Chapter 14: SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes 1. 2. When a competitive firm doubles the amount it sells, the price remains the same, so its total revenue doubles. The price faced by a profit-maximizing firm is equal to its marginal cost because if price ere above marginal cost, the firm could increase profits by increasing output, hile if price ere belo marginal cost, the firm could increase profits by decreasing output. ! profit-maximizing firm decides to shut do n in the short run hen price is less than average variable cost. "n the long run, a firm ill exit a mar#et hen price is less than average total cost. $. "n the long run, ith free entry and exit, the price in the mar#et is equal to both a firm%s marginal cost and its average total cost, as &igure 1 sho s. The firm chooses its quantity so that marginal cost equals price' doing so ensures that the firm is maximizing its profit. "n the long run, entry into and exit from the industry drive the price of the good to the minimum point on the average-total-cost curve.

i!ure 1 Questi"#s $"r Re%ie& 1. ! competitive firm is a firm in a mar#et in hich( )1* there are many buyers and many sellers in the mar#et' )2* the goods offered by the various sellers are largely the same' and )$* usually firms can freely enter or exit the mar#et. &igure 2 sho s the cost curves for a typical firm. &or a given price )such as P+*, the level
7

2.

Chapter 14/Firms in Competitive Markets 8

of output that maximizes profit is the output here marginal cost equals price )Q+*, as long as price is greater than average variable cost at that point )in the short run*, or greater than average total cost )in the long run*.

i!ure ' $. ,. -. ! firm ill shut do n temporarily if the revenue it ould get from producing is less than the variable costs of production. This occurs if price is less than average variable cost. ! firm ill exit a mar#et if the revenue it ould get if it stayed in business is less than its total cost. This occurs if price is less than average total cost. ! firm.s price equals marginal cost in both the short run and the long run. "n both the short run and the long run, price equals marginal revenue. The firm should increase output as long as marginal revenue exceeds marginal cost, and reduce output if marginal revenue is less than marginal cost. /rofits are maximized hen marginal revenue equals marginal cost. The firm.s price equals the minimum of average total cost only in the long run. "n the short run, price may be greater than average total cost, in hich case the firm is ma#ing profits, or price may be less than average total cost, in hich case the firm is ma#ing losses. 1ut the situation is different in the long run. "f firms are ma#ing profits, other firms ill enter the industry, hich ill lo er the price of the good. "f firms are ma#ing losses, they ill exit the industry, hich ill raise the price of the good. 2ntry or exit continues until firms are ma#ing neither profits nor losses. !t that point, price equals average total cost. 4ar#et supply curves are typically more elastic in the long run than in the short run. "n a competitive mar#et, since entry or exit occurs until price equals the minimum of average total cost, the supply curve is perfectly elastic in the long run.

0.

3.

Chapter 14/Firms in Competitive Markets 9

Pr"()e*s a#+ ,pp)icati"#s 1. ! competitive mar#et is one in hich( )1* there are many buyers and many sellers in the mar#et' )2* the goods offered by the various sellers are largely the same' and )$* usually firms can freely enter or exit the mar#et. 5f these goods, bottled ater is probably the closest to a competitive mar#et. Tap ater is a natural monopoly because there.s only one seller. 6ola and beer are not perfectly competitive because every brand is slightly different. 7ince a ne customer is offering to pay 8$99 for one dose, marginal revenue bet een 299 and 291 doses is 8$99. 7o e must find out if marginal cost is greater than or less than 8$99. To do this, calculate total cost for 299 doses and 291 doses, and calculate the increase in total cost. 4ultiplying quantity by average total cost, e find that total cost rises from 8,9,999 to 8,9,,91, so marginal cost is 8,91. 7o your roommate should not ma#e the additional dose. a. b. ,. :emembering that price equals marginal cost hen firms are maximizing profit, e #no the marginal cost must be $9 cents, since that is the price. The industry is not in long-run equilibrium since price exceeds average total cost.

2.

$.

5nce you have ordered the dinner, its cost is sun#, so it does not represent an opportunity cost. !s a result, the cost of the dinner should not influence your decision about stuffing yourself. 7ince 1ob%s average total cost is 82;9<19 = 82;, hich is greater than the price, he ill exit the industry in the long run. 7ince fixed cost is 8$9, average variable cost is )82;9 8$9*<19 = 82-, hich is less than price, so 1ob on%t shut do n in the short run.

-.

0.

>ere%s the table sho ing costs, revenues, and profits( Qua#tit9 1 2 $ , T"ta) C"st 8; ? 19 11 1$ 1? Mar!i#a ) C"st --81 1 1 2 0 T"ta) Re%e#ue 89 ; 10 2, $2 ,9 Mar!i#a ) Re%e#ue --8; ; ; ; ; Pr"$it 8 -; -1 0 1$ 1? 21

Chapter 14/Firms in Competitive Markets 10

0 3 a. b. c.

23 $3

; 19

,; -0

; ;

21 1?

The firm should produce - or 0 units to maximize profit. 4arginal revenue and marginal cost are graphed in &igure $. The curves cross at a quantity bet een - and 0 units, yielding the same ans er as in part )a*. This industry is competitive since marginal revenue is the same for each quantity. The industry is not in long-run equilibrium, since profit is positive.

i!ure . 3. a. &igure , sho s the short-run effect of declining demand for beef. The shift of the industry demand curve from D1 to D2 reduces the quantity from Q1 to Q2 and reduces the price from P1 to P2. This affects the firm, reducing its quantity from q1 to q2. 1efore the decline in the price, the firm as ma#ing zero profits' after ards, profits are negative, as average total cost exceeds price.

Chapter 14/Firms in Competitive Markets 11

i!ure 4 b. &igure - sho s the long-run effect of declining demand for beef. 7ince firms ere losing money in the short run, some firms leave the industry. This shifts the supply curve from S1 to S$. The shift of the supply curve is @ust enough to increase the price bac# to its original level, P1. !s a result, industry output falls still further, to Q$. &or firms that remain in the industry, the rise in the price to P1 returns them to their original situation, producing quantity q1 and earning zero profits.

i!ure / ;. &igure 0 sho s that although high prices cause an industry to expand, entry into the industry eventually returns prices to the point of minimum average total cost. "n the figure, the industry is originally in long-run equilibrium. The industry produces output Q1, here supply curve S1 intersects demand curve D1, and the price is P1. !t this point

Chapter 14/Firms in Competitive Markets 12

the typical firm produces output q1. 7ince price equals average total cost at that point, the firm ma#es zero economic profit. Ao suppose an increase in demand occurs, ith the demand curve shifting to D2. This causes Bhigh pricesB in the industry, as the price rises to P2. "t also causes the industry to increase output to Q2. With the higher price, the typical firm increases its output from q1 to q2, and no ma#es positive profits, since price exceeds average total cost. >o ever, the positive profits that firms earn encourage other firms to enter the industry. Their entry, Ban expansion in an industry,B leads the supply curve to shift to S$. The ne equilibrium reduces the price bac# to P1, Bbringing an end to high prices and manufacturers. prosperity,B since no firms produce q1 and earn zero profit again. The only long-lasting effect is that industry output is Q$, a higher level than originally.

