Answers to Questions in Chapter 7



Answers to Questions in Chapter 8

Note: No. before ( indicates a page number

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176 ( Think of ten different products or services and estimate roughly how many firms there are in the market. (You will need to decide whether ‘the market’ is a local one, a national one or an international one.) In what ways do the firms compete in each of the cases you have identified?

You will see when you think about this question that it is often difficult to identify the boundaries of a market. Take a product like chocolate. If the product is defined as bars of chocolate, then there are probably about three or four different makes available, but maybe only one or two in any one shop. If, however, the product is defined to include filled chocolate bars, then there are may more varieties available, but, of course, several made by each individual company (such as Cadbury's, Mars, Nestlé, etc). You will also notice for many products that there are one or two large producers, and many small producers, making the market a hybrid form of oligopoly if the large producers dominate the market.

The sorts of competition to look out for are: price competition, advertising, product specification, product availability, after sales service, etc.

176 ( Give some other examples of monopolistic competition. (Try looking through the Yellow Pages if you are stuck.)

Examples include: taxis, car hire, pubs, hotels and restaurants, insurance agents, estate agents, child minders, office equipment suppliers, air conditioning installers, antique dealers, computer systems.

177 ( 1. Why may the local ‘deli’ charge higher prices than supermarkets for `essential items' and yet very similar prices for delicatessen items?

Because the demand for such essential items from the local shop is likely to be less price-elastic than the demand for delicatessen items: if people run out of basic items, they will want to obtain them straight away rather than waiting until they visit the supermarket. Also the supermarkets may obtain bulk discount from their suppliers on basic items, but not on delicatessen items, where the turnover is much lower.

177 ( 2. Which of these two items is a petrol station more likely to sell at a discount: (a) oil; (b) sweets? Why?

Oil (especially in large cans). The reason is that demand is more price elastic. People will be tempted to buy now, rather than waiting, if they see a reasonable discount (or a free gift). In the case of sweets, these are often an impulse buy and the price is very low anyway relative to the amount already spent on petrol. A penny or two price reduction will probably make very little difference to sales.

178 ( (Box 8.2)1. What other business, apart from fast food outlets, are in competition with restaurants?

Pubs, clubs and cafés are the obvious examples. As many people look upon a meal in a restaurant as an ‘evening out’, however, other forms of entertainment such as cinemas and theatres may also compete with restaurants.

178 ( (Box 8.2)2. In which segments of the market do you think competition through price to be (a) important (b) unimportant

We would expect price competition to be most important in segments where the other characteristics such as quality, surroundings are very similarly and at the lower end of the price range. It will be relatively unimportant in higher price restaurants particularly those catering for customers on expenses.

179 ( 1. Why does the LRMC curve cross the MRL curve directly below the tangency point of the LRAC and ARL curves?

At the tangency point the slope of the long-run AC and long-run MC are the same, and thus the slope of the long-run TC and long-run TR must be the same. But the slope of the long-run TC gives the long-run MC and the slope of the long-run TR gives the long-run MR. Thus the long-run MC must equal the long-run MR.

Another way of answering the question is to note that long-run profits are maximised where long-run MR equals long-run MC (at QL). But at QL, long-run AR equals long-run AC, whilst at any other output long-run AR is below long-run AC. Thus profits must be maximised at QL for this reason too.

179 ( 2. Assuming that supernormal profits can be made in the short run, will there be any difference in the long-run and short-run elasticity of demand? Explain.

Yes. The entry of new firms, attracted by the supernormal profits, will make the long-run demand for the firm more elastic: there are now more alternatives for consumers to choose from.

180 ( Why will additional advertising lead to smaller and smaller increases in sales?

Because fewer and fewer additional people will see each extra advert (i.e. many of the people will have seen the adverts already and thus there will be little additional effect on their demand).

180 ( Does this imply that if, say, half of the petrol stations were closed down, the consumer would benefit? (Clue: what would happen to the demand curves of the remaining stations?)

