2. (5 points) Explain how an airline with a monopoly on trans- Brazilian flights could benefit by purposely making its 2nd class seats more uncomfortable than necessary.
1. (5 points) Show on a diagram how commitment to a low-cost technology shifts the reaction curves as a Top Dog strategy in a Cournot duopoly.
ANSWER. Firm 1's reaction curve shifts to the right when it invests in a low-cost technology, because for any given output by Firm 2, Firm 1 is willing to produce more now that its costs are lower. The Nash output of Firm 1 rises, and Firm 2's falls in response. By committing to a technology that makes it Tougher, , Firm 1 induces Firm 2 to be Softer and reduce its output, which is what the Top Dog strategy consists of. This was the easiest question on the quiz.
2. (5 points) Explain how an airline with a monopoly on trans-
Brazilian flights could benefit by purposely making its 2nd class
seats more uncomfortable than necessary.
ANSWER. The airline would like to charge more to rich customers than to poor customers. If the seats are exactly the same in first and second class, then the prices can't be different, or nobody would travel first class. One way to attract people to first class is to make it more luxurious. Another way is by making second class less comfortable. Usually, an airline would benefit more by raising the quality of the first class, since it would increase the reservation prices of the rich customers that way. It could happen, tho, that the airline could do better by cheaply reducing the quality of second class so as to deter the rich customers from sitting there. This would work if the poor customers don't mind uncomfortable seats very much compared to rich customers.
It is not quite right to say that if the seats are less comfortable, the customers will all be willing to pay more for first class. There must be some customers who stay with the uncomfortable seats, or there is no point in the airline having any second-class seats at all. They are a monopoly, so they can always raise first-class prices.
Also, it is wrong to say that with lower quality, the price will fall, and the airline will increase its profits by higher volume. The price is only falling because fewer people want to travel when the quality is lower--- if the price just stayed the same, the volume will fall. If the airline just wants to increase volume, all it has to do is keep quality the same and reduce the price.
3. (10 points) Your new real estate management company is buying plumbing services from a variety of contractors. You know that 30 percent of the contractors are excellent, and 70 percent are mediocre. You would offer $30,000 to the good contractor and \$20,000 to the mediocre one for a year's plumbing services if you could be assured of the contractor's quality.
(a) If you cannot be assured of quality, how much should you offer?
ANSWER. $23,000.
(b) To produce a slick, professional sales pitch costs the excellent contractor $1000 per hour of presentation, but the mediocre contractor $2000 per hour. If there is a separating equilibrium in this market, how long should you require a sales pitch to be before you believe that the company has high quality?
ANSWER. Call the length X. X must be big enough that if you offer $30,000 to a contractor who goes on that long, no mediocre contractor will want to pay that much for a presentation. The payoff for a mediocre contractor if he does not bother with a professional-quality presentation is 20,000 (not zero-- you, and presumably other customers, are willing to pay 20,000 for a mediocre plumber). The payoff if he goes on for X hours is 30, 000 - 2,000X. Equating these yields X = 5. The excellent contractor is happy to go on that long, because his payoff is then 30,000 - 1,000X= 25,000, quite a bit better than the 20,000 he would get without a presentation.
Thus, in the separating equilibrium, mediocre contractors will not try professional presentations, and will be paid 20,000, and excellent contractors will make 5-hour presentations and be paid 30,000.
4. (10 points) The article below talks about drug rivalry between Lilly/Icos and Pfizer. Is annual spending on R+D in this industry by different companies more like strategic substitutes or strategic complements? Show what the reaction curves would look like for both cases. Then say which you think applies here, and why the other shape of reaction curve would not be appropriate.
ANSWER. Pfizer invested in research to discover the impotence drug Viagra, and was the first mover in this game. Lilly is now investing in research to discover an impotence drug that would compete with Viagra, using the investment method of a joint venture with Icos.
Thus, when Pfizer increased its research spending, Lilly also increased its research spending. It seems that research spending is a strategic complement. If Pfizer increasing its research had diminished Lilly's spending-- if Lilly had given up on impotence drugs, for example-- then research would be a strategic substitute. But that did not happen here.
In graphing either kind of strategy, the research spending of Lilly would be on one axis and of Pfizer on the other axis. If research is a strategic complement, the two curves would both slope up to the northeast. If research is a strategic complement, the two curves would both slope down to the southeast.
Most of the newspaper article, about Icos and the science involved, is irrelevant. Your task was to extract the strategies of Lilly and Pfizer from the article and determine that the rest was irrelevant.
Strikes Deal With Eli Lilly to Develop Viagra-Like Drug With Fewer Side Effects Wall Street Journal; New York; Oct 2, 1998, B6, Eastern edition; By Ralph T. King Jr.;
Icos Corp. struck a lucrative deal with Eli Lilly & Co. to develop an impotence drug that appears to have fewer side effects than Viagra and could be on the market by late 2001.
Terms of the joint venture call for Lilly to cover development costs of the drug, known as IC351, for three years and pay Icos $75 million up-front plus undisclosed milestone payments. Icos said the two companies will split marketing costs and profits in North America and Europe.
The deal signals strong prospects for IC351, which Icos has previously downplayed citing insufficient clinical-test data. But recent results from a small Phase II trial in Europe showed that the drug significantly improved erectile response with minor side effects. Last June, a published report comparing it favorably to Viagra, which adds a blue tinge to some users' vision, temporarily drove Icos's stock up 30%.
In Nasdaq Stock Market trading, Icos's stock closed up $1.625, or 9.2%, at $19.375. In composite trading on the New York Stock Exchange, Lilly closed down $2 at $75.3125.
The collaboration reflects the drug industry's growing reliance on biotechnology for new products, and the experience of Icos Chairman George Rathmann, the former chairman of Amgen Inc. In 1985, in order to develop the biotech field's most-successful drug, erythropietin, Amgen had to share what became a huge monopoly with Johnson & Johnson, a deal Dr. Rathmann lived to regret, he said in a recent interview. But in this case, analysts say, Lilly's 50% profit share is justified by the fact that the companies will probably have to wage a marketing war with Pfizer Inc., the maker of Viagra.
Icos, based in Bothell, Wash., had other financing options. Its biggest shareholder, Bill Gates, chairman of Microsoft Corp., had indicated a willingness to help Icos fund IC351's development itself, Dr. Rathmann said. But Dr. Rathmann concluded that a pharmaceutical partner would speed the drug to market and pose far less risk to Icos, he said.
Indianapolis-based Lilly said it will take a pretax third-quarter charge of about $127.5 million, or seven cents a share, reflecting the initial $75 million payment to Icos and certain other payments in the deal. Lilly also said it now expects its 1998 tax rate to be about 23%, rather than the 25% forecast earlier. As a result, Lilly's third- quarter results will include a one-time gain of about three cents a share for the reversal of earlier accruals, Lilly said.
Meanwhile, Icos is moving ahead with two larger Phase II studies involving 475 patients in the U.S. and Europe, an Icos spokeswoman said. In the European study, patients will take the drug daily, while U.S. patients will take it only prior to sexual intercourse. Icos and Lilly will jointly design a final, or Phase III, study to be launched next year.
Some of the 350 patients already treated have complained of headaches or general aches but no other ill effects, the spokeswoman said.