BUSINESS AND INDUSTRIAL ECONOMICS [A-L]

A.Y. 2018/2019

Final exam – July 12th, 2019

Solutions

NAME _____________________________________ SURNAME ____________________________________

STUDENT ID (Matricola)____________________________________________________________________

MULTIPLE-CHOICE QUESTIONS
Please, indicate your answers in the following table. We will consider and evaluate only answers reported
in this table. You do not need to provide explanations for your answers. However, if you want to add a note
to an answer (e.g., an assumption, a clarification, an explanation), please write “YES” in the last column.

Question A B C D Notes
1 X
2 X
3 X
4 X
5 X
6 X
7 X
8 X
9 X
10 X
11 X
12 X
13 X
14 X
15 X

Notes to the questions

1
STRUCTURED QUESTIONS

Exercise
a) Consider two firms having the same marginal cost of production MC = 0, but producing slightly different goods.
Specifically, firm 1 faces the demand y1 = 27 - 0.5p1 + 0.7p2, while firm 2 faces the demand y2 = 27 - 0.5p2 + 0.7p1.
Find the equilibrium when the two firms compete on prices and play their strategies simultaneously and
independently. Does the Bertrand paradox arise in this case? Explain. [3 points]

 Each firm maximizes its own profit, which is function of the quantity produced by both of them:
o π1(y1,y2) = R1 - C1 = y1*p1 - y1*MC = (27 – 0,5p1 + 0,7p2)*p1 = 27p1 – 0,5p12 + 0,7p1p2
o π2(y1,y2) = R2 - C2 = y2*p2 – y2*MC = (27 – 0,5p2 + 0,7p1)*p2 = 27p2 – 0,5p22 + 0,7p1p2

 Applying the first order condition:

 Solving the system:

 no Bertrand paradox because goods produced not homogenous

b) Pamela owns a restaurant and hired Andres as a worker for her kitchen. The daily revenue can be either XH =
80 or XL = 40. The revenue depends on two things: demand and Andres’ effort. Andres can work hard e = 1 or be
lazy e = 0. If Andres works hard the probability of success is 0.7; if Alfred is lazy the probability of success is 0.2.
Pamela, who is the principal, is risk-neutral and maximizes her (expected) profits πP = X − w, where w is the wage
she will pay to Andres. Andres (agent) is risk-averse and has payoff πA = √𝑤−e (notice that this is his utility of
wealth net of the cost of exerting the effort). Instead of working in the restaurant Andres could work in a bar for
36 dollars a day which would involve effort (e=1).
Suppose that the effort is observable. Find the profit-maximizing wage if (i) Pamela wants Andres to be lazy (ii)
Pamela wants Andres to work hard. Which level of effort would Pamela choose? [2,5 points]

If effort is observable, then in order to max her profits Pamela only needs to offer the lowest acceptable wage to
Andres in either case. Wages offered by the principal should be high enough so that agents payoff from
participating in the project is at least as high as agent’s reservation utility (value of the outside option). If P
wants A to be lazy, she just needs to pay him the same as what he’ll get at the bar √36−1, which is $25, which
results in an equivalent payoff of 5.
If she wants him to work hard, then she needs to satisfy √36−1, = 5, so w = 36 (that is provided he works hard,
which she can verify, and pay him nothing otherwise).
P wants to max her profits, so she’ll choose the level of effort that results in higher expected profits for her.
If she contacts A to exert low effort level her expected payoff is πP (e = 0) = 0.2 · 80 + 0.8 · 40 − 25 = 16 + 32 −
25 = 23.
If she contacts A to exert high effort level, her expected payoff is πP (e = 1) = 0.7 · 80 + 0.3 · 40 − 36 = 56 + 12 −
36 = 32.
πP (e = 0) < πP (e = 1), Pamela will prefer Andres to work hard.

2
c) Assume a homogeneous good market for cellular phones with only five firms present in the market, in which
each firm acts as if it has a “share-of-the-market” demand curve of 20 percent of the market demand. The market
demand is Q=100-P. All cellular phone producers have constant marginal and average costs of $50. Initially the
price is $50.
Firm 1 and 2 have decided to merge. They can lower their costs of production from $50 to $48 because of
economies of scale of combined operations. They expect that as the market leader they can lead the industry to a
price of $60. If social benefits and costs are computed on an “industry-wide” basis, should the merger be approved?
[2,5 points]
1: social surplus pre-merger:

P=50, Q=100 - 50 = 50

Maximum price paid is 100

CS0 = 1/2 (100 – 50)(50-0) = 1250

PS0 = 0

TS0=1250

1: social surplus post-merger:

P=60, Q=100 - 60 = 40 (q=8 for each)

CS1 = 1/2 (100 – 60)(40-0) = 800

PS1 = PS received by firms 1 and 2 + PS received by firms 3, 4 and 5

(60-48)*16 + (60-50)*24 = 432

TS1=800+432=1232

TS1<TS0 Merger NOT approved

3
Mini-case [7 points]

Read the following mini-case and answer the following questions basing on the concepts and models that
we have studied in class.
Although the flood of Internet IPOs has abated over the past year, scores of freshly minted public companies
continue to play a central role in shaping the new economy. The health of these companies hinges to a large
degree on the strength of their leaders, including their boards of directors. Unfortunately, the makeup of
many of their boards is deeply flawed, compromising their ability to provide independent oversight and to
act in the best long-term interests of the companies and their public shareholders. In our review of 50 of
1999's largest Internet IPOs, we found that the typical board has seven directors: two members of
management, two venture capitalists, one other significant shareholder, and only two independent,
"outside" directors. No doubt, there are advantages to this lean structure. The small size and cohesiveness of
such a board, together with the high level of commitment and industry knowledge of its directors, can help a
start-up move with the speed and flexibility that the new economy demands. But that advantage comes at
too high a price. For one thing, these boards lack the independence from management that's critical to
effective oversight. When outside directors are outnumbered by insiders- company executives and
venture capitalists – a board cannot be trusted to monitor management's decisions and actions objectively.
This is particularly true when insiders are in control of the board's compensation and audit committees, and
that's often the case at newly public, venture-backed companies today.
From Lorsch J.W., Zelleke A.S., Pick K. (2001) Unbalanced boards. Harvard Business Review
1. Why, in board of directors, is it crucial to have a good balance between insiders and outside directors? [3
points]?
 The board of directors is a specialized monitoring entity, which serves the purpose of controlling
that managers act in the interest of the owners (e.g., shareholders)
 Outside directors assure an impartial monitoring, but they may lack firm-specific knowledge
 Insiders do possess firm-specific knowledge, but they may champion the interest of the managers
at the detriment of the owners
 Thus, a good balance between insiders and outside directors assures both impartial monitoring
and the availability of firm-specific knowledge
2. What are the advantages and disadvantages of having venture capitalists sitting in the board of directors
of startups? [3 points]
 Advantage: Venture capitalists
o Often bring to the firm industry-specific knowledge
o Coach the management
o Act to maximize firm’s value
o Signal the good quality of the firm
 Disadvantage: Venture capitalists
o Sometimes aim at a quick exit, thus maximizing short term instead of long term value
o May disagree with the management on the right course of action
3. Provide one example for the following statement “the board of directors can signal the quality of the firm”
[1 points]
 A biotech startup appoints a famous scientist in biology on its board of directors
 The reputation of the scientist acts as a signal of the firm quality
 Indeed, if the firm were not of good quality the scientist would not have accepted the offer