Matching E Multiple Choice d. a & b a. Identifying different types of customers and avoiding arbitrage by customers c.

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1 ECON-115 Industrial Organization Midterm 01 Key Version 2k14 PART I: Matching. Match the terms on the left with the definitions on the right. (1/2 point each) 1 Arbitrage E a. When the seller charges a single price for entry and a fixed number of products 2 Block pricing A b. You cannot buy the products individually, only together 3 Consumer surplus I c. The reason sellers sometimes leave some of the consumer surplus to certain groups of customers 4 Group discount G d. In one form, it explains how many shops a monopolist should open along a single street 5 Incentive compatibility C e. When one consumer sells a low-priced product to another to consume 6 Non-linear pricing J f. The maximum price a consumer is willing to pay 7 Personalized pricing H g. Children under 12 get in free is one example 8 Reservation price F h. This is also known as 1 st Degree Price Discrimination 9 Hotelling spatial model D i. The difference between how much a consumer values a product and what he or she pays for it 10 Pure Bundling B j. A quantity discount is one example PART II: Multiple Choice. For questions 11 30, circle the best answer. (1/2 point each) 11. Price discrimination is: a. Common in the economy b. Charging different prices for the same good c. Illegal d. a & b 12. Firms wishing to price discriminate confront two problems: a. Identifying different types of customers and avoiding arbitrage by customers b. Identifying different types of customers and providing proper discounts c. Avoiding first and second degree arbitrage d. Firms have no problems; price discrimination is easy to do 13. Third-degree Price Discrimination is also known as: a. Unfair pricing b. Exponential pricing c. Linear pricing d. Personalized pricing

2 14. In order to implement Third-degree Price Discrimination, a firm must be able to: a. Maximize profits b. Offer uniform pricing to all types of consumers c. Minimize costs d. Identify consumer groups by some observable characteristic 15. In practicing Third-degree Price Discrimination, firms must follow this rule: a. Consumers with low elasticity of demand should be charged a low price. b. Consumers with low elasticity of demand should be charged a high price. c. Consumers with high elasticity of demand should be charged a high price. d. It doesn t matter one way or another. 16. If the monopolist engages in Third-degree Price Discrimination selling the same product to two distinct Markets 1 and 2, what is one profit maximizing rule that must be followed? a. MR (both markets) MC b. MR market 1 > MR market 2 c. MR market 1 < MR market 2 d. MR market 1 = MR market 2 For problems 17 19, use the following information: You come into possession of three similar rare stamps. The market for these stamps consists of three stamp collectors willing to pay $30,000, $20,000 and $10,000 respectively. If you behave like a standard monopolist, your best outcome is to price each stamp at $20,000, sell two and pocket $40,000 in profits (assume your costs are $0). But you know you can engage in personalized price discrimination and sell each collector a stamp for the maximum price he or she is willing to pay. 17. If you sell two stamps for $20,000 each, the consumer surplus is: a. $0 b. $10,000 c. $20,000 d. $40, If you practice personalized pricing and sell each collector a stamp for the maximum price he or she will pay, what is the consumer surplus? a. $0 b. $10,000 c. $20,000 d. $40,000

3 19. If you practice personalized pricing and sell each collector a stamp for the maximum price he or she is willing to pay, what are your profits (assume your costs are $0)? a. $10,000 b. $20,000 c. $60,000 d. Unknown 20. Second-degree Price Discrimination is called non-linear because: a. Costs don t line up b. Unit price depends on the quantity purchased c. Demand function is non-linear d. Unit prices are unchanged 21. Under horizontal product differentiation, firms serve different types of customers by offering products with: a. Different characteristics b. Variation in quality c. Differences in price d. All of the above For questions 22 23, use the following information: Adding an additional shop requires n*(n+1) < tn/2f, where n = number of shops, t = transportation costs to a shop, N = number of consumers and F = the fixed costs of opening a shop. 22. If F = $100,000, N = 1,000,000 and t = $1.00, what is the value of tn/2f? a. 1 b. 2 c. 4 d Given your answer in 22, if the firm already operates 2 shops, should it add a third? a. Yes b. No c. Not enough information to say d. It depends on other factors 24. One of the reasons the Standard Oil Trust was created in 1882 was: a. To relocate itself to New Jersey b. To avoid future inheritance taxes c. To spread the benefits of railroad rebates between various Standard Oil companies d. To combine all the Standard Oil companies to one group, to make them more efficient

4 25. Standard Oil enjoyed the benefits of Second-degree Price Discrimination in the form of price rebates from the railroads. Standard Oil received these rebates in part because it operated as an evener for the railroads. What does that imply? a. Standard Oil only shipped liquids, which always rise to an even level in tank cards b. Standard Oil evened-out shipments between railroads to keep them from pricing too low c. Standard Oil s rebated freights rates were consistent, i.e., even d. Actually nothing. It s just a cute nickname for Standard Oil 26. The decision by firms to bundle products a. Always means more profits b. Must be decided on a case by case basis c. Makes production more efficient d. None of the above 27. A tie-in sale normally implies a. Different users are charged different prices depending on usage b. Different users are charged different prices depending group membership c. Different users are charged different prices depending on location d. Different users are charged the same price no matter how much they use 28. Increasing total welfare always means: a. Consumer surplus increases b. Consumer surplus declines c. Consumer surplus remains static d. All of the above are possible 29. Under First-degree Price Discrimination, social welfare (total surplus): a. Always declines b. Always increases c. Always remains unchanged d. All of the above are possible 30. Under First-degree Price Discrimination, the firm ends up: a. Losing money b. Extracting the whole consumer surplus c. Sharing the consumer surplus d. None of the above

