Exam questions Flashcards
Give two reasons for unrelated diversification that are not efficiency enhancing
A) Diversification of the portfolio benefits shareholders by reducing risks
B) Managerial reasons: managers favor growth as size is related to prestige, higher salary, and lower dismissal risk.
Explain the relationship between the concepts of “relationship-specific investments” and sunk costs.
Relationship-specific investments involve costs/investments (made to enhance the efficiency of inter-firm transaction relationships) that are at least partially sunk costs: once made, the firm cannot recoup these costs, and they cannot use the investments -with the same efficiency- for a different transaction.
Relationship specific investments related sunk costs make firms stick to their transaction partner, even if the partner can appropriately have “quasi-rents” from the firm through holdup (prices only have to be above the variable costs or the next best alternative sales opportunity
Is the statement true or false: “The value of a strategic commitment is higher in industries with greater horizontal differentiation, everything else equal.”
FALSE (2p).
With more differentiation, an aggressive move, e.g., a cost reduction or plant investment, has less effect on rivals and, most important, does not affect the rival’s strategy much. The direct (beneficial) effect of strategic commitment dominates over indirect strategic effects (2p).
What is throughput and why is it important for reaching economies of scale?
Throughput is the amount of products (inputs) that move through a production process in a given amount of time. It is important to ensure scale economies. Having a large production capacity is not sufficient, the firm also needs a sufficiently large production level, i.e., throughput
In a perfectly competitive market, is a firm’s demand more or less elastic than market demand? Explain your answer
In perfect competition, a firm’s demand is infinitely elastic, so “more”.
Explain why uniform-delivered pricing may facilitate collusion.
This applies when firms are geographically dispersed and transportation costs are high (e.g., cement). Under uniform delivered pricing, the firm quotes a single delivered price for all buyers and absorbs the freight charges itself. It facilitates cooperative pricing by allowing firms to make more surgical responses to price cutting by rivals. That is, it only has to retaliate by cutting prices for some of its customers which makes it less costly and more credible.
According to the so-called sunk cost effect, are large firms more or less innovative than potential entrants? Explain your answer.
Large established firms have sunk investments in some technology and ignore these sunk costs in evaluating the various technological alternatives. For a potential newcomer these upfront investments in the technology are not (yet) sunk. Accordingly, the incumbent values its technology more than the potential entrant and is therefore less likely to invest in a new technology.
What is the so-called Hold-up Problem? Is this problem positively or negatively related to the amount of quasi-rent? Explain your answer.
The hold-up problem is the problem that arises when a party in a contractual relationship exploits the other party’s vulnerability due to relationship-specific assets. The quasi-rent is the difference between the profit you get when everything goes ahead as planned and the profit you get from your next-best option. This implies that the problem of the hold-up is bigger the larger the quasi-rent, all else equal
According to the so-called efficiency effect, is an incumbent monopolist more or less innovative than a potential entrant.
The efficiency effect highlights that large established firms have more to lose from another firm’s entry than that firm has to gain from entering the market. Hence, the efficiency effect makes the incumbent’s incentive to innovate stronger than that of a potential entrant
What is the Innovator’s Dilemma?
The innovator’s dilemma is the problem that arises when innovative investments by incumbents cannibalize their successful business model while failure to innovate may invite entry
What is the essence of the replacement effect (the innovator’s dilemma)?
An entrant has more to gain from innovation than a monopolist. An entrant can replace a monopolist, but a monopolist can only replace itself.
What is the essence of the efficiency effect?
The incentive to innovate from an incumbent of stronger than that from a potential entrant. The Incumbent wants to keep the entrant out.
What is the essence of the sunk cost effect? (innovator’s dilemma)
Commitment to technology with sunk costs will create bias. A firm that has not yet committed to technology is not biased.
What is the essence of the productivity effect?
How a firm spreads its resources for the most effective way of research. Incumbents are often betters at the allocation of research dollars.
What are the four attributes Poters identifies in a firm’s home market that promote or impede a firm ability to achieve competitive advantage in global markets?
Factor conditions (describe a nation’s positions regarding factors of production)
Demand conditions (include size, growth, and character of home demand for the firm’s products)
Related supplier or support industries (suppliers or support with strong internationally work in favor)
Strategy, structure, and rivalry (context of competition)
What is a relationship-specific investment?
