Review for Exam 4

1
Review for Exam 4

• Econ 2020

2
Format

• About 30-35 multiple choice questions worth 2
  points each.
• Short problems similar to those on the homework.
• Fill-in-the blanks.
• Chapters 8, 10, 11, 16 plus my notes on imperfect
  competition.

3
Industry Structure

• Perfect Competition Many firms produce an
  identical output. No firm can affect market
  price.
• Monopolistic competition A large number of
  firms produce slightly differentiated products.
• Oligopoly An industry is dominated by a few
  firms.
• Monopoly A single firm produces all the output.

4
Profit
For all firms Profit TR - TC To maximize
profit, all firms set MR MC
5
Marginal Revenue

• Under perfect competition, MR price of the
  output
• Under other structures, MR is always less than
  price because firm-level demand is not perfectly
  elastic and the price falls for every unit of
  output increase in sales.
• Since all firms set MRMC to maximize profits, if
  MR
• Any time a firm-demand is downward sloping, then
  MC

6
Calculate Marginal Revenue

• Marginal Revenue is the change in TR divided by
  the change in quantity (table)
• For linear inverse demand
  P A Bquantity
• MR A 2Bquantity

7
Examples

• P 200 5q MR 200 10q
• P 30 2 q MR 30 4q
• P 50 20q MR 50 40q

8
Working with MR

• Demand is elastic if MR0
• Demand is inelastic if MR
• MR 200 10q is positive for quantity less than
  20, negative for quantities greater than 20.
• So Demand is elastic for quantities less than 20,
  inelastic for quantities more than 20.

9
You try it

• P 800 5 q
• P 120 6 q
• P 350 3.5q
• For all these inverse demand curves, find the
  formula for MR and then find the regions over
  which the demand is elastic and inelastic.

10
You try it

• P 800 5 q
• MR 800 10 q. Demand elastic if q is less
  than 80, inelastic if q is greater than 80.
• P 120 6 q
• MR 120 12q. Demand elastic if q is less than
  10, inelastic if q is greater than 10.
• P 350 3.5q
• MR 350-7q. Demand elastic for q less than 50,
  inelastic for q greater than 50.

11
Marginal Revenue -- Table
12
Perfect Competition
Short-Run Equilibrium P MC. May have an
economic profit, may break-even, or may have an
economic loss. Long-Run Equilibrium P MC, P
AC ZERO ECONOMIC profits This is the only
industry structure where PMR and thus the only
industry structure where PMC
13
Monopoly
Short-Run Equilibrium We set MR MC PMR so
therefore PMC Will usually have an economic
profit (e.g. PAC) Long-Run Equilibrium Same
as short run since no firms can enter the
market.
14
Monopolistic Competition
Short-Run Equilibrium We set MRMC PMR, PMC
Will usually have an economic profit (e.g.
PAC). Looks like a monopoly. Long-Run
Equilibrium We set MRMC PMR, PMC But PAC.
Zero economic profit.
15
Profit Max and the Monopolist
We calculate the MC, which is the change in Total
Cost divided by the change in output. It cannot
be a negative number. We calculate the MR, which
is the change in Total Revenue divided by the
change in output. It can be a negative
number. We find the point where MRMC. In a
table, we then read across to find price and
quantity to define the profit-maximizing point
(as in homework).
16
Study Questions
Look at this diagram. What sort of firm is
this? ______________ What is the
profit-maximizing quantity? _______________ What
will the price be?______ What is Marginal
Cost? _______ What is Average Cost?
_______ What is the Marginal Revenue? ___________
monopoly
600
16
8
12
8
17
More about this diagram
To find profit-maximizing point, we find the
place where MR MC
Then, we read the quantity off the
horizontal axis -- 600
We find the price from the demand curve.
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Other Information
Total Revenue is price quantity. 16600
9600 Total Cost ACquantity 12600
7200 Profit TR-TC 9600-7200 2400
Another way to calculate Profit
(Price-AC)quantity (16-12)600 2400
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Another Example
What is the maximum profit this firm can
earn each day?
Price8 AC 6 Output 30 Max Profit
(8-6)30 60
20
Oligopoly
No stable equilibrium. May resemble a monopoly
if firms collude. May move toward zero economic
profits. Depends.
21
Imperfect Competition
Imperfect Competition prevails in an industry
whenever individual sellers have some measure of
control of their output price. Under
imperfect competition, the firm faces a downward
sloping demand curve.
22
The Level of Control
Imperfect competition does not mean that a firm
has absolute control over price. If a product
with many substitutes (or even one close
substitute) is priced well above the
substitutes, few if any consumers will buy it.
23
Graphical Depiction
Firm Level Demand Curves
p
p
d
d
q
q
perfect competition
imperfect competition
24
Monopoly
Monopoly means one seller. In this
extreme form of imperfect competition, there is
only one firm producing and selling a
product. For a monopoly, the firm demand curve
is the same as the market demand curve.
25
Oligopoly
Oligopoly means few sellers. The
important feature is that each firm can affect
the market price. Oligopolies are common in
the United States e.g. automobiles,
appliances, breakfast cereals, airlines.
Oligopolies can engage in rivalry, where each
firm competes fiercely for market share, or they
can collude (illegal in U.S.) and behave as a
monopoly.
26
Oligopoly
Oligopolies can produce identical products (crude
oil) or branded products (appliances). The
latter situation is sometimes called a
differentiated oligopoly.
27
Advertising
Firm advertising would not be much use
under perfect competition where each firm
produces an identical product and has only a tiny
share of the market. Advertising can be a form
of rivalry among competitors in an oligopoly. It
can also serve as a barrier to new entrants into
an imperfectly competitive market.
28
Advertising
Advertising may provide some benefits to
consumers if it gives them information about
products.
29
Monopolistic Competition
A large number of sellers produce
differentiated products (branded products). New
firms can enter this sort of industry easily.
30
How do Monopolies and Oligopolies Arise?
There are two main reasons Economies of
scale in production Barriers to entry
31
Monopolistic Competition
Another form of imperfect competition,
Monopolistic Competition, arises when entry and
exit are relatively easy but the product is
differentiated (branded).
32
How does monopolistic competition arise?
The product must be differentiated. Entry and
exit of firms must be easy.
33
A Natural Monopoly
A natural monopoly is the result of an industry
in which AC always decreases with output level.
These are industries characterized by high fixed
costs, so that the decrease in AFC as output
increases is so large that it keeps pushing AC
down.
34
Cost Curves of a Natural Monopoly
AC
MC
q
35
Cost and Industry Structure
Industry structure can be largely determined by
the relationship between the size of the market
and the point at which a typical firms AC
curve starts to rise.
36
Because of the shape of the AC curve,
this industry would likely be a monopoly.

