Fall 2002 MIDTERM EXAM

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1 Econ147 Midterm: Page 1 of 5 NAME: Economics 147 Fall 2002 Pledge: MIDTERM EXAM John Stewart INSTRUCTIONS: - Answer each of the questions in the space provided. If additional space is required, use the backs of the pages but clearly indicated that the answer is continued and where the rest of the answer is to be found. - Neatness and clarity of exposition count. - You may not use books or notes. You may use a calculator. Part I (20 points) Part II (30 points) Part III -1 (16 points) -2 (14 points) -3 (20 points) TOTAL (100 points) I. Define, describe, or in some way demonstrate your knowledge of the following terms as they relate to this course. Technical terms are shown in bold print and require a precise technical definition. (4 points each) $ 1-1. Minimum efficient scale The output level at which a firm first achieves minimum long run average cost. LRAC MES Q 1-2. Lerner Index 1/η where η is the elasticity of the firm s demand curve 1-3. Separation of Ownership and Control A situation in large corporate forms of firms where the decisions are made by hired managers but the firm is owned by a dispersed group of share holders none of whom hold a significant share of the firms stock resulting in a divergence of interests between the owners and the managers Herfindahl-Herschman index (HHI) HHI = 2 Mrktshare i the sum of the square market shares of all firms i in the market. A measure of market concentration 1-5. Marginal Revenue the change in total revenue per change in output dtr(q)/dq = P(1-(1/h)) Where TR(Q) is the total revenue function, Q is output, P is price and h is the price elasticity of demand.

2 Econ147 Midterm: Page 2 of 5 II. Multiple Choice & True and False: Clearly indicate the best answer for each question. (5 points each) For each of the statements listed below, indicated whether the statement is (T)rue or (F)alse. T T a. In the Staples-Office Depot merger case, the FTC found that prices were lower in markets where all three office supply super stores operated than they were in markets in which only one or two of the chains had a store. b. In the Staples-Office Depot merger case, the product market was defined as all retail stores that sell office and school supplies c. In the Staples-Office Depot merger case, the FTC argued that between 1996 and 2000, the number of geographic markets that had more than one office supper store was going to declining anyway, and allowing the merger would only make matters worse d. The major anticompetitive behavior that was alleged in the first Microsoft antitrust case (1995) was that Microsoft had tied the purchase of it word processing software (Word) to its operating system. e. If a market is perfectly contestable, one only needs to have two competitors able to achieve MES in order for the market outcome to be perfectly competitive 2-2. A pure monopolist (not under the threat of entry) has a constant marginal cost curve of $4.00 per unit of output. The monopolist is charging a price of $6.00 per unit of output. At the price the monopolist is currently charging, the elasticity of demand is found to be 3.0. The price being charged by the monopolist a. is too high to maximize profits. b. is too low to maximize profits. c. is the correct quantity price to maximize profits. d. may be either too high or too low (there is not enough information to tell.) 2-3. Explain your answer to question 2.2. If the firm is maximizing profits MC = MR = P(1-(1/h)) In problem 2.2. MC =4, MR= 6(1-(1/3))= 4. Since MC=MR the firm is charging the correct price to maximize profits 2-4. Consider a market where the four firm concentration ratio (CR4) is 80 (on a scale). The theoretical minimum and the maximum possible Herfindahl indices (HHI) for this market would be a. 2000(min) and 6400 (max) b (min) and 6400 (max) c (min) and 5000 (max) d (min) and 5000 (max) e. Unknown, there is not enough information in the problem to compute the minimum and maximum HHI. Max HHI given numbers = d ~ 6400 d is the sum of an infinite number of infinitely small market share which will approach 0. Min HHI = 4 x d ~ 1600 (the eighty percent is equally distributed among the largest 4, the rest is distributed among an infinite number of tiny firms The merger wave of the late 1890's was a. primarily horizontal in nature resulting in the near monopolization of many industries. b. primarily horizontal in nature resulting in loose oligopolies in many industries. c. primarily vertical in nature. d. primarily conglomerate in nature In their paper (from the reading list), Kim and Stewart report that merges in the U.S. during a. universally resulted in an increase in social welfare. b. universally resulted in a decrease in social welfare. c. had mixed results on social welfare but on average social welfare increased from mergers. d. had mixed results on social welfare but on average social welfare decreased from mergers.

