Lipsey & Chrystal: Economics 12e

Instructor's Manual
Oxford University Press, 2011. All rights reserved.
Part Two: Markets and Firms

The four chapters of this Part cover the core microeconomic theory of firms, the second
major group of agents in the economy after consumers; the government is left to Part Four.
They fall into two groups, of one and three chapters respectively.

The first group is just Chapter 6, dealing with the cost structures of firms. This starts by
looking at firms seen as agents of production, and sets down the assumption that their goal
is to maximize profits. This is followed by an overview of production, costs, and profits
without specifying the time period involved. The latter is of course crucial to the relationship
between output and costs, and the chapter goes on to explore this in detail for both the short
and the long run. All the standard concepts, such as total, average and marginal costs, are
developed, together with how input choices will change if input prices do. The chapter ends
with the (very long run) concept of endogenous technical change.

The second group is Chapters 7, 8 and 9, which consider the normal range of market
structures, dealing with perfect competition, monopoly, and imperfect competition
respectively. The discussion of perfect competition in Chapter 7 introduces the different
revenue concepts and the fundamental MR = MC condition for profit maximization by any
firm. Short- and long-run equilibrium are both explored, together with the allocative efficiency
that forms the basis of economists liking for competition, and the idea of economies of
scale.

Chapter 8 moves to the other end of the scale with an analysis of monopoly, contrasting it
with the competitive case. The possibilities of there being more than one firm on the input
side (the multi-plant monopolist) or more than one market on the output side (the price-
discriminating monopolist) are both demonstrated (separately). A discussion of long-run
equilibrium raises the issues of barriers to entry and Schumpeterian creative destruction.
The chapter ends with a look at cartels, where a number of firms act together to reap the
benefits of monopoly.

Finally the intermediate case of imperfect competition is considered in Chapter 9. This starts
with some data on concentration in UK industry and then goes on to consider imperfectly
competitive market structures in general. This is followed by two core sections on
monopolistic competition and oligopoly. The former sets out the basics of the theory and
provides a critique of its empirical relevance; the latter defines the term oligopoly and
explores the reasons why so many industries fall into this category. A discussion of
oligopolists strategic choice between competition and co-operation leads into the fourth
section on game theory, which is the heart of the chapter. Various ideas are introduced,
including the formal concept of a Nash equilibrium, and this material is among the more
difficult in the book. The section ends with another look at competition and co-operation
strategies for two firms, illustrated by a number of real world examples. The last section of
the chapter concerns entry barriers, especially brands and advertising, and the effects of the
presence of oligopoly on the functioning of the economy.

It will be clear from the above summary that a fair amount of material will have been covered
by anyone who works through these four chapters thoroughly. It is worth emphasizing that it
is not all theory: numerous practical illustrations are scattered throughout the text, both in the
boxes and in the case studies towards the end of each chapter. There are also pointers to
techniques and approaches which continuing students will meet later in their courses. The
material on game theory in Chapter 9 is the obvious example here, but the problems of
cartels and the various references to entry barriers also indicate the way ahead.

Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.

Notes for users of the previous edition

Part Two is substantially the same as it was in the eleventh edition. Chapter 6 looks a bit
different, but that is largely because the first two sections from that edition have been merged
into the first section here, with an accompanying change in title, and some content from
there has been moved to a new section at the end of the chapter. The main three sections
on short-run, long-run, and very long-run costs are little changed. Chapters 7, 8 and 9 are
also almost identical to their predecessors, with quite long sections of all three chapters
showing only the odd change in wording. Empirical data and examples have been updated
throughout, however, and all four chapters have acquired at least one new box. The case
studies at the ends of the chapters are probably the most changed sections in this Part of
the book. Both here and in the boxes more use has been made of newspaper material to
provide practical illustrations of the theoretical concepts. The summary and topics for review
at the end of each chapter are obviously revised to reflect any changes in the main text.
Apart from the deletion of one question in Chapter 8, the end-of-chapter questions are
exactly the same as before.


Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.
Chapter 6: The Cost Structure of Firms

This chapter lays the foundation for the production side of the microeconomics part of the
book. The focus is on the firm as opposed to the industry; different industrial structures, from
monopoly to perfect competition, are dealt with in the ensuing chapters. The present chapter
has six substantive parts.

The first section is a brief look at actual firms, seen as agents of production. It first lays down
the basic assumptions that firms aim to maximize profit and that they can be regarded as
single, consistent decision-making units. Then it introduces factors of production and the
production function. Box 6.1 uses airliner construction to illustrate the way modern
production brings together a huge number of often tiny components from all over the world,
and how difficult it can be to secure small quantities of highly specific items. A discussion of
profit-maximizing output leads into the remainder of the chapter by explaining how the
ultimate goal is to derive profit-maximizing output for different market structures, but that first
the relationship between costs and output has to be established for various time horizons.

The second section accordingly covers Costs in the short run. It introduces the terms total,
average and marginal product with a numerical example, and goes on to demonstrate the
law of diminishing returns. The basic cost terms (TC, TFC, TVC, ATC, AFC, AVC, MC)
are explained using a numerical example, and the standard cost curve diagrams are derived.
The section ends with a discussion of how cost varies with output for the different cost
curves. Box 6.2 shows how the ability of firms in practice to under-use their capacity leads to
the average variable cost curve being constant over large ranges of output (rather than
being U-shaped).

