Examiners’ commentaries 2022

Examiners’ commentaries 2022

EC3099 Industrial economics

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2021–22. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2015).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

General remarks

Learning outcomes

At the end of this course and having completed the essential reading and activities you should be
able to:

describe and explain the determinants of the size and structure of firms and the implications
of the separation of ownership and control
describe and explain the pricing behaviour by firms with market power and its welfare
implications
apply analytical models of firm behaviour and strategic interaction to evaluate various
business practices, including tacit collusion, entry deterrence, product differentiation, price
discrimination and vertical restraints
recognise and explain the basic determinants of market structure and the key issues in
competition policy and regulation.

What are the examiners looking for?

Some examination questions will be problem-type questions, while others will be essay-type
questions.

In general, problem-type questions are quite specific as to what you are supposed to do, and a good
answer generally involves some use of mathematics. When you answer problem-type questions in an
examination, all the necessary steps must be shown. Moreover, you should take care to explain what
the mathematics show – do not simply list equations.

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EC3099 Industrial economics

Essay-type questions can be more or less specific, although a good answer to an essay-type question
must include some rigorous economic analysis, usually with reference to some economic model or
models.

Reading and preparation for the examination

It is important to read more widely than just the subject guide. In essay-type questions in
particular, you get a higher mark by including relevant material not in the subject guide. Whatever
the question, exposure to a wider set of readings is usually necessary to understand in depth the
economics involved and to be able to provide correct and comprehensive answers in the examination.

While there is no single best way to organise your study, it may be useful, for each topic in the
syllabus, to start with the relevant chapter of the subject guide, then read the essential and some of
the recommended reading for that particular topic, then come back to the subject guide and
attempt the various learning activities and sample examination questions.

Planning your time in the examination

Use your time efficiently bearing in mind that all questions carry equal weight in the final mark.
Your answers must be as detailed and comprehensive as possible given the time constraints (unless
you are specifically asked to discuss something briefly), but you should not include material which is
not relevant to the question.

Steps to improvement

Your answers to problem-type questions should not simply list mathematical results but they should
also explain what the mathematics mean.

Your answers to essay-type questions must be focused, not too descriptive and must contain rigorous
economic analysis.

Examination revision strategy

Many candidates are disappointed to find that their examination performance is poorer than they
expected. This may be due to a number of reasons, but one particular failing is ‘question
spotting’, that is, confining your examination preparation to a few questions and/or topics which
have come up in past papers for the course. This can have serious consequences.

We recognise that candidates might not cover all topics in the syllabus in the same depth, but you
need to be aware that examiners are free to set questions on any aspect of the syllabus. This
means that you need to study enough of the syllabus to enable you to answer the required number of
examination questions.

The syllabus can be found in the Course information sheet available on the VLE. You should read
the syllabus carefully and ensure that you cover sufficient material in preparation for the
examination. Examiners will vary the topics and questions from year to year and may well set
questions that have not appeared in past papers. Examination papers may legitimately include
questions on any topic in the syllabus. So, although past papers can be helpful during your revision,
you cannot assume that topics or specific questions that have come up in past examinations will
occur again.

If you rely on a question-spotting strategy, it is likely you will find yourself in difficulties
when you sit the examination. We strongly advise you not to adopt this strategy.

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 Examiners’ commentaries 2022

Examiners’ commentaries 2022

EC3099 Industrial economics

Important note

This commentary reflects the examination and assessment arrangements for this course in the
academic year 2021–22. The format and structure of the examination may change in future years,
and any such changes will be publicised on the virtual learning environment (VLE).

Information about the subject guide and the Essential reading

references

Unless otherwise stated, all cross-references will be to the latest version of the subject guide (2015).
You should always attempt to use the most recent edition of any Essential reading textbook, even if
the commentary and/or online reading list and/or subject guide refer to an earlier edition. If
different editions of Essential reading are listed, please check the VLE for reading supplements – if
none are available, please use the contents list and index of the new edition to find the relevant
section.

Comments on specific questions

Candidates should answer FOUR of the following EIGHT questions: TWO from Section A and
TWO from Section B. If more than four questions are answered, only the first questions attempted
will be counted.

Section A

Candidates should answer TWO questions from this section.

Question 1

Discuss the costs and benefits of organising activities internally within a firm or via
the market (or contracts). Hence discuss what determines the size of firms and why
there are limits to integration. Refer to theoretical arguments and formal models as
well as any relevant empirical evidence.

(25 marks)

Reading for this question

Chapter 1 of the subject guide, Tirole (1988, introductory chapter), Church and Ware (2000,
Chapter 3).

