Other Market Structures

Question 1

Monopoly

Answer 1

A market with only one firm

Are price makers (does not have to worry about other prices)

Question 2

Price Taker

Answer 2

Has to worry about other firm’s prices.

Competitive markets (market sets the price)

Question 3

Price maker

Answer 3

Does not have to worry about other prices. Can set the price.

Question 4

Poisoning Effect

Answer 4

Adiditional sale lowers revenue for the rest.

Marginal revenue does not equal price

Marignal revenue = Price - Poisoning effect

Question 5

Market Power

Answer 5

The ability to price at a level higher than marginal cost

Question 7

Which of the following is true for both a monopolist and a firm in a perfectly competitive market?

Answer 7

The firm sets output so that marginal revenue equals marginal cost. Profit-maximizing firms always choose a quantity such that marginal revenue equals marginal cost, regardless of the structure and competitiveness of the market. If producing one more unit costs less than the revenue that will come from that unit, a profit-maximizing will do it. And the firm will keep producing until the cost to produce one more unit is equal to the revenue the firm would get for that unit.

Question 8

When a monopolist is at its profit-maximizing level of output, which of the following statements is true?

Answer 8

Price is higher than marginal revenue. Because a monopolist is the only firm, if it wants to sell another unit of a good, it has to charge a lower price. That creates a poisoning effect, since all the other units of the good also have to see a price drop. As a result, the marginal revenue is lower than the price.

Question 9

A monopolist is producing in the inelastic portion of the market demand curve. It is unable to price discriminate. In order to maximize profits, the monopolist should change price and output in which of the following ways?

Answer 9

Increase price and decrease output. If a monopolist is in the elastic portion of market demand, it can sell more units of the good without lowering the price too much. The poisoning effect is less harmful than the increased revenue from selling more units. So a monopolist should keep decreasing the price and selling more units until it gets to the point where demand is unit elastic. The opposite is true if the monopolist is in the inelastic portion. Then it’s selling too much, and the poisoning effect is large. It should cut back on output and raise prices.

Question 10

Which of these statements is true for a firm in perfect competition but not for a monopolist?

Answer 10

The firm cannot affect the market price for the good. In perfect competition, the firm faces a flat demand curve. The firm is a price taker, so it’s behavior can’t affect the market price. In a monopoly, the firm faces a downward sloping demand curve, and its choice of output determines the price of the good.

Question 11

Which of these statements is true for a monopolist but not for a firm in perfect competition?

Answer 11

The marginal revenue curve lies below the demand curve it faces. For a monopolist, the marginal revenue from the next unit of output is lower than the price of the good, because the monopolist has to lower the price on all the previous goods (the poisoning effect). Hence, marginal revenue is always below demand. For a firm in perfect competition facing a horizontal demand curve (the firm is a price taker), the marginal revenue curve is also horizontal, overlapping the demand curve.

Question 12

Which of the following is true for a monopolist if demand is price inelastic?

Answer 12

Marginal revenue is negative. In the inelastic portion of the demand curve, lowering the price is a bad idea. The drop in revenue from the poisoning effect is bigger than the rise in revenue from selling another unit. Hence, marginal revenue is negative.

Question 13

The profit-maximizing output level for a monopoly occurs where ___________.

Answer 13

The demand curve is elastic. Where the demand curve is elastic, marginal revenue is positive. Where the demand curve is inelastic, marginal revenue is negative. The profit-maximizing output has to be where marginal revenue is positive (or at least zero), since the firm needs to set marginal revenue equal to marginal cost, and marginal cost cannot be negative.

Question 14

Monopolists will…

Answer 14

sell less and price higher as demand is more inelastic

Question 15

Price Discrimination

Answer 15

When a monopoly charges different consumers different prices based on each consumer’s willingness to pay

• No deadweignt loss, but producer gets all surplus and consumer gets none

Question 16

Relative to perfectly competitive firms, a monopolist is inefficient in the long run because a firm in a monopoly __________.

Answer 16

Produces less output than is socially desirable at a price higher than average total cost. Both monopolists and more efficient perfectly competitive firms choose a level of output such that marginal revenue equals marginal cost. But marginal revenue for a monopolist is lower than the price (below the demand curve) due to the poisoning effect. Therefore, monopolists will produce less output that is socially optimal, allowing them to make long run economic profit by charging a price that is higher than average total cost.

Question 17

Price discrimination refers to a firm’s ability to ______________.

Answer 17

Charge a price to each consumer based on his willingness to pay. Price discrimination involves charging different prices to different consumers depending on their willingness to pay. Perfect price discrimination results in all the surplus going to the producer, leaving no surplus for the consumer.

