a. Sells a product differentiated from that of its competitors d. produces at the minimum of average total cost in the long run

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1 I. From Seminar Slides: 3, 4, 5, For each of the following characteristics, say whether it describes a perfectly competitive firm (PC), a monopolistically competitive firm (MC), both, or neither. a. Sells a product differentiated from that of its competitors Answer: MC b. has marginal revenue less than price Answer: MC c. earns economic profit in the long run Answer: neither d. produces at the minimum of average total cost in the long run Answer: PC e. equates marginal revenue and marginal cost Answer: both f. charges a price above marginal cost Answer: MC 4. For each of the following characteristics, say whether it describes a monopoly firm (M), a monopolistically competitive firm (MC), both, or neither. a. faces a downward-sloping demand curve Answer: both b. has marginal revenue less than price Answer: both c. faces the entry of new firms selling similar products Answer: MC d. earns economic profit in the long run Answer: M e. equates marginal revenue and marginal cost 1

2 Answer: both f. produces the socially efficient quantity of output Answer: neither 5. The market for peanut butter in Nutville is monopolistically competitive and in long-run equilibrium. One day, consumer advocate Skippy Jif discovers that all brands of peanut butter in Nutville are identical. Thereafter, the market becomes perfectly competitive and again reaches its long-run equilibrium. Using an appropriate diagram, explain whether each of the following variables increases, decreases, or stays the same for a typical firm in the market. a. Price b. quantity c. average total cost d. marginal cost e. profit Answer: a. The price will fall from PMC to the minimum average total cost (PC) when the market becomes perfectly competitive. b. The quantity produced by a typical firm will rise to QC, which is at the efficient scale of output. 2

3 c. Average total cost will fall as the firm increases its output to the efficient scale. d. Marginal cost will rise as output rises. Marginal cost is now equal to price. e. Profit will not change. In either case, the market will move to longrun equilibrium where all firms will earn zero economic profit. 6. Sleek Sneakers Co. is one of many firms in the market for shoes. a. Assume that Sleek is currently earning short-run economic profit. On a correctly labeled diagram, show Sleek s profit-maximizing output and price, as well as the area representing profit. Answer: Figure below shows Sleek s demand, marginal-revenue, marginal-cost, and average-total-cost curves. The firm will maximize profit at an output level of Q * and a price of P *. The shaded are shows the firm s profits. b. What happens to Sleek s price, output, and profit in the long run? Explain this change in words, and show it on a new diagram. Answer: In the long run, firms will enter, shifting the demand for Sleek s product to the left. Its price and output will fall. Firms will enter until profits are equal to zero (as shown in figure below). 3

4 c. Suppose that over time consumers become more focused on stylistic differences among shoe brands. How would this change in attitudes affect each firm s price elasticity of demand? In the long run, how will this change in demand affect Sleek s price, output, and profit? Answer: As consumers become more focused on the stylistic differences in brands, they will be less focused on price. This will make the demand for each firm s products more price inelastic. The demand curves may become relatively steeper, allowing Sleek to charge a higher price. If these stylistic features cannot be copied, they may serve as a barrier to entry and allow Sleek to earn profit in the long run. d. At the profit-maximizing price you identified in part (c), is Sleek s demand curve elastic or inelastic? Explain. Answer: A firm in monopolistic competition produces where marginal revenue is greater than zero. This means that firm must be operating on the elastic portion of its demand curve. 1. Suppose initially only firm A served the whole market of a specific good. Over time consumers realized that the good has close substitutes and other firms entered the market offering differentiated products. We can conclude that the demand for firm A became elastic. Is this statement true or false? Explain your answer. Answer: true. Consumers at monopolistically competitive market have more variety and can easily change the consumption of a product than they could in case of Monopoly. 2. Why might economists prefer private ownership of monopolies over public ownership of monopolies? Explain. Answer: The private monopolist is governed by the market. Even though the market solution is sub-optimal, it may be better than outcomes generated by publicly owned monopolies. Publicly owned monopolies may 4

