Unit 4 · 15 to 22% of the exam

Unit 4 practice test: Imperfect Competition

twelve questions, every option explained

12 exam-style questions from the unit, free, with an explanation for every option. Most are multiple choice, as on the real exam; a few ask for a number or have you shift a curve on a graph, and sets share one data table, graph or scenario. Covers: Introduction to Imperfectly Competitive Markets; Monopoly; Price Discrimination; Monopolistic Competition; Oligopoly and Game Theory.

Start at question 1

Scenario

The food trucks on Cobalt Street

Dozens of food trucks park on Cobalt Street (invented). Each has its own menu and style, and a new truck can start within a month. Last spring, Fennel and Fire, a truck selling spicy noodle bowls, earned an economic profit: long lines every lunch. By autumn four new noodle trucks had parked nearby, and Fennel and Fire's lines were shorter.

1. Why did new noodle trucks arrive?

  1. Demand for lunch on Cobalt Street had just risen
  2. Fennel and Fire was earning an economic profit, and entry was easy
  3. The city banned other kinds of food trucks
  4. Fennel and Fire was making a loss, so rivals saw a chance
Show the answer

Fennel and Fire's economic profit signaled that this kind of truck earned more than the owners' next best use of their money and time, and entry was easy.

  • Demand for lunch on Cobalt Street had just risen: Entry follows economic profit; a demand change matters only through profit.
  • Correct: Fennel and Fire was earning an economic profit, and entry was easy: Right: profit attracts entry when there are no barriers.
  • The city banned other kinds of food trucks: Nothing in the description says so; entry was easy for any truck.
  • Fennel and Fire was making a loss, so rivals saw a chance: Losses push firms out; rivals entered because of profit.

2. How did the new trucks affect the demand for Fennel and Fire's bowls?

  1. Demand increased and became less elastic
  2. Demand did not change; the truck simply cut its price
  3. Demand decreased and became more elastic
  4. Demand decreased and became perfectly inelastic
Show the answer

With close substitutes nearby, some of its buyers switched, so its demand decreased (shifted left) and became more elastic, since buyers now had more choices.

  • Demand increased and became less elastic: More rivals take buyers away and add substitutes.
  • Demand did not change; the truck simply cut its price: Buyers moved to the new trucks at every price, so demand itself shifted.
  • Correct: Demand decreased and became more elastic: Right: fewer buyers at each price, and more substitutes.
  • Demand decreased and became perfectly inelastic: More substitutes make demand more elastic, not less.

3. If trucks keep entering while there is profit, what will Fennel and Fire earn in the long run?

  1. A smaller but still positive economic profit
  2. An economic loss, since its lines are shorter
  3. Zero accounting profit, with its price equal to MC
  4. Zero economic profit, with its price equal to ATC
Show the answer

Entry continues until each truck's demand is tangent to its ATC: price equals ATC and economic profit is zero (a normal profit).

  • A smaller but still positive economic profit: Easy entry keeps going until economic profit is zero.
  • An economic loss, since its lines are shorter: If losses appeared, trucks would leave until profit returned to zero.
  • Zero accounting profit, with its price equal to MC: Zero economic profit still covers the owner's opportunity costs; and P stays above MC.
  • Correct: Zero economic profit, with its price equal to ATC: Right: entry stops when the profit is gone.

4. Fennel and Fire starts advertising its "secret chili oil" to stand out. If it works, what does it do to the truck's demand curve?

  1. Shifts it right and makes it less elastic
  2. Shifts it left and makes it more elastic
  3. Makes it horizontal, like a price taker's
  4. Lowers its ATC curve, leaving demand where it was
Show the answer

Successful differentiation makes buyers see fewer close substitutes, so demand rises (shifts right) and becomes less elastic, letting the truck raise its price, at least until rivals copy it.

  • Correct: Shifts it right and makes it less elastic: Right: more loyal buyers with fewer substitutes in their eyes.
  • Shifts it left and makes it more elastic: Advertising that works draws buyers in, not away.
  • Makes it horizontal, like a price taker's: Differentiation moves away from a horizontal demand curve.
  • Lowers its ATC curve, leaving demand where it was: Advertising costs money, so it raises ATC; its aim is to raise demand.

Scenario

Skylark Air fares

Skylark Air (invented) is the only airline on the route between two small cities. It sells the same seat for $90 if booked three weeks ahead with a Saturday night stay, and for $260 if booked the week of travel. Tickets carry the traveler's name and cannot be resold. Business travelers usually book late; vacation travelers plan ahead.

5. Which feature of Skylark's fares stops travelers from buying cheap seats and reselling them?

  1. Each ticket carries the traveler's name
  2. Skylark is the sole airline on the route
  3. Seats cost the same to fly whoever books them
  4. Vacation travelers plan their trips ahead
Show the answer

Names on tickets prevent resale; without that, vacation travelers could buy cheap seats and sell them to business travelers, and the two prices could not last.

  • Correct: Each ticket carries the traveler's name: Right: preventing resale keeps the groups apart.
  • Skylark is the sole airline on the route: That gives Skylark market power, another condition; it does not stop resale.
  • Seats cost the same to fly whoever books them: That is why the price gap is discrimination, not a cost difference.
  • Vacation travelers plan their trips ahead: Planning ahead sorts the groups; it does not stop resale.

