Chapter 4: Individual and Market Demand Compare and contrast an individual's demand curve with an Engel curve.

An individual's demand curve shows the quantity demanded of a good, at various price levels. An Engle curve shows the quantity purchased for various levels of income. While a demand curve is derived from a price-consumption curve, an Engle curve is derived from an income-consumption curve. A price consumption curve shows the optimal combinations of two goods that are purchased as the price of one of those goods changes. An income-consumption curve shows the optimal combinations of two goods that are purchased as the income of the consumer changes. To construct any of these curves, we need to have information about preferences (to build indifference curves) and prices and income (to build a budget constraint).

2. Explain how a change in price affects quantity demanded.

The effect of a price change on quantity demanded can be broken into the substitution effect and the income effect. The substitution effect shows the impact of a price change on quantity demanded, assuming that utility remains the same; it captures the impact of a change in relative prices, and is represented by a move along an indifference curve.The income effect assumes that relative prices are constant, while the level of utility changes; it captures the change in consumption caused by a change in purchasing power (or higher level of utility), and is represented by a jump from one indifference curve to another.The substitution effect always causes a consumer to consume more of a good for which the price has decreased, but the income effect can be positive or negative.

3. Compare and contrast the derivation of an individual demand curve with the derivation of a market
demand curve. An individual's demand curve is derived from the exercise that results in a price-consumption curve. In contrast, a market demand curve is derived by summing up the individual demand curves of all consumers in the market. An individual demand curve depends on determinants such as the income and preferences of a single consumer, while a market demand curve is also affected by the number of consumers in the market and by factors that influence the demands of many consumers. Chapter 6: Production 1. Explain the difference between the short run and the long run in microeconomics. The short run and the long run have more to do with the variability of inputs than with time. The short run refers to a period of time during which at least one of the inputs used in production remains fixed. The long run is a period of time sufficiently long for all of the inputs to be changed. For example, the size of the production facility might be fixed in the short run. Faced with a capacity constraint, the firm will try to maximize profit by adjusting output within the confines of its existing capacity. In the long run, the firm worries more about finding the optimal plant size. There is no capacity constraint and the firm concentrates on finding the perfect plant size for the amount of output necessary to maximize profit based on market demand for its output.

2. Describe the relationship between total product, marginal product, and average product in a production
process that uses one variable input (labor). Use words or graphs. The short-run production function shows the relationship between the quantity of labor and the corresponding quantity of output produced when the amount of capital and the state of technology remain constant. Average product equals the quantity of output divided by the corresponding quantity of labor used. Marginal product equals the change in total product given a change in the quantity of labor used. There is a specific geometric relationship between total product, average product and marginal product. Marginal

product is the slope of the total product function. The shape of the production function, and consequently the shape of marginal product, is the result of (eventual) diminishing marginal returns, or diminishing marginal product of labor. Marginal product and average product are related as follows: when marginal product is greater than average product, marginal product rises; when marginal product is less than average product, the average product declines; and when average product is maximized, marginal product and average product are equal. Maximum average product occurs at the point where a ray from the origin is tangent to the total product function. Graphically, the relationship looks as follows:

3.Explain both graphically and in words the difference between diminishing marginal returns to labor in the
short run and diminishing marginal returns in the long run. Diminishing marginal returns in the short run refers to declining marginal product of one input (labor) due to limitations on the use of other fixed inputs. Diminishing returns give rise to the shape of the short-run production function. In the long run, diminishing returns apply to more than one variable input. For example, when both capital and labor are variable, there are various ways of combining capital and labor to obtain the same amount of output, as described by an isoquant. It is possible that, as we increase the quantity of both labor and capital, we have diminishing returns to both labor and capital. This is noted mainly in the quantity obtained from higher and higher isoquant curves. With diminishing returns, that quantity increases at a decreasing rate. Graphically,

The graph on the left, and particularly the section of the short run production function from a to c, describes diminishing returns in the short run--output increases at a decreasing rate with additional units of labor used. The graph on the right describes diminishing returns in the long run--as we increase the quantity of both inputs, the quantity of output obtained from each isoquant increases but by less and less all the time.

