SM14ce_Micro_Chap011(1).doc

Chapter 11 - Monopoly Chapter 11 -Monopoly McConnell Brue Flynn Barbiero 14ce DISCUSSION QUESTIONS 1. “No firm is completely sheltered from rivals; all firms compete for consumer dollars. If that is so, then monopoly does not exist.” Do you agree? Explain. How might you use Chapter 6’s concept of cross elasticity of demand to judge whether a monopoly exists? LO11.1 Answer: Though it is true that “all firms compete for the dollars of consumers,” it is playing on words to hold that monopoly does not exist. If you wish to send a firstclass letter, it is the postal service or nothing. Of course, if the postal service raises its rate to $10 to get a letter across town in two days, you will use a courier, or the phone, or you will fax it. But within sensible limits, say a doubling of the postal rate, there is no alternative to the postal service at anything like it at a comparable price. The same case can be made concerning the monopoly enjoyed by the local electricity company in any town. If you want electric lights, you have to deal with a single company. It is a monopoly in that regard, even though you can switch to oil or natural gas for heating. Of course, you can use oil, natural gas, or kerosene for lighting too—but these are hardly convenient options. The concept of cross elasticity of demand can be used to measure the presence of close substitutes for the product of a monopoly firm. If the cross elasticity of demand is greater than one, then the demand that the monopoly faces is elastic with respect to substitute products, and the firm has less control over its product price than if the cross elasticity of demand were inelastic. In other words, the monopoly faces competition from producers of substitute products. 2. Discuss the major barriers to entry into an industry. Explain how each barrier can foster either monopoly or oligopoly. Which barriers, if any, do you feel give rise to monopoly that is socially justifiable? LO11.2 Answer: Economies of scale are a barrier to entry because of the need for new firms to start big to achieve the low production costs of those already in the industry. However, not all industries need techniques of production that require large scale. In many industries the minimum efficient scale is only a small percentage of domestic consumption. Natural monopolies give rise to monopoly that is socially justifiable. The economies of scale are sometimes such that having two or more firms serving the market would increase costs unreasonably. Two telephone companies, or gas companies, or water companies, or electricity companies in the same city would be highly inconvenient and costly as long as transmission requires wires and pipes. In such instances, it makes sense for government to grant exclusive franchises and then regulate the resulting monopoly to ensure the public interest is protected. Patents and licenses are legal barriers to entry that also, to some extent, are justifiable. If inventions were not protected at all from immediate copying by those who bore none of the costs, the urge to invent and innovate would be lessened and the costly secrecy that is enforced already would have to be much greater and more costly. However, this does not mean that abuses do not exist in the present system and a case can be made for reducing the present seventeen years for which patents are granted. Ownership of essential raw materials is another barrier to entry. It has little social justification except to the extent that the hope of gaining a monopoly in the supply of an essential raw material leads to more prospecting. The Last Word on De Beers is an example. Unfair competition is the last of the barriers and has no social justification at all, which is why price-cutting to bankrupt a rival is illegal. The problem here, though, is to prove that cutthroat competition truly is what it appears to be. 3. How does the demand curve faced by a monopolistic seller differ from that confronting a perfectly competitive firm? Why does it differ? Of what significance is the difference? Why is the monopolist’s demand curve not perfectly inelastic? LO11.3 Answer: The demand curve facing a monopolist is downward sloping; that facing the perfectly competitive firm is horizontal, perfectly elastic. This is so for the competitor because the firm faces a multitude of competitors, all producing perfect substitutes. In these circumstances, the ly competitive firm may sell all that it wishes at the equilibrium price, but it can sell nothing for even so little as one cent higher. The individual firm’s supply is so small a part of the total industry supply that it cannot affect the price. The monopolist, on the other hand, is the industry and therefore is faced by a normal downward sloping industry demand curve. Being the entire industry, the monopolist’s supply is big enough