Answers to Text Questions and Problems Chapter 8

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1 Answers to Text Questions and Problems Chapter 8 Answers to Review Questions 1. The pure monopolist, the oligopolist, and the monopolistically competitive firm all face downward-sloping demand curves. 2. False. A firm with market power is one that faces a downward-sloping demand curve for its product. Such a firm can choose its price or its quantity, but it cannot choose both. Once it chooses one, the other is determined. 3. Without patent or copyright protection, firms would have little incentive to incur the costs needed to develop new products. The gains from encouraging new product development generally outweigh the inefficiency of higher prices. 4. The monopolist must cut price on all units in order to expand sales, whereas the perfectly competitive firm can sell any number of additional units at the market price. 5. A monopolist that charges a single price will set the price higher than that in a perfectly competitive market, so some of the consumer surplus will be transferred to the monopolist. 6. If a monopolist uses price discrimination, it can charge each consumer his or her reservation price. A monopolist that does this until the point at which the reservation price equals marginal cost will capture all of the economic surplus. 7. A perfectly discriminating monopolist will sell exactly the same number of units as in perfectly competition, i.e., producing until price is equal to marginal cost, thus allowing for efficiency. The downside, of course, is the complete transfer of consumer surplus to such a monopolist. 8. False. The natural monopolist, like any other monopolist, sets price above marginal cost. But since marginal cost for the natural monopolist is less than average cost, average cost may exceed price at the profit-maximizing level of output, in which case the monopolist would experience an economic loss. 9. Monopolistic competition is inefficient because advertising increases costs unnecessarily, firms choose inefficiently small scales of operation and operate their plants with excess capacity, and price is greater than marginal cost. espite the inefficiency of monopolistic competition, it does offer variety, which consumers may prefer; to some extent, the benefit of variety may offset the cost of inefficiency. Answers to Problems 1. As shown in the following table, Volvo s greater production volume gives it substantially lower average production cost, and this advantage helps explain why Volvo s market share has in fact been growing relative to Saab s. Saab Volvo Annual production, ,000 Fixed cost $1,000,000,000 $1,000,000,000 Variable cost $0,000,000 $2,000,000,000 Total cost $1,0,000,000 $3,000,000,000 Average cost per car $30,000 $15,000 Copyright 2009 McGraw-Hill Ryerson Limited 1

2 2a. False. The industry demand curve is downward sloping in both cases, but from the individual perfectly competitive firm s point of view, the demand curve is horizontal. Because the individual firm is too small to affect the market price, it can sell as many units as it wishes at that price. b. True. If they try to charge a higher price they will lose all their business; if they try to charge a lower price, they will not be maximizing profit. c. True. This is the essential feature of natural monopoly. 3. Only (c) is true. The monopolist chooses the output level at which marginal revenue equals marginal cost and then charges a price consistent with demand at that level of output. Since price always exceeds marginal revenue, price is greater than marginal cost. There is no shortage: at the output level chosen, quantity demanded and quantity supplied coincide. And the monopolist has no reason to maximize marginal revenue (which would require producing zero units of output). 4. Only (a) is true. The demand curve and the marginal revenue curve would coincide, because the monopolist would sell each successive unit of output at exactly its reservation price, so that unit would generate revenue identical to the reservation price. The final unit of output would be sold at a price equal to marginal cost, so (e) is false: the outcome would be socially efficient. Because two or more consumers might have the same reservation price, (c) is false. 5. The socially desirable price to charge is the one at which the marginal benefit to consumers equals the marginal cost of production. However, natural monopolies are usually characterized by very large fixed costs and relatively low marginal costs. The high fixed costs mean that average cost is greater than marginal cost, so that charging a price equal to marginal cost implies economic losses. 6a. To answer this question, we need a table of Sven s total and marginal revenue: Customer A B C E F G H Reservation price Total revenue ($/day) Marginal revenue Since the cost of each portrait is $12, Sven will set a price consistent with serving only the first five customers. That price is the reservation price of the fifth customer, $34. His profit will be $170 $60, or $110 per day. b. Consumer surplus is $(( 34) + (46 34) + (42 34) + (38 34) + (34 34)) = $40 per day. Copyright 2009 McGraw-Hill Ryerson Limited 2