The third section moves on to the long run. It starts with the link between profit maximization
and cost minimization, and goes on to the principle of substitution: that methods of
production will change if relative input prices do. This is illustrated in Box 6.3. The following
section considers cost curves in the long runthe LRAC, economies and diseconomies of
scale (illustrated in Boxes 6.4 and 6.5), and the sources of increasing returns. The section
ends by showing the link between short- and long-run cost curves (the standard envelope
diagram), and discussing briefly how the curves shift with changes in input prices.

The fourth part of the chapter briefly extends the time period concerned to the very long
run, when endogenous technical change takes place: that is, a change in response to
economic signals. The fifth part clears some necessary ground for the next few chapters by
distinguishing between the economists and the accountants definitions of profit, and by
stressing the signalling role of profits. The chapter ends with two case studies: one on
economies of scale in the UK electricity industry, and one on endogenous materials design,
termed a new industrial revolution.


Notes for users of the previous edition

This chapter looks more different from its eleventh-edition predecessor than it really is. The
first two sections from that edition have been merged into the first section here, with an
accompanying change in title. The old opening sub-section on Firms in reality (pages 114-
115 in the eleventh edition) has been deleted and the sub-section on Costs and profits
(previously pages 117-119) has been moved to near the end of the chapter. The old third,
fourth and fifth sections on costs in the short, long, and very long runs now follow almost
exactly as before as the new second, third and fourth sections. The Costs and profits
material mentioned above then reappears as most of the new fifth section entitled The
Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.
definition of profit in economics. The case studies are unchanged apart from a bit of
updating towards the end of each. The summary and topics for review are revised to reflect
the new order of material, but the end-of chapter questions are unchanged.

Figure and tables in this chapter are unchanged apart from necessary renumbering. Boxes
6.1-6.3 (on Organisation of producers, Kinds of debt instruments and The boundaries of
the firm) have gone; the previous Boxes 6.4 and 6.5 are now 6.2 and 6.3 respectively; and
Boxes 6.1, 6.4 and 6.5 in the present edition are all new.


Answers to end-of-chapter questions

1 Construct the following table:

Innings Marginal Score Cumulative Score Average Score

1 10 10 10.0
2 20 30 15.0
3 50 80 26.7
4 60 140 35.0
5 80 220 44.0
6 100 320 53.3
7 100 420 60.0
8 100 520 65.0
9 70 590 65.6
10 50 640 64.0
11 0 640 58.2
12 10 650 54.2
13 20 670 51.5
14 0 670 47.9


The average rises if the marginal score is above the previous averageas it is in the first
half of the table. The opposite holds in the bottom half.


2 If K is fixed at 100 then the production function becomes Q = 200L. The following table
shows the necessary calculations:

Labour Total Product Average Product Marginal Product

1 200.0 200.0
5 447.2 89.4 61.8
10 632.5 63.2 37.0
20 894.4 44.7 26.2
40 1264.9 31.6 18.5
50 1414.2 28.3 14.9
80 1788.9 22.4 12.5
100 2000.0 20.0 10.6
150 2449.5 16.3 9.0
200 2828.4 14.1 7.6


Marginal product is calculated as TP/L, following the formula on page 113.

Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.

3 (a) See table below. Note that fixed costs are implicitly given as 1,000. It is useful to
include the VC column, although it is not specifically asked for. If AFC is calculated
as 1,000/Q then making sure that ATC = AFC + AVC is an obvious check on the
arithmetic.

(b) See table (all cost figures in ).

Output TC VC AVC ATC AFC MC

0 1,000 0
10.0
20 1,200 200 10.00 60.00 50.00
5.0
40 1,300 300 7.50 32.50 25.00
4.0
60 1,380 380 6.33 23.00 16.67
5.5
100 1,600 600 6.00 16.00 10.00
7.0
200 2,300 1,300 6.50 11.50 5.00
9.0
300 3,200 2,200 7.33 10.67 3.33
11.0
400 4,300 3,300 8.25 10.75 2.50
13.5
500 5,650 4,650 9.30 11.30 2.00
16.0
1,000 13,650 12,650 12.65 13.65 1.00



(c) If P = MR = 11, setting MC = MR gives an output level of 400 units.

(d) Profit = TR TC = (40011) 4300 = 100.

(e) If output = 300, profit = (30011) 3200 = 100
If output = 500, profit = (50011) 5650 = 150

These results suggest that the profit-maximizing output may in fact be a bit below
400.


4 Note that the four levels of output given all divide by 20, and the powers of K and L are
the same. Thus the equation for Q = 1000, for example, which is 1000 = 20(K
0.5
L
0.5
), can
be rewritten as 2500 = KL, which is easier to solve. Example of pairs (K,L) for each level
of Q are as follows (note the symmetry in the pairs of values):

Q = 20 KL = 1 (0.2,5.0) (0.4,2.5) (1.0,1.0) (2.5,0.4) (5.0,0.2)
Q = 100 KL = 25 (1.0,25.0) (2.5,10.0) (5.0,5.0) (10.0,2.5) (25.0,1.0)
Q = 1000 KL = 2500 (10,250) (25,100) (50,50) (100,25) (250,10)
Q = 2000 KL = 10000 (5,2000) (10,1000) (100,100) (1000,10) (2000,5)

Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.

