Answers to Review Quiz
Monopoly and Imperfect Competition
1. The major difference between monopolists and perfect competitors is that:
All firms are guided by the MR = MC condition, at least in our simple world. It is also true that perfectly competitive firms and monopolists both face demand curves. The difference is the shape of the demand curve. The demand curve facing the perfectly competitive firm is perfectly elastic which means that it is horizontal. It is also true that both monopolists and perfect competitors face downward sloping industry demand curves. It is the firm that faces the horizontal demand curve when we are talking about perfect competition. The difference between perfect competition and monopoly is that in the long run perfect competitors earn no economic profit.
2. In the diagram above, a profit maximizing monopolist would charge what price (approximately)?
Profit maximization happens where MR = MC which is where the two curves intersect which is approximately 3.5 units of output . At that level of output you follow up to the demand curve (AR) to find out what the price would be to clear the market. It would be approximately $7.
3. Using the diagram above, calculate the per unit profit for a profit maximizing monopolist (approximately).
Per unit profit would be defined as per unit revenue (AR) - per unit cost (AC). At the profit maximizing level of output this would be approximately $7 - $6 = $1.
4. If this monopolist were interested in a break-even price, which price would you suggest?
Break-even means zero profit. This would happen when AC = AR which would be closest to 5 units of output which could be sold at a price of $6.
5. Which of the following would be likely to happen if an industry moved from a competitive to a monopolistic structure?
The answer to this question is at the center of the debate over the relative merits of competition and the costs of monopoly. If we assume that the cost curves are unaffected by market structure, an assumption which you will not get everyone to agree on, then you can be assured that the movement to monopoly will result in decreased output and higher prices.
6. What if you were interested in maximizing profit from operation of a metropolitan transit system and you knew that the demand elasticity for region A was higher than the demand elasticity for region B. What pricing structure would you employ?
This is a price discrimination problem - setting different prices in different markets when costs do not justify the differences. The rule for a discriminator is to charge a lower price where demand is more elastic so the fare in region A would be lower.
7. The telecommunications industry (phones) has been in a state of rapid change in recent years. If the cost of cellular long-distance and local calls are the same and there are more suppliers of long-distance service, then you would expect that the profit maximizing seller of phone services would:
This is also a price discrimination problem - setting different prices in different markets when costs do not justify the differences. The rule for a discriminator is to charge a lower price where demand is more elastic, but we are not told what the elasticity of demand is in the two markets. We do, however, know that demand is more elastic when there are more substitutes so demand should be more elastic in the long-distance market which should mean lower prices there.
8. Which of the following industries is closest to the monopolistic competition model?
Monopolistic competition occurs when we have a number of sellers selling slightly different products. This is likely to be the case for gas stations.
9. Which of the following characteristics of an industry would increase the likelihood of the formation of a cartel?
A cartel occurs when companies can agree to act as monopolists. This is more likely to happen if there are a few sellers so that they can monitor each others behavior.
10. At a recent social gathering I overheard a conversation between two internet providers discussing the appropriate access fee that they should charge their customers. This behavior would be called:
This is called collusion when firms get together to discuss their pricing strategy. Price leadership would be a type of collusion.
11. In which market structure are you likely to see firms' behavior determined by the behavior of competitors?
It is in oligopoly that you are likely to see firms taking the expected behavior of competitors into account as they plot their optimal strategy.
12. At another recent social gathering (a business meeting of course) I overheard a conversation among some local business people concerning the cost of trash removal. It seems they had taken an introductory economics course and were concerned that the city was getting 'ripped off' by the monopolists - there is only one firm that picks up all of the trash. Which of the following principles would you invoke to make them worry a bit less about the problem?
Contestable markets refer to a situation where there is a potential entrant to the industry - one that is willing to come in if the existing firm raises price above cost. It is the fear of entry that keeps the existing monopolist from raising prices too high.
13. Newport is a very popular summer tourist area and there are large number of restaurants that specialize in seafood. Which market structure would be most representative of the restaurant industry in Newport?
A large number of restaurants all selling meals that are similar is what we would expect with monopolistic competition.
14. While there are large number of restaurants that specialize in seafood, there are only a very few fine dining establishments. Which market structure would be most representative of the fine-dining restaurant industry in Newport?
A few restaurants in the fine dining category is what we would expect with oligopoly.
15. In which industry would you expect to find the highest four-firm concentration ratio?
The suit against Microsoft in 1998 should have helped you answer this one. A four-firm concentration ratio shows the share of industry sales that are accounted for by the four largest firms. You do not need to know much about these specific industries to know that the furor surrounding the Microsoft case is all about Microsoft's enormous share that Windows has of the operating systems market.
16. In which industry would you be most likely to find collusion?
Collusion is not likely to take place in either a perfectly or monopolistically competitive market because there are many firms and coordination would be difficult. In a monopoly, meanwhile, there would be no need for collusion since the firm is the industry - there is only one seller. It is oligopoly where we are likely to find collusion.
17. In the suit against Microsoft, the government was charging that Microsoft used an illegal pricing strategy - predatory pricing. What would be an example of predatory pricing?
Predatory pricing has to do with setting prices that are not directly related to current costs and profit, but are designed to drive competitors from the market. This would happen if the firm were charging a price below MC.
18. Which of the following contributed to the ultimate decline of the OPEC cartel?
All of the above are true when we are dealing with the OPEC cartel. The cost of another barrel of oil is low and we did see a number of new suppliers enter the scene. Also we saw a decline in world-wide demand that put downward pressure on price which prompted the individual suppliers to cheat.
Below is an estimate of a payoff matrix that firm A has created to identify the consequences of a pricing strategy. The firm can either raise or keep the price of its product unchanged, while the major competitor also has the same options. If firm A raises its price and firm B does not, then firm A will lose $50,000 while firm B will gain $100,000. Use this matrix to answer the following two questions.
| B's pricing strategy | |||
Raises price |
Not raise price |
||
Raises price |
$100,000 A |
$100,000 B | |
| A's pricing strategy | $100,000 B |
-$50,000 A | |
Not raise price |
-$50,000 B | $0 A |
|
| $200,000 A | $0 B |
190. If you assume that this matrix is accurate, that neither competitor knew what the other would do, and that the competitors wanted to minimize the down-side of their choice (a minimax solution), then what should firm A do with regard to its pricing strategy?
The answer is to be found by looking across the columns. If A raises its price (top two rows), then the worst it can do is lose $50,000. If A does not raise its price, then the worst it could do would be to break even with a gain of $0. If A were to adopt a minimax strategy, then it would choose not to change the price.
20. If the firms could collude, what would be the optimal strategy to maximize total sales?
The answer may not be the best for the buyers, but the sales will be highest if both firms can get together and agree to raise prices. If they do, sales will be up by $200,000, far better than you would see with any other option.