22 April 2021

Full points: 30
ECN 308E Competition Law and Policy First Midterm Solutions
Make sure to show all your working and calculations for significant partial credit. You must
show all the steps that you did to get to your answer. If you just give me the answer, you
will get 0 even if it is correct. I will also give you 0 if all you give me is a formula without
any working.
Good luck!
Please write your name and ITU ID number on your answer sheet.
Question 1
a) Increasing economic welfare is the primary objective of competition policy. Name three
other objectives of competition policy and how they may work against the primary
objective of increasing economic welfare. [6 points]
b) How can the following policies of the government make competition authorities and courts
adopt a weaker position on competition issues than economic considerations alone would
dictate:
i) environmental policy,
ii) industrial and trade policy? [4 points]
Question 2
A monopoly has an inverse market demand of 𝑃 = 100 − 𝑄 where 𝑃 is the market price and
𝑄 is the market quantity demanded and a constant marginal cost of $50. However, the
monopolist does not use the most advanced technology. If the monopolist was to use the most
advanced technology available, she would have a constant marginal cost of $10.
a) Find the monopoly’s total welfare loss. This will include the welfare loss owing to
allocative inefficiency and productive inefficiency. [5 points]

b) Find the monopoly’s welfare loss only due to productive inefficiency. [5 points]

Question 3

Consider the following duopoly Market A that is a market demand function 𝑄(𝑝). 2 firms
(Firm 1 and Firm 2) selling identical goods with equal constant unit costs 𝑐 compete
infinitely in repeated periods in prices 𝑝. In each period 𝑡, firms set prices simultaneously and
non-cooperatively. Firms have an identical discount 𝛿. Neither firm has a capacity constraint.
If both firms charge the same price 𝑝𝑖 = 𝑝𝑗 = 𝑝 (where 𝑝𝑖 is the price of Firm 𝑖 and where
𝑖 ≠ 𝑗 ) , Firm 1’s market share 𝑠1𝐴 is 0.8 and Firm 2’s market share 𝑠2𝐴 is 0.2. If Firm 𝑖 sets
a price 𝑝𝑖 < 𝑝𝑗 for 𝑗 ≠ 𝑖 then 𝑠𝑖𝐴 = 1 and 𝑠𝑗𝐴 = 0 where 𝑖 = 𝐴, 𝐵 (that is the lower-priced
firm gets all of the market demand).
Consider the following trigger strategy. At 𝑡 = 0 each firm sets 𝑝 = 𝑝𝑚 where 𝑝𝑚 is the price
that maximizes joint profits. At time 𝑡 it sets price as 𝑝𝑚 if all firms before that period 𝑡 have
set 𝑝𝑚 as their price. Otherwise, each firm sets 𝑝 = 𝑐.
a) Derive the two conditions (one incentive constraint for each of the firms) required for
Firm 1 and Firm 2 to sustain the collusive price of 𝑝𝑚 in Market A using the trigger
strategy described above. Also, indicate which of the two conditions is the binding
constraint for collusion. Make sure to show all your working. [5 points].
Now assume that there is another duopoly Market B in which Firm 1 and Firm 2 operate.
All the assumptions of Market A hold for Market B. The only difference is that if the firms
both charge the same price, Firm 1’s market share 𝑠1𝐵 is 0.9 and Firm 2’s market share 𝑠2𝐵
is 0.1.
b) State whether with the additional contact of the two firms in Market B the likelihood of
collusion has increased. Prove your answer. [5 points]
Answers
Question 1
a) [There are 5 other objectives of competition policy. But if you give me any 3 I will give
you full point].

Five other objectives of competition policy and why these objectives may be at odds with
increasing economic welfare are as follows. (1) Defence of smaller firms. Artificially helping
small firms survive that are operating at an inefficient scale of production is in opposition to
the welfare objective. (2) Promotion of market integration. According to this objective there
should be no price discrimination across borders of member European Union countries. But
by not allowing price discrimination, a producer may lose an entire national market if she
chooses to charge a price that is the equilibrium price of another national market and is higher
than the equilibrium price at the market she loses. This may cause a decrease in overall
economic welfare. (3) Economic freedom. Economic freedom would disallow any vertical
restraints such as territorial restraints and resale price maintenance. But such contracts are
known to increase economic welfare at times. (4) Fighting inflation. Price controls may be
instituted to fight inflation but they may lead to increasing economic inefficiency and have
very little effect on actually fighting inflation. (5) Fairness and equity. This objective may
force dominant firms not to charge excessive prices but excessive prices may act as an
incentive for the firms to innovate and market their good (dynamic efficiency). This objective
also may cause competition policy to protect smaller firms by forcing larger firms to charge
higher prices. Smaller firms are sometimes less efficient than larger firms because of
economies of scale.

b) i) By having quality standards on products, environmental policy may cause competition in

quality to be restricted among firms.

ii) Industrial and trade policy sometimes entail favouring inefficient domestic firms by
subsidizing them or making laws in their favour at the expense of more efficient foreign
firms.
Question 2
The total revenue function 𝑇𝑅(𝑄) is:
𝑇𝑅(𝑄) = (100 − 𝑄)𝑄.
Differentiating with respect to 𝑄, we find the marginal revenue function 𝑀𝑅(𝑄):
𝑀𝑅(𝑄) = 100 − 2𝑄.
The monopolist produces at the output level 𝑄 𝑚 where her marginal cost equals the marginal
revenue:
50 = 100 − 2𝑄 𝑚 ,
∴ 𝑄 𝑚 = 25 .
This also implies that the monopoly price is 𝑃𝑚 = 100 − 25 = 75.
If the monopolist used the most advanced technology like a competitive firm her output level
𝑄 𝑚′ would be:
10 = 100 − 2𝑄 𝑚′ ,
∴ 𝑄 𝑚′ = 45 .
And her monopoly price is 𝑃𝑚′ = 100 − 45 = 55.
The figure below shows the situation.

