micro guidelines

8/13/2019 Micro Guidelines

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STRICTLY FOR STUDENTS IN GROUPS 4, 5, 6 & 7

TCC Introduction to Economics 2011/12 Page 15

Continuation of the questions in Guidelines for Microeconomics

3rd

question:

For the diagram please refer to the one we drew for the LRAC, LRMC, SRAC and SRMC for

question 2 in tutorial 3. Recall again that there is always one level of output where the SRexpansion path (for a particular level of fixed input, K) cuts the long run expansion path. At

this level of output SRTC = LRTC and this is where SRAC=LRAC and SRMC=LRMC. Note that

because the SRAC is still the usual u-shaped curve, the minimum of the SRAC will be to the

left i.e. at a smaller output level than where SRAC is tangent to the LRAC. So the first

statement is true. But the second statement is false because we know that at the level of

output where the SRTC and the LRTC are tangent, their slopes are the same which means

that SRMC = LRMC, so the SRMC will still intersect the LRMC at that same level of output

4. arket Structures

1stQuestion

(a) What will happen to equilibrium price, quantity, import and the number of firms inthe industry? Will there be any spill-over effects to other groups in society?

For this question on perfect competition and we are looking at a good (X) that is produced

locally as well as imported.

I am drawing 3 diagrams so that you can see how we derive the final supply curve in the last

diagram. But actually for our discussion, we will only need the first diagram and the last

diagram. The initial market equilibrium is at A and the initial equilibrium price is Po. At this

price, local suppliers are making normal profit (1st diagram) and the market output that

comes from the local producers is XLo. Since at the market equilibrium the marketdemand is at A, and local supply is only at A1 in the diagram, the difference AA1 will be

imported (this comes from the international suppliers).

P

X

P

X

P

X

MCo

ACo

Po Po Po

MCl= SL

Sw Sw

D

XLo

A

XLo Xo

A

Local International Market

A1


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When the government provides local producers with a lump sum subsidy. The lump sum

subsidy as we know reduces the local producers AC curve from ACo to AC1.

In the short run the lump sum subsidy does not change the firms output as MC is not

affected. So there will be no change in the market supply or the market price in the short

run. As price is still at Po, note that the local producers are now making profit in the short

run indicated by the green shaded area.

Long Run: What happens in the long run will depend on whether the subsidy is only given to

the existing firms or new firms are also entitled to the subsidy. So look at both aspects

rather than take one stance.

(i) If the subsidy is only for the existing firms then what we have shown above willalso be our long run equilibrium i.e. the local producers will continue to make profit. [Price

will not change and local producers will be making above normal profit if the subsidy only

applies to existing firms. Number of firms will remain the same. This answer should again be

use in part (c) of this question]

(ii) But if new firms are also entitled to the subsidy, then new firms will enter theindustry and this will increase the market supply. In this case you can see that as the local

supply increases (SL shifts right as shown in the diagram below), but price will not fall and

bring about the usual adjustment back to equilibrium. So the adjustment to the long run

equilibrium must come through another way. As more new firms enter the market it willplace upward pressure on resource prices (labour as well as other resources) as the demand

for these factors increase. The increase in resource price will now shift both the MC and AC

curves up to M1 and AC2.

P

X

P

X

ACo

Po Po Sw

D

XLo

A

XLo Xo

A

Local Market

MCo

AC1

MCl= SL


3/21



(So for the local producer diagram, we shift the MC and AC up such that the minimum of the

new AC is tangent to Po).

The firms new long run equilibrium is at B and each firm is producing a smaller output XL1

and making normal profit once again.

As we know with the entry of new firms, the market supply shifts right (even after taking

into account the increase in resource price) and this will therefore reduce the amount of

good X that will be imported. The extent of fall in imports will depend on how much we shift

the local supply curve to the right which therefore gives us a clue that we can have a few

possible answers. Note that in the diagram above I have shifted the market supply such that

now the entire market is supplied by the local producers (i.e. no imports). [This is one

possible answer when new firms enter when they are also entitled to the lump sum

subsidy]. Alternatively, I could have shifted the local supply to the right but by a smaller

extent then the above i.e. the new local supply is between SL and SL1. In this case we will stillbe importing good X but a smaller quantity will be imported compared with the original

situation.

