International Master of Science in Business Economics

International Master of Science in Business Economics

Economics of Business and Markets

Final Exam

Fátima Barros January 11, 2010

Exercise 1 (4 points)

1. “In the United States concentration ratios are published by the government for specific industries and products based on aggregate national statistics. The interpretations of these concentration measures may misleadingly indicate that markets are less concentrated than it is true.”

Discuss and present all the arguments that might sustain this statement.

1. In 1999, Fiat 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 index of 0.3025. Case’s share of the market was 27%, while Fiat comprised just 13% of the market. If approved, by how much would the post-merger Hirfindahl index increase? Based only on this information, do you think the Justice Department unconditionally approved the merger? Explain.

Exercise 2 (4 points)

Consider that the store Teachers4Life has settled in Lisbon. Its target market are professors interested in economic issues and it is currently intending to sell 3 products: a 1-year subscription of the magazine “The Economist” (X), a 2-days trip to the Portuguese Ministry of Economy and Innovation (Y) and a crash course about “Bundling” (Z).

For its opening day, the store has sent exclusive invitations to 6 VIPs (Very Important Professors) of the faculty FCEE. With the support of a Teaching Assistant (TA), the company was able to estimate the reservation prices of these VIPs, divided into three different types (3 professors of type A, 1 of type B and 2 of type C):

The firm also knows that each consumer is willing to buy at most one of each product on the opening day.

Knowing that the store buys each of these products at a constant price of 10€, compute the profits of the store Teachers4Life for each of the following situations (identify in each case the types of consumers that are going to buy the product(s)):

a)If the store can only apply individual prices to its products.

b)If the store starts selling its products in a bundle of three units, with 1 unit of X, 1 unit of Y and 1 unit of Z.

c)In order to increase the profits, the TA who prepared the table above suggested offering a mixed bundling price scheme, with individual prices and a price for a bundle. But instead of a bundle with 3 units ( X, Y and Z), it should make the bundle with just 2 units ( X and Y).

Is the profit higher than in b)? Justify quantitatively.

Exercise 3 (4 points)

1. An incumbent firm is considering expanding its capacity. It can do so in one of two ways. It can purchase general-purpose equipment and machinery that can be resold at close to its original value. Or it can invest in highly specialized machinery which, once it is put in place, has virtually no salvage value. Assuming that each choice results in the same production costs once installed, under which choice is the incumbent likely to encounter a greater likelihood of entry? Why?

1. In less than one year after the deregulation of the German telecommunicationsmarket at the start of 1998, domestic long-distance rates have fallen bymore than 70%. Deutsche Telekom, the former monopolist, accompanied some ofthese rate drops by increases in monthly fees and local calls. MobilCom, one of themain competitors, fears it may be unable to match the price reductions. Followingthe announcement of a price reduction by Deutche Telekom at the end of 1998,shares of MobilCom fell by 7%. Two other competitors, O.tel.o and MannesmannArcor, said they would match the price cuts. VIAG Interkom, however, accusedTelekom of \competition-distorting behavior," claiming the company is exploiting its(still remaining) monopoly power in the local market to subsidize its long-distancebusiness.

Is this a case of predatory pricing? Present arguments in favor of, and against, such assertion.

Exercise 4 (3 points)

Consider a market with two firms. The two firms compete in quantities and can decide whether they will produce the cooperative level of output (QC) or the non-cooperative level (QNC). The payoffs of these choices are given in the following table:

a)Which is the Nash equilibrium of this game, assuming that it is played only once? Explain if this Nash equilibrium corresponds to the collusive equilibrium. Justify.

Assume now that the game is repeated an infinite number of periods. In each period t both firms observe the last period rival’s production and each firm chooses the production level.

b)Define a trigger strategy on quantities that will lead to the collusive equilibrium (QC,,QC) in each period. For which discount rate [discount factor] is this trigger strategy a Nash equilibrium of this non-cooperative repeated game? (Remember that is the discount factor).

Exercise 5 (5 points)

Consider again the market for cheap smart phones in Portugal. The firms that want to enter the market plan to construct a store from where they distribute the smart phones to the customers. Once all the customers have bought one smart phone, they will keep that device for the rest of their life. For the purpose of the exercise, consider that the cost with the smart phones to the companies is insignificant. However, opening a store has an installation cost of 500€ (equal for both firms).

There are three possible equidistant locations for the stores of firms operating in this sector, namely Faro, Lisbon and Porto, and the Portuguese market for this product has 2000 customers uniformly distributed along the range [0, 2].

These customers decide to buy from the storethat minimizes their total cost, that is, the price charged by the firm plus transportation costs. Those transportation costs are equal to (v-x)2, where “v” is the location of the firm and “x” the location of the customer. The consumers will only buy the product if that total cost is not bigger than their reservation price, equal to 10 €.

Imagine that Alca-Tell decides first where to open the store, and that Sam-Sing observes this decision and chooses its location afterwards.

Consider now that with a probability of 50% the market is extended up to Vigoafter the firms have already chosen their locations, adding another 1000 consumers to the relevant market (also uniformly distributed):

Note: that when the firms enter the market, it is not yet possible to open the store in Vigo.

a)When deciding to enter the market (at positions 0,1 or 2), will Alca-Tell be indifferent between Faro and Porto? Which locations will the firms choose? Explain in words (without calculations).

b)Compute the prices and the profits of both firms if the expansion of the marketoccurs and if both firms remain on the locations that they have chosen initially.

Assume that, after the expansion, only Alca-Tell has the opportunity to change the location of the store (it would have to destroy its previous store and open another one, paying again the installation cost). However, the Portuguese government demands that Alca-Tell decides before enteringwhether it will change its location or not in case of a market expansion, signing a contract that costs 1000€.

Furthermore, it knows the following information:

• If the expansion does not occur, both firms will practice a price equal to 4€.
• If the expansion occurs, and Alca-Tell changes its location, both firms practice a price equal to 9€

c)Should Alca-Tell sign the contract? Justify quantitatively.