Multiple Choice Questions: BUZE400 Economics Semester One, 2015-2016 Prepared By: Behzod Alimov

BUZE400 Economics Semester One, 2015-2016 Prepared by: Behzod Alimov
Tutorial 10
Monopolistic Competition and Oligopoly
Multiple Choice Questions
1. Which of the following conditions does NOT describe a firm in a monopolistically

competitive market?
a. It makes a product different from its competitors.
b. It takes its price as given by market conditions.
c. It maximizes profit both in the short run and in the long run.
d. It has the freedom to enter or exit in the long run.
2. Which of the following goods best fits the definition of monopolistic competition?
a. wheat
b. tap water
c. crude oil
d. soft drinks
3. New firms will enter a monopolistically competitive market if

a. marginal revenue is greater than marginal cost.
b. marginal revenue is greater than average total cost.
c. price is greater than marginal cost.
d. price is greater than average total cost.
4. What is true of a monopolistically competitive market in long-run equilibrium?

a. Price is greater than marginal cost.
b. Price is equal to marginal revenue.
c. Firms make positive economic profits.
d. Firms produce at the minimum of average total cost.
5. If advertising makes consumers more loyal to particular brands, it could ______ the
elasticity of demand and ______ the markup of price over marginal cost.
a. increase, increase
b. increase, decrease
c. decrease, increase
d. decrease, decrease
6. A cartel is an agreement
a. among firms to flood the market and eliminate competition.
b. among firms to steal industrial processes from rival firms.
c. among firms to decrease output and raise price.
d. by the government to restrict imports.
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7. If an oligopolistic industry organizes itself as a cooperative cartel, it will produce a

quantity of output that is __________ the competitive level and __________ the
monopoly level.
a. less than, more than
b. more than, less than
c. less than, equal to
d. equal to, more than
8. In the market for batteries, the three largest firms earn 90% of the total revenue and
there are 35 firms in the industry. This industry is best described as
a. monopolistic competition
b. oligopoly
c. monopoly
d. perfect competition
9. A monopolistically competitive firm is like an oligopolistic firm insofar as

a. both face perfectly elastic demand.
b. both can earn an economic profit in the long run.
c. both have MR curves that lie beneath their demand curves.
d. neither is protected by high barriers to entry.
10. In a Bertrand model with identical firms and a non-differentiated product, price will
increase in response to
a. an increase in the number of firms.
b. a decrease in the number of firms.
c. an increase in marginal cost.
d. a decrease in marginal cost.
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Review Questions and Problems
1. What are the characteristics of a monopolistically competitive market? What

happens to the equilibrium price and quantity in such a market if one firm introduces
a new, improved product?
Answer: The two primary characteristics of a monopolistically competitive market
are that (1) firms compete by selling differentiated products that are highly, but not
perfectly, substitutable and (2) there is free entry and exit from the market. When a
new firm enters a monopolistically competitive market or one firm introduces an
improved product, the demand curve for each of the other firms shifts inward (since
consumers would want to try the new product), reducing the price and quantity
received by those incumbents. Thus, the introduction of a new product by a firm will
reduce the price received and quantity sold of existing products.
2. Explain two benefits that might arise from the existence of brand names.
Answer: Brand names may be beneficial because they provide information to
consumers about the quality of goods. They also give firms an incentive to maintain
high quality, since their reputations are important. But brand names may be
criticized because they may simply differentiate products that are not really different,
as in the case of drugs that are identical with the brand-name drug selling at a much
higher price than the generic drug.
3. Sparkle is one firm of many in the market for toothpaste, which is in long-run
equilibrium.
a. Draw a diagram showing Sparkle’s demand curve, marginal-revenue curve,
average-total-cost curve, and marginal-cost curve. Label Sparkle’s profit-
maximizing output and price.
b. What is Sparkle’s profit? Explain.
c. On your diagram, show the consumer surplus derived from the purchase of
Sparkle toothpaste. Also show the deadweight loss relative to the allocatively
efficient level of output.
d. If the government forced Sparkle to produce the allocatively efficient level of
output, what would happen to the firm? What would happen to Sparkle’s
customers?
Answer:
a. The figure below illustrates the market for Sparkle toothpaste in long-run
equilibrium. The profit-maximizing level of output is QM and the price is PM.
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b. Sparkle’s profit is zero, because at quantity QM, price equals average total cost.
c. The consumer surplus from the purchase of Sparkle toothpaste is areas A+B.
The allocatively efficient level of output occurs where the demand curve
intersects the marginal-cost curve, at QC. The deadweight loss is area C, the
area above marginal cost and below demand, from Q M to QC.
d. If the government forced Sparkle to produce the allocatively efficient level of
output, the firm would lose money because average total cost would exceed
price, so the firm would shut down. If that happened, Sparkle’s customers would
earn no consumer surplus.
4. Consider a monopolistically competitive market with firms. Each firm’s business

opportunities are described by the following demand and total-cost equations:
, .
a. How does , the number of firms in the market, affect each firm’s demand
curve? Why?
b. How many units does each firm produce?
(The answers to this and the next two questions depend on .)
c. What price does each firm charge?
d. How much profit does each firm make?
e. In the long run, how many firms will exist in this market?
Answer:
a. As the number of firms, , increases, demand for the product of each incumbent
firm decreases. A representative firm’s inverse demand function is .
In this demand curve, both the vertical and the horizontal intercept are equal to
. It can be easily noticed that as becomes larger, both the horizontal and
the vertical intercept will become smaller and, as a result, the demand curve will
shift inward. This has a simple explanation: the more firms operate in the
market, the more alternatives are available for people to choose from, and the
smaller is the demand for any individual firm’s product.
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b. Each firm produces at the profit-maximizing point, i.e., where .

