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?
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Answers to questions in Economics by Sloman and Norris
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 longrun 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 longrun 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 longrun 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;
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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
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Answers to questions in Economics by Sloman and Norris
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 noncollusive 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.
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•
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
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Answers to questions in Economics by Sloman and Norris
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
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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 seconddegree 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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