Key for Problem Set #4 1. Provide an example of each of the market structures discussed in chapter 13 of the text. Try to provide an original example (one not discussed in depth either in the text or in class). For each of your examples, please write a sentence to explain why you think your label fits. a. monopolistic competition: Examples include shoe repair shops, laundries, print shops, novelty stores, and wineries. Each of these markets features differentiated products offered by many firms, with relatively free entry. b. oligopoly: Examples include computer spreadsheet software, steel, home appliances, tires, long-distance telephone service, and airlines. Each of these markets has only a few firms, and significant barriers to entry. 2. Consider products that are widely advertised on television. a. Provide three examples of products widely advertised on television. For each example, indicate which of the four market structures we've discussed (perfect competition, monopoly, monopolistic competition) best applies to the market for that product. Examples include beer, automobiles, soft drinks, detergents, and mobile telephone service. b. Do you think that most TV-advertised products tend to fall into the same market structure? If so, provide a couple of sentences to argue why you think this might be the case. If not, argue why not. Most of the products advertised on television, particularly national television, tend to be in oligopolistic industries. TV commercials aim to generate demand for a certain type of product. One concern is that when I advertise, I might accidentally generate demand for my competitors products and not gain much of the benefit for myself. This concern is particularly high when I am only a small player in the market. In part for this reason, one sees very little national TV advertising by monopolistically competitive or perfectly competitive firms. On the other side of the coin, some economists believe some industries may actually be oligopolistic in part because they feature national TV advertising. National TV advertising may serve as a barrier to entry if consumers only purchase, for example, soft drinks they have seen on TV. Since such advertising costs many millions of dollars, upstart firms will have a hard time coming up with enough capital to spend on advertising to compete with Coke and Pepsi. 1
2. BB, question 13.3. In all three products, retailers differentiate themselves by the location and design of their shops, by the service they provide and by their local advertising. Hamburger stores offer different condiments and flavors, and different side dishes. Radio stores offer products that differ in certain features. Cosmetics retailers differ in their products and also in their packaging. 4. BB, question 13.7. The sales-maximizing solution occurs at an output of 250,000 gallons, where marginal revenue is zero. At this output, total revenue is a maximum, $40,000. If the firm expanded to an output of 300,000 gallons, marginal revenue would be negative, and total revenue would fall to $36,000. The sales maximizing output is higher than the profit maximizing output of 150,000 gallons. To arrive at the latter, the firm set marginal revenue equal to marginal cost; since marginal cost is positive, marginal revenue had to be higher than zero, and (since marginal revenue has a negative slope) output was consequently lower. 5. BB, question 13.8. This is an example of "predatory pricing." Biggie hopes to set a price so low that Bargain will be unable to compete and be driven out of business. Furthermore, other potential entrants will be scared off. Biggie may actually suffer losses while this is happening. Eventually however, when Bargain has left, Biggie hopes to act like a monopolist and set a high price. 6. BB, question 13.9. If air transportation were perfectly contestable, Bargain could exit the industry while the price was low, use its assets on some other routes for a while, then return to the Eastwich-Westwich route when Biggie raised prices. So Biggie would never succeed in setting high monopoly prices. 2
7. In the beach city of Santa Barbara, California, there are seven bathing-suit stores, each with the same schedule of costs. The stores' products are differentiated by location, so each firm faces its own downward-sloping demand curve. Each firm's downward-sloping demand schedule is identical. Swim-N-Style is a typical store, with the following demand and cost schedules: Quantity of suits sold (per hour) Price Total Cost TR MR MC AC 1 $68 $70 68 68 70 70 2 66 80 132 64 10 40 3 64 85 192 60 5 28 4 62 90 248 56 5 22 5 60 100 300 52 10 20 6 58 115 348 48 15 19.1 7 56 136 392 44 21 19.4 8 54 164 432 40 28 20 9 52 200 468 36 36 22 10 50 245 500 32 45 25 a. Calculate total revenue, marginal revenue, marginal cost, and average cost at each level of sales for the store. b. If Swim-N-Style is a profit maximizer, what number of suits will it sell per hour? What will its price and profit be? 9 52 268 c. How can you tell that the bathing-suit market in Santa Barbara is not in long-run equilibrium? What will happen because it is out of equilibrium? There is a profit, more competitors enter. 3
