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Chapter 12 – Applied Problems

1. Higher unemployment caused by the recession and higher gasoline prices have contributed to a substantial
reduction during 2008 in the number of vehicles on roads, bridges, and in tunnels. According to The Wall Street
Journal (April 28, 2009), the reduction in demand for toll bridge and tunnel crossings created a serious revenue
problem for many cities. In New York, the number of vehicles traveling across bridges and through tunnels fell from
23.6 million in January 2008 to 21.9 million in January 2009. “That drop presents a challenge, because road tolls
subsidize MTA subways, which are more likely to be used as people get out of their cars.”* In an apparent attempt
to raise toll revenue, the MTA increased tolls by 10 percent on the nine crossings it controls.

a. Is MTA a monopolist in New York City? Do you think MTA possesses a high degree of market power? Why or why
not?

Certainly, MTA has a high degree of market power. This is because MTA is planning to increase the price of toll even
when the demand has fallen. This can happen only in case of monopolistic completion or monopoly when demand is
inelastic.

b. If the marginal cost of letting another vehicle cross a bridge or travel through a tunnel is nearly zero, how should
the MTA set tolls to maximize profit? To maximize toll revenue? How are these two objectives related?

If the marginal cost of letting another vehicle cross a bridge or travel through a tunnel is zero, the toll should charge
price slightly higher than the average cost. It can even charge different prices according to the vehicle size and thus
creating price differentiation. By price differentiation, MTA can earn major profits.

c. With the decrease in demand for bridge and tunnel crossings, what is the optimal way to adjust tolls: raise tolls,
lower tolls, or leave tolls unchanged? Explain carefully?

The optimal way would be hike price till it makes a profit. This is because the demand is inelastic and hiking prices will
not affect the demand to a great extent.

2. QuadPlex Cinema is the only movie theater in Idaho Falls. The nearest rival movie theater, the Cedar Bluff Twin,
is 35 miles away in Pocatello. Thus, QuadPlex Cinema possesses a degree of market power. Despite having market
power, QuadPlex Cinema is currently suffering losses. In a conversation with the owners of QuadPlex, the manager
of the movie theater made the following suggestions: “Since QuadPlex is a local monopoly, we should just increase
ticket prices until we make enough profit.”

a. Comment on this strategy.

Q. cinema enjoys high inelastic demand. Though it has monopoly power, high prices result in lower demand. The
monopolist enjoys high revenues till the cost has not increased, and if the cost increases, low demand at high prices
pose difficult problems to single price monopolist.

b How might the market power of QuadPlex Cinema be measured?

The market power of Q. cinemas can be measured by the elasticity of demand. If demand level does not decrease to
a great extent by a price increase, then there is inelastic demand.

c. What options should QuadPlex consider in the long run?

Instead of just increasing the price, the cinema could adopt a price differentiation strategy. It could charge different
prices according to the demand.
3. The El Dorado Star is the only newspaper in El Dorado, New Mexico. Certainly, the Star competes with The Wall
Street Journal, USA Today, and The New York Times for national news reporting, but the Star offers readers stories
of local interest, such as local news, weather, high-school sporting events, and so on. The El Dorado Star faces the
demand and cost schedules shown in the spreadsheet that follows:

(1) (2) (3)


Number of newspapers per day (Q) Price (P) Total cost per day (TC)
0 0 $2,000
1,000 $1.50 2,100
2,000 1.25 2,200
3,000 1.00 2,360
4,000 0.85 2,520
5,000 0.75 2,700
6,000 0.65 2,890
7,000 0.50 3,090
8,000 0.35 3,310
9,000 0.10 3,550

a. Create a spreadsheet using Microsoft Excel (or any other spreadsheet software) that matches the one above by
entering the output, price, and cost data given.

Same as table above.

b. Use the appropriate formulas to create three new columns (4, 5, and 6) in your spreadsheet for total revenue,
marginal revenue (MR), and marginal cost (MC), respectively. [Computation check: At Q = 3,000, MR = $0.50 and
MC = $0.16]. What price should the manager of the El Dorado Star charge? How many papers should be sold daily
to maximize profit?

