SOLUTIONS TO END-OF-CHAPTER EXERCISES Answers to Thinking Critically Questions 1. The license would be a barrier to entry into the coffeehouse market; entry would no longer be free. This would increase the costs of firms that paid the license fee (the MC and AC curves for these firms would shift upward). The equilibrium price charged by these firms would rise and the equilibrium quantity would fall. But the fee would not affect the price or quantity of the existing firms that were exempt from the fee. The license fee exemption would benefit the incumbent firms but would limit competition and harm consumers. Incumbent firms would have an incentive to lobby the federal government in order to maintain the license fee for new firms and the exemption for themselves. 2. Starbucks would probably consider expanding its menu to include breakfast items. The firm may also attempt to offer items that could attract new consumers during other times; for example, lunch or dinner hours. 12.1 Demand and Marginal Revenue for a Firm in a Monopolistically Competitive Market Learning Objective: Explain why a monopolistically competitive firm has downwardsloping demand and marginal revenue curves. Review Questions 1.1 In both perfectly competitive and monopolistically competitive industries there are many firms and low barriers to entry. However, while products are identical in perfectly competitive markets, products are similar—but not identical—in monopolistically competitive markets. Wheat and many raw materials are sold in perfectly competitive markets; haircuts and restaurant meals are sold in monopolistically competitive markets. 1.2 The local McDonald’s faces a downward-sloping demand curve for Big Macs because if it increases its price, customers will substitute away from Big Macs and buy something else—like burgers at Wendy’s or Burger King. If it raises its prices it won’t lose all of its customers, however, because it is located more conveniently than other restaurants for some people and some people strongly prefer Big Macs to other similar products. 1.3 Total revenue equals price x quantity; average revenue = (total revenue)/quantity (and also equals price); marginal revenue = (change in total revenue)/(change in quantity). Problems and Applications 1.4 ©2010 Pearson Education, Inc. Publishing as Prentice Hall 2 CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting 1.5 The argument is incorrect. The student is forgetting that if the firm is facing a downward-sloping demand curve, it must lower the price to all consumers in order to sell another unit. Because the firm receives a lower price on all but the last unit, the marginal revenue received from the last unit is less than the price. 1.6 All wheat farms are selling identical goods. But coffeehouses do not sell identical goods. If a wheat farmer raises his price above the market price, he will lose all of his buyers. A Starbucks coffeehouse can raise its price without losing all of its buyers because it is selling a product that is not identical to the products sold by other coffeehouses. 1.7 In a perfectly competitive market marginal revenue is equal to price so it cannot be negative. A monopolistically competitive firm produces where marginal revenue equals marginal cost. Because marginal cost is never negative, a monopolistically competitive firm will never produce where marginal revenue is negative. 12.2 How a Monopolistically Competitive Firm Maximizes Profits in the Short Run Learning Objective: Explain how a monopolistically competitive firm maximizes profits in the short run. Review Questions 2.1 To find Sally’s marginal revenue, find the change in revenue as she sells one more Big Mac at the lower price. Initial revenue = $3.25 x 350 = $1,137.50. After the price cut, revenue = $3.20 x 351 = $1,123.20. So her marginal revenue = $1,123.20 – $1,137.50 = –$14.30. 2.2 Renting the extra DVD reduces his profits by $0.20, because the marginal revenue earned on the last DVD is $2.75, while the marginal cost is $2.95. 2.3 Monopolistically competitive firms produce the level of output where marginal revenue equals marginal cost. Because fixed costs have no effect on marginal costs, monopolistically competitive firms can ignore them when deciding how much to produce. ©2010 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting 3 Problems and Applications 2.4 Profit = Revenue – Cost = Quantity x (price – average cost) = 350 x ($3.25 – $3.00) = $87.50. 2.5 a. We need to calculate marginal revenue and marginal cost, which can be done by adding three new columns to the table: Jill should rent five DVDs—this is where MC = MR. She should charge a price of $3.50 per DVD. Her profit will be $17.50 – $16.00 = $1.50. b. The marginal revenue from renting the profit-maximizing DVD is $1.50, which is the same as the marginal cost of renting this DVD. 2.6 Remember that minimizing average costs is not the same as maximizing profits. Often where profits are maximized, average costs are not minimized. Depending on demand, a firm may maximize profits by producing a quantity that is either larger or smaller than the quantity that would minimize average total cost. In this case, we do not have the information on the firm’s revenues that would be necessary to calculate the profit-maximizing quantity of table lamps. 