Transcript January test study guide chapter 6~10

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January study guide
By Namtae Lee
KEY WORDS
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
Market failure: is any situation where the allocation of resources
by free market is not efficient.

Externality: is a transaction where a third party experiences a
loss or benefit as a result of the transaction.


Externality=social benefit=external benefit + private benefit
No externality= social benefit= private benefits.

Merit good: is a good which the marginal social benefits exceed
the marginal social costs.
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A public good: is a good that is non-rivalries and non excludible
and is provided by the government for free.

Demerit good: is a good which the marginal social cost exceeds
marginal social benefit.

Tradable permit: is a system for taxing pollution levels where
pollution licenses are exchangeable between firms on a
secondary market.
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
Negative production
externality
Example: Coal mining: workers die and the
process causes pollution.

Solution:
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Taxes
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Legislation
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Tradable permits
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Negative consumption
externality
Example: Smoking, drinking alcohol,
gambling.
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Solution:
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Taxes
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Legislation
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Advertisement
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Positive production
externality
Example: School, worker training facility
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Solution:
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Subsidies
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State provision
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
Positive consumption
externality
Example: School, worker training facility

Solution:
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Subsidies
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Advertisement
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Legislation
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Practice question #1
Using an appropriate diagram, explain why negative consumption externalities are a type of market
failure.
Market failure occurs when allocation of resources by a free market is not efficient, thus MC does not equal MB. In a
case of negative externality of production costs of society is higher than the private costs. This suggests that the
price of the good is too low and the good is over-produced, which leads to welfare loss. Also, since goods are overproduced allocative efficiency is not achieved, since the marginal cost outweighs the marginal benefit. Then in
negative externality of consumption, the marginal private benefit is higher than the marginal social benefit,
suggesting that the good is over-consumed. Optimal equilibrium or allocative efficiency cannot be achieved.
a)
Another way to look at allocative efficiency is when MSC=MSB. On the left is the negative consumption externality
graph, and the point where MSC=MSB is represented by the red star. Due to the higher private benefit than the
social benefit, there is a welfare which makes MSC=MSB impossible. Then on the right is the negative production
externality graph. In this case the private marginal cost is lower than the marginal social cost, which creates a
welfare and also make MSC=MSB impossible. In conclusion, externalities make welfare loss which makes allocative
efficiency impossible to be achieved.
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b)
Evaluate the measures that a government might adopt to correct market failure arising from negative
externalities.
In a negative production externality, goods are over-produced and too cheap. Such an example is a coal. Thus the
government can put specific tax, which will shift the MPC to the left, thus minimizing the welfare loss and bringing
MSB closer to the optimal point. Also, governments may create legislation and tradable permit. However, all those
solutions are costly and are extremely hard to calculate the right amount of taxes (due to PED). By looking at a
negative production externality graph (on the left), it can be seen that originally the welfare loss was
green+purple, however, after the tax the welfare loss has decreased to only purple.
In negative consumption externality, such as cigarettes, the government can also put indirect taxes, which causes
supply to shift to the left, brining MSB closer to the optimal point. Advertisement is another option. Advertisement
can be used to shift the MPB or demand to the left, thus decreasing welfare loss and shifting MSB closer to the
optimal. In many countries the government puts shocking images of the effects of smoking on cigarette packs.
Again, those solutions are costly. Looking at negative consumption externality graph (on the right) it can be seen
that the welfare loss has decreased to orange from orange + blue.
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a)
Practice question #2
What are positive externalities and how do they arise? Illustrate your answer with examples.
Positive externality of production arise when the MPC is higher than MSB, or when a third party benefits from a
production of a good. An example is tree farm. Tree farms lowers the pollution level by absorbing CO2. Positive
externality of consumption arise when the MSB is higher than MPB, or a third party benefits from a consumption of
a good. An example is education. Education lowers crime rates and it creates more efficient and intelligent
workers.
b)
To what extent should governments attempt to influence markets where positive externalities exist?
The government should intervene to increase production and consumption of goods which have positive externality. In the case
of positive externality of production the government can subsidize, for instance, tree-farmers. Through subsidy the MPC shifts to
the right and MSC comes closer to the optimal point (graph on right). In the case of positive externality of consumption ,such as
education, the government can advertise the merits of education. This increases consumption, shifting MPB to the right and
bringing MSB closer to the optimal (graph on left).However, government does all this through tax money, and thus the
government should intervene only to the extent that the cost does not exceed the benefit or the exceeds the opportunity cost.
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Practice question #3
a)
Using the concept of market failure, explain the statement above from an economists point of view.
Answer below with part b).
b)
With reference to both national policies and international agreement, discuss three solutions that could
be recommended by economist.
The environment is often times free, and thus there are free-riders who does not rationally use the resources, such
as car factory that creates toxic waste and is polluting the air. Such an action has many negative production
externality such as the diseases caused by pollution and destroyed eco system. The cost the car factory pays (MPC)
will be much lower than the cost the society pays for the environmental damage (MSC). Also, the society is not
benefiting as much as the costs, and thus MSB does not equal MSC, which makes allocative efficiency impossible or
causes market failure. Thus, the government should put taxes, create tradable permits, and legislations to make the
free-riders, such as the car factory, pay for the environment damage. This will decrease supply and cause the MPC
to shift left. The welfare loss will diminish and allocative efficiency will be more likely be achieved.
+ Diminishing marginal return
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Law of diminishing marginal return: states that at some point
additional worker will produce less marginal product than the
previous worker.

