SECTION VI ANSWERS TO QUESTIONS

Warm-up questions: A (e). (e). (b). D (b). E (d). F (f). G (e). H (c). I (e). J (a). (e). L (e). M (b). N (d). 0 (b).

General questions: I (e). MR = AR implies a perfectly elastic demand curve. 2 (d). Opdon (c) is incorrect because MR = AR for a competitive firm. 3 (d). First calculate TR - PQ. MR is the change in TR as we increase output by a unit. 4 (c). The price at which the fourth tube can be sold is $18; the loss in revenue on the three tubes which could have been sold at $18.50 each is $1.50 ($50?: x 3), so MR = $18 - $1.50 = $16.50.

5 (b). If is constant, = MC. The monopolist produces where MC = MR, i.e., 4 units. Jt = $6 (verify).

6 (a). If demand is elastic, MR is positive. 7 (c). Its like the welfare loss figure, but is discrete. Method for the discrete case is in Section 11. 8 (c). If MR is zero, TR is constant, so demand is unit elastic. 9 (b). The firm can necessarily increase profit by restiicting output, since demand is inelastic. 10 (b). n = TR-TC = (AR)q - (ATC)q. 11 (d). The monopoly inefficiency arises because P = MB > MC. 12 (e). MR is negative at -$15.50 and demand is therefore inelastic. 13 (e). IfP = AR = MR, the demand curve must be flat, i.e. perfectly elastic. 14 (b). Because supply is perfecdy elastic, the competitive price without the subsidy would be $7. If we assume a linear demand curve, the approximate loss would be (Vz) (2) ($400) = $400. 15(d). As with all welfare loss problems, start by drawing and labeling the figure. Since MC is zero, the optimum number of crossings is that at a price ofzero, i.e. 300 + 1200 - 1500. The welfare loss is therefore (V2)(1200)($3). 16 (b). Again, the first diing to do is to draw the graph. Assume a linear demand curve. Since monopoly profits are $3000, monopoly output is 1500. The gain in consumer surplus if the competitive price of $5 is charged, is (V2) (1500) ($2) plus the monopoly profit $3000. To this we must add the consumer surplus under monopoly, $1500. 17 (c). Where MC = MR. 18 (d). 4 boards can be sold at a price of $80. 19 (d) Tt = (80) (4) - 255. 20 (e). P = MC. 21 (c). MR = MC = 0 implies elasticity -1. 22 (a). MC = MR at 4 units. 23 (e). MR = MC = $5 P > $5. 24 (e). See text. 25 (d). See text. 26 (e). All are true. 27 (e). Regulation can act as an effective barrier to entry. 28 (a). First calculate TR at each output 29 (a). A positive MR indicates elastic demand. 30 (d). MR = 0 implies unit elastic demand because TR is stationary.

31 (a). They would want the bookstores total revenue to be at a maximum, since they get 20% of it. This occurs where MR = 0. Naturally, the bookstore would fa\or a higher price in order to maximize its profits. 32 (e). See text. 33 (a). Jewels are easily resold. Arbitrage. 34 (d). Check Comparing Elasticities in IV. 35 (e). P = AR > MR m monopoly P = AR = MR competidon. 36 (b). At equihbrium monopoly output MB > MC, however large the firm. 37 (a). Arbitrage possibilities. 38 (c). Since the markets are completely isolated and have different demands, the monopolist will want lo price discriminate. Hell produce so that the MR in market A = MR of market = MC = 4. Combined production will be 5 units. Well let you calculate n. 39 (d). Where MR = MC. 40 (b). (P-ATC)Q. 41 (e). Its $2. P = 11, MC = 9. 42 (e). (l/g) (SIO-$5) (4,000,000- 1 .000,000).43 (b). Economic view of efficiency. 44 (a). Economies of scale. 45 (b). Again, draw and label the figure to see what you need to calculate. The area equals (V2) ($2) (600). 46 (b). Same as 44. 47 (d). MR < MC. so decrease output. 48 (e). Demand is inelastic. 49 (e). MR - MC. 50 (b). Implies MR = 0. 51 (b). MR = MC > 0 means demand will be elastic. 52 (c). Then MC = 0, so that in equilib-: rium MR = 0. Hence Ed = 1. 53 (a). By definition. 54 , (c). MR = 0 means = 1. 55 (b). If transhipment from Texas occurs, then in equilibrium, the price in! the two markets can differ only by the cost of transportation. Otherwise arbitrage possibilities will exist • People will buy more Texas crude, and will stop buy-1 ing Califomia crude. This will put upward price prcs-j sure on the Texas crude and downward pressure onj the California crude. When the prices of the twol crudes differ by the cost of transportation, furtherj arbitrage opportunides are exhausted. 56 (b). If trans-l portadon charges were less than $3, these prices couldl not be equilibriums. Arbitrage would make the priccsj converge. If it costs more than $3 to transship, on thel other hand, these prices will be stable. Since oppor tunities for profitable arbitrage get snapped up. may reasonably conclude that arbitrage is unprof itable, i.e.. that transportation charges are prohibidvej 57 (a). Demand would be inelastic in this case. 58 (b) See text 59 (d). See text. 60 (a). All profit-maximiz ing firms produce where MR = MC. 61 (a). monopolist will sell in the elastic portion of the demand curve. 62 (d). If price is less than AVC, the loss from operating will exceed the loss of TFC fron shutting down.

section vii: other priceearchers markets

Monopoly, a single firm with an effective barrier to entry, represents an extreme case of a price-searching firm with market power. At the other extreme are competitive markets in which no individual firm possesses market power; all simply accept the going price. Between these poles he a number of alternative market structures; two will be considered here, oUgopoIy and monopolistic competition.