4. Compare and contrast an isoquant where inputs to production are perfect substitutes with an isoquant
where inputs to production are used in fixed proportions. An isoquant where inputs to production are perfect substitutes is a downward sloping, straight line, where the marginal rate of technical substitution remains constant. It is possible to use either a capital intensive production method or a labor intensive production method to produce the same amount of output. In the case of the fixed-proportions production function, only one combination of labor and capital can be used to produce each level of output. It is impossible to make any substitution among inputs. The isoquant is Lshaped. To produce higher levels of output, inputs must be increased proportionally.

5. Define the term returns to scale and explain increasing, decreasing, and constant returns to scale.
Returns to scale refer to the rate at which output increases as inputs are increased proportionately. Increasing returns to scale occur when output more than doubles as inputs double. Decreasing returns to scale occur when output less than doubles when all inputs are doubled, and constant returns to scale occur when output doubles when all inputs are doubled.

Chapter 7: The Cost of Production

Q1.Explain the difference between accounting cost and economic cost and the difference between sunk costs and fixed costs. Accounting costs include expenses plus depreciation charges for capital equipment. Economists are concerned with economic cost, which is the cost of using resources in production. Opportunity cost is the cost associated with opportunities that are foregone when resources are devoted to a certain use. For example, an owner could have earned a competitive salary by working elsewhere. An economist would count that as a cost but an accountant would not. Sunk costs are costs that cannot be recovered, and fixed costs are costs that cannot be avoided. Special equipment, for example, is a sunk cost because it has no alternative use; its opportunity cost equals zero. Fixed costs are costs that do not vary with the level of output. Even when no output is produced, certain costs still exist. The only way a firm can avoid fixed costs is by going out of business.

2. Describe the relationship between marginal cost and average cost.

An average cost curve has a decreasing portion, an increasing portion, and a point where average cost is minimized. Throughout the decreasing portion of average cost, the marginal cost lies below average cost. Throughout the increasing portion of average cost, marginal cost lies above average cost. And at the minimum point on the average cost curve, average and marginal costs are equal. Another way of describing the same relationship is by thinking about the impact of marginal on average. When the marginal cost is greater than the average cost, the average cost must be rising; and when the marginal cost is less than the average cost (the marginal pulls the average down) the average cost must be declining.

4. Describe the selection of inputs (capital and labor) by a firm whose intent is to produce output at a
minimum cost. A firm minimizes the cost of producing a particular output when the following condition holds: MPL/MPK = w/r. The ratio of marginal productivities of the inputs equals the ratio of their prices. This expression can be rewritten as MPL/w = MPK/r. Expressed this way, the cost minimization condition states that a firm

should choose quantities of inputs so that the last dollar's worth of any input added to the production process yields the same amount of extra output. The marginal product of the last dollar spent on each input is the same. This condition coincides with the tangency of an isocost line and an isoquant.

5. Explain how to derive the long-run total cost curve.

The long-run total cost curve is derived from a map of isocost lines and isoquant curves. The tangency of an isoquant curve and an isocost line yields the least-cost combination of inputs for a particular level of output. The long-run total cost curve shows the least cost of producing each level of output.

6. Define the long-run average cost curve (LAC) and explain how it differs from the short-run average
cost curve. Also, explain the difference between returns to scale and economies of scale.

