ECON 120 - Regulation and Antitrust Policy
Drake University, Spring 2017
William M. Boal

EXAM 2 ANSWER KEY

Version A

I. Multiple choice

(1)a. (2)c. (3)c. (4)a. (5)a. (6)b. (7)c. (8)c. (9)b. (10)a. (11)b. (12)a. (13)d. (14)a. (15)a. (16)a.

II. Problems

(1) [Monopoly, markup formula, Lerner index: 4 pts]

  1. $18, using formula P = MC / (1 + (1/ε)).
  2. 2/3 = 0.667, using formula L = (P-MC)/P or for monopoly L = 1/|ε|.

(2) [Measures of concentration: 6 pts]

  1. 58 percent.
  2. 88 percent.
  3. 1106.

(3) [Cournot duopoly: 14 pts]

  1. RevA = P qA = 15 qA - (qA2/10) - (qA qB/10).
  2. MRA = d RevA / d qA = 15 qA - (2qA/10) - (qB/10).
  3. qA = 60 - (qB/2).
  4. qA* = 40.
  5. Q* = 80, P* = $7.
  6. L = (P-MC)/P = 4/7.
  7. Deadweight loss = $80.

(4) [Joint profit maximization: 10 pts]

  1. MR = 15 - (2Q/10).
  2. Q* = 60.
  3. P* = $9.
  4. L = (P-MC)/P = 2/3.
  5. Deadweight loss = $180.

(5) [Entry barriers and contestable markets: 26 pts]

  1. Min AC = $2.
  2. Min efficient scale = 6 million.
  3. L = (P-MC)/P = 2/3.
  4. P = $3.
  5. AC = $4.
  6. Loss, because P < AC.
  7. $3 million.
  8. Q = 8 million.
  9. AC = $2.
  10. Profit, because entrant's P > AC.
  11. $24 million.
  12. $2, to prevent profitable entry.
  13. L = (P-MC)/P = 0, since P=AC=MC.

(6) [Dominant-firm price leadership: 20 pts]

  1. $2, intercept of supply curve for competitive fringe.
  2. $9, because at this price, quantity supplied by competitive fringe = total quantity demanded.
  3. 3 million, from supply curve for competitive fringe.
  4. 8 million = quantity demanded - quantity supplied by competitive fringe.
  5. Residual demand is a straight line with intercept at $9 (based on answer to part (b)) and intersects market demand at $2 (based on answer to part (a)).
  6. Residual marginal revenue is a straight line with same intercept as residual demand, but twice the slope. So its intercept on horizontal axis must be at 9 million.
  7. DF quantity = 6 million, where DF marginal cost = residual MR.
  8. DF price = $6, from DF demand.
  9. 4 million, from supply curve for competitive fringe.
  10. L = (P-MC)/P = 1/2 = 0.5.

III. Critical thinking [5 pts]

(1) Fast-food industry - economies of scale.

  1. Plant-level economies of scale occur if AC declines as output increases at the level of the plant. For fast-food restaurants, this would occur if cost did not increase as fast as output at individual restaurants. This might occur if larger restaurants could have workers specialize in particular tasks, such as grilling burgers or working the deep friers. However, it seems likely that those opportunities would be exhausted at even medium-sized restaurants.
  2. Firm-level economies of scale occur if AC declines as output increases at the level of the firm. For fast-food restaurants, this would occur if bigger chains enjoyed lower average cost than smaller chains. This might occur if chains can centralize some activities, such as recipe testing, store design, advertising, IT, etc.

(2) Cournot example worked in class - extended.

  1. The loss of consumer surplus is the area of the trapezoid bounded by horizontal lines at the new and old prices, the vertical axis, and the demand curve. That area is $187.50.
  2. The gain in profit is most easily calculated as follows. Under Cournot duopoly, Firm 1's profit is $100 and Firm 2's profit is $900, for a total of $1000. Under monopoly, Firm 2's profit is $1225. The gain is thus $225.
  3. Because the loss of consumer surplus is less than gain in profit, monopoly by Firm 2 is better than Cournot duopoly. (This perhaps surprising result is due to the fact that Firm 1's costs are so high. If both firms had the same cost, the loss of consumer surplus from moving to monopoly would be greater than the gain in profit.)

Version B

I. Multiple choice

(1)c. (2)a. (3)b. (4)b. (5)a. (6)b. (7)b. (8)d. (9)a. (10)b. (11)c. (12)b. (13)b. (14)c. (15)b. (16)b.

II. Problems

(1) [Monopoly, markup formula, Lerner index: 4 pts]

  1. $20, using formula P = MC / (1 + (1/ε)).
  2. 2/5 = 0.4, using formula L = (P-MC)/P or for monopoly L = 1/|ε|.

(2) [Measures of concentration: 6 pts]

  1. 45 percent.
  2. 63 percent.
  3. 761.

(3) [Cournot duopoly: 14 pts]

  1. RevA = P qA = 20 qA - (qA2/10) - (qA qB/10).
  2. MRA = d RevA / d qA = 20 qA - (2qA/10) - (qB/10).
  3. qA = 90 - (qB/2).
  4. qA* = 60.
  5. Q* = 120, P* = $8.
  6. L = (P-MC)/P = 3/4 = 0.75.
  7. Deadweight loss = $180.

(4) [Joint profit maximization: 10 pts]

  1. MR = 20 - (2Q/10).
  2. Q* = 90.
  3. P* = $11.
  4. L = (P-MC)/P = 9/11.
  5. Deadweight loss = $405.

(5) [Entry barriers and contestable markets: 26 pts]

  1. Min AC = $3.
  2. Min efficient scale = 5 million.
  3. L = (P-MC)/P = 4/7.
  4. P = $4.
  5. AC = $5.
  6. Loss, because P < AC.
  7. $3 million.
  8. Q = 8 million.
  9. AC = $3.
  10. Profit, because entrant's P > AC.
  11. $24 million.
  12. $3, to prevent profitable entry.
  13. L = (P-MC)/P = 0, since P=AC=MC.

(6) [Dominant-firm price leadership: 20 pts]

  1. $3, intercept of supply curve for competitive fringe.
  2. $9, because at this price, quantity supplied by competitive fringe = total quantity demanded.
  3. 5 million, from supply curve for competitive fringe.
  4. 2 million = quantity demanded - quantity supplied by competitive fringe.
  5. Residual demand is a straight line with intercept at $9 (based on answer to part (b)) and intersects market demand at $3 (based on answer to part (a)).
  6. Residual marginal revenue is a straight line with same intercept as residual demand, but twice the slope. So its intercept on horizontal axis must be at 9 million.
  7. DF quantity = 6 million, where DF marginal cost = residual MR.
  8. DF price = $6, from DF demand.
  9. 3 million, from supply curve for competitive fringe.
  10. L = (P-MC)/P = 1/2 = 0.5.

III. Critical thinking

Same as Version A.

[end of answer key]