But we can even show another possibility for this question. We could have shifted the

supply curve even further right (right of SL1) as shown in the diagram below:

Had the entry of firms increased the market supply to SL2, there are now again two possibleconclusions:

X

ACo

Po Po Sw

D

XLo

A

XLo Xo

LocalMarket

AC1

P P

A

MCoMCl= SL

AC2

B

SL1

XL1

X

ACl

Po Po Sw

D

XLo

A

XLo Xo

Local Market

ACl1

P P

Po

A

MClMCl= SL

ACl2

B

SL1

XL1

SL2

B

MCl2

MC1


4/21



(i) If exports are not allowed i.e. the country cannot export good X, then from the diagram

you can see that since market supply has increased to SL2, the price of X will fall to the new

equilibrium B (intersection of SL2 and the D curve). [This is another possible conclusion you

could come out with which is that market price could fall if local supply increases beyond

local demand and exports are not allowed]

(ii) But if exports are allowed and X can be sold at the same price Po , then we are looking

at another possibility as shown in the diagram below. This is the same diagram as the above

except that if X can be exported, the new market equilibrium will now be at point C. Since

the market price is still at Po and the local demand at this price is at point A in the marketdiagram, the excess output of X that is now produced (i.e. AC) will be exported. [So this is

another possible conclusion you could have thought of which is that price will remain at Po

and AC will be exported].

Spill-over effects to other groups in society: In all the cases we saw where there was no

change in the market price - there will be no change in consumer surplus of those who buy

good X (area of consumer surplus remains the same as the demand curve is at the same

position as well). But recall that the entry of new firms caused wage and the price of other

resources to increase. Therefore labour and the owners of capital will benefit from the lump

sum subsidy even though the subsidy was given to the producers. So other members of

society have benefitted besides the firms.

(b) Critics of the government argued that while the policy may help in reducing imports,

it would be catastrophic for export. Consider the impact of your answer in (a) on another

industry in which local firms (who are not eligible for any subsidy) sell both locally and

abroad.

So we are now looking at the export industry (lets call it good Y) as you can see from the

wording in the last sentence another industry in which local firms sell both locally and

abroad)

X

ACl

Po Po Dw

DL

XLo

A

XLo XL1

Local Market

ACl1

P P

Po

A

MClMCo= SL

ACl2

B

XL1

SL2

C

MCl2


5/21



We have seen that it is true that the policy did reduce imports. How would it then affect

exports? The link between what happened in the import industry and the export industry is

through the increase in wage and the prices of other resources. The export industry will

therefore see an increase in their production cost i.e. the MC and AC of the expo rting firms

will shift up to MC1 and AC1.

Initially the market equilibrium was at point B as shown in the diagram above and the

equilibrium price of good Y was Po. At this price, Po, note that the market output at B is

greater than the local demand which is at point A. The excess produced i.e. AB will be

exported.

When resource price increased, each firm in the short run will want to produce less. This

reduces the market supply and may cause the market price to increase if the local supply

falls to SL1 for e.g. (the market price would then increase to P1). At this short run price of

P1, the exporting firms will be producing the output at B (YL1, in the first diagram) and they

will be making losses equal to the green shaded area. Note that even in the short run it is

possible that the exporting industry will no longer be exporting but will be producing only

for the local market (which is what I have shown in the diagram above). In the long run,

some firms will leave the market and this further reduces the market supply and increases

the market price until normal profits are restored which is when the market supply is at SL2

and the market price, P2.

