~~EC3099 ZB d0

This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON EC3099 ZB

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route

Industrial Economics

Tuesday, 28 May 2013 : 2.30pm to 5.30pm

Candidates should answer FOUR of the following EIGHT questions, including at least ONE
from Section A, ONE from Section B and TWO further questions from either section. All
questions carry equal marks.

If more questions are answered than requested, only the first answers attempted will be counted.

PLEASE TURN OVER

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SECTION A

Answer one question and no more than two further questions from this section.

1. Describe how the existence of capacity constraints can allow firms in a homogeneous good industry to
set price above marginal cost and make positive profits. Then comment briefly on how this analysis
can provide a foundation for the widely used Cournot model of oligopoly. (25 marks)

2. Answer all parts:

(a) ‘It is reasonable for competition policy to be tougher on horizontal mergers than on vertical
mergers because the effects of increasing concentration are more ambiguous for vertical
mergers.’ Do you agree or disagree with this quote? Explain your answer. (9 marks)

(b) Can barriers to entry be welfare improving? Explain why or why not. (8 marks)

(c) ‘Consumers should welcome a firm’s offer to meet a competitor’s prices, as this guarantees
more competitive outcomes in the industry.’ Do you agree or disagree with this quote? Explain
your answer. (8 marks)

3. Answer all parts:

(a) Consider an industry of N ≥ 2 firms with different marginal costs selling a homogeneous good
and competing in prices. Show that in any Nash equilibrium of this game at least one firm makes
zero profit. (6 marks)

(b) ‘Third degree price discrimination can lower both a monopolist’s profit and consumer surplus
compared to uniform pricing.’ Do you agree with this statement? Explain your answer.
(6 marks)

(c) A manufacturer produces a homogeneous good at constant unit cost c and sells to a single retailer
at price w. The retailer resells the good to final consumers at price p. No services are provided by
the retailer. Using this setup, explain why ‘double marginalisation’ creates inefficiency for the
firms and also reduces consumer welfare. Describe how double marginalisation can be
eliminated. What additional complications arise when the retailer can also provide pre-sale
services that increase the demand for the product? (13 marks)

4. Describe, with reference to theory as well as empirical evidence, the ways in which competition and
regulation may interact. Include in your answer a discussion of situations where the two are viewed as
substitutes, as well as of situations where they are viewed as complements. (25 marks)

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SECTION B

Answer one question and no more than two further questions from this section.

5. Consider the following model of a vertical relationship between a buyer and a seller. There are two
periods and the two parties can, if they wish, trade one unit of an indivisible good in period 2.
Let v denote the value of the good to the buyer, c the production cost, and p the trading price.
Assume that c < 1/2. Both c and v are commonly known at the beginning of period 2. The seller can
invest in period 1 to increase the value of the good to the buyer (for instance, he can spend on R&D to
increase the quality of the product). In particular, v(I) = 3I  I2/2. The level of investment I cannot be
specified in a contract because it is not verifiable and therefore such a contract would not be
enforceable in court.

(a) What is the efficient level of investment? (7 marks)

(b) In the absence of any contract, what is the level of investment chosen by the seller if the ex post
surplus is to be divided equally between the two parties? Explain why this level is not efficient.
(10 marks)

(c) Suppose that the parties sign a contract which gives to the seller the right to choose the trading
price in period 2 (i.e. after the investment has been made). What will be the level of I chosen by
the seller? Explain the intuition for this result. (8 marks)

6. A monopolist sells to customers located in two different countries in Europe. Production and transport
costs are zero. There is a fixed cost F of operating in country 1 and a fixed cost G of operating in
country 2. The demand functions for the good in each country are q1 = 1 – p1 and q2 = 1/2 – p2.

(a) If the monopolist engages in third degree price discrimination, calculate the profit-maximising
price, profit and consumer surplus in each country. Under what conditions on F and G does the
firm choose to serve both markets rather than operate in only one of the markets? (9 marks)

(b) Now suppose the European Commission forbids different prices within the European Union.
Calculate the new profit-maximising price, profit and consumer surplus. (8 marks)

(c) Does this restriction make it more or less likely that the firm chooses to serve both countries? To
answer this, derive the specific conditions on F and G and compare them to part (a). What do
you conclude about the welfare effects of third degree price discrimination? Are these results
general, or specific to this case? Explain your answer. (8 marks)

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7. Two firms producing a homogeneous good compete in a two-stage game. In stage 1, firm 1 can
purchase cost-reducing capital equipment k. In stage 2, firms compete by simultaneously choosing
quantities. Firm 1’s total cost (including the cost of the capital equipment) is q1(2 – k/4) + k2/18, where
q1 is firm 1’s output. Firm 2’s cost is 2q2, where q2 is firm 2’s output. Market (inverse) demand is
given by P = 50 – 2Q, where Q = q1 + q2.
(a) Derive the firms’ reaction functions for the game in stage 2. What is the effect of k on the
reaction functions? Illustrate your answer with a plot of the reaction functions for different levels
of k. (6 marks)
(b) Find the subgame perfect equilibrium quantities. What is the level of investment, k, that firm 1
makes at stage 1? (7 marks)
(c) Now suppose the firms play a three-stage game. In stage 1, the incumbent firm 1 purchases cost-
reducing capital equipment k. In stage 2, firm 2 decides to enter or not. If firm 2 enters, the firms
compete by simultaneously choosing quantities in stage 3. If firm 2 does not enter, firm 1 is a
monopolist in stage 3. Market demand and cost functions are given as before. There is no entry
cost for firm 2. What level of k would firm 1 have to choose in order to deter firm 2 from
entering? Should (or can) firm 1 deter entry? (6 marks)
(d) How might your answer in part (c) change if firm 2 had to incur a positive entry cost F to enter
the industry at stage 2 of the game? Explain. (6 marks)

8. Consider the following model of vertical product differentiation. Consumers are uniformly distributed
with density S (a measure of market size) over the interval (L, H), where H = L + 1. Consumer i is
characterized by a taste parameter i and obtains utility ui(s, p) = is – p from purchasing a good of
quality s at price p. Note that the parameter  can be interpreted as consumer income. There are two
firms, 1 and 2, each producing one good of differing qualities s1 and s2, where s2 > s1. The marginal
cost of production for each firm is c. The two firms compete by simultaneously setting prices.
(a) Assume that each consumer buys a single unit of the good. Show that the demand functions for
the products of firms 1 and 2 are given, respectively, by:
 p  p1   p  p1 
D1(p1, p2) = S  2   L  and D2(p1, p2) = S  H  2 .
 s 2  s1   s 2  s1 
(Hint: define the ‘marginal consumer’ who is just indifferent between buying from firm 1 and
buying from firm 2.) (6 marks)
(b) Compute the Nash equilibrium prices. What condition is required to ensure that all consumers
buy one unit of the good, i.e. that there are no consumers who prefer not to buy? What condition
is required to ensure that both firms have positive demand? What can you conclude, more
generally, about the effect of consumer taste (or income) heterogeneity on the number of firms in
vertically differentiated markets? (7 marks)
(c) Compute the Nash equilibrium profits. Explain how profits depend on the qualities s1 and s2.
(6 marks)
(d) How does market size S affect equilibrium demand, price and profits? How does this and
previous results relate to the ‘finiteness property’ of many models of vertical product
differentiation? (6 marks)

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