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Econ 22060: Principles of Microeconomics
Dr. Kathryn Wilson
Fall, 2000
Due: Thursday, October 25
Homework 4 – Answer Key
1. Use the following two graphs to answer this question. The first graph shows the costs for a firm in
perfect competition. The second graph shows the industry demand and supply curves.
Industry
MC
ATC
AVC
ATC
Price
Price
Firm
18
17
16
15
14
13
12
11
10
9
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5
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1
0
AVC
MC
0
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quantity
8
9
10 11 12
18
17
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11
10
9
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1
0
S
D2
``
D1
0
2000
4000
6000
8000
10000
12000
Quantity
a. Assume that the industry has demand curve D1 (the lower of the two demand curves) and the supply curve S.
What will be the short run price, quantity sold by the industry, and quantity sold by the profit-maximizing firm?
How much are the firm’s profits? To find the short run price and quantity sold by the industry we look at
where the industry supply and demand curves cross, which is a price of $8 and a quantity of 3000. To find
the quantity sold by the firm, we have to find out how many the firm chooses to sell for a price of $8. We
know they will sell until marginal revenue ($8) = marginal cost. This happens at a quantity of 3. Profits =
(Price – ATC) * q = ($8 – $11)*3 = -$9.
b. Based on your answer to part a, explain in words what you think will happen in the long run. In addition, give
the long-run equilibrium price, quantity sold by the industry, quantity sold by the profit-maximizing firm, and firm’s
profits. Firms in this industry are losing money so while they will stay open in the short run (since they are
covering variable costs) they will shut down in the long run. As firms shut down, the industry supply curve
shifts in, raising price. Firms will keep leaving the industry until profits are up to zero, which happens when
the price is where marginal cost crosses ATC, $10. Any price lower than $10 and firms would be losing
money so keep leaving the industry. Any price higher than $10 and firms would be making positive profits so
new firms would enter the industry. Thus the long run equilibrium price is $10. At a price of $10 each firm
wants to sell a quantity of 5. To find the quantity sold for the industry, we look to see how many people
demand at a price of $10, which is 1,000. The firm’s profit = ($10 - $10)*5 = 0.
c. Assume that the industry has demand curve D2 (the higher of the two demand curves) and the supply curve S.
What will be the short run price, quantity sold by the industry, and quantity sold by the profit-maximizing firm?
How much are the firm’s profits? We solve this the same way we did part a. Supply and Demand cross at a
price of $13 and quantity of 8000. For a price of $13, each firm wants to sell 8. Profits = ($13 - $12)*8 = $8.
d. Based on your answer to part a, explain in words what you think will happen in the long run. In addition, give
the long-run equilibrium price, quantity sold by the industry, quantity sold by the profit-maximizing firm, and firm’s
profits. Since firms are earning a positive profit, new firms will enter the industry. This will shift out the
industry supply curve and drive down price and profit. Firms will keep entering until profit is driven to zero,
which happens at a price of $10 (just like in part b). Each firm chooses to sell 5 and we find the industry
quantity by looking at how many people demand for $10, which is 11,000. Profit = ($10 - $10) * 5 = 0.
2. Use the following graph for a monopoly to answer this question.
50
45
40
35
30
25
20
15
10
5
0
MC
ATC
D
1000
900
800
700
600
500
400
300
200
100
MR
0
Price
Monopoly
Quantity
a. What will be the price and quantity sold for the monopoly? How much is the monopoly earning in
profits? We first have to draw in the firm’s marginal revenue curve. Since demand crosses at 1000,
marginal revenue crosses at 500. Second, we find the quantity where MR = MC, which is 300. Third, we go
up to the demand curve to find the price, $35. Profits = (P – ATC) * Q = ($35 - $27.50) * 300 = $750.
b. Based on your answer to part a, explain in words what you think will happen in the long run. In
addition, give the long-run equilibrium price, quantity sold by the monopoly, and monopoly’s profits.
