BMAN24431 ECONOMIC ANALYSIS I

Section A

Question 1

Answer any four parts of the question (10 marks for each part).

a)  Bertrand's theory predicts price competition drives firms'profits down to zero even if there are only two competitors in the market. Why don't we observe this in practice very often? [10 marks]

b)  John Lewis frequently announces that the company sets very competitive prices for all its department stores: “Each John Lewis shop checks the prices of likely rivals in the local area. If a competitor within the area sells the same product that is part of our standard offer at a low price, John Lewis will reduce the price to match the rival's price. We are never undersold.” How will a game theorist interpret John Lewis' pricing strategy? Use a numerical example to illustrate your analysis. [10 marks]

c)  Microsoft bundles the majority of its products into a single package called Office. Explain standard economic reasons that underlie the business practice. Explain in detail strategic considerations that may lie behind Microsoft’s practice. How will the suit of Google’s products that comes close to Microsoft Office change market prices? [10 marks]

d)  Explain why collusive pricing is difficult in one-period competition and easier when firms interact with each other over a number of periods. Describe a strategy that a cartel’s members, such as De Beers or Saudi Arabia, use to ensure the stability of the cartel.  [10 marks]

e)   Suppose that an increase in consumer confidence raises consumers’ expectations about their future income and thus increases the amount they want to consume today. This might be interpreted as an upward shift in the consumption function. Use a graph to explain how this shift may affect investment and the interest rate. [10 marks]

f)   Suppose a wave of credit card fraud causes consumers to use cash more frequently in transactions. Use the Liquidity Preference model to show how these events shift the LM curve.  [10 marks]

g)  Explain the Quantity Theory of Money (QTM).  What determines the rate of inflation in this theory? [10 marks]

h)  How may advances in 3D printing affect international trade? [10 marks]

Section B

Answer one question (30 marks).

Question 2

a)   Carefully define predatory pricing. Why is predatory pricing unlikely to occur when all firms are identical or when no substantial sunk costs exist? Further, explain why driving a rival into bankruptcy does not, by itself, enable the predator to charge monopoly prices.  [Hint: What happens to the assets of the bankrupt firm?  [10 marks]

b)  XaA Drug markets a drug Vioxx for which the company holds several patents. The patents were registered in different countries more than 14 years ago and will expire in some countries in a few years. Propose a pricing strategy that helps XaA Drug hold to its market share by reducing the chance of entry by new generic producers. Define the pricing strategy precisely. State the conditions under which the strategy succeeds. Use a relevant graph to illustrate your analysis. [10 marks]

a)  Uber has access to realtime data on demand for transportation services and supply of drivers registered on the platform across cities. How may Uber use the data to devise an efficient pricing strategy? Propose a specific pricing strategy and illustrate it using a relevant line graph. How will the pricing strategy help adjust demand and supply? Will the pricing strategy help market efficiency? [10 marks]

Question 3

a)   Suppose   the   government   discontinues   a   certification   program   that   allows consumers to differentiate good used cars from bad ones. Consumers cannot tell the difference  otherwise,  but  sellers  know  which  type  of  cars  they  have  in  their possession. Using a simple numerical example explain how the market for used cars may evolve overtime. [12 marks]

b)  Life insurance companies require applicants to submit to a physical examination as proof of insurability prior to issuing standard life insurance policies. In contrast, credit card companies offer their customers a type of insurance called “credit life insurance’’ which pays off the credit card balance if the cardholder dies. Would you expect insurance premiums to be higher (per dollar of death benefits) on standard life or credit card life policies? Explain your answer. [10 marks]

c)  Prosecutors  representing  the  Securities  and  Exchange  Commission  recently announced criminal charges against 13 individuals for engaging in insider trading. According to the SEC’s director of enforcement, a trading ring acting on inside information “compromises the markets’ integrity and investors’ trust …” Explain why? [8 marks]

Question 4

a)  Your company is planning to auction off a manufacturing plant in Asia. You are asked to determine an auction design that will generate the highest revenue for the company. You believe that bidders will value the plant independently. Which design would you choose, and why?[8 marks]

b)  Suppose you lead a UK advisory board responsible for granting spectrum licences for operating the 5th  generation mobile phones. The UK mobile phone industry is dominated by 5 strong incumbents who own the infra-structure for operating the 4th generation mobile phones. The government aims to offer these licences to the most efficient firms while maximizing the revenue from the sale of the licences for the taxpayers.

i.      Explain why auction is an efficient method of exchange in the market for telecommunication licences.

ii.      Design  a  multi-unit  auction  that  generates  the  highest  revenue  for  the government while ensuring that the licences are granted to the most efficient bidders.

iii.      Explain the theoretical justification behind the choice of the auction design. [12 marks]

c)  Your firm has set aside £600 million to purchase aluminium for a new model of sport  car that the  firm  starts  producing  from  next  year.  Design  a  tender with suppliers so as to maximize the amount of aluminium that could be purchased given the budget. Explain why auction may be most efficient in acquiring the highest amount of aluminium possible. Justify the design of the auction. [10 marks]

