This Document Contains Chapters 14 to 16 Oligopoly Chapter 14 1. The accompanying table presents market share data for the U.S. breakfast cereal market. Company Market share Kellogg 28% General Mills 28 PepsiCo (Quaker Oats) 14 Kraft 13 Private Label 11 Other 6 Data from: Advertising Age a. Use the data provided to calculate the Herfindahl-Hirschman Index (HHI) for the market. b. Based on this HHI, how would you describe the market structure in the U.S. breakfast cereal market? 1. a. The HHI is 282 + 282 + 142 + 132 + 112 + 62 = 784 + 784 + 196 + 169 + 121 + 36 = 2,090. b. Since the HHI is less than 2,500, the industry is somewhat competitive. 2. The accompanying table shows the demand schedule for vitamin D. Suppose that the marginal cost of producing vitamin D is zero. Price of vitamin D (per ton) $8 Quantity of vitamin D demanded (tons) 0 7 10 6 20 5 30 4 40 3 50 2 60 1 70 a. Assume that BASF is the only producer of vitamin D and acts as a monopolist. It currently produces 40 tons of vitamin D at $4 per ton. If BASF were to produce 10 more tons, what would be the price effect for BASF? What would be the quantity effect? Would BASF have an incentive to produce those 10 additional tons? 14 b. Now assume that Roche enters the market by also producing vitamin D and the market is now a duopoly. BASF and Roche agree to produce 40 tons of vitamin D in total, 20 tons each. BASF cannot be punished for deviating from the agreement with Roche. If BASF, on its own, were to deviate from that agreement and produce 10 more tons, what would be the price effect for BASF? What would be the quantity effect for BASF? Would BASF have an incentive to produce those 10 additional tons? 2. a. If BASF produces 10 more tons, it now produces 50 tons and the price would fall to $3 per ton. That is, on each of the 40 tons it was already producing, it would lose $1. So the price effect is 40 × (−$1) = −$40. Since BASF produces an additional 10 tons and sells them at $3, the quantity effect is 10 × $3 = $30. So BASF gains $30 revenue from producing 10 additional tons, but it loses $40 revenue from producing those 10 additional tons. Since the marginal cost is zero, additional production does not change BASF’s cost. Since BASF loses revenue, it has no incentive to produce the 10 additional tons. b. If BASF produces 10 more tons, the total produced is now 50 tons and the price would fall to $3. That is, on each of the 20 tons it was already producing, it would lose $1. So the price effect is 20 × (−$1) = −$20. Since BASF produces an additional 10 tons and sells them at $3, the quantity effect is 10 × $3 = $30. So BASF gains $30 revenue from producing 10 additional tons, and it loses only $20 revenue, resulting in an overall increase in revenue of $10. Since the marginal cost is zero, there is no change to BASF’s cost. Since producing the 10 additional tons raises BASF’s revenue by $10, BASF does have an incentive to produce 10 additional tons. 3. The market for olive oil in New York City is controlled by two families, the Sopranos and the Contraltos. Both families will ruthlessly eliminate any other family that attempts to enter the New York City olive oil market. The marginal cost of producing olive oil is constant and equal to $40 per gallon. There is no fixed cost. The accompanying table gives the market demand schedule for olive oil. Price of olive oil (per gallon) Quantity of olive oil demanded (gallons) $100 1,000 90 1,500 80 2,000 70 2,500 60 3,000 50 3,500 40 4,000 30 4,500 20 5,000 10 5,500 a. Suppose the Sopranos and the Contraltos form a cartel. For each of the quantities given in the table, calculate the total revenue for their cartel and the marginal revenue for each additional gallon. How many gallons of olive oil would the cartel sell in total and at what price? The two families share the market equally (each produces half of the total output of the cartel). How much profit does each family make? b. Uncle Junior, the head of the Soprano family, breaks the agreement and sells 500 more gallons of olive oil than under the cartel agreement. Assuming the Contraltos maintain the agreement, how does this affect the price for olive oil and the profits earned by each family? c. Anthony Contralto, the head of the Contralto family, decides to punish Uncle Junior by increasing his sales by 500 gallons as well. How much profit does each family earn now? 3. a. The accompanying table shows the total revenue and the marginal revenue for the cartel. Since a cartel acts like a monopolist, it will maximize profit by producing up to the point where marginal cost equals marginal revenue. For all gallons up to 2,000 gallons, marginal revenue is greater than marginal cost. Producing any more would mean that marginal revenue is less than marginal cost. So the cartel will produce 2,000 gallons and sell them at $80 each. Since the two families share the market equally, each family has revenue of 1,000 × $80 = $80,000. The marginal cost per gallon is constant at $40, so the total cost (remember there is no fixed cost!) of producing 1,000 gallons is $40,000. So each family makes a profit of $80,000 − $40,000 = $40,000. Price of olive oil (per gallon) Quantity of olive oil demanded (gallons) $100 1,000 Total revenue Marginal revenue $100,000 $70 90 1,500 135,000 80 2,000 160,000 70 2,500 175,000 60 3,000 180,000 50 30 10 −10 50 3,500 175,000 40 4,000 160,000 30 4,500 135,000 20 5,000 100,000 −30 −50 −70 −90 10 5,500 55,000 b. Now the Sopranos sell 1,500 gallons and the Contraltos sell 1,000 gallons, for a total output of 2,500 gallons. So the price falls to $70 per gallon. The Sopranos have revenue of 1,500 × $70 = $105,000 and cost of 1,500 × $40 = $60,000. So their profit is $105,000 − $60,000 = $45,000. The Contraltos have revenue of 1,000 × $70 = $70,000 and cost of 1,000 × $40 = $40,000. So their profit is $70,000 − $40,000 = $30,000. c. If both the Contraltos and the Sopranos sell 1,500 gallons each, the total output in this duopoly is 3,000 gallons, and the price falls to $60 per gallon. Each family has revenue of 1,500 × $60 = $90,000 and cost of 1,500 × $40 = $60,000. So each family’s profit is $30,000. 4. In France, the market for bottled water is controlled by two large firms, Perrier and Evian. Each firm has a fixed cost of €1 million and a constant marginal cost of €2 per liter of bottled water (€1 = 1 euro). The following table gives the market demand schedule for bottled water in France. Price of bottled water (per liter) Quantity of bottled water demanded (millions of liters) €10 0 9 1 8 2 7 3 6 4 5 5 4 6 3 7 2 8 1 9 a. Suppose the two firms form a cartel and act as a monopolist. Calculate marginal revenue for the cartel. What will the monopoly price and output be? Assuming the firms divide the output evenly, how much will each produce and what will each firm’s profits be? b. Now suppose Perrier decides to increase production by 1 million liters. Evian doesn’t change its production. What will the new market price and output be? What is Perrier’s profit? What is Evian’s profit? c. What if Perrier increases production by 3 million liters? Evian doesn’t change its production. What would Perrier’s output and profits be relative to those in part b? d. What do your results tell you about the likelihood of cheating on such agreements? 4. a. The accompanying table calculates total revenue and marginal revenue for the cartel. The cartel maximizes profit by producing whenever marginal revenue is greater than marginal cost (which here is €2). That is, the cartel produces a quantity of 4 million liters and sells them at a price of €6 per liter. If the firms divide production equally, each produces 2 million liters and has revenue of 2 million × €6 = €12 million. Since the fixed cost is €1 million and each liter’s marginal cost is €2, each firm has profit of €12 million − €1 million − (2 million × €2) = €7 million. Price of bottled water (per liter) Quantity of bottled water demanded (millions of liters) Total revenue (millions) €10 0 €0 Marginal revenue (millions) €9 9 1 9 8 2 16 7 3 21 6 4 24 5 5 25 7 5 3 1 −1 4 6 24 −3 3 7 21 −5 2 8 16 1 9 9 −7 b. If Perrier increases production by 1 million liters, the total produced now is 5 million liters and the price is €5. Perrier now produces 3 million liters and so has profit of (3 million × €5) − €1 − (3 million × €2) = €8 million. Evian’s profit, however, falls to (2 million × €5) − €1 million − (2 million × €2) = €5. c. If Perrier increases production by 3 million liters, the total produced is 7 million liters and the price is €3. Perrier produces 5 million liters and so has profit of (5 million × €3) − €1 million − (5 million × €2) = €4 million. This profit is lower than in part b. This implies that although Perrier has an incentive to increase production somewhat, it does not have an incentive to increase production dramatically. d. Since each firm can