ASSIGNMENT 2

MANAGERIAL ECONOMICS
Choose a minimum of 4 questions. 2 conceptual and computational questions, and 2
problems and applications for each chapter from chapter 7 to chapter 14.
English or Bahasa is acceptable.

BRAMANTYO CIPTA ADI

20/468967/NEK/00362

MAGISTER MANAGEMENT
FAKULTAS EKONOMI DAN BISNIS
UNIVERSITAS GADJAH MADA
2020
 CHAPTER 7: The Nature of Industry

Conceptual and Computation Questions

1. Ten firms compete in a market to sell product X. The total sales of all firms selling
the product are $2 million. Ranking the firms’ sales from highest to lowest, we find
the top four firms’ sales to be $260,000, $220,000, $150,000, and $130,000,
respectively. Calculate the four-firm concentration ratio in the market for product
X.
Answer:
The four-firm concentration ratio is:

3. Suppose the own price elasticity of market demand for retail gasoline is −0.8, the
Rothschild index is 0.5, and a typical gasoline retailer enjoys sales of $1.5 million
annually. What is the price elasticity of demand for a representative gasoline
retailer’s product?
Answer:
.
The elasticity of demand for a representative firm in the industry is –1.6

6. Under what conditions might the Justice Department approve a merger between
two companies that operate in an industry with a premerger Herfindahl-Hirschman
index of 2,900 if the postmerger index is expected to increase by 225?
Answer:
To the extent that the HHIs are based on too narrow a definition of the product (or
geographic) market or the impact of foreign competition, the merger might be
allowed. It might also be allowed if one of the firms is in financial trouble, or if
significant economies of scale exist in the industry.

10. The four-firm concentration ratios for industries X and Y are 81 percent and 74
percent, respectively, while the corresponding Herfindahl-Hirschman indexes are
3,100 and 1,600. The Dansby-Willig performance index for industry X is 0.7, while
that for industry Y is 0.55. Based on this information, which would lead to the
greater increase in social welfare: a slight increase in industry X’s output or a slight
increase in industry Y’s output?
Answer:

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 A slight increase in output in industry X will have the greatest impact on increasing
social welfare since the Dansby-Willig index is higher in industry X.
Problems and Aplications
11. You work at a firm on Wall Street that specializes in mergers, and you are the team
leader in charge of getting approval for a merger between two major beer
manufacturers in the United States. While Table 7–2 in the text indicates that the
four-firm concentration ratio for all of the breweries operating in the United States
is 90 percent, your team has put together a report suggesting that the merger does
not present antitrust concerns even though the two firms each enjoys a 15 percent
share of the U.S. market. Provide an outline of your report.
Answer:
The four-firm concentration ratios in Table 7-2 are likely to overstate the level of
concentration in the U.S. Imported beers account for much of the sales in the U.S. It
is likely that the brewing industry is much less concentrated than Table 7-2 leads
us to believe.

12. Forey, Inc., competes against many other firms in a highly competitive industry.
Over the last decade, several firms have entered this industry and, as a
consequence, Forey is earning a return on investment that roughly equals the
interest rate. Furthermore, the four-firm concentration ratio and the Herfinahl-
Hirschman index are both quite small, but the Rohschild index is significantly
greater than zero. Based on this information, which market structure best
characterizes the industry in which Forey competes?
Answer:
This industry is most likely monopolistically competitive. Monopolistically
competitive industries have concentration measures close to zero, but since each
firm’s product is slightly differentiated, the Rothschild index will be greater than
zero (unlike perfectly competitive markets).

16. Suppose Fiat recently entered into an Agreement and Plan of Merger with Case for
$4.3 billion. Prior to the merger, the market for four-wheel-drive tractors consisted
of five firms. The market was highly concentrated, with a Herfindahl-Hirschman
index of 2,765. Case’s share of that market was 22 percent, while Fiat comprised
just 12 percent of the market. If approved, by how much would the postmerger
Herfindahl-Hirschman index increase? Based only on this information, do you think
the Justice Department would challenge the merger?
Answer:
If approved, the merger would raise the HHI by 10,000[(0.22 + 0.12)2 – (0.22)2 –
(0.12)2] = 528 points. This means the post-merger HHI would be 3,293 (= 2,765 +

2
 528). Since the post-merger HHI is greater than 2,500 and the change in HHI is
greater than 200, this merger likely will be challenged by the government.