No. Demand would become less elastic and the lack of competition may enable remaining petrol stations to make supernormal profits in the long run as well as the short run. The consumer would only benefit from a reduced number of firms if there was still sufficient competition to allow profits to be kept at a normal level, and if cost conditions changed so that the LRAC now continued sloping downward for longer (so that the point of tangency is at a higher output): this would require changes in technology such as new computerised systems which allow one cashier to handle a larger number of customers.

181 ( Which would you rather have: five restaurants to choose from, each with very different menus and each having spare tables so that you could always guarantee getting one; or just two restaurants to choose from, charging a bit less but with less choice and where you have to book a table quite a long time in advance?

Many people would choose the first, but clearly it is a question of personal preference.

183 ( How will advertising affect the cartel's MC and AR curves? How will this affect the profit-maximizing output? Is there any problem here for the cartel in fixing the price?

If the advertising increases total cartel sales, the cartel's AR curve will shift to the right and possibly become less elastic. The MC curve will only shift if the advertising varies with output. Given that the amount that member firms will advertise is not known and, even if it were, the effects of any amount of advertising on AR is also not known, so it is impossible for the cartel to identify the profit-maximizing price with any degree of precision.

183 ( If this `fair' solution were adopted, what effect would it have on the industry MC curve in Figure 8.3?

It would be likely to shift it upwards, given that additional output would not merely come from the most efficient producers, but rather from all producers in proportion to their market share. Also, over time, by protecting companies' market share in this way, there would be less competition to adopt new more efficient techniques.

184 ( (Box 8.4) 1. Try applying Hotelling’s theory to the policies of the two major parties

Those to the left will always vote labor (or at least not for the Coalition) and those to the extreme right will always vote for the Coalition (or at least not for Labor). Thus the parties will try to occupy the ‘middle ground’ of politics and have very similar policies – which, of course, they do. This point is explored further in section.

184 ( (Box 8.4) 2. In the beach example will total sales of ice-cream be greater if the stalls keep to the inspector’s location, or where they are in the centre of the beach?

In the inspector’s location. Because people at either end of the beach now have further to walk to get an ice-cream some will decide it is not worth the effort.

185 ( Draw a pair of diagrams like those in Figure 8.4. Illustrate what would happen if there were a rise in market demand and no rise in the costs of either the leader or the followers. Would there be an equal percentage increase in the output of both leader and followers?

The Dmarket curve would shift to the right. This would cause the Dleader curve also to shift to the right (now intersecting the vertical axis at the price where the Sall other firms curve crosses the new Dmarket curve). There would be a corresponding rightward shift in the leader's MR curve, which would cause the leader to increase output to where the new MR curve intersects with its MC curve, and to raise price to the point on its demand curve vertically above the new MR/MC intersection.

Whether there would be an equal percentage increase in the output of both leader and followers depends on the shapes of the various curves and the initial market share of each.

186 ( (Box 8.4) 1. The Commonwealth Bank, in announcing the cut of 0.35%, said it was based on an analysis of the cost of funds. Why was it important for it do this?

Because otherwise the other banks might have cut their rates by the full 0.5% in an attempt to increase their market share. (See the kinked demand curve model of non-collusive oligopoly on pp. 197-8.)

186 ( (Box 8.4)2.What form of price leadership is this?

As there is no dominant firm in the industry it is barometric price leadership.

187 ( If a firm has a typically shaped average cost curve and sets prices 10 per cent above average cost, what will its supply curve look like?

It will be vertically above the AC curve by 10 per cent: i.e. it will get further apart from the AC curve, the higher the AC curve is that demand is highly inelastic and was increasing over time.

187 ( In which of the following industries is collusion likely to occur: bricks, beer, margarine, cement, crisps, washing powder, blank audio or video cassettes, carpets?

In all cases collusion is quite likely: check out the factors favouring collusion on page 187. In some cases it is more likely than others: for example, in the case of cement, where there is little product differentiation and a limited number of producers, collusion is more likely than in the case of carpets, where there is much more product differentiation.

188 ( (Box 8.5) Illustrate what was happening here on a demand and supply diagram. Remember that demand was highly inelastic and was increasing over time.

