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Chapter 9 Monopoly, Oligopoly, and Monopolistic Competition

Chapter 9 Monopoly, Oligopoly, and Monopolistic Competition. 6 additional Questions Even-numbered Qs. Additional Question #1. Market power measures the firm’s ability to Under cut its competitors. Resist union wage demands. Raise its price without losing all of its sales.

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Chapter 9 Monopoly, Oligopoly, and Monopolistic Competition

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  1. Chapter 9Monopoly, Oligopoly, and Monopolistic Competition 6 additional Questions Even-numbered Qs

  2. Additional Question #1 Market power measures the firm’s ability to • Under cut its competitors. • Resist union wage demands. • Raise its price without losing all of its sales. • Influence the price its competitors charge. • Force consumers to pay prices higher than their reservation prices. Ans: C

  3. This is the way that economists define what market power is. • A firm has more market power if it is able to raise the price of its product more and not losing as many customers. • Firms in a perfectly competitive market do not have any market power at all. - Substitution goods are available • If a firm raises its price in a perfectly competitive market, all its customers will switch to another firm which is selling the same product at the market price.

  4. A firm which is a monopolist has the most market power. • Because it is the only firm selling a certain kind of product, if it raises the price, there will still be some customers staying behind. • Of course, that does not mean when a firm has market power, it will not lose any sales at all. When price rises, quantity demanded inevitably drops (law of demand). • It just mean the firm will not lose all its customers, unlike in the case of perfect competition.

  5. Additional Question #2 Suppose a firm increases its labour usage and office space (the only inputs used) by 10% and observes a 13% increase in output. The firm has • Increasing returns to scale. • Constant returns to scale. • Violated the law of diminishing marginal returns. • Increased its average costs. • Reduced its total costs. Ans: A

  6. A firm is said to have constant returns to scale when an x% increase in inputs results in an x% rise in output. • A firm is said to have decreasing returns to scale when an x% increase in inputs leads to a less than x% rise in output. • A firm is said to have increasing returns to scale when an x% increase in inputs causes a more than x% rise in output.

  7. Additional Question #3 • a) For a monopolist to maximize profit, the firm will choose to produce __ units and charge a price of ___. • 3.5; $33.50 B) 7; $19.30 • C) 7; $5 D) 3.5; $5 E) 3.5; $22.50 • b) The socially efficient price and output combination is • $5 and 7. B) $5 and 3.5. • C) $19.30 and 7. D) $22.50 and 3.5. E) $33.50 and 3.5.

  8. P • A) For a monopolist to maximize profit, the firm will choose to produce ? Units and charge a price of ? . • Is the firm a price setter or a price taker? • Price setter (monopolist) • Therefore, we can simplify the diagram into this. MC MR D Q

  9. P • The π-max quantity is where MR=MC. • Therefore, Q*=3.5. • A monopolist will charge the reservation price of Q* according to the Demand schedule. • Therefore, Price will be $22.50 (E) 22.50 MC MR D 3.5 Q

  10. P • B) The socially efficient Price and Output combination is ? . • The Socially Efficient point is where MC meets Demand. • This is the point where all potential surpluses have been extracted. • The respective P and Q are $5 and 7. (A) MC 5 MR D 7 Q

  11. Additional Question #4 The difference between consumer surplus given the monopoly market structure and consumer surplus with the socially efficient quantity is the area _______. A) LEI B) GCEI C) 0GI D) GJI E) GCEL Ans. B

  12. Price • The Socially Eff. Point is where MC meets D. • The CS when it is socially efficient is area GJI. J MC I G D MR Quantity

  13. Price • But if it is a monopoly, P will be higher and Q will be lower. • Q is determined by MR=MC • P is the corresponding reservation price on the Demand curve. J MC E C I G D MR A Quantity

  14. Price • CS under monopoly is area CJE. • The difference between CS (monopoly) and CS (social efficient) is area GCEI. • Ans. B J MC E C I G D MR A Quantity

  15. Additional Question #5 Which of the following situations will come closest to perfect price discrimination? • Charging a different price on different days. • Charging a different price at the end of the year. • Negotiating a price with a group of customers. • Negotiating a price with each individual consumer. • Offering instant, in store rebates. Ans: D

  16. Price Discrimination is a way to reduce inefficiency in a monopoly, and also a way for monopolist to capture the entire consumers’ surplus. • The practice of charging each buyer a different price for essentially the same good or service. • Perfect price discrimination is also called ‘First Degree Price Discrimination’. • The price charged is the maximum or the exact reservation price the customer is willing to pay. • In view of this, Option D is the closest to perfect price discrimination.

