Chapter 7 - Answer

Solutions Manual

CHAPTER 7 COMPETITION AND POLICIES TOWARDS MONOPOLIES AND OLIGOPOLIES, PRIVATIZATION AND DEREGULATION SUGGESTED ANSWERS TO THE REVIEW QUESTIONS I. Questions 1. Pure monopoly refers to the case where: a) there is a single firm selling the commodity, b) there are no close substitutes for the commodity, and c) entry into the industry is very difficult or impossible. If we further assume that the monopolist has perfect knowledge of present and future prices and costs, we have perfect monopoly. 2. The firm may control the entire supply of raw materials required to produce the commodity. For example, up to World War II, Alcoa (a U.S. company) owned or controlled almost every source of bauxite – the raw material necessary to produce aluminum in the U.S. and thus had a complete monopoly over the production of aluminum in the U.S. The firm may own a patent which precludes other firms from producing the same commodity. For example, when cellophane was first introduced, Dupont had monopoly power in its production based on patents. A monopoly may be established by a government franchise. In this case, the firm is set up as the sole producer and distributor of a good or service but is subjected to governmental control in certain aspects of its operation. In some industries, increasing returns to scale may operate over a sufficiently large range of outputs as to leave only one firm to produce the equilibrium industry output. These are called natural monopolies and are fairly common in the areas of public utilities and transportation. What

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the government usually does in these cases is to allow the monopolist to operate but subjects him to government control. 3. a. Monopolistic competition refers to the market organization in which there are many sellers of a differentiated product. Monopolistic competition is very common in the retail and service sectors of our economy. Examples of monopolistic competition are the numerous barber shops, gasoline stations, grocery stores, liquor stores, drug stores and so on located in close proximity to one another. b. The competitive element results from the fact that in a monopolistically competitive industry (as in perfectly competitive industry) there are so many firms that the activities of each have no perceptible effect on the other firms in the industry. The monopoly element results because the many sellers in the industry sell a differentiated rather than a homogeneous product. c. Technically speaking, we cannot define the industry under monopolistic competition because each firm produces a somewhat different product. All we can do is to group together firms producing closely related commodities and refer to them as a “product group”. However, because of the product differentiation, we cannot construct the “industry” D and S curves and we do not have a single equilibrium price but a cluster of prices. Thus, our graphical analysis must be confined to the typical or representative firm. 4. a. Oligopoly is the form of market organization in which there are few sellers of a commodity. If there are only two sellers, we have a duopoly. If the product is homogeneous (e.g., steel, cement and copper) we have a pure oligopoly. For simplicity, we deal mostly with a pure duopoly. Oligopoly is the most prevalent form of market organization in the manufacturing sector of modern economies and arises for the same general reasons as monopoly (i.e., economies of scale, control over an essential resource, government licensing and patents). b. The interdependence among the firms in the industry is the single most important characteristic setting oligopoly apart from other market structures. This interdependence is the natural result of fewness. That is, since there are few firms in an oligopolistic industry, when one of them lowers its price, undertakes a successful advertising campaign, or introduces a better model, the demand 7-2

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curve faced by other oligopolists will shift down so the other oligopolist react. c. Oligopoly theory achieves specific cases or models. These few models, however, do accomplish three things: (1) they show clearly the nature of oligopolistic interdependence, (2) they point out the gaps that a satisfactory theory of oligopoly must fill, and (3) they give some indication as to how very difficult this branch of microeconomics really is and how long we may have to wait to get a general theory of oligopoly. In short, oligopoly theory is one of the least satisfactory segments of microeconomics. 5. a. The natural barriers to entry into such oligopolistic industries as the car, aluminum and steel industries are the smallness of the market in relation to efficient operation and the huge amounts of capital and specialized input required to start efficient operation. Some of the artificial barriers to entry are economies of scale, control over an essential resource, government licensing and patents. When entry is blocked or at least restricted, the firms in an oligopolistic industry can earn long-run profits. b. In the long run, oligopoly may lead to the following harmful effects: (1) as in monopoly, price usually exceeds LAC in oligopolistic markets, (2) the oligopolist usually does not produce at the lowest point on his LAC curve, (3) P > LMC, so there is an under allocation of the economy’s resources to the firms in the oligopolistic industry, and (4) when oligopolist produce a differentiated product, too much may be spent on advertising and model changes. c. For technological reasons, many products such as cars, steel and aluminum cannot possibly be produced under conditions of perfect competition or their cost of production would be prohibitive. In addition, oligopolists spend a great deal of their profits on research and development and many economists believe that this leads to much faster technological advance and higher standards of living than if the industry were organized along perfectly competitive lines. Finally, some advertising is useful since it informs consumers and some product differentiation has the economic value of satisfying the different tastes of different consumers. 6. The concept is diametrically opposed to the economist’s view of perfect competition. It describes a competitive market which stresses the rivalry 7-3