Relationship-specific investments are investments made to make a transaction with a partner firm more efficient. They create value but are at the same time only useful for that specific transaction (relationship specific)
What are the reasons to make?
Incomplete contracting
Coordination of production flow through the vertical chain
To avoid leakage of private information
Avoid paying transaction costs
relationship-specific assets causing them not to switch partners
To avoid rents and quasi-rents
To avoid the holdup problem
Vertical integration is more attractive when…
When the ability of the outside market specialist is limited
The larger the scale of the firm’s product market activities
The greater the extent to which involved in production are relationship-specific
What are structural entry barriers?
Control of essential resources
Economies of scale and scope
Marketing advantages of incumbency
What are entry-deterring strategies that create high entry costs?
Aggressive price reductions to move down the learning curve
Intensive advertising to create brand loyalty
Acquisition of patents for all variants of a product
What are entry-deterring strategies that change an entrant’s expectation of post-entry competition?
Enhancement of firm’s reputation for predation through the announcement
Limit pricing
Holding of excess capacity
What is the folk theorem?
The folk theorem implies that cooperative pricing behavior is a possible outcome in an oligopolistic industry, even if all firms act unilaterally
If firms expect to interact indefinitely and have sufficiently low discount rates, then any price between the monopoly price and marginal cost can be sustained as an equilibrium
What are the impediments to imitation?
Legal restrictions
Superior access to inputs or customers
Market size and scale economies
Intangible barriers to imitating a firm’s distinctive capabilities: causal ambiguity,
dependence on historical circumstances, and social complexity
What is throughput and why is it important for reaching economies of scale?
Throughput is the amount of products (inputs) that move through a production process in a given amount of time. It is important to ensure scale economies. Having a large production capacity is not sufficient, the firm also needs a sufficiently large production level, i.e., throughput
Suppose that a firm is a cost leader and that its demand is price elastic. What type of strategy should this firm adopt to exploit its competitive advantage? What type of strategy should this firm adopt when its demand is price inelastic? Explain
When its demand is price elastic, it should adopt a share strategy. This is because a price cut will gain lots of market share. The key here is to exploit the competitive advantage through a higher market share. When demand is price inelastic, it should adopt a margin strategy. The key here is to exploit the advantage through higher profit margins as a price cut gains little share.
What is the revenue destruction effect?
The pursuit of individual self-interest does not maximize the profits of the group as a whole. This is known as the revenue destruction effect. Smaller firms are often most willing to disrupt pricing stability.
In a perfectly competitive market, is a firm’s demand more or less elastic than market
demand? Explain your answer
In perfect competition, a firm’s demand is infinitely elastic, so “more”.
What is judo economics and how is judo economics related to the revenue destruction effect?
Judo economics is the recognition that small firms and potential entrants can use the incumbent’s size to their own advantage. The revenue destruction effect states that a large incumbent loses more revenue when slashing prices than smaller rivals.
Explain Sutton’s theory of endogenous sunk costs
Sunk investments by incumbents that create barriers to entry
Explain why uniform delivered pricing may facilitate collusion. (2 points)
This applies when firms are geographically dispersed and transportation costs are high (e.g., cement). Under uniform delivered pricing, the firm quotes a single delivered price for all buyers and absorbs the freight charges itself. It facilitates cooperative pricing by allowing firms to make more surgical responses to price cutting by rivals. That is, it only has to retaliate by cutting prices for some of its customers which makes it less costly and more credible.
According to the so-called sunk cost effect, are large firms more or less innovative than potential entrants? Explain your answer.
Large established firms have sunk investments in some technology and ignore these sunk costs in evaluating the various technological alternatives. For a potential newcomer, these upfront investments in the technology are not (yet) sunk. Accordingly, the incumbent values its technology more than the potential entrant and is therefore less likely to invest in new technology.
Suppose that the Herfindahl index in a market is roughly 0.33. What is the numbers
equivalent of firms in this market? What type of market structure characterizes this industry
The numbers equivalent is 3 and the market structure is oligopolistic
What three criteria must be fulfilled if a commitment is to be successful.
