Industrial Organization: Markets and Strategies
Paul Belleflamme and Martin Peitz
published by Cambridge University Press
Part I. Getting started
Exercises
Exercise 1 Free trade and competitive markets [included in 2nd edition of the
book]
Consider the market for shoes in country A. Demand is assumed to be 100p
where pis the final consumer price. Suppose that country A does not produce
shoes and that there are two importers B and C. The export prices for shoes
in both countries are pB= 59:99 and pC, respectively. Furthermore suppose
that country A is a small country so that its demand does not influence export
prices. Suppose that, initially, country A levies a uniform import tariff of t= 10
on each pair of imported shoes.
1. Assume pC= 45. What is the effect on demand and welfare in country A
if country A signs a free trade agreement with country B?
2. Assume pC= 50. What is now the effect on demand and welfare in
country A if country A signs a free trade agreement with country B?
Solutions to Exercise 1 In the absence of a free-trade agreement with country
B, the consumers in country A always buy shoes from country C as pC+t < 59:99+t
Exercise 2 Monopoly problem [included in 2nd edition of the book]
Consider a monopolist with a linear demand curve: q=abp, where
a; b > 0. It produces at constant marginal cost cand has no fixed cost. Assume
that 0< c < a=b.
1. Find the monopoly price, quantity, and profits.
2. Derive the inverse demand curve P(q). Draw P(q), the MR-curve, and the
MC-curve in a diagram. Explain why we need the assumption c < a=b.
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3. Does it matter that the monopolist sets price instead of quantity?
4. Calculate the deadweight loss of monopoly.
5. A change in bresults in two opposing effects on the deadweight loss. Cal-
culate the effect of a change in bon the deadweight loss.
6. Derive the price elasticity of demand for any price. How does change
with p?
7. Show mathematically as well as graphically that the price elasticity of
demand > 1at the monopoly price.
Solutions to Exercise 2
1. The monopoly chooses pto maximize = (pc)(abp). The first-order
2. The inverse demand curve P(q)is obtained by inverting q=abp:bp =
aq,p=a=b q=b. The intercept on the vertical axis (where price is
3. No, because the monopoly controls the demand function, i.e., the relationship
4. The first-best is achieved at marginal cost pricing: p=c; the corresponding
quantity is q=abc. Welfare is then equal to W= (1=2) (a=b c) (abc) =
5. The price elasticity of demand is defined as
(p) = q0(p)p
6. We have that
Exercise 3 Two-period monopoly problem [included in 2nd edition of the book]
Consider a monopolist that produces for two periods. The demand curves
in both periods are qt= 1 ptfor t= 1;2. The marginal costs are cin the first
and and cq1in the second period. Here, is a small and positive number.
There is a discount factor of between the periods.
1. Explain briefly how the monopolist’s problem changes compared to a sit-
uation where the marginal cost is c in both periods.
2. Find the quantities q1and q2that the monopolist chooses in the two
periods. Hint: Start by solving the monopolist’s problem in the second
period and then continue to the first period.
3. Evaluate the effect of and discuss your result.
Solutions to Exercise 3
1. If the marginal cost is cin both periods, then the two periods are unrelated (as
the monopolist’s decisions in the first period do not affect the demand nor the
2. In the second period, the monopolist chooses q2to maximize 2=1q2q2
cq1q2. The optimum is easily found as q2= (1=2) 1c+q1, result-
3. Suppose first that = 0; then there is no link between the two periods and the
firm produces the same quantity q(0) = (1 c)=2in both periods. Now take
> 0; then we see that the firm has an incentive to produce a larger quantity
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Exercise 4 Market structure for rating agencies1
In the recent financial crisis, rating agencies have become a focus of attention.
The market has traditionally been dominated by a few big agencies, currently
Standard & Poor, Moody’s and Fitch. In 2006, the Securities and Exchange
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