NAME: ____________________________

SID:

________________________

The University of Sydney

Economics of Competition and Strategy ECOS 2201

Mid-semester exam

Instructions
Part A: Answer the multiple choice questions on the answer sheet provided with a pencil.
Part B: Answer the short answer questions on this question sheet in the space provided.
Time: 60 minutes
Permitted materials: Non-programmable calculators
There are 40 marks in total in this exam. Each of the multiple choice questions are worth 1 mark
(total 20 marks + 1 bonus mark). The short answer question is worth 20 marks in total.

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Part A: Multiple Choice (20 marks each question is worth 1 marks each, with 1 bonus question).
Instructions: Answer all 21 questions by marking the computer cards provided

1. An advantage of opening up a firms network to potential rivals is:

a. it potentially enhances a firms commitment to future low prices
b. it can increase the value of the network by increasing the provision of complementary goods.
c. it increases the likelihood that valuable proprietary knowledge is transferred to rivals
d. (a) and (b)
e. (b) and (c)

2. Hedonic prices

a. estimate the contribution that different aspects of a product make to its overall value (price)
b. are particularly useful for evaluating optimal prices for new products
c. can help a firm make choices regarding what aspects of the product need to be improved
d. (a) and (c)
e. (b) and (c)

3. A transfer price

a. merely transfers profit between divisions

b. should reflect the opportunity cost of the input
c. should include all fixed costs, averaged over all production
d. always should be set to equal the price of the input in the market place
e. none of the above statements are true

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Consider a Hotelling model similar to the one studied in class for the next five questions. Two firms,
A and B, are located 10km apart from each other at either end of a road. Consumers are uniformly
distributed along the road. Other than their location, the firms sell an identical product. Firms
simultaneously set prices (pa and pb for firms A and B respectively), and consumers buy from the
firm that has the lowest full price, which includes the dollar price plus the transport cost of getting
to the vendor. Each consumer has a transport cost of t per unit distance travelled. Assume that the
firms have zero marginal costs of production.

4. Find the consumer, located at x*, who is indifferent between buying from either A or B

a. x* = 20 +(pb pa)/2t
b. x* = (pb pa)/20t
c. x* = 5 (pb pa)/2t
d. x* = 5 +(pb pa)/2t
e. x* =5t2 + (pb pa)/2t

5. The best-response function (or reaction function) for firm A is:

a. pa(pb) = x*
b. pa(pb) = 5t + pb/2
c. pa(pb) = 10t2 pb/2
d. pa(pb) = 5t pb/2
e. pa(pb) = pb

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6. The profit-maximising prices for firm A and B are:

a. pa* = 10t = pb*

b. pa* = 5t = pb*
c. pa* = t/2 = pb*
d. pa* = 10t; pb* = 10 - t
e. pa* = t = pb*

7. The profit of firm A (a) in equilibrium is:

a. a = t
b. a = 50t
c. a = 25t
d. a = 10t2
e. a = t/2

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8. Now consider entry into the market by a potential rival. The rival enters at the location between
the firms that maximises its profit. Once it has chosen its location the entrant sets price
(simultaneous with its rivals) so as to maximise profit. To enter the market the entrant must incur a
sunk cost of F. For what values of t will the entrant choose to enter the market?

a. It is not possible to determine

b. t < F
c. t > 50t
d. t <50F2
e. t > F/25

9. A merchant buyer strategy is more likely when:

a. coordination will cause leakage of vital firm intellectual property to rivals

b there are no other firms with the requisite skills to produce inputs into the production process.
c. the greatest return relates to winning the overall contract rather than controlling every single
aspect of the project
d. The production process is relatively simple
e. none of the above

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10. There are two firms selling an identical product, simultaneously setting price. The demand curve
for the market is P = 1 q. Consumers buy from the cheapest vendor; if both have the same price
consumer spilt themselves 50:50 between the sellers. Each seller has a constant marginal cost of .
One of the firms is offered a new technology that reduces their marginal cost or production to zero.
What is the most that this firm would be willing to pay for this technology?

