1. Among monopoly, oligopoly, monopolistic competition, and perfect competition, how would
you classify the markets for each of the following drinks?
a. tap water
b. bottled water
c. cola
d. beer
2. A large share of the world supply of diamonds comes from Russia and South Africa. Suppose that
the marginal cost of mining diamonds is constant at $1,000 per diamond, and the demand for
diamonds is described by the following schedule:
Price
$8,000 7,000 6,000 5,000 4,000 3,000 2,000 1,000
Quantity
5,000 6,000 7,000 8,000 9,000 10,000 11,000 12,000
a. If there were many suppliers of diamonds, what would be the price and quantity?
b. If there were only one supplier of diamonds, what would be the price and quantity?
c. If Russia and South Africa formed a cartel, what would be the price and quantity? If the
countries split the market evenly, what would be South Africa’s production and profit?
What would happen to South Africa’s profit if it increased its production by 1,000 while
Russia stuck to the cartel agreement?
d. Use your answer to part (c) to explain why cartel agreements are often not successful.
3. Consider trade relations between the United States and Mexico. Assume that the leaders of the
two countries believe the payoffs to alternative trade policies are as follows:
United States’ decision
Low tariff
High tariff
US gains $25bn
Mexico gains $25bn
US gains $10bn
Mexico gains $30bn
US gains $30bn
Mexico gains $10bn
US gains $20bn
Mexico gains $20bn
Low tariff
Mexico’s
decision
High tariff
a. What is the dominant strategy for the United States? For Mexico? Explain.
b. Define Nash equilibrium. What is the Nash equilibrium for trade policy?
In 1993, the U.S. Congress ratified the North American Free Trade Agreement, in which
the United States and Mexico agreed to reduce trade barriers simultaneously. Do the
perceived payoffs shown here justify this approach to trade policy?
d. Based on your understanding of the gains from trade, do you think these payoffs
actually reflect a nation’s welfare under the four possible outcomes?
4. For each of the following, say whether it describes a perfectly competitive firm, a
monopolistically competitive firm, both, or neither.
a. Charges a price equal to marginal cost.
b. Has marginal revenue equal to price.
c. Faces barriers to entry.
d. Produces a product that is identical to that of its competitors.
e. Earns zero economic profit in the long run.
f. Produces where marginal revenue is greater than marginal cost.
c.
5. For each of the following characteristics, say whether it describes a monopoly firm, a
monopolistically competitive firm, both, or neither.
a. Faces a downward-sloping demand curve.
b. Has marginal revenue less than price.
c. Faces the entry of new firms selling similar products.
d. Earns economic profit in the long run.
e. Equates marginal revenue and marginal cost.
f. Produces the socially efficient quantity of output.
6. Sparkle is one firm of many in the market for toothpaste, which is in long-run equilibrium.
a. Draw a diagram showing Sparkle’s demand curve, marginal-revenue curve, averagetotal-cost curve, and marginal-cost curve. Label Sparkle’s profit maximizing output and
price.
b. What is Sparkle’s profit? Explain.
c. On your diagram, show the consumer surplus derived from the purchase of Sparkle
toothpaste. Also show the deadweight loss relative to the efficient level of output.
d. If the government forced Sparkle to produce the efficient level of output, what would
happen to the firm? What would happen to Sparkle’s customers?
1.
a. Tap water is a perfectly competitive market because there are many taps and the product
does not differ across sellers.
b. Bottled water is a monopolistically competitive market. There are many sellers of bottled
water, but each firm tries to differentiate its own brand from the rest.
c. The cola market is an oligopoly. There are only a few firms that control a large portion of
the market.
d. The beer market is an oligopoly. There are only a few firms that control a large portion of
the market.
