Goolsbee 2e Solutions Manual Ch09 PDF

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Market Power and Monopoly

9

1. People are always complaining about Facebook: It changed the way its news feed works, the privacy settings are awful, there are too many game notifi cations, and so on. Recognizing dissatisfaction with Facebook, Google tried three times to enter the social networking market, first with Buzz, then with Wave, and now with Google Plus. Users say that the Google Plus platform is far superior to Facebook’s, yet Google Plus appears to be failing. Explain why consumers might reject a superior product for an inferior one in a market like this. 1. Facebook is a network good; that is, a good whose value to a consumer increases with the number of other consumers of the product. As such, Facebook users face very high switching costs, which users are not willing to swallow to switch to a superior product. 2. Consumers in Carlandia are willing to purchase up Costs to 100,000 cars each year. Suppose the long-run ($/unit) average cost curve for auto producers in Carlandia $40,000 looks like that shown in the figure on the right. 30,000 a. If the supply side of Carlandia’s auto market has 10 identical fi rms operating, what is the 20,000 lowest potential price that consumers might be 10,000 LAC able to purchase a car for? b. If the supply side of Carlandia’s auto market Quantity 0 10 20 30 40 50 60 70 80 90 100 is served by a monopolist, what is the lowest (thousands) potential price that consumers might be able to purchase a car for? c. Conventional wisdom suggests that competition is preferred to monopoly. Do your answers to (a) and (b) support this widely held view? d. Suppose the car market in Carlandia is served by a monopolist. One day, fed up with the mediocre quality of the existing supplier’s offerings, a resident decides to open a competing car company. What are the new company’s chances of lasting in this industry? Explain your reasoning. 2. a. With 10 identical firms supplying a market for 100,000 cars, each firm would produce 10,000 cars, resulting in an average total cost of $30,000 per car. This is the minimum price that consumers would have to pay in order to keep the car manufacturers in business. b. A monopolist could supply all 100,000 cars, bringing the average total cost (and therefore the lowest potential price) down to $10,000. c. The monopoly outcome results in fewer resources used to manufacture each car, and therefore is more efficient on the production side. However, there could be an inefficiency due to the deadweight loss resulting from monopoly pricing. d. A new entrant would be at a cost disadvantage because they would be starting at a lower quantity and therefore at a higher point on the average total cost curve. 3. Identify and explain the sources of market power for each case listed below: a. In the early 1990s, the DeBeers diamond cartel controlled almost all of the world’s rough diamond production. b. Microsoft’s Word has a virtual monopoly in word processing. c. Union Pacific dominates the rail shipping market in the north central United States. d. In Louisiana, people must pass a licensing test before they can arrange flowers. 3. a. b. c. d.

DeBeers had control of a key input because of its nearly exclusive ownership of diamond mines. Microsoft’s market power arises from switching costs associated with the network effects of its software. The substantial economies of scale in railroads allow Union Pacific to operate as a natural monopoly. The licensing requirement is a form of government regulation that creates a barrier to entry.

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4. Indicate whether the following statements are true or false, and then explain your answers: a. The marginal revenue from selling another unit of eggs can never be higher than the price of eggs. b. Because the price a seller charges is always greater than $0, the marginal revenue from selling another unit must also be greater than $0. 4. a. True. There are two effects that occur when a firm sells an additional unit of output. The first effect is the additional revenue generated from selling another egg at the now lower price, which increases revenue. The second effect occurs because the incremental unit drives down the market price for all the units in the market. This second effect is a negative number given a downward-sloping demand curve. Overall, the first effect equals the price. Since the second effect is negative, the sum of the two effects—that is, the marginal revenue of selling the additional unit—can never be higher than the price when demand is downward-sloping. △P Q. The change in price corresponding to a change in quantity, △P/△Q, is a b. False. Recall that MR = P + _ △Q measure of how steep the demand curve is. When the demand curve is really steep, price falls significantly in response to an increase in output. △P/△Q is a large negative number in this case. This will tend to make MR smaller and it can even result in MR being negative.

