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Name _________________________ Principles of Micro Lance Howe, SPRING 2007 Monopoly, Monopolistic Competition, Oligopoly, and Optimal Choice of Inputs Instructions: Answer each question completely. This HW is worth 20 points total. I. (5 points) Monopoly and Monopolistic Competition In 1971 Nike co-founder and Oregon track coach, Bill Bowerman, created the modern distance running shoe – using a waffle iron. The 1972 Olympic trials were Nikes real debut and by 1979 Nike controlled over 50% of the running shoe market. For our purposes suppose that Nike was a perfect Monopoly and faced demand and cost conditions described below (in millions of dollars): Output 0 10 20 30 40 50 60 70 80 90 100 Price 120 110 100 90 80 70 60 50 40 30 20 Total Cost 1950 2000 2100 2250 2450 2700 3000 3400 3950 4700 5700 a.) The level of output Nike would choose to produce is ______. The selling price at this level of output is ______ and the corresponding profit is ______. [Hint: remember marginal is change in total over change in quantity – in this problem quantity changes by more than 1 unit] b.) Suppose that Nike demand falls after Reebok, New Balance and several other competitors enter the market. Assume that this monopolistically competitive market is in long-run equilibrium. Assuming that Nike’s costs don’t change (but note that demand has changed), Nike finds that profit is maximized by producing Q = 30. What is Nike’s price at this level of output? What is their profit? c.) Illustrate the movement from monopoly (part a) to monopolistic competition (part b) in the figure at right. Draw average cost and marginal cost curves and then the demand and marginal revenue curves associated with monopoly (part a) and monopolistic competition (part b). [Hint: as with other cost and revenue curves we have drawn, approximations are fine] d.) If this were a perfectly competitive industry and all firms had cost curves similar to Nikes, the long-run price would be _____(round to the nearest tenth). The corresponding level of profit would be _______. e.) Which form of industrial organization would be better for society in terms of cost and output? Which would be better in terms of variety? Is society better off or worse off relative to the case when Nike was a pure monopoly? Page 1 of 4 II. (5 points) Monopolistic Competition In Santa Monica there are seven bathing suit stores, each with the same schedule of costs and each facing an identical demand curve. Swim N Style is a typical store that faces the demand schedule and total costs shown below. Output Price Total Cost 1 68 70 2 66 80 3 64 85 4 62 90 5 60 100 6 58 115 7 56 136 8 54 164 9 52 200 10 50 245 a. Using the blank columns, calculate total cost, marginal cost, average cost, total revenue, and marginal revenue at each level of sales. b. If Swim N Style is a profit maximizer, it sells ___ suits per hour. It’s price will be ___ and the corresponding profit will be ___. c. Is the Santa Monica bathing suit industry in long run equilibrium? Why or why not? d. What will happen in the industry over the next few years? Now suppose that seventeen new bathing suit stores enter the market, joining the seven that already existed. As a consequence, the demand schedule facing Swim N Style (and all other stores) falls, while the cost schedules remain constant. Output Total Cost 1 31.5 70 2 28.5 80 3 25.5 85 4 22.5 90 5 19.5 100 6 16.5 115 7 13.5 136 8 10.5 164 9 7.5 200 10 4.5 245 d. What number of suits will Swim N Style sell now? e. What price will Swim and Style charge? What will the level of profits be? f. Price Is the market in long-run equilibrium now? Explain. Page 2 of 4 III. (5 points) Oligopoly and Game Theory United and Continental are competing for holiday travelers on the Los Angeles-Chicago airline route. This is a market that can be described as oligopolistic: it has high barriers to entry and low variable costs of production. If each firm charges a high price each firm will earn profits of $300 million each. However, if one airline charges a low price while the other charges a high price the airline charging the low price earns profits of $440 million while the airline charging a high price earns profits of $100 million. If both airlines charge low prices they will make profits of $125 million. a. In the space below set up a payoff matrix for Continental and United. b. If United knows that Continental will charge a high price, and it has no reason to be concerned about retaliation, what is United’s best response? c. If Continental knows that United will charge a high price, and it has no reason to be concerned about retaliation, what is Continental’s best response? d. Find the Nash equilibrium for the game described above and briefly explain why it provides a solution to the game. e. From the results above, is (High Price, High Price) a stable equilibrium? What does this imply about the ability of firms to collude? f. How could your answers be different if this game were repeated several times? Page 3 of 4 IV. (5 points) Monopoly and Monopoly Power Suppose that Marlin, of Marlin’s Monster Fish Trips, is a the single provider of local fish trips in the city of Oxnard. His company provides day-long fish trips at the following prices and costs: QS TC 0 1 2 3 4 5 40 48 62 110 170 240 MC New MC AC P QD 100 90 80 70 60 50 0 1 2 3 4 5 TR MR a. The number of trips Marlin would choose to provide is ____. The selling price at this level of output is _____ and the corresponding profit is ______. b. If all firms have cost curves similar to Marlin’s and this industry were characterized by perfect competition, what would be the long-run price? c. Suppose that Oxnard city counsel members are upset at Martin’s monopoly primarily because he is restricting the number of fishing trips relative to the number the counsel believes would be optimal. After some consultation the counsel decides to tax Marlin’s profits a flat 50%. They reason that he will need to provide more trips in order to increase his profits to the level they were before the tax. How many trips does Martin now provide? What will be the daily amount of Oxnard’s tax revenue? Does the counsel succeed in its goal of increasing Marlin’s output? d. After reviewing Marlin’s behavior, the city decides to eliminate the flat tax and imposes a “fishing tax” of $50 per boat trip on Marlin. What is Marlin’s new level of output and price (Hint: Marlin’s cost per trip is increased by the amount of the tax)? What is the amount of the new tax revenue for the city? Again, has the city achieved its goal of increasing Marlins output? e. Disheartened in the effectiveness of the taxes the counsel decides to adopt a proposal that encourages entrants into the Oxnard fishing industry. All taxes are eliminated, and by the next year several fishing companies have opened. Suppose that the industry is now best characterized by monopolistic competition and is in long-run equilibrium. If Marlin is producing at a profit maximizing output level of 1 trip what price is he charging? What are his profits? f. What does this simple problem indicate about the key to monopoly power? Page 4 of 4