3 c. The socially efficient number is 8, since each customer has a reservation price that exceeds the marginal cost of production. d. Sven will produce 8 portraits, and his economic profit will be $( ) $96 = $192 per day. e. No consumer surplus is generated. f. The ability to offer a rebate coupon allows Sven to divide his market into two sub-markets. The table of total and marginal revenue for the list-price sub-market is as follows: Customer A B C E Reservation price Total revenue ($) Marginal revenue Sven should set the price at $34 and sell 5 photos per day in this market. In the discount-price submarket, the table of total and marginal revenue is as follows: Customer F G H Reservation price Total revenue ($/day) Marginal revenue The discount price should be $22; Sven should sell three photos in this market. g. Sven s economic profit is now $(34 5) + $(22 3) $96 = $140. The consumer surplus is $( ) $170 + $( ) $66 = $52. 7a. The marginal revenue curves are 12 4Q, 8 6Q, and 10 8Q, respectively. b. The Charlottetown Cinema should set marginal revenue equal to marginal cost in each market. The resulting quantities in each market are 2, 100, and 100, respectively. The corresponding prices are $7 for adults on Saturday night, $5 for children on Sunday afternoon, and $6 for adults on Sunday afternoon. Copyright 2009 McGraw-Hill Ryerson Limited 3

4 8ab. MR = 80 Q. P 80 P* MC Q* 160 Q MR c. The equilibrium quantity is found where MR=MC, which is at Q* = 70. The price is found where this quantity meets the demand curve, at P* = $45. d. Profit = total revenue total cost = ($45)(70) $400 ($10)(70) = 20. e. Consumer Surplus = (1/2)(70)($80 $45) = $ a. Price $1 $0.90 $0.80 $0.70 $0.60 $0. $0.40 $0.30 $0.20 $0.10 Quantity Total $1 $1.80 $2.40 $2.80 $3.00 $3.00 $2.80 $2.40 $1.80 $1 Revenue Marginal Revenue $1 $0.80 $0.60 $0.40 $0.20 $0 $.20 $.40 $.60 $.80 b. MR = MC at a price of $0.60. c. Profit = 5 $( ) = $2. Consumer surplus = ($1 $0.60) + ($0.90 $0.60) + ($0.80 $0.60) + ($0.70 $0.60) = $1. d. She should set P = MC; therefore P = $0.20. e. She would charge persons A through I their respective reservation prices, earning her a profit of $3.60, which is the same as the total economic surplus in part (d). 10a. The market is monopolistically competitive, because, while Indira has competitors in the lemonade market, she is able to differentiate her lemonade from that of her competitors. b. As in problem 9, she will produce where MR = MC, which is at a price of $0.60. At this price, she can sell five cups of lemonade. c. Her variable costs equal 5 $0.20 = $1.00 per day, or $7.00 per week. The fixed cost of her signs is $1.00 per week, for a total weekly cost of $8.00. If Indira were a perfect competitor, the advertising costs would not be needed, so her costs would be lower by $1.00, the cost of the signs. Copyright 2009 McGraw-Hill Ryerson Limited 4

5 d. Indira s weekly revenue is $21.00 from selling 5 cups of lemonade at a price of $0.60 for 7 days. Her total cost is $8.00, so her weekly profit is thus $ e. Indira s economic profit will draw in new competitors, reducing her demand and eliminating her profit. 11a. P LRAC MC A perfectly competitive firm faces a perfectly elastic demand curve. In the long run, the firm produces at the minimum point on its long-run average cost curve, making zero economic profit. b. P LRAC MC MR A monopolistically competitive firm faces a downward-sloping demand curve. While the firm makes zero profit in the long run, it does not produce at the minimum point on its long-run average cost curve. c. A driver would do more driving per shift if the market was perfectly competitive, as the profitmaximizing quantity is higher for a perfectly competitive firm than for a monopolistically competitive firm. However, the equilibrium price is higher for the monopolistically competitive firm, so a passenger would pay a higher price in that case. Copyright 2009 McGraw-Hill Ryerson Limited 5

