ECON 221 UCLA Competitive Fridge Model Economics Questions

econ 221

University Of California Los Angeles


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I’m stuck on a Economics question and need an explanation.

Please answer Questions 4a to 7b

The last two questions textbook is in the PDF Monopoly Quality Degradation and Regulation in Cable Television.

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First Exam for Econ 221 Industrial Organization Spring 2020 Instructions The exam is out of 45 points. The exam is due by 5 pm on 3/27 (48 hours total). To submit your exam, please email me at, a pdf copy of your answers. The exam is open book/note, but I will not tolerate plagiarism. Email me if you have clarifying questions. Good Luck!! Problems Question 1: Explain one of the two ways we proved setting MR=MC maximized firm profits. (2 pts) Supply: Q = 4p Demand: Q = -2P +12 1 Total Costs: TC= 𝑄2 2 Question 2a: Find the competitive market equilibrium price and quantity. (2 pts) Question 2b: Find the profit-maximizing quantity produced by an individual firm in the above market. (2 pts) Question 2c: How many firms will produce in this market? (1 pt) Question 2d: Calculate consumer and producer surplus in the above market. (2 pts) Question 3a: Now assume the above market has a single producer (i.e., is a monopoly). Find the market equilibrium price and quantity. (4 pts) Question 3b: Calculate consumer and producer surplus in the above market. (4 pts) Question 4a: In the dominant firm with a competitive fringe model, the dominant firm behaves like what kind of firm? (1 pt) Question 4b: In the dominant firm with a competitive fringe model, the firms within the competitive fringe behave like what kind of firm? (1 pt) Question 4c: When the dominant firm raises prices, what are the two reasons their quantity produced decreases? (2 pts) Question 4d: Explain one of the factors that determine the dominant firm’s market power. (2 pts) Question 4e: In the dominant firm with a competitive fringe model, firm behavior varies across three price ranges. Explain this pattern in words and graphically (i.e., your explanation should include three separate graphs). (3 pts) Question 5a: What is the Coase Conjecture? (2 pts) Question 5b: What are two strategies firms use to counter the Coase Conjecture? (2 pts) Question 5c: Broadly, what is the goal of strategies firms use to counter the Coase Conjecture? (3 pts) Question 5d: Under what market conditions is the Pacman Strategy more likely to hold than the Coase Conjecture? (2 pts) Question 6a: Describe two sources of Dead Weight Loss (i.e., inefficiency) associated with market power discussed in class. (2 pts) Question 6b: How is X-Inefficiency related to the Economies of Scale benefit of monopolies? (2 pts) Question 7a: In Monopoly Quality Degradation and Regulation in Cable Television, why did companies with multiple bundles increase prices and quality relative to areas with a single bundle? (3 pts) Question 7b: In Monopoly, Quality, and Regulation, what characteristic of the theoretical framework made government regulation difficult? (3 pts) Monopoly Quality Degradation and Regulation in Cable Television Gregory S. Crawford University of Arizona Matthew Shum Johns Hopkins University Abstract Using an empirical framework based on the Mussa-Rosen model of monopoly quality choice, we calculate the degree of quality degradation in cable television markets and the impact of regulation on those choices. We find lower bounds of quality degradation ranging from 11 to 45 percent of offered service qualities. Furthermore, cable operators in markets with local regulatory oversight offer significantly higher quality, less degradation, and greater quality per dollar, despite higher prices. 1. Introduction In many markets, firms choose not only the prices but also the qualities of their products. In many cases, this is the primary dimension on which firms compete, as in pharmaceutical, media, and professional services and many high-technology markets. Theorists have long recognized that in the presence of imperfect competition, offered qualities can be distorted from the social optimum because firms equate private instead of social marginal benefits and marginal costs (Dixit and Stiglitz 1977; Spence 1980). This induces a welfare loss analogous to that from price distortions. Indeed, aspects of a firm’s product offerings, and not pricing, have been the focus of recent highly contested antitrust cases (for example, Microsoft, GE/Honeywell). The tendency of firms with market power to distort quality has been most clearly formulated in the monopoly nonlinear pricing literature, in which it is shown that the firm’s products suffer from quality degradation (Mussa and Rosen 1978; Maskin and Riley 1984). Because products of different qualities are substitutes, a monopolist cannot simultaneously offer each consumer his or her efficient quality and also extract his or her full surplus, even with a fully nonlinear We would like to thank Gary Biglaiser, Silke Januszewski, Eugenio Miravete, and seminar participants at Northwestern University, the University of California, Los Angeles, the National Bureau of Economic Research 2002 winter program meeting, the Society for Economic Dynamics 2002 meeting, the 2004 Kiel-Munich Workshop on Network Industries, and the 2004 Centre for Economic Policy Research conference Competition in the New Economy for helpful comments. [Journal of Law and Economics, vol. 50 (February 2007)] 䉷 2007 by The University of Chicago. All rights reserved. 