Principles of Business Economics - GuidanceNotes

7/31/2019 Principles of Business Economics - GuidanceNotes

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Guidance notes for Topics for Discussion

Contents

Chapters Pages

1. Business Economics: An Overview 2

2. The Analysis of Consumer Demand 11

3. The Analysis of Production Costs 17

4. Analysis of the Firms Supply Decision 26

5. Demand, Supply and Price Determination 33

6. Analysis of Perfectly Competitive Markets 41

7. Analysis of Monopoly Markets 48

8. Analysis of Monopolistically Competitive Markets 53

9. Oligopoly 59

10. Managerial Objectives and the Firm 68

11. Understanding Competitive Strategy 77

12. Understanding Pricing Strategies 87

13. Understanding the Market for Labour 9514. Understanding the Market for Capital 106

15. Understanding the Market for Natural Resources 115

16. Government and Business 121

17. Business and Economic Forecasting 129

18. Business Economics A Checklist for Managers 134


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C H A P T E R 1

Business Economics: An Overview

Question 1

What do you understand by the microeconomic environment and macroeconomic environmentof the firm? List some of the key issues, which the management should be aware of under bothof these headings.

Guidance

The Microeconomic Environmentdeals with: operation of the firm in its immediate market

determination of prices

the firms revenues, costs and employment levels etc.

The Macroeconomic Environmentdeals with:

the general economic conditions of the wider economy of which each firm forms a part.

Key issues under these headings:

(a) Microeconomic environment the factors that enter into price determination, notably market demand and supply.

the factors that enter into the costs of production, notably the output produced, thecosts of factor inputs (land, labour and capital), the scale of production and theefficiency with which the production process is managed.

(b) Macroeconomic environment

the level of economic activity.

the impact of macroeconomic policies involving decisions by government and thecentral bank.

international developments including, for example, the impact of exchange ratesand international trade.

Chapter references: pp. 1 2 and Figure 1.1.


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Question 2

Consider the main issues that the management might take into consideration when deciding howto allocate the firms resources.

Guidance

Management has to decide whatto produce, how to produce and for whom the different goodsand services are to be supplied.

Decisions will be driven by the following:

objectives of the firm

risk and uncertainty

externalities demand in the marketplace

availability of resources

opportunity costs

production costs including the prices of factor inputs

the impact of technology

time dimension (short-run versus long-run).

Chapter references: pp. 3 13 and Figures 1.2 and 1.3.


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Question 3

What do you understand by the term opportunity cost? Give examples from the decision-making of (a) a government policy-maker, (b) a private-sector manager and (c) a public-sector

manager.

Guidance

Opportunity cost is what we forgo when we decide to use resources in one use as againstanother.

Examples:

(a) government

spending more on defence and less on healthcare

increasing taxation and the consequent reduction of private consumer spending

repairing a school roof and spending less on road repairs.

(b) private-sector manager

investing more in new industrial buildings and therefore lower profits distributed

investing in capital equipment as a substitute for manual workers

expanding overseas rather than investing at home.

(c) public-sector manager

employing more doctors and fewer nurses building a new municipal swimming pool instead of more municipal housing

increasing refuse collection services instead of spending more on street cleaning.



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Question 4

From your own experience, give examples of diminishing marginal returns from economicactivity.

Guidance

The concept of diminishing marginal returns refers to the situation whereby as we applymore of one input (e.g. labour) to another input (e.g. capital or land) and then after some

point the resulting increase in output becomes smaller and smaller.

Examples:

growing more and more crops from the same piece of land

trying to produce output beyond the normal full capacity production level by simplysupplying more and more workers

increasing the number of banking staff in a branch without appropriate increases incomputing facilities and physical office space

trying to operate more and more trains with a given rail infrastructure

the impact on educational attainment of excessively increasing the number of studentsthat each teacher is responsible for.



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Question 5

What do you understand by the term externalities? When are they likely to be important?

Guidance

Externalities are the benefits and costs that arise from production and consumption butwhich are not reflected in market prices. These are alternatively called social costs andbenefits.

They are likely to be important for several reasons, involving:

costs: environmental effects, for example, pollution and noise

benefits: the wider social impact of health and education spending faster journey timesbecause of measures, which reduce road congestion etc.

An assessment of the relative costs and benefits will have implications for public-sectorexpenditure and taxation and the allocation of resources.

Recognition of externalities is the focus of a branch of economics known as Cost-BenefitAnalysis.

Chapter references: p. 13 and for discussion of Cost-Benefit Analysis seepp. 324 6, Chapter 14.


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Question 6

Compare and contrast the different forms of competition found in market economies. What arethe possible implications for government economic policy?

Guidance

Forms of market structure:

(a) Perfect competition

very large number of small, independent buyers and sellers.

(b) Monopolistic competition

very large number of producers supplying slightly differentiated goods and servicesto the market.

(c) Oligopoly

a few, relatively large suppliers competing in the market on the basis of a widerange of marketing options including price.

(d) Monopoly

a sole supplier of a goods or service to the market, which can choose either to setthe selling price or to determine the quantity provided to the market.

For further information, comparing and contrasting these different forms of marketstructure, see Figure 1.4 in the book, p. 18.

Implications for government economic policy involve:

decisions regarding the optimal market structure for each industrial sector to maximisesocial welfare

the decisions of firms under oligopoly and monopoly, which have obvious implicationsfor competition policy including market dominance, mergers and takeovers andrestrictive trade practices

competition issues arising from advertising and branding, which may lead thegovernment to introduce consumer protection measures including policy involvingadvertising standards.



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Question 7

What methods might be used to assess a firms competitive environment?

Guidance

Assessing the firms external environment using, for example, a political, economic, socialand technological (PEST) analysis.

Assessing the competitive forces impacting on the firm using Porters Five Forces Model.

An assessment of the firms competitive environment enables the firm to take stock of itsstrengths and weaknesses in an appropriate context.



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Question 8

How might a firm decide on the appropriate strategies to adopt to achieve and maintain acompetitive advantage?

Guidance

The firm will need to make an honest assessment of its external environment and itsinternal resource capabilities.

The firm needs to assess the market structure and the forms of competition it faces.

One approach will be to complete PEST and Five Forces analyses followed by a strengths,weaknessess, opportunities and threats (SWOT) analysis.

The firm will need to take account of its competitive positioning in the marketplace inparticular, determining whether it is best to adopt one of the following strategies:

cost leadership

differentiation

focus.



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Question 9

Select a company with which you are familiar. Conduct a detailed assessment of its competitiveenvironment in terms of:

(a) A PEST analysis

(b) Porters Five Forces Model.

In the context of this assessment, conduct a SWOT analysis of the company.

Guidance

In addressing these tasks, there are a number of points to note to ensure that appropriateanalyses are undertaken.

PEST analysis: avoid producing long lists of every conceivable factor and events that just might

impact on the firm

focus on what you consider to be the key or most important factors and be prepared todefend their inclusion

remember that a PEST analysis is seeking to detect trends in the external environmentof the firm, which will lead to opportunities and threats.

Porters Five Forces Model:

the objective here is to identify the different forces impacting the competitiveenvironment of the firm and hence profitability

avoid lists, which simply identify existing rivals, customers, products etc. the focusmust be placed on the dynamics of the competitive environment

seek to identify the relative importance or impact of each of the Five Forces oncompetition and profitability

this will help focus in on the strategic decisions to be made.

SWOT analysis:

it is important to avoid generating long lists of strengths and weaknesses

those identified should be relevant in the context of the opportunities and threats youdiscuss resulting from the PEST and Five Forces analyses.



