1-4. Nash Equilibrium outcome of a game theory model where all players are doing the best they can given the actions of all other players.

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1 Econ147 Final: Page 1 of 7 NAME: KEY onor Pledge Economics 147 Spring 05 FINAL 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 (25 points) Part II (15 points) Part III-1 (25 points) -2 ( points) -3 (15 points) (Bonus 10 points) -4 ( points) -5 (10 points) Part IV ( points) TOTAL (150 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. (5 points each) 1-1. Rule of Reason Legal standard (for antitrust cases) where not only the action but also the motivation and consequences of the action are considered in a legal determination of guilt (liability) erfindahl Index Measure of market concentration = ( i ) I n S where S is the market share of the ith 2 i furn i= Raising Rival s costs An entry deterrence strategy where a firm makes an investment in some sort of entry barrier (advertising, vertical contract etc.) that then forces the rival firm to incur higher costs in order to compete Nash Equilibrium outcome of a game theory model where all players are doing the best they can given the actions of all other players Market Extension Merger a merger between two firms that produce the same product, but not direct competitors because they are in different geographic markets.

2 Econ147 Final: Page 2 of 7 II. Multiple Choice & True False: Clearly indicate the best answer for each question. (5 points each) In his analysis of in his article on the Ready-to-eat Cereal Industry, Schmalensee argues (mark True or False for each statement) T scale economies in the cereal manufacturing industry are not very large. T firms were able to block entry by proliferating cereal brands. F the industry suffered from destructive price competition. F large profits in the industry had resulted in many firms attempting to enter the market and the incumbent firms had responded with predatory pricing. F the dominant firms had achieved their advantage through technological superiority in the production process 2-2. For each of the statements listed below, indicated whether the statement is (T)rue or (F)alse. T The Jerrold Electronic Case, discussed in class, is an example to tying being used to facilitate price discrimination. F The Toys R Us case is an example of full line forcing where toy manufactures were forcing Toy R Us to take their full line of toys if they wanted to get adequate supplies of the toy manufacturer s most popular items. F The 1984 NCAA case is a classic example of a price fixing case decided under a per se interpretation of Section 1 of the Sherman Act. T The Dorfman-Steiner model predicts that a monopolistic firm will advertise more intensively than a competitive firm. T A market with 2 firms (one with are market share of 75% and the other with a market share of 25% have a erfindahl index of 6250 (on a 0 to 10,000 scale) = The right hand side of the table below lists the important sections of the antitrust law that were covered in class. Directly below are listed 5 potential violations of antitrust law. For each type of violation, list the letter of the most applicable section of the antitrust law. Violations _B a. Monopolization & attempt to monopolize _F b. Mergers that lessen competition _D c. Price discrimination that lessens competition _A d. Conspiratorial price fixing _E e. Exclusive dealing and tying arrangements. Antitrust Law A. Section 1, Sherman Act B. Section 2, Sherman Act C. Section 5, FTC Act D. Section 2, Clayton Act (Robinson-Patman Act) E. Section 3, Clayton Act F. Section 7, Clayton Act

3 Econ147 Final: Page 3 of 7 III. Graphs and Problems Points as indicated (For graph problems, use the same labels as indicated in the question.) 3-1. Consider the follow game between two firms E, the potential entrant and I, the incumbent firm. Firm I can either choose to make a $72 dollar investment in advertising or not. After I has made his choice, E can choose whether to enter the market or not. If there is only one firm in the market (i.e. E does not enter) profits will be $150. If there are two firms in the market (i.e. E does enter) each firm will receive a profit of $70. Important: these profits do not include the cost of the advertising investment so if the investment is made, profits would be reduced by $72. Firm E can enter the market with no additional cost if firm I chooses not to advertise, but can only enter the market by investing and equal amount ($72) if I has chosen to make the investment in advertising. If E decides not to enter, his profits are zero. a. Complete the payoff matrix for the game shown below. P I and P E are the profits of firms I and E respectively. (8 points) Incumbent (Firm I) Potential Entrant (Firm E) Invest in advertising Don t invest in advertising Enter the market P I _-2=70-72_ P E _-2=70-72_ P I _70 P E 70 Don t enter the market P I _78= P E 0 P I 150 P E 0 b. Is it possible for firm I to deter entry? Yes / No. Explain. (3 points) If the incumbent makes the investment on advertising, the entrant will face negative profits if it enters (profits will be zero if it doesn t enter) so entry will be deterred. c. Does firm I have a dominant strategy? Yes / No. Explain. (3 points) profit for the Incumbent are always higher if it does not invest in advertising 70 compared to -2 with no entry; 150 compared to 78 if there is entry. d. What is the equilibrium of the game? Explain. (3 points) Even though there is a dominant strategy for I, he will not use it. Note that if he doesn t invest the other firm will enter and profits will be 70, if he does invest the other firm will not enter and his profits will be 78 which is larger. Given that he gets to play first, he will invest and the other firm will not enter. e. ow do your answers for parts b., c., and d. change if the cost of the advertising invest is $90 instead of $72? (8 points) Part Answer change? Why? b. Yes / No It is still possible to deter entry, it just no longer make any sense to do so c. Yes / No e still has a dominant strategy which is to not invest d. Yes / No Now the best he can achieve, given the reaction of the entrant is to not invest and entry will occur.

