Problem Set 4

ECON 1150 Principles of Microeconomics

Due date: Aug 2, 2023
1. "A monopolistically competitive market in which there are no entry barriers will have the
identical long-run equilibrium as if the market were perfectly competitive." Is this
statement true or false? Please explain.

False, because the long-term equilibrium in a market with no entry barriers and monopolistic
competition will differ from the equilibrium in a market with perfect competition. Monopolistic
competition results in variable profitability and a lack of allocative efficiency due to product
differentiation and price power.

The diagram below shows selected cost and revenue curves for a firm in a
monopolistically competitive industry.

a) What quantity does the firm produce, what price does it charge, and what is its
economic profit?
b) In the long run, how does this firm change its price and the quantity it produces?
c) Does this firm have excess capacity in the long run? If it has excess capacity in the
long run, why doesn’t it decrease its plant size?
d) Is the market efficient or inefficient? Explain your answer.

a1) This is a monopolistically competitive industry and it produces at the point where the
marginal cost equals the marginal revenue of the firm
(30 - 15) * 450 = 6750
b1) Because the business is now earning an economic profit, additional enterprises will be
drawn to the profits and enter the market. The arrival of new enterprises reduces demand for
established firms, and the demand curve moves to the left. New enterprises continue to enter the

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 market until economic profits reach zero, at which point the price equals the average total cost
(ATC). In the long term, the company will charge a cheaper price and quantity than in the short
run. The introduction of new enterprises will boost market production.

c1) In the long run, the company does have surplus capacity. To achieve surplus capacity, the
company must deviate from its profit maximisation point, that is, lower the price equivalent to
the marginal cost of production. As a result, the firm's output decisions will remain unchanged.

d1) Given this, a market that is monopolistically competitive is inefficient in terms of allocative
efficiency. The market price is greater than the marginal cost, resulting in a deadweight loss in
the market. Deadweight loss reflects a loss of total market welfare since certain potentially
mutually advantageous transactions (consumer surplus and producer surplus) are not realised as a
result of the higher price and lower quantity produced in comparison to a fully competitive
market.

2. Bud and Wise are the only two producers of aniseed beer, a New Age product designed
to displace root beer. Bud and Wise are trying to figure out how much of this new beer to
produce. They know:
i). If they both produce 10,000 litres a day, they will make the maximum attainable joint
economic profit of $200,000 a day, or $100,000 a day each.
ii). If either firm produces 20,000 litres a day while the other produces 10,000 litres a
day, the one that produces 20,000 litres will make an economic profit of $150,000 and the
other will incur an economic loss of $50,000.
iii). If both produce 20,000 litres a day, each firm will make zero economic profit.
a) Construct a payoff matrix for the game that Bud and Wise must play.
b) Find the Nash equilibrium for the game.

Wise produce 10,000L

Wise produces 20,000

Bud 10K Bud $100,000

Bud -$50,000

Bud $150,000 Bud $0

Bud 20K

1. Both Bud and Wise produce 10,000 liters a day.

 Bud's profit: $100,000

 Wise's profit: $100,000

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 2. Both Bud and Wise produce 20,000 liters a day.

 Bud's profit: $0
 Wise's profit: $0

3. In the following table, the first two columns show the demand schedule for electricity
from a coal-burning utility; the third column shows the utility’s marginal cost of
producing electricity. The marginal external cost of the pollution created equals the
marginal cost.
Price (cents per kilowatt) Quantity (kilowatts per day) Marginal cost (cents per
kilowatt)
4 500 10
8 400 8
12 300 6
16 200 4
20 100 2
a) Without any government regulation, what is the quantity of electricity produced, the
price of it, and the marginal external cost of the pollution generated?
b) If the government levies a pollution tax such that the utility produces the efficient
quantity, what is the price of electricity, the tax levied, and the government tax
revenue per day?

a) The utility generates 500 kilowatts (amount delivered) at a price of 4 cents per
kilowatt since the marginal cost of producing energy is 10 cents per kilowatt,
which is less than the price. As the price rises, the utility lowers its output based
on the amount required and its marginal cost.

So, in the absence of government control, the amount of power generated is 500
kilowatts, the price is 4 cents per kilowatt, and the marginal external cost of
pollution is 10 cents per kilowatt.

b) The government can levy a pollution tax equal to the marginal external cost to
achieve an efficient amount of power generation. This tax will internalise the
external cost of pollution, requiring utilities to include environmental costs in
their production choices. Efficient quantity, the quantity demanded should be
equal to the quantity supplied by the utility at its marginal cost.
The marginal external cost of pollution is 2 cents per kilowatt
Difference between the efficient price and the utility's marginal cost is the pollution tax

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20 cents per kW - 2 cents per kW = 18 cents per kW.
The tax revenue per day is the pollution tax multiplied by the quantity produced:
18 cents per kW * 100 kW = 1800 cents = $18.