to affect prices. By decreasing output, the monopolist can force the price up. Increasing output will drive it down. Part of the demand curve facing a monopolist could be perfectly inelastic; if the monopolist put only a very few items on the market, it is possible the firm could sell them all at, say, $1, or $2, or $3. But it is the very fact that the monopolist could sell the same amount at higher and higher prices that would ensure that the profitmaximizing monopolist would not, in fact, sell in this perfectly inelastic range of the demand curve. Indeed, the monopolist would not sell in even the still slightly inelastic range of the demand curve. The reason is that so long as the demand curve is inelastic, MR must be negative, but since the MC of any item can hardly be negative also, the monopolist’s profit must decrease if it produces here. To equate a positive MR with MC, the monopolist must produce in the elastic range of its demand curve. 4. Assume that a monopolist and a perfectly competitive firm have the same unit costs. Contrast the two with respect to (a) price, (b) output, (c) profits, (d) allocation of resources, and (e) impact on income transfers. Since both monopolists and competitive firms follow the MC = MR rule in maximizing profits, how do you account for the different results? Why might the costs of a perfectly competitive firm and those of a monopolist be different? What are the implications of such a cost difference? LO11.5 Answer: With the same costs, the monopolist will charge a higher price, have a smaller output, and have higher economic profits in both the short run and the long run than the competitor. As a matter of fact, the competitor will have no economic profits in the long run even though it might have some in the short run. Because the monopolist does not produce at the point of minimum ATC and does not equate price and MC, its allocation of resources is inferior to that of the competitor. Specifically, resources are underallocated to monopolistic industries. Since a monopolist is more likely than the competitor to make economic profits in the short run and is, moreover, the only one of the two able to make economic profits in the long run, the distribution of income is more unequal with monopoly than with competition. In competition, MR = P because the firm’s supply is so insignificant a part of industry supply that its output has no effect on price. It can sell all that it wishes at the price established by demand and the total industry supply. The firm cannot force the price up by holding back part or all of its supply. The monopolist, on the other hand, is the industry. When it increases the quantity it produces, price drops. When it decreases the quantity it produces, price rises. In these circumstances, MR is always less than price for the monopolist; to sell more it must lower the price on all units, including those it could have sold at the higher price had it not put more on the market. When the monopolist equates MR and MC, it is not selling at that price: The monopolist’s selling price is on the demand curve, vertically above the point of intersection of MR and MC. Thus, the monopolist’s price will be higher than the competitor’s. Economies of scale may be such as to ensure that one large firm can produce at lower cost than a multitude of small firms. This is certainly the case with most public utilities. And in such industries as basic steel-making and car manufacturing, competition would involve a very high cost. On the other hand, monopolies may suffer from Xinefficiency, the inefficiency that a lack of competition allows. Monopolies may also incur nonproductive costs through “rentseeking” expenditures. For example, they may try to influence legislation that protects their monopoly powers. 5. Critically evaluate and explain each statement: LO11.5 a. Because they can control product price, monopolists are always assured of profitable production by simply charging the highest price consumers will pay. b. The monopolist seeks the output that will yield the greatest per?unit profit. c. An excess of price over marginal cost is the market’s way of signaling the need for more production of a good. d. The more profitable a firm, the greater its monopoly power. e. The monopolist has a pricing policy; the competitive producer does not. f. With respect to resource allocation, the interests of the seller and of society coincide in a perfectly competitive market but conflict in a monopolized market. Answer: a. The statement is false. If the monopolist charged the highest price consumers would pay, it would sell precisely one unit! (Conceivably, it might sell a little more than one if more than one consumer made matching bids for the first unit offered.) It is highly unlikely that the sale of one unit (or a very few) would cover the very high AFC of one or a