6 d. In both cases, a driver would earn exactly the opportunity cost of his or her time in the long run. This is because profits are driven to zero in the long run whether the market is perfectly or monopolistically competitive. e. In the monopolistically competitive case, the driver drives less, but because of the shape of the average cost curve, this means that average cost is higher than in the perfectly competitive case. So a driver would make zero profit in either case, even though the price is higher under monopolistic competition. Sample Homework Assignment 1. A firm s total cost function is TC = Q, where fixed cost equals 2 and marginal cost equals 0.5 per unit. a. Graph the firm s marginal cost and average total cost functions. b. Find total fixed cost, total variable cost and average total cost for this function. Break average total cost into average fixed cost and average variable cost. c. What happens to average variable cost and average fixed cost as output rises? d. Will ATC ever equal MC? If so, at what quantity? If not, why not? 2. You own and operate a fruit stand. Your demand curve is given by P = Q, where P is in dollars and Q is in kilograms of fruit. Your marginal cost curve is MC = 0.006Q. Your fixed cost equals $10. a. Graph your demand and marginal cost curves. b. erive and graph your marginal revenue curve. c. Calculate the profit-maximizing price and quantity and show them on your graph. d. Calculate your profit. e. Calculate consumer surplus at the profit-maximizing price and quantity. 3. You own and operate a dry cleaning business. You are the only dry cleaning service in the area and your goal is to maximize profit. You clean a business suit for 8 customers per day, each with a reservation price shown in the table below. The cost of cleaning each suit is $4.25. Customer Reservation price ($ per cleaning) A 6.00 B 5.80 C E 5.20 F 5.00 G 4.80 H 4.60 a. Find the profit-maximizing price and quantity, and your resulting profit, if you charge a single price to clean suits. b. How much consumer surplus is generated each day at the profit-maximizing price? c. What is the socially efficient number of cleanings? d. Suppose consumers A, B, C, and are women and consumers E, F, G, and H are men. If you charge a different price for cleaning suits to men and women, what will the price and quantity be for men and women? e. Calculate consumer surplus and profit if men and women are charged different prices. Copyright 2009 McGraw-Hill Ryerson Limited 6

7 Multiple Choice Quiz 1. A firm with some latitude to determine its own price is called a price a. setter. b. taker. c. maximizer. d. discriminator. e. chooser. 2. Which of the following is not a type of imperfect competition? a. Pure monopoly. b. Natural monopoly. c. Oligopoly. d. Monopolistic competition. e. All of the above are types of imperfect competition. 3. The demand curve for a monopolist is a. downward sloping. b. horizontal. c. vertical. d. equal to the marginal revenue curve. e. upward sloping. 4. Market power refers to a firm s ability to a. set price. b. lower costs. c. produce output. d. control sales. e. eliminate rivals. 5. Which of the following can lead to market power? a. Economies of scale. b. Exclusive control over inputs. c. Patents. d. Government licences. e. All of the above. 6. With economies of scale, a. average cost declines as output increases. b. marginal cost declines as output increases. c. output doubles when inputs double. d. all of the above. e. none of the above. Copyright 2009 McGraw-Hill Ryerson Limited 7