Describe each one and explain its importance (3 points)
It must be credible, visible irreversible and understandable
Irreversible: The firm can back down if the commitment does not have the desired effect
Visible and understandable: It must be visible and understandable or rivals will have nothing to react to
Credible: It must be credible so that rivals believe the firm will actually carry out the commitment
Describe three of the taxonomy of business strategies
- Fat cat: Compliment, Soft and make Confidently take care of self
- Top dog: Substitutes, Tough and make Assert dominance
- Puppy dog ploy: Compliment, Tough refrain placate top dog and enjoy available scraps
What is the difference between influence cost and agency cost?
Agency costs are the costs associated with shirking and the administrative controls to deter it. Influence costs are the costs of activities aimed at influencing the distribution of benefits inside an organization.
What is tapered integration?
Tapered integration represents a mixture of vertical integration and market exchange
Name two factors that prevent complete contracting. Explain
Bounded rationality: Bounded rationality refers to limits on the capacity of individuals to process information, deal with complexity, and pursue rational aims. Boundedly rational parties cannot contemplate or enumerate every contingency that might arise during transaction.
Assymmetric information: Even if the parties can foresee all contingencies and specify and measure relevant performance dimensions, a contract may still be incomplete because the parties do not have equal access to all contract information. If one party knows something that the other does not, then information is assymmetric.
Is asset specificity positively or negatively related to quasi-rent? Explain.
asset specificity is positively related to quasi-rent because more specific assets tend to have a greater difference between their best use and their next best use, leading to higher quasi-rents
It is often argued that a firm should integrate backwards to capture the profits of their suppliers. Explain why this argument is incorrect.
This argument is incorrect because the flaw stems from the difference between accounting profit and economic profit.
Accounting profit is the simple difference between revenues and expenses
Economic profit, by contrast, represents the difference between the accounting profits from a given activity and the accounting proftis from investing resources in the most lucrative alternative activity
Economic profit is in that sense much more useful for business desicions.
Therefore, even if an upstream supplier is making accounting profits, this does not imply that it is making economic profits or that a downstream manufacturing firm could increase its own economic profits by internalizing the activity
Name three sources of economies of scale and scope
Purchasing: Larger purchasers can get better prices by reducing seller cots or by demonstrating greater willingness to shop around
Advertising: Fixed costs of producing advertisemnets generate scale economies; umbrella branding spread marketing costs over more customers
Inventories: Consolidating inventories reduces stocking and outage costs
Is marginal revenue positive or negative when demand is inelastic? Explain
Marginal revenue is negative. Here, the increase in output brought about by a reduction in price will lower total sales revenue
Explain why it is not necessary to have economies of scale to realize learning economies.
Within a given time period, a firm may have constant costs of production. Yet, these costs may be lower at all output levels in subsequent periods.
What do economist mean with the minimum efficient scale of production (MES)? Suppose that in some given industry the available technology is such that average cost equals marginal cost at all output levels. What is the MES in this industry? Explain your answer.
The MES is the smallest level of output at which economies of scale are exhausted. (1 point) Since marginal costs are constant, the minimum efficient scale is zero.
One popular method to determine the relevant market is the SSNIP test. Explain how this test works.
The SSNIP stands for “small but significant nontransitory increase in price”. It basically asks whether a proposed group of firms can increase its profits through a price increase of 5% for at least one year. If so, there is limited outside competition. If not, then the relevant market is larger than this group of firms.
Consider a market with one dominant firm and five smaller equal-sized competitors. The dominant firm has a market share of 50%. What is the 4-firm concentration ratio in this industry? And, what is the Herfindahl-index in this industry?
The 4-firm concentration ratio is 0.80 (or 80%) (1 point) and the Herfindahl is 0.25 + 0.05 = 0.3
What is the so-called Hold-up Problem? Is this problem positively or negatively related to the amount of quasi-rent? Explainyour answer.
The hold-up problem is the problem that arises when a party in a contractual relationship exploits the other party’s vulnerability due to relationship specific assets.The quasi-rent is the difference between the profit you get when everything goes ahead as planned and the profit you get from your next-best option. This implies that the problem of hold-up is bigger the larger is the quasi-rent, all else equal. Hold-up problem correct (1 point), relation with quasi-rent correct (1 point), explanation correct (1 point).