significantly increase its profit by moderately increasing production, the likelihood of cheating is high. 5. To preserve the North Atlantic fish stocks, it is decided that only two fishing fleets, one from the United States and the other from the European Union, can fish in those waters. Suppose that the fisheries agreement breaks down, so that the fleets behave noncooperatively. Assume that the United States and the European Union each can send out either one or two fleets. The more fleets in the area, the more fish they catch in total but the lower the catch of each fleet. The accompanying matrix shows the profit (in dollars) per week earned by the two sides. European Union 1 fleet $10,000 profit 2 fleets $12,000 profit United States 1 fleet $10,000 profit $4,000 profit $4,000 profit $7,500 profit 2 fleets $12,000 profit $7,500 profit a. What is the noncooperative Nash equilibrium? Will each side choose to send out one or two fleets? b. Suppose that the fish stocks are being depleted. Each region considers the future and comes to a tit-for-tat agreement whereby each side will send only one fleet out as long as the other does the same. If either of them breaks the agreement and sends out a second fleet, the other will also send out two and will continue to do so until its competitor sends out only one fleet. If both play this tit-for-tat strategy, how much profit will each make every week? 5. a. If the European Union has only one fleet, the United States will have a higher profit if it sends out two fleets ($12,000 rather than $10,000). If the European Union sends out two fleets, the United States will have a higher profit if it also sends out two fleets ($7,500 rather than $4,000). The same reasoning will persuade the European Union that its best strategy is also to send out two fleets whether the United States sends out one or two. Both parties will send out two fleets, each earning only $7,500 each instead of the $10,000 they would each have earned if they had each limited themselves to one fleet. b. If both play a tit-for-tat strategy, they each will begin by sending out one fleet. The week after that, each does what the other one did the week before—that is, each again sends out one fleet, and so on. As a result, the United States and the European Union will each have a profit of $10,000 every week. 6. Untied and Air “R” Us are the only two airlines operating flights between Collegeville and Bigtown. That is, they operate in a duopoly. Each airline can charge either a high price or a low price for a ticket. The accompanying matrix shows their payoffs, in profits per seat (in dollars), for any choice that the two airlines can make. Air “R” Us Low price High price $20 profit $0 profit Low price Untied $20 profit $50 profit $50 profit $40 profit High price $0 profit $40 profit a. Suppose the two airlines play a one-shot game—that is, they interact only once and never again. What will be the Nash (noncooperative) equilibrium in this one-shot game? b. Now suppose the two airlines play this game twice. And suppose each airline can play one of two strategies: it can play either always charge the low price or tit for tat—that is, it starts off charging the high price in the first period, and then in the second period it does whatever the other airline did in the previous period. Write down the payoffs to Untied from the following four possibilities: i. Untied plays always charge the low price when Air “R” Us also plays always charge the low price. ii. Untied plays always charge the low price when Air “R” Us plays tit for tat. iii. Untied plays tit for tat when Air “R” Us plays always charge the low price. iv. Untied plays tit for tat when Air “R” Us also plays tit for tat. 6. a. This is a prisoners’ dilemma situation. Whatever Air “R” Us does, it is best for Untied to charge the low price; whatever Untied does, it is best for Air “R” Us to charge the low price. So the Nash (noncooperative) equilibrium is for both airlines to charge the low price. b. These are Untied’s payoffs: i. Both airlines charge the low price in both periods, so Untied’s payoffs are $20 in the first period and $20 in the second period, for a total of $20 + $20 = $40. ii. In the first period, Untied charges the low price and Air “R” Us charges the high price for a payoff to Untied of $50. In the second period, Untied and Air “R” Us both charge the low price for a payoff to Untied of $20. Untied’s payoffs are therefore $50 + $20 = $70. iii. In the first period, Untied charges the high price and Air “R” Us charges the low price for a payoff to Untied of $0. In the second period, both airlines charge the low price for a payoff to Untied of $20. Untied’s total payoff is therefore $0 + $20 = $20. iv. Both airlines charge the high price in both periods, so Untied’s payoffs are $40 in both periods, for a total of $40 + $40 = $80. 7. Suppose that Coke and Pepsi are the only two producers of cola drinks, making them duopolists. Both companies have zero marginal cost and a fixed cost of $100,000. a. Assume first that consumers regard Coke and Pepsi as perfect substitutes. Currently both are sold for $0.20 per can, and at that price each company sells 4 million cans per day. i. How large is Pepsi’s profit? ii. If Pepsi were to raise its price to $0.30 per can, and Coke did not respond, what would happen to Pepsi’s profit? b. Now suppose that each company advertises to differentiate its product from the other company’s. As a result of advertising, Pepsi realizes that if it raises or lowers its price, it will sell less or more of its product, as shown by the demand schedule in the accompanying table. Price of Pepsi (per can) Quantity of Pepsi demanded (millions of cans) $0.10 5 0.20 4 0.30 3 0.40 2 0.50 1 If Pepsi now were to raise its price to $0.30 per can, what would happen to its profit? c. Comparing your answer to part a(i) and to part b, what is the maximum amount Pepsi would be willing to spend on advertising? 7. a. i. Pepsi sells 4 million cans at $0.20 for total revenue of $0.20 × 4 million = $800,000. Its only cost is the fixed cost of $100,000, so its profit is $800,000 − $100,000 = $700,000. ii. If Pepsi were to raise its price, it would lose all its customers. This is because customers regard Coke and Pepsi as identical products and so will buy none of the product that is more expensive. So Pepsi loses money, its fixed cost: its loss will be $100,000. b. If Pepsi now raises its price to $0.30, it will lose some customers but not all customers. It will sell 3 million cans at a price of $0.30 per can and so have total revenue of $0.30 × 3 million = $900,000. Since its only cost is the fixed cost, Pepsi’s profit is $900,000 − $100,000 = $800,000. c. Since Pepsi can raise its revenue by $100,000 (from $700,000 without advertising to $800,000 with advertising), it should be willing to spend at most $100,000 on an advertising campaign. 8. Schick and Gillette spend huge sums of money each year to advertise their razors in an attempt to steal customers from each other. Suppose each year Schick and Gillette have to decide whether or not they want to spend money on advertising. If neither firm advertises, each will earn a profit of $2 million. If they both advertise, each will earn a profit of $1.5 million. If one firm advertises and the other does not, the firm that advertises will earn a profit of $2.8 million and the other firm will earn $1 million. a. Use a payoff matrix to depict this problem. b. Suppose Schick and Gillette can write an enforceable contract about what they will do. What is the cooperative solution to this game? c. What is the Nash equilibrium without an enforceable contract? Explain why this is the likely outcome. 8. a. See the accompanying payoff matrix. Gillette Advertise Advertise Schick Do not advertise $1.5 million profit $1 million profit Do not advertise $1.5 million profit $2.8 million profit $2.8 million profit $2 million profit $1 million profit $2 million profit b. Each firm should not advertise, since this would maximize joint profits. Each firm then earns a profit of $2 million. c. Each firm will consider what its best action is depending on the action of the other firm. If Gillette advertises, Schick should as well, since it will earn $1.5 million instead of $1 million. If Gillette does not advertise, Schick should advertise, since $2.8 million is better than $2 million. So no matter what Gillette does, the best action for Schick is to advertise. The same logic applies to Gillette. As a result, each firm will advertise, yielding profit of $1.5 million for each firm. This is a prisoners’ dilemma situation. 