5 Capital is more expensive, so it will make sense to use less of itsomething our trial and
error searching should bear in mind. As before it is easier to use the equations in the
second column of the table above. In fact with the factor price ratio of 1:2 we will want the
factors in the ratio 2:1that is, L = 2K. Thus if M is the number in the second column
above (so KL = M) then L = (M). We have

Q = 20 KL = 1 L = 0.5 Cost-minimizing combination (1.42,0.71)
Q = 100 KL = 25 L = 12.5 Cost-minimizing combination (7.07,3.54)
Q = 1000 KL = 2500 L = 1250 Cost-minimizing combination (70.7,35.4)
Q = 100 KL = 10000 L = 5000 Cost-minimizing combination (141.4,70.7)

Trial and error will not hit these exactly, of course, and in any case it may be sensible to
limit the answers to integral values of K and L.


6 With K = 100so cost of K is 1000
Q = 20 KL = 1 L = 0.01 TC = 1000.05 AC = 50.0025
Q = 100 KL = 25 L = 0.25 TC = 1001.25 AC = 10.0125
Q = 1000 KL = 2500 L = 25 TC = 1125 AC = 1.125
Q = 2000 KL = 10000 L = 100 TC = 1500 AC = 0.75

With K = 16so cost of K is 160
Q = 20 KL = 1 L = 0.0625 TC = 160.3125 AC = 8.015625
Q = 100 KL = 25 L = 1.5625 TC = 167.8125 AC = 1.678125
Q = 1000 KL = 2500 L = 156.25 TC = 941.25 AC = 0.94125
Q = 2000 KL = 10000 L = 625 TC = 3285 AC = 1.6425

With K = 25so cost of K is 250
Q = 20 KL = 1 L = 0.04 TC = 250.2 AC = 12.51
Q = 100 KL = 25 L = 1 TC = 255 AC = 2.55
Q = 1000 KL = 2500 L = 100 TC = 750 AC = 0.75
Q = 2000 KL = 10000 L = 400 TC = 2250 AC = 1.125

With K = 36so cost of K is 360
Q = 20 KL = 1 L = 0.027778 TC = 360.13889 AC = 18.006944
Q = 100 KL = 25 L = 0.694444 TC = 363.47222 AC = 3.6347222
Q = 1000 KL = 2500 L = 69.44444 TC = 707.22222 AC = 0.7072222
Q = 2000 KL = 10000 L = 277.7778 TC = 1748.8889 AC = 0.8744444

With K = 49so cost of K is 490
Q = 20 KL = 1 L = 0.020408 TC = 490.10204 AC = 24.505102
Q = 100 KL = 25 L = 0.510204 TC = 492.55102 AC = 4.9255102
Q = 1000 KL = 2500 L = 51.02041 TC = 745.10204 AC = 0.745102
Q = 2000 KL = 10000 L = 204.0816 TC = 1510.4082 AC = 0.7552041

With K = 64so cost of K is 640
Q = 20 KL = 1 L = 0.015625 TC = 640.07813 AC = 32.003906
Q = 100 KL = 25 L = 0.390625 TC = 641.95313 AC = 6.4195313
Q = 1000 KL = 2500 L = 39.0625 TC = 835.3125 AC = 0.8353125
Q = 2000 KL = 10000 L = 156.25 TC = 1421.25 AC = 0.710625

Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.

With K = 81so cost of K is 810
Q = 20 KL = 1 L = 0.012346 TC = 810.06173 AC = 40.503086
Q = 100 KL = 25 L = 0.308642 TC = 811.54321 AC = 8.1154321
Q = 1000 KL = 2500 L = 30.86420 TC = 964.32099 AC = 0.964321
Q = 2000 KL = 10000 L = 123.4568 TC = 1427.284 AC = 0.713642


7 Textbook material, as discussed on pages 125126. Note that what firms (and newspaper
headlines) call profit includes a normal return on capital.


8 The law of diminishing returns affects the shape of the average and marginal cost curves.
(Note that this is stated clearly on page 116.) They must eventually increase, as the
marginal and average products of the variable input must eventually fall.



9 Note that economies of scale is just another term for increasing returns to scale. The
varying returns describe what happens when all inputs are changed in the same
proportions (for example, all inputs are doubled), which is why it is a long-run
phenomenon. If output increases by a higher proportion than inputs we have increasing
returns, etc. Sources of increasing returns are discussed on pages 121122 of the main
text.

Teaching Note This question is a useful prompt to clarify the distinction between
diminishing returnsto one factor onlyand decreasing returns (to scale)when all
factors are changed simultaneously.
Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.
Chapter 7: Perfect Competition

This chapter is the first of three covering the standard range of market structures. Firms in
this chapter are price-takers. The material covered here is standard, both in terms of content
and the way the argument is developed.

