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UNIVERSITY OF TORONTO SCARBOROUGH DEPARTMENT OF MANAGEMENT ECMC02: Topics in Price Theory (Intermediate Microeconomics II) Problem Set-4 (Solutions) Supplemental 1. a) The profit-maximizing price is p* and the profit-maximizing quantity is Q*. b) Economic profits are positive and are between p* and ATC* for all Q* units. This is a rectangle with height p*-ATC* and length Q* for (p*-ATC*)Q*. c) The economic profits will not persist in the long run since there is free entry in monopolistic competition. The demand curve for TCH will shift inward as more firms enter the coffeehouse industry. The demand curve for TCH coffee will continue to shift inward until there are no longer any positive economic profits. Figure 1 Price MC p* ATC ATC* Q* MR D 2. a) Free entry in monopolistically competitive markets has resulted in new firms entering to get some of the positive economic profits. This entry shifts TCH’s demand curve inward. Consequently, the marginal revenue curve has shifted inward as well. These two curves continue to shift until there are zero economic profits. The MC and ATC curves do not shift. b) Monopolistically competitive markets are often called inefficient because they do not drive costs to their minimum point on the average cost curve in the long run as in perfectly competitive markets. This is because there is product differentiation in monopolistically competitive markets. c) In the short run, the monopolistically competitive firm is closer to the lowest point on its ATC curve than in the long run. This aspect makes the short run look better than the long run. But, the change that occurs in the long run is new firms enter, which shifts the demand curve for any particular brand to the left. Though this puts production on a higher point on the average cost
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curve, the fact that new firms have entered means there are more “brands” on the market. For example, a larger selection of a slightly differentiated product means more kinds of toothpaste, more coffee houses, more kinds of cigarettes, etc. So, efficiency is sacrificed as we move from the short run to the long run for the sake of a wider selection of brands of a particular product; efficiency is sacrificed for variety. Figure 2 MC Price ATC MR D 3. a) q* = 13 because that’s where MC=MR. b) p* = $37.00 c) (p-ATC)*Q equals (37-16)13 = $273.00. d) They will go to zero economic profits in the long run because there is entry in monopolistically competitive markets. New firms will be attracted to this industry until there are no longer positive economic profits to be made. e) The positive economic profits in the short run will attract the entry of new firms, resulting in more firms in the long run. f) The positive economic profits would have existed in the long run if there is no entry of firms.
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