0022-2186/2007/5001-0007$10.00 181 182 The Journal of LAW & ECONOMICS tariff. Instead, under standard assumptions, quality for all but consumers with the highest tastes for quality is distorted downward. Furthermore, consumers with low preferences for quality may be excluded entirely from the market. Regulation, by either minimum quality standards or price caps, generally reduces distortions but can have ambiguous effects on prices and welfare (Besanko, Donnenfeld, and White 1987, 1988). Despite the widespread acknowledgment of the potential for quality degradation, measures of its extent and implications for outcomes in real-world markets are few. In this paper, we analyze quality degradation in a market long thought subject to its effects: the cable television industry. To do so, we introduce an empirical framework based on the Mussa-Rosen model that exploits the optimality conditions for the monopolist’s quality choice problem to recover measures of the quality of the monopolist’s offerings. This permits us to directly measure how much cable monopolies degrade quality relative to a competitive alternative. It also allows us to measure the impact of local regulatory oversight on ameliorating monopoly quality distortion. We present two main results. First, we find evidence of substantial quality degradation in the cable television industry across a variety of specifications. While some firms offer two or three goods, most offer just a single product quality. Furthermore, offered qualities are at least 11.1 percent and 30.3 percent less in three-good markets and 44.7 percent less in two-good markets than what would be provided in a competitive market offering the same number of goods. Second, we find that local regulatory oversight—in the form of certification by the local franchise authority to cap cable prices—has important ameliorative effects. Systems in franchise areas where the local franchise authority was certified offer an estimated 25.1 percent more services, 24.1 percent higher quality for low- and medium-quality goods (where offered), and greater quality per dollar to consumers despite higher prices. These results are consistent with the impact of minimum quality standards and could be of significant interest to policy makers concerned about the effectiveness of past regulatory interventions in the industry but troubled by continued growth in cable prices.1 The rest of this paper is organized as follows. In Section 2, we survey the canonical Mussa and Rosen (1978) model of monopoly quality choice that forms the foundation of the empirical analysis. We also present extensions to this model developed by Besanko, Donnenfeld, and White (1988) to allow for quality choice in the presence of regulation. In Section 3, we describe the cable television industry and discuss its suitability for this empirical analysis, followed in Section 4 by the empirical model and algorithm for recovering quality measures. Section 5 presents the results, and Section 6 concludes. 1 The most recent report on cable prices by the Federal Communications Commission (FCC) found prices increased by 5.4 percent for the 12 months ending January 1, 2004, slightly less than the 5-year compound annual increase of 7.5 percent from 1998 to 2003 and far higher than the 1.5 percent increase in the Consumer Price Index over the same period (FCC 2005a). Regulation in Cable Television 183 2. The Incentives to Degrade Quality In this section, we discuss the quality degradation result from the theory of monopoly nonlinear pricing using a simple, two-type version of the model of Mussa and Rosen (1978).2 Consider a monopolist selling two goods, q1 and q2, whose qualities can be freely varied over Q p [0, Q]. Consumers are assumed to be differentiated by a type parameter that takes on three distinct values, t0, t1, and t2 (t 0 ! t 1 ! t 2), with respective probabilities fi (with f0 ⫹ f1 ⫹ f2 p 1) and k associated cumulative distribution function Fk { 冘jp0 fi. Type 0, t 0, is included to allow for the possibility that some consumers prefer not to purchase either of the firm’s products.3 For convenience, we assume the hazard function for the type distribution, fi / (1 ⫺ Fi), is increasing in i.4 The monopolist is assumed to be able to offer a nonlinear tariff specifying a different total price per quality variant offered, P1 and P2. The firm knows the distribution of types in the population and selects the tariff that maximizes its expected profit (with the expectation taken over consumer types). Consumer preferences are assumed to be quasi-linear in money, ui { u(q, ti) p v(q, ti) ⫺ P(q). A consumer of type ti is assumed to choose that bundle, q i, which maximizes his or her utility, so that q i { arg max u(q, ti), i p 1, 2. (1) q苸{q1,q 2} Furthermore, given that no consumer can be forced to participate in the contract, the monopolist’s choice of qualities and prices must be such that the consumer voluntarily chooses to accept the contract, which requires u(q i , ti) ≥ 0, i p 1, 2. (2) Equations (1) and (2) are the incentive compatibility (hereafter IC) and individual rationality (IR) constraints. The firm’s optimization problem is then to maximize expected profits, 冘 2 max E[p] p P(q) fi[P(q i) ⫺ C(q i)], (3) ip1 subject to optimal behavior by consumers, as encompassed in the IC and IR 2 Since the derivations in this section are standard, we omit a number of technical details; see, for example, Laffont and Tirole (1993, chap. 2) for complete details. Furthermore, the Mussa-Rosen model has recently been extended by Rochet and Stole (2002) to allow households random private values for the outside option, with interesting implications for the extent of and patterns in quality degradation. We explore the differing implications of these models in ongoing work (Crawford and Shum 2005) and note that the results we present here are conditional on our assumed form for household preferences. 