GuidancenotesforTopicsforDiscussion

Contents
Chapters 1. BusinessEconomics:AnOverview 2. TheAnalysisofConsumerDemand 3. TheAnalysisofProductionCosts 4. AnalysisoftheFirmsSupplyDecision 5. Demand,SupplyandPriceDetermination 6. AnalysisofPerfectlyCompetitiveMarkets 7. AnalysisofMonopolyMarkets 8. AnalysisofMonopolisticallyCompetitiveMarkets 9. Oligopoly 10. ManagerialObjectivesandtheFirm 11. UnderstandingCompetitiveStrategy 12. UnderstandingPricingStrategies 13. UnderstandingtheMarketforLabour 14. UnderstandingtheMarketforCapital 15. UnderstandingtheMarketforNaturalResources 16. GovernmentandBusiness 17. BusinessandEconomicForecasting 18. BusinessEconomicsAChecklistforManagers Pages 2 11 17 26 33 41 48 53 59 68 77 87 95 106 115 121 129 134

C H A P T E R 1

BusinessEconomics:AnOverview
Question1
Whatdoyouunderstandbythemicroeconomicenvironmentandmacroeconomicenvironment ofthefirm?Listsomeofthekeyissues,whichthemanagementshouldbeawareofunderboth oftheseheadings.

Guidance
The MicroeconomicEnvironmentdealswith: operationofthefirminitsimmediatemarket determinationofprices thefirmsrevenues,costsandemploymentlevelsetc. The MacroeconomicEnvironmentdealswith: thegeneraleconomicconditionsofthewidereconomyofwhicheachfirmformsapart. Keyissuesundertheseheadings: (a) Microeconomicenvironment thefactorsthatenterintopricedetermination,notablymarketdemandandsupply. thefactorsthatenterintothecostsofproduction,notablytheoutputproduced,the costs of factor inputs (land, labour and capital), the scale of production and the efficiencywithwhichtheproductionprocessismanaged. (b) Macroeconomicenvironment thelevelofeconomicactivity. theimpact of macroeconomicpolicies involving decisions by government andthe centralbank. international developments including, for example, the impact of exchange rates andinternationaltrade. Chapterreferences:pp.1 2andFigure1.1.

Question2
Considerthemainissuesthatthemanagementmighttakeintoconsiderationwhendecidinghow toallocatethefirmsresources.

Guidance
Managementhastodecide whattoproduce,how toproduceand forwhom thedifferentgoods andservicesaretobesupplied. Decisionswillbedrivenbythefollowing: objectivesofthefirm riskanduncertainty externalities demandinthemarketplace availabilityofresources opportunitycosts productioncostsincludingthepricesoffactorinputs theimpactoftechnology timedimension(shortrunversuslongrun).

Chapterreferences:pp.3 13andFigures1.2and1.3.

Question3
What do you understand by the term opportunity cost? Give examples from the decision makingof(a)agovernmentpolicymaker,(b)aprivatesectormanagerand(c)apublicsector manager.

Guidance
Opportunitycostis what we forgo when we decideto useresources in oneuseas against another. Examples: (a) government spendingmoreondefenceandlessonhealthcare increasingtaxationandtheconsequentreductionofprivateconsumerspending repairingaschoolroofandspendinglessonroadrepairs. (b) privatesectormanager investingmoreinnewindustrialbuildingsandthereforelowerprofitsdistributed investingincapitalequipmentasasubstitute formanualworkers expandingoverseasratherthaninvestingathome. (c) publicsectormanager employingmoredoctorsandfewernurses buildinganewmunicipalswimmingpoolinsteadofmoremunicipalhousing increasingrefusecollectionservicesinsteadofspendingmoreonstreetcleaning. Chapterreferences:pp.5 7andFigure1.3.

Question4
From your own experience, give examples of diminishing marginal returns from economic activity.

Guidance
The concept of diminishing marginal returns refers to the situation whereby as we apply moreof oneinput (e.g. labour)to anotherinput (e.g. capitalor land)andthenaftersome pointtheresultingincreaseinoutputbecomessmallerandsmaller. Examples: growingmoreandmorecropsfromthesamepieceofland trying to produce output beyond the normal full capacity production level by simply supplyingmoreandmoreworkers increasing the number of banking staff in a branch without appropriate increases in computingfacilitiesandphysicalofficespace tryingtooperatemoreandmoretrainswithagivenrailinfrastructure theimpactoneducationalattainment ofexcessivelyincreasingthenumberofstudents thateachteacherisresponsiblefor. Chapterreferences:pp.7 9andFigure1.3.

Question5
Whatdoyouunderstandbythetermexternalities?Whenaretheylikelytobeimportant?

Guidance
Externalities are the benefits and costs that arise from production and consumption but which are not reflected in market prices. These are alternatively called social costs and benefits. Theyarelikelytobeimportantforseveralreasons,involving: costs:environmentaleffects,forexample,pollutionandnoise benefits:thewidersocialimpactofhealthandeducationspendingfasterjourneytimes becauseofmeasures,whichreduceroadcongestionetc.

An assessment of the relative costs and benefits will have implications for publicsector expenditureandtaxationandtheallocationofresources. Recognition of externalities is the focus of a branch of economics known as CostBenefit Analysis. Chapterreferences:p.13andfordiscussionofCostBenefitAnalysissee pp.324 6,Chapter14.

Question6
Compareandcontrastthedifferentformsofcompetitionfoundinmarketeconomies.Whatare thepossibleimplicationsforgovernmenteconomicpolicy?

Guidance
Formsofmarketstructure: (a) Perfectcompetition verylargenumberofsmall,independentbuyersandsellers. (b) Monopolisticcompetition verylargenumberofproducerssupplyingslightlydifferentiatedgoodsandservices tothemarket. (c) Oligopoly a few, relatively large suppliers competing in the market on the basis of a wide rangeofmarketingoptionsincludingprice. (d) Monopoly asolesupplierofagoods orservicetothemarket,whichcanchooseeithertoset thesellingpriceortodeterminethequantityprovidedtothemarket. For further information, comparing and contrasting these different forms of market structure,seeFigure1.4inthebook,p.18. Implicationsforgovernmenteconomicpolicyinvolve: decisionsregardingtheoptimalmarketstructureforeachindustrialsectortomaximise socialwelfare thedecisionsoffirmsunderoligopolyandmonopoly,whichhaveobviousimplications for competition policy including market dominance, mergers and takeovers and restrictivetradepractices competition issues arising from advertising and branding, which may lead the government to introduce consumer protection measures including policy involving advertisingstandards.

Chapterreferences:pp.16 20andFigure1.4.

Question7
Whatmethodsmightbeusedtoassessafirmscompetitiveenvironment?

Guidance
Assessingthefirmsexternalenvironmentusing,forexample,apolitical,economic,social andtechnological(PEST)analysis. AssessingthecompetitiveforcesimpactingonthefirmusingPortersFiveForcesModel. Anassessment ofthefirms competitive environmentenables thefirmtotakestock ofits strengthsandweaknessesinanappropriatecontext. Chapterreferences:pp.19 22andFigures1.5and1.6.

Question8
How might a firm decide on the appropriate strategies to adopt to achieve and maintain a competitiveadvantage?

Guidance
The firm will need to make an honest assessment of its external environment and its internalresourcecapabilities. Thefirmneedstoassessthemarketstructureandtheformsofcompetitionitfaces. OneapproachwillbetocompletePESTandFiveForcesanalysesfollowedbyastrengths, weaknessess,opportunitiesandthreats(SWOT)analysis. Thefirmwillneedtotakeaccount ofitscompetitivepositioninginthemarketplacein particular,determiningwhetheritisbesttoadoptoneofthefollowingstrategies: costleadership differentiation focus.

Chapterreferences:pp.21 22andFigures1.5and1.6.

Question9
Selectacompanywithwhichyouarefamiliar.Conductadetailedassessmentofitscompetitive environmentintermsof: (a) APESTanalysis (b) PortersFiveForcesModel. Inthecontextofthisassessment,conductaSWOTanalysisofthecompany.

Guidance
In addressing these tasks, there are a number of points to note to ensure that appropriate analysesareundertaken. PESTanalysis: avoid producing long lists of every conceivable factor and events that just might impactonthefirm focusonwhatyouconsidertobethekeyormostimportantfactorsandbepreparedto defendtheirinclusion rememberthataPESTanalysisisseekingtodetecttrendsintheexternalenvironment ofthefirm,whichwillleadtoopportunitiesandthreats.

PortersFiveForcesModel: the objective here is to identify the different forces impacting the competitive environmentofthefirmandhenceprofitability avoid lists, which simply identify existing rivals, customers, products etc. the focus mustbeplacedonthe dynamicsofthecompetitiveenvironment seek to identify the relative importance or impact of each of the Five Forces on competitionandprofitability thiswillhelpfocusinonthestrategicdecisionstobemade.

SWOTanalysis: itisimportanttoavoidgeneratinglonglistsofstrengthsandweaknesses thoseidentifiedshouldberelevant inthecontext ofthe opportunities andthreatsyou discussresultingfromthePESTandFiveForcesanalyses.

Chapterreferences:pp.19 22andFigures1.5 and1.6.

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C H A P T E R 2

TheAnalysisofConsumerDemand
Question1
A marketing manager at the Ford Company in Belgium is preparing a briefing on consumer demandforanewmodeltobesoldmainlyinotherpartsofEurope.Considertheissuesthatthis briefing shouldcontain.

Guidance
Considerationshouldbegiventoawiderangeoffactors,whicharelikelytoimpactupon thedemandforthenewmodelincludingthefollowing: theownpriceelasticityofdemand thepriceofcompetingcarmodels thepriceofcomplementarygoodsandservices(including,forexample,carinsurance, roadtaxandfuelcharges,etc.) thescaleofadvertisingexpenditure,whichmaybeneededtobuildupthebrandimage thelevelanddistributionofdisposableincomes theimportanceofwealtheffectsandtheimplicationsforconsumerdemandincluding, forexample,propertyvalues changesinconsumerstastesandpreferences thecostandavailabilityofcredit expectationsconcerningfuturepricerisesandavailabilityofthenewmodel populationstructureandtrends.

Particular attention should be devoted to an assessment of the extent to which these determinantsofdemandmaychangeinthefuture,whichmayresultinashiftinthedemand curveforthenewcarmodel. Chapterreferences:pp.29 31,36 38andFigures2.2,2.3and2.4.

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Question2
Draw what you consider may be the demand curve for this new model in say, the United Kingdom.Illustratetheeffectofthefollowing: (a) afallinthesterlingeuroexchangerate (b) arecessionintheUnitedKingdomand (c) anincreaseinthepriceofHondacarsmadeintheUnitedKingdom.

Guidance
(a) AfallinthesterlingeuroexchangeratewillmakecarsimportedfromBelgium(presumably pricedineuros)moreexpensiveforUKbuyers.Hence,theUKdemandcurvewillshiftto theleft. (b) Arecession inthe United Kingdom willreduce demand in general,as aresult ofa lower levelofnationalincomehencetheUKdemandcurvewillshifttotheleft. (c) AnincreaseinthepriceofasubstituteHondacarsmadeintheUnitedKingdomwill, ceterisparibus,resultinBelgiummadecarsbecomingmorepricecompetitivehence,the UKdemandcurveforBelgiumcarsshouldshifttotheright. Chapterreferences:pp.36 38andFigures2.3 and2.4.

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Question3
Usingtheconcept ofconsumersurplus,explain why asupplier might wishtocharge moreto onegroupofconsumersthananother.

Guidance
The decision to charge more to one group of consumers than another involves an appreciationofpricediscrimination.Ifasupplierisabletochargeeachgrouponthebasis of the highest price that each is willing to pay, this ensures that no consumer surplus remains.Thisgivesrisetothenotionofadiscriminatingmonopolistwherebyeachgroupis charged a price that just equals the valuation, which they each place on each unit of the goodconsumed. Inthisway,thesupplierwillseektomaximiseprofits. Chapterreferences:p.33 36andFigure2.2.

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Question4
Contrastthelikelymarketingstrategiesof: (a) afoodretailersellingviatheInternetand (b) afinewinesretailer. Explain the reasons for the differences based on the classification of goods outlined in this chapter.

Guidance
Thedifferenceinmarketingstrategieswillbedependentonseveralissues,primarily: theextenttowhichthedemandforfoodandthedemandforfinewinesaresensitiveto changesinpricesandincomes thenatureofthefoodbeingretailed:normal,inferiororGiffenproducts theimportanceofbrandinginthecontextofVeblenproducts(suchasfinewines).

Chapterreferences:pp.38 41.

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Question5
Abuscompanyoperatestworoutes.Onroute1,researchsuggeststhatthepriceelasticityis0.8 andontheotherroute1.3.Thecompanyhasdecidedtorevisefaresupwardsonbothroutesby 10%thisyear.Commentonthedecision. Whatalternativepricingstrategywouldyousuggest?

Guidance
Inthecaseofroute1,anincreaseinfaresof10%willleadtoanincreaseinoverallrevenue tothebuscompany.Thisfollowsbecausedemandonthisrouteisrelativelypriceinelastic (i.e.islessthanroute1inabsoluteterms). Revenue will fall on route 2 since demand here is relatively price elastic (i.e. more than route 1 in absolute terms). As price is increased, overall demand will fall by a greater proportion. Thebuscompanyshouldconsiderdroppingthepriceonroute2sincedemandshouldrise proportionately more. However, this decision will depend upon how much spare capacity existsonthebusesusedonthisrouteandothercostsassociatedwiththisdecision. Similarly, prices could be raised still further on route 1. However, the company must be madeawarethattheelasticityofdemandisnotconstantthevaluewilldifferatdifferent pricelevels. Chapterreferences:pp.41 52andFigures2.5 2.8.

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Question6
An international hotel chain calculates that this year demand for its accommodation in Kuala Lumpurwillriseby15%.Theincomesofcustomersareestimatedbythehotelmanagementto berising byaround10%. (a) Assumingallotherconditionsofdemandareunchanged,whatdothesefiguressuggest abouttheincomeelasticityofdemandforthehotelaccommodation? (b) In practice, what other factors would need to be taken into consideration before acceptingthisincomeelasticityfigureasthesolebasisforestimatingthehotelsfuture demand?

Guidance
(a) A rise in demand in excess of a rise in income suggests that the demand for hotel accommodationisincomeelastic.Inotherwords,asincomesrise,demandissettoriseat anevenfasterrate.Thissuggeststhatsuchaccommodationisregardedasaluxurygood. (b) The hotel chain should consider what is happening with respect to a number of other factors,namely: the market for other forms of accommodation (such as bed and breakfast facilities, selfcateringapartments,etc.) theimpactofexchangeratemovementsonthedemandfromforeigntravellers other economic variables, such as the cost of borrowing, changes in share prices, property values,businessandconsumerconfidence,etc. thegeneraleconomicconditions.

Chapterreferences:pp.36 41.

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C H A P T E R 3

TheAnalysisofProductionCosts
Question1
Explainthedistinctionbetweenvariableand fixedcostsofproduction.

Guidance
Considerationshouldbegiventothetypesofinputsandthetimeperiodunderreview. Variablecosts arethosecosts that varyas outputvaries.Fixedcosts arethosethat do not varywithoutput.Intheeconomicshortrunproductionsituationoneormorefactorinputs isfixedinsupply,forexamplelandorcapital,whereasoneormoreinputswillbevariable insupply,suchaslabour,inwhichcaseitischangesinthecostsofthevariableinputsthat drivesupthetotalcosts ofproduction.Intheeconomiclongrunproductionsituationall factor inputs are variable in supply so total costs are affected by the costs of employing additionalunitsofallinputs. Marginal costs ofproductionarecalculatedas an incremental changein thetotalcosts of production. Hence it is the variable costs that cause variations in marginal cost. Marginal cost is differentiated as shortrun marginal cost (to reflect the production shortrun with oneormorefixedfactorinputs)andlongrunmarginalcosts(thatrelatetochangesintotal costswhereallinputsarevariableinsupply). Usuallyitwillbeeasiertovarythequantityoflabouremployedthanlandandcapitalused butinprincipleanyfactorofproductioncouldbeeitheravariablefactororafixedfactor. Chapterreferences:pp.69 71andFigure3.1.

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Question2
Using an appropriate diagram, discuss the relationship between marginal cost, averaged fixed cost,averagevariablecostandaveragetotalcost.

Guidance
The appropriate diagram is Figure 3.5 from the book, which is based on the data in Table3.3. Thedifferenttypesofproductioncostsarerelatedbecause: marginalcostistheincrementalchangeintotalcostasoutputvaries marginalcostisaffectedbyvariablecostsonly averagevariablecostplusaveragefixedcostequalsaveragetotalcost.

Particular points to note about the relationship between the different cost curves are the following: averagefixedcost(AFC)continuouslydeclinesandtheareaunderthecurveisalways thesame(andequalsthetotalfixedcost) the marginal cost curve intersects the minimum points of the average variable cost (AVC)andaveragetotalcostcurves(ATC) the vertical distancebetweenthe AVCand ATCcurves is equaltotheaverage fixed costs,hence asoutputrisestheAVCandATCcurvesmoveclosertogether.

Chapterreferences:pp.69 74and7880Figure3.5andTable3.3.

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Question3
Using the discussion of costs included in this chapter and the discussion of demand in Chapter2,explainthesuccessofalargeinternationalmotorcarmanufacturer,suchasToyota.

Guidance
This question requires you to use the theory in Chapter 3 rather than simply regurgitate the theory.This is always moretricky,butalso moreinteresting!It is agoodtestofthe extent to whichyoureallyunderstandthetheory. Theanswershouldincludethefollowingdiscussion: Economiesofscaleandlearningorexperienceeconomies.Toyotaproduceslargevolumes of vehicles in each of its plants each month, gaining economies of scale. You should consider some of these economies, such as procurement, marketing and production economies.Also,Toyotaisanexperiencedvehiclemanufacturer,whichhaslearnedhowto produce cars most economically without unduly compromising on product quality (forexample,Toyotausesproductiontechniquesthatithasperfectedovertheyearssuchas justintimeproduction,economisingonthecostsofholdingstocksofmaterials,andtotal qualitymanagement,whichthroughtheorganisationofvehicledesignandtheproduction processreducesvehicledefects.). Economies ofscope: Toyotacertainlybenefitsfromproducingarange of vehicles, which allows it to apportion certain common and joint costs across a wider number of vehicles, suchasmarketingcostsandenginedesigncosts. Toyota is a wellmanaged firm and therefore the reasonable expectation is that Xinefficiencieswillbeminimised. Through economies of scale, learning economies and minimising Xinefficiencies, Toyotais abletoproduce vehicles that it canpricecompetitively whilestill beingableto generateprofit.Youshoulddrawappropriatecost(andrevenuediagrams,fromChapter2) toillustrateyouranswer. YoumightalsogoontodiscusssomeotherissuesthatimpactonToyotassuccess,suchas exchange rates, trade barriers, management training, and so on, but these issues, whilerelevant,gobeyondthescopeofChapter3. Chapterreferences:pp.81 98andFigures3.8 3.16.