The opening section of the chapter sets out to explain the concept of market structure, a
pre-requisite for what is to come. The distinction is drawn between a competitive market
structure and competitive behaviour. Box 7.1 is based on a newspaper report of the
increased demand for dark chocolate in America and looks forward to the discussion of the
(perfectly competitive) cocoa market in a case study at the end of the chapter.

The main part of the chapter starts off with the assumptions underlying the theory of perfect
competition, and defines such a market in terms of the zero market power held by its
constituent firms. Box 7.2 sets out clearly and intuitively the meaning of perfect competition,
using the example of a single farmer producing wheat. The concepts of demand, revenue,
average revenue and marginal revenue are then introduced, before going on to examine
the short-run equilibrium of the firm in a new section. If the firm operates at all it will produce
where MR = MC. This allows us to derive the short-run supply curves of both firm and
industry, and hence to find the short-run equilibrium price (at industry equilibrium). The fact
that short-run profits may be negative, zero or positive is noted.

We then move on to long-run equilibrium, allowing for entry and exit in the industry and their
effects on the industry supply curve. Long-run responses to a change in demand are
analysed, along with a detailed study of the long-run industry supply curve and how its shape
can vary. Two boxes explore the effects of changes in input costs and of changing
technology, and a further box considers the fate of declining industries. External economies
of scale are introduced and contrasted with internal economies. Finally it is explained why
perfectly competitive firms must have exhausted all economies of scale.

The fifth section explores the allocative efficiency of perfect competition, using the
concepts of consumers surplus introduced briefly in Chapter 5 and producers surplus
(new here). Efficiency is defined in terms of maximizing the sum of these two. This is
followed by a brief conclusion and two case studies. The first explores the market for cocoa,
emphasising how global demand and supply determine the price of the product and how an
individual cocoa farmer can do little other than accept that price, in the short run at least. The
second pursues a similar line for the world copper market, tracing movements in demand
and supply over the last quarter of a century.


Note for users of the previous edition

This chapter corresponds very closely to Chapter 7 in the previous edition. The only
significant change is the introduction of Box 7.1 (which of course means the other boxes are
renumbered). The material in the introduction has been rearranged somewhat and there is
some updating and new material in the two case studies. A couple of paragraphs have been
cut in Box 7.4 (Box 7.3, as was) but otherwise it is really only the odd word here and there.
The end-of-chapter questions remain the same.

Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.
Answers to end-of-chapter questions

1 Total revenue is 1500, 7500 and 150,000 at the three levels of output. Average
revenue and marginal revenue remain at 15 for all levels of output under perfect
competition (see Figure 7.4 for example).


2 There are two ways to tackle this question. The quick one is to use the MC = MR
condition for profit maximization, especially as we know that MR = 15 throughout. Then it
is easy to see from the question that MC = 15 when output rises from 105 to 106, so 106
is the answer. Alternatively we can construct the table below (which will also help with
Question 3). This suggests that either 105 or 106 will give the same maximum profit of
215.

Output TVC TC MC TR AVC ATC

100 1,000 1,300 1,500 200 10.00 13.00
101 1,010 1,310 10 1,515 205 10.00 12.97
102 1,021 1,321 11 1,530 209 10.01 12.95
103 1,033 1,333 12 1,545 212 10.03 12.94
104 1,046 1,346 13 1,560 214 10.06 12.94
105 1,060 1,360 14 1,575 215 10.10 12.95
106 1,075 1,375 15 1,590 215 10.14 12.97
107 1,091 1,391 16 1,605 214 10.20 13.00
108 1,108 1,408 17 1,620 212 10.26 13.04



3 AVC and ATC have been added to the table above.

Profit is 215 at the profit-maximizing level of output, and falls away either side of that.

If the sales price were 12 then MR = 12 too. MC = 12 at an output of 103, so that
would be the new profit-maximizing output. TR would then be 12103 = 1,236 so profit
= 1,236 1,333 = 97.

Teaching Note This question is an obvious prompt to revise the distinction between the
long run and the short run for competitive firms. The price of 12 is what is referred to as an
exit-inducing price on page 141. In the short run the firm will continue trading, as variable
costs are being covered, but in the long run it will close down.


4 (a) Consistentespecially in the short run. In the long run all firms have access to the
same technology, so in theory all would be using the same technology. In reality
however continuous technical change means that different firms will be using
different technologies (see the discussion on page 141).

(b) Consistentthe industry demand curve is downward sloping, so advertising makes
sense at the industry level.

(c) Inconsistentunder perfect competition each firm can sell as much as it likes at the
going price, so there is no point in advertising.

(d) Inconsistent24 firms is not large enough for perfect competition.

Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.
(e) Consistenteconomic profits are possible in the short run. One would expect new
firms to have entered the industry in later years, thus increasing supply and driving
down the price.

(f) Consistentanything else is not possible under perfect competition.


5 The three rules are given on pages 136137. The explanation is also given in the text.


6 The report on the health benefits of barley would lead to the (industry) demand curve for
barley shifting to the right: more would be demanded at any given price. In the short run
the supply of barley is fixed, as it depends on what was sown the previous year, so the
industry supply curve does not move (abstracting for a moment from the possibility of
importssee below). Price will rise, so barley farmers will enjoy supernormal profits. The
converse will happen in the wheat market, where demand will fall as some customers
switch to barley products on health grounds. Wheat farmers will make economic losses.
However they are still likely to harvest their wheat, as price is unlikely to drop far enough
to make it not worth selling wheat (after all, the report has not said there is anything
actually wrong with consuming wheat).