2.7 a. Profit = Total revenue – total cost. Because profit fell, total cost must have increased faster than total revenue increased. b. On the first graph, Total revenue = $100 x 100 units = $10,000. Total cost = $80 x 100 units = $8,000. Profit = $10,000 – $8,000 = $2,000. On the second graph, Total revenue = $120 x 100 units = $12,000. Total cost = $130 x 100 units = $13,000. Profit = $12,000 – $13,000 = –$1,000 (loss of $1,000). The company goes from a $2,000 profit to a $1,000 loss, while the total revenue increases from $10,000 to $12,000. ©2010 Pearson Education, Inc. Publishing as Prentice Hall 4 CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting 2.8 The drop in profits per item of clothing doesn’t necessarily indicate that cutting prices was a bad idea. If J.Crew is maximizing profits, it will set its output where MC = MR and charge the highest price that people are willing to pay for this quantity. It may have been forced to cut its prices (and profits per item) because demand fell. (In fact, according to the article, this was the case.) Keeping its prices at the old level may have caused even greater economic losses of profit. 2.9 The graph shows that when the marginal and average total cost curves shift up, the profitmaximizing price rises from P 1 to P 2 . Germano seems to be assuming that demand is perfectly elastic, which it is unlikely to be. If a publisher does not raise the price of a book following an increase in its production cost, its marginal revenue from the last few copies will be less than the marginal cost—so it will earn a smaller profit than it would at a higher price. 2.10 a. The demand for ordering these items online must be price elastic. As you learned in chapter 6, price elastic means as price decreases by a specific percentage, quantity demanded increases by a greater percentage, causing total revenue to increase. ©2010 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting 5 b. P 1 is the non-profit-maximizing price Amazon was charging before the price cut. P 2 is the profit-maximizing price. Cutting the price increases the quantity of books sold from Q 1 to Q 2 , which is the profit-maximizing level. 2.11 a. Initial revenue = $440 x 500,000 = $220,000,000. Revenue after price cut: $360 x 800,000 = $288,000,000. So, he expected total revenue to rise. b. Recall that the midpoint formula uses the average of the initial and final quantity and the initial and final price. The average of the initial and final prices of Model T’s is $440 + $360 = $400 2 and the average of the initial and final quantities is 500,000 + 800,000 = 650,000. 2 So, the percentage change in the quantity demanded = 800,000 − 500,000 × 100 = 46.2% , 650,000 and the percentage change in the price = $360 − $440 × 100 = −20.0%. $400 So, the price elasticity of demand for Model T’s = 46.2% = −2.3. −20.0% ©2010 Pearson Education, Inc. Publishing as Prentice Hall 6 CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting c. Profit = Revenue – Cost. $60,000,000 = $288,000,000 – (ATC x 800,000); therefore, to earn a profit of $60,000,000, the ATC for making 800,000 cars must be $285. ATC for 500,000 Model T’s: Total Cost = Revenue – Profit = $220,000,000 – $60,000,000 = $160,000,000. Therefore, ATC = $160,000,000/500,000 = $320. So, the ATC of producing 800,000 Model T’s was lower than the ATC of producing 500,000 Model T’s. d. Yes. If the profit is the same and he is selling more cars, he must be making a smaller profit per car. We can check this by calculating the profit per car (price minus ATC): For 500,000 cars, profit per car = $440 – $320 = $120 per car; for 800,000 cars, profit per car = $360 – $285 = $75 per car. What Happens to Profits in the Long Run? 12.3 Learning Objective: Analyze the situation of a monopolistically competitive firm in the long run. Review Questions 3.1 New firms entering an industry cause the demand curves for the products of existing firms to shift to the left. Existing firms will be able to sell less at every price, so their profits will decline. 3.2 Economic profits take into account opportunity costs. Accounting profits do not. So, economic profits will typically be smaller than accounting profits. If a firm has zero accounting profits, it will be making an economic loss, while a firm with zero economic profits will have positive accounting profits. Problems and Applications 3.3 a. She should rent 55 DVDs at a price of $4.50 each. This is the quantity at which MC = MR. b. Her loss is equal to the difference between price and average total cost, multiplied by quantity = ($4.50 − $5.50) x 55 = −$55.00. Because the price is greater than her average variable cost, she should continue to operate and not shut down in the short run. c. No, because she is taking a loss. If such losses persist, she should shut down her store and exit the industry. 3.4 The analysis is incorrect. The student has forgotten that economic costs include a normal rate of return on the owners’ investment in the firm. Therefore, firms will not leave the industry when earning zero economic profit. Also, in the long run, the price will be equal to average cost, not above average cost as the student mentioned. 3.5 Higher competition in an industry generally means lower prices for consumers. As more firms enter an industry, the demand for each individual firm’s product decreases. The decrease in demand shifts the individual firm’s demand curve to the left, which lowers the selling price, which is good for consumers. If the industry is competitive, the firm’s demand curve will eventually shift to the point where it is tangent to the average cost curve. This is where price is equal to average total cost, which means the firm is breaking even, which compared to earning a profit, is bad for shareholders. 