  17. Additional Question #6 In its efforts to keep medical costs down, the government has decided to impose a $15 price ceiling on a weekly dose of this drug. What is likely to happen? The firm will produce 400 doses per week causing excess supply of this drug on the market. This drug will disappear from the market. The firm will produce 325 doses per week, just meeting consumer demand. The firm will produce 200 doses per week, the quantity at which price equals MC. New firms will enter this market due to the high quantity demanded at $15. P D 150 125 45 25 ATC 15 MC Q 220 150 250 300 350 400 Ans: B MR

  18. P D $150 125 $45 Loss $25 ATC $15 MC Q 220 150 250 300 350 400 MR

  19. As there is a price ceiling of $15, the MR of selling a dose is no longer the original MR that is derived from the Demand curve. • The MR is now $15 • Therefore, if the manufacturer is to produce anything, the profit-max quantity would be where MC meets the new MR ($15).

  20. P • Price ceiling is $15. • Profit-max quantity is 220. • However, the AC of each dose is $45. • Therefore, the producer will be making a loss when there is a price ceiling. • It will choose not to produce at all. (B) D $45 ATC $15 MC 220 Q

  21. Chapter 9, Problem 2 • State whether the following statements are true or false, and explain why. • In a perfectly competitive industry, the industry demand curve is horizontal, whereas for a monopoly it is downward-sloping. b) Perfectly competitive firms have no control over the price they charge for the product. c) For a natural monopoly, average cost declines as the number of units produced increases over the relevant output range. False True True

  22. 2a) In a perfectly competitive industry, the industry demand curve is horizontal, whereas for a monopoly it is downward-sloping. False Perfectly competitive firm: Firms are price-taker, no control and no influence over price. Goal is to choose the optimal output level to maximize the profit. Firms can sell as much as it wishes at the given price level. Therefore, Demand curve is perfectly elastic (horizontal) Price D Quantity

  23. Imperfectly competitive firm: Have market power: a firm’s ability to raise the price of a good without losing all its sales. They are price setter. Face a negatively sloped Demand curve Price D Quantity

  24. In the firm’s point of view, Demand curve is horizontal for Perfectly Competitive Firm Demand curve is downward-sloping for Imperfectly Competitive Firm However, the industry demand curve is downward-sloping in BOTH case. Supply curve and Demand curve intersect to determine the equilibrium price.

  25. 2b) Perfectly competitive firms have no control over the price they charge for the product. True, according to the assumption of Perfectly Competitive Firm. Perfectly Competitive Firm is a price-taker and has no control or no influence over the price at which it sells its product. Their goal is to choose the optimal output level to maximize its profit. They can sell as much output as they wish at the market price. If they set price higher than market price, they will lose all their businesses, can’t sell any of its output. If they set price lower than market price, they will not be maximizing profit.

  26. 2c) For a natural monopoly, average cost declines as the number of units produced increases over the relevant output range. True. This is the essential feature of natural monopoly. TC = FC + VC (or MC*Q) ATC = FC/Q + MC For a natural monopoly, its production usually entails large fixed start-up costs and low variable costs. i.e. software production The invention of new software usually entails a large fixed start-up cost. Once the invention is done, additional copies of the software can be produced at a very low marginal cost. As quantity increases, marginal cost of an additional output is low and ATC declines steadily.

