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2023 | Book

Industrial Organization

Practice Exercises with Answer Keys


About this book

Revised and updated for the second edition, this textbook presents over 100 exercises on industrial organization with detailed answer keys. While most textbooks on industrial organization focus on theory and empirical findings, this textbook offers practical examples and exercises helping predict firm behavior in different industries. The book emphasizes the game-theoretic tools used in each type of exercise, so students can systematically apply them to other markets, forms of competition, or information environments where firms, consumers, and regulating agencies interact.

The book begins with examples that analyze different models of firm behavior and interaction; starting with monopoly and moving through the Cournot model of simultaneous quantity competition, the Bertrand model simultaneous price competition, and sequential competition. The following chapters apply game-theoretic tools to situations of increasing complexity: regulation; R&D incentives; mergers and collusion; bundling incentives; incomplete information, signaling, and competition; networks and switching costs. In addition to providing algebraic simplifications, some chapters also offer the unique feature of worked exercises based on published journal articles by leading scholars in the field. Finally, exercises are ranked according to their difficulty, with a letter (A-C) next to the exercise number, which allows students to pace their studies and instructors to structure their classes accordingly. The second edition contains additional exercises optimized for study at the upper undergraduate level.

Providing a rigorous, yet practical introduction to the field of industrial organization, this textbook is appropriate for advanced undergraduate and graduate students in economics and finance.

