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Vertically Integrated - Industrial Organization - Past Exam, Exams of Industrial management

Tezpur UniversityIndustrial management

Vertically Integrated, Marginal Costs, Differentiated Products, Downstream Firms, Repeated Game, Monopoly Outcome, Marginal Costs, Vertically Integrated, Equilibrium Strategies, Integrated Firm. Above mentioned are some hints to Industrial Organization exam paper.

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Industrial Organization Field Exam, August 2008
Answer both questions. (Question II has a multi-page text for analysis.)
Question I:
Consider an industry with M upstream firms and N downstream firms. All of the firms
have zero marginal costs and zero fixed costs. The upstream firms produce a homogenous
product and, if not vertically integrated, compete in price. The downstream firms sell
differentiated products and compete in price. Let be the joint monopoly profit for the
industry.
a) Suppose the firms are not vertically integrated. The upstream firms offer two-part
tariffs (w,F) to each of the downstream firms, where w is a per-unit rate and F is a fixed
fee. The firms play a repeated game and all firms have a discount factor δ per period. Is
there a symmetric subgame perfect equilibrium in which the M upstream firms share the
monopoly profits for the industry? In general terms, what do the two-part tariffs look like
for equilibrium strategies that might support the monopoly outcome? For what values of
does this equilibrium exist?
b) Now suppose there are only two upstream firms (U1 and U2) and two downstream
firms (D1 and D2), all with zero marginal costs and zero fixed costs. As in part (a), the
upstream firms supply homogenous products; the downstream firms sell differentiated
products and compete in prices.
i) Suppose the firms are not vertically integrated. The firms play a repeated
game and all firms have a discount factor δ per period. For what values of
does there exist a subgame perfect equilibrium in which the upstream
firms share the industry monopoly profits. What do the two-part tariffs
look like for the equilibrium strategies? [You can apply the result in part
(a)]
ii) Now suppose that firms U1 and D1 vertically integrate, while firms U2 and
D2 remain unintegrated. Explain, in as much detail as you can, how the
vertical integration affects the ability of the industry to maintain an
equilibrium with monopoly profits. Specifically, describe how the vertical
integration of U1-D1 affects:
a. The profit that U2 can earn if it deviates from an implicitly
collusive price and
b. The profit that the integrated firm U1-D1 can earn if it deviates
from an implicitly collusive price.
c) What does this analysis tell you about the effects of vertical integration on the
ability of firms to act collusively?
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Industrial Organization Field Exam, August 2008

Answer both questions. (Question II has a multi-page text for analysis.)

Question I:

Consider an industry with M upstream firms and N downstream firms. All of the firms

have zero marginal costs and zero fixed costs. The upstream firms produce a homogenous

product and, if not vertically integrated, compete in price. The downstream firms sell

differentiated products and compete in price. Let  be the joint monopoly profit for the

industry.

a) Suppose the firms are not vertically integrated. The upstream firms offer two-part

tariffs ( w , F ) to each of the downstream firms, where w is a per-unit rate and F is a fixed

fee. The firms play a repeated game and all firms have a discount factor δ per period. Is

there a symmetric subgame perfect equilibrium in which the M upstream firms share the

monopoly profits for the industry? In general terms, what do the two-part tariffs look like

for equilibrium strategies that might support the monopoly outcome? For what values of

 does this equilibrium exist?

b) Now suppose there are only two upstream firms (U 1 and U 2 ) and two downstream

firms (D 1 and D 2 ), all with zero marginal costs and zero fixed costs. As in part (a), the

upstream firms supply homogenous products; the downstream firms sell differentiated

products and compete in prices.

i) Suppose the firms are not vertically integrated. The firms play a repeated

game and all firms have a discount factor δ per period. For what values of

 does there exist a subgame perfect equilibrium in which the upstream

firms share the industry monopoly profits. What do the two-part tariffs

look like for the equilibrium strategies? [You can apply the result in part

(a)]

ii) Now suppose that firms U 1 and D 1 vertically integrate, while firms U 2 and

D 2 remain unintegrated. Explain, in as much detail as you can, how the

vertical integration affects the ability of the industry to maintain an

equilibrium with monopoly profits. Specifically, describe how the vertical

integration of U 1 -D 1 affects:

a. The profit that U 2 can earn if it deviates from an implicitly

collusive price and

b. The profit that the integrated firm U 1 -D 1 can earn if it deviates

from an implicitly collusive price.

c) What does this analysis tell you about the effects of vertical integration on the

ability of firms to act collusively?

Question II: Comment on the following (a press release from the Department of Justice

Antitrust Division):

STATEMENT OF THE DEPARTMENT OF JUSTICE ANTITRUST DIVISION

ON ITS DECISION TO CLOSE ITS INVESTIGATION OF

XM SATELLITE RADIO HOLDINGS INC.'S MERGER

WITH SIRIUS SATELLITE RADIO INC.

Evidence Does Not Establish that Combination of Satellite Radio Providers Would Substantially Reduce Competition

WASHINGTON — The Department of Justice's Antitrust Division issued the following statement today after announcing the closing of its investigation into the proposed merger of XM Satellite Radio Holdings Inc. with Sirius Satellite Radio Inc.:

"After a careful and thorough review of the proposed transaction, the Division concluded that the evidence does not demonstrate that the proposed merger of XM and Sirius is likely to substantially lessen competition, and that the transaction therefore is not likely to harm consumers. The Division reached this conclusion because the evidence did not show that the merger would enable the parties to profitably increase prices to satellite radio customers for several reasons, including: a lack of competition between the parties in important segments even without the merger; the competitive alternative services available to consumers; technological change that is expected to make those alternatives increasingly attractive over time; and efficiencies likely to flow from the transaction that could benefit consumers.