CHAPTER 8: Managing in Competitive, Monopolistic, and Monopolistically

Competitive Markets

Conceptual and Computation Questions

5. You are the manager of a firm that produces a product according to the cost
function C(qi) = 160 + 58qi − 6qi2 + qi3. Determine the short-run supply function if:
a. You operate a perfectly competitive business.
b. You operate a monopoly
c. You operate a monopolistically competitive business
Answer:
a. A perfectly competitive firm’s supply curve is its marginal cost curve above the
minimum of its AVC curve.

.
Since MC and AVC are equal at the minimum point of AVC, set MCi = AVCi to get
, or qi = 3. AVC is minimized at an output of 3
units, and the corresponding AVC is . Thus the
firm’s supply curve is described by the equation if P ≥
$49, otherwise, the firm produces zero units.
b. A monopolist produces where MR = MC and thus does not have a supply curve.
c. A monopolistically competitive firm produces where MR = MC and thus does
not have a supply curve.

7. You are the manager of a monopolistically competitive firm, and your demand and
cost functions are given by Q = 36 − 4P and C(Q) = 4 + 4Q + Q2.
a. Find the inverse demand function for your firm’s product.
b. Determine the profit-maximizing price and level of production.
c. Calculate your firm’s maximum profits.
d. What long-run adjustments should you expect?
Answer:
a. Q = 3 units; P = $70.
b. Q = 4 units; P = $60.
c. DWL=1/2 ($70-$40)(1)=$15.

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8. The elasticity of demand for a firm’s product is –2.5 and its advertising elasticity of
demand is 0.2.
a. Determine the firm’s optimal advertising-to-sales ratio.
b. If the firm’s revenues are $40,000, what is its profit-maximizing level of
advertising?
Answer:
a. The optimal advertising to sales ratio is given by .
b. .

Problems and Aplications

12. You are the manager of a small U.S. firm that sells nails in a competitive U.S. market
(the nails you sell are a standardized commodity; stores view your nails as identical
to those available from hundreds of other firms). You are concerned about two
events you recently learned about through trade publications: (1) the overall
market supply of nails will decrease by 2 percent, due to exit by foreign
competitors, and (2) due to a growing U.S. economy, the overall market demand for
nails will increase by 2 percent. Based on this information, should you plan to
increase or decrease your production of nails?
Answer:
Since you are a perfectly competitive firm, the price you charge is determined in a
competitive market. The two events summarized will result in a decrease in market
supply and an increase in the market demand, resulting in a higher market price
(from P0 to P1 in the graphs below). The profit-maximizing response to this higher
price is to increase output. This is because you are a price taker (hence P = MR = the
demand for our product) and the increase in price from P0 to P1 means that MR
> MC at the old output. It is profitable to increase output from q0 to q1, as shown
below.

4
 P r ice
M ark e t P ric e MC

S1 P1

P1 S0
P0
P0 D1

D0

M ark et Q u a n tity q0 q1 F ir m ’ s O u tp u t

13. When the first Pizza Hut opened its doors back in 1958, it offered consumers one
style of pizza: its Original Thin Crust Pizza. Since its modest beginnings, Pizza Hut
has established itself as the leader of the $25 billion pizza industry. Today, Pizza
Hut offers six styles of pizza, including Pan Pizza, Stuffed Crust Pizza, and its Hand-
Tossed Style. Explain why Pizza Hut has expanded its offerings of pizza over the
past six decades, and discuss the long-run profitability of such a strategy.
Answer:
It competes in a monopolistically competitive market. Short run profits may be
earned by introducing new products more quickly than rivals. Over time, other
firms will innovate too, so in the long run Pizza Hut earns zero economic profits.

14. You are the manager of a small pharmaceutical company that received a patent on
a new drug three years ago. Despite strong sales ($150 million last year) and a low
marginal cost of producing the product ($0.50 per pill), your company has yet to
show a profit from selling the drug. This is, in part, due to the fact that the company
spent $1.7 billion developing the drug and obtaining FDA approval. An economist
has estimated that, at the current price of $1.50 per pill, the own price elasticity of
demand for the drug is –2. Based on this information, what can you do to boost
profits?
Answer:
Profit maximization requires equating MR and MC.

MC = $0.50, MR > MC.

This means the firm can increase profits by reducing price in order to sell more
pills.

