Part B: Problem Set -Vertical FDI (65 points total): Consider two...

Part B: Problem Set -Vertical FDI (65 points total):

Consider two firms. The first firm is based in Slovenia and produces ball bearings (upstream firm). The cost of producing ball bearings is 6per unit. The second firm is based in Greece. This firm produces machines (downstream firm). To produce one machine, the Greek firm must buy 2 ball bearings (ignore shipping costs between Slovenia and Greece). In addition, for each machine it makes, it has a production cost of 4 per machine. Machines are then sold according to the demand curve:P = 240 -2Q where P is the price of a machine and Q is the total number of machines sold. For the next four questions, assume that both firms are monopolists.

1.(5 points) Write down the profit function for the Greek firm, knowing that it imports ball bearings from the Slovenian supplier(Hint: Given the use of 2 ball bearings per machine, what is the total cost paid for ball bearings to produce one machine?)

2.(5 points) Taking the price of ball bearings as given, solve for the optimal quantity of machines produced and sold by the Greek producer.

3.(7 points) Write down the profit function for the Slovenian ball bearings supplier. Substitute for the quantity demanded using the demand coming from the Greek machine producer.(Hint: recall that the demand for ballbearings is 2 times the quantity of machines produced)

4.(10 points) Calculate:

a.the equilibrium price of ball bearings

b.the equilibrium price of a machine

c.the quantity of machines produced and sold

d.the quantity of ball bearings produced and sold

e.the profits of the Slovenian firm

f.the profits of the Greek firm

Suppose now that the Greek firm becomes a multinational corporation by acquiring the Slovenian supplier. In doing so, it must pay a fixed cost of 1,000 to the Greek government (Hint: treat this payment fee in the same way you would treat a fixed cost of production).

5.(5 points) Write down the profit function of the Greek multinational firm, combining the profits from each production plant (in Greece and in Slovenia).

6.(8 points) What would be the optimal quantity of machines produced by the Greek MNC? What would be the equilibrium price of machines? What would be the total profit earned by the MNC? How do these values compare to the previous scenario when the two firms acted as independent enterprises?

7.(5 points) Calculate the price of ball bearings that would ensure the same profit for the Slovenian subsidiaries that earned when acting as an independent monopolist.

8.(5points) Using the price of ball bearings determined in the question above, calculate the profit earned by the Greek plant. (Hint: the calculated profit should be equal to the total profits for the MNC minus the profits of the Slovenian affiliate)

9.(5 points) Now assume that the Greek machine producer buys the ball bearings from the Slovenian subsidiary at cost. In this case, what is the quantity of machines produced by the Greek plant? What is the equilibrium price of a machine? What is the profit earned by the Greek producer? What is the profit earned by the Slovenian subsidiary? What is the total profit earned by the MNC?How do these calculations compare to answers from question 6?

10.(5 points) Explain the "double marginalization" concept and how it operates in this context. What is the main reason causing of the double marginalization problem?

11.(5 points) Explain the "hold-up" problem. When does it arise and how is it related to the "double marginalization" problem?