Hey, this is for all my students in second year... I've gotten more emails in the past week about how to do the sample questions for I.O. so I sat down for an hour and did them all. I didn't do it with numbers just the theory because the numbers are really easy. You should be able to do all 10 of these in an hour, so when you get the numbers on the midterm you won't run over the 3.5 hour deadline. If you have any questions stop emailing me and leave it in the comments, but most of it is self explainitory...

I guess for anyone else reading my blog your welcome to see what we do in economics second year lol.

It isn't formated very well but it is just a guide, work around it. Question 9 I skipped because its very easy and just the same as B.E.

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Question 1 : Monopoly, dominant firm and welfare

Consider a market in which inverted market demand is given by P = a – bQ and in which there are two kinds of firms: Firm 1 and the fringe. Firm 1 has unlimited capacity, constant marginal cost equal to c1 and fixed costs equal to F1. The total capacity of the fringe is K. Each fringe firm has a marginal cost of c2 and fixed costs of F2.

[Note : You will be given numbers for a, b, K, c1, c2, F2, F1]

a) (10 marks) Monopoly. Suppose that the fringe firms do not enter and thus that firm 1 acts as a monopolist. Find the monopoly level of output, price, profits, consumer surplus, social welfare and efficiency loss.

Steps:
1. Find Q: Set MR = MC
• MR = P + Q[dP/dQ]
2. Find P: Sub Q into the inverted demand
3. Find profits, consumer surplus, social welfare, efficiently loss
• Profits = (P – MC)Q – FC1
• Consumer Surplus = ½ (MAX – P)Q
• Social Welfare = profits + consumer surplus
• Efficiency loss = ½ (P – MC) (Q monopoly – Q d=s)

b) (10 marks) Dominant firm. Now suppose that the fringe firms enter and thus that Firm 1 acts as a dominant firm. Find the equilibrium level of output, price, profits, consumer surplus and social welfare. Does entry increase social welfare?

1. Find q1: Set MR = MC1
• MR = P + q[dP/dQ][dQ/dq1]
2. Find Q = q1 + K
3. Find P: Sub Q into the inverted demand
4. Find profits, consumer surplus, social welfare, efficiently loss
• Profits DF = (P – MC1)q – FC1
• Profits Fringe = (P – MC2)k – FC2
• Consumer Surplus = ½ (MAX – P)Q
• Social Welfare = profits DF + profits Fringe + consumer surplus
•


Question 2 : Agency problem
a) (10 marks). What is the agency problem? What are examples of agency problems? What are the implications of unresolved agency problems for industrial organization?

-A separation of ownership and control gives rise to the agency problem managers wish to maximize salaries, control, and prestige which is contradictory to shareholders which want to maximize profits (conflicting)

Examples:
• Lack of cost minimization
• Lack of innovation
• Unrelated diversification (buying alternative companies (with dividends) being motivated by personal issues not profit maximization)
• Resistance to downsizing

-Implications: industrial organization assumes that firms maximize profits which is only a reasonable assumption if the agency problem can be resolved, so if present industrial organization cannot take place effectively

b) (10 marks). What mechanisms can be used to resolve the agency problem? Critically evaluate the effectiveness of these mechanisms.

Possible ways to solve the agency problem
• managerial labor market reputation
• shareholder monitoring
o Problems : free-rider information
• managerial incentives
o Problems : performance measures, risk
• product market competition
o More intense product market competition increases the risk of bankruptcy. Bankrputcy tarnishes a manager's reputation. In order to avoid bankruptcy manager's must work harder to increase the profits of the firm and are thus less prone to pursuing personal objectives which do not improve the firm's bottom line. Since manager's objectives are more aligned with those of the firm then the agency problem is reduced.
• market for corporate control
o Problems : Bargaining, value destruction, value redistribution


Question 3 : Horizontal boundary
a) (10 marks). What determines a firm’s horizontal boundary? Explain the sources of production related economies of scale and scope. Explain the sources of non-production related economies of scale and scope? Explain the sources of diseconomies of scale?

-A firm’s horizontal boundary refers to the level of output and number of products produced, this is determined by the presence of economics of scale (declining AC) and scope (costs less to produce two together then separate).