AC minimum
AC curve (firm)
D (market)
quantity
37
Because of the shape of this AC curve,
this industry would likely be competitive.

AC curve (firm)
D (market)
quantity
38
Because of the shape of this AC curve,
this industry would likely be an oligopoly.

AC curve (firm)
D (market)
quantity
39
Game Theory

• Useful for understanding the behavior of firms in
  imperfect competition.
• Involves players, strategies, and payoffs.

40
Game Theory Example
Does Ace have a dominant strategy? Does
Deuce? Why is this game an example of Prisoners
Dilemma?
41
If the table is confusing

• Examine the players one by one.
• Look at Aces options. The company can 1)
  advertise or 2) not advertise.
• If its rival advertises, then Ace would earn
  2,000 by advertising and 1,000 if it doesnt,
  making advertising Aces best choice.
• If its rival doesnt advertise, then Ace would
  earn 3,500 by advertising and 3,400 if it
  doesnt, making advertising Aces best choice.
• Because advertising is Aces best choice in both
  situations, advertising is Aces dominant
  strategy.

42
Now work the problem for Deuce

• Look at Deuces options. The company can 1)
  advertise or 2) not advertise.
• If its rival advertises, then Deuce would earn
  2,500 by advertising and 1,500 if it doesnt,
  making advertising Deuces best choice.
• If its rival doesnt advertise, then Deuce would
  earn 5,000 by advertising and 4,600 if it
  doesnt, making advertising Deuces best choice.
• Because advertising is Deuces best choice in
  both situations, advertising is Deuces dominant
  strategy.

43
In this problem

• Both Ace and Deuce have a dominant strategy,
  advertise.
• But if they both advertise, they earn less than
  if they both chose not to advertise.
• But in the absence of collusion or outside
  intervention, neither firm will select not
  advertising, because of the payoffs, explained
  previously.
• This game thus has the form of a prisoners
  dilemma.

44
Prisoners Dilemma

• Each player has one dominant strategy.
• When they play the dominant strategy, they are
  both worse off than they would be if they played
  the dominated strategy.
• But without intervention or collusion, they will
  play their dominant strategy or risk losing more
  if the other firm plays its dominant strategy.

45
A Different Game
46
Payoffs for the Orcs

• If the trolls join Sauron The Orcs get 2,500 if
  they join Sauron, and 100 if they dont, so
  their best choice in this case is to join Sauron.
• If the trolls dont join Sauron The Orcs get
  2,000 if they join Sauron and 200 if they
  dont, so joining Sauron is again the Orcs best
  choice.
• For the Orcs, joining Sauron is a dominant
  strategy. It pays off higher than the
  alternative, whatever the Trolls do.