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C H A P T E R 2

The Analysis of Consumer Demand

Question 1

A marketing manager at the Ford Company in Belgium is preparing a briefing on consumerdemand for a new model to be sold mainly in other parts of Europe. Consider the issues that this

briefing should contain.

Guidance

Consideration should be given to a wide range of factors, which are likely to impact uponthe demand for the new model including the following:

the own price elasticity of demand

the price of competing car models

the price of complementary goods and services (including, for example, car insurance,road tax and fuel charges, etc.)

the scale of advertising expenditure, which may be needed to build up the brand image

the level and distribution of disposable incomes

the importance of wealth effects and the implications for consumer demand including,for example, property values

changes in consumers tastes and preferences

the cost and availability of credit

expectations concerning future price rises and availability of the new model

population structure and trends.

Particular attention should be devoted to an assessment of the extent to which thesedeterminants of demand may change in the future, which may result in a shift in the demand

curve for the new car model.

Chapter references: pp. 29 31, 36 38 and Figures 2.2, 2.3 and 2.4.


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Question 2

Draw what you consider may be the demand curve for this new model in say, the UnitedKingdom. Illustrate the effect of the following:

(a) a fall in the sterling-euro exchange rate

(b) a recession in the United Kingdom and

(c) an increase in the price of Honda cars made in the United Kingdom.

Guidance

(a) A fall in the sterling-euro exchange rate will make cars imported from Belgium (presumablypriced in euros) more expensive for UK buyers. Hence, the UK demand curve will shift t othe left.

(b) A recession in the United Kingdom will reduce demand in general, as a result of a lowerlevel of national income hence the UK demand curve will shift to the left.

(c) An increase in the price of a substitute Honda cars made in the United Kingdom will,ceteris paribus, result in Belgium-made cars becoming more price competitive hence, theUK demand curve for Belgium cars should shift to the right.



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Question 3

Using the concept of consumer surplus, explain why a supplier might wish to charge more toone group of consumers than another.

Guidance

The decision to charge more to one group of consumers than another involves anappreciation ofprice discrimination. If a supplier is able to charge each group on the basisof the highest price that each is willing to pay, this ensures that no consumer surplusremains. This gives rise to the notion of a discriminating monopolistwhereby each group ischarged a price that just equals the valuation, which they each place on each unit of thegood consumed.

In this way, the supplier will seek to maximise profits.

Chapter references: p. 33 36 and Figure 2.2.


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Question 4

Contrast the likely marketing strategies of:

(a) a food retailer selling via the Internet and

(b) a fine wines retailer.

Explain the reasons for the differences based on the classification of goods outlined in thischapter.

Guidance

The difference in marketing strategies will be dependent on several issues, primarily:

the extent to which the demand for food and the demand for fine wines are sensitive tochanges in prices and incomes

the nature of the food being retailed: normal, inferior or Giffen products

the importance of branding in the context of Veblen products (such as fine wines).

Chapter references: pp. 38 41.


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Question 5

A bus company operates two routes. On route 1, research suggests that the price elasticity is -0.8and on the other route -1.3. The company has decided to revise fares upwards on both routes by

10% this year. Comment on the decision.

What alternative pricing strategy would you suggest?

Guidance

In the case of route 1, an increase in fares of 10% will lead to an increase in overall revenueto the bus company. This follows because demand on this route is relatively price inelastic(i.e. is less than route 1 in absolute terms).

Revenue will fall on route 2 since demand here is relatively price elastic (i.e. more thanroute 1 in absolute terms). As price is increased, overall demand will fall by a greater

proportion.

The bus company should consider droppingthe price on route 2 since demand should riseproportionately more. However, this decision will depend upon how much spare capacityexists on the buses used on this route and other costs associated with this decision.

Similarly, prices could be raised still further on route 1. However, the company must bemade aware that the elasticity of demand is not constant the value will differ at different

price levels.

Chapter references: pp. 41 52 and Figures 2.5 2.8.


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Question 6

An international hotel chain calculates that this year demand for its accommodation in KualaLumpur will rise by 15%. The incomes of customers are estimated by the hotel management to

be rising by around 10%.

(a) Assuming all other conditions of demand are unchanged, what do these figures suggestabout the income elasticity of demand for the hotel accommodation?

(b) In practice, what other factors would need to be taken into consideration beforeaccepting this income elasticity figure as the sole basis for estimating the hotels futuredemand?

Guidance

(a) A rise in demand in excess of a rise in income suggests that the demand for hotelaccommodation is income elastic. In other words, as incomes rise, demand is set to rise atan even faster rate. This suggests that such accommodation is regarded as a luxury good.

(b) The hotel chain should consider what is happening with respect to a number of otherfactors, namely:

the market for other forms of accommodation (such as bed and breakfast facilities,self-catering apartments, etc.)

the impact of exchange rate movements on the demand from foreign travellers

other economic variables, such as the cost of borrowing, changes in share prices,property values, business and consumer confidence, etc.

the general economic conditions.



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C H A P T E R 3

The Analysis of Production Costs

Question 1

Explain the distinction between variable and fixedcosts of production.

Guidance

Consideration should be given to the types of inputs and the time period under review.

Variable costs are those costs that vary as output varies. Fixed costs are those that do notvary with output. In the economic short-run production situation one or more factor inputsis fixed in supply, for example land or capital, whereas one or more inputs will be variablein supply, such as labour, in which case it is changes in the costs of the variable inputs thatdrives up the total costs of production. In the economic long-run production situation allfactor inputs are variable in supply so total costs are affected by the costs of employingadditional units of all inputs.

Marginal costs of production are calculated as an incremental change in the total costs ofproduction. Hence it is the variable costs that cause variations in marginal cost. Marginalcost is differentiated as short-run marginal cost (to reflect the production short-run with

one or more fixed factor inputs) and long-run marginal costs (that relate to changes in totalcosts where all inputs are variable in supply).

Usually it will be easier to vary the quantity of labour employed than land and capital usedbut in principle any factor of production could be either a variable factor or a fixed factor.



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Question 2

Using an appropriate diagram, discuss the relationship between marginal cost, averaged fixedcost, average variable cost and average total cost.

Guidance

The appropriate diagram is Figure 3.5 from the book, which is based on the data inTable 3.3.

The different types of production costs are related because:

marginal cost is the incremental change in total cost as output varies

marginal cost is affected by variable costs only

average variable cost plus average fixed cost equals average total cost.

Particular points to note about the relationship between the different cost curves are thefollowing:

average fixed cost (AFC) continuously declines and the area under the curve is alwaysthe same (and equals the total fixed cost)

the marginal cost curve intersects the minimum points of the average variable cost(AVC) and average total cost curves (ATC)

the vertical distance between the AVC and ATC curves is equal to the average fixed

costs, hence as output rises the AVC and ATC curves move closer together.

Chapter references: pp. 69 74 and 78 80 Figure 3.5 and Table 3.3.


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Question 3

Using the discussion of costs included in this chapter and the discussion of demand inChapter 2, explain the success of a large international motorcar manufacturer, such as Toyota.

Guidance

This question requires you to use the theory in Chapter 3 rather than simply regurgitate thetheory. This is always more tricky, but also more interesting! It is a good test of the extent towhich you really understand the theory.

The answer should include the following discussion:

Economies of scale and learning or experience economies. Toyota produces large volumesof vehicles in each of its plants each month, gaining economies of scale. You should

consider some of these economies, such as procurement, marketing and productioneconomies. Also, Toyota is an experienced vehicle manufacturer, which has learned how to

produce cars most economically without unduly compromising on product quality(for example, Toyota uses production techniques that it has perfected over the years such asjust-in-time production, economising on the costs of holding stocks of materials, and totalquality management, which through the organisation of vehicle design and the production

process reduces vehicle defects.).

