BUSINESS AND INDUSTRIAL ECONOMICS

A.Y. 2022/2023
BIE classroom exam – July 12th, 2023
Length of the exam: 90 minutes

NAME _____________________________________ SURNAME ____________________________________

STUDENT ID_(matricula)___________________________________________________________________

MULTIPLE-CHOICE QUESTIONS [10 points]

You do not need to provide explanations for your answers. However, if you want to add a note to a response
(e.g., an assumption, a clarification, an illustration), please write it in the paper sheets you will upload as a
unique .pdf file.

1. Which of the following statements on critical mass is FALSE?

a. The price charged by a firm for launching a network good affects whether the network good reaches
critical mass because the firm leverages network effects to attract further users
b. If a firm offering a network good does not incur high fixed costs, the firm does not need to attain the
critical mass to survive because of the flexible structure
c. If the number of users buying the network good of firm A has reached critical mass, it is less likely
that firm B will win the competition by simply introducing a new network good at a lower price
d. Network goods benefit from a critical mass of users as the value of the product or service increases
with the number of participants, further reinforcing switching costs that discourage users from
switching to alternative goods

2. A merger between two firms that are direct rivals (i.e., are active in the same “relevant market”) can
significantly impede effective competition because of unilateral effects when
a. The merged entity can easily orchestrate collusion in the market
b. The merged entity enjoys larger economies of scale than its rivals and can drive its competitors out of
the market by charging lower prices
c. The merged entity combines goods that are not demand substitutes
d. None of the other statements is correct

3. Which of the following statements on pricing strategies is TRUE?

a. In setting their pricing strategy, platform businesses usually charge high transaction fees to attract and
retain those users who are the most quality- and price-sensitive
b. Competition is the best way of recovering the allocative inefficiency (i.e., price greater than marginal
costs) lost in monopoly pricing. However, in the case of natural monopoly, regulation is the best
alternative since competition is not feasible
c. In the presence of high uncertainty, new entrants usually engage in limiting pricing or predatory
pricing because they can leverage on incumbents’ lack of resources
d. Collusive pricing is more likely to be observed when a large and heterogenous (in size) number of
firms interact frequently
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4. Firms 1-6 are active in industries A, B, and C. The table reports firms’ shares of sales in each industry.
Compute C3, C4, and HI as a proxy of market concentration. Which of the following statements is TRUE?
Firm Industry A Industry B Industry C
1 0.550 0.800 0.200
2 0.100 0.050 0.200
3 0.100 0.050 0.200
4 0.175 0.035 0.100
5 0.050 0.045 0.100
6 0.025 0.020 0.200

a. According to Schumpeter’s view (Mark II), firms in industry C have more incentives to innovate than
those in the other industries
b. According to Schumpeter’s view (Mark II), firms in industry C have more incentives to innovate than
those in the industry B
c. According to Arrow’s view, firms in industry C have more incentives to innovate than those in the
other industries
d. According to Arrow’s view, firms in industry B have more incentives to innovate than those in the
other industries

5. In firms where there is a separation between ownership and control, agency problems arise because
a. Managers and owners have conflicting goals, managers are better informed than owners on how to
run the firm, and both owners and managers are risk neutral
b. Managers and owners have conflicting goals, managers are better informed than owners on how to
run the firm, managers are risk neutral, while owners are risk-averse
c. Managers and owners have conflicting goals, owners are better informed than managers on how to
run the firm, managers are risk-averse, while owners are risk neutral
d. None of the answers above is correct

6. Which of the following statements on public goods and their provision is TRUE? Public provision of public
goods
a. Leads to overconsumption and market inefficiency
b. Creates excessive competition and resource scarcity
c. Hinders innovation and economic growth
d. Addresses the free-rider problem and promotes societal welfare

7. Which of the following statements on signaling theory is TRUE? Signaling theory

a. Claims that individuals can convey their true abilities and characteristics to others
b. Proposes that individuals always engage in deceptive signaling to gain an advantage
c. Implies that individuals have no incentive to send signals about their qualities to others
d. States that signals are irrelevant and have no impact on actors’ decision-making processes

