nNEXTIAS ECONOMICS OPTIONAL Microeconomics Numericals Q1. A monopolist faces a market demand curve given by: Q=70-p a. If the monopolist can produce at constant average and marginal costs of AC = MC = 6, what output level will the monopolist choose in order to maximize profits? What is the price at this output level? What are the monopolist’s profits? b. Assume instead that the monopolist has a cost structure where total costs are described by C(Q) = .25Q?- 5Q + 300 With the monopolist facing the same market demand and marginal revenue, what price- quantity combination will be chosen now to maximize profits? What will profits be? c. Assume now that a third cost structure explains the monopolist’s position, with total costs given by: C = .0133Q3 - 5Q + 250 Again, calculate the monopolist’s price-quantity combination that maximizes profits. What will profit be? Hint: Set MC = MR as usual and use the quadratic formula to solve the second- order equation for Q. d. Graph the market demand curve, the MR curve, and the three marginal cost curves from parts (a), (b), and (c). Notice that the monopolist's profit-making ability is constrained by (1) the market demand curve (along with its associated MR curve) and (2) the cost structure underlying production. Solution: By: Vibhas JhaMarket demand Q = 70 -P, MR = 70-2Q a. AC = MC =6. To maximize profits, set MC = MR. 6=70-2Q Q=32P=38 m=(P—AC) Q= (38-6) 32= 1024 b. C=.25Q?—5Q +300, MC=.5Q-5, SetMC=MR 5Q-5=70-2Q Q=30 P=40 t= TR—TC = (30)(40) — [.25(30)?-5 (30) + 300] = 825, ce. C=.0133Q3- 5Q + 250. MC = .040?-5 MC =MR Therefore: .04Q? + 2Q -75=0. Quadratic formula gives Q = 25. IfQ= 25, P=45 R=1125 C=332.8 (MC=20) 1=792.2 Q2. A single firm monopolizes the entire market for widgets and can produce at constant average and marginal costs of AC = MC = 10. Originally, the firm faces a market demand curve given by Q = 60 - P. By: Vibhas Jhaa. Calculate the profit-maximizing price-quantity combination for the firm. What are the firm's profits? o . Now assume that the market demand curve shifts outward (becoming steeper) and is given by: Q = 45 - .5P. What is the firm's profit-maximizing price-quantity combination now? What are the firm’s profits? c. Instead of the assumptions of part (b), assume that the market demand curve shifts outward (becoming flatter) and is given by: Q= 100 - 2P. What is the firm’s profit-maximizing price-quantity combination now? What are the firm’s profits? d. Graph the three different situations of parts (a), (b), and (c). Using your results, explain why there is no real supply curve for a monopoly. Solution: a, AC = MC = 10, Q= 60 -P, MR=60-2Q For profit maximum, MC=MR — 10=60-2Q Q=25 P=35 t= TR—TC = (25)(35) — (25)(10) = 625. b. AC=MC = 10, Q= 45 - 5P, MR=90-4Q. For profit maximum, MC=MR 10=90-4Q Q=20 P=50 tr = (20)(50) — (20)(10) = 800 c. AC=MC = 10, Q= 100- 2P, MR = 50-Q. For profit maximum, MC=MR 10=50-Q Q=40 P=30. tt = (40)(30) — (40)(10) = 800. Note: Here the inverse elasticity rule is clearly illustrated: By: Vibhas JhaP-MC Problem Part P a 14.71 =(35—10)/35 b =.5(50/20) =—1.25 .80 = (50 10)/50 c -2(30/40) =-1.5 67 = (30- 10)/30 P| MC=AC = 10 d. The supply curve for a monopoly is a single point, namely, that quantity-price combination which corresponds to the quantity for which MC = MR. Any attempt to connect equilibrium points (price- quantity points) on the market demand curves has little meaning and brings about a strange shape. One reason for this is that as the demand curve shifts, its elasticity (and its MR curve) usually changes, bringing about widely varying price and quantity changes. Q3. Suppose a monopoly market has a demand function in which quantity demanded depends not only on market price (P) but also on the amount of advertising the firm does (A, measured in dollars). The specific form of this function is: Q = (20-P)(1 + .1A—.01A2) The monopolistic firm's cost function is given by: By: Vibhas JhaC=10Q+15+A. a. Suppose there is no advertising (A = 0). What output will the profit- maximizing firm choose? What market price will this yield? What will be the monopoly's profits? z Now let the firm also choose its optimal level of advertising expenditure. In this situation, what output level will be chosen? What price will this yield? What will the level of advertising be? What are the firm's profits in this case? Hint: This can be worked out most easily by assuming the monopoly chooses the profit-maximizing price rather than quantity. Solution: Q = (20-P)(1 +.1A-.01A2) Let K=1+.1A + .01A? dK =.1-.02A dA = PQ—C = (20P — P’)K — (200 - 10P)K—15-A dit = (20— 2P)K + 10K =0 dP a. 20-2P= P=15 regardless of KorA IfA=0,Q=5,C=65 m= 10 b. If P=15, 1 = 75K — 50K —- 15 -A=25K- 15-A=10+41.5A— 0.2547 d= 1.5-0.5A=0soA=3 dP Q=5(1 +.3—.09) = 6.05 PQ=90.75 C=60.5+15+3=78.5 1 = 12.25; this represents an increase over the case A = 0. Q4. Suppose a perfectly competitive industry can produce widgets at a constant marginal cost of $10 per unit. Monopolized marginal costs rise to $12 per unit because $2 per unit must be paid to lobbyists to retain the widget producers’ favored position. Suppose the market demand for widgets is given by: Q = 1,000 - SOP. a. Calculate the perfectly competitive and monopoly outputs and prices. By: Vibhas Jhab. Calculate the total loss of consumer surplus from monopolization of widget production. c. Graph your results and explain how they differ from the usual analysis. Solution: a. For perfect competition, MC = $10. For monopoly MC = $12 QD = 1000 — 50P. The competitive solution is P = MC = $10, Thus Q = 500 Monopoly: P = 20- 1/50 Q. PQ=20Q - 1/50 Q? Produce where MR = MC. MR = 20- 1/25Q = 12. Q=200, P = $16. o . See graph below. Price Consumer Surplus for Monopoly 5 (4)(200) = 400 Gonsumer Surplus P.C. 4 (10)(500) = 2500 200 500 Quantity Loss of consumer surplus = Competitive CS — monopoly CS = 2500 — 400 = 2100. c. Of this 2100 loss, 800 is a transfer into monopoly profit, 400 is a loss from increased costs under monopoly, and 900 is a “pure” deadweight loss. Q5. Assume for simplicity that a monopolist has no costs of production and faces a demand curve given by: Q = 150 - P. a. Calculate the profit-maximizing price-quantity combination for this monopolist. Also calculate the monopolist's profit. By: Vibhas Jhab. Suppose instead that there are two firms in the market facing the demand and cost conditions just described for their identical products. Firms choose quantities simultaneously as in the Cournot model. Compute the outputs in the Nash equilibrium. Also compute market output, price, and firm profits c. Suppose the two firms choose prices simultaneously as in the Bertrand model. Compute the prices in the Nash equilibrium. Also compute firm output and profit as well as market output. d. Graph the demand curve and indicate where the market price- quantity combinations from parts (a)-(c) appear on the curve. Solution: Q=150-P MC =0 a. A zero cost monopolist would produce that output for which MR is equal to 0. (MR = MC = 0). MR = 0 at one half of the demand curve’s horizontal intercept. Therefore, Q=75 P=75 1=5625 o . gi + q2 = 150- P Demand curve for firm 1: q1 = (150 — q2) - P Profit maximizing output level: q: = (150 — qa) 2 Demand curve for firm 2: qz = (150 — qi) - P Profit maximizing output level: qz = (150 — qi) 2 Market equilibrium: qi = [150 - (150 — q:)/2]- 2 qn = 150 - 75 + qi/2 = 37.5 + qul4 2 4q: = 150 + qi 3q1= 150 qi = 50, q2 = 50, P= 50 TH = Te = $2,500. Thotai = 5,000 c. Under perfect competition, P = MC = 0. Q= 150, P=0, 1=0. By: Vibhas Jha150 120 100 80 Q=75 P=\75 50 Q=100P=50 20 Q=150P=0 20 40 60 80100 140 Q \wr Q6. Following Cournot's nineteenth-century example of two natural springs, we assume that each spring owner has a large supply of (possibly healthful) water and faces the problem of how much to provide the market. A firm's cost of pumping and bottling qi liters is Ci(qi) = cqji, implying that marginal costs are a constant c per liter. Inverse demand for spring water is: P(Q)=a-Q, (6.1) By: Vibhas Jhawhere a is the demand intercept (measuring the strength of spring-water demand) and Q = q: + qzis total spring-water output. Examine various models of how this market might operate under Bertrand, Cournot and Perfect cartel. Solution: Bertrand model. In the Nash equilibrium of the Bertrand game, the two firms set prices equal to marginal cost. Hence market price is P*= ¢, total output is Q* = a - c, firm profit is Tr* = 0, and total profit for all firms is [1* = 0. For the Bertrand quantity to be positive we must have a>, which we will assume throughout the problem. Cournot model. Profits for the two Cournot firms are: TH = P(Q)qr - cq: = (a - qi - Qe -C)qr, The = P(Q)q2 - cq2 = (a - qi - G2 - Cc) qe. (6.2) Using the first-order conditions to solve for the best-response functions, we obtain: qi=a-@-c qe=a-qi-c. (6.3) 2 2 Solving Equations 6.3 simultaneously yields the Nash equilibrium: qi* = qo" =a-c (6.4) 3 Total output is thus Q* = (%)(a -c). Substituting total output into the inverse demand curve implies an equilibrium price of P* = (a + 2c)/3. Substituting price and outputs into the profit functions (Equations 6.2) implies 111” = Tre" = (1/9)(a - c)?, so total market profit equals M* = ™* + Te” = (2/9)(a- o)? Perfect cartel. The objective function for a perfect cartel involves joint profits: 1 + Tha = (a - qr - Q2 - C)qi +(a - Qh - G2 -C)qz (6.5) The two first-order conditions for maximizing Equation 6.5 with respect to q: and q2 are the same: A(T + TH) = A(T + Te) = a - 2q1- 2qa-c=0 (6.6) oq: dq2 By: Vibhas JhaThe first-order conditions do not pin down market shares for firms in a perfect cartel because they produce identical products at constant marginal cost. But Equation 6.6 does pin down total output: qi* + q2* = Q* = (A)(a-c). Substituting total output into inverse demand implies that the cartel price is P* = (%4)(a - c). Substituting price and quantities into Equation 6.5 implies a total cartel profit of Mt = (”)(a - 6? By: Vibhas Jha