3.6 If consumers believe that all coffee is equal, then consumers have no reason to choose Starbucks coffee over any other coffee, and Starbucks would not be able to charge a higher price than any of its competitors. To convince consumers that all coffee is not equal, Starbucks could use marketing to differentiate its product. This could include advertising, store design, and store location. ©2010 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting 7 3.7 Saks may have difficulty in becoming the low-priced, luxury clothing retailer. If Saks is discounting prices on luxury clothing, other luxury clothing retailers are likely to follow suit. This will give Saks no price advantage over competing retailers. One thing that may help Saks is providing better customer service than its competition, and if this is important to consumers. With hhgregg, customer service is very important, since they are selling electronics and appliances, products which consumers may need help or reliable information in terms of features, quality, and operation. This is generally not the case with respect to clothing. This will more likely make hhgregg’s strategy more successful in the long run than that of Saks. 3.8 It will be very difficult to become rich by following the advice found in a book because if the book really has a good idea, then a lot of people will follow its advice. In the process, they will compete away the profits from following the advice. Only those who pounce on the profit opportunity quickly will earn great profits before imitators enter the market and eliminate the profits. (In addition, if the author’s advice is really that valuable, he or she will probably want to keep it secret, using it in his or her own business rather than telling rivals about it.) 3.9 The skeptics who think that “Starbucks’ game is almost over” think that other firms will soon be copying Starbucks so well that the demand for Starbucks’ products will decline and it won’t be able to earn high economic profits any more. 3.10 L’Oreal may see lower costs and greater profits in the short run, but its failure to continue to develop new products would result in greater competition and lower profits in the long run. Perfect Competition and Monopolistic Competition 12.4 Comparing Learning Objective: Compare the efficiency of monopolistic competition and perfect competition. Review Questions 4.1 In the long run, the perfectly competitive firm charges a price equal to the marginal cost of making the product and it produces the quantity that minimizes average total cost. It is allocatively and productively efficient. Monopolistically competitive firms charge a price that is above the marginal cost (not allocatively efficient) and produce a quantity that is less than the amount that minimizes average total cost (not productively efficient). Despite these differences, perfectly competitive and monopolistically competitive firms both earn zero economic profits in the long run. 4.2 Monopolistic competition probably doesn’t cause a significant loss in economic well-being to society. The loss or gain can be measured by total economic surplus. Although monopolistically competitive firms reduce total economic surplus by producing less than the efficient amount (creating a deadweight loss), they also increase consumer surplus because people are willing to pay more for variety and for products that are more closely suited to their tastes. Problems and Applications 4.3 There is no contradiction between producing where price is greater than marginal cost and zero profits. Zero profits mean that price equals average cost. Under perfect competition price equals marginal revenue and zero profit implies marginal cost equals average cost. This last equality does not hold under monopolistic competition, where firms in the long run produce where average cost is greater than marginal cost. ©2010 Pearson Education, Inc. Publishing as Prentice Hall 8 4.4 CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting a. This firm is a monopolistically competitive firm. We know this because it faces a downwardsloping demand curve. A perfectly competitive firm’s demand curve would be horizontal. b. We know the graph shows a short-run equilibrium because the demand curve is above the ATC. This means that price is greater than average total cost, so the firm is earning economic profits. Monopolistically competitive firms only earn economic profits in the short run. c. If the firm were perfectly competitive, it would produce the quantity where the ATC is at its minimum. On the graph, this quantity is seven. 4.5 Few will agree. Firms differentiate their products to appeal to consumers’ varied tastes. The success of product differentiation strategies indicates that many consumers find differentiated products preferable to the alternatives. Consumers are, therefore, better off than they would be if companies did not differentiate their products—consumers are willing to pay for the higher costs (“waste”) caused by differentiation. 4.6 a. By limiting the number of stores the clothes are sold at, the prices can be kept high and the product differentiated from lower priced products. If Juicy sold its clothes at Wal-Mart, it would be seen as a lower-quality brand, which would be likely to cause prices and profits to fall. b. Juicy is less likely to maintain product differentiation over time because entry into the clothing industry is easier than entry into the computer industry. 