very few units. And even a monopolist that does produce sensibly where MR = MC may still suffer a loss: P can be below ATC at all levels. b. The statement is false. The monopolist seeks the output that will yield the greatest profit. The profit equation is Q(P  ATC). It is not (P  ATC). If the monopolist sells one unit for $100 when ATC is $60, then its profit per unit and total profit is $40 (= $100  $60). Nice, but if the same monopolist can sell 1,000 units for $40 when ATC is $39, then, though its per unit profit is a mere $1 (= $40  $39), its total profit is $1,000 [= 1,000($40  $39)]. This is much better than $40. c. The statement is true. Price is the value society sets on the last item produced. Marginal cost is the value to society of the alternative production forgone when the last item is produced. When P>MC, society is willing to pay more than the opportunity cost of the last item’s production. d. This statement can be true and probably is in many cases. Large profits allow expansion to gain economies of scale and thus prevent the late entry of smaller rivals. Large profits also enable the firm to price below cost, to engage (illegally) in a price war. Moreover, large profits in the short run are often associated with monopoly power. In the long run, only a firm with monopoly power can gain economic profits; in competition such profits would invariably be competed away by new entry. e. The statement is true. The monopolist must equate MR and MC. Having determined at what quantity this equality occurs, the monopolist simultaneously sets price. This price differs at each output because the demand curve is downsloping. The competitor accepts the price given by total industry supply and demand. Knowing this externally given price, the competitor then equates it with the firm’s MC and produces the amount determined by this equality. f. The statement is true. In competition, P = MC. This means that the value society sets on the last item produced (its price) is equal to the cost of the alternative commodities that are not produced. This is because producing the last item of the commodity in question is its MC. In monopoly, P>MC. This means that society values the last item produced more than its cost. 6. Assume a monopolistic publisher has agreed to pay an author 10 percent of the total revenue from the sales of a text. Will the author and the publisher want to charge the same price for the text? Explain. LO11.5 Answer: The publisher is a monopolist seeking to maximize profits. This will occur at the quantity of output where MC = MR. (See Figure 11.4) [[[COMMENT BY Thomas Barbiero]]] Caption should read Figure 11.4 [[[---]]] The author who will receive 10% of the total revenue will maximize his payment if the book is priced where MR = 0. This will occur where the price elasticity of demand is equal to 1 and total revenue is maximum. (See Figure 11.3) [[[COMMENT BY Thomas Barbiero]]] The caption should read Figure 11.3 [[[---]]] The author would prefer a lower price than the publisher. Consult Key Graph 11.4 and compare the price charged where MC = MR and the price that would be necessary to maximize total revenue when MR = 0. This is a highly unlikely outcome since the publisher, whether economically literate or not, is certain to recognize the revenue maximizing price as disadvantageous. 7. U.S. pharmaceutical companies charge different prices for prescription drugs to buyers in different nations, depending on elasticity of demand and government-imposed price ceilings. Explain why these companies, for profit reasons, oppose laws allowing reimportation of drugs to the United States. LO11.6 Answer: U.S. pharmaceutical companies are price discriminating based in part on the different elasticities of demand in different nations. Reimportation allows reselling of the goods, making it more difficult to price discriminate. To the extent they could still charge different prices, the difference in prices would have to be small enough so that reimportation was not profitable. Prohibition of reimportation would allow pharmaceutical companies to charge the profit-maximizing price in each nation, without fear of being undercut back in the U.S. by those in nations where the drugs are cheaper. 