( )

*5. Consider the demand curve for otter food shown below: Price ($/unit) $8 7 6 5 4 3 2 1 0

D 1

2

3

4

5

6

7

8

Quantity of otter food

a. Indicate the area representing the total revenue Oscar the otter food seller would receive if he chose a price of $6. b. On the same graph, indicate the area representing the total revenue Oscar the seller would receive if he chose a price of $5. c. You should now have added two rectangles to your graph; however, because of some overlap, it actually appears that you’ve added three. One of the three is common to both scenarios above. The other two (smaller) rectangles are specifi c to scenario (a) or scenario (b). Label each rectangle with “A,” “B,” or “both” to indicate which scenario each rectangle belongs to. d. Indicate what happens (gain or loss) to rectangle A as Oscar reduces his price from $6 to $5. Why? e. Indicate what happens (gain or loss) to rectangle B as Oscar reduces his price from $6 to $5. Why? f. Calculate the area of rectangle A and the area of rectangle B. Then, subtract the area of A from the area of B. g. Calculate the marginal revenue Oscar receives when he sells a 4th unit, by subtracting the total revenue from selling 3 units from the total revenue from selling 4 units. Does your answer agree with the number you calculated in (f )? Explain. 5. a., b. and c. d. As Oscar reduces his price from $6 to $5, the rectangle A represents the loss. This is the revenue lost from decreasing the price. e. As Oscar reduces his price from $6 to $5, the rectangle B represents the gain. This is the revenue gained from decreasing the price and selling more units. f. The area of rectangle A is

Price ($/unit)

($6 – $5) × 3 = $3 The area of rectangle B is $5 × (4 – 3) = $5 Subtracting area A from area B, we obtain $5 – $3 = $2.

$8 7 6 5 4 3 2 1 0

Total revenue at price $6 Total revenue at price $5

A Both

B D

1

2

3

4

5

6

7

8

Quantity of otter food

Market Power and Monopoly

Chapter 9

g. The marginal revenue from selling a 4th unit is MR = TR B – TR A = ($5 × 4) – ($6 × 3) = $2 Therefore, the result corresponds to the value obtained in (f ).

6. In Cleveland, Clive sells 15 cloves at a price of $5 each. If Clive lowers his price by 10%, to $4.50 per clove, he will sell 16, or 6.67% more. In Dallas, Delores sells 15 cloves for $5 each. If Delores lowers her price by 2%, to $4.90, she will sell 16 cloves, or 6.67% more. a. Classify the demand curves that Clive and Delores face as elastic or inelastic. b. Determine the marginal revenue of the 16th unit for Clive. Then, compute the marginal revenue of the 16th unit for Delores. c. How does the marginal revenue received by a seller depend on the price elasticity of demand? Explain your answer. 6. a. Clive’s price elasticity of demand equals 6.67% 2 ≈ – 0.67 _ = –  _ –10%

3

Therefore, Clive faces a relatively inelastic demand curve. Delores’s price elasticity of demand equals 6.67% 10 ≈ – 3.33 _ = –  _ –2%

3

Therefore, Delores faces a relatively elastic demand curve. b. The marginal revenue of the 16th unit for Clive is ($16 × 4.5) – ($15 × 5) = $72 – $75 = – $3 The marginal revenue of the 16th unit for Delores is ($16 × 4.9) – ($15 × 5) = $78.4 – $75 = $3.4 c. If demand is inelastic, then marginal revenue will be negative: In order to sell an extra unit, the firm would have to lower the price so much that the loss in revenue on the non-incremental units would outweigh the gain from selling the incremental unit. If demand is elastic, then marginal revenue will be positive because the additional unit would not drive down the price so much.

7. In the chapter, we noted that the marginal revenue a seller receives can be expressed as MR = P + (ΔP/ΔQ) × Q. a. Using this formula as a starting point, show that marginal revenue can be expressed as MR = P(1 + 1/E D), where E D is the price elasticity of demand. b. Using your knowledge about the price elasticity of demand, explain why the marginal revenue a fi rm with market power receives must always be less than the price. c. Using your knowledge of the price elasticity of demand, explain why the marginal revenue a perfectly competitive firm receives must be equal to the price. 7. a.

( ) △Q = P + ( _) △P

△P × Q MR = P + _ △Q –1

×Q

Now, multiply the second term by P/P, which is equivalent to 1: /Q _ ( △Q △ P /P ) 1 = P (1 + _ E )

MR = P +

D

–1

× P = P + (E D)–1 × P

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b. Since the price elasticity of demand is always less than or equal to 0, the term in parentheses is always less than 1, and the marginal revenue must be less than the price P. c. A perfectly competitive fi rm faces a perfectly elastic demand curve; thus, DEequals –∞, which implies MR = P.

