ECO10004: ECONOMIC PRINCIPLES

WEEK 6_TUTORIAL QUESTIONS

Key concepts: Market structures, Perfect Competition, Monopolistic Competition,
Oligopoly, Monopoly, Marginal Revenue

Short-answer Questions
Question 1) For each of the following firms, determine what type of market structures they
are operating in. Clearly explain why. Also, comment the amount of market power each
firm holds.

a. Woolworths is competing with two other supermarket chains: Coles and Aldi for
market share in Victoria.

Lecturer’s Oligopoly. There are only three big supermarket chains in Victoria: Woolworths, Coles and
Aldi. (Some may also count IGA). The barriers to entry in this industry are high due to a large
amount of capital required. Each firm holds a considerable amount of market power.

Student’s Oligopoly market structure. This is because they are barries to entry and exit.

b. John sets up a booth selling corn in a farmers’ market. There are 50 other corn booths
just like his.

Lecturer’s Perfect competition. The corn John sells is identical to the other 50 booths. As there are too
many suppliers in this market, each individual player like John holds a tiny fraction of the
market share. How each of them behaves does not have any effect on the market as a whole.
A firm in a market of perfect competition does not carry any market power. They are the price
takers, meaning they would sell at whatever the prevailing market price is.

Student’s Perfect Competition market structure. This is because there have large booths and selling
homogeneus product. Also, they are price taker.

c. Peter runs a restaurant on Glenferrie Road. There are about 25 other restaurants in the
area.

Lecturer’s Monopolistic competition. It is true that there are many restaurants other than Peter’s on
Glenferrie Road. However, Peter does not necessarily offer exactly identical products to his
competitors. He has the ability to differentiate, whether in terms of the food, the service or the
restaurant decoration. Thanks to the possibility of differentiation, Peter does hold a certain
amount of market power. The demand curve for his restaurant will be downward sloping
instead of being horizontal like a firm in perfect competition.
Student’s Monopolistic Competition market structure. Each restaurant’s style are different, they might
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 selling differentiated products and they are price maker.

d. When someone wants to send any letter that weighs less than 250g, Australia Post is
the only choice.

Lecturer’s Monopoly. Since Australia Post is the only supplier of letter sending service in Australia, it is
a monopolist. Australia Post holds the greatest amount of market power, when compared with
the other three firms above.

Student’s Monopoly market structure. Australia Post is a single and unique station. There is no other
substitutes.

Question 2) In a small town of Swinville, a movie rental store is ready to rent out the latest
Batman movie. (The vampire from Twilight now stars as the latest Caped Crusader).

The store needs to decide how much to charge for each rent. If the price is set at $8, it is
deemed too expensive and no one will rent regardless of how popular Batman is. If the price
is lowered down to $7.50, one customer will rent the movie every week. Suppose that every
time the price is lowered by $0.50, the store will attract one additional customer.

The table below summarises all possible combinations of prices and the number of customers
for the store.

Number of Price Total Revenue Average Marginal

customers (per (P) Revenue Revenue
week)
0 $8.00
1 7.50
2 7.00
3 6.50
4 6.00
5 5.50
6 5.00
7 4.50
8 4.00

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 a. Calculate the amount of total revenue, average revenue and marginal revenue, and fill
in the table above.

(i) (ii) (iii) = (i)*(ii) (iv) = (iii) / (i) (v)

Number of Price Total Revenue Average Marginal
customers (P) Revenue Revenue
(per week)
0 $8.00 - - -
1 $7.50 $7.50 $7.50 $7.50
2 $7.00 $14.00 $7.00 $6.50
3 $6.50 $19.50 $6.50 $5.50
4 $6.00 $24.00 $6.00 $4.50
5 $5.50 $27.50 $5.50 $3.50
6 $5.00 $30.00 $5.00 $2.50
7 $4.50 $31.50 $4.50 $1.50
8 $4.00 $32.00 $4.00 $0.50

b. What can you say about the relationship between price, average revenue and marginal
revenue? Why is marginal revenue always lower than price?

