Industrial Organization exam questions

Firm boundaries

The horizontal boundaries of the firm

Question

How does umbrella branding aid economies of scale and scope?

1. Increases effectiveness of advertising due to a greater presence
2. Increases effectiveness of advertising due to national advertising
3. Increases effectiveness of advertising due to offering a broad product line under one name
4. Increased cost effectiveness through purchasing as a cooperative
5. Increased cost effectiveness through bulk purchasing

Answer

3

Question

Which of the following best describes economies of scope?

1. The average cost declines as output increases
2. The average cost increases as output increases
3. The average cost remains constant as output increases
4. Savings are achieved when a firm produces a wider variety of goods
5. Savings are achieved when a firm produces a decreased variety of goods

Answer

4

Question

Which of the following is not a product specific fixed cost?

1. The cost to manufacture a special die to make an aircraft fuselage
2. The cost of developing graphics software to facilitate video game development
3. The cost of a one-week training program preceding the implementation of a specific management initiative
4. The time and expense required to set up a textbook before printing it
5. The cost of administrative expenses

Answer

5

Question

A firm produces two products, X and Y. The production technology displays the following costs, where C(i,j) represents the cost of producing i units of X and j units of Y:

• C(0,50) = 100

• C(0,100) = 210

• C(5,0) = 150

• C(10,0) = 320

• C(5,50) = 240

• C(10,100) = 500

Does this production technology display economies of scale? Of scope?

Answer

This technology does not display economies of scale. The cost per unit of making 50 units of Y is $2, and the cost of making 100 units of Y is $2.10. Since the cost per unit does not decrease as the quantity of Y increases, this technology does not display economies of scale in the production of Y. The result is analogous in looking at the costs of making X, as well as looking at the costs of making X and Y together in greater quantities.

This technology does display economies of scope in the production of X and Y. The cost of making 5 units of X is $150 and the cost of making 50 units of Y is $100. Made separately, the total cost of making 5 units of X and 50 units of Y is $250. The cost of making 5 units of X and 50 units of Y together is $240.

Question

Economies of scale are usually associated with the spreading of fixed costs, such as when a manufacturer builds a factory. But the spreading of fixed costs is also important for economies of scale associated with marketing, R&D, and purchasing. Explain.

Answer

Fixed costs are those costs that do not vary directly with output. Fixed costs must be expended in order to initiate production, but also for activities such as selling the output or developing improvements to the output. As the firms scale of operation increases in terms of volume of output and number of products produced, functions related to marketing, R&D and purchasing are spread over more units—hence reducing the cost of each of these activities per unit sold. For example, once a firm invests in developing a new product, those R&D costs are fixed regardless of the scale of that product.

Question

What are the main differences between economies of scales and learning economies?

Answer

Economies of scale are said to exist if average costs decrease as output increases. Learning economies, a source of economies of scale, refer to a reduction in average costs due the accumulation of experience and know-how.

Question

Suppose you wanted to quantify a firm's learning experience. One possible measure is the firm's lifetime cumulative output. What are the advantages and disadvantages of this measure? Can you offer a superior alternative measure?

Answer

The magnitude of learning benefits is often expressed in terms of a slope. The slope for a given production process is calculated by examining how far average costs decline as cumulative production output doubles. It is important to use cumulative output rather than output during a given time period to distinguish between learning effects and other scale effects.

Question

Why Do Firms Diversify? Discuss potential benefit(s) of diversification.

Answer

Diversification aims to reduce the company risks of demand fluctuation, offering a more linear income from customers. It can also exploit economies of scale and scope if different final goods can involve the same raw materials, machineries, or distribution channels employed for the goods a company is already producing, lowering the cost per unit. It can also allow to exploit internal capital markets, to allocate resources where needed if some products are not yet generating substantial revenues.

Other benefits can include product bundling, when complementary products of the same brand are sold together at a lower price than the two alone. Diversifying requires an initial investment and sometimes may not be as desired by shareholders as it is by managers, but market mechanisms like leverage buy outs mitigate the risk of abuse.

Question

What are the advantages and disadvantages of diversification?
What can be done to prevent managers from abusing it?

Answer

Shareholders have a more diversified portfolio and are able to reduce their risks within the same company.

Diversification involves an initial cost and a continuous cost for management control.

Question

How does the firm-level elasticity of demand shape the opportunities for making profit in an industry?

Answer

TODO

The vertical boundaries of the firm

Question

What is a reason that companies might want to "buy" instead of "make" talent from the market when looking to acquire employees with a particular skill set?

1. External training methods are better than internal ones
2. Companies are always willing to pay more for external employees
3. External training is more advanced (up-to-date) than internal
4. Scale economies can result in fixed education costs while in house education methods may be more expensive
5. Externally trained employees are more likely to become better business leaders

Answer

4

Question

The reduction of coordination and holdup problems depends on:

1. Governance arrangements
2. Manager contracts
3. Required quality of finished product
4. Cost of upstream vertical supplies
5. None of the above

Answer

1

Question

Which of the following is not a characteristic of a complete contract?

1. The contract allows a party to exploit weaknesses in another party's position as the transaction unfolds
2. Elimination of opportunistic behaviors
3. Stipulation of each party's responsibilities and rights
4. Binding instruction for each party on courses of action as the transaction unfolds
5. Must be enforceable

Answer

1

Question

A manufacturer of pencils contemplates backward integration into production of rape seed oil, a key ingredient in manufacturing the rubber-like material (called factice) that forms the eraser. Rape seed oil is traded in world commodity markets and its price fluctuates as supply and demand conditions change.

The argument has been made in favor of vertical integration: "Pencil production is very utilization sensitive, i.e., a plant that operates at full capacity can produce pencils at a much lower cost per unit than a plant that operates at less than full capacity. Owning our own source of supply of rape seed oil insulates us from short-run supply-demand imbalances and therefore will give us a competitive advantage over rival producers."

Explain why this argument is wrong.

Answer

Ensuring supply might be a valid argument for vertical integration if the market for rape seed oil were extremely illiquid and inefficient, but it is traded freely on world commodity exchanges. In this case, there are no economic benefits to vertical integration that cannot be achieved through market exchange – an arms-length transaction is simply internalized within the firm if transfer prices are set at the market level.
However, if transfer prices are held constant, this will lead to inefficient use of rape seed oil.
The firm will fail to use the optimal quantity of rape seed oil in downstream production and would subsidize its upstream division when market prices were low or support its downstream division when market prices were high.

