Solutions for End of Chapter Questions

Chapter 8

Easy
1 A competitive industry has free entry and exit. Why does free exit matter? How would the
analysis change if it was costly to exit?
1 Free entry and exit allow us to think about each period separately. Once exit is costly, the firm
has to make a long-run decision from the outset. Even though profits are available during the
period after an entrant joins the industry, the entrant has to think about how many periods it
will be in the industry and whether the cumulative profit is sufficient to pay the costs of exit at
the end. Clearly, entrants may not bid profits down to zero in the long run. Existing firms
therefore have a degree of monopoly power. Perfect competition is no longer possible.

A-head: 8.1 Perfect competition

Learning objective: Perfect competition
Type: Conceptual understanding

2 We rarely see a perfectly competitive market because all the assumptions underlying
competitive markets rarely hold together in reality. Why do we need to study something that
may not exist in the real world?
2 We need to study perfectly competitive markets, for two main reasons. First, a perfectly
competitive market may be considered a good approximation for many markets. For example,
markets such as those for agricultural products, the stock market, the house market and so on.
Second, a perfectly competitive market can be seen as a benchmark, an almost ideal situation,
that we can use for comparison with other, possibly more realistic, market structures.

A-head: 8.1 Perfect competition

Learning objective: Perfect competition
Type: Conceptual understanding

3 Compare perfect competition and monopoly on the basis of:

(a) the number of buyers and sellers.
(b) the market supply curve.
(c) the nature of the good sold in the market.
3 (a) The number of buyers and sellers: A competitive market has many sellers and buyers while a
monopoly has a single seller and many buyers.
(b) The market supply curve: A o petiti e fi ’s sho t u supply u e is the short-run
marginal cost curve (SMC) above the point at which the SMC curve crosses the lowest point on
the short-run average variable cost curve (SAVC) curve. A monopolist does not have a supply
curve independent of demand conditions. A monopolist simultaneously examines demand and
cost to decide how much to produce and what to charge.
(c) The nature of the good sold in the market: Perfectly competitive firms sell identical or
homogeneous goods that can be substituted for each other, while a monopolist may sell a good
for which there are no close substitutes.

A-head: 8.1 Perfect competition, 8.5 Pure monopoly: the opposite limiting case
Learning objective: Perfect competition, Pure monopoly
Type: Conceptual understanding

4 True or False: (a) In a monopoly market, the social welfare is always lower than in a competitive
market? (b) Price discrimination is likely to be most effective when the good being sold is a
standardized commodity. (c) A firm charges different prices to customers buying different
quantities. This is an example of third-degree price discrimination.
4 (a) True: A profit-maximizing monopolist produces at an output that is below and a price that is
above that which would produce the optimum allocation of resources.
(b) False: Price discrimination in a standardized commodity is unlikely to work. Those buying at
the low price resell to those paying the high price, undercutting price discrimination.
(c) False: Second-degree price discrimination occurs when customers who buy different
quantities are charged different unit prices. Third-degree price discrimination takes place when
the monopoly divides its customers into different groups according to some characteristics that
affect their demand, and charge each group a different price.

A-head: 8.7 Output and price under monopoly and competition, 8.8 A monopoly has no supply
curve
Learning objective: How output compares under monopoly and perfect competition, how price
dis i i atio affe ts a o opolist’s output a d p ofits
Type: Conceptual understanding

5 Common fallacies Why are these statements wrong? (a) Since competitive firms break even in
the long run, there is no incentive to be a competitive firm. (b) By breaking up monopolies, we
always get more output at a lower price.
5 (a) In the long run, competitive firms make zero economic profits. Normal profit, the minimum
necessary to reward the entrepreneur, is earned in a competitive market.
(b) Not necessarily: in a natural monopoly, economies of scale may be lost and therefore costs
and prices may rise.

A-head: 8.2 A perfectly competitive fi ’s supply de isio , 8. Natural monopoly

Learning objective: Perfect competition, Why a o opolist’s output e uates MC a d MR
Type: Conceptual understanding

Medium
6 The following table reports the data on total costs of a competitive firm. We know that the
market price is P = £44.

