QUESTION
Instructions
Economics Department
School of Economics and Finance
Additional Tutorial Exercises ‐ Set 2
313658 Microeconomics 300
Semester 2 2012
Dr Julian Inchauspe, Unit UC & Lecturer
Due on: Your Assigned Tutorial Session in Week 8
Fill the empty gaps on this page.
Use the answer sheet on page 6 to answer the multiple choice questions.
Handwritten answers are acceptable.
Submit your answers by giving a hard copy of your answers to your Tutor during your assigned
Tutorial session.
Plagiarism or cheating will not be tolerated and may lead to a mark of 0 (zero) and further
disciplinary actions.
First Name:……………..……………………………………………………………………………
Last Name:.…………………………………………………………………………………………..
Signature:……………………………………………………………………………………………..
Tutor:……………..…………………………………………………………………………………….
Day and Time of Tutorial:……………………………………………………………………..
MARK: /100
Microeconomics 300 ‐ Semester 1, 2012 Additional Tutorial Exercises – Set 2
Part I‐ Answer Questions
I.1. (25 Marks) In certain town in WA, Aussie Gas Inc. is the only provider of natural gas to households and industries. Taking
into account this fact, answer these questions:
(a) If the objective of Aussie Gas Inc. is to maximize profits, how would this monopolist set the price and the
quantity
according to economic theory? How would this outcome compare to the situation that would prevail if the market was
perfectly competitive? Use a graph to illustrate your answer. (7 Marks)
(b) The government is concerned about the consequences of having a monopolistic market structure in this market and
wants
to introduce some regulation. How should the government regulate the price of natural gas according to economic
theory? Use a graph to illustrate your answer. (7 Marks)
(c) Do you think that government regulation could bring a Pareto‐improvement (i.e. make the market more Pareto‐efficient)
in this case? Explain carefully
and define Pareto‐efficiency and deadweight losses in the context of this market structure. (7
Marks)
(d) A government official has proposed an alternative idea to price regulation. She noted that Aussie Gas emerged as a
natural monopolist because high fixed entry costs were necessary (construction of pipelines, etc.). She also knows that
there are other Australian firms that are interested in providing gas in this city if they could have access to the existing
pipeline network which is owned by Aussie Gas. Considering this, the government official is proposing a regulation under
which any firm could use this network if
they paid a usage marginal cost per cubic metre to Aussie Gas. Do you think that
this alternative idea for introducing competition could work? Do you think that price regulation would still be necessary in
this market if more firms come in? (4 Marks)
I.2. (25 Marks) Suppose that you
have been hired as an external consultant by Bigger Union movie theatres to estimate the
optimal discounts for different type of consumers.
Some data has been provided to you. Based on several surveys, data collection and previous experience, the demand by
different groups of consumers as follows:
i. Demand by students:
306
ii. Demand by aged people:
423
iii. Demand by people other than i and ii paying a “normal” ticket price:
2
742
where is the ticket price, and is the quantity in thousands of tickets per year.
In addition, you know that Bigger Union has a contract with major US film distributors to play their movies. According to this
contract, the distributors charge 6 AU$ per viewer, irrespective of which
movie is played. This cost is considered to be
the only relevant marginal cost. Based on this information, answer the following questions:
(a) If the different groups of people are charge different prices for seeing a same movie in a same theatre, what is the
economic terminology that best describes
this practice? (3 Marks)
(b) To prepare your report, finalise the table below by filling the empty gaps. Provide a graphical representation of your
answer. (20 Marks)
Type of Ticket
Expected Annual Sales
(No. Of Tickets)
Ticket Price Discount (%)
Normal (full price) 0
Student
Aged People
Microeconomics 300 ‐ Semester 1, 2012 Additional Tutorial Exercises – Set 2
(c) Do you think that Bigger Union could obtain higher profits by charging a single price to all consumers? (2 Marks)
I.3. (25 Marks) Suppose that certain duopoly is characterized by quantity leadership as in Stackelberg’s model. Firm 1 is the
quantity‐leader and Firm 2 is the quantity‐follower.
You are also given the following information:
Demand: 130 10
,
Firm 1 Cost Function:
10
Firm 2 Cost Function:
10
Now, follow these instructions:
(a) Find Firm 2’s reaction curve and explain its meaning. (10 Marks)
(b) Solve the Leader’s maximization problem subject to the Follower’s reaction and find the equilibrium values of
and
. Do you think that in reality these values will be achieved? (10 Marks)
(c) Represent your answers in a graph. (5 Marks)
Part II‐ Multiple Choice Questions (25 Marks)
Each multiple‐choice question is worth 2.5 Marks. Only one of the options is correct. Use the answer sheet at the end of this
document to answer these questions. You do not need to provide explanations for the option you choose.
