EconS 404, Professor Rosenman

week 5

1.  

The graph to the left tells the story. At a service charge (price) of $1.00 per ticket too many consumers (Q₁) would try to buy tickets through computerized ticket services. Especially when the number of tickets is limited, say at Q₃, there is clearly an opportunity for a higher price. If Ticketmaster were to lower its service charge to something less that $2.50 on average, maybe to $2.00, it could sell all the tickets to an event. Sometimes exclusive sales rights is the correct strategy, at least to maximize profit, but not along with a lower service charge. Ticketmaster would try to sell Q(pi) at a service charge of P(pi) each.

2. Local customers of places like Disneyland are more sensitive to price (have a more elastic demand) than out-of-town vacationers, for whom the theme park entrance fee is only a small part of total expense. Out-of-town vacationers are already committed to the park. The graph.1 shows how Disney gains. (Graph not needed, as long as you recognize that the demand for locals is flatter -- that is, more elastic).

Out-of-town customers are there for Disneyland, and have relatively steep demand. Local residents have more choices, including such easy entertainment as movies or pizza, and thus have more elastic demand. With a common marginal cost (shown as constant for simplicity) Disneyland charges out-of-town tourists $27.50, but local residents only $20.00. It attracts Q_R local customers, instead of only Q_R* if the price is $27.50. Moreover, if Disney is to really gain from this program, then the additional profit, which equals triangle def minus the rectangle abdc must be positive.

3.  Since airlines continue flying, we can assume for the marginal flights price exceeds average cost at the point where price equals marginal cost.  That means that profits are helped.  In other words, for the marginal flights, marginal revenue (total revenue for the flight) must have exceeded the marginal cost of the flight.

4.  This is a kinked demand curve model. To protect market share, firms follow price decreases.  Since none gain much new business (only a few new customer enter) the price drops are not sustained, and prices move back to P0.  They don't generally follow price increases because they do gain lots of new customers because customers flee the company that raises its price.  Only large costs increases, such as a move from MC2 to MC1, would cause price increases.

TECHNICAL QUESTIONS 

1.   Suppose we have a firm which faces a total cost of TC=0.5Q²-10Q+200 and a demand curve Q=1500-50P, which can be rewritten P=30-Q/50

a)  Find the profit maximizing and revenue maximizing output and price for this firm. (Hint:  TR=Total revenue = P*Q.  Substitute for P to find TR as a function of Q.  Profit = TR-TC.  Maximize profit by taking the derivative with respect to Q and setting equal to zero, and maximize revenue by taking the derivative of TR with respect to Q and setting equal to 0).

We have TR=30Q-(Q²/50) and TC=0.5Q²-10Q+200 so Profit=30Q-(Q²/50)-(0.5Q²-10Q+200).  Taking the derivative of this, we find the MR=MC rule, that is, 30-(Q/25)=Q-10 which means 1000=26Q or Q=38.46 and P=29.23.

For revenue maximization, take the derivative of TR and set equal to 0:  30-(Q/25)=0 or Q=750. In this case, P=15.

b)  If the firm is assessed a license fee of 50, what would we expect to happen to its output under each goal? 

Since the license fee is a fixed cost -- it doesn't affect marginal values, so they would not change.

2.  FDIC increase.

This has to do with the dynamics of perfect competition.  Firms are forced to charge the market price, so they at first absorb the increase.  Of course, it is a change in MC, so the MC curve shifts up a bit, as will the AC.  But first firms try to hold the line, since the market price is Pm.  but at that price, they lose money, so firms exit the market, shifting the short run supply left to SRS2, which raises the market price to P2, where again profit is zero.

3.   Suppose a local town wants to raise more tax revenues. It is considering two taxes. One tax would be imposed on local cable television, which has a monopoly. The other tax is on gasoline, which is sold in a competitive market environment. An economist testifies that consumers would pay all the tax on gasoline, but the cable television company would share part of that tax. But gasoline station owners say their competitive market would force them to absorb the tax, while the monopoly cable television company plans to just pass the tax on to its customers. Who is correct, and why?  (HINT:  Think about profit maximization rules, and the relationship between P, AC and MC in long run equilibrium under both market structures.)

As we saw in question 4, in a perfect competition eventually all the tax will be passed on to the consumers.  But in a monopoly the increase in cost from the tax is shared:

I let MC be constant, for ease.  The firm produces where MR=MC, so without the tax, output=Q1 and price=P1.  Adding the tax to MC, it shifts up to the blue line, MC+T.  When MR=MC+T, price is P2 and output is Q2.  Notice, P2-P1 is less than the tax.

4. Compare the incidence (who pays) and burden (total welfare or profit loss) of a per unit tax in monopolistic competition and oligopoly. If the firm is assessed with a tax, figure how much is passed on, and the effect on the number and size of firms in the market.

For a monopolistic competition, assuming the tax does not push the MC curve beyond the vertical portion of the MR curve, the firm absorbs the entire tax.

For a monopolistic competition, the tax increases LAC, so firms make negative profits.  Firms will leave the market, until prices and demand have adjusted to zero economic profits again.  We would expect, with fewer firms, that prices will be higher, and firms will be larger (since the demand will shift out as firms leave the market).

5.  We see frequent price changes in the airline industry. Why would this behavior be inconsistent with the kinked demand curve model of oligopoly? With which model is it most consistent? Explain. 

In the kinked demand curve model, firms absorb many small changes in costs.  Thus, prices change infrequently, and so the model does not fit the airline industry with its frequent price changes.  In monopolistic competition as costs change, firms adjust, so this is a more suitable model for the airline industry.