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 Section A: Only four question. Choose any 4. Word limit is 200 words per question 

 Section B: choose any one question: It has 3 parts. each part should be 200 words 

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2 ½ Hours

THE UNIVERSITY OF MANCHESTER

ECONOMIC ANALYSIS I: FIRMS, MARKETS & THE ECONOMY

23 January 2019

14:00 – 16:30

Answer THREE questions:

Answer ANY FOUR parts of the question from SECTION A

and

Answer ONE question from SECTION B

and

Answer ONE question from SECTION C

THIS QUESTION PAPER MUST NOT BE REMOVED FROM THE EXAMINATION
ROOM

Electronic calculators may be used in accordance with University regulations

© The University of Manchester, 2019.

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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) Why might we assume that the domestic real interest rate equals the world real

interest rate?
[10 marks]

g) 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]

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SECTION B

Answer ONE question from this section (worth 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]

c) Uber has access to real time 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 over time.

[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]

Question 3 continues overleaf PTO

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Question 3 continued

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 tax payers.

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 £300 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]

Section B continues overleaf PTO

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Section B continued

Question 5

a) Explain the Quantity Theory of Money (QTM). What determines the rate of
inflation in this theory? Does empirical evidence support QTM?

[20 marks]

b) What are the Fisher equation and Fisher effect?
[10 marks]

SECTION C

Answer ONE question from this section

Question 6

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]

Section C continues overleaf PTO

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Section C continued

Question 7

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? [8 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? [10 marks]

Question 8

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
per cent 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 a long 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’s hard for new competitors to raise enough capital to enter the market at all.

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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 per cent 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 vice versa.
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.

In refining today, the investment decisions that the companies make have such a
direct impact on prices that it’s rational for each of them individually to limit capacity.
… High gas prices usually provoke one of two explanations: either they’re evidence
of a conspiracy or they’re just the result of the free market at work. The good news is
that there’s no conspiracy. The bad news is that there’s also no free market.

a) The theory of price competition outlines conditions when firms tend to
compete over prices. Explain in detail these conditions. Are there any of the
conditions present in the current case? If the answer is positive, why has the
U.S. refinery market rarely ever experienced price competition?

[12 marks]

b) During the period, the number of players in the U.S. refinery market went
down through mergers and acquisitions. Use a relevant economic theory to
explain reasons behind the reduction in the number of firms in the industry.

[8 marks]

c) Suppose technological advances help further reduce the price of solar panels,
batteries and electric cars, making them serious competitors to traditional
cars. How will such an event affect the effectiveness of the strategy you have
identified in the case?

[6 marks]

d) Identify a possible policy that the U.S government can introduce to increase
competition in the refinery market.

[4 marks]

END OF EXAMINATION PAPER

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