CH short answer study questions Answer Section

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1 CH short answer study questions Answer Section ESSAY 1. ANS: There are a large number firms; each produces a slightly different product; firms compete on price, quality and marketing; and firms are free to enter and exit. As a result of these characteristics, there are no dominant firms and each firms have a small market share. Because the firms produce differentiated products, firms can charge a markup and, in the long run, firms have excess capacity. PTS: 1 DIF: Level 2: Using definitions OBJ: Checkpoint 15.1 TOP: Monopolistic competition definition 2. ANS: The statement is correct. In monopolistic competition firms compete by producing similar but slightly differentiated products. PTS: 1 DIF: Level 2: Using definitions OBJ: Checkpoint 15.1 TOP: Monopolistic competition definition 3. ANS: In monopolistic competition, the product is differentiated. This fact gives each firm some control over price, so each firm's demand curve is downward sloping. Because there are many close substitutes for these firms' goods, demand is elastic. These firms must lower their price to sell more; therefore the marginal revenue curve is beneath the demand curve. In perfect competition, the product is homogeneous, which makes firms price-takers, able to sell as much as they wish at the market price. Therefore, marginal revenue equals price, and the marginal revenue curve and the demand curve are the same and are horizontal. In monopoly, there is only one firm. The firm faces the market demand, which is steep, because there are no close substitutes for the good. The firm must lower its price to sell more, so for a single-price monopoly, the marginal revenue curve is beneath the demand curve. PTS: 1 DIF: Level 5: Critical thinking OBJ: Checkpoint 15.1 TOP: Monopolistic competition definition 4. ANS: Both Coca-Cola and Pepsi Cola are among the four largest firms in the soft drink market, so a merger between the two firms would (drastically) raise the four-firm concentration ratio and (drastically) raise the Herfindahl-Hirschman Index. PTS: 1 DIF: Level 3: Using models OBJ: Checkpoint 15.1 TOP: Four-firm concentration ratio 1

2 5. ANS: The Herfindahl-Hirschman Index, or HHI, is an index used to measure the extent to which a market is dominated by a small number of firms. The HHI equals the sum of the squared percentage market shares of each of the 50 largest firms in the market. A monopoly will have a HHI of 10,000 whereas perfect competition will have a small HHI. PTS: 1 DIF: Level 1: Definition OBJ: Checkpoint 15.1 TOP: Herfindahl-Hirschman Index 6. ANS: The four-firm concentration ratio is 29 percent. The four-firm concentration ratio is less than 40 percent, so the industry would be regarded as competitive. PTS: 1 DIF: Level 3: Using models OBJ: Checkpoint 15.1 TOP: Four-firm concentration ratio 7. ANS: Industry A has a four-firm concentration ratio of 59 percent and a Herfindahl-Hirschman Index of 1,186. Industry B has a four-firm concentration ratio of 39 percent and Herfindahl-Hirschman Index of 914. PTS: 1 DIF: Level 3: Using models OBJ: Checkpoint 15.1 TOP: Herfindahl-Hirschman Index 8. ANS: The statement is incorrect. A firm in monopolistic competition maximizes its profit by producing where its marginal revenue equals its marginal cost. Because the marginal revenue is less than the price for a firm in monopolistic competition, it definitely is not the case that the firm produces where its price equals its marginal cost! TOP: Monopolistic competition output and price 9. ANS: In the long run, a firm in monopolistic competition can earn only zero economic profit, that is, a normal profit. It cannot earn a positive economic profit because there are no barriers to entry. So if a firm in monopolistic competition is earning an economic profit, in the long run new firms enter the market, produce a similar product, and decrease the demand for the initial firm's product. Entry continues until the firms earn zero economic profit, which is a normal profit. TOP: Monopolistic competition long run 10. ANS: Entry into monopolistically competitive markets is easy because there are no barriers to entry. So when firms in monopolistic competition have an economic profit, other firms are attracted to enter the industry, thereby decreasing profits for everyone. Entry continues as long as there is an economic profit so, in the long run when all entry is completed, the firms earn only a normal profit, that is, zero economic profit. TOP: Monopolistic competition long run 2

