Spring 2004 FINAL EXAM

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1 Econ147 Final: Page 1 of 8 NAME: Honor Pledge Economics 147 Spring 2004 FINAL EXAM John Stewart INSTRUCTIONS: - Answer each of the questions in the space provided. If additional space is required, use the backs of the pages but clearly indicated that the answer is continued and where the rest of the answer is to be found. - Neatness and clarity of exposition count. - You may not use books or notes. You may use a calculator. Part I (20 points) Part II (30 points) Part III-1 (20 points) -2 (20 points) -3 (10 points) -4 (10 points) -5 (10 points) Part IV (20 points) TOTAL (140 points) Bonus (10 points) I. Define, describe, or in some way demonstrate your knowledge of the following terms as they relate to this course. Technical terms are shown in bold print and require a precise technical definition. (4 points each) 1-1. Credible threat 1-2. Lerner Index 1-3. Nash Equilibrium 1-4. Chamberlin Model 1-5. Limit price

2 Econ147 Final: Page 2 of 8 II. Multiple Choice & True False: Clearly indicate the best answer for each question. (5 points each) Fly-By-Night Airway has a marginal cost of $70 for flying an additional passenger from Newark to Detroit. FBN's regular fair is $140 but for senior citizens the charge a fair of $80. Market research show that the price elasticity of demand for regular customers is 2.0 and the price elasticity for senior citizens is 4.0. Assuming the FBN's objective is to maximize profits, which of the statements below is correct. (Show your work in the space provided.) a. Both prices are a the correct level. b. Both prices are too high. c. Both prices are too low. d. The Senior Citizen price is too high; the regular price too low. e. The Senior Citizen price is too low; the regular price correct. f. None of the above statements are correct In his analysis of in his article on the Ready-to-eat Cereal Industry, Schmalensee argues (mark True or False for each statement) production scale economies in the cereal manufacturing industry were small, but multi-brand economies were significant so that minimum efficient scale product required that a firm have at least 25% of the market. there were significant technical barriers to entry because of the complexity of the production process. the industry suffered from destructive price competition. though profits were higher than in other food manufacturing industries, there had been virtually no entry of new firms for decades. the dominant firms had achieved their advantage through using brand proliferation to block entry The statements below refer to antitrust case that were assigned as reading or that were discussed in class. For each of the statements listed below, indicated whether the statement is (T)rue or (F)alse. In the Amino Acid Lysine Case (1996), Section 7 of the Clayton Act was used to block a merger between Archer-Daniels-Midland and a large Korean manufacture of Lysine. The school milk case is a classic example of the enforcement of Section 1 of the Sherman Act. In the 2001 Microsoft case, the trial judge concluded that the relevant economic market was web browser software. In a Section 2 Sherman Act case, it is necessary to prove both that the accused firm had market power and that it obtained or held that power through the use of predatory or exclusionary tactics. Toys R Us (2000) was found by the FTC to be engaged in illegal vertical restraint because it tried to stop toy manufactures from selling to discount club stores For each of the statements listed below, indicated whether the statement is (T)rue or (F)alse. The 1984 NCAA was decided under a rule of reason interpretation of Section 1 of the Sherman Act. The Dorfman-Steiner model predicts that a competitive firm never advertise. A market with 10 equal sized firms (each firm has a market share of 10%) will have a Herfindahl index of 1000 (on a 0 to 10,000 scale). Stewart and Kim (1993) confirmed Williamson s theory by presenting empirical evidence that mergers resulted in welfare gains. Non profit corporations in the US are exempt from the antitrust laws.

3 Econ147 Final: Page 3 of Consider a market where total accounting profits are $100,000 and, on average, firms in this market are realizing an 10% rate of return on their investment. The average rate of return in all industries of similar risk is 7.5% but in very competitive market firms average only 5%. Total sales in the market are $500,000. In calculating monopoly welfare loss consider wether the following statements apply to the calculation as the would have been made by (H)arberger, (C)owling & Mueller,(B)oth or (N)either and the mark the correct letter in the space in front of the statement. a. Monopoly profits are $50,000. b. Monopoly profits are $25,000 c. The deadweight welfare loss is = ½ P x Q d. The price elasticity of demand in this market is 1. f. Monopoly welfare loss in this market is less than $ Consider the following regression equation estimated by John Kwoka. The regression was estimated using a sample of FTC Line of Business markets observed in the 1970s. PCM = H KO DISP GROW CDUM MCDR (4.04) (4.64) (2.61) (2.32) (3.65) (3.17) where t ratios are in parentheses; R 2 =.178 PCM is the price cost margin observed in the market (the percent by which price exceeds average variable cost) H is the market Herfindahl index (measured on a scale of 0 to 1) KO is the capital output ratio (value of capital in the market divide by total sales) DISP is a measure of the degree to which the market is really composed of a number of local markets. GROW is a measure of the demand growth rate in the market. CDUM is a dummy variable for consumer goods markets (has a value of one if the market is a consumer good market and value of 0 otherwise.) MCDR is the cost disadvantage ratio (a measure of scale economies; the large the scale economies in the market, the large will be the value of MCDR). Using the regression equation above, mark each statement below as (T)rue of (F)alse. a. All of the variable included in the regression equation are with probability at least ninety percent not equal to zero. b. Given the regression results, it is less likely that the true effect of the capital output ratio (KO) on price cost margins is zero than it is that the true effect of market growth (GROW) on profits is zero. c. A market that is a pure monopoly has an estimated price-cost margin of 40% (.400). If that market could be structured as a perfectly competitive market, we would predict that its margins would fall to 15% (.15) d. The six variable included in the regression "explain" about 18% of the variation of price-cost margins observed in the sample. e. On average price-cost margins in consumer goods markets are about 3.8% higher than they are in nonconsumer goods markets.