?.

a. b.

i!ure 0 &igure 3 sho s the typical firm in the industry, ith average total cost ATC1, marginal cost MC1, and price P1. The ne process reduces >i-Tech%s marginal cost to MC2 and its average total cost to ATC2, but the price remains at P1 since other firms cannot use the ne process. Thus >i-Tech earns positive profits. When the patent expires and other firms are free to use the technology, all firms% average-total-cost curves decline to ATC2, so the mar#et price falls to P$ and firms earn no profits.

c.

Chapter 14/Firms in Competitive Markets 13

i!ure 1 19. The rise in the price of petroleum increases production costs for individual firms and thus shifts the industry supply curve up, as sho n in &igure ;. The typical firm.s initial marginal-cost curve is MC1 and its average-total-cost curve is ATC1. "n the initial equilibrium, the industry supply curve, S1, intersects the demand curve at price P1, hich is equal to the minimum average total cost of the typical firm. Thus the typical firm earns no economic profit. The increase in the price of oil shifts the typical firm.s cost curves up to MC2 and ATC2, and shifts the industry supply curve up to S2. The equilibrium price rises from P1 to P2, but the price does not increase by as much as the increase in marginal cost for the firm. !s a result, price is less than average total cost for the firm, so profits are negative. "n the long run, the negative profits lead some firms to exit the industry. !s they do so, the industry-supply curve shifts to the left. This continues until the price rises to equal the minimum point on the firm.s average-total-cost curve. The long-run equilibrium occurs ith supply curve S$, equilibrium price P$, industry output Q$, and firm.s output q$. Thus, in the long run, profits are zero again and there are fe er firms in the industry.

Chapter 14/Firms in Competitive Markets 14

i!ure 2 11. a. &igure ? illustrates the situation in the C.7. textile industry. With no international trade, the mar#et is in long-run equilibrium. 7upply intersects demand at quantity Q1 and price 8$9, ith a typical firm producing output q1.

i!ure 3 b. The effect of imports at 82- is that the mar#et supply curve follo s the old supply curve up to a price of 82-, then becomes horizontal at that price. !s a result, demand exceeds domestic supply, so the country imports textiles from other countries. The typical domestic firm no reduces its output from q1 to q2, incurring losses, since the large fixed costs imply that average total cost ill be much higher than the price. "n the long run, domestic firms ill be unable to compete ith foreign firms because their costs are too high. !ll the domestic firms ill exit the industry and

c.

Chapter 14/Firms in Competitive Markets 15

other countries ill supply enough to satisfy the entire domestic demand. 12. a. &igure 19 sho s the current equilibrium in the mar#et for pretzels. The supply curve, S1, intersects the demand curve at price P1. 2ach stand produces quantity q1 of pretzels, so the total number of pretzels produced is 1,999 x q1. 7tands earn zero profit, since price equals average total cost. "f the city government restricts the number of pretzel stands to ;99, the industrysupply curve shifts to S2. The mar#et price rises to P2, and individual firms produce output q2. "ndustry output is no ;99 x q2. Ao the price exceeds average total cost, so each firm is ma#ing a positive profit. Without restrictions on the mar#et, this ould induce other firms to enter the mar#et, but they cannot, since the government has limited the number of licenses. The city could charge a license fee for the licenses. 7ince it is a lump-sum fee for the license, not based on the quantity of sales, such a tax has no effect on marginal cost, so on.t affect the firm.s output. "t ill, ho ever, reduce the firm.s profits. !s long as the firm is left ith a zero or positive profit, it ill continue to operate. 7o the license fee that brings the most money to the city is to charge each firm the amount )P2 - ATC2*q2, the amount of the firm.s profit.

b.

c.

i!ure 14 1$. a. &igure 11 illustrates the gold mar#et )industry* and a representative gold mine )firm*. The demand curve, D1, intersects the supply curve at industry quantity Q1 and price P1. 7ince the industry is in long-run equilibrium, the price equals the minimum point on the representative firm.s average total cost curve, so the firm produces output q1 and ma#es zero profit. The increase in @e elry demand leads to an increase in the demand for gold, shifting the demand curve to D2. "n the short run, the price rises to P2, industry output rises to Q2, and the representative firm.s output rises to q2. 7ince price no

b.

Chapter 14/Firms in Competitive Markets 16

exceeds average total cost, the representative firm no earns positive profits. c. 7ince gold mines are earning positive economic profits, over time other firms ill enter the industry. This ill shift the supply curve to the right, reducing the price belo P2. 1ut it.s unli#ely that the price ill fall all the ay bac# to P1, since gold is in short supply. 6osts for ne firms are li#ely to be higher than for older firms, since they.ll have to discover ne gold sources. 7o it.s li#ely that the longrun supply curve in the gold industry is up ard sloping. That means the long-run equilibrium price ill be higher than it as initially.

i!ure 11 1,. a. &igure 12 sho s cost curves for a 6alifornia refiner and a non-6alifornia refiner. 7ince the 6alifornia refiner has access to lo er-cost oil, its costs are lo er.

i!ure 1' b. "n long-run equilibrium, the price is determined by the costs of non-6alifornia refiners, since 6alifornia refiners cannot supply the entire mar#et. The mar#et

Chapter 14/Firms in Competitive Markets 17

price ill equal the minimum average total cost of the other refiners' they ill thus earn zero profits. 7ince 6alifornia refiners have lo er costs, they ill earn positive profits, equal to )P+ - ATCC* x QC. c. Des, there is a subsidy to 6alifornia refiners that is not passed on to consumers. The subsidy accounts for the long-run profits of the 6alifornia refiners. "t arises simply because the oil cannot be exported.

