PROBLEMS
1. In the beach city of Santa Barbara, California, there are seven bathing suit stores, each
with the same schedule of costs and each facing an identical demand curve. Swim N
Style is a typical store:
Suits sold
(per hour) Price Total Cost
1 $68 $70
2 66 80
3 64 85
4 62 90
5 60 100
6 58 115
7 56 136
8 54 164
9 52 200
10 50 245
a) Calculate total revenue, marginal revenue, marginal cost, and average cost at each
level of sales for the store.
b) If Swim N Style is a profit maximizer, what number of suits will it sell per hour?
What will its price and profit be?
c) How can you tell that the bathing suit market in Santa Barbara is not in long-run
equilibrium? What will happen because it is out of equilibrium?
Solution:
a)
Suit
Sold Price TC TR MR MC AC
1 68 70 68 68 70 70.00
2 66 80 132 64 10 40.00
3 64 85 192 60 5 28.33
4 62 90 248 56 5 22.50
2. Seventeen new bathing suit stores enter the Santa Barbara market, joining the seven that
already existed. As a consequence, the demand schedule facing Swim N Style (and all
other stores) falls, while the cost schedules remain constant as in Problem 1:
Suits sold
(per hour) Price
1 $31.50
2 28.50
3 25.50
4 22.50
5 19.50
6 16.50
7 13.50
8 10.50
9 7.50
10 4.50
a) What number of suits will Swim N Style sell now?
b) What price will it charge, and what will its profit be?
c) Is the market in long-run equilibrium now? Why?
d) What is the average cost per swimsuit sold?
e) How many swimsuits are sold in Santa Barbara each hour, and what is the total cost
incurred?
f) From your calculations in Problem 1, identify the sales level at which Swim N Style’s
average cost would be a minimum. What is this average cost?
g) Suppose the number of swimsuits sold remained constant, but the number of stores
was reduced so that each was operating at its point of minimum average cost. How
many stores would be in operation? What would be the total costs of all the stores
taken together? Compare this to your answer in e) above.
h) Summarize briefly what you have learned from this problem about the efficiency of
monopolistic competition.
Solution:
a) Four units
b) $22.5, zero
3. Gas Guzzler Motors is one of three major auto producers. It is currently producing 6,000
cars a day, and selling them at a price of $10,000 each. Its marketing department tells it
that its demand curve depends critically upon whether its competitors match its price
changes. If they do not change their prices when GG does, schedule l will apply; if they
match GG’s price changes, schedule 2 will apply. The schedules are as follows:
Cars Schedule 1 Schedule 2
(in 000s) Price per car Price per car
1 $12,500 $15,000
2 12,000 14,000
3 11,500 13,000
4 11,000 12,000
5 10,500 11,000
6 10,000 10,000
7 9,500 9,000
8 9,000 8,000
9 8,500 7,000
10 8,000 6,000
a) Calculate the marginal revenue (for increments of thousands of cars) associated with
each demand schedule.
b) Draw the two demand and MR curves on graph paper.
c) Assume now that, if GG raises its price, its competitors will not raise theirs, but that,
if it lowers it price, they will match the price cuts. On the graph paper, show the
effective demand curve and marginal revenue curve that face GG.
Solution:
a)
Cars
(in 000s)
Schedule 1
Price per car
Schedule 2
Price per car MR1 MR2
1 $12,500 $15,000 12,500 15,000
2 12,000 14,000 11,500 13,000
b)
c)
4. Gas Guzzler Motors faces the total cost schedule shown in column 1:
Cars Total Cost (in $000,000)
(in 000s) 1. 2 3. 4
1 $8.5 $9.9 $7.6 $6.0
2 12.5 15.3 10.7 7.0
3 17.0 21.2 14.3 8.0
4 22.0 27.6 18.4 9.0
5 27.5 34.5 23.0 10.5
6 33.5 41.9 28.1 12.5
7 40.0 49.8 33.7 15.0
8 47.0 58.2 39.8 18.0
9 54.5 67.1 46.4 21.5
10 62.5 76.5 53.5 25.5
a) Calculate GG’s marginal cost schedule.
b) By comparing the marginal cost with the marginal revenue in part c) of Problem 3,
determine GG’s equilibrium level of output and price.
c) Suppose now that GG’s total costs change, in succession, to the levels shown in
columns 2, 3, and 4. In each case, how will GG change the number of cars it
produces, and the price it charges?
d) How do you explain the relative stability of price and output, in the face of substantial
changes in costs?
