Economics 2302 T-1 Review for Exam 3

 

As you know, the third exam covers material presented in video lessons 9 – 11 and textbook chapters 10 – 12 and 16.  As always, I urge you to review the Telecourse Guide Lesson Objectives, Lesson Focus Points, and Practice Test for each of the lessons in addition to studying this review. 

You will recall that the second exam covered the market structure called perfect competition.  Perfect competition is a model market structure that gives the student a foundation for analyzing the profit maximizing behavior of a firm in an industry that gives “ideal results” in long run equilibrium.  As we learn about other, real world market structures, we should compare the results from these to that of perfect competition.  The comparison is in terms of efficient allocation of resources, price, and economic profit in the long run.  Watch for review items that refer back to perfect competition as you proceed.  You might want to go back to the lessons and chapters on cost of production and perfect competition before reviewing the chapters and lessons specifically covered by this exam.

For this exam you will need to:

  1. Know the definition of monopoly.
  2. Understand why a firm that faces a downward sloping demand curve is a price setter rather than a price taker. 
  3. Understand that monopoly power is the power to restrict output in order to charge a higher price and make economic profits.  This is only possible if the firm faces a downward sloping demand curve (demand is not perfectly elastic).
  4. Understand that when demand slopes downward, marginal revenue is not equal to price for quantities greater than 1 unit.  Marginal revenue is below the demand curve for quantities greater than 1.  This happens because when demand slopes downward, it is showing that a firm must lower prices on all units in order to sell an additional unit. 
  5. Understand that a monopoly maximizes profit or minimizes loss by producing the quantity where marginal revenue equals marginal cost.  This is true for all market structures.  But in perfect competition, the firm face a perfectly elastic (horizontal) demand curve, so marginal revenue was equal to price.  So in perfect competition the firm produced the quantity where MR (and price)=MC.  When the monopoly produces where MR=MC, price is greater than MR and therefore price is greater than MC.  Hence we see the monopoly does not “efficiently allocate resources”.
  6. Understand the significance of barriers to entry for monopoly.  Know the various kinds of barriers to entry.  Understand what a “natural monopoly” is.  Know how Alcoa gained monopoly power in producing aluminum.
  7. Study a graph of a downward sloping demand curve and the marginal revenue curve that is derived from it alongside a graph of total revenue.  Note that total revenue is maximum at the quantity where marginal revenue is zero.  For lower quantities (and higher prices), as the firm lowers the price to sell more, total revenue increases.  What is true about the elasticity of demand when a lower price results in an increase in total revenue?  Note that for quantities beyond that where marginal revenue is zero, marginal revenue becomes negative.  So lowering the price now causes total revenue to decrease.  What is true about the elasticity of demand in this region where lowering the price causes TR to drop?
  8. Study a graph showing a firms average total cost and marginal cost along with a downward sloping demand curve and marginal revenue curve.  Be able to find the profit maximizing quantity (where MR=MC).  Having found the quantity where MR=MC, look up to the demand curve to see the price that would be charged to sell this quantity.  Now that you see the price and quantity, you can multiply these to find total revenue.  At the profit maximizing quantity you found using MR=MC, look at ATC to see cost per unit.  This amount multiplied by quantity will give total cost.  Profit then, will be the difference between TR and TC.  Another way to quickly see the economic profit is to take the difference between price (per unit) and ATC, which gives profit per unit, then multiply by quantity to get total economic profit.
  9. Understand that monopoly might continue to earn an economic profit in the long run while in perfect competition economic profits are competed away in the long run.  Compared to perfect competition, the monopolist’s price will be higher and quantity will be lower.  In perfect competition, price equals marginal revenue, but in monopoly, price is above marginal revenue.  If an industry that was in perfect competition suddenly became a monopoly, quantity would be reduced and price would increase (made possible by monopoly power) so that profits would increase.
  10. Be familiar with approaches to regulating monopoly, especially a natural monopoly.  An approach that requires price to equal marginal cost, as it would in perfect competition, would not work when marginal cost is below the average total cost curve.  Why?  What would this mean in terms of profit or loss.  Would it make sense to do this if it required government subsidy to keep the firm in business?
  11. Know the definition of monopolistic competition. 
  12. Be familiar with a graph showing ATC, MC, demand, and marginal revenue for a firm in monopolistic competition.  Understand that like monopoly, the demand curve slopes downward, so MR will be below the demand curve.  Use MR and MC to find the profit maximizing or loss minimizing level of output.  Having found the quantity where MR=MC, look up to demand to see the price.  If price is above ATC, the firm will earn an economic profit in the short run.  Be able to figure this just like in pure monopoly.
  13. Understand how, in monopolistic competition, if firms are making economic profits in the short run, new firms will enter the industry in the long run.  This would reduce existing firms’ share of demand and therefore reduce their profits.  On a graph like the one mentioned in item 12 above, picture the demand and marginal revenue decreasing until demand is just tangent to ATC.  Note that at this point MR will equal MC at the quantity where demand is tangent to ATC, so normal profits (zero economic profit) will be received.
  14. Understand the conditions for long run equilibrium in monopolistic competition and how this is arrived at.  Note on the graph, when long run equilibrium is arrived at, quantity will be to the left of minimum ATC (because of the slope of the demand curve).  This means that there will be excess capacity in monopolistic competition in the long run.  Remember that in perfect competition in long run equilibrium, firms produced where price and MR equaled ATC at minimum ATC.
  15. Be able to compare monopolistic competition to perfect competition in terms of short run and long run results. 