8. Seventeen new bathing-suit stores enter the Santa Barbara market, joining the seven that already existed. As a consequence, the demand schedule facing Swim-N-Style (and the identical schedules facing all other stores) falls, while the cost schedules remain the same as in the previous problem: Quantity of suits sold (per hour) Price Total Cost 1 $31.50 $70 2 28.50 80 3 25.50 85 4 22.50 90 5 19.50 100 6 16.50 115 7 13.50 136 8 10.50 164 9 7.50 200 10 4.50 245 a. What number of suits will Swim-N-Style sell? 4 b. What price will it charge, and what will its profit be? 22.5 0 c. Is the market in long-run equilibrium now? Why or why not? Yes, no profits d. What is the average cost per swimsuit sold? 22.5 e. How many swimsuits are sold in Santa Barbara each hour, and what is the total cost incurred? 96 2160 f. From your calculations in Problem 1, identify the sales level at which Swim-N-Style's average cost would be a minimum. What is this average cost? 6 19.1 g. Suppose the number of swimsuits sold remained constant, but the number of stores was reduced so that each was operating at its point of minimum average cost. How many stores would be in operation? 16 What would be the total costs of all the stores taken together? 1495 Compare this to your answer in (e) above. less than 2160 h. Summarize briefly what you have learned from this problem about the inefficiency of monopolistic competition. less efficient i. Can you think of any efficiency benefits that can occur with monopolistic competition, perhaps making up for the inefficiency identified in part (h)? More product variety, better matching individual consumers tastes. 4
9. Gas Guzzler Motors is one of three major auto producers. It is currently producing 6,000 cars a day, and selling them at a price of $10,000 each. Its marketing department tells it that its demand curve depends critically upon whether its competitors match its price changes. If the competitors do not change their prices when GG does, schedule 1 will apply; if competitors match all price changes by GG, schedule 2 will apply. The schedules are as follows. Cars (in 000s) Schedule 1: Schedule 2: Price per Car MR Price per Car MR 1 $12,500 12500 $15,000 15000 2 12,000 11500 14,000 13000 3 11,500 10500 13,000 11000 4 11,000 9500 12,000 9000 5 10,500 8500 11,000 7000 6 10,000 7500 10,000 5000 7 9,500 6500 9,000 3000 8 9,000 5500 8,000 1000 9 8,500 4500 7,000-1000 10 8,000 3500 6,000-3000 a. Calculate the marginal revenue (for increments of thousands of cars) associated with each demand schedule. b. Draw the two demand and MR curves on a diagram, and label them clearly. $16,000 $14,000 $12,000 $10,000 price 1 MR 1 Price 2 MR2 $8,000 $6,000 $4,000 $2,000 $- $(2,000) 1 2 3 4 5 6 7 8 9 10 $(4,000) 5
c. Assume now that, if GG raises its price, its competitors will not raise theirs, but that, if it lowers its price, its competitors will match the price cuts. On a new diagram, show the effective demand curve and marginal revenue curve that face GG. $14,000 $12,000 $10,000 $8,000 $6,000 $4,000 Price MR $2,000 $- $(2,000) 1 2 3 4 5 6 7 8 9 10 $(4,000) d. Now assume that GG faces the cost schedule shown in Cost Schedule 1 below. By comparing marginal costs with marginal revenues, determine GG's equilibrium levels of output and price. Will produce 6 because MC is 6 and MR is 7.5- but at 7 MC is 6.5 and MR 3. Total cost (in $000,000) Cars Cost Schedule 1 Cost Schedule 2 Cost Schedule 3 Cost Schedule 4 1 $8.5 $9.9 $7.6 $6.0 2 12.5 15.3 10.7 7.0 3 17.0 21.2 14.3 8.0 4 22.0 27.6 18.4 9.0 5 27.5 34.5 23.0 10.5 6 33.5 41.9 28.1 12.5 7 40.0 49.8 33.7 15.0 8 47.0 58.2 39.8 18.0 9 54.5 67.1 46.4 21.5 10 62.5 76.5 53.5 25.5 e. Suppose that GG's costs increase to those of Schedule 2. What are equilibrium output and price now? Still 6. Repeat this exercise for decreases in cost, to Cost Schedule 3 still 6 and Cost Schedule 4. 7 now. 6