47
For the Trolls

• If the Orcs join Sauron The Trolls get 2,500 if
  they join Sauron and 1,500 if they dont, so in
  this situation, they do better joining Sauron.
• If the Orcs dont join Sauron The Trolls get
  3,500 if they join Sauron and 5,000 if they
  dont join Sauron, so in this case the Trolls are
  better off if they dont join Sauron.
• The Trolls do not have a dominant strategy. In
  one case (Orcs join Sauron) they are better off
  joining Sauron. In the other case (Orcs dont
  join Sauron), they are better off not joining
  Sauron.

48
Solution to Orc-Troll Game

• Since the Orcs have a dominant strategy (join
  Sauron), they will play it.
• The Trolls know the Orcs will play their dominant
  strategy, so they know the Orcs will join Sauron.
• If the Orcs join Sauron, the trolls should also
  join Sauron.
• So the solution to this game is Orcs and Trolls
  both join Sauron.
• If at least one of the 2 players has a dominant
  strategy, the game will have a Nash
  equilibrium.

49
Monopolies

• Chapter 10

50
Marginal Revenue for a Monopoly
Because price falls as output increases, MR for
a monopolist must be found by taking the change
in total revenue and dividing by the change in
output. TR is price times output.
? TR ?Y
______
MR
51
Marginal Revenue of a Monopolist
Remember the relationship between elasticity and
TR we learned earlier? When demand is elastic,
TR rises as output increases. When demand is
inelastic, TR falls as output increases.

52
Marginal Revenue of a Monopolist
When demand is inelastic, TR falls as output
increases. If TR is falling, then MR would be
negative. Thus, a monopolist would not produce
in the inelastic portion of its demand curve.

53
Profit-Maximizing Point
The profit-maximizing point for a
monopolist occurs where MR MC. In this case,
not only quantity but price will be determined.
54
Steps
Calculate MR and MC for each level of
output. Find output level where MRMC. Read
price that corresponds to that output level from
the demand curve.
55
Graph of profit-maximizing
MC
p
AC
d
MR
q
56
For a monopoly
Price MC Price MR Price (usually) minimum
AC in long run
57
Monopolies and Supply
A monopolist does not have a supply curve. Supply
for a monopolist is a single point.
58
Profits for monopoly
MC
p
AC
Profit is the pink rectangle.
d
MR
q
59
Graphing monopoly rents
Draw a line to where MC intersects demand. The
portion of the profit above that line is
monopoly rent.
MC
p
AC
d
MR
q
60
Dead-weight loss.
Dead-weight loss from a monopoly is the triangle
to the right of the monopoly profits.
MC
p
AC
d
MR
q
61
Monopoly rent and dead-weight loss come from
consumer surplus lost to monopoly.
If the industry were competitive, price would
equal MC. Consumer surplus would be the yellow
triangle shown here.
MC
AC
pc
d
qc
62
Under Monopoly, Consumer Surplus is smaller.
The orange triangle is consumer surplus under
monopoly. Part of the lost surplus is monopoly
rent. Part is dead-weight loss.
MC
p
AC
pc
d
qc
q
63
Chapter 10

• Other forms of imperfect competition

64
Oligopolies
Oligopolies are common in the U.S.
65
Strategic Interaction
When only a few firms operate in market, they
will probably recognize their interdependence.
Strategic interaction occurs when each firms
business plan depends on the behavior of its
rivals.
66
Collusive Oligopoly
When firms in an oligopoly actively cooperate
with each other, they engage in collusion. Two
or more firms jointly set their prices or
outputs, divide the market, or make other
business decisions together.
67
Cartel
One type of collusive oligopoly is a cartel. A
cartel is an organization of independent firms,
producing similar products, that work together to
raise prices and restrict output. Cartels are
illegal in the U.S., but firms are often tempted
to engage in tacit collusion.
68
The problem of cheating
Cartels may fall apart if firms are tempted to
cheat, either by undercutting prices or producing
more than their share of the total output.
69
Monopolistic Competition
Under monopolistic competition, there are many
firms and entry into the industry is relatively
easy. The difference between perfect
competition and monopolistic competition is that
the product is not identical, hence each firm
faces a downward sloping demand for its own
product.
70
Examples of Monopolistic Competition
Shampoos, frozen foods, detergent, cosmetics,
magazines, etc. Differentiated by products
intrinsic attributes. Gas stations, restaurants,
grocery stores. These firms are often
differentiated by location.
71
Product Differentiation
Because of product differentiation, each firm in
monopolistic competition faces a downward sloping
demand curve, as in a monopoly. The difference
is that new firms can easily enter the market if
the profits earned by one firm are too high.
72
Short-run situation for firm under monopolistic
competition
Solution looks like regular monopoly
p
d
mr
q
73
Long-Run Equilibrium for Monopolistic Competition.
priceAC priceMC profits 0 price is not at
the minimum point of AC curve.
MC
AC
p
d
mr