Economies of scope: Toyota certainly benefits from producing a range of vehicles, whichallows it to apportion certain common and joint costs across a wider number of vehicles,such as marketing costs and engine design costs.

Toyota is a well-managed firm and therefore the reasonable expectation is thatX-inefficiencies will be minimised.

Through economies of scale, learning economies and minimising X-inefficiencies,Toyota is able to produce vehicles that it can price competitively while still being able togenerate profit. You should draw appropriate cost (and revenue diagrams, from Chapter 2)to illustrate your answer.

You might also go on to discuss some other issues that impact on Toyotas success, such asexchange rates, trade barriers, management training, and so on, but these issues,while relevant, go beyond the scope of Chapter 3.

Chapter references: pp. 81 98 and Figures 3.8 3.16.


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Question 4

The Meetoo Company produces shirts at a factory in Singapore. The shirts currently sell fromthe factory at $15 each but cost $18 to produce (AFC=$4, AVC=$14). Mike Smart, chief

accountant, has advised the board in New York to shut the Singapore factory. What is yourview? What other information might you need before reaching a decision.

Guidance

The first step is to define the goal of the firm. If it is to maximise profits (or even makesome profit) it is currently failing. The temptation is therefore to close the factory. If thefirm is, say, a state firm or run by some charitable body its goal may be different(e.g. employment protection), in which case the owners may be willing to operate thefactory at a loss, provided they can find the funding to do this.

In some circumstances a firms output might be part of a more complex supply chainoperated by the owners and the owners will make their economic decisions based on the

profitability of the entire supply chain rather than each individual unit within it.For example, it would not pay a soft drinks manufacturer to close down its bottling plant ifthere was no other or cheaper bottling facility available even if the bottling plant losesmoney, provided that the overall soft drinks business is profitable.

Let us suppose that the factory belongs to profit-oriented owners and there are no effects onother parts of a business to consider. Does it make sense to shut down productionimmediately and, if not, would it do so at any future time even if revenues and costs did notalter in the meantime? The answer to this question is it all depends!

If the firm has already invested in plant or office space or other fixed factors of productionand their cost cannot be recouped by resale of the facilities and capital equipment, such as ata liquidation auction, then it could pay the firm to continue in production until such timeas the facilities and capital equipment need to be replaced. When investing in new capitalequipment a profit maximising firm will want a reasonable expectation that its revenues willexceed its total costs (fixed and variable). But once the investment has taken place and theinvestment is what we call sunk, then the decision rule is: do revenues exceed thevariable costs of production?. Provided that the variable costs, which are avoidable costsif production does not occur, are covered then production is worthwhile to the firm.Any additional net revenues after meeting the variable costs can be put towards offsetting

some of the fixed costs. The other way to look at this is that the loss would be greater to thefirm if it shut down production in the short-run.

So with all of this in mind, what about the Singapore factory? The key to answering thisquestion lies in the contribution margin, that is to say the difference between the selling

price and the average variable costs of production (or variable costs per unit produced).

The firm makes an overall loss on each shirt sold of $3, but if the firm were to shut downproduction it would still have to meet its fixed costs, which are equivalent to $4 per shirtcurrently sold. To calculate the total fixed costs we would need to know the number ofshirts currently produced and this is not given in the question. But it is clear that the firm


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has appreciable fixed costs because each shirt bears a cost of $4 to cover the total fixedcosts.

By continuing to produce the firm makes a loss of $3 per shirt, whereas if it shut down(and therefore earned no revenue) the loss would be higher (at $4 multiplied by the numberof shirts currently sold).

Another way of looking at this is to identify that by continuing to produce and sell the shirtsat $15 the firm covers its average variable costs of $14 and makes a contribution towardsthe fixed costs of $1.

It therefore does not appear to pay the firm to shut down production at present. On the faceof it, however, it would not pay the firm to replace its fixed assets in the future. At that pointin time, unless circumstances change, it would seem advisable for the firm to withdrawfrom the market.



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Question 5

Offscale, an office equipment supplier, has expanded its operations dramatically over the last 10years. As sales rose at first unit costs fell and then levelled out. Now there are signs of rising

costs. Investigation suggests that diseconomies of scale have set in. Offscale is still run by itsfounding director and two sons. Explain, using an appropriate diagram, what has beenhappening to costs over the last decade. Make suggestions as to what actions might be taken to

prevent diseconomies of scale.

Guidance

The answer is concerned with the shape of the long-run average cost curve and the effects ofeconomies and diseconomies of scale. Offscale has been in production for a number ofyears. At first the firm benefited from increasing returns to scale and average costs of

production declined with greater output volume. Later it appears that the firm had rising unitcosts of production this is the evidence of decreasing returns to scale.

The question suggests that diseconomies of scale are the problem. But costs may also berising because of poor management of resources or X-inefficiency. In other words, the sameresources with the same technology could produce the same output more cheaply with bettermanagement.

If diseconomies of scale are the root cause then, in the absence of technologicalimprovements, perhaps the firm should consider reducing output or, at the very least,recognising its production methods.

If X-inefficiency is the problem then reorganising production and improving the resourcemanagement would seem to be the solution.

Chapter references: pp. 81 87 Figures 3.8, 3.9 and 3.16.


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Question 6

Choose a firm in a sector with which you are familiar and consider the role of innovation withinthe firm in sustaining its competitive advantage.

Guidance

The question allows you to choose the firm. This requires that you take an interest in thebusiness and financial press or at least your local businesses.

Innovation should improve competitiveness through new product offerings in the marketand by driving down the costs of production in both cases the firms competitivenessshould be improved.

Some firms, notably firms in industries with fast changes in technologies and products, needto invest heavily in R&D to sustain a constant stream of innovation. Innovation can take

place in terms of new products or new and more efficient production processes for existingproducts.

Innovation driven firms include Microsoft in the information technology (IT) sector, AT&Tin telecommunications and Sony in consumer electronics. Another innovation drivenindustry is pharmaceuticals, but most industries have some innovation.

Innovation in terms of new products will reinforce a differentiation competitive strategy,while innovation in production processes may well be crucial to sustaining a cost-focusedstrategy (see the discussion in Chapter 11 on strategic positioning, pp. 221 224).

Innovation is different to invention. Innovation implies the use of new technologies andproduction methods in the production process. Invention proceeds innovation.

Chapter references: p. 82 on Research and development, pp. 86 87 and p. 91 Figure 3.10.


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Question 7

Assess the significance of new information-based technology for the future of the retail bankingindustry. Illustrate your answer using appropriate cost diagrams.

Guidance

The answer to this question draws on a number of the issues that you would have consideredwhen answering Question 6. Consideration should be given to innovation involving the role ofchanges in IT in reducing costs of production.

New IT should both reduce the costs of providing services (improve banking processes) andprovide an opportunity to introduce new banking services to achieve a competitiveadvantage (e.g. Internet banking, telephone banking and more sophisticated electronic cashdispensers). In the future, who knows what new banking services may be introduced.

New products increase the demand for banking services causing a shift in the demand curvefor banking services.

It is important, however, that IT not only allows banks to become more efficient at whatthey do now, but also allows them to extend and refine their product range.

Those banks that invest in the most effectively used IT systems will reap the greatestcompetitive benefits in terms of both supply and demand curve effects.

As costs are driven down and product innovation occurs it will become more difficult forbanks to compete that lag behind in the introduction of IT.

IT is expensive and therefore economies of scale may become more important in retailbanking. This may lead to mergers and takeovers.

New IT may alter the type of staff employed with an impact on relative wages.

