Answer Key for Practice Final

Economics 411
Professor Kenneth Troske
Spring 2015
Answer Key
Practice Final
Directions: You would have 120 minutes to complete this exam.
Section I—Multiple Choice. 50 points—each question worth 5 points
1.
All of the following are examples of barriers to entry, except
a. Government protection through patents or licensing agreements.
b. Well-known brands.
c. Low capital requirements for entry.
d. Lower costs driven by economies of scale.
Answer: c
2.
Nash equilibrium
a.
Is where one player maximizes his payoff and the other doesn’t.
b.
Is where each player maximizes his own payoff given the action of the other
player.
c.
Is where both players are maximizing their combined payoff.
d.
Is a unique prediction of the likely outcome of the game.
Answer: b.
3.
The workers who will prefer piece-rate pay will usually be
a. less present-oriented than average.
b. less motivated than average.
c. more productive than average.
d. more risk-averse than average.
Answer: c.
4.
When a firm charges each customer the maximum price that the customer is willing to pay,
the firm
a.
engages in a discrete pricing strategy.
b.
charges the average reservation price.
c.
engages in second-degree price discrimination.
d.
engages in first-degree price discrimination.
Answer: d
5.
If a firm can sell its product for more than its fixed costs, but not for more than its total
costs:
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a.
b.
c.
d.
It will shut down
It will lower its fixed costs
It will continue to operate in the short run at a loss
It will increase its production quantity
Answer: c
6.
How does umbrella branding aid economies of scale and scope?
a. Increases effectiveness of advertising due to a greater presence
b. Increases effectiveness of advertising due to national advertising
c. Increases effectiveness of advertising due to offering a broad product line under one
name
d. Increased cost effectiveness through purchasing as a cooperative
e. Increased cost effectiveness through bulk purchasing
Answer: c
7.
Oligopoly is a market structure in which
a.
firms are price takers.
b.
there exist numerous firms, each producing a product that is a close, but
imperfect, substitute for the products of other firms.
c.
there are only a few sellers.
d.
there is only one seller.
Answer: c
8.
What term describes a market where a monopolist cannot raise price above long run average
cost?
a. Blockaded
b. Perfectly contestable
c. Accommodated
d. Deterred
Answer: b
9.
Which of the following is a true argument regarding the make-or-buy decision process?
a. Firms should make an asset, rather than buy it, if that asset is a source of competitive
advantage for the firm
b. Firms should make, rather than buy, to avoid paying a profit margin to independent
firms
c. Firms should buy, rather than make, in general, because market firms are subject to
the discipline of the market and must be efficient and innovative to survive
d. Firms should make, rather than buy, because a vertically integrated producer will be
able to avoid paying high market prices for the input during periods of peak demand
or scarce supply
Answer: c
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10. Why do price-sensitive buyers tend to harm cooperative pricing in a market?
a. There is an increase in temptation to cut price, even if competitors are expected to
match
b. There is a resultant decrease in the frequency of interaction between competitors
c. There is an increase in the probability of misreads
d. There is an increase in detection lags because prices of competitors are more difficult
to monitor
Answer: a
Section II—Discussion Question and Problems.
11. You are the owner of a firm. Discuss how you would structure your compensation policy
under the following circumstances:
a. (10 points) All workers are equally productive but individual output cannot be
observed. You cannot measure individual output directly, but you can compare the
output of one worker relative to another. Individual output is variable and a worker’s
output increases with their effort. Cooperation among employees is not important for
producing output.
Answer: Here the best compensation scheme is to set up a tournament between workers
(or between the worker and some bench-mark). Workers are paid or promoted based on
their performance relative to their fellow workers. This will elicit the optimal amount of
effort from the workers and thus is efficient.
b.
(10 points) Worker output is variable and increases with their effort. How hard a
worker works is an increasing function of their wage (the more they get paid the
harder they work). You can easily observe worker output but you cannot easily
observe how hard they work.
