EACH EXAM PAPER WILL HAVE FOUR MICROECONOMICS QUESTIONS – you must answer AT LEAST
ONE MICROECONOMICS QUESTION.
TOPICS:
RBV
SCP
HoldUp Make-or Buy
Game Theory
Auctions
Behavioural – Prospect Theory
Behavioural – Thinking Fast / slow or System 1 / System 2
Information economics / info asymmetry: Market for Lemons
Page 9 onwards contains topic notes on each topic.
Page 7 has a generic marking scheme indicating the types of features considered in the marking of
exam answers.
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Sample questions:
Game Theory
1. Two burglars are caught in the vicinity of a house that has been broken into. They are taken
in for questioning as they are known criminals and the Police are certain that one, or possibly
both, committed the crime (in fact they did it together). the position is:
Player B: Confess Don’t Confess
Player A: Confess (-5, -5) (-12, 0)
Don’t Confess (0, -12) (-1, -1)
Where payoffs are stated: (Player A (Row player) Payoff, Player B (Column player) Payoff)
a. Explain the concept of Dominant Strategy and identify any for the participants of this
game. (10 marks)
b. Explain the concept of ‘equilibrium’ in game theory. Does the game have an
equilibrium, and if so what type of equilibrium is it? (10 marks)
c. To what extent does game theory rely on individuals having accurate information on
their own and their rivals’ potential strategies and associated payoffs? (5 marks)
ANSWER NOTES
a. From topic notes… Dominated strategies: a strategy that is worse than all other strategies
regardless of the choice of the other player, or possibly ‘less than in some cases and at best equal to
in the other cases’ (Weakly Dominated).
In this case Player A has dom.strategy of Don’t Confess (0 or -1) rather than (-5 or -12); Player B has
the dominant strategy of Don’t Confess – also for them (0 or -1) rather than (-5 or -12).
b. Equilibrium may be dominant strategy equilibrium – where each player has a dominant strategy
which they choose, and the outcome will be this combination. If this is not possible, there may be a
Nash Equilibrium – where each player does not have an incentive to move from their present
location. E.g. if they would not gain by switching strategy, they have no reason to move even if their
position is not ‘dominant’. If both players are on a ‘Nash Strategy’, then the game will settle in that
position, as neither player has an incentive to change behaviour.
If there is a dominant strategy equilibrium, it must also be a Nash equilibrium.
c. Game theory commonly assumes (in standard assumptions) that individuals have information on
the other players’ possible strategies and the payoffs they would receive associated with these. This
appears very unrealistic. A player does not actually need this level of information on the other
players to decide on a dominant strategy, in principle, as they know enough from their own payoffs
to see that they dom.strat. would be better, regardless of what the other players do. Similarly a
game could find a Nash Equilibrium based on players’ analysis of their own payoffs, and without
needing information on the other players (consider the game in this question, for example). Solving
sequential games by ‘backward induction’ does rely on the analysis of other player’s choices, though,
so information assumptions are more relevant for choice of strategies there.
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SCP:
2.
a. To what extent can the Structure-Conduct-Performance model be used to explain
individual firm performance? (13 marks)
b. Can it still be useful to competition regulators? (5 marks)
c. How useful is it when dissimilar firms co-exist and compete in the same market?
(7 marks)
Also consider: importance of dynamics / feedback effects, and Bain’s focus on Economies of Scale in
particular industries that caused common cost advantages and, as a result, barriers to new firms.
ANSWER NOTES
a.
Outline SCP framework; elements in the S, C and P sections; introduce the potential feedback from
one part of the model to the others (dynamics of the industry model) e.g. where firm conduct and
performance will affect firm size and number of competitors.
SCP originally assumed that industry structure was a determinant of firm performance, via conduct
implications of the industry structure. In this sense it ignores individual level differences for firms.
The analysis in detail, though, breaking down the different aspects of industry conduct and
performance provide a good level of understanding of influences on the firm and the choices that
they make, so that the SCP framework can be used when analysing firms in the context of their
competitors (even if this was not the original intention).
b. The model is still used as a framework in regulatory investigations. It is not assumed to be a
‘causal model’, however, as much as a framework for gathering and analysing information about the
situation of firms and their industries (and competitors in other sectors / industries).
c. The SCP model assumes that industry structure is the fundamental driver of the Conduct (and
therefore the ultimate Performance) of firms. Qualitative differences in the firms may be considered
as part of the structure stage, but are part of the basic model. Differences in conduct might also be
discussed in a way that reflects differences between the firms there. As such the causal model
originally suggested for the SCP doesn’t apply well to these cases, but the framework can be used to
organise information on them (as suggested in part b).