TR = P x Q

MR = (TR2 – TR1)/(Q2 – Q1)

MC = (TC2 – TC1)/(Q2 – Q1)

(1)
(3) (4) (5) (6)
Number of (2)
Total Cost per Total Revenue Marginal Marginal Cost
newspapers per Price (P)
Day (TC) (TR) Revenue (MR) (MC)
day
0 0.00 2,000 0
1,000 1.50 2,100 1,500 1.50 0.10
2,000 1.25 2,200 2,500 1.00 0.10
3,000 1.00 2,360 3,000 0.50 0.16
4,000 0.85 2,520 3,400 0.40 0.16
5,000 0.75 2,700 3,750 0.35 0.18
6,000 0.65 2,890 3,900 0.15 0.19
7,000 0.50 3,090 3,500 -0.40 0.20
8,000 0.35 3,310 2,800 -0.70 0.22
9,000 0.10 3,550 900 -1.90 0.24

The profit is maximised when MC = MR. In the given case, MR and MC do not equal each other at any point, the nearest
they can reach is when MR = 0.35 and MC = 0.18. After this point, MC starts exceeding MR.

The maximization of output happens when Q = 5,000 and P = $0.75.


c. At the price and output level you answered in part b, is the El Dorado Star making the greatest possible amount
of total revenue? Is this what you expected? Explain why or why not.

The firm is making highest revenue when Q = 6,000. This is because monopolist does not work like competitive sellers.
They charge differential prices to attain maximum profits.

d. Use the appropriate formulas to create two new columns (7 and 8) for total profit and profit margin, respectively.
What is the maximum profit the El Dorado Star can earn? What is the maximum possible profit margin? Are profit
and profit margin maximized at the same point on demand?

(1) (3) (5)


(4) (6) (7) (8)
Number of (2) Total Cost Marginal
Total Marginal Total Profit
newspapers Price (P) per Day Revenue
Revenue (TR) Cost (MC) Profit Margin
per day (TC) (MR)
0 0.00 2,000 0
1,000 1.50 2,100 1,500 1.50 0.10 -600 -0.40
2,000 1.25 2,200 2,500 1.00 0.10 300 0.12
3,000 1.00 2,360 3,000 0.50 0.16 640 0.21
4,000 0.85 2,520 3,400 0.40 0.16 880 0.26
5,000 0.75 2,700 3,750 0.35 0.18 1,050 0.28
6,000 0.65 2,890 3,900 0.15 0.19 1,010 0.26
7,000 0.50 3,090 3,500 -0.40 0.20 410 0.12
8,000 0.35 3,310 2,800 -0.70 0.22 -510 -0.18
9,000 0.10 3,550 900 -1.90 0.24 -2,650 -2.94

Profit Margin and Total Profit are maximized at quantity 5,000.

e. What is the total fixed cost for the El Dorado Star? Create a new spreadsheet in which total fixed cost increases
to $5,000. What price should the manager charge? How many papers should be sold in the short run? What should
the owners of the Star do in the long run?

(1) (3) (5)


(4) (6) (7) (8)
Number of (2) Total Cost Marginal
Total Marginal Total Profit
newspapers Price (P) per Day Revenue
Revenue (TR) Cost (MC) Profit Margin
per day (TC) (MR)
0 0.00 2,000 0
1,000 1.50 7,100 1,500 1.50 0.10 -5,600 -3.73
2,000 1.25 7,200 2,500 1.00 0.10 -4,700 -1.88
3,000 1.00 7,360 3,000 0.50 0.16 -4,360 -1.45
4,000 0.85 7,520 3,400 0.40 0.16 -4,120 -1.21
5,000 0.75 7,700 3,750 0.35 0.18 -3,950 -1.05
6,000 0.65 7,890 3,900 0.15 0.19 -3,990 -1.02
7,000 0.50 8,090 3,500 -0.40 0.20 -4,590 -1.31
8,000 0.35 8,310 2,800 -0.70 0.22 -5,510 -1.97
9,000 0.10 8,550 900 -1.90 0.24 -7,650 -8.50

Though the marginal cost and revenue intersect at Q = 5,000, the profit margin is negative for all quantities.

