Economics Model Answers Nine - 2013
1. Identify an industry not mentioned in the lecture that is an oligopoly, and explain why.
- The video game industry (consisting of companies like Nintendo, Sony and the manufacturer of X-box) is an example of an oligopoly, because there are few competitors. There are barriers to entry of high investment costs and effort in order to create a new video game company. Also, most of the video game systems are similar.
2. Order the types of industries from those having the lowest price (due to the greatest competition) to those having the highest price (due to the least competition).
- 1) Perfect Competition
- 2) Perfectly Contestable Markets
- 3) Monopolistic Competition
- 4) Oligopoly
- 5) Cartel
- 6) Monopoly
3. Explain which specific type of industry (e.g., oligopoly or something else) each of these quotes probably refers to: (1) "She's the finest hair stylist in town; no one has her special style!", (2) "Crazy Eddie ... his low prices are INSANE!", (3) "Don't like his prices? He's the only one in town selling what you need."
- 1) Monopolistic Competition 2) Perfect Competition 3) Monopoly
- Explained by a student (CM): It is Monopolistic Competition because the hair dresser offers a differentiated product that is not a perfect substitute. 2. It is Perfect Competition because the prices are driven very low because there are probably a lot of substitutes and rival firms. 3. It is a Monopoly because the prices are able to increase substantially due to the lack of perfect substitutes and rival firms.
- Explained by another student (NL): Statement 1 likely refers to a state of monopolistic competition, since, although there are other hair stylists to provide competition, her product is preferable and can raise prices without losing customers. Statement 2 probably speaks of a state of perfect competition, since the firm is forced (by competition) to keep his prices very low. Statement 3 is referring to a monopoly, since he is the only supplier in the town and is able to hold his prices very high without losing customers.
4. List how monopolies can be established.
- 1. Government can create monopolies by operation of law.
- 2. The licensing of professionals creates a barrier to entry.
- 3. The control of a valuable resource (such as power) can result in a monopoly.
- 4. Economies of scale can create a monopoly by rewarding the biggest company with the lowest average cost.
- 5. Government grants of patents and copyrights also create monopolies over particular inventions or works.
5. What prevents a monopoly from increasing its prices without limitation? Explain.
- The Law of Demand applies to every seller, including monopolies. If a monopoly increased its price to infinity, then it would have no sales. Thus a monopoly cannot increase its prices without limitation. It is still limited by the Law of Demand, and a monopoly increases its price no higher than where marginal revenue equals marginal cost.
- Explained by a student (AM): The law of demand still applies the monopolies, such as if a monopoly charges too much for its product people will just live without it rather than paying the price.
Answer question 6, and then 2 out of the subsequent 3 questions:
6. Where is the Nash equilibrium for this set of options, where (x,y) represents the profits to (Firm A, Firm B)? Explain.
|Firm A Does Not Reduce Output||Firm A Reduces Output|
|Firm B Does Not Reduce Output||(50,50)||(100,25)|
|Firm B Reduces Output||(25,100)||(75,75)|
- Unfortunately, there is a mistake in the ordering of the paired numbers used in this problem. The numbers were in the wrong order because a firm's profits should increase, not decrease, when it increases output in an oligopoly. As mistakenly written above, we can start from (50,50) and realize that firm B can increase its profits by reducing output, which takes us to (25,100). But then the other firm can increase its profits by reducing output, which takes us to equilibrium at (75,75). Any movement away from that point would start of chain of events that would lead back to that point, so it is a true equilibrium. But that is an uninteresting solution, and unrealistic in a free market.
- The chart should have had the ordered pairs reversed:
|Firm A Does Not Reduce Output||Firm A Reduces Output|
|Firm B Does Not Reduce Output||(50,50)||(25,100)|
|Firm B Reduces Output||(100,25)||(75,75)|
- In the corrected version above, from the point (50,50) neither firm can increase its own profits by reducing its own output. So that is equilibrium. To check the answer, we can start from (75,75). From there, either firm can increase its profits by increasing its output, and it does. But from the new point the other firm can increase its profits by increasing its output, and the market ends up at where both firms have increased their output, with profits of (50,50). Spend a few minutes trying each approach to confirm that is the equilibrium - the Nash equilibrium.
7. Monopolies: should the government regulate them? Or is regulation worse?
- The Coase theorem demonstrates that when government imposes requirements and regulations on the free market, then there are more transaction costs. The government should let the invisible hand take care of it and not interfere. This suggests that government should stay out, even when there are monopolies.
- But the opposing argument is that monopolies are very harmful to the economy. Freedom does require some laws, such as laws against violent crimes. Laws against anti-competitive conduct by monopolies make for a better economy.
- (student MY) I think the government should regulate monopolies. Competition is always better. than just one person/firm taking over and raising the prices sky high and not giving any one else a chance. Competition is better for the market. It allows trade/buying/selling to continue normally. Everyone fighting for the lowest prices, and best quality.
- (student CL) In my opinion, monopolies should be regulated by the government because the detriment of a monopoly's existence is worse than a government regulation preventing its growth. A monopoly is not good for the consumer because it can raise prices and lower output to take advantage of the consumers that have no choice but to pay the higher price. Monopolies can do this because there is no competition that can offer a lower price. Without any regulation, a monopoly could destroy all of its competition by buying those who offer lower prices. For these reasons, even though a government regulation may be bad for the free market, it still is not as bad as the continuation of an unstoppable monopoly.
8. Does the "deadweight loss" equal the "consumer surplus"? Explain the relationship.
- No, it doesn’t. The deadweight loss reduces the consumer surplus. The deadweight loss also reduces part of the producer surplus. Deadweight losses result in lost benefits to the public.
- Due to the deadweight loss, consumers are forced to spend more than they would like to on something, because the monopoly is the only provider of it.
9. How does a monopolist maximize his profits?
- A monopolist keeps increasing and increasing his price until his marginal revenue declines to equal marginal cost.