Answer: Here the firm wants to pay the worker a wage that will get the worker to work
as hard as possible. In other words, the firm wants to pay an efficiency wage. The firm
sets the wage by comparing the value of the additional amount of output the worker
produces when they are paid an extra dollar an hour against the cost of paying the
worker an additional dollar an hour. The optimal wage will be where the value of the
additional output obtained by increasing the wage is exactly equal to the cost of
increasing the wage.
12. Consider an industry in which market demand is given by: P = 302-2Q and MR=302-4Q.
There are two firms in this industry with costs given by: ATC = MC = 2 (neither firm has
any fixed costs).
a. (5 points) Suppose the two firms join together to act as one firm and jointly maximize
profits. What is the equilibrium price and quantity? What are each firm's profits?
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Answer: Q=75, P=152, Q1 = Q2 = 75/2 π =$11,250 π1 = π2 = $5625
b. (10 points) If the two firms act like Cournot duopolists what is each firm's reaction
function? How much output is produced by each firm and what is the equilibrium
price in the market? What are each firm's profits?
Answer: Q1 = 75 - ½Q2, Q2 = 75 - ½Q1, Q1=Q2=50, Q=100, P=102, π1 = π2 = 5000
c. (5 points) If the Bertrand model is assumed to be the correct model for this market,
how much output is produced by each firm and what is the equilibrium price? What
are each firm's profits?
Answer: Q=150, P=2, Q1 = Q2 = 75, π1 = π2 = 0
d. (5 points) Why are models of oligopoly markets so much more complicated than the
perfectly competitive or monopoly models?
Answer: Because in oligopoly markets there are only a few sellers so you need to model
how firms react to the behavior of their rivals.
13. (5 points) Given an example of the “mind games” that Frontier Airlines played with United
Airlines.
Answer:
• Fly only twice a day to cities where United flies out of Denver
• Schedule flights that arrive and depart at different times than United’s flights
• Wait until United announces it schedule before setting its own schedule
• Keep its own prices close enough to United’s prices so as not to provoke an
aggressive response
14. (10 points) Researchers have found that industries with high entry rates tended to also have
high exit rates. Can you explain this finding? What does this imply for pricing strategies of
incumbent firms?
Answer: Production exhibiting low economies of scale (a condition that weakens entry
barriers) and requiring little or no investment in specialized assets (a condition that
weakens exit as well as entry barriers) is frequently observed in industries exhibiting high
entry and high exit. Consider the following scenario: Firms in an industry with no entry
barrier face increased demand. If these firms begin to earn positive profits, entry occurs,
especially if there are little or no exit barriers. As demand turns down, firms exit the
industry. If barriers to entry or exit existed, this industry might not exhibit this pattern.
15. (10 points) Canon has manufactured high quality cameras since it was founded in 1933.
SLR-cameras (i.e., not point and shoot cameras) are purchased in two parts: the body and
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the lenses. Photographers who want a Canon product must make the upfront investment in
the expensive camera body. Canon earns significant profits from the sale of camera bodies
and then earns a stream of profits from camera lenses. An owner of a Canon camera body
can also purchase lenses from other companies that produce Canon-compatible products.
Would Canon be better off if there were no other firms that made Canon-compatible lenses?
Answer: No, Canon is better off with competitors manufacturing and selling Canoncompatible lenses. Photographers make the upfront investment in the Canon camera body,
on which Canon earns a significant profit. In part, purchasers of the Canon body do so
because they know there are options available to them for lenses other than those
manufactured by Canon. Canon’s sales of camera bodies would decrease if it monopolized
the market for lenses to fit its cameras. By allowing competitors to make lenses for its
camera bodies, Canon realizes increased sales of the bodies, which generate significant
monopoly profits, as well as a stream of normal profits from the sale of lenses – although
not monopoly profits on lens sales.
16. (5 points) Bauxite mines and alumina refineries are usually owned by the same company
(bauxite is an ore that is used to produce alumina). Explain why.
Answer: Bauxite mining and aluminum refining both involve large irreversible investment in
specific capital assets. The reason for the asset specificity is locational—site specificity—
because bauxite is costly to transport. Thus, there is a cost advantage in locating aluminum
refining close to the bauxite mine. So that neither the owner of the bauxite mine not the
owner of the alumina refinery in vulnerable to being held up, it makes sense for them to be
owned by the same entity.
