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[Exam Tutorial] ECO206 Term Test 3 Full Study Package

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University of Toronto St. George

ECO206 – Microeconomic Theory 1. Midterm III Structure Based on analysis of past midterms, there are four main topics that are covered in the third midterm of ECO206: Monopoly, Price Discrimination, Game Theory and Strategic Thinking and Oligopoly. The midterm is usually about 2 hours long and consists of 3 to 5 questions with 3 to 5 sub-questions per question. The total number of questions, including sub-questions, is roughly 12 to 15. 2. Midterm II Statistics 2012 2013 Monopoly 3 4 Price 1 1 Discrimination Game Theory and 5 4 Strategic Thinking Oligopoly 4 3 Total 13 12 Midterm III Questions - Statistics Oligopoly Monopoly 28% 28% Game Theory and Price Discrimination Strategic Thinking 8% 36% Figure 1 - Midterm III Statistics Topic 1: Monopoly Knowledge Summary:  Monopoly is a market structure that is defined by one seller/producer in a market  Can make decisions over how much to produce or what price to charge  The industry’s market demand curve is the same as the monopolist’s demand curve (unlike perfect competition – firm’s demand curve is perfectly elastic and industry’s demand curve is downward sloping)  The marginal revenue of a monopolist is not equal to the price it charges because in order to sell more output, the monopolist has to lower its prices  Monopolists are price makers whereas perfectly competitive firms are price takers (understanding the differences between perfect competition and monopoly will help in understanding the main fundamentals of monopoly structure).  The marginal revenue curve of a monopolist has the same intercept as the monopolist’s demand curve, but twice the slope.  Price elasticity of demand is greatly related to marginal revenue of a monopolist and what prices it should charge. If a monopolist finds itself on an inelastic portion of the demand curve, it can increase profits by raising prices and lowering quantity. If it finds itself on the elastic portion of the demand curve it can increase profits by lowering prices and decreasing quantity  Keep in mind that the goal of a At red star: MR =0, revenue is maximized at this point and PED=-1 monopolist, for our purposes, is to maximize profit.  On a linear demand curve, consumer spending and thus monopolist revenue is maximized when the price elasticity of a good is equal to -1 (i.e. it is unitary elastic). This is the point where marginal revenue is equal to 0 (i.e. where total revenue is maximized, since marginal revenue is the first derivative of the total revenue curve). But, recall the objective of a monopolist is to profit maximize not revenue maximize. So it will not choose to operate where MR=0 but instead where MR=MC (at yellow star). At this point monopolist is producing restricted output at a higher price  creates a deadweight loss. The only time MR=0 is a profit maximizing point is if MC=0 where MC is marginal cost. Fixed costs must be accounted for in the case where MC = 0. Examples from past tests on the next page will elaborate on this.  Why is MC=MR the profit maximizing quantity? Because we know that: Profit = Total Revenue – Total Cost. Suppose this expression is a function of quantity (x). The first derivatives of the RHS will be MR and MC respectively. Setting it equal to 0 we have: MC=MR.  Useful formula for MR: MR = P (1 + ) where P(x) is price as a function of quantity, and PED is price elasticity of demand.  Can also use: MR = price + (change in price)x(quantity sold at old price)  Using the first formula and letting x=1, we can say:  Rearranging we get: , where PED is a negative number. P – MC is known as the monopoly mark up, or how much the monopolist marks up in price above the perfectly competitive price level (which is P=MC) And is the monopoly mark up ratio (or the Lerner’s index). Summary of Questions to be Asked:  What is the profit maximizing level of output and price level?  Calculating fixed costs under positive profit levels  Illustrating monopoly profits and profit maximizing output and price level  Demand under different pricing policies (form of price discrimination, will be covered in Topic 2 but intertwined with monopolies)  To calculate the Lerner index/ mark up ratio Related Past Test Questions: 2013 Midterm III Question 2 Topic 2: Price Discrimination Knowledge Summary:  We are going to focus on three main types of price discrimination: 1. First degree price discrimination: also known as “perfect” price discrimination because it assumes that the monopolist is aware of the reservation price of every single consumer. i.e. it is an individualized price. One way to achieve this is by using a two-part tariff: includes a lump sum fee and a per unit cost. The demand curve becomes the marginal revenue curve when a monopolist uses perfect price discrimination because each consumer is offered a different price (based on their reservation price). Therefore, the monopolist will produce an efficient level of supply but it will accrue the entire consumer surplus. Why is supply efficient? Because the monopolist will produce quantity at which MC= D (=MR).  Notice that the economic profit (green area) under price discrimination is much larger than under a single price policy. 2. Third degree price discrimination: also known as “imperfect” price discrimination. It involves offering per unit prices (no fixed fees) to different consumers who want to buy multiple units of the good. It is unrealistic to think that a producer can perfectly discriminate among its consumers. In this pricing strategy, the producer will identify different marginal curves based on different consumers and produce quantity at MR=MC. This gives rise to different price levels and deadweight loss because the monopolist is restricting quantity at MR=MC. 3. Second degree price discrimination: type of pricing strategy that allows a monopolist to “infer” the type of consumer it is facing. It is often hard to tell who is a “high demander” versus a “low demander” so will try to give consumers an opportunity to ‘self-identify’ themselves. This involves a single nonlinear price schedule, or offering different quantities of a good at different prices. Example: airline tickets – business versus economy.  In conclusion: no deadweight loss under first degree pricing strategy (although this strategy is unrealistic) but deadweight loss is expected under second and third degree price discrimination. Summary of Questions to be Asked:  Calculating and illustrating the largest fixed fee that a monopolist could impose on consumers  Derive prices under first, third and second degree price discrimination  Graphically show consumer and producer surplus under different pricing strategies  Justify optimal pricing strategies Related Past Test Questions: 2012 Midterm II Question 2 Topic 3: Game Theory and Strategic Thinking  Games are going to be defined in terms of the following: 1. Players 2. Order of play: simultaneously versus sequentially 3. Choices 4. Informational Environment: complete versus asymmetrical information 5. Payoffs  Simple game: 2 players with a finite number of strategies – involves a payoff matrix Players: A and B, Order of play: simultaneous, Choices: A – Top, Bottom; B – left, right, Informational environment: complete, Payoffs: matrix below (A, B). Player B Player Left Right A Top 1,2 0,1 Bottom 2,1 1,0  Dominant strategy is the choice/action that always gives a higher payoff to a player. In the example above, the dominant strategy for player A is to play bottom. The dominant
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