a. 3/4
b. 1/4
c. 1/2
d. 3/16
e. 1/16

11. A way of softening price competition between rivals is to

a. lower marginal cost

b. increase product differentiation
c. lower the transport costs of consumers
d. increase a firms capacity
e. none of the above

12. Which statement is true?

a. A firm should pre-empt its rivals when the value of commitment is low
b. A credible commitment is only of value if it can be changed
c. Firms should always pre-empt their rivals
d. Being a follower can sometimes be a more profitable strategy
e. None of the above

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13. Which statement is true?

a. Generating a network of customers can create an entry barrier

b. Commitment to win a price war relies on accentuating product differences
c. Cream skimming involves targeting the largest section of consumers in a mass market
d. Two actions (or choice variables) are strategic complements if when one firm increases its choice
variable, the best-response of its rival is to decrease its action.
e. None of the above statements are true

14. What statement is true?

a. In a Nash equilibrium each partys payoff is maximised.

b. In a Nash equilibrium each party plays their dominant strategy.
c. In a Nash equilibrium total surplus is maximised.
d. A Nash equilibrium is always the Prisoners dilemma outcome.
e. None of the above.

15. Consider a Hotelling model of product differentiation, in which two incumbent firms are trying to
pre-empt and prevent the entry of a potential rival. Which statement is true?
a. The two incumbent firms need to be earning zero economic profit in order to prevent entry by the
rival.
b. The two firms can prevent entry by the potential rival even if they are earning positive
economic profit.
c. In order to prevent entry, the two firms need to cooperate and act as a monopolist.
d. In order to prevent entry, the two firms need to be sufficiently close such that a potential entrant
would make no mark-up over their marginal cost (that is price would equal marginal cost).
e. Both firms need to locate in the middle of the distribution.

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16. In order to create a barrier to entry a firm might want to:

a. subsidise providers of a complementary product.
b. sell to the first buyers of a new product at below cost.
c. licence technology to potential rivals to commit so as to commit low future price for consumers
d. lobby the government for new legislation that increases the exit costs from the industry.
e. all of the above.

17. Consider the sixth force, complementarity, outlined by McAfee. Which statement is true?
a. Complementary products are likely to be underprovided in the market, given the positive spillover
between firms.
b. The existence of complementary products provides an incentive for firms to merge.
c. Complementarity suggests that firms should be wary of cooperating with other firms, because
rivalry is the key to firm success.
d. Both a and b are correct.
e. Both b and c are correct.

18. An incumbent firm is considering what size factory to build, anticipating that a potential rival (the
entrant) will observe her choice and then decide whether to enter the market or not. The incumbent
knows that a larger factory (a larger fixed cost) reduces her marginal cost of production (her MC). If
the entrant comes into the market, the two firms compete on prices, and these choices of the two
firms are strategic complements. If the entrant decides to stay out of the market, the incumbent is a
monopolist. Which statement is true?
a. If the incumbent chooses to deter entry, she will build a factory large enough to ensure that the
entrant will make zero profits if it decides to enter the market.
b. If accommodating entry, the incumbent might choose to build a small factory to reduce price
competition after the entrant comes into the market.
c. If accommodating entry, the incumbent will choose a factory size so as to ensure that they have
an advantage in the price war that will occur following entry by the rival.
d. a and b are correct.
e. a and c are correct.

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19. A coherent strategy could involve the following:

a. A low-cost model, targeted at high-value consumers.
b. A low-cost model, selling a medium quality products aimed at the mass market.
c. A low-cost model attempting to minimise quality as the first priority.
d. Selling a high-quality product, but attempting to minimise the cost of provision for the
complementary product.
e. None of the above

20. Without substantial barriers to entry or exit, we could expect:

a. Zero economic profits in such an industry.
b. The firms will cooperate and maintain positive economic profits in the medium to long run.
c. Given excessive entry, economic profits will be negative in the long run.
d. Economic profits in the industry will be eroded in the long run
e. None of the above

21. Hold-up can occur when:

a. A buyer and seller are in a specific relationship (they cannot trade with anyone else) and the
contract between the two parties will be renegotiated.
b. A buyer and seller are in a specific relationship (they cannot trade with anyone else) and the
contract between the buyer and seller has been signed on before any investment has to be made
and it will not be renegotiated.
c. When a buyer has all of the bargaining power, but she must make an important investment and
contract will be renegotiated.
d. When a buyer is buying a generic input in a competitive market.
e. None of the above.