Someth ing else coul d have also happened to th is exporti ng industr y. If the price Po

indicates the opportunity to export or import then it is possible that with the increase in

cost the exporting industry could very well be replaced by imports (this means we are

looking at the case good Y can be imported at Po) as the domestic price of Y (the export

good) at P2 is now higher than the price the foreign sellers are supplying it for (i.e. Po). This

therefore means that good Y will now be supplied by international firms as well (i.e.

imported). Note that if this should happen i.e. good Y is now imported at the price Po there

will be no change in consumer surplus at all.

Y

ACo

Po Po

Dw

DL

YLo

A

YLo

Firm Market

AClP

P

A

MCo MCo= SL

C

YL1

SL1

B

MClo

P1 P1

DP2 P2

B

YL2

C

YL1YL2

SL2


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(c) The same critics argued that this is an expensive way of improving welfare. Instead,

they proposed that the government either restrict the subsidy to firms which are already in

the market or offered a unit subsidy to local consumers of the imported good. How would

these proposals affect your answers to (a) and (b). Which of the three schemes would be

more effective?

If the subsidy was given only to existing firms : Please refer to the earlier answer.

Unit subsidy to consumers of the imported good (good X):

The unit subsidy on consumers of the imported good will shift the local demand to the right

(as shown by D + S). But this will have no effect on the market price which remains at Po.

Therefore local firms will continue to produce the same output XLo which means that moreX will be imported (initial imports= Xo XLo and now the quantity imported = Xo XLo. As firms are still making normal profit there will be no entry of new firms. Hence,there will be no upward pressure on wages and other resource price. So the unit subsidy on

consumers of the imported good will not affect the export industry as there is no change in

the resource price now. Only consumers of the imported good will benefit from the subsidy.

The amount of subsidy is shown by the shaded area.

2nd

Question

(a) Initial set up

P

X

P

X

ACl

Po Po Sw

D

XLo

A

XLo Xo

A

Local Market

MCl

MCl= SL

D+S

Xo

B

P

X

P

X

P

X

P

Dso

DFo

Smoothies Drinkers Health Freaks

ACo

MCo

A

Xo

So=MCo

Po Po Po Po

DTo

A

Xo

AF

Xyo

As

Xxo

Firm Market


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Dont forget to do a bit of write up on the initial set-up stating about the market price,

market out, firms position and the two consumers spending. Note that besides drawing the

demand curves to show the different PED, I have also drawn the demand curve of the

Smoothies drinkers further out as they are the majority.

(a) & (c) Short run and long run effects of an increase in the price of Mangoes

Short-Run:

Health Freaks, mango and kiwis are gross substitutes; Smoothie drinkers mangoes and

kiwis are complements. Hence when the price of mangoes increases, the demand for kiwis

by the health freaks will increase whilst the demand for kiwis by Smoothie drinkers decline.

Because Smoothie Drinkers form the majority, it therefore means there will be a fall in themarket demand and hence the market price for kiwis in the short-run.

At P1, competitive firms will be producing a smaller output at B (X1) and they are now

making losses equal to the shaded area. Health Freaks are buying more kiwis at BF but we

are unable to determine what has happened to their spending at BF (although P has

declined and X has increased, we cannot use their PED to determine what has happened to

their spending as we have moved to a different demand curve). As for the Smoothie

Drinkers, they are buying less kiwis in the short run at Bs and also spending less as both

price and quantity bought have declined.

Long Run: Some firms will leave the market. This reduces the market supply and increases

the market price. Assuming that the exit of firms does not affect the price of labour or other

factors of production (should you decide to assume otherwise there is nothing to stop you

from doing so), market price will fall to S1 and market price will return to its original level,

Po. With price back at Po in the long run, the competitive firm will be producing its original

output once again and making normal profit. Though firms are back to producing their

original output level, market output at C has declined as there are now lesser firms in the

market. Smoothie Drinkers will be buying even less kiwis and spending even less than in the

short run since their demand is elastic. They are also spending less than they did oribinally.