Question

In each of the following situations, why are firms likely to benefit from vertical integration?

1. A grain elevator is located at the terminus of a rail line
2. A manufacturer of a product with a national brand name reputation uses distributors that arrange for advertising and promotional activities in local markets
3. A biotech firm develops a new product that will be produced, tested, and distributed by an established pharmaceutical company

Answer

1. A grain elevator owner would benefit from vertical integration for several reasons:

   • Coordination Costs: The use of market firms often present coordination problems. This is problematic for inputs with design attributes that require a precise fit between different components. It may be that storage bins and railcars need to be so designed. Timing is another important factor with grain.
     The grain operator would want to ship the grain as soon as possible to avoid spoilage, etc. Since only one rail line operator is likely to exist, it will have few incentives to closely coordinate with the grain elevator owner. Having centralized administrative control as an integrated firm would solve these coordination problems.
   • Transactions Costs: Arranging for timely pick-up and delivery through contracts could be extremely difficult and costly to enforce if the rail line operator lacks competition and can act opportunistically. Furthermore, the rail line operator can charge a higher fee for its services. (holdup problem)
   • Processing Efficiencies: Locating assets side-by-side may allow the operators to economize on transportation or inventory costs or to take advantage of processing efficiencies. (This is a concept called site specificity, which is discussed in Chapter 3.)
   • Economies of Scale: The grain operator may be able to achieve distribution economies of scale by having its own rail operation as opposed to contracting with individual transportation providers.

2. The manufacturer would benefit from vertical integration for several reasons:

   • Coordination Costs: The manufacturer will be better able to coordinate national and local advertising and promotions, thus conveying a consistent message/brand image across local markets and maximizing the impact of advertising and promotions on sales. (Sequencing).
   • The manufacturer can better coordinate the release of new products with local advertising and promotional activities. (Timing).
   • A manufacturer's own distributors/sales force will be focused on selling only its products, whereas independent distributors have competing interests since they will also be selling products from rival manufacturers. May even be that the distributor's promotional activities violate the manufacturer's intended image of the product.

3. The biotech firm would benefit from vertical integration for several reasons:

   • Coordination Costs: Given the level of importance of the design attributes (mix of component chemicals, performance specifications, etc.) for a new biotech product, the coordination of these activities is critical for the pharmaceutical company to avoid potentially costly mistakes.
   • Leakage of Private Information: The biotech firm will likely have to divulge proprietary product information in order for the pharmaceutical company to manufacture the new product. As a result, the biotech firm risks giving up valuable product design information that could be used by the pharmaceutical company to develop a competing product.
   • Transaction Costs: In order to prevent the pharmaceutical company from producing or distributing a competing product, the biotech firm would have to incur significant contracting costs. Enforcement, in particular, could be difficult given the complexity of the product.

Question

Discuss the firm's arrangements that can help to avoid the risk of holdup.

Answer

Holdup problem can be avoided using self-enforceable contracts. In this way, for example, downstream firm's payment is automatic and cannot be just cancelled. We can think about smart contracts based on blockchain technology.

Another solution is the possibility of owning the assets and use the counterpart as an "independent worker". We can think about GM and Ford that own the machinery to produce some componer ut these components are produced by third party firms.

Another solution is to use relational contracts with long term agreements and renegotiation clauses or options.

Another solution, that goes beyond the arrangements between firms, is complete vertical integration.

Question

Universities tent to be highly integrated – all department tent too belong to the same organization. There is not a technical reason why a university could not consist of freestanding departments linked together by contracts, much in the same way that a network organization links freestanding businesses.
Why do you suppose that universities are not organized in this way?

Answer

The underlying reasons behind the existence of integrated universities include:

• Coordination Costs: There are several issues with regard to coordination, such as
  • timing: individual departments must coordinate around a common academic calendar
  • sequencing: a common sequence of courses towards degree requirements needs to exist
• Organizational Issues: The university departments are bound by ties of social similarity such that they value their association with each other in addition to any monetary issues involved in their departments. This commitment supplements the more formal governances inside the university making internal governance more effective than market governance. Culture can also complement formal governance mechanisms within the university making the internal organization more effective than the market could be. Contracting a common culture for a "networked" university promises to be virtually impossible.
• Economies of Scale: By remaining integrated, a university can take advantage of several economies of scale, including
  • purchasing economies of scale,
  • marketing economies of scale in attracting both students and professors,
  • the spreading of fixed investments such as real estate, information technology and sports-related investments,
  • the spreading of administrative overhead.

These activities could not be accomplished as efficiently through contracting.

Question

Why does assymetric information lead to inefficient actions?

Answer

Why does assymetric information lead to inefficient actions?

Question

Some contracts, such as those between municipalities and highway construction firms, are extremely long with terms spelled out in minute detail. Others, such as between consulting firms and their clients, are short and fairly vague about the division of responsibilities. What factors might determine such differences in contract length and detail?

Answer

Factors that might determine differences in contract length and detail include verifiability and measurability of performance. In the case of the highway construction contract, it may be easier to specify the terms of performance than in the case of the consulting project. That is, it may be easier to specify design specifications, timing, acceptable road quality, etc. When performance under a contract is extremely complicated to specify, as one would expect in the case of the consulting contract, it may be difficult to elaborate each party's rights and responsibilities within a written contract. The language in such contracts is often left vague and open-ended because it is not clear what constitutes fulfillment of the contract.

Question

In many modern U.S. industries the following patterns seem to hold: What factors might explain these patterns?

Answer

• Small firms are more likely to outsource production of inputs than are large firms;
  Small firms are more likely to outsource the production of inputs because they are unable to reach the necessary scale efficiencies in-house. Vertical integration would leave them uncompetitive.
• Standard inputs (such as a simple transistor that can be used by several electronics manufacturers) are more likely to be outsourced than "tailor-made" inputs (such as a circuit board designed for a single manufacturer's specific needs).
  Complex inputs are more likely to be made in-house than standard inputs because the specificity of these products and the assets required to produce them leads to the ‘hold- up' problem. The upstream firm is at risk from the expropriation of the profits it makes from the production of the inputs, which are worth less in alternative uses. As a result the upstream firm will underinvest and fail to produce the inputs at the optimal level of quality and efficiency for the downstream firm, which may also be exposed to high costs if there is any supply disruption. Therefore it is often more efficient for the downstream firm to take control of the production of complex inputs themselves.