f. How do you explain the relative stability of price and output, in the face of substantial changes in costs? Total cost is changing a lot, but marginal cost is not. Also, MR is very steeply sloped around an output of 6, so MC would have to be very different to produce a change in optimal output. 10. Consider the topic of market externalities. a. Provide two examples of goods whose production causes detrimental externalities. Explain. Examples include CFCs in aerosol cans, which deplete the ozone layer; coal that is strip-mined; paper products that are produced by destroying natural habitats for wildlife in old-growth forests; next-door neighbors enjoying loud music. b. Provide two examples of goods whose production causes positive externalities. Explain. Examples include freshly painted houses; employee training received at one firm but then used at another when the employee changes jobs; parking lots that are nicely landscaped to hide the ugly asphalt from the view of pedestrians; bakeries that give off a pleasant aroma; art situated in public places. 11. Provide two examples of public goods. Discuss, in each case, why additional users do not deplete them, and why it is difficult to exclude people from using them. National defense is an example of a public good. If national security forces keep hostile forces from invading our country, then all of our citizens benefit by keeping their way of life. The defense does not become any less effective if more citizens use it, and there is no way to selectively allow some people to opt out (we can t allow hostile foreign forces to selectively invade and loot some homes but not others). 12. Identify three examples of goods and services provided by your local government. Which of these are "public goods" as economists use the term? Explain. Examples include schools, garbage collection, police protection, and road maintenance. Schools and garbage collection do not seem so much like public goods. They could certainly be provided privately, for a fee. They do require more resources when there are more consumers, and private firms could certainly exclude consumers who don t pay. Road maintenance could also be done privately, if roads were all toll-based, but collecting the tolls might be too inconvenient to make that worthwhile. Up to a point, roads do not cost any more when there are more consumers, but after a certain point, congestion and road wear increase a lot with additional consumers. So roads have some aspects of public goods, but are certainly not pure public goods. Police protection is the closest to being a public good, because it is nearly impossible to selectively exclude non-paying users from enjoying safe streets, and because adding another law-abiding consumer does not reduce the ability of other consumers to enjoy safe streets. 7
13. Identify what type of market failure is involved in each of the following: a. Shipping companies do not build the lighthouses they need. A nonexcludable good which if one company builds all can benefit from, therefore no one builds it. b. The effluent from pulp and paper mills pollutes a river. Negative externality. c. Fossil fuels are being depleted rapidly. Allocation of resources between present and future. d. The proportion of Americans in poverty is rising. Inequality of income distribution. e. Ticket prices to string-quartet concerts are rising. Cost disease. f. Many people fail to keep their front lawns neatly mowed. Negative externality. 14. BB, question 15.2. Each student will have different answers but likely candidates include: the VCR, compact disks, cellular phones, microwave popcorn, digital television, digital audio tape recorders, camcorders, automobile airbags, automobile antilock brakes, digital cordless telephones, and the World Wide Web. 15. BB, question 15.5. Grey received nothing for his efforts. The average economic profits include the economic profits of all participants in a market. In many markets the first firm to introduce an innovation receives large economic profits but subsequent entrants may receive little if any economic profits. Therefore the average economic profits are quite low. 16. BB, question 15.6. For the reasons outlined in questions #4 and #5. In many markets the first firm to introduce an innovation receives large economic profits. In essence this is a "winner-take-all" scenario. Also if firms do not keep up with competitors in terms of product attractiveness and improved process efficiency that lowers costs, they will lose out to their rivals and end up losing money. All firms in an industry will continue to invest. 17. BB, question 15.7. The sharing of technology among existing firms in an industry lowers the operating costs of these firms. Thus the existing firms in an industry have a cost advantage compared to new entrant. This cost advantage may be a significant barrier to entry. 8
