ps4_ans - Department of Economics University of California...

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Economics 121 Page 1 Problem Set 4 Answer Department of Economics Fall 2004 University of California Woroch/Lopez/Sydnor Economics 121: Problem Set 4 Answer Sheet True/False/Uncertain: Explain your answer. 1. Although a monopolist has a smaller incentive to invest in a cost-reducing innovation than a perfectly competitive firm, at least it reduces the price it charges after the innovation, thereby benefiting consumers. TRUE/UNCERTAIN. Recall MR = MC so if a cost-reducing innovating makes MC go down, MR will go down as well. Since MR decreases as p decreases , then a decrease in MR will imply a decrease in p . This is what we referred to as the (cost) “pass through rate.” In the case of linear monopoly, it is 50%: for each $1 decrease in unit cost, monopoly price will be reduced by $0.50. Note that a competitive firm who innovates may not have an incentive to reduce price. For instance, consider Bertrand competition – if one firm invests in cost savings it will simply undercut the other firms by as little as possible and gain the full market. The reason you might say this statement is uncertain is that it might not be the case that the monopolist has less incentive – for example if by cutting costs the monopolist deters entry it may reap monopoly profits for an extended time – the key here is that in a dynamic setting the difference in incentives to the monopolist and competitive firm may be different. 2. Selling a product below cost is predation. FALSE/UNCERTAIN. Selling a product below its cost (marginal or otherwise) is one mechanism firms use in predation. It does not have to signal predation, however. Grocery stores commonly sell turkeys below cost at Thanksgiving in order to pull people into the store and get them to buy all the other items they need (this is called a loss-leader). It would be hard to argue that Safeway is intending on driving Albertson’s out of the market with such a tactic. Instead it is a temporary marketing strategy. 3. Large fixed costs and difficulty in selling off capital assets make predation less likely. UNCERTAIN. These large fixed costs and difficulty selling off capital assets will mean that firms facing predation are going to be more likely to try to weather the storm longer and are less likely to exit when the predator undercuts prices, floods the market, etc… This makes predation less successful and thus we would think less likely. However, if the predator firm did in fact succeed in driving out the other firm(s), the large difficult-to-recover fixed costs are going to serve as a barrier to entry for new firms and thus makes predation more profitable should they predator be able to drive the other firms out. 4. Vertical mergers are total-welfare enhancing. UNCERTAIN. Vertical merges can be total-welfare enhancing, such as mergers between upstream and downstream monopolists, where the double marginalization problem is eliminated.
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