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RBV:
3.
a. How does the Resource Based View of the firm provide and improvement on the analysis
of firm performance? (12 marks)
b. Why does Penrose suggest that tacit knowledge provides the greatest opportunity for
sustainable advantage? (7 marks)
c. Why is ‘organisational readiness’ such an important feature of a successful firm’s
‘resources’? (6 marks)
ANSWER NOTES
a. The Resource Based View developed in reaction to the work on industry structure in ‘mainstream’
microeconomics which did explain variation in the success (profit, growth, etc.) of individual firms
that were, as far as the aspects of the firm and industry considered by economists, similar. SCP,
which developed at the same time as RBV, continues to focus first on the industry level
characteristics that affect any firm; the RBV looks at the characteristics within the firm, and tries to
use these to explain performance (this can be done without forgetting there are external, industry
level influences on the firm, but the danger is that it assumes individual, internal differences lead to
the differences in performance – which might not be the case).
b. Valuable resources are assumed to create competitive advantage (Porter, years after Penrose,
coined this idea). Knowledge can be very valuable and form an advantage over firms who do not
possess it. Knowledge acquisition takes time, which means that imitators are unable to immediately
copy a leading firm and catch it up. Explicit knowledge may be ‘trainable’ but implicit or ‘tacit’
knowledge is something that is not clearly understood by people who hold it and so cannot be
copied easily, or trained into people. Instead it is imperfectly understood often (leading to
performance having ‘causal ambiguity’). It is largely gained by experience in the firm. This also
means that setting up new facilities away from successful sites may not reproduce the success of the
first, if the first site is successful due to these ‘tacit knowledge’ elements – so it has its disadvantages.
Simple knowledge is easier to copy out to other branches of the firm.
c. The possession of valuable and effective resources (such as tacit knowledge) is essential for firms
to be effective and successful – but these resources must be being used to be productive. The ability
to organise them and bring them into use quickly to address new opportunities is essential if firms
are to beat competitors. This leads to the development of the ‘VRIN’ model (reviewing the resources
that are Valuable, Rare, Inimitable and Non-substitutable) into VRIO – O for ‘Organisationally ready’.
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Auctions:
4.
a. Explain why auctions provide an important mechanism for those wanting to sell items
periodically rather than frequently. (8 marks)
b. Why is it suggested that all Auction mechanisms lead to the same revenue outcome for
the seller? (9 marks)
c. What conditions are necessary for the seller to get a ‘fair’ price in an auction?
(8 marks)
ANSWER NOTES
a. Whilst markets operate efficiently when they have large numbers of participants and frequent
trading, they are not as likely to operate at ‘appropriate’ prices, and prices are not as likely to adjust
cleanly to reflect circumstances, when less trading takes place. This creates a bit problem for scarce
or rare items, as they are not sold often as so prices are likely to be problematic. Auctions which sell
one item at a time, and ‘gather’ sellers together in a sale, help to address this problem. (Keep in
mind, though, that the number of potential buyers is a significant influence on the winning bidders
bid level – see parts b and c.)
b. The ‘Revenue Equivalence Theorem’ concludes that a number of ‘standard’ auctions that fulfil a
short list of conditions will lead to the winning bidders paying (approximately) the same price. This is
likely to be a ‘minimum increment’ higher than the second highest valuer’s valuation of the product,
as this ensures that they no longer want it and it is left to the winning (highest) bidder. Each
individual has a personal ‘valuation’, and also a personal maximum bid – that should be less than the
personal valuation, rationally, as paying valuation leaves no benefit to the trade. We can create an
‘order of valuers’ whose bidding should reflect their valuations.
In the English auction (rising called out bids), the winner must first raise bids to exhaust other
bidders – so beating the personal maximum bid of the second highest valuer – guaranteed to win if
slightly higher than second highest valuers valuation.
The Dutch auction (descending clock), the winner must ‘bid’ (just) above their estimate of the second
highest valuers valuation to guarantee winning. The First-price Sealed Bid Auction winner must
submit a bid above this same level. The Second-price Sealed Bid (Vickrey) Auction is expected to bid
‘full value’ knowing that they will only pay the second valuers valuation – so bid is higher, but
revenue paid over is again approximately the second highest valuation.
c. (and relevant to b. as well) For RET: Essentials – it must be the case that:
 award of ‘contract’ for item goes to the highest bidder (but not necessarily at that price) and
 should be a (known) probability distribution of valuations for the potential bidders.
Also – list of assumptions necessary (McAfee & McMillan, 1987) that it holds for any ‘benchmark’
auction that has:
 ‘All of the bidders are risk-neutral;
 Each bidder has a private valuation for the item independently drawn from some probability
distribution;
 The bidders possess symmetric information;
 The payment is represented as a function of only the bids.’
Pricing difficulties arise when there are ‘common value’ and ‘private value’ buyers in the same
auction. If there is a known probability distribution of private valuations, this is less likely to cause
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problems in terms of ‘irrational’ values, but still have potential issues – e.g. housing buyers
competing against holiday-home buyers (with different basis for their valuations).
This doesn’t consider the ‘winner’s curse’ of overpayment – but this is also a regular feature of
Auction questions.