This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON EC3099 ZA

BSc degrees and Diplomas for Graduates in Economics, Management, Finance and the
Social Sciences, the Diplomas in Economics and Social Sciences and Access Route

Industrial Economics

Thursday, 3 May 2012 : 10.00am to 1.00pm

Candidates should answer FOUR of the following EIGHT questions, including at least ONE
from Section A, ONE from Section B and TWO further questions from either section. All
questions carry equal marks.

© University of London 2012

SECTION A

1. Shareholders may or may not be able to observe the effort exerted by the manager of their firm. On
the other hand, they can typically observe an outcome which depends on the level of effort that is
exerted, such as the firm’s output or profit. Describe how shareholders can design employment
contracts that give the manager incentives to exert the right amount of effort (from the shareholders’
point of view) when:
(a) the effort of the manager is observable, and
(b) the effort of the manager is unobservable.

2. Discuss how tacit collusion between firms may be sustainable as an equilibrium when firms interact
repeatedly. Explain how this analysis may help clarify some of the conditions facilitating or hindering
collusion. What do you think are the policy implications of the analysis?

3. Indicate whether each statement below is true or false, and give a brief reason for your answer.

(a) A firm that sells two complementary products will price them lower than if they were sold by
two separate firms. (5 marks)

(b) The Cournot oligopoly model is useless for analysing competition among firms because:
i. firms normally choose prices, not quantities, and
ii. firms normally don't take their decisions simultaneously. (5 marks)

(c) Resale price maintenance should be illegal. (5 marks)

(d) Entry deterrence and entry accommodation call for the same strategy when product decisions are
strategic substitutes, and for opposing strategies when product decisions are strategic
complements. (5 marks)

(e) Price competition is less intense in more concentrated industries. (5 marks)

4. ‘Price-cap regulation is more efficient than rate of return regulation.’ Discuss this statement, with
reference to an economic analysis of the links between type of regulation, incentives of regulated firms
to reduce costs, allocative efficiency, and productive efficiency.

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SECTION B

5. Consider an industry with free entry and inverse market demand p = a – bQ, where p is price and Q is
total industry output. Each firm has a constant marginal cost c. Firms play a two-stage game with
entry at a fixed and sunk cost F in the first stage, followed by quantity or price competition in the
second stage.

(a) Suppose that firms compete in the second stage of the game by simultaneously setting quantities.
Determine the number of firms that will enter at equilibrium and examine how this number and
total output will be affected by;
i. a technological change that reduces F and
ii. a technological change that reduces c. (9 marks)

(b) Suppose that firms compete in the second stage of the game by simultaneously setting prices.
Determine the number of firms that will enter at equilibrium and examine how this number and
total output will be affected by:
i. a technological change that reduces F and
ii. a technological change that reduces c. (9 marks)

(c) Discuss how the number of firms that enter at equilibrium would be affected if firms colluded in
the second stage. (7 marks)

6. A property developer is selling new villas in Spain. The cost of building each villa is 100,000 euros.
There are two types of potential buyers. Type 1 buyers are willing to pay up to 250,000 – 10,000M,
where M is the number of months that they would have to wait before taking possession of the villa.
Type 2 buyers are willing to pay up to 200,000 – 1,000M. Let us assume for simplicity that the
developer could supply all villas immediately if he/she wanted. Assume further that there are 20
impatient (i.e. type 1) buyers and 20 patient (i.e. type 2) buyers. Each buyer buys at most one villa.
The developer cannot tell the different types of buyers apart. Moreover, administrative fees are high
enough to prevent any reselling between buyers.

(a) Suppose first that M = 0. What is the price that maximises the developer’s profit? How much
profit does the developer make? (5 marks)

(b) Suppose now that the developer can choose M as well as the price he/she asks for the villa. The
developer offers two options. In the first option, the villa costs 190,000 and is available in 6
months. In the second option, the villa costs 240,000 and is available now. Which option will a
type 1 buyer choose? Which option will a type 2 buyer choose? How much profit does the
developer make? (10 marks)

(c) Can the developer do even better than in part (b)? How? What is the most profitable
combination of offers that the developer can select? (10 marks)

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7. An upstream manufacturer whose marginal cost is c = 6 sells his product to two retailers who play a
two stage game. First, the retailers simultaneously and independently decide whether or not to launch
an advertising campaign. If at least one retailer pays for the advertising campaign, market demand is
high: p = AH − Q, where AH = 24 and Q denotes total quantity in the market. If neither one launches
the advertising campaign, demand is low: p = AL − Q, where AL = 15. The advertising campaign costs
S = 28. The manufacturer cannot launch the advertising campaign himself and cannot force the
retailers to pay for it. Next, given the high or low demand, the retailers simultaneously and
independently choose quantities. Each retailer gets the product from the manufacturer for the unit
price r = c = 6 and also pays a fixed franchise fee equal to T.

(a) What are the retailers’ equilibrium profits if both pay S, if one of them pays S and if neither of
them pays S? Is the advertising campaign launched in the Nash equilibrium? What is the
maximum franchise fee that the manufacturer can extract from the two retailers? (12 marks)

(b) Suppose the manufacturer can impose a resale price maintenance agreement on each retailer,
saying that they are to sell the good for a price p* = 15. In this case, each retailer will have half
of the market. What are the retailers’ equilibrium profits if both pay S, if one of them pays S and
if neither of them pays S? Is the advertising campaign launched in the Nash equilibrium? What
is the maximum franchise fee that the manufacturer can extract from the two retailers? Compare
this with the manufacturer’s profit in part (a) and provide intuition for the result. (13 marks)

8. Consider a homogeneous good industry with inverse demand given by P = 100 – 2Q, where Q is total
industry output. There is one incumbent firm in the industry and one potential entrant. Each firm has
cost function Ci = 10qi, where qi is output of firm i. Entry into the industry implies a sunk cost of E.
Suppose that the firms play the following game: at stage 1 the incumbent chooses a level of output; at
stage 2, the potential entrant (having observed the incumbent's choice) decides whether to enter or not
and, if it enters, it chooses its own output.

(a) Compute the entrant's reaction function and show that the entrant's equilibrium profit is
decreasing in the incumbent's output. (7 marks)

(b) If the incumbent firm decides to accommodate entry, what is its optimal choice of output and the
corresponding profit? (6 marks)

(c) What output should the incumbent set in order to deter entry? What is the corresponding profit?
How do these depend on E? Provide some intuition. (7 marks)

(d) Determine the lowest value of E such that the incumbent prefers to deter entry. (5 marks)

END OF PAPER

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