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Profit Maximizing in the Market for Air Travel

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Formerly, the market for air travel within Europe was highly regulated. Entry of new airlines was severely restricted, and air fares were set by regulation. Partly as a result, European air fares were higher than U.S. fares for routes of comparable distance. Suppose that, for a given European air route (say, London to Rome), annual air travel demand is estimated to be

Q = 1,500 - 3P (or equivalently, P = 500 - Q/3)

where Q is the number of trips in thousands and P is the one-way fare in dollars. (For example, 600 thousands annual trips are taken when the fare is $300.) In addition, the long-run average (one-way) cost per passenger along this route is estimated to be $200 (Note that in this case, average cost is the same as marginal cost).

a. Some economists have suggested that during the 1980s and 1990s there was an implicit cartel among European air carriers whereby the airlines charged monopoly fares under the shield of regulation. Given the preceding facts, find the profit-maximizing fare and the annual number of passenger trips.

b. In the last 10 years, deregulation has been the norm in the European market, and this has spurred new entry and competition from discount air carriers such as Ryan Air and EasyJet. Find the price and quantity for the European air route if perfect competition becomes the norm.

c. Given your results in parts (a) and (b), explain why society dislikes monopoly.

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Solution Preview

a) In a monopoly market, the profit-maximizing point is where Marginal Revenue (MR) = Marginal Cost (MC).

We are told that MC = 200

To find MR, first find Total Revenue (TR):
TR = PQ
TR = (500 - Q/3)Q
TR = 500Q - (Q^2)/3

MR is the ...

Solution Summary

This solution uses mathematical analysis to calculate the equilibrium fare and number of trips under both monopoly and perfect competition. The results show why society dislikes monopoly.

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CLEP TEST HELP

Dear Sir:

I am preparing for the Clep test and I am studying out of a book from the library. However, there are no answers so that I can see if I am on the right track. Can you please assist me witht he following questions?

1. If marginal cost is less than average cost, average cost must fall when more
units are produced. T F

2. The demand curve for a firm?s product is also the curve showing
a. total revenue
b. marginal revenue
c. average revenue
d. average profits

3. If marginal revenue and marginal cost are not equal, a firm can maximize its
profits by
a. increasing output if MR > MC
b. decreasing output if MC > MR
c. moving to the output where the slopes of TR and TC are equal
d. all the above are correct

4. Thomas Edison once complained that he was not making a profit selling light
bulbs because his factories were operating 25% below capacity. He estimated
that he could increase output 25% with a 2% increase in production cost. He
sold the additional 25% at a profit on the foreign market although at a price
below what he called the ?cost of production.? We can deduce that Edison really
meant
a. marginal cost was below average cost but less than marginal revenue
b. average cost was greater than variable cost, which exceeded marginal revenue.
c. variable cost exceeded fixed cost but was less than marginal revenue
d. marginal cost was above average cost but greater than marginal revenue

5. Most goods and services that American consumers buy are supplied by
a. oligopolies or monopolistic competitors
b. firms producing where price equals short-run average variable cost
c. firms operating in markets with homogeneous products
d. price takers.

6. To determine whether a market is perfectly competitive, economists examine
the
a. number of firms in the market
b. similarities among the products of the different firms in the market
c. ease of entry and exit by firms in the market
d. economists examine all of the above

7. The basic reason that perfect competition is an ideal of efficiency is that
in perfect competition, marginal revenue always equals
a. total revenue
b. average cost
c. price
d. marginal fixed cost

8. The short-run supply curve for a perfectly competitive firm is that part of
its marginal cost curve that lies above its average variable cost curve. T
F

9. A perfectly competitive firm's profit-maximizing output is 100 units. At
that output level, price = $60, short-run average fixed cost = $25 and
short-run average variable cost = $40. The firm
a. should shut down because it is losing $500
b. should stay open because if it closed down it would lose $4000, which is
more than it loses by staying open
c. should stay open because if it closed it would lose $2500, which is more
than it loses by staying open
d. should stay open because if it closed it would lose $6500, which is more
than it loses by staying open