18. BB, question 21.3. The tax is regressive, since the average tax rate falls as income rises: Tax Rate Income Tax Marginal Average $20,000 $2,000.10 30,000 2,700.07.09 40,000 3,200.05.08 50,000 3,500.03.07 19. BB, question 21.7. a. Before the tax is imposed, at equilibrium the price is $4.00 and the quantity is 240 million cartons. b. After the tax is imposed, the supply curve shifts up by the amount of the tax: Price Price Quantity Quantity (including tax) (excluding tax) Demanded Supplied $4.25 $3.00 210 160 4.50 3.25 180 180 4.75 3.50 150 200 5.00 3.75 120 240 So the new equilibrium quantity will be 180. The price paid by the consumers (including the tax) will be $4.50, and the price received by the producers (excluding the tax) will be $3.25. c. Regardless of who pay it, the tax is a wedge of $1.25, in between the price paid by the consumer and the price received by the seller. In the situation described in (b), the seller may list the price at $3.25, and then require the buyer to pay a tax of $1.25 above this. Or the seller may list the price at $4.50, and take $1.25 out of this to give to the government. In either case, the net price paid by the consumer is $4.50, the net price received by the seller is $3.25, and the equilibrium quantity is 180. d. The sellers shift $0.50 of the tax to the buyers, since the market price rises from $4.00 to $4.50. They do this by reducing output from 240 to 180, and this reduction in output raises the market price. 9
e. There is excess burden borne by both buyers and sellers. The buyers' excess burden arises from the fact that they are purchasing fewer cigarettes than before the tax. The sellers' excess burden arises from the fact that they are producing fewer cigarettes than before. f. Cigarette consumption has fallen from 240 million cartons to 180 million cartons. This may actually be the goal that the government sought, in its attempt to improve health. 20. BB, question 21.8. a. Without the tax, the equilibrium is still a price of $4.00 and a quantity of 240. b. When the tax is imposed, the supply shifts up by the amount of the tax, but in this case the supply curve is more elastic. The new equilibrium is at a price of $4.75 and a quantity of 150: Price Price Quantity Quantity (including tax). (excluding tax) Demanded Supplied $4.25 $3.00 210 60 4.50 3.25 180 105 4.75 3.50 150 150 5.00 3.75 120 195 c. In this case, the price is higher and the quantity lower. Because the supply curve is more elastic, suppliers have been able to shift rnore of the burden of the tax to buyers, by cutting back production more. 10
21. (Optional - 20 extra-credit points). In class, we played an oligopoly game between N different firms with homogeneous goods and identical production technologies. Each firm simultaneously chose its output quantity, and the total output by all N firms determined the market price. (This game is called the Cournot game by economists, as it was first analyzed by a French economist named Cournot in the 1800s.) For concreteness, let's consider the case with N=5 firms. For each firm, AC=MC=10. The market demand is given by the following inverse demand curve: P = 100 - Q. Recall that in this game, each of the 5 different firms chooses its own quantity (q1, q2, q3, q4, q5), and the total market quantity Q is given by the sum of the five firms' choices: Q = q1+q2+q3+q4+q5. a. If the firms wish to work as a cartel to maximize their joint profits, what total quantity should be produced? 45 Assume that the firms agree to divide the profits equally by each producing identical levels of output; what quantity should each individual firm produce? 9 What will be the market price, 55 and what will be the amount of profit earned by each firm? 405 b. Demonstrate that if each other firm produces the quantity prescribed in part (a), then firm 1 can earn more profits by deviating from the prescription. If firm one produces 5 more units the price falls to 50, but they sell 14 now at $50 for a TR of $700 less a cost of $140 means a profit of $560. This is larger than above. What does this tell us about the stability of the cartel? There is great incentive to cheat, so a cartel is relatively unstable. c. Find the symmetric Nash equilibrium output for this game. That is, find the level of output for each firm such that, if all the other firms produce the prescribed output, firm 1 will have no incentive to deviate from the prescribed level of output. What will be the level of output for each firm, 15 what will be the market price, 25 and what will be the profit for each firm in this equilibrium? 225 d. How does the Nash equilibrium compare to the cartel solution in (a)? higher output, lower price, less profits 22. (Optional - 10 extra-credit points). Provide a newspaper article describing a particular tax. Describe whether you see any excess burden arising under this tax, and if so, what is the nature of the excess burden. 11