9. Over the last 40 years the Organization of Petroleum Exporting Countries (OPEC) has had varied success in forming and maintaining its cartel agreements. Explain how the following factors may contribute to the difficulty of forming and/or maintaining its price and output agreements. a. New oil fields are discovered and increased drilling is undertaken in the Gulf of Mexico and the North Sea by nonmembers of OPEC. b. Crude oil is a product that is differentiated by sulfur content: it costs less to refine low-sulfur crude oil into gasoline. Different OPEC countries possess oil reserves of different sulfur content. c. Cars powered by hydrogen are developed. 9. a. With the discovery of new oil by nonmembers of OPEC, there is increased competition. This will lead to a fall in market price and make the cartel agreement harder to maintain. b. The OPEC countries sell a differentiated and complex product. This complicates the decision about what prices to set for what types of oil and makes enforcement of a cartel agreement more difficult. Much of the conflict within OPEC rests on the price differential that is set between high- and low-quality oils. c. The development of a hydrogen-powered car would make it more difficult to form or maintain an agreement. Remember that a cartel essentially acts like a monopoly. A cartel’s (or a monopoly’s) market power is eroded if there is entry of new firms or the development of substitute products. 10. Suppose you are an economist working for the Antitrust Division of the Justice Department. In each of the following cases you are given the task of determining whether the behavior warrants an antitrust investigation for possible illegal acts or is just an example of undesirable, but not illegal, tacit collusion. Explain your reasoning. a. Two companies dominate the industry for industrial lasers. Several people sit on the boards of directors of both companies. b. Three banks dominate the market for banking in a given state. Their profits have been going up recently as they add new fees for customer transactions. Advertising among the banks is fierce, and new branches are springing up in many locations. c. The two oil companies that produce most of the petroleum for the western half of the United States have decided to forgo building their own pipelines and to share a common pipeline, the only means of transporting petroleum products to that market. d. The two major companies that dominate the market for herbal supplements have each created a subsidiary that sells the same product as the parent company in large quantities but with a generic name. e. The two largest credit card companies, Passport and OmniCard, have required all retailers who accept their cards to agree to limit their use of rival credit cards. 10. a. This warrants an antitrust investigation because it is likely that having the same set of people sit on the two boards will facilitate cartel-like behavior. b. This does not warrant an antitrust investigation. The intensity of advertising and competition by location indicates that the banks are engaged in nonprice competition. c. This warrants an antitrust investigation. By using the same pipeline, each company can monitor how much output the other is producing. This facilitates cartel-like behavior. d. This does not warrant an antitrust investigation. These two companies are actively competing, albeit by using their subsidiaries. e. This warrants an antitrust investigation. These two companies are acting together to shut out a rival. 11. In 2015, Anheuser-Busch InBev offered $104.2 billion to acquire SABMiller. The U.S. Justice Department approved the merger, but only after the two beer giants agreed to sell off a number of brands, including Miller Lite, Peroni, and Snow (the world’s top selling beer produced in China). Anheuser-Busch InBev sought the merger to increase its global market share. The accompanying table presents the global market share before and after the merger for the world’s ten largest brewers. Market share Brewers Before merger After merger AB InBev 21% 29% SABMiller 10 — Heineken 9 11 Carlsberg 6 6 China Resource Brewery Ltd. 6 6 Tsingtao Brewery Group 4 4 Molson-Coors 3 4 Yanjing 3 3 Kirin 2 2 BGI/Groupe Castel 2 2 a. Using the table, calculate the HHI for the global beer market both before and after the merger. b. Based on the HHI calculated in part a, how has the market structure for the global beer industry changed? 11. a. The HHI before the merger is: 212 + 102 + 92 + 62 + 62 + 42 + 32 + 32 + 22 + 22 = 441 + 100 + 81 + 36 + 36 + 16 + 9 + 9 + 4 + 4 = 736. The HHI after the merger is: 292 + 112 + 62 + 62 + 42 + 42 + 32 + 22 + 22 = 841 + 121 + 36 + 36 + 16 + 16 + 9 + 4 + 4 = 1,083. b. Before and after the merger the global beer industry HHI is less than 1,500, indicating that the market is un-concentrated and strongly competitive. By increasing the HHI from 736 to 1,083, the merger has pushed the market in the direction of moderate concentration, making it somewhat less competitive than it was before the merger. 12. In 2011, the Justice Department rejected AT&T’s proposal to purchase T-Mobile for $39 billion due to anticompetitive concerns. A few years later, Sprint launched its own attempt to purchase T-Mobile. In 2016, Sprint’s discussions with T-Mobile about a potential takeover were still ongoing. a. Use the accompanying table to calculate the HHI before and after the proposed 2011 merger of AT&T and T-Mobile. b. Use the table to calculate the HHI before and after the proposed merger of Sprint and T-Mobile in 2016. c. Based on your calculations in parts a and b, do you think the Justice Department is likely to approve a merger between Sprint and T-Mobile? Carrier 2011 2016 Verizon 34% 35% AT&T 32 32 Sprint 17 14 T-Mobile 10 17 12. a. The HHI in 2011 before the proposed AT&T and T-Mobile merger is: 342 + 322 + 172 + 102 = 1,156 + 1,024 + 289 + 100 = 2,569. If the merger between AT&T and T-Mobile were approved, the industry HHI would be: 342 + 422 + 172 = 1,156 + 1,764 + 289 = 3,209. b. The HHI in 2016 before the proposed Sprint and T-Mobile merger is: 352 + 322 + 142 + 172 = 1,225 + 1,024 + 196 + 289 = 2,734. If the merger between Sprint and T-Mobile were approved the industry HHI would be: 352 + 322 + 312 = 1,225 + 1,024 + 961 = 3,210. c. Even before both proposed mergers, the wireless phone industry would be considered highly concentrated. Given that the Justice Department rejected AT&T’s proposal to purchase T-Mobile, it is likely to do the same with Sprint’s proposed bid to acquire T-Mobile. 13. Use these steps to find the antitrust claim made by the Justice Department to prevent the merger of Anheuser-Busch InBev and Grupo Modelo. Refer to the antitrust claim to answer the questions that follow. i. Go to U.S. Department of Justice, Antitrust Division (www.justice.gov/atr). ii. Click on “Antitrust Case Filings” in the bar at the left and then click “Filter and Sort.” iii. Set Date to “2013,” Case Type to “Civil Merger,” and select Search. iv. Find the case U.S. v. Anheuser-Busch InBev SA/NV and Grupo Modelo S.A.B. de C.V. Click on the title to go to the website for the case. v. Scroll to the bottom of the web page and click on “Complaint.” Then click on “Attachment” to review the case. a. Prior to the merger, what is the U.S. market share for Anheuser-Busch InBev and Grupo Modelo? (See the pie chart on page 2.) b. In part IV, section C (Relevant Geographic Market), how does the Justice Department define a beer market? Why? c. Based on the information in part V, in how many markets would the proposed merger exceed the HHI threshold of 2,500 points and be considered highly concentrated? d. In Appendix A, find the post-merger HHI calculations. Note that “Delta HHI” means the change in HHI. Which market experiences the greatest increase in the HHI ratio and is the most concentrated? Which market is the least concentrated? After the merger, what happens to the HHI for the United States as a whole? 13. a. Prior to the merger, Anheuser-Busch InBev held 39% of the U.S. beer market and Grupo Modelo controlled 7%. b. A market is defined as a Metropolitan Statistical Area (MSA). MSAs reflect “the locations of the customers who purchase beer, rather than the locations of breweries.” c. According to line 41, the proposed merger would result in 20 of the 26 markets having an HHI in excess of 2,500 points. Even in the six markets under an HHI of 2,500 the merger would still create a combined market share greater than 30%. d. The greatest increase in the HHI occurs in Oklahoma City, Oklahoma. Oklahoma City would also have the largest concentration ratio with an HHI of 4,886. The San Francisco/Oakland, California, MSA has the smallest postmerger HHI ratio of 1,822. The post-merger HHI for the entire United States would increase from 2,300 to 2,866, moving it above the 2,500 threshold. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 14. Let’s revisit the fisheries agreement introduced in Problem 5 stating that to preserve the North Atlantic fish stocks, it is decided that only two fishing fleets, one from the United States (U.S.) and the other from the European Union (EU), can fish in those waters. The accompanying table shows the market demand schedule per week for fish from these waters. The only costs are fixed costs, so fishing fleets maximize profit by maximizing revenue. Price of fish (per pound) Quantity of fish demanded (pounds) $17 1,800 16 2,000 15 2,100 14 2,200 12 2,300 a. If both fishing fleets collude, what is the revenue-maximizing output for the North Atlantic fishery? What price will a pound of fish sell for? b. If both fishing fleets collude and share the output equally, what is the revenue to the EU fleet? To the U.S. fleet? c. Suppose the EU fleet cheats by expanding its own catch by 100 pounds per week. The U.S. fleet doesn’t change its catch. What is the revenue to the U.S. fleet? To the EU fleet? d. In retaliation for the cheating by the EU fleet, the U.S. fleet also expands its catch by 100 pounds per week. What is the revenue to the U.S. fleet? To the EU fleet? 14. a. The accompanying table calculates the total revenue for the entire North Atlantic fishery for different output quantities. The revenue-maximizing output is 2,000 pounds per week, which will fetch a price of $16 per pound. Price of fish (per pound) Quantity of fish demanded (pounds) Total revenue $17 1,800 $30,600 16 2,000 32,000 15 2,100 31,500 14 2,200 30,800 12 2,300 27,600 b. If they share the output equally, the U.S. and the EU fleets will each catch 1,000 pounds per week and have revenue of $16,000 per week. c. If the EU fleet cheats and catches 100 pounds more, the total caught will be 2,100 pounds, which will cause the price to fall to $15. The EU fleet’s revenue will now be 1,100 × $15 = $16,500, and the U.S. fleet’s revenue will fall to 1,000 × $15 = $15,000. d. Now the total caught will be 2,200 pounds, which will bring the price down to $14 per pound. Since each fleet now catches 1,100 pounds, each will have revenue of 1,100 × $14 = $15,400. Monopolistic Competition Chapter 15 and Product Differentiation 1. Use the three conditions for monopolistic competition discussed in the chapter to decide which of the following firms are likely to be operating as monopolistic competitors. If they are not monopolistically competitive firms, are they monopolists, oligopolists, or perfectly competitive firms? a. A local band that plays for weddings, parties, and so on b. Minute Maid, a producer of individual-serving juice boxes c. Your local dry cleaner d. A farmer who produces soybeans 1. The three conditions for monopolistic competition are (1) a large number of producers, (2) differentiated products, and (3) free entry and exit. a. There are many bands that play at weddings, parties, and so on. There are no significant barriers to entry or exit. And products are differentiated by quality (for instance, some bands have better musicians or better electronic equipment) or by style (for instance, different bands play different types of music). All three conditions for monopolistic competition are fulfilled. b. The industry for individual-serving juice boxes is dominated by a few very large firms (for example, Minute Maid, Welch’s, and Kool Aid), and there are significant barriers to entry, in part because of the large costs (for example, advertising) involved in gaining any market share of the national market. Products are, however, differentiated—in some cases, the only differences are in the minds of consumers. Because of the small number of competitors, the industry is closer to oligopoly. c. There are a large number of dry cleaners, and each produces a product differentiated by location: customers are likely to prefer to use the dry cleaner closest to their home or workplace. Finally, there are no significant barriers to entry. This is a monopolistically competitive market. d. There are a large number of soybean farmers, and there is free entry and exit in this industry. However, soybeans are not differentiated from each other— they are a standardized product. No individual soybean farmer has market power. This industry is therefore a perfectly competitive industry. 2. You are thinking of setting up a coffee shop. The market structure for coffee shops is monopolistic competition. There are three Starbucks shops and two other coffee shops very much like Starbucks in your town already. In order for you to have some degree of market power, you may want to differentiate your coffee shop. Thinking about the three different ways in which products can be differentiated, explain how you would decide whether you should copy Starbucks or whether you should sell coffee in a completely different way. 2. There are three ways in which you can differentiate your product: by style or type, by location, and by quality. If you decide to copy Starbucks both in style (for example, you copy the décor of the shop and the service) and in quality (for example, you serve coffee made from the same coffee beans, brewed in exactly the same way), you will still most likely differentiate your product by location: your coffee shop will be closer for some people than any of the other shops, and that gives you some degree of market power. But you could further differentiate your product by style (for example, you could serve coffee in porcelain cups brought to the table by waiters) or by quality (for example, you could serve only organic, shade-grown coffee). All these will help you create a differentiated product that gives you more market power—that is, the power to raise prices. You would, of course, need to determine whether it allows you to raise prices sufficiently to cover the cost of paying for waiters and higher-quality coffee. 3. The market structure of the local gas station industry is monopolistic competition. Suppose that currently each gas station incurs a loss. Draw a diagram for a typical gas station to show this short-run situation. Then, in a separate diagram, show what will happen to the typical gas station in the long run. Explain your reasoning. 3. Each gas station will produce the output, and so charge the price, that maximizes its profit or minimizes its loss. That is, it will produce quantity QU, where marginal cost equals marginal revenue, and so charge price PU. Since the price PU is lower than average total cost at the quantity QU, ATCU, each gas station incurs a loss. That is, the situation for the typical gas station looks like the accompanying diagram. Price, cost, marginal revenue ATCU PU MC ATC Loss MRU DU Quantity QU Since gas stations are incurring losses, in the long run some will exit the industry. This shifts the demand and marginal revenue curves for each of the remaining gas stations rightward. Exit continues until each remaining gas station makes zero profit. This is the long-run equilibrium. The situation for the typical gas station in this equilibrium is illustrated in the accompanying diagram. Demand has increased to the level at which this gas station makes zero profit at a price of PMC and a quantity of QMC. Price, cost, marginal revenue MC ATC PMC = ATCMC MRMC QMC DMC Quantity 4. The local hairdresser industry has the market structure of monopolistic competition. Your hairdresser boasts that he is making a profit and that if he continues to do so, he will be able to retire in five years. Use a diagram to illustrate your hairdresser’s current situation. Do you expect this to last? In a separate diagram, draw what you expect to happen in the long run. Explain your reasoning. 4. Your hairdresser currently makes a profit. His demand, marginal revenue, marginal cost, and average total cost curves are shown in the accompanying diagram. Price, cost, marginal revenue PP ATCP MC ATC Profit DP MRP Quantity QP Since this hairdresser (and all other hairdressers) makes a profit equal to the shaded rectangle by producing quantity QP at a price PP, there will be entry into this industry. As more hairdressers open shops in town, demand for the typical existing hairdresser will fall—the demand curve and marginal revenue curve shift leftward. This will continue to the point at which no hairdresser makes positive profit. This eliminates the incentive for further entry into the industry, and long-run equilibrium is reached. The situation is illustrated in the accompanying diagram. Price, cost, marginal revenue MC ATC PMC = ATCMC MRMC QMC DMC Quantity The best the typical hairdresser can do is to produce quantity QMC at a price of PMC. Since price equals average total cost at this quantity, each hairdresser will make exactly zero profit. 5. Magnificent Blooms is a florist in a monopolistically competitive industry. It is a successful operation, producing the quantity that minimizes its average total cost and making a profit. The owner also says that at its current level of output, its marginal cost is above marginal revenue. Illustrate the current situation of Magnificent Blooms in a diagram. Answer the following questions by illustrating with a diagram. a. In the short run, could Magnificent Blooms increase its profit? b. In the long run, could Magnificent Blooms increase its profit? 