Industries in which only a small number of firms share the market are termed oligopolies. Alternatively, some firms may be able to create their own individual market by product differentiation, i.e., by producing close but imperfect subsdtutes for competing products. This market structure is termed monopolistic compedtion and it is to that which we now turn.

S3 MONOPOUSTIC COMPETITION

In monopolistic compeddon each firm has managed successfully to differentiate its product in the minds of buyers. Thus, the candy bar with the less fattening center represents a somewhat imperfect substitute for the candy bar with the "nuttier flavor." Slighdy different characteristics, brand loyalty, and geographical location in the case of retailers can create product ( differentiation.

Insofar as such firms successfully differentiate

products, they achieve a degree of market power. For example, ifa perfect competitor raises price one cent above the going rate,100%ofiiisxustomerswilldesert to buy the idendcal good elsewhere. If a monopolistic competitor docs so, not all sales wUl be lost because no other firm sells cxacdy the same product. The product is differentiated. Hence, the monopohstic competitors demand curve slopes downward, making the analysis analogous to monopoly. Specifically, marginal revenue (MR) falls below price and firms maximize profits where marginal cost equals marginal revenue, instead of where marginal cost equals price.

Figure I describes the short run profit equilibrium of the monopolistic competitor, with the shaded zrez being profit. You will recognize the equilibrium as essentially that of the short run monopolist. Nonetheless, unlike monopoly no special barriers to new competition exist in monopolistic competition. Entry is open. As a result, profit seeking firms selling similar but not identical products are attracted into the industry in the long run.

As enuy occurs, the long run demand curve for the product shifts to the left, thereby becoming more elastic. (See Comparing Elasticities in Section I\ if you dont remember why.) Moreover, as we also saw-in Section IV, the presence of closer subsdtutes reinforces the rising demand elasdcity. Clearly, if the long

run demand becomes perfecdy elasdc, we would be back to perfect compeddon. For this reason many economists today believe a strong tendency towzurd perfect competition represents the sole long run outcome in the absence of go\emment created entry barriers.

In Figure II the established firms long run demand curve shifts leftward undl it strikes its average total cost curve. Thereafter entry becomes no longer profitable. Hence, in the long run, profits are normal (zero), and price = average lotal cost = average revenue. Note finally in Figure II that the marginal revenue curve intersects the marginal cost curve direcdy below the point of tangency between average total cost and AR, so that the firm is indeed maximizing profit

The fundamental novelty of the monopolisdc compeddon model is that long run equilibriiun occurs on a downward sloping section of the firms average total cost curve. Thus, unlike perfect competitors, monopolistically compeddve firms do not produce where average total cost is minimized. For this reason monopolisdc compeddon is sometimes said to generate excess capacity. This means not that existing facilities or personnel are necessarily idle, but rather, that average total cost would fall if output were expanded, perhaps by adding new facilities.

Although excess profits are eliminated in monopolistic competition, welfare losses are not at the long run equilibrium level of output, q* in Figure II. marginal cost remains less than price. Consequendy, the welfare loss analysis in Section VI holds for monopolistic competition. Specifically, the marginal benefit to society of additional production is greater than the marginal cost.of producing it. Monopolistic competition is therefore inefficient.

Finally, because entry is open in monopolistically competitive markets, large numbers of firms are common. In return for this inefficiency the consumer receives a good deal of variety, i.e., many competing brands of apparel, shampoo, candies, yogurt, toiletries, and other products, commonly thought to be monopolistically competitive. Moreover, the long run elasticity of demand for many, if not for most, such products may be quite high. If so, we pay perhaps a smalLprice in inefficiency for the.gain of a great,deal of variety.

OUGOPOLY

Oligopoly, competition between a few sellers, can be difficult to analyze. There is one simple reason for this. Economists attempt to find the firms profit maximizing level of output, i.e., that at which marginal revenue equals marginal cost Clearly, this requires] that we know the firms marginal re\enue curve. Butj in oligopoly the firms marginal revenue depends! upon the reactions of a few competitors. These can be J unclear. For example, if competitors match an oligop-l olists price decrease, marginal revenue may be nega-j tive at the new price, but if they dont, marginal »-] enue may be positive. Thus, because of the firms} interdependence, oligopoly marginal revenue con-j tains a so-called "conjectural" element absent in other! market structures. In other words, the oligopolist may] need to make a conjecture concerning how competi-j tors will react to his price and output decisions.

JOINT MAXIMIZING CARTELS

In any case, since the number of sellers is small.I the possibility of collusion cannot be summarily ruledj