II.1. If a market operates under perfect competition, in the long run:
□ (a) 0.
□ (b) .
□ (c) .
□ (d) None of the above.
II.2. A reason why natural monopolies exist
may be:
□ (a) Inelasc demand.
□ (b) High entry cost, i.e. high initial fixed investment is required.
□ (c) Patents.
□ (d) All of the above.
II.3. Suppose that a monopolist supplies the amount of output
3
and
. This monopolist could increase
profits by:
□ (a) Increasing output and reducing the price.
□ (b) Reducing output and increasing the price.
□ (c) Increasing output and increasing the price.
□ (d) Reducing output and reducing the price.
,
Microeconomics 300 ‐ Semester 1, 2012 Additional Tutorial Exercises – Set 2
II.4. The main reason why some firms may want to form a cartel is:
□ (a) To capture the whole consumers’ surplus.
□ (b) To increase profits by reducing output.
□ (c) To increase profits by joining forces to produce more output.
□ (d) To maximize the amount of damage caused on society.
II.5. Under second‐degree price discrimination:
□ (a) Quantity discounts are applied.
□ (b) Each consumer pays a different price for a same quanty.
□ (c) A two‐part tariff is used.
□ (d) None of the above.
II.6. The Regional Playback Control (RPC) system is an international convention set
by the DVD Copy Control Association in
California to divide the world into six DVD‐markets: 1. US and Canada, 2. Europe and Japan, 3. Asia, 4. Oceania and Latin
America and 5. Africa, Russia and Eastern Europe. Economic theory suggests that with this convention:
□ (a) US film‐distributors had
to sacrifice profits to make DVDs available to poor consumers in the world.
□ (b) Price competition and trade among the above defined regions was encouraged.
□ (c) The DVD consumers’ surplus became zero.
□ (d) US film‐distributors were able to significantly increase their profits.
II.7. Pareto‐efficiency means:
□ (a)
That every market participant is in the best situation she can be.
□ (b) That no market participant can be better‐off without making somebody else worse‐off.
□ (c) That nobody could possibly be worse‐off.
□ (d) That income and well‐being is equally distributed among market participants.
II.8. Which of the following situations is NOT Pareto‐efficient:
□ (a) A monopoly with third‐degree price discrimination.
□ (b) A monopoly with first‐degree price discrimination.
□ (c) A two‐part tariff.
□ (d) Perfect competition.
4
Microeconomics 300 ‐ Semester 1, 2012 Additional Tutorial Exercises – Set 2
II.9. Suppose that two vendors are located on a beach that is 100 metres long and that their costumers are evenly spread along
this beach. According to Hotelling’s theory, if the vendors are not collaborative with each other, the most likely final physical
location of the vendors will be:
□ (a) Random.
□ (b) Each of them will be located 25 metres away from each extreme, meaning that consumers will have to walk no more
than 25 metres to buy ice‐cream.
□ (c) Both of them will end up right in the middle, meaning that consumers will have to walk up
to 50 metres.
□ (d) Any place as the location does not affect the demand that each vendor will be facing.
II. 10. Suppose that Firm 1 and Firm 2 are the only suppliers in certain market. Firm 1 may become a price‐leader and Firm 2
may become a price‐
follower because:
□ (a) Firm 1 has a cost advantage, i.e.
.
□ (b) Firm 2 wants to avoid a price war.
□ (c) Both firms want to avoid a price war.
□ (d) All of the above.
References
5
Varian, HR (2010), Intermediate microeconomics: a modern approach, 8th edn, International Student Edition, W. W. Norton
& Company, New York.
Microeconomics 300 ‐ Semester 1, 2012 Additional Tutorial Exercises – Set 2
Answer Sheet for Multiple‐Choice Questions in Part II
Question
Answer
(a, b, c or d)
Correct/Incorrect
(Marker Only)
II.1
II.2
II.3
II.4
II.5
II.6
II.7
II.8
II.9
II.10
TOTAL PART II /25
6
SOLUTION
1. Question 1
1.1(a): Monopoly Price Determination
A monopoly is a market condition where there is existence of a single firm dominating the market, with no close competitor of the product produced by the firm. Thus in the case of a monopoly market the firm has the right to determine the price and output being the sole player in the market. The monopoly is said to produce the output that maximises the level of economic profit of the firm i.e. the maximization of the difference between total revenue and total costs. The price is set to the level corresponding where the difference between the total cost and total revenue is the maximum. Graphically the theory can be explained as:
Marginal Cost (MC)
Price Po B
(Monopoly A
Price) Demand
Marginal Revenue
Monopoly Quantity Total Quantity
Figure 1 : Monopoly Price Determination
The above figure represents the determination of monopoly price, The x axis represents the quantity produced and the Y axis represents the Price of the product the monopolist sets the monopoly price where there is maximization of monopoly revenues or in other words where MR= MC, The intersection of the MR and MC curves determines the profit maximization output for the monopolist at the corresponding price of Po. The monopolist does not charge the price at the intersection of the MR and MC but the price corresponding to the demand curve producing the profit maximization quantity.
