Q1. Price/Output Equilibrium. Suppose Target Stores, Inc.

, sell RainAway, an innovative product with polymers used to coat the windshields of cars, planes, and boats. RainAway makes windshields and other such surfaces slick enough for rain to slide off easily. In the case of windshields, RainAway makes it possible to avoid the use of windshield wiper blades except during the most torrential downpours. During recent years, RainAway has used its unique windshield coating product to successfully exploited a small but profitable niche in the market. However, RainAway's monopoly position in this market niche is now threatened by a competitor's announcement of a new product with capabilities similar to those of the RainAway product. A. Complete the following table based on the RainAway product's price, output and costs per year:

Case Output (000)

0 1 2 3 4 5

Price

Total Revenue ($000)

14 13 12 11 10

Marginal Revenue ($000)

Total Cost ($000)

$ 1 13 25 36 44 55

Marginal Cost ($000)

$15

B. While RainAway still enjoys a monopoly position, what is their output, price, and profit at the profit-maximizing activity level? C. What is the output, price, and profit for this product if a monopolistically competitive equilibrium evolves in this market following the successful introduction of the competitor's product? (Assume similar cost conditions for each firm.) Answer A.

Case Output (000)

0 1 2 3 4 5

Price

Total Revenue ($000)

$ 0 14 26 36 44 50 14 13 12 11 10

Marginal Revenue ($000)

-$14 12 10 8 6

Total Cost ($000)

$ 1 13 25 36 44 55

Marginal Cost ($000)

-$12 12 11 8 11

$15

B. The profit-maximizing activity level is found where MR = MC. As a monopoly, MR = MC

= $12(000) at the Q = 2(000) activity level. This implies P = $13 and = TR TC = $26 $25 = $1(000) per year. C. The monopolistically competitive equilibrium occurs where MR = MC and zero excess profits are earned, and TR = TC. Here, MR = MC = $8(000) and TR = TC = $44(000) at Q = 4(000) units per year, with P = $11 and = TR TC = $0 per year.

Q2. Dominant Strategies. Suppose two competitors each face important strategic decisions where the payoff to each decision depends upon the reactions of the competitor. Firm A can choose either row in the payoff matrix defined below, whereas firm B can choose either column. For firm A the choice is either "up" or "down;" for firm B the choice is either "left" or "right." Notice that neither firm can unilaterally choose a given cell in the profit payoff matrix. The ultimate result of this one-shot, simultaneous-move game depends upon the choices made by both competitors. In this payoff matrix, strategic decisions made by firm A or firm B could signify decisions to offer a money-back guarantee, lower prices, offer free shipping, and so on. The first number in each cell is the profit payoff to firm A; the second number is the profit payoff to firm B. Firm B Firm A Competitive Strategy Up Down Left $6 million; $1 million $2 million; $2 million Right $4 million; $3.5 million $3 million; $3 million

A. Is there a dominant strategy for firm A? If so, what is it? B. Is there a dominant strategy for firm B? If so, what is it?

Answer
A. Yes, there is a dominant strategy for firm A. Notice that if firm B chooses "left," the highest payoff of $6 million can be achieved if Firm A chooses "up." On the other hand, if firm B chooses "right," the highest payoff of $4 million can be achieved if firm A chooses "up." Therefore, no matter what firm B decides to do, firm A comes out best by choosing "up." B. Yes, "right" is a dominant strategy for firm B. If firm A chooses "up," the highest payoff of $3.5 million can be achieved if firm B chooses "right." On the other hand, if firm A chooses "down" the highest payoff of $3 million can be achieved if firm B again chooses "right." No matter what firm A chooses, the highest payoff for firm B results if B chooses "right." Therefore, "right" is a dominant strategy for firm B.

Q3. Price Discrimination. The Fun-Land Amusement Park is a 40-acre fun park full of rides, shows, and shops. Fun-Land's marketing department segments its customer base into two parts: local patrons and tourists. Fun-Land assumes local patrons are more price sensitive than out-of-town tourists. Yearly demand and marginal revenue relations for overnight lodging services, Q, are as follows: Locals PL= $40 $0.0005QL MRL= TRL/ QL = $40 $0.001QL

Tourists PT= $50 $0.0004QT MRT= TRT/ QT = $50 $0.0008QT

Average variable costs for labor and materials are constant at $20 per unit. A.Assuming the company can discriminate in pricing between locals and tourist customers through coupons distributed to locals via local shops, calculate the profitmaximizing price, output, and total profit contribution levels. B.Calculate point price elasticities of demand for each customer class at the activity levels identified in part A. Are the differences in these elasticities consistent with your recommended price differential? Explain.