Approaching the question

A good answer would outline the transaction cost theory, including defining and discussing the
significance of the underlying concepts that lead to the possibility of opportunistic behaviour or
hold-up. This discussion should lead to a statement of the main theoretical prediction of the

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EC3099 Industrial economics

theory: the more specific the investments required for the production and sale of a product, the
higher the probability of integration (i.e. common ownership) as opposed to a contractual
relationship between independent firms. A formal model, such as the one presented in the
subject guide, could be outlined to formalise some key results of the transactions cost approach.

A good answer would also include a discussion of the property rights theory, and clarify why
integration solves or reduces the problem of potential opportunistic behaviour. The main idea is
that integration reduces opportunistic behaviour because if, say, firm A acquires firm B, then the
manager of firm B loses control of the physical assets of firm B, and therefore has much less
bargaining power. An important result that should be mentioned is that highly complementary
assets would be more likely to combine in common ownership on efficiency grounds, but
independent assets should not be combined: combination in this case would raise the incentives
to underinvest because the gains would be split between the two formerly independent owners,
and so there would be relatively large costs to integration.

A very good answer might outline a formal model to illustrate the property rights approach,
clarify the circumstances under which there are benefits to integration and discuss which party
should have the rights of control in the case of vertical merger. For the final part, you should
draw from the empirical discussion in the subject guide or other relevant empirical evidence.

Question 2

Answer all parts (a), (b) and (c) of this question.

(a) Empirical evidence suggests that McDonald’s restaurants that are wholly owned
by the parent company tend to charge lower prices than do independent
franchise ones. How can this difference be explained?
(5 marks)
(b) Is exclusive dealing anti-competitive? If you wished to pursue a case of exclusive
dealing, what evidence would you look for to prove your case of anti-competitive
behaviour? As a defendant, what evidence would you cite in your defence?
(10 marks)
(c) In light of your answer to part (b) above, how would you suggest that
governments should approach policy toward exclusive dealing?
(10 marks)

Reading for this question

Chapter 8 of the subject guide, Tirole (1988, Chapter 4), Church and Ware (2000, Chapter 22).

Approaching the question

(a) A possible reason is double marginalisation in the case where an upstream firm
(McDonald’s) sells to an independent downstream firm and both firms have market power.
This can be eliminated through vertical integration, leading to lower consumer prices. Other
possible reasons can be mentioned.
(b) A good answer would first define exclusive dealing. Next, it would discuss theoretical
arguments and empirical evidence for the view that the welfare implications of exclusive
dealing are generally ambiguous. It might be helpful in doing this to draw from one or two
case studies. A good answer would point out the possible effects of exclusive dealing on
prices and level of services, and also discuss other possible implications, such as entry
deterrence.
Evidence to prove anti-competitive behaviour could include direct evidence of the practice
that would restrict provision of a particular product or class of products to consumers; entry

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 Examiners’ commentaries 2022

deterrence at either downstream or upstream levels; long-term contracts; lack of service

provision; requests to provide supply that are refused; soft inter-brand competition and/or
lack of/inaccessible appropriate comparative information for consumers; tacit collusion; and
email trails pointing to exclusive dealing being carried out as a way to restrict competition.
Evidence in defence of the practice could be high quality of service provision or simply a
large service component of purchases; modest prices; entry or agreements to supply; tough
inter-brand competition and access for consumers to multiple brands; and email trails
pointing to efficiency gains from exclusive dealing.
(c) A good answer would first define the per se and rule of reason approaches in competition
policy, outlined in Chapter 10 of the subject guide, and relate them to the theoretical
arguments presented in part (b). It could then discuss general pros and cons of these
approaches as part of the answer. A very good answer would mention that empirically
vertical restraints often appear to improve consumer welfare and would provide a discussion
of the practice of competition policy toward exclusive dealing in particular.

Question 3

Indicate whether each statement below is true or false, and give a brief explanation
for your answer.

(a) A firm that sells two substitute products will price them higher than if they
were sold by two separate firms.
(5 marks)
(b) Customers are not necessarily better off when firms provide a guarantee to
match any competitor’s low price than when such guarantees are not available.
(5 marks)
(c) Predatory pricing is always a credible strategy, so it is something we should
always worry about as a matter of competition policy.
(5 marks)
(d) Contestability is a theory that has a good empirical basis, so large companies in
concentrated markets are probably quite constrained in their pricing and should
rarely be a concern for competition policy.
(5 marks)
(e) A merger between two firms in a Cournot industry is generally unprofitable for
the firms involved.
(5 marks)

Reading for this question

For (a), Chapter 3 of the subject guide, Tirole (1988, Chapters 1 and 5), Church and Ware
(2000, Chapters 4 and 8).

For (b), Chapter 4 of the subject guide, Tirole (1988, Chapter 6), Church and Ware (2000,
Chapter 10).

