Exercises

1. Suppose there is a single monopoly firm that produces a single good, Q. The ordinary demand curve for this good is:

where P is the price of the good and Q is the quantity demanded. Suppose that marginal costs of production are constant and equal to c = 0.

(a) What is the Pareto-optimal price and quantity? How much profit does the firm earn if it charges this price?

Now suppose that the good is potentially harmful to consumers. Let 0 < l < 1 be the consumer's expected dollar loss per unit of the good consumed. The firm can completely eliminate these losses by taking care when it produces each unit of the good. The firm's per-unit cost of care is k < l. Consumers are assumed to be unable to take care, but can perfectly observe the firm's choice of care.

(b) Is it efficient for the firm to take care? Explain.

Now consider the following legal rules:

  • • No Liability
  • • Strict Liability
  • • Negligence Rule where the due standard of care is the efficient level of care.

Suppose that the firm acts as a monopolist.

  • (c) For each legal rule, compute the firm's profits when it takes care and when it does not take care. Does the monopolist always choose the efficient level of care? Which legal rule maximises aggregate welfare? Which legal rule does the firm prefer? Which legal rule do consumers prefer?
  • (d) Suppose that when implementing the negligence rule in part (b), the court makes a mistake and sets the due standard of care below the efficient level of care. Does your answer in part (b) change?
  • (e) Would your answers in parts (a) and (b) change if k > l?

Now suppose that consumers misperceive the losses that are associated with consuming the potentially harmful good. Specifically, if the actual expected losses are l > 0, the consumer perceives these as (1 - a)l. Here,

0 < a < 1 is the degree of the consumer's misperception. If a = 0 then the consumer correctly perceives the potential losses that might be incurred, and if a = 1 then the consumer completely misperceives the potential losses.

Consider again the following legal rules:

  • • No Liability
  • • Strict Liability
  • • Negligence Rule where the due standard of care is the efficient level of care.

Suppose again that the firm acts as a monopolist.

  • (f) For each legal rule and for any level of a, compute the firm's profits when it takes care and when it does not. Does the monopolist always choose the efficient level of care? Which legal rule maximises aggregate welfare? Which legal rule does the firm prefer? Which legal rule do consumers prefer?
  • (g) Now suppose that there are now two firms in the industry, labelled A and B. They act as Cournot duopolists, choosing quantities Q and Q (and levels of care) to maximise their own profits, taking the quantity choice and choice of care of the other firms as given.

Consider the following legal rules:

  • • No Liability
  • • Strict Liability
  • • Negligence Rule where the due standard of care is the efficient level of care.

(h) For each legal rule and for any level of a, find the Cournot equilibrium choice of quantities and care levels. Do the firms always choose the efficient level of care? Which legal rule maximises aggregate welfare? Which legal rule do the firms prefer? Which legal rule do consumers prefer?

 
Source
< Prev   CONTENTS   Source   Next >