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Advanced Industrial Organization: Problem Set 2 CRN 25965 - ECON 485 B Pascal Courty University of Victoria

There is no need to write long answers. I provide suggested length in word count to help you practice making clear and concise answers.

Exercise 1 Damaged-good strategy (25%, 40 words per answer on average)

A firm sells a product in a market where there are two types of consumers, high and low-valuation consumers. There are equally many of the two types of consumers, and the total number of consumers is normalized to 1. The product has value 3 to the high-valuation consumers and value 1 to the low-valuation consumers. All consumers have unit demand, i.e., they buy either one unit or

do not participate. The product is produced at constant marginal cost equal to

0.

1. Find the profit maximizing price and calculate the firm’s profit.

2. The firm considers introducing a damaged version of the product. The damaged version is produced at constant marginal cost equal to 1/10. It results in a utility of 5/10 to the low-valuation consumers and of 6/10 to the high valuation consumers. Find the optimal price of the normal and of the damaged version of the product. Should the firm introduce the damaged version? What are the welfare consequences of the introduction of the damaged version?

Exercise 2 Bundling (25%, 30 words per answer on average)

Suppose that a monopolist produces two products, product 1 and product 2. There is a mass 1 of consumers. A share λ of consumers are heterogeneous among each other and are described by their type θ. This type is distributed uniformly on the unit interval. The willingness-to-pay for product 1 is assumed to be r 1 = θ and r 2 = 1 θ. A share (1 λ)/2 of consumers has willingness to pay r 1 = 2/3 and r 2 = 0. The remaining share (1 λ)/2 of consumers has willingness to pay r 1 = 0 and r 2 = 2/3. Firms can sell products 1 and 2 independently at prices p 1 and p 2 , respectively. Alternatively, it may only sell

a bundle at price p. This is a situation referred to as pure bundling. A third possibility is that the firm sells the bundle and the independent products, a situation referred to as mixed bundling.

1. Suppose λ = 1. Determine whether independent selling, pure or mixed bundling are profit maximizing. Calculate associated prices and profits.

2. Suppose that λ > 0 and characterize the solution under independent sell- ing for all λ > 0.

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3. Suppose that λ = 4/5. Characterize the profit-maximizing solution under independent selling, pure bundling, and mixed bundling. Show which of the selling strategies is profit-maximizing. Discuss your result.

4. Suppose that λ = 2/3. Characterize the profit-maximizing solution under independent selling, pure bundling, and mixed bundling. Show which of the selling strategies is profit-maximizing. Discuss your result.

Exercise 3 Research Article (50%, 40 words per answer on average)

Timothy Bresnahan and Peter Reiss. Entry and Competition in Concentrated

Markets. Journal of Political Economy, 1991. You should read sections I and

II and only what is necessary to understand Figures 3 and 4 in section III (you

can skip IIIC and IV). A local market is populated by S consumers. Each consumer has demand

d(p) = 100 p for a homogenous product (such as dental care, plumbing). Firms have to invest fixed cost F to enter the market and then pay c(q) = q 2

to produce q units.

1. (a) Compute the inverse demand curve p(Q) in a local market. (b) Plot p(Q) for S = 1, S = 2 and S = 100. What happens to p(Q) when the number of consumers in the market increases?

2. (a) What is the smallest population size S such that a monopolist earns non-negative profits? Denote that value s M . (b) What is the smallest population size such each member of a cartel formed of n firms earns non-negative profits?

3. Consider a large local market (S large) with many firms who are price taker and earn zero profits. How many consumers does each firm serve? Denote that value s .

4. (a) Show that s M and s are positive if and only if F < 50 2 . (b) Assume this condition holds and show that s M < s . Interpret.

5. Consider a local market where there are n identical firms. Define firm size s n as the observed number of consumers served by each firm. Provide informal arguments: (a) Why would you expect firm size to increase with the number of firms in a market (s n+1 > s n )? (b) Why should the ratio s n+1 /s n converge to one as n increases?

6. How would you derive s M , s 2 and s from Figure 3?

7. From looking at Figure 4, which markets would you think are the least competitive? What could explain differences in plots across markets?

8. Would the approach presented in the paper work for other markets such as retailing, food industry, restaurants?

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