- In short run, price is greater than average variable cost, so the firm should not shut down. Otherwise, the firm will
incur losses equal to fixed cost of $5,000.

- The fixed cost will spread over quantities in the long run, the profits will increase.
4. Tots-R-Us operates the only day-care center in an exclusive neighborhood just outside of Washington, D.C. Tots-
R-Us is making substantial economic profit, but the owners know that new day-care centers will soon learn of this
highly profitable market and attempt to enter the market. The owners decide to begin spending immediately a
rather large sum on advertising designed to decrease elasticity. Should they wait until new firms actually enter?
Explain how advertising can be employed to allow Tots-R-Us to keep price above average cost without encouraging
entry

The Market Power Theory of Advertising says established firms use advertising to create/raise entry barrier for new
entrants. Use of advertising helps the firm in creating brand value and differentiates its brand from other brands.
Advertising makes the consumers see the brand as slightly different product which cannot be substituted fully. This
makes it hard for new competitors to enter market and substitute the existing product.

It takes time to build brand loyalty so T-R-Us should not wait for new entrants to enter the market. They should start
advertising to create entry barrier for new entrants. If consumers are able to differentiate T-R-Us's service and consider
it as a different service (nit just Day care center), new entrants will find it difficult to create market presence. Also
product differentiation (say not just day care center or say special day care center, how T-RUs advertises its service
and how consumers recognize it) will allow T-R-Us to charge price more than new entrants can charge and so they can
keep their price above average cost. New entrants will have to spend heavily to create brand awareness which will
drive their cost up. They will not be able to charge high price and will find it difficult to break even.

5. Antitrust authorities at the Federal Trade Commission are reviewing your company’s recent merger with a rival
firm. The FTC is concerned that the merger of two rival firms in the same market will increase market power. A
hearing is scheduled for your company to present arguments that your firm has not increased its market power
through this merger. Can you do this? How? What evidence might you bring to the hearing?

“Market power” refers to the ability of a firm to control the market price of a good or service. The Herfindahl-
Hirschman Index or HHI is described as the measure of the size of firm’s share in the marker in relation to the industry
and an indicator of the amount of competition among them.
In reality, it is not possible for two rival companies to merge and not experience an increase in their market powers.
If the two companies merge, a part of the competition gets eliminated allowing the merged companies to stand above
the rest of the market.
One way to prevent an increase their market power due to merger is by producing a new product which is similar to
their primary product but different enough that the consumers want the new product. This new differentiated product
can be offered at a lower price attracting people to buy it.
Since the new product is now cheaper and more affordable, the company is able to make a profit, yet they do not
make such a substantial amount of profits by increasing their market power.
The new product would barely cover the cost of supplies and operating cost in the long run. However, this will allow
the firm to reach out to other consumers and attract them into purchasing the higher end product, which is a better
quality and lasting product.
A proposal of a new merger leads the Federal Trade Commission and the Department of Justice of the US anti-trust
authorities to use the Herfindalh Index in order to prove that the merged companies will not increase the market
power.
When a company’s HHI increases, the market’s competition and efficiency decrease leading to the creation of a
monopoly. Since monopolies are harmful to the market, the Federal Trade Commission and Department of Justice will
not allow the requested merger.
The merged companies would need to ensure that they are not creating a monopoly. A creation of monopoly will give
the new firm the ability to eliminate their competition.
When a monopoly is created, there is often an extreme price increase which forces the consumers to pay a higher
price as there is no other company for the consumers to use.
Market power lends itself to possible abuse and consumer exploitation. Antitrust legislation limits a company's ability
to wield significant market power and levies substantial penalties on those in violation.
6. You own a small bank in a state that is now considering allowing interstate banking. You oppose interstate
banking because it will be possible for the very large money center banks in New York, Chicago, and San Francisco
to open branches in your bank’s geographic market area. While proponents of interstate banking point to the
benefits to consumers of increased competition, you worry that economies of scale might ultimately force your now
profitable bank out of business. Explain how economies of scale (if significant economies of scale in fact do exist)
could result in your bank being forced out of business in the long run.