Solution:
a)
Cars
(in 000s) MC1
1 $8.50
2 4
3 4.5
5. Three oligopolists, A, B, and C, produce an identical product, Q. Q is produced under
conditions of constant costs, that is, AC = MC = $100. The market demand schedule for
Q is:
Price Quantity Demanded
$1,000 0
950 25
900 50
850 75
800 100
750 125
700 150
650 175
600 200
550 225
500 250
450 275
400 300
a) A, B, and C decide to act illegally as a cartel, to divide the market equally among the
three of them, and to set the price and output that will maximize their total profits.
What price and output do they set? What is the output level that each of the firms
agrees to? What profit is earned by each firm and by the three firms together?
b) A is impressed with the honesty of B and C, and believes they will keep to their
agreements. They do, and A cheats by increasing output by 25 units. What is the new
market price? How have the profit levels of A, B, and C changed? How have total
profits in the industry changed?
c) What actions are B and C likely to take in retaliation? Show how these actions will
affect the market price, and the profit levels of the three firms.
d) What can you learn from this problem about the likely stability of a cartel?
Solution:
a) They will set a price of $550 and sell a total output of 225 units. Each firm will agree
to sell 75 units. Each firm will earn a profit of $33,750 and the three firms together
DISCUSSION QUESTIONS
1. This is an oligopoly game that can be played with about 20 students, divided into about
four or five groups. If your class is smaller, make the groups smaller. If it is much larger,
divide it in sections, or adjust the formulas in the game. The instructions are:
a) Form groups of three or four students. Each group takes a firm name.
b) The instructor or group leader acts as market/calculator/referee.
c) For each firm, average cost = marginal cost = $10.
d) Each group confers privately, and then submits a piece of paper to the market,
showing its output for the current period. No collusion is allowed.
e) The market (the referee) calculates the market price by adding the output of all the
firms and using this formula for the demand curve: P = $100 – Q. The price is
announced.
f) Each firm uses its price to calculate its revenue and profit; these are written on the
board.
g) Repeat steps d), e), and f) for several periods, keeping a running record of profits each
period.
Notes to Instructors:
a) This game is a good way of showing students how the decisions of oligopolists are
interactive one with another.
b) If the firms were to act as a cartel, the profit-maximizing output for the market would
2. In monopolistic competition, the differentiation of firms’ products leads to negatively
sloping demand curves, and this in turn leads to a long-run equilibrium characterized by
excess capacity and costs that are above the minimum attainable. Do you believe the
government should take action to standardize products so as to make demand curves for
monopolistic competitors more elastic, and thereby eliminate the wastefulness of excess
capacity? Why or why not?
Suggested Answer: Government intervention in the market has its own merits and
3. Standardized products (for example, steel) characterize some oligopolistic markets, while
differentiated products (for example, automobiles) characterize others. What differences
in firm behavior would you expect to exist because of this?
Suggested Answer: Oligopolistic decisions are, by their very nature, interdependent. In
order to avoid uncertainties, firms in the oligopoly market may enter into a formal or
4. What are the benefits and costs to society of advertising by automobile companies? By
beer companies?
Suggested Answer: Advertising will help the customers have a better understanding about
the product. It eliminates information asymmetry to an extent. However, some people
5. Do you think that the practice of price leadership in an oligopolistic industry is harmful to
the public interest? Should the government take steps to prevent it?
Suggested Answer: Price leadership does overcome some problems for the firms that
result from oligopolistic interdependence, although it does not provide the only possible