5 PART III. Problems Solve the following Price Discrimination Problems. Please show your work. (2 ½ points each) 31. A salesman sells the same product in New York and LA. The demand curve for this product in New York is P NY = 20 Q NY and in LA it s P LA = 10 Q LA. For all customers, marginal cost = $2. a. What is the profit maximizing price, if the salesperson charges both New York and LA customers the same price? Q NY = 20 - P NY + Q LA = 10 - P LA = Q = 30 2P Rearranging 2P = 30 Q P = 15 Q/2 TR = P*Q = 15Q Q 2 /2 MR = TR = 15 Q MR = MC = 2 = 15 Q -13 = -Q Q = 13 P = 15 13/2 = $8.50 i) What are the quantities sold in New York and Los Angeles? Q NY = = Q LA = = 1.50 Q = 13 ii) What is the total profit for transactions in both cities? Profit = TR TC = 13(8.50) 13(2) = $84.50 b. Suppose the sales person adopts a third-degree pricing strategy, charging different prices in New York and LA. What are the profit maximizing prices in both cities? TR NY = P*Q = 20Q Q 2 MR NY = TR NY = 20 2Q MR = MC 20 2Q = 2-2Q = -18 Q NY = 9 Plug back into equation P NY = 20 9 = $11 TR LA = P*Q = 10Q Q 2 MR LA = TR LA = 10 2Q MR = MC 10 2Q = 2-2Q = -8 Q LA = 4 Plug back into equation P LA = 10 4 = $6 i) What are the quantities sold in New York and LA? How does the aggregate quantity compare with the quantity in Part a? Q NY = 9 Q LA = 4 The aggregate quantity is still 13, meaning that they have captured more of the consumer surplus. ii) What is the aggregate profit for sales in both New York and LA? Total profit = TR TC = 9(11) + 4(6) 13(2) = $97

6 32. A popular energy drink has two types of users. Heavy users value a bottle at $6.00 and are willing to buy a second bottle, but only if it sells for $4.00. Light users value a bottle at only $5.00 and under no circumstances would purchase a second bottle. Assume there are 100 heavy users and 100 light users and that the seller s cost per bottle = $2.00. a. Price per bottle = $7 What is the quantity sold? 0 What is the total revenue? 0 What is the producer surplus (profit)? 0 What is the consumer surplus? 0 What is the total surplus? 0 b. Price per bottle = $4.00 What is the quantity sold? 2(100)+100 = 300 What is the total revenue? 300($4.00) = $1,200 What is the producer surplus (profit)? $1,200 - $2.00(300) = $600 What is the consumer surplus? 100($6.00-$4.00) + 100($4.00-$4.00) ($5.00-$4.00) = $300 What is the total surplus? $600 + $300 = $900 c. Seller offers a quantity discount First bottle for $5.00 $1.00 off the second bottle ($4.00 price) What is the quantity sold? 2(100) = 300 What is the total revenue? 5.00(100) (100) (100) = $1,400 What is the producer surplus (profit)? $1,400 $2.00(300) = $800 What is the consumer surplus? 100($6.00-$5.00) + 100($4.00-$4.00) + 100($5.00-$5.00) = $100 What is the total surplus? $800 + $100 = $900 d. What is the difference in Total Surplus (Consumer Surplus + Profit) between b. and c.? Given your answer, why do you as a seller prefer offering the quantity discount? The difference in Total Surplus is $900 - $900 = 0. As a seller, I prefer to offer the quantity discount because it allows me to capture more of the consumer surplus as profits ($200 more).

7 Part IV. SHORT Essay Please choose one of the following two topics to write a short (~100 word) essay. For TOPIC 2 provide actual dollar amounts as required. (5 points) TOPIC 1: First-, Second- and Third- degree Price Discrimination may increase total welfare (total surplus). Briefly explain why price discrimination may increase total welfare and why even if total welfare is increased the consumer surplus might be reduced or completely disappear. TOPIC 2: Briefly explain Pure Bundling and Mixed Bundling and then use the information below to illustrate the revenue advantage of Pure Bundling. Specifically, how much more revenue will a monopolist earn using a Pure Bundling strategy rather than selling each item individually? CUSTOMER Price for a Cheeseburger Price for a Bag of Fries Customer A will pay: $4.00 for a cheeseburger $2.00 for a bag of fries Customer B will pay: $3.00 for a cheeseburger $3.00 for a bag of fries Topic 1: Price discrimination may increase total welfare because they are able to capture consumers that were not willing to pay at a certain price level. Thus, the consumer benefits from the product and the firm captures the surplus as profits. If a firm uses first degree price discrimination, then that means that they know the maximum price that they can charge each consumer. This means that all of the consumer surplus will be captured as profits (producer surplus). Topic 2: Pure bundling is when products can only be bought together and cannot be sold individually. Mixed bundling gives you the option of buying the products individually. If the monopolist were to bundle, revenue would be $6 ($4 + $2 or $3 + $3) from each customer. Selling each item individually would mean a loss of potential revenue (i.e. selling at $3.00 for a cheeseburger or $2.00 for a bag of fries, instead of selling them together).