8. Explain verbally and graphically how price (rate) regulation may improve the performance of monopolies. In your answer distinguish between (a) socially optimal (marginal?cost) pricing and (b) fair?return (average?total?cost) pricing. What is the “dilemma of regulation”? LO11.7 Answer: Monopolies that are natural monopolies are normally subject to regulation. Because of extensive economies of scale, marginal cost is less than average total cost throughout the range of output. An unregulated monopolist would produce at Qm when MC = MR and enjoy an economic profit. Society would be better off with a larger quantity. Output level Qr would be socially optimal because MC = Price and allocative efficiency would be achieved. However, the firm would lose money producing at Qr since ATC exceeds the price. In order for the firm to survive, public subsidies out of tax revenue would be necessary. Another option for regulators is to allow a fair-return price that would allow the firm to break even economically (cover all costs including a normal profit). Setting price equal to ATC would deliver Qf output and only partially solve the underallocation of resources. Despite this dilemma regulation can improve on the results of monopoly from the social point of view. Price regulation (even at the fairreturn price) can simultaneously reduce price, increase output, and reduce the economic profits of monopolies. 9. It has been proposed that natural monopolists should be allowed to determine their profit-maximizing outputs and prices and then government should tax their profits away and distribute them to consumers in proportion to their purchases from the monopoly.  Is this proposal as socially desirable as requiring monopolists to equate price with marginal cost or average total cost? LO11.7 Answer: No, the proposal does not consider that the output of the natural monopolist would still be at the suboptimal level where P > MC.  Too little would be produced and there would be an underallocation of resources.  Theoretically, it would be more desirable to force the natural monopolist to charge a price equal to marginal cost and subsidize any losses.  Even setting price equal to ATC would be an improvement over this proposal.  This fair-return pricing would allow for a normal profit and ensure greater production than the proposal would. 10. LAST WORD How do network effects help Facebook fend off smaller social-networking rivals?  Could an online retailer doing half as much business compete on an equal footing with Amazon in terms of costs?  Explain. Answer: The purpose of social-networking sites it to interact with other people. The fact that Facebook is the most popular, is one of the things that helps keep it the most popular.  Why would users choose to join a site with fewer other users, when they can be a part of the social-networking site with the most activity. This also means most companies will choose to advertise on Facebook instead of its rivals. Amazon benefits greatly from its economies of scale.  Due to its large number of sales, the cost per sale for Amazon is fairly low.  An online retailer that does less business would have higher costs per sale; and therefore, have to charge higher prices to consumers.  Most consumers would continue to choose Amazon due to the lower prices. Economies of scale make it very hard for a smaller retailer to compete with Amazon. REVIEW QUESTIONS Which of the following could explain why a firm is a monopoly? Select one or more answers from the choices shown. LO11.2 a. Patents b. Economies of scale. c. Inelastic demand. d. Government licenses. e. Downsloping market demand. Answer: Patents, Economics of scale, and Government licenses. A firm is a monopoly when it is the only firm in its industry.  A firm may be the only firm in its industry for a variety of reasons.  These include holding patents that legally prevent any other firm from duplicating its products; having economics of scale that allow the firm to produce at a lower cost than potential rivals; and enjoying government licenses that make it the sole legal producer of a product in a given area. 2. The MR curve of perfectly competitive firm is horizontal. The MR curve of monopoly firm is: LO11.3 a. Horizontal, too. b. Upsloping. c. Downsloping. d. It depends. Answer: Downsloping. The MR curve of a monopoly firm is downsloping because the only way for a monopoly firm to increase the amount of output that it sells is by lowering the price it charges in order to move down along its downsloping demand curve. But the monopolist must lower the price not just on additional units but also on earlier units, too. As a result, the MR that the firm collects declines with each successive unit that it wishes to sell. Graphically, this implies that the MR curve is downsloping, as MR declines with output. 