Economic Applications 2018-2019

Week 4, Tutorial Sheet 3 Answers

This tutorial sheet is based around chapter 14 and 15 of Mankiw and Taylor “Economics” and the
corresponding lecture notes. Students are required to have read these chapters before the tutorial.
Your tutor may not have time to go over all questions in tutorial; however, students are responsible
for revising the answer sheets on their own time.

Chapter 14 of the textbook relates to monopoly, and chapter 15 relates to monopolistic competition.

Make sure you submit your homework to your tutor before the start of your tutorial.

1. A publisher faces the following demand schedule for the next novel of one of its popular authors:

Price (€) Quantity demanded

100               0

90 100,000

80 200,000

70 300,000

60 400,000

50 500,000

40 600,000

30 700,000

20 800,000

10 900,000

  0 1,000,000    

The author is paid €2 million to write the book, and the marginal cost of publishing the book is a
constant €10 per book.

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 a. Compute total revenue, total cost and profit at each quantity. What quantity would a profit-
maximising publisher choose? What price would it charge?

See table above the computed values of TR, TC & Profit using the following formulas:

TR = P x Q

TC = FC + VC

VC = Q x MC (Because MC is constant in this example.)

Profit = TR – TC

The profit maximizing quantity is Qmaxprofit= 500,000 at the point where MR=MC. The
corresponding price that the publisher will charge is P = €50.

b. Compute marginal revenue. (Recall that MR = ΔTR/ ΔQ.) How does marginal revenue
compare to the price? Explain.

See table above for computed MR.

The MR is always below the price which is P=AR.

 A monopolist’s marginal revenue is always less than the price of its good.
o The demand curve is downward sloping.
o When a monopoly drops the price to sell one more unit, the revenue received
from previously sold units also decreases.
 When a monopoly increases the amount it sells, it has two effects on total revenue (P ´
Q).
o The output effect—more output is sold, so Q is higher & TR increases.
o The price effect—price falls, so P is lower & TR decreases.

c. Graph the marginal revenue, marginal cost and demand curves. At what quantity do the
marginal revenue and marginal cost curves cross? What does this signify?

MR & MC curves cross at Q = 500,000 which is the Q maxprofit that maximises the profits for the
publisher.

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 d. In your graph, shade in the deadweight loss. Explain in words what this means.

See below in the graph the black doted line triangle which shows the deadweight loss in the
example. The deadweight loss refers to the welfare losses as there are some transactions that do
not take place due to the higher price. Recall that in the case of monopoly –as here in this
example- the monopolist due to the market power (s)he holds can set the price above the MC
(mark-up).

e. If the author were paid €3 million instead of €2 million to write the book, how would this
affect the publisher's decision regarding the price to charge? Explain.

The payment to the author is a fixed cost. Any changes on fixed cost leave unchanged the price
at which the publisher will decide to charge. The publisher decides the quantity to produce in
order to maximise his/her profits and this decision is independent of the FC. Recall that the
quantity that maximises profit corresponds to the quantity at the intersection of MR and MC
curves (MR=MC). Given this Qmaxprofit, the publisher decides upon the price to charge by
referring to the demand curve (P=AR) which also independent of the FC. Therefore, in the case
that the author receives €3 million instead of €2 million to write the book, the price will remain
unchanged but the profits of the publisher will be lower as the FC has increased. (See the
corresponding columns below in the ‘extension’ of the above table).

f. Suppose the publisher was not profit-maximising but was concerned with maximizing
economic efficiency. What price would it charge for the book? How much profit would it
make at this price?

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Considering a non-profit-maximising publisher that (s)he priotises economic efficiency, (s)he
will charge a price equal to the marginal cost (P=MC). At the point the efficient quantity is
produced. More precisely on the particular example:

P = MC = €10 and Qefficient = 900,000

The profit will be negative. Profit = -2,000,000 which is the fixed cost that the publisher has to
bear for paying the author to write the book.

2. Explain what is meant by price discrimination and give an example. Discuss how the concept of
perfect price discrimination can help a monopolist firm to extract maximum profit from its
consumers. How realistic is this concept?

Price discrimination refers to the situation where the same good is sold at different prices to
different customers, even though the costs for producing for the two customers are the same.

A typical example of price discrimination is the theater or cinema tickets where different prices
are offered for different categories customers. For instance, those who wish to pay more to have
a better seat in a theater or those who are willing to book online cinema tickets to get a discount.
In both cases the same product (the play or the movie) is offered to all customers and the cost of
producing it is the same but different prices are charged depending on the ‘category’ of
customers.

Using perfect price discrimination, a monopolist can extract all the consumer surplus as profit
by charging to each consumer a price equal to the value (s)he (the consumer) has for the
product.

Recall from your lecture notes:

Producer
Surplus

In real life price discrimination is very common but perfect price discrimination is not as it is
very difficult to know the exact value of a product for each consumer in the market.
3. Consider the delivery of mail. In general, what is the shape of the average total cost curve? How
might the shape differ between isolated rural areas and densely populated urban areas? How might the
shape have changed over time? Explain.

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In general, the average total cost curve will look:

This U-shape ATC curve implying that initially by producing more the average cost drops but
after some quantity (where we observe the minimum ATC) the ATC increases as the quantity
produced increases.

In the particular example of mail delivery, the shape of an ATC curve though might differ when
we consider the case of an isolated rural area or a populated urban area.

In the case of isolated rural areas, we would expect that delivery of mail is difficult and more
mail for delivery can be associated with higher ATC as in order to deliver an extra mail might
require high cost in terms of time, fuel, etc. needed to approach the isolated area. In that case
the ATC will look like:

In densely populated urban areas, on the other hand we would expect the ATC to drop as more
mail can be delivered with no (much more) cost for the extra mail delivered. The ATC curve
will look like:

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Over time, the expectation should be that marginal costs are reduced by improvements in
technology which should reduce the slope of the average cost curve, making it flatter.

