MICRO

ECONOMICS
COURSE CODE: 9303
ASSIGNMENT: 02
Question No # 1:
Discuss the inefficiency of
monopoly as it relates to dead
weight loss. Include a graphical
representation to show
monopolies affect consumer
and producer surplus.

Answer:
Monopoly can lead to
inefficiencies in the market,
primarily through the creation
of deadweight loss, which
occurs when the quantity of a
good produced and consumed
is less than the socially optimal
level. In a competitive market,
prices tend to equal marginal
cost (MC), leading to efficient
allocation of resources.
However, a monopolist sets the
price above marginal cost to
maximize profit, resulting in
reduced output and a loss of
consumer and producer
surplus.
  Inefficiency of Monopoly
1. Price Setting: A monopolist
faces a downward-sloping
demand curve, meaning they
can choose a price above
marginal cost. This creates a
price that exceeds the
competitive price.
2. Reduced Quantity: Because
of the higher price, the quantity
produced is lower than the
socially optimal quantity found
in a competitive market.
3. Dead weight loss: reduction
in quantity leads to a
deadweight loss (DWL),
represented as the area
between the demand curve and
the marginal cost curve, This
area represents the loss of
economic efficiency when the
quantity of a good traded in the
market is less than the optimal
level.
Graphical Representation
To visualize these concepts,
consider the following key
elements in a standard demand
and supply graph:
Axes: Price on the vertical
axis and Quantity on the
horizontal axis.
Demand Curve (D):
Downward sloping, indicating
that as price decreases,
quantity demanded
increases.
 Marginal Cost Curve (MC):
Upward sloping, representing
the additional cost of
producing one more unit.
Monopoly Price and
Quantity:
The monopolist sets price at
the point where marginal
revenue (MR) equals marginal
cost (MC).
This occurs at quantity.
 Competitive Price and
Quantity:
The competitive equilibrium
occurs where demand equals
marginal cost, leading to price
and quantity.
Surpluses
Consumer Surplus (CS): The
area above the price and
below the demand curve. In
a monopoly, CS is reduced
compared to a competitive
market.
Producer Surplus (PS): The
area below the price and
 above the MC curve. In a
monopoly, PS may increase
due to higher prices but is
still less efficient overall.
Deadweight Loss Area:
The deadweight loss is
represented graphically as the
triangle formed between:
The demand curve (above the
monopolist’s quantity)
The marginal cost curve (below
the monopolist’s quantity).
In summary, monopolies lead
to inefficiencies by reducing
quantity produced and
increasing prices, resulting in
lost consumer and producer
surplus and creating
deadweight loss in the
economy.
Question No # 2:
Explore the concept of the
revealed preference theory.
How does it value the choices
a consumer makes under
different budget constraints?

Answer:
Revealed preference theory is
an economic concept that seeks
to understand consumer
behavior by analyzing the
choices consumers make under
varying budget constraints. It
posits that the preferences of
individuals can be inferred from
their purchasing decisions,
rather than relying on self-
reported utility or satisfaction.
 Key Components of
Revealed Preference Theory:
1. Choice Observation: The
theory suggests that if a
consumer chooses one bundle
of goods over another when
both are affordable, this choice
reveals that the preferred
bundle provides at least as
much utility as the other
2. Budget Constraints: The
consumer's choices are
influenced by their budget
constraints. As the budget
changes, the optimal choice
may shift, revealing preferences
over time.
3. Consistency of Preferences:
Revealed preference theory
assumes that consumers have
consistent preferences. If a
consumer prefers A over B and
B over C, then A should be
preferred over C, aligning with
the principle of transitivity.
4. Indifference Curves: While
revealed preference theory
does not explicitly use
indifference curves, the choices
made can be graphically
represented in a similar
manner, showing the
consumer's preference ordering
  Valuing Choices Under
Different Constraints:
Comparison Across Budgets: By
observing how a consumer's
choices change as their income
or prices change, economists
can infer the relative values and
preferences for different goods.
For instance, if a consumer
buys more of a good when their
income increases, it suggests
that good is a normal good.

Substitution Effect: When

prices change, consumers
will substitute one good for
another based on their
preferences. The theory
helps to understand how the
consumer reallocates their
spending when faced with
different prices.
Welfare Analysis: The
choices made under different
budget constraints can also
inform welfare analysis. By
assessing which bundles
were chosen and which were
not, economists can evaluate
consumer welfare and the
impact of policies, such as
subsidies or taxes.
 Limitations:
Assumption of Rationality:
The theory assumes rational
 behavior, which may not
always hold true in real-
world situations where
consumers face cognitive
biases or irrational
influences.
Data Dependency: The
analysis relies heavily on
observed choices, which can
sometimes lead to
ambiguous interpretations if
preferences are not stable.
In summary, revealed
preference theory provides a
framework for understanding
consumer choice by examining
how decisions change with
varying budget constraints,
ultimately revealing underlying
preferences and informing
economic analysis.
Question No # 3:
Describe the nature of a firm's
behaviour in monopolistic
competition especially
focusing on the product
differentiation and the
demand curve. How does this
affect the equilibrium of the
firm?

