Practice questions for Quiz 4

Please note that all of the material on Quiz 4 comes only from the videos in the module for the Week of
June 28, 2021.

These questions are simply for your benefit. You do not need to submit your responses to me.

1. What are the characteristics of a monopoly?

In the case of a pure monopoly, there is ONE firm in an industry. The firm and the industry are
indistinguishable from each other. The firm produces a good or service for which there are no
close substitutes. There is only one firm because it is difficult or impossible for another firm to
exist in that industry. A monopoly is a price maker, meaning it can set the price it charges. In
cases where there is a super-dominant firm with more than approximately 90% of industry
sales, the firm may be referred to as a monopoly. Notice it is not a pure monopoly, which is the
term reserved for the case when there is only one firm. For all practical purposes, although a
firm with 90% or more of industry sales is not a pure monopoly, it will likely act like one. In this
class, we can think of a monopoly as an industry with one firm.

2. Can a monopoly form without government intervention?

There are a number of ways in which a monopoly can form, and some do not involve
government intervention. For example, the firm may simply be the best at what it does
(technological or managerial superiority). Or, it may have access to some key input to which no
one else has access. The firm may have cost advantages from large-scale production. The
company might be protected from competitors because there are high start-up costs to new
firms that want to enter the industry. The firm may be the only left because it has bought out
competitors. Finally, the company may take deliberate action to prevent competitor entry.

3. Can a monopoly form due to government intervention?

Sometimes a government helps in the formation of a monopoly. This might be by a government

4. Describe the shape of the demand curve of a monopoly.

The demand curve of a monopoly is downward sloping. It corresponds to the market demand
curve since the firm is the industry.

5. Describe the shape of the marginal revenue curve of a monopoly.

The marginal revenue curve of a monopoly is also downward sloping. It starts on the vertical
axis at the same point as the demand curve. The marginal revenue curve lies under the demand
curve. Its slope is twice that of the demand curve. This means that at any price, the marginal
revenue curve lies half-way between the vertical axis and the demand curve.
6. Is a monopoly guaranteed to have an economic profit?

A monopoly is not guaranteed to have an economic profit. In the short run it can have an
economic profit, economic loss, or economic break even, just like any other firm. In the long
run, it can have an economic profit, and likely will. The firm might not have an economic profit
due to insufficient demand, excessively high costs, or some combination of the two.

7. How can a monopoly have an economic profit in the long run when a perfectly competitive firm
cannot?

A monopoly can have an economic profit in the long run because something prevents
competitors from entering which could make the profit disappear. In the case of perfect
competition, there is easy entry and exit, so competitors can easily enter if there is a profit, or
easily exit if there is a loss. In perfect competition, entry and exit occur until the economic profit
is zero in the long run.

8. If a monopoly has a profit, what can be said about price and average total cost?

As with any firm that has a profit, price must be greater than average total cost.

9. Describe the graph of a monopoly with a profit.

If a monopoly has a profit, the average total cost curve dips below the demand curve. Also, at
the output where marginal revenue equals marginal cost, price (read off the demand curve) will
be above average total cost (read off the ATC curve).

10. Describe the graph of a monopoly with a loss.

If a monopoly has a loss, the average total cost curve is entirely above the demand curve. Also,
at the output where marginal revenue equals marginal cost, ATC (read off the average total cost
curve) will be above price (read off the demand curve).

11. Describe the graph of a monopoly with break even (zero economic profit).

If a monopoly has break even, the average total cost curve is tangent to the demand curve at
the output where marginal revenue equals marginal cost. At this output, price (read off the
demand curve) will be at the same value as ATC (read off the ATC curve).

12. Suppose the following is true for a monopoly at the output where MR = MC: P < ATC, and P >
AVC. What is happening?

In the case described, the firm is producing the profit-maximizing output since its output is
where MR = MC. Since price is less than average total cost, the firm has a loss. However, notice
that price is greater than average variable cost. This means the firm will lose less if it stays open
than if shuts down. So, the firm should stay open in the short run. REMEMBER – the shut-down
rule works in all market structures, even though it was introduced under perfect competition.
13. What is price discrimination?