Question

Why a firm using a capital-intensive production process is more likely to vertically integrate?

Answer

Capital intensive firms often face high fixed costs that require an high minimum efficiency scale.

By vertically integrating, it can spread fixed costs such as R&D, machinery and advertisement over a large production quantity

Question

What are the main reasons to make and to buy?

Answer

The main reasons to make are:

• avoid coordination with third parties
• avoid the leak of private information
• avoid transaction costs and contractual issues

The main reasons to buy are:

• lower prices from market firms thanks to their learning economies or internal economies of scale
• avoid agency costs and internal issues

Question

How can double marginalisation affect the firm strategic decision to vertically integrate, i.e. to merger?

Answer

Double marginalisation happens when both upsteam and downstreams suppliers apply a markup to the price of the products they sell, the final price is higher than in the case where only a vertically integrated firm produces the good, as there is only a single markup.

In this case by vertically integrating it is possible to offer a good at a lower price.

Question

What is an incomplete contract and what are its main features? Hint: also talk about possible mitigations for negative characteristics

Answer

Incomplete contracts are characterized by bounded rationality, coordination problems and opportunism.

Integration and its alternatives

Question

Analysts often array strategic alliances and joint ventures on a continuum that begins with "using the market" and ends with "full integration". Do you agree that these fall along a natural continuum?

Answer

No. Alliances and joint ventures fall somewhere between arm's-length market transactions and full vertical integration. As in arm's length market transactions, the parties to the alliance remain independent business organizations. But a strategic alliance involves much more coordination, cooperation, and information sharing than an arm's length transaction. A joint venture is a particular type of strategic alliance in which two or more firms create, and jointly own, a new independent organization. The firms involved with a joint venture integrate a subset of their firms assets with the assets of one or more other firms.

Question

What does the Keiretsu system have in common with traditional strategic alliances and joint ventures? What are some of the differences?

Answer

Keiretsu are closely related to subcontractor networks, but they involve a somewhat more formalized set of institutional linkages. Usually the key elements of the vertical chain are represented in a keiretsu. The firms in a keiretsu exchange equity shares, and place individuals on each other's boards of directors - U.S. firms are in many cases prohibited from these practices under the U.S. antitrust laws.

Question

The following is an excerpt from an actual strategic plan (company and product names have been changed to protect the innocent):
Acme's primary raw material is PVC sheet that is produced by three major vendors within the United States. Acme, a small consumer products manufacturer, is consolidating down to a single vendor. Continued growth by this vendor assures Acme that it will be able to meet its needs in the future.
Assume that Acme's chosen vendor will grow as forecast. Offer a scenario to Acme management that might convince them that they should rethink their decision to rely on a single vendor. What do you recommend that Acme do to minimize the risk(s) that you have identified? Are there any drawbacks with your recommendation?

Answer

Acme must have a valid reason for using a single supplier. A key merit of Acme's approach is asset specificity on the vendor's side, when the vendor might be encouraged to make specific investments.
However, there is the potential of hold-up problems created by decreasing the number of vendors down from three to one. The likelihood of hold-up problems would depend on the degree of asset specificity and switching costs. The amount of implicit and explicit costs related to hold-up problems would depend on the level of inventory, customers' expectations and brand reputation. For example, if Acme can only produce its product with Company X's component and Company X ceases shipments, unless Acme has sufficient amount in inventory of the components, Acme will incur significant losses immediately due to lack of sales.

In order to minimize its risks, Acme could second source or backward integrate (partially or fully). Second sourcing or backward integration protects the firm from hold-up but may drive costs by reducing purchasing discounts, increasing production coordination and requiring additional investments by the second source. An alternative solution would be for Acme to consider tapered integration. Tapered integration poses the usual make-or-buy problems, such as high costs, coordination problems and poor incentives.

Question

Describe the trade-off between technical efficiency and agency efficiency an organization can face

Answer

The costs and benefits of relying on the market can be classified as relating to either technical efficiency or agency efficiency.

Technical efficiency indicates whether the firm is using the least-cost production process.
A firm could achieve technical efficiency by purchasing the good in question from a market firm or by investing to develop the skills itself.

Agency efficiency refers to the extent to which the exchange of goods and services in the vertical chain has been organized to minimize the coordination, agency, and transaction costs.
A firm could achieve agency efficiency by improving its structure and agent monitoring.

For example, when a computer maker obtains memory chips from themarket, the firm may improve its technical efficiency by buying from specialized chip manufacturers. But this arrangement may reduce agency efficiency by necessitating detailed contracts that specify performance and rewards. The appropriate vertical organization of production must balance technical and agency efficiencies.

Question

How can an organization achieve the advantages of vertical integration wihout integrating?
Provide some examples of countries where this is a consolidated practice.

Answer

A company can benefit long term contracts, as it happens in Japan with keiretsu and South Korea with chaebol.

It can also mitigate variation in suppliers prices by purchasing futures in the commodity market.

Market and competitive analysis

Competitors and competition

Question

What term describes the differentiation of a product when only some consumers prefer it to competing products (holding price equal)?

1. Horizontal differentiation
2. Vertical differentiation
3. Idiosyncratic differentiation
4. Spatial differentiation
5. Non-price differentiation

Answer

1

Question

Which of the following firms maintains a monopoly or cartel by controlling essential inputs thus creating a barrier to entry?

1. DeBeers in diamonds
2. Nike in shoes
3. Pepsi in beverages
4. Subway in sandwich fast food
5. Levis in denim jeans

Answer

1

Question

Why are the concepts of own and cross-price elasticities of demand essential to competitor identification and market definition?

Answer

The magnitude of consumer responses to changes in a product market’s (or industry’s) price is measured by the own-price elasticity of demand, which equals the percentage change in a product market’s sales that results from a 1 percent change in price. If an industry raises price and consequently loses most of its customers to another industry (or industries), we conclude that the market under consideration faces close substitute products (or the product market competes with other product markets).

Measuring the own-price elasticity of demand tells us whether a product faces close substitutes, but it does not identify what those substitutes might be. We can identify substitutes by measuring the cross-price elasticity of demand between two products. The cross-price elasticity measures the percentage change in demand for good Y that results from a 1- percent change in good X. The higher is the cross-price elasticity, the more readily consumers substitute between two goods when the price of one good is increased.