On the other hand in the case of a perfectly competitive market, an individual firm is unable to determine price or output because of existence of a large number of firms in the market. The bargaining power of an individual firm is almost non-existent. Thus, the price and the quantity are market determined. One of the basic differences between monopoly and perfect competition is the Demand curve , a firm operating in a perfectly competitive market has a perfectly elastic demand curve indicating that price has no effect on the quantity on the other hand a monopolist has a downward sloping demand curve. Let us see the profits maximization price for a firm in perfect competition graphically.
Price MC (Marginal Cost)
ATC Po Price = Marginal Revenue = AR
Quantity (Q)
Figure 2 : Perfect Competitive Price Determination
The profit maximization output in a perfectly competitive firm the determined at the intersection of the MR and MC producing Quantity Q at the price corresponding Po. A Perfectly competitive firm charges the price corresponding to the profit maximising output.
(Mankiw et al, 2009)
1.1 (b) Introduction of Government Regulation in a Monopoly
The government regulates the price in a monopoly market to ensure some fairness in the market to avoid a situation where the consumer is charged an extremely high price for a particular product. If the government introduces regulation in the monopoly market, then the government would force the monopolist to charge a price below the profit maximization level corresponding to the monopolist demand. This practice would result in some reduction of profits to the monopolist, but the benefits would be passed on to the consumers in the form of lower prices thus, introducing somewhat efficiency in the market. Let us understand the situation graphically.
Marginal Cost (MC)
Price Po
Pg
Quantity (Q) Q1
Figure 3: Price regulation and Price determination in a Monopoly
In the above figure in the case when no government regulation has been introduced the monopolist produces a Quantity (Q) and charges a price corresponding to the demand curve i.e. Po .The price charged is the difference between the Marginal Costs and Marginal revenues. On the other hand with the introduction of government regulation the monopolist has been forced to charge a price Pg lower than the price charged by the monopolist this causes the consumer to consume the quantity Q1 resulting in the lower economic profits for the monopolist as evident in the figure. Thus in the long run the monopoly will not stay in business if heavy subsidization is introduced. The regulators should apply a rate-of-return policy, regulating agencies focus on the rate of return on invested capital (accounting profit)earned by a monopoly (fair rate of return).
(Mankiw et al , 2006 , Depoorter, 1999)
1.1(c): Pareto Efficiency and Deadweight losses
The government regulation will not lead to creation of a Pareto efficient situation rather would increase the dead weight losses in the already imperfect market situation.
Pareto efficiency can be defined as the allocation of the resources in such a way that no individual is better or worse off in the market. Existence of Pareto efficient market in a monopoly the results are quite ambiguous. As a monopoly charges a price that is above the marginal costs hence all consumers are not willing to pay such a high price. The quantity sold and produced by the economy is at below the socially efficient levels. The dead weight loss in the figure can be defined as the area of the triangle between the demand curves and the marginal costs. This dead weight loss is minimised to some extent in the case when government regulation is introduced. The government regulation tries to regulate the monopoly market in such a way that some sort of fair pricing is introduced in the system.
Price Marginal Costs (MC)
Po
Price
MR Demand Curve (AR)
Quantity (Q)
Figure 4: Representation of the Monopoly Deadweight loss
The inefficiency in the market is reprinted by the dead weight depicted in the shaded area. The dead weight loss is a result of existence of the market inefficiency caused by existence of the monopoly .A monopolist charges a high Price Po at the inefficient output levels on Q.
However the introduction of the government regulation is likely to introduce some efficiency in the market, thereby minimising the dead weight loss in the market. Minimization of the dead weight loss implies the creation of an efficient market situation where output levels are maximised at socially efficient prices determined by the government. Let us explain the situation graphically.
Price Marginal Costs (MC)
Price Regulation
MR AR (Demand)
Figure 5: Dead weight Loss with government regulation
The dead weight loss is clearly minimised as can be seen from the figure. The area of the dead weight loss is minimised with the government regulation thereby introducing market efficiency. The inefficiency in the market is somewhat offset by the governments attempt to regulate the market and introduce fair pricing.