3 This “outside type” is generally not included in the typical theoretical exposition. We include it here to facilitate empirical implementation of the model, in which there are always some consumers who purchase the “outside good.” 4 This rules out bunching of types at a single quality variant. Wilson (1993, chap. 8.1) presents a detailed discussion of the conditions under which this assumption is likely to be violated. The Journal of LAW & ECONOMICS 184 constraints. The term C(q i) is the firm’s cost function, which is assumed to be purely additive across consumers.5 Define the total surplus function S(q, ti) { v(q, ti) ⫺ C(q). Using a common trick from the screening literature, we can rewrite profits as the difference between the total and consumer surplus: 冘 2 max E[p] p u(q) fi[S(q i , ti) ⫺ u(q i , ti)]. (4) ip1 In this reformulated problem, the monopolist solves for the optimal utility quality schedule and determines optimal prices (given utilities) from the binding IC constraints. Under standard assumptions, we can use the IC constraint to rewrite the objective function, which yields max E[p] p f1[S(q 1,t 1) ⫺ u 1] ⫹ f2{S(q 2 , t 2 ) ⫺ [v(q 1, t 2 ) ⫺ v(q 1, t 1)] ⫺ u 1}. (5) q1,q 2 ,u1 This problem is solved by setting the utility of the lowest type to zero, u 1 p 0, and maximizing the resulting unconstrained objective function with respect to q 1 and q 2. The corresponding first-order conditions are Sq(q 1, t 1) p 1 ⫺ F1 [vq(q 1, t 2 ) ⫺ vq(q 1, t 1)] and Sq(q 2 , t 2 ) p 0, f1 (6) where vq { ⭸v/⭸q. Quality degradation for the low type (i p 1) is visible from equation (6). The socially optimal quality for each type, denoted q** i , is that which sets the derivative of the total surplus function to zero, Sq(q, ti) p 0. In equation (6), however, we see that q 1 is chosen so that Sq(q, t 1) 1 0, which implies that q*1 ! q** 1 : quality is degraded to low types. However, there is no degradation at the top for the higher type t 2. Given optimal qualities from equation (6), optimal prices fall out naturally from the IR and IC constraints. Since u 1 p 0, p*1 p v(q*, 1 t 1) and p* 2 p v(q*, 2 t 2 ) ⫺ [v(q*, 1 t 2 ) ⫺ v(q*, 1 t 1)] p p* 1 ⫹ [v(q*, 2 t 2) ⫺ v(q*, t )] . 1 2 Figure 1, which is adapted from Maskin and Riley (1984), demonstrates graphically the solution for the one-dimensional case with N p 2. At this point, we focus only on the solid curves in that figure. The monopolist would like to extract all consumer surplus by offering product qualities q** and q** and 1 2 charging prices p** and p** , but with such an offering the high type would 1 2 prefer to mimic the low and select q** (note for a given quality, consumer utility 1 is higher the lower on the figure they can locate). The constrained optimum is given by variables with single asterisks. As above, the high type continues to consume the efficient quality (and pays a lower price), but quality to the low type is degraded, from q** to q*1 . 1 5 We make the usual curvature assumptions v1 1 0, v11 ≤ 0, v2 1 0, c 1 0, and c 1 0 , as well as the normalization that v(0, ti) p 0 for all i. Furthermore, we maintain the standard single-crossing condition that uqt 1 0 , which implies that higher types have greater willingness to pay (WTP) for quality at any price or that consumers may be ordered by their type, t. Regulation in Cable Television 185 Figure 1. Quality degradation with two types adapted from Maskin and Riley (1984) 2.1. Continuous Types but Discrete Qualities The theory described in the previous section applies also to the case of continuous types but to discrete qualities. To see this, suppose instead that consumer types are continuously distributed on [T, T] with probability density function f(t) but that the monopolist has decided to offer just two qualities regardless. He or she may do so for a number of reasons. There may be fixed costs associated with the design, production, or marketing of products of different qualities. Or there may be incremental (especially marketing) costs of offering numerous goods. If these are large, the monopolist will offer only those products that can cover his or her fixed costs, limiting the number of products in the market (Spence 1980; Dixit and Stiglitz 1977). Suppose the firm offered arbitrary qualities q 1 and q 2. Who would buy these goods? All consumers for whom u(q 2 , t) ≥ u(q 1, t) and u(q 2 , t) ≥ 0 would buy good 2. Because of the structure of the problem—notably the single-crossing condition—only the first of these constraints would bind. Let t 2 denote the consumer type that is just indifferent between purchasing the two goods and t 1 denote the analogous