Microeconomic I

1. Explain how monopolist reach a profit maximization and price determination? What are
the differences between a monopolist and a perfect competition firm to reach profit
maximization? Explain using graph. Show that the monopolists output and price is
inefficient market allocation.

Answer:

Firms in perfect competition act as a price taker, the quantity produced doesn’t change the price on
the market therefore P=MR. However, a monopolist act as a price maker, the price of a good
depends on the quantity it produces. And since monopolist produces unique product, it faces the
entire downward sloping market demand curve on its own, therefore the MR<P.

Perfect Competition Monopoly

Price ($)

6 6
5 5
4 Demand 4 Demand
3 3
MR
2 2
MR
1 1
Quantity
0 1 2 3 4 5 6 0 1 2 3 4 5 6

To reach max profit, monopolist uses same principles as firms in perfect competition, they produce
level of output when MC=MR. However, since monopolist have market power to control price, it can
control its quantity produced so that the profit is max. Monopolist produces quantity Q* as it fulfill
MC=MR, but the firm don’t sell at P0 price (P0 is the actual cost the firm expensed to produce Q*).
Instead, the firm set the price higher at p* where the Q* meet the demand curve. The profit of the
company is on yellow rectangle (P0 -P*-E- A)
Price

MC

ATC

E
P*

A
P0

MR Demand

Quantity
0 Q* (MC=MR)
Excess Capacity
• There is no excess capacity in perfect competition in the long run.
• Free entry results in competitive firms producing at the point where average total
cost is minimized, which is the efficient scale of the firm.
• There is excess capacity in monopolistic competition in the long run.
• In monopolistic competition, output is less than the efficient scale of perfect
competition.

Markup Over Marginal Cost

• For a competitive firm, price equals marginal cost.
• For a monopolistically competitive firm, price exceeds marginal cost.
• Because price exceeds marginal cost, an extra unit sold at the posted price means
more profit for the monopolistically competitive firm.
 2. Suppose a monopolist faces the demand curve in two separated markets: 𝑸𝟏 = 𝟒𝟖 − 𝑷𝟏
and 𝑸𝟐 = 𝟒𝟖 − 𝟐𝑷𝟐. And that the monopolist can serve both of these markets at a
constant marginal cost of 12.
a. Calculate output and prices for each market that give a monopolist profit
maximization. How much is the profit maximum?
b. Calculate the dead weight loss in the two markets
c. Suppose the monopolist has a single price policy, Calculate output and prices that
give a monopolist profit maximization. How much is the profit maximum?
Calculate the dead weight loss.
d. What can you conclude about allocation losses in these two cases?

Answer:

a. Output and prices

A. Market 1

Demand function 𝑄1 = 48 − 𝑃1 , Inverse demand function 𝑃1 = 48 − 𝑄1

𝑇𝑅 = 𝑃1 𝑄1
𝑇𝑅 = (48 − 𝑄1 )𝑄1
𝑇𝑅 = 48𝑄1 − 𝑄1 2

𝑀𝑅 = 48 − 2𝑄1

Profit Maximum when MR=MC

𝑀𝑅 = 𝑀𝐶
48 − 2𝑄1 = 12
𝑄1 = 18

𝑃1 = 48 − 𝑄1
𝑃1 = 30

Profit for Market 1 MC=12 TC=12Q

𝜋1 = 𝑇𝑅 − 𝑇𝐶
𝜋1 = 𝑃1 𝑄1 – 12𝑄1
𝜋1 = 30 ∙ 18– 12 ∙ 18
𝜋1 = 324

B. Market 2
1
Demand function 𝑄2 = 48 − 2𝑃2 Inverse demand function 𝑃2 = 24 − 2 𝑄2
𝑇𝑅 = 𝑃2 𝑄2
1
𝑇𝑅 = (24 − 𝑄2 )𝑄2
2
1
𝑇𝑅 = 24𝑄2 − 𝑄2 2
2