A. With price discrimination, profits are maximized by setting MR = MC in each market, where MC = AVC = $20 (because AVC is constant). Locals MRL $40 $0.001QL 0.001QL QL PL = MC = $20 = 20 = 20,000 = $40 $0.0005(20,000) = $30

Tourists MRT $50 $0.0008QT 0.0008QT QT PT = MC = $20 = 30 = 37,500 = $50 $0.0004(37,500) = $35

The profit contribution earned by the Fun-Land Amusement Park is: = PLQL + PTQ T AVC(QL + QT) = $30(20,000) + $35(37,500) $20(20,000 + 37,500) = $762,500

B.

Yes, a higher price for Tourist customers is consistent with the lower degree of price elasticity observed in that market.

Locals QL P = 80,000 2,000PL = QL/PL PL/QL

= 2,000 ($30/20,000) = 3 Tourists QT P = 125,000 2,500PT = QT/PT PT/QT

= 2,500 ($35/37,500) = 2.33

Q4. Theory of Regulation. The Badger Power & Light Company generates electricity, and in the process emits sulfur dioxide into the local atmosphere. As a concerned citizen, you are appalled at the aesthetic and environmental implications of the company's policies, as well as the potential health hazard to the local population. A. B. Pollution is a negative production externality and an example of market failure. What might you cite as reasons why markets fail? In analyzing remedies to the current situation, consider two general types of controls to limit pollution:

Regulations--licenses, permits, compulsory standards, and so on. Charges--excise taxes on polluting fuels (coal, oil, and so forth), pollution discharge taxes, and others. Review each of these methods of pollution control. 1. 2. Determine the incentive structure for the polluter under each form of control. Decide who pays for a clean environment under each form of control. (Note that each form of control has definite implications about who owns the property rights to the environment.) Defend a particular form of control on the basis of your analysis, including both efficiency and equity considerations.

3.

Sample Correct Answer

A.

Markets can fail due to:

(i) Structural problems: Fewness in the number of buyers and/or sellers.

(ii) Incentive problems: If some product benefit (cost) is not reflected in firm revenues (costs), then non-optimal production quantities and output prices will result due to improper firm incentives.

B.

Methods of pollution control:

(i) Incentive structure:

(a) Regulation: Incentive is to avoid regulation, be made a "special case." (b) Charges: Incentive is to reduce pollution in order to avoid charges.

(ii) Who pays for clean environment?

(a) Regulation: Company (its customers) pays to reduce pollution. (b) Charges: Company (its customers) pays to reduce pollution. again, society's right to a clean environment is implied.

(iii) Defense of the alternatives:

Efficiency considerations favor charges as a more efficient method of pollution control.

Equity considerations make the choice among pollution control methods less certain.

(a) Regulation: Insures due process, a day in court, for the polluter. (b) Charges: Polluter should pay full costs of production consumption.

Q5. Demand Estimation for Public Goods. Assume that students and nonstudents have revealed their group demands for secondary education, a public good, in the local school district as follows: P1 = $5,000 Q (Student demand)

P2 = $2,500 Q

(Nonstudent demand)

where P is price and Q is the number of student educated per year in the local school district. A. B. Calculate the total or aggregate demand for secondary education. The marginal cost of secondary education is given by the expression:

MC = $500 + $5Q

where MC is marginal cost and Q is again the number of students. Determine the socially optimal amount of publicly-supported secondary education in the local school district.

Sample Correct Answer

A.

Total or aggregate demand for public goods such as secondary education is determined by a vertical summation of individual student and nonstudent demand curves:

Total demand = P1 + P2 = $5,000 Q + $2,500 Q = $7,500 $2Q B. The socially optimal amount of publicly-supported secondary education in the local school district is determined by the intersection of demand and supply:

Demand = Supply

P1 + P2 = MC $7,500 $2Q = $500 + 5Q 7Q = 7,000

Q = 1,000

And,

P = $7,500 $2(1,000) = $5,500

(Demand)

P = $500 + $5(1,000) = $5,500

(Supply)