# ECON 444 ECON444 Midterm 1 Answers (Penn State University)

ECON 444 ECON444 Midterm 1 with Answers (Penn State University)

1. When two firms merge, give a reason we might we expect prices in the industry to go down. Explain your answer.

2. When two firms merge, give a reason we might we expect prices in the industry to go up. Explain your answer.

3. Suppose demand in the market for candy is P (Q) = 100 − 3Q, and the equilibrium price is 30. What is the elasticity of demand in equilibrium?

4. What is the definition of a dominant strategy?

What does it mean for a good to be divisible? Give an example of a divisible good.

Suppose there are five identical firms competing in Cournot compeition. In equilibrium, what is the Herfindahl-Hirschman Index (HHI) for this market?

7. Between Facebook and Google Search, which service exhibits stronger network effects and switching costs? Explain why and how this makes it easier for this product (Face- book or Google Search) to maintain a monopolistic position.

8. Everything else equal, should the Justice department be more likely to challenge merg- ers in an industry that is more elastic or more inelastic? Explain your answer.

Problem 2. (40 points, each part is weighted equally.) Colombian Caffeine and Ethiopian Brew are the only two firms in the coffee market in Suburbia. Residents of Suburbia view the two coffees as homogeneous products, and the demand curve for coffee is P (Q) = 180 − 2Q. The firms have different cost curves. The total cost function for Colombian Caffeine, which imports coffee from Colombia, is Cc(qc) = 200 + 10qc. Ethiopian imports from Ethiopia, which is farther away, so it has a higher marginal cost and a total cost function of Ce(qe) = 300 + 20qe. The two firms are engaged in Cournot competition.

2. What is the best response function for Colombian Caffeine.

3. What is the best response function for Ethiopian Brew?

4. What is the equilibrium strategy profile?

5. What is the total quantity of coffee supplied in equilibrium?

6. What is the equilibrium price?

7. What is consumer surplus in equilibrium?

8. How much profit does each firm make?

Problem 3. (35 points, each part is weighted equally.) The owner of Colombian Caffeine proposes a merger to the owner of Ethiopian Brew, which would create a monopoly in the Suburbia coffee market. You are hired to help them analyze the impacts of the merger. As in the previous problem, residents of Suburbia continue to perceive the two coffees as homogeneous products. Demand remains the same. The merged firm can choose to import from either Colombia or Ethiopia according to the same cost functions given above.

1. Should the merged firm import coffee only from Colombia, only from Ethiopia, or from a mix of both locations. Explain your answer.

2. Write down the profit optimization problem for the merged firm.

3. How much coffee should the merged firm supply to the market?

4. What is the price in the monopoly market?

5. What are profits of the merged firm? Are they larger or smaller than the combined

profits for the two separate firms?

6. What is the Lerner Index (or markup) of the merged firm?

7. Colombian Coffee offers to buy Ethiopian Brew for $1,000. If Ethiopian accepts, the owners of Colombian get all the profits of the merged firm. If not, no merger occurs and the two firms compete in Cournot competition. Should Ethiopian accept this offer? Explain your answer.

Problem 4. (25 points, each part weighted equally) Two street vendors, Allen Snacks and Beaver Pizza are selling slices of pizza in State College. City regulations require they post their price on their food card before setting up, and cannot change prices during the day. Therefore, neither learns the other’s price before deciding on their own price. The city further requires that the choose one of only three prices $1, $2, or $3. State College has 200 potential pizza buyers. However 40 of them will only buy a pizza if it costs less than $2.50. All pizza buyers will purchase pizza from the low-price provider. If Allen and Beaver set the same price, sales are split evenly. The firm’s cost of producing pizza is zero, both firms wish to maximize profits.

1. Draw the normal form for this game. Be sure to fully label your picture to receive full credit.

List the best responses of Beaver Pizza to each possible pure strategy of Allen Snacks.

List all Nash Equilibria of this game.

If the two vendors could coordinate to maximize total profits, what strategy profile would they prefer?

5. Explain why your answer to the previous part is or is not a Nash Equilibrium.