Question

For question number 15 give an explanation to the following scenarios. (9.5 pts)

Scenario A: In a monopoly market the lure of above-normal profits may give a firm an incentive to develop new products and technologies.

Scenario B: The rising demand for eclecticity in California during the year 2000 decreased the elasticity of demand for electricity generators, giving the generating companies an incentive to close down plane and send electricity prices soaring.

Scenario C: Why do monopolistic competitive firms use advertising to inform consumers about their products?

Scenario D: As more firms enter a monopolistic competitive market, why does the market demand curve stays the same?

Answer 1

(Scenario A)

A monopolist earns super-normal profits in short run if its price, derived by equality of MR and MC curves, lies above ATC curve. Market demand remaining unchanged, the lower the ATC, the higher the price, so firms have an incentive to develop new products to increase economies of scope, and new technologies to lower ATC, in order to increase profits.

(Scenario B)

A decrease in elasticity of demand means that demand has become more inelastic compared to earlier period. Therefore, if electricity companies close down plants and increase electricity price, consumers are now less price-sensitive than before (since demand is inelastic), therefore a rise in price will increase total revenue.

(Scenario C)

In monopolistic competition, there are numerous sellers in the market but each sells a slightly differentiated product, therefore they act as price setters. Advertising is a major tool of product differentiation by such firms.

(Scenario D)

Entry of new firms in monopolistically competitive market increases market supply, but market demand is not affected by new entry, which is solely a supply side factor. Market demand remains unchanged, but individual firm's demand falls.