Lecturer’s Based on the table above, the following observations can be made:

i. Price and average revenue are always the same.

ii. Marginal Revenue is always lower than average revenue (price) except for the
first unit sold.
The reason for this is because in order to sell more units, a firm must lower
down the selling price. This is according to the law of demand or the inverse
relationship between price and quantity demanded, remember?

Marginal Revenue is lower than Average Revenue for all firms except for those in perfect
competition. In perfect competition, the firm sells at the market price, which is unchanged
(except for external shocks on the entire market). Thus, marginal revenue equals to average
revenue in perfect competition.

Student’s The relationship between price, average revenue and marginal revenue are negative. When
the price decrease, the quantity demand increase and the revenue follow to increase. Marginal
always lower than price this is because it change against the quantity demand change.

c. Based on your calculations, graph the demand curve and the marginal revenue curve
for the movie rental store in the question. What can you say about the relationship
between the demand curve and the marginal revenue curve?

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 For firms in a market of monopolistic competition or monopoly, the demand curve and the
marginal revenue curve are always downward sloping. The only exception is firms in a
market of perfect competition whether the demand curve and the marginal revenue curve are
both horizontal.

Furthermore, since marginal revenue is always lower than average revenue (except for the
first unit sold), the marginal revenue curve is always below the demand curve.
This is an important point to remember whenever you draw a graph for an individual firm in
a market of monopolistic competition or monopoly.

Question 3) A student makes the following argument: “In a monopolistic competition

market, when a firm sells another unit of its product, the additional revenue the firm
receives is equal to the price. If the price is $10, then the additional revenue is also $10.
Therefore, it is incorrect to state that marginal revenue is always less than price in a
monopolistic competition market”.

Clearly explain whether you agree with this argument.

Lecturer’s We should disagree with the student’s argument.

We must remember that for a firm in the market of monopolistic competition, its demand
curve is downward sloping. This means in order to sell one additional unit; the firm must
lower the price to all consumers. Because the firm receives a lower price on all but the last
unit, the marginal revenue received from the last unit is less than the price.

Student’s Yes, I agree with this argument. If the situation that the price is unchange when the quantity
demand/selling units increase, then this argument “marginal revenue is not always less than
the price” is correct. For example, the price of the product is $10 in every different demand
level, 2 demand total revenue are $20, 3 demand total revenue are $30 and 4 demand total
revenue are $40. The marginal in each level is the same of $10. So, in the situation of
unchange in the price level, marginal revenue is not always less than the price.
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Question 4) John’s restaurant is one of many on Glenferrie Road. His restaurant, therefore,
operates in a market of monopolistic competition. Australia Post is the provider of letter
sending service in Australia. Therefore, the letter sending service market is a monopoly
and Australia Post is a monopolist.

a. Draw one diagram that represents John’s restaurant, a monopolistically competitive

firm. Draw a separate diagram that represents Australia Post, a monopolist. On each
of the diagrams, make sure to show the following curves: Marginal Cost, Average
Total Cost, Marginal Revenue and Demand. Also remember to label the axes fully.

b. On each of the diagrams in (a), show clearly the level of output at which profit will be
maximised. Why does this level output maximise profits?

Diagram for John’s restaurant

Diagram for Australia Post

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 When you draw the firm diagram for a firm in the market of monopolistic competition or
monopoly, you should pay attention to the following things:

 MC and ATC curves meet each other at the lowest point of ATC.
 The MR and Demand curves must be downward sloping. And the Demand curve
is always to the right of (aka above) MR.
 The profit-maximising quantity (Q*) is where MR intersects with MC.
 Based on Q*, you can figure out the Price Level (P*) by going up until you reach
the Demand curve
 Based on Q*, you can figure out the Average Total Cost (ATC*) by going up until
you reach the ATC curve.

