Module 5 (Competition & Differentiation)

Question 1

A monopolist’s profits are maximized when:

A - The average revenue is lower than the average cost.
B - The average revenue equals the average cost.
C - The marginal revenue exceeds the marginal cost.
D - The marginal revenue equals the marginal cost.

Answer 1

D - The marginal revenue equals the marginal cost.

The monopolist’s revenue is maximized when marginal revenue is equal to the marginal cost.

Question 2

Suppose that when a monopolistic car manufacturer raised its prices, it lost half of its customer base, but reported higher profits than before.
Which of the following can be concluded?

A - Consumer willingness to pay decreased.
B - The demand curve was upward sloping.
C - The firm was originally pricing where marginal revenue was greater than marginal cost.
D - The firm was originally pricing where marginal revenue was lower than marginal cost.

Answer 2

D - The firm was originally pricing where marginal revenue was lower than marginal cost.

The fact that the manufacturer could increase its revenues by raising prices and narrowing the client base indicated that the WTP of the high-type consumers was sufficiently higher than the WTP of the low-type consumers to make it inefficient to serve the low-type consumers.

Question 3

A monopolistic seller of rare oriental rugs discovers that 60% of the population is willing to pay $1,000 for a rug. The remaining 40% of the population is willing to pay $2000. Each rug costs $600 to produce.
How much should the monopolist charge for each rug?

A - $600
B - $1000
C - $1500
D - $2000

Answer 3

D - $2000

Charging $2000 would lead to 40% of the population purchasing at $1400 profit each. If there are 100 customers, that would be total profits of $56,000.

Question 4

A monopolistic seller of sports cars has traced out the following demand curve: 10 customers have willingness to pay (WTP) of $100K each, another 10 customers have WTP of $150K each, another 10 customers have WTP of $200K each; and a further 15 customers have WTP of $250K. Each sports car costs $50K to produce, but the production process requires a fixed machinery investment of $1.5M as well. The seller is considering setting one of the following prices:

I. A price of $150K
II. A price of $200K
III. A price of $250K

What is the order of the profits, from greatest to least, generated by these three pricing schemes?

Answer 4

II > I > III

Pricing scheme I would generate a profit of ($150K-$50K) * 35 - $1.5M = $2M. Pricing scheme II would generate ($200-$50K) * 25 - $1.5M =$2.25M. Pricing scheme III would generate ($250K-$50K) * 15 - $1.5M = $1.5M.

Question 5

A monopolist faces this demand curve and incurs a cost of $20 for each unit it sells.

What will be the price and quantity sold?

A - The price will be $20 and the quantity sold will be 15
B - The price will be $50 and the quantity sold will be 15
C - The price will be $40 and the quantity sold will be 20
D - The price will be $20 and the quantity sold will be 30

Answer 5

B - The price will be $50 and the quantity sold will be 15

Marginal cost = marginal revenue at a quantity of 15. The monopolist will sell 15 cars, and determine price based on the demand curve.

Question 6

A monopolistic producer of caviar has historically sold all of its caviar to 10 distributors. Recently, one of the distributors has acquired all of its competitors, becoming the caviar producer’s sole customer.

How are the caviar producer’s prices and profits likely to change as a result of this downstream consolidation?

A - Prices and profits will not change
B - Prices and profits will decrease
C - Prices and profits will increase
D - Prices will decrease and profits will not change

Answer 6

B - Prices and profits will decrease

The customer now has the power to negotiate price with the seller, and prices will likely fall as a result. Profit will decrease as the customer captures an increased share of the surplus.

Question 7

A fan of classical music would like to attend the symphony multiple times in a given month, but her willingness to pay for each subsequent performance decreases with the number of performances she has already attended. In particular, she is willing to pay $150 for the first performance, $100 for the second, and $60 for the third. The cost of each ticket to the symphony amounts to roughly $40.

Which of the two-part tariff schemes listed below yields the highest profit to the symphony from the given fan?

A - Charge $100 monthly membership fee, and $60 per ticket
B - Charge a $190 monthly membership fee, and $40 per ticket
C - Charge only a $300 monthly membership
D - Charge no monthly membership, and $100 per ticket

Answer 7

B - Charge a $190 monthly membership fee, and $40 per ticket

At these prices, the customer would attend all three performances, and would pay her total WTP of $310, resulting in $190 in profits for the symphony.

Question 8

An opera house is offering three performances, and has two types of consumers. The performances are “Carmen,” “Madama Butterfly,” and “Eugene Onegin.” Consumer 1 has WTP of $100 for a ticket to “Carmen,” $200 for “Madama Butterfly,” and $70 for “Eugene Onegin.” Consumer 2 has WTP of $120 for “Carmen,” $100 for “Madama Butterfly,” and $150 for “Eugene Onegin.” Each ticket costs the opera house $40.

