Assignment two: chapter 4, 5 and 6.

Exercise 1: “The degree of monopoly power is limited by the elasticity of demand.” Comment.

Solution: Optimal monopoly pricing leads to the following relation between the price-cost margin
and demand elasticity: (p - MC) / p = 1/IεI, where p is price, MC marginal cost, and ε demand
elasticity. It follows that the greater the value of ε the lower the value of (p – MC) and the lower
monopoly profits. A monopolist facing a vary elastic demand curve makes profits at the level of
competitive firm.

Exercise 2: One study estimates the long-run demand elasticity of AT&T in the period 1988–
1991 to be around 10.60 Assuming the estimate is correct, what does this imply in terms of
AT&T’s market power?

Solution: A demand elasticity of 10 implies that AT&T’s demand is very elastic. In fact, the author
for the study that produced this estimate computes the welfare loss due to AT&T’s market power
to be less than 1% of sales volume.

Exercise 3: After spending 10 years and $1.5 billion, you have finally gotten Food and Drug
Administration (FDA) approval to sell your new patented wonder drug, which reduces the aches
and pains associated with aging joints. You will market this drug under the brand name of Ageless.
Market research indicates that the elasticity of demand for Ageless is 1.25 (at all points on the
demand curve). You estimate the marginal cost of manufacturing and selling one additional dose
of Ageless is $1.

a. What is the profit-maximizing price per dose of Ageless?

b. Would you expect the elasticity of demand you face for Ageless to rise or fall when
your patent expires?

Solution:

1. Our general markup rule states that (p - MC) / p = 1/IεI, where ε is the elasticity of demand
facing the firm at the point on the demand curve at which the firm operates. With a constant
elasticity of demand and constant marginal cost, as in this problem, we can use this formula so
solve directly for the profit-maximizing price, p*. Here we get (p*-1)/p* = 1,25. Solving for the
optimal price gives p* = $5. Equivalently, one can directly use the other version of the markup

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formula, p = MC IεI /(IεI – 1), to get p = 1x1,25 / (1,25 – 1), which again gives p* = $5. Of course,
the R&D expenditures are now sunk and thus do not enter into the pricing decision.

2. The level of demand for ageless must fall now that there are many very close substitutes in the
form of generic version. Hopefully, your brand will still allow you to command a premium price,
but surely at any given price you will sell less as a result of the presence of the generic competition.

The elasticity of demand for Ageless will very likely rise now that closer substitutes are available.
Customers will presumably be more price sensitive, and thus will induce you to set a lower price.

Exercise 4:

Suppose the demand curve is Q = 12.5 – 0.25P.

a What is the marginal revenue curve that corresponds to this demand curve?
a Calculate marginal revenue when Q = 6.
a Calculate marginal revenue when Q = 7.

Solution:

a First, we need to solve for the inverse demand curve by rearranging the demand function so
that price is on the left side by itself:

Q = 12.5 – 0.25P ; 0.25P = 12.5 – Q ; P = 50 – 4Q.

So, we know that the inverse demand curve is P = 50 – 4Q, with a = 50 and b = 4.
Because MR = a – 2bQ, we know that MR = 50 – 8Q.

b. We can plug these values into our MR equation to solve for marginal revenue:
When Q = 6, MR = 50 – 8(6) = 50 – 48 = 2. When Q = 7, MR = 50 – 8(7) = 50 – 56 = – 6.
Note that, as we discussed above, MR falls as Q rises and can even become negative.

Exercise 5: The market for laundry detergent is monopolistically competitive. Each firm owns one
brand, and each brand has effectively differentiated itself so that is has some market power (i.e.,
faces a downward sloping demand curve). Still, no brand earns economic profits because entry
causes the demand for each brand to shift in until the seller can just break even. All firms have
identical cost functions, which are U-shaped.
Suppose that the government does a study on detergents and finds out they are all alike. The public
is notified of these findings and suddenly drops allegiance to any brand. What happens to price
when this product that was brand-differentiated becomes a commodity? What happens to total
sales? What happens to the number of firms in the market?

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Solution:

Based on the information provided, it seems that the initial situation in this market is like the long-
run equilibrium of monopolistic competition model; see Figure 6.3 (Book). The government’s
announcement has turned a differentiated product into a homogeneous one. In terms of the graph
in Figure 6.3, this implies a flattening of the demand curve faced by each firm and a new long-run
equilibrium where d (now horizontal) is tangent to the AC curve. At this new long-run equilibrium,
price is given by p’LR and each firm’s output is given by q’LR.
Clearly, the new equilibrium implies a lower price and a higher output per firm: p’ LR < pLR and
q’LR > qLR.

Suppose that price were to drop from pLR to p’LR without changing the degree of product
differentiation or the number of firms. This would imply an output per firm equal to q’SR, where
q’SR is greater than qLR but lower than q’LR. If we take into account the disappearance of product
differentiation (and continue with the same number of firms), then the output per firme would be
less than q’SR. Therefore, in the post-announcement long-run equilibrium, some firms will need to
exit the market.

