Answers to pause-for-thought questions in Essentials of Economics (3rd edition), John Sloman

Answers to Pause-for-Thought Questions

Chapter 4

p119Give one more example in each of the four market categories in Table 4.1.

Perfect competition: grains; foreign exchange.

Monopolistic competition: taxis; van hire.

Oligopoly: (homogeneous) white sugar; (differentiated) beer; banks.

Monopoly: National Grid Company (electricity transmission); local bus company on specific routes.

p122Will the industry supply be zero below a price of P5 in Figure 4.2?

Once the price dips below a firm’s AVC curve, it will stop production. But only if all firms have the same AVC curve will the entire industry stop production. If some firms have a lower AVC curve than the firm illustrated in Figure 4.2 (b), then industry supply will not be zero at P5.

p130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.

p136Think of two examples of highly contestable monopolies (or oligopolies). How well is the consumer’s interest served?

Bus company operating a particular route: the market may be large enough for only one company, but the market is highly contestable, especially if other bus companies are already established on other routes in the area. A reduction in fares may be the result of the threat of competition.

The deregulation of the UK Directory Enquires service in 2003 made the previous monopoly of BT in this area contestable. This led to several new directory enquiry providers. The consumer benefits in so far as the competition drives down call costs, although to make an informed choice such call costs need to be transparent. The degree of contestability depends on the costs of setting up such a service and the exit costs if the company fails to make sufficient profit. Both these costs could be quite low for a company that already has a call-centre infrastructure and could use such as centre for other purposes, or could hire it out to other companies. Alternatively, the company could hire such services from a call-centre operator. Again, this could keep entry and exit costs low.

p138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.

p139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).

p143If this ‘fair’ solution were adopted, what effect would it have on the industry MC curve in Figure 4.9?

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.

p147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.

p153Assume that there are two major oil companies operating filling stations in an area. The first promises to match the other’s prices. The other promises to sell at 1p per litre cheaper than the first. Describe the likely sequence of events in this ‘game’ and the likely eventual outcome. Could the promise of the second company be seen as credible?

Prices would be driven down, and hence profits reduced, until one of the companies could no longer stick to its promise – either the first accepting that its price will be 1p above the second, or the second accepting the same price as the first. Alternatively both companies simultaneously may decide to abandon their policy and collude to raise prices. This may involve a secret meeting between them, or simply ‘letting it be known’ that they would be willing to raise prices, providing that the other company did the same.

The promise of the second company could be seen as credible if it had lower costs or greater financial backing than the first company. In such circumstances, the first company may be forced to give up its policy first. If they have similar costs and financial strength, then the threat is not credible.

p154Give an example of decisions that two firms could make in sequence, each one affecting the other’s next decision.

Two supermarket chains are thinking of expanding into the small ‘metro’ stores segment of the market in a particular city that does not have any such stores. There is room in the market for only one in each of three suburbs, with the third having little prospect of making a profit in the short run. The first mover may succeed in gaining planning permission for the most profitable of the three. This will give the second an advantage in gaining planning permission in the second most profitable, given than the local authorities will want to maintain as much competition as possible. Both will have to consider, however, what they do about the third, which is only marginally profitable, but could help to develop the image of their other metro store in the city. They will also have to consider whether if the other company opened the third store this would deny them an opportunity of ever having a second metro store in the city: a store which could be profitable at some point in the future.

p156Assume that two brewers announce that they are about to merge. What information would you need to help you decide whether the merger would be in the consumer’s interests?

You would need information on the likely impact on costs, prices and choice. If there are substantial economies of scale to be gained, then that is an argument in favour. If, however, it meant that there would be less choice for consumers in particular parts of the country, then the reduction in competition may lead to an increase in profit margins, which might more than offset the economies of scale and result in higher prices. A crucial question here is whether the two brewers were competing previously, or whether they were operating on different parts of the market (in terms of product or region). The more they were competing previously, the greater the potential gain in market power and the greater the likelihood of an increase in prices.