𝑀𝑅 = 24 − 𝑄2
Profit Maximum when MR=MC
𝑀𝑅 = 𝑀𝐶
24 − 𝑄2 = 12
𝑄2 = 12

1
𝑃2 = 24 − 𝑄2
2
𝑃2 = 18

Profit for Market 2 MC=12 TC=12Q

𝜋2 = 𝑇𝑅 − 𝑇𝐶
𝜋2 = 𝑃2 𝑄2 – 12𝑄2
𝜋2 = 18 ∙ 12– 12 ∙ 12
𝜋2 = 72

Total Profit = 𝜋1 + 𝜋2
= 324 + 72
= 396

b. DWL
A. Market 1

Profit maximization on perfect competition market (P=MC=12)

𝑄1 = 48 − 𝑃1
𝑄1 = 48 − 12 Price
𝑄1 = 36
48

30−12 ∙(36−18)
Dead Weight Loss= 2
= 162 30

12 MC

MR Demand

24 48
Quantity
0
B. Market 2 18 36

Profit maximization on perfect competition market (P=MC=12)

𝑄2 = 48 − 2𝑃2
𝑄2 = 48 − 24 Price
𝑄2 = 24

18−12 ∙(24−12) 24
Dead Weight Loss= 2
= 36
18

12 MC

Total DWL for both markets = 162+36=198

MR Demand

24 48
Quantity
0
12 24
 c. the monopolist has a single price policy

it means 𝑃1 = 𝑃2 ;

𝑄 = 𝑄1 + 𝑄2
𝑄 = 48 − 𝑃 + 48 − 2𝑃
1
𝑄 = 96 − 3𝑃 or 𝑃 = 32 − 3 𝑄

𝑇𝑅 = 𝑃𝑄
1
𝑇𝑅 = (32 − 𝑄) 𝑄
3
1
𝑇𝑅 = 32𝑄 − 𝑄2
3
2
𝑀𝑅 = 32 − 𝑄
3

Profit Maximum when MR=MC

1
𝑀𝑅 = 𝑀𝐶 𝑃 = 32 − 3 𝑄
2 1
32 − 3 𝑄 = 12 𝑃 = 32 − 3 30
𝑄 = 30 𝑃 = 22

Profit for two markets MC=12 TC=12Q

𝜋 = 𝑇𝑅 − 𝑇𝐶
𝜋 = 𝑃𝑄– 12𝑄
𝜋 = 22 ∙ 30– 12 ∙ 30
𝜋 = 300

Total profit for single pricing is less than if price discrimination is applied as in question 2.a.
(300<396)

Dead Weight Loss for single pricing:

Profit maximization on perfect competition market (P=MC=12)
𝑄 = 96 − 3𝑃
Price
𝑄 = 96 − 3 ∙ 12
𝑄 = 60
32
22−12 ∙(60−30)
Dead Weight Loss= 2
= 150
22

12 MC

MR Demand

48 96
Quantity
0
30 60
d. allocation losses in these two cases
 3. The demand for a good is given by the linear demand curve 𝑸 = 𝟏𝟐𝟎 − 𝑷. Costs are zero.
a. Find the solutions for output, price and profit under Cournot Duopoly condition
b. Find the solutions for output, price and profit under Stackelberg condition

Answer:

a. Output, price and profit under Cournot condition

Quantity produce is 𝑄 = 𝑄1 + 𝑄2 and inverse demand function is 𝑃 = 120 − (𝑄1 + 𝑄2 )
A. Firm 1 Quantity

𝑇𝑅1 = 𝑃 𝑄1
𝑇𝑅1 = (120 − (𝑄1 + 𝑄2 )) 𝑄1
𝑇𝑅1 = 120𝑄1 − 𝑄1 2 − 𝑄1 𝑄2 Therefore 𝑀𝑅1 = 120 − 2𝑄1 − 𝑄2

