Question

5) Suppose a firm has market power and faces a downward sloping demand curve for its product, and its marginal cost curve is upward sloping. If the firm reduces its price, then: A) consumer and producer surplus must increase. B) consumer surplus increases, producer surplus may increase or decrease. C) consumer surplus increases, producer surplus must decline. D) consumer and producer surplus must decline.

Answer 1

A firm whose demand curve is downward sloping and has market power is believed to be a firm under monopoly. If the firm reduces its price the consumer's surplus (the difference between the expected price and actual price to pay) will increase as the actual price will decrease thus increasing in consumer's surplus. On the other hand, the producer's surplus (the difference between the ability to supply and the actual supply) may increase or decrease. When price decrease, demand increases other things remaining constant as per the law of demand and therefore demand curve will shift as the demand will become more elastic than before thus the producer's surplus may increase. On the other hand, when price decreases, the revenue will shrink and therefore supply will be reduced and there is a direct relationship between the supply of goods and producers surplus. Thus with a decrease in supply, the producer's surplus will also decrease.

Therefore, the correct answer is (B) consumer surplus increases, producer surplus may increase or decrease.