503 GR Spring 2000
John Leeth Bentley College
Problem Set 7
Hyman Page 317, questions 3, 4, and 9. Key Terms 1. a group of firms acting together to coordinate output decisions and control prices as if they were a single monopoly. the difference between the output corresponding to minimum possible average cost and that produced by the monopolistically competitive firm in the long run. one dominant firm in an industry that sets its price to maximize its own profits, after which other firms follow its lead by setting exactly the same price. exists when more than one seller competes for sales with other sellers of competitive products, each of whom has some control over price.
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Multiple Choice 1. The demand and marginal revenue curves faced by a monopolistic competitor are flatter or more elastic than the demand and marginal revenue curves faced by a monopolist because: a. the demand for the good is very responsive to changes in income. b. the goods produced in the industry, while not perfect substitutes, are nevertheless close substitutes. c. the goods in the industry are unique and are not substitutes. d. entry and exiting by firms makes consumers more responsive to price changes.
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In the long run, economic profits cause the monopolistically competitive industry and a shift in the demand and marginal revenue curves. a. entry into, leftward b. entry into, rightward c. exiting from, leftward d. exiting from, rightward In a monopolistically competitive industry, short-run losses or economic profits will cause the demand curve to shift to the point where in long-run equilibrium, it: a. intersects the supply curve. b. intersects the average variable cost curve. c. is just tangent to the average cost curve. d. is just tangent to the marginal cost curve. Monopolistic competition and perfect competition are similar in which of the following ways? a. In long-run equilibrium, economic profits are zero. b. Price exceeds marginal cost. c. Price equals minimum average cost. d. There is relative freedom of entry and exit. e. A and d. If each oligopolist in a given industry matches price cuts but does not match price increases: a. price wars develop, resulting in zero economic profits. b. prices become rigid at the intersection of the marginal revenue and average cost curves. c. prices become flexible due to the price-cutting behavior. d. prices become rigid at the kink in the demand curve. Price warring creates an incentive by oligopolists to collude. A formal agreement to restrict output and share markets is called a: a. pure monopoly. b. restrictive oligopoly. c. cartel. d. quota.
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Short Answer 1. a. b. c. 2. Why does a monopolistic competitor face a downward sloping demand curve? Why can a monopolistic competitor earn only zero economic profit in the long-run? Graph the long-run equilibrium for a monopolistic competitor.
The figure below represents a monopolistically competitive firm in short-run equilibrium.
a. b. c. d. e.
The profit-maximizing or loss-minimizing level of output and price are units and $ , respectively. The firm has short-run economic (profits, losses) equal to area in the figure above. In the long run, causes the firms demand and marginal revenue curves to shift until the demand curve is just tangent to the curve. Show the long-run equilibrium on the figure above. In long-run equilibrium: (1) Price marginal cost (2) Price average cost (3) Price minimum average cost (4) Economic profit = $
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Consider the following figure of an oligopolist.
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Explain the behavioral reactions of rival oligopolists that produced the kink in the demand curve. Profits are maximized at a level of output where equals . Price = $ and quantity = units. Show on the figure above the effect of an increase in marginal costs of $5 at each level of output and a decrease of $5. An increase in marginal cost of $5 at each level of output causes the profit-maximizing price and quantity to . A decrease in marginal cost of $5 at each level of output causes the profit-maximizing price and quantity to . Prices are (rigid, flexible) given certain shifts in the marginal cost curve in the discontinuous section of the marginal revenue curve. Assume the widget industry is perfectly competitive and is currently in long-run equilibrium. Graph the market and the representative firm. If a cartel is formed what will happen to the price and sales of widgets? On the graph you drew for part (a), show the new price and level of sales in the market and for the representative firm. Label the firms economic profits. Can the firm make even greater profits if it cheats on the cartel? Explain and support your answer graphically? Do economists expect cartels to be long lasting? Why or why not?
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Suppose two firms, A and B, sell the same product and are in stiff competition with each other. Currently the competition between them is so stiff that each earns only $10,000 profits. The two firms decide to enter into a cartel agreement in which each agrees to raise and price, once prices are raised, not to undercut the other. If they hold to the agreement, each firm will earn profits of $50,000. But if one firm holds to the cartel agreement, and the other does not, the one that does not hold to the agreement will earn profits of $100,000, and the one that does will earn $5,000 profits. Of course, if neither holds to the agreement, then both will be back where they started earning $10,000 profits. a. b. c. Based on the information above set up the payoff matrix. What is the dominant strategy for each firm? Explain. What would you predict would happen to the cartel? Explain.
Abbreviated Solutions
Hyman Page 317 3. In the long-run, new firms will enter the industry until prices fall to equal average costs. See Boxes 2 and 3 (pages 301-302) for a graphically analysis. 4. Because the industry is monopolistically competitive, economic profits will fall to zero before AC reaches its minimum possible value of $20. The downward sloping demand curve for any given firm will be tangent to the AC curve at a level of output less than that corresponding to minimum possible AC. Each firm would adjust output until its marginal cost rose to equal the cartel price. As this happens the quantity of output on the market would increase causing price to fall and profits to decline. See Box 6, page 309, for a graphical presentation. (Note: to maximize industry profits the cartel should produce 10 thousand units of output per day, but when each firm individually attempts to maximize profits at the cartel price of $3, 18 thousand units of output is produced.) The cartel must set up an enforcement mechanism to penalize firms that exceed their quotas.
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Key Terms 1. 2. 3. 4. cartel excess capacity price leader imperfect competition
Multiple Choice 1. b Short Answer
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The monopolistic competitor faces a downward sloping demand curve for its product because it produces a close, but not a perfect substitute, for other firms products. If the monopolistic competitor raises price it will lose some sales as people buy alternative products, but it will not lose all sales as some customers find the product to be better than that produced by other firms. The heterogeneity of output means that some people will continue buying the product even if the price is slightly greater than that charged by other firms. Easy entry and exit allows a monopolistically competitive firm to earn only a zero economic profit in the long run. See Box 3, page 302. i units, $d losses, eFgd exiting, rightward, AC (1) exceeds, (2) equals, (3) exceeds, (4) $0 The kink in the demand curve results form rival oligopolists matching price cuts but not matching price increases. The logic is that the firm must match price cuts or lose market share. With price increases, a firm could increase market share by not matching the price increase and capturing a portion of the market share previously held by the oligopolist that raised its price. As a resul...