Industrial Organization

Problem Set 3
1. How can an elastic demand curve deter the formation of a cartel?
2. Explain why collusive pricing is difficult in one-period competition and easier when firms interact
over a number of periods.
3. Discuss factors that may facilitate collusion.
4. Suppose that market demand is described by P = 100 − (Q + q ), where P is the market price, Q
is the output of the incumbent firm and q is the output of a potential entrant to the market. The
incumbent firm’s total cost function is T C (Q) = 40Q, whereas the cost function of the entrant is
T C (q ) = 100 + 40q , where 100 is a sunk cost incurred to enter the market.
a. If the entrant observes the incumbent producing Q units of output and expects this output level
to be maintained, write down the equation for the residual demand curve that the entrant firm
faces.
b. If the entrant firm maximizes profit given the residual demand curve in a., what output q e will
the entrant produce? (Your answer should be a function of Q.)
c. How much output would the incumbent firm have to produce to just keep the entrant out of the
market? That is, solve for the limit output QL . At what price will the incumbent sell the limit
output?
5. Please solve the Practice Problem 12.3 at page 282 from the textbook.
6. Explain why predatory strategies do not work in an industry if no substantial sunk costs exist.
7. Why is predatory pricing unlikely to occur when all firms are identical?
8. Tiger-el is an upstream manufacturer of electric trains that sells wholesale to The Great Toy Store, the
only such store in the area. Demand for the trains at the retail store in inverse form is P = 1, 000 − 2Q,
where Q is the total number of trains sold. The Great Toy Store incurs no service cost in selling the
train. Its only cost is the wholesale price it pays for each train. Tiger-el incurs a production cost of
$40 per train.
a. What wholesale price should Tiger-el charge for its trains? What price will these trains sell for
at retail? How many trains will be sold?
b. What profit will Tiger-el and The Great Toy Store earn under the pricing choices you found in
part a.? What is the total profit of these two firms?
c. Now assume Tiger-el and The Great Toy Store merge into one firm and they are maximizing
joint profits. What would be the retail price and quantity sold in this case? Calculate the joint
profits.
d. Compare the total profits you find in part b. and c.. Which one is greater? Why?
9. Suppose a monopolist manufacturer sells his products through a monopolist retailer. The marginal
cost of production is c = 5. Assume that retail demand is Q(p, s) = s(10 − p)100, where s is retailer’s
level of effort to sell the product. The cost of effort is φ(s) = s2 and it does not depend on the
quantity sold.

a. If manufacturer sets the wholesale price w = 6, what will be the retail effort level and the retail
price? How much output will be sold? What will be the profits of each firm?
b. Would the profits of the manufacturer rise or fall if the wholesale price is w = 7?
c. What is the optimal effort level, price and output if the manufacturer and the retailer are fully
integrated?
10. Why are consumers and firms worse off with successive monopolies upstream and downstream than
when there is a single, integrated monopoly?
11. Some products require special, custom-made trucks to transport by road. If a trucking company
contracts with a manufacturer for the transportation of such a product and invests in custom-made
trucks, how might this investment give rise to subsequent opportunistic behavior of the manufacturer,
the trucking company, or both? How can such behavior be prevented?
12. Why would a monopoly manufacturer offer a distributor an exclusive territory, and what problem
might this create for the manufacturer?
13. Vermont Castings is a manufacturer of wood-burning stoves, a somewhat complex product. One of
Vermont Castings’ dealers once complained about the terms of the relations between manufacturer
and dealers, stating that ”the worst disappointment is spending a great deal of time with a customer
only to lose him to Applewood [a competing retailer] because of price.” Specifically, the dealer
lamented ”the loss of 3 sales of V.C. stoves today to people whom we educated and spent long hours
with.”
How do you think this problem can be solved? How would you defend your solution in an antitrust/competition policy court?
14. Two major music companies-Sony and Warner Music-have been subject to an antitrust inquiry by
the FTC over allegations that they illegally discouraged retail discounting of compact disks. The
investigation is centered on the practice of announcing suggested prices. Suggested prices are not
illegal, only agreements among firms on such prices are illegal. But in practice, retailers that advertise
or promote CDs at a price below the suggested price are denied cash payments by the manufacturers,
in effect ”forcing” such suggested prices.
How would you decide on this case?
15. Should the European Union outlaw the practice of exclusive territories in car dealerships? Why or
why not?

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