As for the health freaks they will be buying less but spending more (their demand is

P

X

P

X

P

X

P

Dso

DFo

Smoothies Drinkers Health Freaks

ACo

MCo

A

Xo

So=MCo

Po PoPo

Po

DTo

A

Xo

AF

XFo

As

Xso

Firm Market

Ds1

Bs

DF1

DT1

BBP1 P1 P1 P1

BF

Xs1 XF1 X1 X1

Cs

Xs2

XF2

CF

S1

C

X2


8/21



inelastic) than in the short run. But compared with the initial position, they are buying more

and spending more in the long run.

3rd

Question:

(a) Show diagrammatically the initial set-up and the equilibrium distribution of sales

between consumers of x and producers of y.

We still have a situation of 2 groups demanding X but what is important to take note of is

that while one group is buying X for consumption purposes, the other group are actually

producers of Y who are buying X so as to use it as an input for producing Y.

I will leave the short write up to you but note that the market demand DT is a summation ofDxo and Dyo. Remember to mention the sales to those who are buying for consumption is

Po. Xxo and the sales to the producers of Y= Po.Xyo.

(b) How would an increase in the price of y affect the short run equilibrium in the

market assuming that x and y are considered by consumers as gross substitutes?

(c) What will happen in the long run?

When price of y increases (consumers will buy less y) and since consumers of X regard x and

y as gross substitutes their demand for x therefore increases. In addition we must not forget

that producers of Y use x as an input for producing Y. Hence when the price of Y increasethey will want to produce more Y (dont forget that we are looking at the supply side) which

therefore means they need more inputs and therefore the demand for X also increases. So

both the consumers of X and the producers of y will buy more X. As both are demanding

more X this therefore increases the market demand for x as well. In the short run the

market price of x increases to P1.

P

X

P

X

P

X

P

Dxo Dyo

Consumers Producers of Y

ACo

MCo

A

Xo

So=MCo

Po Po Po Po

DTo

A

Xo

Ay

Xyo

Ax

Xxo

Firm Market


9/21



At the short run price of P1, competitive firms are producing a bigger output X1 at B and

making profit equal to the shaded area. Market output likewise increases to X1 in theshort run. The producers of Y are now buying more X as they move to By and they are also

spending more on X at By than they did at Ay (both P and quantity are higher at By). As for

those who consume X for itself, they are also buying more X and also spending more on x

(both P and quantity are higher at Bx than at Ax).

Long run: New firms will enter the market. This increases the market supply and lowers the

market price. Assuming that the entry of new firms will not affect the price of resources,

new firms will continue to enter until market supply is at S1 and market price falls back to

Po. Competitive firms are back to producing their original output and making normal p rofit.

Both the consumers of X and the producers of good y are buying even more X in the longrun as they move to Cx and Cy respectively. Both groups are spending more compared with

their original positions at Ax and Ay respectively (at the same price the quantity is now

bugger) but we are unable to say about their spending in the long run compared with the

short run as we do not know their price elasticities of demand.

(d) How would your answer change if x and y are considered as complements by

consumers?

Price of y increases but now consumers of x regard x and y as complements.

P

X

P

X

P

X

P

Dxo Dyo


ACo

MCo

A

Xo

So=MCo

Po Po Po Po

DTo

A

Xo

Ay

Xyo

Ax

Xxo

Firm Market

Dx1

Bx

Dy1

By

DTo

BP1 P1 P1 P1

Xx1 Xy1

B

X1 X1

DT1

S1

X

CCy

Xy2

Cx

Xx2


10/21



Our analysis remains the same for the producers of y i.e. their demand for x increases since

they need more X in order to produce more y. But since x and y are now regarded as

complements by consumers, the increase in the price of y will now cause them to buy less x

since they will be buying less y. So while the demand for x by the producers of y increases,

the demand of the consumers of x falls, which means that there is now some offsetting

effect. Anything could happen in this case actually but in the suggested answer in the

examiners report they chose a very simple case where the increase in t he demand for x by