Chapter 1/: SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes 1. ! mar#et might have a monopoly because( )1* a #ey resource is o ned by a single firm' )2* the government gives a single firm the exclusive right to produce some good' and )$* the costs of production ma#e a single producer more efficient than a large number of producers. 2xamples of monopolies include( )1* the ater producer in a small to n, hich o ns a #ey resource, the one ell in to n' )2* pharmaceutical companies ho are given a patent on a ne drug by the government' and )$* a bridge, hich is a natural monopoly because )if the bridge is uncongested* having @ust one bridge is efficient. 4any other examples are possible. 2. ! monopolist chooses the amount of output to produce by finding the quantity at hich marginal revenue equals marginal cost. "t finds the price to charge by finding the point on the demand curve at that quantity. ! monopolist produces a quantity of output that%s less than the quantity of output that maximizes total surplus because it produces the quantity at hich marginal cost equals marginal revenue rather than the quantity at hich marginal cost equals price. /olicyma#ers can respond to the inefficiencies caused by monopolies in one of four ays( )1* by trying to ma#e monopolized industries more competitive' )2* by regulating the behavior of the monopolies' )$* by turning some private monopolies into public enterprises' and ),* by doing nothing at all. !ntitrust la s prohibit mergers of large companies and prevent them from coordinating their activities in ays that ma#e mar#ets less competitive, but such la s may #eep companies from merging to gain from synergies. 7ome monopolies, especially natural monopolies, are regulated by the government, but it is hard to #eep a monopoly in business, achieve marginal-cost pricing, and give the monopolist incentive to reduce costs. /rivate monopolies can be ta#en over by the government, but the companies are not li#ely to be ell run. 7ometimes doing nothing at all may seem to be the best solution, but there are clearly dead eight losses from monopoly that society ill have to bear. 2xamples of price discrimination include( )1* movie tic#ets, for hich children and

$.

,.

-.

Chapter 14/Firms in Competitive Markets 18

senior citizens get lo er prices' )2* airline prices, hich are different for business and leisure travelers' )$* discount coupons, hich lead to different prices for people ho value their time in different ays' ),* financial aid, hich offers college tuition at lo er prices to poor students and higher prices to ealthy students' and )-* quantity discounts, hich offer lo er prices for higher quantities, capturing more of a buyer%s illingness to pay. 4any other examples are possible. /erfect price discrimination reduces consumer surplus, increases producer surplus by the same amount, and has no effect on total surplus, compared to a competitive mar#et. 6ompared to a monopoly that charges a single price, perfect price discrimination reduces consumer surplus, increases producer surplus, and increases total surplus, since there is no dead eight loss. Questi"#s $"r Re%ie& 1. !n example of a government-created monopoly comes from the existence of patent and copyright la s. 1oth allo firms or individuals to be monopolies for extended periods of timeE29 years for patents, forever for copyrights. 1ut this monopoly po er is good, because ithout it, no one ould rite a boo# )because anyone could print copies of it, so the author ould get no income* and no firm ould invest in research and development to invent ne products or drugs )since any other company could produce or sell them, and the firm ould get no profit from its investment*. !n industry is a natural monopoly hen a single firm can supply a good or service to an entire mar#et at a smaller cost than could t o or more firms. !s a mar#et gro s it may evolve from a natural monopoly to a competitive mar#et. ! monopolist.s marginal revenue is less than the price of its product because( )1* its demand curve is the mar#et demand curve, so )2* to increase the amount sold, the monopolist must lo er the price of its good for every unit it sells. )$* This cut in prices reduces revenue on the units it as already selling. ! monopolist.s marginal revenue can be negative because to get purchasers to buy an additional unit of the good, the firm must reduce its price on all units of the good. The fact that it sells a greater quantity increases revenue, but the decline in price decreases revenue. The overall effect depends on the elasticity of the demand curve. "f the demand curve is inelastic, marginal revenue ill be negative.

2.

$.

Chapter 14/Firms in Competitive Markets 19

,.

&igure 1 sho s the demand, marginal-revenue, and marginal-cost curves for a monopolist. The intersection of the marginal-revenue and marginal-cost curves determines the profit-maximizing level of output, Qm. The demand curve then sho s the profit-maximizing price, Pm.

i!ure 1 -. The level of output that maximizes total surplus in &igure 1 is here the demand curve intersects the marginal-cost curve, Qc. The dead eight loss from monopoly is the triangular area bet een Qc and Qm that is above the marginal-cost curve and belo the demand curve. "t represents dead eight loss, since society loses total surplus because of monopoly, equal to the value of the good )measured by the height of the demand curve* less the cost of production )given by the height of the marginal-cost curve*, for the quantities bet een Qm and Qc. The government has the po er to regulate mergers bet een firms because of antitrust la s. &irms might ant to merge to increase operating efficiency and reduce costs, something that is good for society, or to gain monopoly po er, hich is bad for society. When regulators tell a natural monopoly that it must set price equal to marginal cost, t o problems arise. The first is that, because a natural monopoly has a constant marginal cost that is less than average cost, setting price equal to marginal cost means that the price is less than average cost, so the firm ill lose money. The firm ould then exit the industry unless the government subsidized it. >o ever, getting revenue for such a subsidy ould cause the government to raise other taxes, increasing the dead eight loss. The second problem of using costs to set price is that it gives the monopoly no incentive to reduce costs. 5ne example of price discrimination is in publishing boo#s. /ublishers charge a much higher price for hardbac# boo#s than for paperbac# boo#sEfar higher than the difference in production costs. /ublishers do this because die-hard fans ill pay more for a

0.

3.

;.

Chapter 14/Firms in Competitive Markets 20

hardbac# boo# hen the boo# is first released. Those ho don.t value the boo# as highly ill ait for the paperbac# version to come out. The publisher ma#es greater profit this ay than if it charged @ust one price. ! second example is the pricing of movie tic#ets. Theaters give discounts to children and senior citizens because they have a lo er illingness to pay for a tic#et. 6harging different prices helps the theater increase its profit above hat it ould be if it charged @ust one price. Pr"()e*s a#+ ,pp)icati"#s 1. The follo ing table sho s revenue, costs, and profits, here quantities are in thousands, and total revenue, total cost, and profit are in millions of dollars( Price 8 199 ?9 ;9 39 09 -9 ,9 $9 29 19 9 a. Qua#tit516444s7 9 199 299 $99 ,99 -99 099 399 ;99 ?99 1,999 T"ta) Re%e#ue 89 ? 10 21 2, 22, 21 10 ? 9 Mar!i#a ) Re%e#ue ---8? 3 $ 1 -1 -$ --3 -? T"ta) C"st 82 $ , 0 3 ; ? 19 11 12 Pr"$it 8 -2 0 12 10 1; 1; 10 12 0 -2 -12

! profit-maximizing publisher ould choose a quantity of ,99,999 at a price of 809 or a quantity of -99,999 at a price of 8-9' both combinations ould lead to profits of 81; million. 4arginal revenue is al ays less than price. /rice falls hen quantity rises because the demand curve slopes do n ard, but marginal revenue falls even more than price because the firm loses revenue on all the units of the good sold hen it lo ers the price. &igure 2 sho s the marginal-revenue, marginal-cost, and demand curves. The marginal-revenue and marginal-cost curves cross bet een quantities of ,99,999 and -99,999. This signifies that the firm maximizes profits in that region.

b.

c.