a) The shaded region shows the total welfare loss from monopoly.
The total welfare loss is the area of the rectangle ABCD and the triangle ECF. To find this
area we also need to calculate the output level at which the constant marginal cost line at $10
intersects with the demand function. This is the competitive level of output 𝑄 𝑐 :
10 = 100 − 𝑄 𝑐 ,
∴ 𝑄 𝑐 = 90 .
The total welfare is thus:
1
𝑇𝑜𝑡𝑎𝑙 𝑤𝑒𝑙𝑓𝑎𝑟𝑒 𝑙𝑜𝑠𝑠 = [(50 − 10) × 25] + [2 × (90 − 25) × (75 − 10)],

∴ 𝑻𝒐𝒕𝒂𝒍 𝒘𝒆𝒍𝒇𝒂𝒓𝒆 𝒍𝒐𝒔𝒔 = $𝟑𝟏𝟏𝟐. 𝟓𝟎.

b) The welfare loss only due to productive inefficiency can be found by subtracting the area
of the triangle HIF from the total welfare loss. The triangle HIF is the deadweight loss
only due to allocative inefficiency. This region is shown in the shaded region in the figure
below.
The shaded area can be found by subtracting the area of the right trapezoid AGED from the
area of the right trapezoid BGEC.
1
𝑊𝑒𝑙𝑓𝑎𝑟𝑒 𝑙𝑜𝑠𝑠 𝑑𝑢𝑒 𝑡𝑜 𝑝𝑟𝑜𝑑𝑢𝑐𝑡𝑖𝑣𝑒 𝑖𝑛𝑒𝑓𝑓𝑖𝑐𝑖𝑒𝑛𝑐𝑦 = 3112.5 − [2 × (55 − 10) ×
(90 − 45)],

∴ 𝑾𝒆𝒍𝒇𝒂𝒓𝒆 𝒍𝒐𝒔𝒔 𝒅𝒖𝒆 𝒕𝒐 𝒑𝒓𝒐𝒅𝒖𝒄𝒕𝒊𝒗𝒆 𝒊𝒏𝒆𝒇𝒇𝒊𝒄𝒊𝒆𝒏𝒄𝒚 = 𝟑𝟏𝟏𝟐. 𝟓 − 𝟏𝟎𝟏𝟐. 𝟓 = $𝟐𝟏𝟎𝟎.

Question 3
a) The incentive constraint for firm 𝑖 = 1,2 is given by
𝑠𝑖𝐴 (𝑝𝑚 −𝑐)𝑄(𝑝𝑚 )
− (𝑝𝑚 − 𝑐)𝑄(𝑝𝑚 ) ≥ 0,
1−𝛿

𝑖𝑠𝐴
⇒ 1−𝛿 − 1 ≥ 0,

⇒ 𝑠𝑖𝐴 ≥ 1 − 𝛿,

⇒ 𝛿 ≥ 1 − 𝑠𝑖𝐴 . (1)
Substituting the values of 𝑠1𝐴 and 𝑠2𝐴 into Inequality (1), we get the incentive constraints
for Firm 1 and Firm 2 respectively:
𝜹 ≥ 𝟎. 𝟐, (2)
𝜹 ≥ 𝟎. 𝟖. (3)
 Inequality (2) is the incentive constraint for Firm 1 and Inequality (3) is the incentive
constraint for Firm 2. The incentive constraint for Firm 2 Inequality (3) is the binding
constraint.
b) With multi-market contact the incentive constraint for firm 𝑖 = 1,2 is given by:
𝑠𝑖𝐴 (𝑝𝑚 −𝑐)𝑄(𝑝𝑚 ) 𝑠𝑖𝐵 (𝑝𝑚 −𝑐)𝑄(𝑝𝑚 )
+ − 2(𝑝𝑚 − 𝑐)𝑄(𝑝𝑚 ) ≥ 0,
1−𝛿 1−𝛿
⇒ 𝑠𝑖 + 𝑠𝑖𝐵
𝐴
≥ 2 − 2𝛿,
(𝑠𝑖𝐴 +𝑠𝑖𝐵 )
⇒𝛿 ≥1− . (4)
2

Substituting the values of 𝑠1𝐴 , 𝑠1𝐵 , 𝑠2𝐴 and 𝑠2𝐵 into Inequality (4), we get the incentive
constraints for Firm 1 and Firm 2 respectively:
𝜹 ≥ 𝟎. 𝟏𝟓, (5)
𝜹 ≥ 𝟎. 𝟖𝟓. (6)
With multi-market contact, we see again Firm 2’s incentive constraint Inequality (6) is
binding.
Comparing the binding constraints with single-market contact (Inequality (3)) and with multi-
market contact (Inequality (6)), we find the likelihood of collusion decreases with multi-
market contact. This is because Inequality (6) is a tighter constraint than Inequality (3). In
this case, multi-market contact decreases the probability of collusion because it decreases
firm symmetry instead of increasing it.