the producers of y exactly offset the decrease in demand by the consumers of x. For this to

happen it means that both have an equal share of the market demand for X. If this is the

case then there will be no change in the market demand for x and hence no change in the

market price too. Competitive firms will continue to produce the same output and make

normal profit. The only change is that the producers of y will be buying more x but there is a

reduction in the consumption of x by the consumers of x who are now at Bx. (You couldhave come up with another assumption and arrived at another conclusion as there is nothing

is the question to tell us who is the majority and who is the minority but can you see that this

is a smart choice as the question is already length enough and if you were to assume

otherwise you will need more time to complete your answer).

Monopoly1

stQuestion

(a) Explain the inefficiency created by a monopolist.

The first thing to remember when answering this question is to note that there are two

types of efficiency, i.e. productive and allocative efficiency. Firms in all market structures

including the monopolist are productive efficient because they all produce on their cost

curves. The cost curves as you know is derived from the expansion path and points on the

expansion part represents the least cost method of producing the different output levels.

The monopolist is, however, allocative inefficient because it does not produce the output

where P=MC but where MR >MC (and therefore since the Dd curve (which is P) is above the

MR curve P>MC). P indicates the marginal benefit to society from a good and MC

indicates the marginal cost to society of producing the good. When a firm produces whereP>MC it means that societys marginal benefit is greater than the additional cost of

P

X

P

X

P

X

P

Dxo Dyo


ACo

MCo

A

Xo

So=MCo

Po Po Po Po

DTo

A

Xo

Ay

Xyo

Ax

Xxo

Firm Market

Dx1

Dy1

Bx

Xx1

By

Xy1


11/21



producing the good. It therefore means that society wants more of this good but the firm is

producing an insufficient amount and because of this we then have the area of the

deadweight loss, a loss to society because the firm is producing less than what society

wants.

(b) Would the government proposal help in solving the problem?

The payment of an annual license fixed fee will raise the monopolists fixed cost and hence

its average cost. This will still not make the monopolist allocative efficient. The fact that the

license fee did not change the monopolists MC means that the monopolist will s till produce

the same output and charge the same price as before. So it will still produce where MR=MC

(and P>MC). The only change is that the imposition of the fixed license fee will reduce the

monopolists initial profit (the striped area) to the smaller red border area as shown in the

diagram below.

From the diagram above the amount of tax collected by the government is the loss in the

monopolist profit (the shaded area between the two AC curves). If the government uses this

sum of money and transfer it to the more needy members in society it will then help to

improve societys welfare and hence to some extent reduce the inefficiency of the

monopolist but note that it doesnt change the fact that the monopolist is still not producing

where P=MC.

(c) Critics of the government argued that a fixed fee is not enough to offset themonopolists inefficiency as it does not take into account the size of their market. A better

way to do this, they argue, would be to tax monopolists according to their output. Discuss

this claim.

Tax the according to their output: to put this simply it means that now we are looking at a

unit monopolist tax which will therefore increase the monopolists MC and AC.

P

MR

D

X

Po

XO

MC

ACo

AC1

P=MC

ACo

Xpc


12/21



In this case now, the monopolist will change the output it produces as MC has changed. It

will in fact produce a smaller output than before (now it is X1) and will move further away

from the output level where P=MC. The further it moves away from P=MC the bigger will be

the deadweight loss. So again efficiency will not be achieved. And like before we see a

reduction in the monopolists profit which will go to the government as revenue and which

the government could use to benefit the more needy in society.

(d) A monopolist faces the following demand function: p(x) = x. The cost function is

given by c(x) = cx.(i) Express the measure of the monopolists inefficiency as a function of the marginal

cost.

(ii) What would happen to price elasticity, equilibrium price and output when there is anincrease in .

