BUSINESS AND INDUSTRIAL ECONOMICS

Final exam
July 20th 2020

NAME AND SURNAME (personal code)

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Multiple choice questions

1) Two firms compete in a Stackelberg duopoly facing the following demand function: P = 10,100 –
500Q. Both the leader and the follower have the following total cost function: TC = 100Q i . The
quantity produced by the leader is:

a) Two times the quantity of the follower. BONUS

b) Three times the quantity of the follower.
c) Four times the quantity of the follower.
d) All the three other options are incorrect.

2) All of the following couples of concepts are linked by common theoretical foundations or
significant similarities, apart from one. Which one is it?

a) Bounded rationality and routines.

b) Ownership advantage and factor of competitive advantage.
c) Path-dependence and alignment of incentives. BONUS
d) Transaction cost evasion and internalization advantage.

3) In June 2022 three firms are active in the production of “clever sunglasses” which will be soon
launched in the market; each firm is producing and planning to launch a different version. At first
glance, they appear as normal sunglasses (and they can be used in that way) but once “switched on”,
they become “smart” and allow the user to access multimedia content (software, movies, videos, etc.).
The cleversunglasses are constituted by an operating system and by applications which are clickable
with simple “eyes movements”. The three firms have adopted three different operating systems,
which are not technically compatible: the software written for the operating system A cannot be read
by operating systems B and C, and vice versa. However, once a software is produced for A, the costs
of conversion to the other operating systems is null. Finally, it is worth noting that the price at which
the cleversunglasses will be commercialized will be fairly high relatively to normal sunglasses, but
on the other hand the three companies are going to launch the three versions at a similar price. Note
also that the main software producers have declared to be eager (i.e. to wish) to adopt a multi-homing
strategy. On the basis of this information, please gauge the soundness of the following propositions:

a) Because of the presence of indirect network externalities, it is very likely that the value of the
market will significantly increase in the near future; and it is also very likely that the market
will soon evolve towards a “winner takes all” equilibrium.
b) Notwithstanding the presence of indirect network externalities, it is not sure that the value of
the market will significantly increase in the near future; nevertheless if this were the case, it
is very likely that the market will soon evolve towards a “winner takes all” equilibrium.
c) Notwithstanding the presence of indirect network externalities, it is not sure that the value of
the market will significantly increase in the near future; in any case, it is not necessarily true
that the market will soon evolve towards a “winner takes all” equilibrium. BONUS
 d) Because of the presence of indirect network externalities, it is very likely that the value of the
market will significantly increase in the near future; in any case, it is not necessarily true that
the market will soon evolve towards a “winner takes all” equilibrium.

4) Consider a monopolist with demand: Q = 120 – 2p and marginal cost: MC= 40. Suppose that the
monopolist can perfectly price discriminate consumers. The social welfare will be equal to:

a) 0.
b) 400. BONUS
c) -200.
d) All the three other options are incorrect.

5) The estimated demand function for a given prospected service is given by: Q = 4 – p. In the market
there is only one firm in the condition to deliver this service. The total cost function of this firm is
given by the following expression: TC(Q) = 4 + Q2. Based on the economics reasoning, and on the
comparison between the average cost curve and the demand curve, please gauge the following
statements:

a) This market should not exist from a social welfare point of view. BONUS
b) This market should exist from a social welfare point of view and it is a natural monopoly.
c) This market should exist from a social welfare point of view but it is not necessarily a natural
monopoly.
d) This market should not exist from a social welfare point of view unless it is organized as a
natural monopoly.

6) Which of the following is not a characteristic of the ‘emissions trading’ (i.e. tradeable permits)
policy instrument?

a) It involves a mechanism whereby the permits available are initially distributed to producers
who are potential emitters of a given pollutant.
b) The price mechanism for tradeable emissions permits helps to allocate the restricted supply
of permits to those who most value them.
c) All producers are required to be equally efficient in reducing emissions of the pollutant.
BONUS
d) The right to pollute can be transferred between different parties at a price determined by the
market in tradeable emissions permits.

7) The “replacement effect” (Arrow, 1962) is the only fundamental concept behind which one of the
following statements:

a) Monopoly has more resources than perfect competition to devote to innovative activities.
b) Perfect competition exerts greater incentives than monopoly in spurring innovative activities.
BONUS
c) The relationship between intensity of competition and innovation is U-shaped.
d) The relationship between intensity of competition and innovation is inverted U-shaped.

8) An insurance company aims at introducing a new health insurance in the market. The insurance
company believes that with probability 50% prospective consumers are high-risk patients, with
probability 50% low-risk patients. For a high-risk patient the health insurance is worth 10,000$,
whereas for a low-risk patient, the value is 2,000$. For the insurance company, the cost of providing
insurance is 11,000$ for a high-risk patient and 0$ for a low-risk patient. Based on these numbers,
the insurance company is considering two possible prices for the new health insurance: 5,700$ or
15,000$. Considering the only (Bayesian)-Nash equilibrium of the sequential game, tell which will
be the price charged for the health insurance (p) and who will buy the new health insurance:

a) p = 5,700$; only low-risk patients will buy the new health insurance.
b) p = 5,700$; both low-risk and high-risk patients will buy the new health insurance.
c) p = 15,000$; neither low-risk nor high-risk patients will buy the new health insurance.
BONUS
d) p = 15,000$; only low-risk patients will buy the new health insurance.

