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BUS-111

MICROECONOMICS

PROBLEM SET 7 – Imperfect Competition
1.

a.

b.
c.

d.
e.

f.

A publisher faces the following demand for the next novel of one of its authors:
The author is paid £2 million to write the book, and the marginal cost of publishing
the book is a constant £10 per book.
Compute the total revenue, total cost and profit at each quantity. What quantity
would a profit-maximising publisher choose? What price Price
Quantity
would it charge?
(£) Demanded
Compute marginal revenue. How does marginal revenue
100
0
compare to the price? Explain why this is.
90
100,000
Graph the marginal revenue, marginal cost and demand curves.
80
200,000
At what quantity do the MC and MR curves cross? What does
70
300,000
this signify?
60
400,000
In your graph, label the deadweight loss. What does this
50
500,000
represent?
40
600,000
If the author were paid £3 million instead of £2 million, how
30
700,000
would this affect the publisher’s decision regarding the price to
20
800,000
charge? Explain.
10
900,000
Suppose the publisher was not profit-maximising but was
0
1,000,000
concerned with maximising economic efficiency. What price
would it then charge for the book? What profit would it make at this price?
The following table shows revenue, costs, and profits:

a.

Price
(£)

Quantity
(1,000s)

100
90
80
70
60
50
40
30
20
10
0

0
100
200
300
400
500
600
700
800
900
1,000

Total
Revenue
(£millions)
0
9
16
21
24
25
24
21
16
9
0

Marginal
Revenue
(£)
---90
70
50
30
10
-10
-30
-50
-70
-90

Total Cost
(£millions)

Profit
(£millions)

2
3
4
5
6
7
8
9
10
11
12

-2
6
12
16
18
18
16
12
6
-2
-12

A profit-maximizing publisher would choose a quantity of 400,000 at a price of
£60 or a quantity of 500,000 at a price of £50; both combinations would lead to
profits of £18 million.
b. Marginal revenue is always equal to or less than price. Price falls when quantity
rises because the demand curve slopes
downward, but marginal revenue falls
even more than price because the firm
loses revenue on all the units of the
good sold when it lowers the price.
c. The diagram to the right shows the
marginal-revenue, marginal-cost, and
demand curves. The marginal-revenue
and marginal-cost curves cross

Identify the level of output that maximises revenue in that market and explain why revenue is maximised at that output.000. e. Why does a profit maximising monopolist not produce the output that maximises its revenue? Marginal revenue is the change in total revenue arising from selling one more unit of a good. to increase the amount sold. the revenue maximising output is Q1 where MR=0. Thus. because the monopolist produces less than the socially efficient level of output. the publisher would have negative profits equal to the amount paid to the author. . In the diagram above. marginal revenue will be negative. Marginal revenue at this output. The overall effect depends on the price elasticity of demand. Define marginal revenue. a. At that price. total revenue cannot be maximised when MR>0. This cut in price reduces the revenue on the units it was already selling. Draw a diagram to explain how marginal revenue for the whole market is related to the demand curve.between quantities of 400. b. b. marginal revenue is the derivative of total revenue with respect to output: MR = dTR/dQ ≈ ∆TR/∆Q. c.000 and 500. because that is the marginal cost of the book. the monopolist must lower the price of its good for every unit it sells. The only thing that would be affected would be the firm’s profit. because there would be no change in marginal cost or marginal revenue. the publisher would not change the price. d. is greater than zero. This means an increase in output will increase revenue. To maximize economic efficiency. f. Hence. a. the publisher would set the price at £10 per book. the firm must reduce its price on all units of the good. A monopolist's marginal revenue can be negative because to get purchasers to buy an additional unit of the good. This signifies that the firm maximizes profits in that region. An increase in output of one unit will increase revenue by MR0. but the decline in price decreases the firm’s revenue. MR0. Deadweight loss means that the total surplus in the economy is less than it would be if the market were competitive. If demand is inelastic. If the author were paid £3 million instead of £2 million. More formally. The area of deadweight loss is marked “DWL” in the figure. The fact that it sells a greater quantity increases the firm’s revenue. 2. Consider output Q0. A monopolist's marginal revenue is less than the price of its product because its demand curve is the market demand curve. which would fall. The author’s fee is a fixed cost – it does not vary as the quantity of books sold varies.

the profit-maximizing quantity can never occur where marginal revenue is negative. so revenue would increase. the firm will always choose an output where MR is positive. . Explain why a monopolist will always produce a quantity at which the demand curve is elastic. If the firm produced a quantity for which demand was inelastic. Therefore. Marginal costs are positive for any level of output. MR2. Because a firm maximizes profit where marginal cost equals marginal revenue. A profit maximising firm will always set MC=MR. quantity would fall by a smaller percentage than the rise in price. and marginal cost is never negative. Thus the firm should keep raising its price until profits are maximized. (Hint: if demand is inelastic and the firm raises its price. Define natural monopoly. 3. Increasing quantity requires a greater percentage reduction in price. marginal revenue is negative. As the diagram below shows. This means a decrease in output will increase revenue. total revenue cannot be maximised when MR<0. What does the size of a market have to do with whether an industry is a natural monopoly? Natural monopoly exists when a single firm can produce the entire market output at a lower cost than would be possible if there were several firms in the market. At that point it is no longer a natural monopoly. so profit would be higher. the firm would have higher revenue and lower costs. it can never be on the inelastic portion of the demand curve. Thus. so revenue declines. Because costs would decrease at a lower quantity. then if the firm raised its price. another way to see this is to note that on an inelastic portion of the demand curve. which must happen on an elastic portion of the demand curve.c. Consider output Q2. As a market grows. it may become large enough that two or more firms can survive in the industry. Hence. to maximise profit. Marginal revenue at this output. Total revenue can only be maximised when MR=0. what happens to total revenue and to total costs?) A monopolist always produces a quantity at which demand is elastic. 4. and so TR is not maximised. is less than zero.

free entry and exit. c. monopolistic or monopolistically competitive. c. f. g. strawberry jam – monopolistic competition – many producers. d. mains sewerage – monopoly – one producer. g. b. relatively free entry and exit. Classify the following markets as perfectly competitive. differentiation by brand. no product differentiation. wooden HB pencils bottled water cola copper local telephone service strawberry jam lipstick There is no definite answer to this question. Perfectly competition. free entry and exit. a. free entry and exit. e.5. high barriers to entry because of massive fixed costs. wooden HB pencils – perfect competition – many producers. . free entry and exit. differentiation by brand. b. d. bottled water – monopolistic competition – many producers. e. lipstick – monopolistic competition – many producers. monopoly and monopolistic competition are economic models rather than classifications for real world industries. cola – oligopoly – there are only a few firms that control a large portion of the market. differentiation by brand. no product differentiation. but the model that most closely resembles each of these markets is as follows: a. copper – perfect competition – many producers. and explain your answers. f.