Diminishing marginal return occurs when MP starts to decrease,
which starts from the 5th worker.
v
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When MP=0 TP
starts to decrease.
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MP intersect AP at
its highest point
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Increasing
marginal return
starts from the 1st
worker until the 5th
worker.
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Cost graph
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AFC starts to decrease due to spreading the overhead.
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MC decreases due to increasing marginal returns, and starts
to increase again due to law of diminishing return.
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MC intersect ATC and AVC at their lowest point.
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v
ATC lies above AFC
and AVC because
ATC=AFC+AVC.
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Cost graph
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AFC starts to decrease due to spreading the overhead.
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MC decreases due to increasing marginal returns, and starts
to increase again due to law of diminishing return.
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MC intersect ATC and AVC at their lowest point.
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v
ATC lies above AFC
and AVC because
ATC=AFC+AVC.
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Economics of scale
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Economics of scale: increase in input leads to a larger
proportional increase in output. Caused by cheaper resources due
to bulk purchase, more advanced capital in factories, etc.
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Constant return to scale: increase in input leads to a
proportionally identical increase in output.
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v
Dis-economics of
scale: increase in
input leads to
smaller proportional
increase in output.
Caused by
miscommunication,
etc.
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Profit maximization
For any firms in any type
of market, profit is
maximized when
MR=MC
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a)
Practice question #1
Explain the relationship in the short run between the marginal costs of a firm and its average total cost.
First relationship is that MC intersect ATC at its lowest point.
Second relationship is that the average total cost of a firm
decreases when the marginal cost is below the average total cost.
Third relationship is that the average total cost of a firm increases
when the marginal cost is above the average total cost.
Define the law of diminishing returns and assess the likelihood that it will be experienced by a firm
producing a product in a consumer good market.
Law of diminishing return is when one additional worker produces less marginal product than the previous that of the previous
worker. In a consumer good market, which is a market that produces final goods ,such as clothes and foods, that directly satisfy
the consumers, law of diminishing returns is common. This is because in the short run a firm can only react to the change in
the demand by increasing its variable cost or the labor. For instance as the demand for McDonald’s burger increases, the
manager of McDonald can only, in the short-run, hire more workers because expanding land or installing a new machine is
timely. As a result, there are three workers flipping a meat Pattie at one meat Pattie machine, whereas in the past only one
worker flipped the meat Pattie. In the past, the one worker flipped 50 meat patties per hour because there was plenty of rooms
to fry patties in the machine. However, now each worker only flips 20 meat patties per hour because the machine is shared by
three people and there just isn't enough room. The McDonald experiences the law of diminishing marginal return. Like
McDonald, a firm producing consumer good, in the short-run, only react by changing its variable costs, which leads to too
many workers sharing one machinery. Therefore, law of marginal return occurs.
b)
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a)
Practice question #2
What are the distinction between decreasing returns to scale and diminishing marginal returns?
First distinction is that decreasing returns to scale occurs when no factors of production are fixed, while
diminishing marginal return occurs when all factors of production but labor (variable cost) are fixed.
Second distinction is diminishing marginal return is only for the short-run, while the decreasing returns to
scale is for the run long.
a)