6. Why does Skylark charge late bookers more?

  1. Late bookers cost Skylark more to fly, so their seats are priced higher
  2. Late bookers' demand is less elastic: they need to fly on that day
  3. Late bookers' demand is more elastic, so they pay more
  4. Late bookers are fewer, so each ticket is scarcer
Show the answer

Late bookers are mostly business travelers who must fly on a given day, so their demand is less elastic. Charging the less elastic group the higher price raises Skylark's profit.

  • Late bookers cost Skylark more to fly, so their seats are priced higher: The seat is the same; the price gap comes from demand, not cost.
  • Correct: Late bookers' demand is less elastic: they need to fly on that day: Right: the higher price goes to the less price-sensitive group.
  • Late bookers' demand is more elastic, so they pay more: A more elastic group would get the lower price.
  • Late bookers are fewer, so each ticket is scarcer: The price follows how sensitive each group is to price.

7. Compared with charging one price to everyone, Skylark's two fares most likely

  1. lower the number of seats sold and raise Skylark's profit
  2. raise the number of seats sold and lower Skylark's profit
  3. raise the number of seats sold and Skylark's profit
  4. leave seats sold unchanged and lower fares on average
Show the answer

Selling cheap seats to vacation travelers who would not pay one higher single price lets Skylark fill more seats, so output rises, and profit rises because it captures more of buyers' willingness to pay.

  • lower the number of seats sold and raise Skylark's profit: The low fare adds buyers, so seats sold rise.
  • raise the number of seats sold and lower Skylark's profit: Skylark would not choose a pricing plan that lowers its profit.
  • Correct: raise the number of seats sold and Skylark's profit: Right: the low fare adds travelers who would not buy at one high price.
  • leave seats sold unchanged and lower fares on average: The cheap fare reaches new buyers, so quantity changes.

8. A monopolist sells 400 units at $30 each. At that quantity its average total cost is $22. What is its economic profit, in dollars?

Type a number. A four-function calculator is allowed, as on the exam.

Show the answer

Profit\text{Profit}=(P−ATC)×Q= (P - \text{ATC}) \times Q=(30−22)×400= (30 - 22) \times 400=3,200= 3{,}200 dollars.

  • Answer: 3200

9. A firm has market power when it

  1. sells more output than any other firm in the market
  2. can raise its price without losing all of its customers
  3. earns positive accounting profit
  4. can sell as much as it likes at the market price set by others
Show the answer

Market power is the ability to raise the price above marginal cost without losing all of its customers; such a firm is a price maker and faces a downward-sloping demand curve.

  • sells more output than any other firm in the market: A large firm can still be a price taker if its product is identical to many rivals'.
  • Correct: can raise its price without losing all of its customers: Right: that is what makes it a price maker.
  • earns positive accounting profit: Accounting profit says nothing about whether the firm can set its own price.
  • can sell as much as it likes at the market price set by others: That describes a price taker, which has no market power.

10. The city replaces the lump-sum license fee with a per-unit tax of $1 on every unit the monopolist sells. What happens?

  1. Quantity falls and the price rises
  2. Quantity and price stay the same and profit falls
  3. Quantity rises and the price falls
  4. Price rises by the full $1 and quantity stays the same
Show the answer

A per-unit tax raises marginal cost, so MC crosses MR at a smaller quantity, and the price read from demand rises. (A lump-sum tax would leave MC, price and quantity unchanged.)

  • Correct: Quantity falls and the price rises: Right: MC shifts up, so MR = MC at a smaller quantity, higher on demand.
  • Quantity and price stay the same and profit falls: That is the effect of a lump-sum tax, which does not change MC.
  • Quantity rises and the price falls: A tax on each unit makes each unit more costly; the firm makes fewer.
  • Price rises by the full $1 and quantity stays the same: Quantity changes because MC changes; the price rise depends on demand.

11. Price discrimination is

  1. charging a higher price for a better version of a good that costs more to make
  2. charging more in a city where shipping costs are higher
  3. cutting the price for each buyer by the same amount during a sale
  4. selling one good at different prices to different buyers, not due to cost
Show the answer

Price discrimination is selling the same good to different buyers at different prices, where the price gap does not come from a difference in cost.

  • charging a higher price for a better version of a good that costs more to make: A better version costs more to make; that is not price discrimination.
  • charging more in a city where shipping costs are higher: A price gap that follows a cost gap is not discrimination.
  • cutting the price for each buyer by the same amount during a sale: A sale for all buyers is one price, not different prices for different buyers.
  • Correct: selling one good at different prices to different buyers, not due to cost: Right: the prices differ because buyers differ.

12. A cell of a payoff matrix is a Nash equilibrium when

  1. neither player can gain by changing its strategy alone
  2. it gives the largest combined payoff
  3. both players earn the same payoff
  4. one player earns its largest payoff in the matrix
Show the answer

In a Nash equilibrium each player is making its best response to the other's choice, so neither can gain by changing its own strategy alone.

  • Correct: neither player can gain by changing its strategy alone: Right: each choice is a best response to the other.
  • it gives the largest combined payoff: The joint-payoff cell may not be stable; in a prisoner's dilemma it is not.
  • both players earn the same payoff: Equal payoffs have nothing to do with whether either player would switch.
  • one player earns its largest payoff in the matrix: The other player may want to switch from that cell.