In the longer term (which here means the following year) some farmers will change from
wheat to barley (a relatively easy changeboth are arable crops, and can generally be
grown on the same ground), and other farmers may switch from other crops, attracted by
the supernormal profits in barley production. This will move the supply curves for barley
and wheat to the right and left respectively, thus lowering the barley price and raising the
wheat price. Normal levels of profits will be restored in both industries. In practice this
might not all happen in one go, especially if the demand curves continue to shift as
consumers tastes reflect the new information.

If the markets are open to imports and exports the above processes would be modified
somewhat. For example, foreign barley producers might decide to export some of their
barley to the country concerned when the price there rises, and domestic wheat
producers do have the option of exporting some of their surplus production. But the main
argument still holds.

Note that this question provides a good illustration of demand curves shifting due to a
change in tastes, as discussed in Chapter 3 (page 43).


7 Entry barriers permit supernormal profits to be maintained; the latter may attract entry, but
the barriers stop it actually taking place (or at least slow it down). Important barriers in
practice would include (see any intermediate industrial textbook for a fuller discussion):
patents;
the need for government permits or licences to operate in certain industries;
existing firms control over raw materials or other inputs into production;
shortages of certain types of input, particularly skilled labour;
brand allegiance among consumers;
economies of scale.

As the last entry above suggests, economies of scale are a standard barrier to entry. If
scale economies are large then a large firm can always undercut a small firm, and with a
homogeneous product the end position would logically be a monopoly. Some industries
Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.
may be a natural monopoly for this reason (we come to this idea in Chapter 8, and at
greater length in Chapter 13), although in practice the monopolizing forces may be
mitigated by transport costs and product differentiation, if not by government intervention.

Teaching Note Entry barriers have not been introduced yetthey come in Chapter 8.


8 Technical progress will tend to lower the cost curves for a firm which uses new plant and
equipment. This means that new plants will earn positive profits, and will therefore be built
immediately. This is turn will push the short-run industry supply curve to the right, and
lower price. The expansion in capacity and the fall in price will continue until price equals
ATC for the new plants. Older plants will now be making a loss, and will tend to leave the
industry (see below). Eventually the industry will settle down to a new equilibrium in which
all plants use the new technology and make zero profits at the new lower price. See Box
7.5.

Students should be able to think of several reasons why some industries decline and
others grow. Demand changes are the obvious cause, as the invention of new products
reduces the demand for older substitutes (paraffin and electric heaters, or typewriters and
personal computers, for example). In some cases a raw material may run out, or
overseas competition may undercut domestic producers (steel, shipbuilding, and so on
are examples for the UK). Note the difference here between an industry which is declining
as a whole, or world-wide (the paraffin heaters case), and one which is declining in some
countries only (shipbuilding, for example).

A firm should quit a declining industry when it can no longer cover its variable costs
(discussed at various points in this chapter in the main text).


9 Input prices are the main factor here. See Figure 7.11 and the surrounding text for the
explanation.


10 Allocative efficiency occurs when it is impossible to reallocate resources so as to make
someone better off without also making someone else worse off. See the discussion in
the text on pages 147149.


Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.
Chapter 8: Monopoly

This chapter is the second of three covering the standard range of market structures. It goes
to the opposite end of the spectrum from the previous chapter on perfect competition. There
is now only one firm in the industry (or, in part of the chapter, several firms acting as a
cartel). Again the material covered here is fairly standard, both in terms of content and the
way the argument is developed. The focus is on private firms, but there is a brief look ahead
in the introduction to the public policy discussion in Chapter 13, and Box 8.1 and the first case
study consider recent moves to dismantle monopolies in postal services and other (previously)
state-owned industries.

The first main part of the chapter deals with a monopolist charging a single price. It points out
that the firms demand curve is now the same as the industrys, and goes on to set out the
relations between average, marginal and total revenue. The short-run equilibrium of the
monopolist is shown on the standard diagram where MR = MC; the text stresses that this can
only occur in the upper half of the demand curve (which is linear throughout the chapter). The
monopolys profit level is discussed, and the absence of a supply curve. Finally the case of the
multi-plant monopolist is introduced, although only briefly. In particular, the results that this
monopolist will set the marginal costs of all plants equal, and that the firms MC curve is the
horizontal sum of the MC curves of the individual plants, are stated but not shown
diagrammatically.

The short second section considers the allocative inefficiency of the monopolist, comparing it
with the case of perfect competition in Chapter 7. The deadweight loss is defined.

The third section goes on to the case of the price-discriminating monopolist. After
defining the term it discusses why such practices should be profitable, considering
discrimination on a number of different bases, and the conditions necessary for the pursuit of
discrimination. The consequences are then set out, in terms of higher profits and (generally)
output. [Note the use of generally here; this result is not always true, but it is for the case of
linear demand and increasing marginal cost used in Figure 8.7 and the appendix. These
assumptions are, reasonably enough, not explicitly noted in the text.] The section ends with
a brief discussion of the normative aspects of price discrimination, and Box 8.3 gives some
useful examples (including one from the thirteenth century BC).