3 11. ANS: The efficient output is the level that minimizes the average total cost. Excess capacity occurs if the firm produces less than the amount of output that minimizes average total cost. In this case, the firm could boost its output and lower its average total cost. Firms in monopolistic competition have excess capacity. Firms in perfect competition produce at the minimum of the average total cost. They produce at the efficient scale of output and so do not have excess capacity. TOP: Monopolistic competition excess capacity 12. ANS: To determine the quantity produced, the firm will set marginal cost equal to marginal revenue. Therefore it is necessary to determine the marginal revenue. The marginal revenue going from 3 to 4 units is $12 and the marginal revenue going from 4 to 5 units is $8. Thus the marginal revenue at 4 units is $10, which equals the marginal cost. Therefore the firm produces 4 units. The demand schedule shows that for 4 units, the price will be $16 per unit. The firm's economic profit per unit equals the price, $16, minus its average total cost, $10.50, or an economic profit of $5.50 per unit. The firm produces 4 units, so its total economic profit is $ The firm is in a short-run equilibrium because it is able to earn an economic profit. In the long run, entry will decrease its demand so that it no longer can earn an economic profit. PTS: 1 DIF: Level 3: Using models OBJ: Checkpoint 15.2 TOP: Monopolistic competition output and price 13. ANS: a. 40 pizzas per day b. $12.00 per pizza c. $320 d. $480 e. Tony has an economic profit of $160. f. This is not a long-run equilibrium because Tony is earning an economic profit. In the long run, new firms will enter and Tony's economic profit will be eliminated. PTS: 1 DIF: Level 3: Using models OBJ: Checkpoint 15.2 TOP: Monopolistic competition output and price 14. ANS: In order to maintain (or regain) economic profit, a firm in monopolistic competition must continually develop new products that are unique and/or of high quality (or make consumers believe this). Advertising lets firms signal this information. So all firms in monopolistic competition tend to advertise extensively. Advertising is a fixed cost and it shifts the ATC curve upward. Even though it shifts to the ATC curve upward, the total average cost might be lower if it increases the amount sold by enough. Because advertising is a fixed cost, it has no effect on the marginal cost, so the MC curve does not change. Because all firms advertise, advertising might or might not increase demand for a specific firm. When all firms advertise, the demand curve and marginal revenue curve for a specific firm become more elastic. PTS: 1 DIF: Level 2: Using definitions OBJ: Checkpoint 15.3 TOP: Advertising 3

4 15. ANS: No other market structure has the characteristic that one firm's actions can affect the actions of its competitors. In monopoly, there are no competitors to affect. And in perfect competition and monopolistic competition, there are so many competitors that any one firm's actions have no measurable impact on its competitors. Oligopoly is unique in that it is the only market structure in which one firm's actions affect the actions of its competitors. PTS: 1 DIF: Level 2: Using definitions OBJ: Checkpoint 16.1 TOP: Oligopoly 16. ANS: A cartel is a group of firms acting together to decrease output, raise price, and increase economic profit. The difficulty faced by a cartel is the fact that each member has the incentive to cheat on the cartel and increase its output. If a member increases its output and the rest of the cartel members do not, the cheating member's profits will increase substantially. Each member reasons that if it is the only cheater, it can significantly increase its profit and so each firm has an incentive to cheat. PTS: 1 DIF: Level 2: Using definitions OBJ: Checkpoint 16.1 TOP: Cartel 17. ANS: Cartels are typically kept secret because they are illegal. In the United States and many other countries, it is illegal for firms to collude to form a cartel. It is illegal because when firms collude they do so in order to restrict output, raise prices, and capture consumer surplus in order to increase their economic profit. PTS: 1 DIF: Level 2: Using definitions OBJ: Checkpoint 16.1 TOP: Cartel 18. ANS: The statement is incorrect; it reverses the outcomes. If the firms in an oligopoly operate as a monopoly, the industry produces the least output and if they operate as perfect competitors, the industry produces the most output. PTS: 1 DIF: Level 2: Using definitions OBJ: Checkpoint 16.2 TOP: Range of outcomes 19. ANS: The best outcome for society is when the firms act as perfect competitors. Perfect competition produces the efficient quantity of output. A monopoly restricts the quantity of output it produces and creates a deadweight loss, which harms society So society is better off if the firms compete rather than collude and operate as a monopoly. PTS: 1 DIF: Level 5: Critical thinking OBJ: Checkpoint 16.2 TOP: Range of outcomes 20. ANS: If the firms operate as a monopoly, they produce a total of 200 units per day and set a price of $12 per unit. If the firms compete and operate as perfect competitors, they produce 400 units per day and the price is $4 per unit. The range of possible outcomes exists because firms in oligopoly have the choice of colluding to decrease output to monopoly levels or cheating on the cartel and increase output to its efficient level. A range of prices also exists between the monopoly price and the perfectly competitive price. PTS: 1 DIF: Level 3: Using models OBJ: Checkpoint 16.2 TOP: Range of outcomes for an oligopoly 4