Chapter references: pp. 86 89 and 97 98 Figures 3.8 and 3.10.


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Question 8

Using isoquant and isocost analysis discuss how the optimal combination of factor inputsemployed by a firm should be decided.

Guidance

The relevant material is in Appendix 3.1 to the book, pages 101-108. But before attemptingto answer this question check that your course requires study of isoquant and isocost curveanalysis, not all business economics courses do so.

Isoquant curves map out levels of production obtainable from different combinations offactor inputs assuming that they are used efficiently.

Isocost curves map out the costs of these factor inputs assuming different input prices.

Each isoquant curve identifies a given level of output and every isocost curve a given levelof expenditure on factor inputs.

The most economic production occurs where output is maximised for any given expenditureon inputs. The result is an output and combination of factor inputs that cannot be improvedon in the sense of obtaining a higher output from the given budget or expenditure on inputs.

Chapter reference: Appendix 3.1 and Figures A3.1 to A3.5.


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C H A P T E R 4

Analysis of the Firms Supply Decision

Question 1

What factors enter into the decision of a car-manufacturing firm to launch a new model?

Guidance

This question requires you to identify those matters that you might reasonably expect a carmanufacturer to consider.

Factors that we can expect include (a) the likely demand for the new model (b) the existingcompetition (c) expected new competition (competitors launching rival models)(d) forecast model design costs (e) forecast production costs (e) forecast marketing anddistribution costs (f) existing excess capacity.

In other words, the manufacturer needs to take into account a range of matters that are likelyto impact upon the demand for the new model and the cost of supplying that model.Only when these considerations have been appropriately evaluated can the firm begin toestablish the price at which it plans to sell the new model. Price could be crucial to thesuccess of the launch, especially if the price elasticity of the cars is high.

The firm will also need to consider the consequences of the launch timing. Would it pay todelay the launch, perhaps until after a competitor reveals its new vehicle? Is there anadvantage in being first to market?

The firm will also need to consider the most appropriate organisation of its value chain tosupply the vehicle.

Chapter references: this question calls on information from across the chapter and consolidateslearning from the earlier chapters on demand, costs of production and supply.


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Question 2

Using the concept of elasticity of supply, explain why raw material prices often tend to be lessstable than manufactured good prices.

Guidance

Elasticity of supply is a measure of the responsiveness of supply to a change in price.

Where supply is price elastic, producers can alter their supply substantially when pricevaries (the extent to which they can do this varies directly with the supply elasticity).Where supply is price inelastic supply can be varied less easily in response to price changes.

Where supply is less easy to vary quickly, prices are likely to fluctuate more as demandchanges. In the case of raw material production, there tend to be various suppliers and

supply tends to be relatively price inelastic compared with many manufactured products.Also, raw materials often come from poorer countries that are less able to accommodate asignificant fall in production by earning extra income elsewhere. When prices rise it maytake much longer to expand raw material production than manufacturing production(though this will depend upon the particular production technology used).



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Question 3

Consider how a hotel owner would decide how to price hotel rooms:

(a) when deciding whether to build the hotel at the outset

(b) having built the hotel, so as to ensure that the maximum number of rooms is occupiedeach evening.

Guidance

Before building the hotel the owner will wish to set a room price that covers the total costsof supplying the room including earning a normal profit. In other words, the room priceshould be set on a full cost basis or equivalent to the average total cost of providingrooms.

Once the hotel is built, however, the owner has a sunk cost, the cost of the hotel buildingand facilities. In other words, there are fixed costs of production that will have to be metwhether rooms are filled or not. In which case the hotel owner should be willing to accept aroom price that at least covers the variable costs of providing the room (e.g. staffing costs,laundry and cleaning costs, heating and water costs and meals if provided). This is why youcan often negotiate a lower price for a hotel room if you arrive at the hotel late in the day.The hotel owner is better off renting the room to you for the night at below full cost thanleaving it empty. You do run the risk, however, that the hotel is already full and you areturned away!

Another way of looking at this issue is in terms of elasticity of supply. Once the hotel isbuilt, the total supply of rooms is perfectly inelastic.

This pricing strategy makes sense provided that not too many potential customers are risktakers and do not book in advance, arrive late and try to bargain the room rate down. It is forthis reason that some hotels will not offer a lower rate late in the day. They fear the impacton their overall revenues from bookings.

Chapter references: pp. 112 115 also see the discussion in Chapter 3 pages 7880.


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Question 4

(a) Draw a value chain for a typical retail bank.

(b) Discuss where most value is likely to be created and why.(c) Consider what are likely to be the main core competencies and distinctive capabilities

that a retail bank will need to have to sustain competitive advantage.

Guidance

(a) The value chain shows where value is added at each stage of production and supply.A typical value chain for a manufacturing firm is provided in Figure 4.5 on page 118 of thetextbook. This will need to be amended to reflect the manner in which retail bankingservices are supplied: inbound logistics will involve procuring supplies of paper,Information Technology (IT) products, telecommunications etc. operations in terms of

providing an integrated branch banking service and the marketing and sales of bankservices. Although banks do not provide an after sales service in terms of, say, repair andwarranty work, service is a key attribute of a successful retail bank. Indeed, professionalservices are built and sustained by providing consumers with a high quality of service.

(b) Therefore, value is most likely to be created in terms of providing service, including speedy,efficient and polite branch staff, smooth operating head office functions and innovation infinancial products to attract and retain customers. For example, closing the branch networkwould certainly be disastrous unless some other avenue to customers is being used such asInternet and/or telephone banking. Most retail bank customers still depend on local

branches.

(c) Core competencies are based on information or knowledge of financial products and theirefficient and effective provision to retail customers. They are also based on the informationsystems including IT systems that sustain this knowledge base and information flow.Distinctive capabilities relate to training of staff, reputation of the bank (would you putyour money with an unknown entity?) and ownership and organisation of an integratedretail banking system. Another distinctive capability is innovation in financial services.

Chapter references: pp. 115 120 and 122 124 Figures 4.4 and 4.5.


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Question 5

On what basis might a house-building company decide whether to employ its own bricklayers,carpenters, plumbers etc., rather than using subcontracting firms?

Guidance

Most building firms buy in these specialist services. One reason might be that they haveinsufficient work to justify employing their own full-time staff. Generally the reason relatesto the theory of transaction costs. For example, you might think that bricklaying is a corecompetence in building but this is not so. Large building companies are best viewed ascontracting firms that contract to buy land and build homes and offices (in some cases theymay build premises on land owned by separate landowners or property developers).They organise the supply chain and may market the homes and offices to potentialconsumers (though in some instances this activity may be contracted out to other parties,

such as estate agents).

What drives the decision whether to outsource an activity or do it internally within the firmis transaction costs. The theory of contraction costs is concerned with the economics of thedecision as to the boundary of the firm. Transaction costs include the costs of negotiating,monitoring and enforcing market contracts. For example, if a building firm contracts for

plumbers it must first find the possible plumbers to use, negotiate the contract price(perhaps through a tendering process), monitor the quality of the plumbing work providedand enforce the contract if there are contract disputes, for example over whether the

plumbing provided is as set out in the contract (this may incur legal costs if a negotiatedsolution cannot be found).

These transaction costs when contracting for building services need to be set against thecosts of a firm employing its own bricklayers, carpenters, plumbers etc., which include thecosts of hiring staff, perhaps training them and supervising their activities as employees(if on fixed salaries they may have an incentive to minimise their effort). These staffmanagement costs can be interpreted as a kind of internal transaction cost.



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Question 6

Give examples of firms with which you are familiar, which are either:

(a) vertically integrated(b) horizontally integrated or

(c) conglomerates.