How should the opera house bundle the goods?

A - Bundle the three operas together.
B - Bundle “Madama Butterfly” and “Eugene Onegin,” and sell “Carmen” separately.
C - Bundle “Carmen” and “Eugene Onegin,” and sell “Madama Butterfly” separately.
D - Sell each opera separately.

Answer 8

A - Bundle the three operas together.

A bundle of the three operas would be priced at $370, and the opera would earn a total of $740 in revenues, or $500 in profits.

Question 9

The round-trip business class airfare from Boston to Amsterdam (from August 18 through August 21) is $6,000. The round-trip business class airfare from Boston to Amsterdam to Athens and then returning to Boston (from August 18 through August 31) is $4,000.

What is the most likely explanation for this price difference?

A - The multi-city travelers probably care more about the comfort of their seats, whereas the Boston-Amsterdam travelers might be willing to buy coach seats since they will spend less total time in flight.
B - The Boston-Amsterdam travelers are probably more flexible to choose their dates of travel than the multi-city travelers, since they only need to spend a few days overseas.
C - The Boston-Amsterdam roundtrip travelers are more likely to be on business, whereas the multi-city travelers going to Greece are likely to be on vacation, and therefore more price-sensitive.
D - The Boston-Amsterdam flights must be more costly for the airline than the three flights in the multi-city trip combined.

Answer 9

C - The Boston-Amsterdam roundtrip travelers are more likely to be on business, whereas the multi-city travelers going to Greece are likely to be on vacation, and therefore more price-sensitive.

A 3-day trip to Amsterdam (during weekdays) is more likely to be a business trip than a longer trip, including weekends, to multiple destinations. Vacation travelers are typically more flexible in their dates and destinations, and more price-conscious, since they are actually paying the bill.

Question 10

“Marginal revenue” refers to the:

A - revenue earned on the last unit sold.
B - variable cost to produce an extra unit.
C - total revenue divided by the total number of units sold.
D - change in total revenue that results from selling an extra unit.

Answer 10

D - change in total revenue that results from selling an extra unit.

Marginal revenue takes into account both the extra revenue from selling one more unit to a customer and the lost revenue from lowering the price that will be charged to customers that would have bought the product already.

Question 11

What does Marginal Cost (MC) equal?

Answer 11

The additional cost incurred in producing an extra unit of output.

Question 12

What is marginal revenue?

Answer 12

Marginal Revenue = The additional revenue earned by producing extra unit(s) of a product or service.

or, the difference in revenue divided by the increase in units sold.

Question 13

Suppose that a museum of modern art discovers the following: adults are willing to pay $20 per ticket to see a Monet exhibit. Students are willing to pay less; 60% of students have WTP of $15, and 40% are willing to pay up to $10. There are no marginal costs to allowing more viewers into the museum. The museum manager decides to set the regular price at $20, and offer a student discount.

What discount should it offer?

A - 10%
B - 25%
C - 33%
D - 50%

Answer 13

D- 50%

At $10, all of the students will be willing to purchase a ticket. Imagine there are 100 students total: this would lead to revenue (and profits) of $1000, compared to $900 at a price of $15.

Question 14

A chocolatier produces truffles and sells each 1 pound box of truffles for $20. However, the chocolatier knows that some consumers would be willing to pay more than the cost of the chocolate, but less than $20 per pound, and wishes to sell truffles to these consumers as well.

Which of the following price discrimination methods relies on the chocolatier knowing which types of consumers are likely to have a lower willingness to pay?

A - Offering one free box of truffles to anyone who purchases two boxes
B - Selling misshaped truffles in bulk at a price of $12 per pound
C - Offering a discount to students and seniors
D - Offering a 20% off sale on a single type of truffle each week

Answer 14

C - Offering a discount to students and seniors

This method relies on the chocolatier knowing that students and seniors are the consumers who have a lower WTP.

Question 15

An artisan who creates customized furniture has a customer who is interested in purchasing several pieces of furniture. The artisan decides to sell the furniture via a two-part tariff, charging a fee to work with the customer and an additional price for each individual piece of furniture.

How should the artisan determine the price of each piece of furniture?

A - Estimate the customer’s willingness to pay and set the per-unit price equal to the average WTP.
B - Set the price of each piece of furniture equal to the marginal cost of producing it.
C - Set the price between the marginal cost of producing the most costly unit and the customer’s lowest estimated willingness to pay.
D - Set the per-unit price to $0 and capture value through the fee instead.

Answer 15

B - Set the price of each piece of furniture equal to the marginal cost of producing it.

An optimal two-part tariff prices each unit at marginal cost, and charges a lump sum fee on top.

Question 16

In the situation of the artisan in the previous question, assume that the artisan has an accurate estimate of the customer’s willingness to pay for each unit, and sets the lump sum fee just low enough that the customer decides to pay it. Remember that we are only assessing the artisan’s transactions with one customer.