4. Sparkle is one firm of many in the market for toothpaste, which is in long-run equilibrium.

We consider the market for toothpaste to be a monopolistically competitive market as there are
many sellers, free entry and exit but the product is at least slightly differentiated from the ones
that the other firms in the market produce.

a. Draw a diagram showing Sparkle's demand curve, marginal revenue curve, average total cost
curve and marginal cost curve. Label Sparkle's profit-maximizing output and price.

b. What is Sparkle's profit? Explain.

Recall that because of the free entry and exit assumption, firms will enter and exit the market
until the firms are making exactly zero economic profits.

Profit = (P - ATC) ´ Q and since P=ATC in the long-run, Profit = 0.

For a monopolistically competitive firm, price exceeds marginal cost (P > MC). This mark-up
implies that an extra unit sold at the posted price means more profit for the monopolistically
competitive firm. According to an old quip, monopolistically competitive markets are those in
which sellers send greetings cards to the buyers. Why? (Check p.318 of your textbook.)

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 c. On your diagram, show the consumer surplus derived from the purchase of Sparkle
toothpaste. Also show the deadweight loss relative to the efficient level of output.

The consumer surplus (CS on the graph) is the triangular area below the demand curve and
above the dotted line showing the price and by the vertical axis.

The deadweight loss (DWL on the graph) is the triangle shaped below the demand curve, above
the MC curve and to the right of the dotted line showing the quantity produced.

d. If the government forced Sparkle to produce the efficient level of output, what would happen
to the firm? What would happen to Sparkle's customers?

If Sparkle was forced by the government to produce the efficient level of output, because as a
monopolistic competitor is making zero profits already, requiring them to lower their prices to
equal marginal cost would cause them to make losses. In this case Sparkle’s customers will turn
to other monopolistic competitors of Sparkle for buying toothpaste. The closing down of
Sparkle will reduce the product variety for the customers in the market.

Although the efficient level of output is the desirable one, it is not easy for policymakers to fix
the problem of inefficiency in a monopolistically competitive market. If the government tries to
enforce marginal-cost pricing, policymakers would need to regulate all firms that produce
differentiated products. Because such products are so common in the economy, the
administrative burden of such regulation would be overwhelming.

Moreover, regulating monopolistic competitors would entail all the problems of regulating
natural monopolies. In particular, because monopolistic competitors are making zero profits
already, requiring them to lower their prices to equal marginal cost would cause them to make
losses. To keep these firms in business, the government would need to help them cover these
losses. Rather than raising taxes to pay for these subsidies, policymakers may decide it is better
to live with the inefficiency of monopolistic pricing.

Another way in which monopolistic competition may be socially inefficient is that the number of
firms in the market may not be the ‘ideal’ one. That is, there may be too much or too little
entry. One way to think about this problem is in terms of the externalities associated with entry.
Whenever a new firm considers entering the market with a new product, it considers only the
profit it would make. Yet its entry would also have two external effects:

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The product-variety externality. Because consumers get some consumer surplus from the
introduction of a new product, entry of a new firm conveys a positive externality on consumers.
The business-stealing externality. Because other firms lose customers and profits from the entry
of a new competitor, entry of a new firm imposes a negative externality on existing firms.

5. Discuss what is meant by contestable markets and explain how firms may deviate from profit
maximising behaviour?

The key characteristic of a perfectly contestable market (the benchmark to explain firms’
behaviours) was that firms were influenced by the threat of new entrants into a market. The
more highly contestable a market is, the lower the barriers to entry. We have seen how, in
monopolistically competitive markets, despite the fact that each firm has some monopoly
control over its product, the ease of entry and exit means that in the long run profits can be
competed away as new firms enter the market. This threat of new entrants may make firms
behave in a way that departs from what was assumed to be the traditional goal of firms – to
maximize profits.

Firms may deliberately limit profits made to discourage new entrants. Profits might be limited
by what is termed entry limit pricing. This refers to a situation where a firm will keep prices
lower than they could be in order to deter new entrants. Similarly, firms may also practise
predatory or destroyer pricing whereby the price is held below average cost for a period to try
and force out competitors or prevent new firms from entering the market. Incumbent firms
may be in a position to do this because they may have been able to gain some advantages of
economies of scale which new entrants may not be able to exploit.

In a contestable market firms may also erect other artificial barriers to prevent entry into the
industry by new firms. Such barriers might include operating at over-capacity, which provides
the opportunity to flood the market and drive down price in the event of a threat of entry.
Firms will also carry out aggressive marketing and branding strategies to ‘tighten’ up the
market or find ways of reducing costs and increasing efficiency to gain competitive advantage.

Firms may aim to gain a competitive advantage which is defined as the advantages firms can
gain over another which are both distinctive and defensible. These sources are not simply to be
found in terms of new product development but through close investigation and analysis of the
supply chain, where little changes might make a difference to the cost base of a firm which it
can then exploit to its advantage.

Hit-and-run tactics might be evident in a contestable market where firms enter the industry,
take the profit and get out quickly (possible because of the freedom of entry and exit). In other
cases firms may indulge in what is termed cream-skimming – identifying parts of the market
that are high in value added and exploiting those markets.

6. Discuss the costs and benefits to society of advertising.

 Critics of advertising argue that:

 Firms advertise in order to manipulate people’s tastes.
 It impedes competition by implying that products are more different than they
really are.
 Defenders argue that advertising:
 provides information to consumers
 increases competition by offering a greater variety of products and prices.
 The willingness of a firm to spend advertising dollars can be a signal to consumers
about the quality of the product being offered.