For (c), Chapter 5 of the subject guide, Tirole (1988, Chapter 9), Church and Ware (2000,
Chapter 21).

For (d), Chapter 5 of the subject guide, Tirole (1988, Chapter 8), Church and Ware (2000,
Chapter 14).

For (e), Chapters 3 and 10 of the subject guide, Tirole (1988, Chapter 5), Church and Ware
(2000, Chapters 8 and 23).

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EC3099 Industrial economics

Approaching the question

(a) True. A firm that sells two substitute products will tend to price them higher than if they
were sold by separate firms because increasing the price of one product will result in
increased consumption of the second product (since they are substitutes). This positive
externality is not taken into account by firms when products are sold by separate firms but
it is taken into account by a multiproduct firm.
(b) True. A low price guarantee may be a practice facilitating collusion, aimed at modifying the
payoffs in a non-cooperative game so that the incentive to price low is reduced. In
particular, under a low-price guarantee, a price cut by a rival firm may not be rewarded
with any additional market share since it will be immediately matched. The low-price
guarantee may actually raise equilibrium prices by facilitating collusion.
(c) False. Predatory pricing refers to pricing low (often below marginal cost) in order to drive
another firm out of an industry so as to benefit by raising prices later. In order for this
strategy to be credible, the low price needs either to carry a reputation benefit that makes
low price optimal in a repeated interaction setting (as in the chain store example); or to be
justified by the fact that rival firms may be facing financial constraints caused by
asymmetric information. Hence, predatory pricing is an important concern only in settings
where credibility can be argued.
(d) False. Contestability has quite stringent assumptions that often are not satisfied in practice,
so it is a theory that should be used with caution. In particular, the assumptions of no sunk
costs and entry occurring quicker than prices can change make it difficult to apply.
Contestability has been argued in selected cases (airline routes, operating systems) but not
very convincingly.
(e) False. It can be profitable if the firms are asymmetric, or the merger results in cost
efficiencies, or it creates a monopoly or a Stackelberg leader in the industry.

Question 4

Answer both parts (a) and (b) of this question.

(a) What are the features of an industry that is susceptible to direct regulation,
rather than allowing competition to discipline prices and quality? Why would
regulation be selected, rather than allowing competition policy to operate ex
post to discipline behaviour?
(12 marks)
(b) What are the effects of price cap regulation on the quality of services provided?
Why would price caps and quality regulation often be observed to occur
together? Discuss with reference to theoretical arguments and any relevant
empirical evidence.
(13 marks)

Reading for this question

Chapter 11 of the subject guide; Armstrong, Cowan and Vickers, Regulatory Reform; Church and
Ware (2000, Chapters 24–26).

Approaching the question

(a) In some industries effective competition is either impossible or predictably difficult. Natural
monopoly is the typical case, where falling average costs make marginal cost pricing
unprofitable for single firms and entry unlikely. A good answer would start by explaining
and illustrating natural monopoly and how regulation can improve efficiency in this case,

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 Examiners’ commentaries 2022

using average cost pricing and a two-part tariff as illustrations. Other cases than natural
monopolies may also benefit from regulation, however. Significant sunk costs, first-mover
advantages, or other barriers to entry can result in ineffective competition in the longer term
so that regulation can be desirable as a way to limit market power and establish efficiency
even where true natural monopoly is not present. In such cases, however, regulation may
not be the only or even the best solution, as regulation is imperfect (due to regulatory
capture, the direct cost of regulatory structures, and incentive problems with regulation).
Breaking up the monopolist may in some cases be enough to ensure effective competition,
rather than relying on access pricing regulation to promote entry. A good answer would
elaborate on most or all of these points.
(b) Service quality, to the extent that it is costly, may well suffer under a price cap unless other
methods are used to maintain it. A good answer would review, based on the material in
Chapter 11 of the subject guide, the advantages of a price cap for dynamic efficiency, but
this could equally result in cutting quality where quality is costly or requires effort. To the
extent that quality requires investment, price cap regulation may also result in
underprovision of quality appealing to the argument that investment may be sunk at the
time of the price cap review and so would not enter into the regulator’s decision. Candidates
could discuss empirical evidence, such as taxi services, service guarantees in postal services,
water quality regulation or consistency in provision of electricity or gas, and safety
regulation for transport.

Section B

Candidates should answer TWO questions from this section.

Question 5

Ben is considering a job as manager of a bookshop. His utility function is

U = w − 120, where w is the total of all monetary payments to him and 120
represents the effort cost to him of running the bookshop. We initially assume that
Ben’s effort can be observed by the owners and will always be exerted. Ben’s next
best alternative to managing the bookshop provides him with zero utility. The
shop’s revenue is uncertain: there is a 30% chance the shop earns 1,200, a 40%
chance it earns 750 and a 30% chance it earns 300. The shop’s only cost is Ben’s
compensation.