Answer:
In monopolistic competition,
firms operate in a market
characterized by many sellers
offering differentiated products.
This product differentiation is
crucial, as it allows each firm to
have some degree of market
power, enabling them to set
prices above marginal cost.
1. Variety of Products: Firms
distinguish their products
through branding, quality,
features, or customer service.
This creates a perception of
uniqueness among consumers.
2. Consumer Preferences:
Because products are not
perfect substitutes, consumers
may prefer one firm's product
over another’s, leading to
brand loyalty.
1. Downward Sloping Demand:
Each firm faces a downward
sloping demand curve,
indicating that as the firm raises
its price, the quantity
demanded will decrease. This
reflects the product
differentiation, as consumers
will switch to substitutes
offered by competitors if the
price increases.
2. Elasticity: The demand curve
is relatively elastic due to the
availability of substitutes. A
small increase in price can lead
to a significant drop in quantity
demanded.
 Equilibrium of the Firm
1. Short-Run Equilibrium: In
the short run, a firm can earn
supernormal profits if its
product is sufficiently
differentiated and it effectively
captures consumer
preferences. The firm
maximizes profit where
marginal cost (MC) equals
marginal revenue (MR).
2. Long-Run Equilibrium: In the
long run, the presence of
supernormal profits attracts
new entrants into the market.
As more firms enter, the
demand for each existing firm’s
product decreases, shifting the
demand curve leftward.
Eventually, firms reach a point
where they earn only normal
profits (zero economic profit) at
the equilibrium where price
equals average total cost (ATC).
Conclusion:
In summary, firms in
monopolistic competition
behave by leveraging product
differentiation to gain some
control over pricing, resulting in
a downward sloping demand
curve. This dynamic leads to
short-run profits, but long-run
adjustments due to new
entrants lead to an equilibrium
where firms earn normal
profits, balancing the need for
differentiation with the
competitive pressures of the
market.
Question No # 4:
Explain the concept of
simultaneous quantity setting
in a Cournot equilibrium
within an oligopoly market.
How does this strategy differ
from simultaneous price
setting?
Answer:
In a Cournot equilibrium within
an oligopoly market, firms
compete by simultaneously
choosing the quantities of a
homogeneous product they will
produce. The key aspect of this
strategy is that each firm makes
its quantity decision based on
the anticipated quantities
chosen by its rivals. This leads
to a Nash equilibrium where no
firm can improve its profit by
unilaterally changing its output,
given the outputs of the other
firms.
  Key Features of
Simultaneous Quantity
Setting:

1. Output Decision: Each firm

selects how much to produce,
considering the production
levels of its competitors.
2. Market Price: The market
price is determined by the total
quantity supplied by all firms,
which is a function of the
aggregate output.
3. Reaction Functions: Each
firm has a reaction function
that indicates how much output
it will produce in response to
the output levels of its
competitors.
 Comparison with
Simultaneous Price Setting:

1. Nature of Competition:
In simultaneous quantity
setting (Cournot), firms
compete on quantities, leading
to strategic interdependence in
output decisions.
In simultaneous price setting
(Bertrand), firms compete on
prices, which can lead to more
aggressive competition, often
driving prices down to marginal
cost in homogeneous goods.
2. Equilibrium Outcome:
Cournot equilibrium results in a
higher market price and lower
total output compared to
perfect competition but higher
than monopoly. Bertrand
equilibrium, especially with
identical products, often results
in prices equating to marginal
cost, significantly lowering
market prices.
3. Strategic Focus:
In Cournot, firms focus on
optimizing production levels,
anticipating competitors'
output decisions.
In Bertrand, firms focus on
pricing strategies, reacting to
competitors' price changes.
Overall, the choice between
simultaneous quantity and
price setting fundamentally
alters the dynamics of
competition and the resulting
market outcomes in
oligopolistic markets.
Question No # 5:
Discuss the impact of
monopolistic power in both
the product and factor
markets. How does this power
influence factor pricing and
market outcomes?

Answer:
Monopolistic power can
significantly impact both
product and factor markets,
leading to various
consequences for pricing,
market outcomes, and overall
economic efficiency.

 Impact on Product
Markets

1. Pricing Power: Monopolies

can set prices above marginal
costs, leading to higher
consumer prices compared to
competitive markets. This
results in decreased consumer
surplus and potential
deadweight loss, where some
consumers who would benefit
from the product at a lower
price are excluded from the
market.
2. Output Levels: Monopolistic
firms typically produce less
than what would be produced
in a competitive market. This
restricted output can reduce
overall market efficiency and
lead to allocative inefficiency,
where resources are not
distributed according to
consumer preferences.
3. Product Variety and
Innovation: While monopolies
may have the resources to
invest in research and
development, they might lack
the incentive to innovate due to
the absence of competition.
This can lead to stagnation in
product variety and
technological advancement.
Impact on Factor Markets
1. Wage Setting: In factor
markets, a monopolistic
employer can exert significant
influence over wage levels. By
being the dominant buyer of
labor, the firm can set wages
below what would prevail in a
competitive market, leading to
reduced income for workers.
2. Employment Levels:
Monopolistic power can also
affect employment. With the
ability to pay lower wages,
monopolies might not hire as
many workers as would be the
case in a competitive
environment, leading to higher
unemployment rates in the
affected sectors.
3. Resource Allocation: The
monopolistic control over
factor inputs can distort
resource allocation.
Monopolies might favor certain
factors or suppliers that benefit
their market position, which
can create inefficiencies and
limit competition among
suppliers.

 Overall Market Outcomes

1. Inefficiency: The
combination of higher prices,
lower output, and reduced
innovation contributes to
economic inefficiency.
Monopolistic markets often fail
to allocate resources in a
manner that maximizes social
welfare.
2. Barriers to Entry:
Monopolies can create
significant barriers to entry for
potential competitors, further
entrenching their market
power. This can lead to a lack of
competition, which perpetuates
the negative impacts discussed.
3.Market Power Dynamics:
Monopolistic firms may engage
in practices that consolidate
their power, such as predatory
pricing or exclusive contracts,
which can deter new entrants
and maintain their dominance
over time.
Conclusion:
In summary, monopolistic
power affects both product and
factor markets by distorting
prices, output levels, and
resource allocation. These
impacts lead to inefficiencies
and reduced welfare for
consumers and workers alike,
emphasizing the need for
regulatory oversight to mitigate
the negative effects of
monopolies.