# Coffee is produced at a constant marginal cost of \$1.00 a pound. Due to a shortage of cocoa beans, the marginal cost rises to \$2.00 a pound.

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1 Microeconomics, Module 11: Monopoly (Chapter 10) Illustrative Test Questions (The attached PDF file has better formatting.) Updated: June 27, 2005 Question 11.1: Monopoly All but which of the following are true regarding monopoly? A. A monopoly occurs when an industry has only a single firm. B. A monopolist, unlike a competitive firm, can affect market prices by its actions. C. A monopolist s marginal revenue is less than the demand price. D. A monopolist, like a competitive firm, seeks to maximize profits. E. All of A, B, C, and D are true. Answer 11.1: A Two firms may exist in an industry, but if they sell in different markets, they may both be monopolists. It is hard to define an industry (or a market), and the textbook does not require that there be only one firm in the industry. Statement C is true if the demand curve is downward sloping, which is true for all demand curves. Statement D is true since all firms seek to maximize profits in economics textbooks. Question 11.2: Price and Marginal Cost Coffee is produced at a constant marginal cost of \$1.00 a pound. Due to a shortage of cocoa beans, the marginal cost rises to \$2.00 a pound.! If coffee is produced in a competitive market, the market price will rise by a pound.! If coffee is produced by a monopolist, the market price will rise by a pound. A. less than \$1.00; less than \$1.00 B. exactly \$1.00; less than \$1.00 C. less than \$1.00; exactly \$1.00 D. exactly \$1.00; more than \$1.00 E. more than \$1.00; exactly \$1.00 Answer 11.2: B In a competitive market, price equals marginal cost, so if the marginal cost rises, the price rises by the same amount. In a monopoly, the price rises by less than the rise in the

2 marginal cost. This is not a benefit of monopoly, since if marginal cost falls, the competitive price falls by the same amount, whereas the monopoly price falls by less than the marginal cost. Exercise 11.3: Marginal Revenue and Price Elasticity of Demand How is marginal revenue related to the price elasticity of demand? Solution 11.3: Marginal revenue = Price (1 1/ ) Question 11.4: Monopoly and Elasticity All but which of the following are true regarding monopoly and elasticity? A. A linear demand curve is elastic when quantity is small and inelastic when quantity is large. B. A linear demand curve is elastic when price is high and inelastic when price is low. C. A monopolist operates where marginal revenue is positive. D. A monopolist operates on the inelastic portion of the demand curve. E. All of A, B, C, and D are true. Answer 11.4: D If demand were inelastic, the monopolist would raise the price.! Quantity would decrease by less than the proportional increase in the price, so total revenue would increase.! Cost decreases because the quantity decreases.! Total profit (= total revenue minus total cost) increases. Exercise 11.5: Diamonds Diamonds are mined in South Africa. Suppose a civil war in South Africa closes the diamond mines, lowers the supply of diamonds, and pushes up the price of diamonds. The price rise is so great that the total revenue of diamond cutters increases. Is this evidence that the diamond industry is monopolistic? Solution 11.5: It is not evidence of a monopoly. A drop in quantity leads to a rise in total revenue, implying that marginal revenue is negative. Since a monopolist produces where marginal revenue equals marginal cost, and since marginal cost is positive, a monopolist never operates where marginal revenue is negative.

3 (By the way, diamonds are produced by a cartel; the market is not competitive at all. But that s real life; this illustrative test question is theory.) Exercise 11.6: Monopoly and Social Gain or Loss Show graphically how a monopoly results in lower social gain than a competitive industry. Solution 11.6: Suppose the industry has a monopolistic supplier and that a competitive industry would produce with the same industry-wide marginal cost curve as the monopolist s. Competition Monopoly Consumers Surplus A+B+C+D+E A+B Producers Surplus F+G+H C+D+F+G Social Gain A+B+C+D+E+F+G+ A+B+C+D+F+ Dead Weight Loss E+H The competitive industry produces at Q c, and the monopolist produces at Q m. The monopoly creates a deadweight loss of E + H; it is more efficient to produce more than Q. The monopoly decreases consumers surplus, but increases producers surplus (i.e., H < C+D) because otherwise the monopolist would produce a higher output. m Question 11.7: Monopoly Profits