The different between P* and ATC* (if there is any) tells you the maximum amount of profit
(or the minimum amount of loss) the firm can achieve.

c. Look closely at the two diagrams. What do you think is the difference in the Demand
curve between John’s restaurant and Australia Post? What do you think is the
difference in the possibility of making economic profits between John’s restaurant
and Australia Post?

With respect to the demand curves, the demand curve for John’s restaurant is flatter. Since
the restaurant operates in a market of monopolistic competition, there are many substitutes
(other restaurants with similar or different food). Recall what we learned from Topic 3:
Elasticity: When there are many substitutes, the demand for the product is more elastic. This
makes the demand curve flatter.

On the other hand, Australia Post is a monopolist, in other words, the only supplier in the
market of letter sending services. If people want to send letters, Australia Post is the only
choice. The absence of an exact substitute makes the demand for Australia Post more
inelastic and its demand curve steeper.

One may wonder that because there is no exact substitute for Australia Post, shouldn’t the
demand curve be vertical (perfectly inelastic) instead of steep (highly inelastic)? The answer
is that while there is no exact substitute, close substitutes are available. For example, instead
of writing and sending letters, people may email each other or send their messages via
various social media sites. This explains why the demand for letter sending services provided
by Australia Post is not perfectly inelastic.

With respect to the possibility of making economic profits, Australia Post has a higher chance
than John’s restaurant. Being a monopolist, Australia Post holds a greater amount of market
power, hence a greater chance to achieve an economic profit.

On the other hand, suppose that John’s restaurant serves a unique dish which is hugely
successful. As a result, John is able to make an economic profit in the short run. However, the
nature of a market of monopolistic competition dictates that barriers to entry are low and in
the long run there will be firms that will copy that dish. The ensuing competition will
eventually drive John’s economic profit down to zero.

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This applies to almost every firm in a market of monopolistic competition. It is highly likely
that firms must accept zero economic profit in the long run, which is shown on the above
diagram for John’s restaurant.

d. A student makes the following argument: “Since Australia Post is the only provider of
letter sending service (a monopolist), it holds a massive amount of market power.
Australia Post is able to set the price at whatever it likes. As a result, Australia Post is
always guaranteed of making economic profit”. Do you agree with the above
argument? Clearly explain why.

We should disagree with this argument. In fact, it is very common for students to make such
a mistake. Seeing a monopolist, students tend to be eager to conclude that a monopolist,
being the only supplier, has enormous power which enables it to set both the price and the
quantity. This is categorically wrong. A monopolist, despite all its market power, can only set
EITHER the quantity OR the price. Naturally, the monopoly will choose to set the quantity
where MR = MC since it will help maximise profits. The price, on the other hand, will be left
to the market (i.e. consumers) to decide. Remember that the demand curve for a monopolist,
albeit being rather inelastic and flat, remains downward sloping.

Australia Post has been struggling as people do not seem to send letters anymore. In 2015, its
chief executive declared letter sending was in “terminal and structural decline”. The demand
for letter posting grows ever weaker and the demand curve continues to shift to the left until
it is entirely below the ATC curve, making losses inevitable. In 2015, Australia Post reported
a loss of $222 million, the first in more than 30 years.

(Source: Wiggins, J, 2015, Sydney Morning Herald. Link:

https://www.smh.com.au/business/australia-post-posts-222m-loss-letter-posting-in-terminal-
decline-20150925-gjup78.html

The two graphs below illustrate how Australia Post fell into its current predicament.

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The left graph illustrates Australia Post in the past when the demand for letter posting was
still strong and Australia Post was able to earn an economic profit.

The right graph illustrates Australia Post more recently when demand continues to weaken.
The demand curve and the marginal curve keep shifting to the left to the point where the
demand curve stays completely below the ATC curve. The best Australia Post can do is to
minimise its loss.