4 Econ147 Final: Page 4 of 8 III. Graphs and Problems Points as indicated (For graph problems, use the same labels as indicated in the question.) 3-1. (20 points) Consider a market with a market demand curve: P = Q where P is the price ($ per unit) and Q is the quantity; and where all firms have identical constant marginal cost of $20.00 per unit. a. If the market is structure as perfect competition, then the equilibrium market price will be P comp = and the market equilibrium quantity will be Q comp =. b. If the market is structure as a duopoly with only two firm that compete as a Cournot duopoly, the market equilibrium price will be P cournot = and the market equilibrium quantity will be Q cournot =. c. Now consider a merger between the two firms in which the merger allow the two firm to become a monopolist and allows the merged firm to reduce its marginal cost to $18.00 per unit. What will be the market equilibrium quantity and price that will result form the merger? P merger = Q merger = d. Relative to the Cournot market outcome (part b), was social welfare increased or decreased by the merger? How large was the change in welfare caused by the merger? (Numerical answer required) Explain your thought process and show your work. (Hint: draw a diagram as a guide to how the make the welfare calculation.) Welfare increases or decreases? (Circle one) Change in welfare =

5 Econ147 Final: Page 5 of (20 points) Consider a market in which there is one very large dominant firm and a large number of small price-taking fringe firms. The diagram shows the market demand (D MARKET ), the supply curve of the fringe firms (S fringe ) and the marginal cost curve of the dominant firm (MC DOMINANT ). You may ignore entry in this problem. (Mathematically, the dominant firm has a constant marginal cost MC DOMINANT =.5, the market demand curve is P =5 -.05Q, and the fringe firm supply (marginal cost) curve is MC fringe = Q fringe $5 $4 $3 $2 $1 Market Price DMARKET SFRINGE MCDOMINANT Market Quantitiy a. On the diagram, draw in the demand curve faced by the dominant firm and the marginal revenue curve associated with the dominant firm s demand curve. Clearly label the curves. b. Assuming that the dominant firm is a profit maximizer, what level of output will the dominant firm choose to produce? (Numerical answer required, but you may use the graph as the basis for getting your numbers) c. What will be the market price and total market output in equilibrium? (Numerical answer required, but you may use the graph as the basis for getting your numbers) Price = Quantity = 3.3 (10 points) Now consider a slightly different situation but using the same information as you used in problem 3.2. Let the dominant firm be a monopoly and the current incumbent firm, and consider the fringe firms to be potential entrants. The Incumbent firm will announce a price and then produce the quantity necessary for the announced price to be realized. Given the announced price, the fringe firms can either decide to enter (and produce a quantity that maximizes their profits at that price. Remember that they are price takers so will produce along the fringe supply curve,) or they can decide not to enter (and thus produce zero). a. (1 point) Is there a limit price in this model? yes or no b. (2 points) If yes, what is the limit price (numerical answer required, put none if there isn t a limit price) c. (7 points) Will the Incumbent firm charge the limit price or will the incumbent firm price as a dominant firm as he did in the previous problem? (Problem 3.2.) Explain your answer completely.

6 Econ147 Final: Page 6 of (10 points) Consider a market with an Incumbent (Firm I) with constant marginal cost (MC I = 4)and facing a market demand P = Q. The firm faces one potential entrant (Firm E) with identical marginal cost (MC E = 4). a. Assume that the incumbent can announce what strategy it will follow if the potential entrant comes into to the market. For each strategy listed below, state whether the threat is credible, and what the potential entrants likely reaction would be to the announced action of the incumbent assuming that the potential entrant believes the threat (i.e. will Firm E enter? How much will he produce?) (Hint: what will incumbent firm and entering firm profits be in each case?) Strategy 1: I will produce the monopoly level of output, and if you enter, I will increase my output to the competitive level. Credible yes or no, Entrants likely reaction: Strategy 2: I will produce the monopoly level of output, and if you enter I will hold to that level of output. Credible yes or no, Entrants likely reaction: Strategy 3: I will produce the monopoly level of output, and if the you enter, I will accommodate entry and compete with the entrant as a Cournot firm. Credible yes or no, Entrants likely reaction: b. Now suppose the incumbent discovers that if he invests 25 dollars in advertising that the other firm will have to match this expenditure or it will be unable to enter the market. Will the incumbent make the investment? What strategy will he follow (which one from part A) Will his actions deter entry? Explain your answer (10 points) Consider the following pay-off matrix for two firms in duopoly game. Firm B s Action Firm A s Action High Price Low Price High Price 100, ,90 Low Price 110, 25 90, 80 First consider the situation as a one shot Game. a. Does Firm A have a dominant strategy?. If yes, what is it? b. Does Firm B have a dominant strategy?. If yes, what is it? c. If both players have full information, does this game have a one shot Nash Equilibrium? If yes, what is the equilibrium. d. If we were to consider a world in which this game were to played repeatedly, rather than as a single shot game,

7 Econ147 Final: Page 7 of 8 what would you expect the outcome to be? Explain your logic carefully. IV. Short Essay (20 points) A major theme in our discussion of antitrust policy is that there are often two opposite interpretations of a given behavior of firms. The same action might be interpreted as firms acting to increase the efficiency of the market while the same action might be interpreted as the firm acting to enhance or exploit its market power. This problem is most obvious in the antitrust treatment of vertical restrictions. Discuss the above paragraph using illustrations for one from one or more of the antitrust case you have read or that were discussed in class. Make sure you clearly describe the action and how it might have both efficiency and anticompetive effects. Bonus (10 points) During the course of the semester we often used the soft drink industry as an example. List 5 facts that you learned about this industry. (Silly or obvious facts that you would have know anyway will not be counted)

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