CHAPTER 6: Monopoly and Imperfect Competition

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1 CHAPTER 6: Monopoly and Imperfect Competition 1a. Column 1 (price): -, 2, 2, 2, 2; Column 2 (quantity): 0, 1000, 2000, 3000, 4000; Column 3 (total revenue): 0, 2000, 4000, 6000, 8000; Column 4 (marginal revenue): 2, 2, 2, 2. The demand curve is a horizontal line at $2 per litre. Because average revenue (price) is constant for a seller in a perfectly competitive market, the business s demand and marginal revenue curves are identical b. Column 1 (price): -, 400, 300, 200, 100, 0; Column 2 (quantity): 0, 60, 120, 180, 240, 300; Column 3 (total revenue): 0, , , , , 0; Column 4 (marginal revenue): 400, 200, 0, -200, FIGURE 6A 1 Demand and Marginal Revenue Curves for Biodata Software Biodata Software s monopoly status means that it faces the downward-sloping market demand curve. Because average revenue (price) falls as output increases, marginal revenue is below price. Chapter 6 54

2 c. Column 1 (price): -, 0.95, 0.90, 0.85, 0.80; Column 2 (quantity): 0, 100, 200, 300, 400; Column 3 (total revenue): 0, 95; 180, 255, 320; Column 4 (marginal revenue): , 0.75, FIGURE 6A 2 Demand and Marginal Revenue Curves for Stan s Coffee Shop As a seller in a monopolistically competitive market, Stan s Coffee Shop faces an elastic downward-sloping demand curve. The fall in average revenue (price) as output increases causes marginal revenue to be below price. d. Column 1 (price): -, 3.00, 2.50, 2.00, 1.50; Column 2 (quantity): 0, 2000, 4000, 5000, 6000; Column 3 (total revenue): 0, 6000, , , 9000; Column 4 (marginal revenue): 3.00, 2.00, 0, Chapter 6 55

3 FIGURE 6A 3 Demand and Marginal Revenue Curves for The Big Hair Company Given its participation in an oligopoly characterized by rivalry, the Big Hair Company faces a kinked demand curve. Therefore, its marginal revenue curve is composed of two linear segments joined by a vertical line. 2a. Column 3 (total revenue): 0, 4500, 8000, , , ; Column 5 (marginal revenue): 4.50, 3.50, 2.50, 1.50, 0.50; Column 6 (marginal cost): 2.00, 1.00, 1.50, 4.50, 8.00; Column 7 (average cost): 5.00, 3.00, 2.50, 3.00, Chapter 6 56

4 FIGURE 6A 4 Profit-Maximization Graph for Presto Cleaners $ p er shir t Qu ant it y o f Dr y cleanin g (shir t s p er m o nt h ) b. The profit-maximizing quantity of 3000 shirts is found at point a, where the MR and MC curves intersect. The profit-maximizing price of $3.50 is vertical coordinate of point b, found by extending a vertical line up to the demand curve. The $3000 profit is shown by the area of the shaded rectangle ($1 x 3000), whose height ($1) is the difference between price ($3.50 at point b) and average cost ($2.50 at point c), and whose width is quantity of output (3000). Using the table, 3000 shirts is the profit-maximizing quantity because it is where marginal revenue (which is falling from $2.50 to $1.50) and marginal cost (which is rising from $1.50 to $4.50) pass through a range of common values. The $3000 total profit can be found by deducting total cost ($7500) from total revenue ($10 500). c. Presto is making a positive economic profit, so that in the long run new entrants can be expected in this market, pushing Presto's demand curve to the left (due to lost customers) and making it more elastic (due to more close substitutes). This process will continue until Presto is breaking even in long run equilibrium. d. Column 3 (total revenue): 0, 3000, 5000, 6000, 6000, 5000; Column 5 (marginal revenue): 3.00, 2.00, 1.00, 0, -1.00; Column 6 (marginal cost): Chapter 6 57

