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DD309-16J Doing economics: people, markets and policy

TMA 02 The assignment

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Important: These pages provide guidance on how to write your assignment. Please ensure you read all of this information right through until the checklist at the end.

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Before you start work on this assignment, please ensure that you have read the Assessment Guidance specific to this module and are familiar with the advice in  Social Sciences Assessment Information. These sources contain support and guidance that you may need in writing your TMA including, for example, advice on plagiarism,  referencing and the  marking system. Note that failure to comply with relevant guidance could result in the loss of marks or other penalties.

There are three parts to this TMA. Answer all three parts, noting the word limits. On the following pages you will find guidance on how to complete each of the different parts of this assignment.

Part A (25% of the marks)

Two retailers, Rose and Little, supply a small town with all its food requirements. Both are considering whether to maintain or discount their prices via a summer sale in the month of July. Their payoffs under different combinations of decisions are given as follows:

  • If Rose discounts, and Little does not, Rose will receive a profit of £1000 per week and Little will receive a profit of £200 per week.
  • If Rose keeps prices as they are, and Little discounts, Rose will receive a profit of £100 per week and Little will receive a profit of £1300 per week.
  • If both Rose and Little discount, they will receive profits of £300 and £400 per week respectively.
  • If Rose and Little maintain prices, they will receive profits of £900 and £800 per week respectively.

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  1. Draw a payoff matrix to show this as a one-shot game in which each retailer has to make a decision without knowing what the other will do. (5 marks)
  2. Assuming both firms are rational and fully informed about the payoffs of the game, describe any dominant strategies they might have and justify your answer in full. (5 marks)
  3. What, if any, are the Nash equilibria strategies and outcomes of this game? Explain your answer in full. (5 marks)
  4. Now suppose that Little has the ability to unilaterally discount its prices before Rose can make its decision. Draw a diagram of the sequential game showing all three subgames and use backward induction reasoning to argue for the rational solution to this game. (5 marks)
  5. Suppose Little and Rose were considering whether or not to discount prices on a daily basis. How would this change the game and the optimal behaviour in it? (5 marks)

Word limit:  700 words

Part B (worth 25% of the marks)

To answer this question, you will have to analyse the dataset FINSERV_TMA02_2016.gdt, which can be found in the ‘Assessment resources’ section of the module website. The file contains data on output, Q (measured by log turnover) and two inputs, labour, L (measured by log employee numbers) and capital, K (measured by log assets) for pharmaceutical firms from the AMADEUS dataset of European registered firms. Note: data was observed for firms in 2012 and the variables Q, L and K are already in logs.

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  1. Generate the summary statistics for the three variables: Q, L and K. Report and briefly describe the results. (5 marks)
  2. Using scatter plots and correlation coefficients, assess the strength of the linear association between output (Q) and each of the two inputs, labour (L) and capital (K). (5 marks)
  3. Write down (as a linear equation) the econometric model that represents a production function in which output (Q) is a linear function of capital (K). Estimate the coefficients using a simple OLS regression model. Interpret your results. (5 marks)
  4. Extend the production function by adding labour (L) as an additional independent variable. Write down the extended model, estimate the coefficients and interpret the results. (5 marks)
  5. Compare the results for the two models estimated in Question 3 and Question 4 and use them to explain the consequences of omitting relevant variables when using a simple (univariate) regression. (5 marks) Word limit: 700 words

Part C (worth 50% of the marks)

‘Competition policy is a complex balancing act.’ Using economic theories taught in Block 2 of this module and the extracts ‘Airline competition: The collusion delusion’ (below) and pp. 5−8, in particular, of ‘Google antitrust proceedings: digital business and competition’ (in ‘Assessment resources’), write an essay explaining what needs to be balanced and what the main challenges are likely to be.

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Word limit:  1400 words

Airline  competition: The collusion delusion

Gulliver  business travel, The Economist, 10 July 2015

A group of flyers is suing America’s big four carriers – Delta, American, United and Southwest – alleging that they have been colluding to keep ticket prices high. It follows the news last week that America’s Department of Justice is to investigate the carriers over the same issue. At issue is the fact that even as fuel prices have come down, prices have not. The Wall Street

Journal explains

The U.S. airline industry is enjoying some of its strongest profits ever, after years of consolidation and the past year’s plunge in the price of fuel, which had been the industry’s biggest cost. U.S. carriers have earned nearly $25 billion since the start of 2013, after a $33 billion loss the previous decade, according to government data.

Meanwhile, airfares have risen, though slightly. Government data shows that from 2007 to 2014, the average U.S. domestic fare increased 5% to $391, adjusted for inflation. Still, inflation-adjusted fares are down 16.3% from their peak in 2000. Other data from Airlines Reporting Corp., an aviation data firm, show domestic fares have generally decreased so far this year.

The charges may be difficult to make stick. It is unlikely that the airlines have been working to an explicitly agreed plan to fleece customers; few expect to find a paper trail. If there has been collusion, it is much more likely that carriers have tacitly shied away from competing on certain routes, allowing incumbents a free hand to set prices.

