Short Response Question pg. 125 – Oligopoly

Explain why prices tend to be quite stable in a non-collusive oligopoly.

Oligopoly is where a few firms dominate an industry. The industry is made up of quite a few firms or not very many, as long as a large percentage of the industry’s output is shared by just a small number of firms. Collusion is the process of when firms in an oligopolistic market cooperate to decide on the price that they are going to cell their product for (together they act as a monopoly). Non-collusive oligopoly occurs when the firms in an oligopoly do not collude, meaning they do not decide on a price together. This means that each oligopolistic firm needs to be very aware of the reactions of other firms when making pricing decisions. The prices in a non-collusive oligopoly tend to be quite stable for various reasons. First of all, firms are afraid to raise prices above the current market price, because the other firms would keep their price, meaning that most consumers will stop buying from the firm that is charging the higher price, and purchase their products from the other firms which sell very similar products, but for a lower price. So, if firms in a non-collusive oligopoly raise their price, they will lose trade, sales, and most likely profit. On the other hand, firms are also not able to lower their prices below the current market price, because then other firms would follow, and maybe go as far as selling their products at an even lower price. This would create a price war where each firm would try to sell their product at the lowest price, to increase the quantity demanded for that firm, but this would harm all the firms involved since they would all be gaining losses. This can be illustrated by a graph. Above the market price, the demand is relatively elastic, since a small increase in price would lead to a large fall in quantity demanded. Below the market price, the demand curve is less elastic, since a decrease in price is unlikely to lead to a noticeable increase in quantity demanded. All in all, the prices tend to be quite stable in a non-collusive oligopoly because a slight increase in price would lead to a large fall in quantity demanded, since the demand is relatively elastic, and a decrease in price would not lead to an increase in quantity demanded, so it would not lead to great profits.

Short Response Question pg 118 – Monopolistic Competition

Explain whether or not a firm in monopolistic competition earning abnormal profits is productively and allocatively efficient.




A firm in monopolistic competition is able to earn abnormal profits if it is maximizing its profit by producing at the level of output where MC = MR, and the AC is less than the selling price. A firm is productively efficient if it produces at the lowest possible cost per unit, which is at the point where MC = AC. Allocative efficiency is when the firm produces at the socially optimum level of output, which is where MC = AR. In other words, the demand curve reflects the signal that consumers send out to producers about how much of a product the consumers need and want. The point of allocative efficiency is where the benefit of society equals the firm’s cost. If a firm in monopolistic competition is earning abnormal profits, it is neither productively nor allocatively efficient. Since it produces at the profit maximizing output, where the marginal cost is equal to the marginal revenue, the output produced is q. Since the firm is profit seeking, it does not produce at q₁ (productively efficient) or at q₂ (allocatively efficient). The inefficiency is not, however, due to the firm's ability to restrict output and increase price (as it is in a monopoly). The inefficiency is due to the consumer's demand for variety. Even though the products are not produced at the "socially optimum level of output", consumers are not worse off with monopolistic competition than with perfect competition. The monopolistic competition provides variety in the products for consumers to choose from, so the consumers do not suffer from the firm's lack of allocative and productive efficiency.

Short Response Questions pg. 112

1) Explain the level of output at which a monopoly firm will produce.

A monopoly firm will produce at the level of output which maximizes the monopolist’s profit. In order to maximize profit, it produces at the level of output where marginal cost is equal to marginal revenue. Since the monopoly is the only firm producing a certain product, the monopolist is the industry, so the monopolist’s demand curve is the industry’s demand curve and is downwards sloping. Because the demand curve is downwards sloping, there is an inverse relationship between quantity demanded and price. This means that the monopolist can either control the price or the level of output, but not both. It would seem that a monopolist would have total control over both price and level of output, but in order to sell more they must lower their price. The monopolist’s marginal revenue curve is below the demand curve, so in order for the monopoly firm to maximize its profit, the level of output at which the monopolist is producing is where marginal cost equals marginal revenue. Furthermore, if the monopolist has experienced economies of scale and have an average cost curve that is below the demand curve, it is possible for the monopolist to be making abnormal profits.

