Ch07-AK

1) Monopolists charge P>MC. The price doesn’t give you any information about the cost of production since consumers are willing to pay a price greater than the marginal cost of production for more output, monopolies lead to market inefficiency. Monopolists restrict output and maximize profit at the expense of society. Note: Assuming no external costs or benefits (a topic for next chapter), profit maximizing perfect competitors also maximize social welfare, even though they do not explicitly intend to do so. (Revisit the “Invisible Hand” discussion).

2)  AT&T once had a monopoly on telephone service. If you wanted service, you had to go to AT&T. If their service was terrible, you had no alternative company to provide it. Knowing this, AT&T had little incentive to innovate within the telephone industry. The US government saw a problem. Rather than enforce Average-Cost pricing or offer corporate welfare, they chose another option: bread up the monopoly.

 

     In the time since AT&T’s breakup, we have seen massive innovation from rotary dial to dial tone to cordless phones, to cell phones. In the 1980s, regulators could not envision a time when 10-digit dialing would be necessary for all calls. But the increase in competition increased the incentive to innovate, and technology has advanced rapidly since the breakup.

 

     Note: Some students noted that monopolies with patent protection certainly reduce further innovation. If you somehow discover a way to make Blu-Ray disks work better, for example, Sony will prohibit you from bringing your product to the market (unless you pay Sony a large licensing fee).

 

     Also, in the AT&T example, the government may have been imposing average cost pricing before the breakup. If so, AT&T would not even have an incentive to lower costs (another form of innovation), since they would still earn zero economic profits after implementing the improvements.

 

3)  Free Response. Possibilities: i – The Hamilton Movie Theater charges less money to students than to faculty; ii – airline flights are cheaper for people who plan to take trips far in advance (as opposed to business travelers who often fly on a moment’s notice); iii – Tuition is more expensive for students from wealthy families than for low income students. Note that in each of these cases, the supplier can easily identify the group of consumers to which each individual person belongs (i.e., student vs. non-student; plan-ahead traveler vs. spur-of-moment traveler; high vs. low income family).

 

4A)    MR from women: MRW = 1000 – 2Q

          MR from men: MRM = 500 – 2Q

 

4B)    Women: MR = MC → 1000 – 2Q = 250 → Q = 375

                   Use Demand Curve: P = 1000 – 375 → P = 625

          Men: MR = MC → 500 – 2Q = 250 → Q = 125

                   Use Demand Curve: P = 500 – 125 → P = 375

 

4C)    Draw sketches (if it helps)

          Consumer Surplus is the yellow triangle. Use the formula for a triangle to find: CS = 0.5*(Intercept – P*)Q*

          Producer Surplus is the blue rectangle. PS = (P* – MC)Q*

 

          CSW = 0.5*(1000 – 625)*375 = 70,312.5

          PSW = (625 – 250)*375 = 140,625

          CSM = 0.5*(500 – 375)*125 = 7812.5

          PSM = (375 – 250)*125 = 15,625

          Social Welfare = 234,375

 

4D)    Remember that market demand is simply the sum of individual demands at any given price level. Graphically, this will look the Women’s demand curve as long as prices exceed $500. Once the drop below this level, however, demand comes from both men and women, so the market demand curve has a kink.

          You really weren’t expected to find the equation for demand after this kink algebraically, but you could. First, rearrange the demand curves for men and women for Q… That is,

          QW = 1000 – P

          QM = 500 – P

          Then you can find total demand by adding these two curves:

          Q = 1500 – 2P

          Finally, rearrange this and set it equal to P…

          P = 750 – 0.5Q

         

          What you should notice is that MR and MC intersect each other at a quantity before men enter the market (the MR curve beyond Q=500 is beyond the scope of this course… Imagine a kink to the MR curve at Q=500, and a slope equaling -1 instead of -2). Thus, the monopolist only sells products to women. We saw in part 4B and 4C that the equilibrium price, quantity, and social welfare generated by selling to women are: P = 625, Q = 375; Welfare = 210,937.5

 

4E)    Price discrimination increased social welfare! (Note that this will not always be true, but is in this case). From an economist point of view, we would encourage this discrimination. Welfare among women would not change, but welfare among men rises, so the populace is likely to support price discrimination (unless women are ethically opposed to it).

 

          As you can probably imagine, there are several scenarios in which price discrimination increases welfare by a large margin for a minority group, but decreases it slightly for the majority. Even if the net welfare effect on society as a whole is positive, the majority will vote against these types of policies in a democratic system. Conversely, there are also price discrimination policies that democratic societies support even though they reduce efficiency.