Table of Contents

Chapter 1. Monopoly
This chapter explores monopoly models, where a single firm operates in an industry. We first study the output decisions of this type of firm in a simplified setting with linear demand and constant marginal costs. Exercise 1.2 then extends our analysis to a context where the monopolist faces a convex cost function (i.e., increasing marginal costs) which may occur when, intuitively, producing further units becomes increasingly expensive. Exercises 1.3 also examine more general environments where the firm faces a generic inverse demand function and a generic cost function, while Exercise 1.4 focuses on settings where the monopolist faces a convex, concave, or linear demand.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 2. Simultaneous Quantity Competition
After studying markets with only one firm in Chap. 1, we now turn to industries with two or more firms (oligopolies) either compete in quantities (Chap. 2) or in prices (Chap. 3). In this chapter, we assume that every firm chooses independently and simultaneously its output level, yielding an equilibrium output for each firm and an equilibrium aggregate output for the industry. Given this aggregate output, the equilibrium price is determined by the demand function entailing equilibrium profits for each firm.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 3. Simultaneous Price Competition
This chapter considers similar industries as those we analyzed in Chap. 2, but assuming that firms compete in prices. In this setting, every firm simultaneously and independently chooses the price for its product. When firms sell a homogeneous good (such as the same cereal variety, cement, or other minerals), the firm setting the lowest price captures all sales while all other firms sell zero units. When firms sell heterogeneous goods (such as clothing), the firm setting the lowest price may attract more, but not all the customers.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 4. Sequential Competition
In this chapter, we start analyzing strategic settings where firms interact sequentially, rather than simultaneously, as opposed to most of the exercises in Chaps. 2 and 3. In this type of industries, one or more firms choose their output level in a first stage (often referred to as the industry “leader”) and, observing this output level/s, other firms respond by selecting their output level/s (and thus are known as the industry “followers”).
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 5. Regulating Imperfectly Competitive Markets
This chapter takes a regulatory approach by considering some of the models of imperfect competition analyzed in previous chapters (monopoly and oligopolies with different numbers of firms) and examines different policy tools that can induce firms to produce the output level that maximizes the social welfare (we refer to this output level as the “socially optimal output”), such as subsidies and taxes for each unit of output that the firm produces.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 6. R&D Incentives
In this chapter, we study firms’ incentives to invest in research and development (R&D) with the goal of lowering their production costs in subsequent periods. Exercise 6.1 starts analyzing these incentives in a stylized setting, a monopoly where a single firm operates in all periods. In this context, the monopolist anticipates that any R&D investment today will lower its production costs in the next period, when it still maintains a monopolistic position. In other words, the monopolist does not have incentives to invest in R&D to become more competitive in the future, relative to its rivals. In oligopoly models, however, every firm considers this incentive to improve its relative cost advantage. Exercises 6.2 and 6.3 examine this incentive, first in an oligopoly where firms compete in quantities (Exercise 6.2) and then in one where firms compete in prices (Exercise 6.3). In both exercises, we evaluate whether firms may have more or less incentives to invest in R&D than what they would under monopoly, which helps us identify whether the presence of more than one firm provides firm with an additional incentive to invest, relative to monopoly, or with less incentives. Exercise 6.4 then evaluates the welfare that arises in equilibrium, comparing whether that under monopoly is larger than under oligopoly, and Exercise 6.5 examines if R&D investments increase in oligopolistic markets that became more competitive (with more firms).
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 7. Mergers
This chapter studies firms’ incentives to merge in imperfectly competitive markets. Exercise 7.1 begins with the basic setting of mergers between two firms into a monopoly. Exercise 7.2 extends into the setting of mergers between k firms in an industry with N firms. We show that when the number of firms that merge is sufficiently high, mergers become profitable as the gain in market power more than offsets the output increase of the firms that do not merge, and this is referred to as the “80% rule” after Salant et al. (1983). Exercise 7.3 suggests that when there are three or more firms merging together, the merger is unsustainable because every participating firm has incentives to leave and free ride on output reduction of the merger to increase its own output and profit levels. Exercise 7.4, in contrast, studies Bertrand mergers with three differentiated firms, showing that both partial and full mergers are sustainable when firms merge to soften price competition. Exercise 7.5 analyzes Cournot mergers with differentiated products, showing that as firms produce more homogeneous products, competition becomes more intense so more firms need to participate in order to sustain the merger. Exercise 7.6 shows that mergers between horizontally differentiated firms do not increase welfare when firms are relatively symmetric in costs, but are welfare-enhancing when firms are significantly cost-asymmetric in shifting output from the less to the more efficient firm.
Exercise 7.7 finds that companies have stronger incentives to merge when the merged firm benefits from cost-reduction effects. Exercise 7.8 suggests that when firms merge to gain economies of scope, they have more incentives to merge than when they suffer diseconomies of scope. Exercise 7.9 finds that if two firms in a homogeneous market of N firms merge to gain Stackelberg leadership, these two firms have incentives to merge under all parameter conditions. Exercise 7.10 analyzes mergers in a sequential-move game. We report that while a leader has incentives to acquire a follower, those incentives are weakened when the follower market becomes more competitive. To summarize, the existence of outsiders weakens firms’ incentives to merge, unless the merged firm gains significant market power, enjoys cost advantage, or maintains output leadership.
Exercise 7.11 develops the case for the “tragedy of the anticommons,” where firms, unlike a cartel which limits the extraction of common pool resources, increase the production of complementary goods relative to their competitive levels. Finally, Exercise 7.12 analyzes merger incentives in polluting markets, suggesting that emission fees can facilitate mergers of environmentally differentiated firms.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 8. Collusion
