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565320900
Foundations of Economic Analysis
Homework #5-1
Stratton
Name _______KEY_____________
Objective: to provide practice and assessment of your understanding of monopoly, monopolistic
competition, and oligopoly. (Hint: you may want to work out your answers on another sheet of
paper and transfer your work to this one to avoid submitting a messy worksheet.)
Instructions: For each term, write a short definition in your own words and explain the
significance of the term in the space provided or attach additional sheets if necessary. Each
numbered question is worth 2 points – total xx points.
Definitions:
1.
Barriers to entry – Costs which make entry into a market difficult. These might be caused
by economies of scale, critical input ownership or control, government rules, or other
conditions.
2.
Concentration ratios – It is one measure of market power. Measure the percentage of total
market sales (revenue or some other measure) accounted for (controlled by) the largest
firms in the market. Thus it uses one point on the sales distribution to estimate market
concentration and power. The two most common are the top 4 and top 8 concentration
ratios.
3.
HHI (Herfindahl-Hirschman Index) – A measure of market concentration and power that
uses the entire sales distribution, rather than just one point on the distribution.
Its formula
n
2
is the sum of the square of each firm’s market share. HHI 
S

i
1
4.
Market power – Market power is a firm’s ability to control the price at which it sells its
product. It can also indicate the extent to which the firm can earn long run profits.
5.
Monopolistic competition – A market structure which is characterized by many (usually
relatively small) firms selling similar, but differentiated products.
6.
Oligopoly – A market structure which is characterized by few (usually relatively large)
firms selling similar or undifferentiated products. This is the only market structure in
which the impact of managerial decisions depends on the reactions of their rivals. Thus it
is characterized by mutual interdependence. There are large barriers to entry and the
firms tend to make a profit in the long run.
7.
Monopoly – A market structure which is characterized by a single (usually large) firm
selling a “unique” product (no close substitutes). There are large barriers to entry and the
firm will make a profit in the long run.
8.
Price searcher – a term indicating that firms can control (at least to some extent) the price
at which they can sell their output.
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9.
Foundations of Economic Analysis
Stratton
Public good – A good that is characterized by non-rival consumption and for which the
costs of exclusion are very high.
10. Non-rival consumption – Consumption of the good by one person does not affect its
consumption by another. Thus once it is provided, everyone can consume it
simultaneously. The MC of supplying other consumers is zero.
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Instructions: Answer the questions in the space provided or attach additional sheets if necessary
Problems
Scenario 1:
Below are a hypothetical market demand function for a market and the cost
functions for a monopoly firm in the market. Data is rounded to nearest whole number. Use this
information to describe the current short run situation in the market. Be sure to show all of your
work to receive credit. AR: Q=250 – 5 P or P = 50 – (Q/5) => TR = 50Q – (Q2/5); MR = 50 –
2(Q/5)
Price
Market
Demand
MR
$35
$34
$33
$32
$31
$30
$29
$28
$27
$26
$25
75
80
85
90
95
100
105
110
115
120
125
20
18
16
14
12
10
8
6
4
2
0
TR
Firm
Output
Firm
MC
Firm
ATC
Firm
AVC
TC
75
80
85
90
95
100
105
110
115
120
125
$8
$9
$11
$14
$18
$23
$29
$36
$44
$53
$63
$6
$6
$6
$7
$7
$8
$9
$10
$12
$14
$16
$3
$4
$4
$5
$5
$6
$7
$9
$10
$12
$14
$450
$495
$550
$620
$710
$825
$970
$1,150
$1,370
$1,635
$1,950
$2,625
$2,720
$2,805
$2,880
$2,945
$3,000
$3,045
$3,080
$3,105
$3,120
$3,125
11. What is the average revenue function for firms in this market? [Remember revenue
functions show revenue at all output levels.] – As with all non-discriminating markets,
AR = P; so AR function is same as demand curve.
12. What is the marginal revenue function for firms in this market? – MR see table above. Or
MR = 50 – 2(Q/5).
13. Calculate the total revenue function for this firm. – TR see table above. Or TR = 50Q –
(Q2/5).
14. Calculate the total cost function for this firm. [Remember cost functions show cost at all
output levels.] – TC = ATC * Q; see table above.
15. What is the profit maximizing output level for this firm? – MR=MC at 90 units of output.
16. If the firm is a non-discriminating monopolist, what price will the firm charge? – The
firm will charge a price at which they can sell 90 units of output. That price is $32 per
unit.
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17. Calculate the profit (or loss) for this firm. – Profit = TR – TC = $2,880 - $620 = $2260;
Alternatively, Profit = (AR – ATC) * Q = ($32 - $7) * 90 = $2,250.
18. Estimate the Lerner Index for this firm. – Lerner Index = (P - MC)/P = (32 – 14)/32 =
0.5625.
Scenario 2:
This section assesses your ability to identify and interpret information provided
by a graph of the various market structures. Assume this graph depicts the information available
to a monopoly firm.