8 7. A monopoly that results due to economies of scale is called a(n) monopoly. a. imperfect b. pure c. scale d. natural e. cost 8. A monopolist s marginal revenue a. is below price. b. can be negative. c. can be derived from the demand curve. d. is half of quantity demanded when price is 0. e. all of the above. 9. Charging different prices to different consumers for the same good is an example of a. monopolization. b. increasing returns to scale. c. price discrimination. d. perfect competition. e. monopolistic competition. 10. Monopolistic competition is inefficient because a. advertising increases costs unnecessarily. b. firms choose inefficiently small scales of operation. c. firms operate their plants with excess capacity. d. price is greater than marginal cost. e. all of the above. Problems/Short Answer 1. You own and operate a t-shirt stand. Your demand curve is given by P = Q. Your marginal cost curve is MC = 10. Your fixed cost equals 300. a. Graph your demand and marginal cost curves. b. erive and graph your marginal revenue curve. c. Calculate and profit maximizing price and quantity, and show them on your graph. d. Calculate your profit. e. Calculate consumer surplus at the profit-maximizing price and quantity. Copyright 2009 McGraw-Hill Ryerson Limited 8

9 2. You decide to open a lemonade stand outside your residence on a hot summer day. You know the distribution of reservation prices for the people who will walk by your stand each day, given in the table below. Each cup of lemonade costs you 30 cents to produce and you have no fixed costs. Person Reservation price A 1.10 B 1.00 C E 0.70 F 0.60 G 0. H 0.40 I 0.30 J 0.20 a. Calculate the marginal revenue of selling each additional cup of lemonade. b. What is your profit-maximizing price? c. At the profit-maximizing price, what are profit and consumer surplus? d. What price should you charge to maximize total economic surplus? e. How could you use price discrimination to increase your profit? If you use perfect price discrimination, how does profit compare to total economic surplus? Answer Key to Extra Questions in Instructor s Manual Sample Homework Assignment 1a. Price ATC MC Copyright 2009 McGraw-Hill Ryerson Limited 9

10 b. TFC = 2, TVC = 0.5Q, ATC = 2/Q + 0.5, AFC = 2/Q, AVC = 0.5Q/Q = 0.5. c. AFC declines as Q increases, AVC remains constant at 0.5. d. No, MC = 0.5 and ATC = /Q, so ATC cannot equal MC unless Q is infinite. 2a. Price 0.5 MC MR 62.5 Kilograms of fruit b. MR = Q. c. Profit-maximizing price = $0.4, profit-maximizing quantity =. d. Profit = TR TC = ($0.4 ) $10 ($0.3 ) = $5. e. Consumer surplus = (½)()($0.1) = $2.5. 3a. P = $5.20, Q = 5, profit = TR TC = ($5.20 5) ($4.25 5) = $4.75. b. Consumer surplus = $0.8 + $0.6 + $0.4 + $0.2 = $2.00. c. Since each reservation price is above the cost of production, the socially optimal quantity is 8. d. You sell 4 cleanings to women for a price of $5.40 and 3 cleanings to men for a price of $4.80. e. Consumer surplus = $0.6 + $0.4 + $0.2 + $0.4 + $0.2 = $1.80. Profit = profit from women + profit from men = [($5.40 4) ($4.25 4)] + [($4.80 3) ($4.25 3)] = $6.25. Multiple Choice 1. a 2. e 3. a 4. a 5. e 6. a 7. d 8. e 9. c 10. e Copyright 2009 McGraw-Hill Ryerson Limited 10

11 Problems/Short Answer 1a. Price MC MR Number of t-shirts b. MR = Q. c. Profit-maximizing price = $35, profit-maximizing quantity = 100. d. Profit = TR TC = ($35 100) [$300 + ($10 100)] = $1200. e. Consumer surplus = (½)(100)($25) = $12. 2a. Quantity Marginal revenue b. Profit-maximizing price = $0.70. c. Profit = TR TC = ($0.70 5) ($0.30 5) = $2.00. Consumer surplus = $0.4 + $0.3 + $0.2 + $0.1 = $1.00. d. To maximize total economic surplus, set P = MC = $0.30. e. Charge each person their reservation price so that profit equals total economic surplus in part (d). Copyright 2009 McGraw-Hill Ryerson Limited 11