Handout 18 (Monopolistic Competition, and Externalities) with Solutions

Handout 18 Monopolistic Competition, and Externalities This handout contains exercises of - Monopolistically Competitive Market - Externalities, Taxes and Subsidies Things you should know - What are the characteristics of monopolistically competitive markets? How do you find the short-run and long-run equilibrium? - What is the marginal private benefits/costs? What is the marginal social benefits/costs? - How to find the equilibrium outcomes under private decisions? How to find the socially optimal outcomes? - How to achieve the socially optimal outcomes? - When taxes are imposed, what are the burdens borne by each side – the consumers and the producers – of the market Exercises Question 1 (Monopolistically Competitive Market) 1. Which of the following statements is false in a monopolistically competitive market? a. In the long run, each firm will earn zero economic profit. b. The cost of variety arises from each firm not producing at the lowest average total cost in the long run. c. Since each firm is earning zero economic profit in the long run, there is no deadweight loss. d. Product differentiation is one of the features of this market. 2. In the long run, the demand for a particular firm in a monopolistically competitive industry _______________ as the positive profits attracts entry. In other words, the demand for this particular firm is [ more / less ] elastic. 3. Suppose the restaurants industry is initially in the long-run equilibrium and there are many varieties of restaurants. The economy recovers from recession in the city of Madison, causing a rise in demands for eating out. Explain what would happen to the restaurants industry in both short run and long run. Question 2 (Monopolistically Competitive Market) 1. This firm in a monopolistically competitive industry is in the [ short-run / long-run ] equilibrium and earning a profit/loss of ___________. The profit-maximizing level of output for this firm is ___________, setting the price at __________. If this picture does not represent long-run equilibrium, this industry is expected to witness [ entry / exit ] of firms in the long-run. This firm will receive a profit of _____________ by producing [ more / less ] and selling at [ lower / higher ] price in the long run. This arises due to _____________________________________. Highlight the area that represents deadweight loss. 2. For a monopolistically competitive firm that is experiencing AC > P > MC = MR. This firm is in the [ short-run / long-run ] equilibrium, it is expected that firms [ enter / exit ]. 1 Question 3 (Monopolistically Competitive Market) This firm in a monopolistically competitive industry is in [ short-run / long-run ] equilibrium. The profit-maximizing level of output is ___________ and it sells the output at the price of ____________. The profits this firm earn is _______. The consumer surplus is __________. Explain how one would find the deadweight loss, highlight the said area. Question 4 (Externalities) The production of fluorescent lamp involves hazardous Mercury (Hg), which is dumped into the river after the production process. Firms have marginal (private) cost of producing fluorescent lamp given by MPC = 30 + Q. For each lamp produced, the mercury cleanup in the river costs $30. The firms face the demand for fluorescent lamp given by P = 480 – 2Q, which is marginal private benefit. There are no externalities from consuming the lamps. 1. Is the externality negative or positive on production or consumption? Give the equations for marginal social cost and marginal social benefit. 2. Without consideration of societal consequence, what is the market equilibrium quantity that firms produce? At what price? 3. If firms think about the societal consequence, what is the socially optimal quantity that firms produce? At what price? 4. Observing the devastating result from firms neglecting the social cost, the government wishes to step in and imposes the regulation so that firms produce at the socially optimal quantity. Design a regulation to dis-incentivize producers from the market outcome. 5. From the regulation designed in 4., which is a taxation, who bears the burden of this taxation? Calculate the tax burden on each party. Which side of the market is relatively more elastic? Question 5 (Externalities) You are hosting a post-game party at Camp Randall. The marginal cost to you in hosting the party is given by MPC = 20 + Q. The marginal private benefit of partying is MPB = 100 – Q. The party makes everyone happy, so the positive externality caused by the party is given by 20. 1. Write down the marginal social cost and marginal social benefit. 2. Is the party under-supplied or over-supplied compared to socially optimal outcome? 3. Find both market outcome by market arrangements and socially optimal outcome, compare the answers. 4. How can the government incentivize you to achieve the socially optimal outcome? 2