Question

How does industry-level price elasticity of demand shape the opportunities for making profit in an industry? How does firm-level price elasticity of demand shape the opportunities for making profit in an industry?

Answer

The industry price elasticity of demand indicates the percentage change in quantity demanded per percentage change in price when all firms simultaneously change price. It determines the limits on firms' abilities to profit from collective price increases and thus shapes profit opportunities in environments where firms are able to coordinate their pricing behavior to more closely resemble that of a monopolist.

The firm level price elasticity of demand indicates the percentage change in a firms quantity demanded per percentage change in price when that firm changes its price but other competing firms do not. This elasticity will determine the perceived benefits from a price cut aimed at stealing business from competitors. The larger the elasticity is (in absolute value), the stronger the temptation is on the part of a firm to cut price. This elasticity thus shapes industry profitability by influencing the likelihood of destabilizing price-cutting behavior by firms. Thus, the greater the firm-level elasticity of demand, the greater is the potential for price wars and reductions in overall profits.

Question

What is the "revenue destruction effect"? As the number of Cournot competitors in a market increases, the price generally falls. What does this have to do with the revenue destruction effect? Smaller firms often have greater incentives to reduce prices than do larger firms. What does this have to do with the revenue destruction effect?

Answer

When a firm expands its output, it reduces the market price and thus lowers the sales revenue of its rivals—this is referred to at the "revenue destruction effect". Each firm seeks to maximize its own profit and not total industry profit. The smaller is a firm’s share of industry sales, the greater the divergence between its private gain and the revenue destruction effect from output expansion. This suggests that as the number of firms in an industry exhibiting Cournot competition increases, the greater is the divergence between the Cournot equilibrium and the collusive outcome.

Question

Numerous studies have shown that there is usually a systematic relationship between concentration and price. What is this relationship? Offer two brief explanations for this relationship.

Answer

Leonard Weiss summarized he results of price and concentration studies in over 20 industries, including cement, railroad freight, supermarkets, and gasoline retailing. He finds that with few exceptions, prices tend to be higher in concentrated markets. Consider an industry with a high concentration ratio because there are a small number of Cournot competitors. If each firm’s share of industry sales is large, the divergence between a firm’s private gain and the revenue destruction effect from output expansion is small. Hence, total industry output and price are closer to the levels that would be chosen by a profit-maximizing monopolist. Alternatively, an industry with a high concentration ratio that has a small number of sellers is able to engage more successfully in tacit collusion.

Question

What factors, besides the number of firms in the market, might affect margins?

Answer

An important source of variations in price-cost margins across industries is due to regulation, product differentiation, the nature of sales transactions, and the concentration of buyers.
Also, it is difficult to control for the way in which price cost margins are calculated. Since the predictions of economic theory pertain to the market between price and marginal cost, price-cost margins should be computed using marginal cost. However, accounting cost data usually allow the researcher to infer average cost rather than marginal cost.

Question

The following are the approximate market shares of different brands of soft drinks during the 1980’s:

• Coke 40%
• Pepsi 30%
• 7-Up 10%
• Dr. Pepper 10%
• All other brands 10%

Compute the Herfindahl for the soft drink market. Suppose Pepsi acquired 7-Up. Compute the most merger Herfindahl. What assumptions did you make?
Federal antitrust agencies would be concerned to see a Herfindahl increase of the magnitude you computed in (a), and might challenge the merger. Pepsi could respond by offering a different market definition. What market definitions might they propose? Why would this change the Herfindahl?

Answer

1. 0.4^2 + 0.3^2 + 0.1^2 + 0.1^2 = Herfindahl index = 0.16+0.09+0.01+0.01 = 0.27
   If Pepsi and 7-Up merged:
   0.4^2 + 0.4^2 + 0.1^2 = Herfindahl index = 0.16+0.16+0.01 = 0.33
   The assumptions of the above include that the market shares of firms in the industry do not change as a result of the merger of two players (Pepsi and 7-Up).
2. Pepsi should consider a market definition that would cause the market shares of firms to appear more fragmented. That is, Pepsi should attempt to increase the size of the denominator that determines its market share. For example, Pepsi might argue that the market definition is the "junk food market" – which includes chips and candy. This would have the affect of making the market Pepsi competes in more fragmented.

Question

What indices can be used to measure market concentration?

Answer

The N-firm concentration ratio tells the combined market share of the largest N players of a market. This index increases with the number of N.

The Herfindahl index tells the potentiais the sum of the squares of the market shares of the firms of a market. The square factor attributes more value to larger firms, while smaller firms are penalized.

The Herfindahl index in a market with N equal-size firms is 1/N. For example, a market with a Herfindhahl index of 0.20 is about as competitive as a market with 5 equal-sized firms, whether or not there are exactly 5 firms in the market.

When calculating a Herfindahl, it is sufficient to restrict attention to firms with market shares of 0.01 or larger, since the squared shares of smaller firms are too small to affect the Herfindahl.

Question

"The only way to succeed in a market with homogeneous products is to produce more efficiently than most other firms."
Does this imply that efficiency is less important in oligopoly and monopoly markets?

Answer

Oligopolists and monopolists benefit from an higher bargaining power extracting more surplus from consumers.

Efficiency is still important in lowering input costs.

Question

In what ways are monopolistically competitive markets "monopolistic"? In what ways are they "competitive"?

Answer

They are competitive as they offer similar products horizontally differentiated, but are considered monopolistic as the strategic decisions of a player don't influence another one's business.

Entry and exit

Question

Which of the following is a method a monopolist firm might use to prevent entry into a market?

1. Limit pricing
2. Predatory pricing
3. Capacity expansion
4. All of the above
5. None of the above

Answer

1

Question

"All else equal, an incumbent would prefer blockaded entry to deterable entry."
Comment.

Answer

Entry is blockaded if the incumbent need not undertake any entry-deterring strategies to deter entry. Blockaded entry may result when there are structural entry barriers, perhaps because production requires significant fixed investments. Blockaded entry may also result if the entrant expects unfavorable postentry competition, perhaps because the entrant’s product is undifferentiated from those of the incumbents.