8. Juanita maintains the only greenhouse in isolated Point Barrow, Alaska, and therefore has a monopoly on the sale of fresh flowers. Her hired-gun statistician estimates that the elasticity of demand for her fl owers is –0.5. Explain intuitively how you know that Juanita cannot be maximizing profits. (Hint: Think about total revenue and total costs.) 8. If a monopolist is operating at a point where demand is inelastic, then total revenue would actually increase with an increase in price. Because Juanita is operating at a point where the absolute value of elasticity is less than 1, she could raise her price and see an increase in total revenue while at the same time lowering her costs due to selling a smaller quantity of fl owers.

. 9. The inverse demand for fresh fl owers in Point Barrow, Alaska, is given by P = 10 – .01dQ a. Use the demand function above to derive the associated marginal revenue function. (In other words, express marginal revenue as a function of Q.) b. At what quantity does marginal revenue = 0? c. What is special about a situation where MR = 0? (Hint: You may want to graph the demand and marginal revenue curves, and incorporate what you learned about elasticity in Chapter 2.) 9. a. Double the coeffi cient on Qd to arrive at MR = 10 – .02Qd b. Set MR equal to 0: 10 − 0.02Q d = 0 10 = 0.02Qd Q d = 500 c. Total revenue is maximized when marginal revenue equals zero.

*10. Consider the graph below, which illustrates the demand for Fluff. Fluff can be produced at a constant marginal and average total cost of $4 per case. Price ($/case) $20

4

MC D

0

100

Quantity of Fluff (cases)

a. Draw in a carefully constructed marginal revenue curve. b. Apply the MR = MC rule to determine the profit-maximizing level of output. What price must the monopolist charge to maximize profit? c. Calculate the profi t earned by the monopolist. d. The slope of the demand curve indicates that in order to sell one more unit, the price must fall by 20 cents. Verify that the seller cannot increase profit by reducing price and selling slightly more. e. The slope of the demand curve indicates that if the price of Fluff increases by 20 cents, consumers will buy one less unit. Verify that the seller cannot increase profit by increasing price and selling slightly less.

Market Power and Monopoly

Chapter 9

10. a. The inverse demand function is P = 20 – 0.2Q Find MR by doubling the coeffi cient on Q in the inverse demand function. MR = 20 – 0.4Q Price ($/case) $20

4

MC MR

0

50

D 100

Quantity of Fluff (cases)

b. Applying the MR = MC rule, we get 20 – 0.4Q = 4 Q = 40 The profi t-maximizing level of output is 40. The price that the monopolist must charge to maximize profi t is P = 20 – (0.2 × 40) = $12 c. The profit earned by the monopolist is π = TR – TC = ($12 × 40) – ($4 × 40) = $320 d. Suppose that the seller decreases the price by 20 cents to sell one more unit of the good. The profi t becomes π = TR – TC = ($11.80 × 41) – ($4 × 41) = $483.8 – $164 = $319.80 e. Suppose that the seller increases the price by 20 cents and sells one less unit of the good. The profit becomes π = TR – TC = ($12.20 × 39) – ($4 × 39) = $319.80

*11. Irwin is a monopoly seller of specialty bearings. Price Consider the graph to the right, which illustrates the ($/dozen) demand and marginal revenue curves for Irwin’s 30-weight ball bearings, along with the marginal and MC ATC average total costs of producing bearings: a. Find the monopolist’s profi t-maximizing level of $100 output. b. Determine the price the monopolist should charge 60 to maximize profi t. c. Draw an appropriate rectangle on your graph to represent the total revenue the seller receives from MR D selling the profi t-maximizing quantity of bearings at the profi t-maximizing price. 0 60 100 130 150 170 d. Draw an appropriate rectangle on your graph to Quantity of bearings(dozens) represent the total cost of producing ball bearings at the profi t-maximizing quantity. e. The difference in the areas you drew in (c) and (d) represents profit. Calculate the profit Irwin earns from selling 30-weight ball bearings.

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11. a. The monopolist will maximize its profi t by producing the level of output at which MR = MC, that is, 100 dozen bearings. b. The monopolist should charge $100 per dozen to maximize profi t. c. Price ($/dozen)

Total revenue MC

ATC

$100 60

MR 0

D

60 100 130 150 170 Quantity of bearings(dozens)

d.