The long-run average cost curve relates the average cost of production to output when all inputs are variable. The short-run average cost curve relates the average cost of production to output when the level of capital is fixed. While the shape of the short-run average cost curve comes from diminishing marginal returns, the shape of the long-run average cost curve comes from returns to scale. With constant returns to scale, the total cost curve is an upward-sloping, straight line, and the average cost curve is horizontal. With increasing returns to scale, doubling the inputs more than doubles the output; consequently, the average cost of production in the long run falls with output. With decreasing returns to scale, the long-run average cost curve is upward sloping. The difference between returns to scale and economies of scale lies in the use of inputs (in fixed or variable proportions) and its impact on output and cost. For example, increasing returns to scale means that output more than doubles when the quantities of all inputs (or inputs used in constant proportions) double. Economies of scale occur when a doubling of output requires less than a doubling of cost. Economies of scale may be the result of changing input proportions.

7. Define economies of scope and the product transformation curve.

Economies of scope refer to the production or cost advantages that a firm enjoys when it produces two or more products in the same inputs, production facilities, marketing, or administration. Economies of scope exist when the joint output of a single firm is greater than the output of two single separate firms. A product transformation curve shows the combinations of two outputs that can be produced with a given set of inputs.

8. Define the learning curve and relate it to production costs and economies of scale.
The learning curve is a graph relating the amount of inputs needed to produce each unit of output to its cumulative output. It shows how a firm "learns" as cumulative output increases. This concept is particularly important for helping new firms in an industry obtain an accurate measure of labor requirements. When learning exists, particularly at the early stages of production, the labor requirement falls with increased production. And as a firm learns, higher levels of output require less and less amounts of labor to produce. Lower costs are possible as a result of economies of scale or because of learning. Economies of scale result in a move downward along the average cost curve, while learning results in a downward shift of the average cost curve.

Chapter 8: Profit Maximization and Competitive Sup ply Describe the three basic assumptions of the model of perfect competition. The model of perfect competition rests on three basic assumptions: (1) price taking, (2) product homogeneity, and (3) free entry and exit. Price taking means that firms have no impact on market price. Each firm sells a small portion of total output and takes the market price as given. Price taking also applies to consumers. Each consumer buys such a small portion of total output that she has no impact on market price and therefore takes the price as given. Product homogeneity means that firms produce and sell identical or nearly identical products. This means that the products of all of the firms are perfectly substitutable with one another. No firm can raise the price of its product above the price of other firms without losing most or all of its business. Homogeneity ensures that there is a single market price. Oil, certain raw materials, and agricultural commodities are examples of homogeneous products. Free entry and exit means that suppliers can easily enter or exit a market, and buyers can easily switch from one supplier to another. The assumption of free entry and exit is important to ensure that firms can freely enter industries if they see a profit opportunity and exit if they are suffering loses. Even if a market is not perfectly competitive, comparing that market to the perfectly competitive case can be useful.

2. Explain why the assumed objective of firms, which is to maximize profit, has been controversial.
The assumption of profit maximization is reasonable and avoids unnecessary complications; however, profit maximization does not dominate the decisions of all firms. Profit maximization is in the best interest of the stockholders, but stockholders are not the ones running the firm. Managers run firms, and their interests differ from those of stockholders. Unless the owners hold the managers accountable for their actions, managers will tend to seek objectives other than profit maximization. To secure their jobs, for example, managers would tend to maximize the size of the operation or revenues rather than profits. In the long run, however, firms will not survive in a competitive environment unless they make profit maximization one of their highest priorities.

3. Draw a graph and explain in words the competitive firms decision to produce or shut down in the
short run.

Refer to the graph above. For any price level above the minimum point on the ATC curve, the price is greater than the average economic cost of production and the firm makes a positive economic profit by producing. Consequently, it will choose to produce. If the price level falls between P0 and P1, the firm has a component of cost (mainly capital investment amortized as an ongoing fixed cost) that cannot be avoided. In this case, the firm is better off producing at a loss than shutting down. The firm will generate enough revenue to pay for all of its variable cost and have some money left to pay for part of its fixed cost. The shutdown rule states that a firm should shut down if the price is less than the average economic cost of production at the profit-maximizing output. More precisely, if the price falls below the average variable cost of production, the firm should shut down.