(iii) What would happen to the level of inefficiency as a result of the increase in ?(i) Given :P= x and C(x) = cx (remember that P=demand and C(x) is the total cost)

Hence the profit maximizing output of the monopolist is where MR=MC

2x = c

c

_____ = x

2

And the price to charge for this output level (substitute the X into the demand curve

equation):

P = x

P

MR

D

X

Po

XO

MC

ACo

AC1

P=MC

MC1

X1

P1


13/21



c

P = ______

2

1

P= ___( + c)

2

The competitive output and price:

P = MC

x = c

c

_____ = x

Price under perfect competition = c (cos MC=c)

(i) The area of the deadweight loss: b. h where b= base is the difference between the

competitive output and that of the monopolist; and h=height is the difference between the

monopolists price and the competitive price.

c c 2 ( c)( c) c

Base: _____ - _____ = _______________ = _______

2 2 2

Height:

1 1

___( + c) c = ___ ( c)2 2

1 c c ( c)2

Area of deadweight loss: ___ . _____ . _____ = ______

2 2 2 8

This shows that the deadweight loss is a function of the MC which is c. An increase in c will

reduce the size of the deadweight loss.

(ii) is the slope of the demand curve. How does it affect the ?


14/21



An the demand curve becomes steeper which therefore means that falls (this givesyou an idea as to what your answer will be)

dX P

= _____ . ____dP X

The slope of the demand curve is dP/dx = . The first part of the elasticity formula dx/dp is

the inverse of the slope of the demand curve. Therefore

dX 1

___ = ____

dP

1 P

= ____ . _____ x

So an 1/becomes smaller

Output of the monopolist:

c

_____ = x

2

An X

Price the monopolist charges:

1

P= ___( + c)

2

An therefore does not affect the P

(ii)

1 c c ( c)2

Area of deadweight loss: ___ . _____ . _____ = ______

2 2 2 8

An reduce the deadweight loss which means a reduction in the inefficiency of themonopolist.


15/21



2ndQuestion:

(a)

The diagram above shows that the monopolist was originally producing output Xo

and charging the price Po and that it was making profit above normal. According to

the question the technology available to the competitor is such that the minimum of

the competitors AC curve is below the monopolists current price i.e. below Po. In

order not to repeat our answer take a look at part (b) of the question which states

that the minimum AC is below the monopolists price (Po) but above whe re the

monopolists MC=D i.e. point B in the diagram. Hence in part (a) I have drawn the

competitors AV curve such that the minimum of the AC is below the monopolists

price Po and below B (note that the minimum AC of the competitor is still drawn

above that of the monopolists AV curve because if it is not so the monopolist will

not be a monopolist in the first place.

Based on the above diagram the main question we need to answer is whether the

monopolist will still produce output Xo and charge the price Po in the presence of

competition. The diagram shows us that the lowest price at which the competitor

can charge and still be able to survive is P1. So if the competitor charges the price P1

it means that the monopolist will also have to sell at the price P1. At the price P1

consumers want the output indicated by point C, so the question is whether the

monopolist will increase his output from the current position A to C? If the

monopolist has to sell at P1 the monopolist will increase his output to that indicated

by point E (where P1=MC). The difference between what the monopolist is willing to

supply and the quantity that its consumers want to buy will then be supplied by the

competitor.

This therefore means that the monopolist will remain in the market and that he will

share the market with the competitor (who will be making normal profit). The

monopolist will still be making profit as P1 is higher than its AC when he produces

P

MR

D

X

MC

AC

P

P1

Xo X

Po

P1

MC

AC

E

B

C

A

MonopolistCompetitor


16/21



the output at E but the profit he earns will be smaller than before since MC > MR for

the output he produces from A to E.

