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Diseconomies of scale, and the law of diminishing return

Compared to other markets, why do economists consider perfect competition to be the most efficient market structure? Perfect competition is the most efficient market structure because, in the long run, each firm in the market will be producing at its minimum average cost, or per-unit. This means that consumers get desired goods and services at the lowest possible prices, and also that the firms are economizing on society’s scarce resources to the greatest extent possible.

What is the difference between the concepts of diseconomies of scale, and the law of diminishing return? (4 marks)

Law of diminishing return occurs in the short-run when one factor is fixed. If the variable factor of production is increased, there comes a point where it will become less productive and therefore there will eventually be a decreasing marginal and then average product.

When long-run average total cost rises as output increases, there are said to be diseconomies of scale.

a. Sally owns a ceiling fan company. Last year, she sold 1000 ceiling fans at $50 each, and each fan cost her $20. Before going into the ceiling fan business, she worked as a fan-dancer at $25,000 a year. She used her own money to buy the fans by withdrawing the money from her savings account where it was earning five percent annual interest. Calculate Sally’s economic profit and her accounting profit. Should Sally continue with her ceiling fan business? Explain. (6 marks)

If her economic profit is at least zero, Sally should stay in business. Her TR = $50,000 and her total accounting cost is $20,000, for an accounting profit of $30,000. She forgoes interest on savings of $20,000 (.05) = $1,000 as well as forgone earnings of $25,000. This leaves $4,000 in economic profit, so she should stay in business.

Bob Edwards owns a bagel shop. Bob hires an economist who assesses the shape of the bagel shop's average total cost (ATC) curve as a function of the number of bagels produced. The results indicate a U-shaped average total cost curve. Bob's economist explains that ATC is U-shaped for two reasons. The first reason is the existence of diminishing marginal product, which causes it to rise. What is the second reason? Explain your answer. Assume that the marginal cost curve is linear. (4 marks)

Average fixed cost always declines as output rises because fixed cost is being spread over a larger number of units, thus causing the average total cost curve to fall.

a. Provide two circumstances in which monopoly may offer efficiency advantages over competition. (4 marks)

A monopolist might be better positioned to exploit economies of scale leasing to an equilibrium which gives a higher output and a lower price than under competitive conditions.

As firms are able to earn abnormal profits in the long run there may be a faster rate of technological development that will reduce costs and produce better quality products for consumers. This is because the monopolist will invest profits into research and development to promote dynamic efficiency.

Explain the practice of tying and discuss why it is controversial. (5 marks)

Tying is the practice of bundling goods for sale. It is controversial because it is perceived as a tool for expanding the market power of firms by forcing consumers to purchase additional products. However, economists are skeptical that a buyer’s willingness to pay increases just because to products are bundled together. In other words, simply bundling two products together doesn’t necessarily add any value. It is more accurately believed to be a form of price discrimination.

Describe the source of tension between cooperation and self-interest in a market characterized by oligopoly. Use an example of an actual cartel arrangement to demonstrate why this tension creates instability in cartels. (5 marks)

The source of the tension exists because total profits are maximized when oligopolists cooperate on price and quantity by operating as a monopolist. However, individual profits can be gained by individuals cheating on their cooperative agreement. This is why cooperative agreements among members of a cartel are inherently unstable.

a. If the average total cost curve is falling, what is necessarily true of the marginal cost curve? If the average total cost curve is rising, what is necessarily true of the marginal cost curve? (5 marks)

When average total cost curve is falling it is necessarily above the marginal cost curve. If the average total cost curve is rising, it is necessarily below the marginal cost curve.

Describe the difference between average revenue and marginal revenue. Why are both of these revenue measures important to a profit-maximizing firm? (5 marks)

Average revenue is total revenue divided by the amount of output. Marginal revenue is the change in total revenue from the sale of each additional unit of output. Marginal revenue is used to determine the profit-maximizing level of production and average revenue is used to help determine the level of profits.

Describe the process by which the market for capital and the market for land reach equilibrium. As part of your description, elaborate on the role of the stock of the resource versus the flow of services from the resource. (6 marks)

Equilibrium in the markets for land and capital are governed by the value of marginal product for these factors relative to their supply. One difference between these markets and the market for labor is the distinction between rental value (flow) and purchase price (stock). This difference is reconciled by noting that in efficient markets, the purchase price should reflect the value of the stream of services provided by the land or capital (or the sum of rental values appropriately discounted).

a. List and explain two conditions necessary for firms to be able to successfully practice price discrimination. (2 marks)

Differences in price elasticity of demand between markets: There must be a different price elasticity of demand from each group of consumers. The firm is then able to charge a higher price to the group with a more price inelastic demand and a relatively lower price to the group with a more elastic demand. By adopting such a strategy, the firm can increase its total revenue and profits. To profit maximize, the firm will seek to set marginal revenue = to marginal cost in each separate (segmented) market.