3. Use the demand schedule below to calculate total revenue and marginal revenue at each quantity. Plot the demand, total?revenue, and marginal-revenue curves, and explain the relationships between them. Explain why the marginal revenue of the fourth unit of output is $3.50, even though its price is $5. Use Chapter 6’s total?revenue test for price elasticity to designate the elastic and inelastic segments of your graphed demand curve. What generalization can you make as to the relationship between marginal revenue and elasticity of demand? Suppose the marginal cost of successive units of output was zero. What output would the profit?seeking firm produce? Finally, use your analysis to explain why a monopolist would never produce in the inelastic region of demand. LO11.3 Answer: To calculate Total Revenue multiply price (P) by Quantity Demanded (Q): TR = P x Q. To calculate Marginal Revenue find the change in total revenue for each unit demanded: MR = ? TR = TR (i+1) - TR(i). See table below. Price (P) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $7.00 0 $0 NA 6.50 1 6.50 $6.50 6.00 2 12.00 5.50 5.50 3 16.50 4.50 5.00 4 20.00 3.50 4.50 5 22.50 2.50 4.00 6 24.00 1.50 3.50 7 24.50 0.50 3.00 8 24.00 -0.50 2.50 9 22.50 -1.50 Because TR is increasing at a diminishing rate, MR is declining. When TR turns downward (starts decreasing), MR becomes negative. Marginal revenue is below D because to sell an extra unit, the monopolist must lower the price on the marginal unit as well as on each of the preceding units sold. Four units sell for $5.00 each, but three of these four could have been sold for $5.50 had the monopolist been satisfied to sell only three. Having decided to sell four, the monopolist had to lower the price of the first three from $5.50 to $5.00, sacrificing $.50 on each for a total of $1.50. This “loss” of $1.50 explains the difference between the $5.00 price obtained on the fourth unit of output and its marginal revenue of $3.50. Demand is elastic from P = $6.50 to P = $3.50, a range where TR is rising. The curve is of unitary elasticity at P = $3.50, where TR is at its maximum. The curve is inelastic from then on as the price continues to decrease and TR is falling. When MR is positive, demand is elastic. When MR is zero, demand is of unitary elasticity. When MR is negative, demand is inelastic. If MC is zero, the monopolist should produce 7 units where MR is also zero. It would never produce where demand is inelastic because MR is negative there while MC is positive. The graph below summarizes the analysis discussed above. 4. How often do perfectly competitive firms engage in price discrimination? LO11.6 a. Never. b. Rarely. c. Often. d. Always. Answer: Never. Note that this question asks about perfectly competitive firms, not monopolies! Perfectly competitive firms never engage in price discrimination because they have no way of charging different prices to different consumers. This is true because perfectly competitive firms are price takers who have no influence over the market price.  Each and every unit that they produce must be sold in the market at the market price.  As a result, they have no ability to charge different prices to different consumers - as must be done when engaging in price discrimination. 5. Suppose that a monopolist can segregate his buyers into two different groups to which he can charge two different prices. In order to maximize profit, the monopolist should charge a higher price to the group that has: LO11.6 a. The higher elasticity of demand. b. The lower elasticity of demand. c. Richer members. Answer: the lower elasticity of demand. In order to maximize profit, the monopolist should charge a higher price to the group that has the lower elasticity of demand. This is true because a lower elasticity implies that a given increase in price will lead to a smaller decline in quantity demanded. Thus, it will be more profitable to assign the higher price to the group with the lower elasticity because the quantity that they demand will fall off less if the higher price were assigned to the group with the higher elasticity of demand. 6. The socially optimal price (P = MC) is socially optimal because: LO11.7 a. It reduces the monopolist’s profit. b. It yields a normal profit. c. It minimizes ATC. d. It achieves allocative efficiency. Answer: It achieves allocative efficiency The socially optimal price is socially optimal because it achieves allocative efficiency. This is true because the socially optimal price is determined be where the downsloping demand curve intersects the upsloping MC curve, thereby causing the regulated monopoly to produce every unit for which benefits exceed costs. 7. The main problem with imposing the socially optimal price (P = MC) on a monopoly is that the socially optimal price: LO11.7 a. May be so low that the regulated monopoly can’t break even. b. May cause the regulated monopoly to engage in price discrimination. c. May be higher than the monopoly price. Answer: May be so low that the regulated monopoly can’t break even. The main problem with imposing the socially optimal price (P = MC) on a monopoly is that the socially optimal price may be so low that the regulated monopoly can't break even.  In such situations, alternatives must be found in order to prevent the monopoly from going bankrupt and thereby denying society the chance to purchase the good or service made by the monopoly.  