(a) If the owners were to offer Ben one third of the shop’s revenue, what would his
expected utility be? Would he accept such a contract?
(4 marks)
(b) Suppose instead that the owners decided to offer Ben a fixed salary, plus a
bonus of 200 if the store earns 1,200. What minimum fixed salary would he
need to be paid in order to accept the contract?
(4 marks)
(c) The aim of the owners is to maximise profit. What compensation package will
they offer Ben: one third of revenue, or the fixed salary with bonus scheme as
above? Explain your answer.
(4 marks)

Suppose now that effort is not observable by the owners and Ben can choose
whether to exert effort or not. If Ben exerts effort, his utility is again given by
U = w − 120 and the shop’s revenue is uncertain in the same way as before. If he
does not exert effort, he has no effort cost, so his utility is just w, and the shop’s
revenue is 300 for certain.

(d) If the owners were to offer Ben one third of the shop’s revenue, would he accept
the contract and if so would he choose to exert effort or not?
(4 marks)

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EC3099 Industrial economics

(e) If the owners decided to offer him a fixed salary, plus a bonus of 200 if the shop
earns 1,200, would Ben choose to exert effort or not? What minimum fixed
salary would he need to be paid in order to accept the contract in this case?
(4 marks)
(f ) What compensation package will the owners offer Ben: one third of revenue, or
the fixed salary with bonus scheme as above? Explain your answer. Compare
with your result in part (c) and provide intuition.
(5 marks)

Reading for this question

Chapter 2 of the subject guide, Tirole (1988, introductory chapter), Church and Ware (2000,
Chapter 3).

Approaching the question

(a) We need to compare Ben’s utility if he accepts the contract to his utility if he rejects, which
is zero. If he is offered a third of the shop’s revenue, his expected utility if he accepts is:
     
1 1 1
E(U ) = 0.3 × × 1,200 − 120 + 0.4 × × 750 − 120 + 0.3 × × 300 − 120 = 130.
3 3 3

Since Ben’s expected utility if he accepts is greater than his utility if he rejects, he will
accept.

(b) To accept the contract, Ben’s expected utility if he accepts must be greater than or at least
equal to his utility if he rejects, which is zero. Ben’s expected utility under this scheme is:

E(U ) = 0.3 × (f + 200 − 120) + 0.4 × (f − 120) + 0.3 × (f − 120) = f − 60

where f is the fixed salary. He will accept if E(U ) ≥ 0 ⇔ f ≥ 60. The minimum fixed
salary Ben would require is 60.

(c) We need to derive and compare the expected profits under the two compensation options. If
Ben is offered a third of the revenue, the shop’s expected profit will be:
     
2 2 2
E(Π) = 0.3 × × 1,200 + 0.4 × × 750 + 0.3 × × 300 = 500.
3 3 3

If Ben is offered a fixed salary plus bonus, we know from part (b) that the minimum salary
he must get in order to accept the contract is 60. So the shop’s expected profit will be:

E(Π) = 0.3 × (1,200 − 60 − 200) + 0.4 × (750 − 60) + 0.3 × (300 − 60) = 630.

We conclude that the owners will offer the fixed salary plus bonus scheme.

(d) To exert effort, Ben’s expected utility must be greater if he exerts effort rather than not. If
he is offered a third of the shop’s revenue, his utility if he accepts the contract but does not
exert effort is:
1
U NE = × 300 − 0 = 100.
3
His expected utility if he exerts effort is:
     
E 1 1 1
E(U ) = 0.3 × × 1,200 − 120 + 0.4 × × 750 − 120 + 0.3 × × 300 − 120 = 130.
3 3 3

We have E(U E ) > U NE > U0 , therefore he will accept the contract and choose to exert
effort.

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 Examiners’ commentaries 2022

(e) To exert effort, Ben’s expected utility must be greater if he exerts effort rather than not. If
he is offered a fixed salary f plus a bonus of 200 if the shop’s revenue is 1,200, his utility if
he accepts the contract but does not exert effort is U NE = f . His expected utility if he
exerts effort is:

E(U E ) = 0.3 × (f + 200 − 120) + 0.4 × (f − 120) + 0.3 × (f − 120) = f − 60.