Barriers to prevent consumers switching from one supplier to another: The firm must be able to prevent “market seepage” or “consumer switching” – defined as a process whereby consumers who have purchased a good or service at a lower price are able to re-sell it to those consumers who would have normally paid the expensive price. This can be done in a number of ways, – and is probably easier to achieve with the provision of a unique service such as a haircut rather than with the exchange of tangible goods. Seepage might be prevented by selling a product to consumers at unique and different points in time – for example with the use of time specific airline tickets that cannot be resold under any circumstances.

Explain how each of the following industries practices price discrimination:

(6 marks)

restaurant

Restaurants sometimes have children’s menus. It can be profitable if adults who come to restaurants with children are, on the average, more sensitive to prices on menus than adults who come to restaurants without children. Children often do not value restaurant food and service, and often waste a large part of their food. Parents know this and do not want to pay a lot for their child's meal. If restaurants treat children like adults, the restaurants may lose customers as families switch to fast-food restaurants. If this explanation is correct, then restaurants price discriminate.

airline

Airlines charge different prices for seats on the same plane, depending on when the ticket was purchased, how long the traveler will be staying at the destination, etc. Of course, the cost of operating the plane is independent of these variables.

Hairdresser

A hairdresser may charge a lower price to children than to adults. The reason they do this is that they believe children to have a differing elasticity of demand to adults. In other words, the price needed to maximize revenue from children is not the same as the price needed to maximize revenue from adults. By charging different prices they will maximize revenue from both groups

Calculate the total revenue without price discrimination as well as with price discrimination, and complete the table with your calculations. (4 marks)

Price

Qd

TR

TR (with perfect price discrimination)

30

0

------

------

22

10

220

220

14

16

224

304

10

24

240

464

7

38

266

562

Briefly describe the characteristics of each of the following market types. Give an example of each market type. (8 marks)

pure competition

The goods being offered for sale must all be the same. The buyers and sellers must be so numerous that no single buyer or seller influences the market price. Buyers and sellers are price takers. An example would be the wheat market.

Monopoly

A monopoly is a market in which there is only one seller and the seller sets the price of the product, given the demand curve for that product. An example would be a local cable television company.

Oligopoly

An oligopoly is a market in which there are only a few sellers, and the sellers do not always compete aggressively. An example would be airline routes.

monopolistic competition

Monopolistic competition is a market containing many sellers offering slightly different products. Because the products are not the same, sellers have some ability to set price. An example would be the software industry.

Use the graph below to explain why a profit-maximizing monopolistically competitive firm must operate at excess capacity. Why is a perfectly competitive firm not subject to the same constraint? (6 marks)

Competitive firms do not face downward-sloping demand. The graph shows the firm choosing a level of production in which the intersection of marginal revenue and marginal cost occurs at an output level where average total cost is decreasing. This profit-maximizing output level is less than the efficient scale (minimum of average total cost) and therefore the firm is said to be operating at excess capacity.

If the monopolist depicted in the graph below sets a price of $10 and sells 100 units, the corresponding marginal revenue is $5 and marginal cost $3. What recommendation regarding price and quantity would you give this monopolist? Explain your answer. (6 marks)

Since MR exceeds MC, recommend an increase in output. Greater sales will require a price reduction. So reduce P below $10 and increase Q above 100.

The marketing division of a firm has measured demand for its product and reports that it is Q = 24 – P, where Q is units and P is price per unit in dollars. The cost is given in the table below. Complete the table and determine the profit-maximizing level of output for this firm. (6 marks)

As indicated in the table below, the optimal output is Q = 5, where MR = MC = 5.80.

Output

Total Cost

Price

Revenue

Profit

0

10

24

0

-10

1

18

22

22

4

2

20

20

40

20

3

22

18

54

32

4

25

16

64

30

5

29

14

70

41

6

34

12

72

38

7

40

10

70

30

8

48

8

64

16

Define the following terms and explain their importance to the study of economics.

(9 marks)

barriers to entry

Barriers to entry make it difficult or impossible for other firms to enter an industry, thus allowing monopoly to continue to exist. Some examples of barriers include legal restriction on entry, patents, control of scarce resources, large sunk costs, technical superiority, and economies of scale.

Patent

A patent is a government-granted legal monopoly given to the inventor of a new product or process. During the life of the patent, the firm has a protected monopoly position. Thus, it serves as a barrier to entry.

natural monopoly

A natural monopoly is an industry in which advantages of large-scale production make it possible for a single firm to produce the entire output of the market at lower average cost than a number of firms each producing a smaller quantity. Most natural monopolies are regulated utilities.

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