Questions - Johan Lindén, Mälardalens högskola



Chapter 12MonopolyQuestions What is meant by market power? What are the ways in which a monopoly gains market power?Answer: Market power relates to the ability of sellers to affect prices. For the monopolist, market power arises because of barriers to entry. Barriers to entry are obstacles that prevent potential competitors from entering the market. There are two types of market power that arise from barriers to entry: legal market power and natural market power. Legal market power occurs when a firm obtains market power through barriers to entry created not by the firm itself, but by the government. For example, firms gain market power through patents and copyrights. Natural market power arises when the monopolist owns or controls a key resource necessary for production or there are economies of scale in production over the relevant range of output. Use a graph to explain the difference between a competitive firm’s average total cost curve and the average total cost curve of a natural monopoly.Answer: A natural monopoly enjoys economies of scale over the relevant range of output. Economies of scale occur when the average total cost per unit of output decreases as total output increases. This means that the average total cost curve for a natural monopoly is continuously declining and is negatively sloped. On the other hand, a perfectly competitive firm faces a U-shaped average total cost in the long run, which suggests that it faces increasing returns to scale, constant returns to scale, and diminishing returns to scale. Figure (a) shows the average total cost curve of a competitive firm in the long run. Figure (b) shows the average total cost curve of a natural monopoly in the long run. What does it mean to say that a good generates network externalities? Answer: For a good with network externalities, the value of the good to any particular consumer increases as more customers begin to use it. For example, the value to you of being on Facebook is higher the more people who use Facebook. Therefore by acquiring a large customer base, a particular firm may acquire market power. Examine the following items and state whether each is a legal or natural monopoly: Railway infrastructure in the United States. A seawater desalinization company in the United States. A bicycle pedal manufacturing company in Denmark. A mining company in South Africa. An art restoration company in Serbia.Answer: a.A natural monopolyb.A legal monopoly – patent c.A legal monopoly – copyright d.A legal monopoly – patent e.A natural monopoly There is no difference between a monopoly arising due to legal market power and a monopoly resulting from natural market power. Do you agree? Explain.Answer: The statement is false. There are two types of market power that arise from barriers to entry: legal market power and natural market power. Legal market power occurs when a firm obtains market power through barriers to entry created not by the firm itself, but by the government. For example, firms gain market power through patents and copyrights. Natural market power arises when the monopolist owns or controls a key resource necessary for production or there are economies of scale in production over the relevant range of output.Prior to the liberalization of the telecommunication market in Singapore, there was only one company, Singapore Telecoms, which provided phone services in Singapore. Did this mean that Singapore Telecoms could charge any price it desired for its services? Explain your answer. Answer: The statement is false. The monopolist is powerful but cannot sell at a point beyond the market demand curve; a monopoly cannot set any price it wishes to because it faces a downward-sloping market demand curve. With an increase in price, the firm will sell a smaller number of units but will gain more revenue per unit sold. With a decrease in price, the number of units sold will increase but the revenue per unit will fall. What is the difference between a perfectly competitive firm’s demand curve and a monopolist’s demand curve? Answer: A perfectly competitive firm's demand curve is horizontal since the firm is a price taker and it is the same as its marginal revenue curve. A monopolist's demand curve is downward sloping since the firm's demand curve is the market demand curve and it is above the marginal revenue curve. Refer to the diagram below:Monopolist's demand curve:Competitive firm's demand curve:What is the relationship between price, marginal revenue, and total revenue for a monopolist? Answer: As shown in the following figure, the total revenue curve takes on a hump-back shape because it increases when marginal revenue is positive and decreases when marginal revenue is negative. For this reason, total revenue is at its maximum when the marginal revenue curve crosses the x-axis — that is the point where an additional unit of output causes marginal revenue to equal zero.Both competitive firms and monopolies produce at the level where marginal cost equals marginal revenue. Then, other things remaining the same, why is price lower in a competitive market than in a monopoly? Answer: In both market structures, firms produce the level of output such that marginal cost equals marginal revenue. A firm in a perfectly competitive market faces a