This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON 279 0099 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 for
External Students

Industrial Economics

Monday, 6 June 2011 : 2.30pm to 5.30pm

Candidates should answer FOUR of the following EIGHT questions. All questions carry
equal marks.

© University of London 2011

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1. Answer both parts.

(a) ‘While profit maximization is often taken to be the goal of the firm in standard industrial
economics models, this is an unrealistic and misleading view of firm behaviour in the real
world.’ Discuss this statement, pointing out reasons why profit maximization is or is not a
reasonable hypothesis of firm behaviour. (13 marks)

(b) Alice owns a restaurant and needs to hire a new waiter. Bob is considering working for
Alice. Currently, Bob is working in a job where he can make £20,000 a year without
exerting any effort. Alice offers to pay Bob a base salary of £16,000 a year plus tips
(which are £10 per table served) if Bob serves at least 1,000 tables over the year. If Bob
serves less than 1,000 tables, Alice can see this and she will pay him no base salary. Of
course, Bob can still keep his tips. Bob’s cost of effort is C(t) = t2/200, where t is the
number of tables served. Show that Bob will accept this contract and serve exactly 1000
tables. (12 marks)

2. Answer both parts.

(a) Consider two firms producing a homogeneous good and competing by setting prices each
period for an infinite number of periods. Each of the two firms owns a minority share k of
its rival. This share is small so that each firm keeps full control of its own activities and
decisions; the rival just receives share k of the firm’s profits. Analyse how this pattern of
cross-ownership affects the likelihood of collusion between the two firms. (10 marks)

(b) To produce a certain homogeneous final good, n manufacturers need two complementary
technologies. The patents for these are held by two firms, A and B, that separately license
the technologies at a per unit royalty fee wi (i = A, B). The game is as follows. At stage 1,
the patent holders simultaneously and independently decide the level of the royalty. At
stage 2, the manufacturers compete by simultaneously setting prices and incur marginal
production costs c + wA + wB, where c is a constant. They face market demand q = 1 – p.
As usual, if several manufacturers all charge the same lowest price, demand is equally
shared among them; manufacturers having higher prices have zero demand.

i. Find the equilibrium levels of royalty fees and final prices.

Consider now an alternative situation where the two patent holders assign the exploitation
of their patents to a patent pool. It is now the pool that sets the levels of both royalties.

ii. Find the equilibrium levels of royalties and final prices under the patent pool and
compare them with the situation in part i.

iii. Show that forming the patent pool is both profitable for the patent holders and good
for consumers.
(15 marks)

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3. Answer both parts.

(a) Suppose two operators offer differentiated services and compete in prices in the
telecommunications market. Using reaction curves, analyse how a price cap imposed on
one of the two firms affects the equilibrium prices and profits. (10 marks)

(b) Assume a franchise is to be auctioned off. Market demand is Q = 100 – P, where Q is the
quantity of the good demanded when the price is P. Suppose there are just two firms
competing for this franchise. Firm 1’s cost function is C1 = 100 + q1 and firm 2’s cost
function is C2 = 12q2, where qi is the output of firm i. The franchise is auctioned off using
an auction where the firm offering the lowest price per unit of output wins the franchise.

i. Who will win the franchise and what will the winning bid be?

ii. Now suppose the government decides to issue the franchise to the firm that offers the
largest lump sum fee to the government. The franchise owner is then free to charge
any price per unit of output. Who will win the franchise and what will the winning
franchise fee be?
(15 marks)

4. Suppose that you are the CEO of Cellco, a wireless communications company located in
Valleytown. Since Valleytown is surrounded by mountains from all sides, only your company
can provide cellular phone service for the local consumers. There are two types of customers:
business customers (B) who value each minute of communication at vB = £0.15, and personal use
customers (P) who value each minute of communication at vP = £0.10. That is, if customer of
type i (i is either B or P) talks q minutes per month and pays a monthly fee p, her utility is Ui =
vi q − p.

You do not know which customer is which type and would like to offer two different plans: a
business plan which provides qB = 1200 minutes for the flat monthly fee pB and a personal use
plan which provides qP = 800 minutes for the flat monthly fee pP. You want business customers
to choose the business plan and personal use customers to choose the personal use plan. For
simplicity, assume that your customers never want extra minutes.

(a) Your marketing manager proposes to charge business customers pB = £180 and personal
use customers pP = £80. Will this achieve your aims? Why or why not?

(b) Can you find the profit-maximizing way to price the two plans, so that each type of
customer takes the plan designed for her type?

(c) Flipping through the Valleytown Yellow Pages, you realize that you have nB = 100
business customers. What is the minimum number of personal use customers that you need
to have in order to prefer to offer two different plans as opposed to just a business plan?

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5. Consider an industry with inverse demand given by p = 12 − Q. There are two firms: the
incumbent (I) and a potential entrant (E). The incumbent moves first by choosing a level of
quantity qI from the interval [0, 4]. The entrant observes qI and decides whether or not to enter
and how much to produce if it enters (qE). There is no fixed cost of entry. If the entrant decides
to stay out, its profit is zero and the incumbent enjoys a monopoly position. Suppose that both
the incumbent and the entrant have identical marginal costs equal to c = 8.

(a) Derive the subgame perfect equilibrium of this game? What are the quantities produced by
the incumbent and the entrant? What are their profits?

(b) What is the minimum quantity that must be produced by the incumbent to deter entry?
Will the incumbent ever try to deter entry by increasing quantity?

Now suppose that before the above two-stage game begins the incumbent can purchase new
equipment: it can either stay with the old equipment that leaves its marginal cost at c = 8 or
spend an additional amount K = 5 on new equipment which cuts its marginal cost to cL = 6.

(c) If the incumbent purchases new equipment and anticipates entry, what quantity does it
produce? Will it successfully deter entry? What is the incumbent’s payoff?

(d) Will the incumbent choose to purchase new equipment before the two-stage game begins?
Explain why or why not.

6. ‘Vertical restraints can be used to increase efficiency in a market, but they may also restrict
competition.’ Discuss, with reference to economic theory as well as any relevant empirical
evidence.

7. Answer both parts.

(a) Competition law in the country of Wonderland prohibits all mergers that result in a single
firm having more than 75% of any market. Assess this law from a welfare perspective.
What would your advice be to a new government that proposes to make changes to this
law? (10 marks)

(b) Suppose there are three identical firms thinking about entering a market in which there is
no incumbent firm. There is a small but positive cost of entry F. The product is
homogeneous, with inverse demand p = 1 – Q, where Q is aggregate quantity. Unit cost is
zero.

i. Suppose the firms compete in prices if they enter. Determine the number of firms
that enter, and compute the equilibrium price and profits per firm.

ii. Suppose that firms compete in quantities if they enter and F = 1/20. Determine the
number of firms that enter, and compute the equilibrium price and profits per firm.

iii. How does the equilibrium in (ii) change if F = 1/10?

iv. Comment more generally on how the equilibrium level of concentration in a market
depends on the size of the sunk cost and the intensity of price competition.
(15 marks)

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8. Explain the rationale for government policy toward research and development in the form of:

i. a patent system, and

ii. R&D subsidies.

Then discuss the advantages and disadvantages of these policies, citing examples where
appropriate and discussing circumstances under which each of these two systems might
dominate.

END OF PAPER

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