Questions for Review with Answers
Chapter 14. Competition Theory II. Imperfect Competition
I. Basics
Chapter 14 – Question 1
The theory of imperfect competition is the same as the theory of market structures and also the same as the theory of industrial organisation. Explain.
* The theory of imperfect competition deals with monopolies, oligopolies and monopolistic firms. Where one of these three sorts of firms are prevalent in an industry, this is an form of industrial organisation and a market structure.
Chapter 14 – Question 2
What about perfect competition: is it also a market structure and a form of industrial organisation?
* It is a market structure, but not a form of industrial organisation. Where competitors are completely isolated and independent of each other, organisation is not a suitable term to describe them.
Chapter 14 – Question 3
How does the OECD classify market structures?
* According to the causes of big size: economies of scale and differentiation.
There are four categories:
| LS = Large scale economies | SS = Small scale economies (these are not diseconomies) | |
| HP = Homogeneous product | DP = Differentiated product |
Chapter 14 – Question 4
What question is answered by applying the concentration ratio?
* The size of the market share that the leading firms have between them. A five-firm concentration ratio of 50 percent indicates that the overall market share of the five biggest firms in an industry is 50 percent.
Chapter 14 – Question 5
How does the Herfindahl index measure concentration?
* It the sum of the squares of the market shares of all firms in an industry.
II. Two Charts to Compare Perfect and Imperfect Competition
Chapter 14 – Question 6
Here are some characteristics that all imperfect competitors have in common. Explain each of them and contrast them with the characteristics of perfect competitors.
A. They have normal rather than horizontal demand curves.
B. Marginal revenue is below price.
C. Marginal cost is below price.
D. Imperfect competitors do not maximise total surplus.
* A. Unlike perfect competitors, they are not faced with infinite demand. To sell additional units, they must lower price for their entire output.
* B. Marginal revenue is price minus the loss incurred by lowering price for their entire output. For a perfect competitor, price is equal for all units.
* C. Like perfect competitors, they expand output until MC equals MR. As MR is below price, MC is also below price.
* D. They cannot maximise total surplus because their demand curves and their supply curves (=their marginal-cost curves) do not intersect and because they do not sell at marginal cost. For perfect competitors, the supply curve is identical with their marginal cost curve, which intersects the demand curve at the equilibrium price.
III. Monopoly
Chapter 14 – Question 7
What is a natural monopoly?
* A natural monopolist can produce a good cheaper than two firms could produce it.
Chapter 14 – Question 8
Explain why the lack of substitutes is a sine-qua-non for monopolist power.
* This is so for a very simple reason: When the only butcher in your neighbourhood sells over-priced meat, you can decide to become a vegetarian or to buy meat in another neighbourhood. When a company has a monopoly on providing your town with electricity, you have no choice but buying it from this company.
Chapter 14 – Question 9
What is a cartel?
* A cartel consists of a number of firms acting as one.
Chapter 14 – Question 10
Explain how a monopoly determines the quantity supplied and price.
* Like any firm, it determines quantity supplied by expanding output until MC = MR. It then sets the price that its demand curve indicates for this quantity.
Chapter 14 – Question 11
Why is maximising total surplus simply impossible for a monopolist?
* It is impossible because it requires an intersection of the supply curve with the demand curve. As the marginal-revenue curve of a monopolist lies below its demand curve, this intersection cannot occur. Stepping up output to make the intersection between the demand curve and its marginal-cost curve (which is its supply curve) possible would entail losses (marginal revenue would be below marginal cost).
Chapter 14 – Question 12
A monopoly increases output from 10 to 11 units and lowers price from $2,000 to $1,900. What is its marginal revenue?
* $900. Before the changes, it earned 10 x $2,000 = $20,000. After the change, it earns 11 x $1,900 = $20,900.
Chapter 14 – Question 13
Do you remember between which points in the standard graph the welfare-loss triangle is located?
* A. Price on demand curve charged by monopoly
B. MC =MR
C. MC = Price on demand curve
IV. Oligopoly
Chapter 14 – Question 14
What sort of game is the prisoners' dilemma?
* The prisoners' dilemma is a non-co-operative and non-zero game. Non-co-operative because there is either no agreement or an existent agreement can be violated. Non-zero because individual and collective outcomes vary with the decisions of participants.
Chapter 14 – Question 15
What lessons does it convey?
* It conveys two lessons: Cheating - i.e. competing - improves individual outcomes provided it is not answered by cheating. Cheating always makes collective outcomes worse.
Chapter 14 – Question 16
What is Nash equilibrium?
* A situation with three characteristics: (1) none of the firms involved has an incentive to alter its decisions, (2) output is above monopoly output, (3) price is below monopoly price.
Chapter 14 – Question 17
What does contestability stand for?
* It means that, although there is an oligopoly, new firms can enter the industry.
V. Monopolistic Competition
Chapter 14 – Question 18
Monopolistic firms cannot minimise average total costs. Why not?
* Monopolistic firms have excess capacity. At efficient scale, where MC equals ATC, costs exceed price indicated on the demand curve. This is so because the firm's demand curve has been shifted to the left by competitors.
Chapter 14 – Question 19
Explain a monopolistic firm's price formation.
* First it sets its price like a monopoly: It expands output until MC = MR and then charges the pertaining price on the demand curve. When its demand curve has been shifted down by competitors, it charges the price where the ATC curve is tangent to its demand curve.
VI. Chart to Compare All Four Kinds of Market Structure
Chapter 14 – Question 20
You have seen that there are four market structures: perfect competition and the three structures comprised by imperfect competition. To which of them do the statements below apply?
A. Output is such that MC = MR.
B. The marginal revenue curve slopes downwards.
C. The demand curve is above the marginal revenue curve.
D. The marginal cost curve slopes upwards.
* A. To all four.
* B. To all imperfect competitors.
* C. To all imperfect competitors.
* D. To all four.
VII. The Costs and Benefits of Advertising and Differentiation
Chapter 14 – Question 21
Which firms neither advertise nor differentiate their products?
* Monopolies and perfect competitors.
Chapter 14 – Question 22
Advertising of incumbent firms is a sizeable entry barrier for newcomers. Why?
* An unknown product must conquer market shares of well established products.
Chapter 14 – Question 23
Why do firms spend so much on advertising although they know that we do not like it?
* Economists say the reason is signalling. They signal that their product deserves such high advertising expenditure.
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