Practice problems answers.
1. List three limitations of markets (or roles for the government in market systems).
We discussed several in class. Three important ones include:
-Markets can restrict competition (government role: prevent monopolies)
-Not everything is for sale (government role: prevent harmful or dangerous goods from being exchanged on markets).
-Markets can price some goods and services “wrong” in that they do not accurately reflect benefits and costs (government role: tax or subsidize goods and services to more include full benefits and costs).
2. List four barriers to entry.
-Control over and essential input.
-High fixed costs (Economies of scale)
-Government granted barriers (patents and copyrights)
-Network economies
3. Firm A is a hair salon, B is an automobile manufacturer, C is rancher, and D is a company with a patent. What type of industry does each firm most likely operate in?
A = monopolistically competitive; B = oligopoly; C = perfectly competitive; D = monopoly.
4. When a firm is experiencing economies of scale, what does it mean is true of their average total cost? Explain why this is the case.
It means average total cost is decreasing as output expands. This is the case because the firm has high startup costs and low marginal costs.
5. Suppose a firm has startup costs equal to $100,000 and marginal costs are constant equal to $50. What are their average total costs at Q=10,000 and Q=20,000. How many units do they have to produce to become profitable if the market price equals $100?
The average total costs at Q = 10,000 equal $600,000/10,000 = $60.
The average total costs at Q = 20,000 equal $1,100,000/20,000 = $55.
The fact that average total costs are decreasing as output expands shows that they are experiencing economies of scale.
The firm becomes profitable when TR = TC; TR = $100 * Q and TC = 100,000 + $50 * Q , so TR = TC when Q = 2,000 (TR = TC = $200,000).
6. What is the major difference between a perfectly competitive firm’s demand and a monopolistic firm’s demand? Why are they different?
Monopolistic firms have market power, while perfectly competitive firms do not. This means monopolistic firms can increase price without losing all of their sales, and therefore they have a downward sloping demand curve.
Use the following diagram representing a monopolist’s demand to answer the following questions.
7. What is the marginal revenue to the monopolist shown above associated with selling the 6th unit?
$4 (because total revenue changes from $50= $10 *5 to $54=$9*6).
8. Use the following diagram representing a monopoly to answer the following questions
a.) What is the profit maximizing quantity of production?
Q=2400
b.) What is the profit maximizing price to charge?
P=12
c.) What do profits equal?
Profits=(P-ATC)*Q = ($12-$8)*2400 = 9600
d.) What could we expect price and quantity to be if this were a competitive industry?
P=9; Q=3300.
9. Use the following diagram to answer the following questions.
a) What letters represent the areas of consumer and producer surplus if the market above is competitive?Consumer=ABC; Producer=DEF
b) What letters represent the area of deadweight loss associated with a monopoly?
C and E
c) What letters represent the areas of consumer and producers surplus and deadweight loss if the firm above represents a perfectly price discriminating monopolist?Producer surplus=ABCDEF; there is no deadweight loss area or consumer surplus.
10. Fill in the empty cells in the following table representing a monopoly’s production/costs.
Q / P / TR / MR / MC / FC / TC0 / 0 / 0 / 0 / 10 / 10
1 / 50 / 50 / 50 / 5 / 10 / 15
2 / 40 / 80 / 30 / 7 / 10 / 22
3 / 30 / 90 / 10 / 9 / 10 / 31
4 / 25 / 100 / 10 / 10 / 10 / 41
5 / 21 / 105 / 5 / 11 / 10 / 52
6 / 15 / 90 / -15 / 15 / 10 / 67
a) What is the profit maximizing price and quantity for the single price monopolist shown above?
Q= 4; P=25 (where MR=MC).
b) What do their profits equal?
TR=$100; TC=$41; profits = $59
c) If this represented a competitive industry what would the market P and Q equal?
If competitive, P=MC, so the price would be 15 and the quantity would be 6.
d) If this represented a perfectly price discriminating monopolist what would the market Q equal?
The profit maximizing quantity is 6 (the same as the competitive outcome).
11. As firms price discriminate more, producer surplus always rises, consumer surplus may rise or fall, and deadweight loss always falls.
- Suppose the firm above is able to price discriminate, charges a price of $80 for the first 120 units, and a price of $60 for the next 50 units. Calculate the change in consumer and producer surplus and deadweight loss as a result of this price discrimination (compared to if they were a single price monopolist).
Producers gain $1,000 in surplus ($60-$40)*(170-120), while consumers gain $500 in surplus ½ ($80-
$60)*(170-120).
Deadweight loss decreases by the total gains in surplus ($1,500)
13. Suppose the market for dishwashing liquid has the following firms and market shares:
Cascade - 60%, Palmolive – 20%, Dawn – 10%, Sparkle – 10%
a.Calculate the H.H.I. for this industry.
HHI=602+202+102+102=4200
b) Suppose Dawn and Sparkle merge to form “Sparkling-Dawn.” What would the new H.H.I. equal?