Chapter 14/Firms in Competitive Markets 21

i!ure ' d. The area of dead eight loss is mar#ed FGWHI in the figure. Gead eight loss means that the total surplus in the economy is less than it ould be if the mar#et ere competitive, since the monopolist produces less than the socially efficient level of output. "f the author ere paid 8$ million instead of 82 million, the publisher ouldn%t change the price, since there ould be no change in marginal cost or marginal revenue. The only thing that ould be affected ould be the firm%s profit, hich ould fall. To maximize economic efficiency, the publisher ould set the price at 819 per boo#, since that%s the marginal cost of the boo#. !t that price, the publisher ould have negative profits equal to the amount paid to the author.

e.

f.

Chapter 14/Firms in Competitive Markets 22

i!ure . 2. &igure $ illustrates a natural monopolist setting price, PATC, equal to average total cost. The equilibrium quantity is QATC. 4arginal cost pricing ould yield the price PMC and quantity QMC. &or quantities bet een QATC and QMC, the benefit to consumers )measured by the demand curve* exceeds the cost of production )measured by the marginal cost curve*. This means that the dead eight loss from setting price equal to average total cost is the triangular area sho n in the figure. 4ail delivery has an al ays-declining average-total-cost curve, since there are large fixed costs for equipment. The marginal cost of delivering a letter is very small. >o ever, the costs are higher in isolated rural areas than they are in densely populated urban areas, since transportation costs differ. 5ver time, increased automation has reduced marginal cost and increased fixed costs, so the average-total-cost curve has become steeper at small quantities and flatter at high quantities. "f the price of tap ater rises, the demand for bottled ater increases. This is sho n in &igure , as a shift to the right in the demand curve from D1 to D2. The corresponding marginal-revenue curves are MR1 and MR2. The profit-maximizing level of output is here marginal cost equals marginal revenue. /rior to the increase in the price of tap ater, the profit-maximizing level of output is Q1' after the price increase, it rises to Q2. The profit-maximizing price is sho n on the demand curve( it is P1 before the price of tap ater rises, and it rises to P2 after. !verage cost is AC1 before the price of tap ater rises and AC2 after. /rofit increases from )P1 - AC1* x Q1 to )P2 - AC2* x Q2.

$.

,.

Chapter 14/Firms in Competitive Markets 23

i!ure 4 -. a. &igure - illustrates the mar#et for groceries hen there are many competing supermar#ets ith constant marginal cost. 5utput is Q6, price is P6, consumer surplus is area !, producer surplus is zero, and total surplus is area !.

i!ure / b. "f the supermar#ets merge, &igure 0 illustrates the ne situation. Juantity declines from QC to QM and price rises to PM. !rea ! in &igure - is equal to area 1 K 6 K G K 2 K & in &igure 0. 6onsumer surplus is no area 1 K 6, producer surplus is area G K 2, and total surplus is area 1 K 6 K G K 2. 6onsumers transfer the amount of area G K 2 to producers and the dead eight loss is area &.

Chapter 14/Firms in Competitive Markets 24

i!ure 0 0. a. The follo ing table sho s total revenue and marginal revenue for each price and quantity sold( Pric e 2, 22 29 1; 10 1, b. c. 3. Qua#tit19,999 29,999 ,,9,999 $9,999 099,999 ,9,999 329,999 -9,999 ;99,999 09,999 ;,9,999 /rofits are maximized at a price of 810 and quantity of -9,999. !t that point, profit is 8--9,999. !s Lohnny.s agent, you should recommend that he demand 8--9,999 from them, so he instead of the record company receives all of the profit. , $99,999 -,9,999 ; 2-9,999 --9,999 12 299,999 -29,999 10 1-9,999 ,-9,999 T"ta) Re%e#ue 8 2,9,999 Mar!i#a ) Re%e#ue ---8 29 T"ta) C"st 8 -9,999 199,999 Pr"$it 8 1?9,999 $,9,999

"14.s monopoly po er ill be constrained to the extent that people can substitute other computers for mainframes. 7o the government might have loo#ed at the demand curve facing "14, or the divergence bet een "14.s price and marginal cost, to get some idea

Chapter 14/Firms in Competitive Markets 25

of ho severe the monopoly problem as. ;. a. The table belo sho s total revenue and marginal revenue for the bridge. The profit-maximizing price ould be here revenue is maximized, hich ill occur here marginal revenue equals zero, since marginal cost equals zero. This occurs at a price of 8, and quantity of ,99. The efficient level of output is ;99, since that.s here price equals marginal cost equals zero. The profit-maximizing quantity is lo er than the efficient quantity because the firm is a monopolist.

Price 8; 3 0 , $ 2 1 9 b.

Qua#tit9 199 299 $99 ,99 -99 099 399 ;99

T"ta) Re%e#ue Mar!i#a) Re%e#ue 89 ---399 83 1,299 1,-99 $ 1,099 1 1,-99 -1 1,299 -$ 399 -9 -3

The company should not build the bridge because its profits are negative. The most revenue it can earn is 81,099,999 and the cost is 82,999,999, so it ould lose 8,99,999.

i!ure 1 c. "f the government ere to build the bridge, it should set price equal to marginal

Chapter 14/Firms in Competitive Markets 26

cost to be efficient. 1ut marginal cost is zero, so the government should not charge people to use the bridge. d. Des, the government should build the bridge, because it ould increase society.s total surplus. !s sho n in &igure 3, total surplus has area 1<2 x ; x ;99,999 = 8$,299,999, hich exceeds the cost of building the bridge. &igure ; illustrates the drug company.s situation. They ill produce quantity Q1 at price P1. /rofits are equal to )P1 - AC1* x Q1.

?.

a.

i!ure 2 b. The tax on the drug increases both marginal cost and average cost by the amount of the tax. !s a result, as sho n in &igure ?, quantity is reduced to Q2, price rises to P2, and average cost plus tax rises to AC2.

Chapter 14/Firms in Competitive Markets 27

i!ure 3 c. The tax definitely reduces profits. !fter all, the firm could have produced quantity Q2 at price P2 before the tax as imposed, but it chose not to because this level did not maximize profit before the tax occurred. ! tax of 819,999 regardless of ho many bottles of the drug are produced ould result in the quantity produced at Q1 and the price at P1 in &igure ; because such a tax does not affect marginal cost or marginal revenue. "t does, ho ever, raise average cost' in fact, profits decline by exactly 819,999.

d.

19.

