Economics of Tourism and Recreation

Assignment 3

Due March 21, 2010

NAME: ______

ID:______

Competitive Markets

  1. List the conditions under which markets are competitive.
  • There are many firms
  • All firms produce identical goods
  • Consumers have information on the prices charegd by firms
  • There are no barriers to entry
  1. When will firms enter a market? When will firms exit a market?

Firms will enter a market when there are positive economic profits (above normal profits) and exit when there are negative economic profits (below normal profits).

  1. Explain what will happen to the number of firms in an industry if the demand for the good rises.
  • If the demand for a good rises, the price will rise.
  • When the price rises, profits will rise above normal (positive economic profits)
  • The positive economic profits will attract new firms to enter the industry
  • When new firms enter, supply increases and the price falls
  • When price falls, the profits fall.
  • The process continues until profits are normal (zero economic profits)
  1. Using supply and demand curves, show the gains from trade under competitive markets.

The hashed area in the graph below is the gains from trade.

  1. Demonstrate that the gains from trade are maximized under competitive markets.

To demonstrate this we just need to show any quantity different from the equilibrium makes one worse off.

First consider quantities less than Qe. If somehow we forced production and consumption to be less than Qe we would be losing out on some gains from trade, since all Qe units have some gains from trade. For instance in the graph below, if the quantity is QL, then we lose out on the gains from trade on the units between QL and Qe, given by the wedge shape with the cross hashes.

We have shown that for any quantity less than Qe the gains from trade are lower. If we can also show that for any quantity greater than Qe the gains from trade are lower, then it must be that the gains from trade are maximized at Qe.

Suppose for some reason the quantity produced and consumed is given by QH, which is greater than Qe. This would imply that the units between Qe and QH have a marginal cost (given by the height of the supply curve) greater than their marginal benefit (given by the height of the demand curve). Hence these units have “losses” from trade, not gains from trade. Thus our total gains from trade would be the gains from trade on the Qe units minus the losses from trade on the units between Qe and QH, which is obviously less than the gains form trade on the Qe units. This is pictured in the graph below.

Since the any quantity less than Qe has lower gains from trade than Qe, and any quantity greater than Qe has lower gains from trade, it must be that the gains from trade are at their maximum at Qe.

  1. What is monopoly power?

The degree of monopoly power is the degree of control a firm has over price. Consider the two demand curves below. The first one has a higher degree of monopoly power since there is a greater range of price the firm can choose from, while the second has a low degree of monopoly power.

  1. Draw two demand curves. One for a firm with a low degree of monopoly power and the other for a firm with a high degree of monopoly power.
  1. What determines how much monopoly power a firm has?

The availability of substitute goods determines the degree of monopoly power. Sellers who sell substitute goods compete with the firm with monopoly power. So if few substitutes are available then we would think there is a high degree of monopoly power. If many substitutes are available then there is low degree of monopoly power.

  1. What is the source for long-lasting, high degree monopoly power?

Barriers to entry is the only source for long-lasting, high degree monopoly power.

  1. Draw a graph comparing the competitive outcome with the monopolist outcome. Be sure to identify the monopolist and competitive price, the monopolist and competitive quantity, and the deadweight loss of a monopolist.

  1. Who benefits from monopoly? Who loses due to monopoly?

Who Benefits from Monopoly

The owners of the monopoly enjoy high profits.

Who Loses from Monopoly

  1. Consumers…they pay higher prices and get less of the good.
  2. Workers…Since there is less produced under a monopoly, fewer workers are employed. The demand for the workers may be lower, implying lower wages as well.
  3. Related Business…Recall that if a price of a complement rises, the demand for the good falls. Hence if a complementary good becomes monopolized, its price will be higher, and the demand for related goods will fall. For examples, if airlines become a monopoly, the price of airline travel will increase; this will then cause a decrease in demand for other tourism related businesses.

Since the workers in the tourism industry and related tourism business are hurt by a monopolized tourism sector, monopoly presents a negative outcome that the government should ensure does not occur.

  1. Suppose the air travel industry is monopolized. Use the supply and demand graph to explain the impact in the market for hotels?