2.
a. If there were many suppliers of diamonds, price would equal marginal cost ($1,000), so
the quantity would be 12,000.
b. With only one supplier of diamonds, quantity would be set where marginal cost equals
marginal revenue. The following table derives marginal revenue:
Price
(,000 of $)
Quantity
(,000)
Total revenue
(,000,000 of $)
8
7
6
5
4
3
2
1
5
6
7
8
9
10
11
12
40
42
42
40
36
30
22
12
Marginal
revenue
(,000,000 of $)
---2
0
–2
–4
–6
–8
–10
With marginal cost of $1,000 per diamond, or $1 million per thousand diamonds, the
monopoly will maximize profits at a price of $7,000 and a quantity of 6,000. Additional
production beyond this point would lead to a situation where marginal revenue is lower
than marginal cost.
c. If Russia and South Africa formed a cartel, they would set price and quantity like a
monopolist, so the price would be $7,000 and the quantity would be 6,000. If they split the
market evenly, they would share total revenue of $42 million and costs of $6 million, for a
total profit of $36 million. So each would produce 3,000 diamonds and get a profit of $18
million. If Russia produced 3,000 diamonds and South Africa produced 4,000, the price
would decline to $6,000. South Africa’s revenue would rise to $24 million, costs would be
$4 million, so profits would be $20 million, which is an increase of $2 million.
d. Cartel agreements are often not successful because one party has a strong incentive to
cheat to make more profit. In this case, each could increase profit by $2 million by
producing an extra 1,000 diamonds. However, if both countries did this, profits would
decline for both of them.
3.
a. If Mexico imposes low tariffs, then the United States is better off with high tariffs, because
it gets $30 billion with high tariffs and only $25 billion with low tariffs. If Mexico imposes
high tariffs, then the United States is better off with high tariffs, because it get $20 billion
with high tariffs and only $10 billion with low tariffs. So the United States has a dominant
strategy of high tariffs. If the United States imposes low tariffs, then Mexico is better off
with high tariffs, because it gets $30 billion with high tariffs and only $25 billion with low
tariffs. If the United States imposes high tariffs, then Mexico is better off with high tariffs,
because it gets $20 billion with high tariffs and only $10 billion with low tariffs. So Mexico
has a dominant strategy of high tariffs.
b. A Nash equilibrium is a situation in which economic actors interacting with one another
each choose their best strategy given the strategies others have chosen. The Nash
equilibrium in this case is for each country to have high tariffs.
c.
The NAFTA agreement represents cooperation between the two countries. Each country
reduces tariffs and both are better off as a result.
d. The payoffs in the upper left and lower right parts of the box do reflect a nation’s welfare.
Trade is beneficial and tariffs are a barrier to trade. However, the payoffs in the upper
right and lower left parts of the box are not valid. A tariff hurts domestic consumers and
helps domestic producers, but total surplus declines. So it would be more accurate for
these two areas of the box to show that both countries’ welfare will decline if they
imposed high tariffs, whether or not the other country had high or low tariffs.
4.
a. A firm in perfect competition charges a price equal to marginal cost.
b. A firm in perfect competition has marginal revenue equal to price.
c. Neither a firm in monopolistic competition nor in perfect competition faces barriers to
entry.
d. A firm in perfect competition produces a product that is identical to that of its competitors.
e. Both a firm in monopolistic competition and a firm in perfect competition earn zero
economic profit in the long run.
f. Neither a firm in monopolistic competition nor in perfect competition produces where
marginal revenue is greater than marginal cost.
5.
a. Both a firm in monopolistic competition and a monopoly firm face a downward-sloping
demand curve.
b. Both a firm in monopolistic competition and a monopoly firm have marginal revenue that
is less than price.
c. A firm in monopolistic competition faces the entry of new firms selling similar products.
d. A monopoly firm earns economic profit in the long run.
e. Both a firm in monopolistic competition and a monopoly firm equate marginal revenue
and marginal cost.
f. Neither a firm in monopolistic competition nor a monopoly firm produce the socially
efficient quantity of output.
6.
a. Figure 1 illustrates the market for Sparkle toothpaste in long-run equilibrium. The profitmaximizing level of output is QM and the price is PM.
Figure 1.
b. Sparkle’s profit is zero, because at quantity QM, price equals average total cost.
c. The consumer surplus from the purchase of Sparkle toothpaste is areas A + B. The
efficient level of output occurs where the demand curve intersects the marginal-cost curve,
at QC. The deadweight loss is area C, the area above marginal cost and below demand,
from QM to QC.
d. If the government forced Sparkle to produce the efficient level of output, the firm would
lose money because average total cost would exceed price, so the firm would shut down.
If that happened, Sparkle’s customers would earn no consumer surplus.