Economies of scale refer to the fall in the average cost as output increases in the long run. If a small bank is enjoying
economies of scale in the short run due to low competitors, this will attract new competitors in the market. However,
if interstate banking is allowed in the state then these small banks would face high competition.
• The new banks will offer consumers variety of services that small banks can’t provide.
• The cost of operations will be low for large banks due to high volume sale of services. Economies of scale will not
exist in the long run due to high competition.
• Consumers will shift from small banks to large banks due to low interest rates on loans and varied services, as a
result of which small banks would exit from the market.

7. The Harley-Davidson motorcycle company, which had a copyright on the word “hog,” applied for exclusive rights
to its engine sound. Why would a company want copyrights on two such mundane things?

Demand for a product is not just created by it price but also by its brand value, luxury, quality etc.
- H. Davidson copyrighted the word “hog” which means that the product is more associated by the Harley Davidson
fans with that word. It is a kind of image Harley Davidson wants to create among its customers.
- When a company creates such an image, it creates product differentiation where the demand for that product
becomes highly inelastic with respect to price. People are ready to pay huge amounts for that image and brand.

8. The Wall Street Journal reported that businesses are aggressively pushing consumers to pay bills electronically.
Numerous banks dropped their monthly fees for online bill paying, and many merchants are offering incentives for
customers to sign up for online bill payment. Aside from the direct cost savings to businesses, such as lower postage
and other administrative costs, what other reason might explain business’s interest in online bill payment?

Online bill payment may help banks in many ways:


• This might reduce the time taken to process bill payment as online payment gets direct. This will in turn reduce the
cost of banks and companies like electricity, gas etc.
• The bank can advertise free of cost. Also, firms can pass on the low cost to consumers in the form of low price.
• The cash flow would increase and so would the average collection period.
• There are less chances of defaulting as bouncing of cheques etc. are not possible when the payment is made online.
The online mode is transparent, clear and convenient for both consumers and company.
9. Even if the firms in a monopolistically competitive market collude successfully and fix price, economic profit will
still be competed away if there is unrestricted entry. Explain. Will price be higher or lower under such an agreement
in long-run equilibrium than would be the case if firms didn’t collude? Explain.

The monopolistic competitive markets have two important features: - Differentiated products with different sellers -
Low barriers to entry If there are economic profits in the market, more sellers will be attracted to such an industry. In
monopolistic firm the demand curve of each firm (AR) shifts inward as suppliers increase. The following shows the
combined demand curve, D, and separate demand curve D1 and D2 of the two firms:

Though the combined demand curve is higher, even if the firms collude, more firms will enter into market in
monopolistic competitive market. The economic profit would go down and normal profits would prevail in the long
run. The firms will have to sell differentiated products and create a brand to sustain long run in the market.

10. The Ali Baba Co. is the only supplier of a particular type of Oriental carpet. The estimated demand for its carpets
is:

Q = 112,000 – 500P + 5M

where Q = number of carpets, P = price of carpets (dollars per unit), and M = consumers’ income per capita. The
estimated average variable cost function for Ali Baba’s carpets is:

AVC = 200 – 0.012Q + 0.000002Q2

Consumers’ income per capita is expected to be $20,000 and total fixed cost is $100,000.

a. How many carpets should the firm produce to maximize profit?

It is given that income per capita, M = $20,000 and TFC = $100,000. The number of carpets the firms should produce
can be calculated by equating marginal revenue to marginal cost.

