QUESTION 1 [10 MARKS]

Suppose the government wishes to combat the undesirable effects of a monopoly through the use of a subsidy to achieve a more allocative efficient level of output. a. Define the governments objective. Why would a lump-sum subsidy not achieve the governments objective? [2 marks] The governments objective is to maximize general social welfare which consists of the sum of consumer surplus and producer surplus, by restoring deadweight loss caused by a monopolist charging above the price of perfect competitive market. In particular as shown in Figure 1, the government is aiming at lowering the price charged by a monopoly from to , while increasing quantity of consumption from to , where and denotes for the price and quantity in a perfect competitive market respectively. As a result, the overall welfare is increased by the area of .

Figure 1 Figure 1 depicts a monopolists pricing strategy, both with or without governments lump sum subsidy. The marginal cost of production, , is independent of the subsidy as it is provided in a lump-sum payment. Providing a lump-sum subsidy will not achieve the governments objective because it does not fundamentally alter a monopolists marginal cost. A monopolys price strategy is to charge at a market price where marginal revenue equals to its marginal cost, . For a profit maximizing monopoly it will not alter its pricing strategy as its marginal cost curve, , is unchanged even being subsidized.

b. Use a graphical proof to show how a per-unit-of-output subsidy might achieve the governments objective. [2 marks] Per-unit-of-output subsidy has different impacts on output of production as it lowers the marginal cost curve of production by the size of the subsidy, as shown in Figure 2.

Figure 2 The marginal cost of production, , is lowered by the size of the subsidy represented by the vertical distance between points . The new marginal cost curve is , in order to maximize profit the monopolist now producing at while charging at market price . Obviously since the new marginal cost curve is lower than that without subsidy, the new market equilibrium quantity is greater than while price charged is lower than . Thus it is possible to subsidize at an appropriate level in which the new quantity of output is indifferent to the output level in a perfect competitive market. That is, the government is able to achieve its objective by providing a per-unit subsidy of an appropriate size where the monopolists new quantity of output is equal to a competitive markets output , and the market price stays at the competitive markets price correspondingly.

c. Suppose the government wants its subsidy to maximise the difference between the total value of the good to consumers and the goods total cost. Show that, in order to achieve this goal, the government should set

Where t is the per-unit subsidy and P is the competitive price. Explain your result intuitively. [6 marks] The total value of the good to consumers is the aggregate consumer surplus at the purchased quantity . The goods total cost is the area under the marginal cost curve from nil to the quantity of production . The difference between the total value of the good to consumers and the total cost of the good is the social welfare, representing by the area under demand curve and above the marginal cost curve, from nil to the quantity of production. The maximum of the social welfare is unique, and can only be achieved by equilibrating supply and demand at point in Figure 3.

Figure 3 For example, suppose the size of the subsidy leads to a production quantity and price at point on the demand curve, that is, the marginal curve of the monopolist is . The social welfare can be increased by producing an extra unit of output, where the aggregate social welfare is gained by part of the area . This process can be continued until area becomes zero, or point converges to point . Contrarily, if an economy starts at some point to the left of point , there exists excess production 7

of which producer surplus is negative. The social welfare can be improved by moving equilibrium towards point .

QUESTION 2 [10 MARKS]

You are the CEO of ABC Technology Ltd, an innovative producer of sleek mobile electronic devices. ABC Technology has developed technology that allows it to manufacture its range of products faster and at a lower cost than its only rival, XYZ Technology Ltd. As a result, ABC technology has used this advantage to be the first to produce a new ThinkPad computer and choose its profit-maximising output level in the market. The inverse demand function for the ThinkPad is . ABC Technologys ( ) costs are given by and XYZ Technologys costs are given by ( ) . a. What type of industry structure is represented in this example? [1 mark] It is a Duopoly (or Oligopoly with two players) industry structure in which two producers compete with each other in an identical product market. b. What is ABC Technologys profit-maximizing output level? XYZ Technologys? What is the market's equilibrium price? [3 marks] Suppose each firm chooses output level to maximize its profit (the Cournot model). Profit maximizing strategy is described as following maximization problem: [ [ ( ( )] )] ( ( ) ) (1.1)

Substituting in the cost functions ( ), Equation (1.1) can be written as (1.2) Using the first-order conditions to solve for the best-response functions, Equation (1.2) gives:

(1.3)

Solving Equation (1.3) simultaneously yields the Nash equilibrium of the Cournot model (1.4) 9

The profit maximization output level for firm ABC and XYZ is 20.58 and 19.71 units respectively. Total output is thus . Substituting total output into the demand curve implies an equilibrium price of . c. How much profit does each firm earn? Explain the profit outcome. [2 marks] Substituting price and outputs into the profit functions as in Equation (1.2) implies (1.5) Firm ABC earns a profit of $3389.11 and firm XYZ earns a profit of $3107.87. d. Ignoring anti-competition considerations, would it be profitable for ABC Technology to merge with XYZ Technology? (Assume the merged firm adopts ABCs cost structure.) [3 marks] The merged firm becomes a monopolist and will produce quantity of output subject to following profit maximizing problem: ( ) ( ) is: (1.7) Substituting total output into the inverse demand function implies an equilibrium price of . The total market profit before and after the merge is: ( ) (1.6)

The first-order condition corresponds to the profit maximizing output

(1.8)

The new market profit is greater than market profit before the merge, both firms can be better off by merging.