Price discrimination is a pricing strategy used by firms to increase their profitability. It involves
charging different customers different prices for the same good or service. It can only be used
by firms that have control over the price they charge.

14. Employee and student discounts are examples of what kind of price discrimination?

When a firm charges different prices to different customers based on a group affiliation, the firm
is using third degree price discrimination.

15. Why do firms use price discrimination?

Price discrimination can lead to higher profits. Notice the key word “can.” There is no
guarantee that price discrimination will lead to higher profits because there is a cost in doing
this.

16. Aside from security concerns, why do airlines check identification when someone checks in at
the airport for a flight?

When airlines check identification at the airport upon check-in, they are preventing resale of
discounted tickets. Remember that preventing resale is a necessary condition for price
discrimination to work. The firm must prevent an after-market, where clever consumers might
beat the price-discriminating firm at its own game.

17. How would you compare the output of a monopoly to that of a perfectly competitive industry?

A monopoly produces less than its perfectly competitive counterpart. Notice the comparison is
done at the industry level, not the firm level.

18. How would you compare the price of a monopoly to that of a perfectly competitive industry?

A monopoly charges a higher price than its perfectly competitive counterpart.

19. What is the efficiency criterion from the firm perspective?

A firm produces efficiently (firm perspective) if it produces the output where it minimizes its
per-unit costs of production. Said another way, this is the output corresponding to the
minimum point of the average total cost curve. This criterion is the same regardless of market
structure.

20. Does a monopoly produce the efficient output (firm perspective)?

A monopoly does not produce efficiently (firm perspective). It is not under the threat of
competition from other firms.

21. What is the efficiency criterion (society perspective)?

A firm produces efficiently (society perspective) if it produces the output where marginal cost
equals price. Said another way, this is the output corresponding to where the marginal cost
curve crosses the demand curve.
22. Does a monopoly produce the efficient output (society perspective)?

A monopoly does not produce the efficient output (society perspective). It produces the output
where marginal cost equals marginal revenue (not price). This is a smaller output than the one
that would be efficient from the societal viewpoint.

23. What is a natural monopoly?

A natural monopoly is a situation in which one firm is able to produce the output for an entire
industry at a lower average total cost than if there were multiple firms.

24. What is the risk of a government allowing a natural monopoly to continue and why would a
government be willing to take on this risk?

The risk of letting a natural monopoly to continue operations as a monopoly is that the firm will
be the only one in its industry. Consumers will have no choices, and the firm might abuse
consumers in the form of inferior service and/or higher prices. Governments are sometimes
willing to let natural monopolies continue because they establish a regulatory body to monitor
the monopoly’s behavior to ensure there is no consumer abuse. In addition, at least in theory,
since the natural monopoly’s costs will be lower than if there were multiple firms, there is a
chance that the cost savings could be passed on to the consumers in the form of lower prices.

25. What characteristics of monopolistic competition are shared with perfect competition?

Monopolistic competition and perfect competition have three characteristics in common. In

26. What characteristics of monopolistic competition are shared with monopoly?

There are two characteristics shared by monopolistic competition and monopoly. In both there
is some uniqueness to the product/service sold (“heterogeneous product”). In addition, in both
cases the firm is a price maker. A monopoly has complete control over price because there are
no substitutes. A monopolistically competitive firm can set its own price but within limits
because there are competing firms.

27. How would you describe the graph of a monopolistically competitive firm?

The graph of a monopolistically competitive firm looks identical to that of a monopoly.

28. How does the graph of a monopolistically competitive firm differ from that of a monopoly?

At first this question may seem strange given the answer to the previous question. However,
there are two differences even though you cannot see them in an obvious way. The demand
curve of a monopolistically competitive firm is more elastic than that of a monopoly. This is
because consumers are more price sensitive due to the presence of substitute goods/services.
In addition, the quantities on the horizontal axis are likely to be bigger in the case of a
monopoly. This is not always the case, but it often is.
29. What is possible for a monopolistically competitive firm in the short run?

