PROBLEM SET 6 by HvlyGaI

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									                                    PROBLEM SET 6

                             Problems for Chapters 10 and 11

1.     a. Explain the meaning of a “kinked demand curve” and under what circumstances a firm
operating in an oligopoly would have one.
       b. On the graph below draw a case in which marginal cost changes, but a firm with a
kinked demand curve DOES NOT change the price it charges.
       P




         P1                              A                     MC




                                                       D

                                             MR
                                      Q1                                    Q
       c. On the graph below draw a case in which marginal cost changes, and a firm with a
kinked demand curve DOES change the price it charges.
       P




         P1                              A                     MC




                                                       D

                                              MR
                                       Q1                                     Q
                                                     2



       2. Suppose that two rival firms (Firm A and Firm B) are considering whether or not to
          allocate lots of resources to advertising their product (“HIGH ADVERTISING
          BUDGET”) or just a small share of resources (“LOW ADVERTISING BUDGET”). The
          success of each strategy in generating profits for each firm depends on the advertising
          strategy the rival firm follows.
              a. Using the pay-off matrix below, indicate which strategy is optimal for the two
                  firms combined (“the group”).

                                       PAY-OFF MATRIX
                                                               FIRM B’S ACTIONS
                                                High Advertising Budget Low Advertising Budget
                          High Advertising      A: profit = +10,000      A: profit = +50,000
                              Budget            B: profit = +10,000      B: profit = +7,000
FIRM A’S ACTIONS
                          Low Advertising       A: profit = +7,000            A: profit = +30,000
                              Budget            B: profit = +50,000           B: profit = +30,000

             b.      Figure out which advertising strategy is in each individual firm’s best interest by
    filling out the chart below.

     FIRM A’S BEST INDIVIDUAL STRATEGY                   FIRM B’S BEST INDIVIDUAL STRATEGY
      If Firm B implements                                If Firm A implements
     high advertising budget                             high advertising budget

      If Firm B implements                                If Firm A implements
     low advertising budget                              low advertising budget


               c. Which advertising strategy will more likely be implemented by the two firms in
                  the industry if they cannot credibly collude with each other? Explain.
                                                      3


        3. Suppose that two rival airlines (American and United) are considering whether or not to
           offer a frequent flyer program that gives free flights to customers who accumulate
           enough miles flying on the airline. The success of such a program in generating profits
           for each airline depends on whether its rival offers a similar program.
               a. Using the pay-off matrix below, indicate which strategy is optimal for the two
                   airlines combined (“the group”).

                                       PAY-OFF MATRIX
                                                               UNITED’S (U) ACTIONS
                                                      Offer program         Do not offer program
                                     Offer        A: profit = +40,000    A: profit = +60,000
                                    program       U: profit = +40,000    U: profit = +10,000
AMERICAN’S (A) ACTIONS
                                  Do not offer    A: profit = +10,000        A: profit = +50,000
                                   program        U: profit = +60,000        U: profit = +50,000

            b.      Figure out which strategy is in each individual airline’s best interest by filling
    out the chart below.

 AMERICAN’S BEST INDIVIDUAL STRATEGY                      UNITED’S BEST INDIVIDUAL STRATEGY

  If United offers program                                 If American offers
                                                               program

   If United does not offer                               If American does not
           program                                            offer program


                d. Which strategy will more likely be implemented by the two airlines if they cannot
                   credibly collude with each other? Explain.
                                               4



4.     Use the diagram of a monopolistically competitive firm below to help you answer the
questions.


              $

                                                                 MC             ATC


              P4                                                                  AVC

              P3



              P2
              P1                                                                          D=P




                                                           MR
                   0                               Q1 Q2        Q3                    Q

       a.     Where does a monopolistically competitive firm get its “market power”?
       b.     What “rule” do you use to find the monopolistically competitive firm’s profit-
              maximizing level of output?
       c.     According to the diagram, what is the firm’s profit-maximizing level of output?
       d.     What price will the firm charge?
       e.     Does the diagram show a long-run or short-run situation? How can you tell?
       f.     FILL IN THE BLANKS: In long-run equilibrium, the average total cost curve
              will be tangent to the _______________ curve and the economic profits will be
              _____.


                             TEXT, p. 244 #3, p. 259: #4 a,b, c.
                                               5


                                          ANSWERS

1.     a.      A kinked demand curve occurs if a firm’s rivals match price decreases but do not
match price increases.
       b.
       P




            P1                             A
                                                          MC’ MC




                                                          D

                                                MR
                                        Q1                                       Q
       c.
       P                                      MC’



            P2
            P1                             A                      MC




                                                          D

                                                MR
                               Q2        Q1                                      Q
                                                     6


   2.      a.      The industry as a whole (the two firms combined) will earn higher profits if the
   two rivals each implement a low advertising budget (In the other outcomes, the industry as
   whole makes lower total profits than if they both implement a low advertising budget and at least
   one firm makes lower profits than if they both implement a low advertising budget).
           b.
    FIRM A’S BEST INDIVIDUAL STRATEGY                  FIRM B’S BEST INDIVIDUAL STRATEGY
     If Firm B implements       High advertising        If Firm A implements     High advertising
    high advertising budget           budget           high advertising budget        budget

     If Firm B implements       High advertising          If Firm A implements      High advertising
    low advertising budget          budget               low advertising budget         budget

               c. They will each implement the strategy that is in their individual best interest, i.e.
                  each will implement a high advertising budget. The waste of money implies that
                  the two firms combined are worse off than if they both pursued a low advertising
                  budget.

   3.      a.      The industry as a whole (the two airlines combined) will earn higher profits if the
   two rivals each do not offer a frequent flyer program (In the other outcomes, the industry as a
   whole makes lower profits than if they both decline to offer a frequent flyer program, and at least
   one of the airlines earns lower profits than if they both decline to offer a frequent flyer program).
           b.
AMERICAN’S BEST INDIVIDUAL STRATEGY                       UNITED’S BEST INDIVIDUAL STRATEGY
                                 Offer frequent                                       Offer frequent flyer
 If United offers program         flyer program            If American offers               program
                                                                program

  If United does not offer        Offer frequent          If American does not       Offer frequent flyer
          program                 flyer program               offer program               program

               c. They will each implement the strategy that is in their individual best interest, i.e.
                  each will offer a frequent flyer program. The waste of money implies that the
                  two firms combined are worse off than if they both chosen not to implement the
                  program.

   4.     a.      From differentiated product based on customer loyalty.
          b.      MR = MC.
          c.      Q1 where MR = MC.
          d.      Short-run because there is both an ATC curve and an AVC curve, implying fixed
                  costs.
          e.      demand, zero.

   5.      a.     The widget firm will maximize profits and produce 20 units of output where price
   (marginal revenue) = marginal private cost. 20 units of output is too high because it does not
   take into account the costs the associated pollution imposes on society (external costs)
           b.     The external costs are $75.
                                              7


c.      The optimal level of output for society is 5 widgets where price (marginal revenue)
equals social marginal cost. The amount of pollution released when 5 widgets are produced is
the optimal level of pollution.

TEXT, p. 244 #3
     a. (i). 11
         (ii) 13
     b. (i) 9
         (ii) 7

TEXT, p. 259 #4:
       a. $12
       b. 6
       c. TR = $12 x 6 = $72. TC = ATC x Q = $8.33 (approx.) x 6 = $49.98  Total Profit =
$72 - $49.98 = $22.02.

								
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