Question 18

The graph below portrays a market with a single-price monopolist. MC = Marginal Cost, ATC = Average Total Cost, D = Demand, and MR = Marginal Revenue.

To maximize profit, the monopolist should choose which combination of output and price?

Answer 18

Q1; P4. A monopolist, like all firms, chooses output at a point where marginal cost equals marginal revenue. If the next unit of a good brings in more money (marginal revenue) than it costs to make (marginal cost), the firm will make it. Here, MR = MC at point Q1. To find the price, start at this point (where MC = MR), then trace up to the demand curve and over to the vertical axis at P4.

Question 19

Refer to the graph in Question 3A. If the monopolist could engage in perfect price discrimination, what output would it choose to maximize profit?

Answer 19

Q2. In perfect price discrimination, a firm figures out exactly how much each consumer is willing to pay, then charges them that price. The firm will keep selling units up until the point where the consumers’ willingness to pay (represented by the demand curve) meets marginal cost. In this market, that happens at a quantity of Q2.

Question 20

A firm with market power uses price discrimination to ___________.

Answer 20

Earn a higher profit. Firms use price discrimination to extract consumer surplus and turn it into profit for themselves. If you’re willing to pay $10 for a sandwich, and the firm doesn’t know this and charges a market price of $5, then you come away with $5 of surplus. If the firm knows how hungry you are, they can charge you $9.99 and take away your surplus.

Question 21

Natural Monopoly:

Answer 21

A type of monopoly that occurs when fixed costs are incredibly high, which means average total cost is always dropping as output increases.

Question 22

Barriers to Entry

Answer 22

The initial fixed costs that a new firm must face if they want to enter a market

Question 23

Patent

Answer 23

Legal exclusive right given to a firm to sell their product for a specified period of time; a way that the government can create a monopoly

Question 24

Which of the following allows a firm to capture all the surplus in a market?

Answer 24

Perfect price discrimination. If a firm can charge each consumer exactly the amount of her willingness to pay, the consumer gets no surplus and all the surplus goes to the firm. And if the firm can do this for all consumers (in other words, if it can perfectly price discriminate), the firm captures all the surplus in the market.

Question 25

A natural monopoly may exist in situations in which ___________.

Answer 25

The fixed costs of entering an industry are enormous, but marginal costs are low, so average total cost declines for all units of output.In a natural monopoly, there are enormous costs to starting the business (think laying down a new electrical grid), but once the fixed costs are paid, increasing output is easy to do. Other firms face high barriers to entry in the form of the enormous fixed costs and being forced to compete against an incumbent enjoying low marginal costs.

Question 26

Which of the following is a possible source of a firm’s ability to be a monopoly?

Answer 26

Barriers to entry. Significant barriers to entry, such as large fixed costs or government regulation, are one set of factors that can lead to and sustain a monopoly. If other firms are kept from entering a market in which there is a single monopoly firm operating, that monopoly can be allowed to persist without feeling the pressure of competitive market forces.

Question 27

Suppose that Novutra is a pharmaceutical company that just discovered a new cancer drug and is granted a patent on the drug. As long as the patent is in effect, Novutra will choose an output level for which ____________.

Answer 27

Marginal revenue is equal to marginal cost. Profit-maximizing firms always choose a quantity such that marginal revenue equals marginal cost, regardless of the structure and competitiveness of the market. While it is true that the patent may give Novutra a monopoly on this particular drug, that does not change Novutra’s goal of choosing an output level for which marginal revenue is equal to marginal cost.

Question 28

Oligopoly

Answer 28

A market structure with only a few firms, each with some market power

Question 29

Cartel

Answer 29

A group of producers with an agreement to work together to limit output and increase profit

Question 30

Cooperative cartels essentially create a

Answer 30

monopoly

However, cartels are hard to keep together for many reasons.

Question 31

Which of the following best characterizes an oligopoly market?

Answer 31

There are a small number of firms that produce a product and compete with one another. An oligopoly market is one in which there are a handful of firms, and each of them have some market power and compete with one another. Sometimes they may collude, but not always.

Question 32

Interdependence among firms is a feature of which of the following markets?

Answer 32

Oligopoly. In oligopolies, since there are only a handful of firms, what each firm does impacts the others substantially. In perfect competition, by contrast, each firm is too small to affect the other firms in the market that much.

Question 33

A cartel model of oligopoly predicts that ___________.

Answer 33

Firms act in unison to set the monopoly price or output. A cartel refers to a situation in an oligopoly where a handful of firms coordinate with each other in order to act like a monopoly.