Question 5

The Mundell-Fleming model assumes that the world interest rate r* is an exogenous variable.

a)  What might cause the world interest rate to rise? [6 marks]

b)  In the Mundell-Fleming model with a floating exchange rate, what happens to aggregate income, the exchange rate and the trade balance when the world interest rate rises? [12 marks]

c)   In the Mundell-Fleming model with a fixed exchange rate, what happens to aggregate income, the exchange rate and the trade balance when the world interest rate rises? [12 marks]

Question 6

a)   Define disinflation. Why is it costly and difficult to reduce inflation? Are there ways to reduce these costs?      [10 marks]

b)  During the financial crisis, house prices fell in the U.S and a number of banks went bankrupt. Explain why the rise of bankruptcies in the banking sector lowered corporate investment and deepened the recession during the 2008-9 financial crisis. [10 marks]

c)  Expected inflation is a key driver of inflation. Central banks seek to manage expectations by setting inflation targets or by following rules such as Taylor rule.  Explain  inflation  targeting  and  the  Taylor  rule.  How  may  inflation targeting and Taylor rule give rise to different policy responses to  serious recessions?         [10      marks]

Section C

Answer one question (30 marks).

Question 8

Consider an industry with two firms where the inverse demand function follows: P = 5,100 - 0.5Q. Strong legal barriers limit entry to the market. The cost function of each firm is given by C(qi) = 750qi.

a)   Suppose  each firm chooses its profit-maximizing level of output on the assumption  that  its  rival’s  output  is  fixed.  Find  each  firm’s  “reaction function” . [8 marks]

b)  Calculate the equilibrium output of each firm – the values of q1  and q2  for which both firms are doing as well as they can, given their competitor’s output. What are the market price and profit of each firm? Explain the assumptions you have made in deriving the reaction functions.  [8 marks]

Assume Firm 1 develops an assembly method that changes its cost function to C(q1) = 500q1.

c)  How will this technological advance impact the equilibrium outputs of the firms and profits? [8 marks]

d)  Explain the conditions under which the technological progress may enable the innovator firm to force its rival out. [6 marks]

Question 9

a)   Define the notions of absolute and comparative advantage, provide examples for each concepts, and explain three sources of comparative advantage. [6 marks]

b)   Explain the core idea of the Hecksher-Ohlin (H-O) theory of trade. What are the assumptions underlying the theory? How does the theory differ from the concept of comparative advantage? Explain a key limitation of the H-O theory. [12 marks]

c)   Explain the core ideas behind Paul Krugman’s theory of international trade. How does the theory differ from the theory of comparative advantage? Your answer should include relevant graphs. [12 marks]

Question 10

Answer all the questions at the end of the case study (Extracted from The New Yorker):

At first glance, there’s nothing unusual about the refinery that Marathon Oil owns in Garyville, Louisiana. Like most refineries, it is in a small town near a port. It can refine two hundred and forty-five thousand barrels of oil a day, which is around the industry median. The only thing that’s special about the Garyville facility is that it was opened in 1976. That makes it the last refinery ever built in the United States.

In fact, over the past twenty-five years, the number of refineries in the U.S. has been cut in half, and although the remaining ones have expanded, they haven’t kept up with the growing demand for gasoline. The Energy Secretary has exhorted oil companies to use some of their hefty profits to expand refining capacity, and Congress is considering streamlining the environmental regulations that add to the expense of building new refineries.

The lack of capacity looks like an ideal business model to oil refiners. There are so few refineries in the U.S. now that they are run tight to the bone, using about ninety percent of their total capacity. The result is that refining has become tremendously lucrative. Last year, refiners’ profits jumped thirty-nine per cent, to twenty four billion dollars, and this year should be even better. Even when crude-oil prices fall, Gasoline prices remain high.

The refining industry isn’t a normal marketplace. Refineries are huge investments - a new one costs at least two billion dollars - and they take along time to open. This means that although refiners might make more money by opening new facilities and thus serving more customers, they’d rather take the sure money than gamble. It also means it’shard for new competitors to raise enough capital to enter the market at all.

What’s more, over the past fifteen years refiners have been buying each other up, creating an industry that’s highly consolidated. In 1993, the five biggest refiners in the U.S. controlled thirty-five percent of the market. By 2004, they controlled fifty-six per cent. And refining is primarily a regional business. In some urban areas a federal requirement determines what formula can be used, depending on the quality of their air. That makes it hard to ship gas across state lines, and shrinks the number of refiners that provide a particular blend of gas, giving each refiner more power. In California in 2003, seven companies controlled ninety-five per cent of the refining market.

In refining, you can sometimes make more money by selling less gas, or viceversa. Far from needing to add capacity, refiners can flourish even when they subtract it. When Hurricanes Katrina and Rita hit the Gulf Coast, for instance, Marathon Oil had to shut down two of its refineries, including Garyville. But the price spike that followed was so big that Marathon made twice as much from its refining operations in the third quarter of 2005 as it had a year earlier.