Entry is deterred if the incumbent can keep the entrant out by employing entry- deterring strategies, such as limit pricing, predatory pricing and capacity expansion. Moreover, the cost of the entry-deterring strategy is more than offset by the additional profits that the incumbent enjoys in the less competitive environment. However, entry- deterring strategies are generally met with various degrees of success.

Control of essential resources, economies of scale and scope, and marketing advantages of incumbency are types of entry barriers. The firm who is able to use one or a combination of these entry barriers to blockade entry does not have to actively guard itself against entry and so can focus on other activities. If entry is deterred rather than blockaded, the incumbent must actively engage in predatory acts to discourage entry.
A threat of entry will most definitely constrain the incumbent. Given the incumbent might prefer to be passive rather than active about discouraging entry, blockaded entry would be preferable to deterable entry.

Question

Explain why economies of scale do not protect incumbents from hit-and-run entry unless the associated fixed costs are sunk. Does the learning curve limit contestability?

Answer

If the firm’s investments are nonsunk, this suggests the firm can exit and recover the costs of its investments. This reduces the risk associated with entry and, therefore, increases the likelihood of hit-and-run entry. If the firm enjoys lower costs as a result of the learning curve, the market is less likely to be contestable. The learning firm’s enjoy as a by-product of one production process are unlikely to be applicable to other processes – hence the learning is tied to this particular activity. Since the learning cannot leave the activity, hit-and-run entry is less attractive.

Question

How a firm behaves toward existing competitors is a major determinant of whether it will face entry by new competitors. Explain.

Answer

If a firm is "tough" towards existing competitors (for example, the firm is involved in price or non-price competition), the firm will face less entry because entrants will expect lower profits than if the incumbent were more tolerant of entry. However, if the incumbent has a "soft" stance towards the existing competitors, the entrant may take this a signal for some accommodation of entry and thus the entry rate could be higher. The incumbent signals what post-entry competition will be like through its current behavior toward other firms in the industry.

Question

Why is uncertainty a key to the success of entry-deterrence?

Answer

Entry deterring strategies include limit pricing, predatory pricing and capacity expansions.

• Limit Pricing: If entrants operated in a world of certainty, it would be difficult to find a rational explanation for limit pricing. In general, entering firms must be uncertain about some characteristic of the incumbent firm or the level of market demand. The incumbent wants the entrant to believe that post entry prices will be low. If the entrant is sure about the factors that determine postentry pricing, it can calculate the incumbent’s payoffs from all possible postentry pricing scenarios and correctly forecast the postentry price. If the entrant is uncertain about the postentry price, however, then the incumbent’s pricing strategy could affect the entrant’s expectations.
• Predatory Pricing: As with limit pricing, predatory pricing would appear to be irrational if entrants operated under certainty. If, however, entrants lack certainty, then price-cutting by an incumbent may affect the entrants expectations of the incumbent’s future pricing strategies. Operating under uncertainty makes it more difficult for the entrant to rule out a bad postentry scenario and therefore predatory pricing may, indeed, discourage entry.
• Excess Capacity: Unlike predatory pricing and limit pricing, excess capacity can deter entry even when the entrant possesses full information about the incumbent’s costs and strategic direction. If the incumbent is holding an entry deterring level of capacity it is actually in the incumbent’s interest to convey this information to would be entrants. If, however, the incumbent is unable to hold an entry-deterring level of investment, then the incumbent might hope the entrant is uncertain about the level of capacity the incumbent actually holds.

Question

In most mode of entry deterrence, the incumbent engages in predatory practices that harm a potential entrant. Can these models be reversed, so that the entrant engages in predatory practices? If so then what are the practical differences between incumbents and entrants?

Answer

Entrants and incumbents roles can be switched in the theoretical models and the results will hold true. If the entrant has deep pockets then it can engage in predatory practices to drive incumbent out. Incumbents have an advantage in that they in most cases would have created brand loyalty or reputation, network externalities, and lower costs due to learning curve. Taking all the above factors into account, it is less likely that entrant will pursue predatory practices.

Question

Consider a firm selling two products, A and B, that substitute for each other. Suppose that an entrant introduces a product that is identical to product A. What factors do you think will affect (a) whether a price war is initiated, and (b) who wins the price war?

Answer

Given the incumbent is producing two substitute goods, the incumbent has more lose if a price war erupts. The reason is, if the incumbent lowers the price of good A to match the price of the entrant’s identical offering, the incumbent loses revenues on good B as well as on good A because customers who used to purchase B will substitute toward good A. If exit barriers are minimal, the incumbent might prefer to exit the market for good A rather than endure a price war. The incumbent is more likely to stay and fight if exit barriers are high and/or good A and B are weak substitutes. Clearly the probability of a price war decreases if the level of demand for these goods is high relative to the combined capacities of the firms.

Question

"Economic theories of how price wars begin presume that firms would prefer their industry price to be high"
Comment.

Answer

Consider a firm (firm X) whose output is only slightly differentiated from the output of other firms in the industry. If the firm X’s rivals lower their prices, than firm X will loose significant market share and will consequently suffer a reduction in profits. Collectively, the firms in the industry have lower profits after a price reduction— however, it is possible that even though the total profit pie is smaller, some firms are better off after the price reduction. However, since total industry profits are lower, more firms see their profits decline than see their profits increase—hence, we can presume that, on average, firms prefer industry price to be high.

Question

Why do misreads and misjudgements encourage firms to lower prices?

Answer

Consider what might happen when two firms are playing tit-for-tat, and there is a chance that a cooperative move is misread an uncooperative one. The firm that misreads the cooperative move as an uncooperative one responds by making an uncooperative move in the next period. The firm lowers price in order to enforce the tit-for-tat strategy. It is possible that a firm mistakes the actions of its rival as aggressive and so reacts with a price cut in order to protect volume.

Question

Firms operating at or near capacity are unlikely to instigate price wars. Briefly explain.

Answer

Firms who lower price earn less on every unit they sell up to the quantity they sold before the price reduction. However, this loss can be offset by an increase in units sold due to the now lower price. If a firm is at or near capacity, its ability to expand quantity sold is constrained and hence the firm cannot recover the forgone profits from selling each unit at a lower margin. The capacity constrained firm has little incentive to initiate a price reduction.

