BMAN20320 ECONOMIC ANALYSIS I MOCK EXAM PAPER
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BMAN20320
ECONOMIC ANALYSIS I
MOCK EXAM PAPER
Question 1
Answer anyfour parts of the question (10 marks for each part).
a) A government increases excise taxes to increase tax revenues. Examine the impact of such an increase on the equilibrium prices paid and quantities consumed by consumers in a market characterised by (i) Sweezy oligopoly, (ii) Cournot oligopoly, and (iii) Bertrand oligopoly, and determine which of these market settings is likely to generate the greatest increase in tax revenues. [10 marks]
b) 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]
c) You publish a monthly magazine for women, generating revenue partly by offering advertising spaces on the magazine's cover to other firms. A Jewellery producer suggests sponsoring free gifts with the magazine in exchange for its name being placed on the cover every month. The jewellery firm argues such a strategy enables the magazine to extend its market share. Would you consider the strategy to offer sponsored free gifts as optimal and accept the proposal? (Hint: think like a game theorist.) [10 marks]
d) An efficient firm employs inputs in such proportions that the marginal product and price ratios for all inputs are equal. In terms of capital budgeting, this implies that the marginal cost of debt should equal the marginal cost of equity in the optimal capital structure. In practice, firms often issue debt at interest rates substantially below the yield that investors require on the firm’s equity shares. Does this mean that many firms are not operating with optimal capital structures? Explain. [10 marks]
e) 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 pound of death benefits) on standard life or credit card life policies? Explain your answer. [10 Marks]
f) 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]
g) ‘The price level depends not only on today’s money supply but on the money supply expected in the future’ . Discuss. [10 marks]
Question 2
a) 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]
b) Between 1995 and 1997, American Airlines competed in the Dallas/Ft Worth Airport against several low-cost carriers. In response to these low-cost carriers, American Airlines reduced its price and increased service on selected routes. One of the low-cost carriers consequently stopped service, which led American Airlines to increase its price. Explain American Airlines’ business strategy. Under what conditions is the strategy likely to succeed? When may the strategy reduce future entry to the market? [10 marks]
c) 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. XaA Drug’s CEO has started developing strategies to maintain its market share after the patents expire. 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]
Question 3
a) What conditions are necessary before price discrimination is both possible and profitable? Why does price discrimination result in higher profits? [8 marks]
b) 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? [12 marks]
c) As a manager of a chain of movie theatres that are monopolies in their respective markets, you have noticed much higher demand on weekends than during the week. You therefore conducted a study that has revealed two different demand curves at your movie theatres. On weekends, the inverse demand function is P = 15 – 0.001 Q; on weekdays, it is P = 10 – 0.001Q. You acquire legal rights from movie producers to show their films at a fixed cost of £20,000 per movie, plus a £2 “royalty” for each movie-goer entering your theatres. Devise a pricing strategy to maximize your firm’s profits. [10 marks]
Question 4
a) Uber intends to sell stocks publicly next year using Dutch auction. You aim to purchase 1000 Uber’s shares. Explain the rule to decide your optimal bid for each share. How will your bid relate to the number of participants in the auction. [6 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 tax payers.
1) Define common value auctions and explain why such auctions may give rise to the Winner’s curse phenomenon. [4 marks]
2) Why do different auction designs yield different revenues for common value auctions? [4 marks]
3) Design a multi-units auction that avoids Winner’s curse, generates the highest revenue for the UK government and ensures the licences are granted to the most efficient bidders. Explain the justifications behind the auction design. [6 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 an auction may be the most efficient in acquiring the highest amount of aluminium possible. Justify the design of the auction. [10 marks]
Question 5
The Mundell-Fleming model for a small open economy assumes that the world interest rate r* is an exogenous variable.
a) How are the interest rates in the domestic and foreign markets determined? [8 marks]
b) Assume the small open economy adopts a floating exchange rate. What will happen to aggregate income, the exchange rate and the trade balance when the US government substantially reduces taxes? Use graphs to show your analysis. [12 marks]
c) Alternatively suppose the small open economy switches to a fixed exchange rate. What will happen to aggregate income, the exchange rate and the trade balance when the US economy experiences a fiscal expansion? Use graphs to show your analysis. [10 marks]
Question 6
ArmDigital produces a unique computer chip X300 universally used in mobile devices. The demand for the chip follows inverse demand function P = 100 – Q. The costs of production follow C(q) = 50 + 30q. The government have recently asked ArmDigital to break into two firms to create competition in the market and lower the price. The two firms will be called IqChip and Qchip and share the same technology.