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Question4
TheMeetooCompanyproducesshirtsatafactoryinSingapore.Theshirtscurrentlysellfrom the 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 your view?Whatotherinformationmightyouneedbeforereachingadecision.

Guidance
The first step is to define the goal of the firm. If it is to maximise profits (or even make some profit) it is currently failing. The temptation is therefore to close the factory. If the firm 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 the factoryataloss,providedtheycanfindthefundingtodothis. In some circumstances a firms output might be part of a more complex supply chain operated 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. Forexample,itwouldnotpayasoftdrinksmanufacturertoclosedownitsbottlingplantif there was no other or cheaper bottling facility available even if the bottling plant loses money,providedthattheoverallsoftdrinksbusinessisprofitable. Letussupposethatthefactorybelongstoprofitorientedownersandtherearenoeffectson other parts of a business to consider. Does it make sense to shut down production immediatelyand,ifnot,woulditdosoatanyfuturetimeevenifrevenuesandcostsdidnot alterinthemeantime?Theanswertothisquestionisitalldepends! Ifthefirmhasalreadyinvestedinplantorofficespaceorotherfixedfactorsofproduction andtheircostcannotberecoupedbyresaleofthefacilitiesandcapitalequipment,suchasat aliquidationauction,thenitcouldpaythefirmtocontinueinproductionuntilsuchtime as thefacilities andcapital equipment needtobereplaced.When investing innew capital equipmentaprofitmaximisingfirmwillwantareasonableexpectationthatitsrevenueswill exceeditstotalcosts(fixedandvariable).Butoncetheinvestmenthastakenplaceandthe investment is what we call sunk, then the decision rule is: do revenues exceed the variablecostsofproduction?.Providedthatthevariablecosts,whichareavoidablecosts if production does not occur, are covered then production is worthwhile to the firm. Anyadditionalnet revenues after meetingthe variablecosts canbeput towards offsetting someofthefixedcosts.Theotherwaytolookatthisisthatthelosswouldbegreatertothe firmifitshutdownproductionintheshortrun. So with all of this in mind, what about the Singapore factory? The key to answering this question lies inthecontribution margin,that is tosaythe differencebetweentheselling priceandtheaveragevariablecostsofproduction(orvariablecostsperunitproduced). Thefirmmakesanoverallloss oneachshirtsoldof$3,butifthefirmweretoshutdown productionit wouldstill haveto meet itsfixed costs,whichare equivalent to$4pershirt currently sold. To calculate the total fixed costs we would need to know the number of shirtscurrentlyproducedandthis is not giveninthe question.But it is clearthatthefirm

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has appreciable fixed costs because each shirt bears a cost of $4 to cover the total fixed costs. By continuing to produce the firm makes a loss of $3 per shirt, whereas if it shut down (andthereforeearnednorevenue)thelosswouldbehigher(at$4multipliedbythenumber ofshirtscurrentlysold). Anotherwayoflookingatthisistoidentifythatbycontinuingtoproduceandselltheshirts at $15thefirmcovers itsaveragevariablecosts of$14and makes a contributiontowards thefixedcostsof$1. Itthereforedoesnotappeartopaythefirmtoshutdownproductionatpresent.Ontheface ofit,however,itwouldnotpaythefirmtoreplaceitsfixedassetsinthefuture.Atthatpoint in time, unless circumstances change, it would seem advisable for the firm to withdraw fromthemarket. Chapterreferences:pp.78 80andFigure3.7.

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Question5
Offscale,anofficeequipmentsupplier,hasexpandeditsoperationsdramaticallyoverthelast10 years.As sales roseat firstunit costs fellandthenlevelled out.Nowtherearesigns ofrising costs.Investigationsuggests that diseconomies ofscale haveset in.Offscale is stillrunby its founding director and two sons. Explain, using an appropriate diagram, what has been happeningtocostsoverthelastdecade.Makesuggestionsastowhatactionsmightbetakento preventdiseconomiesofscale.

Guidance
Theanswerisconcernedwiththeshapeofthelongrunaveragecostcurveandtheeffectsof economies and diseconomies of scale. Offscale has been in production for a number of years. At first the firm benefited from increasing returns to scale and average costs of productiondeclinedwithgreateroutputvolume.Lateritappearsthatthefirmhadrisingunit costsofproductionthisistheevidenceofdecreasingreturnstoscale. The question suggests that diseconomies of scale are the problem. But costs may also be risingbecauseofpoormanagementofresourcesorXinefficiency.Inotherwords,thesame resourceswiththesametechnologycouldproducethesameoutputmorecheaplywithbetter management. If diseconomies of scale are the root cause then, in the absence of technological improvements, perhaps the firm should consider reducing output or, at the very least, recognisingitsproductionmethods. If Xinefficiency is the problem then reorganising production and improving the resource managementwouldseemtobethesolution. Chapterreferences:pp.81 87Figures3.8,3.9and3.16.

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Question6
Chooseafirminasectorwithwhichyouarefamiliarandconsidertheroleofinnovationwithin thefirminsustainingitscompetitiveadvantage.

Guidance
Thequestionallows youtochoosethefirm.This requires that youtakeaninterestin the businessandfinancialpressoratleastyourlocalbusinesses. Innovation should improve competitiveness through new product offerings in the market and by driving down the costs of production in both cases the firms competitiveness shouldbeimproved. Somefirms,notablyfirmsinindustrieswithfastchangesintechnologiesandproducts,need to invest heavily in R&D to sustain a constant stream of innovation. Innovation can take placeintermsofnewproductsornewandmoreefficientproductionprocessesforexisting products. InnovationdrivenfirmsincludeMicrosoftintheinformationtechnology(IT)sector,AT&T in telecommunications and Sony in consumer electronics. Another innovation driven industryispharmaceuticals,butmostindustrieshavesomeinnovation. Innovationinterms ofnewproductswillreinforceadifferentiationcompetitivestrategy, whileinnovationinproductionprocessesmaywellbecrucialtosustainingacostfocused strategy(seethediscussioninChapter11onstrategicpositioning,pp.221 224). Innovation is different toinvention.Innovationimplies theuse of newtechnologiesand productionmethodsintheproductionprocess.Inventionproceedsinnovation. Chapterreferences:p.82onResearchanddevelopment,pp.86 87andp.91Figure3.10.

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Question7
Assessthesignificanceofnewinformationbasedtechnologyforthefutureoftheretailbanking industry.Illustrateyouranswerusingappropriatecostdiagrams.

Guidance
Theanswertothisquestiondrawsonanumberoftheissuesthatyouwouldhaveconsidered whenansweringQuestion6.Considerationshouldbegiventoinnovationinvolvingtheroleof changesinITinreducingcostsofproduction. NewITshouldbothreducethecostsofprovidingservices(improvebankingprocesses)and provide an opportunity to introduce new banking services to achieve a competitive advantage(e.g.Internetbanking,telephonebankingandmoresophisticatedelectroniccash dispensers). In the future, who knows what new banking services may be introduced. Newproductsincreasethedemandforbankingservicescausingashiftinthedemandcurve forbankingservices. It is important, however, that IT not only allows banks to become more efficient at what theydonow,butalsoallowsthemtoextendandrefinetheirproductrange. Those banks that invest in the most effectively used IT systems will reap the greatest competitivebenefitsintermsofbothsupplyanddemandcurveeffects. As costs aredrivendownandproduct innovation occurs it willbecome more difficult for bankstocompetethatlagbehindintheintroductionofIT. IT is expensive and therefore economies of scale may become more important in retail banking.Thismayleadtomergersandtakeovers. NewITmayalterthetypeofstaffemployedwithanimpactonrelativewages. Chapterreferences:pp.86 89and9798Figures3.8and3.10.

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Question8
Using isoquant and isocost analysis discuss how the optimal combination of factor inputs employedbyafirmshouldbedecided.

Guidance
TherelevantmaterialisinAppendix3.1tothebook,pages101-108.Butbeforeattempting toanswerthisquestioncheckthatyourcourserequiresstudyofisoquantandisocostcurve analysis,notallbusinesseconomicscoursesdoso. Isoquant curves map out levels of production obtainable from different combinations of factorinputsassumingthattheyareusedefficiently. Isocostcurvesmapoutthecostsofthesefactorinputsassumingdifferentinputprices. Eachisoquantcurveidentifiesagivenlevelofoutputandeveryisocostcurveagivenlevel ofexpenditureonfactorinputs. Themosteconomicproductionoccurswhereoutputismaximisedforanygivenexpenditure oninputs.Theresultisanoutputandcombinationoffactorinputsthatcannotbeimproved oninthesenseofobtainingahigheroutputfromthegivenbudgetorexpenditureoninputs. Chapterreference:Appendix3.1andFiguresA3.1toA3.5.

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C H A P T E R 4

AnalysisoftheFirmsSupplyDecision
Question1
Whatfactorsenterintothedecisionofacarmanufacturingfirmtolaunchanewmodel?

Guidance
Thisquestionrequiresyoutoidentifythosemattersthatyoumightreasonablyexpectacar manufacturertoconsider. Factorsthatwecanexpectinclude(a)thelikelydemandforthenewmodel(b)theexisting competition (c) expected new competition (competitors launching rival models) (d) forecast model design costs (e) forecast production costs (e) forecast marketing and distributioncosts(f)existingexcesscapacity. Inotherwords,themanufacturerneedstotakeintoaccountarangeofmattersthatare likely to 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 to establish the price at which it plans to sell the new model. Price could be crucial to the successofthelaunch,especiallyifthepriceelasticityofthecarsishigh. Thefirmwillalsoneedtoconsidertheconsequencesofthelaunchtiming.Woulditpayto delay the launch, perhaps until after a competitor reveals its new vehicle? Is there an advantageinbeingfirsttomarket? Thefirmwillalsoneedtoconsiderthemostappropriateorganisationofitsvaluechainto supplythevehicle. Chapterreferences:thisquestioncallsoninformationfromacrossthechapterandconsolidates learningfromtheearlierchaptersondemand,costsofproductionandsupply.

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Question2
Usingtheconceptofelasticityofsupply,explainwhyrawmaterialpricesoftentendtobeless stablethanmanufacturedgoodprices.

Guidance
Elasticityofsupplyisameasureoftheresponsivenessofsupplytoachangeinprice. Where supply is price elastic, producers can alter their supply substantially when price varies (the extent to which they can do this varies directly with the supply elasticity). Wheresupplyispriceinelasticsupplycanbevariedlesseasilyinresponsetopricechanges. Where supply is less easy to vary quickly, prices are likely to fluctuate more as demand changes. 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,rawmaterials oftencomefrompoorercountriesthatarelessabletoaccommodatea significant fall in production by earning extra income elsewhere. When prices rise it may take much longer to expand raw material production than manufacturing production (thoughthiswilldependupontheparticularproductiontechnologyused). Chapterreferences:pp.114 116.

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Question3
Considerhowahotelownerwoulddecidehowtopricehotelrooms: (a) whendecidingwhethertobuildthehotelattheoutset (b) havingbuiltthehotel,soastoensurethatthemaximumnumberofroomsis occupied eachevening.

Guidance
Beforebuildingthehoteltheownerwillwishtosetaroompricethatcoversthetotalcosts of supplying the room including earning a normal profit. In other words, the room price should be set on a full cost basis or equivalent to the average total cost of providing rooms. Oncethehotelisbuilt,however,theownerhasasunkcost,thecostofthehotelbuilding andfacilities.In other words,thereare fixedcosts ofproductionthat will havetobe met whetherroomsarefilledornot.Inwhichcasethehotelownershouldbewillingtoaccepta roompricethatatleastcoversthevariablecostsofprovidingtheroom(e.g.staffingcosts, laundryandcleaningcosts,heatingandwatercostsandmealsifprovided).Thisiswhyyou canoftennegotiatealowerpriceforahotelroomifyouarriveatthehotellateintheday. The hotel owneris betteroffrentingtheroomtoyouforthenight atbelowfullcostthan leaving it empty. You do run the risk, however, that the hotel is already full and you are turnedaway! Another way of looking at this issue is in terms of elasticity of supply. Once the hotel is built,thetotalsupplyofroomsisperfectlyinelastic. This pricingstrategy makes senseprovidedthat not too manypotentialcustomers arerisk takersanddonotbookinadvance,arrivelateandtrytobargaintheroomratedown.Itisfor thisreasonthatsomehotelswillnotofferalowerratelateintheday.Theyfeartheimpact ontheiroverallrevenuesfrombookings. Chapterreferences:pp.112 115alsoseethediscussioninChapter3pages7880.

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Question4
(a) Drawavaluechainforatypicalretailbank. (b) Discusswheremostvalueislikelytobecreatedandwhy. (c) Considerwhat arelikelytobethe maincorecompetencies anddistinctivecapabilities thataretailbankwillneedtohavetosustaincompetitiveadvantage.

Guidance
(a) The value chain shows where value is added at each stage of production and supply. AtypicalvaluechainforamanufacturingfirmisprovidedinFigure4.5onpage118ofthe textbook. This will need to be amended to reflect the manner in which retail banking services 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 bank services.Althoughbanks donotprovideanaftersalesserviceintermsof,say,repairand warranty work, service is a key attribute of a successful retail bank. Indeed, professional servicesarebuiltandsustainedbyprovidingconsumerswithahighqualityofservice. (b) Therefore,valueismostlikelytobecreatedintermsofprovidingservice,includingspeedy, efficientandpolitebranchstaff,smoothoperatingheadofficefunctionsandinnovationin financialproductstoattractandretaincustomers.Forexample,closingthebranchnetwork wouldcertainlybedisastrousunlesssomeotheravenuetocustomersisbeingusedsuchas Internet and/or telephone banking. Most retail bank customers still depend on local branches. (c) Corecompetencies arebased on information orknowledge offinancialproductsandtheir efficientandeffectiveprovisiontoretailcustomers.Theyarealsobasedontheinformation systems including IT systems that sustain this knowledge base and information flow. Distinctive capabilities relate to training of staff, reputation of the bank (would you put your money with an unknown entity?) and ownership and organisation of an integrated retailbankingsystem.Anotherdistinctivecapabilityisinnovationinfinancialservices. Chapterreferences:pp.115 120and122124Figures4.4and4.5.

29

Question5
Onwhatbasismightahousebuildingcompanydecidewhethertoemployitsownbricklayers, carpenters,plumbersetc.,ratherthanusingsubcontractingfirms?

Guidance
Most building firms buy in these specialist services. One reason might be that they have insufficientworktojustifyemployingtheirownfulltimestaff.Generallythereasonrelates tothetheoryoftransactioncosts.Forexample, you might thinkthat bricklaying is acore competence in building but this is not so. Large building companies are best viewed as contractingfirmsthatcontracttobuylandandbuildhomesandoffices(insomecasesthey may build premises on land owned by separate landowners or property developers). They organise the supply chain and may market the homes and offices to potential consumers (though in some instances this activity may be contracted out to other parties, suchasestateagents). Whatdrivesthedecisionwhethertooutsourceanactivityordoitinternallywithinthefirm istransactioncosts.Thetheoryofcontractioncostsisconcernedwiththeeconomicsofthe decisionastotheboundaryofthefirm.Transactioncostsincludethecostsofnegotiating, 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 (perhapsthroughatenderingprocess),monitorthequality oftheplumbingworkprovided and 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 negotiated solutioncannotbefound). These transaction costs when contracting for building services need to be set against the costsofafirmemployingitsownbricklayers,carpenters,plumbersetc.,whichincludethe costs 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 staff managementcostscanbeinterpretedasakindofinternaltransactioncost. Chapterreferences:pp.120 122.

30

Question6
Giveexamplesoffirmswithwhichyouarefamiliar,whichareeither: (a) verticallyintegrated (b) horizontallyintegratedor (c) conglomerates. Consider the merits of these forms of organising production with reference to the firms you havelisted.

Guidance
Thisquestionasksyoutoselectyourownexamples. Verticalintegrationoccurswheredifferentstages inthesupplyorvaluechainarebrought within the direct ownership and control of the firm for example a Television (TV) manufacturer purchasing a materials supplier (called backward integration) or a retail outlet(calledforwardintegration). Horizontal integrationinvolves mergers andtakeoversbetweenfirms at thesamestageof manufacture(e.g.aTVmanufacturerbuyingtheproductionfacilitiesandbrandsofarival TVmanufacturer). Conglomeratemergersinvolvefirmsbuyinginterestsinunrelatedindustriesandeconomic activities(e.g.atobaccocompanypurchasingabank). Chapterreferences:pp.124 125.

31

Question7
Alocalradiostationisabouttonegotiatearenewalofitsoperatinglicence.Writeareportfor its management setting out the approach that the management should take to the contract renewal.Thecurrentoperatingcostsofthestationare$600mperannum,theannualisedcapital costs are $150m, and the annual revenues from advertisers total $800m. There is no other revenue. In addition, the station pays the state licensing authority $30m per annum for an operatinglicence.Itisrumouredthatthelicensingauthorityintendstoraisetheannuallicence feeto$70mperannuminthenextfranchiseperiod.Thestationanditsfacilitieswerebuiltfive yearsagoatacostof$900m,whichisbeingwrittenoffonastraightlinebasisoverapredicted tenyearlife(i.e.$90mperannum).Theannualisedcapitalcostof$150miscomposedof$90m depreciationand$60mininterestchargesonloansincurredtofinancethecapitalinvestment. In writing yourreport,establish whethertheradiostationshouldseekalicencerenewal ifthe rumourednewlicencefeeprovestobecorrect.

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 services includinganormalprofit. Annual operating and capital costs total $750m and revenues $800m, so at the outset the station is profitable after the $30m licensing authority charge (indeed, assuming the costs already include a normal profit the station is earning an annual supernormal profit or economicrentof$20m).Ifthelicensingauthorityraisesthelicencefeeto$70mperannum thenclearlythestationwillstartmakinganannualloss,of$50m. This question is a variation on similar questions in earlier chapters on the economics of shutting down production in the short and longrun. If the station has to pay the $90m depreciationchargeandthe$60minterestchargeswhetherthestationoperatesthentheloss by not operating (and hencereceivingzerorevenue) wouldbe$150m.This is largerthan thelossfromoperating($50m)sothestationshouldcontinuetooperate. This conclusion holds provided that the $150m in capital charges must continue. If the station was closed and the firm as a legal entity was wound up these charges might be avoided. Under some legal jurisdictions the loan creditors may be able to mount legal actionsfordebtrecoveryfromthestationsdirectorsbutmoreusuallytheywillbeprotected providedthatthefirmhaslimitedliabilitystatus.Anotherpossibilityisthatthestations capitalassetscouldbesoldtoanalternativeownerforasufficientsumtorecoupthecapital costsandrepaytheloans. Yourreportshouldcovertheseissues.Youshouldalsoreflectonthepossibilityofmaking economiesinoperatingcostsandboostingrevenues.Howmightthisbedone? Chapter references: the material in the chapter is generally relevant, as is the discussion in Chapter3,pp.78 80.

