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Econ 22060 – Principles of Microeconomics
Spring, 2001
Dr. Kathryn Wilson
Due: Tuesday, March 20
Homework #4 – Answer Key
1. Answer the following true or false and explain why.
a) If firms are producing at the minimum of the average total cost curve, then the firms are being
economic efficient and we will have no deadweight loss. False. Firms are economic efficient if they are
selling the quantity where Marginal Benefit to Society = Marginal Cost to Society. We find this where
demand crosses the marginal cost curve. Being at the minimum of the ATC curve does not guarantee that
we are where demand crosses marginal cost.
b) If there is deadweight loss with a monopoly (the market is not economic efficient) then the monopoly
could increase its profits by changing the price or quantity it sells. False. The monopoly cares only about
maximizing profits (where marginal revenue = marginal cost), not about being economic efficient. Economic
efficiency is an issue for society – are we making the “right” quantity of the good. Moving to the quantity
with no deadweight loss would mean selling a higher quantity at a lower price than what maximizes profit for
the monopoly.
c) Excess capacity implies we could be producing at a lower average total cost in monopolistic
competition if we had fewer firms each producing a higher quantity. True. The firms are producing at a
quantity that is less than the quantity that would minimize their costs. If the firms were producing a higher
quantity, their average total cost would be lower. (Remember, though, firms do not have the goal of
minimizing costs – their goal is to maximize profit.)
d) The reason firms in monopolistic competition face a downward sloping demand curve is because there
are many firms in the industry. False. The reason the firm faces a downward sloping demand curve is
because the product is differentiated. This means that if the firm charges a higher price, it will lose some but
not all of its customers.
e) In general, if there are more firms in an industry, the demand curve for an individual firm becomes
more elastic. True. If there are more firms, then there are more substitutes available for any 1 firm’s
product. We discussed that the demand curve for a firm in monopolistic competition will be more elastic
than if the product were sold by a monopoly. Similarly, if the firm is perfect competition, the firms demand
curve is perfectly elastic (flat) so that if the firm tries to charge a price higher than the market price it won’t
be able to sell anything.
f) Perfect competition is the only market structure that results in the market operating at the economic
efficient level. True. The economic efficient level is where the marginal benefit to society equals the
marginal cost to society, which we can find at the spot price = MC. All firms will produce where MR = MC in
order to maximize profit. However, in perfect competition, MR is the same thing as price (if they want to sell
one more unit, they can do so at the market price so the extra revenue they collect is whatever the price is) so
the firm produces where price = MC. In the other market structures, marginal revenue is different from
price; they produce where MR = MC, but this is not where Price = MC.
2. Provide a short answer for each of the following questions.
a) What market structure characteristic do we need to have in an industry to guarantee that the long run
profits of a firm will be zero? Why? In order for long run profits to equal zero, there must be easy entry
into the industry. If firms in an industry are earning positive profits but there are barriers to entry, then
even though some firms will WANT to enter the industry they won’t be able to. If we have no barriers, then
new firms will enter the industry, shifting out the industry supply curve and driving down price and profits.
b) How does a difference in product differentiation affect the results for an industry characterized by
monopolistic competition compared to perfect competition? Product differentiation is important because it
means people will buy from a firm even if it charges a price different than the market price because they like
the differentiated product better than the other products. (For example, I paid more for a pizza this weekend
than I would have paid at other pizza places because I like the pizza I bought better than what other pizza
places sell.) This results in a firm’s demand curve that is downward sloping. The net result for society is that
we have a variety of prices for a product (instead of just one price), we have deadweight loss, and we have
excess capacity.
c) In general, explain what we expect to see happen in terms of price, quantity sold, profit, and consumer
surplus if there is a lot of competition in an industry compared to an industry with very little competition.
If there is a lot of competition, then the competition will drive down price resulting in a lower price and a
higher quantity being sold. This is good for consumers (the lower price and higher quantity) so consumer
surplus goes up. However, this is bad for the producers and profit is smaller with a lot of competition
compared to little competition. If we look at it from the other perspective, if there is no (or little) competition,
firms will restrict the quantity they sell in order to drive up the price to the point where they maximize profit.
d) Which of the following is more important in influencing the market results for an industry
characterized by oligopoly: the fact there are only a few sellers or product differentiation? Explain.
The fact there are only a few sellers is definitely more important. Only having a few sellers means that each
seller’s actions affect the other sellers so that what is best for me to do depends on what the other firms do. In
some industries with oligopoly firms have differentiated product, but in others they have homogeneous
products.
e) If a firm is earning positive profits, what will happen in the long run if the firm is in an industry
characterized by perfect competition? by monopolistic competition? my monopoly?
If the industry is perfect competition, then there are no barriers to entry. In the long run, new firms will
enter the industry. This will shift the industry supply curve out, driving down the market price and
increasing the industry quantity. The result of the lower price is that firms profits get pushed to zero.