Like any other firm, in the short run a monopolistically competitive firm can have an economic
profit, economic break even, or economics loss.

30. In the long run, what must be true for a monopolistically competitive firm?

In the long run a monopolistically competitive firm must have an economic break even (zero
economic profit). This is for the same reasoning as in the case of perfect competition. There is
perfect information (or at least very good information) and there is easy entry/exit. So, if firms
have an economic profit, there will be competitor entry and the profit will disappear. If there
are losses, competitors exit, and the loss will disappear.

31. In the transition from the short run to the long run, what typically happens to average total
cost?

In transitioning from short run to long run, average total cost tends to decrease. This is because
firms find ways to economize and produce a given amount of output at a lower cost.

32. How does the graph of a monopolistically competitive firm look in the long run?

In the long run, a monopolistically competitive firm has zero economic profit. In the graph, the
ATC curve is tangent to the demand curve.

33. What are the characteristics of oligopoly?

Characteristics of oligopoly include: few firms in the industry; barriers to entry; firms are price
makers (within limits); firms are interdependent; and products are usually heterogeneous. It is
the market structure to associate with “big business.”

34. What are the implications if an oligopoly decides to ignore the competition?

If an oligopoly ignores the competition, it will behave like a monopoly and the observations of
monopoly apply, such as the graph for a firm with a downward-sloping demand curve. This
strategy is rarely followed. It is foolish to ignore competitors, and firms that do this usually do
not survive long.

35. What is the term used to describe implied cooperative behavior among firms in an oligopoly?

Tacit collusion describes the implied cooperation among oligopolistic firms. There is no direct
communication or coordination of activities. From the outside it may look as though the
companies have formally arranged to cooperate, but there is in fact no coordination in decisions
of output quantities or price.

36. What is a cartel?

A cartel is a group of firms that formally communicate output and price decisions. Although
they remain separate firms, they try to act like a single firm through their coordinated efforts.
Their intention is to obtain the high profits often enjoyed by monopolies and to reduce output.
37. What are the problems with a cartel?

There are two main problems with a cartel. In most countries they are illegal. In the U.S.,
cartels are illegal. If firms try to coordinate actions on output and price, they can be heavily
fined and essentially forced out of business. Another problem with cartels is that there is a huge
incentive to cheat. When a cartel restricts output to cause an increase in the selling price, the
firms in a cartel want to offer more for sale. This temptation becomes overwhelming, cheating
occurs, and the agreement falls apart. This is why most cartels are not successful for long
periods of time since there is rarely an efficient way of punishing cheaters.

38. In the sales maximization model, how do you determine the quantity of output to produce?

The output in the sales maximization model is found where marginal revenue equals zero.
Notice, this is different from the profit-maximizing output where marginal revenue equals
marginal cost. Graphically, the output under the sales maximization model is found where the
marginal revenue curve touches the horizontal axis. This quantity of output is larger than the
output corresponding to where marginal revenue equals marginal cost.

39. Why is there a “kink” in the kinked demand curve model?

The kink in the demand curve model comes from the fact that the demand curve for the firm is
actually made up of two separate demand curves—one that is relatively flat, and one that is
relatively steep. The flat demand curve is relevant when competitors do not respond to the
firm’s price changes (that is, competitors keep their prices fixed). The steep demand curve is
relevant when competitors do respond to the firm’s price changes.

40. Why is there a sticky price at the kink in the kinked demand curve model?

The sticky price corresponds to the kink in the kinked demand curve model because the firm
finds itself in a no-win situation with respect to price changes. Competitors match price
decreases but do not match price increases. The firm faces inelastic demand if it lowers its price
and elastic demand if it raises its price. Any price change results in lower revenue.