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8. Which of the following statements is TRUE? In a highly competitive industry, potential entrants enter when
incumbents gain economic profits. This happens when the price is
a. Lower than the short run minimum average cost. In this case, new entrants can quickly attract
customers
b. Higher than the long run minimum average cost. However, the entry of new firms causes an increase
in price and the exit of firms that make losses
c. Lower than the short-run marginal costs. In this case, new entrants can quickly attract customers
d. None of the other statements is TRUE

9. In defining the relevant market, what share of sales would have to be lost to make a hypothetical price increase
unprofitable? Consider the following conditions: (1) the initial output amounts to 1,000,000 units, (2) the
initial price amounts to 0.5 €/unit, (3) the marginal cost amounts to 0.35 €/unit, (4) due to a price increase, the
final price amounts to 1.5 €/unit. The critical loss amounts to
a. 53.49%
b. 13.04%
c. 46.51%
d. None of the other statements is TRUE

10. Which of the following statements is FALSE? According to industrial economists

a. There is consistent evidence that innovation negatively relates to industry concentration
b. The divide-and-conquer strategy prescribes that a platform owner should charge higher prices to the
group of participants with the higher demand inelasticity to recover the alleged loss from the other
group of users characterized by higher demand elasticity
c. The allocation of property rights over a critical asset in a transaction between two parties influences
their incentives to make relational-specific investments
d. Including internal and external members on the Board of Directors reduces the principal-agent
problems.

STRUCTURED QUESTION
OPEN QUESTIONS [10 points]
Please, read the section reported below from the article “One of the giants”, which appeared in The Economist
on September 7th, 2013.
Coase studied “commerce” at the London School of Economics (LSE), chosed to tour America’s industrial cities
in the hope of answering a question that troubled him: why did companies exist?
Economists of the time were enthralled by the special magic of the price mechanism. Coase realised that firms
would exist when it was cheaper and easier to co-ordinate activity within a centrally planned organisation
than to spell out contract details for every step in the production process.
[…] His contribution also centred on market “externalities”: economic choices that impose social costs or
benefits on others. Factory pollution may disturb or poison nearby residents, for example. Earlier generations of
economists diagnosed a market failure that governments could set to rights. The polluting factory does not face
any costs from spouting black smoke over a town: the costs are “external” from its perspective. A tax on pollution
would internalise the cost, however. The price mechanism would work once more, as the tax encouraged the
factory’s managers to reduce pollution to socially optimal levels.
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In the world of theory, without transaction costs, no government intervention would be needed to address
externalities. The factory owners and the residents could work out side-payments on their own. Residents
might pay the factory to emit less or the factory might pay the town for leeway to pollute more. Either way an
efficient outcome should result without government help.
Yet Mr Coase recognised that neither private bargaining nor a pollution tax can make a market perfectly efficient
given transaction costs like the expense of monitoring a factory’s emissions. Mr Coase reckoned the law had a
critical economic responsibility: to minimise the disruptive effect of these costs on markets. A system of clear and
easily transferable property rights (in this case, the right to pollute) can play a role like that of the firm, allowing
useful economic activity to take place that might otherwise be gummed up by the hassle of negotiating and
enforcing contracts.

Using the concepts and notions of the BIE course, answer the following questions. Note that each answer cannot
exceed 300/400 words.
Question 1: “Why do firms exist?” Relate this notion to the mainstream theories discussed in class. Explain why
firms tend to be centrally organized, and in doing so, provide real-world examples. [5 points]
Question 2: “The factory owners and the residents could work out side-payments on their own. Residents
might pay the factory to emit less or the factory might pay the town for leeway to pollute more.” Relate this
notion to the mainstream theories discussed in class, provide a meaningful and comprehensive explanation of the
phenomenon, and illustrate noteworthy examples. [5 points]
SOLUTIONS OPEN QUESTIONS
Question 1: “Why do firms exist?” Relate this notion to the mainstream theory discussed in class. Explain why
firms tend to be centrally organized, and in doing so, provide real-world examples. [5 points]
Key concepts
• Identify the correct theory and definition: reference of the theory of transaction cost conceived as costs that
economic agents incur while engaging in transactions on the market both ex-ante (e.g., search costs,
bargaining, contracting) as well as ex-post (e.g., contract drafting, contract enforcement). Practical examples
are appreciated.
[1 point: the concept is properly identified and discussed clearly and comprehensively]
[0.5 point: the concept is not fully addressed]

