practice problems for final exam_5_5

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Arizona State University *

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40149

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Economics

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Feb 20, 2024

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Part 1: True/False/Uncertain: Credit depends entirely upon your BRIEF explanation (1 paragraph is usually plenty). (7 points each; 42 points total) 1.1 As we look across coal mines and coal-fired power plants, the theory of specific investment suggests that common ownership (vertical integration) is least important for plants located at the mouth of a coal mine because the efficiencies of co-location ensure high mutual profits regardless of ownership form. True, False, or Uncertain? Explain. False. Mine-mouth power plants have a high degree of specific investment (in Joskow’s paper on contracting in this sector, he argues site, capital, and supply specificity are all highest for these plants. These investments therefore are extremely susceptible to potential “hold-up” problems ex post. Williamson’s theory of investment specificity therefore predicts that vertical integration (or very long-term contracts that mimic common ownership) is most efficient for these types of vertical relationships. 1.2 Search cost models predict more price dispersion across local gasoline service stations in the price of regular gasoline than in the price of a flat tire repair because a tank of gasoline costs more. True, False, or Uncertain? Explain. Likely to be false (credit may be given for alternative well-explained and well-argued answers). Search costs and search benefits are likely to be higher for gasoline than for tire repairs. Gasoline prices are posted in large signs visible from the road, so it is easy to learn what price is charged by each station (low search cost). Consumers generally have considerable flexibility when they purchase gasoline, so they can explore prices at a number of possible stations ((low search cost). Since gasoline is purchased frequently, the benefits of finding a consistently low-price station are realized over multiple purchases (high search benefits, assuming station’s relative prices are similar over time). In contrast, the price of a flat tire repair requires calling or stopping at a station and asking about the price (high search cost), consumers who have a flat tire may need that repair done quickly and in a close-by station (high search cost), and aren’t likely to need this service often (reducing the benefit of search). Applying the intuition of Sorensen’s search cost model of pharmaceutical prices, these factors suggest less price dispersion (relative to mean price) for gasoline than for tire repairs. [Maybe a potential 14.33 project?] 1.3 The recent decline in housing prices across the U.S. is likely to produce significant decreases in the income of the average realtor. True, False, or Uncertain? Explain. False (with caveat). This question asks you to draw on the discussion of the realtor market. If commission rates as a percent of house values are approximately fixed (less true now than in the period analyzed by Hsieh and Moretti, but perhaps still more true than assuming they are independent of house values), lower house prices reduce realtor income per transaction. With a fixed number of realtors, this would reduce income/realtor (perhaps true in the very short-run). But since this is a relatively free entry/exit market, we would expect exit of realtors to the point where expected realtor income will once again equal opportunity wages.

1.4 Firms that expect to compete in prices (Bertrand) have a greater incentive to differentiate their products through advertising than do firms that expect to compete in quantities (Cournot), all else equal. True, False, or Uncertain? Explain. True. Since differentiation softens price competition, increasing profitability, it is likely to be more important in pricing games, where the equilibrium with no differentiation is P=MC. 1.5 In a capacity-constrained pricing game with proportional (random) rationing like CSG market D, you do better when your rival’s price is far below your price than when your rival’s price is just slightly below your price, all else equal. True, False, or Uncertain? Explain. True, if your rival’s capacity is low relative to market demand, and product differentiation is low (as it is in market D). Basically, your residual demand is much greater when your capacity-constrained rival charges a very low price than when that rival just epsilon-undercuts you, increasing your potential profits. Refer to the model of Bertrand competition with homogeneous goods and capacity constraints. Intuition: Since very low prices generate a lot of consumer demand for that product, proportional rationing means that more of the consumers buying from your rival are low willingness- to-pay consumers who wouldn’t buy the product at the higher price. This will leave more of the high value customers in the market after your rival runs out of output, ready to purchase from you (these generate your residual demand curve). If your rival just epsilon-undercuts your price, all the consumers they sell to would have purchased from you. At this price, there also is less excess demand relative to your rival’s fixed capacity. These factors substantially reduce your residual demand, reducing your potential profits. Note that this effect is not as important when product differentiation is high, since a rationed consumer with a high valuation for your rival’s product isn’t likely to have a high valuation for your product. 1.6 Congress recently extended the length of copyright protection by about 20 years. To maximize social welfare (measured by the sum of producer and consumer surplus), the extension should have applied only to work created after the extension, not to existing copyrighted works. True, False, or Uncertain? Explain. True. Copyrights, by creating a legal monopoly, increase the price above marginal cost, inducing deadweight loss (the gain to producers is less than the lost surplus of consumers). But if works were sold at marginal cost in a competitive marketplace, their creators might not be willing to invest their time in creating those works in the first place, since they wouldn’t be able to appropriate the surplus created by the work. We’re willing to sustain the deadweight loss (static inefficiency) to provide incentives for creation of new works (dynamic efficiency). An extension for existing work increases producer profits over the extension period, but those profits are more than offset by a reduction in consumer surplus, if profits and consumer surplus are equally weighted in social welfare. Once works have been created under the old copyright regime, there is no further incentive effect, so the extension increases deadweight loss without any offsetting benefit. 1.7 DuPont’s decision to add substantially to its titanium dioxide capacity in the 1970s was strategic because the scale of the expansion was determined by expected future market growth, not current conditions. True, False, or Uncertain? Explain. False. We call it strategic because the level of DuPont’s investment was determined not only by the direct benefits of the investment on DuPont profits, but also by its intended effect on reducing