19. In a statement to Gillette’s shareholders, its CEO indicated, “Despite several new
product launches, Gillette’s advertising-to-sales declined dramatically . . . to 7.5
percent last year. Gillette’s advertising spending, in fact, is one of the lowest in our
peer group of consumer product companies.” If the elasticity of demand for
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 Gillette’s consumer products is similar to that of other firms in its peer group
(which averages –4), what is Gillette’s advertising elasticity? Is Gillette’s demand
more or less responsive to advertising than other firms in its peer group?
Answer:

Gillette’s advertising elasticity is 0.3. Gillette’s demand is less responsive to

advertising than its rivals. Their higher advertising-to-sales ratio imply a greater
advertising elasticity.

CHAPTER 9: Basic Oligopoly Models

Conceptual and Computation Questions

2. The inverse market demand in a homogeneous-product Cournot duopoly is P = 200
−3(Q1 + Q2) and costs are C1(Q1) = 26Q1 and C2(Q2) = 32Q2.
a. Determine the reaction function for each firm.
b. Calculate each firm’s equilibrium output.
c. Calculate the equilibrium market price.
d. Calculate the profit each firm earns in equilibrium.
Answer:
a. and
b. Q1 = 20; Q2 = 18.
c. P = 200 – 3(38) = $86.
d. Π1 = $1,200; Π2 = $972.

4. The inverse demand for a homogeneous-product Stackelberg duopoly is P= 16,000

− 4Q. The cost structures for the leader and the follower, respectively, are CL(QL) =
4,000QLand CF(QF) = 6,000QF.
a. What is the follower’s reaction function?
b. Determine the equilibrium output level for both the leader and the follower.
c. Determine the equilibrium market price.
d. Determine the profits of the leader and the follower.
Answer:
a.
b. QL = 1,750; QF = 375.
c. P = 16,000 – 4(2,125) = $7,500.
d. ΠL = $6,125,000; ΠF = $562,500.

7. Two firms compete in a market to sell a homogeneous product with inverse

demand function P = 600 − 3Q. Each firm produces at a constant marginal cost of
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 $300 and has no fixed costs. Use this information to compare the output levels and
profits in settings characterized by Cournot, Stackelberg, Bertrand, and collusive
behavior.
Answer:
Model Output Profits
Cournot Q1 = Q2 = 33.33 π1 = π2 = $3,333.33
Stackelberg QL = 50; QF = 25 πL = $3,750; πF = $1,875
Bertrand Market output = 100 units Zero
Collusion Market output = 50 units Industry Profits = $7,500

Problems and Aplications

11. Ford executives announced that the company would extend its most dramatic
consumer incentive program in the company’s long history—the Ford Drive
America Program. The program provides consumers with either cash back or zero
percent financing for new Ford vehicles. As the manager of a Ford franchise, how
would you expect this program to impact your firm’s bottom line?
Answer:
This would positively impact sales and the firm’s bottom line if Ford is the only
company to offer such a program. However, one would expect rivals (such as GM)
to respond with a similar plan. This would reduce the impact of Ford’s program
on your sales and bottom line. Indeed, GM did quickly respond with its Drive
America program.

12. You are the manager of BlackSpot Computers, which competes directly with
Condensed Computers to sell high-powered computers to businesses. From the
two businesse’s perspectives, the two products are indistinguishable. The large
investment required to build production facilities prohibits other firms from
entering this market, and existing firms operate under the assumption that the
rival will hold output constant. The inverse market demand for computers is P =
5,900 − Q, and both firms produce at a marginal cost of $800 per computer.
Currently, BlackSpot earns revenues of $4.25 million and profits (net of
investment, R&D, and other fixed costs) of $890,000. The engineering department
at BlackSpot has been steadily working on developing an assembly method that
would dramatically reduce the marginal cost of producing these high-powered
computers and has found a process that allows it to manufacture each computer
at a marginal cost of $500. How will this technological advance impact your
production and pricing plans? How will it impact BlackSpot’s bottom line?
Answer:

7
 This market is a homogeneous product Cournot oligopoly. Using the given
information about demand and costs, each firm has a reaction function of
.
Solving for equilibrium quantities results in each firm producing 1700 units. This
means the market price is P = 5,900 – (3,400) = $2,500.
Since BlackSpot’s marginal cost is $800, it follows that its profit gross of fixed
costs is (P – MC)Qi = ($2,500 - $800)(1,700) = $2,890,000. (Since profits net of
fixed costs are only $890,000, it follows that BlackSpot’s fixed costs are $2
million). When marginal cost for BlackSpot falls to $500 (but Condensed
Computers’ marginal cost remains at $800), BlackSpot’s new reaction function
becomes .
Solving for equilibrium quantities using this new reaction function for BlackSpot
(but the old one for Condensed Computers) gives us 1,900 units produced by
BlackSpot and 1,600 units produced by Condensed Computers.
So, the market price is P = 5,900 – (1,900 + 1,600) = $2,400. BlackSpot’s profit
becomes ($2,400 – $500)(1,900) – $2,000,000 = $1,610,000.
So, profit increases by $720,000.