32

C H A P T E R 5

Demand,SupplyandPriceDetermination
Question1
TheOrganisation ofPetroleumExportingCountries (OPEC)cartel has justannouncedcutsin productionlevels,whichareexpectedtodriveupthespotpriceofabarrelofoilby20%inthe comingweeks.Usingappropriatedemandandsupplydiagrams,examine: (a) Theimpactontheretailprice ofpetrol. (b) Thelikelyimpactontheelectricitysupplymarket,bearinginmindthatoilisaninput intoelectricitygenerationaswellasbeingasubstitutesourceofenergy.

Guidance
This question allows you to demonstrate your grasp of the economics of demand and supply. 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. Forexample,themoreelasticisdemandthelargerthereductioninpetroldemandthatthe priceincreasewillprovoke.Inconsequence,thepetrolcompanies willabsorbsomeofthe effectsofthecrudeoilpricerise.Theextenttowhichthepetrolcompaniesabsorbthecost willdependupontheelasticityofsupply.Forexample,themoreinelasticthesupplytheless ablewillbethepetrolcompaniestocutbackoutputasdemanddeclines. Inpractice,thedemandforpetroltendstobepriceinelasticbecausevehicleusershaveno substitutefuelandpetrolcompaniescanaltertheamountofrefinedpetrolthattheyplaceon the market tosome degree(though having largefixedcosts theyhavetobecarefulnot to increasetheiraveragetotalcostsofsupplysharplybecauseofoutputreductions). Youcanillustratethelikelyeffectifyoudrawthedemandcurvewithasteeperslopethan thesupplycurve.Theriseinthepriceofcrudeoilmovesthesupplycurveforpetrolatthe pump to the left because it increases the costs of production. By identifying the new equilibriumpriceyoucanascertainhowfarthepriceofpetrolhasincreasedtoconsumers. Thepetrolsuppliersabsorbtheremainderofthecostincrease. In the case of electricity generation the impact on the price and output of electricity is similar with high fixed costs in generation but perhaps a greater ability on the part of consumers to switch to other forms of fuel, especially over time (for example, there are different fuels for central heating but no real alternatives for powering cars). However, theadditionalissuehereisthatifoilisthemainalternativefueltoelectricity,thecompanies shouldbeabletopass on more ofthe costtoconsumers becausetheprice ofthe obvious substitute,fuelhasalsorisen.

33

 Thediagramforelectricitygenerationwillalsoshowashiftinthesupplycurvetotheleft becauseofhigherproductioncosts. Chapterreferences:pp.134 135andFigure5.3.

34

Question2
In todays Budget statement by the Government, a new specific tax of $2 per unit has been leviedoneachbottleofwinesold.Assumethatbeforetheimpositionofthisnewtax,thesaleof winewastaxfree.AnewsflashontelevisionclaimsthatTaxcauseswinepricestoriseby$2 perbottle.Evaluatethisstatement.

Guidance
ThisanswertothisquestioninvolvesmanyofthefeaturesoftheanswertoQuestion1. Ataxincreaseraisesthesellingpriceandcanbeillustratedasashiftinthesupplycurveto theleft. It is mostunlikely, however,that consumers wouldbearthefull taximposition of$2per unit.Ifstoresraisedthepricebythefullamountofthetax,theywouldseedemanddecline dependent upon the price elasticity of demand for wine. Only if demand elasticity was perfectlyinelastic(averticaldemandcurve)wouldthe$2priceincreasehavenoeffect on winesales.Thisisveryunlikely. Theresult willbethatsomeofthetaxwillbebornebythesuppliers.Theextenttowhich thetaxis paidbycustomers orsuppliers depends upontheprice elasticity of demandand supplyinthemarket. Chapterreferences:pp.138 142andFigures5.4and5.5.

35

Question3
Giveexamplesofgoodsorserviceswheretheincidenceofasalestaxislikelytofallprimarily on: (a) consumers (b) producers.

Guidance
ThetheoryrelevanttoansweringQuestion2applieshere. Consumersbearmoreofthetaxthemoretheirdemandispriceinelasticandthegreaterthe elasticityofsupply. Productswhereasalestaxismostlikelytofallmostheavilyonconsumersarethosewhere therearefewifanysubstitutese.g.petrol,commuterrailfares. Productswhereasalestaxismostlikelytofallmostheavilyonproducersarethosewhere consumers may have many acceptable substitutes and producers are unable to alter their supplysignificantlyforsometime e.g.ataxoncinemaseatsbut not ontheatreseatsand otherformsofentertainment. Chapterreferences:pp.138 142andFigures5.4and5.5.

36

Question4
Explain,usingdemandandsupplyanalysis,whyagriculturalsurplusesariseundertheEuropean Common Agricultural Policy (CAP) in which farmers receive large subsidies linked to productionlevels.

Guidance
TheEuropeanCAPhas anumber ofcomponentsincludingpurchasing excess production, protection from imports and export subsidies. However, the issue we are concerned with here is the manner in which the policy keeps market prices in Europe for agricultural productsabovetheircompetitivemarketclearinglevel. Whenthepriceisabovethemarketequilibriumtherewillbeexcesssupply.Theresponsein a competitive market is for prices to fall. But the CAP removes much of the excess productionfromEuropeanmarketsthusretainingthehigherprice. The objective is to smooth out agricultural prices and provide a secure revenue flow to encourageinvestment inEuropeanfarming.Inyearsofabundant harvests,stocksarebuilt upandreleasedtothemarketinyearsofbadharvests. Inpractice,however,duetocontinuingpoliticalpressurefromfarminglobbiesagricultural priceshavetendedtoremainabovetheirmarketclearinglevelsforconsiderablelengthsof time.Thishasledtolargestocksofsomegoodsandinturncostlystorageandinsomecases theireventualdestruction.Morerecentlytherehasbeenactiontoreducetheoutputoffarms throughinitiativessuchassetasideschemes,wherefarmersaresubsidisedtotakelandout ofproduction. Yourdiscussionshouldbebasedaroundademandandsupplyanalysis andthesubject of theequilibriumprice. Chapterreferences:pp.131 134and142145 andFigure5.1.

37

Question5
It is often claimed that the free market leads to an economically efficient allocation of resources but is this allocation necessarily equitable from a social welfare perspective? Assessthisquestionwithreferencetothedomestichousingmarket.

Guidance
Thefreemarket is economicallyefficient whenit ishighlycompetitive.Theresultisboth allocativeandproductive efficiency.That is tosayno otherallocation oftheresources could improve economic welfare and the output is produced with the leastcost use of resources. Theseresultsdepend,however,ontheexistingincomeandwealthdistribution,whichmay bedeemedinequitable.Adifferentincomeandwealthdistributionwouldleadtoadifferent pattern of demand and supply and therefore a different welfare maximising allocation of resources. Inaddition,economicwelfarewillnotnecessarilybemaximisedinafreemarketifthereare marketimperfections,suchasmonopolyorexternalities. Thehousingmarketisaninterestingmarkettoshowyourgraspofdemandandsupplyand theeconomicwelfareimplications. Housingtendstobeveryinelasticinsupply(atleastintheshortrun).Atthesametimewe allneedsomewheretolive,sohousingintotal(thoughnotindividualproperties)hasavery price inelastic demand. This applies whether we are discussing the market for house purchasesorhouserentals.Demandinbothcasesisnotperfectlypriceinelasticbecauseas prices continue to rise some of us may switch from buying to renting (or vice versa) or choose to live in caravans and tents instead. Others may be priced out of the housing market. In answering this question you should demonstrate a good understanding of demand and supplyanalysis,the operationofcompetitive marketsandrecognisethat while economics mayconcentrateontheefficientuseofresourcesitshouldnotloosesightoftheimpacton socialwellbeing. Chapterreferences:pp.131 138andFigure5.1.

38

Question6
During the past decade, microchip prices have fluctuated wildly on world markets, reflecting periods ofexcess demandfollowedbyexcesssupply.Usingappropriatediagrams,explainthe impactoftimelagsintheproductionofmicrochipsonpricelevels.

Guidance
Figure5.1isthe standarddiagramillustratingexcessdemand.However,thisquestiondraws yourattentiontotheroleoftimelagsinproduction.Thatistosaythatcurrentsupplycannot respond immediately to demand changes. When this is the case, supply is likely to be a functionofpastprice. While it is common to discuss the cobweb theory in relation to agricultural markets becausesupplycan most obviously not respond immediatelytopricechangesin farming, the analysis can be applied to any market where similar time lags apply. You should thereforeuseFigure5.8asthebasisformuchofyourdiscussion. Chapterreferences:pp.142 145andFigure5.8.

39

Question7
Whywouldyouexpectthewholesalepriceofcoffeeinworldmarketstofluctuatemorethanthe wholesalepriceofdailynewspapers?

Guidance
Someoftheanalysisissimilartothatwhichappliestothepreviousquestion. Newspapersareprinteddailyorweeklyandthereforesupplycanbeveryquicklyadjusted to changes in demand provided that there is some spare printing capacity available. Bycontrast,coffeeproductioncannotbealteredquickly. In consequence, whereas newspaper production can be represented using the standard demandandsupplydiagramwithdemandandsupplycurvesshiftingsmoothlytorestorean equilibriumpricewheneithertheconditionsofdemandorsupplychange,coffeeproduction follows a slower and less predictable movement to the longrun equilibrium price, asrepresentedbycobwebtheory. Chapterreferences:pp.131136andFigures5.1,5.2and5.3andpp.142145andFigures 5.8and5.9.

40

C H A P T E R 6

AnalysisofPerfectlyCompetitiveMarkets
Question1
(a) Giveexamplesofmarketsthatmostcloselyequatetoperfectlycompetitiveones. (b) Inwhatwaysdotheyfallshortofbeingperfectlycompetitive?

Guidance
Perfectcompetitiondemandsverystrictassumptionsthatareunlikelytobefoundinmany ifanymarketsintherealworld.Marketsthat mostcloselyequatetoperfectlycompetitive ones are those in which thereare very large numbers of buyers and suppliers, reasonably freeentryandexitfromthemarketandwellinformedconsumers.Itisinsuchmarketsthat thepurchasedecisionisdrivenbyprice. Anexampleofthisisacompetitivestockmarket,asexistsinmajorfinancialcentres,such asNewYork,LondonandTokyo.Here,aparticularcompanyssharewilltradeatthesame priceatanygiventime.Ifitdidnot,thenarbitragerswouldpurchasetheshareatthelower priceandresellitatthehigherpriceforprofit.Thisactionwouldequalisetheprice.Inother words,noonewouldbuyaMicrosoftshareat$100ifanequivalentMicrosoftsharecould beboughtfor$99. Otherexamplesofverycompetitivemarketsdrivenbypricearethemarketsforagricultural products,mineralsandoil.Thisiswhyapricecanbequoteddailyforsuchproductsinthe financialpress,suchasthepriceofBrentcrudeoil. Inallthesemarketstheproductishomogeneous. However, none of these markets need necessarily be perfectly competitive. All markets have some information imperfections including stock markets otherwise how do we accountforsomeonebuyingastockjustbeforeitfallsinprice?(Rememberthatinperfect competitionthereisperfectinformationaboutthefuture.)Also,whiletheremaybealarge number 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 is alsoarelativelysmallnumberofinternationaloilcompaniesthataccountformostoftheoil purchases. Inotherwords,inrealworldmarketsthestrictassumptions ofperfectcompetitionarenot met. Chapterreferences:pp.151157Figures6.26.5.

41

Question2
Ifallproductsweresoldinperfectlycompetitivemarkets,whymaytheallocationofresources beparetooptimal?

Guidance
Thestartofthisanswershouldsetoutclearlyaboutwhatperfectcompetitionisanddefine Paretooptimalityandallocativeefficiency. Theanswershould thengoontoexplain,whyifallmarketswereperfectlycompetitivePareto optimalityresults. You can conclude that it is this powerful result that leads economists to argue for competitioninmarkets. Chapterreferences:pp.159.

42

Question3
Whywouldmanagershavenodiscretioninsettingthepricesofproductsorservicesinperfectly competitivemarkets?

Guidance
Oddlyasitmayfirstsound,ifmarketswereperfectlycompetitivetherewouldbelittlefor managerstodo.Pricesandoutputswouldbesetgiventhecompetitivedemandandsupply conditions and firms would accept the going market price. There would be no role for marketingbecauseall firmsproductsarethesameunderperfect competition (there is no brandingofproducts,forexample). After explainingthis,youcango onto demonstrateyourprowess inthetheory ofperfect competition by explaining the model and drawing the perfect competition diagrams for marketequilibriumintheshortandlongrun. Chapterreferences:pp.152 157 andFigures6.2and6.4.

43

Question4
(a) Whyisitarguedthatafirmoperatinginaperfectlycompetitivemarketwillproduceat thetechnicallyoptimumlevelofproductionin thelongrunbutnottheshortrun? (b) Whatdoesthisimplyabouttheefficientallocationofresourcesinperfectlycompetitive markets?

Guidance
Thetechnicallyoptimumlevelofproductionisthatatwhichproductioncostsperunitareat theirlowest.Thisisattheminimumpointofthelongrunaveragetotalcostcurve. Inansweringthefirstpartofthis question youwill needtoshowthat youcandistinguish between the equilibrium price and output in the shortrun and longrun under perfect competition and draw the appropriate diagrams. Once you have drawn the diagrams you will be able to identify clearly that in the shortrun the firm under conditions of perfect competitiondoesnotproduceattheminimumpointonitslongrunaveragetotalcostcurve, butitdoessointhelongrun. Theimplicationofanefficientallocationofresourcesisstraightforward.Efficientallocation requiresthatresourcesbeallocatedsothatnoalternativeallocationwouldimproveeconomic welfare. The resulting allocative efficiency is known as Pareto optimal. Also, theresultingset of outputs mustbeproducedat leastcost orwithproductive efficiency. Under conditions of perfect competition, in the longrun both allocative and productive efficiencyisachieved. Itisnotsurprising,therefore,thateconomistsfavourcompetition. Chapterreferences:pp.157 159andFigures6.4and6.5.

44

Question5
Ifamarketisperfectlycompetitive,whatwouldbetheeffectofanincreaseinthedemandfora goodorserviceontheoutputandprice: (a) intheshortrun (b) inthelongrun?

Guidance
Anincreaseindemandshiftsthe marketdemandcurvetotherightleadingtoariseinprice. Foreachindividualfirmintheperfectlycompetitivemarket,this meansthatthepriceand thedemandcurveitfaces,rises.Theresultissupernormalprofit. In the longrun, 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 of supernormalprofits.Eachfirminthemarketwillnowfacealowerpriceanddemandcurve. Inansweringthisquestionyouwillneedtobeabletoreproduceandexplainthediagrams showingthemarketequilibriumintheshortrunandlongrun. Chapterreferences:pp.152 157andFigures6.2and6.4.

45

Question6
Afirminperfectcompetitionmakesnoeconomicprofitinthelongrun.Discuss.

Guidance
This question requires you to explain the difference between a normal profit and a supernormalprofit. Anormalprofit hastobeearnedorthefirmwillleavethemarket,henceeconomiststreat normalprofitasanothercostofproduction. By contrast, supernormal profit is an economic rent or excess profit above normal profit. Itisthisprofitthatisbeingreferredtointhequestionaseconomicprofit. Using the perfect competition diagrams illustrating the shortrun and longrun market equilibria,youshouldthenexplainhoweconomicprofitiscompetedawayinthelongrun throughmarketentrybynewsuppliers. Chapterreferences:pp.152 157andFigures6.2and6.3.

46

Question7
(a) Explain why a firm in a perfectly competitive market may continue to produce even whenlossesarebeingmade. (b) Explainwhysuchasituationcannotbesustainedoveralongtimeperiod.

Guidance
This question is a little trickier than the previous questions and needs you to blend the knowledgegainedfromthereadinginanearlierchapteraboutshuttingdownproductionin the short and longrun (pp. 71 75) with the perfect competition model set out in this chapter. Providedthat afirmcanat leastcoverits variable costs it willcontinuetoproduce inthe shortrun. This is because even larger losses would be made if the firms shut down production (assuming that the fixed assets have no opportunity cost). In the longrun, however,thefirmmustcoverbothitsvariableandfixedcostsifitistobeprofitable. Youshouldexplainthiswithrelevant diagramsanddiscussion,usingthereferences given below. Chapterreferences:pp.78 80andFigure3.7, andpp.152 157andFigure6.3.

47

C H A P T E R 7

AnalysisofMonopolyMarkets
Question1
Untilthe1990stelecommunicationscompaniessuchasDeutscheTelekomandFranceTelecom monopolised the delivery of their fixedline telecommunication services. If these corporations had achieved maximum profit, what would this have meant in terms of allocative and productiveefficiency?

Guidance
Anobviousstartingpointistodefineallocativeandproductiveefficiency. Allocative efficiency is concerned with allocating resources so as to maximise social welfare 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, which meanscombiningfactorsofproductionsoastomaximisetheoutputforgivenfactorprices. Thereisnoneedtoknowmuchaboutthetwocompaniesmentionedinthequestion.Butit isnecessarytodrawadiagramsothatyoucanidentifypreciselywhereallocativeefficiency occurs.Thefirmsaremonopolies,sothediagramneededisthestandardmonopolydiagram of this chapter. A profit maximising firm will determine its output according to where MC=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 a monopoly would lead to lower consumer surplus, higher profit (economic rent) and, importantly,adeadweightloss. The monopoly diagram is drawn on the assumption that the monopolist will not be productivelyinefficient.Butyoucanamendthediagramtoshowproductiveinefficiencyby raisingthe marginalandaverage cost curves onthe diagram.This leads toan even lower profit maximising output.It does, however,also meanthat profitsare loweredbecause of thehighercosts.Ourexpectationis,therefore,thataprofit maximisingmonopolistwillbe allocativelyinefficientbutproductivelyefficient. Inpractice,however,thelackofcompetitionmayleadamonopolisttobelessfocusedon production efficiency the result is that the monopolist then forgoes some profit for an easylife. Theabovediscussionhasnotconsideredpossibledynamicgainsfromafirmhavingavery high market share. These possible gains, that can easily be exaggerated, are discussed on pages158 159. Chapterreferences:pp.166 172andFigures7.1and7.2.

48

Question2
Inwhatwaysmightstateownershipofamonopolyaffectpriceandoutputdecisionsandwhy?

Guidance
Governments may be less concerned with profit maximisation than wider social welfare maximisation. 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 lower pricesandthereforemoreconsumersurplus. Another (perhaps more realistic) alternative is enterprises may be used to meet political goals, such as minimising redundancies or locating investments on political rather than economiccriteria.Inwhichcase,theresultwillbeproductiveinefficiencyevenifallocative efficiencyisachieved. Ifinachievingwidersocialandpoliticalgoalsenterprisesrelyonstatefundingratherthan user charges for some of their financing, then this will have implications for the level of taxationorlevelsofinvestmentinotherareasofpublicexpenditure.Taxationmovesprices frommarginalsupplycostsandthereforecancreateallocativeinefficiencyelsewhereinthe economy. Itshouldbeclearthatadiscussionofpricingandoutputunderstateownershipiscomplex and dependent upon the precise goals of government and the impact of government decisionsonthewidereconomy. Indevelopingthisanswer,youshouldbeabletoappreciatewhatimpactprivatisationofthe enterprises is likelytohaveonpriceand output(atleastintheabsence ofcontinuedstate regulation). Chapterreferences:pp.166 170andFigure7.2.