Consider the merits of these forms of organising production with reference to the firms youhave listed.

Guidance

This question asks you to select your own examples.

Vertical integration occurs where different stages in the supply or value chain are broughtwithin the direct ownership and control of the firm for example a Television (TV)manufacturer purchasing a materials supplier (called backward integration) or a retailoutlet (called forward integration).

Horizontal integration involves mergers and takeovers between firms at the same stage ofmanufacture (e.g. a TV manufacturer buying the production facilities and brands of a rivalTV manufacturer).

Conglomerate mergers involve firms buying interests in unrelated industries and economicactivities (e.g. a tobacco company purchasing a bank).



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Question 7

A local radio station is about to negotiate a renewal of its operating licence. Write a report forits management setting out the approach that the management should take to the contract

renewal. The current operating costs of the station are $600m per annum, the annualised capitalcosts are $150m, and the annual revenues from advertisers total $800m. There is no otherrevenue. In addition, the station pays the state licensing authority $30m per annum for anoperating licence. It is rumoured that the licensing authority intends to raise the annual licencefee to $70m per annum in the next franchise period. The station and its facilities were built fiveyears ago at a cost of $900m, which is being written off on a straight-line basis over a predictedten-year life (i.e. $90m per annum). The annualised capital cost of $150m is composed of $90mdepreciation and $60m in interest charges on loans incurred to finance the capital investment.

In writing your report, establish whether the radio station should seek a licence renewal if therumoured new licence fee proves to be correct.

Guidance

The decision to renew the licence, assuming the radio station intends to make a profit,will be based on whether the revenue covers the costs of providing the radio servicesincluding a normal profit.

Annual operating and capital costs total $750m and revenues $800m, so at the outset thestation is profitable after the $30m licensing authority charge (indeed, assuming the costsalready include a normal profit the station is earning an annual supernormal profit oreconomic rent of $20m). If the licensing authority raises the licence fee to $70m per annumthen clearly the station will start making an annual loss, of $50m.

This question is a variation on similar questions in earlier chapters on the economics ofshutting down production in the short and long-run. If the station has to pay the $90mdepreciation charge and the $60m interest charges whether the station operates then the loss

by not operating (and hence receiving zero revenue) would be $150m. This is larger thanthe loss from operating ($50m) so the station should continue to operate.

This conclusion holds provided that the $150m in capital charges must continue. If thestation was closed and the firm as a legal entity was wound up these charges might beavoided. Under some legal jurisdictions the loan creditors may be able to mount legalactions for debt recovery from the stations directors but more usually they will be protected

provided that the firm has limited liability status. Another possibility is that the stationscapital assets could be sold to an alternative owner for a sufficient sum to recoup the capitalcosts and repay the loans.

Your report should cover these issues. You should also reflect on the possibility of makingeconomies in operating costs and boosting revenues. How might this be done?

Chapter references: the material in the chapter is generally relevant, as is the discussion inChapter 3, pp. 78 80.


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C H A P T E R 5

Demand, Supply and Price Determination

Question 1

The Organisation of Petroleum Exporting Countries (OPEC) cartel has just announced cuts inproduction levels, which are expected to drive up the spot price of a barrel of oil by 20% in thecoming weeks. Using appropriate demand and supply diagrams, examine:

(a) The impact on the retail price of petrol.

(b) The likely impact on the electricity-supply market, bearing in mind that oil is an inputinto electricity generation as well as being a substitute source of energy.

Guidance

This question allows you to demonstrate your grasp of the economics of demand andsupply.

A reduction in crude oil supplies will have an impact on the price of petrol at the pump.The extent of the price adjustment depends on the elasticity of demand and supply.For example, the more elastic is demand the larger the reduction in petrol demand that the

price increase will provoke. In consequence, the petrol companies will absorb some of theeffects of the crude oil price rise. The extent to which the petrol companies absorb the cost

will depend upon the elasticity of supply. For example, the more inelastic the supply the lessable will be the petrol companies to cutback output as demand declines.

In practice, the demand for petrol tends to be price inelastic because vehicle users have nosubstitute fuel and petrol companies can alter the amount of refined petrol that they place onthe market to some degree (though having large fixed costs they have to be careful not toincrease their average total costs of supply sharply because of output reductions).

You can illustrate the likely effect if you draw the demand curve with a steeper slope thanthe supply curve. The rise in the price of crude oil moves the supply curve for petrol at the

pump to the left because it increases the costs of production. By identifying the newequilibrium price you can ascertain how far the price of petrol has increased to consumers.The petrol suppliers absorb the remainder of the cost increase.

In the case of electricity generation the impact on the price and output of electricity issimilar with high fixed costs in generation but perhaps a greater ability on the part ofconsumers to switch to other forms of fuel, especially over time (for example, there aredifferent fuels for central heating but no real alternatives for powering cars). However,the additional issue here is that if oil is the main alternative fuel to electricity, the companiesshould be able to pass on more of the cost to consumers because the price of the obvioussubstitute, fuel has also risen.


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The diagram for electricity generation will also show a shift in the supply curve to the leftbecause of higher production costs.



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Question 2

In todays Budget statement by the Government, a new specific tax of $2 per unit has beenlevied on each bottle of wine sold. Assume that before the imposition of this new tax, the sale of

wine was tax-free. A newsflash on television claims that Tax causes wine prices to rise by $2per bottle. Evaluate this statement.

Guidance

This answer to this question involves many of the features of the answer to Question 1.

A tax increase raises the selling price and can be illustrated as a shift in the supply curve tothe left.

It is most unlikely, however, that consumers would bear the full tax imposition of $2 perunit. If stores raised the price by the full amount of the tax, they would see demand declinedependent upon the price elasticity of demand for wine. Only if demand elasticity was

perfectly inelastic (a vertical demand curve) would the $2 price increase have no effect onwine sales. This is very unlikely.

The result will be that some of the tax will be borne by the suppliers. The extent to whichthe tax is paid by customers or suppliers depends upon the price elasticity of demand andsupply in the market.



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Question 3

Give examples of goods or services where the incidence of a sales tax is likely to fall primarilyon:

(a) consumers

(b) producers.

Guidance

The theory relevant to answering Question 2 applies here.

Consumers bear more of the tax the more their demand is price inelastic and the greater theelasticity of supply.

Products where a sales tax is most likely to fall most heavily on consumers are those wherethere are few if any substitutes e.g. petrol, commuter rail fares.

Products where a sales tax is most likely to fall most heavily on producers are those whereconsumers may have many acceptable substitutes and producers are unable to alter theirsupply significantly for some time e.g. a tax on cinema seats but not on theatre seats andother forms of entertainment.



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Question 4

Explain, using demand and supply analysis, why agricultural surpluses arise under the EuropeanCommon Agricultural Policy (CAP) in which farmers receive large subsidies linked to

production levels.

Guidance

The European CAP has a number of components including purchasing excess production,protection from imports and export subsidies. However, the issue we are concerned withhere is the manner in which the policy keeps market prices in Europe for agricultural

products above their competitive market clearing level.

When the price is above the market equilibrium there will be excess supply. The response ina competitive market is for prices to fall. But the CAP removes much of the excess

production from European markets thus retaining the higher price.

The objective is to smooth out agricultural prices and provide a secure revenue flow toencourage investment in European farming. In years of abundant harvests, stocks are builtup and released to the market in years of bad harvests.

In practice, however, due to continuing political pressure from farming lobbies agriculturalprices have tended to remain above their market clearing levels for considerable lengths oftime. This has led to large stocks of some goods and in turn costly storage and in some casestheir eventual destruction. More recently there has been action to reduce the output of farmsthrough initiatives such as set aside schemes, where farmers are subsidised to take land outof production.