5. The current situation of Magnificent Blooms is illustrated in the accompanying diagram. It produces quantity Q1 at the minimum point of its average total cost curve, and it charges price P1, making profit equal to the shaded rectangular area. Price, cost, marginal revenue MC PP P1 ATCP ATC1 ATC Profit DP QP Q1 MRP Quantity a. Yes, Magnificent Blooms could increase its profit in the short run by producing less. It would maximize its profit by producing quantity QP, the quantity at which marginal revenue equals marginal cost, and selling it at a price PP, making a profit equal to the striped area. b. No. In the long run, Magnificent Blooms will make zero profit. The fact that it is making profits in the short run induces other firms to enter the industry. In the long run, this shifts its demand curve and marginal revenue curve leftward to the point where it makes zero profit, as shown in the accompanying diagram. Price, cost, marginal revenue MC ATC PMC = ATCMC MRMC DMC QMC Quantity 6. “In the long run, there is no difference between monopolistic competition and perfect competition.” Discuss whether this statement is true, false, or ambiguous with respect to the following criteria. a. The price charged to consumers b. The average total cost of production c. The efficiency of the market outcome d. The typical firm’s profit in the long run 6. a. According to this criterion, the statement is false. The price charged to consumers is higher in monopolistic competition than it is in perfect competition. All firms in a perfectly competitive market will charge a price equal to marginal cost and equal to minimum average total cost, the lowest point on the average total cost curve. The typical firm in a monopolistically competitive industry will charge a price that is higher than marginal cost and also higher than minimum average total cost. b. According to this criterion, the statement is false. The average total cost of production is higher for a monopolistically competitive firm than for a perfectly competitive firm. For a perfectly competitive firm in the long run, there is no way of lowering the average total cost of production: it produces at minimum average total cost. Monopolistically competitive firms, however, have excess capacity: if they were to produce more, they could lower their average total cost, but this would result in a reduction in profit or a loss. c. According to this criterion, the statement is ambiguous. The market outcome under perfect competition is clearly efficient: price equals marginal cost, so no firm wants to produce more output at a price at which consumers want to buy more output. That is, no mutually beneficial trades between consumers and producers go unexploited. The efficiency of monopolistic competition, however, is ambiguous. In the market outcome, price exceeds marginal cost, so there are beneficial trades that go unexploited in this case. But consumers also gain from the variety of products that monopolistic competition provides, which is not the case under perfect competition. So it is ambiguous whether consumers are better or worse off when an industry is monopolistically competitive. d. According to this criterion, the statement is true. Both perfectly competitive firms and monopolistically competitive firms earn zero profits in the long run, since entry into (or exit from) the industry eliminates all profits (or, in the case of exit, transforms losses to zero profit). In this respect, perfect competition and monopolistic competition are similar. 7. “In both the short run and in the long run, the typical firm in monopolistic competition and a monopolist each make a profit.” Do you agree with this statement? Explain your reasoning. 7. In the short run, a monopolist makes positive profit. Whether a firm in monopolistic competition makes a profit depends on how many firms there are in the industry. If there are “too few” firms in the industry (relative to the long-run equilibrium number of firms), then a typical firm in monopolistic competition will make a profit. But if there are “too many” firms in the industry (relative to the long-run equilibrium number of firms), then a typical firm in monopolistic competition will incur a loss in the short run. In the long run, a monopolist makes positive profit. But in the long-run equilibrium in a monopolistically competitive industry, all firms make zero profit. This is because in the long run in a monopolistically competitive industry, enough firms have entered or exited the market to shift a typical firm’s demand curve so that it is tangent to the firm’s average total cost curve at the firm’s profit-maximizing quantity. The typical firm makes zero profit. 8. The market for clothes has the structure of monopolistic competition. What impact will fewer firms in this industry have on you as a consumer? Address the following issues. a. Variety of clothes b. Differences in quality of service c. Price 8. a. In monopolistic competition, firms seek to differentiate themselves by, among other things, the type of clothes they sell. And to you, as a customer, there is value in diversity: many consumers value being able to wear clothes that are different from those the people around them wear. If there are fewer firms in this industry, there will also be less variety. b. Monopolistically competitive firms also seek to differentiate themselves through the quality of service they offer. There will be stores that take your measurements before making specific recommendations about which clothes to buy. And there will be stores where you help yourself to clothes piled in a heap on a big table. If there are fewer firms in this industry, there will be less diversity in service quality. It will be less likely that each consumer finds a store with just the quality of service he or she prefers. c. If there are fewer firms in this industry, each firm will sell a greater quantity and so have lower average total cost of production. As a result, it is likely that prices will also be lower. From this perspective, you might prefer to have fewer firms. 9. For each of the following situations, decide whether advertising is directly informative about the product or simply an indirect signal of its quality. Explain your reasoning. a. Football great Peyton Manning drives a Buick in a TV commercial and claims that he prefers it to any other car. b. A Craigslist ad states, “For sale: 1999 Honda Civic, 160,000 miles, new transmission.” c. McDonald’s spends millions of dollars on an advertising campaign that proclaims: “I’m lovin’ it.” d. Subway advertises one of its sandwiches by claiming that it contains 6 grams of fat and fewer than 300 calories. 9. a. This commercial is not directly informative about the product since every car manufacturer can claim that its car is better than any other; this is not a statement that can be easily verified by the purchaser before purchase. However, Peyton Manning commands a very high fee for advertising. What the commercial therefore signals is something like “we can afford to pay Peyton Manning’s fee since we are a company with a superior product.” b. This ad is directly informative about the product. It states specific information (that, on inspection of the car, you could easily verify before purchase). Since it can be so easily verified, this information is likely to be true. c. This type of advertising provides an indirect signal of the quality of McDonald’s food. By spending millions on advertising, McDonald’s signals that it is confident that once it attracts a buyer to its product, that buyer will buy its products again (creating more profit for McDonald’s in the future). d. This type of advertising is directly informative about the product because it contains specific information that could easily be verified. If this claim were false, it would very quickly be discredited. So the claim is likely to be true and informs you directly about the product. 10. In each of the following cases, explain how the advertisement functions as a signal to a potential buyer. Explain what information the buyer lacks that is being supplied by the advertisement and how the information supplied by the advertisement is likely to affect the buyer’s willingness to buy the good. a. “Looking for work. Excellent references from previous employers available.” b. “Electronic equipment for sale. All merchandise carries a one-year, no-questions-asked warranty.” c. “Car for sale by original owner. All repair and maintenance records available.” 