49

Question3
Afirmintendstotakeoveritsonlyrivalinthemarketandbecomethesolesupplier: (a) givereasonswhythefirmmaybeadoptingthisstrategy (b) considerhowthecountryscompetitionauthorityislikelytoassesstheconsequencesof thetakeover (c) forwhatreasonsmightthecompetitionauthority:(i)prohibit(ii)allowthetakeoverto proceed?

Guidance
In answering the first part of this question, takeovers can occur for a number of reasons. Ontheonehand,thecombinedfirmmayexpecttoachievecostsavingsthroughsharingthe labourforce,buildingsandcapitalequipment.Itmayalsoplantocombinesalesforcesand marketing expenditures toboostjoint sales.Inotherwords,thefirmanticipates efficiency gains with economic benefits. On the other hand, the motivation may be simply to monopolisethemarket,leadingtohigherprices,loweroutputandlowerconsumerchoice. Theresponseofacompetitionauthoritywill,therefore,bedependentuponwhichofthese twosetsofmotivationsforthetakeoveritsuspectstobedominant.Inarrivingatitsdecision itwillneedto(a)definetheproductmarkettoassessthedegreeofdemandsidesubstitution (can consumers switch to an acceptable alternative supply quickly?) and supplyside substitution (if the firm raised price could existing or new firms respond swiftly and compete,therebymakingthepriceincreaseunsustainable?). Iftheauthority should decidethat theresult ofthetakeover is likelytobetheabuse ofa dominantpositioninthemarketplaceorasignificantreductionincompetitionitislikelyto ruleagainstthetakeover.Thiswillbetheobviousconclusionifthereislikelytobelimited demandsideorsupplysidesubstitution. Chapterreferences:pp.166 172andFigure7.2(youmayalsoliketoconsultpp.358 361in Chapter16onCompetitionPolicy).

50

Question4
Mailservicesinmostcountries,areprovidedbyasinglesupplier(whichisoftenstateowned). Whyis it importantto definethemarket carefullybeforedecidingwhetherthesesuppliersare monopolistsintheirownterritories?

Guidance
Most letter collection and deliveries are supplied by a monopoly with the exception of premium services (e.g. express mail), though some countries are introducing more competition. Thequestionisconcernedwiththedefinitionofamonopoly.Technically,amonopolistis thesolesupplierofagoodorservice.Butthissortofdefinitionimpliesthatthemarketis clearly defined, which is rarely the case. For example, a firm may have a monopoly of normalpostaldeliveries,butarepremiumservicespartofthesamemarketoraretheyina different 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 services accordingtothepricescharged. Also, post is a form of communication. If we widen the market definition to communications then we need to consider telephone services, Internet, email and fax. Inwhichcase,theshareofthemarketthatthepostalservicesuppliesshrinks. Itshouldbeclear,therefore,thatthewidertheappropriatemarketdefinitionthelesslikelyit is that a single firm will monopolise the market. The wider the market the greater the potential for both supplyside and demandside substitution (for further details, see the GuidanceNotestoQuestion3above). Chapterreferences:pp.165 166and172174.

51

Question5
IntheUnitedStatesofAmerica,steelworkerssupportedbytheiremployerssuccessfullylobby their government for import controls and other state aid. Why do some observers support the workers while others label their actions as rentseeking behaviour? What is the relationship (ifany)betweenthebehaviourofUSsteelworkersandthebehaviouroffirmsthatcolludetofix pricestoconsumers?Shouldweadoptthesameanalyticalprocesstojudgebothsituations?

Guidance
ImportcontrolsonsteelprotecttheproductionofsteelintheUnitedStatesand,therefore, thejobsofsteelworkers.Insofarastheresult istoraisepricestoconsumersandrestrict choice,there willbeawelfareloss.Inthis sense,theresult involvesatransferof income fromconsumersofsteel(andsteelproducts)intheUnitedStatestosteelworkersinterms ofwagesandtheiremployersintermsofprofits. The lobbying effort is therefore a form of rentseeking behaviour with higher prices and lower output sold in the market leading to a deadweight welfare loss. The reason some wouldsupport the workers is becauseofafearof joblosses andthe widersocial welfare implications. Inthesensethattheworkersandtheiremployersarerentseeking,theirbehaviourandthat ofcolludingfirms is similar.Theresult is loweroutput,higherprices andaloss ofsocial welfare. However, there may be public sympathy for the steel workers because they are trying to protect their jobs and communities. Colluding firms are simply trying to earn economicrentattheexpenseofconsumers. Itisforthisreasonthatsomemightbeuncomfortableusingthesameanalyticaltechniqueof rent seeking to assess the lobbying against imports that threaten jobs and to assess the economic effects of colluding firms. However, to economists, both import controls and collusionsimilarlyraisepricesandcanimpactadverselyonsocialwelfare. Chapterreferences:pp.174 175andFigure7.2.

52

C H A P T E R 8

AnalysisofMonopolisticallyCompetitiveMarkets
Question1
(a) Give examples of markets that most closely equate to monopolistically competitive ones. (b) Describe the ways in which these markets differ from markets that are strictly monopolisticallycompetitive.

Guidance
Liketheothertheoreticalmodelsofmarketsdiscussedinthebook,monopolisticcompetition occursunderanumberofstrictconditionsorassumptions.Theremustbealargenumberof firms competing in the market and each has only an insignificantly small share of the market.Thismeansthateachfirmisa'pricetaker',acceptingthegoingmarketpricesetby marketdemandandsupply.Eachfirmisassumedtohavethesameorverysimilarcostsof production. There is free entry and exit from the market and the firms produce similar (thoughnotidentical)products. So,wearelookingforverycompetitivemarketswithlargenumbersofcompetingfirmsand involvingsomelimiteddegreeofproductdifferentiation.Examplesmightincludetakeaway foodrestaurants,iftherearealot inyourneighbourhoodandtheyarelittledifferentiated highstreethairdresserswhereconsumersarechoosingbetweenthemonpricetaxisifthere arelargenumberscompetingandplumbingfirms. In practice, these markets may not be good examples of monopolistic competition. Inparticular,consumerstendtodifferentiatebetweentakeawayfoodrestaurantswithsome (e.g. McDonalds) having considerable brand loyalty some hairdressing firms can charge more than others either because of their reputation or location taxi charges tend to be regulated by the municipality thereby reducing price competition and the demand for plumbingservicescanexceedthesupply,leadingtoreducedcompetition. Chapterreference:p.179.

53

Question2
Towhatextentdomanagershavediscretionwhensettingpricesinmonopolisticallycompetitive markets?

Guidance
Managers in monopolistically competitive markets have no discretion and must be price takers.This follows fromtheassumptions underlying the monopolisticcompetition model (summarisedintheGuidanceNotestoQuestion1above)andparticularlytheverylimited product differentiation.Consumers buy onpriceandfirms mustpriceat the going market price. Chapterreferences:pp.180 181andFigures8.1and8.2.

54

Question3
(a) Considertheroleofmarketingandadvertisinginmonopolisticallycompetitivemarkets. (b) Whywillfirmstendtoallocateresourcestothedevelopmentofabrandstrategy?

Guidance
The lack of product differentiation in monopolistically competitive markets makes, inprinciple,marketingandadvertisingproblematic.Whereconsumerstreatproductsreadily assubstitutes,afirmadvertisingandmarketingitsproductwilltendtostimulatethesalesof itscompetitorsproducts too.This canbeexpectedto limit the incentiveforanyindividual firmtospendonmarketingandadvertising. Atthesametime,however,ifafirmcandevelopbrandloyaltyamongstconsumers itcan thenmoveawayfromhavingtocompeteundertheconditionsofmonopolisticcompetition. Brandloyaltyreducesthewillingnessofconsumerstoswitchtocompetitorsproductseven whenpricesarelower. Afirm can,therefore,be expectedtotryto developabrandpromotionstrategyto reduce consumer switching which is the same thing as saying that a brand promotion strategy reduces the (positive) crossprice elasticity of demand between the firms product and its competitorsproducts. Chapterreference:pp.183 184.

55

Question4
Whataretheeconomicwelfarecostsassociatedwithmonopolisticcompetition?

Guidance
Whenassessingtheeconomicwelfarecosts,perfectcompetitionistheobviouscomparison. Underperfect competitioninthelongrunbothallocativeandproductiveefficiencyoccur. In other words, P=MC (allocative efficiency) and production occurs where average total cost (ATC) is minimised (production efficiency). By contrast, under monopolistic competitioninthelongrunP>MCandATCarenotminimised.Theresultishigherprices andhigheraveragecostsofproduction. However,perfectcompetitionisatheoreticalextreme. Chapterreferences:pp.182 184andFigures8.2and8.3.

56

Question5
Discusstheroleofadvertisinginamonopolisticallycompetitiveindustry.Inwhatsensemight advertisingexpenditurebyaparticularfirmintheindustrybewasteful?

Guidance
TheanswerissimilartothatforQuestion3above,whichyoushouldreferto. Advertising expenditure uses up economic resources and therefore has an opportunity (economic)cost.Whileinformativeadvertisingthat improves consumerchoice maybean efficient use of resources, in the sense that the resources would not lead to a higher economicwelfareifusedelsewhereintheeconomy,otherformsofadvertisingmaybeless easytodefend. Chapterreference:pp.183 184.

57

Question6
Compareandcontrasttheshortrunandlongrunequilibriumfacingafirmunderconditionsof monopolisticcompetition.

Guidance
Theshortruninvolvesaperiodinwhichfirmscannotenter(orexit)themarket.Therefore, supernormalprofitscanbeearned. In the longrun, these profits will be competed away by market entry. In the longrun, firmsinmonopolisticcompetitionearnonlyanormalprofit. Answering this question requires drawing the appropriate shortrun and longrun market equilibriumdiagramsandexplainingthedifferentprice,outputandprofitconsequences. Chapterreferences:pp.180 181andFigures8.1and8.2.

58

C H A P T E R 9

Oligopoly
Question1
Ollipollyisacompanyproducingbusinessmagazines,whichhasonemainrivalinthemarket, Polliolly.Ollipollyhas45%ofthemarketandPolliolly,55%. (a) WhattypeofmarketdoesOllipollyoperatein? (b) What competitive strategy would you suggest to the board of Ollipolly to improve: (i)itsmarketshareand(ii)itsprofitability? (c) Would it be in the interests of the two companies to merge or for one to acquire the other?

Guidance
(a) Ollipollyoperatesinaparticulartypeofoligopolisticmarketwherethemarketisshared betweentwofirms.Thisiscalledaduopolymarket. (b) As inalloligopolisticmarkets,informulatingacompetitivestrategythereneedstobe attention 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 could increase its market share by pricing lower and attracting consumers from Polliolly. But what wouldbePolliollysresponse? If it matchedthepricecut the market shares mightnotchange.Moreover,thepriceelasticityofdemanddeterminesthetotalrevenue earnedbybothfirms (ifdemandis elasticthenthetotalrevenue earnedfromsales by both firms would rise, whereas if demand was price inelastic the total sales revenue woulddeclinefollowingapricereduction). The kinked demand curve could be used to show the possible effect of a price reduction. Youcouldalsoanswerthequestionusingagametheoreticanalysis. Theimpactonprofitabilitydependsonwhathappenstorevenueandcostsofproductionas price and output change. In general, reducing price is a higher risk strategy than other marketinginitiatives,suchasadvertisinganddevelopingastrongbrandbecauseitiseasier fortherivalfirmtomatchquickly. Your answer should therefore explore the likely responses in the market to different marketinginitiatives.Anotherpossibilitywouldbetotryandreducethecostsofproduction, whichcouldresultinapriceadvantageinthemarketorahigherprofit.Youshouldexplore howthismightbeachieved willitrequirenewinvestment?

59

 (c) Merger or acquisition would make the market a monopoly and would lead to higher profitability through the removal of competition unless there were considerable cost savings from the resulting economies of scale. It is unlikely, however, that the competitionauthoritieswouldstandasideandallowthistohappen! Chapterreference:materialthroughoutthechapter.

60

Question2
WithreferencetothePrisonersDilemma,explainwhycollusionisoftenafeatureofoligopoly markets.

Guidance
The Prisoners Dilemma is concerned with the dilemma that a prisoner faces when being questionedbythepoliceandcannotcommunicatewithanaccomplice.Shouldtheprisoner confessornot?Theanswerdependsuponwhethertheaccompliceconfesses. This Dilemma, which is a classic of game theory, is endemic in oligopoly markets. Firmschangingprices,consideringadvertisingcampaigns,investingetc.,coulddosowith moreconfidenceoftheoutcomeiftheyknewhowtheircompetitorfirmswouldreact. Collusionbetweenfirmsisequivalenttotheprisonerscommunicatingsecretlyandagreeing ajointstrategythatmaximisestheirutility.Iffirmsarecolludedperfectly(i.e.therewasno uncertainty and no cheating), then they could act as a monopolist and increase price, reduceoutputandincreasetheir(joint)profit. It should now be clear why competition law makes such collusion, e.g. in the form of cartels,illegal.Theyarenotinthepublicinterest. Chapterreferences:pp.194 199andFigure 9.3.

61

Question3
Identifytwo oligopolistic industries and compareandcontrast the ways in whichthefirms in theseindustriescompete.Explainthereasonsforanydifferencesincompetitivebehaviourthat youidentify.

Guidance
Thefirmsarelikelytoactsoastotryandincreaseproductdifferentiation.Inotherwords, they will wish to reduce the (positive) crossprice elasticity of demand between their productandcompetitorssubstitutes.Bydoingso,theygainsomemonopolypowerandcan makesupernormalprofits(economicrent). Oneofthefirmsmaybeapriceleader. You should therefore be looking at the firms marketing strategies and product mix. Differencesincompetitivebehaviourwillreflectdifferencesinproductmix,anydifferences inproductioncostsandanydifferences inmanagementstrategies(e.g.theirgoalsinterms of longrun or shortrun profit maximisation). In some industries government policy may alsoimpactonthestrategyadoptedthroughprohibitions,taxesandsubsidies,exchangerate policyetc. Chapterreference:materialthroughoutthechapter.

62

Question4
Using the kinked demand curve model, identify why oligopoly markets may be subject to relativepricestability,interspersedwithperiodsofaggressivepricewars.

Guidance
The kinked demand curve model is concerned with an oligopoly market where if a firm increases its prices its competitors do not alter their prices. The firm therefore suffers a significant loss of revenue and market share. In contrast, if the firm reduces its price its competitorsalsoreduceprice. Theresultisanincentiveforfirmstomaintainpricestability.However,ifonefirmwereto reduce its price this would trigger price reductions. If the first firm were to cut its price againtoseekcompetitiveadvantage,itscompetitorscanbeexpectedtorespondoncemore withpricecuts.Theresultwouldbeapricewar. Chapterreferences:pp.190 194 andFigures9.1and9.2.

63

Question5
Explainwhynonpricecompetitionisoftenfoundinoligopolisticmarkets.

Guidance
The answer to this question is similar to that for Question 4, which you should refer to again. Becausepricereductionscanleadtopricewarsthatleadtoallfirmssufferinglowerprofits, otherforms of marketingbecome moreattractive.Theseforms of marketingaregenerally aimed at building up brand loyalty e.g. through advertising. The result is to reduce the (positive) crossprice elasticity of demand of the firms product. If fully successful, theultimateoutcomewouldbethatthefirmwouldbecome,ineffect,amonopolistthatis tosayitsproductwouldnolongerbeviewedbyconsumersashavinganyclosesubstitutes. Inpractice,marketingisunlikelytobesosuccessfulandthecrosspriceelasticitywithother firmsproductswillremainabovezero,ifdiminishedbymarketing. Chapterreference:materialthroughoutthechapter.

64

Question6
JoeandDavidowntheonlytworestaurantsinavillage.Theyhavereachedasecretagreement thattheywilleachservesmallerportionsoffoodtoincreasetheirprofit margins.Underwhat circumstancesistheagreementlikelyto: (a) hold (b) breakdown?

Guidance
Joe and David are in a duopoly market for restaurant meals (assuming consumers are unwillingtotraveloutsidethevillagetoobtaintheirmeals).Bycolluding,theycanactlike amonopolistandmaximisetheirjointprofits. However, while this outcome is attractive to Joe and David, there must be trust between them.ShouldJoecheatandnotreducetheportionscustomerswillpresumablyswitchaway fromDavidsrestaurant. We therefore have a game here between Joe and David. Given that the size of portions would be easy for both Joe and David to monitor, cheating could only give a very short termadvantage.Therefore,theagreementmightwellhold.Itwouldbemoreproblematicif theagreementwaslesseasytopolice. Nevertheless,JoemightconsiderthatbypointingtoDavidsmuchsmallerportions(whata mean guy!) he will win longterm consumer loyalty and David will lose out. In other words,evenwhereanagreementiseasytopoliceforconformance,ifoneofthepartiesto the agreement would see longterm damage to its competitors reputation (or brand) by cheating,cheatingcouldbethedominantstrategy. Youshoulddevelopthislineofargumentbasedonthelessonsfromgametheorysetoutin the chapter and highlight the importance of trust, reputation and policing in collusive agreements.Youcanalsobringintoyouranswerthetimeperiodoftheagreementandthe issueoffiniteversusinfinitegames. Chapterreferences:pp.194 199andFigure9.3.

65

Question7
Assume that hotel Y is considering four possible strategies to increase its occupancy rate. Thesestrategiesareasfollows: (a) toreducepriceoverall by10% (b) toincreaseadvertisingexpenditureby30% (c) toofferenhancedfacilitiestoitsguests (d) toenterintoanewagencyagreementwithatravelpromotioncompany. Thecompanyconsidersthatitisverylikelythatitscompetitorswillrespondwithsimilardeals. Thequestionprovidesapayoffmatrixtoanalyse. (i) WhichofthefourstrategiesshouldhotelYadoptifitfollowsamaximaxrule? (ii) WhichofthefourstrategiesshouldhotelYadoptifitfollowsamaximinrule? (iii) Under what circumstances is the hotel management likely to adopt a maximin over a maximaxstrategy?

Guidance
Thisgametheoryquestionisansweredbycarefulscrutinyofthepayoffmatrixgiveninthe question. (i) Thehotelshouldadoptstrategy(b)onamaximaxrulebecausethepayoffismaximised atthelevel120.Theotherstrategieshavecausedmaximumpayoffsof20,50and30. (ii) Thehotelshouldadoptstrategy(c)ifitfollowsamaximinrulebecausethelowestpay offis10fromthestrategy.Theotherstrategiesreachlowerpayoffsof5,10and0. (iii) The hotel management will adopt the maximin rule if it is risk averse because the potential lowest payoff is higher with strategy (c) than strategy (b). The maximax strategy would be one favoured by an optimistic management that was risk neutral (unconcernedaboutthelevelofrisk). Chapterreferences:pp.194 199.