Since the firm is earning positive profits, new firms will want to enter the industry. However, with a
monopoly there are barriers to entry so no new firms can enter. This means there is no reason for the
monopoly to change price or quantity. Everything will be the same as in part a: P=$35, Q=300, Profits=$750.
c. Is the market efficient with the monopoly? If so, explain how you know this. If not, state what
quantity would be economically efficient and why that quantity would be economically efficient.
No. In order to be efficient, it has to be that we keep producing until the point that for the last unit produced
the marginal benefit to society equals the marginal cost to society. We find the marginal benefit to society
from looking at the demand curve. For the 300 th unit, the marginal benefit is $35. To find marginal cost to
society, we look at the marginal cost curve. The marginal cost of the 300th unit is $20. Since MB > MC
($35 > $20), we are not being efficient. It is good that we produced that 300 th unit, but we should be
producing more. The quantity that is economically efficient is where marginal cost curve crosses the demand
curve, 450 units. For the 450th unit the marginal benefit is $27.50 and the marginal cost is $27.50.
d. If instead of being a monopoly, the graph above were for a firm in monopolistic competition, how (if
at all) would your answers be different to parts a, b, and c of this question? (In other words, how would
you answer parts a, b, and c if the question was for monopolistic competition instead of monopoly.)
The answer to parts a and c would be the same for monopolistic competition or monopoly. Both monopoly
and monopolistic competition face a downward sloping demand curve so we solve the problem by drawing
the marginal revenue curve, finding the quantity where MR = MC, and going to demand to find the price. In
addition, for both monopoly and monopolistic competition, the firm is going to sell a quantity less than the
quantity that is economic efficient (Marginal Benefit will be greater than Marginal Cost for the last unit sold).
However, my answer to part b would be different. If this were monopolistic competition and the firm was
earning positive economic profits, there are no barriers to entry so new firms would be able to enter the
industry. This will shift the industry demand curve out, driving down industry price and shifting in the
demand curve for the firm’s product. New firms will continue entering until profits are pushed to zero.
3. This question requires that you integrate what we have learned about the different market structures.
Each section assumes a different set of market characteristics for textbooks in Kent. You don’t need to
include any actual numbers in your answer, just explain what is happening.
a. Assume that the University bookstore is the only place where students can buy textbooks. (There are
no other stores that carry textbooks and you cannot but them anywhere else.) What would be the market
structure? What would you expect in terms of price of textbooks and profits for the bookstore?
University bookstore would have a monopoly on textbooks since they are the only firm that sells them. We
would expect to see a higher price for textbooks and fewer textbooks being sold. The lack of competition
results in smaller consumer surplus and larger profits for the bookstore.
b. Assume that DuBois also sells textbooks so now students have a choice between buying books at the
University bookstore or DuBois. What would be the market structure? If the bookstores wanted to
maximize joint profits, what would they do? Is this what you would expect to be what happens? Explain
why this is or is not what you would expect to see. In general, how would prices and profits compare to
the prices and profits in part a? Now the market is characterized by oligopoly because there are just a few
(two) firms. However, this added competition means that DuBois and University bookstore will try to get
customers to come to their bookstore rather than the other, either by having lower prices or better service.
The result will be good for customers as we expect the price of textbooks to fall compared to part a, and the
profits of the firm will be smaller than in part a. Ideally for the bookstores, DuBois and University bookstore
would cooperate with each other, both charging high prices and limiting the number of books they sell.
However, this probably isn’t what we would see in reality for two reasons. First, in the United States it is
illegal for the firms to cooperate with each other in setting prices (based on the Sherman Anti-Trust Act).