Harry ants to sell as many drin#s as possible ithout losing money, so he ants to set quantity here price )demand* equals average cost, hich occurs at quantity QH and price PH in &igure 19. 6urly ants to bring in as much revenue as possible, hich occurs here marginal revenue equals zero, at quantity QC and price PC. 4oe ants to maximize profits, hich occurs here marginal cost equals marginal revenue, at quantity QM and price PM.

i!ure 14 11. a. Hong-distance phone service as originally a natural monopoly because installation of phone lines across the country meant that one firm.s costs ere much lo er than if t o or more firms did the same thing. With communications satellites, the cost is no different if one firm supplies them or if many firms do so. 7o the industry evolved from a natural monopoly to a competitive mar#et. "t is efficient to have competition in long-distance phone service and regulated

b.

c.

Chapter 14/Firms in Competitive Markets 28

monopolies in local phone service because local phone service remains a natural monopoly )being based on land lines* hile long-distance service is a competitive mar#et )being based on satellites*. 12. a. The patent gives the company a monopoly, as sho n in &igure 11. !t a quantity of QM and price of PM, consumer surplus is area ! K 1, producer surplus is area 6 K G, and total surplus is area ! K 1 K 6 K G.

i!ure 11 b. "f the firm can perfectly price discriminate, it ill produce quantity QC and extract all the consumer surplus. 6onsumer surplus is zero and producer surplus is ! K 1 K 6 K G K 2, as is total surplus. Gead eight loss is reduced from area 2 to zero. There is a transfer of surplus from consumers to producers of area ! K 1.

1$.

! monopolist al ays produces a quantity at hich the demand curve is elastic. "f the firm produced a quantity for hich the demand curve ere inelastic, then if the firm raised its price, quantity ould fall by a smaller percentage than the rise in price, so revenue ould increase. 7ince costs ould decrease at a lo er quantity, the firm ould have higher revenue and lo er costs, so profit ould be higher. Thus the firm should #eep raising its price until profits are maximized, hich must happen on an elastic portion of the demand curve. !nother ay to see this is to note that on an inelastic portion of the demand curve, marginal revenue is negative. "ncreasing quantity requires a greater percentage reduction in price, so revenue declines. 7ince a firm maximizes profit here marginal cost equals marginal revenue, and marginal cost is never negative, the profit-maximizing quantity can never occur here marginal revenue is negative, so can never be on an inelastic portion of the demand curve.

Chapter 14/Firms in Competitive Markets 29

1,.

Though 1ritney 7pears has a monopoly on her o n singing, there are many other singers in the mar#et. "f 7pears ere to raise her price too much, people ould substitute to other singers. 7o there is no need for the government to regulate the price of her concerts. 1ecause the marginal cost of the music as virtually zero, Aapster enhanced economic efficiency because those individuals ho valued the music more than zero but less than the selling price ere able to consume it. >o ever, in the long run, musicians and record companies ould have no incentive to release ne music because everyone could o n a copy of it ithout paying for it. The courts eventually shut Aapster do n because they believed that this access violated copyright la s. a. &igure 12 sho s the cost, demand, and marginal-revenue curves for the monopolist. Without price discrimination, the monopolist ould charge price PM and produce quantity QM.

1-.

10.

i!ure 1/81' b. c. d. The monopolist.s profit consists of the t o areas labeled M, consumer surplus is the t o areas labeled D, and the dead eight loss is the area labeled N. "f the monopolist can perfectly price discriminate, it produces quantity QC, and has profit equal to M K D K N. The monopolist.s profit increases from M to M K D K N, an increase in the amount D K N. The change in total surplus is area N. The rise in monopolist.s profit is greater than the change in total surplus, since monopolist.s profit increases both by the amount of dead eight loss )N* and by the transfer from consumers to the monopolist )D*. ! monopolist ould pay the fixed cost that allo s it to discriminate as long as D

e.

Chapter 14/Firms in Competitive Markets 30

K N )the increase in profits* exceeds 6 )the fixed cost*. f. ! benevolent social planner ho cared about maximizing total surplus ould ant the monopolist to price discriminate only if N )the dead eight loss from monopoly* exceeded 6 )the fixed cost* since total surplus rises by N - 6. The monopolist has a greater incentive to price discriminate )it ill do so if D K N O 6* than the social planner ould allo )she ould allo it only if N O 6*. Thus if N P 6 but D K N O 6, the monopolist ill price discriminate even though it is not in society.s best interest.

g.

Chapter 10: SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes 1. 5ligopoly is a mar#et structure in hich only a fe sellers offer similar or identical products. 2xamples include the mar#et for tennis balls and the orld mar#et for crude oil. 4onopolistic competition is a mar#et structure in hich many firms sell products that are similar but not identical. 2xamples include the mar#ets for novels, movies, 6Gs, and computer games. "f the members of an oligopoly could agree on a total quantity to produce, they ould choose to produce the monopoly quantity, acting in collusion as if they ere a monopoly. "f the members of the oligopoly ma#e production decisions individually, they produce a greater quantity than the monopoly quantity because self-interest leads them to produce more than the monopoly quantity.
3. The prisoners i!emma is the stor" o# t$o %rimina!s s&spe%te o# %ommittin' a %rime( in $hi%h the senten%e that ea%h re%eives epen s )oth on his or her e%ision $hether to %on#ess or remain si!ent an on the e%ision ma e )" the other. The #o!!o$in' ta)!e sho$s the prisoners %hoi%es*

2.

B"##ie9s :ecisi"# 6onfess :emain 7ilent 6onfess 1onnie gets ; years 6lyde gets ; years 1onnie goes free 6lyde gets 29 years :emain 7ilent 1onnie gets 29 years 6lyde goes free 1onnie gets 1 year 6lyde gets 1 year

C)-+e9s :ecisi"#

The li#ely outcome is that both ill confess, since that%s a dominant strategy for both. The prisoners% dilemma teaches us that oligopolies have trouble maintaining monopoly profits because each oligopolist has an incentive to cheat.

Chapter 14/Firms in Competitive Markets 31

,.

"t is illegal for businesses to ma#e an agreement about reducing quantities or raising prices. !ntitrust la s are controversial because it isn%t al ays clear hich #inds of behavior these la s should prohibit, such as resale price maintenance, predatory pricing, and tying.