  27. Chapter 9, Problem 4 • If a monopolist could perfectly price-discriminate: a) The marginal revenue curve and the demand curve would coincide. b) The marginal revenue curve and the marginal cost curve would coincide. c) Every consumer would pay a different price. d) Marginal revenue would become negative at some output level. e) The resulting pattern of exchange would still be socially inefficient. Ans: a

  28. Perfectly discriminating monopolist: a firm that charges each buyer exactly the highest price he is willing to pay (his reservation price). So that each unit would generate revenue that is identical to the reservation price. MR = D Demand curve captures the buyer’s reservation price. MR curve captures the Monopolist’s revenue from selling an additional unit of output. So, for the perfect price discriminator, marginal revenue curve becomes identical with the demand curve. Therefore, (A) is True.

  29. (C) Every consumer would pay a different price. False: Two or more consumers might have the same reservation price. (D) Marginal revenue would become negative at some output level. False: no such rule for perfectly price-discriminate. MR could be negative even if it’s not under price-discriminate. • The resulting pattern of exchange would still be socially inefficient. False: The final unit of output would be sold at a price equal to MC---- socially efficient. Monopolist will charge exactly a the consumer’s reservation price until the last consumer’s reservation price equals to the monopolist’s MC, P=MC.

  30. Chapter 9, Problem 6 What is socially desirable price for a natural monopoly to charge? Why will a natural monopoly that attempts to charge the socially desirable price invariably suffer an economic loss? MC MR D

  31. The socially efficiency price is achieved when marginal benefit to consumer (not MB for monopolist) equals the marginal cost to society. Marginal benefit to consumer, the most that buyers willing to pay for an additional unit of output, which is shown on the monopolist’s demand curve. Marginal cost to society is the same as the cost to monopolist, which is shown on the monopolist’s marginal cost curve. Therefore, social efficiency is achieved when market demand curve intersects the monopolist’s marginal cost curve.

  32. Why will a natural monopoly that attempts to charge the socially desirable price invariably suffer an economic loss? • Economic loss when P < ATC. • Natural monopolies are usually characterized by very large fixed start-up costs and relatively low marginal costs. ATC = FC/Q + MC • The high fixed costs mean that average cost is greater than marginal cost. ATC > MC • If a natural monopoly attempts to charge a socially desirable price, P=MC Economic loss when P < ATC

  33. Firm with high FC (Economic Loss) Firm with low FC (Economic Profit) MC MC ATC Mono. Price ATC Mono. Price ATC ATC MR D MR D

  34. Chapter 9, Problem 8 Serena is a single-price, profit maximizing monopolist in the sale of her own patented perfume whose demand and marginal cost curves are as shown. Relative to the consumer surplus that would result at the socially optimal quantity and price, how much consumer surplus is lost from her selling at the monopolistic profit-maximizing quantity and price?

  35. P Net Loss in consumer surplus MC 60 $ per ounce 40 Perfectly competitive output: P=MC 30 Loss in producer surplus 20 Monopolistic output: P>MR=MC 10 Transfer from CS to monopoly producers MR D Q 0 8 12 24 Ounces/day

  36. P Net Loss in consumer surplus MC 60 Gain in producer surplus 40 30 Loss in producer surplus 20 10 MR D Q 0 8 12 24 Ounces/day

  37. Perfectly competitive output: P=MR=MC • 12 ounces, $30 each ounce • Monopolistic output: P > MR=MC • The firm still produce at MR=MC, but it charges a price higher than MC • 8 ounces, $40 each ounce • Serena produces less than the perfectly competitive output • Consumers loss due to the monopolistic price • Loss in consumer surplus = the area of the trapezoid between $30 and $40 = (8 +12) * ($40 - $30) *1/2 = $100

  38. However, part of loss in consumer surplus is actually transferred to the monopoly producers • The portion of the loss of consumer surplus is not a loss to society. It is a redistribution from consumers to the monopoly producers • That is the area of rectangle between $30 and $40 • Transfer from consumer surplus to monopoly rent = ($40 - $30) * 8 * = $80 • Net loss in consumer surplus (shown in green) = $100 - $80 = $20

  39. Chapter 9, Problem 10 Beth is a second-grader who sells lemonade on a street corner in your neighborhood. Each cup of lemonade costs Beth 20 cents to produce; she has no fixed costs. The reservation prices for the 10 people who walk by Beth’s lemonade stand each day are listed in the following table. Beth knows the distribution of reservation prices (that is, she knows that one person is willing to pay $1, another $0.9, and so on), but she does not know any specific individual’s reservation price.