Evaluate the options available to a firm experiencing decreasing returns to scale to reduce its costs and
remain competitive, using an example to guide your response.
Decreasing returns to scale occurs when a firm becomes too large, and there is miscommunication and lack of incentives for
workers to work at their full efficiency. For instance, a manager in Toyota does not feel like the well-being of the company
has much impact on him and therefore acts rude to his consumers and workers. Toyota has variety of options to correct this
behavior. First option is to give stocks to the managers or executives. By giving fair amount of stocks to managers or
executive, it gives incentives for them to work at higher efficiency and care for the well-being of the company. Therefore, the
managers will try to increase his worker’s productivity and correct the miscommunications. Also, the stocks for higher-ups
give the workers at the lower ranking an incentive to be promoted. Another option is to create system in which the work and
efficiency of a lower ranked worker reflects the work efficiency of executive or managers. A problem in mega firms like
Toyota is that managers promote bad workers to create a comparison of the quality of work, and therefore, make himself look
good. To fix this problem, the quality of work done by the lower-ranked workers should measure the ability of managers,
because it is the manager’s job to manage his workers. Through this, bad workers will not be promoted, and the manager
will constantly try his best to increase efficiency and productivity of his workers.
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Practice question #3
a)
At what level of output should a firm produce to maximize its total profit? Use a diagram to help explain
your response
The firms should produce at the point in which MR=MC. This is because
when the marginal cost is equal to the marginal profit, there is no more
profit to be gained from producing less or more. When the marginal
revenue is greater than the marginal cost, there is a profit to be gained by
producing more. When the marginal cost is greater than marginal profit,
there is more profit to be gained by producing less. Therefore, MR=MC is
the only incident in which there is no more profit to be gained, and thus
profit is maximized.
a)
Whatever the type of market structure, profit maximization will always be the only goal of firms.
Discuss.
This is statement is mostly all true but sometimes not. For instance Amazon does not aim to maximize profit, but aims to gain the
market share. But, in the long-run Amazons aims to get rid of other competitors, and thus maximize their profit by becoming a
monopoly. Another instance is Costco. Costco pays about $17 per hour to its workers, which is about $7 higher than the wage its
competitors pay. By decreasing its wage or variable cost, Costco could potentially increase its profit, but it does not do so
because the CEO of the company disagrees with low wages. However, one could argue that the generosity of Costco’s wage is
to gain the consumer’s affection and is a type of marketing.
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Perfect competition firms
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There can only be short-run abnormal profit because no
barriers to entry and exit attracts new competitors in the long
run.
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Allocative efficiency, in which P=MC is achieved.
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Productive
efficiency is also
achieved, in which
firms produce at its
minimum ATC.
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Practice question #1
Using a suitable diagram, explain the difference between short-run equilibrium and long-run
equilibrium in perfect competition
For a firms in the perfect competition, short-run equilibrium is the only instance in which abnormal profit or
economic loss can be made. In other words, it is the only instance in which ATC does not equal AR. This is due to
various determinants of demand, such as shift in consumer preference, which causes a perfect competition firm
such as brownie bakery to experience a rise or fall in demand. In the case of abnormal profit, the abnormal profit
will attract new competitors, which spreads the demand and diminishes abnormal profit. In the case of economic
loss, the no barrier to exit will allow many existing firms to exit the market, and again spread the demand and
get rid of the economic loss. Therefore, the difference between short-run equilibrium and long run equilibrium is
that in the short-run the ATC does not necessarily equal AR, but in the long-run ATC equals AR. Or to put it in