Profit Maximum when MR=MC

𝑀𝑅1 = 𝑀𝐶
120 − 2𝑄1 − 𝑄2 = 0
1
𝑄1 = 60 − 𝑄2
2

B. Firm 2 Quantity

𝑇𝑅2 = 𝑃 𝑄2
𝑇𝑅2 = (120 − (𝑄1 + 𝑄2 )) 𝑄2
𝑇𝑅2 = 120𝑄2 − 𝑄2 2 − 𝑄1 𝑄2 Therefore 𝑀𝑅2 = 120 − 2𝑄2 − 𝑄1

Profit Maximum when MR=MC

𝑀𝑅2 = 𝑀𝐶
120 − 2𝑄2 − 𝑄1 = 0
1
𝑄2 = 60 − 𝑄1
2

C. Both Firms Decisions

1
𝑄1 = 60 − 𝑄2 𝑃 = 120 − (𝑄1 + 𝑄2 )
2
1 1
𝑄1 = 60 − 2 60 − 2 𝑄1 𝑃 = 120 − 40 + 40
𝑄1 = 40 = 𝑄2 𝑃 = 40

D. Profit

𝜋1 = 𝜋2 = 𝑇𝑅 − 𝑇𝐶
𝜋1 = 𝜋2 = 𝑃𝑄 − 0
𝜋1 = 𝜋2 = 40 ∙ 40 − 0
𝜋1 = 𝜋2 = 1600
 b. Output, price and profit under Stackelberg condition
A. Follower reaction function

Quantity produce is 𝑄 = 𝑄1 + 𝑄2 and inverse demand function is 𝑃 = 120 − (𝑄1 + 𝑄2 )

𝑇𝑅2 = 𝑃 𝑄2
𝑇𝑅2 = (120 − (𝑄1 + 𝑄2 )) 𝑄2
𝑇𝑅2 = 120𝑄2 − 𝑄2 2 − 𝑄1 𝑄2 Therefore 𝑀𝑅2 = 120 − 2𝑄2 − 𝑄1

Profit Maximum when MR=MC

𝑀𝑅2 = 𝑀𝐶
120 − 2𝑄2 − 𝑄1 = 0
1
𝑄2 = 60 − 𝑄1
2

B. Leader reaction function

inverse demand function is 𝑃 = 120 − (𝑄1 + 𝑄2 )

1
𝑃 = 120 − (𝑄1 + (60 − 2 𝑄1 ))
1
𝑃 = 60 − 2 𝑄1
𝑇𝑅1 = 𝑃 𝑄1
1
𝑇𝑅1 = (60 − 𝑄 )𝑄
2 1 1
1
𝑇𝑅1 = 60𝑄1 − 2 𝑄1 2 Therefore 𝑀𝑅1 = 60 − 𝑄1

Profit Maximum when MR=MC

𝑀𝑅1 = 𝑀𝐶
60 − 𝑄1 = 0
1
𝑄1 = 60 Therefore 𝑄2 = 60 − 𝑄1
2
1
𝑄2 = 60 − 2 60
𝑄2 = 30

Thus 𝑃 = 120 − (𝑄1 + 𝑄2 )

𝑃 = 120 − (60 + 30)
𝑃 = 30

C. Profit

𝜋1 = 𝑇𝑅 − 𝑇𝐶 𝜋2 = 𝑇𝑅 − 𝑇𝐶
𝜋1 = 𝑃 𝑄1 − 0 𝜋2 = 𝑃 𝑄2 − 0
𝜋1 = 30 ∙ 60 𝜋2 = 30 ∙ 30
𝜋1 = 1800 𝜋2 = 900
 4. a. Explain about the derivation of demand for labor in producing good

The demand for all factor inputs, including labour, is a derived demand i.e. the demand depends on
the demand for the products they produce