$40
MC
$35
$30
ATC
Dollars
$25
$20
AVC
$15
$10
$5
$0
0
D=AR
MR
25
50
75
100
125
150
175
200
225
250
Units per m onth
19. Identify and label each of the five (5) curves. – MC, ATC, AVC, Demand or AR, and
MR.
20. As best you can, using the graph identify the profit maximizing output level. Explain why
this output level maximizes profits. – Profit max occurs at MC=MR [output about 75
units]. This max profits, because the additional cost of every unit produced is less than
the additional benefit and the production of the next additional unit would add more to
costs than benefits (revenues).
21. At what price will this firm sell its output? Why can’t it charge more for its output? – The
firm will charge about $25 per unit. It cannot charge more and still sell all 75 units.
Consumers are not willing and able to pay more and buy all 75 units.
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22. Calculate the economic profit (or loss) for this firm. Explain how you know it is a profit
(or loss). – Profit = TR – TC = (AR – AC)*Q. In our case: ($25 - $14)*75 = $825. This is
a profit because AR>AC or TR>TC.
23. Explain the impact of a government imposed price ceiling of $20 per unit on this firm. Be
sure to indicate any change in output, unit price, and profits. – If the government were to
impose a price ceiling of $20, then the AR and MR would be horizontal to about 100
units of output. MC < MR for first 100 units; MC > MR above 100 units. The ATC is
about equal at both 75 and 100 units of output. Thus the price would be $20, output
would be 100, and profit would be ($20 - $14)*100. = $600. This is $225 less than
without the restriction.
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Scenario 3:
This section assesses your ability to identify and interpret information provided
by a graph of the various market structures. Assume this graph depicts the information available
to a representative firm in the market.
$40
$35
$30
Dollars
$25
$20
$15
$10
$5
$0
0
25
50
75
100
125
150
175
200
225
250
Units per m onth
24. Please describe the market structure represented and explain your reasoning. Be sure to
clearly indicate the differentiating characteristics that allowed you to identify the market
structure. (censored)
25. As best you can, using the graph identify the profit maximizing output level. Explain why
this output level maximizes profits. – Profit max occurs at MC=MR [output about 60
units]. This max profits, because the additional cost of every unit produced is less than
the additional benefit and the production of the next additional unit would add more to
costs than benefits (revenues).
26. Calculate the economic profit (or loss) for this firm. Explain how you know it is a profit
(or loss). – Profit = TR – TC = (AR – AC)*Q. In our case: ($15 - $15)*60 = $0. This is
zero economic profit because AR=AC or TR=TC.
27. Explain the impact of a government imposed price floor of $20 per unit on this firm. Be
sure to indicate any change in output, unit price, and profits. – At a price of $20, no
output would be sold. The quantity demanded at $20 is zero.
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28. Explain the impact of a government imposed price ceiling of $20 per unit on this firm. Be
sure to indicate any change in output, unit price, and profits. – Since this firm maximizes
profits at a price of $15 a price ceiling of $20 would have no impact.
29. Explain the impact of a government imposed price ceiling of $12 per unit on this firm. Be
sure to indicate any change in output, unit price, and profits. – If the price ceiling is $12
per unit, the firm’s AR and MR become flat from an output level of 0 to about 85 units of
output. At about 85 units of output MR = MC, the profit maximizing output. Thus the
price ceiling would reduce the unit price and increase output. Since price (AR) is less
than ATC (but higher than AVC) at 85 units of output, the firm would be making an
operating loss (of about $2 per unit or $170), but would not shut down in the short run.
30. Carefully describe how the graph would change from a successful advertising campaign
that increased the firm’s market share and customer loyalty. – If the advertising campaign
increased market share, the firm’s demand curve would shift to the right. If the
advertising campaign increased consumer loyalty, it would mean fewer customers would
switch if the price increased (demand becomes more inelastic or less elastic). For the firm
this should translate into a less elastic demand to the right of current demand and allow
increased price and output (in SR). However, the advertising would also increase fixed
costs and thus tend to reduce profits.
Short answer problems:
31. If monopolies reduce economic efficiency as compared to perfect competition, as we
have argued, why do governments try to protect particular sellers against the competition
that additional entrants would create? – (censored)
32. How might government restrictions on advertising benefit producers? – (censored)
33. Advertising increases the costs of production. Why is it unlikely that this increased cost
will change the output level? Most advertising costs are not related to sales, so are
essentially fixed. FC determines profitability, but not optimal output level.
34. Some purposes of advertising are to differentiate a product, build brand loyal and
increase market power. To the extent that the advertising is successful, one could argue
that it increases inefficiency. What economic benefits does advertising provide that, at
least partially, offset these inefficiencies? – (censored)
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35. Explain what is meant by “non-price competition” and why it is used. – Non-price
competition is the act of using non-price characteristics of a product to differentiate it
from rival (substitute) products to increase consumer demand for the product. It includes
style, size, features, location, branding, etc. It is used to differentiate one’s product and to
capture market share.
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