Chapter 1
Introduction
Welcome to the solutions manual for Industrial Organization: A Strategic Approach (IOSA) by
Jeffrey Church and Roger Ware. This
... [Show More] manual contains the solutions to the end of chapter problems
found in IOSA. The solutions should have sufficient detail that students can follow the derivations
and replicate the solutions. The solutions are available by chapter in three different configurations:
all problems, odd problems, and even problems at
http://www.econ.ucalgary.ca/iosa/IM/
In addition there are three versions of this solutions manual, corresponding to all, odd, or even
problems.
The solutions were prepared with the assistance of David Krause at the University of Calgary
and Andrea Wilson and Alexendra Lai both at Queen’s University.
Warning
Instructors may not post these pdf files on their websites unless they are able to restrict access to only
their students. Please be considerate of other instructors who may use these problems for exams
and assignments and will not appreciate their students having access to the solutions. Resist the
temptation to post the answers and impose—potentially significant—costs on other IO instructors.
Comments
If you have questions, comments, and/or find errors please contact either
Jeffrey Church ([email protected]) for chapters 2, 3, 4, 7, 8, 9, 10, 11, 12, 13, 14, 19, 24,
25, and 26 or
Roger Ware ([email protected]) for chapters 5, 6, 15, 16, 17, 18, 20, 21, 22, and 23.
1
2 Church and Ware Solutions Manual
Chapter 2
The Welfare Economics of Market
Power
1. Profit maximization by a monopolist requires producing where
P m
(1
1
"
) = MC(Qm
):
On the inelastic portion of demand, " < 1 which implies that (1=") > 1. So on the inelastic
portion of demand MR is negative and since MC is not, the monopolist can increase profits
by reducing output. Intuitively, on the inelastic portion of the demand curve a 1% increase
in price leads to a reduction in demand less than 1%, so total revenue increases as price
increases and quantity decreases. Profits will increase because total revenue rises and total
cost decreases. This will be true until demand becomes elastic, in which case an increase in
price (or equivalently a reduction in output) will decrease both total revenue and total cost.
Provided MC > MR, the reduction in output will increase profits.
2. Deadweight loss is equal to DWL = (1=2)(P m MCm
)(Qc Qm
). Multiply through by
(P m
=P m
)(Qm
=Qm
), rearrange and let K = (Qc Qm
)=Qm
. Then DWL equals
(1=2)KLP mQm
:
If MC is constant then Qc = 2Qm
and K = 1. For K < 1, Qc < 2Qm
which is true if
marginal cost is increasing.
3. The welfare effects of lowering the price of long distance service (market one) to its marginal
cost and raising the price of local service (market two) to its marginal cost are shown in Figure
2.1. Consumers of local service suffer a loss of surplus equal to the sum of areas A and B,
so the move is not a Pareto improvement. It is however a PPI since total surplus increases by
F in market one and by G in market two. If the firm was breaking even at the initial prices,
quasi-rents in market one of E would equal the sum of its operating losses in market two (the
sum of areas G, A, and B) and its fixed costs.
4. (a) Since the number of cabs is unstated, it is reasonable to infer that this is a question about
the long-run equilibrium and that the number of cabs is variable. If so zero economic
profits requires that the equilibrium price be 5. At this price the number of rides is 1000,
so if each taxi cab operates at capacity, the minimum number of taxi cabs is 50
4 Church and Ware Solutions Manual
P
A B
C
D
E F
G
MC
D2 D1
P1
P2
Q2 Q1
Figure 2.1: Problem 2.3
Chapter 2. The Welfare Economics of Market Power 5
Q
P
(a)
(b)
(c)
D
D
1
2
SSR(n=70)
SSR(n=50)
1000 1400
5
25
Figure 2.2: Problem 2.4
(b) For P 5 the supply of rides is perfectly inelastic and equal to 1000. The price that
clears the market by setting the quantity demanded equal to 1000 is 25. So P = 25, Q = 1000, and the profit per taxi cab is 400.
(c) Free entry insures that the price is restored to 5. At this price 1400 rides are demanded
and the minimum number of taxi cabs will be 70. Profits of 400 attracts entrants, and
price falls as supply increases until profits become zero.
(d) See Figure 2.2
5. (a) For p 5 the short-run supply is 1900 rides. Demand equals supply when p = 5 and
the profit per taxi cab is zero. The taxi cab market is in long-run equilibrium because
economic profits are zero.
(b) In the short-run capacity is fixed and the price must increase to 55 to reduce demand to
1900 rides. At this price the profit per taxi cab is 1000. The long-run competitive price
is 5, so the new long-run equilibrium number of rides is 2900, provided by 145 taxi cabs,
and the profit per taxi cab is zero.
(c) In aggregate at p = 5 the taxi cab drivers are willing to supply up to 2900 rides. At p = 5
demand is 1400 rides, so there is no capacity constraint and the short-run equilibrium is
6 Church and Ware Solutions Manual
q = 1400, p = 5, and = 0. It is reasonable to assume that each cab will operate at
capacity in the long run, so there will be exit and the number of cabs will fall to 70 and
the long-run equilibrium will be q = 1400, p = 5, n = 70, and = 0.
6. (a) Setting price equal to marginal cost and solving for y, the supply function of a competitive firm is
y(p) = p
2w
if f is a sunk expenditure since then marginal cost is always greater than average avoidable cost. If f is not sunk then this is the supply function provided p > pmin. Setting
MC = 8y equal to AC = 4y + 100=y and solving for y yields ymin = 5, so pmin = 40.
If p = pmin then the firm is indifferent between supplying 0 and 5. For p < pmin the
firm will supply 0.
Since there are n identical firms, the market supply function is
ny(p) = S(p) = np
2w
if f is sunk. If f is avoidable then this is the supply function provided p > 40. For
p < 40 supply is zero.
(b) The competitive equilibrium price is found by setting supply equal to demand, D(p) =
S(p), or
A p =
np
2w
:
Solving for p,
p
c(n) = 2wA
2w + n
:
Substituting this into either D(p) or S(p) the equilibrium quantity is
Qc(n) = nA
2w + n
:
Substituting the equilibrium price into the supply function for a firm, each firm produces
y
c(n) = A
2w + n
:
The profits of each firm are defined as = py C(y). Substituting in the expressions
for p, y, and C(y) as a function of n, equilibrium profits as a function of n are
c(n) = wA2
(2w + n)2 f
if f is avoidable and equilibrium quasi-rents are
c(n) = wA2
(2w + n)2
if f is a sunk expenditure.
(c) For f avoidable p = 80, Q = 20, y = 10, and = 300. The market equilibrium is
illustrated in Figure 2.3 and the representative firm in Figure 2.4. For f sunk the market
equilibrium is illustrated in Figure 2.5 and the representative firm is illustrated in Figure
2.6 in the short-run and Figure 2.4 in the long-r [Show Less]