Doing Business Around the World A83220
Topic 10—Course Overview Sample Problems
Theory of the Firm
In many developed economies, the corporation is the most prevalent form of firm ownership in terms of total sales. For example, in the US, corporations account for approximately 90% of total firm sales.
a. Please explain why the limited liability feature of corporations contributes to the ability of this form of firm ownership to grow.
b. There has been much written on the problem of separation of ownership from control in corporations. In the early 1990s, stock options were introduced as a possible solution to this problem because managers whose compensation included stock options had objectives that were closer to those of firm owners (stockholders). However, there is strong evidence that stock options had other problematic effects on the way firms were run. Please discuss these effects and comment briefly on them.
Theory of the Firm: Fixed vs. Variable Costs
Rapid Trans runs a commuter train line with the following cost and usage characteristics:
Total fixed cost per day: $900
Total variable cost per train trip: $10, regardless of the number of passengers
No. of trips during rush hour: 20
No. of trips during off-peak hrs: 10
No. of passengers per rush hr. trip: 200
No. of passengers per off-peak trip: 10
Price per passenger per trip: $1.50
Rapid Trans hires a management consultant to advise it regarding train usage strategy. The management consultant argues as follows: the total cost of running the train is $40 per trip ($30 in fixed costs ($900/30 trips) + $10 in variable costs) regardless of the number of passengers. So, the cost per passenger is 20 cents per passenger during rush hour trips and $4 per passenger during off peak hour trips. The consultant concludes that Rapid Trans is losing money during off peak hour trips and therefore should reduce the number of off peak hour trips as much as possible.
I suggest that Rapid Trans fire the management consultant and hire you instead. Can you explain why the consultant is wrong and what you would recommend doing instead?
Strategies in Monopolistically Competitive Markets
a. What is the “monopolistic” aspect of a Monopolistically Competitive Market?
b. Give three examples of successful “monopolistically competitive” products and the strategy underlying their success.
Strategies in Monopolistically Competitive Markets
a. Suppose you are the head of marketing for a consumer products company. Suppose that you believe that you already have a monopoly (or near monopoly) of the market for one of your products. However, you are eager to propose a new (fairly expensive) advertising campaign for this product that you feel will significantly improve its profitability. Use a graphical analysis (remember you are an economist) to illustrate your proposal.
b. Now suppose you are a member of the board of directors of this consumer product company. Although you are impressed by the head of marketing’s presentation, you are concerned that he may not be correct in his estimate of the increased profitability that will result from the new ad campaign. What parts of his presentation would you question?
Strategies in Monopoly Markets
How does the elasticity of demand for a product or service impact a monopolist’s profit and strategies?
Strategies in Non-Cooperative Oligopoly Markets
In the movie business, one of the trickiest decisions producers face is what type of movie to make. Suppose there are 2 movie studios and that their the producers are trying to decide whether to make an Action Adventure (AA) or Romantic Comedy (RC) movie. Suppose each of the studios does not know what type of movie the competing studio is planning to make that same year and that they do not trust each other in the least. They face the following payoff matrix.
Studio 1
RC AA
Studio 2 RC (50,50) (90,60)
AA (60,90) (75,75)
(The figures in parentheses show total estimated box office revenues in millions for Studio 1, then for Studio 2.)
a.
What strategy (make an AA or RC movie) will each of the studios chose?
What is the payoff to each of the 2 studios given the strategies they choose?
b. Now, suppose that AA are much more expensive to make than RC and therefore the expected profitability of the two types of movies differ. Suppose that AA cost $70 million per movie and RC cost $25 million per movie.
What is the new strategy for each of the studios? Is it different from the one in a?
What is the payoff to each of the 2 studios given the strategies they choose?
Strategies in Cooperative Oligopoly Markets
In 2001, the European Antitrust Commission fined several of the world’s largest pharmaceutical companies approximately $800 million euros for conspiring to fix prices and the market shares of vitamin products in the 1990s. In that same year, the US Department of Justice (DOJ) found that the auction houses Sotheby’s and Christies were guilty of colluding to fix prices (commission levels) in the art auction market. Price fixing harms consumers because it results in higher prices paid by buyers.
a. In your view, how was this bad for competition, i.e. how does it harm the competitive process, including other competitors who were not engaging in price fixing?
b. In particular, in view of their behavior, why didn’t new competitors enter the market and offer lower prices and/or better service?
Strategies in Large-Share Markets
a. Give two examples of industries (include a list of the market participants in this industry) which are characterized by a high degree of market concentration but do not necessarily exhibit a significant degree of market power, i.e. do not have the ability to price significantly above cost.
b. Give two examples of industries (include a list of the market participants in this industry) which are characterized by a high degree of concentration but, in your estimation, do exhibit a significant degree of market power. Please distinguish whether, in your view, the market power is related to lack of competition among the market participants or to other types of advantages (e.g. branding, reputation, successful product differentiation, etc.)
Government Intervention into Markets—Regulation of Natural Monopolies
The price cap for the Italian highway system we studied in class is:
DT or = DP – X + B*DQ
where DT = the permitted increase in the toll in the given year
DP = the most recent estimate of inflation
X = the productivity index in the given year--a measure of technological change or productivity improvement-- which would cause costs to decline.
DQ = the quality index in the given year
B = a corrective factor (between 0 and 0.5) which is linked to the overall quality achieved over the past 5 years.
a. What are the advantages for this regulated monopoly from being subject to price cap rather than cost-based regulation?
b. What are the disadvantages?
c. From consumers point of view (e.g. people who use the highway system) is price cap regulation preferable to cost based regulation, and why or why not?
d. What is the importance of the role of the quality index Q? What problems may arise if the quality index were excluded from the formula?
Government Intervention into Markets--Antitrust
An important area of antitrust enforcement are merger guidelines whereby government antitrust authorities consider whether a merger should be allowed or disallowed.
a. Describe the guidelines involved in whether a particular merger should be subject to government review (in the US these are referred to as the “Dept. of Justice Merger Guidelines.”)
b. Describe the main factors considered by the government in deciding whether to accept or reject a proposed merger.
c. Give an example of a proposed merger that was either accepted or rejected and discuss the reasons involved.
Government Intervention into Markets: Deregulation and Privatization
Even in market-based economies, there are many examples of government intervention into markets, principally due to the presence of market imperfections, failures, externalities, equity considerations, etc. At the same time, economists believe that it is equally important that governments remove themselves from markets when the conditions change so that intervention is no longer needed or warranted.
a. What factors determine whether an industry is ripe for the end of intervention, i.e. deregulation or privatization?
b. Discuss one or more examples of deregulation or privatization and the rationale behind it.
c. Give an example of an industry or sector that you believe should be privatized or deregulated and why.
Imperfect Information
The “lemons” problem generally arises because of asymmetric information – the seller has more information about quality than the buyer. Why is the “lemons” problem unlikely to arise in the market for “real” lemons (i.e., the fruit)?
Information and its Effect on Market Outcomes
Consider the following market for used computers. Potential buyers have limited information regarding the quality of used computers. They believe, on average, that 60 % of the used computers are of good quality, which they value at $1000 per computer, whereas the rest (40%) are lemons which they value at $200.
a. Show that this inability to better distinguish good used computers from bad ones will result in bad computers driving out good computers, that is good computers will not be available in this market. (Remember: George Akerloff won the Nobel prize for this one!)
b. If buyers in this market figure this out (i.e. that only bad computers will be sold in this market) what will the price of used computers be?
c. What can be done in the market for used computers to avoid this outcome (unavailability of good computers in the market)?