Pricing with Market Power – Solved Question Paper

Review Questions 7
316-660 Managerial Economics
Microeconomics
TOPIC 7:
PRICING WITH MARKET POWER
1. Big Pit Diamonds is a monopoly supplier of diamonds. It produces diamonds at a
fixed cost of $10,000, and an extra labour cost of $6 per diamond supplied. Big Pit
Diamonds can act as a single-price monopolist. Its marketing division finds that the
demand schedule for diamonds is:
Price per diamond
22
20
18
16
14
12
10
8
6
Qty of diamonds
demanded
0
1000
2000
3000
4000
5000
6000
7000
8000
a) Calculate TR and MR per 1000 diamonds.
b) To maximise profit what level of output should Big Pit Diamonds choose, and what
price? What are profits and consumer surplus?
c) What do you think would be the long-run outcome in this market if there was free
entry by new suppliers?
2. (Krugman and Wells, p.404) The structure of the petrol station industry in
Melbourne is monopolistically competitive. Suppose that currently each petrol station
is making negative profits. Draw a diagram to show this short run situation. Then, in
a separate diagram, show what will happen to the typical petrol station in the long run.
Explain your answer.
3. (GKM, p.388) The markers of Aspro pain reliever do a lot of advertising and have
very loyal customers. In contrast, the makers of generic aspirin do no advertising, and
their customers shop only for the lowest price. Assume that the marginal costs of
Aspro and generic aspirin are the same and constant.
a) Draw a diagram showing Aspro’s demand, MR and MC curves. Label Aspro’s
price and mark-up over MC.
b) Repeat part a) for a supplier of generic aspirin. How do the diagrams differ?
Which company has the largest mark-up? Why?
c) Which company has the biggest incentive for quality control? Why?
4. A monopolist has the following total revenues and total costs:
Quantity
0
1
2
3
4
5
6
7
8
9
10
Total Revenue
0
150
280
390
480
550
600
630
640
630
600
Total Cost
70
79
84
94
114
148
196
261
351
481
656
a) Calculate marginal revenue, marginal cost, and derive the demand curve.
b) Determine the profit maximising price and quantity and calculate the resulting
total profit. Explain why output is not at the point where marginal revenue equals
price.
c) The government imposes a fixed license fee of $400 that the monopolist must pay
to continue in operation. What is the effect of this fee on the firm’s price and
output policy?
5. Consider the following data on quantity demanded and price per hour for car park
spaces in Boomtown. The car park is owned by Mega-Monopolist, the sole supplier
of car park services in the town:
Price per
hour($)
8
7
6
5
4
3
2
1
Quantity
demanded per
hour
1
2
3
4
5
6
7
8
Mega-Monopolist has a marginal cost of supplying each car park space of $1 per
hour, and fixed costs equal to $10 per hour. By government regulations, MegaMonopolist must charge the same price to all consumers.
a) (3%) What is the profit maximising quantity/price for Mega-Monopolist to choose?
b) (6%) Suppose the government pays a subsidy of $2 per hour for each car park
space used by consumers. How would this affect the profit maximising quantity for
Mega-Monopolist? What price will be paid by consumers? What price will be
received by suppliers?
c) (6%) Now suppose the government introduces a lump-sum licence fee of $20 per
hour (regardless of the number of parking spaces used) that Mega-Monopolist must
pay to be able to operate. (And again assume as in part (a) that there is no subsidy.)
Would Mega-Monopolist choose to operate? Would it make any difference if MegaMonopolist was allowed to engage in perfect price discrimination?
Review Questions 7
316-660 Managerial Economics
Microeconomics
SOLUTIONS TO REVIEW QUESTIONS
TOPIC 7:
PRICING WITH MARKET POWER
1. a)
Price per diamond Qty of diamonds
demanded
22
0
20
1000
18
2000
16
3000
14
4000
12
5000
10
6000
8
7000
6
8000
TR ($)
MR per 1000 ($)
20,000
36,000
48,000
56,000
60,000
60,000
56,000
48,000
20,000
16,000
12,000
8,000
4,000
0
-4,000
-8,000
b) The SRMC of producing 1000 diamonds is $6,000. Hence the firm should produce
4,000 diamonds. (For the next 1,000 diamonds MR = $4,000 Price per hour = $5
b)
Price per
hour +
subsidy
(Supplier
price)
10
9
8
7
6
5
4
3
Qty
TR
demanded
MR
MC
1
2
3
4
5
6
7
8
10
8
6
4
2
0
-2
-4
1
1
1
1
1
1
1
1
10
18
24
28
30
30
28
24
Profit maximising quantity = 5 spaces; Price received by supplier = $6; Price paid by
consumers = $4.
c) Profits = TR – VC – FC => Profits per hour = (4x$5) – (4x$1) – $10 = $6.
Hence if a lump-sum licence fee of $20 per hour is introduced, then Mega-Monopolist
would choose not to operate. But if Mega-Monopolist can engage in perfect price
discrimination, it can earn TR = ($8+$7+$6+$5+$4+$3+$2+$1) = $36. (Note that it
will choose to supply units up to where a consumer has a willingness to pay equal to
MC; that is $1.) Then Profits per hour = $36 – (8x$1) – $10 = $18. Hence, MegaMonopolist would still choose not to operate as its profits per hour are less than the
lump-sum licence fee of $20.
…