Q 1 2 3 4 5 6 7 8 9
TC 4 16 36 64 100 144 196 256 324

Find the marginal cost curve. In a graph, plot the marginal revenue and the marginal cost curves
and show the amount of output that the firm should produce.
6
Q TC MC
1 4
2 16 12
3 36 20
4 64 28
5 100 36
6 144 44
7 196 52
8 256 60
9 324 68

MC = MR at 6 units of output. This is the amount the firm should produce to maximize profits.

A-head: 8.2 A perfe tly o petitive fi ’s supply de isio

Learning objective: Why a perfectly competitive firm equates marginal cost and price
Type: Calculation, graphing

7 Draw a diagram showing a competitive industry in short-run equilibrium. Suppose this is the
wool industry. The development of artificial fibres reduces the demand for wool. (a) Show what
happens in the short run if all sheep farmers have identical costs. (b) What happens in the long
run if there are high-cost and low-cost sheep farmers in the industry?
7
(a) The demand curve shifts down, price falls to P1 and the firm reduces quantity to Q1. Firms lose
money in the short run, as the price is lower than average cost. However, revenue exceeds
variable costs as P1 > AVC, which helps them to pay off at least some of the fixed costs to which
they are committed in the short run.
(b) In the long run, higher-cost firms leave the industry. As they do so, price gradually rises and the
industry has fewer firms and a lower total output.

A-head: 8.4 Comparative statics for a competitive industry

Learning objective: Comparative static analysis of a competitive industry
Type: Graphing, application

8 The table shows the demand curve facing a monopolist who produces at a constant marginal
cost of £6. Calculate the mo opolist’s a gi al e e ue u e. What is the e uili iu output?
What is the equilibrium price?

Price (£) 8 7 6 5 4 3 2 1 0
Quantity 1 2 3 4 5 6 7 8 9
8
Q 1 2 3 4 5 6
P 8 7 6 5 4 3
TR 8 14 18 20 20 18
MR 8 6 4 2 0 −2

Monopolist has Q = 2, P = 7.

A-head: 8.6 Profit-maximizing output for a monopolist

Lea i g o je tive: Why a o opolist’s output e uates MC a d MR
Type: Calculation

9 The table shows the demand curve facing a monopolist who produces at a constant marginal
cost of £6.
 Price (£) 8 7 6 5 4 3 2 1 0
Quantity 1 2 3 4 5 6 7 8 9

Now suppose that, in addition to the constant marginal cost of £6, the monopolist has a fixed
cost of £2. How does this affect the o opolist’s output, p i e a d p ofits? Why?
9 A change in fixed costs has no effect on output providing the firm can still cover its variable
costs. The profit maximising output is determined by marginal costs and revenues, and marginal
cost is unaffected by a change in fixed costs. In this case, profits are still positive.

Q 1 2 3 4 5 6
P 8 7 6 5 4 3
TR 8 14 18 20 20 18
MR 8 6 4 2 0 −2

A-head: 8.6 Profit-maximizing output for a monopolist

Learning objective: Why a o opolist’s output e uates MC a d MR
Type: Conceptual understanding

10 A monopolist faces the following inverse market demand: P  50  Q . Suppose that the total
cost faced by the monopolist is TC  10Q . Find the profit maximizing quantity produced by the
monopolist. What about the price charged by the monopolist? Find the deadweight loss in the
market. Illustrate your answer in a diagram.

10 First construct a table, say for arbitrary quantities from 5 to 40 in fives, from which you can draw
demand and marginal revenue curves.

Q P (50 – Q) TR (P x Q) MR
5 45 225
10 40 400 35
15 35 525 25
20 30 600 15
25 25 625 5
30 20 600 -5
35 15 525 -15
40 10 400 -25

Plot the De a d a d MR u es o a g aph, e e e i g to plot the MR u e half a spa e a k

Since total cost is 10Q, average and marginal costs must both be 10. Add the AC/MC line,
ho izo tal at . Note that it osses the o opolist’s MR u e at a output of . F o this,
track to the demand curve for the price, which is 30.
A perfectly competitive industry would produce at B, with 40 units of output at a price of 10. By
restricting output to 20, the monopolist creates a social cost or deadweight loss represented by
the triangle ABC, since between 20 units and 40 units, social marginal benefit exceeds social
marginal cost and society would gain by expanding output by 20 units more. The o opolist’s
profits = £400 (20 units sold at a profit of 20 per unit = £400 per period.)