The next section moves on to the long-run equilibrium of the monopolist, which brings in the
topic of entry barriers and Schumpeters creative destruction. The last theoretical section is
entitled Cartels as monopolies and makes the point that monopolistic behaviour is not
limited to the case where only one firm exists. It includes a subsection on the problems
facing cartels, in terms of their stability given the incentive to cheat.

There are four case studies in this chapter. The first explores the recent change of mind over
whether state-owned monopolies are really the natural monopolies they were once thought
to be, and extends the discussion of postal monopolies in Box 3.1 into the telecoms, energy,
and water industries.

The discussion on Cartels as monopolies is picked up neatly in the second (and quite long)
case study, which is about the OPEC cartel. It starts with the 1973 oil price rise. An initial
period of success in the 1970s was followed by reactions in both supply and demand which,
combined with increasing incentives for members of the cartel to cheat, led to a large fall in
OPECs market power. The cartel subsequently recovered market share and therefore power
as world oil consumption rose in the 1990s, aided by the growth of China and India, although a
2010 newspaper report makes it clear that incentives for cartel members to over-produce have
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not gone away. The case study ends with some general theoretical lessons from OPECs
experience.

The third case study is entitled Tamiflu: a monopoly that may not last. Tamiflu is an antiviral
drug that gained huge increases in sales as a result of the bird flu outbreak of 2005, but the
case study explains why this was not the bonanza it might have been for the patent-holder and
the sole licensed manufacturer, Roche. The drugs were largely bought by government-
controlled health authorities, who have some market power too [notethe word monopsony is
not used here], and political factors also came into play. There was a boost to the
manufacturer from the swine flu outbreak of 2009, but the text ends by pointing out that even a
patent does not provide protection against new competing drugs.

The last case study, a short one entitled Fares fair?, concerns a news story about an Office
of Fair Trading investigation into minicab cartels in the UK.

An appendix to this chapter sets out a more formal analysis of price discrimination, using
diagrams.


Note for users of the previous edition

Like the last chapter, this one follows its predecessor in the eleventh edition fairly closely,
with little change in the theoretical sections. Again there is a new Box 8.1 at the start (so the
two pre-existing boxes get renumbered) and minor rewording and updating throughout the
chapter. The largest revision is to the case studies: the first and fourth are new, and the
second and third have both been extensively updated.

It is worth noting here that the technical appendix on price discrimination has been retained,
even though it is no longer mentioned in the Part Two outline on page 107. The end-of
chapter questions are the same as before except that the old Question 4 has been cut (so
following questions are renumbered).


Answers to end-of-chapter questions

1 The table below reproduces parts of the table from Chapter 6, Question 3. The previous
cost figures have been put into italics. MR is the change in TR divided by the change in
output. Profits are denoted by .

Output TC AC MC P TR MR

0 1,000 0 0 1,000
10.0 19.2
20 1,200 60.00 19.20 384 816
5.0 17.6
40 1,300 32.50 18.40 736 564
4.0 16.0
60 1,380 23.00 17.60 1,056 324
5.5 13.6
100 1,600 16.00 16.00 1,600 0
7.0 8.0
200 2,300 11.50 12.00 2,400 +100
9.0 0.0
300 3,200 10.67 8.00 2,400 800
11.0 8.0
400 4,300 10.75 4.00 1,600 2,700
13.5 16.0
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500 5,650 11.30 0.00 0 5,650
16.0
1,000 13,650 13.65


(a) See table.

(b) Over the range 100200, MR (= 8.0) is above MC (= 7.0), and goes from 0 to +100.
However MR is falling fast (it is zero over the next 100 units of output), so a value
well below 200 for optimal output seems justified (note this is supported by the graph
below). If we take an output of 150, price would be 14.0 according to the equation
given. This yields a TR of 2100, and total cost is about 1950, so profit would be about
150.

(c) The graph looks like the one below (stopping the sales axis at 500):

-6000
-4000
-2000
0
2000
4000
6000
0 100 200 300 400 500
Sales

TC
TR

2 The rule for price discrimination is to set MR
1
= MR
2
= MC. The easy way to solve this is
mathematically:

MR
1
= 20 0.08 q
1
= MC = 4 q
1
* = 200 p
1
* = 12 TR
1
= 2400

MR
2
= 10 0.04 q
2
= MC = 4 q
2
* = 150 p
2
* = 7 TR
2
= 1050

Profit = 2400 + 1050 (3504) = 2050

Using the data as given produces the table below. It is not immediately obvious what the
right answers are, particularly for q
1
as MR
1
does not show up as 4.0. However going
between the figures of 8.0 and 0.0 gives q
1
= 200. MR
2
does appear as 4.0 between
outputs of 100 and 200, so take the mid-point of 150. Then we have q
1
= 200, p
1
= 12.0,
q
2
= 150, p
2
= 7.0, giving TR = 2400 + 1050 = 3450 and TC = 1400. Profit is then 2050 as
before.