We have E(U E ) < U NE , so Ben will not exert effort, if he accepts the contact. And he will
accept the contract provided U NE > U0 ⇔ f ≥ 0.
(f) We need to derive and compare the expected profits under the two compensation options.
If Ben is offered a third of the revenue, we know from part (d) that he will accept the
contract and exert effort. The shop’s expected profit will be:
     
2 2 2
E(Π) = 0.3 × × 1,200 + 0.4 × × 750 + 0.3 × × 300 = 500.
3 3 3
If Ben is offered a fixed salary plus bonus, we know from part (e) that the minimum salary
he must get in order to accept the contract is zero and we also know that he will exert no
effort. So the shop’s profit will be 300 − 0 = 300 for certain.
We conclude that the owners will offer Ben a third of the shop’s revenue.
This contrasts with the result in part (c) because now effort is unobservable and Ben will
not exert any effort unless he is offered a third of revenue – the salary plus bonus scheme is
not sufficiently generous to induce Ben to exert effort. Without his effort the shop’s
expected revenue will be very low. It is best for the owners to induce Ben to exert effort, so
that expected revenue is high, even though part of the revenue will be paid to him.

Question 6

Answer both parts (a) and (b) of this question.

(a) Consider a market where there are two differentiated goods. The demand for
good 1 is given by q1 = a − bp1 + dp2 and the demand for good 2 is given by
q2 = a − bp2 + dp1 , where a > 0 and 0 < d < b. The production cost of each
good is zero. Each good is produced by a different firm and the firms set prices
sequentially. In particular, firm 2 can observe the price set by firm 1 before
setting its own price. Compute the subgame-perfect equilibrium prices of firm 1
and firm 2 in this two-stage game. Which firm has an advantage, firm 1 or firm
2? Explain the intuition for your result.
(8 marks)
(b) An incumbent monopolist operates in an environment where demand can be
divided into two distinct periods. In each period demand is given by
pt = 12 − Qt , where Qt , t = 1, 2, is the total quantity available for sale in period
t (assume the product is not storable) and pt is the price in period t. The
monopolist’s total cost over the two periods is C I = 2(q1I + q2I ) + F I , where qtI ,
t = 1, 2, is the amount produced by the monopolist in period t and F I = 5 is a
fixed cost, incurred in period 1.
i. Calculate the profit-maximising monopoly quantity and price in each period
and the firm’s total profit over the two periods.
(4 marks)
ii. Suppose that the incumbent monopolist must commit itself in the first
period to maintaining the same price in both periods. Suppose also that a
new firm may enter the market in period 2, and that if it decides to enter its
cost function is given by q E + F E , where q E is the entrant’s output choice
and F E = 18 is a fixed cost. What is the highest price that the incumbent
monopolist can charge and still deter entry?
(7 marks)

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EC3099 Industrial economics

iii. Assume further that the incumbent monopolist has a discount factor of 1
(i.e. the period 2 profit has the same value as the period 1 profit). Is it
worthwhile for the incumbent to deter entry? Explain your reasoning.
(6 marks)

Reading for this question

For (a), Chapter 6 of the subject guide, Tirole (1988, Chapter 7), Church and Ware (2000,
Chapter 11).

For (b), Chapter 5 of the subject guide, Tirole (Chapters 1 and 8), Church and Ware (Chapters 4
and 13–16).

Approaching the question

(a) In the second stage of the two-stage game, firm 2 chooses p2 to maximise:
Π2 = p2 (a − bp2 + dp1 )
taking p1 as given. The first-order condition is ∂Π2 /∂p2 = 0, which we solve for p2 to obtain
the reaction function of firm 2:
a + dp1
p2 = .
2b
In the first stage, firm 1 chooses p1 to maximise Π1 = p1 (a − bp1 + dp2 ) anticipating that
firm 2 will then choose p2 according to its reaction function. In mathematical terms, firm 1
therefore chooses p1 to maximise:
 
d(a + dp1 )
Π1 = p1 a − bp1 + .
2b
The solution to this maximisation problem is given by setting ∂Π1 /∂p1 = 0. We get:
a(2b + d)
p∗1 = .
2(2b2 − d2 )
Substituting this value of p1 into the expression for p2 above, we obtain:
a(4b2 + 2bd − d2 )
p∗2 = .
4b(2b2 − d2 )
It can be checked that p∗1 > p∗2 . The firms’ actions in this game are strategic complements.
Firm 2 can undercut firm 1 and obtain a higher share of the market and a larger profit.
(b) i. Since demand in each period is independent of the other period, the monopoly price in
each period can be calculated independently, and with the given specification it is the
same in each period. Setting marginal cost = marginal revenue, we obtain the
profit-maximising quantity q M = 5 and price pM = 7 in each period. The overall profit is
7 × 5 + 7 × 5 − 2(5 + 5) − 5 = 45.
ii. If the incumbent is committed to a fixed price in both periods, then by charging a
slightly lower price the entrant can obtain the entire market. To deter entry therefore the
incumbent must set a price such that any slightly lower price offered by the entrant will
result in negative profits for the entrant. In other words, we need to calculate the price p
such that when q E = Q, we have (p − c)q E − F E = 0, where c = 1 is the entrant’s
marginal cost.
Given the specification of the demand and cost functions, this implies:
(12 − q E − 1)q E − 18 = 0
which is a quadratic equation with solutions 2 and 9. The entrant’s profit will be
negative if q E < 2 or q E > 9. This corresponds to the entrant’s price being either higher
than 10 or lower than 3. We conclude that the highest price the incumbent monopolist
can set and still deter entry is 3. The entrant would need to set a price lower than 3 in
order to make any sales but would then be making negative profit.