another way, in the short-run firms can make abnormal profit or economic loss, but in the long-run firms can only
be at break-even point.
a)
b)
To what extent is the perfectly competitive market likely to exist in the real world?
Perfectly competitive market is all most always a theoretical market. Therefore, it is very unlikely to exist in the
real world. The reason is because in a perfect competition the products are completely identical, there is no
barriers of entry or exit, and the market share is divided equally among the firms. The problem with this is that in
the real world even agricultural goods have branding, which differentiate the good, and a large cooperation such
as Dole control much of the market share. Therefore, most firms are in the monopolistic competition.
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Practice question #2
Using a diagram, explain how allocative efficiency and productive efficiency will be achieved in longrun equilibrium in perfect competition
In the short-run, a perfect competition firm like brownie bakery (actually a monopolistic competition but…),
might experience a high demand compared to the supply. Therefore, the equilibrium cost of the brownie rise,
and the firms can survive without creating at the minimum ATC, or the firm can survive without producing at a
point in which P=MC because the scarcity of brownie have created consumers who are willing to pay above the
marginal cot. Therefore, neither productive efficiency or allocative efficiency is achieved. But, in the long-run the
easy barriers to entry causes new competitors, and supply has increased and spreads the demand. Now, the
consumers are aware that brownie is not scarce and is more price elastic. Therefore, for the bakery, not
producing at the minimum ATC causes economic losses, and selling the brownie at above the P=MC causes
demand to significantly decrease. Therefore, in the long-run allocative and productive efficiency is achieved.
a)
Evaluate the view that consumers, not producers, are the main beneficiaries of perfectly competitive
market structure.
In perfectly competitive market there can only be economic profit in the short-run, and there is equally likely chance that there
will be economic loss. Therefore, assuming that the probability are 50% each, then there is essentially no economic profit.
Therefore, the firms will be only at a break-even point, and will not be earning much. But, for the consumers the no barriers to
entry and exit forces the firms to produce at productive efficiency and allocative efficiency, which allows the consumers to enjoy
purchasing the good at the minimum price. Therefore, the consumers benefit from this market.
a)
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Practice question #3
A firm in perfect competition is producing at the profit-maximizing output, but making a loss using
diagrammatic analysis, explain how this is possible.
Such a case only occurs in the short-run, and reasons can be a shift in
demand, caused for instance by shift in consumer taste and
preference. Lets use brownie and muffin as an example. Consumers
who were previously consuming brownie has started consuming
muffin instead. Therefore, the demand for the brownie has shifted
left. This causes the equilibrium price to decrease, and the ATC is
now greater than the AR. But even at this point of economic loss, the
firm is producing at the point in which MC=MR because it wants to
minimize the economic loss. Despite the firm producing at MR=MC,
the demand is not enough to compensate for the fixed and variable
costs, which causes an economic loss.
a)
a)
Discuss the claim that all costs are identical among different firms in a perfectly competitive market. If
this claim is correct, then why do some firms shut down before other when earing economic loss?
In a perfect competition, all goods are identical and demand is spread equally. Therefore, the firms are producing the same
product at a same quantity. Thus, the costs are identical in all firms. Despite this, the reason for why some shut down before
others when earning economic loss is because of the opportunity cost. Lets use Sam and Daniel as an example. They are both
selling brownies in New-York, and is facing an economic loss at the moment. Sam shuts down after 2 weeks of economic losses,
because he values his opportunity cost, which is selling cakes, higher than the current economic losses and the future profit he
will be making. But, Daniel does not close because he view his opportunity cost, which is selling rocks, as not as valuable as the
current economic loss and the future profit he will make. Therefore, the difference is in the value of opportunity cost.
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Monopoly

