ECON 200.

Introduction to Microeconomics Homework 5 Part II

Name:________________________________________

[Multiple Choice]

1. A firm is a natural monopoly if it exhibits the following as its output increases: (d)
a. decreasing marginal revenue
b. increasing marginal cost
c. decreasing average revenue
d. decreasing average total cost

2. For a profit-maximizing monopoly that charges the same price to all consumers, what is the
relationship between price P, marginal revenue MR, and marginal cost MC? (b)
a. P = MR and MR = MC.
b. P > MR and MR = MC.
c. P = MR and MR > MC.
d. P > MR and MR > MC.

3. Compared to the social optimum, a monopoly firm chooses (a)

a. a quantity that is too low and a price that is too high.
b. a quantity that is too high and a price that is too low.
c. a quantity and a price that are both too high.
d. a quantity and a price that are both too low

4. The deadweight loss from monopoly arises because (b)

a. the monopoly firm makes higher profits than a competitive firm would.
b. some potential consumers who forgo buying the good value it more than its marginal cost.
c. consumers who buy the good have to pay more than marginal cost, reducing their consumer
surplus.
d. the monopoly firm chooses a quantity that fails to equate price and average revenue.

5. Which of the following goods best fits the definition of monopolistic competition? (d)
a. wheat
b. tap water
c. crude oil
d. soft drinks

6. What is true of a monopolistically competitive market in long-run equilibrium? (a)

a. Price is greater than marginal cost.
b. Price is equal to marginal revenue.
c. Firms make positive economic profits.
d. Firms produce at the minimum of average total cost.
[Short Answer]

1. A publisher faces the following demand schedule for the next novel from one of its popular authors:

Price Quantity
Demanded
$100 0 novels
90 100,000
80 200,000
70 300,000
60 400,000
50 500,000
40 600,000
30 700,000
20 800,000
10 900,000
0 1000,000

The author is paid $2 million to write the book, and the marginal cost of publishing the book is a
constant $10 per book.

a. Compute total revenue, total cost, and profit at each quantity. What quantity would a profit-
maximizing publisher choose? What price would it charge?

The following table shows revenue, costs, and profits:

Price Quantity Total Marginal Total Cost Profit

Revenue Revenue
$100 0 $0 ---- $2,000,000 $-2,000,000
90 100,000 9,000,000 $90 3,000,000 6,000,000
80 200,000 16,000,000 70 4,000,000 12,000,000
70 300,000 21,000,000 50 5,000,000 16,000,000
60 400,000 24,000,000 30 6,000,000 18,000,000
50 500,000 25,000,000 10 7,000,000 18,000,000
40 600,000 24,000,000 -10 8,000,000 16,000,000
30 700,000 21,000,000 -30 9,000,000 12,000,000
20 800,000 16,000,000 -50 10,000,000 6,000,000
10 900,000 9,000,000 -70 11,000,000 -2,000,000
0 1,000,000 0 -90 12,000,000 -12,000,000

A profit-maximizing publisher would choose a quantity of 400,000 at a price of $60 or a quantity

of 500,000 at a price of $50; both combinations would lead to profits of $18 million

b. Compute marginal revenue. (Recall that MR =dTR/dQ.) How does marginal revenue compare to the
price? Explain.
Marginal revenue is less than price. Price falls when quantity rises because the demand curve
slopes downward, but marginal revenue falls even more than price because the firm loses revenue on all
the units of the good sold when it lowers the price
c. Graph the marginal-revenue, marginal-cost, and demand curves. At what quantity do the marginal-
revenue and marginal-cost curves cross? What does this signify?
The figure shows the marginal-revenue, marginal-cost, and demand curves. The marginal-
revenue and marginal-cost curves cross between quantities of 400,000 and 500,000. This signifies that
the firm maximizes profits in that region

d. In your graph, shade in the deadweight loss. Explain in words what this means.
The area of deadweight loss is marked “DWL” in the figure. Deadweight loss means that the
total surplus in the economy is less than it would be if the market were competitive, because the
monopolist produces less than the socially efficient level of output

e. If the author were paid $3 million instead of $2 million to write the book, how would this affect the
publisher’s decision regarding what price to charge? Explain.
If the author were paid $3 million instead of $2 million, the publisher would not change the
price, because there would be no change in marginal cost or marginal revenue. The only thing that
would be affected would be the firm’s profit, which would fall

f. Suppose the publisher was not profit-maximizing but was concerned with maximizing economic
efficiency. What price would it charge for the book? How much profit would it make at this price?
To maximize economic efficiency, the publisher would set the price at $10 per book, because
that is the marginal cost of the book. At that price, the publisher would have negative profits equal to
the amount paid to the author
2. A small town is served by many competing supermarkets, which have the same constant marginal
cost.