5 restrict output to levels below the private market outcome and thus generate an even lower level of social surplus than a private profitmaximizing monopolist. Private owners have an incentive to minimize cost as long as they reap benefits in the form of higher profits. Government bureaucrats have no incentive to reduce costs. The losers are customers and taxpayers, whose only recourse is the political system. 3. Use a graph to demonstrate why a profit-maximizing monopolistically competitive firm must operate at excess capacity. Explain why a perfectly competitive firm is not subject to the same constraint. Answer: Competitive firms do not face downward-sloping demand. The graph shows the firm choosing a level of production in which the intersection of marginal revenue and marginal cost occurs at an output level where average total cost is decreasing. This profit-maximizing output level is less than the efficient scale (minimum of average total cost), and therefore the firm is said to be operating with excess capacity. 4. Assume the role of a critic of advertising. Describe the characteristics of advertising that reduce the effectiveness of markets and decrease the social welfare of society. Answer: Advertising manipulates people's tastes and is psychological rather than informational. As a result, advertising creates a desire for a product that might not otherwise exist. Advertising may also impede competition by convincing consumers that products that are identical have significant differences 5

6 5. Assume the role of a defender of advertising. Describe the characteristics of advertising that enhance the effectiveness of markets and increase the social welfare of society. Answer: Advertising provides information to consumers and thus allows consumers to make more informed (and therefore better) choices. Advertising fosters competition by making consumers more aware of prices and product characteristics in a market. II. 1. A natural monopoly is producing an output level of 1,000 units per day. If the monopoly is broken up into 5 firms, then average total cost for each of the 5 firms a. will exceed the monopolist's average total cost b. will equal the monopolist's average total cost c. will fall below the monopolist's average total cost d. may equal or fall below the monopolist's average total cost e. may equal or exceed the monopolist's average total cost Answer: a 2. Which of the following goods would be most likely to be produced by a monopoly? a. Beer b. Kofola c. margarine d. electricity e. Skoda automobiles Answer: d 3. Patents and copyrights are designed to a. eliminate above-normal profit in the short run b. move monopoly prices closer to prices that would occur under perfect competition c. prevent the capitalization of monopoly profit d. allow a period of above-normal profit to encourage innovation e. limit a monopoly's rent-seeking activities Answer: d 4. The concept of network externalities is most relevant to purchasers of a. computer software. b. automobiles. c. television sets. d. radios. Answer: a 5. For the single-price monopoly, marginal revenue is a. more important than marginal cost 6

7 b. always more than marginal cost c. always less than average cost d. always less than the price of output e. more significant than total revenue Answer: c 6. The supply curve of a single-price monopolist a. coincides with its marginal cost curve above its average total cost curve b. coincides with its marginal cost curve above its average variable cost curve c. is established by the government d. slopes downward due to substantial economies of scale e. does not exist Answer: e 7. Consider a single-price monopolist that is in equilibrium at output level Q* and price P*. If the government imposes a new tax on the firm of $25 per unit of output, then a. output and price will remain at Q* and P* b. output will fall and price will rise by $25 c. output will fall and price will fall by less than $25 d. output will rise and price will fall by $25 e. output will fall and the price will rise by less than $25 Answer: e 8. If a monopolist incurs a large fixed cost that shifts its average total cost curve upward, the effect on price and output will be a. price and output will both rise b. price will rise and output will fall c. the firm will lower its price so that elastic demand will raise revenues to cover the additional cost d. the firm will pass the higher cost on to customers without changing the amount consumers will buy e. there will be no effect on price or output Answer: e 9. When the demand for a monopolist's output falls, the monopolist will a. not change the price, since it has no competition. b. raise the price in order to compensate for the lower demand. c. charge a lower price. d. cut its costs in order to maintain its profit margin. Answer: b 7

8 10. According to the figure above, the profit is maximized at a. A b. B c. C d. D e. E Answer: c 11. According to the same figure above, the revenue is maximized at a. A b. B c. C d. D e. E Answer: b 12. All of the following, except one, are characteristics of monopolistic competition. Which is the exception? a. There is a large number of sellers. b. Each seller faces a horizontal demand curve for its product. c. There are no significant barriers to entry or exit. d. Sellers produce differentiated products. e. There is a large number of buyers. Answer: b 13. The demand curve faced by a monopolistically competitive firm a. is the same as the market demand curve b. is less elastic than the one faced by firms in perfect competition c. is perfectly elastic 8