13. PC Connection and CDW are two online retailers that compete in an Internet
market for digital cameras. While the products they sell are similar, the firms
attempt to differentiate themselves through their service policies. Over the last
couple of months, PC Connection has matched CDW’s price cuts but has not
matched its price increases. Suppose that when PC Connection matches CDW’s
price changes, the inverse demand curve for CDW’s cameras is given by P = 1,500
− 3Q. When it does not match price changes, CDW’s inverse demand curve is P =
900 − 0.50Q. Based on this information, determine CDW’s inverse demand and
marginal revenue functions over the last couple of months. Over what range will
changes in marginal cost have no effect on CDW’s profit-maximizing level of
output?
Answer:
The inverse demand function for this Sweezy oligopoly is

The marginal revenue function is

8
 Therefore, changes in marginal cost in the range of $60 and $660 will not result in
a change in the profit-maximizing level of output.

CHAPTER 10: Game Theory: Inside Oligopoly

Conceptual and Computation Questions

6. Consider a two-player, sequential-move game where each player can choose to
play right or left. Player 1 moves first. Player 2 observes player 1’s actual move
and then decides to move right or left. If player 1 moves right, player 1 receives $0
and player 2 receives $25. If both players move left, player 1 receives –$5 and
player 2 receives $10. If player 1 moves left and player 2 moves right, player 1
receives $20 and player 2 receives $20.
a. Write this game in extensive form.
b. Find the Nash equilibrium outcomes to this game.
c. Which of the equilibrium outcomes is most reasonable?
Answer:
a. See the accompanying figure:

Left (-$5, $10)

2
Left

Right ($20, $20)

1

Right
($0, $25)

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 b. ($0, $25) and ($20, $20).
c. ($20, $20) is the only subgame perfect equilibrium; the only reason ($0, $25) is
a Nash equilibrium is because Player 2 threatens to play left if 1 plays left. This
threat isn’t credible.

7. Use the following extensive-form game to answer the following questions.

a. List the feasible strategies for player 1 and player 2.
b. Identify the Nash equilibria to this game.
c. Find the subgame perfect equilibrium.

Answer:
a. Player 1 has two feasible strategies: A or B. Player 2 has four feasible
strategies: (1) W if A and Y if B; (2) X if A and Y if B; (3) W if A and Z if B; (4) X if
A and Z if B.
b. There are three Nash equilibria, listed as follows: 1) Player 1 plays A, and
Player 2 plays W if A and Y if B, 2) Player 1 plays B, and Player 2 plays W if A
and Z if B, 3) Player 1 plays B, and Player 2 plays X if A and Z if B. The first
equilibrium results in payoffs of (60, 120). The last two equilibria each result
in payoffs of (100, 150).
c. The subgame perfect equilibrium is: Player 1 plays B, and Player 2 plays W if A
and Z if B. Here, Player 2 makes the optimal choice for him at each node of the
game, and makes only credible threats. These strategies result in payoffs of
(100, 150).

9. Use the following payoff matrix to answer the following questions.

a. Determine the dominant strategy for each player. If such strategies do not
exist, explain why not.
b. Determine the secure strategy for each player. If such strategies do not exist,
explain why not.

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 c. Determine the Nash equilibrium of this game. If such an equilibrium does not
exist, explain why not.
Answer:
a. Both players have dominant strategies. Player 1’s dominant strategy is A and
Player 2’s dominant strategy is C.
b. Player 1’s secure strategy is A. Player 2’s secure strategy is C.
c. The Nash equilibrium is for Player 1 to play A and Player 2 to play C, resulting
in payoffs of (-10, -10).

10. Using the same payoff matrix as in question 9, suppose this game is infinitely
repeated and that the interest rate is sufficiently “low.” Identify trigger strategies
that permit players 1 and 2 to earn equilibrium payoffs of 140 and 180,
respectively, in each period.
Answer:
Player 1’s trigger strategy to sustain a profit of $140 is to play B until Player 2
deviates from strategy D, then play A forever after. Player 2’s trigger strategy is to
play D until Player 1 deviates from strategy B, then play C forever after
Problems and Aplications
14. Suppose a UAW labor contract with General Dynamics is being renegotiated. Some
of the many issues on the table include job security, health benefits, and wages. If
you are an executive in charge of human resource issues at General Dynamics,
would you be better off (a) letting the union bear the expense of crafting a
document summarizing its desired compensation or (b) making the union a take-
it-or-leave-it offer?
Answer:
The savings from letting the union use its own pen and ink to craft the document
are most likely small compared to the advantage you would gain by making a
take-it-or-leave-it offer.