This chapter studies firms’ incentives to collude in imperfectly competitive markets. Exercise 8.1 identifies the range of discount factors that support the collusion of two firms. Extending into a multiple firm context, Exercise 8.2 indicates that it becomes more difficult for firms to collude as the profit gain from cheating increases with the number of firms, so that every firm needs to assign a sufficiently high value on future profits to sustain collusion.
We are also interested in analyzing firms’ repeated interaction when competing in prices. Exercise 8.3 investigates firms’ incentives to collude in prices when two firms sell homogeneous products. Exercise 8.4–8.5 allows for product differentiation, where we show that firms can collude under a wider range of discount rates when products become more differentiated. Exercise 8.6 examines markets with time-varying demand, showing that in markets with growing (shrinking) demand, collusion can be sustained under less (more) restrictive conditions on discount rates as the deviating firm faces larger (smaller) punishments in future periods. In sum, collusion is easier when goods are more differentiated and markets are more concentrated and expanding.
Exercises 8.7 and 8.8 examine how collusive incentives are affected when firms’ production costs are convex, instead of linear. In particular, Exercise 8.7 considers that firms’ costs are symmetric, while Exercise 8.8 allows for cost asymmetries. Intuitively, all firms produce a positive output in the cartel, which becomes more attractive when firms are more asymmetric, since they can shift a larger output share to the most efficient firm, ultimately increasing cartel profits.
We further consider the effects of prosecution on the stability of a cartel. Exercise 8.9 shows that collusion becomes more difficult when firms are subject to prosecution that dissolves the cartel with a positive probability in every period. Interestingly, a heavier penalty makes collusion easier to sustain since firms now have lower expected gains from output coordination that makes deviation less profitable. Exercise 8.10 illustrates that the same results hold when firms compete on prices.
Exercise 8.11 investigates collusive behavior when firms exhibit economies of scope, while Exercise 8.12 examines collusive behavior under temporary punishment. We show that the tit-for-tat strategy cannot be sustained in equilibrium because one-period reversal to the Nash equilibrium output does not offset the firm’s instantaneous gain from deviation. However, the longer the punishment phrase, the more future profits that the firm loses so that collusion can be sustained under a wider range of discount rates. Exercise 8.13 studies the condition for which firms find collusion sustainable and punishment credible, where full (partial) collusion can be supported when discount factors are relatively high (low). Exercise 8.14 considers intermittent collusion, which requires higher discount factors when firms collude less frequently.
Exercise 8.15 demonstrates that collusion is more difficult to sustain when prices are inflexible. Exercise 8.16, based on Exercise 7.​9, suggests that when a firm deviates from a Stackelberg cartel and loses output leadership, this firm is less likely to deviate than when it retains output leadership after the deviation, as in Exercise 8.17. Exercise 8.18 reveals that cost-reduction effects may facilitate (hinder) collusion when firms have stronger incentives to collude (defect).
Exercise 8.19 evaluates leniency programs, where antitrust authorities seek to induce one of the colluding firms to provide evidence against the cartel in exchange for a pecuniary reward, such as a reduced fine or shorter prison sentences. Exercise 8.20 further shows that when the antitrust authority is able to prove firms guilty of collusion when an investigation is opened, firms still have incentives to collude when they consider investigation to be a rare event. However, once an investigation is opened, firms may pledge guilty and pay a reduced fine to provide evidence against the cartel.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 9. Bundling Incentives
This chapter explores settings where a monopolist offers two goods to customers who exhibit correlated valuations for each good. For instance, in a market with two consumers, i and j, and two goods, A and B, customer i is the individual with the highest valuation for good A but he is the one with the lowest value for good B. In this context, the monopolist can offer to sell each good, A and B, at a different price or, alternatively, sell the bundle of both goods at a single price. This is the setting that we consider in Exercise 9.1, showing that, when consumer valuations are negatively correlated, a firm has incentives to only offer the bundle and make a higher profit than selling each good separately. Exercise 9.2 considers bundling decisions when the valuations for the two products, A and B, are positively correlated, Exercise 9.3 provides a numerical example, and Exercise 9.4 extends our analysis to a setting where valuations can be negatively or positively correlated. Interestingly, we show that bundling is only profitable when valuations are negatively correlated.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 10. Incomplete Information, Signaling, and Competition
This chapter analyzes strategic interaction of firms under incomplete information. Exercise 10.1 studies entry decisions when the incumbent’s cost is unobservable to the entrant. We show that the low-cost firm can strategically increase output relative to the complete information setting, to the level that the high-cost firm cannot profitably imitate, in order to deter entry. Exercise 10.2 examines the firm’s incentives to offer damaged goods at an extra cost. We find that consumers are better off since high-value consumers can buy the undamaged version of the good at a lower price, while low-value consumers can buy the damaged good who are otherwise not served. Exercise 10.3 considers firms’ incentives to invest in corporate social responsibility (CSR) when consumers do not receive accurate signal on product quality. We report that the high-quality firm can invest in CSR to signal its product differentiation from low-quality rivals, and CSR investments are usually observed in market with noisy signals such as fashionable clothes, cosmetics, and electronics to distinguish from counterfeit or inferior products. Exercise 10.4 identifies firms’ intertemporal pricing decisions when they can advertise and poach consumers from one another. We find that in a symmetric setting, every firm obtains an equal share of the market in the first period and sells to its rival’s consumers at a price half of that selling to its own consumers in the second period.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Chapter 11. Networks and Switching Costs
This chapter studies the strategic interaction of firms in the presence of network effects, where the adoption of the same technology or standard by several firms allows each firm to benefit from larger market demand, lower production cost, or both. This can happen even when the technology that firms adopt is inferior to other technologies, such as the Blue-ray disk, often regarded as inferior to high-definition DVDs.
Pak-Sing Choi, Eric Dunaway, Felix Muñoz-Garcia
Industrial Organization
Pak-Sing Choi
Eric Dunaway
Felix Muñoz-Garcia
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