Quiz 4 Ec21 W2014 Solutions.pdf

Quiz 4 Ec21 W2014 Solutions.pdf - Economics 21 Winter 2014...

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Page 1 of 5 Economics 21 Winter 2014 Quiz 4 Solutions 1. Short Answer Questions (15 points) a. (3 points) Define “natural monopoly.” A market has a natural monopoly if one firm can produce the total output of the market at a lower cost than several firms could. With a natural monopoly, it is more efficient to have only one firm produce than to have more than one firm produce. Natural monopolies are characterized by falling ATC for output levels corresponding to market demand. A firm may be a natural monopoly even if its cost curve does not fall at all levels of output. Thus, a cost function with economies of scale everywhere is a sufficient but not a necessary condition for a natural monopoly. b. (4 points) Explain in words why a profit-maximizing monopoly will never operate on the inelastic part of a demand curve (i.e., will never set a quantity where the demand curve is inelastic). If a monopolist were to operate on the inelastic part of a demand curve, it could raise its price by 1 percent and the quantity demanded would fall by less than 1 percent (because inelastic demand means the percentage change in quantity is less in absolute value than the percentage change in price). Hence, revenue would increase, but cost would decrease because quantity has decreased. Therefore, profits (=revenue-cost) would increase. This means that the monopolist is not maximizing profits because it could increase profits by reducing output. The monopolist will therefore reduce output until it reaches a point on an elastic section of the demand curve where MR=MC. c. (3 points) Define “Nash equilibrium.” A Nash equilibrium is a set of actions such that, taking the actions of others as given, no player has an incentive deviate (change his/her action). Note: a Nash equilibrium also exists for games (situations) where players are not firms and where actions are something other than choosing quantity. d. (5 points) Suppose a law outlawing price discrimination is repealed. After the repeal, a profit-maximizing monopolist starts to practice group price discrimination but keeps its total output at the same quantity as before the repeal. Explain the effect of the repeal of the law (i) on the profits of the monopolist and (ii) on Social Surplus. Almost all credit is for the quality of your explanation, so make sure you clearly explain the reason why each effect occurs. (i) Profit would increase because the monopolist choses to practice price discrimination rather than charge a single price (which is still allowed). The monopolist only takes actions that maximize its profits, so profits must have increased. (ii) Price discrimination will reduce Social Surplus in this case. In general, price discrimination has two effects on Social Surplus.
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