Allocative efficiency is not achieved

Productive efficiency is not achieved

Often times there is abnormal profit
st degree price discrimination
1
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
The producer knows the price elasticity of demand of each
consumer.

Charges the highest price to each consumers.

Producers surplus
completely replace
consumer surplus
nd degree price discrimination
2
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
The producers know that consumers are willing to buy additional
amount if the prices of the good decrease.

Example: buy two get one free
rd degree price discrimination
3
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
Producers know that different consumer groups have different
price elasticity

Example: cinema charge more to adults than it charges students.
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Practice question #1
Explain using an appropriate diagram, why price and marginal revenue are not equal for the
monopolist.
Price= average revenue for the firm, and it does not equal the marginal revenue because the marginal revenue
decreases at twice the rate.
a)
Evaluate the government’s decision to use anti-trust legislation to break a large technology company up
to dozens of smaller companies.
The government views that the company is producing at a shortage, and is instead selling at a point in which MR=0. Therefore, it
causes low quantities of goods produced at a high price, and allocative efficiency is not achieved because price (AR) is higher
than marginal cost. And we can also see that the low quantity produced increases the producer surplus at the cost of consumer
surplus. Therefore, the consumers are at a disadvantage in every way. Thus government separates the technology company up
to smaller individual companies, in hopes to cause competition, which will result to higher quantity of goods produced at a
lower price, more innovations, and increased consumer surplus. This anti-trust legislation will benefit consumers, but will cause
the technology firm to lose large amount of revenue.
a)
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Practice question #2
Explain, using an appropriate diagram, how the monopolist determines the profit-maximizing level of
output and price
Monopolist face a down-sloping demand curve, and they aim to produce at
the unit elasticity. Therefore, the monopolists decrease price to increase
quantity demanded, until the marginal revenue becomes zero. At this level,
the total revenue is maximized. Then profit is maximized by producing at
the MR=MC output. In other words, the monopolists produce at the elastic
section of the demand curve.
a)
Discuss the view that competitive markets are always more efficient than monopolies.
Competitive markets are always more efficient than monopolies. In a perfect competition the firms have to produce at
productive efficiency (minimum ATC) because if they produce do not produce at the minimum ATC the firm will experience
an economic loss. Also, the firms have to produce at allocative efficiency (P=MC) because that is the profit maximizing point.
If the firm produces when P is higher than MC, the demand is perfectly elastic and thus significantly decrease. If the firm
produces when P is lower than MC, the quantity demanded will increase but total revenue will decrease and wont be enough
to compensate for the variable and fixed cost. But, in monopolies both efficiencies are not achieved. The firm does not
produce at productive efficiency because they do not produce enough quantities of good, due to profit maximization.
Allocative efficiency is not achieved because the firm’s price is higher than the marginal cost, because the firm is not
producing enough of the good. Thus, competitive markets are always more efficient than monopolies.
a)
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Practice question #3
Explain, using an appropriate diagram, why the monopolist would choose to operate in the elastic
portion of their demand curve.
The revenue maximizing monopolist, more specifically, would choose to
operate in the unit elastic portion of their demand curve, which is usually
when MR=0. At this point there is no further marginal revenue to be made
by producing more quantities, and thus the total revenue is maximized.
a)
Or for profit maximizing firms, working in the elastic portion means that
the price can be set high, and in this portion the marginal revenue is still
positive and total cost is lower. But, in the inelastic segment, the marginal
revenue is negative and prices have to be set low, with higher total costs.
