Assignment 2: The Theory of the Firm, Labor Markets, and Imperfect Information

1. Discuss what is monopolistic about monopolistic competition and the difference between perfect competition and monopolistic competition.

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Pure monopoly and perfect competition are the two opposites of the market spectrum. Monopolistic competition is between them nearer to the competitive side; it has the following features (Stone, 2011, pp.237-238):

A lot of competitors with a small market share;

Low barriers for entry and exit in a market;

Product differentiation. It implies that many small monopolistic competitors offer products that consumers perceive differently.

Product differentiation is the main factor that defines the monopolistic character of monopolistic competition. Monopolistic competitors differentiate their product through advertising, innovation, location, etc. It gives them an ability to increase prices without a threat of losing their customers while it is impossible in case of competition. In other words, product differentiation provides a monopolistic competitor with modest monopolist power that allows adjusting its output in ways that establish control over product price.

Further, monopolistic nature of monopolistic competition manifests in the similarity of its demand curve to the monopolists demand, but with more elasticity of demand. It is explained by the availability of substitutes in the market that can result in a substantial decrease in output demanded upon any increase in prices (Stone, 2011, p.238). In addition, like a monopolist, monopolistic competitive firms face a marginal revenue curve with a negative slope (Tian, 2013, p. 199).

The differences between perfect and monopolistic competitions include the following:

Monopolistic competition with a lot of small competitors, low entry, and exit barriers in the market looks like perfect competition, but, in contrast to homogeneous products of the last one, it has differentiated products.

In comparison with the long-run output and price for perfect competitors, output of monopolistic competitors is a little lower and is sold at higher price. In other words, monopolistic competitive firms earn profit by producing less and charging more.

Real competition between companies in conditions of perfect competition that is slightly diluted in monopolistic competition.

The absence of monopoly power of participants in perfect competitions; meanwhile, monopolistic competitors have such power.

2. Movie theaters charge differing prices to adults, children, and students; additionally, most theatres charge lower prices for afternoon showings. Discuss this pricing strategy and how it can maximize profits for the movie theater.

Movie theaters as firms that sell differentiated products through innovation, advertising, or location have some monopoly pricing power. Firms with some monopoly power utilize the concept of price discrimination - charging different consumer groups different prices for the same product - to increase their profits (Stone, 2011, p. 215). Likewise, movie theaters charge differing prices to adults, children, and students; additionally, most theatres charge lower prices for afternoon showings. For example, children and students might pay less for a movie ticket than adults do. Their successful price discrimination is based on the following (Stone, 2011, p. 216):

Having some monopoly power or control over prices;

An ability to separate markets into different consumers groups depending on their elasticity of demand;

Preventing arbitrage that implies making impossible or unprofitable for low-price buyers to resell to higher-price buyers.

The first price discrimination implies charging each consumer the maximum price that he/she can afford. The second-degree price differentiation implies charging different prices to customers depending on the quantities of the product they purchase. For example, companies may

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charge a high price for initial purchases, and then reduce the price when consumers have bought a certain quantity. Movie theaters use second-degree discrimination where customers are targeted by their action (visiting afternoon showings). The third-degree price discrimination means charging different prices to different groups of consumers. Movie theaters also use third-degree price discrimination where customers are targeted by their type adults, children, and students (Nalebuff, 2009, p. 223). The less elastic market (adults) is offered a price that is higher than the price offered to the more elastic market (children and students). Profits are maximized for both markets by selling additional output at lower prices in elastic markets and lower output at increased price that is not so much more that they end up being excluded from the market in inelastic markets (Nalebuff, 2009, p. 223). Theaters earn profits that exceed those which would come from a normal one-price policy. In addition, with an offer of afternoon showings at discounting price, high-value customers have the option to act like low-value customers.

Thus, movie theaters increase profits by charging separate prices for different groups. Profits are maximized for all markets. Besides, discounting prices for afternoon showings generate profits from all separate groups. Theaters that have some monopoly power can offer separate prices without driving their customers from higher-priced shows to lower-priced ones.

3. When you apply for an insurance policy, such as life insurance or health insurance, the insurance company will require you to get a physical examination. The results of the physical exam are shared with the insurance company. Explain why insurance companies may require applicants to receive a physical exam using the concept of adverse selection.

The requirement of insurance companies for applicants to receive a physical exam is explained by the concept of adverse selection. Adverse selection occurs when firms sell products of different qualities at the same price because of asymmetric information (Stone, 2011, p.85).

Asymmetric information for insurance companies is originated from the fact that people who are above the average risk, on the basis of which insurance rates are determined, are most likely to purchase insurance. It leads to the increase of higher risk policy holders in the client base of insurance companies or the adverse asymmetry of the insurance pool. Therefore, insurers have to make payouts exceeding projections and incur financial losses.

To cope with this problem, insurers offer policies at different prices to different groups. The requirement to receive a physical exam reduces asymmetric information and provides more accurate separation of groups. This separation allows low-risk individuals to get policies with high deductible and co-payments, but lower monthly premium. However, high-risk individuals perceive these policies to be not attractive due to the projection of their high cost caused by the payment of all their monthly premiums, many co-payments, and full deductible.

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