Industrial Organization Field Examination Department of Economics, Michigan State University May 9,2008

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1 Industrial Organization Field Examination Department of Economics, Michigan State University May 9,2008 This examination is four hours long. There are Three Parts in the exam. Note that you have choices in Parts B and C. It is important to show how you arrive at your answers and offer whatever insights you may otherwise provide into the issue at hand, so that you can be given partial credit even if you are unable to derive analytic results. If you believe there is some ambiguity in the question (which I doubt), be sure to spell out exactly how you are interpreting the question. Good Luck! Part A: Answer ALL questions in this part (total of 40 points, each question accounting for 10 points) 1. (10 points) Bresnahan and Reiss (1990) use information on the number of automobile dealerships in isolated rural towns to test for specific market behavior (such as monopolists taking actions to block entry). They present a simultaneous entry model where there exist multiple equilibria. Explain how Bresnahan and Reiss address this multiple equilibria issue in their estimation. 2. (10 points) Two firms, j =1,2, operate in two symmetric markets, A and B. Demand in each market is given by Q('). Firm 1 has a constant marginal cost of CL in market A and CH in market B, which CL < CH. Firm 2 is the opposite: it has marginal cost CH in market A and CL in market B. Consider an infinite horizon game with d being the discount factor. In solving this problem, simplify the analysis by assuming that firms play optimalpunishments following a deviation, which give both firms zero profits as in Bernheim and Whinston (1 990). (a) Consider market A alone (the situation is similar for market B). Show that a collusive outcome (i.e., a price higher than ch) can be sustained in A if 6 is sufficiently large, provided that the less efficient firm has a market share of at least 1-6. (b) Now consider collusive equilibria taking multi-market contact into account. Show that collusive equilibria exist in which the less efficient firm withdraws completely from each market. Show that the firms can sustain monopoly prices pm(cl) if 6 is sufficiently large. Discuss welfare implications of multi-market contact in light of this problem. 3. (1 0 points) Consider a relationship between an input supplier and an input buyer. Both the buyer and seller can make investments that increase the economic surplus realized from trade. More specifically, the buyer and seller can make investments of I, and 5,

2 respectively that increase the buyer's valuation of the input. The buyers' valuation of the input is: If the buyer pays the supplier p for the in put, the buyer's profits is v(ib, Is) -p - I, and the supplier's profits isp - c - I,. (a) Determine the efficient levels of investments (i.e., the levels of investment that maximize total gains from trade). What is total surplus? (b) Suppose that are observable, but not verifiable to any third party. Suppose, further, that the two parties bargain after investments have been made according to the Nash bargaining solution (i.e.,p evenly divides the surplus from trade). What levels of investment would the buyer and supplier choose? Are these levels efficient? Why or why not? (c) Now suppose that the two parties sign a contract that gives the buyer the right to determinep. What levels of investments would the buyer and supplier choose under this contract? What is the total surplus? Compare this outcome with the efficient outcome and the outcome in (b). (d) Now suppose that the two parties sign a contract that gives the seller the right to determinep. Answer the same questions above in (c). (e) Comment on the effect of bargaining power on investment efficiency. 4. (10 points) Consider two independent products, A and B. They are unrelated in the sense that they can be consumed independently and their values to consumers are independent of whether they are consumed separately or together. Consumers, whose total measure is normalized to 1, have a unit demand for each product. The market for product A is monopolized by firm 1 with unit production cost of ca = 0. All consumers have valuation of VA for product A. It is assumed that entry to market A is not feasible. The market for product B, however, is served by two firms, firm 1 and firm 2, who engage in price competition. Their unit production costs for product B are the same and given by CB. As in Whinston (1990), I assume that product B is differentiated. More specifically, consider a Hotelling-type price competition for product B in which two firms are located at the end points of the unit interval. Consumers are uniformly distributed along the interval. They demand only one unit of the good B with reservation values of vb, which is assumed to be sufficiently large to ensure that the market is covered. We identify a consumer with the point in the interval that represents her ideal variety of a product B. A consumer buying a product B located at the distance of x away from her ideal variety will incur utility loss of tx, in addition to the price of the good, where t is a "transport" cost parameter. Bothfirms are already in the market and have paid sunk cost of entry, if there is any. Thus, in contrast to Whinston (1 990), entry and