(b)

Note the position of the competitors AC curve its minimum AC is below the

monopolists price Po and above the level where MC=D (i.e. point B). In view of the position of the competitors AC curve, the minimum price at which the

competitor is able to sell its output and still survive is P2. Like before this means that

the monopolist will not be able to sell at a price higher than P2 or else no one will

buy from the monopolist. Having to sell at P2, what then is the output the

monopolist will produce? If you take a look at the graph above you can see that at

the price P2, the monopolist will now increase his output from A to C. Note that

when the monopolist increases his output from A to C, for this extra output he

produces MC > MR which therefore means that there will be some decline in his

profit (compared with the profit at A) but nevertheless at C he is still making profit

above normal (this can be seen by comparing the price P2, with the AC of producingthe output at C). The output the monopolist now produces will satisfy the entire

market demand which therefore means that the competitor will not have a share of

the market.

(b) In this part of the question we are given the monopolists total cost C(x) = X2From the total cost we will be able to derive the MC and AC:

dC(x)

MC = ______ = 2X

dX

P

MR

D

X

MC

AC

P

P2

Xo X

PoP2

MC

AC

B

C

A

MonopolistCompetitor


17/21



C(x)

AC = ______ = X

X

Note that the monopolist maximizes his profit where MR=MC and

1

since MR = P 1 - ___

Therefore we can rewrite the profit maximizing condition as:

1

P 1 - ___ = 2X

2X

Therefore P = ________

1

1 - ____

Profit () = Total revenue Total Cost

2X = ________ . X - X2

1

1 - ____

Profit per unit (average profit):

2X________ - X

1

1 - ____

Therefore an increase in the will reduce the profit per unit as the increase in reduces 1/and therefore increases 11/.


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Monopolistic CompetitionstQuestion

It is true that in the long run monopolistic competitive firms can only earn normal profit.

This is because like perfect competition, monopolistic competition is also a market structurewhere there are no or minimal barriers to entry or exit. Hence, if for example monopolistic

competitive firms are making profit above normal, new firms will enter and they will

continue to enter until normal profits are restores. Although both the competitive and

monopolistic competitive firm can only make normal profits in the long run, it is however

not true that the monopolistic competitive firm will be as efficient as the perfectly

competitive firm. This means that while the competitive firm will be producing where P=MC

(condition for efficiency), the monopolistically competitive firm though making normal

profit too will be producing an output level where P > MC. This is because unlike the

perfectly competitive firm whose demand is horizontal (since it is a price taker) and hence

will be producing at minimum AC (that is where MC = AC) when it is making normal profit(so P=AC =MC at that output level), note that the monopolistically competitive firms

demand curve is not horizontal but negatively sloped as it has some degree of market

power since the firms are selling differentiated products. Since it faces a negatively sloped

demand curve, the MR curve lies below the demand curve. Hence when the

monopolistically competitive firm is making normal profit (P=AC) at its profit maximizing

output level, which is where MR=MC, P > MC since P > MR. Refer to the diagram below:

P

MR

D

X

MC

AC

Pmc

Xmc

PPCD=P=AR=MR

XPC

When the competitive firm is making

normal profit, producing output Xpc, note

that P=MC which is the condition for

allocative efficiency

When the monopolistically competitive firm is making

normal profit, producing output Xmc, note that P>MC.

It is therefore inefficient.


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2ndQuestion:

Use the same diagram as for the 1st question except that you need to remove the perfectly

competitive situation. So like before explain why under monopolistic competitive firm can

only make normal profit in the long run. Highlight the fact that even though the

monopolistically competitive firm is earning only normal profits in the long run (P=AC), the

output that it produces is however one where P > MC.

The degree of monopolistic power is measured by the ability of the firm to deviate from

marginal cost pricing and the greater the difference between P and MC the greater

therefore is the degree of monopolistic power.

The degree of monopolistic power, you will recall is measured by the ratio MC/P and it is

equal to:

MC 1

___ = 1 - ____

P

In the case of perfect competition, the firms demand curve is horizontal and hence the is. When the is , note that 1/ tends to zero, hence MC/P = 1. Since the perfectlycompetitive firm is a price taker, meaning that it has no market power at all, therefore when

MC/P = 1 it indicates the absence of market power (for it to be 1 there is no deviation

between P and MC). The monopolistic competitive firms demand curve is not a h orizontal

line but it is negatively sloped and therefore its is definitely much smaller than that of theperfectly competitive firm. From the equation for MC/P we can see that the smaller is ,the bigger is the ratio 1/ and hence the smaller is MC/P. The fact that MC/P becomessmaller indicates a greater degree of monopolistic power (it shows the deviation between P

and MC).