Second, while the bookstores might agree to charge high prices, each bookstore has an incentive to cheat on
their agreement and sell more books at a lower price than they agreed to.
c. It is now possible to buy textbooks over the internet at a variety of on-line bookstores. In addition,
students can buy textbooks at DuBois or at the University bookstore. What is the current market
structure? How will price and profits be different than in part a? How might the bookstore respond to the
fact there is now more competition than in part a? Now we are moving into a more competitive market
structure, such as monopolistic competition. The additional competition will result in lower prices, more
books being sold, and lower profits for the bookstores. In response to this, the bookstore will want to
differentiate themselves from the competition – they might emphasize the personal service you can get from
them that is not available from the on-line stores or they might provide other services that aren’t available
from the competition. By keeping their product differentiated, they are trying to make sure you buy your
books from them rather than on-line and thus they can charge a higher price and get a bigger profit.
4. Answer the following True or False, and explain.
a. If a firm in monopolistic competition wants to sell one more, the marginal revenue they receive is
equal to the price of the product. FALSE. A firm in monopolistic competition faces a downward sloping
demand curve. This means that if they want to sell more of the product, the only way to do so is to lower
the price they charge. The marginal revenue they get from selling one more unit is lower than the price
they charge because while they collect this price from the last customer, they collect less than they could
have collected from other customers if they didn’t try to sell to this customer.
b. The primary difference between perfect competition and monopolistic competition is that in
monopolistic competition the product is homogeneous. FALSE. The primary difference is that in
perfect competition, the product is homogeneous. For monopolistic competition, the product is slightly
differentiated. This gives each firm a “mini-monopoly”, so to speak, in that they are the only firm that
sells exactly that product. Because firms have differentiated products, even if they charge a price higher
than the market price they will still have customers so in monopolistic competition the firm faces a
downward sloping demand curve while in perfect competition the firm faces a horizontal demand curve.
c. In the long run, if a firm in monopolistic competition is earning a profit, new firms will enter and the
firm’s demand curve will shift in. TRUE. There are no barriers to entry in monopolistic competition,
so if there are positive profits, new firms will enter. When new firms enter, the demand for any given
firm will shift in – for any given price, people will want to buy less of the good from that firm as more
firms open up.
d. In the long run, if a monopoly is earning a profit, new firms will enter and the firm’s demand curve
will shift in. FALSE. Because of barriers to entry, new firms will not enter the industry.
e. A firm has excess capacity if they are operating at the minimum of the average total cost curve. Due
to time constraints, we did not get to talk about excess capacity, so you are not responsible for it.
f.
The only time the market will give us an economic efficient long run equilibrium is if the market is
characterized by perfect competition. TRUE. In order to have economic efficiency, we must be where
marginal benefit = marginal cost. This only happens where the demand curve (which shows marginal
benefit) crosses the marginal cost curve. Perfect competition is the only market structure where firms
maximizing profit (selling where MR = MC) result in a quantity where Price = MC (since for perfect
competition the marginal revenue they receive is the price they charge but for all the other market
structures the marginal revenue is less than price).
g.
If a monopoly is not being economic efficient, then it is not maximizing profits. FALSE. The market
is economic efficient if we are selling where for the last unit sold the marginal benefit to society equals the
marginal cost to society. We find marginal benefit by looking at the demand curve, or the price paid for
the product. In other words, then, the efficient quantity is where P = MC. However, in order to
maximize profits, the firm want to sell where MR = MC. In order to sell one more unit, the firm has to
lower its price. This results in MR being less than the price charged. Since P > MR, when the firm sells
where MR = MC, they are selling where P > MC.
h.
From the perspective of consumers, prices will be lowest and consumer surplus highest if the market
structure is monopoly. FALSE. In fact, price will be highest and consumer surplus lowest if the market
structure is monopoly. Consumers face lower prices and more consumer surplus when there is more
competition. Price is at its lowest and consumer surplus is at its highest when the market is perfect
competition.
i.
If we have ease of entry into an industry, then we always expect long run profits to be zero (or very
close to zero). TRUE. If there is easy entry, then new firms will enter the industry. As firms enter the
industry, the industry supply curve shifts out and price falls. Firms will continue entering until they have
driven price down to the point where economic profits are zero (and thus there is no reason to come into
the industry).