  40. a) Calculate the marginal revenue of selling an additional cup of lemonade. (Start by figuring out the price Beth would charge if she produced only one cup of lemonade, an calculate the total revenue; then find the price Beth would charge if she sold two cups of lemonade; and so on.) First, we need to compute the Total Revenue according to different people’s reservation price. For example, If she charges $1 for one lemonade, she attracts 1 customer. TR = $1 If she charges $0.9 for one lemonade, she attracts 2 customers. TR = $1.8 If she charges $0.8 for one lemonade, she attracts 3 customers. TR = $2.4 And so on…

  41. a)

  42. What is Beth’s profit-maximizing price? Her profit-maximizing price is at the point where MR=MC. Her MC to produce each cup of lemonade is $20 cents. Her profit-maximizing price is $0.6.

  43. At the price, what are Beth’s economic profit and total consumer surplus? At the profit-maximizing price of $0.6, she produces 5 cups. Total revenue: $3 Explicit cost: Each cup of lemonade costs 20 cents, $0.2 x 5 = $1 Her Economic profit = $3 - $1 = $2

  44. c) Consumer Surplus: Difference between buyer’s reservation price and the actual price they pay. If Beth charges $0.6 each, 5 persons will buy the lemonade. Person A: ($1 - $0.6) = $0.4 Person B: ($0.9 - $0.6) = $0.3 Person C: ($0.8 - $0.6) = $0.2 Person D: ($0.7 - $0.6) = $0.1 Person E: ($0.6 - $0.6) = $0 Total consumer surplus: $1

  45. What price should Beth charge if she wants to maximize total economic surplus? Total economic surplus is maximized if she charges P=MC. MC = $0.2 That is, she should set P=MC = $0.2 and sell 9cups of lemonade. Total economic surplus: ($1 - $0.2) + ($0.9 - $0.2) + ($0.8 - $0.2) + ($0.7 - $0.2) + ($0.6 - $0.2) + ($0.5 - $0.2) + ($0.4 - $0.2) + ($0.3 - $0.2) + ($0.2 - $0.2) = $3.6

  46. Now suppose Beth can tell the reservation price of each person. What price would she charge each person if she wanted to maximize profit? Compare her profit to the total surplus calculated in part d. Beth can charge each buyer exactly his or her reservation price to maximize profit. MC to produce one lemonade is $0.2. Therefore, she will sell lemonade to nine consumers (consumer A to I) and will charge exactly his or her reservation price. Her total revenue is identical to the consumer’s reservation price.

  47. By doing so, her TR is: $1 + $0.9 + $0.8 + $0.7 + $0.6 + $0.5 + $0.4 + $0.3 + $0.2 = $5.4 TC to sell 9 cups of lemonade: 9 x $0.2 = $1.8 Economic profit: $5.4 - $1.8 = $3.6 This economic profit is the same as the total surplus in part d. • Without Price Discrimination, Economic profit = $2, consumer surplus = $1 • With Price Discrimination, Economic profit = $3.6, consumer surplus = $0 (because monopolist is charging exactly their reservation prices, Economic surplus equals to producer surplus.)

  48. With Price discrimination, Monopolist could earn a larger economic profit. • Price discrimination is: • a way for monopolist to capture consumer surplus and to increase its profits • Monopolist charges exactly the consumer’s reservation price, so consumer surplus equals to zero. • All consumer surplus is transferred to the producer. • Thus, Economic surplus equals exact to Producer surplus. • a way to reduce inefficiency • Monopolist will charge exactly a consumer’s reservation price until the last consumer’s reservation price equals to the monopolist’s MC, P=MC. • Thus, the usual deadweight loss associated with monopoly disappears.

  49. End of Chapter 9

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