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Part B: Short answer question. Answer in the space provided. Answers that extend outside of the
space provided for each part will not be examined. Answer the questions using the tools of analysis
you have learnt from this unit of study. (20 marks)

Firm A and B produce homogenous products at a marginal cost of $5 per unit. The market
demand is P = 20 Q, where Q = qA + qB.
a. Assume the firms simultaneously set qA and qB. What is the equilibrium output qA*,
market price P and firm Bs profit?

A = (20 qA qB 5).qA

dA/dqA = 20 2qA qB 5 = 0

qA*(qB) = (15 qB)/2

Similarly, qB*(qA) = (15 qA)/2

Solve simultaneously, so that qA* = qB* = 5

P = $10; B = $25

b. Now assume that firm A sets qA first; this output is observed by firm B before makes its
choice of qB. What are the equilibrium outcomes for qA, qB and market price? Are the
equilibrium choices for firm A and B strategic complements or substitutes? Explain.

Solve backwards:

B = (20 qA qB 5).qA
dB/dqB = 0, hence qB = (15 qA)/2

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1st stage:
A = (20 qaA [15 - qA]/2).qA

dA/dqA = 7.5 qA = 0, hence qA* = 7.5

qB* = (15 7.5)/2 = 3.75

P = 8.75

Strategic substitutes

c. As in part b, firm A sets its quantity first; this is observed by firm B before B makes its
choice. Firm A is considering a strategy of deterring entry into the market by B. What
quantity does A need to produce in order to deter B from entering into the market. Is this a
sensible strategy for A to undertake? Explain.

Se qA so that

qB = 0 = (15 qA)/2

qA = 15

This is not sensible, as not maximising profit for firm A too costly to deter entry. We know
that the profit maximising choice for firm A is given in part (b). But also note that here to
deter entry p = c= 5, so firm A makes no profit at all. It can do better by producing less (and
the best it can do is given in part b above)

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d. Again consider the Stackelberg set up with A producing first, followed by B, but now As
output is hidden so that B does not observe qA before it chooses its output. What will be the
equilibrium outcome be? What if As output is observable, but A can change its output after
B has made its choice of qB? Again, please explain.

In both cases, outcome is the same as in part (a)

If cannot commit, A will reoptimise for any choice of qB. The only NE is qA = qB = 5 (from
part a the Cournot outcome_

If qA is unobservable it is as if each firm is choosing their output simultaneously; the only

NE is the one in part a in which qA = qB = 5.

e. Now consider different problem. Using the tools from class, outline one reason as to why a
firm might want to make rather than buy an input. What are the critiques of the reason you
suggested? (A good answer will possibly include diagrams or a mathematical model to
supplement your economic intuition.)

Different answers were acceptable here. For example

Double marginalisation integrate to avoid the double mark-up.

BUT why not use a contract with a fixed fee and a per unit price set at MC at the profitmaximising level of output?

Hold-up: if production requires a specific relationship, potential that a party making an

investment will not get the full return from their effort (holdup). Bring production into the
firm, to avoid two parties wishing to renegotiate this gives the investor the full return from
their effort, providing greater incentive to invest increasing total surplus (profit)
BUT: why is hold-up reduced when transaction is brought inside the firm? Still in a specific
relationship that requires investment. Problem still might exist.

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Complementary products: provision of a complementary product under provided because it

produces a spillover or externality. Bring production inside the firm to internalise the
spillover, providing correct incentives to provide the related product.
BUT problem still might exist if product/service offered by separate divisions that act like
separate profit maximisers (profit centres) within an organisation
Also, a firm wants to concentrate on producing what it knows how to produce might not
have the skills in making the related product.
What about using a long-term contract (that is, dont necessarily need vertical integration to
solve the under-provision problem).

END OF THE EXAM

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