perfectly elastic demand curve. As a result, marginal revenue for a competitive firm is equal to price. Therefore when a competitive firm equates marginal revenue and marginal cost it also equates price and marginal cost. For a monopolist, however, marginal revenue is less than marginal cost. A monopolist faces a downward sloping market demand curve. As a consequence a monopolist must reduce price in order to sell an additional unit of its product. Therefore, for a monopolist, marginal revenue is less than price; the difference between price and marginal revenue is the effect of reducing price in order to sell more output. As a result, when a monopolist equates marginal revenue and marginal cost price will be greater than marginal cost (since price is greater than marginal revenue).Why does a monopoly firm not have a supply curve?Answer: Firms that are price takers will decide how much to produce based on the given market price. The quantity at which the marginal cost of producing the last unit of a good is equal to any given market price determines the firm’s supply decisions. However, monopolists do not vary their production based on market price because they set the price; it is not relevant to ask how much of a good a monopolist will produce at a given price. Since a monopolist’s production decision is based on demand, it cannot be depicted as an independent supply curve (keep in mind that the supply curve is willingness to sell at various prices, regardless of demand). A monopolist chooses both price and quantity.Explain why firms practice the following price discrimination and classify the types of price discrimination. A hotel charges walk-in customers a higher price than customers who book rooms in advance. A supermarket is promoting a particular brand of canned food with a “buy two, get one free” offer. Theaters charge a higher price during weekends and a lower price during weekdays for the same movie. Answer: Depending on the cost in terms of time and effort required this may or may not be price discrimination. If the cost is higher to cut a woman’s hair than for a man’s, then there is no price discrimination. However, if this is not so, then this is a case of third-degree price discrimination.This is an example of second-degree price discrimination where consumers are charged different prices based on the characteristics of their purchase.This is an example of third-degree price discrimination where price varies based on a customer’s attributes. Why can a government choose to set a price ceiling for natural monopolies? Answer: Governments can set a price ceiling in a monopolized market that is equal to marginal cost, which will likely be lower than the average total cost. This means that the firm will experience economic losses that may lead to an exit from the industry. Alternatively, the government could require firms to set the price at average total cost. This would allow the monopolist to stay in business as the firm would not incur losses. The problem is that the price is higher than the marginal revenue and marginal cost. This means that the firm cannot produce enough goods or provide enough services because the price will be too high for the consumers. Setting a price ceiling means that a firm has no incentive to minimize costs or to innovate. Are there any cases where a monopoly is beneficial to the economy? Explain.Answer: Firms that are allowed monopoly profits search out every possible avenue for innovative technologies that they can bring to market. If there were perfect competition, firms would have less of a reason to invest in research and development because they would not enjoy the same levels of profit from innovation. Through entry, economic profits would be driven to zero in the long run. If innovators are not granted protection, profits may not be available to spur invention. So, granting patents and copyrights involves a tradeoff between the deadweight loss of a monopoly and the incentive for research and development. It may also be the case that the firm is a natural monopoly, which means it will enjoy economies of scale that make it more efficient for a single firm to operate in the market. Splitting supply between firms will leave each seller with higher costs and lower profits.ProblemsThis chapter explains that a monopoly is an industry structure in which only one firm provides a good or a service that has no close substitutes. Examine the following statements and explain if you agree or not: In case of natural monopolies, the companies should be state-owned because their activity needs to be regulated by the government. In case of large industries, the companies need a competitive attitude in the market even if there is vertical integration because consumers need to maximize their benefits. In all sectors of an economy, there should be no economic concentration because the companies should have a wide distribution of power. Answer: In the case of natural monopolies, based on the economies of scale concept, it is efficient for a single firm to serve the entire market, because it can do so at a lower cost than any larger number of firms could. There are to be considered the high infrastructural costs and other barriers to entry that are relative to the size of market, which gives those industries important advantages over