Your discussion should be based around a demand and supply analysis and the subject ofthe equilibrium price.

Chapter references: pp. 131 134 and 142 145 and Figure 5.1.


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Question 5

It is often claimed that the free market leads to an economically efficient allocation ofresources but is this allocation necessarily equitable from a social welfare perspective?

Assess this question with reference to the domestic housing market.

Guidance

The free market is economically efficient when it is highly competitive. The result is bothallocative and productive efficiency. That is to say no other allocation of the resourcescould improve economic welfare and the output is produced with the least-cost use ofresources.

These results depend, however, on the existing income and wealth distribution, which maybe deemed inequitable. A different income and wealth distribution would lead to a different

pattern of demand and supply and therefore a different welfare maximising allocation ofresources.

In addition, economic welfare will not necessarily be maximised in a free market if there aremarket imperfections, such as monopoly or externalities.

The housing market is an interesting market to show your grasp of demand and supply andthe economic welfare implications.

Housing tends to be very inelastic in supply (at least in the short-run). At the same time weall need somewhere to live, so housing in total (though not individual properties) has a very

price inelastic demand. This applies whether we are discussing the market for housepurchases or house rentals. Demand in both cases is not perfectly price inelastic because asprices continue to rise some of us may switch from buying to renting (or vice versa) orchoose to live in caravans and tents instead. Others may be priced out of the housingmarket.

In answering this question you should demonstrate a good understanding of demand andsupply analysis, the operation of competitive markets and recognise that while economicsmay concentrate on the efficient use of resources it should not loose sight of the impact onsocial well-being.



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Question 6

During the past decade, microchip prices have fluctuated wildly on world markets, reflectingperiods of excess demand followed by excess supply. Using appropriate diagrams, explain the

impact of time lags in the production of microchips on price levels.

Guidance

Figure 5.1 is the standard diagram illustrating excess demand. However, this question drawsyour attention to the role of time lags in production. That is to say that current supply cannotrespond immediately to demand changes. When this is the case, supply is likely to be afunction of past price.

While it is common to discuss the cobweb theory in relation to agricultural marketsbecause supply can most obviously not respond immediately to price changes in farming,

the analysis can be applied to any market where similar time lags apply. You shouldtherefore use Figure 5.8 as the basis for much of your discussion.



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Question 7

Why would you expect the wholesale price of coffee in world markets to fluctuate more than thewholesale price of daily newspapers?

Guidance

Some of the analysis is similar to that which applies to the previous question.

Newspapers are printed daily or weekly and therefore supply can be very quickly adjustedto changes in demand provided that there is some spare printing capacity available.By contrast, coffee production cannot be altered quickly.

In consequence, whereas newspaper production can be represented using the standarddemand and supply diagram with demand and supply curves shifting smoothly to restore an

equilibrium price when either the conditions of demand or supply change, coffee productionfollows a slower and less predictable movement to the long-run equilibrium price,as represented by cobweb theory.

Chapter references: pp. 131 136 and Figures 5.1, 5.2 and 5.3 and pp. 142 145 and Figures5.8 and 5.9.


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C H A P T E R 6

Analysis of Perfectly Competitive Markets

Question 1

(a) Give examples of markets that most closely equate to perfectly competitive ones.

(b) In what ways do they fall short of being perfectly competitive?

Guidance

Perfect competition demands very strict assumptions that are unlikely to be found in manyif any markets in the real world. Markets that most closely equate to perfectly competitiveones are those in which there are very large numbers of buyers and suppliers, reasonablyfree entry and exit from the market and well informed consumers. It is in such markets thatthe purchase decision is driven by price.

An example of this is a competitive stock market, as exists in major financial centres, suchas New York, London and Tokyo. Here, a particular companys share will trade at the same

price at any given time. If it did not, then arbitragers would purchase the share at the lowerprice and resell it at the higher price for profit. This action would equalise the price. In otherwords, no one would buy a Microsoft share at $100 if an equivalent Microsoft share could

be bought for $99.

Other examples of very competitive markets driven by price are the markets for agriculturalproducts, minerals and oil. This is why a price can be quoted daily for such products in thefinancial press, such as the price of Brent crude oil.

In all these markets the product is homogeneous.

However, none of these markets need necessarily be perfectly competitive. All marketshave some information imperfections including stock markets otherwise how do weaccount for someone buying a stock just before it falls in price? (Remember that in perfectcompetition there is perfect information about the future.) Also, while there may be a largenumber of buyers and sellers the number is not infinite and in the case of some products

producer cartels exist (OPEC being the best known example). In the oil industry, there isalso a relatively small number of international oil companies that account for most of the oil

purchases.

In other words, in real world markets the strict assumptions of perfect competition are notmet.

Chapter references: pp.151 157 Figures 6.2 6.5.


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Question 2

If all products were sold in perfectly competitive markets, why may the allocation of resourcesbe pareto optimal?

Guidance

The start of this answer should set out clearly about what perfect competition is and definePareto optimality and allocative efficiency.

The answer should then go on to explain, why if all markets were perfectly competitive Paretooptimality results.

You can conclude that it is this powerful result that leads economists to argue forcompetition in markets.

Chapter references: pp. 159.


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Question 3

Why would managers have no discretion in setting the prices of products or services in perfectlycompetitive markets?

Guidance

Oddly as it may first sound, if markets were perfectly competitive there would be little formanagers to do. Prices and outputs would be set given the competitive demand and supplyconditions and firms would accept the going market price. There would be no role formarketing because all firms products are the same under perfect competition (there is nobranding of products, for example).

After explaining this, you can go on to demonstrate your prowess in the theory of perfectcompetition by explaining the model and drawing the perfect competition diagrams for

market equilibrium in the short and long-run.



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Question 4

(a) Why is it argued that a firm operating in a perfectly competitive market will produce at

the technically optimum level of production in the long-run but not the short-run?(b) What does this imply about the efficient allocation of resources in perfectly competitive

markets?

Guidance

The technically optimum level of production is that at which production costs per unit are attheir lowest. This is at the minimum point of the long-run average total cost curve.

In answering the first part of this question you will need to show that you can distinguishbetween the equilibrium price and output in the short-run and long-run under perfect

competition and draw the appropriate diagrams. Once you have drawn the diagrams youwill be able to identify clearly that in the short-run the firm under conditions of perfectcompetition does not produce at the minimum point on its long-run average total cost curve,

but it does so in the long-run.

The implication of an efficient allocation of resources is straightforward. Efficient allocationrequires that resources be allocated so that no alternative allocation would improve economicwelfare. The resulting allocative efficiency is known as Pareto optimal. Also,the resulting set of outputs must be produced at least cost or with productive efficiency.Under conditions of perfect competition, in the long-run both allocative and productiveefficiency is achieved.

It is not surprising, therefore, that economists favour competition.



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Question 5

If a market is perfectly competitive, what would be the effect of an increase in the demand for agood or service on the output and price:

(a) in the short-run

(b) in the long-run?

Guidance

An increase in demand shifts the market demand curve to the right leading to a rise in price.For each individual firm in the perfectly competitive market, this means that the price andthe demand curve it faces, rises. The result is supernormal profit.

In the long-run, new firms will be attracted into the market by the profits being earned.The result will be an increase in the market supply, a fall in price and the removal ofsupernormal profits. Each firm in the market will now face a lower price and demand curve.

In answering this question you will need to be able to reproduce and explain the diagramsshowing the market equilibrium in the short-run and long-run.



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Question 6

A firm in perfect competition makes no economic profit in the long-run. Discuss.