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 Examiners’ commentaries 2022

iii. The incumbent has two plausible choices: (i) charge the monopoly price and make the
monopoly profit in period 1, and then lose the entire market in period 2, or (ii) charge
the entry-deterring price.
If the incumbent charges the monopoly price of 5 in period 1, the gross profit will be 25,
and the fixed cost is 5, so total net profit will be 20. Note that having committed to that
price and realising that there will be entry in period 2 and that the entrant will set a
price slightly lower than 5, the incumbent will not produce anything in period 2.
If the incumbent charges the entry-deterring price of 3, there will be no entry in period
2. The incumbent will sell quantity equal to 9 and make a gross profit of (3 − 2) × 9 = 9
in each period. The fixed cost is 5, so overall net profit will be 13. Thus it is more
profitable to charge the monopoly price in period 1 and permit entry in period 2 than to
deter entry.

Question 7

Answer both parts (a) and (b) of this question.

(a) Funworld is a monopolist supplying rides at an amusement park. There is a

large pool of identical customers. The demand for rides of each customer is
given by Q = 100 − P , where P is the charge per ride. The marginal cost of
supplying rides has two components: c, the cost of supplying the equipment,
and d, the cost of printing and collecting tickets. Both c and d are constant and
independent of the number of rides offered at the park. Funworld is considering
two pricing policies. Policy 1 is an entrance fee and a charge for each ride.
Policy 2 is just an entrance fee. The advantage of policy 2 is that the firm does
not incur the costs of printing and collecting tickets.
i. What is the profit-maximising entrance fee, charge per ride, total number of
rides supplied per customer and total profit under each policy?
(6 marks)
ii. Assume c = 18. Under what condition will profit under policy 1 exceed profit
under policy 2? Provide intuition for your answer.
(6 marks)
(b) Consumers are uniformly distributed with density S along the city of Arrow, a
linear city of length one. Each consumer buys one unit of a homogeneous
product. There are two firms selling the product: firm L is located at the
left-hand end of the city and firm R is located at the right-hand end. Unit
production costs are zero. The firms compete by simultaneously setting prices.
In addition to the price of the product, consumers incur linear transport costs.
These are normally t per unit of distance travelled. However, firm L is
considering an arrangement with a bus company so that customers can reach it
with transport cost 0.5t per unit of distance travelled (the cost of reaching firm
R would remain t per unit of distance travelled).
i. Calculate the equilibrium prices and profits of the two firms if firm L does
not use a bus service for its customers.
(5 marks)
ii. Calculate the equilibrium prices and profits of the two firms if firm L uses a
bus service for its customers. Compare the profits with those in part i. and
explain the intuition for your result.
(7 marks)
iii. Now assume that firm L does not use a bus service for its customers but the
local authority is planning to introduce bus services in the city of Arrow.
This will have two effects. On the one hand, all customers of firms L and R
will be facing a transport cost equal to 0.5t per unit of distance travelled. On
the other hand, the city will become more attractive to outsiders and its

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EC3099 Industrial economics

population, as well as the number of the two firms’ customers, is expected to

double. Should the two firms welcome these plans? Explain.
(3 marks)

Reading for this question

For (a), Chapter 7 of the subject guide, Tirole (1988, Chapter 3), Church and Ware (2000,
Chapter 5).

For (b), Chapter 6 of the subject guide, Tirole (1988, Chapter 7), Church and Ware (2000,
Chapter 11).

