Management Engineering - Business & Industrial Economics

Full exam

BUSINESS AND INDUSTRIAL ECONOMICS [G-O] Final exam July 20 th 2021 NAME AND SURNAME ________________________________________________________________ STUDENT ID________________________________________________________________ Multiple choice questions 1) Please evaluate the trueness of the following statements regarding the cellophane fallacy related to the SSNIP test: a) a monopolist ALWAYS sets an optimal price in correspondence of the inelastic portion of the demand curve, and for this reason, an increase in the current level of price might INDUCE customers to switch to other products that would not necessarily be substitutes under competitive conditions. b) a monopolist NEVER sets an optimal price in correspondence of the inelastic portion of the demand curve, and for this reason, an increase in the current level of price might INDUCE customers to switch to other products that would not necessarily be substitutes under competitive conditions. BONUS c) a monopolist NEVER sets an optimal price in correspondence of the inelastic portion of the demand curve, and for this reason, an increase in the current level of price might DISCOURAGE customers to switch to other products that would not necessarily be substitutes under competitive conditions. d) a monopolist ALWAYS sets an optimal price in correspondence of the inelastic portion of the demand curve, and for this reason, an increase in the current level of price might DISCOURAGE customers to switch to other products that would not necessarily be substitutes under competitive conditions. 2) There are two cities: Brighton and Hove. Electricity service distribution in both areas is a natural monopoly. The two monopolies and the two areas are identical in every aspect (e.g. n° consumers) except for two crucial factors: 1) consumers of Brighton are much more price-sensitive than those of Hove, who conversely are very reluctant to change their consumption patterns even in the presence of high electricity prices; 2) fixed costs of providing the service in Hove are much higher than those needed in Brighton. On the basis of this information, from a theoretical point of view, which strategy the regulator should pursue in the two different geographical contexts, among the following options: a) We can say that in both areas the regulator should implement a 1 st best solution, since deadweight loss is huge in both areas in case of a 2 nd best solution. b) We can say that in both areas the regulator should implement a 2 nd best solution, since in both areas deadweight loss is affordable. c) We can’t say which strategy among the 1 st and 2 nd best solutions is the best one since we do not know the difference in terms of deadweight losses between the two areas. BONUS d) We can say that in Brighton the regulator should preferably pursue a 1 st best solution, while in Hove also a 2 nd best solution would be ok given that deadweight loss after a 2 nd best solution is huge in Brighton and affordable in Hove. 3) Suppose that demand in a market is given by: P = 80 – Q and all firms have constant marginal cost of MC = $40. Market is competitive so all firms charge a price equal to $40. Let one firm have innovation that lowers cost to MC = $20. There are no capacity constraints. Evaluate the following statements: a) Thanks to this drastic innovation, the innovating firm will become a monopolist and will charge a price just below $40. b) Thanks to this drastic innovation the innovating firm will not become a monopolist and can’t charge a price just below $40. c) Even if the innovation is not drastic, the innovating firm will become a monopolist and will charge a price just below $40. BONUS d) Even if the innovation is not drastic, the innovating firm will become a monopolist and will charge a price equal to $50. 4) There is a monopoly in a retail market with an inverse demand curve given by P = 10 – Q, no fixed costs and use of only 1 input for each unit of output (e.g. 1 engine for 1 car). Now suppose that the wholesale market where this input is produced is also a monopoly, and the wholesale monopolist bears a constant marginal cost for producing the input equal to 6. Please indicate the optimal price that the wholesaler will settle to the retailer. a) 8. BONUS b) 9. c) 10. d) None of the other options is correct. 5) A very famous and successful restaurant chain is evaluating the possibility to enter the business of domotics (i.e. smart houses). The industry of smart houses has been evaluated by multiple analysts as being very profitable in the long run. Moreover, a reputed team of ad hoc experts has determined that the expected future profits far exceed the costs to set up the business. Based on this information: a) The company should diversify into domotics. b) The company should think twice before diversifying, mainly because of the attractiveness test. c) The company should think twice before diversifying, mainly because of the cost-of-entry test. d) The company should think twice before diversifying, mainly because of the better-off test. BONUS 6) A steel mill jointly produces steel and pollution. Nearby there is also a fishery firm. Both firms are price takers (P steel = 8 and P fish = 10). The total cost function for the steel mill is S 2 - (x - 4) 2, where S is the quantity of steel produced and x are the units of pollution. The total cost function for the fishery is f 2, where f is the quantity of fish produced. a) The negative effect of pollution can be internalized by merging the two firms, but the merged firm will reach a global profit which is inferior with respect to the sum of profits achievable separately by the two firms. b) The negative effect of pollution can be internalized by merging the two firms, and the merged firm will reach a global profit which is greater than the sum of profits achievable separately by the two firms. This is a Pareto efficient outcome. c) The negative effect of pollution can be internalized