5 2.00, 1.00, 1.50, 4.50, 8.00; Column 7 (average cost): 5.00, 3.00, 2.50, 3.00, e. FIGURE 6A 5 The loss-minimizing quantity is now 2000 shirts, which is the nearest quantity rounded to the 1000 from point a, where the MR and MC curves intersect, and the loss-minimizing price is $2.50, found at point b. The $1000 loss is shown by the area of the shaded rectangle ($0.50 x 2000), whose height ($0.50) is the difference between price ($2.50 at point b) and average cost ($3.00 at point c), and whose width is quantity of output (2000). Using the table, 2000 shirts is the loss-maximizing quantity because it is where marginal revenue (which is falling from $2.00 to $1.00) and marginal cost (which is rising from $1.00 to $1.50) pass through a range of common values. The $1000 total loss can be found by deducting total cost ($6000) from total revenue ($5000). 3a. Column 3 (total revenue): 0, 63, 120, 171, 170, 165; Column 5 (marginal revenue): 2.10, 1.90, 1.70, -0.10, -0.50; Column 6 (marginal cost): 1.33, 0.67, 0.53, 1.30, 3.00; Column 7 (average cost): 3.00, 1.83, 1.40, 1.39, Chapter 6 58

6 FIGURE 6A-6 Profit-Maximization Graph for Citrus Delight $ p er car t o n Tho u sand s o f Car t o ns p er Day The demand curve is kinked at a prevailing price of $1.90, suggesting that this business operates in an oligopoly characterized by rivalry. If Citrus Delight raises its price, it loses a relatively large proportion of its customers, because its rivals keep their prices constant. On the other hand, a reduction in price by Citrus Delight causes only a relatively small increase in quantity demanded, because its rivals match any price drop. Given its kinked demand curve, Citrus Delight s marginal revenue curve is made up of two linear segments, each corresponding to one of the segments of the demand curve, with these two MR segments joined by a vertical line. b. The profit-maximizing quantity of cartons is found at point a, where the MR and MC curves intersect. The profit-maximizing price of $1.90 is the vertical coordinate of the kink in the demand curve, at point b, found by extending a vertical line up to the demand curve. The $ profit is shown by the area of the shaded rectangle ($.50 x ), whose height ($.50) is the difference between price ($1.90 at point b) and average cost ($1.40 at point c), and whose width is quantity of output (90 000). Chapter 6 59

7 c. No. Because of barriers to entry in this market, Citrus Delight can continue making positive profits in the long run. d. Column 3 (total revenue): 0, 63, 120, 171, 170, 165; Column 5 (marginal revenue): 2.10, 1.90, 1.70, -0.10, -0.50; Column 6 (marginal cost): 1.67, 1.00, 0.87, 1.50, 3.50; Column 7 (average cost): 4.13, 2.57, 2.00, 1.95, e. FIGURE 6A 7 The loss-minimizing quantity is cartons as shown at point a, where the MR and MC curves intersect, and the loss-minimizing price is $1.90, found at the kink in the demand curve at point b. The $9000 loss is shown by the area of the shaded rectangle ($0.10 x ), whose height ($0.10) is the difference between price ($1.90 at point b) and average cost ($200 at point c), and whose width is quantity of output (90 000). This is the same price as before, though now the business is making a loss. This illustrates the case where a change in costs for an oligopolist in a market characterized by rivalry has no effect on the price the business chooses to charge. 4a. Column 3 (total revenue): 0, , , , , , 0; Column 5 (marginal revenue): 350, 210, 70, -70, -210, -350, Column 6 (marginal cost): 40, 20, 3, 2, 20, 110; Column 7 (average cost): 535, 278, 186, 140, Chapter 6 60

8 116, 115. FIGURE 6A 8 Profit-Maximization Graph for True North Railways Chapter 6 61

9 The business would never freely choose to operate in the output range where marginal revenue is negative, because in this range each new unit of output not only raises total cost but also reduces total revenue. Thus it is impossible for the profit-maximizing quantity to occur in this output range. b. The profit-maximizing quantity of 150 passengers is found at point a, where the MR and MC curves intersect. The profit-maximizing price of $210 is the vertical coordinate of the kink in the demand curve, at point b, found by extending a vertical line up to the demand curve. The $3600 profit is shown by the area of the upper shaded rectangle ($24 x 150), whose height ($24) is the difference between price ($210 at point b) and average cost ($186 at point c), and whose width is quantity of output (150). c. The average-cost price is $140 (point d in the graph), associated with a quantity of 200 passengers. At this price, the business is breaking even, since total revenue and total cost both equal $ A problem connected with this regulated price is the potential inefficiency caused by a lack of incentive for the business to control costs, since any rise in the average cost curve will presumably result in the business being allowed to charge a higher price. d. Column 3 (total revenue): 0, , , , , , ; Column 5 (marginal revenue): 500, 360, 220, 80, -60, -200, Column 6 (marginal cost): 40, 20, 3, 2, 20, 110; Column 7 (average cost): 535, 278, 186, 140, 116, 115. Chapter 6 62