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Output P
1
TR
1
MR
1
P
2
TR
2
MR
2



20 19.20 384 9.60 192
17.6 8.8
40 18.40 736 9.20 368
16.0 8.0
60 17.60 1,056 8.80 528
13.6 6.8
100 16.00 1,600 8.00 800
8.0 4.0
200 12.00 2,400 6.00 1,200
0.0 0.0
300 8.00 2,400 4.00 1,200
8.0 -4.0
400 4.00 1,600 2.00 800
16.0 -8.0
500 0.00 0 0.00 0



Note that there is no point in comparing the results here with those in Question 1 (where
there was no discrimination), because the second market here is additional to the one we
had before.


3 The first demand curve is p = 20 0.04q; inverting this gives q = 500 25p, so dq/dp =
25. Elasticity () = (p/q).(dq/dp), so for the listed sales levels we get the results below.
Similarly the second curve is p = 10 0.02q, which gives q = 500 50p and dq/dp = 50.

Output P
1

1
P
2

2



20 19.2 24.00 9.60 24.00
40 18.4 11.50 9.20 11.50
60 17.6 7.33 8.80 7.33
100 16.0 4.00 8.00 4.00
200 12.0 1.50 6.00 1.50
300 8.0 0.67 4.00 0.67
400 4.0 0.25 2.00 0.25
500 0.0 0.00 0.00 0.00


Total revenue is maximized for output between 200 and 300, which produces a value of
between 1.50 and 0.67. In fact TR is maximized halfway down the demand curve, when
MR = 0, at an output of 250; at this point price in Market 1 is 10, so = (10/250)
(25) = 1. Again, Market 2 gives (5/250).(50) = 1, as expected.

Demand is inelastic at sales levels 300 and 400 in the table; TR is given in the table for
Question 2 above.


4 Figure 8.6 gives the answer: the monopoly generates a deadweight loss.


5 Basically the cartel behaves like a monopolist, restricting output and raising price. This,
and the reasons for instability, are well explained in the penultimate section of the
chapter.
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6 It should adjust output until the marginal cost in each plant is the same. The explanation
is basically a proof by contradiction: if the marginal cost in one plant was higher it would
pay the firm to shift some production to the other plant, until the two marginal costs come
into line. Note that if both plants had constant but different marginal costs, then the plant
with the higher MC would be shut down. See text on page 159160.


7 Because it can take advantage of the different demand curves in the different markets
(assuming they are differentif not, there is no benefit to the separation). This is price
discriminationsee pages 161164 of the main text.


8 Because marginal revenue will be negative there. If demand is inelastic the monopolist
could raise its price by (say) X per cent. This will reduce output by less than X per cent
(by definition of inelastic) and thus total revenue will rise. Additionally costs will (almost
certainly) fall, so profits will get a double boost. The monopolist will continue to raise price
until demand is no longer inelastic. See page 158 in the text.

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Chapter 9: Imperfect Competition

This chapter analyzes markets that fall between the polar extremes of perfect competition
(covered in Chapter 7) and monopoly (Chapter 8). This range includes the vast majority of
markets in practice. The chapter has an introduction, five sections of theory and one section of
case studies. The introduction looks at patterns of concentration in manufacturing, using five-
firm concentration ratios for the UK; it also includes Box 9.1 on globalization of production
and competition.

The first main section considers imperfectly competitive market structures in general,
introducing the ideas of product differentiation, administered prices (that is, firms are price-
makers), non-price competition and unexploited scale economies. The second section
concerns monopolistic competition as developed by Chamberlin. It sets out the assumptions
and the nature of equilibrium, and the equilibrium excess capacity which offsets the benefits of
product differentiation with this market structure. The section ends with a consideration of the
(rather limited) empirical relevance of the theory.

The third section concerns oligopoly. It starts with a clear definition of the term, distinguished
from other market structures by the strategic nature of firms behaviour. The text then goes on
to consider why so many industries are dominated by a few large firms, looking at both natural
and firm-created reasons. Box 9.3 provides an illustration from the world of UK supermarkets.
We then move on to the core of the subject with the oligopolists choice between competition
and co-operation; there is a reference here back to the discussion of cartels in Chapter 8. This
leads into the fourth section, entitled Oligopoly as a game, which (not surprisingly) is an
introduction to game theory. It defines various ideas and develops a simple non-economics
example to give a feel for what is going on in a game structure (page 189) before introducing
the concepts of a Nash equilibrium and a dominant strategy. Box 9.4 explains the Prisoners
Dilemma, the Battle of the Sexes and the idea of a zero-sum game. The main text goes on to
explore co-operative and competitive strategies for two firms, and some real-world strategic
gamesinvolving supermarkets and airlinesare set out in Box 9.5.

The chapter then changes tone somewhat. The first half of the fifth section looks at entry
barriers, such as brand proliferation (illustrated for the case of alcoholic drinks in Box 9.6),
advertising, and product innovation, followed by a subsection on Contestable markets and
potential entry. The text stresses that contestability must be understood as a variable (page
195), as in reality there are always some sunk costs. The final part of the section examines the
effects of oligopoly on the functioning of the economy in three areas: resource allocation and
price signals, where the conclusion is that these operate in a similar way as they do with
perfect competition; the level of profits, which depend on the levels of competition and barriers
to entry; and how conducive oligopoly is to long-run innovation (harking back to the discussion
of creative destruction in Chapter 8)the answer being that it is conducive.