by merging the two firms, and the merged firm will reach a global profit which is greater than the sum of profits achievable separately by the two firms. However, this is not a Pareto efficient outcome. d) None of the other options is correct. BONUS 7) Please read the following Schumpeter’s excerpt from his masterpiece “Capitalism, Socialism and Democracy”: “[….]More precisely, our question may be formulated as follows: given a socialist system […], is it possible to derive, from its data and from the rules of rational behavior, uniquely determined decisions as to what and how to produce by the central board or ministry of production? The answer is in the affirmative. There is nothing wrong with the pure logic of socialism.” What the Austrian School (e.g. von Hayek) would object about this statement: a) necessary data are too dispersed for socialism to work properly, and competitive prices emerging from markets are effective “information vehicles” (i.e. conveyers) to signal scarcity in the economic system. BONUS b) necessary data are too concentrated for socialism to work properly, and competitive prices emerging from markets are effective “information vehicles” (i.e. conveyers) to signal scarcity in the economic system. c) necessary data are too concentrated for socialism to work properly, and non-competitive prices emerging from markets are effective “information vehicles” (i.e. conveyers) to signal scarcity in the economic system. d) necessary data are too dispersed for socialism to work properly, and non-competitive prices emerging from markets are effective “information vehicles” (i.e. conveyers) to signal scarcity in the economic system. 8) If potential buyers have difficulty separating lemons from good used cars, what will they do? [Note: correct answer was a), but I have benevolently considered valid also option c), so 2 correct answers] a) They will take this into account in the prices they are willing to pay. BONUS b) They will not take this into account in the prices they are willing to pay. c) They will be willing to pay the same price for either type of car. BONUS d) They will pay a price for a car that is always too high, because of the presence of adverse selection. 9) If there were no principal-agent problem: a) Firms would not exist. b) Property rights theory would lose validity. c) Team productivity theory would lose validity. BONUS d) Transaction costs theory would lose validity. 10) Consider a perfectly symmetric oligopoly (i.e. all oligopolists have the same market share). In this setting, which of the following results is impossible? [Note: oligopoly is perfectly symmetric, so all firms should have the same market share (so in this case 7.5%+7.5%+ 7.5%, etc. etc.), but then 7.5% is impossible, since 100 divided by 7.5 gives an impossible number of firms (i.e. 13.3333)] a) Herfindhal index = 0.25. b) Concentration ratio C2 = 15%. BONUS c) Gini index < 0.5. d) All the reported results are theoretically possible, given the information provided. Structured question In the market for teleportation devices there is currently only one firm, which has enjoyed monopoly profits for a very long time. However, the teleportation patent has just expired, and it is now facing potential entry from a competitor. The inverse demand function in the market is: P = 451 – 3Q. The incumbent and the potential new entrant have the same cost structure, summarized by the following total cost function: TC = 1600 + Q 2 + 3Q. a) Explain the key similarities and differences between the Bain, Sylos Labini and Modigliani model with economies of scale and the one without. Solution: See slide number 26 of the set named “Entry barriers and deterrence”. In solving the following points, stick to the assumptions of the Bain, Sylos Labini and Modigliani model with economies of scale. b) For the incumbent, deterring the new entrant is indispensable. The management of the company is currently producing 100 to this end. However, John, a junior employee, thinks that this quantity is excessive. He argues that 80 would be enough to deter the new entrant while securing a higher level of profits. Is he right? Solution: P = 451 – 3 (80 + Q entrant )  P = 211 – 3Q entrant TR entrant = (211 – 3Q entrant ) Q entrant MR entrant = 211 – 6Q entrant MC entrant = 2Q entrant + 3 MR = MC  Q entrant * = 26 TT entrant * = (211 – 3*26)*26 – (1600 + 26 2+3*26) = 1104 > 0  The new entrant would enter. Thus, John is wrong. c) Following John’s remark, the high-level management of the company decided to hire a team of professional strategic consultants to inquire into the matter. The consulting team agrees with John in saying that 100 is not the optimal entry-deterring quantity. In the consulting report, it is written that the current quantity produced is costing the firm 4431 in foregone profits. However, it was later discovered that the member of the consulting team that wrote the report was drunk. Is the number written in the report correct? Solution The optimal entry-deterring quantity is the one that makes the AC curve of the new entrant tangent to the residual demand curve. AC = 1600/Q +Q +3. Tangency  (1–1600/Q^2) = -3  Q = 20; AC = 103. X – 20*3 = 103  X = 163 (required intercept of the inverse residual demand curve). 451 – 3Q = 163  Q* = 96 (optimal entry deterring quantity). TT deterrence * - TT deterrence = [(451 – 3*96)*96 – (1600 + 96 2 + 3*96)] – [(451 – 3*100)*100 – (1600 + 100 2 + 3*100)] = 1344 ≠ 4431 Hence, the consulting team probably got everything correct, but the drunk consultant spelled the foregone profits backwards in the report. d) Explain why, according to price limit theory, “P – AC” is a proxy for the height of entry barriers. Solution According to price limit theory, “P – AC” tells you how much the incumbent can afford to raise the price above the average cost without inducing entry. The higher the entry barriers, the more the incumbent can do so. Thus, the higher the observed difference between P and AC, the higher the entry barriers.