10. a. The seller here is the job-seeker, who is selling his or her labor to a potential employer. The potential employer lacks information on how good an employee the job-seeker is—how dependable, diligent, and so on. By being willing to provide excellent references from previous employers, the job-seeker signals that he or she is a good employee. As a result, the potential employer is more willing to hire that person. b. The potential buyer lacks information on how good the merchandise is. By being willing to provide a one-year, no-questions-asked warranty, the seller signals to the potential buyer that the merchandise is of high quality. As a result, the potential buyer is more willing to buy the good. c. The potential buyer lacks information on how good the used car is. By being willing to provide the repair and maintenance records, the seller signals to the potential buyer that this is a good-quality used car. As a result, the potential buyer is more willing to buy it. 11. The accompanying table shows the Herfindahl–Hirschman Index (HHI) for the restaurant, cereal, movie studio, and laundry detergent industries as well as the advertising expenditures of the top 10 firms in each industry. Use the information in the table to answer the following questions. Industry Restaurants Cereal Movie studios Laundry detergent HHI Advertising expenditures (millions) 179 $1,784 2,598 732 918 3,324 2,750 132 a. Which market structure—oligopoly or monopolistic competition—best characterizes each of the industries? b. Based on your answer to part a, which type of market structure has higher advertising expenditures? Use the characteristics of each market structure to explain why this relationship might exist. 11. a. Recall from Chapter 14 that according to Justice Department guidelines, an HHI below 1,500 indicates a strongly competitive market, an HHI between 1,500 and 2,500 indicates a somewhat competitive market, and an HHI over 2,500 indicates an oligopoly. So you should expect monopolistically competitive industries to have an HHI below 1,500 and oligopolies to have an HHI above 2,500. So the four industries are: Restaurants: HHI below 1,500—monopolistic competition Cereal: HHI over 2,500—oligopoly Movie studios: HHI below 1,500—monopolistic competition Laundry detergent: HHI over 2,500—oligopoly b. The market structure and advertising expenditures in each of the four industries correlate as follows: Restaurants: monopolistic competition and high advertising expenditures Cereal: oligopoly and medium advertising expenditures Movie studios: monopolistic competition and high advertising expenditures Laundry detergent: oligopoly and low advertising expenditures There are higher advertising expenditures in the two monopolistically competitive industries—restaurants and movie studios. Monopolistically competitive firms advertise in order to earn short-run profits through product differentiation. Because there are no barriers to entry in monopolistic competition, firms must advertise and differentiate their products in order to earn short-run profits. There are lower advertising expenditures in the two oligopolistic industries, cereal and laundry detergents. They can advertise less because oligopolistic industries have barriers to entry and therefore do not need to rely on product differentiation to counter entry into the market. 12. McDonald’s spends millions of dollars each year on legal protection of its brand name, thereby preventing any unauthorized use of it. Explain what information this conveys to you as a consumer about the quality of McDonald’s products. 12. The fast-food industry is a monopolistically competitive one, and companies attempt to differentiate their product from that of other firms. McDonald’s invests money in maintaining its brand name, which differentiates it from other companies. The amount of money spent on creating and maintaining a brand name does not convey any specific information about McDonald’s products. But it does convey, indirectly, that McDonald’s is in this market for the long haul, that it has a reputation to protect, and that it will interact repeatedly with its customers. In this sense, the amount of money spent on maintaining a brand name signals to you as a consumer that McDonald’s will provide products of consistent quality. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 13. The restaurant business in town is a monopolistically competitive industry in long-run equilibrium. One restaurant owner asks for your advice. She tells you that, each night, not all tables in her restaurant are full. She also tells you that she would attract more customers if she lowered the prices on her menu and that doing so would lower her average total cost. Should she lower her prices? Draw a diagram showing the demand curve, marginal revenue curve, marginal cost curve, and average total cost curve for this restaurant to explain your advice. Show in your diagram what would happen to the restaurant owner’s profit if she were to lower the price so that she sells the minimum-cost output. 13. She should not lower her price. Since the industry is in long-run equilibrium, each restaurant makes zero profit. That is, the restaurant’s demand, marginal revenue, marginal cost, and average total cost curves are as shown in the accompanying diagram. Price, cost, marginal revenue MC ATC PMC ATC1 P1 Loss DMC MRMC QMC Q1 Quantity The restaurant owner produces output (the number of tables served) QMC at a price of PMC . The price is equal to average total cost, so she makes zero profit. If she were to lower the price to P1, she would attract more customers and sell the minimum-cost output Q1. That is, there is excess capacity: each restaurant in town could produce more output at a lower average total cost. But lowering the price to P1 would cause the restaurant owner to incur a loss equal to the shaded rectangle in the diagram, since price is now below average total cost, ATC1. In fact, there is no price other than PMC at which the restaurant owner does not incur a loss. So she should not change the prices on her menu. Externalities 1. What type of externality (positive or negative) is present in each of the following examples? Is the marginal social benefit of the activity greater than or equal to the marginal benefit to the individual? Is the marginal social cost of the activity greater than or equal to the marginal cost to the individual? Without intervention, will there be too little or too much (relative to what would be socially optimal) of this activity? a. Mr. Chau plants lots of colorful flowers in his front yard. b. Your next-door neighbor likes to build bonfires in his backyard, and sparks often drift onto your house. c. Maija, who lives next to an apple orchard, decides to keep bees to produce honey. d. Justine buys a large SUV that consumes a lot of gasoline. 1. a. This is a positive externality: since other people enjoy looking at Mr. Chau’s flowers, the marginal social benefit of looking at the flowers is greater than the marginal benefit to Mr. Chau of looking at them. As a result, fewer flowers will be planted than is socially optimal. b. This is a negative externality: an external cost, the risk that your house will catch fire from the sparks from your neighbor’s bonfire, is imposed on you. That is, the marginal social cost is greater than the marginal cost incurred by your neighbor. Since your neighbor does not take this external cost into account, there will be more bonfires in your neighbor’s yard than is socially optimal. c. This is a positive externality: since bees pollinate her neighbor’s apple trees and therefore confer an external benefit on the owner of the apple orchard, the marginal social benefit is greater than the marginal benefit to Maija. Since Maija does not take the external benefit into account, she will keep fewer bees than is socially optimal. d. This is a negative externality: the burning of gasoline produces toxic gases that impose an external cost on others. The marginal social cost is greater than the marginal cost incurred by Justine. As a result, more people will purchase SUVs than is socially optimal. 