The initial demand and supply curves intersect at a price of $3 per barrel. The actions of OPEC in 1973/4 can be shown by a shift in the supply curve to the left, which, given the inelastic nature of the demand curve, causes price to rise substantially to over $12 per barrel. Then during the mid to late 1970s, the demand curve shifts to the right (demand was increasing over time), which combined with a slight movement back to the right of the supply curve, allowed sales (Q) to resume their pre 1973 level while price still remained above the $12 per barrel level.

188 ( (Box 8.5) 1. What conditions facilitate the formation of a cartel? Which of these conditions were to be found in the oil market in (a) the early 1970s; (b) the mid-1980s?

For the conditions that facilitate the formation of a cartel, see the list of factors favouring collusion in pages 200-1. Taking the points in order as they appear on pages 200-1:

• There are relatively few oil producing countries: but more in the 1980s than there were in the 1970s.

• The OPEC members meet openly to discuss pricing and quotas: both in the 1970s and 1980s.

• Production methods are relatively similar, although costs vary according to the accessibility of the oil.

• The (final) product is very similar and there is an international price for each type of crude.

• Saudi Arabia is the dominant member of OPEC: its dominance over the world market, however, waned from the mid-1980s as non-OPEC production increased and there was a world glut of oil.

• Entry barriers, however, have not been significant. This allowed several non-OPEC members (e.g. Mexico, Norway and the UK) to break into the market.

• The market is relatively stable in the short run (given the price and income inelasticity of demand). There has been a problem, however, of a decline in demand over the longer term.

• Governments round the world have been relatively powerless to curb OPEC's collusion, although from time to time (e.g. during the Gulf War) the USA has released oil from its huge stock piles to prevent excessive price increases.

188 ( (Box 8.5) 2. Could OPEC have done anything to prevent the long-term decline in real oil prices from 1981 to 1999?

Very little, given that the supply of substitutes (both oil and non-oil) for OPEC oil have increased substantially. Perhaps, with hindsight, if OPEC had not raised prices so much in 1973/74 and 1979 there would have been less incentive to develop substitutes and to break the power of the cartel.

188 ( (Box 8.5) 3. Many oil analysts are predicting a rapid decline in world oil output from the mid-1990s as world reserves are depleted. What effect is this likely to have on OPEC's behaviour?

The fall in output will drive up prices. Provided that OPEC can prevent its members from pumping oil more rapidly to take advantage of the rising price, OPEC's power could increase. It could demonstrate to its members the rising trend in oil prices and attempt to persuade them of the benefit of reducing production even further. It could `sell' this policy to the world as one of being prudent with dwindling oil stocks.

191 ( (Box 8.6) 1. How would Bill’s choice of strategy be affected if he had instead been involved in a joint crime with Grant, Pauline, Diana and Dave, and they had all been caught?

The more people there were involved in the crime, the greater would be the likelihood of one of them confessing and therefore the greater the temptation for Nigel to confess.

191 ( (Box 8.6) 2. Can you think of any other non-economic examples of the prisoners' dilemma?

Children in a class previously agreeing not to do homework for a test, but parents keeping them apart so that they can persuade their children to do their homework, telling them, `The other children will also be doing theirs and you will not want to be shown up by doing badly compared with them.'

194 ( Which of the following are examples of effective countervailing power?

(a) A water company buying cement from Boral.

(b) A large office hiring a photocopier from Rank Xerox.

(c) Myer buying clothes from a garment manufacturer.

(d) A small country store (but the only one for kilometres around) buying food from a wholesaler.

None are particularly good examples. The closest is (a) as water companies buy large quantities of cement (or reservoirs) and Boral has considerable monopoly power. In the other examples one of the pair of firms has no, or little, monopoly power.

197 ( (Box 8.7) 1. What steps might shareholders take to get managers to act in the shareholders’ interests?

Develop a remuneration scheme which links pay to profits or the share price. One example is the use of stock options. Managers are given an option to purchase shares in the company at a certain price (the exercise price). If the share price rises above the exercise price the manager can buy at the exercise price and immediately sell at the market price at a profit.