"The Division's investigation indicated that the parties are not likely to compete with respect to many segments of the satellite radio business even in the absence of the merger. Because customers must acquire equipment that is specialized to the satellite radio service to which they subscribe, and which cannot receive the other provider's signal, there has never been significant competition for customers who have already subscribed to one or the other service. For potential new subscribers, past competition has resulted in XM and Sirius entering long-term, sole-source contracts that provide incentives to all of the major auto manufacturers to install their radios in new vehicles. The car manufacturer channel accounts for a large and growing share of all satellite radio sales; yet, as a result of these contracts, there is not likely to be significant further competition between the parties for satellite radio equipment and service sold through this channel for many years. In the retail channel, where the parties likely would continue to compete to attract new subscribers absent the merger, the Division found that the evidence did not support defining a market limited to the two satellite radio firms that would exclude various alternative sources for audio entertainment, and similarly did not establish that the combined firm could profitably sustain an increased price to satellite radio consumers. Substantial cost savings likely to flow from the transaction also undermined any inference of competitive harm. Finally, the likely evolution of technology in the future, including the expected introduction in the next several years of mobile broadband Internet devices, made it even more unlikely that the transaction would harm consumers in the longer term. Accordingly, the Division has closed its investigation of the proposed merger."

ANALYSIS

Because XM and Sirius would no longer compete with one another in the retail channel following the merger, the Division examined what alternatives, if any, were available to consumers interested in purchasing satellite radio service, and specifically whether the relevant market was limited to the two satellite radio providers, such that their combination would create a monopoly. The parties contended that they compete with a variety of other sources of audio entertainment, including traditional AM/FM radio, HD Radio, MP3 players ( e.g. , iPods®), and audio offerings delivered through wireless telephones. Those options, used individually or in combination, offer many consumers attributes of satellite radio service that they may find attractive. The parties further contended that these audio entertainment alternatives were sufficient to prevent the merged company from profitably raising prices to consumers in the retail channel for example, through less discounting of equipment prices, increased subscription prices, or reductions in the quality of equipment or service.

The Division found that evidence developed in the investigation did not support defining a market limited to the two satellite radio firms, and similarly did not establish that the combined firm could profitably sustain an increased price to satellite radio consumers. XM and Sirius seek to attract subscribers in a wide variety of ways, including by offering commercial-free music (with digital sound quality), exclusive programming (such as Howard Stern on Sirius and "Oprah & Friends" on XM), niche music formats, out-of-market sporting events, and a variety of news and talk formats in a service that is accessible nationwide. The variety of these offerings reflects an effort to attract consumers with highly differentiated interests and tastes. Thus, while the satellite radio offerings of XM and Sirius likely are the closest substitutes for some current or potential customers, the two offerings do not appear to be the closest substitutes for other current or potential customers. For example, a potential customer considering purchasing XM service primarily to listen to Major League Baseball games or one considering purchasing Sirius service primarily to listen to Howard Stern may not view the other satellite radio service, which lacks the desired content, as a particularly close substitute. Similarly, many customers buying radios in the retail channel are acquiring an additional receiver to add to an existing XM or Sirius subscription for their car radio, and these customers likely would not respond to a price increase by choosing a radio linked to the other satellite radio provider. The evidence did not demonstrate that the number of current or potential customers that view XM and Sirius as the closest alternatives is large enough to make a price increase profitable. Importantly in this regard, the parties do not appear to have the ability to identify and price discriminate against those actual or potential customers that view XM and Sirius as the closest substitutes.

Likely Efficiencies

To the extent there were some concern that the combined firm might be able profitably to increase prices in the mass-market retail channel, efficiencies flowing from the transaction likely would undermine any such concern. The Division's investigation confirmed that the parties are likely to realize significant variable and fixed cost savings through the merger. It was not possible to estimate the magnitude of the efficiencies with precision due to the lack of evidentiary support provided by XM and Sirius, and many of the efficiencies claimed by the parties were not credited or were discounted because they did not reflect improvements in economic welfare, could have been achieved without the proposed transaction, or were not likely to be realized within the next several years. Nevertheless, the Division estimated the likely variable cost savings those savings most likely to be passed on to consumers in the form of lower prices to be substantial. For example, the merger is likely to allow the parties to consolidate development, production and distribution efforts on a single line of radios and thereby eliminate duplicative costs and realize economies of scale. These efficiencies alone likely would be sufficient to undermine an inference of competitive harm.

Effect of Technological Change

Any inference of a competitive concern was further limited by the fact that a number of technology platforms are under development that are likely to offer new or improved alternatives to satellite radio. Most notable is the expected introduction within several years of next-generation wireless networks capable of streaming Internet radio to mobile devices. While it is difficult to predict which of these alternatives will be successful and the precise timing of their availability as an attractive alternative, a significant number of consumers in the future are likely to consider one or more of these platforms as an attractive alternative to satellite radio. The likely evolution of technology played an important role in the Division's assessment of competitive effects in the longer term because, for example, consumers are likely to have access to new alternatives, including mobile broadband Internet devices, by the time the current long-term contracts between the parties and car manufacturers expire.