A-head: 8.6 Profit-maximizing output for a monopolist, 8.7 Output and price under monopoly and
competition
Learning objective: Why a o opolist’s output e uates MC a d MR, How output compares under
monopoly and perfect competition
Type: Calculation, graphing

11 The following table reports the total cost for a natural monopoly:
Q 1 2 3 4 5 6 7 8 9
TC 22 24 26 28 30 32 34 36 38
Find the average cost curve and plot it in a graph. What about the marginal cost curve? What is
the relationship between the two curves?
11
Q TC MC ATC
1 22 22
2 24 2 12
3 26 2 8.66
4 28 2 7
5 30 2 6
6 32 2 5.33
7 34 2 4.85
8 36 2 4.5
9 38 2 4.22

Usually the marginal cost (MC) curve cuts the average total cost (ATC) curve from below at its lowest
point. This is because when MC is below ATC then ATC is pulled downward, and when it is above
ATC, the ATC curve is pulled upwards.
In this example, MC is constant at 2. The ATC curve will continue to be pulled downwards towards
the MC curve, but will never quite reach it.
Note that a monopolist does not have a supply curve independent of demand conditions. A
monopolist examines demand and cost, determines the output where MC = MR and charges the
market clearing price according to demand at that output.

A-head: 8.10 Natural monopoly

Learning objective: Why a o opolist’s output e uates MC a d MR
Type: Calculation, graphing, interpretation

Hard

12 Consider a perfectly competitive firm that has a total cost of producing output given by:
TC  10Q  2Q 2 . The market price is P = 54. Find the profit maximizing quantity produced by
the firm.
12 In equilibrium in perfect competition TC = TR.
At Price =54, TR = 54Q
Equating TC = 54Q
54Q = 10Q + 2Q ²
44Q = 2Q²
44 = 2Q²/Q
44= 2Q
 Q = 22

Therefore, the profit maximizing output of the firm is 22 units per period.

A-head: 8.2 A pe fe tly o petitive fi ’s supply de isio

Learning objective: why a perfectly competitive firm equates marginal cost and price
Type: Calculation

13 Suppose that the total output produced in a competitive market is 200 units. Suppose there are
n identical firms in the market. Each firm then produces an amount 200/n. The total cost of a
2
 200 
TC   
single firm in the market is  n  . If the market price is P = 10, find the number of firms
active in the market.
13 In equilibrium in perfect competition TC = TR
At price P, TR = 200 x 10 =2000
Equating TC = 2000
(200/n)2 x n = 2000
200/n x 200/n x n =2000
40000/n = 2000
40000 = 2000n
20 = n
Therefore there are 20 firms in the industry.

A-head: 8.2 A pe fe tly o petitive fi ’s supply de isio

Learning objective: why a perfectly competitive firm equates marginal cost and price
Type: Calculation

14 A fi ’s a ket po e a e easu ed y its a ility to aise p i e a o e a gi al ost. Relati e

to the level of marginal cost, this measure is (P – MC)/MC. How do you expect this to be related
to the elasticity of de a d fo the o opolist’s output?
14 It turns out that the absolute value of the inverse of the price elasticity of demand PED equals (P
– MC)/MC. The more inelastic is the demand curve that it faces, the larger the monopoly power
of the firm. The easiest way to prove this is mathematically. MR = change in PQ = P + Q (dP/dQ)
where the second term is the reduction in existing revenue caused by having to cut prices to sell
more output. Noting that MC = MR at profit-maximizing output, we have MC/P = 1 + (1/PED).
Hence (MC – P)/P = 1/PED. Remember, price elasticities are negative; we can multiply both sides
by –1 to get the result. For readers without knowledge of calculus, remember this was a harder
question! We do not use calculus anywhere in the text. The intuitive idea that a more inelastic
demand curve allows a firm to raise prices more above marginal cost makes perfect sense even
without all the maths.

A-head: 8.6 Profit-maximizing output for a monopolist

Learning objective: Pure monopoly
Type: Interpretation