If the industry is monopolistic competition, again there are no barriers to entry. In the long run, new firms
will enter the industry. This will shift the industry supply curve out, driving down the market price and
increasing the industry quantity. The result for the firm is that the demand curve for the firm’s product
shifts in. This is intuitive if we think of what the demand curve for the firm is telling us – for any given price,
how many do people want to buy? If the market price is falling and more alternatives are available, then if
the price of the product for this firm stayed exactly the same, fewer people would want to buy from this firm.
For every price, a lower quantity would be demanded from the firm. The result of the demand curve shifting
in is that the firm charges a lower price and the firm’s profits get pushed to zero (or close). (If the firm is able
to keep its product differentiated, then it might still be able to earn a small positive profit.)
If the industry is monopoly, then even though new firms want to enter, there are barriers that keep the firms
from entering. Therefore, since there is no new competition, there is no reason for the monopoly to change its
price or quantity. It can continue earning the same profits in the long run.
3. The following graphs are for a firm and an industry characterized by perfect competition.
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a. What will be the short run price, quantity sold by the firm, and quantity sold by the industry?
We find the short run price by looking at where industry supply and demand cross, in this case at a price of
$40 and a Quantity of 3000. To find the quantity the firm wants to sell, we find where the marginal cost
equals $40 (where MC = MR), which is a quantity of 3.
b. What are the firm’s profits in the short run?
Profits = (price – ATC) * quantity = (40 – 55)*3 = -15*3 = $ -45. The firm is losing $45. (Note, though, that
the firm still wants to stay open in the short run since the price ($40) is higher than average variable cost
($37.5). Even though the firm is losing money, it is not losing as much money as if it shut down in the short
run.)
c. Given the firm’s profits in part b, explain in words what will happen in the long run.
Since the firm is losing money, firms will leave the industry. As firms leave the industry, the supply curve for
the industry will shift in. This will result in a higher price. Firms will keep leaving until the price has been
pushed up to where profits equal zero. This happens where MC = ATC, which is a price of $50.
d. What will be the long run price, quantity sold by the firm, quantity sold by the industry, and profits for
the firm? In part c we see that the price will be $50, and for $50 each firm wants to sell 5. To find the
quantity sold by the industry, we have to look at the demand curve. New firms have entered, pushing out
supply, until the new supply crosses demand at a price of $50. This occurs at a Quantity of 1000. The firm’s
profits are zero (price = $50 and ATC = $50 so profits =(50-50)*5=$0).
e. How many firms will there be in the industry in the long run?
We know that 1000 is being sold by the industry and each firm is selling 5. To find the number of firms, we
take Q  q = 1000  5 = 200. There are 200 firms each selling 5 units to give us a total of 1000 units being
sold.
4. The following graph shows the demand curve and cost curves for a firm in monopolistic competition.
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a) What will be the short-run profit-maximizing price and quantity for the firm? The firm maximizes
profits by selling where MR = MC. I have drawn the MR curve in the graph – it crosses the X axis ½ the
distance that the demand curve crosses the axis (since demand crosses at 1000, MR crosses at 500). MR
equals MC at a quantity of 250. To find price, we go up to the demand curve to see how much people are
willing to pay for 250 units. The price is about $57.
b) What will be the firm’s short-run profits? Profits = (price – ATC)*quantity = ($57 - $43) * 250 = $3750.
c) Based on your answer in b, what do you expect to happen in the long run? Since this is monopolistic
competition, there are no barriers to entry. New firms will enter the industry since there are positive profits.
As new firms enter the industry, the demand curve for this firm will shift inward, resulting in lower price and
profit. The firms profits will either be pushed to zero or close to zero (if the firm can keep a differentiated
product even when all the new firms come in the industry, it might be able to earn small positive profits in the
long run).
d) How would your answer to part c be different if the firm were a monopoly instead of a firm in
monopolistic competition? If it were a monopoly, there would be barriers to entry. Even though new firms
would want to enter the industry, they would not be able to. The price would stay at $57 and profits would
stay at $3750.
e) What quantity would have no excess capacity? Explain. What quantity would be economically
efficient? Explain. In order to have no excess capacity, the firm would have to be producing the quantity
that results in the lowest possible ATC. This happens at a quantity of 300. Since this firm is only selling 250,
it has excess capacity – the average total cost of producing 250 is $43 while if it produced 300 the average total
cost would be $42. To be economically efficient, the firm would have to produce where demand crosses MC,
which is a quantity of about 375. This is the quantity where the marginal benefit of the last unit produced
equals the marginal cost of making it. (Remember, though, the goal of the firm is not to have the lowest
possible ATC or be economic efficient but rather to maximize profit, and this happens at the quantity of 250.)