These alternatives include providing a public subsidy to make up for the firm's losses or switching to fair return pricing, which would guarantee that the regulated monopoly could make a normal profit and thereby remain in business. PROBLEMS 1. Suppose a monopolist is faced with the demand schedule shown below and the same cost data as the competitive producer discussed in problem 4 at the end of Chapter 10. Calculate the missing total?revenue and marginal?revenue amounts, and determine the profit?maximizing price and profit?maximizing output for this monopolist. What is the monopolist’s profit? Verify your answer graphically and by comparing total revenue and total cost. LO11.4 Answer: Price (P) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $115 0 $0 NA 100 1 100 100 83 2 166 66 71 3 213 47 63 4 252 39 55 5 275 23 48 6 288 13 42 7 294 6 37 8 296 2 33 9 297 1 29 10 290 -7 Profit-maximizing price = $63; profit-maximizing quantity = 4 units; monopolist’s profit = $42. The graph should have the general shape of Figure 11.4. [[[COMMENT BY Thomas Barbiero]]] The figure caption should read11.4 [[[---]]] Feedback: To calculate Total Revenue multiply price (P) by Quantity Demanded (Q): TR = P x Q To calculate Marginal Revenue find the change in total revenue for each unit demanded: MR = ? TR = TR (i+1) – TR (i). See table below. Price (P) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $115 0 $0 NA 100 1 100 100 83 2 166 66 71 3 213 47 63 4 252 39 55 5 275 23 48 6 288 13 42 7 294 6 37 8 296 2 33 9 297 1 29 10 290 -7 To determine profit?maximizing price and profit?maximizing output for this monopolist use the cost data in the table below. To find the profit maximizing quantity compare marginal revenue from the first table above with the marginal cost from second table. Price (P) Quantity Demanded (Q) Marginal Revenue (MR) Marginal Cost (MC) $115 0 NA NA 100 1 $100 $45 83 2 66 40 71 3 47 35 63 4 39 30 55 5 23 35 48 6 13 40 42 7 6 45 37 8 2 55 33 9 1 65 29 10 -7 75 Starting with the first unit MR=$100 > MC=$45, produce this unit. The same logic applies to units 2, 3, and 4. However, for the fifth unit MR=$23 < MC=$35. Thus, the firm does NOT produce this unit. (NOTE: We have modified the MR=MC rule to MR>MC, which is more general. Produce all units where MR>MC.) The profit maximizing quantity produced is 4 units. The profit maximizing price is the price associated with the profit maximizing quantity, 4 units. Thus, the profit maximizing price is $63. The monopolist's profit equals total revenue minus total cost. Total revenue equals $252 at 4 units of output. We still need total cost. From the 'cost data' table we see that average total cost (ATC) equals $52.50. Since ATC equals total cost divided by quantity we can determine total cost from the ATC cost data. ATC = Total Cost / Quantity or Total Cost = Quantity x ATC = 4 x $52.50 = $210 Profit = $252 - $210 = $42 Another approach is to use the following relationship. Profit = TR -TC Divide through by Q Profit/Q = TR/Q -TC/Q Since TR/Q = Average Revenue = P and TC/Q = ATC, we have: Profit/Q = P -ATC Rearranging, Profit = Q (P - ATC) = 4($63 - $52.50) = 4 x $10.5 = $42. Either approach above will work. The graph should have the general shape of Figure 11.4. [[[COMMENT BY Thomas Barbiero]]] The caption should read Figure 11.4 [[[---]]] [[[COMMENT BY Thomas Barbiero]]] [[[---]]] 2. Suppose that a price?discriminating monopolist has segregated its market into two groups of buyers. The first group described by the demand and revenue data that you developed for problem 1. The demand and revenue data for the second group of buyers is shown in the accompanying table. Assume that MC is $13 in both markets and MC = ATC at all output levels. What price will the firm charge in each market? Based solely on these two prices, which market has the higher price elasticity of demand? What will be this monopolist’s total economic profit? LO11.6 Answer: Price in market 1 = $48; price in market 2 = $33; the second market has the higher price elasticity of demand; total economic profit = $330. Feedback: Let's start with the second market. Marginal cost is $13 for all output levels. The marginal revenue from producing the 6th unit is $13 (=$198- $185), so this is the last unit produced by the firm for this market. Thus, the marginal revenue equals marginal cost rule results in 6 units being produced in this market (MR=MC=$13 at 6 units in this market). The price the firm charges in this market is $33, which is the price associated with the 6th unit. The firm’s profit in this market can be found using the following relationship (see problem 1 in this chapter for derivation). Profit Market 2 = Q (P - ATC) = 6($33 - $13) = 6 x $20 = $120. The first market is found in problem 1 (Table reproduced below): Price (P) Quantity Demanded (Q) Total Revenue (TR) Marginal Revenue (MR) $115 0 $0 NA 100 1 100 100 83 2 166 66 71 3 213 47 63 4 252 39 55 5 275 23 48 6 288 13 42 7 294 