15. Price comparison services on the Internet (as well as “shopbots”) are a popular
way for retailers to advertise their products and a convenient way for consumers
to simultaneously obtain price quotes from several firms selling an identical
product. Suppose that you are the manager of Digital Camera, Inc., a firm that
specializes in selling digital cameras to consumers that advertises with an
Internet price comparison service. In the market for one particular high-end
camera, you have only one rival firm—The Camera Shop—with which you’ve
competed for the last four years by setting prices day after day. Being savvy
entrepreneurs, the ease of using the Internet to monitor rival firms’ prices has
enabled you and your rival to charge extremely high prices for this particular
camera. In a recent newspaper article, you read that The Camera Shop has
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 exhausted its venture capital and that no new investors are willing to sink money
into the company. As a result, The Camera Shop will discontinue its operations
next mont. Will this information alter your pricing decisions today?
Answer:
Since we know for certain that the game will end in 1 month, our optimal strategy
in the finitely repeated pricing game with a known endpoint is to reduce price
(defect) from the implicit collusive agreement between us and the rival.

CHAPTER 11: Price Strategies for Firms with Market Power

Conceptual and Computation Questions

1. Based on the best available econometric estimates, the market elasticity of
demand for your firm’s product is –2. The marginal cost of producing the product
is constant at $150, while average total cost at current production levels is $225.
Determine your optimal per unit price if:
a. You are a monopolist.
b. You compete against one other firm in a Cournot oligopoly.
c. You compete against 19 other firms in a Cournot oligopoly.
Answer:
a. E = EF = EM, .
b.
c.

4. You are the manager of a monopoly that sells a product to two groups of
consumers in different parts of the country. Group 1’s elasticity of demand is −3,
while group 2’s is −5. Your marginal cost of producing the product is $40.
a. Determine your optimal markups and prices under third-degree price
discrimination.

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 b. Identify the conditions under which third-degree price discrimination
enhances profits.
Answer:
a.

b. There are two different groups with different (and identifiable) elasticities of
demand. In addition, we must be able to prevent resale between the groups.

5. You are the manager of a monopoly. A typical consumer’s inverse demand

function for your firm’s product is P = 250 − 40Q, and your cost function is C(Q) =
10Q.
a. Determine the optimal two-part pricing strategy.
b. How much additional profit do you earn using a two-part pricing strategy
compared with charging this consumer a per-unit price?

Answer:
a. Charge a per-unit fee equal of $10, which equals marginal cost. At this price,
you will sell 6 units. The fixed fee then should be (250 – 10)(6)(0.5) = $720.
b. The optimal per-unit price is determined where MR = MC, or 250 - 80Q = 10.
Solving yields Q = 3 units and P = $130. The profits at this output and price are
($130 - $10)(3) = $360. Thus, you earn $360 more by two-part pricing.

Problems and Aplications

11. You are the owner of a local Honda dealership. Unlike other dealerships in the
area, you take pride in your “no-haggle” sales policy. Last year, your dealership
earned record profits of $1.5 million. In your market, you compete against two
other dealers, and the market-level price elasticity of demand for midsized Honda
automobiles is −1.3. In each of the last five years, your dealership has sold more
midsized automobiles than any other Honda dealership in the nation. This entitled
your dealership to an additional 30 percent off the manufacturer’s suggested
retail price (MSRP) in each year. Taking this into account, your marginal cost of a
midsized automobile is $12,000. What price should you charge for a midsized
automobile if you expect to maintain your record profits?
Answer:
Since this is a three-firm oligopoly in the market, and -1.3 is the market-level
elasticity in your market, the profit-maximizing price is as follows:

13
 .

14. According to International Data Corporation (IDC), the number of worldwide

smartphone owners will soon exceed 1.5 billion. That number is expected to grow
at nearly 10 percent per year for the next five years. While the actual cost of a
smartphone is about $300, wireless carriers in some countries offer their
customers a “free” smartphone with a two-year wireless service agreement. Is this
pricing strategy rational?
Answer:
Yes. It is consistent with cross subsidization. Phones and services are
complements in demand. In addition, there may be cost complementarities and
economies of scope since it is cheaper for providers to train employees to activate
in-house phones rather than other brands purchased elsewhere.
This strategy is also consistent with bundling. In this case, the company may say
that the phone is “free,” but in actuality it is part of a bundle that cannot be
broken apart. For the reasons identified in the text, both cross subsidization and
bundling can be used to enhance profits.