• Root of transaction costs and manifestation: bounded rationality causes contract incompleteness which in
turn exposes agents to potential hold-up and opportunistic behaviors problems in market transactions.
[1 point: the concept is properly identified and discussed clearly and comprehensively]
[0.5 point: the concept is not fully addressed]

• Discuss why firms exist and why they tend to be centrally organized:
▪ market transactions imply transaction costs, which are eliminated by internalizing these transactions
within firms’ boundaries. Firms, therefore, tend to grow in size when the cost of internalizing market
transactions is lower than resorting to specialists in the market
▪ Transaction costs shape firms’ boundaries in choosing between market (resort to market transactions)
and hierarchy (internalize transactions). In other words, transactions costs are one driver in the
choice between market transactions and vertical integration and discussion about relational-specific
investments and the relationship between technical and agency efficiency leading to vertical
integration
[2 point: the concept is properly identified and discussed clearly and comprehensively]
[1 point: the concept is not fully addressed]

• Provide real-world examples of firms that are vertically integrated as for example Zara’s vertical integration
strategy referring to industry trends and/or firms’ features that explain Zara’s strategy coherently with what
theory predicts. It is also possible to briefly discuss the possible reasons for Zara’s vertical integration
strategy by highlighting related advantages and disadvantages
4
[1 point: the concept is properly identified and discussed clearly and comprehensively]
[0.5 point: the concept is not fully addressed]

Eventually, we evaluate concepts which depart from the key ones but that may offer original and meaningful
insights
- Real worlds examples
- Advantages and disadvantages of vertical integration
[max +0.5]

Question 2: “The factory owners and the residents could work out side-payments on their own. Residents
might pay the factory to emit less or the factory might pay the town for leeway to pollute more.” Relate this
notion to the mainstream theory discussed during the course and provide a meaningful and comprehensive
explanation of the phenomenon while providing noteworthy examples. [5 points]
• Identify the correct theory and definition: reference to the concept of externalities and why they generate
inefficiencies and a market failure. Particular emphasis on negative production externalities (e.g., agents
engaging in activities causing a negative externality do not fully bear the costs)
[1 point: the concept is properly identified and discussed clearly and comprehensively]
[0.5 point: the concept is not fully addressed]

• Discuss Coase’s insights on property rights as a remedy for production externalities: in the presence of well-
defined property rights and in the absence of transaction costs, economic agents can negotiate and reach an
efficient outcome. Moreover, if the agents’ preferences are quasi-linear in money, the efficient allocation of
resources is achieved regardless the initial allocation of property rights.
[2 point: the concept is properly identified and discussed clearly and comprehensively]
[1 point: the concept is not fully addressed]

• Discuss possible limitations of the Coase’s theorem: transaction costs and other factors may limit the
applicability of the Coase theorem. For example, it may be difficult to define and enforce property rights,
negotiate agreements, or ensure that all agents are involved in the bargaining process. In such cases,
government intervention through regulations, taxes, or subsidies may be necessary to address production
externalities and achieve an efficient outcome.
[1 point: the concept is properly identified and discussed clearly and comprehensively]
[0.5 point: the concept is not fully addressed]

• Provide real world examples of negative production externalities and possible remedies to externality with
or without policy intervention
[1 point: the concept is properly identified and discussed clearly and comprehensively]
[0.5 point: the concept is not fully addressed]

Eventually, we evaluate concepts which depart from the key ones but that may offer original and meaningful
insights
- Discuss other possible remedies like merge and taxes
- Pareto efficient allocations
[max +0.5]