Questi"#s $"r Re%ie& 1. "f a group of sellers could form a cartel, they ould try to set quantity and price li#e a monopolist. They ould set quantity at the point here marginal revenue equals marginal cost, and set price at the corresponding point on the demand curve. &irms in an oligopoly produce a quantity of output greater than the level produced by monopoly at a price lo er than the monopoly price. &irms in an oligopoly produce a quantity of output less than the level produced by a perfectly competitive mar#et at a price greater than the perfectly competitive price. !s the number of sellers in an oligopoly gro s larger, an oligopolistic mar#et loo#s more and more li#e a competitive mar#et. The price approaches marginal cost, and the quantity produced approaches the socially efficient level. The prisoners. dilemma is a game bet een t o people or firms that illustrates hy it is difficult for opponents to cooperate even hen cooperation ould ma#e them all better off. 2ach person or firm has a great incentive to cheat on any cooperative agreement to ma#e himself or itself better off. The arms race, advertising, and common resources are some examples of ho the prisoners. dilemma helps explain behavior. "n the arms race during the 6old War, the Cnited 7tates and the 7oviet Cnion couldn.t agree on arms reductions because each as fearful that after cooperating for a hile, the other country ould cheat. "n advertising, t o companies ould be better off if neither advertised, but each is fearful that if it doesn.t advertise, the other company ill. When t o companies share a common resource, they ould be better off sharing it. 1ut fearful that the other company ill use more of the common resource, each company ends up overusing it. !ntitrust la s prohibit firms from trying to monopolize a mar#et. They are used to prevent mergers that ould lead to excessive mar#et po er in any firm and to #eep oligopolists from acting together in ays that ould ma#e the mar#et less competitive. :esale price maintenance occurs hen a holesaler sets a minimum price that retailers can charge. This might seem to be anticompetitive because it prevents retailers from competing on price. 1ut that is doubtful because( )1* if the holesaler has mar#et po er, it can exercise such po er through the holesale price' )2* holesalers have no

2. $. ,.

-.

0.

3.

;.

Chapter 14/Firms in Competitive Markets 32

incentive to discourage competition among retailers since doing so reduces the quantity sold' and )$* maintaining a minimum price may be valuable so retailers ill provide customers ith good service. Pr"()e*s a#+ ,pp)icati"#s 1. a. b. 5/26 members ere trying to reach an agreement to cut production so they could raise the price. They ere unable to agree on cutting production because each country has an incentive to cheat on any agreement. The turmoil is a decline in the price of oil because of increased production. 5/26 ould li#e Aor ay and 1ritain to @oin their cartel so they could act li#e a monopoly. "f there ere many suppliers of diamonds, price ould equal marginal cost )81,999*, so the quantity ould be 12,999. With only one supplier of diamonds, quantity ould be set here marginal cost equals marginal revenue. The follo ing table derives marginal revenue( Qua#tit5th"usa#+s7 0 3 ; ? 19 11 12 T"ta) Re%e#ue 5*i))i"#s "$ +"))ars7 ,9 ,2 ,2 ,9 $0 $9 22 12 Mar!i#a) Re%e#ue 5*i))i"#s "$ +"))ars7 ---2 9 Q2 Q, Q0 Q; Q19

c. 2. a. b.

Price 5th"usa#+s "$ +"))ars7 ; 3 0 , $ 2 1

With marginal cost of 81,999 per diamond, or 81 million per thousand diamonds, the monopoly ill maximize profits at a price of 83,999 and a quantity of 0,999. !dditional production beyond this point ould lead to a situation here marginal revenue is lo er than marginal cost. c. "f :ussia and 7outh !frica formed a cartel, they ould set price and quantity li#e a monopolist, so the price ould be 83,999 and the quantity ould be 0,999. "f they split the mar#et evenly, they ould share total revenue of 8,2 million and costs of 80 million, for a total profit of 8$0 million. 7o each ould produce $,999 diamonds and get a profit of 81; million. "f :ussia produced $,999 diamonds and 7outh !frica produced ,,999, the price ould decline to 80,999. 7outh !frica.s

Chapter 14/Firms in Competitive Markets 33

revenue ould rise to 82, million, costs ould be 8, million, so profits ould be 829 million, hich is an increase of 82 million. d. 6artel agreements are often not successful because one party has a strong incentive to cheat to ma#e more profit. "n this case, each could increase profit by 82 million by producing an extra thousand diamonds. >o ever, if both countries did this, profits ould decline for both of them. 1uyers ho are oligopolists try to decrease the prices of goods they buy. The o ners of baseball teams ould li#e to #eep players. salaries lo . This goal is difficult to achieve because each team has an incentive to cheat on any agreement, since they ill be able to attract better players by offering higher salaries. The salary cap ould have formalized the collusion on salaries and helped to prevent any team from cheating.

$.

a. b.

c. ,.

4any ans ers are possible, such as pic#ing hich movie to see ith your friend or negotiating the price of a car. The common lin# among all the activities is that there are @ust a fe people involved ho act strategically. a. "f 4exico imposes lo tariffs, then the Cnited 7tates is better off ith high tariffs, since it gets 8$9 billion ith high tariffs and only 82- billion ith lo tariffs. "f 4exico imposes high tariffs, then the Cnited 7tates is better off ith high tariffs, since it gets 829 billion ith high tariffs and only 819 billion ith lo tariffs. 7o the Cnited 7tates has a dominant strategy of high tariffs. "f the Cnited 7tates imposes lo tariffs, then 4exico is better off ith high tariffs, since it gets 8$9 billion ith high tariffs and only 82- billion ith lo tariffs. "f the Cnited 7tates imposes high tariffs, then 4exico is better off ith high tariffs, since it gets 829 billion ith high tariffs and only 819 billion ith lo tariffs. 7o 4exico has a dominant strategy of high tariffs. b. ! Aash equilibrium is a situation in hich economic actors interacting ith one another each choose their best strategy given the strategies others have chosen. The Aash equilibrium in this case is for each country to have high tariffs. The A!&T! agreement represents cooperation bet een the t o countries. 2ach country reduces tariffs and both are better off as a result. The payoffs in the upper left and lo er right parts of the box do reflect a nation.s elfare. Trade is beneficial and tariffs are a barrier to trade. >o ever, the payoffs in the upper right and lo er left parts of the box are not valid. ! tariff hurts domestic consumers and helps domestic producers, but total surplus declines, as e sa in 6hapter ?. 7o it ould be more accurate for these t o

-.

c. d.

Chapter 14/Firms in Competitive Markets 34

areas of the box to sho that both countries. elfare ill decline if they imposed high tariffs, hether or not the other country had high or lo tariffs. 0. a. Gropping the letter grade by t o letters )e.g., ! to 6* if you have no fun gives the payoffs sho n in this table(

;"ur :ecisi"# C)ass*ate9 s :ecisi"# Wor# Wor# Dou get a 6 6lassmate gets a 6 7hir# Dou get a G 6lassmate gets a 1 7hir# Dou get a 1 6lassmate gets a G Dou get a G 6lassmate gets a G

b.

The li#ely outcome is that both of you ill shir#. "f your classmate or#s, you.re better off shir#ing, because you ould rather have an overall 1 )a 1 grade and fun* then an overall 6 )an ! grade and no fun*. "f your classmate shir#s, you are indifferent bet een or#ing for an overall G )a 1 grade ith no fun* and shir#ing for an overall G )a G grade and fun*. 7o your dominant strategy is to shir#. Dour classmate faces the same payoffs, so ill also shir#. 1ut if you are li#ely to or# ith the same person again, you have a greater incentive to or#, so that your classmate ill or#, so you ill both be better off. "n repeated games, cooperation is more li#ely.