q
74
Measuring Waste from Imperfect Competition
We can measure the efficiency loss
from imperfect competition by looking at consumer
surplus. If the industry could be competitive,
then price is set where supply (representing MC)
equals demand.
75
Competitive Solution
Consumer Surplus
MC
AC
p
MR
d
q
76
Monopoly Solution
Consumer Surplus
MC
AC
pm
pc
MR
d
qm
qc
77
Monopoly Solution
Consumer Surplus plus extra profits. Some of
the lost area of consumer surplus goes to
monopoly profits.
MC

pm
pc
MR
d
qc
qm
78
Dead-Weight Loss
The orange triangle is dead-weight loss. This
area of former consumer surplus does not go into
profits to the monopoly. It is just lost.
MC
pm
pc
MR
d
qc
qm
79
Empirical Studies of Costs of Monopolies
Economists have measured the dead-weight loss of
imperfect competition in the U.S. Recent studies
have found the loss to be between 0.5 and 2 of
GNP. It is also important to remember that
imperfect competition can promote innovation
and discovery. Also, the cost structure of an
industry could lead to higher prices if there
were many firms.
80
Public Goods and Tax Policy
81
Government Provisionof Public Goods

• Public Goods versus Private Goods
• Public Good
• A good or service that, to at least some degree,
  is both non-rival and non-excludable
• Note not all goods provided by the government
  are "public goods."

82
Government Provisionof Public Goods

• Public Goods versus Private Goods
• Non-rival Good
• A good whose consumption by one person does not
  diminish its availability for others
• Non-excludable Good
• A good that is difficult, or costly, to exclude
  non-payers from consuming

83
Government Provisionof Public Goods

• Pure public goods are usually provided by
  government because
• For-profit private firms would find it difficult
  to recover their costs of production.
• Since the MC of serving additional users is zero
  once the good has been produced, charging for the
  good would be inefficient.

84
Government Provisionof Public Goods

• Public Goods versus Private Goods
• Collective Good
• A good or service that, to at least some degree,
  is non-rival but excludable
• Pure Private Good
• One for which non-payers can easily be excluded
  and for which each unit consumed by one person
  means one less unit available for others

85
Government Provisionof Public Goods

• Public Goods versus Private Goods
• Pure Commons Good
• One for which non-payers cannot easily be
  excluded and for which each unit consumed by one
  person means one less unit available for others

86
Types of Goods

• Private excludable and rival (if I consume it,
  you can't, and it is easy to keep non-payers from
  consuming. Example chocolate chip cookie)
• Public non-excludable and non-rival (my using
  the good does not reduce it, and it is difficult
  to keep non-payers from benefitting. Example
  law enforcement)

87
Types of Goods

• Commons non-excludable and rival (if I consume
  it, you can't, and it is difficult to keep
  non-payers from consuming. Example commonly
  held grazing lands)
• Collective excludable and non-rival (my using
  the good does not reduce it, and it is easy to
  keep non-payers from benefitting. Example
  telephone service)

88
The Classification of Private, Public, and Hybrid
Goods
Nonrival
Low
High
Low
High
High
High Low
Low
Nonexcludable
89
Public or private good?

• Some goods have some excludable and some
  non-excludable benefits.
• Example health care, education
• These goods have strong positive externalities
  but some of the benefits are excludable.
• For example, if Jim gets a flu shot and John
  doesn't, John won't get the flu from Jim but he
  might get it from someone else.

90
Public or private goods?

• Some goods are non-rival up to a point, but once
  a certain use level is exceeded, the benefits per
  user start to decrease.
• Example parks, libraries

91
Government Provisionof Public Goods

• Public Goods versus Private Goods
• A pure public good should be provided by the
  government only when the benefit exceeds the
  cost.
• The cost of the public good is the sum of the
  explicit and implicit costs incurred to produce
  it.

92
Government Provisionof Public Goods

• Public Goods versus Private Goods
• The benefit of the public good is the sum of the
  reservation prices of all people who want the
  good.

93
Government Provisionof Public Goods

• Paying for Public Goods
• Not everyone benefits equally from a public good
  or service.
• One way to pay for the public good or service is
  to tax people in proportion to their willingness
  to pay, but that is normally not known.
• Another way is to use a head tax and people are
  taxed an equal dollar amount.
• A proportional tax can be used and people pay a
  percent of their income.
• A progressive tax can be used and people pay a
  higher percentage of their income as their income
  rises.
• Because willingness to pay is often related to
  income, voters are more likely to support paying
  for public goods with a proportional or
  progressive tax, rather than a head tax.