4. Describe the response of a firm to a change in input prices.

When an input price changes, it costs more to produce an additional unit of output than it did before. This means that the firm's marginal cost curve shifts upward. As a result, the new profit-maximizing level of output, where price equals marginal cost, will be lower than before.

5. Define the price elasticity of market supply and explain its behavior in the short run.
The price elasticity of market supply measures the sensitivity of industry output to market price. Since marginal cost is upward sloping, supply elasticity will always be a positive value. When marginal costs increase slowly in response to increases in output, supply is relatively elastic. When marginal costs are steep, supply is relatively inelastic. As firms reach maximum capacity, supply becomes perfectly inelastic. If capacity utilization is low and firms can easily expand output, their marginal cost curves will be relatively flat or even horizontal at which point market supply becomes perfectly elastic.

6. List and explain the three conditions necessary for long-run competitive equilibrium, and explain
the relationship between economic rent and producer surplus. The three conditions that lead to long-run competitive equilibrium are (1) all firms in the industry are maximizing profits; (2) no firm has an incentive either to enter or exit the industry because all firms are earning zero economic profit, and (3) the price of the product is such that the quantity supplied is equal to the quantity demanded.

Economic rent is the amount that firms are willing to pay for an input less the minimum amount necessary to obtain it. Producer surplus is the difference between market price and marginal cost. In the long run, the producer surplus that a firm earns consists of the economic rent that it enjoys from all its scarce resources. An example is the economic rent associated with a good location. In this case, economic rent is the difference between this location and a less attractive one. Although economic profit in perfectly competitive markets is zero in the long run, economic rent can be positive.

7. Associate the long-run elasticity of supply with the long-run supply curve.
In a constant-cost industry, the long-run supply curve is horizontal, and the long-run supply is infinitely elastic. In an increasing-cost industry, the long-run supply elasticity will be positive but finite. The magnitude of the elasticity will depend on the extent to which input costs increase as market demand expands. An industry that uses abundant inputs will have a more elastic long-run supply curve.

Chapter 9: The Analysis of Competitive Markets

Explain why we use consumer surplus and producer surplus to measure the impact of government intervention in otherwise unregulated markets. Consumer surplus measures the aggregate net benefit that consumers obtain from a competitive market. For some consumers, the value of the good exceeds the price they pay. Producer surplus is analogous to consumer surplus. Producer surplus comes from the difference between the price producers receive for an additional unit sold and the cost of producing it. It measures the benefit that lower-cost producers enjoy by producing at a cost that is less than the market price they obtain from the sale of output. Government intervention in the form of price controls affects the amounts of consumer and producer surplus and generates gains for some and losses for others. It also generates losses that do not accrue to anyone, called deadweight losses. These gains and losses can be observed by examining the areas around the framework of supply and demand.

2. Suppose that the government imposes a price ceiling. Assume that supply is relatively elastic.
Explain the difference in the impact of this price control when demand is relatively elastic versus when demand is relatively inelastic. When demand is relatively elastic, the gain in consumer surplus can be greater than the loss, and consumers will benefit from a price ceiling. When demand is relatively inelastic, the deadweight loss can be greater than the gain, in which case consumers are made worse off from a price ceiling. This analysis assumes that supply is also relatively elastic. When both supply and demand are relatively inelastic, a price ceiling can result in large gains and small deadweight losses.

3. Define market failure and explain two instances of market failure where government intervention
might be desirable. Market failure is a situation in which an unregulated competitive market is inefficient because prices fail to provide proper signals to consumers and producers. If left alone, the market will produce quantities that may be privately efficient but not socially efficient. Two instances of market failure are externalities and imperfect information. Externalities are benefits and costs of market transactions not reflected in prices. Someone other than the parties involved in the market exchange benefits or loses from that exchange. For example, a producer may fail to consider the social cost of the pollution associated with more output produced. Imperfect information means that consumers lack the information necessary to make utility-maximizing purchasing decisions. Government intervention (e.g. requiring truth in labeling) may then be desirable.

