Microeconomics Chapter 10

With a monopoly, marginal cost is less than price. Does that mean too much or too little is produced by a monopoly for allocative efficiency? Why?

Given that marginal cost is less than price for a monopoly, the marginal utility / marginal cost ratio for the monopoly's product will be greater than the marginal utility / marginal cost ratio for the rest of the economy, assuming that the rest of the economy is closer to being competitive. Thus, if the rest of the economy produces less and those resources are moved to the monopolistic industry, there will be a net gain in satisfaction. The monopolist, in other words, is producing too little for allocative efficiency.

Barrier to Entry

Some factor that prevents firms from entering an industry when economic profits are being earned.

"It has been said that a monopolist charges the highest price the market will bear." Is that true? Why or why not?

The monopoly will charge a price where it can sell the quantity produced when marginal cost equals marginal revenue. That will not be the highest price it can charge; it will be the price that maximizes profits.

Explain, in your own words, why marginal revenue for a monopolist declines as output increases.

An answer should include much of the following: A monopolist faces the market demand curve. It is the market. However, the law of demand tells us that to increase sales by one, the price must decrease. Thus, if the monopolist is to sell one more unit, it will gain the revenue from the additional unit, but lose revenues on all units sold up to the last one. If the monopolist continues to expand output, marginal revenue will decline. The additional revenue from selling one more unit will be less, and the reduction in price will be on larger numbers of units sold.

In your own words, what would happen to an inventor of a new product if there was no patent (if it was a competitive market)?

Competitors would enter the market by using the new invention. With new suppliers entering the firm, competitive pricing would drive the price down. The price might drop far enough that the original inventor (who still bears the research and development costs) will not even be able to make a normal profit, and he/she may be driven out of the market. These effects may further reduce the inventor's incentive to invent other new products

In your own words, why does a monopoly always produce where demand is elastic? Or is it inelastic? Explain which is correct and why.

1. A profit-maximizing monopolist will produce where marginal cost is equal to marginal revenue. 2. Marginal cost is always going to be positive (or at least never negative). 3. Because marginal cost is equal to marginal revenue if the monopolist maximizes profits and marginal cost is always positive, marginal revenue has to be positive. 4. Marginal revenue is only positive where demand is elastic. The logic behind the fourth step is as follows. Marginal revenue is the change in revenue from producing one more unit of the good. If the price is lowered to sell one more unit and total revenue rises as a result, that is, marginal revenue is positive, the percentage increase in the quantity must be greater than the percentage decrease in the price. That is the definition of an elastic demand. So, while the monopolists face demand curves that are often relative less responsive to price changes than other goods (due to the low number of substitutes), they will produce along the portion of the demand curve that is elastic.

Natural Monopoly

A firm that can produce at a lower average cost per unit of output than a number of smaller firms producing a similar amount of total output.

Price Discrimination

A producer charges different prices for different units of output of the same product for reasons other than differences in costs.

Monopoly

A single firm in an industry with barriers to entry and no close substitute goods.

Why does it make little sense to have many small firms when production is characterized by economies of scale?

Small firms will have relatively high average costs and larger firms will have relatively lower average costs. A group of small firms will not be able to compete with a single or a smaller number of larger firms because the larger firm or firms will have lower costs. If prices are lowered through competition, the prices may be below average cost for the small firms, but at or above average cost for the large firms.

Suppose firms face increasing returns to scale throughout the range of possible firm sizes. Discuss the advantage and disadvantages, in terms of economic efficiency, of allowing a single firm to dominate the market.

The answer should include the following issues. Fewer resources will be used to produce the product if a single firm produces the good or service. Economic efficiency will be enhanced. However, the single firm will not produce an amount that is economically efficient because of its market power. Thus, the outcome will be less than economically efficient. The dilemma is how to take advantage of the economies of scale and at the same time end up with an economically efficient amount of output.

In your own words, explain why a firm should produce where marginal revenue is equal to marginal cost (or as close to equal as possible).

Your answer should discuss how if marginal revenue is greater than marginal cost, then profits increase as quantity increases. If marginal revenue is less than marginal cost, then profits are decreasing as quantity increases. The point where marginal revenue is equal to marginal cost occurs when profits are maximized.