Business Economics 2016/17 Group assignment

Answer all three questions. Marks are indicated in parentheses and sum to 100.

Question 1. There are 5 competing petrol stations over a 100 mile stretch of road (Shell, BP,
Texaco, Esso and Gulf), each setting their price for unleaded petrol daily. The managers of these
stations consider tacitly colluding to set a higher price for unleaded petrol. As the quality of the
unleaded petrol is identical, they know that any station that undercuts will win the market.

The stations estimate that the daily demand for petrol on this road is Q = 50,000 25,000P,
where P denotes the price per litre of unleaded petrol and Q is litres of unleaded petrol. The
marginal cost of providing petrol is 1 per litre for all firms.

(a) If the stations were to interact only once (compete on one day only), what price would
you expect to prevail for unleaded petrol along the stretch of road? Explain your answer.
[10 marks]

(b) Compute the price that would be charged for unleaded petrol if the market were a
monopoly. How many litres of petrol would the monopolist sell daily and what profits
would he make?
[10 marks]

(c) Now suppose stations interact indefinitely. They wish to collude to price unleaded petrol
at the monopoly level. Suppose station managers have a discount factor of = 0.7. There
is an understanding that if any petrol station undercuts, the rest will punish by reverting to
the price set in (a) forever. Is collusion sustainable amongst the 5 stations? What is the
maximum number of stations that could sustain collusion? [10 marks]

Question 2. You manage Flying Scotsman, a small rail company connecting London to
Edinburgh. You determine that the demand for a one-way ticket to Edinburgh from Seniors (> 60
years of age) and from the rest of the population is:

General public Seniors

Off-peak 280 2P 240 4P
Peak 680 2P 200 4P

P denotes the price of the one-way ticket. The marginal cost of an additional passenger is zero,
but the train only has a capacity of 280 seats. No standing passengers are permitted so the
maximum number of tickets sold is 280.

(a) Can you charge a different price to different markets of passengers? If yes, how? [6
marks]

(b) Find the profit maximizing prices for Seniors and for the general public both for peak and
off-peak travel. [12 marks]

(c) Flying Scotsman has a contract with Scottish Shine, a firm that cleans the train in
Edinburgh after passengers disembark. Initially, Flying Scotsman pays Scottish Shine a
1
 fixed fee for their services. Upon renewal of the contract, the owner of Scottish Shine
argues it is more expensive to clean trains with more passengers. You agree to pay
Scottish Shine Q2 for cleaning, where Q is the total number of passengers who travelled
on the train.

What are the new profit maximising prices for Seniors and for the general public
travelling off-peak? Hint: find the optimal number of passengers in an off-peak train. [12
marks]

Question 3. You are the CEO of Outback Cables, a firm that provides pay-TV services in rural
Australian towns that do not receive any other television services. Your company is thinking of
building a pay-TV network in the Australian town of Broome. Building the network will cost
AUD$200m and once the network is built this cost is sunk. There is a 50% chance that the cable-
TV services to Broome will be highly successful in which case your company makes revenues of
AUD$320m in present value terms. There is also a 50% chance that the cable-TV services to
Broome will be unsuccessful, in which case your company makes revenues of only AUD$140m
in present value terms. Your company could, of course, not spend any money and not build the
network.

(a) Draw up the decision tree representing the choice facing your company. Do you
recommend to build the network or not? Why? [10 marks]

You are informed that the regulator has passed a new rule. If you build a network then you must
allow your rival pay-TV company, KangaTel, to use the network. If KangaTel chooses to use the
network then it must pay you half the cost of construction, AUD$100m. But competition from
KangaTel will lower the total revenue from pay-TV in Broome. If pay-TV is a success and
KangaTel is a producer then the present value of total revenue is only AUD$280m, or
AUD$140m each for your company and KangaTel. If pay-TV is unsuccessful and KangaTel is a
producer then the present value of total revenue is only AUD$100m, or AUD$50m each for your
company and KangaTel. Note that KangaTel will never build its own network.

(b) Suppose that KangaTel must decide whether it wants to use the Outback Cables network
before you build your network. Thus, if it wants to use your network it must tell you
before you build the network. Will KangaTel decide to use your network, or not? Will
Outback Cables build the network, or not? Explain your answer. [10 marks]

(c) Suppose that KangaTel only has to decide whether or not it wants to use the Outback
Cables network after it has seen whether pay-TV is successful or unsuccessful. If it
decides to use your network it only has to pay you the AUD$100m after it makes its
decision. Draw the game tree representing the interaction between your firm and
KangaTel. When, if ever, will KangaTel want to use your network? Will you build the
network or not? Is your decision the same or different to your decision in part (b)?
Explain. [10 marks]

(d) It is sometimes argued that regulation which improves competition can reduce risky
investment. Does your answer to this question confirm or rebut this claim? Briefly
explain why regulation might influence risky investment. [10 marks]