Exam questions

Question 1

Give two reasons for unrelated diversification that are not efficiency enhancing

Answer 1

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.

Question 2

Explain the relationship between the concepts of “relationship-specific investments” and sunk costs.

Answer 2

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

Question 3

Is the statement true or false: “The value of a strategic commitment is higher in industries with greater horizontal differentiation, everything else equal.”

Answer 3

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).

Question 4

What is throughput and why is it important for reaching economies of scale?

Answer 4

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

Question 5

In a perfectly competitive market, is a firm’s demand more or less elastic than market demand? Explain your answer

Answer 5

In perfect competition, a firm’s demand is infinitely elastic, so “more”.

Question 6

Explain why uniform-delivered pricing may facilitate collusion.

Answer 6

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.

Question 7

According to the so-called sunk cost effect, are large firms more or less innovative than potential entrants? Explain your answer.

Answer 7

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.

Question 8

What is the so-called Hold-up Problem? Is this problem positively or negatively related to the amount of quasi-rent? Explain your answer.

Answer 8

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

Question 9

According to the so-called efficiency effect, is an incumbent monopolist more or less innovative than a potential entrant.

Answer 9

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

Question 10

What is the Innovator’s Dilemma?

Answer 10

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

Question 11

What is the essence of the replacement effect (the innovator’s dilemma)?

Answer 11

An entrant has more to gain from innovation than a monopolist. An entrant can replace a monopolist, but a monopolist can only replace itself.

Question 12

What is the essence of the efficiency effect?

Answer 12

The incentive to innovate from an incumbent of stronger than that from a potential entrant. The Incumbent wants to keep the entrant out.

Question 13

What is the essence of the sunk cost effect? (innovator’s dilemma)

Answer 13

Commitment to technology with sunk costs will create bias. A firm that has not yet committed to technology is not biased.

Question 14

What is the essence of the productivity effect?

Answer 14

How a firm spreads its resources for the most effective way of research. Incumbents are often betters at the allocation of research dollars.

Question 15

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?

Answer 15

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)

Question 16

What is a relationship-specific investment?

Answer 16

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)

Question 17

What are the reasons to make?

Answer 17

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

Question 18

Vertical integration is more attractive when…

Answer 18

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

Question 19

What are structural entry barriers?

Answer 19

Control of essential resources
Economies of scale and scope
Marketing advantages of incumbency

Question 20

What are entry-deterring strategies that create high entry costs?

Answer 20

Aggressive price reductions to move down the learning curve
Intensive advertising to create brand loyalty
Acquisition of patents for all variants of a product

Question 21

What are entry-deterring strategies that change an entrant’s expectation of post-entry competition?

Answer 21

Enhancement of firm’s reputation for predation through the announcement
Limit pricing
Holding of excess capacity

Question 22

What is the folk theorem?

Answer 22

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

Question 23

What are the impediments to imitation?

Answer 23

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

Question 24

What is throughput and why is it important for reaching economies of scale?

Answer 24

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

Question 25

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

Answer 25

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.

Question 26

What is the revenue destruction effect?

Answer 26

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.

Question 27

In a perfectly competitive market, is a firm’s demand more or less elastic than market
demand? Explain your answer

Answer 27

In perfect competition, a firm’s demand is infinitely elastic, so “more”.

Question 28

What is judo economics and how is judo economics related to the revenue destruction effect?

Answer 28

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.

Question 29

Explain Sutton’s theory of endogenous sunk costs

Answer 29

Sunk investments by incumbents that create barriers to entry

Question 30

Explain why uniform delivered pricing may facilitate collusion. (2 points)

Answer 30

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.

Question 31

According to the so-called sunk cost effect, are large firms more or less innovative than potential entrants? Explain your answer.

Answer 31

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.

Question 32

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

Answer 32

The numbers equivalent is 3 and the market structure is oligopolistic

Question 33

What three criteria must be fulfilled if a commitment is to be successful.
Describe each one and explain its importance (3 points)

Answer 33

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

Question 34

Describe three of the taxonomy of business strategies

Answer 34

• 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

Question 35

What is the difference between influence cost and agency cost?

Answer 35

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.

Question 36

What is tapered integration?

Answer 36

Tapered integration represents a mixture of vertical integration and market exchange

Question 37

Name two factors that prevent complete contracting. Explain

Answer 37

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.

Question 38

Is asset specificity positively or negatively related to quasi-rent? Explain.

Answer 38

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

Question 39

It is often argued that a firm should integrate backwards to capture the profits of their suppliers. Explain why this argument is incorrect.

Answer 39

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

Question 40

Name three sources of economies of scale and scope

Answer 40

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

Question 41

Is marginal revenue positive or negative when demand is inelastic? Explain

Answer 41

Marginal revenue is negative. Here, the increase in output brought about by a reduction in price will lower total sales revenue

Question 42

Explain why it is not necessary to have economies of scale to realize learning economies.

Answer 42

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.

Question 43

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.

Answer 43

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.

Question 44

One popular method to determine the relevant market is the SSNIP test. Explain how this test works.

Answer 44

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.

Question 45

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?

Answer 45

The 4-firm concentration ratio is 0.80 (or 80%) (1 point) and the Herfindahl is 0.25 + 0.05 = 0.3

Question 46

What is the so-called Hold-up Problem? Is this problem positively or negatively related to the amount of quasi-rent? Explainyour answer.

Answer 46

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).