4 Which of the following is true regarding monopoly profits? A. The loss of social welfare from monopoly results from the good being produced at less than the competitive quantity. B. The loss of social welfare from monopoly results from the good being sold at more than the competitive price. C. One remedy for the dead weight loss of monopoly is to remove a monopolist s profits with an excise tax. D. One remedy for the dead weight loss of monopoly is to remove a monopolist s profits with an income tax. E. None of A, B, C, or D is true. Answer 11.7: A (The economic incidence of a tax is not the same as the legal incidence. The monopolist passes off both the excise tax and the income tax to consumers.) Exercise 11.8: Monopoly Diagrams A. Show graphically how an optimal subsidy can be used to eliminate the deadweight loss resulting from a monopoly. B. Suppose the subsidy is larger than the optimal one. Show how this can result in a deadweight loss greater than that from the unsubsidized monopoly. (You are not responsible for the sections on monopolies and subsidies; we have included the graphs below to you more practice reading the graphs and identifying areas.)

5 Monopoly Competition Unsubsidized Subsidized Consumers Surplus A+B+C+D+E A+B A+B+C+D+E Producers Surplus F+G+H C+D+F+G F+G+H+I+J+K Taxpayer Cost I+J+K Social Gain A+B+C+D+E+F+G+H A+B+C+D+F+G A+B+C+D+E+F+G+H Now suppose the subsidy is larger than S, such that the marginal cost curve moves down to MC, inducing production of Q, which sells at a price P. Since production is above the competitive quantity, the deadweight loss is Z. Under the unsubsidized monopoly, the deadweight loss is E+H. If Z is bigger than E+H, the subsidy has made things worse. Exercise 11.9: Monopoly and Price Ceilings Show graphically the demand and marginal revenue curves facing a monopolist if the government imposes a price ceiling at the competitive price. (You are not responsible for price ceilings and monopolies; we have included this graph to give you practice reading and interpreting the areas.)

6 The competitive price is P c, so the demand facing the monopolist is flat up to Q c, the competitive output. Exercise 11.10: Monopoly and Regulation Show graphically how zero-profit regulation of a monopolist can lead to output that is less than the competitive output. (This topic is germane to insurance, but the final exams do not test this graph.)

7 Under zero-profit regulation, firm produce where price equals average cost, shown on the graphs as Q, which can be more or less than Q. z c Exercise 11.11: Fair Return on Capital Insurance rates are often regulated by allowing a fair return on capital. Is this the same as zero-profit regulation? Does this regulation give insurers the incentive to keep costs low? Solution 11.11: Zero profit means zero economic profit; the firm makes just enough accounting profit to cover the cost of capital. This is the fair return on capital. This regulation does not give the insurer an incentive to keep costs low because the insurer can raise prices to cover the higher costs. Exercise 11.12: Natural Monopoly, Profits, and Competition Show graphically that a natural monopoly would earn negative profits if it were forced to set prices competitively.

8 Since the marginal cost curve intersects the average cost curve at the minimum average cost, the marginal cost curve crosses demand where price is less than average cost; if the firm prices competitively, it will earn negative profit. Under conditions of natural monopoly, a competitive industry can t survive because the firms can t cover their costs. Exercise 11.13: Natural Monopoly and Competition The text says that it s unfair to compare the social gain from a natural monopoly with that under competition. Why is this so? Solution 11.13: The comparison is unfair because the natural monopoly could not exist under competitive conditions. The competitive industry is purely hypothetical. Exercise 11.14: Patent Protection What two items must be considered to set the optimal length of a patent? Solution 11.14:! the losses from monopoly production! the gains from promoting invention

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