OligopolyGenerally the answer for all the questions on the duopoly model are the same for the first

part - Draw the very same diagram which I used to explain the duopoly model. State clearly

that we assume that the demand curve is represented by the equation P= - X and thatwe also assume that Cost is zero. Then show the output under perfect competition,

monopoly and oligopoly (how you arrive at these different output solutions and in the case

of the duopoly remember to use the equation showing how they act like a monopolist for

the remaining market).

Then for the 1stQuestion, your focus will be:

Is there any similarity between the Nash equilibrium in a duopolistic industry and the

prisoners dilemma? Definitely yes in the sense that in the prisoners dilemma where the

two prisoners did not collude (given the tendency to cheat) they ended up at the Nash


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Equilibrium, an outcome that is not the best. Had they been able to collude the equilibrium

outcome would have been better for both. Likewise in the duopolist ic industry as illustrated

by the diagram you drew. By not colluding, they end up each producing 1/3 of the market

output and making profit. However, had they colluded and acted as one big monopolist they

would have each produced of the market output (since the monopolist produces the

market output) and the profit they would have made would have been even more than the

duopolistic situation. (please remember that since cost is zero, the revenue will be equal to

the profit).

For the 2ndQuestion your focus will be:

You need to bring in two things here

(i) Bad for the players (firms)here you need to highlight the profit that the firms earnand obviously the duopoly is earning less profit than had they colluded together and acted

like a single monopolist. Highlight the areas representing their profit.

(ii) You need to focus on the condition for efficiency which is where P=MC. Highlightthat output the duopoly produces to maximize its profit is where MR=MC and at this output

level P > MC. So the duopoly is not efficient and because of this we have an area of

deadweight loss. Show the area of the deadweight loss which is that triangle between the

competitive output and the duopolist output and the price of the duopoly. But what is

important to note is that the deadweight loss here is less than had the two acted as a single

monopolist i.e. had they colluded.

For the 3rd

Question your focus will be:

The focus here is on efficiency, which means that the answer here looks at whether the

duopoly produces the output where P=MC. The answer here is the same as the 2ndquestion

(ii) but we focus more on comparing it with the competitive market.

One more additional question on the duopoly:

When demand is given by p(x) =1004x, and the marginal cost is zero, the equilibrium of a

duopoly would be 20. True or false? Explain.2011ZB

This is my solution as the examiners report is not available.

What you need to do for this question is to compute the market output or the competitive

output in the same manner that we did in class using the same diagram. The competitive or

market output is where P=MC i.e. 100 4x = 0100 = 4x, therefore x = 25.

Then use the equations for the output of firm A and firm B, and use one of them to prove

that the output of each duopolist is 1/3 of the market output.

XA= (/ XB)

XB= (/ XA)

Solving for: X

A

= (/ (/ X

A

))X

A= (/ / + X

A)


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XA= ( / + XA)

0.75XA= 0.25 /

XA= 0.333 /

Solving for XBwill give us the same answer, so each will supply a third of the competitive

market output.

Now we will apply it to the question. Since the market output is 25, therefore the combine

output of the duopolist which is 2/3 on the market output will be 16.67 and not 20 as stated

in the question.

The total output of two firms behaving non-cooperatively is smaller than if the market were

supplied by a single monopolist. True or false, explain 2004ZB

Draw the same diagram and state the same assumptions and determine the competitive

output as well as the single monopolists output. Now if the two firms in the duopoly model

behave non-cooperatively and both of them behave like monopolist, then their total outputwould be the market output or the competitive output which is double the output of the

single monopolist.

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