6 37 8 296 2 33 9 297 1 29 10 290 -7 Again, marginal cost is $13 for all output levels. The marginal revenue equals marginal cost rule results in 6 units being produced in this market as well (MR=MC=$13 at 6 units in this market). The price the firm charges in this market is $48, which is the price associated with the 6th unit. The firm’s profit in this market can be found using the following relationship (see problem 1 in this chapter for derivation). Profit Market 1 = Q (P - ATC) = 6($48 - $13) = 6 x $35 = $210. The combined profit from both markets gives us total profit. Total Profit = Profit Market 1 + Profit Market 2 = $120 + $210 = $330 Since the firm charges a lower price in the second market (a price of $48), this market has the higher price elasticity of demand. 3. Assume that the most efficient production technology available for making vitamin pills has the cost structure given in the following table. Note that output is measured as the number of bottles of vitamins produced per day and that costs include a normal profit. LO11.6 a. What is ATC per unit for each level of output listed in the table? b. Is this a decreasing?cost industry? (Answer yes or no). c. Suppose that the market price for a bottle of vitamins is $2.50 and that at that price the total market quantity demanded is 75,000,000 bottles. How many firms will there be in this industry? d. Suppose that instead the market quantity demanded at a price of $2.50 is only 75,000. How many firms do you expect there to be in this industry? e. Review your answers to parts b, c, and d. Does the level of demand determine this industry’s market structure? Answers: (a) ATC per bottle is $4 per bottle at 25,000 bottles, $3 per bottle at 50,000 bottles, $2.50 per bottle at 75,000 units, and $2.76 per bottle at 100,000 units. (b) No. (c) There will be 1000 firms in this industry. (d) There will be one firm in this industry. (e) Yes. Feedback: a. To find Average Total Cost (ATC) divide Total Cost by Output (Quantity). ATC = Total Cost / Output Output TC MC ATC 25,000 $100,000 $0.50 $4.00 50,000 150,000 1.00 $3.00 75,000 187,500 2.50 $2.50 100,000 275,500 3.00 $2.76 b. No, the ATC cost does NOT decline for all levels of output. c. Since $2.50 is minimum ATC, firms will produce at this level of output. Any firm that deviated from this level would incur a higher ATC and would be unprofitable at the market price of $2.50. The total number of firms can be found by dividing the market quantity demanded by output produced by a firm at the ATC of $2.50, which is 75,000. Number of Firms = Market Quantity Demanded / Output Minimum ATC = 75,000,000/75,000 =1000. d. The total number of firms under this assumption is: Number of Firms = Market Quantity Demanded / Output Minimum ATC = 75,000/75,000 =1. e. Yes, high demand will result in a competitive industry while very low demand can result in a monopoly industry. 4. A new production technology for making vitamins is invented by a college professor who decides not to patent it. Thus, it is available for anybody to copy and put into use. The TC per bottle for production up to 100,000 bottles per day is given in the following table. LO11.6 a. What is ATC for each level of output listed in the table? b. Suppose that for each 25,000?bottle per day increase in production above 100,000 bottles per day, TC increases by $5,000 (so that, for instance, 125,000 bottles per day would generate total costs of $85,000 and 150,000 bottles per day would generate total costs of $90,000). Is this a decreasing?cost industry? c. Suppose that the price of a bottle of vitamins is $1.33 and that at that price the total quantity demanded by consumers is 75,000,000 bottles. How many firms will there be in this industry? d. Suppose that instead the market quantity demanded at a price of $1.33 is only 75,000. How many firms do you expect there to be in this industry? e. Review your answers to parts b, c, and d. Does the level of demand determine this industry’s market structure? f. Compare your answer to part d of this question with your answer to part d of problem 3. Do both production technologies show constant returns to scale? Answers: a. ATC per bottle is $2.00 per bottle for 25,000 bottles, $1.40 per bottle for 50,000 bottles, $1 per bottle for 75,000 bottles, and $0.80 per bottle for 100,000 bottles. b. Yes, this is a decreasing cost industry. c. Only one firm since this is a natural monopoly situation. d. Only one firm since this is a natural monopoly situation. e. No, the level of demand does not determine this market’s structure. f. No, the new technology of this problem shows economies of scale and this industry is therefore a decreasing-cost industry. Feedback: a. To find Average Total Cost (ATC) divide Total Cost by Output (Quantity). ATC = Total Cost / Output Output TC ATC 25,000 $50,000 $2.00 50,000 70,000 $1.40 75,000 