potential competitors. Natural monopolies have high fixed costs, for a product that does not depend on output, but its marginal cost of producing one more unit of a good or service is roughly constant, and small. In the case of industrial activities, consumers want those companies to be in competition, because this gives rise to wide-ranging and diverse outcomes. Competition between sellers can be fierce, with relatively low prices and high production, innovation and marketing tools to attract more consumers. This could lead to an efficient outcome for the consumers. Product differentiation may be homogenous (chemicals) or heterogenous (cars).In all other sector of economy, there is no need for price-makers, only for price-takers. The consumers want perfectly competitive markets with low entry and exit barriers, homogeneity of products and services, perfect knowledge about quality and prices.Critically analyze the following and explain whether you agree or disagree: Janet knows a lot of people who do not like Marmite, a yeast extract that is used as a spread on toast. She says that Marmite is so unpopular that Unilever, the company that manufactures Marmite?, cannot possibly have any monopoly power. Edgar says that a single firm in the wind power industry is unlikely to have a significant degree of monopoly power for an extended period of time. Since the cost of producing an additional unit of wind energy is so low, a large number of firms can enter the market and compete away economic profits. Answer: Janet is incorrect in assuming that a company cannot have monopoly power in a market simply because she knows a lot of people who do not like the product. A firm’s market power depends on its ability to set prices in the market. If Unilever is the only firm in the market for yeast spread and Marmite does not have any close substitutes, it is likely that Unilever has monopoly power. Edgar is incorrect as he ignores the fixed cost of operating in the wind energy market. While the marginal cost of producing wind energy may be low, a firm that wishes to enter the market will face substantial fixed costs. This high fixed cost serves as a barrier to entry in the market which means that an incumbent will enjoy a significant degree of monopoly power. Textbook publishers hope to maximize profits. Authors, however, face very different incentives. Authors are typically paid royalties, which are a specified percentage of total revenue from the sale of a book. And so, for example, if an author’s contract says that she will receive 20 percent of the revenues from the sale of a text and the publisher’s total revenues are $100,000, the author’s royalties will be $20,000. Who will prefer a higher price for the text, the publisher or the author?Answer: The publisher is likely to prefer a higher price for the text. The diagram below helps explain this problem. The publisher wants to maximize profits and therefore would prefer to sell Q1 books, the quantity that equates MR and MC. The publisher would therefore like to choose the price P1. In contrast, an author who wishes to maximize royalties will want to maximize total revenues; the author in our example maximizes 20 percent of total revenues by maximizing total revenues. In order to maximize total revenue, the author would choose Q2, the quantity such that MR = 0. If MR = 0, then total revenues will not rise if the publisher sells one more book nor rise if the publisher sells one fewer book. The author would therefore like to choose P2, which is less than the publisher’s preferred price P1.A profit maximizing translational firm produces upholstery items. It has factories in other countries that specialize in producing seats, padding, springs, and fabric cover. Each factory receives 10 percent of the profit because the parent company wants to encourage innovation and higher quality products. If the total revenues of the parent company are $5,000,000, then each factory receives $500,000 to develop itself. Who will benefit from higher prices, the mother company or the factories? Explain.Answer: We learned from the chapter that when price decreases, total revenue increases if the quantity effect dominates the price effect, or decreases if the price effect dominates the quantity effect.From the graph, we notice that if the company chooses a price of $6,000, it will sell 10 pieces, but if it chooses a price of $8,000 or higher, it will sell nothing, despite having a monopoly. Lowering the price to $4,000 will allow the company to sell 5 more units (the quantity effect), thus an increase in revenues occurs. However, the consumers who were buying at $5,000 will buy at $4,000, so there is a loss in revenues (price effect). Calculating the areas, the price effect is equal to $15,000 and the quantity effect is $80,000. In this case, the price effect is lower than the quantity effect, thus the total revenues increase and the demand is elastic over this range of the demand curve.A monopolist producing with a constant average cost and marginal cost of $6 has the following demand for its product.PriceQuantity$101$92$83$74$65Calculate total and marginal revenue for each output level. Find the optimal output and price. Determine the profit or loss as this output.Answers:Total revenue is obtained by multiplying price by quantity. Marginal revenue