3.

2ven though the ban on cigarette advertising increased the profits of cigarette companies, it as good public policy because it reduced the quantity of cigarette consumption. 7ince cigarette consumption imposes an externality because of its health costs, the reduction in quantity is beneficial. a. The decision box for this game is( Bra#i$$9s :ecisi"# Ho /rice >igh /rice Ho Ho profits for 1raniff Rery lo profits for /ric Ho profits for !merican 1raniff e >igh /rofits for !merican >ig >igh profits for 1raniff 4edium profits for h Rery lo profits for 1raniff /ric !merican 4edium profits for e !merican

;.

,*erica#9 s :ecisi"#

Chapter 14/Firms in Competitive Markets 35

b.

"f 1raniff sets a lo price, !merican ill set a lo price. "f 1raniff sets a high price, !merican ill set a lo price. 7o !merican has a dominant strategy to set a lo price. "f !merican sets a lo price, 1raniff ill set a lo price. "f !merican sets a high price, 1raniff ill set a lo price. 7o 1raniff has a dominant strategy to set a lo price. 7ince both have a dominant strategy to set a lo price, the Aash equilibrium is for both to set a lo price.

c.

! better outcome ould be for both airlines to set a high price' then they ould both get higher profits. 1ut that outcome could only be achieved by cooperation )collusion*. "f that happened, consumers ould lose because prices ould be higher and quantity ould be lo er. "f Lones has 19 co s and 7mith has 19, for a total of 29 co s, each co produces 8,,999 of mil#. 7ince a co costs 81,999, profits ould be 8$,999 per co , or 8$9,999 for each farmer. "f one farmer had 19 co s and the other farmer had 29 co s, for a total of $9 co s, each co produces 8$,999 of mil#. /rofits per co ould be 82,999, so the farmer ith 19 co s ma#es 829,999' the farmer ith 29 co s ma#es 8,9,999. "f both farmers have 29 co s, for a total of ,9 co s, each co produces 82,999 of mil#. /rofit per co is 81,999, so each farmer.s profit is 829,999. The results are sho n in the table( <"#es= :ecisi"# S*ith9s :ecisi"# 19 co s 19 co s 8$9,999 profit for Lones 8$9,999 profit for 7mith 829,999 profit for Lones 8,9,999 profit for 7mith 29 co s 8,9,999 profit for Lones 829,999 profit for 7mith

?.

a.

29 co s

829,999 profit for Lones 829,999 profit for 7mith

b.

"f Lones had 19 co s, 7mith ould ant 29 co s. "f Lones had 29 co s, 7mith ould be indifferent )get the same profit* if he had 19 or 29 co s. 7o 7mith has a dominant strategy of having 29 co s.

Chapter 14/Firms in Competitive Markets 36

"f 7mith had 19 co s, Lones ould ant 29 co s. "f 7mith had 29 co s, Lones ould be indifferent )get the same profit* if he had 19 or 29 co s. 7o Lones has a dominant strategy of having 29 co s. The Aash equilibrium is for each farmer to have 29 co s, since that is the dominant strategy for each. They each ma#e profits of 829,999. 1ut they ould both be better off if they cooperated and each had only 19 co s' then profit ould be 8$9,999 each. c. The problem illustrates ho a common field may be overused, reducing the profits of producers. 7ince people tend to overuse common fields, it is more efficient for people to o n their o n portion of the field. Thus, over time, common fields have been divided up and o ned privately.

19.

Hittle Sona should not believe this threat from 1ig 1re because it is not in 1ig 1re %s interest to carry out the threat. "f Hittle Sona enters, 1ig 1re can set a high price, in hich case it ma#es 8$ million, or 1ig 1re can set a lo price, in hich case it ma#es 81 million. Thus the threat is an empty one, hich Hittle Sona should ignore' Hittle Sona should enter the mar#et. Aeither player has a dominant strategy in this game. Leff should hit left if 7teve guesses right and Leff should hit right if 7teve guesses left. 7teve should guess left if Leff hits left and 7teve should guess right if Leff hits right. Thus, if Leff stuc# ith a particular strategy )left or right*, 7teve ould be able to guess it easily after a fe points. ! better strategy for Leff is to randomly choose hether to hit the ball left or right, sometimes hitting left and other times hitting right.

11.

Chapter 11: SOLUTIONS TO TEXT PROBLEMS:

Quick Quizzes 1. The three #ey attributes of monopolistic competition are( )1* there are many sellers' )2* each firm produces a slightly different product' and )$* firms can enter or exit the mar#et freely. &igure 1 sho s the long-run equilibrium in a monopolistically competitive mar#et. This equilibrium differs from that in a perfectly competitive mar#et because price exceeds marginal cost and the firm doesn%t produce at the minimum point of average total cost.

Chapter 14/Firms in Competitive Markets 37

i!ure 1 2. !dvertising may ma#e mar#ets less competitive because it manipulates people%s tastes rather than being informative. !dvertising gives consumers the perception that there is a greater difference bet een t o products than really exists. That ma#es the demand curve for a product more inelastic, so the firms then charge greater mar#ups over marginal cost. >o ever, some advertising could ma#e mar#ets more competitive, since advertising is @ust one more method of competition bet een products and since it sometimes provides useful information to consumers, allo ing them to more easily ta#e advantage of price differences. "n addition, expensive advertising can be a signal of quality. !dvertising also allo s entry, since advertising can be used to inform consumers about a ne product. 1rand names may be beneficial because they provide information to consumers about the quality of goods. They also give firms an incentive to maintain high quality, since their reputations are important. 1ut brand names may be criticized because they may simply differentiate products that are not really different, as in the case of drugs that are identical but the brand-name drug sells at a much higher price than the generic drug. Questi"#s $"r Re%ie& 1. The three attributes of monopolistic competition are( )1* there are many sellers' )2* each seller produces a slightly different product' and )$* firms can enter or exit the mar#et ithout restriction. 4onopolistic competition is li#e monopoly because firms face a do n ard-sloping demand curve, so price exceeds marginal cost. 4onopolistic competition is li#e perfect competition because, in the long run, price equals average total cost, as free entry and exit drive economic profit to zero. "n &igure 2, a firm has demand curve D1 and marginal-revenue curve MR1. The firm is ma#ing profits because at quantity Q1, price )P1* is above average total cost )ATC*. Those profits induce other firms to enter the industry, causing the demand curve to shift

2.