66

Question8
Howshouldcompetitionauthoritiesreacttotheannouncementofacartelarrangementbetween a countrys largest breweries to maintain beer prices and allocate regional markets amongst them? Would your answer be different if the national breweries faced intense competitive pressurefromimportedbeers?

Guidance
Operatingthiscartelintheabsenceofalternativebeerstoconsumersfromimportersseems clearlytobeagainstthepublicinterest. By raising prices and reducing choice through allocation of regional markets consumers suffer a decline in welfare or consumer surplus. Although the firms would earn economicrents,therewouldstillbesomedeadweightloss.Deadweightlossis discussed inChapter7,whichdealswithmonopolymarkets. The existence of imported beers makes the outcome less easy to identify precisely. If the volumeandscope of importedbeers was tobesuchthat consumers retained considerable choice and the decision to raise prices by the domestic breweries failed to hold, asconsumersswitchedtotheimportedbeers,thenthecartelisobviouslylessdamagingto social welfare. Indeed, in these circumstances we would expect the cartel to quickly collapse,asitwouldnolongerbeintheinterestsofanyofthedomesticbrewers. However,thedangerexiststhattheimporters mightbeenticedto,overtlyorcovertlyjoin thecartelandtherebyraisethe joint profits.Thentheoutcome is clearly not inthepublic interest. Chapterreferences:pp.200 202.

67

C H A P T E R 1 0

ManagerialObjectivesandtheFirm
Question1
Is profit maximisation a satisfactory assumption when modelling the behaviour of firms? Explainyouranswer.

Guidance
Differentapproachescouldbeadoptedtoansweringthisquestionandtheonebelowisour suggestion. First, what is meant by satisfactory? Profit maximisation may be satisfactory as a predictive device when modelling prices and outputs under different market competitive conditions,butitmaybefarfrombeingdescriptivelysatisfactory. Thetimeperiodneedstobeclarified.Noonecouldexpectafirmtoconsistentlymaximise shortrun profit and, in any event, this may not be compatible with longrun profit maximisation (e.g. cutting marketing expenditure to reduce costs in the shortterm might prejudicelongrunsales). Theprofitmaximisationassumptionispredicatedinthebeliefthatfirmswillknowhowto profit maximise. The model assumes perfect information. In fact, the firm may not have sufficient informationaboutconsumerdemandandmarginalproductioncoststomaximise profitexactly. Thequestiontalksaboutthebehaviouroffirmsandeconomistsoftentalkaboutthefirm raisingprices,thefirmreducingitsoutputandsoon.Infact,itisthemanagementwithin thefirmthatmakessuchdecisions.ItisfromthisperspectivethatsomewouldseetheCyert and March behaviouralist approach and similar approaches as more satisfactory than a profitmaximisationassumptionwhenmodellingfirms'behaviour.Thesemodelslookatthe decisionmakingprocesswithinfirms. However,inaverycompetitivemarketitisdifficulttoseehowafirmcouldsurviveinthe longrununlessitseekstomaximiseprofit. Firms not in the private sector to make profit, e.g. voluntary firms, such as charities and publicsectorfirms,maychoosetopursuesomeotherobjectivethanprofit. Chapterreference:materialthroughoutthechapter.

68

Question2
Whatdoyouunderstandbythetermthegrowthofmanagerialcapitalism?

Guidance
This question is concerned with the division between ownership and control in modern corporations or with corporate governance. Modern corporations contain a principalagent relationship,withshareholdersastheprincipalandseniormanagementastheagent. Itisthemovementawayfromownercontrolledbusinessestowardsshareholdercorporations withshareownershipwidelyspreadthatisassociatedwithmanagerialcapitalism Giventheprincipalagentrelationship,itispossiblethatmanagementmightnotpursuethe interestsofshareholders(maximumprofit)butratheritsowninterests(managerialutility). This would lead to prices and outputs that are not consistent with profit maximisation (MC=MR)forexample,wherethefirmpursuessalesrevenuemaximisation(MC > MR). Chapterreferences:pp.209 215.

69

Question3
Give examples of principalagent relationships in economic transactions and discuss their importancewhenanalysingbusinessdecisions.

Guidance
Theanswertothisquestionbuildsontheanswertothepreviousone,whichyoushouldread first. Whereaprincipalagentrelationshipexistsbusinessdecisionsmaynotbecompatiblewith strictprofitmaximisation.Thismeansadifferentoutputandthepricewillbechosen. Examplesexistinprivatesectorcorporationsandingovernment,asexplainedonpage197. However,aprincipalagentrelationship will exist in any economictransaction whereone person or agent acts on behalf of another, e.g. when you use a solicitor to pursue a legal claimonyourbehalf. Chapterreference:pp.211 215andFigure10.1.

70

Question4
Usinganappropriatediagram,showtheeffectofahigherminimumprofitconstraintonasales revenuemaximisingfirm.Towhatextent willthecompetitiveness ofthecapitalmarketaffect wheretheminimumprofitconstraintlies?

Guidance
TheappropriatediagramisFigure10.3onpage217. Raisingtheminimumprofitconstraintshiftsthehorizontalminimumprofitconstraint line upwardsandclosertowardsthemaximumprofit level.Asaconsequence,outputfallsand price willrise(givenadownwardsloping demandcurve).This is likelytoaffect,inturn, thelevelofemploymentinthefirm. Owners ofthefirm(shareholders inprivatesectorcorporations)canbe expectedtoprefer the maximum profit output to any other. If the capital market is very competitive and investorsareperfectlyinformed,investmentfundswillmoveawayfromfirmsthatarenot maximisingprofitstothosethatdo.Inwhichcase,firmswillnotbeabletoattractandretain capitalandremaininbusinessunlessprofitsaremaximised.Evenwhereperfectinformation doesnotexist(thereality),itistobeexpectedthatacompetitivecapitalmarketwillrestrain managementfrompursuingsales overprofits.Thisis thesameasamovementupwardsin theminimumprofitconstraintline. Chapterreferences:pp.216 218andFigure10.3.

71

Question5
InwhatcircumstancesisWilliamsonsmanagerialtheoryofthefirmlikelytobemostapplicable? Underwhatprincipalagentrelationshipsisitlikelytobefound?

Guidance
Williamsons theory is concerned with the potential of management to pursue its own utility and is therefore relevant in a discussion of the consequences of a principalagent relationshipincorporations(seetheanswerstoQuestions1and2). Itis mostlikelytobefoundorbemostapplicablewhereagents(management)canpursue their own goals rather than those of the principals (owners). In practice, managements freedomtopursueitsowngoalsisconstrainedbytheproductmarket(themorecompetitive, generally the less discretion is possible and the more management will need to profit maximise if the firm and management jobs! is to survive) and the capital market (e.g.threatoftakeover).Also,agentscanbeexpectedtoprovideincentivestomanagement topursueprofitusingprofitbonuses,performancerelatedpay,shareoptionschemesetc. Where it is difficult or impossible to pay profit bonuses and the like, where there is no competitive capital market to satisfy and where consumers have little or no choice of products in the marketplace, the greater we would expect the opportunities to be for management to pursue its own utility. Williamsons theory is likely to be particularly relevant,therefore,tostateownedactivities. Chapterreference:pp.218 219.

72

Question6
To what extent do behavioural theories of the firm provide a more useful insight into the behaviouroffirmsthantheothertheoriesreviewedinthischapter?Considertheargumentthat while the behavioural approach is descriptively attractive, it does not lend itself to predicting accuratelypricingandoutputdecisions.

Guidance
Behavioural theories are concerned with behaviour within firms and with the process of decisionmaking.Bycontrast,theothertheoriesinthechapterassumeaparticularkindof behaviourwilloccur(e.g.profitmaximisation,salesrevenuemaximisation). Behaviouraltheoriesprovide,therefore,anapproachthat appears tobemoredescriptively relevant when discussing the behaviour of firms. To illustrate this you should outline the theoryputforwardbyCyertandMarch. However, whether the approach is more useful depends upon the question useful for what? The approach is clearly descriptively more useful but it is not more useful when tryingtopredicthowfirmsinaparticularmarket willbehaveinterms ofsettingpriceand output.This is because eachfirmcanbe expectedtohave itsownpeculiarbehaviourand decisionmakingprocesses. The other models inthe chapterdo havetheadvantage ofbeingabletopredictpriceand output,givencertainstatedconditions. Chapterreferences:pp.223 224andp.226.

73

Question7
Distinguishbetweencorporategovernanceandbusinessethics.

Guidance
Corporategovernanceisconcernedwiththeprincipalagentrelationshipincorporationsor thedivisionofownershipandcontrol. Businessethicsisconcernedwiththenatureofdecisionsmadebyandwithinfirms. Thetwomaybelinkedinthesensethataparticularformofcorporategovernancemaylead toaparticularformofbusinessbehaviour.Forexample,ifthecorporategovernanceregime leads the management to pursue maximum profit above all else this then will affect managementsattitudetoredundancies,environmentalexternalitiesandsoon,whichitmay treatasunfortunatenecessitiesinthepursuitofprofit. Chapterreferences:pp.208 215 andpp.225 226.

74

Question8
Discuss whether a firm interested in maximising shareholder value should be concerned with ethicalissues.

Guidance
Shareholder value is a reflection of the share price. In a competitive capital market, the share price should reflect the stock markets expectations about longterm (discounted) profitability. Afirmmaximisingshareholdervaluemight,therefore,beexpectedtotakeascepticalview ofbusinessethicsiftheyimpactadverselyonprofitability. However, this is not necessarily the case. The firms management may decide that being ethically sound promotes the companys image amongst both consumers and investors. Itmightconsiderthatwhileanunethicalactioncouldraiseprofitstoday,therewouldbean adverse impact over the longer term. The firm might consider that if it took an unethical decisionthegovernmentcouldrespondbyregulatingitsfutureactivitiesatgreatcost. Inotherwords,management needstomakeajudgementconcerningtheextenttowhichit willmaximiseshareholdervaluebyactingethically. Chapterreferences:pp.225 226.

75

Question9
Identifyacompany,whicharguesthatitpursuesanethicallybasedcorporatestrategy. (a) Whataretheethicallybasedaspectsofthestrategy? (b) Whatarethecostsandbenefitstothecompanyarisingfromthisstrategy? (c) What are the costs and benefits to other stakeholder groups, including society in general,arisingfromthisstrategy? (d) Towhatextentcoulditbearguedthatthisethical strategyismerelymarketinghype?

Guidance
Youranswerwill,ofcourse,dependuponthecompanyyouchoose. (a) However, in answering (a) you need to be careful regarding the definition of ethical. While some business actions will find universal or near universal acceptance as unethical(e.g.fraud),others willbe morecontroversial(e.g.is makingsurplus labour redundantinaneconomicrecessionethicalornot?Isundertakingproducttestingusing animalsethicalevenifasaresultdamagetohumansisavoided?). (b) The costs will be those financial outlays that have to be met to operate ethically and revenuesforegonebysooperating.Benefitswillbeintheformofincreasedconsumer andinvestorgoodwillarisingfromtheactions. (c) To discuss the effect on other stakeholder groups requires you to determine the stakeholdersorthosewithaninterestinthedecisionsmadebythefirm. (d) Part (d) is cynical, suggesting that firms could act ethically simply to improve their standing or the standing of their products/brands with consumers, and not from some deeplyheldviewthatitisrighttoactethically. Chapterreferences:pp.225 226.

76

C H A P T E R 1 1

UnderstandingCompetitiveStrategy
Question1
Select an organisation with which you are familiar and prepare a detailed report to help the managementestablishanappropriatecompetitivestrategyforthenextfewyears.

Guidance
ThisquestionrequiresyoutoapplyknowledgeofChapter11andtheearlierchaptersofthe book. The choice of organisation to discuss is yours but the features you are likely to want to coverarethefollowing: themissionandobjectivesofthefirm thefirmsexternalenvironmentandexpectedchanges thefirmsstrategicpositioning theinternalresourcecapabilitiesofthefirmand thefirmsvaluechain.

Useful approaches you can apply are the political, economic, social and technological (PEST) and strengths, weaknesses, opportunities and threats (SWOT) frameworks and perhapstheFiveForcesmodel. Youmightalsowishtolookatcorecompetenciesanddistinctivecapabilities. Chapterreferences:materialthroughoutthechapter.

77

Question2
Conduct a FiveForces analysis of the retail food industry in your home country. Assess the impactofeachoftheFiveForcesontheindustrysprofitabilityoverthenextfiveyears.

Guidance
Itisageneralrulefromeconomicsthatthelessthecompetitioninamarketthemorescope thereisforfirmstomakehigherprofits. TheFiveForces model looks not onlyatrivalryorcompetitionwithintheproductmarket but at the competitive power of buyers and suppliers and the competitive threat from substituteproductsandservicesandnewmarketentrants. Youranalysisoftheretailfoodindustryinyourcountryshouldthereforelookatanumber ofkeyfactors: thedegreeofcompetitionbetweentheexistingretailers,includingtheirrelativemarket shares thedegreetowhichbuyerscanswitchbetweenthefirms theextenttowhichsupplierstotheretailershavemarketpowerand the extent to which new forms of food retailing (e.g. Internet shopping) and new market entrants(e.g.overseasretailersenteringthedomesticmarket)mightimpacton theoverallcompetitiveenvironment.

Chapterreferences:pp.233 236andFigure11.2.

78

Question3
What do youunderstandbythetermPorters genericstrategies?CriticallyappraisePorters argumentsconcerninggenericstrategies.

Guidance
Porters generic strategies are concerned with the positioning in the market placeto gain competitiveadvantage. Portersuggestedtwomainstrategies: lowcostand productdifferentiation.

Youshouldexplainthedifferencesandthengoontodiscusstheissueoffocus. A major criticism of Porters approach relates to whether the strategies can be mixed. Can firms aim successfully to be low cost and product differentiated at the same time? Clearly,differentiationmayinvolveheavyinvestmentinR&Dandbrandbuildingthrough extensive marketing and this weighs against minimising the costs of production. Nevertheless,somefirms,suchassupermarketsarguethattheymustaddressbothstrategies tobeseenbytheirconsumersasprovidingvalueformoney. Chapterreferences:pp.237 240.

79

Question4
Towhatextentisstrategicchangewithinfirms determinedmorebytheorganisationsinternal cultureandpoliticsthanbytheexternalenvironment?

Guidance
Firms must change their products and production processes as their external environment changes if they are to remain competitive. This requires adapting to external changes or maintainingastrategicfit. At thesametime,studies haveshownthat somefirms are moreabletochangeandadapt successfullythanotherfirmsandsomefirmsarebetteratmanagingchangeatcertainstages intheirevolutionthanatotherstages.Thissuggeststhatthequalityoftheinternalresponses within the firm is critical. This conclusion draws attention to the firms internal resource capabilities (e.g. management talent, human resources, information technology (IT) etc.) andbehaviourandattitudeinfirms.Behaviourandattitudeisshapedbywhatsomecallthe firmsculture. Equally,changeinvolveswinnersandloserswithinthefirm.Somemaygainpromotionand statuswhileotherslooseout.Itistobeexpected,therefore,thattheinternalchangeprocess anddecisionmakingwithinthefirmwillbehighlyemotionalandpolitical. Chapterreferences:pp.242 244.

80

Question5
What PEST factors are most likely to cause turbulence in the internal environment of the followingindustries? (a) Internationalpassengerairlinetravel. (b) Oilexploration. (c) Globalmanagementconsultancy. (d) Globaltelecommunications.

Guidance
This question requires you to undertake a PEST analysis for each sector. The issues you highlightintheanswerwillvaryacrossthefourindustriesmentioned. Under international passenger airline travel, for example, details of trends concerning the followingmightenterintoyouranalysis: Political:internationalterrorismgovernmenttogovernmentairtravelagreements Economic:oilprices(amajorairlinecost)liberalisationofairlinemarketstopromote competition privatisation of airlines access to airports (landing slots) and airport pricingpoliciesrisingrealincomes Social: opposition to aircraft noise environmental opposition to new runways increasedinterestininternationaltravel Technological: new aircraft leading to safer and cheaper travel new air traffic managementsystemspermittingmoreflightsperhoursaferallweatherlandingaids.

Chapterreference:p.233(alsoseeChapter1,pp.19 20).

81

Question6
Undertakeaforcefieldmappingforafirmwithwhichyouarefamiliar,detailingthekeyinternal drivers and restrainers, which it is likely to face in the context of managements attempts to increaseprofitability.

Guidance
Aforcefieldmappingisasimplemethodofbringingtogetherthefactorsthatyouconsider willpromotechangeandthefactorsthatyouconsiderwillimpedechangeinthefirm. Examples of typical forces for and against change are shown in Figure 11.7, p.228. Theforcesyouidentifywilldependuponthefirmyouarestudying. Chapterreferences:pp.243 244andFigure11.7.

82

Question7
Considerthe limitations ofthe classicalapproachtostrategy.To what extent does the ideaof emergentstrategiesimproveourunderstandingofthecompetitiveprocess?

Guidance
The classical or traditional approach to strategic management, popular till the 1980s, viewed strategy formulation and implementation in firms as a process with progressive stagesorstepsleadingtoanoptimaloutcomeintermsofcompetitiveadvantage. Morerecenttimeshaveseenarecognitionthatstrategyformulationandimplementationin firmsisgenerallyacombinationofplanningandemergentoutcomes(incrementalresponses tochangesintheexternalenvironment),wherecauseandeffectrelationshipsarenotalways clear. Inthisprocessualistapproachtostrategy,strategyisnotacombinationofclearstepsbut ratheraniterativeprocessinvolvinglearningandadaptation. Thereareotherapproachestostrategy,inadditiontotheclassicalandprocessualistviews, whicharecoveredondedicatedstrategicmanagementcourses. Chapterreferences:pp.240 242andFigures11.4and11.5.

83

Question8
Itisoftensaidthatthedotcombubbleburstatthestartofthismillennium.Usingthetoolsand conceptssetoutinthischapter,preparesomereasonedargumentstoexplainwhythestrategies ofmanydotcomcompaniesweremisconceived.

Guidance
Theenthusiasmtoestablishandinvestindotcomcompaniesdevelopedinthesecondhalf ofthe1990s.Asinthecaseofotherspeculativeinvestmentbubblesinthepast,backtothe South Sea Bubble of the early eighteenth century, investors got carried away by the forecasts of the future demand for dot com products and services. New technology was opening up new forms of service delivery and the opportunity was clearly there for a number of dot com companies to take advantage of the Internet. However, bubbles are associatedwithexcessiveinvestment.Bytheyear2000,itwasevidentthatthemarketwas notexpandingquicklyenoughtoabsorbthegoodsandservicesoftheverylargenumberof dotcomcompaniesthathadbeensetup. Mistakes instrategyrelateto misunderstandingthetime lags between demandandsupply responsesandmisunderstandingthedifferencebetweenthetechnologicalabilitytoprovide aserviceandthe likelyconsumer demandfor that service.Manyforecasts ofthescaleof consumershoppingontheInternet,forexample,weregreatlyoveroptimistic. Some firms have managed to survive the dot com crash, which draws attention to their positioning in the market place (perhaps with some uniquely differentiated offering) and theirresourcebaseincludingmanagementcapabilities. TheformsofanalysisyoumightusetodevelopyouranswerincludetheFiveForcesmodel, PESTandSWOTanalyses. Chapterreferences:materialthroughoutthe chapter.

