1.

Among monopoly, oligopoly, monopolistic competition, and perfect competition, how would you
classify the markets for each of the following drinks?
a. tap water
b. bottled water
c. cola
d. beer
2. A large share of the world supply of diamonds comes from Russia and South Africa. Suppose that
the marginal cost of mining diamonds is constant at $1,000 per diamond, and the demand for
diamonds is described by the following schedule:
Price $8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000
Quantity 5,000 6,000 7,000 8,000 9,000 10,000 11,000 12,000
a. If there were many suppliers of diamonds, what would be the price and quantity?
b. If there were only one supplier of diamonds, what would be the price and quantity?
c. If Russia and South Africa formed a cartel, what would be the price and quantity? If the
countries split the market evenly, what would be South Africa’s production and profit?
What would happen to South Africa’s profit if it increased its production by 1,000 while
Russia stuck to the cartel agreement?
d. Use your answer to part (c) to explain why cartel agreements are often not successful.
3. Consider trade relations between the United States and Mexico. Assume that the leaders of the
two countries believe the payoffs to alternative trade policies are as follows:
United States’ decision

Low tariff High tariff

US gains $25bn US gains $30bn

Low tariff Mexico gains $25bn Mexico gains $10bn
US gains $10bn US gains $20bn
Mexico’s
High tariff Mexico gains $30bn Mexico gains $20bn
decision

a. What is the dominant strategy for the United States? For Mexico? Explain.
b. Define Nash equilibrium. What is the Nash equilibrium for trade policy?
c. In 1993, the U.S. Congress ratified the North American Free Trade Agreement, in which
the United States and Mexico agreed to reduce trade barriers simultaneously. Do the
perceived payoffs shown here justify this approach to trade policy?
d. Based on your understanding of the gains from trade, do you think these payoffs
actually reflect a nation’s welfare under the four possible outcomes?
4. For each of the following, say whether it describes a perfectly competitive firm, a
monopolistically competitive firm, both, or neither.
a. Charges a price equal to marginal cost.
b. Has marginal revenue equal to price.
c. Faces barriers to entry.
d. Produces a product that is identical to that of its competitors.
e. Earns zero economic profit in the long run.
f. Produces where marginal revenue is greater than marginal cost.
5. For each of the following characteristics, say whether it describes a monopoly firm, a
monopolistically competitive firm, both, or neither.
a. Faces a downward-sloping demand curve.
b. Has marginal revenue less than price.
 c. Faces the entry of new firms selling similar products.
d. Earns economic profit in the long run.
e. Equates marginal revenue and marginal cost.
f. Produces the socially efficient quantity of output.
6. Sparkle is one firm of many in the market for toothpaste, which is in long-run equilibrium.
a. Draw a diagram showing Sparkle’s demand curve, marginal-revenue curve, average-
total-cost curve, and marginal-cost curve. Label Sparkle’s profit maximizing output and
price.
b. What is Sparkle’s profit? Explain.
c. On your diagram, show the consumer surplus derived from the purchase of Sparkle
toothpaste. Also show the deadweight loss relative to the efficient level of output.
d. If the government forced Sparkle to produce the efficient level of output, what would
happen to the firm? What would happen to Sparkle’s customers?

1.

a. Tap water is a perfectly competitive market because there are many taps and
the product does not differ across sellers.
b. Bottled water is a monopolistically competitive market. There are many sellers
of bottled water, but each firm tries to differentiate its own brand from the
rest.
c. The cola market is an oligopoly. There are only a few firms that control a large
portion of the market.
d. The beer market is an oligopoly. There are only a few firms that control a large
portion of the market.
2.
a. If there were many suppliers of diamonds, price would equal marginal cost
($1,000), so the quantity would be 12,000.
b. With only one supplier of diamonds, quantity would be set where marginal cost
equals marginal revenue. The following table derives marginal revenue:

Marginal
Price Quantity Total revenue
revenue
(,000 of $) (,000) (,000,000 of $)
(,000,000 of $)
8 5 40 ----
7 6 42 2
6 7 42 0
5 8 40 –2
4 9 36 –4
3 10 30 –6
2 11 22 –8
1 12 12 –10