3 Econ147 Midterm: Page 3 of 5 III. Graphs and Problems Points as indicated (For graph problems, use the same labels as indicated in the question.) 3-1. (16 points) Consider an industry with $1,000,000 of total sales revenue. The industry has accounting profits of $200,000. These profits represent a 10% rate of return on capital invested in the industry. The average rate of return on investment across all industries is 5% and the rate of return in "competitively" structured industries is 3%. Answer the questions below using either the method of Harberger or Cowling and Mueller (C&M) and be sure to show and carefully describe all your calculations. (hint: a graph might help you keep it all straight.) A. (4 points) What is the dollar value of monopoly profits that would be estimated the above data if the estimation had been done by Harberger: Monopoly profits= $100,000 C&M: Monopoly profits= $140,000 Harberger: because the observed rate of return is twice the average, would conclude ½ the observed profits are monopoly profits, C&M: because competitive rate of returns is 3% and observed rate is 10%, only 30% of the profits ( $60,000) are normal, 70% are monopoly profits. B. (4 points) On a percentage basis, how much higher is price than the competitive level ( P/P) as it would be calculated by Harberger: ( P/P)= 11.1% (10%) C&M: ( P/P)=16.3% (14%) Harberger: Assuming Q=1, then the monopoly price is 1,000,000. If monopoly is eliminated, price would fall by the amount of the monopoly profits ($100,000) thus the competitive price would be $900,000. The percent difference between the monopoly price and the competitive price is 100,000/900,000=11.1% C&M: Similar logic yields that the competitive price using C&M s method would be $860,000; 140,000/860,000=16.3% Note: Depending on whether you calculate going from competition to monopoly or from monopoly to competition, you will get different answers. I will count either as long as you are consistent (the numbers in ( ) are going from monop. to comp. ) used by C. (4 points) In calculating deadweight welfare loss, what price elasticity of demand (η ) would have been Harberger: η = 1 (by assumption) C&M: η = 6.13 (7.14) = 1/( P/P) D. (4 points) What would have been the welfare loss from monopoly that would have been estimated from these data by (Again: make sure you show and explain your work) Harberger: welfare loss= $5545 ($5000) C&M: welfare loss= $70,000 Harberger: Loss = ½(PQ)( P/P) 2 η = 900,000 x x 1 = $5545 ($5000) C&M: you can use the same formula but the easiest way is Loss = ½ Monopoly profits = $70,000

4 3.2. (14 points) The table to the right summarizes one of the regression equations estimated by Cotterill in his paper on retail food prices that was assigned for this class. The dependent variable in the regression is an index of food prices charged at a Variable Intercept CR4 Indepen Store Sq. Ft. Sq Ft. 2 Dist. to Warehse Pop Growth Econ147 Midterm: Page 4 of 5 Income per cap. Coef n =35 R2=.639 t-stat F=6.82 specific store in a particular Vermont local market (measured in dollars for a specified basket of groceries) and the independent variables are as described below. CR4 is the four firm concentration ratio of the market where the store is located (measure on a 0-1 scale) Indepen Strore is a O, 1 variable taking on a value 1 if the store is an independent and 0 if it is part of a chain Sq. Ft. and Sq. Ft 2 are measurements of the square footage (in 1000's of square ft) of the store (and the square of that measure). Dist, to Warehse is the number of miles from the store to a grocery distribution warehouse Pop Growth is the annual rate of population grow in the geographic market where the store is located. Income per cap. Is the per capita income in the geographic market where the store is located. A. (2 points) The independent variables in the regression explain 63.9% of the variation in observed food price. The R 2 provides this information B. (2 points) List the independent variables with regression coefficients that are statistically different form zero at least a 90% confidence level CR4, IndepnStore, Sq.Ft. Sq.Ft2 all have t statistics greater than 1.6 C. (2 points) List the variables that Cotterill included in the regression to account for differences in demand conditions across markets. PopGrowth, Income per cap. D. (4 points) If a merger were to occur in a market that increased the four firm concentration ratio from.2 to.6, what would be your prediction of how much the price of the basket of groceries would change. Explain how you reached your answer. Change in price = $3.11 The change in CR4 is.4 =.6-.2, the coefficient on CR4 in the regression equation is So.4 x 7.78 = 3.11 E. (4 points) Using the information in the regression equation, what would be a reasonable estimate of how large a grocery store would have to be to reach minimum efficient scale? Explain your answer carefully. Estimate of MES = 20,857 sq. ft. If one assumes we will observe price fall when costs fall and the square foot size of the store is a measure of scale (it s the only thing we have here), then we could look for the point where price reaches it minimum as size varies. If you figure P/ Size from the regression equation you get P/ Size = Sq.Ft. The minimum price will be where P/ Size = 0 which occurs at

5 Econ147 Midterm: Page 5 of (20 points) Consider a market with a demand curve described by the equation P = Q, where P is price (measure in $) and Q is quantity (measure in tons). A. (4 points) If all firms in the market have constant long run average cost equal $20, determine the market price and the market quantity when the market is in long run competitive equilibrium. P comp = $20 Q comp = 1200 Competitive equilibrium will occur where P=MC=AC; where 20 = Q, Q*=1200, plug 1200 back into the demand function and get P*= $20 B. (4 points) Were the market organized a perfect monopoly, what would be the equilibrium market price and quantity? Again assume that the long run average cost is constant and equal to $20) P monop = $35 Q monop = 600 Monopoly will max profits where MC=MR, that is where 20= Q, Q*= 600. Plug 600 back into demand function and get P* = $35 C. (4 points) Using your results from parts A and B, calculate 1) $ value of monopoly profits $9000 = (P-AC) x Q = 15 x 600 2) $ value of monopoly deadweight welfare loss. $4500 because this is a pure monopoly the easiest way is ½ profits (could also do ½ P Q D. (8 points) Consider a merger in this market that has the following effects. Before the merger the market is competitively structured and is producing the competitive level of output. After the merger, the competition in the market is decreased and firms are able to raise price by $10. However, the merger produces some production efficiencies and long run average cost drops to $18. How much does this merger change social welfare? Explain your answer carefully (a graph might be useful in your explanation.) Gain (cost saving) Loss LRAC1 LRAC2 Dollar value of the welfare $400 loss See driagram: Welfare loss ½ 400 x10 = 2000 Cost saving = 2 x 800 =1600 net loss 400

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