84

Question9
CriticallyappraisePortersdiamondasanexplanationofcompetitiveadvantageintheglobal economy.

Guidance
Portersdiamondisanattempttoidentifythosefactorsthatenterintoanexplanationofwhy some nations appear to have industries that are more competitive than in other countries anexampleisJapanuntilthe1990s. The approach looks at the quantity and quality of factors of production, the nature of the demand for products, the existence of related and supporting industries and firm strategy, structure and rivalry. The approach suggests that countries, which are competitive, have adequate and wellqualified labour forces, discerning consumers that require high quality products, strong industrial structures with appropriate supplying industries, and tough internal competition between producers. The result is highquality products producedatlowestcost,whichcanbesoldcompetitivelyintheinternationalmarket. TheapproachextendsPortersFiveForcesModeltotheinternationalarenato explainthe competitiveadvantageofnations. However,themodelhasbeenheavilycriticisedbecauseitseemstoconflictwiththelawof comparative advantage. The latter draws attention to the fact that in competitive international markets countries specialise in what they can produce most competitively. Therefore,one country willbe dominant insomeformsofproductionand willtrade with countriesthatarespecialisinginotherproductareas. Economists,therefore,are happytotalkabout thecompetitiveadvantage offirms but not thecompetitiveadvantageofnations. Chapterreferences:pp.243 245(forthelawofcomparativeadvantageseeourcompaniontext onmacroeconomics, ThePrinciplesofMacroeconomics,FT/PrenticeHall(2004),Chapter13).

85

Question10
Why may the structureconductperformance' (SCP) model be inadequate as a tool for determiningthelevelofprofitabilityacrossindustries?

Guidance
The SCP model has a long history in economics and suggests that market structure determines the conduct or behaviour of firms when determining prices and outputs and thereforetheirperformance,especiallyintermsofprofitsearned. This approach seems to limit management decisions to being a function of the degree of competition in the market place. While this is consistent with the perfect competition, monopoly,monopolisticcompetitionandsomeoligopolymodels,whichrelateconductand performancetomarketstructure,inpracticecompetitivestrategyisnotentirelydetermined bythestructureofthemarket.Forexample,twofirmsoperatinginthesamemarketmight adopt different strategies and achieve different performance outcomes, especially in the shortrun. The content of this chapter has drawn attention to decisionmaking within the firm, withmanagementpossessingsomediscretionoverpricing,outputsetc. Chapterreference:pp.246 247andFigure11.9.

86

C H A P T E R 1 2

UnderstandingPricingStrategies
Question1
Whatarethethreemainfunctionsofpriceinamarketeconomy?

Guidance
Price multiplied by the quantity sold determines the firms total revenue and therefore affectsitsprofitability. Price rations demand (if goods and services were not priced then demand would vastly outstripsupply).Priceisconsideredmoreefficientandpossiblymoreequitableasamethod of supply rationing than the alternatives of either queues (first come first served) or allocationbypoliticiansandbureaucrats. Prices act as a signal in a market economy that supply exceeds demand and production shouldbecutback(fallingprices)orthatdemandexceedssupplyandproductionshouldbe expanded(risingprices). Whilemanagementandaccountantsmaybemainlyconcernedwiththefirstofthesethree roles,economiststend tobeasmuchconcernedwiththelattertwo. Chapterreference:pp.252 253.

87

Question2
Citibankhasappointedyouasaconsultanttohelpinitsreconsiderationofitschargingpolicy for current (cheque) accounts. You are required to set out the principles of the different approachestopricingthatthebankmightadopt.

Guidance
Currentaccountsarenormalgoodsandwecanexpectconsumerstobeinfluencedintheir choiceofabankbythepriceofthechequeaccount onoffer.Thepriceistheinterestrate paidonchequeaccountdeposits,butmightalsobereflectedintheprovisionoffreebanking services. The position of the demand curve will be influenced by the price of substitutes, tastesetc.,intheusualway.Qualityofservice,includingtheavailabilityofbankbranches atwhichchequescanbecashed,canalsobeexpectedtoinfluencetheconsumerschoiceof bank. Pricing decisions start with demand and supply. But you would also need to assess the banks competitive strategy and whether, in the shortterm at least, the bank would be willing merely to break even on cheque accounts (or even operate them at a slight loss) to gain customers (deposits). Perhaps a bank might have a strategy to increase its market shareevenatthecostofshorttermprofits. Youwouldalsoneedtoconsiderthewidermarketingmixalongsideprice. Youwillneedtothinkabouthowthebankshouldpositionitselfbestforexample,isthe chequeaccountonofferinsomewaydistinctinthemarketplace? You would also need to assess the nature of the market in which the bank operates: is it highlycompetitive, oligopolistic or evena monopoly?The latteris mostunlikelybecause weknowtherearemanybanksthatcompeteforchequeaccountconsumers. In other words, there are lots of issues you can bring into the answer of this question, thatdrawonyourknowledgeofpricingstrategies.Itisageneralrulefromeconomicsthat thelessthecompetitioninamarketthemorescopethereisforfirmstomakehigherprofits. Chapterreferences:pp.253 268.

88

Question3
TopholsTravelCompany has decidedtopreserve its profit margin onthe holidays it sells by passingontoconsumersthefullcostofariseintheairfaresitpays.Everyholidaywillbearan equal markup to cover the extra airfare costs. Advise the company of the possible impact of thispolicy.

Guidance
Thecompanyisfacingariseinitscostsandwantstopassthisoninfulltoitscustomers. But itsdecisionshows anignorance oftheprinciples of demandandsupply.The demand curve for holidays can be expected to be downward sloping and probably will be elastic especiallyoverthelongerrun.Raisingpricereducesdemandandiftheelasticityisgreater thanthevalueofone,therevenuereceivedwilldeclinebyminusone. Moreover,theapplicationofanequalmarkup,whileadministrativelyeasyandseemingly 'fair',totallyignoresthedifferentelasticitiesofdemandacrossthedifferentholidaysitsells. Tominimisethelossofsalesrevenuesfromraisingpricesthecompanywouldbeadvisedto raise price by a ratio that is inverse to the elasticity of demand. In other words, the firm shouldapplythehighestincreasewheredemandisthemostpriceinelasticandthelowest increasewheredemandisthemostpriceelastic.Thisisknownineconomicsasthe'Ramsey pricingrule'. However, other considerations may enter into the pricing strategy to prevent the full applicationofthis rule forexample,those withvery inelastic demands maybethosethat havealreadybookedand would find it costlyto switchcompanies,but the company may notwishtoalienatethesecustomersandloosetheirrepeatbusiness. Chapterreferences:pp.259 260.

89

Question4
When DVD players were first launched in the market in the 1990s they were priced much higherthantoday.Howdoyouexplainthis?Doesitalwaysmakesensetopriceanewproduct initiallyatahighpriceandthenreducethepricelater?

Guidance
Therearetwobroadreasonswhyafirmmaywishtochargeahighpriceforanewproduct inthemarket: thefirstreasonrelates tocompetition.Ifthefirmis firstto enterthe market withthe product it may decide to earn a higher profit margin until the competition develops. Thisimpliesaskimmingpolicy the second reason relates to supply costs. The product may have been expensive to research and develop and therefore the firm may wish to price high to recoup these costsquickly.

InthecaseofDVDs,bothreasonsprobablyapplied. Itdoesnotalwaysmakesensetoapplyaskimmingpolicy,however,forseveralreasons: ahighpriceattractscompetitors consumers may react adversely to later price reductions (particularly those who paid theearlierhigherprice)thusdamagingthecompanysimagewithconsumersand the resulting higher price slows down the growth of sales and this can be disadvantageouswherethereareeconomiestobegainedfromlargescaleproduction.

Chapterreferences:pp.267 268andFigure12.4.

90

Question5
Explainwhy:(a)anelectricitygeneratormaychargealowerpriceforunitsofelectricityafter 11pmatnightandbefore7aminthemorning(b)anairlinechargessubstantiallymoretofly 'firstclass'and'businessclass'comparedwith'economyclass'.

Guidance
Thisquestionisessentiallyaskingyoutodifferentiatethereasonfordifferentpriceswhen: (a)costsofproductiondifferand(b)thereissimplepricediscrimination. The time after 11 pm and before 7 am corresponds to an offpeak period in electricity demand. Electricity generation involves large fixed costs and some variable costs (notably fuel inputs). Given that the marginal capacity on the system (the additional generating stations) would have been built so that electricity can be supplied to all consumers that demand electricity in peak periods, the cost of this additional capacity shouldbebornbythepeakusers.Puttingthisanotherway,oncethegeneratingplantisbuilt to meet peak demand, the cost of supplying consumers in the offpeak period is their variable or marginal costs of supply and their share of the fixed costs of the generating stationsthatwouldbeneededsolelytomeettheoffpeakdemand. Moreover,bycharginglessforoffpeakelectricity,thiscreatesanincentiveforconsumers to install appliances that make use of offpeak electricity (e.g. storage heaters) therefore reducing the peak demand and the costs of building even more generating (and transmission) capacity. Different and lower charges for offpeak electricity can thereforeincreaseeconomicefficiency. Bycontrast,theairlinecaseismuchclosertowhateconomistscall purepricediscrimination. The cost of service to firstclass and businessclass travellers is higher than the cost of servicetoeconomyclasstravellers.Firstclassandbusinessclassmaygetprivilegedcheck infacilitiesattheairport,superiorfoodanddrinkontheflightandgreaterlegroombetween seatsetc.However,thisadditionalcostofproductioncannot,initself,justifytheextent of thepricedifferencesbetweenfirstclass,businessclassandeconomytickets. Muchofthepricedifferenceisexplainedbythedifferentelasticitiesofdemand.Firstclass andbusinessclasstravellersmayhavetheirflightspaidforbytheircompaniesorforother reasons belesspricesensitivethan economy class customers.They may havetotravelat particular times, whereas economy class customers may have more discretion as to when theyfly. To reflect the different price elasticities, prices are set higher where demand is less price elastic. Chapterreferences:pp.268 273andFigure12.6andpp.276 278andFigure12.8.

91

Question6
Awatercompanyiscurrentlyoperatingataloss.Itcalculatesthatonewayofremovingtheloss istoraiseitschargepercubicmetreforwaterconsumedanditsfixedconnectionchargebothby 30%.Considerthecaseforadoptingequalordifferentincreasesinthevolumeandconnection charges.

Guidance
Onceagain,thisquestionrelatestoelasticityofdemandinpricingdecisions.Italsorelates tothefactthatwatercompanies,likeotherbusinesses,havefixedcostsandvariablecosts. The water abstraction equipment, treatment plant, pipelines and pumping stations etc., are fixed costs. The costs of chemicals to treat the water, the electricity used in pumping plantsetc.,arevariablecostsofwatersupply. Ifthechargeisraisedby30%forconnectionandsupplyvolumetheimpactwilldependon thefollowing: ifconsumersofwateraremeteredtheycanbeexpectedtoreducethevolumeofwater theyuse theextentofthereductionwilldependuponconsumerspriceelasticity theextenttowhichthewatercompanywillwelcomethisreductionindemanddepends upon its cost structure. Remember that the company will save variable costs but the fixedcostsremain(atleastintheshortrun,whichinwatersupplycouldbemanyyears becausewatersystemassetstendtohavelonglives).

Therefore, if price elasticity were high and costs were largely fixed, raising the volume chargecouldleadtoalargefallinrevenuewithonlyasmallcompensatingfallinthecosts ofprovidingthewater. This might tempt the firm to place much of the price increase on the fixed charge. While most consumers will not choose, as a result, to disconnect from the water supply system,andthereforetheelasticityofdemandtostayconnectedisverylow,somemaydo sosimplybecausetheyarenolongerabletoaffordtostayconnected.Wecanexpectthat poorer families would be most at risk of disconnection. This result may not be socially acceptable. The answer to the question, therefore, requires an appreciation of demand elasticities and the nature of production costs and recognition that water is usually considered to be a productfundamentaltocivilisedlife. Chapterreferences:pp.259 260andpp.278 279.

92

Question7
Givethree examples ofthirddegreeprice discrimination,highlightingin eachcase whyprice discriminationispossibleandthedegree towhichitissustainable.

Guidance
Successful price discrimination requires different price elasticities of demand in different marketsandan inabilitytoarbitrageprofitablybetweenthe markets(i.e.buyinthelower pricedmarketandresellinthehigherpricedone). Examplesofmarketswherethirddegreepricediscriminationmayoccurareasfollows: airtravel(seetheGuidanceNotestoQuestion5above) thesupplyofmotorcarsindifferentnationalmarketsand hotelprices(lowerpricesforcorporatebookings).

Chapterreferences:pp.271 272andFigure12.6.

93

Question8
WhyisitpossibleforEuropeanmotormanufacturerstoselltheircarmodelsatdifferentprices indifferentEuropeancountries?

Guidance
Thevehiclescouldbedifferentlyspecifiedwithextrafeaturesinsomemarketsthatjustify thehighersellingprices. However, it is difficult to believe that this explanation, put forward by the vehicle manufacturers,issufficient. AlthoughtheEuropean Union is supposedtobeasingletrading market,somebarriers to trade in vehicles still exist. In particular, it is claimed that manufacturers put pressure on motordealers inlowprice marketstorefrainfromsellingcars toconsumers from higher pricemarketsinEurope.Thisstrategyismadeeasiertooperatewheretheconsumerscome fromtheUnitedKingdom,whichrequiresrighthanddrivecars. Inotherwords,thefailureofacompletesinglemarkettooperateallowsthemanufacturers toretainwhatappearstobeadegreeofpricediscriminationacrossthemarketsoftheEU memberstates. Chapterreferences:pp.271 272andFigure12.6.

94

C H A P T E R 1 3

UnderstandingtheMarketforLabour
Question1
What do you understand by the terms the marginal value product (MVP) and the marginal revenueproduct(MRP)oflabour?

Guidance
Both reflect the value added to production by each extra person employed in the firm. This is composed of the addition to physical product or physical output (known as the marginalphysicalproduct,(MPP))andtheimpactofsellingthatoutputonthefirmstotal revenue. Marginal value product (MVP) is the term we use to describe this contribution under conditionsofperfectcompetition,whereprice(P)(andtherefore,MR)isconstant.Inwhich case: MVP=MPP P. Under conditions of imperfect competition, including monopoly, the price of the product will alter as the physical volume produced and sold by a firm alters. In this case, wedescribethecontributionasthe marginalrevenueproduct(MRP)where: MRP=MPP MR. Chapterreference:pp.286 290andFigures13.113.3.

95

Question2
HowdoesthecalculationofMVPandMRPdiffer?

Guidance
ThedifferencerelatestothefactthattheMRisnotconstantasoutputchangesexceptunder conditionsofperfectcompetition(also,seeGuidanceNotestoQuestion1above). Chapterreference:pp.286 290andFigures13.1 13.3.

96

Question3
Using marginal productivity theory, explain why a profitmaximising firm will employ fewer peoplewhenthewagethathastobepaidrises,everythingelsebeingequal.

Guidance
In the pursuit of maximum profit a firm will equate the MRP (or MVP in perfect competition) with the marginal cost (MC) of employing labour, which is the wage to be paid to each extra worker employed (other costs of employment, such as employers pensioncontributionsandsocialsecuritycontributionscanbeincludedaspartofthewage to labour). Clearly if the wage (the MC) of employing an extra worker exceeds that workerscontributiontotherevenueofthefirm(MRPorMVP)then,logically,theprofit maximisingfirmwillnotemploythatworker.Similarly,providedthatthewageislessthan theMRP(orMVP)theworkerwillbeemployed.Hence,theoptimalemployment levelis wherethewage(MCofemployment)equalstheMRP(orMVP). Itfollows,therefore,thateverythingelsebeingorremainingequal,whenthewagerisesthe levelofemploymentwillfall. Theeverythingelsebeingequalconditionisimportantbecauseitcouldbethatatthetime thewagerises(forwhateverreason)theproductivityoflabour(MPP)and/orthepriceofthe product(PandthereforeMR)rise.Insuchcircumstances,theeffectsoncostsandrevenues might cancelout leaving employment thesame.It is evenpossiblethat therevenue effect could exceedthecostside effect ofthe higherwage, leaving employmenthigherafterthe wagerise.This shouldnot be interpreted,however,as suggestingthat wagerises have no effectonemploymentbecauseintheabsenceofthewageincrease,withhigherproductivity or output price, the firm would have employed even more, additional workers. The wage risehas,therefore,depressedemployment. Chapter reference: material throughout the chapter, but especially pp. 295 299 and Figure13.7.

97

Question4
How can an understanding of the elasticity of supply of labour help a manager to determine wagesandothertermsofemployment?

Guidance
Theelasticityofsupplyoflabourisameasurement oftheresponsiveness ofthesupplyof labourtoachangeinthewagepaidandismeasuredas: thepercentagechangeinthesupply oflabourdividedbythepercentagechangeinthewagerate. Correctly,thewagehereistherealwageandnotsimplyanincreaseinwagetooffsetthe nationalinflationrate,whichleavesrealorrelativewagesintheeconomyunaffected. Itisusefulformanagerstohaveatleastsomebroadestimateoftheelasticityofsupplyof thelabourtheyemploy.Thisissobecausemanagersthenhaveabetterunderstandingofthe impact of wage changes on the number of people wishing to work for the firm. For example, if the elasticity is very low, a higher wage will need to be offered as an incentivetorecruitagivennumberofadditionalemployees,thaniftheelasticityishigh. Restrictions on the supply of labour into an occupation (e.g. due to qualification requirementsorprofessionalmembership)willreducetheelasticity. Across the economy as a whole elasticity of supply is likely to be lower, the lower the nationalunemploymentrate. Chapterreferences:pp.294 295.

98

Question5
Underwhatcircumstancesaretradeunionsmostlikelytobeabletoobtainwageincreases?

Guidance
Tradeunionsaremorelikelytoobtainwageincreaseswheretheirbargainingpowerishigh andemployersarelessinclinedtofighttheproposedincreases. The larger the percentage of employees in an industry that are unionised, in principle, we would expect the union to be more powerful. The lower the unemployment rate, andhencetheemployersabilitytoreplacestrikingunionmembers,themorepowerfulthe union is likely to be. This is also the case if the employer has limited scope to substitute capitalforthelabour,whichmaynowbemoreexpensive. Employersarelesslikelytofightthewageincreasewhere:(a)theindustryis inimperfect competitionandmuchoftheadditionalwagecostscanbepassedontoconsumersthrough priceincreases(b)theindustrycurrentlyearnssupernormalprofits,sothattheadditional costscanbeabsorbedbythefirm(c)theemployeriscurrentlyamonopsonistandtherefore paysanaveragewagethatislessthantheMRPoflabour(d)wherethefirmissupported bystatesubsidies (e)labourcosts areonlyasmallpart oftotalcosts sothe effect onthe firmstotalcostsofahigherwageissmalland(f)thereisscopeforoffsettingincreasesin labourproductivity. Chapterreferences:pp.295 299andFigure13.7.