4. Use the framework of supply and demand to explain the impact of a minimum wage.
The minimum wage law is an example of a government-imposed price minimum. The effect of setting the wage in the unskilled labor market above the market-clearing wage is an excess quantity of labor supplied. In other words, the minimum wage creates a pool of unemployed workers. Some people who want to work will be unable to do so. The quantity of labor demanded (employed) at the minimum wage is less than the quantity of labor supplied.

5. According to the textbook, what is a more efficient way of helping farmers other than establishing
price supports and/or production quotas? After an exhaustive analysis of price supports, the textbook concludes that a more efficient way of helping farmers, assuming that the objective is to increase their income, is to give them money directly rather than via price supports. Farmers do not produce the unwanted output that results from price supports, and society does not have to divert resources to produce that output. In the case of production quotas, the textbook also concludes that society would clearly be better off if the government simply gave the farmers an amount equal to their gains from a price support but without imposing one which results in additional losses.

6. Compare the effects of a quota with those of a tariff.

Both tariffs and quotas are designed to reduce imports. This reduction results in higher domestic prices, which makes consumers worse off and domestic producers better off. There is also a deadweight loss from restricting imports which consists of an excessive increase in domestic production and a reduction in consumption. A quota differs from a tariff in the way in which government is affected. A tariff that does not eliminate imports completely generates revenue for the government, while a quota generates revenue for foreign producers. The loss of government revenue from a quota must be added to the deadweight loss for society as a whole. Neither tariffs nor quotas are desirable, but quotas are even less desirable than tariffs.

7. Compare and contrast the effects of a specific tax to the effects of a subsidy when the elasticities of
supply and demand are roughly equal. The impact of a specific tax is analogous to the impact of a subsidy. A subsidy is simply a negative tax. With a tax the buyers' price exceeds the sellers' price by the amount of the tax. With a subsidy the sellers' price exceeds the buyers' price by the amount of the subsidy. The effect of a subsidy on quantity produced and consumed is also the opposite of the effect of a tax. Equilibrium quantity increases in the case of a subsidy and decreases in the case of a tax. The benefit of a subsidy is shared roughly equally between buyers and sellers. The same is true for the burden of a tax. However, this is not always the case. Subsidy benefits and tax burdens would not be equally allocated between buyers and sellers if their elasticities differ. Chapter 10: Market Power: Monopoly and Monopsony Explain how the price set by a monopolist compares with the price under perfect competition. In a perfectly competitive market, price equals marginal cost. A monopolist charges a price that exceeds marginal cost. The amount of the monopolist's markup depends inversely on the elasticity of demand. For example, if demand is extremely elastic, price will be very close to marginal cost. In this case, a monopolized market will approximate the competitive one.

2. Describe the monopolys supply curve and compare it to a competitive industrys supply curve.

A monopolistic market has no supply curve. There is no one-to-one relationship between price and quantity supplied. To derive a competitive supply curve, we allowed changes in demand to trace out a series of prices and quantities that represent the marginal cost of production for the industry. In a monopolistic market, the change in price and quantity in response to shifts in demand can be ambiguous. Changes in price may not result in changes in quantity, and changes in output may not lead to changes in price. In sum, a competitive industry supplies a specific quantity at every price. No such relationship exists for a monopolist.

3. Compare the effect of a tax in a competitive industry with the same tax under monopoly.
In a competitive industry, the burden of the tax is shared by producers and consumers. The market price rises by an amount that is less than the tax. Under monopoly, price can sometimes rise by more than the amount of the tax, depending on the elasticity of demand. The marginal cost curve shifts upward by the amount of the tax and the profit-maximizing monopolist is forced to adjust price and output. At low levels of output, where demand is more inelastic, this adjustment may lead to a large increase in price.