Price ($/dozen) MC

ATC

$100 60 Total cost MR 0

D

60 100 130 150 170 Quantity of bearings(dozens)

e. The profi t is π = TR – TC = (100 × $100) – (100 × $60) = $4,000

*12. Suppose that the demand for bentonite is given by Q = 40 – 0.5P, where Q is in tons of bentonite per day and P is the price per ton. Bentonite is produced by a monopolist at a constant marginal and average total cost of $10 per ton. a. Derive the inverse demand and marginal revenue curves faced by the monopolist. b. Equate marginal cost and marginal revenue to determine the profi t-maximizing level of output. c. Find the profi t-maximizing price by plugging the ideal quantity back into the demand curve. d. How would your answer change if marginal cost were instead given by MC = 20 + Q? 12. a. The inverse demand curve is Q = 40 – 0.5P P = 80 – 2Q The marginal revenue is MR = 80 – 4Q b. MR = 80 – 4Q = 10 = MC 4Q = 70 Q = 17.5 The profi t-maximizing level of output is 17.5 tons of bentonite.

Market Power and Monopoly

Chapter 9

c. The profit-maximizing price is 17.5 = 40 – 0.5P 0.5P = 40 – 17.5 P = $45 d. If the marginal cost is 20 + Q, the profit-maximizing quantity is MR = 80 – 4Q = 20 + Q = MC 5Q = 60 Q = 12 The profi t-maximizing price is 12 = 40 – 0.5P P = $56

13. Suppose that econometricians at Hallmark Cards determine that the price elasticity of demand for greeting cards is– 2. a. If Hallmark’s marginal cost of producing cards is constant and equal to $1.00, use the Lerner index to determine what price Hallmark should charge to maximize profit. b. Hallmark hires you to estimate the price elasticity of demand faced by its archrival, American Greetings. Hallmark estimates that American’s marginal cost of producing a greeting card is $1.22. You note that American’s cards sell for an average of $3.25. Assuming that American Greetings is maximizing profi t, calculate their price elasticity of demand. 13. a. Using the Lerner index, we get P – MC 1 _ = – _ P ED 1 P – 1 _ = – _ –2 P

P – 1 = 0.5P P = $2 The profi t-maximizing price is $2. (P – MC) _ b. At the profi t-maximizing point,_ = –1 P ED substitute the given values into the formula: (3.25 – 1.22) 1 _ = – _ 3.25

ED 2.03 1 _ = – _ 3.25 ED

0.625E D = –1 ED = –1.6

14. Many industry-wide studies of the elasticity of demand for cigarettes (an industry dominated by a few fi rms with tremendous market power) indicate a price elasticity near –  0.5. Yet, our study of market power tells us that a fi rm with any market power at all should never operate at a point on its demand curve where demand is inelastic. How can you reconcile these apparently contradictory statements? 14. As we learned in an earlier chapter, elasticity of demand is directly related to the number of substitutes that are available. The fewer substitutes there are, the more inelastic demand tends to be. By definition, an analysis at the industry level signifi cantly decreases the number of substitutes available and is, therefore, likely to indicate a price elasticity of demand that is low (in absolute value) and, perhaps, even less than 1 (in absolute terms). The price elasticity of demand for each individual firm is likely to be higher, as consumers can substitute between fi rms.

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15. When it comes to CD sales, country artist Taylor Swift is twice as popular as Carrie Underwood, and at least four times as popular as Blake Shelton. Yet all of their albums retail for the same price. Does this suggest that music producers are failing to maximize profits? (Hint: Make the reasonable assumption that the marginal cost of producing a CD for any artist is a constant $2. Then, try to construct a graphical example in which very different demand curves produce the same price.) 15. No, this does not suggest a failure to maximize profi t. The figure shows two different demand curves, each with an associated marginal revenue curve. You can fi nd the profit-maximizing point for either curve by setting MR = MC and identifying the corresponding price. D1 reflects a lower level of demand with lower elasticity than D2. On either curve, however, the profi t-maximizing price (P) is the same. The market for Taylor Swift may be larger than for other artists, but the other artists may have more devoted followers with a relatively inelastic demand. Price MR1 D1 P 2

MR2

D2 MC = 2

Quantity

16. Suppose that a monopolistic seller of designer handbags faces the following inverse demand curve: P = 50 – 0.4Q. The seller can produce handbags for a constant marginal and average total cost of $10. a. Calculate the profi t-maximizing price for this seller. b. Suppose the government levies a $4 tax per unit on sellers of handbags. Calculate how this tax will affect the price the monopolist charges its customers. c. Who bears the burden of this tax? 16. a. Find MR by doubling the coeffi cient on Q in the inverse demand function. MR = 50 – 0.8Q The profi...