5 21. ANS: a. As a monopoly, the price will be $15 and the total output will be 30 units. This price and output combination is where they maximize their total profit because it is here that the marginal revenue equals zero. (The marginal revenue equals zero because this is the price and output combination for which total revenue is maximized and marginal revenue equals zero when total revenue is maximized.) b. The perfectly competitive price is equal to marginal cost. Because marginal cost is equal to zero, the price will be $0 and the output will be 60 units. PTS: 1 DIF: Level 4: Applying models OBJ: Checkpoint 16.2 TOP: Range of outcomes for an oligopoly 22. ANS: John Nash proposed the concept of an equilibrium in a game where each player takes the best possible action given the action of other players. A Nash equilibrium is not necessarily the best one for the players. This can be seen in the prisoners' dilemma. Typically the prisoners' dilemma is a game where two prisoners are given rules and payoffs to encourage them to confess to a crime. The prisoners, acting in their own self interest, confess to the crime to minimize their jail time and so confession is the Nash equilibrium. But if the players can communicate with each other, they can improve their position. If they can communicate, they both deny the crime and so both wind up doing less time in jail. PTS: 1 DIF: Level 1: Definition OBJ: Checkpoint 16.3 TOP: Nash equilibrium 23. ANS: In order to keep oil prices high, as has been the case since 1999, OPEC creates a target level of output designed to achieve a particular high price. OPEC's goal is to set a price high enough so that its member nations earn the maximum economic profit. Once the target output is set, OPEC assigns a production quota to each member. As long as each member adheres to its quota the price will remain high and stable. However, from time to time, individual nations cheat on the agreement by producing more oil than they are allowed. Nations cheat because they realize that if they alone cheat, the impact on oil prices will be slight but the impact on their profit will be large. Once this oil shows up on world markets, the supply of oil increases and prices begin to fall. Then, once prices begin to fall other members begin to panic and they start selling more oil too in order to get the highest price they can before a collapse takes place. If every nation cheats, the supply will increase more than if just a few do and the collapse in price becomes a self-realizing prophecy. PTS: 1 DIF: Level 5: Critical thinking OBJ: Checkpoint 16.3 TOP: Cartel cheating 24. ANS: Because there are just a few large firms in an oligopoly, output and pricing decisions made by one firm affect the demand for other firms' goods. To maximize the total joint profit, the firms must cooperate, act like a monopoly so as to restrict output and earn monopoly profits. But each firm has an incentive to cheat on an agreement to restrict output because if it increases production it can (temporarily, at least) earn higher profits. But if all firms increase production, total profits will fall and the market will move toward the competitive equilibrium. PTS: 1 DIF: Level 4: Applying models OBJ: Checkpoint 16.3 TOP: Oligopolists' dilemma 5

6 25. ANS: Game theory is a tool economists use to analyze the behavior of oligopolistic firms because game theory is a tool to study strategic behavior. Game theory shows that because these firms are interdependent, the decisions they make to promote their own self-interest can wind up harming all the firms. Thus the duopolists' dilemma is illustrated using game theory: Firms looking to earn for themselves the maximum possible profit can wind up earning less profit than if they had behaved less self-interestedly and more cooperatively. PTS: 1 DIF: Level 2: Using definitions OBJ: Checkpoint 16.3 TOP: Duopolists' dilemma 26. ANS: An oligopoly might or might not operate efficiently. It operates efficiently if the firms cheat on any agreement and increase output so that it is the same as the perfectly competitive level. In this case, price equals marginal cost and the outcome is efficient. There is no deadweight loss. From the firms' perspectives, this outcome is undesirable because the firms earn only a normal profit. If the firms can play repeated games, detecting and punishing overproduction, the oligopoly is more likely to restrict output to the monopoly level. This outcome is inefficient because marginal cost does not equal marginal benefit. A deadweight loss is created. From the firms' perspective, this outcome is more desirable because the firms earn an economic profit. PTS: 1 DIF: Level 3: Using models OBJ: Checkpoint 16.3 TOP: Efficiency of oligopoly 27. ANS: a. The complete payoff matrix is above. b. Tim and John will both deny involvement. Sally's doll remains bald, but Tim and John each pay Sally $14 so Sally has $28 for a new doll. PTS: 1 DIF: Level 4: Applying models OBJ: Checkpoint 16.3 TOP: Prisoners' dilemma 28. ANS: a. The Nash equilibrium has each firm advertising and hence each firm receiving $100 million in economic profit because both decided to advertise. b. If they could cooperate, they would both choose not to advertise. In this case, each would earn $140 million in economic profit. PTS: 1 DIF: Level 4: Applying models OBJ: Checkpoint 16.3 TOP: Duopolists' dilemma 6