a) Calculate the quantity the firm produces when it operates as a monopoly. Further calculate the monopoly price and profit. [6 marks]
b) Suppose after splitting the firm, the two firms operate as a Cournot oligopoly. Find each firm’s “reaction function.” Interpret the firms’ reaction functions. [8 point]
c) Calculate the Cournot equilibrium outputs, price and profit of each firm. Explain the assumption on which you rely to derive the equilibrium quantities. [6 points]
d) Suppose Qchip discovers a production method that reduces per unit cost to £20. How will this affect the outputs, the market price and the profit of each firm? Will it be likely that Qchip dominate the market again and become a monopoly? [10 marks]
Question 7
SAS has spent £100,000 to develop a statistical software for corporations. It would cost SAS £5000 per unit to install and maintain the software at a client’s site. The firm has one client to date. Market research suggests the client’s demand for the software is Qd = 100 – 0.01P. Using this setting:
a) Calculate the profit that results from charging this client a single per-unit price. [8 marks]
b) Calculate the profit that results from charging £9000 for the first 10 units and £7000 for each additional unit of software purchased. [8 marks]
c) Recommend a pricing strategy that may result in higher profits. Would the pricing strategy outperform perfect price discrimination? [8 marks]
d) An open-source statistical software, R, has just been made freely available online. The software possesses reasonably similar capabilities for data analysis. How will the open-source software affect the effectiveness of your pricing strategy? [6 marks]
Question 8
Answer all the questions at the end of the case study
American Airlines Accused of Illegal Pricing
(Extracted from New York Times)
Senior officials at the Justice Department said the American case was particularly compelling because company documents showed that American, the nation’s second-largest airline, had deliberately embarked on a strategy of selling tickets below cost and incurring significant short-run financial losses in recent years to drive out three low cost competitors – Vanguard Airlines, Sun Jet International and Western Pacific – from Dallas-Fort Worth International Airport.
Executives and lawyers at American said the airline had not violated any antitrust laws but simply matched the fares of its competitors.
In 1998, American flew 70 percent of the scheduled seats out of Dallas-Fort Worth, up from 60 percent in 1991. The government presented evidence showing that after Vanguard announced in September 1996 that it was adding service to Dallas- Fort Worth from three cities in addition to Wichita, Kan., American responded by cutting prices and adding flights on nearly all of Vanguard’s Dallas routes. Two months later, Vanguard abandoned its expansion plans. By June 1997, American had reduced capacity between Wichita and Dallas by 30 percent and raised the average one-way fare by more than 50 percent to more than $90 from about $60.
“American quickly realized that these new carriers could be a significant competitive threat, estimating that as much as a billion and a half dollars of its annual revenues were at risk if they were to succeed,” said Joel I. Klein, the Assistant Attorney General in charge of the antitrust division. “To make sure that this didn’t happen, American adopted a predatory responsive strategy, saturating the market in which the start-up carriers had begun service with as much new, low-fare service of its own as was necessary to drive out the start-ups.”
Attorney General Janet Reno said American “invested in short-term capacity increases and fare reductions to maintain its monopoly – an investment it was able to recover many times over once its smaller rivals had been driven away.”
American Airlines disputed the accusations by the Justice Department that it had priced its fares below cost or flooded the market with flights, and said the lawsuit was little more than sour grapes by smaller airlines, which, unable to compete, had persuaded regulators to bring the case.
“Contrary to the Justice Department’s lawsuit, this action today is very potentially anti-consumer,” said Chris Chiames, a spokesman for the AMR Corporation, the parent company of American. “It would have a chilling effect on the market-place if companies felt they could not match prices of competitors. We simply matched the competition.”
The Justice Department complaint seeks an injunction barring American from cutting prices below cost and increasing flights as part of any effort to stifle competition. … Justice Department officials quoted from company papers describing its “Dallas-Fort Worth Low Cost Carriers Strategy.” The officials said the strategy recognized that “it could prove unprofitable in the short run.” But, according to a company document, the strategy concluded: “The short-term cost or impact on revenue can be viewed as the investment necessary to achieve the desired effect on market share.”
Company executives declined to answer questions about the American Airlines documents that the Government has called incriminating but defended them in general terms: “There is nothing wrong or illegal with tough talk about competition,” Mr Chiames said. Trey Nicoud, a senior lawyer at American Airlines, said, “Looking at aggressive conversation in board rooms is very misleading.”
To win against any airline, the Government’s evidence would need to be strong because predatory pricing cases are difficult to prove. But Justice Department lawyers have argued that it is relatively easy for a large airline to profit after undercutting a rival and driving it out of a market.
Executives from the smaller rivals portrayed as victims by the Government praised the lawsuit. Of the three, Vanguard has since returned to the Dallas-Fort Worth market, Sun Jet no longer serves that airport, and Western Pacific has filed for bankruptcy protection from its creditors and stopped flying in early 1998.
a) Do you agree with the Justice Department that American Airlines engaged in predatory pricing to force its rivals out? Analyze the evidence for and against the Justice Department’s lawsuit. Why did American Airlines prevail at the trial? [5 marks]
b) Can predatory pricing ever succeed in the airline industry? Explain your answer. How would your analysis possibly affect the court ruling? [5 marks]
c) Explain the credible commitment requirement for the success of predatory pricing. Use your analysis to explain why American Airlines extended its reserve capacity during the late 1980s and early 1990s while substantially lowering its fares on almost the routes where it faced competition from low- costs carriers. [10 marks]
d) Design a strategy that enables entrants such as Vanguard to survive the threat of predatory pricing by incumbents. [5 marks]
e) Can new entrants such as Vanguard ever engage in predatory pricing to force incumbents out or incumbents are better at engaging in predatory pricing? [5 marks]
2023-01-17