period 1 and
permit entry in period 2 than to deter entry.
d. For hit and run entry to be feasible in an industry with increasing
returns to scale, the entrant must be able to attract a large enough share
of the market at a high enough price in order to recover the entry costs
which have been sunk. (If there are constant or decreasing returns to
scale then the market can sustain many competitors at all times.) If
prices are easily adjusted then the period of time available for the
entrant to make money will be short, and so either the sunk cost of
entry must be small or hit and run entry is not feasible.
In most industries characterised by increasing returns to scale, the sunk
costs are usually large. However, if the assets required for production
can be leased for short periods at competitive prices (e.g. airlines), then
hit-and-run entry may be feasible.

Question 6
a. The monopolist’s profit function is
W = p1 q 1 + p 2 q 2 = p1 (a < bp 1 + dp 2 ) + p 2 ( a < bp 2 + dp 1 )
The monopolist chooses p and p to maximise this profit. The first-
1 2
order conditions are given by and . Solving this system of two
M a
equations, we obtain p1 = p2 = p = .
2 (b < d )

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99 Industrial economics

b. Firm 1 chooses p to maximise W = p (a – bp + dp ) taking p as given,

1 1 1 1 2 2
while firm 2 chooses p to maximise W = p (a – bp + dp ), taking p as
2 2 2 2 1 1
given. The first-order conditions are, respectively, ,W 1 / ,p1 = 0 and
,W 2 / ,p 2 = 0 . Solving this system of simultaneous equations, we
a
obtain the Bertrand-Nash equilibrium prices p* = . It is easy
2 (b < d )
to check that p* < pM ‹ d > 0, which is true.
c. In the second stage of the two-stage game, firm 2 chooses p2 to
maximise W2 = p2(a – bp2 + dp1), taking p1 as given. The first-order
condition is ,W 2 / ,p 2 = 0 , which we solve for p2 to obtain the reaction
function of firm 2:
a + dp 1
p2 =
2b

In the first stage, firm 1 chooses p to maximise W = p (a – bp + dp ),

1 1 1 1 2
anticipating that firm 2 will then choose p2 according to its reaction
function. In mathematical terms, firm 1 therefore chooses p to
1
maximise
• d ( a + dp 1 ) —
W 1 = p1 ³ a < bp 1 + µ
³– 2b µ˜

The solution to this maximisation problem is given by setting

,W 1 / ,p1 = 0 . We get
a ( 2b + d )
p1 =
2 ( 2b 2 < d 2 )
.
Question 7
This question is something between an essay-type question and a problem-
type question. The answer to the first part must make use of the particular
model outlined in the question, while the second part requires a more
general discussion.
a. The model is the same as that used in the subject guide, Chapter 7,
pp.63–65. The discussion in the subject guide also provides the basic
outline of the answer. Using the notation in the subject guide, uniform
pricing results in an overall profit of NA = NS (c), while tying gives a
1
profit of WSD.
One could also point out that there is a very simple argument that
shows that the monopolist must be better off with a tying arrangement
than with uniform pricing. The general problem of the monopolist
under tying is to choose the price p of the complementary good so as to
maximise
W = NS (p) + (p – c)D(p) – Nc
1 0
This leads to an optimal price p* > c. Under uniform pricing, the
monopolist is constrained to set p = c and derives all his profit from the
basic good, whose price is A = S (c). Thus, under uniform pricing
1
everything is as if the monopolist is faced with the problem of
maximising the above profit function and does not, in fact, do so, since
he chooses p = c instead of p* > c.
b. A more general discussion is required here, although some basic
arguments can be made with reference to the model of part (a). The
fact that p* > c implies that welfare is unambiguously lower under tie-
in sales if both consumer types are served. On the other hand, if tie-in

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 Examination papers and Examiners’ reports 2004

sales are not allowed, the chances increase that the firm will choose to
serve the e types only, so welfare could in fact increase under tie-in
H
sales.

Question 8
A good answer should include a brief review of some basic concepts in the
theoretical analysis of the determinants of market structure: the distinction
between short-run and long-run decisions, the distinction between
exogenous sunk cost industries and endogenous sunk cost industries, and the
bounds approach. The core of the answer should focus on the determinants
of market structure in advertising-intensive industries, and include a
discussion of the relationship between market size and the level of
concentration in these industries. You should then discuss in what ways the
theoretical predictions for advertising-intensive industries differ from those
for exogenous sunk cost industries.
The final part of the question asks for a brief discussion of empirical
evidence. Some empirical evidence (which is consistent with the theory) is
discussed in Chapter 9 of the subject guide, and students are welcome to
discuss other empirical work as well.

Examination paper for 2005

There will be no change to the format, style or number of questions in the
examination paper for 2005.