99

Question6
Considertheimpactonemploymentofadoptinganationalminimumwage,whichexceedsthe competitivemarketequilibriumwagerate.

Guidance
Ifthe national minimum wage forlowerpaid workers werebelowtheircompetitive wage rateitwouldbeineffective. Ifit wereabovethatrate,inprinciplewewouldexpecttheemployment ofsomelowpaid workerstodeclinebecausethenewwagewouldexceedtheirMRP. However,this conclusionassumes that currentlytheseworkers arebeing paidtheirMRP. It also assumes that employers could not make offsetting increases in the productivity of labourthroughorganisingproductionbetter.Ithasalsobeensuggestedthatahigherwage might motivateworkerstherebyincreasingtheirproductivityorreducingtheirtendencyto slackatwork. Chapterreferences:pp.302 303andFigure13.9.

100

Question7
Whymightanemployerandemployeebewillingtosharethecostsassociatedwiththeemployee studyingforaprofessionalqualificationsuchastheMasterofBusinessAdministration(MBA)?

Guidance
TheMBAshouldraisetheMRPofthose whostudyforitbyincreasingtheirbusinessskills. Theywillbeinhigherdemandandbeabletoobtainhigherwages. It is obvious, therefore, why the employee might wish to invest in studying for an MBA (whichhasanopportunitycostintermsoflostearningsduringtheperiodofstudyaswellas the cost of the course fees, etc.). It is, perhaps, less obvious why employers sometimes sponsortheiremployeestostudyfortheMBAandpayallorsomeofthecosts. TheemployercouldrationalisethisactiononthegroundsthatonreturningfromtheMBA theemployeewillbemoreproductiveandprofitabletothefirm. However,theemployerfacesthedilemmathattheemployeemaynotreturntothecompany attheendofthecourse,butinsteadseekemploymentelsewhereforahigherwage.Indeed, logicallythisshouldoccurbecausethecurrentemployer,torecouptheMBAcostsincurred, willneedtopayawagelessthanthereturningemployeesMRP.Anewemployer,whohas not incurred these costs, can afford to offer the employee a wage up to the employees MRP. One response might be for the employer to require that the employee returns to the firm after the MBA for a given period, so that the firm can recoup the MBA costs. However, in many legal jurisdictions such a restrictive contract is ruled illegal under employment legislation dating back to the nineteenth century and intended to protect employees from unscrupulousemployers. Becausetheemployermaynot,therefore,beabletoguaranteereimbursementofanyMBA costsincurred,employersarelikelytotreatinvestinginanemployeesMBAashighrisk and refuse to fund it. In some Western countries MBA students sponsored by employers, especiallyinfull,aredwindlinginnumber. On the other hand, the employer could continue to fund MBA studies as a method of recruitingandretaining employees.In effect,then,the employeeis acceptingasomewhat lower wage than the employer could otherwise have paid in return for being allowed to studyforanMBAduring theiremployment. Theexceptiontotheabovereasoningwouldbeif: (a)theemployercouldreasonablyexpect ahighproportionofMBAgraduatessponsoredtoreturntothefirmor(b)theincentiveof MBAstudyincreasedemploymentandmotivationatworkandresultedinahigherlevelof productivity(andhenceahigherMRP) beforetheemployeeembarkedonthestudies. Chapterreferences:materialthroughoutthechapter.

101

Question8
Whatarethelikelyimplications oflabourimmigrationonwageratesandemployment levels? Consider these implications with respect to the immigration of highly educated and skilled labourincontrastwiththosewithminimaleducationandskilllevels.

Guidance
Immigration increases the supply of labour and increases the elasticity of supply of particulartypesoflabour. This shouldresult inlowerwages and higher employment levels,providedthat thelabour market is competitive.Restrictions onthecompetitivelabour market,suchas strongtrade unions, could limit the downward impact on wages, but this would lead to higher unemployment. Thelevelofskillsandeducationofimmigrantsisimportanttoanunderstandingofwherein the labour market the effects are likely to be mainly felt. If there is already a surplus of unskilled labour in the economy then unemployment is the most likely result of the immigration of unskilled workers. By contrast,the immigration of medical doctors is not likelytoresultinunemploymentifthereisanexistingshortageofdoctors. Theanswershouldbetackledintermsofthesupplyanddemandforlabourintheeconomy asawholeandattheindividualoccupationlevelsandintermsoftheelasticityofdemand andsupplyforparticulartypesoflabour. Chapterreferences:materialthroughoutthechapter.

102

Question9
The government has just announced a 5% decrease in tax for all employees. Using an appropriate diagram,considerthe impact ofthis taxchange onthe labour market,particularly withrespecttothoseonlowwagescomparedwiththoseatthetopendofthepayscale.

Guidance
Taxesonemployeestaketheformofincometaxandsocialsecuritycontributions. Thesetaxesmayreducetheincentivetoworkbyreducingtheemployeesposttaxincome. Therewillbeanincentivetosubstituteleisuretimeforworktime(leisurenowhasalower opportunity cost in terms of posttax wages lost). However, because employees now earn effectivelyless duetothetaxinanygivenworkperiod,theymayactuallyworklongerto make up for the lost earnings (known as an income effect). The substitution effect and incomeeffect oftaxes on employmentthereforepointin opposite directions regardingthe likelyimpactofataxonincentivestowork. In practice, empirical studies of the impact of taxation on work have been similarly inconclusive,but withsome evidencethat incentives to workare moreadversely affected amongst very low and very highincome groups. This makes sense because lowincome earnersmayfindthatfollowingataxincreasetheywouldbebetteroffnotworkingandrely insteadonstatewelfarebenefits.Forhigherincomegroups,ahighertaxisnotsolikelyto necessitate working longer and harder to maintain a given posttax income (to pay the mortgage or rent, feed the family, etc.), but it is likely to make leisure more desirable by reducing its opportunity cost. Hence, in both very low and very high income groups we mightexpectthesubstitutioneffectofthetaxchangetoexceedtheincomeeffect. Turningtotheprecisequestion,whichisconcernedwithataxreduction,theeffectislikely to be more an incentive for very low paid workers to work (the posttax income now exceeds the alternative state welfare payment) and for highincome earners to work more becausetheopportunitycostofleisuretimeisincreased. The precise result will, of course, depend on the nature of the tax reduction. Does it fall equallyonallemployees?Beingapercentagetaxcut,thebenefitsaregreater,thehigherthe incomeearned. Thesevariouseffectscanbereflectedinademandandsupplyoflabourdiagram. Chapterreferences:pp.303 304andFigure13.10.

103

Question10
JubileeProducts Numberofemployees Totaloutputofproducts Priceperunit($)of productsinthemarket

100 101 102 103 104 105 106

5,000 5,100 5,250 5,350 5,400 5,420 5,430

8.00 6.50 5.70 5.50 5.45 5.43 5.42

Thewageratepaidis$550perweek(therearenootheremploymentcosts). From the above data, using MRP theory, determine the number of workers Jubilee Products shouldemployatthegoingwagerate.

Guidance
Thetablebelowshowsthecalculationsrelatedtothequestion: Marginal Physical Product (MPP) Price (perunit) $ = MarginalValue Product (MVP) $

Numberof employees

Totaloutputof products

100 101 102 103 104 105 106

5,000 5,100 5,250 5,350 5,400 5,420 5,430

100 150 100 50 20 10

6.50 5.70 5.50 5.45 5.43 5.42 = = = = = =

650.0 855.0 550.0 272.5 108.6 54.2

104

 With thewageratesetat550perweek,thefirmshouldemploy103workers,i.e.wherethe MRPequatestothewagerate. Chapterreferences:pp.288 290andtableasproducedabove.

105

C H A P T E R 1 4

UnderstandingtheMarketforCapital
Question1
Usinganappropriatediagram,explainhowaprofitmaximisingfirmshoulddecideonthelevel ofitscapitalinvestmentwhenthefirm: (a) isinaperfectlycompetitivecapitalmarket (b) hasmonopsonypowerinthebuyingorhiringofcapitalequipment.

Guidance
Aprofitmaximisingfirmwillconsiderboththecostandbenefitfromemployingadditional unitsofcapital.Morespecifically,thefirm will demandadditional capitalupto thepoint wherethemarginalcostofcapitalequalsitsmarginalrevenueproduct. Inaperfectlycompetitivemarket,thefirms demandforcapitalissosmallthatitbuys or hirescapitalatitsgoingmarketprice. Inamonopsony,marketthefirmisthesolebuyerofaparticularcapitalandthepriceitpays willvarywiththeamountemployed. TherelevantdiagramsareFigures14.1and14.2. Chapterreference:pp.311 313.

106

Question2
StrongSteelsis decidingwhethertoinvestinanewstriprollingmill.Adviseontheapproach thefirmshouldadoptinappraisingthepossibleinvestment.

Guidance
AssumingthatStrongSteelsattemptstomaximiseprofitsitwillneedtotakeaccountofthe expectedreturnfromtheinvestmentandthecostofinvesting.Onlyiftheexpectedreturnis atleastequaltothecostofinvestingwilltheinvestmentbedeemedworthyofundertaking. Eventhenitistheexpectedreturnthatistakenintoaccountasactualreturnsareunknown. Thisiswhyallinvestmentisrisky. Becauseinvestmentreturns occurinthefuturetheywillneeddiscountingtopresent value terms to allow comparison with the current costs of investing (any future costs, such as those resulting from maintenance will also need discounting). The usual approach is to discountthe cashflowsoverthelifeoftheinvestment. Figure14.3providesanoverviewoftheprocess.Pages317321discussdiscountingand contrastitwithapaybackperiodmethodofinvestmentdecisionmaking. The firm will also need to calculate its cost of capital (funds raising). This is usually undertakenusingaweightedaveragecostofcapital(WACC)model(seepages322 -323). Chapterreference:pp.314 324.

107

Question3
Afterconsideringyourreport,StrongSteelshas decidednottoinvestinthenewmillbecause thepaybackperiodis 7 years.Thecompany has apolicy ofinvesting only whenthepayback periodis4yearsorless.Thestriprollingmillwouldhaveanexpectedlifeofatleast15years. Commentonthisdecision.

Guidance
Thepaybackmethodofinvestmentappraisalisusedwidelyandcanbeausefulcrosscheck on the results from using discounted cash flow (DCF) techniques. However, the payback periodmethodisinferiortotheDCFapproachbecauseitdoesnottakeintoaccountpossible positivecashflows(returns)aftertheendofthepaybackperiod. Themill wouldlast15yearsbutStrongSteels haschosentoconsideronlythereturnsfor thefirst4years.Hence,whatmightseemanunprofitableinvestmenttakingthefirst4years intoaccountcouldhavebeenprofitableiftheentirelifeoftheassethadbeenconsidered. Thelongerthepaybackperiodandthehigherthediscountrate(hencethelowertheDCFin lateryears)thecloserthetwomethodsconverge. Also,somefirmsmightfeelthatalthoughanassethasaprojectedlonglife(e.g.15years), thereisahighriskthattheassetcouldbecomeobsolescentduetotechnologicalchangewell beforethetheoreticallimit ofitslife.Hence,theyignorepossiblecashflowsbeyond,say, 4years.ThismaybethecaseinStrongSteels. Nevertheless,itwouldbesensibleforStrongSteelstousetheDCFmethodbeforedeciding whethertoinvest. Chapterreference:pp.318 321.

108

Question4
Explainthe differencebetweenthenetpresent value(NPV)andthe internalrate ofreturn methodsofinvestmentappraisal.

Guidance
BothareDCFmethods. TheNPVmethodusesadiscountrate(usuallyestablishedinrelationtothecostofcapital) to discount future cash flows, with the investment decision depending upon whether the discountedsumispositiveornegative. The internal rate of return method sets a discount rate (or interest rate) that equates the present value of a projects net cash flow to the initial investment. This rate can then be comparedwiththefirmscostofcapitalortherateitusestodecidewhetheraninvestment is worthwhile(sometimes knownasthehurdlerate),whichmaybehighertoreflectrisk (seetheGuidanceNotestoQuestion5below). Chapterreference:pp.319 321.

109

Question5
How should the discount rate be set when a firm appraises its investments using the DCF method?

Guidance
The discount rate should reflect the opportunity cost of using funds for a particular investment. ThismightbecalculatedastheWACC,whichreflectsthecombinedcostofequityanddebt financing. Becauseoftheinherentuncertaintyininvestinginprojectsthathavealonglife,firmsmay decidetoaddariskpremiumtotheWACC.ThediscountrateisthenabovetheWACC this is a very common approach. (Note that this risk premium is different to the risk premiumthatexistsonequityfinancinganddebttakenintoaccountintheWACC.Thisrisk premium is an additional interest charge over the interest rate on risk free bond rates (government bonds) that may be used initially in setting the interest rate on debt when calculatingtheWACC). Chapterreferences:pp.321 324.

110

Question6
Suppose that an investment project is expected to yield net cash over the next five years of $100m(year1),$95m (year2),$75m(year3),$50m(year4)and$80m(year5).Theinitial costoftheprojectis$250m.Attheendofthefifthyeartheinvestmenthasnoresidualvalue. (a) Whatisthepaybackperiod? (b) CalculatetheNPV(assumeadiscountrateof10%). (c) Calculatetheinternalrateofreturn.

Guidance
(a) The payback period is 3 years (technically, slightly less than 3 years). It will be seen thattheinitialcostoftheproject($250m)isrecoupedwithin3years($100m+$95m+ $75m). (b) Giventheformulashownonpage320,theNPViscalculatedas:
$100m $95m $75m $50m $80m NPV = + + + - $250m 1 5 (1+0.1) 2 (1+0.1)3 (1+0.1) 4 (1+0.1) (1+0.1) = [$90.91m + $78.51m + $56.35m + $34.15m + $49.67m ]- $250m = $309.59m -$250m = $59.59m

(c) Giventheformulashown onpage327,we mustcomputethe value ofthe internalrate of return (r), which reduces the NPV of the future cash flows to the cost of the initial investment($250m). Inotherwords:
$100m $95m $75m $50m $80m + + + + - $250m = 0 1 (1+r) 2 (1+r)3 (1+r) 4 (1+r)5 (1+r)

Thevalueoftheinternalrateofreturn(r),inthiscaseis20%. Chapterreferences:pp.318 321.

111

Question7
Howshouldafirmdecideuponitsweightedaveragecostofcapital(WACC)andhowdoesthe WACCenterintoNPVcalculations?

Guidance
The WACC reflects the cost to the firm of raising the funds to invest in capital. It is therefore composed of the costs of raising external debt financing and external equity financing.Wherethefirmusesitsownfunds(ploughedbackprofits)becausethesecould haveearnedareturnifusedelsewhere(e.g.investedingovernmentbonds)anopportunity costinterestratecanbeimputed. Assumingafirmraises 20% of itsfunds for investingthrough new equityand80%from loanfinancing,therelativecostsofthesefundswillbeweighted0.2and0.8respectivelyin obtainingtheWACC. TheWACCthenformsthebasisforthediscountrateusedinNPVcalculations.However, becauseoftheinherentuncertaintyininvestinginprojectsthathavealonglife,firmsmay decidetoaddariskpremiumtotheWACC.ThediscountrateisthenabovetheWACC this is very common. (Again, as we noted earlier on Question 5, this risk premium is differenttotheriskpremiumthatexistsonequityfinancinganddebttakenintoaccountin theWACC.Thisriskpremiumisanadditionalinterestchargeovertheinterestrateonrisk freebondrates(governmentbonds)thatmaybeusedinitiallyinsettingtheinterestrateon debtwhencalculatingtheWACC). Chapterreferences:pp.321 324.

112

Question8
The government is deciding whetherto builda newrail linkbetweentwo expandingregions. The aim is to move traffic from the roads, but building the link will mean demolishing 200 homesatthecostof$120mandwillcostatotalof$1.2bntocomplete.Publicworksschemes haveadiscountrateof10%.Expectedrailreceiptsareputat$100mperannumoverthenext10 years(theassumedlifeoftheinvestmentbeforemajorreinvestmentwillbeneeded).Itwould appearthatthe investmentisnotworthwhile.Doyouagree?

Guidance
Thepresentvalueofthefuturerailreceipts,overthe10yearperiod,isgivenby: $100m (1 + 0.1)
1

$100m (1 + 0.1)
2

$100m (1 + 0.1)
3

+ +

$100m (1 + 0.1)10

= $614.46m

Fromthisfigurewemustdeductthecostoftheproject,givenat1.2bn. TheresultisanegativeNPVfigureof$585.54m. Thissuggeststhattheprojectisnotworthundertakingonfinancialgrounds. However, this is a government project where there are implied externalities or social benefits (connecting two expanding regions and perhaps moving passengers and freight from the roads to rail). The government should, therefore, take into account the social benefitsaswellastheprivateones(therailrevenues).Itshouldalsotakeintoaccountany social costs of the rail link (such as additional noise and disruption during construction). Thelossofthe200homeswillbereflectedinthetotalcost($1.2bn)anddoesnotneedtobe consideredseparatelyprovidingthat the$120m includes adequate compensation forthose affectedbythelossoftheirhomes. Pages324326explainhowthecostbenefitanalysis mightbyundertakenbygovernment. Chapterreferences:pp.324 326.

113

Question9
Doescostbenefitanalysishaveanyparttoplayinprivatesectorinvestmentdecisions?Explain youranswer.

Guidance
Inonesense,theprivatesectordoesundertakecostbenefitanalysiswhenappraisingpossible investments.Itcomparesthecostswiththebenefitswhencalculatingcashflowsandreturns. However, the private firm can be expected to ignore external costs and benefits because theydonotimpactonitsexpendituresandreceipts. Costbenefitanalysis,inthesenseoflookingatallinternalandexternalcostsandbenefits, issomethingusuallyassociatedwithgovernmentinvestmentappraisal.Governmentsshould beconcernedwithexternalities. Nevertheless,because ofgreenpressures andthe like,somefirms donowappraisetheir investmentstakingintoaccountatleastsomeofthelikelyexternalities. Chapterreferences:pp.324 326.

114

C H A P T E R 1 5

UnderstandingtheMarketforNaturalResources
Question1
Housepricerisesarecausedbygreedylandowners.Discuss.

Guidance
Supplierscanonlygetapriceforsomethingifthereisademandforit.Landownersareno different. The price they obtain for their land when sold to house builders reflects the demandforit.Hence,andasDavidRicardoexplainedtwocenturiesagoinhisstudyofthe price ofcorn,theprice of landreflectsthe highpriceof corn or,in ourcase,theprice of housingthatcanbebuiltontheland. Itisforthisreasonthatwetalkaboutlandasearninganeconomicrent,i.e.areturnabove itsopportunitycostortransferearnings. Chapterreference:pp.331 334.

115

Question2
Considerthecasefortheimpositionofadevelopmentlandtaxbygovernment.(Development land tax is a tax on the value of land used for development, e.g. house building or industrial use.)

