Answers to Questions in Chapter 6



Answers to Questions in Chapter 7

Note: No. before ( indicates a page number

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152 ( Give one more example in each category.

Perfect competition: grains; foreign exchange.

Monopolistic competition: local builders; van hire.

Oligopoly: beer; soup powders; insurance companies

Monopoly: Most State railways; BHP.

152 ( Would you expect plumbers and restaurateurs to have the same degree of control over price?

Other things being equal, restaurateurs are likely to produce a more differentiated product/service than plumbers, and are thus likely to face a less elastic demand. This gives them more control over price. Note, however, that the control over price depends on the degree of competition a firm faces. If, therefore, there were only a few plumbers in a given town, but many restaurants, the above arguments may not hold.

154 ( (Box 7.1) What are the advantages and disadvantages of using a 5-firm concentration ratio rather than a 10-firm, 3-firm or even a 1-firm ratio?

The fewer the number of firms used in the ratio, the more useful it is for seeing just how powerful the largest firms are. The problem with only including one or two firms in the ratio, however, is that it will not pick up the significance of the medium-to-large firms. For example, if we look at the 3-firm ratio for two industries, and if in both cases the three largest firms have a 50 per cent market share, but in one industry the next largest three firms have 45 per cent of the market (a highly concentrated industry), but in the other industry the next three largest firms have only 5 per cent of the market (an industry with many competing firms), the 3-firm ratio will not pick up this difference. Clearly, this problem is more acute when using a 2-firm or a 1-firm ratio.

The more the firms used in the ratio, the more useful it is for seeing whether the industry is moderately competitive or very competitive. It will not, however, show whether the industry is dominated by just one or two firms. For example, the 10-firm ratio for two industries may be 90 per cent. But if in one case there are 10 firms of roughly equal size, all with a market share of approximately 9 per cent, then this will be a much more competitive industry than the other one, if that other one is dominated by one large firm which has an 85 per cent market share.

A more complete picture would be given of an industry if more than one ratio were used: perhaps a 1-firm, a 2-firm, a 5-firm and a 10-firm ratio.

155 ( 1. It is sometimes claimed that the market for various stocks and shares is perfectly competitive, or nearly so. Take the case of the market for shares in a large company like NAB. Go through each of the 4 assumptions above and see if they apply in this case. (Don’t be misled by assumption (1). The `firm’ in this case is not NAB itself.)

[Note that the market in this case is for NAB shares not for the products of NAB itself.]

Most aspects of the four assumptions of perfect competition apply.

a) There is a very large number of shareholders (although there are some large institutional shareholders.)

b) People are free to buy NAB shares.

c) All NAB ordinary shares are the same.

d) Buyers and sellers know the current share price, but they have imperfect knowledge of future share prices. This gives rise to speculation in stocks and shares.

155 ( 2. Is the market for gold perfectly competitive?

Nearly. It is similar to the market for NAB shares. There are many buyers and sellers of gold, who are thus price takers, but who have imperfect knowledge of future gold prices. Also, countries with large gold stocks (e.g. the USA) could influence the price by large-scale selling (or buying). [Note also that the `price’ would have to refer to a weighted average of the price in all major currencies to take account of exchange rate fluctuations.]

156 ( (Box 7.2) 1. Why not the Internet work better for replacement buys than for new purchases?

Because you are already familiar with the product.

156 ( (Box 7.2) 1. Give three examples of products that are particularly suitable for selling over the Internet and three that are not. Explain your answers.

Products that are suitable include:

a) books. A low cost item that you will normally know what you want – a favourite author or you may have read a good review.

b) CDs. For similar reasons as in (a).

c) Air line tickets. You know exactly what you are buying and they will normally be cheaper via the internet.

Products that are unsuitable are generally high cost items that you need to see or test or those that have high delivery costs, such as cars, houses, large items of furniture, and stereo systems.

157 ( 1. Why do economists treat normal profit as a cost of production?

Because it is part of the opportunity cost of production. It is the profit sacrificed by not using the capital in some alternative use.

157 ( 2. What determines (a) the level and (b) the rate of normal profit for a particular firm?

It is easier to answer this in the reverse order.

(b) The rate of normal profit is the rate of profit on capital that could be earned by the owner in some alternative industry (involving the same level of risks).

(a) The level of normal profit depends on the total amount of capital employed.

159 ( Illustrate on a diagram similar to Figure 7.3 what would happen in the long-run if price were initially below PL.

The industry supply curve would initially be to the right of Se and average revenue would be below ARL. Firms would be making a loss. They would thus leave the industry. As they did so, the supply curve would shift to the left until it reached Se. At that point, normal profits would be restored and firms would cease leaving the industry.

161 ( 1. What other reasons can you think of why perfect competition is so rare?

• Information on revenue and costs, especially future revenue and costs, is imperfect.

• Producers usually produce differentiated products, one from another.

• There are frequently barriers to the entry of new firms.

161 ( 2. Why does the market for fresh vegetables approximate to perfect competition, whereas that for aircraft does not?

There are limited economies of scale in the production of fresh vegetables and therefore there are many producers. There are such substantial economies of scale in aircraft production, however, that the market is only large enough for a very limited number of producers, each of which, therefore, will have considerable market power.

163 ( As an illustration of the difficulty in identifying monopolies, try to decide which of the following are monopolies: Melbourne trams; your daily newspaper; Bundaberg rum; Interflora; your local deli; Microsoft; the board game ‘Monopoly’. (As you will quickly realise in each case, it depends how you define the industry.)

