Download ECON 5000(001) Spring 2010

Name __________________
ECON 5000(001)
Spring 2010
Exercise 6 – Production Theory under Monopolistic Competition
You are the CEO of a business that that concocts and bottles a sports drink called
RealPro. Your product is much like other sports drinks on the market – i.e., it is water
with some additives; also, there are no significant technical or economic factors that
would prevent new firms from entering the market. So you are in a monopolistically
competitive market. You try to maintain product differentiation via brand name identity
and advertising. This means that there is some inelasticity of demand for your product
and that you try to maintain your share of the total market for sports drinks as best you
can.
You sell your product wholesale in six-pack cartons of bottles or cans. A member of
your staff who has a degree in economics has estimated that the current demand for your
product is
Q/D = 250 – 12.5*P
Where Q/D = quantity demanded (cartons per hour)
P = product wholesale price
1. Fill out Table 6.1 as follows
 Use the demand equation above to calculate the quantity demanded (Q/D) for
each price specified in the table.
 Calculate total revenue (TR) that would result from each P – Q/D combination.
 Calculate marginal revenue (MR) between each P – Q/D combination (remember,
MR = ∆TR / ∆Q).
2. Fill out Table 6.2 as follows
 From the total cost schedule in the table, calculate average total cost (ATC) for
each P – TC combination.
 Calculate marginal cost (MC) between each P – TC combination (remember,
MC = ∆TC / ∆Q).
3. Now inspect the data in the completed tables to answer the following questions re.
your short-run business strategy.
a) Assume that your fixed – variable input relationship is such that when you
select or change your output level, you must do so on the basis of even 10-unit
increments of output. With this in mind, find the price – quantity combination that will
maximize your short-run profit.
Anss.: Profit-maximizing P = $ ________ per carton
Profit-maximizing Q/S = ________ cartons per hour
1
b) Calculate your TR, TC, and economic profit in the short run.
Anss.: TR = $ __________ per hour
TC = $ __________ per hour
Economic Profit = $ __________ per hour
(note with a minus sign if economic profit is negative)
4. Next, let’s explore how some changes in the market for your product might affect your
business in the short-run.
a) Suppose that you get a popular professional athlete to do a very clever and
compelling series of TV commercials promoting your product.
(Answer each of the following by writing INCREASE DECREASE NO CHANGE )
Demand for your product will likely _______________
Your profit-maximizing P will likely _______________
Your profit-maximizing Q/S will likely ________________
Your Economic Profit will likely ____________
b) A public health study reveals that sports drinks are generally very high in
carbohydrates and calories and don’t seem to do much to improve users’ athletic
performance. If these findings are widely believed then
(Answer each of the following by writing INCREASE DECREASE NO CHANGE )
Demand for your product will likely _______________
Your profit-maximizing P will likely _______________
Your profit-maximizing Q/S will likely ________________
Your Economic Profit will likely ____________
5. Now let’s turn to what may happen in the long run in this market. As a reminder, the
monopolistically competitive market theory is that (1) there is “free” entry into and exit
from the market so that (2) if the firms currently in the market are making economic
profits, then new firms will enter and conversely (3) if the firms currently in the market
are making economic losses, then in the long run some of these firms will exit (go out of
business). This principle of entry or exit in the long run has implications re. what will
happen to total market supply and individual firms’ “market share” in the long run,
depending on whether there is entry or exit.
Based on this and your answers to Q. 3 b), above, answer the following (assume
that your economic profit or loss position is typical for firms currently in the industry).
a) Given current economic profit conditions, I would expect firms to __________
the industry in the long run. This would ________________ the demand for my product
(i.e., my market share), ________________ the price that I could charge for my product,
_________________ the quantity I sell, and _____________ my economic profits.
2
b) If/when my industry reaches long run equilibrium, I would expect my product
price to be ____________ and the quantity I sell to be _____________ than currently,
and my economic profits to be ________________ (negative, positive, zero).
6. Finally, let’s explore productive inefficiency in a monopolistically competitive market.
First, be reminded that equilibrium in a perfectly competitive market is the standard of
productive efficiency, in that a perfectly competitive market at equilibrium will produce
the quantity of product at which P = MC = minimum ATC, and economic profit = 0
(normal profit only being earned).
a) Examine Table 6.2 and identify the P – Q combination at which the market
would achieve productive efficiency if it were perfectly competitive.
Anss.: P = MC = ATC = $ __________ per unit
Q = __________ per hour
Productive inefficiency in an imperfectly competitive market is measured in two ways:
(1) Markup – how much greater is the product price in the market compared with what
the price would be if the market were perfectly competitive? (2) Excess capacity – how
much less product is produced in the market compared with the quantity that would be
produced if the market were perfectly competitive?
b) To calculate your markup:
Your profit-maximizing P
= $ __________
(refer to Q. 3a)
Perfectly competitive P
= $ __________
(refer to Q. 6a)
Difference
= $ __________
Percentage difference
= _________ %
(relative to the perfectly competitive price)
c) To calculate your excess capacity:
Your profit-maximizing Q = ________ units/hour
Perfectly competitive Q
= ________ units/hour
Difference
= ________ units/hour
Percentage difference
= _________ %
(relative to the perfectly competitive quantity)
(refer to Q. 3a)
(refer to Q. 6a)
7. In Q. 5 we explored how this industry and market would move toward long-run
equilibrium. But we have enough information to closely estimate long-run equilibrium
conditions for your firm. The easiest way to do this from the information available is via
graphic analysis. To do this
1) Graph your demand and marginal revenue curves from the information in
Table 6.1. (A graph grid template is provided on my course website if you
wish to use it.)
2) Use the data in Table 6.2 to add average total cost and marginal cost curves to
your graph.
3
3) Now draw a new demand curve on the graph which is (a) parallel to the
original D curve and (b) just tangent to (touching) the ATC curve (but not
crossing the ATC curve).
4) Next, draw a new marginal revenue curve based on the new D curve.
5) Locate the point where the new MR curve intersects the MC curve and read
the optimal Q (to the nearest 10 whole units of Q) and market P.
Clearly mark your reading of this P – Q combination on the graph.
Attach your completed Tables 6.1 and 6.2, plus the graph for Q. 7.
4