Remember, regardless of market structure, firms maximize profits by producing the quantity where MR=MC.  In perfect competition, since demand is perfectly elastic, price = marginal revenue at all quantities.  In other market structures like monopoly and monopolistic competition, where demand is less than perfectly elastic, MR is below the demand curve and so MR is less than price.

Remember, in long run equilibrium, economic profits are zero in perfect competition and in monopolistic competition (otherwise firms would enter which is not equilibrium – equilibrium means no tendency for change).

Remember that in perfect competition long run equilibrium is reached at the quantity where ATC is minimum (where MC cuts through ATC) so the firms produce at the most efficient level of output.  Long run equilibrium in monopolistic competition occurs to the left of minimum ATC so there is excess capacity.

  1. Understand that we can criticize monopolistic competition because it does come up to the efficiency standards of perfect competition, that because of product differentiation that results in firms having less than perfectly elastic demand curves, there is some inefficiency, but product differentiation gives us a wide range of product choices – so the little bit of inefficiency may be a small price to pay.
  2. Know the definition of oligopoly.  Understand the importance of interdependence. 
  3. Understand what a concentration ratio is and how it helps us find oligopoly when there is a large number of firms in an industry.
  4. Understand how the Herfindahl-Hirschman index is computed and how it is used.
  5. Understand the tendency for firms in oligopoly to collude. 
  6. Be familiar with OPEC as an example of an international cartel.  Understand that in a cartel like OPEC, members agree to restrict output in order to charge a higher price for their product. 
  7. Know the difference between tacit and overt collusion to limit competition.
  8. Be familiar with game theory.  Know what is meant by “strategic choice”.
  9. Study the “Prisoners’ Dilemma”.  Understand dominant strategy.  Given the “pay-offs” of two different choices for two firms, be able to figure what the likely choice will be.
  10. Understand why economists generally agree that a world with advertising is more competitive than a world without advertising.
  11. Know what price discrimination is and a firm can engage in price discrimination if it is a price setter, can prevent resale by the customers charged the lower price, and is able to segment the market.  Understand that in price discrimination, a firm charges a higher price to customers with a less elastic demand for the product and a lower price to those with a more elastic demand.
  12. Know the definition of marginal revenue product.
  13. Understand the profit maximizing hiring decision is to hire up to where marginal revenue product is equal to the marginal factor cost.  This is an example of the marginal decision rule.  Given a table showing total product for each of a number of units of a variable factor, and given the price pf the product, be able to figure marginal product and marginal revenue product for each variable factor.  Then, if given the cost of a variable factor, determine the number of the factors to hire.
  14. Understand why, in a perfectly competitive market, the firm’s demand curve for an input is the downward sloping portion of its marginal revenue product curve.
  15. Once you understand #29 above, you will understand what kinds of things could cause an increase or decrease in the demand for a factor.
  16. Understand how using more of a substitute factor reduces the demand for a given factor while using more of a complementary factor would increase the demand for a given factor.  Understand how a change in the productivity of a factor changes the demand for the factor.  What are some things that might lead to a change in productivity? 
  17. Know why we say that factor demand is “derived demand”.  What is it derived from?  If there is a change in demand for a finished product or even a change in the quantity demanded of a finished product, there will be a change in the demand for the factor that produces the product.  Understand how this works.
  18. Understand the “backward bending” supply of labor curve.  What does the backward bending portion tell us?
  19.  Understand that perfectly competitive factor markets and product markets both generate an efficient allocation of resources.

 

Remember, the items on this review are intended to help you prepare for questions on your third exam.  The exam is limited to 50 questions and therefore does not hit on every important thing in the chapters and video lessons you have studied since the second exam.  I urge you to review the textbook end of chapter problems as well as the Telecourse Guide Lesson Objectives and Focus Points.  This will help you when it comes time to study for the final exam.