Chapter 20 — Exercises

Section A — Monopolistic competition

A1. Identify three real markets that are monopolistically competitive. For each, name the feature that makes the products differentiated.

A2. Draw a diagram showing a monopolistically competitive firm earning positive economic profit in the short run. Now show how entry shifts the firm's demand curve leftward until profit is zero.

A3. In long-run monopolistic competition equilibrium, P = ATC but P > MC. Why does this mean the firm has "excess capacity"? Is excess capacity a bad thing?

A4. "If all 60 restaurants in downtown Millbrook sold identical food, there would be fewer restaurants but lower prices." Is this true? Would consumers be better off?

A5. How does advertising fit into monopolistic competition? Does advertising increase or decrease efficiency?

Section B — Oligopoly and game theory

B1. Two gas stations on the same intersection each choose: "high price" ($4.00/gallon) or "low price" ($3.50). If both choose high, each earns $8,000/month. If both choose low, each earns $5,000. If one goes low and the other high, the low-price station earns $10,000 and the high-price station earns $3,000. Set up the payoff matrix. Is there a dominant strategy? What is the Nash equilibrium?

B2. In B1, both stations would be better off at (high, high) = $8,000 each. Why don't they cooperate? What does the prisoner's dilemma predict?

B3. If the two gas stations in B1 could make a binding agreement to keep prices high, would they? Is this legal? What law prohibits it?

B4. OPEC tries to restrict oil output to keep prices high. Explain why individual members have an incentive to cheat on their quotas. Why is the cartel partially successful despite the cheating?

B5. Suppose a third gas station opens at the same intersection. How does this change the game? Is cooperation easier or harder with more players?

Section C — Comparing market structures

C1. Classify each of the following into one of the four market structures: - (a) Wheat farming in Kansas - (b) The local restaurant scene in Millbrook - (c) U.S. domestic airlines - (d) Google Search - (e) T-shirt manufacturing in a developing country - (f) U.S. wireless carriers

C2. For each market in C1, identify: the number of firms, whether products are differentiated, whether there are barriers to entry, and how much market power firms have.

C3. Why is oligopoly the hardest market structure to analyze? What makes strategic interaction more complicated than simple profit maximization?

Section D — The Millbrook restaurant case

D1. A new sushi restaurant opens in downtown Millbrook. Use the monopolistic competition framework to predict: (a) its short-run profitability, (b) the response of existing restaurants, (c) the long-run outcome.

D2. The Riverside Bistro (where Maya works) is considering raising its prices by 10%. In a perfectly competitive market, this would cause it to lose all customers. In monopolistic competition, the effect is different. Why? What determines how many customers the Bistro loses?

D3. Millbrook has 60 restaurants for a population of ~85,000 (including students). Is this "too many" restaurants? How would an economist evaluate this?

Section E — Policy debate

E1. "Advertising is wasteful — it doesn't create any new value, it just shifts customers from one firm to another." Evaluate using the monopolistic competition framework.

E2. "OPEC should be illegal under international antitrust law." Evaluate. Why doesn't international antitrust enforcement exist?

E3. "Airline mergers reduce competition and raise prices." Apply the oligopoly framework. When is this true? When might mergers be beneficial (through cost savings)?

Section F — Reflection

  • Which market structure best describes the market for the product you bought most recently?
  • Have you ever noticed the prisoner's dilemma operating in a non-economic context (roommate disputes, group projects, international relations)?
  • Would you rather live in a world with many differentiated products (monopolistic competition) or fewer identical products at lower prices (perfect competition)?

Selected answers in appendices/answers-to-selected.md.