- When the economy is expanding, we see a rise in demand for labour providing that the rise
in output is greater than the increase in labour productivity
- During a recession or a slowdown, the aggregate demand for labour will decline as
businesses look to cut their operations costs and scale back on production.
- In a recession, business failures, plant closures and short term redundancies lead to a
reduction in the derived demand for labour.
- In fast-growing markets, there is often a strong rise in demand for labour – for example an
increase in demand for new apps for smart phones and tablets causes an increase in labour
demand and then higher wage rates for app programmers

b. Some factors influence the change in the demand for labour, explain
- A rise in the level of consumer demand for a product which means that a business needs to
take on more workers (see below on the concept of derived demand)
- An increase in the productivity of labour which makes using labour more cost efficient than
using capital equipment
- A government employment subsidy which allows a business to employ more workers
- The labour demand curve would shift inwards during a recession when sales of goods and
services are in decline, business profits are falling and many employers cannot afford to
keep on their payrolls as many workers. The result is often labour redundancies and an
overall decline in the demand for labour at each wage rate.

5. Currently there are controversies about the effects of smokers consumption of cigarettes
and other tobacco products on third party bystanders (it is often called “secondhand
smoke”). Explain the health effect of secondhand smoke, reciprocal nature of secondhand
smoke externality, private actions and public policies toward the effects

Many of the economic issues that arise in cases of externalities are illustrated by controversies over
secondhand smoke. The term secondhand smoke (or, more formally, environmental tobacco smoke,
or ETS) refers to the effects of smokers’ consumption of cigarettes and other tobacco products on
third-party bystanders. This is a separate issue from the harmful effects of smoking on smokers
themselves— an activity that generally does not involve externalities,strictly defined.

Health Effects of Secondhand Smoke

Although few doubt that secondhand smoke is annoying, the question of whether ETS has serious
health consequences is controversial. The Environmental Protection Agency estimates that
approximately 2,200 people die annually as a result of the increased incidence of lung cancer among
those exposed to ETS. The agency suggests that the figure could be much higher if possible effects of
ETS on heart disease were also taken into account. But these estimates, as is the case for many such
epidemiological calculations, are based on relatively simple comparisons between individuals who
live or work in proximity to smokers and those who do not. It is possible that other factors may
explain such correlations. Regardless of the scientific evidence, however, many people believe that
secondhand smoke is very harmful and a variety of private and public actions have been taken to
mitigate this externality.
 Reciprocal Nature of the ETS Externality

As for all externalities, the ETS externality involves reciprocal effects. Smokers harm bystanders with
their smoke, but attempts to limit the ‘‘rights’’ of smokers impose inconveniences that need not
arise if the bystanders were not present. Although the costs of inconvenience to smokers are seldom
mentioned, they are not necessarily trivial. For example, one study of the potential impact of
workplace restrictions on smoking calculates a loss in smokers’ consumer surplus of approximately
$20 billion per year.1 Of course, such estimates may be far off the mark. But the fact that any
specification of rights to use a ‘‘free’’ resource (here, air) will significantly affect the welfare of the
parties involved makes the issue a controversial one.

Private Actions

For many years, decisions regarding secondhand smoke were handled through private transactions.
People decided when and where to smoke in their homes or in homes they were visiting. Railroads
designated smoking cars; airlines and restaurants had smoking sections, and workers would
negotiate among themselves over whether smoking on the job would be permitted. Such private
restrictions on smoking have been tightened in recent years, mainly in response to market
pressures. For example, all airlines have banned smoking from all flights, and many restaurants have
gone smoke free. Most hotel chains now offer nonsmoking rooms, and some have begun
segregating smokers and nonsmokers by floors. Smoking has also been banned from most public
venues such as movie theaters or sports arenas.

Public Actions

Concern about ETS has also been reflected in the demand for government regulation. The
Occupational Safety and Health Administration has proposed banning virtually all workplace
smoking, and recent polls suggest that many people would support a broader ban on smoking in all
public places. Some economists have asked whether such additional restrictions (beyond those
adopted privately) are really efficient. They ask for clear evidence that private choices by smokers
and nonsmokers have not been adequate for ameliorating most of the adverse effects of smoking
externalities. Given the declining number of smokers and the increasing aggressiveness with which
nonsmokers pursue their rights, however, it seems likely that smoking regulations will become
increasingly restrictive.