Production Related Economics of Scale
• The spreading of fixed costs
o Plant and equipment costs
o Reduced inventory costs
o Specialization of variable inputs

Production Related Economics of Scope
• A single technology can be used to produce many products
• The fixed cost of using the technology is reduced with each application (LCD’s wristwatches and calculators)

Non Production Related Economics of Scale and Scope
• Purchasing economics of scale arise from volume discounts in purchasing inputs
• Advertising economics of scale arise from
o Spreading the fixed costs of the ad
o Paying lower cost per customer reached
• Advertising economics of scope arise from
o Applying reputation from existing goods to new goods
• Research and development scale: spreading fixed costs

Diseconomies of Scale
• High Labour costs
o Extra payments to prevent disutility
• Increased bureaucracy and influence costs
• Irreproducible factors of production (irreplaceable)
• Conflicts of interest (professional services)

b) (10 marks). What are the possible economies of scale and scope and possible diseconomies of scale associated with hypermarts (i.e. hypermarts are large retail stores that sell a wide variety of products from groceries to hardware to clothing).

Economics of Scope
• Transportation of goods are distributed throughout all goods, distribution networks (use the same network)
• Could advertise for the store: reputation advertises across products
o Problem: goods are unrelated

Economics of Scale
• Buying in bulk quantities may be cheaper due to bulk discounts
• Reduced inventory costs because many hypermarts thus not a large inventory
• Can apply the stores reputation through advertising of old goods to newer goods
• Smaller bureaucracy they many smaller stores

Diseconomies of Scale
• Because they require so many types of products may need may different type of specialized employees to sell products, higher labour costs
• Walmark a ‘hyper mart’ is also concerned with the formation of a union which would also raise labour
• Very hard to find incentives for workers to increase productivity because the company is so large

Question 4 : Make versus buy

a) (5 marks) Give three reasons to buy. Explain each reason.

1. The product is standard and there exists a completive market, or the firms demand is below MES.
2. The product is non standard but a non specific tendering process works well (construction) or the market has a good yield of economics of scope
3. There is rapid innovation, the firm wants the newest technology but cannot motivate workers

b) (5 marks) Explain why firms are likely to make rather than buy when the assets used in producing the input are specific. In your answer be sure to explain asset specificity, quasi-rents, incomplete contracts and the hold-up problem. Give a real world example.

• Asset specificity: the assets used in production of the non specific good are very specific and would not have a completive market, or the assets are dedicated which means no other places could use the asset
• in-house provision protects the investor against…
o …opportunistic renegotiation (hold-up) which is…
o …motivated by the incentive to capture quasi-rents (the difference between current contract and the next best alternative.)
o …and made possible if contracts are incomplete & investment costs are sunk

world example

c) (5 marks) Give 2 other reasons (besides asset specificity) to make rather than buy. Explain each reason.

1. There are large costs associated with coordinating the production process
• Transportation and communication networks are poor
2. To keep the source of competitive advantage a secret


d) (5 marks) What are the alternatives to make or buy. What are the features of these alternatives and what are the attractive features of these alternatives.

Joint Ventures (sharing resources)
• Beneficial when
o Complexity makes contracting unattractive
o And there are large costs, transitory and regulation make integration unattractive
Franchising
• Franchisees use franchiser name and business format and retain profit after paying a licensing fee and a small royalty, benefit market incentives

Keiretsu
• Informal long run relationship with suppliers
• Market incentives combined with incentives to make specific investments, easy to keep out competition


Question 5 : Competitive advantage

a) (10 marks) What are the sources of competitive advantage?

1. Scare and immobile resources
• Scarcity is required to prevent imitation
• Immobility is required to prevent rents from going to the resource owner
2. Strategic Fit
• Exists when a firm’s strategy consists of many complementary activities, makes imitation hard because it implies small changes result in large loss in profitability
3. Brand Loyalty
• Product quality matters a lot but can only be verified by purchase (computer)
• If the product is inexpensive, bought regularly and persuasively advertised
4. Network externalities
• Exist if the product demands on how many consumers there are or how many there will be (cell phone)

b) (10 marks) Why have Pepsi and Coke sustained their competitive advantage whereas GM and Ford have gradually lost their competitive advantage?

Scare and Immobile resources
• Coke & Pepsi
-Formula patent (only one formula and immobile, owned by firm)
-other formula less valuable

• Form & GM
-technology, was scare for a while but has become less so

Brand Loyalty
• Coke & Pepsi
-Inexpensive, bought regularly and persuasively advertised
-incentive to keep the same formula, small changes could hurt sales, maintain
reputation

• Form & GM
-reputation for quality
-requires constant motivation
-competitors have been able to surpass

Question 6 : Monopoly and regulation

a) (10 marks). Describe the various ways in which the inefficiency associated with monopoly can be reduced. Explain the impacts of these policies on allocative efficiency and on the incentive for firms to minimise costs.