Question 5) The taxi industry in Victoria was once dominated by major taxi companies
such as 13Cabs, Silver Top Taxis, etc. However, the recent entry of new, innovative ride-
booking services companies such as Uber, Lyft, Didi, Ola, etc. has put immense pressure
on the once dominant traditional taxi companies. Uber and the likes were legalised in
Victoria in 2017, which sparked widespread protest from taxi drivers.

a. Draw a diagram that represents a typical traditional taxi company before the
introduction of Uber. Assume that the taxi industry is a market of monopolistic
competition, and every taxi company was enjoying economic profit before.
On your diagram, show clearly the level of output for profit maximisation and the
area of economic profit.

Diagram for a taxi company before Uber entered

b.

Following the entry of Uber and others, draw a demand-supply graph to illustrate the
effects on the taxi industry as a whole. Draw a separate graph to illustrate the effects
on a typical traditional taxi company.

Once Uber and others enter, the taxi industry will witness an increase in supply since there
are now more suppliers in the market. The supply curve will shift right. Price will decrease,
and quantity will increase in the market for taxi services.
The graph on the next page illustrates this.
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 Diagram for the taxi industry after Uber & others entered

[Don’t let this happen to you] In the past, many students drew the market graph above and
claimed it as the graph for an individual firm. This is totally incorrect. Remember that
whenever you draw a firm graph, you must show the following four curves: MC, ATC, MR
& D; and also highlight the area of economic profit/loss for the firm.

For an individual taxi company, the entrance of Uber and others spells heightened
competition. The market demand (which is unchanged) will now be shared among a greater
number of players.

As a result, the demand for an individual taxi company will decrease. The demand curve and
the marginal revenue curve must shift left. The graph below illustrates.

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 c. Based on the graphs drawn in (b), comment on the changes in price, quantity and
profit for a traditional taxi company after Uber and others entered.

Lecturer’s Solutions:
Based on the graph above, the following observations can be made
i. Quantity will fall due to MR shifting left.
ii. Price will fall due to D shifting left.

Falls in both quantity and price results in economic profits being reduced to zero, as shown
on the graph. If traditional taxi companies do not come up with effective measures to
compete against Uber and the likes, there is a very real threat of them falling into economic
losses.

Question 6) Nathan is a corn farmer. He is among hundreds of farmers who supply corn to
major supermarkets across Victoria. Assume that the corn wholesale industry is a market
of perfect competition. Nathan is currently selling his corn at the market price of $1 per
kilogram.

a. What would happen to Nathan’s business if he raises his selling price to $1.50 per
kilogram? What would happen if he cuts the price to $0.50 per kilogram? What can
you say about the demand curve and the marginal revenue curve in Nathan’s corn
business?

The corn wholesale industry is assumed to be a market of perfect competition. A market of

perfect competition is characterised with a large number of suppliers, all of which sell
identical products. An individual supplier like Nathan does not, under any circumstance,
affect the market as a whole.

If Nathan raises his selling price to $1.50 per kg, all of his customers will turn to other
suppliers and Nathan’s sales will crash down to zero. There is no point for Nathan to cut the
price to $0.50 since his customers are always happy to pay the market price of $1.00 per kg.

As a result, the demand curve and marginal revenue curve for Nathan’s corn business are the
same. Both demand and marginal revenue are represented by a horizontal line, intersecting
the Price axis at P = $1 per kg.

Please note that this is the most important difference between a perfect competition market
and monopolistic competition/monopoly market. As we learned earlier, the demand curve
and marginal revenue curve for a firm in a monopolistic competition/monopoly market are
both downward sloping. And the marginal revenue curve is always below the demand curve.
On the other hand, the demand curve and marginal revenue curve for a firm in a perfect
competition market are the same and are horizontal.

b. Draw a diagram that represents Nathan’s corn business. As for any other business in a
perfect competition market, Nathan’s economic profit is zero.

