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Fifth homework assignment for prof roberts...

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Econ 130, Sec. 5 Fall 2019

Homework 5

Blake Saari 26437875

1. Each of the following statements is misguided. Explain what is wrong: a. It doesn’t hurt an unregulated monopolist to have its cost rise since the monopolist can simply raise its price to cover the extra costs. i. Monopolists only care about their bottom-line and profits. As a result, at a lower quantity produced, the average cost to produce the good will increase and effect the monopolist’s profits. Overall, if the monopolist’s costs rise, profits are likely to go down even if the price of the product increases due to a lower demand at the higher price. b. A regulated monopolist cannot benefit from an outward shift in demand curve since the regulator will not let the monopolist raise its price in response to the higher demand. i. Although the monopolist may not be able to raise their prices in response to an outward shift, the firm would be able to reap the benefits of a higher demand for their products and services. c. An effective way to regulate a price-discriminating monopolist is for the government to require the monopolist to charge the same price to all its customers. i. Forcing monopolists to sell their products for the same price to every consumer is virtually impossible. However, the government could encourage the development of a free market between consumers to exchange good between themselves in order to eliminate price discrimination effectively. d. If the demand curve is linear, then the elasticity of demand is the same at all prices. i. If the demand curve is linear, that does not mean that the elasticity of demand is the same at every price as we have no idea what the supply curve looks like in this instance. 2. Assume that the wine industry is perfectly competitive and that wine is a normal good. Each wine producer incurs fixed cost of $250/month. Currently there are 500 firms in the industry. Suppose that consumers’ average annual income is $55,000 per family. Trace these graphs onto your answer sheet. Or, if you are writing up your homework electronically, you can copy and an paste into a PowerPoint or some other software that will allow you to draw additional lines.

𝑆" SR 𝑆#SR

SLR

MR

P*

𝐷#

q =q 2

1

Q

1

Q

2

Suppose that the wine industry is in long-run equilibrium (Stage II equilibrium as described in class).

Econ 130, Sec. 5 Fall 2019

Homework 5

Blake Saari 26437875

a. Draw the marginal revenue curve (label it MR) of the individual wine producer in Graph 1.

b. Draw the market long-run supply curve label it SLR in Graph 2. c. Show the equilibrium price (label it P0), the firm’s output (q0), and market output (Q0) in the diagrams above. Now suppose that economic studies predict the consumers? Income will increase to $65,000 per year per family. d. What would you expect this change in income to do to the wine industry when the number of firms is fixed? Explain. Show the new equilibrium price (label it P1), the firm?s output (q1), the market output (Q1), and wine producer profits in the diagrams above. Indicate if the profits are positive, negative, or equal to zero. (Hint: To answer this question, you need to draw a short run supply curve in Graph 2. You can label this supply curve SSR.) i. If consumers’ income increases, the demand curve will shift to the right since wine is a normal good. While in a short-run market, prices will rise and give firms positive economic profits. e. What would you expect the change in income to do to the profits of firms in the long run if firms can enter and exit? What happens to the number of wine producers; does it remain at 500? Show the (new) long-run equilibrium price (label it P2), the firm’s output (q2), and market output (Q2) in the diagrams above. i. I can expect the income of firms to be dramatically reduced in the long run as firms have easy entry and exit into the market. As a result, the number of producers will be much higher, increasing competition and driving the price of the product and therefore profits lower. As a result, firms will continue to enter the market until economic profits return to zero again, resulting in firms producing the same amount that they did prior to the demand shift.] 3. Honolulu Waste Management (HWM) has a monopoly on the garbage pickup market in Honolulu. HWM’s costs are shown below.

Econ 130, Sec. 5 Fall 2019

Homework 5

Blake Saari 26437875

a. Given the costs of HWM and the demand curve given in the graph above, explain the most likely reason that HWM has a monopoly. i. A likely reason that HWM has a monopoly on the market is that the firm’s average cost is declining to the point where it intersects the demand curve. As a result, the market offers increasing returns to scale and is most efficient when a single firm is operating it. Therefore, HWM is a natural monopoly. b. What are the profit maximizing levels of output and price? Calculate the profits, consumers’ surplus, and deadweight loss at the profit-maximizing price. i. The profits maximizing level of output is 8, where marginal revenue equals marginal cost. At this quantity supplied, the price on the demand curve is $12, and with an average cost of 10 at Q=10, the firm receives $2 in economic profit for every unit. c. What is the socially optimal output and price? Calculate firm profits and consumers? surplus at the socially optimal price. i. The socially optimal output is at a quantity of 14 and a price of $6, or the point at which MC intersects the demand curve. At this level, the monopoly would have to accept a negative profit because the average cost of $7 is above the price. As a result, the firms profits would be -$14 with the consumer surplus triangle being below the demand curve and above the price. 1 ∗ 14 ∗ (20 − 6 ) = 7 ∗ 14 = $98 2