rival’s investment, thereby increasing DuPont’s market share and profits. Recall that DuPont thought a commitment to build excess capacity in titanium dioxide would reduce rivals’ capacity expansion (as a best response), leading to increased DuPont market share. This failed on several grounds: most notably, DuPont was not able to credibly commit to its capacity expansion before rivals could act. It also turned out that several of DuPont’s assumptions were flawed--most notably, excessively high market demand growth projections and the assumption that environmental regulation would require rivals to shut down their existing capacity. 1.8 MillerCoors and A-B InBev compete in prices in the US beer market. The firms must choose whether to maintain their current prices or increase their prices. Suppose the strategies and pay- offs are given by the matrix below: ( π ABI , π MC ): MillerCoors Strategies A-B InBev Strategies: Increase Price Maintain Current Price Announce Price Increase 100,100 30, 70 Maintain Current Price 70,30 60,60 If A-B InBev and MillerCoors play this as a simultaneous move game exactly once, what, if any, are the pure strategies Nash equilibria of this game? There are two pure strategy Nash Equilibria for this game. (Announce Price Increase, Increase Price) and (Maintain Current Price, Maintain Current Price) are both Nash equilibria. Stating that (100,100) is a Nash Equilibrium is incorrect and would receive partial credit. 1.9 The figure below from Wang ( Journal of Political Economy, 2009) reproduces hourly prices from 3 brands of gasoline in Perth, Australia, over a month-long period. What model of strategic interaction across firms could give rise to pricing patterns such as these? Briefly explain. The most striking feature of this figure are the cyclical prices, with sudden jumps and then slow price decreases. These are explained by Edgeworth cycles. When there are multiple firms that are capacity constrained competing in a homogeneous good like gasoline, firms will undercut each other until one firm decides to raise drastically raise prices, after which other firms follow. The larger competitors are more likely to raise prices. 1.10 We have argued that the EU “abuse of a dominant position” policy places significant constraints on the behavior of a dominant firm that is trying to maintain its position of market dominance. Describe 3 strategies that Cemex relied upon to maintain its dominance in the Mexican cement market that would likely be blocked under EU competition policy. There are a number of potential answers here. They include: • Threatening hardware stores and consumers into exclusive dealing

• Tying hardware and cement sales • Preventing import and export of cement by controlling ports • Acquiring competition Part 2: Model-based problems 2.1 You’ve just won the 100K competition with a new product idea for DVD “walking tours” of the Boston area, and are ready to start production. You estimate summer weekly demand at: [D1] Q k (P K ) = 250 – 10P K You can manufacture to order, and estimate your production costs to be C M,K (Q K ) = 4Q K If you distribute this product yourself by setting up a pushcart network, your weekly distribution costs are an additional C D, K = 550 + Q k a. (7 points) If you produce and distribute the product yourself (vertical integration), what retail price, P K , should you set, and what quantity do you expect to sell? What are your expected weekly profits in this case? Price will be 15, and quantity 100. Expected weekly profits (don’t forget the fixed cost!) are 450. There are two retailers who could distribute the product for you through their network of stores. Each retailer has distribution costs for a new product of: C R = Q R,K and each charges a non-negotiable weekly “shelf” fee of $100 to cover the fixed cost of stocking a new product in its stores. If only one retailer carries your product, it will be a monopoly distributor. If both retailers carry your product, they will compete in retail prices. Consumers do not perceive any differentiation between the retailers, and will buy the product from the store with the lowest retail price (randomizing across stores if the retail price is the same), according to the market demand you estimated above.

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