15. The American Baker’s Association reports that annual sales of bakery goods last
year rose 15 percent, driven by a 50 percent increase in the demand for bran
muffins. Most of the increase was attributed to a report that diets rich in bran help
prevent certain types of cancer. You are the manager of a bakery that produces
and packages gourmet bran muffins, and you currently sell bran muffins in
packages of three. However, as a result of this new report, a typical consumer’s
inverse demand for your bran muffins is now P = 8 – 1.5Q. If your cost of
producing bran muffins is C(Q) = 0.5Q, determine the optimal number of bran
muffins to sell in a single package and the optimal package price.
Answer:
P = MC to obtain 8 - 1.5Q = 0.5 and solve to obtain the optimal package size,
Q = 5 units.
The total value to a consumer of package of 5 muffins is:
(0.5)($8 – $0.50)(5) + ($0.50)(5) = $21.25).

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16. You own a franchise of rental car agencies in Florida. You recently read a report
indicating that about 80 percent of all tourists visit Florida during the winter
months in any given year and that 60 percent of all tourists traveling to Florida by
air rent automobiles. Travelers not planning ahead often have great difficulty
finding rental cars due to high demand. However, during nonwinter months
tourism drops dramatically and travelers have no problem securing rental car
reservations. Determine the optimal pricing strategy, and explain why it is the
best pricing strategy.
Answer:
For reasons identified in the text, peak-load pricing is probably optimal in this
situation. Under this plan, a higher price should be charged during peak winter
months and a lower price charged during off-peak summer months.

CHAPTER 12: The Economics of Information

Conceptual and Computation Questions

6. You are a bidder in an independent private values auction, and you value the
object at $4,000. Each bidder perceives that valuations are uniformly distributed
between $1,500 and $9,000. Determine your optimal bidding strategy in a first-
price, sealed-bid auction when the total number of bidders (including you) is:
a. 2.
b. 10.
c. 100.
Answer:
a. With only two bidders, n = 2. The lowest possible valuation is L = $1,500, and
your own valuation is v = $4,000. Thus, your optimal sealed bid is
.
b. With ten bidders, n = 10. The lowest possible valuation is L = $1,500, and your
own valuation is v = $4,000. Thus, your optimal sealed bid is
.

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 c. With one hundred bidders, n = 100. The lowest possible valuation is L =
$1,500, and your own valuation is v = $4,000. Thus, your optimal
sealed bid is .

7. You are one of five risk-neutral bidders participating in an independent private

values auction. Each bidder perceives that all other bidders’ valuations for the
item are evenly distributed between $10,000 and $30,000. For each of the
following auction types, determine your optimal bidding strategy if you value the
item at $22,000.
a. First-price, sealed-bid auction.
b. Dutch auction.
c. Second-price, sealed-bid auction.
d. English auction.
Answer:
a. With 5 bidders, n = 5. The lowest possible valuation is L = $10,000, and your
own valuation is v = $30,000. Thus, your optimal sealed bid is
.
b. A Dutch auction is strategically equivalent to a first-price sealed bid auction
(see part (a)). Thus, you should let the auctioneer continue to
lower the price until it reaches $19,600, and then yell “Mine!”
c. $22,000, since it is a dominant strategy to bid your true valuation in a second-
price, sealed-bid auction.
d. Remain active until the price exceeds $22,000; then drop out.

8. The text points out that asymmetric information can have deleterious effects on
market outcomes.
a. Explain how asymmetric information about a hidden action or a hidden
characteristic can lead to moral hazard or adverse selection.
b. Discuss a few tactics that managers can use to overcome these problems.
Answer
a. Hidden actions lead to moral hazard; hidden characteristics lead to adverse
selection.
b. Incentive contracts can solve moral hazard problems; screening and sorting
can solve adverse selection problems.