Diagram for Nathan’s corn business

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 c. Suppose that the latest dietary trend is to have a large amount of corn daily since it is
believed to help with weight loss and retaining energy. Consequently, the demand for
corn surges. Draw a graph to illustrate the effects on the market for corn as a whole.
Draw a separate graph to illustrate the effects on Nathan’s corn business.

In the market for corn as a whole, the demand curve will shift right. Market price increases
and so does quantity. The demand for Nathan’s corn business will increase and shift upwards
as a result. The two graphs below illustrate

Diagram for the corn market Diagram for Nathan’s corn business

d. Do you think Nathan can enjoy making an economic profit in the long run? What
would likely happen following the surge in corn demand? Support your answer with
appropriate graphs.

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Nathan will definitely NOT be able to sustain economic profit in the long run. One defining
characteristic of a perfect competition market is that barriers to entry are very low, thus, new
firms can enter the market very easily. The presence of economic profits (thanks to the surge
in demand for corn) will attract new suppliers. Perhaps, farmers who normally grow wheat,
chickpeas, etc. will grow corn as their next crop.

In the corn market, supply will increase, and the supply curve shifts right, which reduces
price to its previous level. For Nathan’s corn business, this means lower demand (due to
greater competition). The demand & marginal revenue curve shifts downward and Nathan is
back at making zero economic profit. The two graphs on the next page illustrate.

Diagram for Nathan’s corn business

Diagram for the corn market

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Multiple Choice Questions

1. The key characteristics of a monopolistically competitive market structure include

a. many small (relative to the total market) sellers acting independently.

b. all sellers sell a homogeneous product.
c. barriers to entry are high.
d. sellers have no incentive to advertise their products.

2. What is the profit-maximising rule for a monopolistically competitive firm?

a. To produce a quantity that maximises market share.

b. To produce a quantity that maximises total revenue.
c. To produce a quantity such that marginal revenue equals marginal cost.
d. To produce a quantity such that price equals marginal cost.

3. Which of the following is NOT a reason why a monopolistically competitive firm

might be able to maintain economic profits in the long run?

a. Creating value for customers

b. Charging a higher price than competitors to generate more sales revenue
c. Achieving lower average costs of production than competitors
d. None of the above

4. Perfect competition is characterised by all of the following except

a. heavy advertising by individual sellers.

b. homogeneous products.
c. sellers are price takers.
d. a horizontal demand curve for individual sellers.

5. Suppose the equilibrium price in a perfectly competitive industry is $15 and a firm in
the industry charges $21. Which of the following will happen?

a. The firm's profits will increase.

b. The firm's revenue will increase.
c. The firm will not sell any output.
d. The firm will sell more output than its competitors.

6. If a monopolist's price is $50 at 63 units of output, and marginal revenue equals

marginal cost, and average total cost equals $43, then the firm's total profit is

a. $3,150
b. $2,709
c. $441
d. $7

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7. Refer to the figure above, what is the marginal revenue of the 6th unit of output?

a. $4
b. $5
c. $9
d. $54

8. A local electricity-generating company has a monopoly that is protected by an entry

barrier that takes the form of

a. control of a key raw material.

b. network externalities.
c. economies of scale.
d. a perfectly inelastic demand curve.

9. Assume the market for organic produce sold at farmers' markets is perfectly
competitive. All else being equal, as more farmers choose to produce and sell organic
produce at farmers' markets, what is likely to happen to the equilibrium price of the
produce and profits of the organic farmers in the long run?

a. The equilibrium price is likely to increase, and profits are likely to remain
unchanged.
b. The equilibrium price is likely to remain unchanged, and profits are likely to
increase.
c. The equilibrium price is likely to decrease, and profits are likely to
decrease.
d. The equilibrium price is likely to increase, and profits are likely to increase.

10. A monopolistically competitive industry that earns economic profits in the short run
will
a. continue to earn economic profits in the long run.
b. experience the entry of new rival firms into the industry in the long run.
c. experience the exit of existing firms out of the industry in the long run.
d. experience a rise in demand in the long run.

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