Firms are more likely to instigate price wars when excess capacity exists. For example, if a firm is experiencing excess capacity, and a new firm enters the market, the new entry will induce even greater excess capacity on the part of the incumbent. If there are economies of scale in production, the costs of idle capacity may rise with the degree of idleness. This suggests that the incumbent will fight harder to retain market share under excess capacity conditions, prices are likely to drop with entry. The firm with excess capacity may lower its price in order to retain or steal market share.

Question

Suppose that you were an industry analyst trying to determine if the leading firms in the automobile manufacturing industry are playing a tit-for-tat pricing game. What real world data would you want to examine? What would you consider to be evidence of tit-for-tat pricing?

Answer

Circumstantial evidence of tit-for-tat pricing is relatively easy to find. Public pricing behavior like the advance announcement of price changes and the use of commitments to meet the lowest available price support price coordination and stability, as does simplified pricing behavior such as having annual pricing reviews. However, hard evidence of tit-for-tat pricing is much harder to come by, unless firms are foolish enough to put a collusive agreement in writing.

You would want detailed data on historical prices and firm profits in an attempt to discern pricing patterns that support above-average industry profitability. One such telltale pattern is a punishment strategy, where all firms lower price to ‘punish’ a renegade firm that reduces its price unilaterally. Then, after a period, all firms raise their price back to the previous, higher level. However, firms can always argue that external circumstances are responsible for the price moves. Furthermore, if collusion is extremely effective, you would not observe punishment behavior at all.

Question

Studies of pricing in the airline industry show that carriers that dominate hub airports (Delta in Atlanta, USAir in Pittsburgh, American in Dallas) tend to charge higher fares, on average, for flights in and out of the hub airport than other, non-dominate, carriers flying in and out of the hub. What might explain this pattern of prices?

Answer

There are several reasons why dominant hub airlines can charge higher prices than non- dominant carriers flying in and out of the hub. First, the convenience that a hub airline provides creates a differentiated product for which the airline can charge a premium. Second, the frequency that hub airlines provide reduces the number of substitute flights available for consumers. This shifts the demand for the hub airline out, reducing the price elasticity for the hub airline’s flights. And finally, smaller airlines may reduce prices below the hub airline prices because the dominant airline has little incentive to retaliate with a price war.

Question

It is often argued that price wars may be more likely to occur during low demand periods than during high demand periods. (This chapter makes that argument.) Are there factors that might reverse this implication? That is, can you think of reasons why the attractiveness of deviating from cooperative pricing might actually be greater during booms (high demand) than during busts (low demand)?

Answer

Deviation from cooperative pricing can occur during economic booms. During periods of high demand, gaining the dominant market share position will capture a higher percentage of industry profits. Also, recognizing the inevitable downturn in their market following a boom period, a firm may be tempted to capture profits to serve as a cushion during an economic downturn. Gaining a dominant market share is more profitable during a boom than during a downturn. Furthermore, if the firm can retain some of it increased share after the boom (through reputational effects, switching costs, etc.) it will be in a better position during the downturn. These factors may tempt a firm to deviate from cooperative pricing during a boom.

Question

Which predatory acts can be used to deter potential market entrants? Which ones instead are used to push opponents out of market? Do these actions optimize the actor payoff? Explain why.

Answer

Limit pricing consist in setting the sell price low enough to make it unprofitable for other players to enter the market.

Predatory pricing consist in lowering the sell price under the marginal cost to push an opponent out of market.

Actors are better off without applying these strategies, but they still pursue them because there is uncertanty about the future and they hope in limiting competition.

Question

What are the factors that an organization should consider when entering a market?
Which ones it should omit?

Answer

The things that a company should consider are:

• market concentration
• concenctration types (oligopoly, perfect competition, ...)
• potential future profits
• real options and opportunity costs
• five force analysis
• value net analysys
• incumbent benefits (learning economies, government subsidies, ...)

It should not account for sunk costs if these have already been occurred.

Dynamics: competing across time

Question

What is a grim trigger strategy in a two firm repeated game?

1. A strategy where a firm will always aggress regardless of how the other firm acts
2. A strategy where a firm will always cooperate regardless of how the other firm acts
3. A strategy in which a firm is prepared to match whatever changes in strategy the competitor makes
4. A strategy in which a firm initially cooperates and then aggresses for the rest of the game as soon as the opponent aggresses
5. A strategy in which a firm is prepared to aggress when its opponent cooperates and cooperate when its opponent aggresses

Answer

4

Question

Which of the following best describes a tit-for-tat strategy?

1. A firm charges a fixed price to every customer
2. A firm is prepared to match whatever change in strategy a competitor makes
3. A firm offers discounts for purchasing in quantity
4. A firm requires customers to enter into long-term purchase contracts
5. None of the above

Answer

2

Question

What are the main differences between the Stackelberg, Cournot and Bertrand models?

Answer

In the Cournot model two companies set at the same time the ideal quantity to produce to maximize their profits.

In the Bertrand model two companies set at the same time the ideal price to sell to maximize their profits.

In Stackelberg model two companies set at consequentely the ideal price to sell to maximize their profits.

Industry analysis

Question

How does the magnitude of scale economies affect the intensity of each of the five forces?

Answer

Economies of scale exist when the average cost of producing output declines as the absolute volume of output increases. Scale economies affect the number of competitors that can compete successfully in an industry. There are likely to be fewer firms in an industry with high scale economies relative to total industry output than in an industry where scale economies are exhausted at relatively low levels of output. Since there are fewer players, the established incumbents would each have large market share and incur low unit production cost.
In this context, scale economies will affect the five forces in the following way.

• Barriers to entry: Scale economies raise the entry barriers. To bring cost to a level comparable to those of existing players, an entrant would have to enter the industry with large capacity and risk strong reaction from the incumbents. An alternative would be to enter at a small scale and face a cost disadvantage. Both options are undesirable to new entrants.
• Rivalry: Scale economies can have competing effects on rivalry. On the one hand, scale economies may intensify rivalry because the players have the incentive to increase their market share to sustain and deepen their scale economies. Rivalry may take the form of price competition, advertising battles and new product introductions. On the other hand, scale economies may result in fewer firms that could facilitate communication and "peaceful coexistence" among industry players.
• Substitutes: Scale economies increase the threat of the substitute products. If the price-performance trade-off of a substitute product improves, firms within the industry lose share which reduces the industry’s own price-performance trade-off.
• Bargaining power of suppliers: If high scale economies result in fewer firms in the industry, it is possible that the bargaining power of suppliers decreases. Fewer firms could co-ordinate their purchases from suppliers, negotiating lower prices and thereby increasing value creation in the industry.
• Bargaining power of buyers: Using the same reasoning for supplier power, scale economies that lead to higher industry concentration could decrease the bargaining power of buyers. Fewer firms could co-ordinate their pricing activities, thereby reducing consumer surplus. On the other hand, however, the existence of scale economies increases the power of buyers who purchase very large quantities.

