# 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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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 …