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among firms. The economist’s view stresses the impersonality of a perfectly competitive market. That is, according to the economist, in a perfectly competitive market there are so many sellers and buyers of a commodity, each so small in relation to the market as not to regard others as competitors or rivals at all. The outputs of all firms in the market are homogeneous and so there is no rivalry among firms based on advertising, quality and style differences. 7. a. Within the limitations imposed by its given scale of plant, the firm can vary the amount of the commodity produced in the short run by varying its use of the variable inputs. b. Since the perfectly competitive firm faces an infinitely elastic demand curve, it can sell any amount of the commodity at the given market price. c. The crucial assumption we make in order to determine the equilibrium output of the firm (i.e., how much the firm wants to produce and sell per time period) is that the firm wants to maximize its total profits. It should be noted that not all firms seek to maximize total profits or minimize total losses at all times. However, the assumption of profit maximization is essential if we are to have general theory of the firm, and in general it leads to more accurate predictions of business behavior than any alternative assumption. The short-run equilibrium of the firm can be looked at from a total revenue (total cost approach) or from a marginal revenue (marginal cost approach). 8. Most economists would answer this question in the affirmative. If some firms appear to have lower costs than other firms, this is due to the fact that they use superior resources or inputs such as more fertile land or superior management. These superior resources under the threat of leaving to work for other firms can extract from the firms using them the higher price or return commensurate with their productivity. In any event, the firm should price all resources it owns, and the forces of competition will force the firm to price all resources it does not own at their opportunity cost. So it is the owners of such superior resources who receive the benefit in the form of higher prices, or returns from their greater productivity rather than the firms employing them in the form of lower costs. This results in all firms having identical cost curves.

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Therefore, all firms just break-even when the perfectly competitive industry is in long-run equilibrium. 9. In a highly competitive industry such as agriculture, lower resource prices might improve the rate of profit in the short run, but in the long run, competition will drive prices down until economic profit is eliminated. Thus, lower resource prices will do little to improve the longrun profitability in such industries. 10. The market price will decline because the profits will attract new firms and capital investment into the market and supply will increase, driving down the price until the profits are eliminated. 11. a. b. c. d.

Increase Increase Increase; firm will earn economic profit Rise (compared with its initial level) if coffee is an increasing-cost industry, but return to initial price if it is a constant-cost industry e. Increase even more than it did in the short run f. Economic profit will return to zero

12. a. b. c. d.

Decline Increase Decline Decline

13. If demand falls or prices go down, this may not necessarily put an end to all the business firms in the industry. The closure of some firms may be beneficial to the other firms because the latter can absorb the unfulfilled orders of the former. The increase in volume of business could result to profitable operations of the remaining firms. 14. Competition virtually forces firms to operate efficiently and produce goods and services that consumers value highly relative to cost. Firms that fail to do so will find it difficult to compete, and eventually losses will drive them from the market. 15. Refer to page 120. 16. Refer to pages 121 and 122.

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17. Refer to pages 122 and 123. II. Multiple Choice Questions 1. 2. 3. 4. 5.

C A D A B

6. 7. 8. 9. 10.

D C A D D

11. 12. 13. 14. 15.

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B D A A D