As the statement in brackets suggests this is not easy. Take Interflora this has a dominant position in the "sending" of flowers but faces competition from other ways of sending ones best wishes-telephone calls, mailing gifts, etc. The closest to a monopoly however the industry is defined is Microsoft.

163 ( Why might Sunrice’s 80% share of the packaged rice market be potentially more profitable than Nestle’s monopoly?

Because the total market for packaged rice is far larger than that for condensed milk.

165 ( Try this brain teaser. A monopoly would be expected to face an inelastic demand. After all, there are no direct substitutes. And yet, if it produces where MR = MC, MR must be positive, demand must therefore be elastic. Therefore the monopolist must face an elastic demand! Can you solve this conundrum?

Demand is elastic at the point where MR = MC. The reason is that MC must be positive and therefore MR must also be positive. But if MR is positive, demand must be elastic. Nevertheless, at any given price a monopoly will face a less elastic demand curve than a firm producing the same good under monopolistic competition or oligopoly. This enables it to raise price further before demand becomes elastic (and before the point is reached where MR = MC).

168 ( (Box 7.4) 1. In what respects might Microsoft’s behaviour be deemed to have been: (a) against the public interest; (b) in the public interest?

a) Prices are likely to be higher, given the lack of competition; there may be less product development, because potential competitors fear Microsoft’s power to block their entry to the market, or drive them from it if they do succeed in entering; less choice for consumers.

b) By developing products that are in general use around the world, it is more convenient for businesses and their employees, who do not have to learn to use different sets of software or have problems with incompatibility of software; monopoly profits can lead to high levels of investment and product development, which can help reduce prices over the longer term.

2. In December 1998, America Online (AOL) announced it was to acquire Netscape Communications, and to form an alliance with Sun Microsystems. The state of South Carolina subsequently dropped its anti-trust suit against Microsoft, stating that ‘the forces of competition are working’. Bill Gates remarked on hearing news of the merger, ‘It’s hard to believe that the Government can still press their case with a straight face. Three of the biggest competitors are banking together and yet the Government is still trying to slow us down.’ Should the AOL–Netscape merger alter attitudes towards the recent business practices of Microsoft?

To the extent that these other companies can use their joint market power to compete with Microsoft, then it is probably in the consumer’s interests. But these competitors will not provide competition across the range of Microsoft’s products. In the case of the Windows operating system and Microsoft Office products, Microsoft has the advantage of an established network of users, and this gives Microsoft a huge market advantage.

3. The problem with being locked-in to a product or technology is only a problem if such a product can be clearly shown to be inferior to an alternative. What difficulties might there be in establishing such a case.

If potential competitors have been prevented from developing superior products or technology, then those products or technology are not available to be compared with the existing products or technology? You are trying to compare an existing situation with a hypothetical one. Even if the competitors do have a produce on the market, its inferiority may be a practical one rather than an intrinsic one –namely that it is incompatible with the market leader’s products or technology.

169 ( If the shares in a monopoly (such as a water company) were very widely distributed among the population, would the shareholders necessarily want the firm to use its monopoly power to make larger profits?

If the water company raised its charges and thereby made a larger profit, shareholders would gain from larger dividends, but as consumers of water would lose from having to pay the higher charges. Except in the case of shareholders with only a few water shares, however, the gain is likely to outweigh the loss. Nevertheless, with shares very widely distributed, the average net gain would be only very small, and the wider the distribution, the more shareholders there would be who would suffer a net loss from the higher charges.

171 ( (Box 7.5) 1. Are entry and exist costs relatively high or low in the airline industry?

Relatively low as aircraft can be leased quite easily.

171 ( (Box 7.5) 2. Can anything be said from the information in the box about the elasticity of demand for air travel?

On the face of it we could conclude that as demand rose by 30% following a real price reduction of 21% that the price elasticity of demand was around 1.5. To draw this conclusion we have to assume that the other influences on demand, income for example, were unchanged (the ceteris paribus assumption). This was not the case. As it is unlikely, however, that real income (or other things) could have changed significantly in this two year period we can safely conclude that the demand is price elastic (>1) but not that it is necessarily around 1.5. If we get too strict about ceteris paribus there is the danger that we end up not being able to draw any conclusion from simple data.

172 ( In which of the following industries are exit costs likely to be low: (a) steel production; (b) market gardening; (c) nuclear power generation; (d) specialist financial advisory services; (e) production of a new drug; (f) mobile discos; (g) truck operators? Are these exit costs dependent on how narrowly the industry is defined?

(a) High. The plant cannot be used for other purposes.

(b) Relatively low. The industry is not very capital intensive, and the various tools and equipment could be sold or transferred to producing other crops.

(c) Very high. The plant cannot be used for other purposes and decommissioning costs are very high.

(d) Low. The capital costs are low and offices can be sold.

(e) Low to moderate. It is likely that a pharmaceutical company can relatively easily switch to producing alternative drugs. Substantial exit costs are only likely to arise if the company is committed to a long-term research and development programme or if equipment is not transferable to producing alternative drugs.

(f) Low to moderate. The exit costs again will depend on the second-hand value of the equipment.

(g) Relatively low if the trucks can be transferred to other areas.

172 ( Give some other examples of hit-and-run competition.

Ice cream vendors on a beach in a heat wave; a plastics company manufacturing a batch of cheap moulded sledges in a snowy spell.

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