HHI=602+202+202=4400
c) Suppose Cascade purchases all other firms and has a pure monopoly. What would the H.H.I. equal?
It would equal 1002=10000 (This is the maximum value of the HHI).
14. The current market shares for U.S. airlines is as follows:
AirlineMarket Share
Delta 16.3%
United 15.7%
Southwest 15.4%
American 12.8%
US Airways 8.4%
JetBlue 5.1%
Alaska 4.1%
a.)Use this information to calculate the current Herfindahl - Hirschman Index(HHI) in this industry (assume any other smaller airlines don’t matter in the calculations). HHI=16.32+15.72+15.42+12.82+8.42+5.12+4.12=1027
b.) According to Justice Department merger guidelines, what type of industry is this (circle one)?
ConcentratedModerately ConcentratedUnconcentrated
c.)If American and US Airways successfully merge, what will the new HHI equal in this industry? Show your work.
If American and USAir merge their new market share will equal 21.2%, and all the others will remain the same, so the new HHI equals:
HHI=21.22+16.32+15.72+15.42++5.12+4.12=1242
15.GM and Chrysler must both decide whether to invest in a new process. Games 1 and 2 below show how their profits depend on the decision they might make.
GAME 1 / GAME 2Chrysler / Chrysler
Invest / Don’t
Invest / Invest / Don’t
Invest
Invest / 5 for each / GM=12
Chrysler=4 / Invest / GM=12
Chrysler=4 / 10 for each
GM / GM
Don’t / GM=4
Chrysler=12 / 10 for each / Don’t / 5 for each / GM=4
Chrysler=12
Invest / Invest
a) What is the Nash equilibrium from each game?
In GAME 1 it is each firm invests. In GAME 2 it is GM invests, Chrysler does not invest.
b) Which of the games above (1, 2, both or neither) represents a prisoner’s dilemma? Explain.
Game 1 represents a prisoner’s dilemma, because the expected outcome (the Nash equilibrium) is not the best outcome. Specifically, in game 1 each firm will invest and have profits equal to 5, whereas if they did not invest they would have profits equal to 10.
In Game 2 the outcome is such that each firm ends up with profits equal to 10, which is the highest possible total profit.
16) Goodyear and Firestone face the following profit and price relationships.
Firestone
P=$100 / P=$60P=$100 / F = 20: G = 36 / F = 33: G = 10
P=$60 / F = 12: G = 35 / F = 11: G = 30
a). What (if any) is Goodyear’s dominant strategy and what is Firestone’s dominant strategy?
Neither Goodyear nor Firestone have a dominant strategy.
b). What (if any) is the Nash equilibrium and expected payoffs to Firestone and Goodyear?
Because neither firm has a dominant strategy, there is no single Nash equilibrium and therefore we cannot predict the payoffs (we know it will be either that they both choose P=$100 or both choose P=$60).
In the above decision tree, Tracy picks first and Amy picks second. Tracy knows Amy's payoffs to each choice and Amy knows Tracy's payoffs.
17) If the payoffs at the end of each branch are as shown, what will the outcome of this game be?
Tracy chooses the lower branch and receives a payoff of 75.
Amy chooses the upper branch and receives a payoff of 150.
18) In the sequential game below, Exxon picks first and Chevron picks second. The payoffs to Chevron and Exxon are represented at the end of each branch. Use it to answer the following question.
a.) What are the expected payoffs to Exxon and Chevron?
Chevron gets 200 and Exxon gets 400.
b.) Does this game represent a prisoner’s dilemma? Explain.
No, because there is no other outcome that makes both Chevron and Exxon better off.
19) What does the existence of a negative externality mean in terms of social costs vs. private costs? What does the existence of a positive externality mean in terms of social benefits vs. private benefits?
A negative externality causes social costs to exceed private costs (by the external costs). A positive externality causes social benefits to exceed private benefits (by the external benefits).
20) The social benefit of producing a unit of a good equals $20 and the social cost equals $15.
The private benefit equals $18 and the private cost equals $15. Does this represent a positive or negative externality? Can we expect this good will be produced or not? If it were produced, would it be good or bad for society?
The social benefit exceeds the private benefit so this represents a positive externality. Because the private benefits exceed the private costs this good will be produced, and it is good for society because social benefits are greater than social costs.
21) Use the diagram below representing a negative externality to answer the following question.
a) What is the expected market quantity (without government intervention)?
Q=80
b) What is the socially optimal quantity in this market?
Q=70
c) What is the area of inefficiency associated with the market outcome.
B
d) Describe how the market can arrive at the socially optimal quantity.
We can apply a tax equal to the external costs associated with this good.
22) With a negative externality present, the market quantity is too high compared to the efficient quantity, and so the government should apply a tax.
23) With a positive externality present, the market quantity is toolowcompared to the efficient quantity, so the government should apply asubsidy.
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