Natural Monopolies
-When one firm can supply cheaper then 2 firms (i.e. water)
-Privatise and regulate price
• Problem quality, no incentive to have high quality
• Problem no service to unprofitable areas, solution government purchases
-Government Owned
• Problem poor monitoring and no real incentives

Non-Natural Monopolies
-i.e. long distance calls
-Introduce competition
• Problem access pricing


b) (10 marks). In markets where the monopolist controls an essential upstream facility explain how introducing competition at the retail stage affects on social welfare when ECPR is used. Use a diagram to illustrate your answer.


-When a new firm enters the market under ECPR a new part of the graph is gained Part C, because the fringe firms can produce at a cheaper cost then the monopoly there is more of the graph which is available however the change in social welfare also carries the new fixed costs involved with the fridge firms

Question 7 : Bertrand

Consider a market in which there are three firms who face constant marginal cost given by ci, i = 1, 2, 3 and an inverted industry demand curve given by P = a – bQ. Firms compete in Bertrand fashion (i.e. Each firm has unlimited capacity and chooses a price pi. Buyers buy from the firm with the lowest price. If all firms charge the same price then buyers allocate themselves equally to each firm).

a) (10 marks). Suppose that the firms have identical marginal costs equal to c. Determine whether or not p1 = p2 = p3 = p > c is a Nash equilibrium. Explain. If these prices constitute an equilibrium then calculate the equilibrium output and profit of each firm.

- p > c is not in Nash equilibrium
-all firms are splitting the market but because buyers choose the lowest price product and the price is above MC there is incentive for a firm to lower its price below the other two competitors
-with a lower price that firm get all the buyers, so if firm 1 expects firm 2 & 3 to price above the marginal cost firm 1 has incentive to price below them yet above MC
-if the firms were to charge under MC then there is incentive to charge the MC so they don’t lose money
-so the Nash equilibrium is at a point where no firm can increase profits by unilaterally changing prices, thus p = c
-calculate equilibrium output: c = inverted demand where Q = 3q
-calculate profit : (p-c)q – fc = 0

b) (10 marks). Suppose that c1 > c2 > c3. Find the Nash equilibrium price, output and profit of each firm. Explain why your chosen set of prices form a Nash equilibrium. Determine whether entry is blockaded, impeded or accommodated.

- price will be set c2 – x > c3
-firms 1 & 2 will make no profits and not produce
-impeded entry because firm 3 is making the price so low that it impedes the entry of firms 1 & 2.

[Note: You will be given numbers for a and b, for p and c in part a), and for c1, c2 and c3 in part b).]


Question 8 : Cournot and innovation

a) (5 marks). Suppose there are n identical firms who each face inverted market demand given by P = a – bQ and who each have constant marginal cost equal to c and zero fixed cost. Find the Cournot equilibrium level of output and profits per firm as a function of n.

note function of n
1. Find q1: Set MR = MC
• MR = P + q1[dP/dQ][dQ/dq1] = MC
2. Find Q = nq1
3. Find P = inverted demand substituting Q
4. Find Profits for all firms
• Profits = (P – AVC) Q

b) (10 marks). Now suppose one of the firms innovates and reduces its marginal cost from c to c – x by increasing its fixed cost from 0 to F. The remaining n – 1 firms do not innovate and thus there costs remain equal to c. Find the post-innovation Cournot levels of output and profits of the innovating firm as functions of n. Find the increase in profits of the innovating firm when n = 3 and when n = 4. What happens to the increase in profits of the innovating firm as n increases from 3 to 4?

1. Find Response Function 1 for innovator
• MR1 = MC1
• P + q1[dP/dQ][dQ/dq1] = MC1
2. Find RF2 for non innovators
• MR2 = MC2
• P + q[dP/dQ][dQ/dq] = MC2
3. Find q1 & q by subsituting
4. Find Q = q1 + nq
5. Find P = inverted demand substituting Q
6. Find Profits for innovating firm
• Profits = (P – MC1)q1 – FC
• Sub n = 3 and n=4 into the profits function, explain what happens with increase

c) (5 marks). Use your solutions in a) and b) to determine the portion of the increase in innovating firm profit that is attributable to the cost savings on the initial level of output of the innovating firm (output effect) for n = 3 and n = 4, and the portion that is attributable to the change in output (strategic effect) for n = 3 and n = 4. What is the impact of increasing n on the output and strategic effects?