With marginal cost of $1,000 per diamond, or $1 million per thousand

diamonds, the monopoly will maximize profits at a price of $7,000 and a
quantity of 6,000. Additional production beyond this point would lead to a
situation where marginal revenue is lower than marginal cost.
c. If Russia and South Africa formed a cartel, they would set price and quantity like
a monopolist, so the price would be $7,000 and the quantity would be 6,000. If
they split the market evenly, they would share total revenue of $42 million and
costs of $6 million, for a total profit of $36 million. So each would produce
3,000 diamonds and get a profit of $18 million. If Russia produced 3,000
diamonds and South Africa produced 4,000, the price would decline to $6,000.
South Africa’s revenue would rise to $24 million, costs would be $4 million, so
profits would be $20 million, which is an increase of $2 million.
d. Cartel agreements are often not successful because one party has a strong
incentive to cheat to make more profit. In this case, each could increase profit
by $2 million by producing an extra 1,000 diamonds. However, if both countries
did this, profits would decline for both of them.
3.
a. If Mexico imposes low tariffs, then the United States is better off with high
tariffs, because it gets $30 billion with high tariffs and only $25 billion with low
tariffs. If Mexico imposes high tariffs, then the United States is better off with
high tariffs, because it get $20 billion with high tariffs and only $10 billion with
low tariffs. So the United States has a dominant strategy of high tariffs. If the
United States imposes low tariffs, then Mexico is better off with high tariffs,
because it gets $30 billion with high tariffs and only $25 billion with low tariffs.
If the United States imposes high tariffs, then Mexico is better off with high
tariffs, because it gets $20 billion with high tariffs and only $10 billion with low
tariffs. So Mexico has a dominant strategy of high tariffs.
b. A Nash equilibrium is a situation in which economic actors interacting with one
another each choose their best strategy given the strategies others have
chosen. The Nash equilibrium in this case is for each country to have high
tariffs.
c. The NAFTA agreement represents cooperation between the two countries.
Each country reduces tariffs and both are better off as a result.
d. The payoffs in the upper left and lower right parts of the box do reflect a
nation’s welfare. Trade is beneficial and tariffs are a barrier to trade. However,
the payoffs in the upper right and lower left parts of the box are not valid. A
tariff hurts domestic consumers and helps domestic producers, but total
surplus declines. So it would be more accurate for these two areas of the box
 to show that both countries’ welfare will decline if they imposed high tariffs,
whether or not the other country had high or low tariffs.
4.
a. A firm in perfect competition charges a price equal to marginal cost.
b. A firm in perfect competition has marginal revenue equal to price.
c. Neither a firm in monopolistic competition nor in perfect competition faces
barriers to entry.
d. A firm in perfect competition produces a product that is identical to that of its
competitors.
e. Both a firm in monopolistic competition and a firm in perfect competition earn
zero economic profit in the long run.
f. Neither a firm in monopolistic competition nor in perfect competition produces
where marginal revenue is greater than marginal cost.
5.
a. Both a firm in monopolistic competition and a monopoly firm face a downward-
sloping demand curve.
b. Both a firm in monopolistic competition and a monopoly firm have marginal
revenue that is less than price.
c. A firm in monopolistic competition faces the entry of new firms selling similar
products.
d. A monopoly firm earns economic profit in the long run.
e. Both a firm in monopolistic competition and a monopoly firm equate marginal
revenue and marginal cost.
f. Neither a firm in monopolistic competition nor a monopoly firm produce the
socially
efficient quantity of output.
6.
a. Figure 1 illustrates the market for Sparkle toothpaste in long-run equilibrium.
The profit-maximizing level of output is QM and the price is PM.

Figure 1.

b. Sparkle’s profit is zero, because at quantity QM, price equals average total
cost.
c. The consumer surplus from the purchase of Sparkle toothpaste is areas A + B.
The efficient level of output occurs where the demand curve intersects the
marginal-cost curve, at QC. The deadweight loss is area C, the area above
marginal cost and below demand, from QM to QC.
d. If the government forced Sparkle to produce the efficient level of output, the
firm would lose money because average total cost would exceed price, so the
firm would shut down. If that happened, Sparkle’s customers would earn no
consumer surplus.