4. Write the expression for the Lerner Index and explain what it means.
The Lerner Index of Monopoly Power is a measure of monopoly power calculated by the difference of price over marginal cost as a fraction of price. Mathematically, L = (P MC)/P. The index has a value between zero and one. The larger the value of L, the greater the degree of monopoly power.

5. List and explain the sources of monopoly power.

Monopoly power depends primarily on elasticity of demand, and the factors that determine a firms elasticity of demand are (1) the elasticity of market demand, (2) the number of firms, and (3) the interaction among firms. A more elastic market demand curve limits the potential monopoly power of individual producers. Attempts by producers to cartelize markets with elastic demands have largely failed. Monopoly power will also fall as the number of firms increases. Monopolies try to prevent entry by imposing barriers to entry such as patents, copyrights and licenses. There are also natural barriers to entry, such as economies of scale, which make it more efficient for a single firm (a natural monopoly) to exist rather than to for two or more firms to produce the market output. Finally, monopoly power is smaller when firms compete aggressively and is larger when they cooperate.

6. Define and explain the concept of rent seeking.

Rent seeking is the amount of money that a monopoly spends trying to preserve monopoly status. It might involve lobbying activities, advertising, or legal efforts to avoid antitrust scrutiny. Rent seeking adds to the social losses that result from the existence of a monopoly. The larger the amount of rent seeking, the larger the social cost to society.

7. Define and explain the concept of a bilateral monopoly.

A bilateral monopoly refers to a market that has only a single buyer and a single seller. There are no rules to determine how the buyers and the seller will react or who will get the best bargain. However, when a few buyers and a few sellers exist in a market, we predict that the monopsony power of buyers will reduce the monopoly power of sellers and vice versa. In general, monopsony power will push price closer to marginal cost, and monopoly power will push price closer to marginal value.

Chapter 11: Pricing with Market Power

The basic objective of any pricing strategy by a firm with market power is to capture and turn as much consumer surplus as possible and turn it into additional profit. Explain.

A firm with market power can earn higher profits by using price discrimination than by charging a single price. The firm knows that some customers would be willing to pay a higher price and others a lower price than the single price. If the firm can identify the different customers and get them to pay different prices, not only will it earn a higher profit, but also make some consumers better off as a result. Besides price discrimination, the firm can use other pricing strategies such as the two-part tariff, bundling and tying in order to extract consumer surplus and turn it into profit. With a two-part tariff, customers are required to pay in advance for the right to purchase units of a good at a later time. Bundling and tying involves selling goods together as a package.

2. Explain the difference between first degree, second degree, and third degree price discrimination.
First-degree price discrimination is the practice of charging the maximum price a customer is willing to pay, called the reservation price. Second-degree discrimination is the practice of charging different prices per unit for different quantities of the same good. Quantity discounts and block pricing are examples of second-degree price discrimination. Third-degree price discrimination is the practice of dividing consumers into two or more groups and charging different prices to each group. This is the most prevalent form of price discrimination.

3. Explain the concept of intertemporal price discrimination.

The objective of intertemporal price discrimination is to divide consumers into high-demand and lowdemand groups by charging a price that is high at first but falls later. Customers who value the product highly and do not want to wait to buy it later have a more inelastic demand curve. A broader group of consumers who have more elastic demands will not buy the product if the price is too high. The strategy is to offer the product initially at the high price, selling mostly to customers with inelastic demands, then lower the price for the group with elastic demands.

4. How should a two-part tariff be applied to a market with a single consumer in order to capture as
much consumer surplus as possible? Provide a short answer. Assuming that the firm knows the consumers demand curve, a way to capture the entire consumer surplus is to set the usage fee equal to marginal cost and the entry fee equal to the total consumer surplus.

5. Define bundling and explain when it makes sense to use it.

Bundling is the practice of selling two or more products as a package. Bundling makes sense when customers have heterogeneous demands and when the firm cannot price discriminate. Bundling is more profitable when the demands for the goods being bundled are negatively correlated. When consumers have a high reservation price for one good and a low reservation price for another, bundling is the ideal strategy.