Yet even if that were true it is not in itself proof of price gouging. The fact that airline bosses are now repeating the mantra of “capacity discipline” – in other words not trying to expand their services too fast just because they are profitable again – is being viewed by some as a smoking gun. The problem is that for years, when the airlines were losing billions, they were criticised for not cutting back their routes enough. “Capacity discipline” might not be proof of tacit collusion, it might just be proof of good management. Airlines should aim to make a profit; for years they sold their tickets for less than it was costing them fly their planes.

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The problem is more to do with the number of competitors. The reasons that American regulators allowed the sector to consolidate from seven major carriers to four is well known: they were badly run, and many had been forced to seek protection from creditors through Chapter 11 bankruptcy. But, having approved the wave of mergers, it would be a bit rich for officials to complain that there are not enough big airlines to ensure competition.

If America was really serious about the issue, it could deal with it in a stroke: open up the domestic aviation market to foreign competition and allow Ryanair, Emirates and the like to fly whichever routes they wanted. (And, yes, the European Union and the Middle East should extend the same courtesy to airlines from outside their regions.) That is not going to happen, of course. It is so much easier to reprimand the incumbents.

In the following pages, you will find:

  • learning outcomes addressed by this assignment
  • student notes for each part of this assignment
  • a checklist to ensure you have done everything required for this assignment.

Learning  outcomes

This assignment gives you the opportunity to demonstrate the following learning outcomes:

Knowledge and understanding You should demonstrate a sound knowledge and understanding of:

  • the microeconomic theory of production, consumption and exchange at post-introductory level with applications
  • the main features, strengths and weaknesses of standard neoclassical microeconomic theory and alternative theoretical approaches
  • key ideas, theories and debates in microeconomic theory with applications to current issues in various areas, such as consumption, households, production, firms, exchange, policy, environment, finance and labour.

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Cognitive skills

You should demonstrate the ability to:

  • define and use key terms and concepts in economics
  • construct effective arguments in analysing economic questions
  • apply economic theories and models to analyse economic problems and events
  • evaluate economic statements and theories
  • use diagrams with verbal explanations of economic issues
  • interpret qualitative and quantitative evidence, such as case studies and articles, and the results of regression analysis.

Key skills

Communication

You should demonstrate the ability to:

  • communicate effectively complex information and arguments in writing, using appropriate academic conventions
  • reference sources following appropriate academic conventions.

Use of numbers

You should demonstrate the ability to:

  • use diagrams to analyse economic issues
  • use game-theoretic analysis to analyse economic issues.

IT

You should demonstrate the ability to:

  • use software packages to carry out statistical analysis.

Practical  and/or professional skills

You should demonstrate the ability to:

  • evaluate competing explanations and theories in relation to evidence
  • analyse economic problems and issues.

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Student notes

Part A assesses your understanding of some of the main ideas and techniques in game theory, which are mainly covered in Chapters 6 and 7. Game theory was also covered in Chapter 1, Section 6.2 and Chapter 4, Section 5.1. Online tutorials, particularly tutorials on game theory, will also provide some useful guidance. For Question 5, you should assume that the game is simultaneous and repeated daily.

Part B assesses your understanding of some of the main ideas in econometrics with an application to production functions. The questions ask you to demonstrate your skills in data analysis, using a dataset on pharmaceutical firms to estimate a production function. The data is already provided in log form, so you do not need to take logs of the variables but you do need to take the fact that variables are logged into account in your explanation.

Part B relates particularly to material in part 1 of the gretl manual. Material on the neoclassical theory of production may be helpful – see, for example, Chapter 5, Section 2. The skills covered in this question include producing and interpreting summary statistics (covered in  online tutorials in Block 1: Econometrics I: Using gretl to analyse data and Practice Exercises I). Part B also covers skills related to simple (univariate) and multiple (multivariate) regression analyses and the differences between the two, concentrating mainly on the interpretation of model coefficients. Multiple regression is introduced in the online tutorials Econometrics II: Bringing economic theory into data analysis and Practice exercises II. A short note about logs is also attached and you may wish to use the search facility of the DD309 for a number of additional references to them.

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Part C asks you to write an essay based on two extracts which relate to competition policies concerning airlines in the US and online search in Europe. The essay question asks you to use theory from Block 2 to discuss some of the key considerations that need to be taken into account when developing and implementing policies to ensure that markets are efficient by virtue of their competitiveness. This essay particularly relates to materials in Chapter 7 which discusses competition policy, strategic behaviour and anti- competitive behaviour. A good answer to this question will demonstrate a good understanding of the relevant economic theory, and make appropriate uses of the extract material to help illustrate the issues involved. Depth of analysis that focuses on the main issues is particularly encouraged.

Reflections on the assignment (not marked)

The purpose of this section is to enhance the dialogue you have with your tutor. You will receive better feedback and guidance if your tutor is well informed about your experience with the module materials. Here are some prompts that will help your dialogue about this TMA:

  • Look back at the feedback you received for your first assignment. What advice was particularly useful? What other advice or type of support would have helped you further?
  • What were the main challenges you encountered while working on the questions in the three parts of the TMA?
  • Did you find any part particularly difficult?
  • To what extent did you overcome the challenges you met?
  • What helped you to overcome the challenges, and what other support could have helped you?

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