2) Using a diagram, explain the concept of a natural monopoly.



An industry is a natural monopoly if there are only enough economies of scale available in the market to support one firm. Examples of natural monopolies include the industries that supply utilities such as water, electricity, and gas. If the monopolist, which is the industry, has the demand curve D1 and its long run average costs are lower than its average revenue for the level of output that the monopolist is producing at, then it is able to earn abnormal profits. The shape and position of the long run average costs curve depends on the economies of scale experienced by the monopolist. If another firm would enter the industry, then the quantity demanded would be shared between the two firms, causing the industry’s demand curve to shift to the left. This causes the long run average costs curve to be positioned above the demand curve, so the firm’s average costs are greater than the firm’s average revenue. For this reason, both firms in the industry would stop earning abnormal profits, and they would not even be able to earn normal profits. The monopolist will only be able to earn abnormal profits again if it manages to produce at the level of output that is demanded in the market. The only way it could do that, though, is by lowering the long run average costs so that it is below the average revenue of the monopolist. However, that would be impossible because the economies of scale are limited so the market can only support one firm.

3) Using appropriate diagrams, explain whether a monopoly is likely to be more efficient or less efficient than a firm in perfect competition.



A monopoly is likely to be less efficient than a firm in perfect competition. Unlike perfect competition, the monopolist produces at the profit maximizing level of output, where there is neither productive efficiency nor allocative efficiency. A monopolist acts in its own interest, while perfect competition takes into account the needs of the consumers. In a monopoly, output is restricted in order to increase the price and to earn the maximum amount of profit. A firm is productively efficient if it produces at the point where average cost equals marginal cost and it is allocatively efficient if it produces at the point where marginal cost is equal to average revenue. However, the monopolist is producing at the level of output where marginal cost is equal to marginal revenue, which explains why it is neither productively nor allocatively efficient. In a perfectly competitive market, the firm produces an optimal mix of goods and services that are demanded by consumers. The competition between firms causes an increase in price to always be competed back down to the equilibrium price, so a firm in perfect competition is always efficient, since their price cannot be forced up because the demand is perfectly elastic, so consumers could easily switch to buying their products from a firm whose price is lower. A monopolist, however, is forced to have higher prices and lower output, so it does not have to be efficient to earn profit.

Monopolistic Business in Thalwil

One of the monopolistic businesses in Thalwil is the movie rental called Bosshard’s Movie Corner. The most obvious characteristic that makes this firm a monopoly is that it is the only movie rental in the whole town. There are no close substitutes to renting a movie, which is another reason why the firm is monopolistic. The closest substitute would be buying the movie from a video store such as Ex Libris, but there the price is much higher meaning that the majority of consumers would rather rent the movie for a cheaper price than buying it for a higher price. Furthermore, since the monopolist is the only supplier of movies that are for rent, it can change the price of the movies by changing output. The firm faces a downward sloping demand curve, so increasing output lowers the price, decreasing output increases the price. The firm will decide upon a price for renting movies that will maximize the firm’s profits. Another characteristic for a monopolistic firm is that it does not have any competitors, so it cannot compete on price. Therefore, to attract new consumers the firm uses non-price competition such as advertising and other promotional approaches. Although Bosshard’s Movie Corner does in fact have competitors when it comes to the price of movies – Ex Libris – it is still a monopolistic firm if you only consider movies that are for rent. The firm uses promotional campaigns such as “rent 2 movies for the price of one” to attract customers.

A pure monopoly is a market in which a single company has control over the entire market for a product, usually because of a barrier to entry such as a technology only available to that company. For the video renting firm in Thalwil to be a pure monopoly, a couple of things would have to be true. The entry to the market would have to be completely blocked, meaning the firm would have no immediate competitors. Barriers to entry may be economies of scale, legal, technological or another type. However, there are no barriers to entry into the market of movie rentals because another firm could easily open a movie rental place if they had the resources, in which case the market would become competitive.