In this case, what will be the deadweight loss and the distribution of surplus?

A - There will be no deadweight loss, and most of the surplus will be captured by the artisan.
B - There will be no deadweight loss, and the surplus will be close to evenly split between the customer and the artisan.
C - There will be some deadweight loss, and most of the surplus will be captured by the artisan.
D - There will be some deadweight loss, and the surplus will be close to evenly split between the customer and the artisan.

Answer 16

A - There will be no deadweight loss, and most of the surplus will be captured by the artisan.

Deadweight loss will be avoided since each piece of furniture is sold at its marginal cost. Once the customer has paid the lump sum fee, he will buy every piece of furniture for which his WTP is more than or equal to its cost. Since the lump sum fee is set barely low enough for the customer to pay it, most of the surplus is going to the artisan through the fee.

Question 17

The tiny town of Nemo has three neighborhoods located on a straight line: Neighborhood 1, Neighborhood 2, and Neighborhood 3, with Neighborhood 2 located equidistant between Neighborhood 1 and Neighborhood 3. There is one daycare center, located on Neighborhood 1. There are 10 families residing in each neighborhood, and each family has one child. Each family is willing to pay $70/day for daycare, and prefers daycare closest to its own neighborhood (though at current distances, families will purchase daycare services even if it’s two neighborhoods away). Families are indifferent between any two daycares in the same neighborhood. Suppose that daycare costs $30/day per child to provide. A new daycare center is thinking of opening in Nemo.

If both daycares will keep their price at $70/day, which neighborhood should the new daycare open in?

A - N 1
B - N 2
C - N 3
D - It doesn’t matter.

Answer 17

B - N2

Being located in Neighborhood 2 would attract all residents of Neighborhoods 2 and 3, and none of the residents of Neighborhood 1, for a surplus of: 20 * ($70 - $30) = $800/day.

Question 18

A town has many fast food restaurants, which charge an average of $6 for a hamburger. However, one fast food restaurant charges $10 for a hamburger and remains very competitive.

Which of the following situations could not, by itself, explain this restaurant’s ability to charge a higher price?

A - The restaurant is in a convenient location near several schools and businesses.
B - The restaurant pays higher monthly rent than its competitors.
C - The restaurant has been around for many years and customers have a nostalgic preference for it.
D - The restaurant offers its milkshakes and fries for a price below the market average.

Answer 18

B - The restaurant pays higher monthly rent than its competitors.

In a competitive market, higher costs alone cannot justify higher prices.

Question 19

A town with a small airport is served by two competing airlines. Which of the following strategies would make the airlines more likely to compete on price?

A - The airlines fly identical planes, with the same type of seat and the same amount of legroom for customers
B - One airline offers meals on board every flight while the other serves no meals but has fewer delayed flights
C - Each airline offers flights to a different set of other cities
D - The airlines offer loyalty programs, motivating existing customers to continue to fly with them

Answer 19

A - The airlines fly identical planes, with the same type of seat and the same amount of legroom for customers

This makes the airlines more similar to each other in non-price ways, making it more likely that they will compete on price.

Question 20

A telephone company offers two services: landlines and Internet. There are two types of customer demographics for these services. One customer demographic values the Internet service at $40/month, but only values landlines at $10/month. The other customer demographic values the Internet service less, at $30/month, but values the landline telephone service at $40/month. The two customer demographics are each comprised of 100 persons. Internet and landlines each cost $30/month to supply to each customer who purchases them (so the cost to supply both products to a customer is $60/month).

Which pricing scheme should the telephone company adopt?

A - Price Internet at $30/month and landlines at $40/month.
B - Price Internet at $40/month and landlines at $40/month.
C - Bundle the two goods at a combined price of $50/month.
D - Bundle the two goods at a combined price of $70/month.

Answer 20

B - Price Internet at $40/month and landlines at $40/month.

100 customers would purchase only Internet, creating profits of $1000. The other 100 customers would only purchase landlines, creating profits of $1000. Total profits would be $2000 per month.

Question 21

A real estate developer is offering identical houses for sale for $350,000 each, and has 20 willing customers. The developer is considering lowering the price to $300,000, since at that price there would be an additional 3 customers willing to purchase houses.

What would be the developer’s change in revenue from lowering the price in this way?

A - -$100,000
B - $100,000
C - $900,000
D - $1,050,000

Answer 21

A - -$100,000

The current revenue is $350,00020 = $7M. By lowering the price, the seller would get $300,00023 = $6.9M, which is $100,000 less. Thus, the developer should not lower the price to $300,000.

Question 22

True or false: When your competitors can’t easily respond to your moves, it can indeed pay to be similar to them.

Answer 22

True