75,000 $1.00 100,000 80,000 $.0.80 b. The last two rows provide the additional cost and output information (you could continue to add rows for additional output). Output TC ATC 25,000 $50,000 $2.00 50,000 70,000 $1.40 75,000 75,000 $1.00 100,000 80,000 $.0.80 125,000 $85,000 $0.68 150,000 $90,000 $0.60 From this additional information we can conclude this is a decreasing cost industry because ATC falls as output increases at all levels. c. Since this is a decreasing cost industry there will only be one firm. d. Again, since this is a decreasing cost industry there will only be one firm. e. No. Since this is a decreasing cost industry there will only be one firm regardless of demand. f. No, the second technology (this problem) has an increasing returns to scale technology. 5. Suppose you have been tasked with regulating a single monopoly firm that sells 50?pound bags of concrete. The firm has fixed costs of $10 million per year and a variable cost of $1 per bag no matter how many bags are produced. LO11.7 a. If this firm kept on increasing its output level, would ATC per bag ever increase? Is this a decreasing?cost industry? b. If you wished to regulate this monopoly by charging the socially optimal price, what price would you charge? At that price, what would be the size of the firm’s profit or loss? Would the firm want to exit the industry? c. You find out that if you set the price at $2 per bag, consumers will demand 10 million bags. How big will the firm’s profit or loss be at that price? d. If consumers instead demanded 20 million bags at a price of $2 per bag, how big would the firm’s profit or loss be? e. Suppose that demand is perfectly inelastic at 20 million bags, so that consumers demand 20 million bags no matter what the price is. What price should you charge if you want the firm to earn only fair rate of return? Assume as always that TC includes a normal profit. Answers: a. ATC will never increase. This is a decreasing cost industry. b. Charge $1 per bag. At that price, the firm would lose its $10 million fixed costs. This firm would be losing money and will want to exit the industry. c. The firm will break even (no profit or loss). d. The firm will make an economic profit of $10 million. e. You should charge $1.50 per bag if you want this firm to earn a fair rate of return. Feedback: a. ATC will never increase. This is a decreasing cost industry. The intuition is that FC get distributed over more and more units so that ATC will fall asymptotically towards the $1 per bag marginal cost. b. Charge $1 per bag since the MC of all bags is $1 per bag. At that price, the firm would lose its $10 million fixed costs (since the price is just enough to cover variable costs). This firm would be losing money and will want to exit the industry. c. The firm's revenue equals $20,000,000 ( = $2 (price) x 10,000,000 (quantity)). The firm's Fixed Cost equals $10,000,000 (given above). The firm's Total Variable Cost equals $10,000,000 ( = $1 (variable cost of producing each bag) x 10,000,000 (quantity)). The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $20,000,000 (=$10,000,000 (Total Fixed Cost) + $10,000,000 (Total Variable Cost)). The firm's profit equals $0 (= $20,000,000 (revenue) - $20,000,000 (total cost)). The firm breaks even. d. The firm's revenue equals $40,000,000 ( = $2 (price) x 20,000,000 (quantity)). The firm's Fixed Cost equals $10,000,000 (given above). The firm's Total Variable Cost equals $20,000,000 ( = $1 (variable cost of producing each bag) x 20,000,000 (quantity)). The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $30,000,000 (=$10,000,000 (Total Fixed Cost) + $20,000,000 (Total Variable Cost)). The firm's profit equals $10,000,000 (= $40,000,000 (revenue) - $30,000,000 (total cost)). e. The fair rate of return is where economic profit is zero (Total Cost above includes normal profit). The first step is to find Total Cost. The firm's Fixed Cost equals $10,000,000 (given above). The firm's Total Variable Cost equals $20,000,000 ( = $1 (variable cost of producing each bag) x 20,000,000 (quantity)). The firm's Total Cost equals the sum of Total Fixed Cost and Total Variable Cost, $30,000,000 (=$10,000,000 (Total Fixed Cost) + $20,000,000 (Total Variable Cost)). The second step is to find revenue (here the price is not known). Revenue = Price (unknown) x 20,000,000. The final step is to use the definition of profit to solve for the unknown price. Profit = Revenue - Total Cost = Price x 20,000,000 - $30,000,000 We can also set profit to zero (fair rate of return requirement): Price x 20,000,000 - $30,000,000 = 0 or Price x 20,000,000 = $30,000,000 which gives us, Price = $30,000,000 / 20,000,000 = $1.50. Thus, the firm should charge $1.50 per bag to earn a fair rate of return. 11-21 Copyright © 2015 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of McGraw-Hill Education.