is obtained by change in total revenue over change in output. Refer to the following table:PriceQuantityTotal RevenueMarginal Revenue$101$10$10$92$18$8$83$24$6$74$28$4$65$30$2The optimal output occurs at MR = MC. Since the marginal cost is $6, the optimal output is 3 units where MR also equals $6. The price is $8.Since Price is $8 and the average cost is $6, the firm is making a profit. The profit is ($8 ? $6) × 3 = $6.Suppose Cattcom is a monopolist in providing communication services. The marker demand curve is P = 100 – Q, its total costs are TC = Q/2 + 100, and its marginal cost is given by: MC = 10 + Q.What is the profit maximizing price and the quantity?Suppose that the government imposes a tax, so the MC = 20 + Q. What is the profit maximizing price and the quantity?Answers:To find the profit maximizing quantity, we need MR. For a downward sloping demand curve, the MR has the same y-intercept and twice the slope of this demand curve: MR = 100 – 2Q. Thus, MC = MR → 10 + Q = 100 – 2Q → Q = 30 units. Using this quantity, the profit maximizing price is P = 100 – Q → P = $70 per unit. If MC = 16 + Q, then 20 + Q = 100 – 2Q → Q = 26.6. The price is P = 100 – Q → P = $73.4.The following graph shows the demand, marginal revenue, and marginal cost curves in a monopoly market.Identify the profit-maximizing price and quantity for this monopolist. What is the value of the consumer surplus, producer surplus, and deadweight loss in the market?How would consumer surplus change if this market was competitive?Answer: The monopolist will maximize profits by producing at the quantity at which marginal cost equals marginal revenue. The marginal revenue curve intersects the marginal cost curve at a quantity of 4 units. Reading off the demand curve, the monopolist should set a price equal to $22.50. The value of consumer surplus (the area highlighted in medium gray in the figure) = ? × 4 × ($40.00 - $22.50) = $35The value of producer surplus (the area highlighted in light gray in the figure) = 4 × ($22.50 - $5.00) = $70Deadweight loss (the area highlighted in dark gray in the figure) = ? × (8 – 4) × ($22.50 - $5.00) = $35If this market was competitive, a firm would produce at the point where the demand curve intersects the marginal cost curve. The area above the marginal cost curve and below the demand curve would be equal to consumer surplus. The value of consumer surplus (the area highlighted in light gray in the figure) = ? × 8 × ($40 - $5) = $140. Suppose that during the weekends, consumers choose to do their shopping in large grocery chains, but during the week, they choose their local corner store to satisfy their immediate needs.How can sellers maximize their profits using the consumers’ preferences? Many retailers observe consumers’ online behavior. What price strategy can large and local grocery retailers choose based on this information? Answer: Sellers try to capture consumer surplus by setting a price that is close or equal to the consumers’ willingness to pay. The consumers state their willingness to pay more while going to large grocery chains, because they buy in bulk, the products that they normally use in high quantities. For daily use, however, they will buy per unit goods. The companies can monitor a consumer’s online behavior based on their online purchasing, browsing history and social media preferences and activity. If the prices seem to be too high for the consumers, they will change their price strategy in the short term, using digital advertising, promotions, coupons, discounts to meet the consumer’s willingness to pay for those goods. Yours is the only stall selling orange juice in a school cafeteria. Your cost of producing one cup of orange juice is $0.50. Currently, you are charging $1 for one cup of orange juice from every student. You discover that students after PE class buy more orange juice from you. On the other hand, students after a class on calculus appear to be neutral to buying the orange juice. If you were to charge the same price from every student, what can you say about the consumer surplus and your profit? If you were to practice price discrimination, what should you do to the price of orange juice when you sell to the two groups of students?Answers:Your marginal cost is $10. If you treat only John, your total revenue is $30 and your total cost is $10, and your profit is $20. If you treat both patients, you will charge a price of $25. In this case, your total revenue is $50, your total cost is $20 and your profit is $30. Hence, the price you charge is $25 and your profit is $30.You will charge each patient his or her reservation prices. This will lead to first-degree price discrimination. Your total revenue is $30 + $25 = $55 and your total cost is $20. Hence, your profit is $35.Consider a small city that is infested by cockroaches. You have just opened the only pest control company in the city. There are two distinct residential areas in the city, high-end area and low-end area, but the cost to exterminate cockroaches is the same in both areas. Consider two consumers with different demand curves. Consumer A stays in the high-end residential area and has a relatively inelastic demand for your pest control service. In contrast, Consumer B stays in the low-end residential area and has a relatively elastic demand for your pest