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BUS-111

MICROECONOMICS

PROBLEM SET 7 Imperfect Competition


1.

a.

b.
c.

d.
e.

f.

A publisher faces the following demand for the next novel of one of its authors:
The author is paid 2 million to write the book, and the marginal cost of publishing
the book is a constant 10 per book.
Compute the total revenue, total cost and profit at each quantity. What quantity
would a profit-maximising publisher choose? What price Price
Quantity
would it charge?
() Demanded
Compute marginal revenue. How does marginal revenue
100
0
compare to the price? Explain why this is.
90
100,000
Graph the marginal revenue, marginal cost and demand curves.
80
200,000
At what quantity do the MC and MR curves cross? What does
70
300,000
this signify?
60
400,000
In your graph, label the deadweight loss. What does this
50
500,000
represent?
40
600,000
If the author were paid 3 million instead of 2 million, how
30
700,000
would this affect the publishers decision regarding the price to
20
800,000
charge? Explain.
10
900,000
Suppose the publisher was not profit-maximising but was
0
1,000,000
concerned with maximising economic efficiency. What price
would it then charge for the book? What profit would it make at this price?
The following table shows revenue, costs, and profits:

a.

Price
()

Quantity
(1,000s)

100
90
80
70
60
50
40
30
20
10
0

0
100
200
300
400
500
600
700
800
900
1,000

Total
Revenue
(millions)
0
9
16
21
24
25
24
21
16
9
0

Marginal
Revenue
()
---90
70
50
30
10
-10
-30
-50
-70
-90

Total Cost
(millions)

Profit
(millions)

2
3
4
5
6
7
8
9
10
11
12

-2
6
12
16
18
18
16
12
6
-2
-12

A profit-maximizing publisher would choose a quantity of 400,000 at a price of


60 or a quantity of 500,000 at a price of 50; both combinations would lead to
profits of 18 million.
b. Marginal revenue is always equal to or less than price. Price falls when quantity
rises because the demand curve slopes
downward, but marginal revenue falls
even more than price because the firm
loses revenue on all the units of the
good sold when it lowers the price.
c. The diagram to the right shows the
marginal-revenue, marginal-cost, and
demand curves. The marginal-revenue
and marginal-cost curves cross

between quantities of 400,000 and 500,000. This signifies that the firm
maximizes profits in that region.
d. The area of deadweight loss is marked DWL in the figure. Deadweight loss
means that the total surplus in the economy is less than it would be if the
market were competitive, because the monopolist produces less than the
socially efficient level of output.
e. If the author were paid 3 million instead of 2 million, the publisher would not
change the price, because there would be no change in marginal cost or
marginal revenue. The only thing that would be affected would be the firms
profit, which would fall. The authors fee is a fixed cost it does not vary as the
quantity of books sold varies.
f. To maximize economic efficiency, the publisher would set the price at 10 per
book, because that is the marginal cost of the book. At that price, the publisher
would have negative profits equal to the amount paid to the author.

2.

a.
b.

c.

a.

Define marginal revenue.


Draw a diagram to explain how marginal revenue for the whole market is related to
the demand curve. Identify the level of output that maximises revenue in that market
and explain why revenue is maximised at that output.
Why does a profit maximising monopolist not produce the output that maximises its
revenue?

Marginal revenue is the change in total revenue arising from selling one more
unit of a good. More formally, marginal revenue is the derivative of total
revenue with respect to output: MR = dTR/dQ TR/Q.
b. A monopolist's marginal revenue is less
than the price of its product because its
demand curve is the market demand
curve. Thus, to increase the amount
sold, the monopolist must lower the
price of its good for every unit it sells.
This cut in price reduces the revenue on
the units it was already selling.
A 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 the firms
revenue, but the decline in price
decreases the firms revenue. The
overall effect depends on the price elasticity of demand. If demand is inelastic,
marginal revenue will be negative.
In the diagram above, the revenue maximising output is Q1 where MR=0.
Consider output Q0. Marginal revenue at this output, MR0, is greater than zero.
This means an increase in output will increase revenue. An increase in output of
one unit will increase revenue by MR0. Hence, total revenue cannot be
maximised when MR>0.

c.

3.

Consider output Q2. Marginal revenue at this output, MR2, is less than zero.
This means a decrease in output will increase revenue. Hence, total revenue
cannot be maximised when MR<0.
Total revenue can only be maximised when MR=0.
Marginal costs are positive for any level of output. A profit maximising firm
will always set MC=MR. Therefore, to maximise profit, the firm will always
choose an output where MR is positive, and so TR is not maximised.

Explain why a monopolist will always produce a quantity at which the demand
curve is elastic. (Hint: if demand is inelastic and the firm raises its price, what
happens to total revenue and to total costs?)
A monopolist always produces a quantity at which demand is elastic. If the firm
produced a quantity for which demand was inelastic, then if the firm raised its
price, quantity would fall by a smaller percentage than the rise in price, so
revenue would increase. Because costs would decrease at a lower quantity, the
firm would have higher revenue and lower costs, so profit would be higher.
Thus the firm should keep raising its price until profits are maximized, which
must happen on an elastic portion of the demand curve.
As the diagram below shows, another way to see this is to note that on an
inelastic portion of the demand curve, marginal revenue is negative. Increasing
quantity requires a greater percentage reduction in price, so revenue declines.
Because a firm maximizes profit where marginal cost equals marginal revenue,
and marginal cost is never negative, the profit-maximizing quantity can never
occur where marginal revenue is negative. Thus, it can never be on the inelastic
portion of the demand curve.

4.

Define natural monopoly. What does the size of a market have to do with whether an
industry is a natural monopoly?
Natural monopoly exists when a single firm can produce the entire market
output at a lower cost than would be possible if there were several firms in the
market. As a market grows, it may become large enough that two or more firms
can survive in the industry. At that point it is no longer a natural monopoly.

5.
a.
b.
c.
d.
e.
f.
g.

Classify the following markets as perfectly competitive, monopolistic or


monopolistically competitive, and explain your answers.
wooden HB pencils
bottled water
cola
copper
local telephone service
strawberry jam
lipstick

There is no definite answer to this question. Perfectly competition, monopoly


and monopolistic competition are economic models rather than classifications
for real world industries, but the model that most closely resembles each of
these markets is as follows:
a. wooden HB pencils perfect competition many producers, no product
differentiation, free entry and exit.
b. bottled water monopolistic competition many producers, differentiation by
brand, free entry and exit.
c. cola oligopoly there are only a few firms that control a large portion of the
market.
d. copper perfect competition many producers, no product differentiation,
relatively free entry and exit.
e. mains sewerage monopoly one producer, high barriers to entry because of
massive fixed costs.
f. strawberry jam monopolistic competition many producers, differentiation
by brand, free entry and exit.
g. lipstick monopolistic competition many producers, differentiation by brand,
free entry and exit.

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