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EXERCISES [10 points]
EXERCISE 1 [4.5 points]
Consider a duopoly regime with two firms (firm 1 and firm 2) facing the demand curve Q = 260 − 4P, where Q
= q1 + q2. Both firms have the following cost function C1(q1) = 20+5𝑞1 and C2(q2) = 10+15𝑞2 . If needed, round
to the second digit after the decimal point.
a.) Suppose that products are homogeneous and the two firms (1 and 2) set their quantity levels simultaneously.
Find the resulting Nash’s equilibrium (quantities, prices, profits). [1.5 points]

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

c.) Calculate the total consumer surplus, total producer surplus, and the total welfare in the market in each of the
two competitive regimes (i.e., Cournot, von Stackelberg). If you were the State, which competitive regime
would you prefer? [1.5 points]

SOLUTION EXERCISE 1 [4.5 points]

a.) Compute the Cournot equilibrium. [1.5 points] Starting from the inverse demand function P = 65 – 1/4
(q1 + q2), firm 1 chooses the quantity q1 that maximizes its profit function:
1 1
𝛱1 (𝑞1 , 𝑞2 ) = 60𝑞1 − 𝑞12 − 𝑞1 𝑞2 − 20
4 4

From the first order condition, we get firm 1’s best reply function:
∂𝛱1 (𝑞1 , 𝑞2 ) 1
= 60 − 1/2𝑞1 − 1/4 𝑞2 = 0 → 𝑞1 = 120 − 𝑞2
∂𝑞1 2
1 1 2
𝛱2 (𝑞1 , 𝑞2 ) = 50𝑞1 𝑞1 𝑞2 − 𝑞2 − 10
4 4

From the first order condition, we get firm 1’s best reply function:
∂𝛱1 (𝑞1 , 𝑞2 ) 1
= 50 − 1/2𝑞2 − 1/4 𝑞1 = 0 → 𝑞2 = 100 − 𝑞1
∂𝑞2 2

b.) Compute the von Stackelberg equilibrium (quantities, prices, profits). [1.5 points]
The game is solved via backward induction, starting from the second stage. In this stage, firm 2
chooses its quantity as in the simultaneous game (Cournot), so its best reply function is:
1
𝑞2 = 100 − 𝑞1
2
(For calculation, 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 the best reply function of
firm 2 into the profit function of firm 1:
1 1
𝛱1 (𝑞1 , 𝑞2 ) = 60𝑞1 − 𝑞12 − 25𝑞1 + 𝑞12 − 20
4 8

From the first order condition, we get firm 1’s optimal quantity:
∂𝛱1 (𝑞1 , 𝑞2 )
= 35 − 1/4𝑞1 = 0 → 𝑞1 = 140
∂𝑞1

q1 q2 Q P Π1 Π2 Points
Cournot 93.33 53.33 146.66 28.33 2157.39 701.42 1.5
VS 140 30 170 22.5 2,430 215 1.5

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e.) Calculate the total consumer surplus, total producer surplus, and the total welfare in the market in each of the
three competitive regimes (i.e., Cournot, von Stackelberg). If you were the State, which competitive regime
would you prefer? [1.5 points]
CS PS TS
Cournot 2688 2888 5576
VS 3612.5 2675 6287

The State would prefer the Von Stackelberg regime as it enables it to gain the highest total welfare. Additional
insights should be added about the economic rationale.
Note: the cost are in terms of a cost function TC(Q)=FC+VC(Q) as a consequence in this case PS is different from
profits.