The chapter ends with a section containing three case studies. The first is the newspaper price
wars previously encountered in Chapter 4. The new material explores the competition
between the tabloids which broke out in May 2002 and again at the start of 2006,
emphasising the explicit and direct (page 198) interaction between a small number of very
close competitors. The second looks at the advantages and disadvantages of brands and
patents as entry barriers, and the third illustrates the creative destruction process alluded to
earlier (mainly by listing products which have been superseded by others over time).


Notes for users of the previous edition

Lipsey & Chrystal: Economics 12e
Instructor's Manual
Oxford University Press, 2011. All rights reserved.
This chapter is largely the same as its predecessor in the eleventh edition, although there is
somewhat more rewriting and updating than in the preceding chapters on perfect
competition and monopoly. Table 9.1 on concentration ratios in the UK has been updated.
The new box this time is the third one (Supermarket rivalry), so only the old Boxes 9.39.5
have to be renumbered. Box 9.5 (previously 9.4) on Real-world strategic games has been
extensively revised, with new newspaper-based material supplementing the supermarkets
example and replacing the text in the airlines example, and the digital TV example cut
altogether. Box 9.6 (9.5 as was) has been extensively updated and expanded to reflect
changes in the alcoholic drinks market. The case studies have not been changed, except for
a short addition on the renewal of the newspaper price wars in 2006. The questions at the
end of the chapter are exactly the same as before.


Answers to end-of-chapter questions

1 (i) (a) Firm A does not have a dominant strategy: if X chooses aggressive then A would
do better with aggressive, but if X chooses passive then so should A. The same
applies to Firm X, as the matrix is symmetric.
(b) The Nash equilibrium is for both to play passive; neither will want to move away
from this position once it is established.
(c) The co-operative equilibrium is clearly also passive for both players.

(ii) (a) Firm A does have a dominant strategy: whichever X chooses, A should choose
aggressive, as its payoff is always greater then. X however does not have a
dominant strategy here (the matrix is not symmetric this time).
(b) The Nash equilibrium is for both to play aggressive; neither will want to move
away from this position once it is established. A will not want to drop into the
(50,60) box by playing passive, and X will also lose out by playing passive
because the outcome is then (160,60), which is a fall of 15 for X.
(c) There is a co-operative solution here, as both firms would be better off if they
played passive and ended up with (110,80). If the firms are also actually collusive
they should go for the maximum total payoff of (160,60) and divide the spoils
between themselves afterwards.

(iii) (a) Firm A does have a dominant strategy: whichever X chooses, A should choose
aggressive. X also has a dominant strategy, but it is to go passive.
(b) The Nash equilibrium is the top right hand corner, with payoffs (320,120).
(c) There is no co-operative solution here, unless the firms are also actually
collusivein which case they should both play passive and split the total payoff of
540 between themselves afterwards.

Teaching Note Observant students may notice that Footnote 9 on page 191 suggests we
should refer to a co-operative solution rather than an equilibrium.


2 (i) It is plausible that both firms would learn to play passive consistently in this game,
even though neither had a dominant strategy in Question 1, especially as (175,175) is
such a clearly superior outcome.

(ii) The Nash equilibrium was for both to play aggressive. The benefits of tacit co-
operation with both playing passive might lead to this in a repeated game, but
aggressive is so beneficial for A that this does not seem very likely.

Lipsey & Chrystal: Economics 12e
Instructor's Manual
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(iii) The Nash equilibrium yields (320,120), which is ideal for A but not very good for X.
There is perhaps a strategy for X of playing aggressive from time to time, which
damages A considerably, with the implicit promise of playing passive consistently if A
doeseffectively offering A 300 for every round of the game rather than a mix of 320
and 250.


3 This is revision material; see Figure 9.1(i) and the accompanying text. If there is pure profit
in the short run, other firms will enter the industry (see page 183).


4 The text discusses brand proliferation and advertising as particularly relevant to oligopoly.
Other barriers to entry mentioned in the answer to Question 7 in Chapter 7 were:
patents;
the need for government permits or licences to operate in certain industries;
existing firms control over raw materials or other inputs into production;
shortages of certain types of input, particularly skilled labour;
economies of scale.

The benefits to existing firms are fairly obvious, as barriers to entry permit supernormal
profits to be maintained (at least in the short run).


5 See the definition on page 189 or page 200. A Nash equilibrium is self-policing because no
firm has an incentive to move away from it.


6 Various answers are possible here. The text has some discussion on page 181. Other
points would include:
monopolistic competition is all about differentiated products, which means non-price
competition;
non-price competition may be seen as less aggressivea mutually destructive quality
war is less likely than a mutually destructive price war;
it may be harder for competitors to monitor;
offering different quality levels, or using advertising, may be seen to expand the market
rather than directly taking market share away from competitors.

All these have an element of live and let live which direct price competition does not, and
which recognises the mutual interdependence of competition among the few (to quote
Fellner).