17. (5 points) In what ways are monopolistically competitive markets “monopolistic?” In what
ways are they “competitive?”
Answer: Monopolistic competitors produce products that are slightly differentiated. In this
regard, in the short-run, monopolistic competitors can earn economic products by
advertising the differences in their products from their competitors. This slight product
differentiation makes a firm’s product unique, or “monopolistic.”
Monopolistic competition also has elements of being competitive. Relatively low barriers to
entry allow other firms to enter the market and compete. This increase in selling firms
reduces individual market share and in the long-run eliminates economic profits.
Monopolistic competitors become “price-takers,” not unlike perfect competitors and earn
only returns on their factors of production.
18. (10 points) Suppose that the oil industry consists of only two producers, Russia and OPEC.
Russia chooses between producing either 2 million or 4 million barrels of oil per day, while
OPEC chooses between producing either 8 million or 10 million barrels of oil per day.
Depending on their decisions, total output in the world market will be 10, 12, or 14 million
barrels. Suppose that the world price of oil will be $120, $90, or $60 depending on how
much oil is produced by each. Extraction costs are $40 per barrel in Russia and $20 per
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barrel in OPEC. Illustrate the choices of strategy and the profit payoffs of each nation in a
2x2 matrix. What do you predict will be the outcome of this game?
Answer: If world output is 10M barrels, then price=$120/barrel.
Π𝑅𝑅 = 2𝑀𝑀($120 − $40) = $160𝑀𝑀
Π𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 = 8𝑀𝑀($120 − $20) = $800𝑀𝑀
If world output is 12M barrels, then price=$90/barrel.
Π𝑅𝑅 = 2𝑀𝑀($90 − $40) = $100𝑀𝑀
Π𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 = 10𝑀𝑀($90 − $20) = $700𝑀𝑀
Or
Π𝑅𝑅 = 4𝑀𝑀($90 − $40) = $200𝑀𝑀
Π𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 = 8𝑀𝑀($90 − $20) = $560𝑀𝑀
If world output is 14M barrels, then price=$60/barrel.
Π𝑅𝑅 = 4𝑀𝑀($60 − $40) = $80𝑀𝑀
Π𝑂𝑂𝑂𝑂𝑂𝑂𝑂𝑂 = 10𝑀𝑀($60 − $20) = $400𝑀𝑀
Payoff Matrix:
Russia
OPEC
8M barrels
160, 800
200,560
2M barrels
4M barrels
10M barrels
100,700
80, 400
Given this payoff matrix OPEC has a dominant strategy to produce 8M barrels. Given
this, Russia’s best response is to produce 4M barrels.
19. (10 points) An incumbent monopolist (I) is making economic profits equal to 5. A potential
entrant (E) is considering entering the monopolist’s market, creating a duopoly. If the
potential entrant stays out, I earns economic profits equal to 0. If E enters the market the
incumbent monopolist must make a decision of how to respond. If the monopolists
accommodates entry by behaving non-aggressively, each firm earns duopoly profits equal to
2. If the incumbent monopolist decides to respond to entry by behaving aggressively and
fighting a price war, each firm suffers economic losses equal to -1.
a.
b.
Draw the game tree for this sequential move game. Explain what you think the
outcome will be.
Suppose the incumbent monopolist announces prior to any initial move by the
potential entrant that if any other firm enters its market it will fight a price war. Now
what do you think the outcome of the game will be?
Answer: a. Below is the game tree with the entrant’s payoffs listed first and the
incumbent’s payoffs listed second.
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Stay Out
(0, 5)
Entrant
Accommodate
Enter
(2, 2)
Incumbent
Fight
(-1, -1)
If the entrant does enter the industry then the incumbent’s best strategy is to
accommodate the entry. Knowing this, the entrant will decide to enter the industry and
the incumbent will accommodate the entry. The outcome will be (2, 2).
b. The outcome of the game will be the same. The incumbent’s threat to fight a price
war if the potential entrant does enter is not credible.
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