EXERCISE 2 [2 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 = 24 is the price of electricity, pf = 20 is the price of the
agricultural products (both firms are price-takers), Ce (e, x) = e2 + (x – 8)2 is the cost for the coal-power plant of
producing electricity (e) jointly with x units of pollution (pollution is a negative 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 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. [2 points]

SOLUTIONS

a.) 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. [2 points]

𝜋𝑓 (𝑓, 𝑥 ) = 20𝑓 − 𝑓𝑥 + 𝑃𝑥𝑋

Starting from the first-order profit-maximization conditions, we obtain:
𝜕Π(f,x)
= −𝑓 + 𝑃𝑥 = 0 → 𝒇∗ = 𝒑𝒙 → supply of farm products
𝜕𝑥
𝜕Π(f,x)
= 20 − 2𝑓 − 𝑥 = 0 → 𝒙∗𝑺 = 𝟐𝟎 − 𝟐𝑷𝒙 → supply of pollution rights
𝜕𝑓

𝜋𝑒(𝑒, 𝑥 ) = 24𝑒 − 𝑒 2 − (𝑥 − 8)2 − 𝑃𝑥𝑋

𝜕Π(e, x)
= 24𝑒 − 2𝑒 = 0 → 𝒆 = 𝟏𝟐 → 𝐬𝐮𝐩𝐩𝐥𝐲 𝐨𝐟 𝐞𝐥𝐞𝐜𝐭𝐫𝐢𝐜𝐢𝐭𝐲
𝜕𝑒
𝜕Π(e, x) 𝟏
= −2(𝑥 − 8) − 𝑃𝑥𝑋 = 0 → 𝒙∗𝑫 = 𝟖 − 𝑷𝒙 → 𝐝𝐞𝐦𝐚𝐧𝐝 𝐨𝐟 𝐩𝐨𝐥𝐥𝐮𝐭𝐢𝐨𝐧 𝐫𝐢𝐠𝐡𝐭𝐬
𝜕𝑥 𝟐
e=12; px=8; f=8 that is f=px ; x=4 that is x=20-2px
𝜋𝑓 (𝑓, 𝑥 ) =96
𝜋𝑒(𝑒, 𝑥 ) = 96

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EXERCISE 3 [3.5 points]

a.) Suppose there are two types of English teachers in the labor market: half are high-skilled (aH), and the other
half are low-skilled (aL). English teachers know their type, but firms do not. Assume that the labor market
for English teachers is perfectly competitive. A high-skilled English teacher’s expected productivity is aH =
5,500, while a low-skilled English teacher’s expected productivity is aL = 3,000. Suppose that firm Alpha
intends to hire English teachers to improve its employees’ English. Alpha considers having a training
certificate from Cambridge University a credible signal of being a high-skilled English teacher. Then, the
firm will offer a wage of wH = 5,500 to all the English teachers with the certificate and wL = 3,000 to the
English teachers without the certificate. The cost (including tuition fees and effort invested) of obtaining the
certificate for high-skilled teachers is cH = 1,500, while the cost for low-skilled teachers is cL = 3,000. Who
has incentives to get the certificate? [1.5 points]

b.) Using the parameters above (aH= 5,500, aL= 3,000, cH = 1,500, cL = 3,000), find the level of education (eH)
that allows high-skilled teachers to signal their ability on the labor market [1 point]
c.) Provide at least three examples of signals that startup founders can use to signal their abilities and the
quality of their startup. In answering this question, try to be original, specific, and synthetic [1 point]
______________________________________________________________________________________
______________________________________________________________________________________
______________________________________________________________________________________

SOLUTIONS
a.) Let e =1 if the English teacher obtains the certificate and e=0 if not.
Compute the payoff of both types of teachers.
High-skilled English teachers’ payoff is:
πH(e = 1) = 5,500− 1,500 = 4,000 > πH(e = 0) = 3,000.
High-skilled teachers find it in their interest to choose e = 1.
Low-skilled English teachers’ payoff is:
πL(e = 1) = 5,500 – 3,000 = 2,500 < πL(e = 0) = 3,000
Low-skill teachers find it outside their interest to choose e = 1.

b.) (aH-aL)/cL< eH< (aH-aL)/ cH

5500-3000/3000 < eH< 5500-3000/1500
0.83 < eH<1.67
c.) Possible examples: i. VC round, ii. executive master in a top-ranked university

General correction rules subject to modification depending on the type of mistake: from -0.1 to -0.3 calculus
mistakes; 0.75 if inverse demand is wrong, ½ point in case the concept is identified but not properly addressed

Do you want your submitted exam to be corrected?

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