1. Calculate profits for the innovating firm in part a
2. Calculate the change in profits
3. Calculate q1(change in MC) = the initial cost savings (output effect)
4. the change in profits – output effect = the strategic effect of the MC reduction on outputs
NOTE do twice for n = 3 & n = 4

Question 9. Cournot and entry

Consider an industry consisting of n firms that produce identical products. There are N buyers in the market and each buyer has a demand curve given by qd = a – P where qd is the amount demanded by each buyer and P is the common industry price. The number of buyers N is a measure of market size. Market demand is equal to the amount demanded by all buyers and is thus given by Q = N(a – P). The inverted market demand curve is thus given by . Each firm chooses output in Cournot fashion and assumes that price is given by the inverted market demand curve. Each firm faces constant marginal cost equal to c per unit and a fixed cost equal to F.

a) (10 marks) Symmetric Cournot equilibrium for given N and n. Derive the Cournot equilibrium level of (i) output per firm, (ii) industry output, (iii) price (iv) profit per firm and (v) social welfare as functions of the number of firms n and the number of buyers N.






b) (5 marks) Cournot level of n. If Cournot firms enter until profits are driven to zero then determine the number of firms n that will enter as a function of N. Find the minimum level of N (denoted N1) required for one firm to enter. If N doubles to 2N1 then can a second firm enter and at least break even? If not then find the minimum level of N (denoted N2) required for a second firm to enter and at least break even.






c) (5 marks). Suppose that there are currently 2 firms in the market. If a third firm were to enter then would this firm earn positive profits and would the entry of this firm raise or lower social welfare.









[Note : You will be given numbers for a, c and F].


Question 10 : Market size, market structure and social welfare

a) (5 marks) Explain why a doubling of market size does not result in a doubling in the number of firms when fixed costs are exogenous? Use a diagram to illustrate your answer.

If fixed costs are endogenous then…
• entry is less responsive to changes in market size

-The more firms which are in the market increase the fixed costs, in so the bigger the market size the more costly it becomes to enter the market making it less sensitive
-the concentration at a certain point reaches a lower bound where no firms are able to enter anymore
-graph looks like concentration y axis, market size x-axis, u-shaped curve, with it’s min value reaching the min concentration in the industry



b) (5 marks) Explain why industry concentration is less responsive to increases in market size in advertising intensive industries than in non-advertising intensive industries.

-advertising increases the fixed costs, for an entrant in an advertising intensive industry he would need to pay a much greater advertising costs then someone entering a non advertising intensive industry
-the bigger the market the bigger the investment needed to be made
-example Beer Industry US vs. Portugal


c) (10 marks) If entry is profitable then does it raise social welfare (i.e. economic welfare is the sum of industry profits and consumer surplus)? Explain using the business stealing and consumer surplus externality effects. Illustrate these two effects using a diagram.

 Entry improves social welfare if it increases…
 …the sum of profit plus consumer surplus…
 When firms enter they…
 …increase price competition and this yields a positive consumer surplus externality which refers to
 …the increase in consumer surplus that is not a transfer from existing firms
 …lower the profits of incumbent firms & this yields a negative business stealing externality which refers to
 …the profit transfer from incumbents to entrants
 If BS externality is greater than the CS externality then profitable entry may increase or decrease SW.
 If BS externality is less than the CS externality then profitable entry will increase SW.










Question 11 : Market power, market conduct and market structure

a) (10 marks). What is market power and how is it measured? How is market concentration measured? What is the relationship between market power, market conduct and market structure according to the conjectural variation model. How can the relationship between market power, market conduct and market structure be explained using the collusion hypothesis, the efficiency hypothesis and the feedback effect?

-Market power is the ability to set prices above costs; it is measured with the Lerner index, which is the weighted sum of the mark ups
-Market concentration is measured with the Herfindahl index, which is the sum of the market shares
- Conjectural variation model: The relationship between market power, market concentration and market structure is L = [(1 + v)/ε]H …
• increase in L means higher market power
• increase in H means higher concentration
• increase in v means more collusion
-efficiency hypothesis: A positive relationship between market power and market structure presence of efficient firms who simultaneously increase concentration
-feedback effect: A positive relationship between market power and market structure can be explained by the ability of firms to collude when there are fewer firms


b) (10 marks). How is the market power of a dominant firm related to its elasticity? How is Microsoft’s market power affected by the durability of its products, piracy, bundling and exclusive dealing?

A firm maximizes profit by…
…setting MR = MC
…Substituting MR = P(1– 1/e) yields…







-which means that elasticity rather than market share determine market power

Microsoft
-durability, piracy = increase elasticity, decrease market power
-bundling (how windows products work on windows), exclusive dealing = decrease elasticity, increase market power