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

TMA 02 The assignment

All rights reserved. No part of this publication may be reproduced, stored in a retrieval system, transmitted or utilized in any form or by any means, electronic, mechanical, photocopying, recording or otherwise, without written permission from the publisher.

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.

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.

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)
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)
What, if any, are the Nash equilibria strategies and outcomes of this game? Explain your answer in full. (5 marks)
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)
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.

Generate the summary statistics for the three variables: Q, L and K. Report and briefly describe the results. (5 marks)
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)
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)
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)
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.

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.

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.

Cognitive skills