Thus to maximize profit or revenue, the firm produces at the elastic portion
of the demand curve.
a)
Compare and contrast different objectives a monopoly may pursue in its price and output-decision.
There are basically two objectives a monopoly may pursue: maximizing profit or maximizing revenue. For a firm deciding to
maximize profit, they will produce at when MR=MC, and produce less quantities and sell them at higher price. But for a firm
wanting to maximize revenue, it would produce at when MR=0 because at this point there is no more revenue to be gained by
producing more or less. There will be more quantities of goods sold at cheaper price.
The profit maximizing firm would gain an abnormal profit of the green+brown
box, while revenue maximizing firm would gain an abnormal profit of
green+blue box.
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a)
Practice question #4
Explain, using example and an appropriate diagram, the concept of a natural monopoly.
Natural monopoly is a “market in which the lowest costs can be achieved when
only one firm is selling to the market” and has high fixed costs. Example can be
water supplying company. It is costly to install pipes and supply water to
individual households, and thus the fixed cost is high. Due to the high fixed
costs, there is high barriers to entry and exit. Firms do not enter the market
because average costs decrease after large amount of outputs and thus it is
timely and inefficient. We can see from the diagram that if 1 firms produce, the
firm can sell the water for about $5 but if 2 firms produces, the water is sold at
$6.
a)
To what extent do natural monopolies act against the best interest of society?
Often times natural monopolies supply goods that have become necessity in current society: electricity, water, and sewage
system. Therefore, the demand is somewhat inelastic and since the firms are monopolies, they are price givers. Thus, they
can name almost any price for the goods. If those natural monopolies were not regulated by the government, and the firm’s
objective was to maximize profit, the cost of the goods would be much higher, and allocative efficiency will not be achieved.
Too few will be served at a too high a price. The firm would act against the best interest of society. But this is obvious
because firms do not start business to be nice, but start business to make money. Therefore, government intervenes and
regulates such firms (by subsidies and such), and this helps lower the price and increase the quantity supplied. Allocative
efficiency is more likely to be achieved. Now the natural monopolies are only slightly acting against the best interest of
society.
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a)
Practice question #5
Explain how a third-degree price discriminator will determine price and output.
Third degree price discriminator knows that different groups of consumers have different price elasticity. For
instance, a businessman needs to make phone-call and thus he is more price inelastic. On contrary a high-school
student only makes phone-calls for social issues, and thus he is more price elastic. The price discriminator will
know this, and charge more to the business man than he will be charging to a high-school student.
a)
Price discriminator of any kind only brings harm to consumers. Discuss.
This statement is not true. Price discriminators will benefit consumers. Lets take an example of cinema tickets. And lets
assume that there is no price discrimination, and thus the theater charges the same amount of $20 per ticket to every
consumer. A businessman who is earning $50,000 a year would be less price elastic, because $20 is only about 0.04% of his
annual income. But for a high school student who gets an allowance of $960 per year ($80 per month), he will be highly
price elastic because $20 is 3% of his annual income. The result will be that ticket will be most likely be only purchased by
businessman, because $20 is just too expensive for the high school student. But, if there is price discrimination, a
businessman will still be able to purchase the ticket, but at the same time high school student will be able to also purchase
the ticket for $10. Therefore, now the service can be enjoyed by more variety of consumers, and thus consumers benefit. In
this case, some might argue that the businessman is at a disadvantage, but this is not true. He is not at a disadvantage
because he is still paying the price he was originally willing to pay. All this are assuming that the price discrimination is