d. The government decides to regulate HWM by imposing a price ceiling of $8. Calculate the firm’s profits, consumers’ surplus, and deadweight loss under the regulated price ceiling. i. If the government imposes a price ceiling of $8, then the price will be the firms new marginal revenue and as a result, produce a quantity of 12 where $8 intersects the demand curve. In order to produce more, ther firm would have to lower its price further, but would wresult in negative marginal revenue. Firms Profit: At Q=12, AC ≈ $7.25, firms profit of $8-7.25=$0.75 per unit. Since Q=12, the firms profit is 9.00 # Consumer Surplus: ∗ (20 − 8) ∗ 12 = $72 3 Deadweight loss: (84-81) = $3 4. Hawaiian Electric Company (HECO) is a monopoly. Let us suppose that increasing returns to scale (IRTS) exist, such that the provision of electricity a natural monopoly.

Econ 130, Sec. 5 Fall 2019

Homework 5

Blake Saari 26437875

The relevant curves for electricity look like the graph below. Note that AC is falling because of IRTS, and that MC is below AC because AC is falling. Trace this graph onto your answer sheet.

a. Label the price and output that HECO would choose if it maximized profits. Label them Pm and Qm.

Pm

Qm

b. Suppose HECO were to price at marginal cost. Label the price and output that would result. Label them Pc and Qc.

Pc Qc

c. HECO would have negative profits if it priced at marginal cost. Show the area of loss on the graph.

Pc Qc

Econ 130, Sec. 5 Fall 2019

Homework 5

Blake Saari 26437875

d.

Pm

Pc Qm

Qc

e. Show the gain in consumer surplus that arises from lowering the price from Pm to Pa.

f. Show that the gain in consumer surplus exceeds the loss in profits to HECO

HECO’s Lost Profit

g. In addition to pricing too high, HECO does not keep costs as low as possible. Workers are paid higher than market wages as a way to subsidize them, and workers have little incentive to be as productive as possible. The AC curve is

Econ 130, Sec. 5 Fall 2019

Homework 5

Blake Saari 26437875

therefore higher than necessary. In the graph below, AC0 is the curve when costs are kept as low as possible; AC1 is the curve that represents HECO?s costs (including the high wages and less-than-fully productive workers). Trace this graph onto your answer sheet. i. The price and output that HECO will choose if the government forces it to price at its average cost (but the government cannot force it to keep costs as low as possible). ii. The loss of consumer surplus that arises because HECO does not keep costs as low as possible. 1. Regulators are unable to force HCEO to keep its costs at a minimum and as a result, the firm has virtually no incentive to keep their costs low as the company earns zero profit anyways. As a result, the government may be able to force suppliers to lower their prices in order to keep the firms costs as low as possible. h. Can you think of a way for the government to assure that costs are as low as possible? (There is no correct answer here.) Your answer should recognize that it is difficult for the government to determine market wages and is especially difficult to determine whether workers are fully productive. i. A government would be able to assure that costs are as low as possible by abolishing workers unions to keep the companies wages low and increase worker productivity. Regulators should also work with the firm’s suppliers to assist the company with getting their recourses for cheaper. i. Finally: HECO doesn’t have an incentive to maintain a high-quality service, which creates occasional power outages that can take a while to restore. Since HECO is compensated for their average cost regardless of the quality of service they provide, people have to live with an inferior service that sometimes imposes great costs on customers. Can you think of any way to correct this problem? (Again, there is no right answer. In fact, I haven’t even been able to think of one good solution. Do you have any ideas?) i. Although HECO doesn’t have an incentive to maintain a high-quality service, regulators at the federal, state and municipal level can fight for better or different service providers that will better serve their constituents. As a result, representatives need to work with their communities to fight for better service and quality....