Problems and Aplications

11. The FCC has hired you as a consultant to design an auction to sell wireless
spectrum rights. The FCC indicates that its goal of using auctions to sell these
spectrum rights is to generate revenue. Since most bidders are large
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 telecommunications companies, you rationally surmise that all participants in the
auction are risk neutral. Which auction type—first-price, second-price, English, or
Dutch—would you recommend if all bidders value spectrum rights identically but
have different estimates of the true underlying value of spectrum rights?
Answer:
Since this is a common value auction, bidders will not bid their own private
estimates because doing so would lead to the winner’s curse. Thus, there will be
an additional incentive for bidders to shade their bids below their estimated
valuations. The English auction format provides bidders the most information
(therefore allowing them to pool information to some extent), mitigating this
problem. For this reason, the English auction would generate the highest expected
revenues in this case.

12. As the manager of Smith Construction, you need to make a decision on the
number of homes to build in a new residential area where you are the only
builder. Unfortunately, you must build the homes before you learn how strong
demand is for homes in this large neighborhood. There is a 60 percent chance of
low demand and a 40 percent chance of high demand. The corresponding
(inverse) demand functions for these two scenarios are P = 300,000 − 400Q and P
= 500,000 − 275Q, respectively. Your cost function is C(Q) = 140,000 + 240,000Q.
How many new homes should you build, and what profits can you expect?
Answer:
My expected inverse demand is
E(P) = 0.6(300,000 – 400Q) + 0.4(500,000 – 275Q)
= 380,000 – 350Q.
Therefore, my expected marginal revenue is E(MR) = 380,000 – 700Q.
My marginal cost is MC = $240,000.
Setting E(MR) = MC yields 380,000 – 700Q = 240,000.
Solving, Q = 200.
The price I expect is thus E(P) = 380,000 – 350(200) = $310,000.
My profits are thus ($310,000 -$240,000)(200) - $140,000 = $13,860,000.

13. Life insurance companies require applicants to submit to a physical examination

as proof of insurability prior to issuing standard life insurance policies. In
contrast, credit card companies offer their customers a type of insurance called
“credit life insurance” that pays off the credit card balance if the cardholder dies.
Would you expect insurance premiums to be higher (per dollar of death benefits)
on standard life or credit life policies?
Answer:

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 One would expect higher premiums on credit life, thanks to adverse selection.
People who cannot pass physicals will select toward this type of insurance,
resulting in higher premiums. Furthermore, people who are healthy and can pass
a physical will be unwilling to pay the higher premiums, thus exacerbating this
effect.

CHAPTER 13: Advanced Topics in Business Strategy

Conceptual and Computation Questions

5. Two firms compete in a Cournot fashion. Firm 1 successfully engages in an activity
that raises its rival’s marginal cost of production.
a. Provide two examples of activities that might raise rivals’ marginal costs.
b. In order for such strategies to be beneficial, is it necessary for the manager of
firm 1 to enjoy hurting the rival?
Answer:
a. Two examples include tactics that raise distribution costs or increase the price
of inputs.
b. No. The benefits stem from the fact that by raising rivals’ costs, your rivals
reduce their own output. This tends to increase the market price, thus
permitting you to expand your own output (and market share) to enjoy higher
profits.

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9. You are the manager of an international firm headquartered in Antarctica. You are
contemplating a business tactic that will permit your firm to raise prices and
increase profits in the long run by eliminating one of your competitors. Do you
think it would make economic sense to expend resources on legal counsel before
implementing your strategy?
Answer:
It would make sense to consult legal counsel prior to implementing predatory
pricing strategies. It is often illegal to price below cost to drive out rivals only to
raise prices in the future.

Problems and Aplications

11. On November 18, 2012, Nintendo released its eighth-generation video game
console, the Wii U. In November 2013, Microsoft and Sony followed suit by
releasing the Xbox One and PlayStation 4, respectively. Although these three video
game consoles have dominated the video game console market, new
microconsoles, which download games from application stores such as Google
Play, have begun entering the market. One such microconsole is Ouya, which
entered the market in 2013. If you were in charge of pricing at Ouya as it entered
the market, what strategy would you pursue?

Answer:
Penetration pricing. There are likely significant network effects in this industry, so
you will need to gain a critical mass of consumers for your product to provide
sufficient value to ultimately charge a profitable price.

12. Between 1995 and 1997, American Airlines competed in the Dallas/Ft. Worth
Airport against several other low-cost carriers. In response to these low-cost
carriers, American Airlines reduced its price and increased service on selected
routes. As a result, one of the low-cost carriers stopped service, which led
American Airlines to increase its price.
Answer:
This pattern of pricing is consistent with predatory pricing, which is illegal under
the Sherman Antitrust Act. However, it is not illegal to lower prices to meet
competition, so the observed pricing is also consistent with competitive behavior.
It is often difficult to establish that a firm priced below marginal cost. For the
case of an airline, this is even more problematic. At one extreme, one might argue
that the marginal cost of putting one more passenger on an existing flight is zero.
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 At the other extreme, one might argue that it is the marginal cost of adding
another flight rather than another passenger that is relevant.

