Unit 1.5.4 ­ Monopolistic Competition Practice Activity 1. The market for energy drinks is monopolistically competitive and currently in a state of long­run equilibrium. On the graph below, show the costs, demand and marginal revenue curves for Rad Ball, one of the dozens of firms producing energy drinks. a. Explain the shape of Rad Ball’s Demand curve. Rad Ball faces a downward sloping demand curve because its product is not identical to other energy drink companies’ products. The slight differentiation gives Rad Ball some price making power, meaning that it can raise or lower its price as it wishes (although demand is relatively elastic due to the high number of substitutes) b. Describe the relationship between Rad Ball’s demand and marginal revenue curves. Just like a single­price monopolist, Rad Ball must lower the price of all its product to sell additional units. For this reason, as the firm increases its output the additional revenue it gets from selling more drinks will be lower than the price it sells them for. 2. Rad Ball embarks on an advertising campaign in which it sponsors several of the world’s top extreme athletes. The campaign is a success. Show the effect of the advertising on Rad Ball’s level of economic profits in the graph below. a. Explain how the ad campaign effects Rad Ball’s costs of production. An ad campaign increases Rad Ball’s fixed costs and thus shifts its ATC curve upwards. b. Explain how the ad campaign effects Rad Ball’s demand and marginal revenue? A successful ad campaign will increase demand and marginal revenue as consumers will become more aware of the product and think that it is better than other energy drinks. Demand will also become more inelastic as some consumers believe that there are no good substitutes for Rad Ball. c. Besides advertising, explain two other types of n on­price competition t hat could have helped Rad Ball earn economic profits in the short­run. Rad Ball could have invested in product innovation, making their energy drinks taste better. This would have allowed it to stand out over the competition and increased demand for it. Rad Ball could have re­branded its product by designing new labelling or packaging to attract new consumers. d. Referring to the characteristics of monopolistically competitive markets, explain what will happen to Rad Ball’s demand and marginal revenue and its level of economic profits in the long­run following its successful ad campaign. Other firms will begin emulating Rad Ball’s marketing techniques, or the number of firms producing energy drinks will simply increase as the economic profits experienced by Rad Ball make the market more attractive to entrepreneurs. Over time demand for Rad Ball will decrease and become more elastic once again. 3. The government, under pressure to reduce its budget deficit, imposes a new per­drink excise tax of 20% on all energy drinks sold in the country. Illustrate the effect that the new tax has on Rad Ball’s costs, revenues and profits in the short­run on the graph below (assuming the market was in equilibrium to start). a. Explain how the new tax affects Rad Ball and its competitors in the short­run. A per unit tax will increase the marginal and average costs of energy drink producers. The firms, which were breaking even before the tax, are now minimizing their losses by producing where MC=MR. b. How will the industry adjust to the government’s excise tax in the long­run? In the long­run this tax will force some energy drink producers to shut down to avoid losses. The demand for the remaining firms’ product will increase (as the amount of competition decreases), until the remaining firms are once again breaking even (and the market is back in equilibrium). c. Under what condition would Rad Ball choose to continue producing energy drinks rather than shutting down following the imposition of the new tax on energy drinks? Indicate on your graph above whether or not Rad Ball will choose to shut down or continue operating. Rad Ball will continue to produce as long as its total fixed costs are greater than its total losses from continuing to produce energy drinks. If the price is greater than the AVC, the firm will continue to produce. As can be seen in the graph, the AVC is still lower than the price of energy drinks at the MC=MR level of output. Rad Ball will continue to produce unless AVC>P, because its total losses from continuing to produce (red area) are smaller than the firm’s total fixed costs (red plus blue areas) 3. Explain why firms in monopolistically competitive markets have a particular interest in product differentiation and non­price competition. The the large number of firms against which the businesses must compete make it particularly difficult for an individual firm to achieve profits by raising or lowering its price. In the long­run, as can be seen above, the typical firm will only break even when producing where MR=MC. The secret to earning profits, therefore, is for the firm to increase demand for its output, and it can do this by innovating, differentiating, and advertising its product to convince consumers that it is better than the competitions’. This way, demand rises for the individual firm, allowing it to earn economic profits without having to raise or lower its price. 4. Referring to the graph you drew in #1 (showing the market for energy drinks in its long­run equilibrium), answer the following questions. a. Is the market for energy drinks allocatively efficient in the long­run? Explain. No, because at the level of output of the typical firm the price is greater than the firm’s marginal cost b. Are Rad Ball and other energy drink manufacturers achieving productive efficiency? Explain. No, because the firm is producing at a quantity that is less than the quantity at which ATC is minimized. In order to maximize their profits, monopolistic competitors will restrict their output and charge a price higher than their minimum ATC. c. “Perfect competition is a more desirable market structure than monopolistic competition” Provide three arguments for and three arguments against this statement. i. Three arguments for: 1. Price is lower in perfect competition 2. Firms are more productively efficient 3. Resources are allocated more efficiently ii. Three arguments against: 1. Perfect competitors produce identical output as one another, so consumers have no product variety 2. Monopolistic competitors are likely to offer better service and product quality than perfect competitors 3. With successful differentiation, monopolistic competitors have the chance to earn economic profits https://www.coursehero.com/file/37300367/154MonopolisticCompetitionANSWERKEYpdf/ Powered by TCPDF (www.tcpdf.org)