Because the total revenue of each firm is equal to , its
marginal revenue will be . The marginal cost of each firm will be
. The profit-maximizing condition is . So,
each firm produces units.

c. The price charged by each firm is equal to .
d. Each firm’s profit is ( )( ) ( ( ) ) .

e. In the long run, monopolistically competitive firms make zero profits. So,
. By solving this equation we get that . This means that
only 5 firms will exist in this market in the long run.
5. How does the number of firms in an oligopoly affect the outcome in its market?
Answer: As the number of sellers in an oligopoly grows larger, an oligopolistic
market looks more and more like a competitive market. The price approaches
marginal cost, and the quantity produced approaches the socially efficient level.
6. A monopolist can produce at a constant average (and marginal) cost of

. It faces a market demand curve given by .
a. Calculate the profit-maximizing price and quantity for this monopolist. Also
calculate its profits.
b. Suppose a second firm enters the market. Let be the output of the first firm
and be the output of the second. Market demand is now given by
.
Assuming that this second firm has the same costs as the first, write the profits
of each firm as functions of and .
c. Suppose (as in the Cournot model) that each firm chooses its profit-maximizing
level of output on the assumption that its competitor’s output is fixed. Find each
firm’s “reaction function” (i.e., the rule that gives its desired output in terms of its
competitor’s output).
d. Calculate the Cournot-Nash equilibrium (i.e., the values of and for which
each firm is doing as well as it can given its competitor’s output). What are the
resulting market price and profits of each firm?
e. Now suppose (as in the Bertrand model) that each firm chooses its profit-
maximizing price—instead of output—on the assumption that its competitor’s
price is fixed. What is the Bertrand-Nash equilibrium (i.e., the values of and
for which each firm is doing as well as it can given its competitor’s price).
What are the resulting market output and profits of each firm? (Note that both
firms are producing a homogeneous good.)
Answer:
a. First solve for the inverse demand function, . Then the marginal
revenue curve has the same intercept and twice the slope:
5
.
Marginal cost is constant at $5. Setting , find the optimal quantity:
, or .
Substitute into the demand function to find price:
.
Assuming fixed costs are zero, profits are equal to
( )( ) ( )( ) .
b. When the second firm enters, price can be written as a function of the output of
both firms: . We may write the profit functions for the two firms:
( ) ( ) , or
and
( ) ( ) , or .
c. Under the Cournot assumption, each firm treats the output of the other firm as a
constant in its maximization calculations. Therefore, Firm 1 chooses to
maximize in part b with being treated as a constant. The change in with
respect to a change in is
This equation is the reaction function for Firm 1, which generates the profit-
maximizing level of output, given the output of Firm 2. Because the problem is
symmetric, the reaction function for Firm 2 is
d. Solve for the values of and that satisfy both reaction functions by
substituting Firm 2’s reaction function into the function for Firm 1:
( )( )
By symmetry, .
To determine the price, substitute and into the demand equation:
.
Profit for Firm 1 is therefore
( ) ( )( ) ( )( )
Firm 2’s profit is the same, so total industry profit is .
e. Because the good is homogeneous, consumers will purchase only from the
lowest-price seller. Thus, if the two firms charge different prices, the lower-price
firm will supply the entire market and the higher-price firm will sell nothing. If
both firms charge the same price, consumers will be indifferent as to which firm
they buy from and each firm will supply half the market.
This implies that the Bertrand-Nash equilibrium is the competitive outcome, i.e.,
. (If any of the firms charged a slightly higher price, then its
rival would undercut it by charging a price equal to $5, thus causing the higher-
price firm to lose all its sales. No firm has any incentive to charge a lower price
either, since this would lead to a net loss.)
Total market output is then , and each firm will supply
. Because , each firm earns zero profit.
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7. The following payoff matrix shows economic profits (in millions of USD) that Coca-
Cola and PepsiCo would earn given different combinations of strategies—advertise
or not advertise—chosen by each. Why do you think both of these companies
spend huge amounts on advertising, even though they could both earn higher
profits if neither advertised? Explain based on the Prisoners’ Dilemma game.
Answer: Advertising is costly but if one firm advertises and the other does not, the
one not advertising loses market share and profit while the one advertising gains
market share and profit. Both firms would be better off if neither advertised but this
outcome is difficult to maintain given each company’s temptation to take advantage
of its rival by advertising.
If both advertise, each makes a profit of $100 million; if one advertises but the other
does not, the one advertising makes a profit of $500 million and the one not
advertising incurs a loss of $100 million; and if neither advertise, each makes a
profit of $300 million. The Nash equilibrium of this game is for each firm to
advertise, as this is where each firm chooses its best possible strategy given the
strategies chosen by its rival.
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BUZE400 Economics Semester One, 2015-2016 Prepared by: Behzod Alimov

Monopolistic Competition and Oligopoly

Multiple Choice Questions

1. Which of the following conditions does NOT describe a firm in a monopolistically

3. New firms will enter a monopolistically competitive market if

4. What is true of a monopolistically competitive market in long-run equilibrium?

7. If an oligopolistic industry organizes itself as a cooperative cartel, it will produce a

9. A monopolistically competitive firm is like an oligopolistic firm insofar as

Review Questions and Problems

1. What are the characteristics of a monopolistically competitive market? What

4. Consider a monopolistically competitive market with firms. Each firm’s business

b. Each firm produces at the profit-maximizing point, i.e., where .

each firm produces units.

d. Each firm’s profit is ( )( ) ( ( ) ) .

6. A monopolist can produce at a constant average (and marginal) cost of

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