second and third degree.
But, in the case of first degree price discrimination, which is unlikely, the consumers are paying the highest possible price
they are willing to pay, and thus there is no consumer surplus. Thus, the consumers are at a loss.
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Practice question #6
With the aid of at least one diagram, explain one way a consumer might gain from the behavior of a
monopolist, and one way a consumer might lose from the behavior of a monopolist.
The possible benefit can be that the large abnormal profit gives more capacity for research and development,
but at the same time there is no incentives to spend money on research and development. Therefore, more clear
possible benefit is the second and third degree price discrimination. As mentioned in question number five,
consumers benefit from second and third price discrimination because the good is accessible to more variety of
consumer groups. For instance, a businessman pays $9 for a cinema ticket, because he earns larger income,
while a student pays only $4 per ticket because he earns smaller income. If the ticket was $9 for the student, he
would not have been able to purchase the ticket because it is too expensive.
a)
A disadvantage of monopolist is that there is no allocative efficiency. Price
does not equal marginal cost. The firms do this because if the profit is
maximized when a good is sold at a lower quantity for a higher price. But, for
the consumers it means that the good is more scarce and thus it is both less
abundant and more expensive.
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Practice question #7
Explain how a monopolist may earn economic profit in the long run
Monopolist have no competition, and thus they are price givers. To maximize profit they produce at MC=MR, and
they do not produce at either productive or allocative efficiency, because producing less quantities at higher
price gives them more profit. They do everything to maximize profit, or sometimes revenue, and since there is
high barriers to entry and exit, there is no competition. Demand stays fairly constant, and profits are maximized.
Then, unlike perfect competition, the short-run abnormal profit is also enjoyed in the long run because of the
high barriers to entry and exit.
a)
Evaluate the view that, compared to competitive markets, monopolies will always harm the consumers.
This statement is almost always true. Monopolies do not produce at either allocative efficiency or productive
efficiency, and therefore there are too little quantity produced at too high a price. The quantity supplied at higher
price increases producer surplus at the cost of consumer surplus. Then, there is no incentives for the monopolies
to research and develop its product ,because there is no competition. On contrary, perfect competition does
everything monopolies don’t do. Perfect competition firms produce at allocative efficiency and productive
efficiency, which means that enough of quantities are supplied at the right price.
a)
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Practice question #8
Monopoly price is higher and output smaller than is socially ideal. The public is the victim.
Explain the economic reasoning behind the statement that monopoly price is higher and output is
smaller than socially ideal.
Socially ideal means allocative efficiency, or when P(AR)=MC. But, the
monopolist do not produce at P=MC because they produce smaller
quantities and sell them at higher prices. Looking at the diagram, it can
be seen that the price is above the marginal cost. If the monopolist
produce more quantities and sell them at cheaper price, allocative
efficiency would possibly be achieved, but the profit would be smaller,
and thus monopolies do not rise quantity supplied.
a)
Do you agree that the public is always the victims of monopoly? Justify your answer.
I do mostly agree with this statement. As answered in part a, allocative efficiency is not achieved and the quantity supplied is
small and the price is high. Thus consumers are at a disadvantage. But, the second and third degree price discrimination
somewhat benefits consumer. The price discrimination allows more variety of consumers, especially consumers who were
not able to pay the original price, to purchase the good. But, overall consumers are the victims of monopoly.
b)
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
Game theory
Is a “branch of mathematics and social sciences that tries to
capture behavior in strategic situations.” Also known as prisoner’s
dilemma.
+
Formal collusion