CHAPTER 14: A Manager’s Guide to Government in the Marketplace

Conceptual and Computation Questions

1. You are the manager in a market composed of eight firms, each of which has a
12.5 percent market share. In addition, each firm has a strong financial position
and is located within a 100-mile radius of its competitors.
a. Calculate the premerger Herfindahl-Hirschman index (HHI) for this market.
b. Suppose that any two of these firms merge. What is the postmerger HHI?
c. Based only on the information contained in this question and on the Horizontal
Merger Guidelines described in this chapter, do you think the Justice
Department (or FTC) would attempt to block a merger between any two of the
firms?
Answer:
a. HHI = 8 × (12.5)2 = 1,250.
b. HHI = 6 × (12.5)2 + (25)2 = 1,562.5.

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 c. The Justice Department may potentially challenge, but since the post-merger
HHI is less than 2,500, it will likely consider other factors before doing so
(e.g., cost savings).

3. You are an industry analyst who specializes in an industry where the market
inverse demand is P = 200 − 4Q. The external marginal cost of producing the
product is MCExternal = 6Q, and the internal cost is MCInternal = 12Q.
a. What is the socially efficient level of output?Given these costs and market
demand, how much output would a competitive industry produce?
b. Given these costs and market demand, how much output would a monopolist
produce?
c. Discuss actions the government might take to induce firms in this industry to
produce the socially efficient level of output.
Answer:
a. Set P = MCExternal + MCInternal to get 200 - 4Q = 18Q. Solving yields Q = 9.09 units.
b. Set P = MCInternal to get 200 - 4Q = 12Q. Solving yields Q = 12.5 units.
c. Set MR = MCInternal to get 200 - 8Q = 12Q. Solving yields Q = 10 units.
d. Pollution taxes or permits can help induce firms to produce the socially
efficient level of output.
10. Is “fairness” the economic basis for government laws and regulations designed to
remedy market failures? If so, why; if not, what is the economic basis?
Answer:
Fairness is not the economic basis for government laws and regulation to remedy
market failures. Instead, market efficiency is the economic basis.

Problems and Aplications

14. A well-known conglomerate that manufactures a multitude of noncompeting
consumer products instituted a corporatewide initiative to encourage the
managers of its many divisions to share consumer demographic information.
However, since the initiative was implemented, the CEO has noticed that less
information is available than ever. Why do you think the CEO’s plan backfired?
Answer:
There is a free rider problem caused by the public-goods nature of obtaining
information. If the manager of one division expends effort gathering information
and shares it, then other division managers receive the benefits without having to
bear any of the costs. Unfortunately, when all division managers think this way,
the result is that very little effort is spent within the firm on information gathering
efforts.
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18. China’s entry into the World Trade Organization (WTO) in 2001 created more
competition between local and foreign firms, and also provided China greater
access to the market for exports. This was particularly true in the market for
rubber since, at the time, China was the world’s second largest consumer of
rubber (China is now the world’s largest consumer of rubber). Shortly after
joining the WTO, China eliminated its import quota on rubber. What impact do
you think the import quota reduction likely had on the price of rubber and the
quantity of rubber exchanged in China? What implications do you think the
elimination of the quota on rubber had on China’s social welfare?
Answer:
Due to the elimination of the import quota on rubber, the price of rubber in China
fell and more rubber was exchanged. Consumers of rubber in China gained while
producers of rubber in China were harmed. Overall, however, social welfare in
China increased due to this change.

23. Moses Inc. is a small electric company that provides power to customers in a small
rural area in the Southwest. The company is currently maximizing its profits by
selling electricity to consumers at a price of $0.15 per kilowatt-hour. Its marginal
cost is $0.05 per kilowatt-hour, and its average cost is $0.15 per kilowatt-hour. A
government regulator is considering a proposal to regulate the firm’s price at
$0.05 per kilowatt-hour. Would such a policy improve social welfare?
Answer:
The policy would not improve social welfare. At the profit-maximizing output
level, Moses is earning zero economic profit since P = ATC. By regulating the
firm’s price to marginal cost, the firm would shut down in the long run. Under this
scenario, consumers would have no electricity source. Consequently, the
deadweight loss resulting from monopoly pricing is less (and social welfare is
higher) than it would otherwise be at the regulated price.
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