10 e. FIGURE 6A 9 The profit-maximizing quantity is 200 passengers as shown at point a, where the MR and MC curves intersect, and the profit-maximizing price is $290, found at point b. The $ profit is shown by the area of the shaded rectangle ($150 x 200), whose height ($150) is the difference between price ($290 at point b) and average cost ($140 at point c), and whose width is quantity of output (200). Using the table, 200 passengers is the profit-maximizing quantity because it is where marginal revenue (which is falling from $80 to - $60) and marginal cost (which is rising from $2 to $20) pass through a range of common values. The $ total loss can be found by deducting total cost ($28 000) from total revenue ($58 000). 5a. If Harvey and Marv can communicate, they will agree not to confess, since then they can both be assured of serving only half a year in jail. This option is preferable to the other cooperative outcome where both confess and receive 3 years in jail. b. If Harvey and Marv cannot communicate, they will each choose the option with the least harmful worst-case scenario. For each, this is the option of confessing. This option s worst-case scenario is 3 years of jail time, as opposed to 5 years of jail time, which is the worst-case scenario of not confessing. This is a dilemma because the two would have been better of if they both had agreed not to confess. Chapter 6 63

11 6a. FIGURE 6A 10 b. If cheating is easily discovered, then both businesses have an incentive not to cheat, which means each makes an annual profit of $ c. If cheating is not easily discovered, then each business will tend to cheat, since the worst-case-scenario profit associated with cheating ($ )is preferable to the worst-case-scenario profit associated with not cheating ($ ). 7. Oligopolists are more likely than perfect competitors to engage in strategic behaviour because the markets that oligopolists operate in are characterized by mutual interdependence. In a setting in which the actions of each seller affect other businesses in the market, it soon becomes clear to each seller that their own profit will be maximized only if they attempt to predict how others will respond to their actions. Such thinking is the basis for strategic behaviour. On the other hand, because perfect competitors are each to small to affect outcomes in their market, strategic behaviour is far less likely to result in any positive gains for any single business. 8. Conglomerate mergers, since these do not increase concentration within a particular industry 9a. 79% [= ($300 million/$380 million) x 100%], since combined sales for the largest four firms are $300 (= $100 + $80 + $65 + $55) million, while total sales in the industry are $380 million. b. An oligopoly, since the concentration ratio exceeds 50%. 10a. underestimate, since imported magazines are not included in this industry s national concentration ratio b. overestimate, since national concentration ratios do not account for the regional dominance of certain telephone companies 11a. This case of product differentiation involves entry into a new market. (i) The company's profits rise as long as the extra sales revenue exceeds the costs of entry. (ii) Presuming the company remains in the new market, it may be able to use entry barriers to keep out potential rivals. (iii) Despite the company's market power, consumers likely gain, since they can buy a previously unavailable product. b. This is a case of an anti-competitive advertising strategy. (i) There is an Chapter 6 64