Chapter 14/Firms in Competitive Markets 38

to D2 and the marginal-revenue curve to shift to MR2. The result is a decline in quantity to Q2, at hich point the price )P2* equals average total cost )ATC*, so profits are no zero.

i!ure '

i!ure . $. ,. &igure $ sho s the long-run equilibrium in a monopolistically competitive mar#et. /rice equals average total cost. /rice is above marginal cost. 7ince, in equilibrium, price is above marginal cost, a monopolistic competitor produces too little output. 1ut this is a hard problem to solve because( )1* the administrative burden of regulating the large number of monopolistically competitive firms ould be

Chapter 14/Firms in Competitive Markets 39

high' and )2* the firms are earning zero economic profits, so forcing them to price at marginal cost means that firms ould lose money unless the government subsidized them. -. !dvertising might reduce economic ell-being because it is costly, manipulates people.s tastes, and impedes competition by ma#ing products appear more different than they really are. 1ut advertising might increase economic ell-being by providing useful information to consumers and fostering competition. !dvertising ith no apparent informational content might convey information to consumers if it provides a signal of quality. ! firm on.t be illing to spend much money advertising a lo -quality good, but ill be illing to spend significantly more advertising a high-quality good. The t o benefits that might arise from the existence of brand names are( )1* brand names provide consumers information about quality hen quality cannot be easily @udged in advance' and )2* brand names give firms an incentive to maintain high quality to maintain the reputation of their brand names.

0.

3.

Pr"()e*s a#+ ,pp)icati"#s 1. a. b. The mar#et for T2 pencils is perfectly competitive since pencils by any manufacturer are identical and there are a large number of manufacturers. The mar#et for bottled ater is monopolistically competitive because of consumers. concerns about quality. !s a result, each producer has a slightly different product. The mar#et for copper is perfectly competitive, since all copper is identical and there are a large number of producers. The mar#et for local telephone service is monopolistic because it is a natural monopolyEit is cheaper for one firm to supply all the output. The mar#et for peanut butter is monopolistically competitive because different brand names exist ith different quality characteristics. The mar#et for lipstic# is monopolistically competitive because lipstic# from different firms differs slightly, but there are a large number of firms ho can enter or exit ithout restriction.

c. d. e. f.

2.

! monopolistic firm produces a product for hich there are no close substitutes, but a monopolistically competitive firm produces a product that is only some hat different from substitute goods. 7o the goods differ in terms of the degree to hich substitutes

Chapter 14/Firms in Competitive Markets 40

exist. $. 4onopolistically competitive firms don.t increase the quantity they produce to lo er the average cost of production because doing so ould require them to lo er their price. The loss in revenue from the lo er price out eighs the benefits of the lo er cost of production. a. &igure , illustrates the mar#et for 7par#le toothpaste in long-run equilibrium. The profit-maximizing level of output is Q4 and the price is P4.

,.

i!ure 4 b. c. 7par#le.s profit is zero, since at quantity Q4, price equals average total cost. The consumer surplus from the purchase of 7par#le toothpaste is area ! K 1. The efficient level of output occurs here the demand curve intersects the marginalcost curve, at Q6. 7o the dead eight loss is area 6, the area above marginal cost and belo demand, from Q4 to Q6.

d.

"f the government forced 7par#le to produce the efficient level of output, the firm ould lose money because average cost ould exceed price, so the firm ould shut do n. "f that happened, 7par#le.s customers ould earn no consumer surplus.

-.

7ince each firm in a monopolistically competitive mar#et produces a product that is slightly different from other products, a monopolistically competitive mar#et has a large number of products. 1ut hether that number is optimal or not depends on t o #ey externalities( the product-variety externality and the business-stealing externality. The

Chapter 14/Firms in Competitive Markets 41

product-variety externality is a positive externality to consumers from the introduction of a ne product. The business-stealing externality is a negative externality because other firms lose customers and profits from the addition of a ne product. 7ince the entrant doesn.t ta#e these externalities into account in deciding hether or not to enter the mar#et, it isn.t clear hether the actual number of products ill be optimal, above optimal, or belo optimal. 0. 1y sending 6hristmas cards to their customers, monopolistically competitive firms are advertising themselves. 7ince they are in a position in hich price exceeds marginal cost, they ould li#e more customers to come in, as sho n in &igure -. 7ince the price, P4, exceeds marginal cost, MC4, any additional customer ho pays the existing price increases the firm.s profits.

i!ure / 3. "f you ere thin#ing of entering the ice-cream business, you ould ant to ma#e ice cream that is slightly different from the existing brands. 1y differentiating your product from others, you gain some mar#et po er. 4any ans ers are possible. The ans ers should explain that commercials are socially useful to the extent that they provide consumers information about the product or demonstrate from the existence of the commercial that the product is orth advertising, and thus is not of lo quality. 6ommercials are socially asteful to the extent that they manipulate people.s tastes and try to ma#e products seem more different than they really are. a. ! family-o ned restaurant ould be more li#ely to advertise than a family-o ned farm because the output of the farm is sold in a perfectly competitive mar#et, in hich there is no reason to advertise, hile the output of the restaurant is sold in a monopolistically competitive mar#et.

;.

?.

Chapter 14/Firms in Competitive Markets 42

b.

! manufacturer of cars is more li#ely to advertise than a manufacturer of for#lifts because there is little difference bet een different brands of industrial products li#e for#lifts, hile there are greater perceived differences bet een consumer products li#e cars. The possible return to advertising is greater in the case of cars than in the case of for#lifts. ! company that invented a reliable atch is li#ely to advertise more than a company that invented a less reliable atch that costs the same amount to ma#e because the company ith the reliable atch ill get many repeat sales over time to cover the cost of the advertising, hile the company ith the less reliable atch ill not. /erdue created a brand name for chic#en by advertising. 1y doing so, he as able to differentiate his product from other chic#en, gaining mar#et po er. 7ociety gained to the extent that /erdue has a great incentive to maintain the quality of his chic#en. 7ociety lost to the extent that the mar#et for chic#en became less competitive, ith the associated dead eight loss. &igure 0 sho s Tylenol.s demand, marginal revenue, and marginal cost curves. Tylenol.s price is PT, its marginal cost is MCT, and its mar#up over marginal cost is PT - MCT.

c.

19.

a. b.

11.

a.

i!ure 0 b. &igure 3 sho s the demand, marginal revenue, and marginal cost curves for a ma#er of acetaminophen. The diagrams differ in that the acetaminophen ma#er faces a horizontal demand curve, hile the ma#er of Tylenol faces a do n ardsloping demand curve. The acetaminophen ma#er has no mar#up of price over marginal cost, hile the ma#er of Tylenol has a positive mar#up, because it has some mar#et po er.

Chapter 14/Firms in Competitive Markets 43

i!ure 1 c. The ma#er of Tylenol has a bigger incentive for careful quality control, because if quality ere poor, the value of its brand name ould deteriorate, sales ould decline, and its advertising ould be orth less.