MR = MC
MR = P x Q
MC = d[(AVC x Q) + TFC]/dQ = d(TVC)/dQ

The demand function needs to bee written as a function of quantity:

Q = 112,000 – 500P + (5 x 20,000)


P = 424 – 0.002Q
TR = P x Q = 424Q – 0.002Q2

Now MC is equal to:

MC = d(200Q – 0.012Q2 + 0.000002Q3)/dQ = 200 – 0.024Q + 0.000006Q2

The optimal quantity achieved by:

MC = MR
200 – 0.024Q + 0.00006Q2 = 424 – 0.004Q
Q = 8,000
b. What is the profit-maximizing price of carpets?

To find the profit maximizing price of carpets:

P = 424 – 0.002Q = 424 – (0.002 x 8,000) = $408

c. What is the maximum amount of profit that the firm can earn selling carpets?

Profit = TR – TC = [424Q – 0.002Q2] – [200Q – 0.012Q2 + 0.000002Q3 + 100,000] = 3,264,000 – 932,128 = $2,331,872

d. Answer parts a through c if consumers’ income per capita is expected to be $30,000 instead.

If consumer income is $30,000, then first we make P the subject of our function:

Q = 112,000 – 500P + (5 x 30,000)

P = 524 – 0.002Q

TR = P x Q = 524Q – 0.002Q2

Now MC is equal to:

MC = d(200Q – 0.012Q2 + 0.000002Q3)/dQ = 200 – 0.024Q + 0.000006Q2

The optimal quantity achieved by:

MC = MR
200 – 0.024Q + 0.00006Q2 = 524 – 0.004Q
Q = 9,202 (approx.)

To find the profit maximizing price of carpets:

P = 524 – 0.002Q = 524 – (0.002 x 9,202) = $505.6


Profit = [524Q – 0.002Q2] – [200Q – 0.012Q2 + 0.000002Q3 + 100,000] = 4,652,494.4 – 24278.37 = $4,628,216.03

11. Dr. Leona Williams, a well-known plastic surgeon, has a reputation for being one of the best surgeons for
reconstructive nose surgery. Dr. Williams enjoys a rather substantial degree of market power in this market. She
has estimated demand for her work to be:

Q = 480 − 0.2P

where Q is the number of nose operations performed monthly and P is the price of a nose operation.

a. What is the inverse demand function for Dr. Williams’s services?

The inverse demand function is with respect to quantity instead of price. The inverse demand function is:

P = 2,400 – 5Q

b. What is the marginal revenue function?

The marginal revenue is the derivative of the total revenue function:

TR = P x Q
TR = 2.400Q – 5Q2
MR = dTR/Dq
MR = 2,400 – 10Q
The average variable cost function for reconstructive nose surgery is estimated to be:

AVC = 2Q2 – 15Q + 400

where AVC is average variable cost (measured in dollars), and Q is the number of operations per month. The doctor’s
fixed costs each month are $8,000.

c. If the doctor wishes to maximize her profit, how many nose operations should she perform each month?

The maximizing profit point is when MR = MC.

MC = d(AVC x Q)/dQ = d(2Q3 – 15Q2 +400Q)/dQ = 6Q2 – 30Q + 400

Now equating MR = MC:

MR = MC
2,400 – 10Q = 6Q2 – 30Q + 400
Q = 20

d. What price should Dr. Williams charge to perform a nose operation?

To find the profit maximizing price, substitute the profit maximizing quantity, 20, in inverse demand equation:
P = 2,400 – 5Q = 2,400 – 5(20) = $2,300

e. How much profit does she earn each month?

Profit is the difference between total revenue and total cost:


Profit = TR – TC = [(2300 x 2) – (2 x 203) + (15 x 202)] – [(400 x 20) – 8,000] = $20,000

12. A firm with two factories, one in Michigan and one in Texas, has decided that it should produce a total of 500
units to maximize profit. The firm is currently producing 200 units in the Michigan factory and 300 units in the Texas
factory. At this allocation between plants, the last unit of output produced in Michigan added $5 to total cost, while
the last unit of output produced in Texas added $3 to total cost.

a. Is the firm maximizing profit? If so, why? If not, what should it do?