1.1(d) Introduction of Competition
The proposal to introduce competition in the market would definitely regulate the prices in the economy to some extent. However the imposing high fixed costs to enter in the market would itself pose as a determent to the competition. As high investment costs accompanied with long gestation periods act as deterrent to the competition. However to introduce competition in the market the government would have to minimise the already existent deterrent in the natural monopoly market. On the other hand the regulation of the market is likely to introduce efficiency in the market and is somewhat a better mechanism to control the monopoly market than relaxing fixed costs rules and regulations that already pose as a deterrent in the economy.
1.2(a) Price Discrimination
The strategy adopted by the theatre to charge different prices to different groups of people is called ‘Price Discrimination’. Price Discrimination can be defined as charging different prices to different customers for reasons other than costs. A monopoly introduces the practice of price discrimination based on the customers will to pay a higher price for the good or the service on offering. To adopt the strategy of price discrimination several factors have to take into account
1. Market power: to follow the strategy of price discrimination the firm must have the power to discriminate in the existing market.
2. Identify the willingness to pay: the firm should be able to identify the willingness to pay in the market. It should be able to group people according to their willingness to pay for the product.
(Hall et al, 2009)
1.2 (b) Graphical Representation
Given the demand functions
Ps = 30 – 6y
Total revenue earned from students Ps x y = (30-6y)y
MR= 30 – 12y
According to monopoly equilibrium MR= MC
30-12y = 6
y = 2
Quantity of tickets sold students is 2 and the price paid by the students is 18
P ag = 42- 3y
Total revenue = (42-3y)y
MR = 42 – 6y
According to monopoly equilibrium MR = MC
Thus y = 6 and the price paid by the aged 24
On the other hand price paid by the normal group is MR= MC price paid is 34 and the number of people paying the price is 17
Type of ticket No of tickets (per thousand ) Price Paid Discount
Normal 17 34 0
Student 2 18 16
Aged 6 24 10
Graphical Representation of Price Discrimination
Price (Students) Price (Normal) MC Price (Aged)
AR MR
Figure 6: Representation of Price Discrimination
From the above figure it is clearly evident that price discrimination has caused different prices to be paid by different groups. Students benefit greatly from the discrimination as they end up paying the lowest price of 18 and receive a maximum discount of Rs16. The aged also benefit from the strategy and receive a discount of 10. Thus discrimination can only be followed in places firstly where there is a willingness to pay different prices for the same product.
1.2(c) Guarantee of Higher profits
The motive of following the price discrimination strategy is to earn higher profits. However by following the one price the firm would eliminate the potential advantage of charging different prices to different consumer. In the above case though the firm is offering discounts to the consumers but it would tend to gain by the large numbers expected to use the products. Thus the strategy would not lead to a reduction in the profits((Hall et al, 2009)
1.3 Duopoly
P = 130 – 10Yt
Cost function of Firm 1:10Y1
Cost Function Firm 2 :10Y2
Yt = Y1 + Y2
Therefore the demand function for the First Duopolistic firm
130 – 10(Y1 + Y2)
Total Revenue = (130 – 10 Y1- 10Y2) (10Y1)
= 1300Y1-100Y1^2 – 100Y1Y2
Therefore the demand function for the 2nd Duopolistic firm
Total Revenue = (130- 10Y1-10Y2)(10Y2)
=1300Y2-100Y1Y2-100Y2^2
To maximise the profits we have the following equations
200Y1+100Y2= 1300
100Y1+200Y2=1300
Y2= 4.3
Y1 = 4.35
YT= 4.35+4.35= 8.7
Thus the equilibrium output under a duopoly is 8.7 and the price obtained by the firm is 43 and for firm 2 43.5. The 2nd firm is a price follower and is following the price obtained by the First firm the price is only marginally higher than the first firm.
Price
4.35
4
Total Demand
D1 D2
Q1 Q2 Total Quantity
Figure 7: Duopoly Equilibrium
Thus the duopoly produces the quantity of 43 units and the duopolistic charge a price of 4 and 4.35 respectively. The firm 2 is a price follower and a close competitors of firm 1 hence the reason for charging a similar prices.
2. Question 2
1. (D)
2. (D)
3. (C)
4. (B)
5. (A)
6. (C)
7. (A)
8. (D)
4. References
• Mankiw, N. Gregory, and Mark P. Taylor. Microeconomics. London: Thomson, 2006. Print.
• Hall, Robert Ernest, and Marc Lieberman. Microeconomics: principles and applications. 3rd ed. Mason, OH: Thomson/South-Western, 2005. Print.
• W.F. Depoorter, Ben . “REGULATION OF NATURAL MONOPOLY.” Center for Advanced Studies in Law and Economics 5400.1 (1999): 1-11. Print.
JH79
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