Question 34

Which of these statements best explains why collusive agreements are hard to maintain?

Answer 34

Any one firm can increase its profit if it is the only firm to violate the agreement. The reason collusion is difficult to maintain is that, for each firm, there’s a big incentive to deviate. If any single firm secretly sets a different price, it can undercut all the other firms and make a huge profit. Since each firm has this temptation to cheat, it is hard to maintain a collusive agreement over time.

Question 35

Imagine a market with only three identical firms that each produce an identical good. If the group of three firms successfully collude to maximize joint profit, the market price of the product will be ____________.

Answer 35

Equal to the price a monopolist would charge. In an oligopoly with only a few firms, the firms will compete with each other, lowering one another’s profits. But if they can collude successfully, the best outcome for the firms is to act as if they are a monopoly, since this gives them the maximum possible profit. Hence, if they successfully collude, they’ll end up at a price that a monopolist will charge. If they can’t, then the price will be below what a monopolist would charge.

Question 36

Game theory

Answer 36

Game oligopolies are playing in a market

Question 37

Nash Equilibrium

Answer 37

In game theory, a Nash Equilibrium occurs when each player has chosen a strategy that it will not want to change, given what the other players have chosen.

Question 38

Payoff Matrix

Answer 38

Outcomes of decisions in game theory

Question 39

Dominant Strategy

Answer 39

In game theory, a strategy which is better than all other strategies – no matter what the other players choose

Question 40

Race to the Bottom

Answer 40

Both players worse off if they don’t cooperate than if they do.

Question 41

Anti-Trust Law

Answer 41

Laws that ban the collusion (or other anti-competitive behavior) between firms in the same market. The law is designed to protect consumers.

Question 42

In game theory, which of the following best characterizes a situation in Nash equilibrium?

Answer 42

Holding all other firms’ strategies constant, no firm wants to change its strategy. In a Nash equilibrium, no player (in this case, a firm) has an incentive to change its strategy given the strategies of the other firms.

Question 43

Game theory is most commonly used for analyzing how firms choose prices in which market structure?

Answer 43

Oligopoly. Game theory can often be a useful tool for modeling oligopolies. In an oligopoly, there are a few key players, and each one’s outcome depends on the other, making it well-suited to be modeled with the tools of game theory. In a monopoly, there’s only one actor, so game theory isn’t useful. In perfect competition and monopolistic competition, there are so many firms that game theory is once again not very useful.

Question 44

The table below shows a payoff matrix for two firms that compete against each other and must decide whether or not to advertise. The first entry indicates Jerry’s Ice Cream’s profit, and the second entry indicates Ben’s Ice Cream’s profit.

What is the dominant strategy for Ben’s Ice Cream?

Answer 44

Not advertise. Ben’s best option is always to not advertise. First, imagine Jerry advertises. Then we’re in the top row of the grid. If Ben advertises, he gets $100. If he doesn’t, he gets $110. Now imagine Jerry doesn’t advertise. Then we’re in the bottom row of the grid. If Ben advertises, he gets $200, but if he doesn’t, he gets $210. So, no matter what Jerry does, Ben is better off not advertising. This is the definition of a dominant strategy.

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Question 45

Refer to the payoff matrix in Question 3A. What is the dominant strategy for Jerry’s Ice Cream?

Answer 45

Advertise. Jerry’s best option is always to advertise. First, imagine Ben advertises. Then we’re in the left column of the grid. If Jerry doesn’t advertise, he gets $70. If he does advertise, Jerry gets $100. Now imagine Ben doesn’t advertise. If Jerry doesn’t advertise, he gets $90, but if he does advertise, he gets $200. So, no matter what Ben does, Jerry is better off advertising. This is the definition of a dominant strategy.

Question 46

Refer to the payoff matrix in Question 3A. What are each of the firm’s profits in the Nash equilibrium?

Answer 46

$200 profit for Jerry’s; $110 profit for Ben’s. In a Nash equilibrium, each player has no incentive to change strategies, given what the other player is doing. In this game, both players have a dominant strategy. Jerry always advertises, and Ben always chooses not to advertise. No matter what Ben does, Jerry’s best option is always to advertise, and he has no incentive to deviate. The same is true for Ben not advertising. Hence, the Nash equilibrium is when Jerry advertises and Ben doesn’t, leading to payoffs of $200 for Jerry and $110 for Ben.

Question 47

The table below shows a payoff matrix for two firms that must decide whether or not to enter a new market. The first entry indicates Firm A’s profit, and the second entry indicates Firm B’s profit.