The profit maximizing condition for any given industry is where marginal revenue is equal to marginal cost. The
marginal revenue should be equal to the separate cost of two plants. In other words the marginal cost of two plants
should equal at profit maximizing level. Here the marginal cost are different, therefore it is not at the profit maximizing
level of output production.

b. If the firm produces 201 units in Michigan and 299 in Texas, what will be the increase (decrease) in the firm’s total
cost?

If the firm produces 201 units in Michigan the increase in total cost would be $5 and, then decrease in total cost in
Texas would $3. The total increase in total cost would be $2.
13. In a recent “earnings call,” a teleconference call to shareholders in which the CEO reports and discusses quarterly
earnings per share, Coca-Cola’s CEO Muhtar Kent bragged about “winning” market share from rival beverage
company PepsiCo. However, rising sugar costs in 2011 are forcing Coke to raise soft drink prices by 3 to 4 percent,
and this could undermine Coke’s market share gains if Pepsi does not also raise its soft drink prices. The Wall Street
Journal (April 27, 2011) reports that, in an effort to continue “winning the market share battle,” Kent plans to
maintain relatively low prices in soft drinks by raising prices disproportionately higher in other categories such as
fruit juices and sport drinks. The WSJ raises the concern that “winning market share may come at too great a
financial cost.”** Discuss some reasons why Coke’s pricing tactics to win market share could in fact reduce Coke’s
profit and earnings per share.

Monopolistic competition creates high product differentiation and competition in low barrier market. The strategy of
Coke to maintain dominance in the soft drink market by increasing price in other beverage segment may cause some
serious problems:
- The cost issue would always be a concern for coke production. At relatively lower price with high cost would create
lower profit margins for coke production. The total profits will fall due to increase in total cost.
- By increasing price in other sector, the company would lose customers of that sector. The total profits would fall due
to low demand.
- The company would lose in both sectors if it follows the holding the market share tactics.

14. In a Wall Street Journal article titled “Sparing Fliers Even Higher Airfares,” Scott McCartney claims that jet fuel
hedging by Southwest Airlines resulted in lower airfares for passengers on all airlines: “Without (the fuel hedging)
windfall, (Southwest) likely would have had to jack up fares well beyond last year’s (fares).”† Other airline industry
analysts have also claimed that Southwest charges no fee for baggage (“Bags Fly Free”) largely because of the
airline’s success in hedging its fuel costs. Evaluate these two claims. [Hint: You should read Illustration 12.4 before
you answer this question.]

Hedging fuel prices may sometimes prove to be beneficial for the company in the short run. In the given case, South
west airlines hedged fuel prices and saved during time of fuel hike prices.

- It is however important to note that while calculating profits, the spot price is taken into consideration and not the
historic price. The hedged amount would be considered historic price and spot price.

- The option of hedging would have been available to all airline firms as South west airline. It was also observed that
Southwest airline incurred huge losses when hedging of fuel prices went wrong.

15.Amtrak, a national passenger railroad heavily subsidized by taxpayers, operates at a huge loss every year.
Recently, officials at Amtrak expressed confidence that they can turn things around by “running the railroad like a
business.” Specifically, Amtrak’s managers plan to raise ticket prices to “trim costs and boost revenues.” What must
be true about Amtrak’s demand elasticity for this plan to work? What effect will raising price have on Amtrak’s
costs?

Don’t have an answer to this.

16. The owners of the Tampa Bay Buccaneers have seen demand for season tickets decline steadily, probably
because the team’s performance is ranked near the bottom of 32 teams in the National Football League. The team
owners are now considering a decrease in season ticket prices. Using graphical analysis, show that when demand
decreases for a monopolist, price must be cut to maximize profit.

Don’t have an answer to this.