Approaching the question

(a) i. Under policy 1, the marginal cost for each ride is c + d. To maximise profit the firm will
set the per-ride charge equal to marginal cost and extract all the surplus of each
customer using the entry fee. Therefore, P = c + d. The number of rides demanded is
Q1 = 100 − c − d. The gross consumer surplus, and therefore the fixed fee F , is equal to
(100 − c − d)Q1 /2 = (100 − c − d)2 /2. The profit per customer is therefore
Π1 = (100 − c − d)2 /2. Note that the cost of running the park will be paid from the
revenue obtained from the rides.
Under policy 2, the firm will make a loss on the rides, but will be able to charge a higher
entrance fee, due to the larger consumer surplus. In particular, since P = 0, the number
of rides each customer will buy is Q2 = 100. The gross consumer surplus, and therefore
the entrance fee, will be F = 100 × 100/2 = 5,000, but running the park will cost
cQ2 = 100c per customer. The profit per customer under this policy is Π2 = 5,000 − 100c.
ii. Policy 1 will be more profitable than policy 2 if:

(100 − c − d)2
Π1 > Π2 ⇔ > 5,000 − 100c.
2
For c = 18, and since 0 < d < 82, this condition becomes (82 − d)2 > 6,400 ⇔ d < 2.
The intuition is that when d is small, the gain from extracting a larger consumer surplus
under policy 2 is small and does not compensate for the loss of revenue c + d per
customer on each ride. Thus policy 1 is more profitable than policy 2.
(b) i. The ‘marginal consumer’, i.e. the consumer who is just indifferent between buying from
firm L or firm R, is located at distance x from the left end of the line, where x is defined
by:
1 pR − pL
pL + tx = pR + t(1 − x) ⇔ x = + .
2 2t
Profits are given by:
ΠL = SpL x and ΠR = SpR (1 − x).
The first-order conditions are:
∂ΠL S ∂ΠR S
= (t + pR − 2pL ) = 0 and = (t − 2pR + pL ) = 0.
∂pL 2t ∂pR 2t
The Nash equilibrium is the solution to the system of the two first-order conditions.
Solving the system we obtain p∗L = p∗R = t. We can also substitute into the expressions
for profit to get Π∗L = Π∗R = St/2.
ii. The marginal consumer is now located at distance y from the left end of the line, where
y is defined by:
t 2 2(pR − pL )
pL + y = pR + t(1 − y) ⇔ y= + .
2 3 3t
Profits are given by:
ΠL = SpL y and ΠR = SpR (1 − y).

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 Examiners’ commentaries 2022

The first-order conditions are:

∂ΠL 2S ∂ΠR S
= (t + pR − 2pL ) = 0 and = (t − 4pR + 2pL ) = 0.
∂pL 3t ∂pR 3t
The Nash equilibrium is the solution to the system of the two first-order conditions.
Solving the system we obtain p∗L = 5t/6 and p∗R = 2t/3. We can also substitute into the
expressions for profit to get Π∗L = 25St/54 (gross of any payment to the bus company)
and Π∗R = 16St/54.
Both Π∗L and Π∗R are lower in part ii. than in part i. The apparently puzzling result that
firm L now makes a lower profit than under symmetric costs can be explained if we
consider the strategic interaction between the firms. All other things equal, a lower
transport cost for firm L means more customers and a higher profit. However, under
these conditions, firm R will charge a lower price. Prices are strategic complements, so a
lower price from one firm induces a response by a lower price from the other firm: a
lower pR will force firm L to also charge less in equilibrium. The higher demand is not
sufficient to offset the effect of the lower prices, so profit will fall not just for firm R but
also for firm L.
iii. We are now back to the symmetric case with transport cost equal to t/2 for all customers
and (expected) consumer density equal to 2S. It is straightforward to check that the
firms’ (expected) profits will not change. In particular, the equilibrium prices will now be
half of what they were in part i., i.e. they will now be p∗L = p∗R = t/2, but demand for
each firm will double. So the firms will be indifferent to the local authority’s plan.

Question 8

Two identical firms produce a homogeneous product and compete in prices. The
capacity of each firm is 4 and each firm has constant marginal cost equal to zero up
to its capacity constraint. Market demand is described by the function
D(p) = 14 − p. If the firms set the same price, they split the demand equally. If the
firms set different prices, the demand of each firm is calculated according to the
efficient rationing rule, i.e. the consumers with the highest willingness to pay are
served by the firm with the lowest price. Suppose first that the firms compete for
one period only.

(a) Show that p1 = p2 = 6, i.e. the pair of prices such that both firms set the same
price, both produce at full capacity and the market clears, can be sustained as a
Nash equilibrium. Calculate the equilibrium profits.
(5 marks)
(b) How would your answer in part (a) change if one of the firms had capacity equal
to 4 and the other had capacity equal to 6? Explain.
(5 marks)

From now on assume that the firms compete for an infinite number of periods (and
the capacity of each firm is 4). The firms’ discount factor is δ ∈ (0, 1). Each firm
plays the following ‘trigger’ strategy: Set the monopoly price pM in the first period.
In period t, t > 1, set pM if p1 = p2 = pM was the outcome in all previous periods;
otherwise, set the price 6.