197 ( 1. Could annoyance to the public ever rebound as a direct cost to the firm?

Yes. The government may be persuaded to tax advertising; local governments may levy charges on companies for bill-boards. Also, on the demand side, consumers may be put off buying the product.

197 ( 2. Choose two products which are extensively advertised. Make out a case for and a case against these particular advertisements.

Check the particular products and the nature of the adverts against the list of points made on pp. 199-200.

197 ( Which of the following markets do you think are contestable?

(a) credit cards; (b) brewing; (c) petrol retailing; (d) insurance services; (e) compact discs?

The least contestable are credit cards and brewing, where the existing companies have considerable control over the market. Petrol retailing and insurance services (especially at the retail level) are relatively contestable because the barriers to entry are low. Exist costs are also relatively low (assuming that petrol stations can be sold easily). New producers of compact discs (the recording companies as opposed to the manufacturers of the basic discs on which recordings are made) face moderately high entry barriers in terms of recording contracts, economies of scale and influence over outlets, but there have been examples of new companies setting up, especially in more specialist parts of the market.

198 ( (Box 8.8) What form of price discrimination is this?

First degree price discrimination – different individual customers are being charged different prices.

199 ( Explain why, if the firm can practise first-degree price discrimination by selling every unit at the maximum price each consumer is prepared to pay, its revenue from selling 200 units will be the blue area plus the red area in Figure 8.11.

Because the demand curve shows the maximum price consumers are prepared to pay for each additional unit purchased. Thus reading from left to right along Figure 7.10, the first unit can be sold at the price corresponding to Q = 1 on the demand curve; the second unit can be sold at the price corresponding to Q = 2 on the demand curve without affecting the price at which the first unit was sold, and so on for each unit. Thus in each case, the marginal revenue (not the average revenue) is given by the demand curve. When all these marginal revenues are added up (up to 200 units), this will give the area under the demand curve (the red plus the blue areas), and being the sum of the marginal revenues, it must equal the total revenue from selling 200 units.

200 ( How would profit-maximizing output and price be determined under third-degree price discrimination if there were three separate markets? Draw a diagram to illustrate your answer.

The overall MR curve would be found by drawing a separate MR curve for each of the three markets (as was done for the two markets in Figure 8.12), and then adding them horizontally. The profit-maximizing output would be found where this total MR curve crossed the MC curve (as in diagram (c) of Figure 8.12). The output in each of the three individual markets would then be found by reading down from the respective MR curve at the level of MR established in the overall market. The price in each market would then be found by reading up to the demand curve (as in diagrams (a) and (b) in Figure 8.12).

201 ( (Box 8.9) 1. Which type of price discrimination is the cinema pursuing: first, second or third degree? Would it be possible for the cinema to pursue either of the other two types?

Third-degree price discrimination. It groups cinema goers into two types: adults and children.

It could not practise first-degree discrimination: it would not be possible to negotiate a separate ticket price with each customer! It could possibly practise a form of second-degree price discrimination, however, if it gave tokens to people each time they purchased a ticket and then sold tickets at reduced prices to people with tokens.

201 ( (Box 8.9) 2. If all cinema seats could be sold to adults in the evenings at the end of the week, but only a few on Mondays and Tuesdays, what price discrimination policy would you recommend to the cinema in order for it to maximise its weekly revenue?

Offer reduced-price tickets to children in the evenings as well as in the afternoon for the first part of the week, but not for the end of the week.

201 ( (Box 8.9) 3. Would the cinema make more profit if it could charge adults a different price in the afternoon and the evenings?

Possibly. The danger for the cinema, however, is that adults who would have gone to the cinema anyway may now choose to go in the afternoon, thereby losing the cinema revenue. Ideally the cinema would like to discriminate in such a way as to encourage people to go in the afternoon at a reduced price who would not have gone at all (whether in the afternoon or the evening) if they had to pay the higher price. One such group may be senior citizens and people on social security. Many cinemas, therefore, find it profitable to sell `concessionary' seats in the afternoon but not the evening.

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