Collusion: is a agreement between firms to limit competition and
raise price.

Firms make formal agreement. Cartel formation

Example: limit output, fix price, restrict innovations.

Is illegal in many countries.

Firms that have made agreements might cheat to increase its
revenue
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Informal collusion

Also called tactit collusion.

One dominating firm establishes price leadership. This is
because if smaller firms cut price, price war would start and the
dominate one will survive and small ones will die.

Difficult to achieve.

Sometimes illegal.
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
Kinked demand curve
Demand becomes elastic as price increases because other firms
will remain their price, and consumers will start purchasing
goods from other firms with cheaper price. TR decreases.
 Demand becomes
inelastic as price
decreases because other
firms will also lower their
price, and this will lead to
price war. TR decreases.

Total revenue is
maximized at the red dot.
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Practice question #1
Analyze to what degree monopolistically competitive firms are considered allocatively and productively
efficiency.
Monopolistically competitive firms can differentiate their products, and thus the demand is less price elastic than
those of perfect competition. Therefore, firms can raise price and produce less quantities without having their
demand significantly decreased. In fact, firms decide to produce less and sell them at a higher price because
this method maximizes more revenue. Thus, either allocative or productive efficiency is achieved. Diagram can
be used to explain this concept. The allocative efficiency is achieved at the red star area, in which P(AR)=MC.
However, the actual price, represented by the black dot, is much higher than the red dot, and thus P does not
equal MC. Allocative efficiency is not achieved. Then, the firm is producing too little to achieve productive
efficiency, and thus the firm is not producing at minimum ATC, represented by the green star. However,
monopolistic competition are the closest (other than perfect competition) to achieving both allocative and
productive efficiency.
a)
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a)
Practice question #2
Using a game theory payoff matrix, explain how firms in an oligopoly face strategic choices.
Lets use Sony and Nintendo as an example. Those companies produce similar game devices that have no or little
close substitutes, and thus are competitors in the market. We assume that those two companies are at the same
situation. Their dilemma is to whether lower or maintain the price. In the game theory diagram, Sony is
represented by the grey box, and Nintendo by the blue box. If both Sony and Nintendo maintain their price, both
company earns total revenue of $80. But if Sony decides to lower its price, while Nintendo decides to maintain its
price, Sony earns TR of $110, while Nintendo earns TR of $40, and vise versa. If both firms lower their price, the
TR becomes $50. Lowering the price might sound like a good idea for Sony because if Nintendo maintain its
price, the TR increases by $30.Same goes for Nintendo. However, if Sony decides to lower its price and Nintendo
follows, both companies TR decreases by $30. Thus, the risk of lowering the price to increase TR is the possible
start of price war, which will cause both companies $30. Likely risking decrease in $30 of TR is not worth the
gaining of possible TR of $30. Thus both firms would likely choose to maintain their prices, because maintaining
price has the lowest risk and gives most benefit to both firms.
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a)
Practice question #3
Why do some oligopolistic firms engage in non-price rather than price competition?
Oligopolistic firms have a kinked demand curve. If a firm increases a price, the demand is highly elastic, and
thus the total revenue will decrease because consumers will start purchasing competitors' goods which are
cheaper. If a firm decides to lower its price, the other competitors will see this as a threat, and likely also lower
their price. This will cause all prices in all firms to decrease, resulting in a price inelastic demand, and starting a
price war which will cause all firms TR to decrease. Thus, lowering price or increasing prices will cause TR to
decrease. Therefore, firms decide to engage in non-price competition.
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Practice question #4
Explain the difference between short-run equilibrium and long run equilibrium in monopolistic
competition.
The differences are the same as that of the perfect competition. In the short-run firms can experience either
economic loss of abnormal profit because of change in demand. However, this economic loss will only exist in
the short-run because few firms will exit the market and demand will spread more between firms, causing
increase in demand and thus increase in TR. The abnormal profit will also exist only in the short-run because new
competitors will be attracted by the profit and enter the market, spreading the demand, causing demand to
decrease for individual firms.
b)
Perfect competition is a more desirable market form than monopolistic competition. Discuss.
a)
This depends on whether you are a producer or a consumer. For producers monopolistic competition is more desirable
because producers have more market power, and thus they can maximize profit by not having to produce at allocative
efficiency and productive efficiency. However, for the consumers, perfect competition is more desirable. This is because in
perfect competition there is allocative efficiency and productive efficiency, which means that goods are cheaper and more
abundant. Also consumers are the price givers and thus they have more power.
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a)
Practice question #5
Explain the difference between monopolistic competition and oligopoly as market structures.
First difference is that more market shares are controlled by large firms in oligopoly than monopolistic
competition. Second difference is that there is higher barriers to entry and exit for oligopoly. Third difference is
that oligopolies are more price control than the monopolistic competition. Fourth difference is that oligopolies
have more differentiated goods than monopolistic competition. Last difference is that long-run abnormal profit or
economic loss can exist in oligopoly but cannot in monopolistic competition.
Discuss the differences between a collusive and a non-collusive oligopoly.
Collusive oligopoly are firms that have decided to meet and formally agree on things such as price, output, and innovations.
Firms in this market are breaking the law. Non-collusive oligopoly are firms that have a informal collusion, and the price is
naturally set by the dominating firm.
b)