Profit+maximizing+markup+for+monopoly+and+monopolistic+competition+and+Cournot.++asymmetric+information,+adverse+selection,+moral+hazard

by: Grant Knies
 * __Profit Maximizing Markup for Monopoly, Monopolistic Competition, and Cournot Oligopoly. Asymmetric Information, Adverse Selection, and Moral Hazard.__**


 * Profit Maximizing Markup for Monopoly, Monopolistic Competition, and Cournot Oligopoly.**


 * __Definition:__** The profit-maximizing markup for monopoly and monopolistic competition indicates the price, equal to marginal cost or greater than marginal cost, which should be charged depending on the own-price elasticity of the product. (Baye, 2006) The formula for price that maximizes profit is the markup factor multiplied by marginal cost (MC). The markup factor is simply the products own-price elasticity (E) divided by one plus the products own-price elasticity (1 + E). The formula for price that maximizes profit for Monopoly and Monopolistic Competition is defined mathematically by:

P = [E / 1+ E] MC

The above is also true for Cournot Oligopolies with only one exception; the number of identical firms making up the Cournot Oligopoly must also be taken into account. The formula for price that maximizes profit in a Cournot Oligopoly is defined mathematically by:

P = [N E / 1+ N E] MC


 * __Application:__** When applying the profit-maximizing markup to a monopoly or a firm competing in a monopolistically competitive environment, there are things two remember. According to J.M. Rives, author of “The Profit-Maximizing Markup Formula with Linear Demand”, the first thing to remember “…is that more elastic demand gives rise to a smaller markup.” When a product has many available substitutes its markup will be low and its profit-maximizing price will be closer to marginal cost. For example, if a company selling shoes in a monopolistically competitive environment and believes that demand for its shoes is less elastic than the demand for its competitor’s shoes, then the company would have a higher markup and price than its competitor, given both companies have equal marginal costs.

The second thing to remember is the direct relationship between marginal cost and the profit-maximizing price. The higher/lower the marginal cost, the higher/lower the profit-maximizing price. For example, company A and company B have the same elasticity and the same markup factor. However, if company A has a higher marginal cost than company B, then company A would also have a higher profit-maximizing price than company B. The difference in the two companies’ profit-maximizing price would simply be the difference between the companies’ marginal costs. When applying the profit-maximizing markup to a Cournot Oligopoly there are three important things to remember. The first two things are mentioned above and are the same if they are being applied to a monopoly, a monopolistically competitive environment, or a Cournot Oligopoly. The third and additional thing to remember when applying the profit-maximizing markup to a Cournot Oligopoly is that as the number of identical firms increases the markup factor gets smaller and the profit-maximizing price gets closer to the marginal cost (Baye 2006).


 * Asymmetric Information, Adverse Selection, and Moral Hazard.**


 * __Definition:__** Asymmetric information is a situation that occurs when one party in an economic transaction has better or more information than the other party. Asymmetric information often appears as adverse selection and moral hazard. Adverse selection takes place when individuals have hidden characteristics and a selection process results in a pool of individuals with undesirable characteristics. Moral hazard takes place when a party to a contract takes a hidden action that benefits that party at the expense of another party (Baye 2006).

Although not always easily distinguishable, the major difference between adverse selection and moral hazard is the difference between hidden characteristics and hidden actions. A hidden characteristic is something one party in an economic transaction knows about itself, but is unknown by the other party (Baye 2006). A hidden action is an action taken by one party in a relationship that cannot be observed by the other party (Baye 2006).


 * __Application:__** There are many real world examples of asymmetric information that leads to problems of adverse selection and moral hazard. The insurance industry, inparticularly, faces many issues concerning asymmetric information. Due to this lack of information, companies spend exorbitant amounts of time and money trying to acquire more accurate information. These costs are ultimately passed on to the consumer. However, in some cases, companies can reduce the negative effects of asymmetric information by using incentive based contracts, signaling, and screening. The following real world examples point out problems caused by asymmetric information.

The first example looked at how adverse selection caused Sierra Health Services to lose $2 million in one month (Wechsler 2007). Humana, a competitor, which was no longer going to offer a certain competing plan, was steering its high-cost customers to Sierra Health Services. Although Humana knew these customers were high-cost, Sierra Health Services had no way of knowing these customers cost level because their high-cost characteristics were hidden.

The second example looked at moral hazard in the car insurance industry (Parsons 2003). An insurance company may insure someone who has a perfect driving record expecting that they will continue to be a safe driver. However, the driver, knowing that he is insured has more incentive to speed (be a reckless driver). Since the insurance company cannot observe the driving habits of the driver, the driving habits are the hidden actions. If speeding is the hidden action, it is a benefit to the driver and it comes at the expense of the insurance company.

The more elastic demand _? A. the bigger the markup factor. B. the smaller the markup factor. C. has no effect on the markup factor. D. none of the above Answer: B The more elastic demand is for a product the smaller the markup factor will be for that product.
 * __Multiple Choice Questions:__**

Given an Oligopoly has 2 or more firms. For which of the following is the profit-maximizing price formula the same? A. Monopoly, Monopolistic Competition, and Oligopoly B. Monopoly and Oligopoly C. Monopolistic Competition and Oligopoly D. Monopoly and Monopolistic Competition Answer: D. The profit-maximizing price formula is the same for monopolies and monopolistically competitive firms. The profit-maximizing price formula for an Oligopoly, must account for the number of firms in the oligopoly.

Everything else being equal, a firm with a marginal cost of $5 will have ? A. a higher profit-maximizing price than a firm with a marginal cost of $10. B. a lower profit-maximizing price than a firm with a marginal cost of $10. C. a lower profit-maximizing price than a firm with a marginal cost of $3. D. none of the above. Answer: B. Firms with higher marginal costs will charge higher prices than firms with lower marginal costs, given everything else is equal.

Moral hazard occurs in situations in which _? A. one party in an economic transaction takes a hidden action that benefits itself at the expense of the other party. B. individuals in an economic transaction have hidden characteristics and where a selection process results in a pool of individuals with undesirable characteristics. C. Both A and B D. None of the above Answer: A. Moral hazard occurs in situations in which one party in an economic transaction takes a hidden action that benefits itself at the expense of the other party.

Asymmetric information refers to situations in which ? A. both parties in an economic transaction have the same information. B. one party in an economic transaction has better information than the other party. C. one party in an economic transaction has more information than the other party. D. Both B and C. E. None of the above. Answer: D. Asymmetric information is when one party in an economic transaction has better and/or more information than the other party.

Baye, M. R. (2006). //Managerial Economics and Business Strategy// (5th Edition ed.). New York: McGraw - Hill Irwin.
 * __References:__**

Parsons, Christopher. (2003). Moral Hazard in Liability Insurance. //The Geneva Papers on Risk and Insurance//, 28(3), p448-471.

Rives, J. M. (1990). The Profit-Maximizing Markup Formula with Linear Demand. //Atlantic Economic Journal//, 18(3), p128.

Wechsler, Jill. (2007). Adverse Selection Cripples Donut-Hole Coverage Plans. //Managed Healthcare Executive//, 17(4), p10.Type in the content of your new page here.