ECO - Industrial Organization Spring 2014 Problem Set 3

Problem Set 3

1. How can an elastic demand curve deter the formation of a cartel?
2. Explain why collusive pricing is difficult in one-period competition and easier when firms interact
over a number of periods.
3. Discuss factors that may facilitate collusion.
4. Suppose that market demand is described by P = 100 − (Q + q ), where P is the market price, Q
is the output of the incumbent firm and q is the output of a potential entrant to the market. The
incumbent firm’s total cost function is T C (Q) = 40Q, whereas the cost function of the entrant is
T C (q ) = 100 + 40q , where 100 is a sunk cost incurred to enter the market.
a. If the entrant observes the incumbent producing Q units of output and expects this output level
to be maintained, write down the equation for the residual demand curve that the entrant firm
faces.
b. If the entrant firm maximizes profit given the residual demand curve in a., what output q e will
the entrant produce? (Your answer should be a function of Q.)
c. How much output would the incumbent firm have to produce to just keep the entrant out of the
market? That is, solve for the limit output QL . At what price will the incumbent sell the limit
output?
5. Please solve the Practice Problem 12.3 at page 282 from the textbook.
6. Explain why predatory strategies do not work in an industry if no substantial sunk costs exist.
7. Why is predatory pricing unlikely to occur when all firms are identical?
8. Tiger-el is an upstream manufacturer of electric trains that sells wholesale to The Great Toy Store, the only such store in the area. Demand for the trains at the retail store in inverse form is P = 1, 000 − 2Q, where Q is the total number of trains sold. The Great Toy Store incurs no service cost in selling the train. Its only cost is the wholesale price it pays for each train. Tiger-el incurs a production cost of
$40 per train.
a. What wholesale price should Tiger-el charge for its trains? What price will these trains sell for
at retail? How many trains will be sold?
b. What profit will Tiger-el and The Great Toy Store earn under the pricing choices you found in
part a.? What is the total profit of these two firms?
c. Now assume Tiger-el and The Great Toy Store merge into one firm and they are maximizing
joint profits. What would be the retail price and quantity sold in this case? Calculate the joint
profits.
d. Compare the total profits you find in part b. and c.. Which one is greater? Why?

10. Why are consumers and firms worse off with successive monopolies upstream and downstream than when there is a single, integrated monopoly?
11. Some products require special, custom-made trucks to transport by road. If a trucking company
contracts with a manufacturer for the transportation of such a product and invests in custom-made
trucks, how might this investment give rise to subsequent opportunistic behavior of the manufacturer,
the trucking company, or both? How can such behavior be prevented?