12.5 How Marketing Differentiates Products Learning Objective: Define marketing and explain how firms use it to differentiate their products. Review Questions 5.1 Marketing consists of all the activities that are necessary for a firm to sell a product to a consumer. Marketing is not limited only to advertising. Product placement and defending a brand name can also be included under marketing. 5.2 Firms are concerned about brand management because maintaining their product’s unique identity and good reputation is necessary to prevent competitors from attracting their customers Problems and Applications 5.3 Advertising is a fixed cost, so it will shift up the ATC curve, but not the MC curve. ©2010 Pearson Education, Inc. Publishing as Prentice Hall CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting 9 5.4 This is a good way to find out what customers want, but it probably isn’t a good way to make a profit because other firms already know this same information and are selling products to these customers. Entering the market with products exactly like the competition will only work if your firm somehow has lower costs than the other firms. On the other hand, firms who discover new information about what customers want can temporarily make a profit supplying a new product, until new firms enter the market and competition drives profits back to zero. 5.5 a. The government allows firms to trademark their products to encourage firms to invest in product improvements and innovation. Firms will only make such investments if they expect to get the benefits of these investments in the form of higher profits from new or differentiated products that cannot be immediately copied by competitors. b. If retailers would choose to continue using the phrase “the big game” after the NFL was issued a trademark, then, consumers would be likely to lose as the investment in the product (the Super Bowl) will probably not increase due to this new trademark. Forcing retailers to pay for using the phrase in their advertisements will raise the retailer’s costs and the prices they charge. More than likely, most retailers would avoid using the phrase once it was trademarked to avoid having to pay the NFL for its use. 5.6 Once a firm’s image is tarnished, it can be very expensive to improve the situation. Advertising and law suits may help, but they can be very expensive. Another famous example of a product image mishap is Reebok’s Incubus running shoes for women. Reebok was surprised to learn that in medieval legend an incubus was a male demon who preyed on sleeping women. After a big frenzy in the press, Reebok changed the shoe’s name. 5.7 A firm’s optimal level of advertising occurs where the marginal cost of advertising equals the marginal revenue earned from advertising. The marginal revenue earned from advertising is the additional revenue from the increased sales resulting from the advertising. For Web advertising, firms can measure how often people click on their ads and how many of those clicks lead to online sales. The payoff to television, radio, and newspaper ads is much harder to measure. Having more quantifiable information as to the success of advertising on the Internet compared to other media forms may lead many firms to prefer advertising on the Internet. 12.6 What Makes a Firm Successful? ©2010 Pearson Education, Inc. Publishing as Prentice Hall 10 CHAPTER 12 | Monopolistic Competition: The Competitive Model in a More Realistic Setting Learning Objective: Identify the key factors that determine a firm’s success. Review Questions 6.1 A monopolistically competitive firm’s profitability depends on its ability to differentiate its products (especially to make them seem more desirable than competitors’ products) and to produce its product at a lower average cost than competing firms. 6.2 A monopolistically competitive firm can continually earn economic profits greater than zero only if it always stays one step ahead of the on-rushing competition. Problems and Applications 6.3 A firm may change market niches because it fears its traditional market is being reduced by competition and hopes the new niche will be more profitable. Starbucks is currently expanding from the coffee only niche to the breakfast/light food niche to combat increasing competition in coffee sales. 6.4 Competition is a risk because it can reduce a firm’s profits. The barriers to entry are low in retailing, so the competition is intense. 6.5 Wal-Mart may have been more successful buying big chains as this reduces competition in the new market. Bigger chains may also allow Wal-Mart to reduce the average costs of advertising and operation in the new market. Larger chains may also have a larger and more loyal base of customers. 6.6 Design flaws can indeed reduce profits for “first movers” and leave room for competitors who can enter the new market with a better product. Firms that are later to enter a market have often had the time to improve the products they offer and also to better gauge what features of the product might be most important to consumers. This was Apple’s approach when entering the market for digital music players. 6.7 According to the text, it is a little of both. There are certain things that skilled managers can control in order to increase the value of their product such as successful differentiation of the product and having lower cost than competing firms. Other factors leading to profits are not so easily controlled and usually happen by sheer luck such as a new road being built near your struggling business. ©2010 Pearson Education, Inc. Publishing as Prentice Hall