Guidance

This question requires you to explain the difference between a normal profit and asupernormal profit.

A normal profit has to be earned or the firm will leave the market, hence economists treatnormal profit as another cost of production.

By contrast, supernormal profit is an economic rent or excess profit above normal profit.It is this profit that is being referred to in the question as economic profit.

Using the perfect competition diagrams illustrating the short-run and long-run marketequilibria, you should then explain how economic profit is competed away in the long-runthrough market entry by new suppliers.



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Question 7

(a) Explain why a firm in a perfectly competitive market may continue to produce evenwhen losses are being made.

(b) Explain why such a situation cannot be sustained over a long time period.

Guidance

This question is a little trickier than the previous questions and needs you to blend theknowledge gained from the reading in an earlier chapter about shutting down production inthe short and long-run (pp. 71 75) with the perfect competition model set out in thischapter.

Provided that a firm can at least cover its variable costs it will continue to produce in the

short-run. This is because even larger losses would be made if the firms shut downproduction (assuming that the fixed assets have no opportunity cost). In the long-run,however, the firm must cover both its variable and fixed costs if it is to be profitable.

You should explain this with relevant diagrams and discussion, using the references givenbelow.

Chapter references: pp. 78 80 and Figure 3.7, and pp. 152 157 and Figure 6.3.


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C H A P T E R 7

Analysis of Monopoly Markets

Question 1

Until the 1990s telecommunications companies such as Deutsche Telekom and France Telecommonopolised the delivery of their fixed-line telecommunication services. If these corporationshad achieved maximum profit, what would this have meant in terms of allocative and

productive efficiency?

Guidance

An obvious starting point is to define allocative and productive efficiency.

Allocative efficiency is concerned with allocating resources so as to maximise socialwelfare and this is associated with (at least in a first best world) marginal cost pricing(P=MC).

Productive efficiency is concerned with producing this output at the lowest cost, whichmeans combining factors of production so as to maximise the output for given factor prices.

There is no need to know much about the two companies mentioned in the question. But itis necessary to draw a diagram so that you can identify precisely where allocative efficiency

occurs. The firms are monopolies, so the diagram needed is the standard monopoly diagramof this chapter. A profit maximising firm will determine its output according to whereMC=MR and this will be at a lower output than where P=MC. The monopolist does not,therefore, maximise social welfare. Moving from a perfectly competitive industry to amonopoly would lead to lower consumer surplus, higher profit (economic rent) and,importantly, a deadweight loss.

The monopoly diagram is drawn on the assumption that the monopolist will not beproductively inefficient. But you can amend the diagram to show productive inefficiency byraising the marginal and average cost curves on the diagram. This leads to an even lower

profit maximising output. It does, however, also mean that profits are lowered because ofthe higher costs. Our expectation is, therefore, that a profit maximising monopolist will beallocatively inefficient but productively efficient.

In practice, however, the lack of competition may lead a monopolist to be less focused onproduction efficiency the result is that the monopolist then forgoes some profit for aneasy life.

The above discussion has not considered possible dynamic gains from a firm having a veryhigh market share. These possible gains, that can easily be exaggerated, are discussed on

pages 158 159.



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Question 2

In what ways might state ownership of a monopoly affect price and output decisions and why?

Guidance

Governments may be less concerned with profit maximisation than wider social welfaremaximisation. In which case, the enterprises may have been directed by government to

produce where P=MC rather than where MC=MR. The result is higher output and lowerprices and therefore more consumer surplus.

Another (perhaps more realistic) alternative is enterprises may be used to meet politicalgoals, such as minimising redundancies or locating investments on political rather thaneconomic criteria. In which case, the result will be productive inefficiency even if allocativeefficiency is achieved.

If in achieving wider social and political goals enterprises rely on state funding rather thanuser charges for some of their financing, then this will have implications for the level oftaxation or levels of investment in other areas of public expenditure. Taxation moves pricesfrom marginal supply costs and therefore can create allocative inefficiency elsewhere in theeconomy.

It should be clear that a discussion of pricing and output under state ownership is complexand dependent upon the precise goals of government and the impact of governmentdecisions on the wider economy.

In developing this answer, you should be able to appreciate what impact privatisation of theenterprises is likely to have on price and output (at least in the absence of continued stateregulation).



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Question 3

A firm intends to take over its only rival in the market and become the sole supplier:

(a) give reasons why the firm may be adopting this strategy(b) consider how the countrys competition authority is likely to assess the consequences of

the takeover

(c) for what reasons might the competition authority: (i) prohibit (ii) allow the takeover toproceed?

Guidance

In answering the first part of this question, takeovers can occur for a number of reasons.On the one hand, the combined firm may expect to achieve cost savings through sharing the

labour force, buildings and capital equipment. It may also plan to combine sales forces andmarketing expenditures to boost joint sales. In other words, the firm anticipates efficiencygains with economic benefits. On the other hand, the motivation may be simply tomonopolise the market, leading to higher prices, lower output and lower consumer choice.

The response of a competition authority will, therefore, be dependent upon which of thesetwo sets of motivations for the takeover it suspects to be dominant. In arriving at its decisionit will need to (a) define the product market to assess the degree of demand-side substitution(can consumers switch to an acceptable alternative supply quickly?) and supply-sidesubstitution (if the firm raised price could existing or new firms respond swiftly andcompete, thereby making the price increase unsustainable?).

If the authority should decide that the result of the takeover is likely to be the abuse of adominant position in the market place or a significant reduction in competition it is likely torule against the takeover. This will be the obvious conclusion if there is likely to be limiteddemand-side or supply-side substitution.

Chapter references: pp. 166 172 and Figure 7.2 (you may also like to consult pp. 358 361 inChapter 16 on Competition Policy).


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Question 4

Mail services in most countries, are provided by a single supplier (which is often state-owned).Why is it important to define the market carefully before deciding whether these suppliers are

monopolists in their own territories?

Guidance

Most letter collection and deliveries are supplied by a monopoly with the exception ofpremium services (e.g. express mail), though some countries are introducing morecompetition.

The question is concerned with the definition of a monopoly. Technically, a monopolist isthe sole supplier of a good or service. But this sort of definition implies that the market isclearly defined, which is rarely the case. For example, a firm may have a monopoly of

normal postal deliveries, but are premium services part of the same market or are they in adifferent market? In reality, the two markets are likely to overlap with some consumers

being willing and able to switch between normal mail services and premium servicesaccording to the prices charged.

Also, post is a form of communication. If we widen the market definition tocommunications then we need to consider telephone services, Internet, email and fax.In which case, the share of the market that the postal service supplies shrinks.

It should be clear, therefore, that the wider the appropriate market definition the less likely itis that a single firm will monopolise the market. The wider the market the greater the

potential for both supply-side and demand-side substitution (for further details, see theGuidance Notes to Question 3 above).

Chapter references: pp. 165 166 and 172 174.


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Question 5

In the United States of America, steel workers supported by their employers successfully lobbytheir government for import controls and other state aid. Why do some observers support the

workers while others label their actions as rent-seeking behaviour? What is the relationship(if any) between the behaviour of US steel workers and the behaviour of firms that collude to fix

prices to consumers? Should we adopt the same analytical process to judge both situations?

Guidance

Import controls on steel protect the production of steel in the United States and, therefore,the jobs of steel workers. In so far as the result is to raise prices to consumers and restrictchoice, there will be a welfare loss. In this sense, the result involves a transfer of incomefrom consumers of steel (and steel products) in the United States to steel workers in termsof wages and their employers in terms of profits.

The lobbying effort is therefore a form of rent-seeking behaviour with higher prices andlower output sold in the market leading to a deadweight welfare loss. The reason somewould support the workers is because of a fear of job losses and the wider social welfareimplications.