(c) Compute the monopoly price and calculate the present discounted value of the
profits that each firm obtains if they collude forever. Then suppose that one of
the firms considers deviating from collusion and calculate the present
discounted value of the profits that the firm (maximally) earns if it deviates.
(7 marks)
(d) For which values of δ can collusion on the monopoly price be sustained as a
subgame perfect equilibrium?
(3 marks)

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EC3099 Industrial economics

(e) Does the fact that firms in this industry are capacity constrained make collusion
using the above trigger strategies easier or harder to sustain as compared to the
case of no capacity constraints? Explain your answer.
(5 marks)

Reading for this question

Chapters 3 and 4 of the subject guide, Tirole (1988, Chapters 5 and 6), Church and Ware (2000,
Chapters 8 and 10).

Approaching the question

(a) The answer to this part is based on the model of price competition under capacity
constraints. At prices p1 = p2 = 6, both firms produce at full capacity and the market
clears. Neither of the firms has an incentive to deviate to a lower price as this would result
in the same amount of sales but at a lower price, and would therefore reduce profit.
Moreover, the efficient rationing rule implies that a firm that deviates to a price p > 6 has
demand D(p) = 14 − 4 − p = 10 − p and profit (10 − p)p, which is decreasing in p for all
p > 5. This implies that deviating to a price above 6 when the rival firm sets a price of 6 is
not profitable. Hence, p1 = p2 = 6 is a Nash equilibrium. Equilibrium profits are
Π1 = Π2 = 6 × 4 = 24.

(b) Suppose firm 1 has capacity 4 and firm 2 has capacity 6. Let’s first check whether
p1 = p2 = 6 is still a Nash equilibrium. At equal prices consumers will be split equally
between the two firms, and since total demand is 14 − 6 = 8, each firm will have sales equal
to 4. Thus firm 1 will produce at full capacity but firm 2 will not. Firm 2 will have an
incentive to price slightly lower than 6 in this case: its profit per unit would only decrease
slightly, but its sales would jump from 4 to 6 because it would now be the low-price firm.
Hence its profit would rise. We conclude that p1 = p2 = 6 is no longer a Nash equilibrium
because firm 2 has an incentive to deviate.
A very good answer could check a few more possibilities, starting with p1 = p2 = 4. At these
prices both firms produce at full capacity and the market clears. Firm 2 will have no
incentive to deviate to a price lower than 4 for the same reason as in part (a). On the other
hand, the efficient rationing rule implies that if firm 2 deviated to a higher price, it would be
facing demand D(p) = 14 − 4 − p. Its profit would be (10 − p)p, which is increasing for
p ∈ [4, 5). So deviating to a price between 4 and 5 when firm 1 sets p1 = 4 is profitable for
firm 2. Hence p1 = p2 = 4 is not a Nash equilibrium. Furthermore, p1 = p2 = 0 (i.e. setting
prices equal to marginal cost and making zero profit) is not a Nash equilibrium either.
Either firm would then have an incentive to increase its price, make some sales at a price
greater than zero (since the rival firm would not be able to satisfy all the demand at its
price of zero) and obtain a positive profit. In fact, there exists in this case a Nash
equilibrium in mixed strategies with prices greater than marginal cost.

(c) The monopoly price is the value of p that maximises (14 − p)p, or pM = 7. The
corresponding quantity is 7 and the monopoly profit is ΠM = 49. Each firm produces 3.5
and obtains profit per period ΠM /2 = 24.5 if it plays the trigger strategy. The present
discounted value of the profits of each firm is:

ΠM 49
= .
2(1 − δ) 2(1 − δ)

The optimal deviation is pM −  ( very small), which allows the firm to sell its entire
capacity at (almost) the monopoly price. The profit in the period of the deviation is:
7 × 4 = 28 (ignoring ). The deviation triggers a reversal to the static Nash equilibrium
forever. The present discounted value of the maximal profits from deviating is:

24δ
28 + 24(δ + δ 2 + δ 3 + · · · ) = 28 + .
1−δ

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 Examiners’ commentaries 2022

(d) Collusion can be sustained as a SPE if:

49 24δ
≥ 28 +
2(1 − δ) 1−δ

or δ ≥ 7/8.
(e) If the firms were not capacity constrained, the one-shot price-setting game would have a
Nash equilibrium with zero profits. The monopoly price and quantity would be the same as
in part (c), and therefore the collusion profits would still be ΠM /(2(1 − δ)). An optimally
deviating capacity unconstrained firm would set a price slightly below the monopoly price,
satisfy all the demand at that price and make profit (almost) ΠM . Collusion would be
sustainable as a SPE if ΠM /(2(1 − δ)) ≥ ΠM , or δ ≥ 1/2. Therefore, capacity constraints in
this industry increase the critical discount factor for collusion to be sustainable, and make
collusion harder to sustain.

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