This paper is not to be removed from the Examination Halls

UNIVERSITY OF LONDON EC3099 ZB

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. In 1948, the Supreme Court in the United States found a quantity discount scheme of Morton Salt to
be illegal under the Robinson-Patman Act. Morton Salt, a virtual monopolist supplier of salt to
downstream retailers, had offered quantity discounts to all its customers but only five retail firms
purchased sufficient quantities to obtain the discount. The Court commented that ‘the legislative
history of the Robinson-Patman Act makes it abundantly clear that Congress considered it to be an evil
that a large buyer could secure a competitive advantage over a small buyer solely because of the large
buyer’s quantity purchasing ability.’

(a) Define price discrimination and describe its different forms. When is it possible to price
discriminate among customers? What is the motivation for a firm to charge different prices
among its customers rather than charge a uniform price? You may use diagrams to support your
answer as appropriate. (8 marks)

(b) In what sense might quantity discounts harm competition or create monopoly, when compared to
a uniform pricing policy? (3 marks)

(c) Describe the welfare effects of the different forms of price discrimination. You may use
diagrams to support your answer as appropriate. If an upstream firm offers quantity discounts to
downstream firms, is welfare likely to rise or fall? Explain your answer. (7 marks)

(d) Should price discrimination be illegal? Explain your answer. (7 marks)

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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. Suppose you are asked to assess the likely effects of a proposed horizontal merger in a particular
industry. What are the things you would look at and how would each of these help you make your
assessment?

SECTION B

5. Suppose the market for smartphones is perfectly competitive. The inverse demand is given by
P = 1 – Q, where P is the price and Q is the total quantity of smartphones in the market. In order to
produce a smartphone, a firm needs access to the patents held by firm R1 and to the patents held by
firm R2. Each of these firms chooses a per unit royalty, respectively r1 and r2, that firms using their
technology must pay on each unit of their output. Besides the cost of paying these royalties, the unit
cost of production of smartphones is equal to c < 1.

(a) Given that R1 charges a royalty r1 and R2 charges a royalty r2 and assuming that r1 + r2 < 1 – c,
what is the market price of smartphones and the quantity of smartphones sold in the market?
(5 marks)

(b) Before the downstream firms choose their output, R1 and R2 simultaneously choose the level of
royalty that they want to charge to the downstream firms. What is the level of royalty that each
firm chooses to charge in equilibrium? What is the resulting equilibrium output of smartphones
as well as the resulting profits for R1 and R2? What is consumer surplus and what is total
welfare measured as the sum of consumer surplus and profits? (8 marks)

(c) Assume now that R1 and R2 set their royalty rates r1 and r2 together so as to maximise their joint
profits. How does the level of royalties chosen compare to the level found in part (b)? How
does the level of price, output, profits, consumer surplus and welfare compare to the levels found
in part (b)? Provide the economic intuition for the differences observed. (5 marks)

(d) Finally assume that R1 and R2 again set their royalties independently but that R1 can commit to
its level of royalty before R2 does. What are the equilibrium royalties and which of the two
firms is better off? Why? (7 marks)

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6. Consider an industry where two firms sell a homogeneous good. The firms have the same constant
marginal cost c and the same discount factor δ. They play the Bertrand game for an infinite number of
periods. That is, in each period they simultaneously have to choose the price at which they will sell.
They face a market demand D(p). When they charge the same price, one firm sells a market share λ
(where ½ < λ < 1) and the other firm sells a market share 1 – λ. The two firms have the following
trigger strategy. In the first period they set a price p*, where p* > c. In the following periods, they
choose the same price p* if both firms have chosen p* in all previous periods, otherwise they choose
the one-shot Bertrand equilibrium price forever.
(a) Find the condition under which these trigger strategies represent an equilibrium. (10 marks)
(b) Practicioners often argue that symmetry among firms facilitates collusion. Does the simple
model used in this question justify their claim? Explain. (8 marks)
(c) Under which condition can the trigger strategies above sustain a fully collusive equilibrium
where the firms charge the joint profit maximising price pm in each period? (7 marks)

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? (10 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?
(15 marks)

8. Two firms, one in Spain and the other in France, act as Cournot competitors in supplying mussels
to Belgium. The demand for mussels in Belgium is p = 100 − 2Q. The marginal production cost
for each firm (including shipping) is 25.
(a) Calculate the Cournot equilibrium in Belgium and the profits of the two firms on their
exports. (7 marks)
(b) Now the French government agrees to subsidise French mussel producers at a level of s per
unit. Recalculate the Cournot equilibrium and compare it to the equilibrium in part (a).
Explain, using a diagram, the intuition for this result. What is the optimal subsidy that the
French should introduce? (10 marks)
(c) What happens if the Spanish government decides to do the same? (8 marks)

END OF PAPER

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