consumer type just indifferent between purchasing good 1 and the outside (or no) good. Then the share of the distribution of consumer types that purchase each good, fi , is given by the integral under the distribution 186 The Journal of LAW & ECONOMICS Figure 2. Continuous types and discrete qualities between the type cut points: fi p ∫t i⫹1 f(t)dt (defining t 0 p T and t 3 p T). Figure i 2 presents a graphical representation of this framework. In that figure, type tA lies between the cut types t 1 and t 2 and so consumes the lower bundle. Type tB lies above the larger cut type t 2, and like that type consumes the higher bundle. For both types tA and t B (and for all types other than the cut types t 1 and t 2), both the participation and incentive constraints hold strictly. The key result is that given these qualities q 1 and q 2 and associated shares f0 , f1, and f2, the monopolist’s profit is described by equation (5) just as in the discrete-type case.6 An important consequence of continuous consumer types is that quality distortion will generally occur for almost all consumers. In particular, only the highest cut type t 2 will consume an efficient quality (q *2 p q ** 2 ). All other types t 1 t 2 that also purchase the high-quality good (like tB) will necessarily receive inefficiently low qualities. Similarly, while quality will still be degraded to the lower cut type (q *1 ! q ** 1 ), it will be lower still for other, higher, types (like tA) that also purchase the low-quality good, t 1 ! t ! t 2. This is also illustrated in 6 This is a subtle point. Were we to specify a particular continuous distribution of consumer types, solving the firm’s problem for the optimal cut types, t ’s, is a challenging problem requiring more sophisticated techniques than those employed here (Crawford and Shum 2005). The insight is that even if firms are making these more sophisticated calculations, the discrete-type first-order conditions must hold for the cut types ultimately chosen by firms. Regulation in Cable Television 187 Figure 1, in which the two dashed curves are indifference curves for the types tA and tB in Figure 2. Type tA, who consumes the same bundle as type t 1, has an efficient bundle that lies to the right of type t 1’s efficient bundle, which implies that the quality distortion to type tA is higher than that to type t 1. Similarly, there is a positive distortion to type tB, even though he or she consumes the same bundle as type t 2, to whom there is no distortion. The theory described above applies analogously for an arbitrary number n of offered qualities. For any n, equation (6) continues to hold, with associated degradation for all but the highest offered quality q n. However, when the type distribution is continuous but the monopolist offers only discrete qualities, the cut types t 1 and t 2, as well as n, the number of offered qualities, are also choice variables. In this paper, while we do not use the monopolist’s optimality conditions for these variables in recovering quality measures, we do briefly analyze the number of goods offered by firms in the empirical analysis. Finally, note that it is typical in models of this type to make additional assumptions on the distribution of consumer types to ensure the optimal prices and qualities are monotonically increasing in types. Because, however, we restrict our attention to the implications of the model for a discrete number of qualities, we do not have to do this. Indeed, it could be the case that in some market n the inverse hazard function of types, [1 ⫺ Fn(t)] /fn(t), is nonmonotonic in t (as in Figure 2). If the firm in market n were to offer a fully nonlinear price/quality schedule in such a case, it would require sophisticated solution techniques involving pooling of types at particular qualities (Wilson 1993). With discrete qualities, however, pooling obtains regardless of the shape of the type distribution. For our purposes, it is convenient if the inverse hazard function d ...
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First Exam for Econ 221 Industrial Organization Spring 2020
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Answer 4a
In the dominant firm with a competitive fridge model, the dominant firm behaves like
monopolist firms. The firm accounts for the biggest share of the market and has a significantly
large share of the market. If the firm has the power to raise the product prices independently,
they can control the entire market competition (Crawford & Shum, 2007).
Answer 4b
In the dominant firm with a competitive fridge model, the dominant firm behaves like
new entrant firms. Such that they seem like they are trying to penetrate a market with a large
competitor who is controlling the overall market (Crawford & Shum, 2007).
Answer 4c
The dominant firm is like a monopoly, but even if it increases the prices, unlike in a
monopolist market, the customers do not leave the market. The thing that will happen to the
dominant firm if it raises the price is to lose its customers to the fringe firms in the industry.
Therefore the dominant firm must take fringe firms into account when increasing the prices
(Crawford & Shum, 2007).
Answer 4d
The factors that give the dominant firm power are the ability to set prices of products
independently. Second, the ability to offer ...

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