control service.If you were to engage in price discrimination, who will you charge a higher price and who a lower price? Explain your answer. What is the type of price discrimination you engage in your answer to part a? What are the conditions for price discrimination to occur? Explain why you will earn a lower profit if you charge the same price to both customers as compared to exercising price discrimination.Answers:You will charge Consumer A a higher price since her demand is relatively inelastic. This implies that Consumer A is not sensitive to price. You will charge Consumer B a lower price since her demand is relatively elastic, which means Consumer B is sensitive to price.This is the third-degree price discrimination where the firm varies its price based on the consumers’ attributes. If you charge a single price, it may be too low for Consumer A, when you can actually earn more by charging a higher price. If you charge too high a price, the price-sensitive Consumer B may not engage your service. Thus, by charging a higher price to Consumer A and a lower price to Consumer B, you can earn more profit than charging a standard price to both consumers.Imagine that you arrive at an economics experiment with six other people and are told that you will simulate a market. You will be the only seller. The other five people will be assigned a dollar value that they will receive if they buy the good for any amount of money (so if a person's value is $6, he will buy the good for any price less than six dollars and will be happy). You are also given the following demand curve, and told that it represents the values that the "buyers" are assigned:If you are told that you can produce as many units as you like at a cost of $2 per unit, what would your marginal cost curve look like? Add the marginal cost curve that you face as the monopolist to the graph.Draw the marginal revenue curve that you face as the monopolist, based on the demand curve given above.What price would you set and what quantity would you produce if you have to post one price at which everyone can purchase the good?Based on the price and quantity you selected in part c, what would consumer surplus be? What would producer surplus be? Is there a deadweight loss?Imagine that you are told that now you can have a discussion with each buyer privately to negotiate a price. Would you still charge everyone the same price? Explain your answer.Calculate the surplus and the deadweight loss for a scenario with perfect price discrimination.Answers: See diagram.To get marginal revenue, first calculate total revenue (TR) for each quantity. To sell one unit, price is $6 so TR = $6. To sell two units, price is $5, so TR = $10. To sell three, price is $4, TR = $12. Four, price is $3, TR = $12. Five, price is $2, TR = $10. And to sell six units, price is $1, so TR = $6. The difference in these numbers gives the marginal revenue, plotted in the diagram. (MR = -$4 for Q = 6 is not shown.)Profit will be maximized at the point where marginal revenue equals marginal cost. This happens at either Q = 2 or Q = 3. For Q = 2, price is $15, for Q = 3, price is $4. Either way profit is maximized.For price of $5, consumer surplus is ($6-$5) + ($5-$5) = $1. For price of $4, consumer surplus is ($6-$4) + ($5-$4) + ($4-$4) = $3. Either of these is a correct answer. The producer surplus is the same either way (which is why there are two correct answers: $6. For price of $5, you will sell two units at marginal cost of $2, so surplus is $10 - $4 = $6. A similar calculation for price of $4 yields $12 - $6 = $6. The deadweight loss in the Q = 2 case is ($4-$2) + ($3 - $2) = $3. For Q = 3, deadweight loss is only ($3 - $2) - $1. In both cases, it is the unrealized trades for which benefit is greater than cost.If you can negotiate a price individually with each buyer, you will be able to charge each buyer a separate price based on his or her willingness to pay. This is perfect price discrimination and will allow you to maximize your surplus by capturing the entire consumer surplus.You would sell to the first five buyers but not the sixth (since her willingness to pay is less than your marginal cost). You would charge each consumer his or her willingness to pay and so in total you would charge them $6 + $5 + $4 + $3 + $2 = $20. Your total cost would be 5 x $2 = $10 and so your producer surplus would equal $20 - $10 = $10. Under perfect price discrimination consumer surplus is zero and producer surplus is the maximized value of total surplus. Thus, perfect price discrimination is socially efficient - it provides the maximum level of social surplus – but the producer captures the entire surplus.A monopolist with constant marginal cost of $4 faces demand QD = 20 - 2P. This implies that the inverse demand curve is P = 10 - (1/2)Q and that the marginal revenue is MR = 10 - Q.Sketch demand, marginal revenue, and marginal cost.What quantity and price will the monopolist set?What is the producer surplus (profit, ignoring fixed costs) for the firm?Answers:See diagram.Set MR = MC, or 10 - Q = 4, thus Q = 6. At this quantity the monopolist charges the highest price possible: P = $7.Area below the price ($7) but above the cost curve. In this case it is a rectangle: PS=($7-$4)(6-0)=$18. ................
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