Which, if either, of the firms have a dominant strategy?

Answer 47

Firm A has a dominant strategy but not Firm B. Firm A should always enter. If Firm B enters, Firm A gets $50 for entering and $0 for not entering. And if Firm B doesn’t enter, Firm A gets $100 for entering and $10 for not entering. Either way, Firm A is better off entering. On the other hand, Firm B WOULD NOT want to enter if Firm A enters (to get a payoff of $10 instead of only $5), but Firm B WOULD want to enter if Firm A doesn’t enter (to get a payoff of $50 instead of only $10). So Firm B does not have a dominant strategy.

Question 48

Refer to the payoff matrix in Question 4A. What is the payoff of each firm in the Nash equilibrium?

Answer 48

$100 profit for Firm A; $10 profit for Firm B. Firm A has a dominant strategy, so it will always enter. Firm B knows that Firm A will enter. And when Firm A enters, Firm B is better off not entering ($10 payoff compared to $5). So Firm A will enter and Firm B will not, leading to payoffs of $100 for Firm A and $10 for Firm B.

Question 49

Product Differentiation

Answer 49

More substitutes = less profit

Therefore, more unique products create less substitutability

More inelasticity equals less subtitution.

Question 50

Monopolistic Competition

Answer 50

A type of imperfect competition that is a mix between a monopoly and perfect competition. Like a monopoly, each firm is the only firm that can sell its good (and has market power), but other firms can make nearly identical goods to compete with the firm.

Question 51

Excess Capacity

Answer 51

Firms with monopolistic competition produce at points below what would it be if avg total cost were minimized.

Question 52

The demand curve for a monopolistically competitive firm is downward sloping because ____________.

Answer 52

No other firm can produce an identical product. A monopolistically competitive firm is like a monopoly in that no one else can make this exact product. Therefore, instead of facing a horizontal demand curve (as in perfect competition), the monopolistically competitive firm faces a downward-sloping demand curve.

Question 53

Firms in monopolistic competition are inefficient in the long-run because they ____________.

Answer 53

Produce less output, at a higher average total cost, compared to firms in perfect competition. Monopolistically-competitive firms in the long-run produce at the point where the downward-sloping demand curve is tangent to average total cost. This happens at a point above the minimum average total cost, and at a lower level of output. This results in inefficiency. More goods would be sold in a perfectly-competitive market.

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Question 54

In long-run equilibrium, which of the following is true of firms in monopolistic competition?

Answer 54

They have excess capacity, price is above marginal cost, and long-run profit is zero. Monopolistically competitive firms choose output at a level below where average total cost is minimized (see previous question). This is inefficient and referred to as “excess capacity.” A monopolistically-competitive firm is like a monopoly and faces a downward-sloping demand curve. When it chooses output so that marginal revenue equals marginal cost, the marginal cost is above (not equal to) price because of the poisoning effect. In the long-run, however, a monopolistically-competitive firm makes zero profits. This is because as long as it makes a profit, other firms will enter and try to make similar goods, and this will continue until profits are driven to zero.

Question 55

Which of the following is true of both monopolistically-competitive firms and perfectly-competitive firms in the long run?

Answer 55

Price equals average total cost. For both perfectly-competitive and monopolistically-competitive firms, price ends up being equal to average total cost in the long run. This is because of competition. If price is above average total cost, then the firm is making a profit. And in both perfect and monopolistic competition, profits attract new competitors who make identical or similar goods, pushing the price and the average total cost towards each other. In perfect competition, new entrants produce an identical good, causing supply to go up and price to go down. In monopolistic competition, new entrants making a similar product steal some of the firm’s customer base, causing demand to go down and price to go down.

Question 56

A monopolistically-competitive firm currently produces and sells 1,000 units of a good. At this output, marginal revenue is $20, average revenue is $25, and average variable cost is $15. What is the price of the good?

Answer 56

$25. If the average revenue is $25, the price is also $25 since the firm is charging the same price for every unit of the good. In fact in this case, we do not need to use the values of marginal revenue and average variable cost to compute the price.

Question 57

Let P = price, MR = marginal revenue, MC = marginal cost, and ATC = average total cost. Consider a firm in monopolistic competition that is in long-run equilibrium. Which of the following is true?

Answer 57

P = ATC; MR = MC; and P > MC. In the long-run, price ends up at average total cost and profits are zero, because profits attract new entrants until this is true. As is the case for all profit-maximizing firms, the firm chooses output so that MR = MC. For a monopolistically-competitive firm, the demand curve is downward sloping, so the price is above marginal cost.