9) According to the classification of transactions (Williamson, 1986), transactions will be governed

by the market only when:

a) Both relationship-specific investments and frequency of transactions are low.

b) Relationship-specific investments are high and frequency of transactions is low.
c) Relationship-specific investments are low, unregardless of the frequency of transactions
which can be low or high. BONUS
d) Relationship-specific investments are low and frequency of transactions is high.

10) Please evaluate the following statements about innovation policy, selecting the most appropriate:

a) One of the major advantage of selective policy measures (i.e. grants) is to enable the policy
maker to indulge in “cherry picking”.
b) One of the major advantage of selective policy measures (i.e. grants) stems from the fact that
they are neutral to the market, so by definition, they do not entail the possibility to introduce
errors or distortions in the market.
c) One of the major advantage of automatic subsidies (i.e. tax credits) is that they do not
complicate the tax system.
d) All the three other options are incorrect. BONUS.
 Structured question

Note: for points c) and d), develop the reasoning step by step (i.e., don’t use shortcut formulas).

a) Define the concept of reaction function and explain its purpose and relevance in the context
of duopolies. Also, develop insight into the applicability of this concept in the real world.

b) Intuitively (without any kind of formalization) explain why, ceteris paribus, the leader is
always better-off in a Stackelberg oligopoly with respect to the baseline Cournot oligopoly
scenario.

c) The market for virtual reality devices has just emerged, and Zorn and Thorn are the only two
companies competing in it, according to a classic Cournot duopoly. The market is
characterized by the following inverse demand function: P = 200 – 3Q, where Q denotes the
total quantity produced in the market. Each firm faces total costs equal to 20 multiplied by the
quantity it decides to produce (TC = 20q i for both firms). Determine equilibrium quantity and
price.

d) Suppose that Thorn has an advantage that allows it to enter the market before Zorn does. In
this case, the competition would take place according to the Stackelberg paradigm with Thorn
as the leader, everything else being equal to point c. However, Zorn has the possibility to
employ a team of top-notch big data analysts that would allow it to overcome Thorn’s
advantage. In this case, the competition would take place according to the Stackelberg
paradigm with Zorn as the leader, everything else being equal to point c. Assume perfect
rationality and perfect information on everything. No extraneous factors exist besides those
strictly mentioned in the exercise. What is the maximum price that Zorn is willing to pay for
the big data analysis?
Solution:

a) Generally, a reaction function is the locus of optimal strategic responses to actions by another player. In the
context of duopolies, actions are choices related to the strategic variable of the focal competition model (e.g. price
for Bertrand, quantity for Cournot and Stackelberg). By definition, at the point where the reaction curves intersect,
the action of each player is the best response to the action of the other, determining an equilibrium. In the real world,
it is unfeasible to perfectly formalize a reaction function. Still, companies often have a pretty accurate understanding
of how other companies will react to certain key decisions, and devise their plans accordingly. This process of
mutual anticipation is the conceptual essence of reaction functions, and it is continuously applied in the real world.

b) Denote with A the focal firm and with B its competitor. In a Stackelberg oligopoly A is the leader and it knows
exactly how the follower will react. Therefore, it will a priori select the best possible scenario, taking into account
the response of B. Thus, the ex-post response of B (which is known a priori) is the only constraint for A. B knows in
advance how A will act, but it can’t do anything about it. Instead, in a Cournot duopoly, not only are both firms
aware of how the other will act, but they are also able to capitalize on that. A knows that B knows how A will act,
and it also knows that, this time, B can devise its strategy accordingly a priori. This poses a harder constraint on the
profit maximization of A.

c) Denote Zorn with 1 and Thorn with 2.

Π1 = q1 (200 – 3q1 – 3q2 ) – 20q1.
Π1 maximization  200 – 6q1 – 3q2 – 20 = 0  q1 = 30 – 0.5q2 (Zorn’s reaction function).
By symmetry, q2 = 30 – 0.5q1 (Thorn’s reaction function).
As explained in point a), equilibrium requires that q1 = 30 – 0.5(30 – 0.5q1)  q1 = q2 = 20.
Thus, Q = 20 + 20 = 40 and P = 200 – 120 = 80.

d) Denote the leader with 1 and the follower with 2.

Reaction functions are equal and already known from point c.
Π1 = q1 [200 – 3q1 – 3 (30 – 0.5q1)] – 20q1.
Π1 maximization  200 – 6q1 – 90 + 3q1 – 20 = 0  q1 = 30  q2 = 30 – 0.5 (30) = 15.
Thus, Q = 30 + 15 = 45 and P = 200 – 90 – 45 = 65.
Hence, the leader’s profits will be equal to 30 (65 – 20) = 1350.
Conversely, the follower’s profits will be equal to 15 (65 – 20) = 675.
The value that the big data analysis has for Zorn is tantamount to the difference between its profits as a leader and
its profits as a follower = 1350 – 675 = 675. Hence, as long as the price for the analysis is lower than 675, Zorn will
be willing to pay for it (being indifferent at 675).