6. Explain the impact of advertising on the profit-maximizing pricing decision of a firm with market
power. Advertising causes the firms demand curve to increase. When demand increases, the firm will adjust the profit-maximizing level of output accordingly. It is important to understand that when a firm advertises, both its output and its costs increase. Advertising is a fixed cost that causes the average cost to increase (marginal cost, however, remains the same). The optimal amount of advertising is determined by the equality of the marginal revenue associated with advertising and the full marginal cost of advertising. The full marginal cost of advertising includes the dollars spent directly on advertising as well as the marginal production cost.

7. Define the advertising elasticity of demand, and explain how it relates to the decision to advertise.
The advertising elasticity of demand (EA) is the percentage change in quantity demanded resulting from a 1 percent increase in advertising expenditures. Firms should advertise more when EA is large, which means

that demand is very sensitive to advertising. Firms should also advertise more when price elasticity of demand (Ep) is small because a small elasticity implies a large mark up of price over marginal cost. Therefore, the marginal profit from an additional unit sold is high. In this case, if advertising can help sell a few more units, it will be worth the cost.

Chapter 12: Monopolistic Competition and Oligopoly

1. Describe the sources of market power for monopolistically competitive and oligopolistic firms.
A monopolistically competitive market is characterized by many firms, free entry and exit, and product differentiation. The amount of monopoly power wielded by a monopolistically competitive firm depends on its success in differentiating its product from those of other firms. Oligopoly is a market with few firms, and entry by new firms is impeded. Market power and profitability in oligopolistic industries depend in part on how the firms interact. Each firm must operate strategically, weighing the probably reactions of its competitors to its own decisions.

2. List the sources of inefficiency in monopolistic competition. Also, is monopolistic competition a

socially undesirable market? Explain. There are two sources of inefficiency in a monopolistically competitive industry: 1) price exceeds marginal cost, which means that consumers value additional output more than it costs to produce additional units of that output, and 2) firms tend to have excess capacity. Average costs would be lower with fewer firms. These inefficiencies make consumers worse off. In most monopolistically competitive markets, however, monopoly power is small and the deadweight loss is small. Also, because firms demand curves are elastic, the amount of excess capacity will also be small. Besides, these inefficiencies must be balanced against the benefits that monopolistically competitive markets provide in terms of product diversity.

3. Describe and briefly explain the Cournot equilibrium.

Cournot equilibrium is a situation in which each firm in a duopoly correctly assumes how much its competitor will produce and sets its own production level accordingly. Cournot equilibrium is an example of Nash equilibrium, where each firm is doing the best it can given what its competitors are doing. Each firm sets the level of output based on the output volume of the other. Cournot equilibrium between duopolists leads to an outcome that is better (for the firms) than perfect competition, but not as good as the outcome from collusion.

4. Explain the possible advantage or disadvantage of being a first mover when choosing output and
price. In the Stackelberg oligopoly model, one firm sets its output before other firms do. Going first gives the first mover a strategic advantage because setting it can set a large level of output, which will force the competitor to set a low level of output for itself. When firms set their prices rather than their quantities, moving first is a disadvantage because if a second firm makes its price decision after observing the first firms decision, it will have the opportunity to undercut price and capture a larger market share.

5. Explain the impact of an increase in costs in the kinked demand curve model.
In the kinked demand curve model of oligopoly, the firms costs can change without resulting in a change in price. Because the demand curve has a kink, a portion of marginal revenue is vertical. When marginal cost increases along the vertical portion of the marginal revenue curve, both the profit-maximizing level of output and price remain the same.

6. List the two conditions necessary for cartel success.

Cartels success depends on two conditions. First, a stable cartel organization must be formed whose members are willing to adhere to the agreements made and avoid the temptation to cheat. Second, the market demand curve for the cartels product should not be highly elastic. A highly elastic demand curve leaves little room for price increases far above marginal cost.