12 increase in the corporation's profits if the extra sales created by increased demand and lower demand elasticity outweigh the extra costs. (ii) Because of the possible negative effect on sales, other businesses in the market will likely be forced to raise their advertising budgets as well, raising the industry's per-unit costs while also strengthening entry barriers against new rivals. (iii) Given the added market power gained by established producers, consumers are likely to be harmed, because of higher prices as well as the reduced chance of added competition in the market. c. This is a case of product differentiation that involves selling an existing product in a new way. (i) The firm can use this strategy to increase profits as long as the benefits of increased demand and lower demand elasticity are greater than the costs of changing the brand name. (ii) If the company's strategy to raise its market power is successful, other cosmetics firms will lose sales unless they engage in similar initiatives. (iii) Consumers, on average, are likely to lose. Though some perfume buyers may gain satisfaction from the new strategies used by sellers, a larger number will be will be forced to pay a higher price due to firms' added costs. d. This is a case of advertising that enhances competition. (i) The lawyer who advertises her prices will increase her income if her revenues rise more than the advertising costs. (ii) Because of pressure from clients and a potential drop in sales, other lawyers may be forced to advertise their prices as well. (iii) Consumers will find it easier to choose a lawyer on the basis of price. Consequently, lawyers have less market power than they did when they did not advertise their prices. It is therefore possible that, despite lawyers' added costs, consumers benefit by paying a lower price than before. e. This is a case where access to advertising is being sold as a revenue generator for the search engine company. It may either promote or inhibit competition. An established search engine may be able to use this feature to increase its market power through the lock-in effect. But this could also be a way for upstarts to gain a foothold in the search engine market. 12. By erasing the distinction between private profile pages and the public pages of large companies, Facebook increased the marketing opportunities for business users interested in promoting and potentially selling products using Facebook. This has helped Facebook maintain its dominance in the social media market, by ensuring that it remains the main social media outlet for many commercial users. Internet Application Question a. In 1995, for example, the Competition Tribunal issued an interim consent for the sale of five printing companies by Rogers Communications to Quebecor Printing Inc, after investigating allegations that the merger would substantially reduce competition in the Canadian printing industry. b. In 1996, for example, the Competition Tribunal ruled on a case involving members of the Interac Association, whose members dominate electronic banking in Canada. These companies -- including major banks, trust companies and credit union societies -- were alleged to have abused their dominant position in the financial industry to block other companies wishing to gain access to the Interac system of automated teller machines. The Tribunal loosened restrictions on Interac membership, amended the Interac Association's pricing practices, and altered rules for approving new electronic networks. Chapter 6 65

13 ANSWERS TO QUESTIONS AT THE END OF THE GAMES PEOPLE PLAY 1. Just as the prospect of destructive self-interested behaviour by the two prisoners who are being interrogated can be overcome through a previous commitment to one other not to talk to the police, so too the two countries that are involved in an arms race can negotiate a mutual reduction in their military arsenals. To be effective, such enforceable social contracts over such things as electricity use help coordinate the actions of large groups of people in order to maximize their joint welfare. 2. Just as the two prisoners who are being interrogated in the prisoner s dilemma are made better off through a mutual bargain not to talk to the police, so too electricity users all benefit once an enforceable rationing mechanism is put in place to counteract the possibility of power outages. ANSWERS TO QUESTIONS AT END OF ONE FOR ANOTHER (at the Online Learning Centre) 1. If the interest rate is viewed as the price of borrowed funds, the demand and supply curves for borrowed funds have the usual shapes. The downwardsloping demand curve represents the inverse relationship between the interest rate and the amount that borrowers wish to borrow, and the upward-sloping supply curve represents the direct relationship between the interest rate and the amount that lenders wish to lend. Attempts to prohibit usury would shift the supply curve for borrowed funds to the left, which would increase the prevailing rate of interest. 2. No. Modern rent controls may be based on Aquinas s notion of the just price - the view that rents should be capped so that landlords are allowed only to maintain their customary place in society. But this is not the only set of beliefs that might underlie rent controls. Usually controls are defended as being necessary to ensure that rentable accommodation remains affordable for those currently occupying it. ANSWERS TO QUESTIONS AT END OF PUMPING UP PRICE (at the Online Learning Centre) 1. As non-opec countries gradually use up their proven reserves, the OPEC cartel has a chance to regain some of its lost market share. By again restricting quantity supplied, OPEC members could cause another significant rise in oil prices. 2a. In the G7 countries, over half of oil expenditures go to taxes, while the other half is split between refiners and exporting countries. Because this surprisingly low share of revenue going to exporting countries, automatically blaming OPEC for any price rise is unfair. In some cases, taxes are the culprit. b. This argument contains a good deal of truth, but the revenue share going to exporting countries is the most volatile component of oil prices, so that often price increases are due to OPEC activity. c. Higher oil tax revenues are spent by domestic governments, enhancing the welfare of the country s citizens. Higher payments to exporting countries do not have this effect. d. It can be argued that gasoline taxes are a useful way of reducing pollution Chapter 6 66

14 caused by the carbon emissions associated with the use of petroleum products. Chapter 6 67

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