Question

How does the magnitude of consumer switching costs affect the intensity of internal rivalry? The extent of entry barriers?

Answer

The presence of switching costs would reduce the intensity of internal rivalry. Switching costs are costs that consumers incur when they switch from one supplier’s product to another’s. As such, consumers when faced with switching costs would not switch product unless a competitor can offer a major improvement in either price or performance. If switching costs are low, consumers are inclined to switch products when a competitor offers better price or service. This could result in price and service competition that would intensify the rivalry among competitors.

In the presence of consumer switching costs, the bar for entrants is set higher. The entrant may have difficulty attracting consumers away for incumbents. Entrants should expect to more easily attract consumers who have yet to participate in the product vs. the customers of existing firms.

Question

Consider an industry whose demand fluctuates over time. Suppose that this industry faces high supplier power. Briefly state how this high supplier power will affect the variability of profits over time.

Answer

Given an industry whose demand fluctuates over time and an input supplier with high supplier, the industry’s variability of profits would decrease. High supplier power exists when an input supplier is able to negotiate prices that extract profits from their customers. In this case, the supplier’s power would be reflected in his/her ability to change prices to reflect demand within the customer’s industry over any given period of time.

For example, if the industry is doing well, the supplier could raise prices to extract a share of the industry’s profits. Conversely, if the industry was doing poorly, the supplier could lower prices. The underlying demand volatility would be reflected in the supplier’s profits rather than the industry’s profits. The industry’s profits would stabilize (at a low level).

Question

What does the concept of "coopetition" add to the five forces approach to industry analysis?

Answer

Coopetition is the concept that the forces that shape industry profits are to a great extent the result of choices made by the individual firms within the industry. As these firms become more savvy regarding the reaction of rivals to their own actions, they will choose actions that reduce the likelihood of losing industry profits to price wars, consumer surplus, and/or ineffective negotiations with suppliers. As each firm comprehends its own role within the industry, firms can collectively fashion strategies which "cause" a force to have only a limited effect. If firms ignore the concept of "coopetition", they must resign themselves to simply reacting to the industry forces.

Question

Briefly describe the five forces of Porter's model and describe how they can arise strategic issues of an industry.

Answer

TODO

Strategic position and dynamics

Strategic positioning for competitive advantage

Question

How can the value chain help a firm identify its strategic position?

Answer

The value chain is a technique for describing the vertical chain of production. The value chain is also a useful device for thinking about how value is created in an organization. The value chain depicts the firm as a collection of value-creating activities, such as production operations, marketing and distribution, and logistics. Each activity in the value chain can potentially add to the benefit (B) that consumers get from the firm’s product and each can add to the cost (C) that the firm incurs in producing and selling the product.

A firm creates more value than competitors only by performing some or all of these activities better than they do. We can often categorize strategic positions into two broad categories, either a cost advantage or a differentiation advantage. If a firm outperforms other firms in activities that generate superior B (differentiation) or in activities that generate a lower C (cost), the firm’s strategic position should rely on these activities.

Question

Consider a market in which consumer indifference curves are relatively steep. Firms in this industry are pursuing two positioning strategies: some firms are producing a basic product that provides satisfactory performance; others are producing an enhanced product that provides performance that is superior to that of the basic product. Consumer surplus parity currently exists in the industry.
Are the prices of the basic and the enhanced product likely to be significantly different or about the same? Why?
How would the answer change if the consumer indifference curves were relatively flat?

Answer

Indifference curves illustrate price-quality combinations that yield the same consumer surplus. The fact that the indifference curve is steep means that consumers are willing to pay significantly more for a good that is of higher quality. Therefore, the prices of the basic and the enhanced product are likely to be significantly different. On the other hand, the prices of the two goods would be about the same if the consumer indifference curves were relatively flat. Flat indifference curves mean that consumers are not willing to pay much more money for a higher benefit.

Question

In the value-creation model presented in this chapter, it is implicitly assumed that all consumers get the identical value (e.g. identical B) from a given product. Do the main conclusions in this chapter change if consumer tastes differ, so that some get more value than others do?

Answer

The main conclusions of this chapter are as relevant if consumer tastes differ as when all consumers get identical value. If every consumer obtained a different B from a particular good, there would still exist meaningful segments that would be profitably served by particular firms—rather than each consumer enjoying the same consumer surplus, each would obtain a different surplus. Consumers would purchase as long as their consumer surplus was positive—this is true whether consumers have the same valuation or not. The fact that the level of surplus consumers received was different across consumers does not fundamentally change the analysis.

Question

Identify one or more experience good. Identify one or more search goods. How does the retailing of experience goods differ from the retailing of search goods? Do these differences help consumers?

Answer

An experience good is a product whose quality can be assessed only after the consumer has actually consumed the product. For example, a buyer could not decide if he likes the taste of a particular beverage until the buyer actually consumes the beverage. Sometimes the product has to be used for a while in order to understand fully how satisfying is consumption of the good. For example, a consumer may not be able to evaluate the quality of his automobile until he has driven that automobile for several weeks.

A search good is one whose objective quality attributes the typical buyer can easily access at the time of purchase. For example, a consumer could determine all the important attributes of a diamond at the time of purchase—wearing the diamond as an owner of the diamond does not generate any additional information.

With search goods, the potential for differentiation lies largely in enhancing the product’s observable features. When a firm is selling a search good that possesses attributes the seller wants the customer to know about, the customer does not have to take the seller at his word—the customer can observe the attributes. The seller must only provide an opportunity for the consumer to fully observe the good. Sellers who do not reveal the attributes of their products at the time of sale will lose sales to sellers who are willing to reveal their products fully to buyers or these sellers would have to heavily discount their prices. The seller’s reputation, however, is not in question—the attributes of the good speak for themselves.