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QUESTION 3 [10 MARKS]

The market demand for Klonks is given by the relationship ( ) , where is the market output, and is the market price. The marginal cost of producing a Klonk is constant at , and there are no fixed costs. a. If a single firm operated in this market, what price would it set? Label this price What profits would the firm earn? [4 marks] .

An operating single firm will charge its price subject to following profit maximizing problem: ( ) ( ) ( ) (1.9)

The first-order condition with respect to price

in Equation (1.9) is: (1.10)

The monopolys price is $15. Substituting total output into the demand function, ( ) , implies an equilibrium Quantity of . And the corresponding profit ( ) .

b. Suppose two firms operate in the market for Klonks and compete by simultaneously choosing prices. The firms produce identical products and compete for a single period. Assume that if both firms set the same price, they share the market equally, and if the prices are unequal, the firm with the lowest price captures the entire market. Carefully describe and illustrate the equilibrium. [6 marks] The unique Nash equilibrium of this Duopoly market where two players simultaneously choosing prices with identical and constant marginal cost (Bertrand Model) is to charge at price . That is, the Nash equilibrium involves both firms charging marginal cost. The following analysis will verify this is the unique equilibrium in such settings. In equilibrium, firms charge a price equal to marginal cost, which in turn is equal to average cost. But a price equal to average cost means firms earn zero profit in equilibrium. However, each of these two firms does not have an incentive to deviate from the equilibrium to other price. For example, if it deviates to a higher price then it will make no sales and therefore no profit, not strictly more than in equilibrium. If it deviates to a lower price then it will make sales but will be earning a negative margin on each unit sold, since price would be below marginal cost. So the firm would earn 11

negative profit, less than in equilibrium. Because there is no possible profitable deviation for the firm, the strategy of charging at marginal cost is a Nash equilibrium. It is clear that marginal cost pricing is the unique strategy. If prices exceeded marginal cost, the high-price firm would gain by undercutting the other slightly and capturing all of market demand. More formally, with no loss of generality, assume firm is the lowprice firm, that is, . There are three exhaustive cases:
a) b) c)

Case a) cannot be a Nash equilibrium. Firm 1 earns a negative margin on every unit it sells and, since it makes positive sales, it must earn negative profit. It should earn higher profit by deviating to a higher price. For example, firm 1 guarantee itself zero profit by deviating to . Case b) cannot be a Nash equilibrium, either. At best firm 2 gets only half of market demand (if ) and at worst gets no demand (if ). Firm 2 could capture all of market demand by undercutting firm 1s price by a tiny amount. This amount could be chosen small enough that market price and total market profit are hardly affected. If prior to the deviation, the deviation would essentially double firm 2s profit. If prior to the deviation, the deviation would result in firm 2 moving from zero to positive profit. In either case, firm 2s deviation would be profitable. Case c) includes the subcase of the Nash equilibrium concluded before, . The only remaining subcase in which is . This subcase cannot be a Nash equilibrium since firm 1 earns zero profit here but could earn positive profit by deviating to a price slightly above but still below .

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QUESTION 4 [10 MARKS]

You have just been hired as manager of a new fitness centre in the city of Sydney. The owner of the fitness centre has commissioned a market study that estimates the average customer's monthly demand curve for visiting the health spa to be . The cost of operating the fitness centre is ( ) , where is the number of visits. The owner has been charging a $20 per-month membership fee and a $5 per-visit fee. Part of your salary is 10 percent of the monthly profits. Suggest a pricing strategy that will increase your salary. Since the demand information is known, it is applicable for the fitness centre to use two-part pricing strategy to extract more surpluses from consumers. The essential principle behind two-part pricing strategy for maximum profit is to set price at marginal cost and charged a membership fee equal to consumer surplus. The marginal cost of operating the health spa is given as: (1.11) Equation (1.11) shows that the marginal cost of operation is constant at 3 dollars per visit. Thus, the entry fee per visit should be set at 3 dollars. The average consumer demand given 3 dollars per visit is: (1.12)

Figure 4 13

The area between the demand curve and the marginal cost curve is the total consumer surplus as shown in Figure 4, which is equal to: ( ) (1.13)

Thus the membership price should be set at $4851.125, with per visit entry price of $3.

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