a. Using a diagram of the market for groceries, show the consumer surplus, producer surplus, and total
surplus.
The figure illustrates the market for groceries when there are many competing supermarkets
with constant marginal cost. Output is QC, price is PC, consumer surplus is area A, producer surplus is
zero, and total surplus is area A

b. Now suppose that the independent supermarkets combine into one chain. Using a new diagram,
show the new consumer surplus, producer surplus, and total surplus. Relative to the competitive market,
what is the transfer from consumers to producers? What is the deadweight loss?
The figure illustrates the new situation when the supermarkets merge. Quantity declines from
QC to QM and price rises to PM. Consumer surplus falls by areas D + E + F to areas B + C. Producer surplus
becomes areas D + E, and total surplus is areas B + C + D + E. Consumers transfer the amount of areas D
+ E to producers and the deadweight loss is area F
3. Johnny Rockabilly has just finished recording his latest CD. His record company’s marketing
department determines that the demand for the CD is as follows:

Price Number of
CDs
$24 10,000
22 20,000
20 30,000
18 40,000
16 50,000
14 60,000

The company can produce the CD with no fixed cost and a variable cost of $5 per CD.

a. Find total revenue for quantity equal to 10,000, 20,000, and so on. What is the marginal revenue for
each 10,000 increase in the quantity sold?

The following table shows total revenue and marginal revenue for each price and quantity sold:

Price Quantity Total Marginal Total Profit

Revenue Revenue Cost
24 10,000 $240,000 ---- $50,000 $190,000
22 20,000 440,000 $20 100,000 340,000
20 30,000 600,000 16 150,000 450,000
18 40,000 720,000 12 200,000 520,000
16 50,000 800,000 8 250,000 550,000
14 60,000 840,000 4 300,000 540,000

b. What quantity of CDs would maximize profit? What would the price be? What would the profit be?
Profits are maximized at a quantity where MR=MC. The quantity at which MC is closest to MR
without exceeding it is 50,000 CDs at a price of $16. At that point, profit is $550,000

c. If you were Johnny’s agent, what recording fee would you advise Johnny to demand from the record
company? Why?
As Johnny's agent, you should recommend that he demand $550,000 from them, so he receives
all of the profit (rather than the record company). The firm would still choose to produce 50,000 CDs
because their marginal cost would not change
4. Larry, Curly, and Moe run the only saloon in town. Larry wants to sell as many drinks as possible
without losing money. Curly wants the saloon to bring in as much revenue as possible. Moe wants to
make the largest possible profits. Using a single diagram of the saloon’s demand curve and its cost
curves, show the price and quantity combinations favored by each of the three partners. Explain.
Larry wants to sell as many drinks as possible without losing money, so he wants to set quantity
where price (demand) equals average total cost, which occurs at quantity QL and price PL in Figure 6.
Curly wants to bring in as much revenue as possible, which occurs where marginal revenue equals zero,
at quantity QC and price PC. Moe wants to maximize profits, which occurs where marginal cost equals
marginal revenue, at quantity QM and price PM

5. Based on market research, a film production company in Ectenia obtains the following information
about the demand and production costs of its new DVD:
Demand: P = 1,000 - 10Q
Total Revenue: TR = 1,000Q - 10Q2
Marginal Revenue: MR = 1,000 - 20Q
Marginal Cost: MC = 100 + 10Q
where Q indicates the number of copies sold and P is the price in Ectenian dollars.

a. Find the price and quantity that maximize the company’s profit.

The figure shows the firm’s demand, marginal revenue, and marginal cost curves. The firm’s
profit is maximized at the output where marginal revenue is equal to marginal cost. Therefore, setting
the two equations equal, we get:

1,000 - 20Q = 100 + 10Q

900 = 30Q
Q = 30
P = 1,000 – 10Q = 700 Ectenian dollars
b. Find the price and quantity that would maximize social welfare.
Social welfare is maximized where price is equal to marginal cost

1,000 - 10Q = 100 + 10Q

900 = 20Q
Q = 45
P = 1,000 - 10Q =550 Ectenian dollars

c. Calculate the deadweight loss from monopoly.

The deadweight loss would be equal to (0.5)(15)(300) = 2,250 Ectenian dollars

6. For each of the following characteristics, say whether it describes a perfectly competitive firm, a
monopolistically competitive firm, both, or neither.

a. sells a product differentiated from that of its competitors

A firm in monopolistic competition sells a differentiated product from its competitors

b. has marginal revenue less than price

A firm in monopolistic competition has marginal revenue less than price

c. earns economic profit in the long run

Neither a firm in monopolistic competition nor in perfect competition earns economic profit in
the long run

d. produces at the minimum of average total cost in the long run

A firm in perfect competition produces at the minimum average total cost in the long run

e. equates marginal revenue and marginal cost

Both a firm in monopolistic competition and a firm in perfect competition equate marginal
revenue and marginal cost

f. charges a price above marginal cost

A firm in monopolistic competition charges a price above marginal cost
7. For each of the following characteristics, say whether it describes a monopoly firm, a monopolistically
competitive firm, both, or neither.