4 Econ147 Final: Page 4 of ( points) Consider a market in which there is one very large dominant firm and a large number of small pricetaking fringe firms. The diagram shows the market demand (D MARKET ), the supply curve of the fringe firms (S fringe ) and the marginal cost curve of the dominant firm (MC DOMINANT ). You may ignore entry in this problem. $5 $4 $3 $2 Market Price DMARKET SFRINGE MCDOMINANT a. On the diagram, draw in the demand curve faced by the dominant firm and the marginal revenue curve associated with the dominant firm s demand curve. Clearly label the curves. Dominant firm demand is Market demand -Fringe supply $1 DDOM MRDOM Market Quantitiy b. Assuming that the dominant firm is a profit maximizer, what level of output will the dominant firm choose to produce? (Numerical answer required) c. What will be the market price and total market output in equilibrium? (Numerical answer required) Price = _$2_ Quantity = _60 d. Which antitrust law might the dominant firm be violating? Explain what would have to be proved in order for the dominant firm to be found in violation of the antitrust law. The dominant firm might be violating Section 2 of the Sherman Act (monopolization). It would have to be shown that the dominant share of the market was large and that it acquired or protected its position with intent. That is it engaged in predatory or exclusionary tactics to get or keep its position

5 Econ147 Final: Page 5 of Consider the Betrand model of pricing of differentiated products that starts from Study Guide 4. There are two firms selling a differentiated product. Price of firm B 60 BRF Demand function for firm B and firm are q B = 96-2p B +p q = 96-2p +p B where q B, q >0 and p B, p <96, and MC B = MC = 12, where MC is the marginal cost of producing the good (which is constant and identical for both firms) BRF B a. Calculate late the best response functions 10 (reaction curves) for each of the firms. Write out the reaction equation for the best response curve for each firm and plot it on the graph provided below. (int: because the demand curves are symmetric, and each firm has the same marginal cost, the best response functions will be symmetric) (4 points) TR = P Q = P 96 2 P + P ( ) ( ) TC = 12Q = P + P π = TR TC δπ Firm would max profits when δ P doing the math, or P b h b = by symmetry P B δπ δp = 96 4 P + P = 0 P this is the reaction function for B 1 = 30 + P 4 B = Price of firm b. What will be the equilibrium price charge by the firms in this market? (4 points) P, P B either solve the two reaction functions or use the graph. c. Calculate each firm s profits and the total market profit at the Bertrand equilibrium. (3 points) Profit firm 1568 Profit firm B 1568 Total market profits 3136 Q B =Q =96-2()+=56 Profits for each firm are (P-AC)Q=(-12)=1568. There are two firms d. Now consider a merger between the two firms. Assume that the new firm charges the same price for each of the differentiated goods P = P =P B (which it will because the demand curves for and B are symmetric). The merged firms demand curve will now be q = 192-2P, where q is the total output of the firm ( q B + q )

6 Econ147 Final: Page 6 of 7 What price will the new firm charge if it is assume to maximize profits? (4 points) P = 54 δ TR = P( P) so TR = P δp δ TC = 12Q = 12( 192 2P so TC = 24 δp δ profits are imized where TR δtc max = P P so P = 24 δ δ solving P = 54 e. (BONUS QUESTION, 10 points) The merger will result in a welfare loss (gain) of (numerical answer required show your work. int: use the graph of the total demand curve below to help you sort out your answer) if P=, Q=112; if P=54, Q=84 P Looking at the diagram you can see the welfare of the two outputs. The merger results in a loss of 1/2(14x28) + (28x28) = 980 difference Q 3-4. ( points) Consider a monopolist manufacturer who sells to good to competitive retailers. The competitive retailers provide no services and thus have marginal cost equal to the price charged by the manufacturer. The final consumer demand curve for the good at retail is P = 100 -Q and the manufacturer has a constant marginal cost of $ per unit of the good. 100 PR= 80 PR= PM= 60 PM= 60 Red shows monopoly manufacturer with competive retailers (pre-merger) Blue shows monopoly manufacture with monopoly retailers (post merger) DW loss = 1/2 x = 0 Profit loss = x = 800 Total loss =1000 MC M a. (6 points) If the manufacturer is a profit maximizing firm, what price will he charge the retail firms (P), and how much of the good will be sold (Q), and what will be the manufacturer s profits? MR M MRR, DM D R 100 P = 60 Q = Profits = 1600_ see red in diagram b. (8 points) Suppose that all of the competitive retailers now merge into a single monopolist retail firms so the market is now structured as a bilateral monopoly. What price will the manufacturer charge the monopolist retailer and what will be the manufacturers profits? P M = 60 Profits M = 800 see blue in diagram What price will the monopoly retailer charge the final consumers and what will be the retailers profits?

7 Econ147 Final: Page 7 of 7 P R = 80 Profits R = 0 see blue in diagram c. (6 points) What was the change in social welfare that resulted from the merger? ow is the change distributed between the manufacturer, the retailers and the consumers? Change in welfare _welfare falls by _1000_ 3.5. The diagrams show a profit maximizing firm's marginal cost function (MC), the market demand and marginal revenue for a firm's product (D M, MR M ), and that same market demand curve divided into two segments (D A and D B ), each with a corresponding marginal revenue curve (MR A and MR B ). If the firm described above can successfully engage in 3rd degree price discrimination, show graphically the price it will charge in each of the two submarkets (P A, P B ) and the quantities it will sell in each of the two submarkets (Q A, Q B ). (10 points) P Market P Sub Market A P Sub Market B DM MC PA DA PB DB QM QA QA QB QB MRM MRA MRB IV. Short Essay ( points) During the semester you were asked too read a number of antitrust cases in the readings book by Kwoka and White. Pick one case that was on the reading list and 1) briefly describe the participants in the case and the actions/behavior that led to the antitrust case, 2) briefly describe the economic issues involved in the case and 3) describe the outcome of the case and its significance.