2. Many dairy farmers in California are adopting a new technology that allows them to produce their own electricity from methane gas captured from animal waste. (One cow can produce up to 2 kilowatts a day.) This practice reduces the amount of methane gas released into the atmosphere. In addition to reducing their own utility bills, the farmers are allowed to sell any electricity they produce at favorable rates. a. Explain how the ability to earn money from capturing and transforming methane gas behaves like a Pigouvian tax on methane gas pollution and can lead dairy farmers to emit the efficient amount of methane gas pollution. b. Suppose some dairy farmers have lower costs of transforming methane into electricity than others. Explain how this system of capturing and selling methane gas leads to an efficient allocation of emissions reduction among farmers. Chapter 16 2. a. Without the new technology, dairy farmers will release methane gas until the marginal social benefit of emissions is zero. With the new technology, there is now an opportunity cost to the farmer from releasing methane gas because there now exists a profitable alternative—turning it into electricity. The financial reward forgone if a farmer emits the methane gas acts like a Pigouvian tax on emissions. If the financial reward is set at the right level—equal to the marginal social cost of a unit of methane gas pollution at the socially optimal level— it will lead dairy farmers to emit the efficient amount of methane gas pollution. b. Farmers who have a lower cost of capturing methane will generate more profit from transformation of their methane than farmers who have a higher cost. So farmers with lower costs will transform more units of methane gas into electricity than will farmers with higher costs. As a result, emissions reduction will be allocated efficiently among dairy farmers. 3. Voluntary environmental programs were extremely popular in the United States, Europe, and Japan in the 1990s. Part of their popularity stems from the fact that these programs do not require legislative authority, which is often hard to obtain. The 33/50 program started by the Environmental Protection Agency (EPA) is an example of such a program. With this program, the EPA attempted to reduce industrial emissions of 17 toxic chemicals by providing information on relatively inexpensive methods of pollution control. Companies were asked to voluntarily commit to reducing emissions from their 1988 levels by 33% by 1992 and by 50% by 1995. The program actually met its second target by 1994. a. As in Figure 16-3, draw marginal benefit curves for pollution generated by two plants, A and B, in 1988. Assume that without government intervention, each plant emits the same amount of pollution, but that at all levels of pollution less than this amount, plant A’s marginal benefit of polluting is less than that of plant B. Label the vertical axis “Marginal benefit to individual polluter” and the horizontal axis “Quantity of pollution emissions.” Mark the quantity of pollution each plant produces without government action. b. Do you expect the total quantity of pollution before the program was put in place to have been less than or more than the optimal quantity of pollution? Why? c. Suppose the plants whose marginal benefit curves you depicted in part a were participants in the 33/50 program. In a replica of your graph from part a, mark targeted levels of pollution in 1995 for the two plants. Which plant was required to reduce emissions more? Was this solution necessarily efficient? d. What kind of environmental policy does the 33/50 program most closely resemble? What is the main shortcoming of such a policy? Compare it to two other types of environmental policies discussed in this chapter. 3. a. The accompanying diagram shows the marginal benefit curve for plant A, MBA, and the marginal benefit curve for plant B, MBB. Without government intervention, both plants produce QMKT pollution. Marginal benefit to individual polluter MBB MBA QMKT Quantity of pollution emissions b. We should expect that the total quantity of pollution before the plan was adopted was above the optimal quantity because pollution generates a negative externality. When the negative externality is not internalized or regulated, it results in higher market activity than is optimal. c. The accompanying diagram shows the targeted level of emissions in 1995, Q1995. Both firms had to reduce their emissions by the same amount. This was not necessarily efficient: since at the quantity Q1995, plant B had a higher marginal benefit of pollution, the situation could have been more efficient by allowing plant B to pollute a little more and asking plant A to reduce its emissions more. Marginal benefit to individual polluter MBB MBA SB(1995) SA(1995) Q1995 QMKT Quantity of pollution emissions d. The 33/50 program set an environmental standard. The main shortcoming of this type of policy is that its inflexibility often prevents pollution reductions from being achieved at the lowest cost. Tradable permits and emissions taxes are more flexible policies than an environmental standard. These policies help to achieve reductions in emissions at the lowest possible cost. 4. According to a report from the U.S. Census Bureau, “the average [lifetime] earnings of a full-time, year round worker with a high school education are about $1.2 million compared with $2.1 million for a college graduate.” This indicates that there is a considerable benefit to a graduate from investing in his or her own education. Tuition at most state universities covers only about two-thirds to three-quarters of the cost, so the state applies a Pigouvian subsidy to college education. If a Pigouvian subsidy is appropriate, is the externality created by a college education a positive or a negative externality? What does this imply about the differences between the costs and benefits that accrue privately to students compared to social costs and benefits? What are some reasons for the differences? 4. If a Pigouvian subsidy is appropriate, the externality is a positive one. This means that the marginal social benefit of education is higher than the private benefit going to graduates. (It is likely that marginal social cost and private cost to graduates do not differ.) One reason the marginal social benefit of education is higher than the private benefit to graduates is that their increased human capital makes other people in the economy more productive, even those who do not have a college education. Also, they are more likely to realize cultural and social achievements from which all of society benefits. 5. The city of Falls Church, Virginia, subsidizes the planting of trees in homeowners’ front yards when they are within 15 feet of the street. a. Using concepts in the chapter, explain why a municipality would subsidize planting trees on private property, but near the street. b. Draw a diagram similar to Figure 16-4 that shows the marginal social benefit, the marginal social cost, and the optimal Pigouvian subsidy on planting trees. 5. a. Trees planted near the street provide external benefits. They provide shade and so keep streets and sidewalks cooler, which makes activities such as walking and bicycling more pleasant for all citizens. They also beautify neighborhoods and can raise property values. And they provide habitat for wildlife which helps to preserve biodiversity. Without the subsidy, the market equilibrium quantity would be below the socially optimal quantity. An optimal Pigouvian subsidy will lead homeowners to plant the socially optimal quantity of trees. b. The accompanying diagram shows the marginal social benefit (MSB) and the marginal social cost (MSC) of planting trees. The marginal social benefit is decreasing: the first trees are planted in the most ideal locations (close to frequently traveled streets, etc.), but subsequent trees must increasingly be planted in less ideal locations. The marginal social cost is increasing: as homeowners have more trees planted, arborists are likely to raise their rates in response to the increased demand for their services. The diagram shows the market equilibrium quantity, QMKT, the socially optimal quantity, QOPT, and the optimal Pigouvian subsidy. Marginal social cost, marginal social benefit Optimal Pigouvian subsidy on planting trees MSC of planting trees O MSB of planting trees QMKT QOPT Quantity of trees 6. Fishing for sablefish has been so intensive that sablefish were threatened with extinction. After several years of banning such fishing, the government is now proposing to introduce tradable vouchers, each of which entitles its holder to a catch of a certain size. Explain how uncontrolled fishing generates a negative externality and how the voucher scheme may overcome the inefficiency created by this externality. 6. An individual fisherman makes decisions about how many fish to catch based on his or her own benefit and cost. However, since catching fish reduces the number of fish that can reproduce, the fisherman's actions impose an external cost on others. As a result, there will be over-fishing—more fish are caught than is socially optimal. Assuming that the number of vouchers allocated to all fishermen corresponds to the socially optimal quantity of fish caught, the voucher scheme could achieve efficiency: it will limit the size of the total catch to the socially optimal quantity. And since the vouchers are tradable, fishermen who are more efficient (can operate at a lower cost) will buy vouchers from less efficient ones, so only the most efficient fishermen will operate. 