a. faces a downward-sloping demand curve

Both a firm in monopolistic competition and a monopoly firm.

b. has marginal revenue less than price

Both a firm in monopolistic competition and a monopoly firm

c. faces the entry of new firms selling similar products

A firm in monopolistic competition faces the entry of new firms selling similar products

d. earns economic profit in the long run

A monopoly firm earns economic profit in the long run

e. equates marginal revenue and marginal cost

Both a firm in monopolistic competition and a monopoly firm equate marginal revenue and
marginal cost

f. produces the socially efficient quantity of output

Neither a firm in monopolistic competition nor a monopoly firm produces the socially efficient
quantity of output

8. You are hired as the consultant to a monopolistically competitive firm. The firm reports the following
information about its price, marginal cost, and average total cost. Can the firm possibly be maximizing
profit? If not, what should it do to increase profit? If the firm is profit maximizing, is the firm in a long-
run equilibrium? If not, what will happen to restore long-run equilibrium?

a. P < MC, P > ATC

The firm is not maximizing profit. For a firm in monopolistic competition, price is greater than
marginal revenue. If price is below marginal cost, marginal revenue must be less than marginal cost.
Thus, the firm should reduce its output to increase its profit

b. P > MC, P < ATC

The firm may be maximizing profit if marginal revenue is equal to marginal cost. However, the
firm is not in long-run equilibrium because price is less than average total cost. In this case, firms will
exit the industry and the demand facing the remaining firms will rise until economic profit is zero

c. P = MC, P > ATC

The firm is not maximizing profit. For a firm in monopolistic competition, price is greater than
marginal revenue. If price is equal to marginal cost, marginal revenue must be less than marginal cost.
Thus, the firm should reduce its output to increase its profit

d. P > MC, P = ATC

The firm could be maximizing profit if marginal revenue is equal to marginal cost. The firm is in
long-run equilibrium because price is equal to average total cost. Therefore, the firm is earning zero
economic profit
9. Sparkle is one firm of many in the market for toothpaste, which is in long-run equilibrium.

a. Draw a diagram showing Sparkle’s demand curve, marginal-revenue curve, average-total-cost curve,
and marginal-cost curve. Label Sparkle’s profit-maximizing output and price.
The figure illustrates the market for Sparkle toothpaste in long-run equilibrium. The profit-
maximizing level of output is QM and the price is PM

b. What is Sparkle’s profit? Explain.

Sparkle's profit is zero, because at quantity QM, price equals average total cost

c. On your diagram, show the consumer surplus derived from the purchase of Sparkle toothpaste. Also
show the deadweight loss relative to the efficient level of output.
The consumer surplus from the purchase of Sparkle toothpaste is areas A + B. The efficient level
of output occurs where the demand curve intersects the marginal-cost curve, at QC. The deadweight loss
is area C, the area above marginal cost and below demand, from QM to QC

d. If the government forced Sparkle to produce the efficient level of output, what would happen to the
firm? What would happen to Sparkle’s customers?
If the government forced Sparkle to produce the efficient level of output, the firm would lose
money because average total cost would exceed price, so the firm would shut down. If that happened,
Sparkle's customers would earn no consumer surplus
10. Sleek Sneakers Co. is one of many firms in the market for shoes.

a. Assume that Sleek is currently earning short-run economic profit. On a correctly labeled diagram,
show Sleek’s profit-maximizing output and price, as well as the area representing profit.
The figure shows Sleek’s demand, marginal-revenue, marginal-cost, and average-total-cost
curves. The firm will maximize profit at an output level of Q * and a price of P *. The shaded are shows
the firm’s profits

b. What happens to Sleek’s price, output, and profit in the long run? Explain this change in words, and
show it on a new diagram.
In the long run, firms will enter, shifting the demand for Sleek’s product to the left. Its price and
output will fall. Firms will enter until profits are equal to zero
c. Suppose that over time consumers become more focused on stylistic differences among shoe brands.
How would this change in attitudes affect each firm’s price elasticity of demand? In the long run, how
will this change in demand affect Sleek’s price, output, and profit?
As consumers become more focused on the stylistic differences in brands, they will be less
focused on price. This will make the demand for each firm’s products more price inelastic. The demand
curves may become relatively steeper, allowing Sleek to charge a higher price. If these stylistic features
cannot be copied, they may serve as a barrier to entry and allow Sleek to earn profit in the long run

d. At the profit-maximizing price you identified in part (c), is Sleek’s demand curve elastic or inelastic?
Explain.
A firm in monopolistic competition produces where marginal revenue is greater than zero. This
means that firm must be operating on the elastic portion of its demand curve