3 exit are not issues. The game is played in two stages. In the first stage, firm 1 (the monopolistic supplier of product A) decides whether or not to bundle the two products. A price game ensues in the second stage with the bundling decision in the previous stage as given. Assume that VA < 3t. (a) Describe the pricing game equilibrium when there is no bundling. What are the profits of each firm? (b) Suppose that firm 1 engages in pure bundling. What are the equilibrium prices for the bundle and firm 2's B product? (Hint: Derive the demand for each firm given firm 1's bundle price and firm 2's price. The next step is to derive reaction hnctions for each firm to get the equilibrium prices.) What are the profits of each firm? Does firm 1 engage in bundling in the first stage? Part B: Choose THREE out of the following four problems. (total of 45 points, each question accounting for 15 points) 5. (15 points) Suppose there are two types of customers (Type A and Type B) that get their pictures taken at Sears Portrait Studio. Assume that Sears cannot distinguish between Type A customers and Type B customers. Type A's utility from paying price p, and obtaining the portrait in t days is - U~(pf, t) = 40- pr -2 t + U where is Type A's utility if she does not purchase the portrait. Type B's utility from paying pricep, and obtaining the portrait in t days is UB(pt, t) = 30- p, - t +E where E is Type B's utility if she does not purchase the portrait. (Both types only demand a single portrait.) There are 300 Type A customers and 200 Type B customers. Assume that Sears can either develop the portrait immediately at the store where the marginal cost per portrait developed is $10 or send it out and have it developed at a marginal cost of $5. If it is sent out of the store, the customer can obtain the portrait in 5 days. a) In (p,, t) space, depict the single crossing property that exists between Type A and Type B consumers. Put t on the x-axis. b) Mathematically derive this single crossing condition. c) In order to maximize profits, what price should Sears charge a customer to obtain the portrait immediately after it is taken (po) and what price should Sears charge a customer who waits 5 days to obtain the portrait (ps)? What are these'profits? Show calculations and provide explanation.

4 d) Now suppose that Sears has the option, for portraits developed out of the store, of holding the portrait for more than 5 days? Now what are Sears' maximum profits and how long should they hold the portraits developed outside of the store? Show calculations and provide explanation. 6. (15 points) Consider the market for health insurance. Suppose there exist three different types of individuals. Type 1 individuals are very healthy, Type 2 individuals are moderately healthy and Type 3 individuals are unhealthy. There are twenty Type 1 individuals, thirty Type 2 individuals and ten Type 3 individuals. Type 1 individuals are willing to pay $1,000 for health insurance, Type 2 individuals are willing to pay $2,000 for health insurance and Type 3 individuals are willing to pay $4,000 for health insurance. Assume the health insurance industry is perfectly competitive and the insurance companies are risk neutral. Suppose the expected medical costs of a healthy individual (Type 1) is $900, the expected medical costs of a moderately healthy individual (Type 2) is $1,500 and the expected medical costs of an unhealthy individual (Type 3) is $3,000. a) Are the individuals risk averse, risk neutral or "risk loving"? Explain. Suppose the extensive form of the game is such that the insurance companies first select a price for health insurance and then the individuals decide whether or not to purchase the insurance. b) As part of a subgame perfect equilibrium, could the price of health insurance be $3,000? Explain. c) Identify the subgame perfect equilibria/equilibrium. Buchmueller and DiNardo (AER 2002) look at a 1993 New York State health care reform whose intent was to curb insurance carrier practices that might limit the ability of small "high-risk" firms to purchase insurance for their employees. This reform imposed restrictions on the extent to which insurers can vary premiums according to subscribers' risk status. New York State imposed a restriction called "pure community rating," which mandates that, for a given plan, the same rate must be charge to all individuals or small groups, regardless of their age, sex or other risk characteristics. Using individual information from the 1988 through 1997 Current Population Surveys and a difference-and-difference estimation strategy, Buchmueller and DilVardo compare the change in health insurance coverage of individuals working in small New York firms to those working in small Pennsylvania and Connecticut firms (two states that did not change the restrictions imposed on insurers in 1993). They find that the percentage of