In the sense that the workers and their employers are rent seeking, their behaviour and thatof colluding firms is similar. The result is lower output, higher prices and a loss of socialwelfare. However, there may be public sympathy for the steel workers because they aretrying to protect their jobs and communities. Colluding firms are simply trying to earneconomic rent at the expense of consumers.

It is for this reason that some might be uncomfortable using the same analytical technique ofrent seeking to assess the lobbying against imports that threaten jobs and to assess theeconomic effects of colluding firms. However, to economists, both import controls andcollusion similarly raise prices and can impact adversely on social welfare.



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C H A P T E R 8

Analysis of Monopolistically Competitive Markets

Question 1

(a) Give examples of markets that most closely equate to monopolistically competitiveones.

(b) Describe the ways in which these markets differ from markets that are strictlymonopolistically competitive.

Guidance Like the other theoretical models of markets discussed in the book, monopolistic competition

occurs under a number of strict conditions or assumptions. There must be a large number offirms competing in the market and each has only an insignificantly small share of themarket. This means that each firm is a 'price taker', accepting the going market price set bymarket demand and supply. Each firm is assumed to have the same or very similar costs of

production. There is free entry and exit from the market and the firms produce similar(though not identical) products.

So, we are looking for very competitive markets with large numbers of competing firms andinvolving some limited degree of product differentiation. Examples might include takeaway

food restaurants, if there are a lot in your neighbourhood and they are little differentiatedhigh street hairdressers where consumers are choosing between them on price taxis if thereare large numbers competing and plumbing firms.

In practice, these markets may not be good examples of monopolistic competition.In particular, consumers tend to differentiate between takeaway food restaurants with some(e.g. McDonalds) having considerable brand loyalty some hairdressing firms can chargemore than others either because of their reputation or location taxi charges tend to beregulated by the municipality thereby reducing price competition and the demand for

plumbing services can exceed the supply, leading to reduced competition.

Chapter reference: p. 179.


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Question 2

To what extent do managers have discretion when setting prices in monopolistically competitivemarkets?

Guidance

Managers in monopolistically competitive markets have no discretion and must be pricetakers. This follows from the assumptions underlying the monopolistic competition model(summarised in the Guidance Notes to Question 1 above) and particularly the very limited

product differentiation. Consumers buy on price and firms must price at the going marketprice.



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Question 3

(a) Consider the role of marketing and advertising in monopolistically competitive markets.

(b) Why will firms tend to allocate resources to the development of a brand strategy?

Guidance

The lack of product differentiation in monopolistically competitive markets makes,in principle, marketing and advertising problematic. Where consumers treat products readilyas substitutes, a firm advertising and marketing its product will tend to stimulate the sales ofits competitors products too. This can be expected to limit the incentive for any individualfirm to spend on marketing and advertising.

At the same time, however, if a firm can develop brand loyalty amongst consumers it can

then move away from having to compete under the conditions of monopolistic competition.Brand loyalty reduces the willingness of consumers to switch to competitors products evenwhen prices are lower.

A firm can, therefore, be expected to try to develop a brand promotion strategy to reduceconsumer switching which is the same thing as saying that a brand promotion strategyreduces the (positive) cross-price elasticity of demand between the firms product and itscompetitors products.

Chapter reference: pp. 183 184.


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Question 4

What are the economic welfare costs associated with monopolistic competition?

Guidance

When assessing the economic welfare costs, perfect competition is the obvious comparison.Under perfect competition in the long-run both allocative and productive efficiency occur.In other words, P=MC (allocative efficiency) and production occurs where average totalcost (ATC) is minimised (production efficiency). By contrast, under monopolisticcompetition in the long-run P>MC and ATC are not minimised. The result is higher pricesand higher average costs of production.

However, perfect competition is a theoretical extreme.



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Question 5

Discuss the role of advertising in a monopolistically competitive industry. In what sense mightadvertising expenditure by a particular firm in the industry be wasteful?

Guidance

The answer is similar to that for Question 3 above, which you should refer to.

Advertising expenditure uses up economic resources and therefore has an opportunity(economic) cost. While informative advertising that improves consumer choice may be anefficient use of resources, in the sense that the resources would not lead to a highereconomic welfare if used elsewhere in the economy, other forms of advertising may be lesseasy to defend.

Chapter reference: pp. 183 184.


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Question 6

Compare and contrast the short-run and long-run equilibrium facing a firm under conditions ofmonopolistic competition.

Guidance

The short-run involves a period in which firms cannot enter (or exit) the market. Therefore,supernormal profits can be earned.

In the long-run, these profits will be competed away by market entry. In the long-run,firms in monopolistic competition earn only a normal profit.

Answering this question requires drawing the appropriate short-run and long-run marketequilibrium diagrams and explaining the different price, output and profit consequences.



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C H A P T E R 9

Oligopoly

Question 1

Ollipolly is a company producing business magazines, which has one main rival in the market,Polliolly. Ollipolly has 45% of the market and Polliolly, 55%.

(a) What type of market does Ollipolly operate in?

(b) What competitive strategy would you suggest to the board of Ollipolly to improve:(i) its market share and (ii) its profitability?

(c) Would it be in the interests of the two companies to merge or for one to acquire theother?

Guidance

(a) Ollipolly operates in a particular type of oligopolistic market where the market is sharedbetween two firms. This is called a duopoly market.

(b) As in all oligopolistic markets, in formulating a competitive strategy there needs to beattention to the likely response of the other firm to any change in price or other

marketing initiative such as an advertising campaign. For example, the firm couldincrease its market share by pricing lower and attracting consumers from Polliolly.But what would be Polliollys response? If it matched the price cut the market sharesmight not change. Moreover, the price elasticity of demand determines the total revenueearned by both firms (if demand is elastic then the total revenue earned from sales by

both firms would rise, whereas if demand was price inelastic the total sales revenuewould decline following a price reduction).

The kinked demand curve could be used to show the possible effect of a price reduction.You could also answer the question using a game theoretic analysis.

The impact on profitability depends on what happens to revenue and costs of production as

price and output change. In general, reducing price is a higher risk strategy than othermarketing initiatives, such as advertising and developing a strong brand because it is easierfor the rival firm to match quickly.

Your answer should therefore explore the likely responses in the market to differentmarketing initiatives. Another possibility would be to try and reduce the costs of production,which could result in a price advantage in the market or a higher profit. You should explorehow this might be achieved will it require new investment?


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(c) Merger or acquisition would make the market a monopoly and would lead to higherprofitability through the removal of competition unless there were considerable costsavings from the resulting economies of scale. It is unlikely, however, that thecompetition authorities would stand aside and allow this to happen!

Chapter reference: material throughout the chapter.


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Question 2

With reference to the Prisoners Dilemma, explain why collusion is often a feature of oligopolymarkets.

Guidance

The Prisoners Dilemma is concerned with the dilemma that a prisoner faces when beingquestioned by the police and cannot communicate with an accomplice. Should the prisonerconfess or not? The answer depends upon whether the accomplice confesses.

This Dilemma, which is a classic of game theory, is endemic in oligopoly markets.Firms changing prices, considering advertising campaigns, investing etc., could do so withmore confidence of the outcome if they knew how their competitor firms would react.

Collusion between firms is equivalent to the prisoners communicating secretly and agreeinga joint strategy that maximises their utility. If firms are colluded perfectly (i.e. there was nouncertainty and no cheating), then they could act as a monopolist and increase price,reduce output and increase their (joint) profit.

It should now be clear why competition law makes such collusion, e.g. in the form ofcartels, illegal. They are not in the public interest.


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