10. In a perfectly competitive industry, if price is higher than long-run
average cost, we may be sure
a. long run equilibrium has not yet been reached
b. new firms will continue to enter the industry
c. the long-run industry supply curve will shift to the right
d. all the above answers are correct

11. The demand curve facing a monopoly firm is
a. horizontal at the market price
b. the same as the market demand curve for the monopolist's product
c. exactly twice as steep as the market demand curve for the good
d. perfectly inelastic at the market price

12. Which of the following will happen if a natural monopoly is broken up into
a number of smaller firms?
a. the price will fall
b. industry output will increase
c. production costs will increase
d. industry output will decrease

13.. A profit-maximizing monopolist will operate where
a. MR = MC and charge a price equal to marginal revenue
b. MR = MC and charge a price equal to marginal cost
c. MR = MC and charge a price corresponding to demand at that level of output
d. MC = MR and charge a price corresponding to average cost.

14. A profit-maximizing monopolist
a. is just as socially efficient as a perfectly competitive firm in
allocating resources to production since he, too, seeks the largest return on
his investment
b. produces an output level at which marginal utility is greater than marginal
cost
c. produces more output than a perfectly competitive industry
d. always produces in the inelastic region of his demand curve

15. So that, under monopoly
a. too small a share of society's resources is used to produce the monopolized
good
b. Adam Smith's invisible hand assures efficient resource allocation
c. Just the right share of society's resources is being used to produce the
monopolized good
d. MC > MU

16. Monopolistic competitors and perfect competitors are alike in
a. having horizontal demand curves
b. earning zero economic profit in the short run
c. earning zero economic profit in the long run
d. relying on advertising to attract buyers to their products

17. According to the excess capacity theorem, if every firm under monopolistic
competition expanded its output,
a. cost per unit of output would rise.
b. cost per unit of output would fall
c. MC and AC would remain unchanged
d. the industry would become less competitive

18. In oligopoly, we expect
a. frequent introduction of new or redesigned products
b. aggressive advertising campaigns
c. intense marketing research into the impact of price changes
d. all the above are correct

19. From economists? point of view, a multifirm cartel usually offers to society
a. all the cost benefits of large-scale production and none of the allocative
inefficiencies of monopoly
b. all the cost benefits of large-scale production and all the allocative
inefficiencies of monopoly
c. none of the cost benefits of large-scale production and none of the
allocative inefficiencies of monopoly
d. none of the cost benefits of large-scale production and all of the
allocative inefficiencies of monopoly

20. A firm now produces its sales-maximizing level of output. If the firm
increased its output by one unit, its marginal revenue would become
a. negative (minus)
b. smaller, but still positive
c. larger but still negative
d. larger but still positive

21. The maximin criterion can be defined as which of the following?
a. a firm seeks the maximum of the minimum payoffs to its various available
strategies
b. a firm seeks the minimum of the maximum losses among its various available
strategies
c. a firm seeks the maximum of the minimum losses to its various available
strategies
d. a firm seeks the maximum of the maximum gains of its various available
strategies

22. At any given airport, the airlines hold long-term leases for passenger
loading gates. New gates cannot be added without approval of the airlines.
Frequent flier programs are also common in the industry. It is, therefore, more
difficult for a new airline to enter a given airport (market). Such factors
(i) are called barriers to entry
(ii) tend to decrease the contestability of the air travel market
a. i and ii
b. i not ii
c. ii not i
d. neither i nor ii

23. An economy is judged to be efficient if
a. it is good at producing what people want
b. it produces things that people may not want but in the least wasteful way
c. it produces things that people want but maybe not in the least wasteful way
d. it is a free-market economy and not a command economy

24. In an ideally efficient free-market economy, MC and MU of a good are equal
to each other because
a, producers and consumers are free to communicate with each other
b. producers and consumers both respond to the same price for a good
c. consumers must accept the price set by producers
d. producers must accept the price set by consumers

25. An economist would say the price is too high for a certain good if
a. poor people could not afford to buy it
b. nobody could afford to buy it
c. the good?s price was above its marginal cost
d. it is an essential good and takes up a big share of people?s income

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