Finally, it is not clear what will happen to total output. On the one hand, each firm’s output goes
up . On the other hand, the number of firms goes down. Which effect dominates depends on how
consumes value product differentiation and how the demand curve shifts as a result of the
government announcement.

Exercise 6:

Assume that the pickle industry is perfectly competi- tive and has 150 producers. One hundred of
these producers are “high-cost” producers, each with a short-run supply curve given by Qhc = 4P.
Fifty of these producers are “low-cost” producers, with a short-run supply curve given by Qlc =
6P. Quantities are measured in jars and prices are dollars per jar.

a. Derive the short-run industry supply curve for pickles.

b. If the market demand curve for jars of pickles is given by Qd = 6,000 – 300P, what are the
market equilibrium price and quantity of pickles?
c. At the price you found in part (b), how many pickles does each high-cost firm produce? Each
low- cost firm?
d. At the price you found in part (b), determine the industry producer surplus.

Solution:

a. To derive the industry short-run supply curve, we need to sum each of the firm short-run supply
curves horizontally. In other words, we need to add each firm’s quantity supplied at each price.

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 Since there are 100 high-cost firms with identical supply curves, we can sum them simply by
multiplying the firm supply curve by 100: QHC = 100Qhc = 100(4P) = 400P
Similarly, we can get the supply of the 50 low-cost firms by summing their individual supply
curves or by multiplying the curve of one firm by 50 (since these 50 firms are assumed to have
identical supply curves): QLC = 50Qlc = 50(6P) = 300P
The short-run industry supply curve is the sum of the supply by high-cost producers and the supply
of low-cost producers: QS = QHC + QLC = 400P + 300P = 700P b. Market equilibrium occurs
where quantity demanded is equal to quantity supplied: QD = QS
6,000 – 300P = 700P ; 1,000P = 6,000 ; P = $6

Exercise 7:

Consider our example of the two snowboard manufacturers, Burton and K2. We just determined
that at the Nash equilibrium for these two firms, each firm produced 600 snowboards at a price of
$300 per board. Now let’s suppose that Burton launches a suc- cessful advertising campaign to
convince snowboarders that its product is superior to K2’s so that the demand for Burton
snowboards rises to qB = 1,000 – 1.5pB + 1.5pK, while the demand for K2 boards falls to qK =
800 – 2pK + 0.5pB. (For simplicity, assume that the marginal cost is still zero for both firms.).

a Derive each firm’s reaction curve.

a What happens to each firm’s optimal price?
a What happens to each firm’s optimal output?
a Draw the reaction curves in a diagram and indicate the equilibrium.

Solution:

a To determine the firms’ reaction curves, we first need to solve for each firm’s marginal
revenue curve:
MRB = 1,000 – 3pB + 1.5pK ; MRK = 800 – 4pK + 0.5pB
By setting each firm’s marginal cost equal to marginal revenue, we can find the firm’s
reaction curve:

MRB = 1,000 – 3pB + 1.5pK = 0 ; 3pB = 1,000 + 1.5pK

pB = 333.33 + 0.5pK
MRK = 800 – 4pK + 0.5pB = 0
4pK = 800 + 0.5pB ; pK = 200 + 0.125pB

b We can solve for the equilibrium by substituting one firm’s reaction curve into the other’s: pB
= 333.33 + 0.5pK
pB = 333.33 + 0.5(200 + 0.125pB ) = 333.33 + 100 + 0.0625pB

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pB = 433.33 + 0.0625 pB ; 0.9375 pB = 433.33 ; pB = $ 462.22

We can then substitute pB back into the reaction function for K2 to get the K2 price:
pK = 200 + 0.125pB = 200 + 0.125(462.22) = 200 + 57.78 = $257.78
So, the successful advertising campaign means that Burton can increase its price from the original
equilibrium price of $300 (which we determined in our initial analysis of this market) to $462.22,
while K2 will have to lower its own price from $300 to $257.78.

c To find each firm’s optimal output, we need to substitute the firms’ prices into the inverse
demand curves for each firm’s product. For Burton,
qB = 1,000 – 1.5pB + 1.5pK = 1,000 – 1.5(462.22) + 1.5(257.78) = 1,000 – 693.33 + 386.67 =
693.34
For K2,
qK = 800 – 2pK + 0.5pB = 800 – 2(257.78) + 0.5(462.22) = 800 – 515.56 + 231.11 = 515.55
Burton now produces more snowboards (693.34 instead of 600), while K2 produces fewer
(515.55 instead of 600).

d. The reaction curves are shown in the diagram below:

K2’s reaction curve
(pK = 200 + 0.125pB)
Burton’s
price, pB
Burton’s reaction curve
$462.22 (pB = 333.33 + 0.5pK)

333.33

0
200 $257.78 K2’s price, PK