5 individuals in small firms covered by insurance did not fall (post- 1993) in New York relative to Pennsylvania and Connecticut. d) Is this finding consistent with adverse selection? Explain. e) Provide two alternative explanations for this empirical result? 7. (15 points) College X has an optional SAT policy which allows an applicant to select whether or not to submit her SAT score to the school. Suppose an applicant's decision is to either not submit her SAT score or to submit her actual SAT score (because the "cost" of lying is very large). Suppose the probability that College X accepts the applicant increases with SAT Score for those who submit and increases with College X's "expectation" of the score for those who do not submit. For simplicity, suppose the applicant has either an SAT score of 1000, 1 100, 1200 or Suppose the probabilities of having these SAT scores are.l,.3,.4 and.2, respectively. These probabilities are common knowledge. The applicant knows her actual SAT score but College X does not (unless the applicant submits her score to the school). a) Suppose College X uses Bayes Rule to infer the applicant's SAT score if she does not submit and that submitting her SAT score is costless for the applicant. What is the Bayesian Nash equilibrium outcome of this game? In a 2005 Econometrica paper, Eyster and Rabin propose a new equilibrium concept which does not assume that College X uses Bayes Rule to infer the applicant's SAT score if she does not submit. Instead, Eyster and Rabin assume that "each player incorrectly believes that with positive probability each profile of types of the other players plays the same mixed action profile that corresponds to their average distribution of actions, rather than their true, type-specific action profile. Players choose their actions to maximize their expected payoffs given their types and these incorrect beliefs about other players' equilibrium strategy." They call this a cursed equilibrium. "In a X-cursed equilibrium, each player correctly predicts the probability distribution over her opponents' actions, but under appreciates the connection between her opponent's equilibrium action profile and their types. Each player plays a best response to beliefs that with probability X, her opponents' actions do not depend on their types, while with probability 1- x their actions do depend on their types." b) If submitting her SAT score is costless for the applicant, could there exist an equilibrium that satisfies the Eyster and Rabin's cursed equilibrium concept where the applicant does not reveal their SAT score of 1200? Explain.

6 c) If submitting her SAT score is costly for the applicant, could there exist an equilibrium that satisfies the Eyster and Rabin's cursed equilibrium concept where the applicant does not reveal their SAT score of 1200? Explain. Mathios (Journal of Law and Economics, 2000) tests the implications of the voluntary disclosure models using a law that mandates salad dressing manufacturers to identify fat content on their labels. Jin & Leslie (Quarterly Journal of Economics, 2003) use restaurant hygiene grade cards in Los Angeles county to test the voluntary disclosure models. d) Neither Mathios nor Jin & Leslie have the private information on those who do not disclose. In fact, Jin & Leslie cannot even identify whether or not certain restaurants disclose their hygiene rating. Explain how Mathios and Jin & Leslie are able to test the voluntary disclosure models without this information. 8. (15 points) Consider a simplified version of the Katz-Shapiro model we discussed in class. There are two incompatible technologies, A and B. The production costs of A technology are zero in the first period and c (>O) in the second period, respectively. The production costs of B are c in the first period and zero in the second period, respectively. There are two users (i =1,2). User 1 makes a technology adoption in the first period whereas user 2 makes the decision in the second period. The standalone values of both technologies are the same at v, which is assumed to be very high. If both users adopt the same technology, there are additional network benefits of A. As in class, we ignore the interim benefits of the first period consumption in the adoption decision of user 1. a) We consider two alternative market structures where (1) both technologies are competitively supplied, and (2) A is competitively supplied whereas B is sponsored. Suppose that c< A. Describe the market outcomes in the two alternative market structures. Compare the market outcomes to the socially optimal outcome. b) Do the same exercise as in (a) with the assumption that c> A. Part C: Choose THREE out of the followingfiveproblems. (total of 15 points, each question accounting for 5 points) 9. (5 points) The cigarette industry has the characteristics of an industry that engages in tacit collusion-the prices are identical from seller to seller and the profits are high. But contradicting this analysis is the fact that the price elasticity of cigarette demand is far below 1. Explain why inelastic demand is often taken to contradict the analysis of tacit collusion and what explanation can be made to reconcile the two analyses.

7 10. (5 points) Use the dominant firm pricing model to explain the historically high oil prices seen today (5 points) Under some analyses, setting a price lower than average variable cost is never a part of normal business behavior and thus should be seen as evidence of predatory pricing. Under other analyses, predatory pricing is never rational and thus observing P<AVC is not evidence of such behavior. Explain whether it is true that charging a price less than average variable cost is never consistent with normal business behavior and then explain the argument that predatory pricing is never rational. 12. (5 points) If you could invest $500,000 today which would generate an annual net profit of $100,000 in perpetuity, calculate 1) the value of the firm and 2) the internal rate of return on investment. State your assumptions and show your work. 13. (5 points) Shipping companies that carry cargo between Asia and North America charge much more to ship containers of freight from China to the US than they charge for shipping containers of freight from the US to Asia. This is due to the fact that ships make round-trips and thus must return to their home port whether they are fully loaded or not. In short, the two halves of the Asia to North America and North America to Asia round trip are joint products. With this in mind, if we observe that the price of shipping a container from China to the US is dropping, would we predict that there would be a corresponding increase or decrease in the charges for shipping containers from the US to China?