9 d. is perfectly inelastic e. has a constant slope Answer: B 14. At the long-run equilibrium output level, a monopolistically competitive firm's average total cost curve a. lies below the demand curve b. is tangent to (just touches but does not cross) the demand curve c. crosses the demand curve from below d. crosses the demand curve from above e. is at its minimum point Answer: B 15. If a firm earns zero economic profit in the long run, then it a. must be in a perfectly competitive market b. must be in a monopolistically competitive market c. cannot be in a monopolistically competitive market d. could be in any of the four major market structures e. is not in an oligopoly Answer: d 16. In which of the following product markets are we likely to observe the largest amount of advertising? a. markets with highly differentiated products b. perfectly competitive markets c. markets in which industrial products are sold d. markets in which there is very little difference between different firms' products Answer: a 17. Which of the following best describes the idea of excess capacity in monopolistic competition? a. Firms produce more output than is socially desirable. b. The output produced by a typical firm is less than what would occur at the minimum point on its ATC curve. c. Due to product differentiation, firms choose output levels where price equals average total cost. d. Firms keep some surplus output on hand in case there is a shift in the demand for their product. Answer: b 18. For a profit-maximizing monopolistically competitive firm, price exceeds marginal cost in a. the short run but not in the long run. b. the long run but not in the short run. 9

10 c. both the short run and the long run. d. neither the short run nor the long run. Answer: c 19. When a market is monopolistically competitive, the typical firm in the market is likely to experience a a. positive profit in the short run and in the long run. b. positive or negative profit in the short run and a zero profit in the long run. c. zero profit in the short run and a positive or negative profit in the long run. d. zero profit in the short run and in the long run. Answer: b 20. Consider the monopolistically competitive firm whose demand curve and cost structure are illustrated in Figure above. Which of the following statements is correct in the short run? a. The firm will produce 100 units and suffer a loss of $100 per week. b. The firm will produce 100 units and suffer a loss of $300 per week. c. The firm will produce zero units and suffer zero loss. d. The firm will produce zero units and suffer a loss of $100 per week. e. The firm will produce zero units and suffer a loss of $300 per week. Answer: E III. 1. Brittany provides manicures at the only salon in town. Her marginal cost is constant at $5 per client, her fixed cost is $25 per day, and she is able to do 8 manicures per day. On a given day, half of her clients are 10

11 willing to pay $15 for a manicure; half are willing to pay only $10. If she charges all of her clients $10, what is her maximum daily profit? Answer: $ The owner of an optometry practice, in a city with more than a hundred other such practices, has the following demand and cost schedules for eye exams: a. Fill in the columns for total revenue, marginal revenue, and marginal cost. (Remember to put MR and MC between output levels.) Answer: b. Briefly explain why an optometry practice (like this one) might face a downward-sloping demand curve, even if it is one out of more than a hundred. (Hint: think of dimensions through which an optometry practice can differentiate its product) Answer: An optometry practice might face a downward-sloping demand curve if it could differentiate its product through location, hours of operation, ambiance, quality of service, or frame selection. 11

12 c. Use the data you filled in for the marginal revenue and marginal cost columns to find the profit-maximizing price and the profit-maximizing number of eye exams per week for this practice. Answer: The profit-maximizing price is $60 and the profit-maximizing number of eye exams per week is 200. d. Suppose that the cost data are in the short run, and that the owner of the practice suddenly realizes that she forgot to include her only fixed cost: her license fee of $2,600 per year (which is $50 per week). Should the practice shut down in the short run? Why or why not? Answer: The decision to shut down in the short run only depends on the variable costs. Here the firm will not shut down. 3. Suppose that the government has decided to tax all the firms in a monopolistically competitive industry. Specifically, suppose it levies a fixed tax on each firm; that is, the amount of the tax is the same regardless of how much output the firm produces. In the short run, how would that tax affect the price, output level, and profit of the typical firm in that industry? What would be the effect in the long run? Answer: In the short run, the tax will shift each firm s ATC curve upward but will have no effect on their MC or MR curves. Therefore, price and output levels will remain the same, but profit will be reduced by the amount of the tax. However, the tax will cause the typical firm to go from earning zero economic profit to suffering a loss. In the long run, exit will occur, shifting each remaining firm s demand curve rightward, until each firm is earning zero economic profit. This will occur at a higher price than without the tax. 12

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