7. The two dry-cleaning companies in Collegetown, College Cleaners and Big Green Cleaners, are a major source of air pollution. Together they currently produce 350 units of air pollution, which the town wants to reduce to 200 units. The accompanying table shows the current pollution level produced by each company and each company’s marginal cost of reducing its pollution. The marginal cost is constant. Initial pollution level (units) Marginal cost of reducing pollution (per unit) College Cleaners 230 $5 Big Green Cleaners 120 $2 Companies a. Suppose that Collegetown passes an environmental standards law that limits each company to 100 units of pollution. What would be the total cost to the two companies of each reducing its pollution emissions to 100 units? Suppose instead that Collegetown issues 100 pollution vouchers to each company, each entitling the company to one unit of pollution, and that these vouchers can be traded. b. How much is each pollution voucher worth to College Cleaners? To Big Green Cleaners? (That is, how much would each company, at most, be willing to pay for one more voucher?) c. Who will sell vouchers and who will buy them? How many vouchers will be traded? d. What is the total cost to the two companies of the pollution controls under this voucher system? 7. a. College Cleaners would have to reduce its pollution level by 130 units, costing it 130 × $5 = $650. Big Green Cleaners would have to reduce its pollution level by 20 units, costing it 20 × $2 = $40. So the total cost of reducing pollution to a total of 200 units would be $650 + $40 = $690. b. One pollution voucher is worth $5 to College Cleaners and $2 to Big Green Cleaners. To see why, consider this: if College Cleaners can obtain one more voucher entitling it to one more unit of pollution, it saves $5 (the cost it would have had to incur to reduce pollution by one unit). c. Each voucher is worth more to College Cleaners than to Big Green Cleaners, so Big Green Cleaners will sell all of its 100 vouchers to College Cleaners (for a price between $2 and $5). d. Big Green Cleaners will reduce its output of pollution to zero, which will cost it 120 × $2 = $240. College Cleaners will now have 200 vouchers and can emit 200 units of pollution, 30 fewer than before. This will cost College Cleaners 30 × $5 = $150. So the total cost of pollution control under this system is $240 + $150 = $390. The prices paid by College Cleaners and received by Big Green Cleaners in trading vouchers cancel each other out—they are pure “transfers” between the two companies. 8. a. EAuction and EMarketplace are two competing internet auction sites, where buyers and sellers transact goods. Each auction site earns money by charging sellers for listing their goods. EAuction has decided to eliminate fees for the first transaction for sellers that are new to its site. Explain why this is likely to be a good strategy for EAuction in its competition with EMarketplace. b. EMarketplace complained to the Justice Department that EAuction’s practice of eliminating fees for new sellers was anti-competitive and would lead to monopolization of the internet auction industry. Is EMarketplace correct? How should the Justice Department respond? c. EAuction stopped its practice of eliminating fees for new sellers. But since it provided much better technical service than its rival, EMarketplace, buyers and sellers came to prefer EAuction. Eventually, EMarketplace closed down, leaving EAuction as a monopolist. Should the Justice Department intervene to break EAuction into two companies? Explain. d. EAuction is now a monopolist in the internet auction industry. It also owns a site that handles payments over the internet, called PayForIt. It is competing with another internet payment site, called PayBuddy. EAuction has now stipulated that any transaction on its auction site must use PayForIt, rather than PayBuddy, for the payment. Should the Justice Department intervene? Explain. 8. a. Internet auction sites are characterized by network externalities: more sellers will want to list their items on the site that more buyers visit, and more buyers will visit a site on which more sellers list items for sale. So it is a good strategy for EAuction to eliminate its fees to first-time sellers. As a result, more sellers will come to EAuction than to EMarketplace, also drawing more buyers to EAuction than to EMarketplace. b. EMarketplace is correct: due to the network externality, EAuction’s practice is anti-competitive and likely to eventually drive EMarketplace out of business. Because actions taken to gain a monopoly advantage are illegal, the Justice Department should intervene and stop EAuction’s practice of eliminating fees for new sellers. c. No, the Justice Department should not intervene. Due to the network externality, the internet auction industry has naturally become a monopoly: buyers and sellers are both better served by an industry with one large auction site than two smaller sites. EAuction did nothing illegal because it became a monopolist through providing better service, rather than by taking anticompetitive actions to gain a monopoly advantage. d. Yes, the Justice Department should intervene. As in the case of Microsoft, EAuction is using its monopoly position in one industry (the internet auction industry) to gain a monopoly in the internet payment industry. It should stop EAuction from requiring that buyers and sellers on its site use PayForIt. 9. Which of the following are characterized by network externalities? Which are not? Explain. a. The choice between installing 110-volt electrical current in structures rather than 220-volt b. The choice between purchasing a Toyota versus a Ford c. The choice of a printer, where each printer requires its own specific type of ink cartridge d. The choice of whether to purchase an iPad Air or an iPad Mini. 9. a. This choice is characterized by a network externality: you want to use the standard that is more widely adopted by other people. That’s because the greater the use of a given electricity standard, the greater the availability of appliances and other electrical items using that standard. b. This choice is not characterized by a network externality because there are millions of Fords and Toyotas already on the road. Consequently, you will easily find a Toyota or Ford repair shop whenever you need one. There would be a network externality present in the choice of buying a new make of car in which you could not be assured of finding a mechanic for it. c. This choice is characterized by a network externality because you want to be assured of finding a cartridge for your printer in the future. If few people use your type of printer, you may be unable to find a cartridge; if many people use the printer, you are much more likely to find a cartridge for it. d. This choice is not characterized by a network externality because an iPad Air and an iPad Mini use the same operating system. So any feature available on one is also available on the other. WORK IT OUT Interactive step-by-step help with solving this problem can be found online. 10. The loud music coming from the sorority next to your dorm is a negative externality that can be directly quantified. The accompanying table shows the marginal social benefit and the marginal social cost per decibel (dB, a measure of volume) of music. Volume of music (dB) Marginal social benefit of dB Marginal social cost of dB $36 $0 30 2 24 4 18 6 12 8 6 10 0 12 90 91 92 93 94 95 96 97 a. Draw the marginal social benefit curve and the marginal social cost curve. Use your diagram to determine the socially optimal volume of music. b. Only the members of the sorority benefit from the music, and they bear none of the cost. Which volume of music will they choose? c. The college imposes a Pigouvian tax of $3 per decibel of music played. From your diagram, determine the volume of music the sorority will now choose. 10. a. The accompanying diagram shows the marginal social cost curve and the marginal social benefit curve of music. The socially optimal volume of music is the volume at which marginal social benefit and marginal social cost are equal (point O in the diagram). This is the case at a volume of 95 dB. Marginal social cost, marginal social benefit of dB $36 MSB 30 24 18 12 9 6 T 3 0 MSC O M 90 91 92 93 94 96 97 95 Volume of music (dB) b. Since the members of the sorority do not bear any of the social cost of playing loud music, they will play music up to the volume where the marginal social benefit is zero (point M in the diagram). This is at a volume of 96.5 dB. c. If the college imposes a Pigouvian tax of $3 per decibel, the sorority now faces a marginal cost of playing music of $3. So they will play music up to the volume where the marginal social benefit is just equal to $3 (point T in the diagram). This is at a volume of 96 dB. This is not the optimal quantity of music, so this is not an optimal Pigouvian tax. Solution Manual for Microeconomics Paul Krugman, Robin Wells 9781319098780
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