Question

A patent gives the inventor exclusive rights to manufacture and sell a product for a certain length of time (usually 17 years). Assume ABCGolf has invented a golf swing analyzer that makes it simple for a golfer to produce a solid golf swing and hit the golf ball long and straight. Further assume that ABCGolf’s patent gives it a monopoly on this golf swing improvement device.

a. ABCGolf is making an economic profit. Draw a correctly labeled graph that includes MR, Demand, MC, and ATC for this monopoly. Be sure your graph correctly shows the profit maximizing price and quantity and shades in the economic profit.

b. The product of ABCGolf uses several exotic raw materials. The government places a tax on those raw materials, and the MC and ATC both increase. How will the profit maximizing price and quantity change as a result? How do you know?

c. Assume that the government cancels ABCGolf’s patent. Other firms are now allowed to produce and sell this very popular device. What will happen to ABCGolf’s profits in the long-run? What will happen to price and quantity in this newly competitive market?

Answer 1

a)

Just remember that profits are maximum when MR=MC. The quantity corresponding to this has been labelled Q*. The price corresponding to this quantity (on the demand curve) has been labelled P*.

Profits are simply the difference between price and average total cost multiplied by the quantity.

b)

A tax increases per unit costs for a firm. This shifts the cost curves up. I've called the pre-tax MC and ATC curves MC_OLD and ATC_OLD and drawn them using dotted lines. Accordingly, the post-tax curves have been named MC_NEW and ATC_NEW and have been drawn normally. Basically, MC_NEW and ATC_NEW are just MC_OLD and ATC_OLD but shifted up a little.

Remember, profits are maximum when marginal cost equals marginal revenue. I've labelled the point where MC_OLD equals MR as B and the point where MC_NEW equals MR as A. The quantities corresponding to these have been labelled Q*_OLD and Q*_NEW. The prices corresponding to these quantities on the demand curve have been named P_OLD and P_NEW. Notice that taxes increase the price and reduce the quantity.

c)

If the government cancels the patent, seeing ABCGolf's supernormal profits more and more firms will enter the market. This will continue till all supernormal profits disappear and economic profits become 0. This can only happen if price equals minimum ATC. Now notice when price equals minimum ATC, quantity is greater while price is much lower. So as the market becomes competitive, quantity increases and price drops.