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Advanced Industrial Organization: Problem Set 3

CRN 25965 - ECON 485 B Pascal Courty University of Victoria

Exercise 1  Counot tacit collusion (40%, 40 words per answer on average)

n firms compete in a market. The market inverse demand is  P (q ) = a − q  andfirms have the same marginal cost. The discount factor is  δ .

1. (a) Derive the static monopoly quantity and profits and the static Cournotquantity and profits. (b) Assume n − 1 firms agree to produce   q . Whatare the optimal deviation profits that the  nth firm can obtain.

2. (a) What are the discounted profits that firms can obtain if they agreeto jointly produce the monopoly quantity and to equally share the mar-ket? What are the discounted profits that a firm can obtain if it deviatesassuming that other firms will play Cournot forever after? What is theminimum discount factor such that tacit collusion is possible?

Exercise 2   Research Article (60%, 40 words per answer on average)

A study of cartel stability: the joint executive committee, 1880-1886. RobertPorter. The Bell Journal of Economics, 1983.

The objective of the paper is to investigate (a) whether changes in firmbehavior explain price and quantity movements and (b) what triggered changesin firm behavior over time.

1. The author argues on page 312 that he can ‘overwhelmingly reject thehypothesis that no switch occurred’. (a) What does this mean? (b) What

feature of the raw data can explain this finding?2. On page 313, the author argues that ‘breakdowns in market discipline

have been attributed to demand slumps’. To show that demand slumpcould trigger price wars, use the model of tacit collusion in Chapter 14(page 346) and assume that firms learn that demand will be lower thanexpected in the future. Show that this can trigger a price war? Call thishypothesis for price wars H1.

3. (a) In the model of tacit collusion (page 346), do firms need to observetheir competitor’s action to implement the grim strategy equilibrium? (b)Assume that demand is random. Could the inability of observing competi-tor’s action trigger price wars? Read subsection 14.2.5 and briefly sketchan equilibrium with price wars that could result. Call this hypothesis forprice wars H2.

4. Can one distinguish between H1 and H2 as candidate explanations forprice wars on the basis of the evidence presented? What piece(s) of evi-dence is key?

5. Summarize the explanation for price wars proposed in the paper.

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