When selling an experience good, sellers must often send signals to buyers that the good will not disappointment the buyer post-purchase. Since the buyer does not get to fully appreciate the good until after the good is consumed, the buyer buys under uncertainty. The seller’s reputation for delivering products that perform as promised becomes an important feature of the purchase process. The selling processes associated with search and experience goods help insure that consumers purchase goods closer to their "ideal" good. Both processes reduce the risks of buying under uncertainty—the attributes of search goods are revealed at the time of purchase and reputation and other credible signals are used to guide consumers in their purchases of experience goods.

Question

Recall from Chapter 2 Adam Smith’s dictum "The Division of Labor is Limited by the Extent of the Market." How does market growth affect the viability of a focus strategy?

Answer

Under a focus strategy, a firm concentrates either on offering a single product or serving a single market segment or both. Four examples of focus strategies are:

• Product specialization: the firm concentrates on producing a single type of product of a variety of different market segments
• Geographic specialization: the firm offers a variety of related products within a narrowly defined geographic market
• Customer specialization: the firm offers a variety of related products to a particular class of customers
• Niche strategy: a firm produces a single product for a single market segment

The basic economic logic of a focus strategy is that the firm is sometimes able to achieve deep economies of scale by concentrating on a particular segment or a particular product that is would be unable to exploit if it expanded beyond the segment or product it is concentrating on. The growth of a market can make a focus strategy that at one time was not feasible become a very profitable opportunity. Growth might also increase the benefits of economies of scale for the focuser. If a market grows to the point where a firm’s economies of scale are exhausted, the firm might have to worry about entry.

Question

"Firms that seek a cost advantage should adopt a learning curve strategy; firms that seek to differentiate their products should not."
Comment on both of these statements.

Answer

A learning curve strategy is one in which a firm seeks to reduce costs by learning. This is but one of many ways in which a firm can achieve a cost advantage. Other cost drivers include: economies of scale, economies of scope, capacity utilization, economies of density, process efficiency, government policy, and a firm’s location.
Learning curves can also confer quality advantages. If there is a first mover advantage in establishing a particular quality position (say the goods are experience goods), then it may pay to push aggressively down the learning curve to gain that quality advantage. Therefore, pursuing a learning curve strategy could be advantageous to both firms that seek a cost advantage and firms that seek to differentiate their products.

Question

Consumers often identify brand names with quality. Do you think branded products usually are of higher quality than generic products and therefore justify their higher prices? If so, why don’t all generic product makers invest to establish brand identity, thereby enabling them to raise price?

Answer

Establishing a brand name is very costly for firms. Large sums of capital must be invested continually over a long period of time before a firm earns a significant brand identity. In the sale of experience goods—goods whose quality cannot be assessed before they are purchased and used—the reputation for quality that a firm establishes can be a significant advantage. Consumers can reason that a firm who has invested continually in its brand identity is unlikely to chisel on quality and risk depreciating its precious brand image. In other words, incurring the cost of establishing a brand identity is a means for firms to signal to consumers that the firm offers quality products. Hence, the expectation is that branded products are of higher quality than generic products and should, therefore, garner higher prices.

We should not expect, however, that all sellers of experience goods would brand their goods. For certain goods consumers may be much more price sensitive than quality sensitive. A firm who incurs costly marketing may find itself unable to pass this cost on to customers who do not sufficiently value the signal that the firm is selling a higher quality product.

Also, establishing a brand identity is less attractive to sellers of search goods, or goods whose quality and other attributes can be established at the time of sale. Since the consumer can ascertain the quality of the product directly, signals of quality are not necessary. Hence, sellers of search goods might be better off selling their products under a generic label. Theoretically, a consumer should not pay a premium for a branded search good because the brand name does not confer any additional information.

Question

Consider a market in which consumer indifference curves are relatively steep.
Firmsin the industry are pursuing two positioning strategies: some firms are producing a basic productthat provides satisfactory performance;
others, are producing an enhanced product that provides perfomance superior to that of the basic product. Consumer surplus parity currently exists in the industry.
Are the prices of the basic product likely to be significantly different or about the same? Why?
How would the answer change if consumer indifference curves were relatively flat?

Answer

TODO

Question

How do economies of scale affect strategic positioning?

Answer

Economies of scales can allow for a cost leadership positioning.

Information and value creation

Question

Explain how many internet firms create value by solving the "shopping problem".

Answer

The customer’s shopping problem involves searching for the highest difference between the benefits and the price of a good.

This search can have a cost itself, but in recent years it has been lowered by services that allow to compare multiple customers simultaneously. In this way a customer can easily set keywords, filters and sort result to find the seller offering the best value for money.

Marketplaces and third party websites can also aim to reduce agency costs of online purchases: by offering customer review and reputation systems, they incentives actors to disclose their quality and act in a repeated game scenario: seller that honor the quality they claim and orders they receive will benefit from the trust of new customers.

Review systems may also help buyers to get more information about experience goods, that otherwise will need to be acquired before understanding their true quality.

Question

Why consumer cannot often obtain all the information they need about a product before purchasing it?

Answer

Due to the intrinsic properties of some goods called either experience or credence. The former only allow the customer to understand the real quality after a purchase, while it is not easy to understand the true value of credence goods even after the purchase.

Sustaining Competitive Advantage

Question

Identify and discuss four types of early-mover advantage.

Answer

Early movers benefit from their market timing in various ways:

• if they can create a product with high switching costs, it will be more difficult for customers to pick an alternative when they will appear later.
• if they are able to create a good quality product, the brand can benefit from loyalty and reputation
• by the time new entrants appear, a firm may have already achieved a the cumulative output necessary for learning economies
• they can also set standards, both in product features or acting as price leaders, by setting a price that its competitor may decide follow

Internal organization

Performance Measurement and Incentives

Question

Which of the following terms best describes a review system in which an employee's supervisor, coworkers and subordinates are all asked to provide information regarding that employee's performance over a period of time?

1. Traditional top down review system
2. 360-degree peer review system
3. Management-by-objective system
4. Subjective performance evaluation
5. Pay-for-performance

Answer

2

Question

Which of the following terms describes a contract based on information that cannot be observed by courts or arbitrators?

1. Explicit incentive contract
2. Implicit incentive contract
3. Risk sharing contract
4. Compensation contract
5. Pay-for-performance

Answer

2

Question

Referring to an implicit incentive contract, present the promotion tournament mechanism.

Answer

TODO

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Authors: Giacomo, Edoardo, Matteo, Luca