Guidance
TheanswerfollowslogicallyfromtheanswertoQuestion1.Iflandearnsaneconomicrent (areturnaboveitsopportunitycostortransferearningsi.e.whatitcouldearninitsnext bestuse)thenthiscanbetaxedawaywithoutaffectingtheincentivetokeepthelandinits currentuse.Forexample,iflandhasatransferpriceof$1000peracreandcurrentlyearns $1200peracre,itwouldbepossibletotaxawayupto$200peracreoftheearningswithout leadingthelandtobewithdrawnfromitscurrentuse. Thisistheargumentbehindapplyingadevelopmentlandtaxtotaxawayforpublicbenefit theeconomicrentsoflandowners. Chapterreferences:pp.331 334.

116

Question3
Willtaxationofeconomicrentsaffecttheallocationofresources?

Guidance
Logically,ifeconomicrentsareearningsabovetransferearningsthentaxingthemwillnot affecttheallocationofresources. However,ifbyaccidentordesignthetaxbecomesexcessiveandexceedstheeconomicrent thentheallocationofresourceswillbeaffected. Chapterreference:pp.331 334.

117

Question4
Discussthecaseforusingpollutionpermitsratherthanprohibitionsonnewproductiontolimit theenvironmentaldamagefromtheproductionofgoodsandservices.

Guidance
Prohibitions orbanspreventfirmsfromdoingsomething,irrespectiveoftheprecisesocial costsandsocialbenefits,whichmayresultfromtheiractivities. By contrast, pollution permits place the onus on firms to decide. Pollution permits are issuedbygovernmentandpermitaparticulartypeofpollution(e.g.wastewaterpollution) uptoastatedlevel.Producerswouldhaveanincentivetocurbpollutionvoluntarilybecause anypollutionpermitsunused orunderusedcould besoldtofirms that had exceededtheir allocationofpermits. Pollutionpermits,unlikeprohibitions,workbyusingpricesignalsandarethereforeusually preferredbyeconomists. Chapterreference:pp.338 339.

118

Question5
Whatissuesarelikelytobeconsideredwhenanenvironmentalauditisconductedby: (a) government (b) aprofitmaximisingfirm?

Guidance
Governmentshouldtakeintoaccount notonlytheprivatecostsandbenefits(i.e.financial costs to the government with respect to construction and operation weighed against financial benefits in terms of user fees) but also the wider social costs and benefits (e.g.pollution[cost]andlivessaved[benefit]). Theprivate firmundertakingan environmental audit might take into account some ofthe more obvious environmental effects of their schemes but might ignore others. This will dependuponthedepthoftheenvironmentalaudit. Chapterreference:pp.336 339.

119

Question6
Considertheroleofpropertyrightsinadiscussionofenvironmentalissues.

Guidance
Propertyrightsaretherightstobenefitfromutilisationandtransferofproperty. Ingeneral,peoplelookaftertheirownprivatepropertybetterthanpublicproperty.Thisis evident,forexample,inwhatisknownasthetragedyofthecommons.Whenlandisheld incommonforgrazingorcultivationeachindividualsactionsmayhavelittleeffectonthe overall result. For example, if 100 farmers use an area of common land for grazing purposes, each farmers actions has a 1% impact on the state of the common land. The result, from history, is overgrazing. No individual farmer has an incentive to limit grazingeventhoughcollectivelyitisintheinterestsofallthefarmerstopreventdamageto theland. Thesamethinkingcanbeappliedtoenvironmentalissues.AlthoughIknowthatusingmy carisenvironmentallydamaging,this hasnoeffect onmydecisiontousemycarbecause my actions can have little or no impact on the state of the environment. Equally, overfishing can be seen as resulting from the fact that no individual fishermen own the propertyrightsintheshoalsoffish. Where property rights exist, economic agents have an incentive to maintain, protect and enhancetheirproperty.Theindividualfarmerwillprotect his/herfieldsfromoverfarming becauseoftheimpactonthefuturevalueoftheland.Ifpropertyrightscanbeattachedto shoalsoffish(asinsalmonfarms)thenownershaveanincentivenottooverfishandwipe outtheirfishstocks. Chapterreference:pp.339 340.

120

C H A P T E R 1 6

GovernmentandBusiness
Question1
Inwhatwaysdogovernmentsimpactonbusinessdecisionmakingtoday?

Guidance
Governments impact on business decisionmaking in a number of ways resulting from decisions concerning taxation and subsidies, industrial and environmental policy, regional andcompetitionpolicyaswellasmacroeconomicpolicydecisions. Taxesandsubsidiesaffectdecisionsbyfirmstoproduceandtoemployfactorinputs. Industrialpolicyandenvironmentalregulationsimpactonproductionandsalesdirectly. Governments defineandprotect privatepropertyrights throughlegislation,thepoliceand the courts.Withoutthisprotectioncommercecouldnotflourish. Governmentsaffectbusinessthroughregionalpolicyandcompetitionpolicy. Governments manage the macro economy through public expenditure and tax changes, thereforeinfluencingthelevelofeconomicactivity. Chapterreferences:materialthroughoutthechapter.

121

Question2
Under what circumstances might governments improve economic welfare by interfering in markettransactions?Whatformsmightgovernmentinterventiontake?

Guidance
Governmentscanimproveeconomicwelfarewherethereismarketfailurethatistosay, themarketfailstoallocateresourcessoastomaximisesocialwelfare. Examples of market failure occur where there are significant externalities, where competition in markets is restricted leading to monopoly abuse, and where goods and services are public goods (defined as nonrival and nonexcludable). Another instance wheregovernmentscouldimprovesocialwelfareiswherethecompetitivemarketproduces adistributionofincomeandwealththatisconsideredsuboptimalonsocialgrounds. Government intervention can take many forms (see the Guidance Notes to Question 1 above). It should be remembered that just as markets can fail so can government intervention. State failure occurs when government intervention in the economy reduces rather than increasessocialwelfare(see the GuidanceNotestoQuestion7below). Chapterreferences:materialthroughoutthechapter.

122

Question3
Using an appropriate diagram, critically discuss the use of government subsidies to higher education.

Guidance
All countries appear to provide some subsidies to higher education to encourage young peopletogotouniversity.Thisresultsfromabeliefthatacompetitivemarketwouldunder supplyhighereducationbecauseofthecostofprivatefees. A subsidy reduces the charge to the user of higher education and therefore increases demandforit(seeFigure16.2).Consequently,thesubsidyattemptstoequatemoreclosely the marginalcost of higher education with the marginalsocialbenefit fromconsuming it. Socialbenefitsariseintermsofthelikelihoodthatsomeonewhohasbenefitedfromhigher education will be less likely to draw on state welfare payments later in life, may be less likelytoresort tocrimetofundtheirlifestyleand less likelytobeaburdenonthesocial services.Equally,theeconomybenefitsfromahigherskilledandmoreflexibleworkforce benefitsnotnecessarilyfullycapturedinthewagespaid. However,thesubsidycouldbeexcessiveleadingtoanoversupplyofhighereducationand a net loss of social welfare. Government subsidies have to be paid for out of taxation, imposingacostontheeconomy. Chapterreference:pp.346 349andFigure16.2.

123

Question4
Consider the different forms industrial policy might take and the implications for corporate strategies.

Guidance
Industrialpolicyisstateinterventionintheeconomytoalterthedevelopmentofindustries fromwhatwouldoccurincompetitiveprivatemarkets. Accelerativeindustrialpolicies aimtospeedupindustrialrestructuring. Decelerativeindustrialpolicies aimtoslowdownindustrialrestructuring. Corporatestrategiesareaffectedbecausebusinesseswilldeveloptheirstrategicplansinthe context oftheirknowledgeabout thegovernments intentions forindustries.Forexample, ifit isknownthatgovernment favours moreinvestment inaparticularsector,andmaybe willingtosupportthiswithfavourabletaxtreatment orsubsidies,theninvestingwillseem moreattractive.Atthesametime,knowledgethatthegovernmentiskeentoseeanindustry replacedsendssignalsthatgovernmentisunlikelytointervenetoprotecttheindustryfrom marketpressures. Chapterreference:pp.352 357.

124

Question5
Whatarethekeyfeaturesofcompetitionpolicyinyourcountry?

Guidance
Competitionpolicyisgovernmentpolicyaimedatpreventingmonopolyabuseeitherinthe formofmarketdominancebyonefirmorcollectivelybyfirmsoperatingcartelsandother restrictivepractices. Competition law varies in detail across countries but usually consists of laws against restrictions onboth market dominanceandrestrictive practices.Manycountries also have legislationtorestrictmergersthatmightlead tomarketdominance. Criticswouldarguethatnormallymonopolypoweriscompetedawaybymarketforcesand thereforegovernmentinvolvementisunnecessary.Also,theywouldarguethatgovernment interventionthrough competitionpolicy is economicallycostlyandprevents economically beneficialmergersandtradingagreementsbetweenfirms. Chapterreference:pp.358 361.

125

Question6
Commentonthelikelyimpactofregionalpolicyonbusinessstrategy.

Guidance
Regional policy involves government intervention in the economy through taxation, subsidiesandplanninglawstoencouragefirmstoinvestinparticularareasofthecountry, normallythosewhereunemploymentlevelsareabovethenationalaverage. Locationdecisionsinbusinessstrategyareaffected.Itmayproveimpossibletoestablisha productionsiteinthemostpreferredareaofthecountry(e.g.thatwhichmakesmostsense in terms of the firms private costs and benefits). Another area of the country might now seemmoreattractiveasalocationbecauseofthegovernmentsubsidiesandtaxbenefits. Itshouldbenotedthatregionalpolicydistortsprivatesectorinvestmentdecisionsandthis can prove damaging if firms locate to areas where they cannot produce the output cost effectivelyoverthelongrunandespeciallyoncethegovernmentsfiscalincentivesend. Chapterreference:pp.361 363.

126

Question7
Whatdoyouunderstandbystatefailure?Whenisstatefailuremostlikelytoarise?

Guidance
Statefailureoccurswhengovernmentinterventionintheeconomylowersratherthanraises social welfare. This occurs where the economic costs of state intervention exceed the economicbenefits. This is most likely to occur where state intervention distorts market forces significantly, underminesenterpriseandcompetition,andslowseconomicgrowth.Thiscouldoccureither becausepoliticianspursuetheirownorsectionalinterestsratherthanthepublicinterestor theylackthenecessaryinformationtoknowwhatisinthepublicinterest.Inotherwords, stateinterventionisassociatedwithboth incentivesandinformation deficiencies. Chapterreference:pp.346 349.

127

Question8
Undertake a PEST analysis for a business with which you are familiar, emphasizing in particular, the ways in which government policies might impact, favourably and adversely, onthebusiness.

Guidance
The PEST technique is introduced on page 19 of the book and requires managers to consider significant political, economic, social and technological developments impacting orlikelytoimpactonthefirmanditsmarket. Government policy can impact on all four factors in the firms environment: political, economic,socialandtechnological,asdiscussedinthechapter. The figure below offers some guidance on the sort of factors, which could be considered when conducting a PEST analysis for any business. The factors listed are, of course, not comprehensivebutmerelyindicativeofsomeofthekeyaspects,whicharelikelytoarise.

Assessmentsof stateoftheart developments

Expectednewproduct developmentsfrom thecompanys R&Dactivities

Competitors developments

ECONOMICTRENDS

Economicgrowth Consumerspending Governmentspending Interestrates Exchangerates Moneysupply Investment

SOCIALTRENDS

TECHNOLOGICAL TRENDS

Changeinsocietalvalues Demographicchanges Newlifestyles Attitudestoworkandleisure

THE BUSINESS

POLITICALTRENDS

Legislation

Politicalalignments

Businessgovernment relations

Chapterreference:material throughoutthechapter.

128

C H A P T E R 1 7

BusinessandEconomicForecasting
Question1
Whatfactorsarelikelytoaffectthemarketforhousesandthedeterminationofhouseprices: (a) nationallyovertimeand (b) locallyatapointintime?

Guidance
Inbothcaseshousepriceswillreflectthedemandandsupplyofhousing.Housepricesfall whenthereisanexcesssupplyofhousesforsaleandrisewhenthereisanexcessdemand. Overtime,housepricesareaffectedbychangesindemandandsupplyconditions,suchas the availability of land for new house building on the supply side and changes in the taxation of house ownership and social and demographic changes on the demand side. Forexample,achange insocialattitudes that leads to apreferenceforownedoverrented housingwillincreasethedemandforhousesforpurchase,aswillmoredivorcesthatleadto moresinglepersonhouseholds. Housepriceslocally,atapointintime,areaffectedbylocaldemographicandsocialfactors andbyissues,suchaslocaleconomicdevelopmentthatdrawsinnewemployersleadingto alargerworkforce.Localhousepriceswillalsoreflecttheexistenceofacceptablesubstitutes, notablyrented housing. Forecasts of house prices over time will be based on timetrend data. The effect on house prices locally, at a point in time, might be estimated using crosssectional data, includingrelevantvariablestoreflectdemandandsupplypatternsgeographically. Chapterreference:materialthroughoutthechapter.

129

Question2
Youhavebeenaskedtowriteareportonthefutureofthemarketformensclothingbyamajor clothingmanufacturer. (a) Outlinebrieflythestructurethatthereportwilltake,highlightingthemainstepsofthe finalanalysis. (b) Whatfactorsdoyouconsiderwillbethemostimportantindeterminingfuturesalesof thecompanysproduct?

Guidance
Thereportisconcernedwiththemarketformensclothingandthereforewithfactorswhich affectorarelikelytoaffectthedemandforandthesupplyofmensclothing. Thesizeofthemarket(thenumberofmen!)ismerelyastartingpointbecausethemarketis affectedbynumerousotherfactors,suchasfashionandincomes. Youshouldstartbytryingtospecifythedemandfunctionformensclothing. Similarly, supply is affected by the price of mens clothing and the number of firms producing but also by factors, such as costs of production and the ability of textile companies to switch production into and out of mens clothing. Another important factor relatestothenumberandqualityofretailoutletsformensclothing. Youshouldattempttospecifythesupplyfunctionformensclothing. The report might, therefore, usefully describe the current state of the market and recent developments, to identify market trends, and then go on to a detailed discussion of the importantdemandandsupplyconsiderationsinthemarketbasedaroundyourdemandand supplyanalysis. Fromthisdiscussionyoushouldbeabletodeducewhatfactorsyouconsidertobethemost importantindeterminingthefuturesalesofthecompanysproduct. Chapterreference:materialthroughoutthechapter.

130

Question3
Youhavebeenappointedbytheboardofanupmarket cosmetics producertoprepareareport concerninganewproductlaunch.Brieflydescribe,howyouwouldassess: (a) thelaunchpriceoftheproduct (b) futuresales,shorttermandlongterm (c) the likelyreactionofcompetitors (d) profitabilityofthenewproduct. Youhavealsobeeninstructedtoidentifydifferentwaysinwhichthenewproductmaybetest marketed,justifyingclearlyyourpreferredmethod.

Guidance
Thepricechosenatthelaunchoftheproductwillbedeterminedbyfactors,suchasthecosts ofproduction,butalsoby(a)thecompetitivenessofthemarket, and(b)thefirmsstrategy. Wecansafelyassumethatthecosmetics market is notperfectlycompetitiveandtherefore the firm has discretion when setting its price. There are broadly two opposite pricing strategiesthatcouldbeadoptedandboth,dependingonthemarketandthefirmsstrategy, couldbevalid. One is a skimming strategy, which means setting a premium price to earn maximum revenues until the competition reacts and introduces cheaper competitor products. This would most obviously be possible where the new product currently has no close substitutes. The otherpricingstrategy involvespromotional orpenetrationpricing, which involves pricing relatively low (at cost or lower, such as at or slightly above variable cost) with a viewtowinningthemaximummarketshare.Thehighmarketsharemightthenprovidean effectivebarriertocompetitorsthinkingofenteringtheindustrylater. Neitherofthesestrategies is immune fromproblems and,inparticular,bothimplyalater changeinprice.Forexample,thepromotionalstrategymaynotbeprofitableunlessprices canberaisedlater. Theremaybenoguaranteeofthis,especiallyifthemarketiscontestable. Future sales in the shortterm and the longterm can be estimated using some of the techniqueslaidoutinthischapter.Notethattheresultsareestimates,whichmightdiverge fromtheactuals,especiallyifthemodellingprocess isdefective.Itisparticularlydifficult to forecast sales for a completely new product because there is no historic evidence on whichtocall. The response of competitors will depend on the barriers to entry into the industry, whichcouldbelegal(e.g.patentprotection)orstrategic(e.g.thefirmsmarketingstrategy). Thelikelyresponseofcompetitorswillinfluencetheinitialpricingpolicyadopted. The profitability of the product will depend upon the revenues achieved from sales compared with the costs of production (including marketing costs). A new product may

131

necessitatehighmarketingexpendituretodrawittotheattentionofconsumers.Thisinturn willinfluencethedecisionontheinitialpricingstrategyadoptedbyaffectingsupplycosts. Beforetheproductlaunchinformationcanbeobtainedonthelikelyresponseofconsumers to particular types of marketing, including pricing, through consumer surveys and market experiments.Thechapteroutlinesanumberofpossiblemethodsforcollectinginformation onconsumerdemand. Chapterreference:seeespeciallypp.368 373andChapter12onpricingstrategies.

132

Question4
Samuel Goldwyn oncestated Never makeforecasts,especiallyabout thefuture.Discuss the pitfallsinvolvedinmakingbusinessforecasts.Howarethesepitfallsbestavoided?

Guidance
Forecasting the future could simply be based on hunch. In the chapter, we have been concerned with forecasting based on collecting mainly quantitative data and adopting statisticalanalysisofthedata.Nevertheless,itisimportanttorecognisethatforecastscanbe wrong even when undertaken using sophisticated econometric modelling. But when undertakencarefullyandthoroughly,statisticalanalysisshouldprovidemorereliableresults thanhunches. Althoughthereisinsufficientspaceinonechaptertodiscussstatisticalforecastingmethods indetail,thechapterdoesprovidepointerstosomeofthemoreimportantfactorsthatneed tobeconsidered. First, it is important to specify the forecasting model correctly, thus including all of the relevant variables that have explanatory power (for example, in forecasting sales, it is important to include in the model all those variables that have importance in determining salesorproxiesforthem). Secondly, it is important to collect relevant and reliable data on the variables identified (remembertheadage:rubbishin,rubbishout!). Thirdly,therelationshipbetweenthevariableswillneedtobeestimatedbasedonthedata and the reliability of the estimates will need to be assessed. Are the results reliable? Therearesomestandarddiagnostictestsrelatingtothereliabilityoftheentireequationand the individual coefficient values. These are based on the statistical measure of what is knownasthestandarderror.Whenforecastingpricesit willalsobeimportanttocontrol forthesocalledidentificationproblem(seepp.378 380). Weallneedtotakeaviewaboutthefutureifwearetorunourlivessuccessfully,andthisis particularly true of businesses and governments. Forecasting the future will always be hazardous, yet, turning Samuel Goldwyns comment on its head, how can we flourish withoutforecastingthefuture? Chapterreferences:materialthroughoutthechapterbutparticularlypp.373 386.

133

C H A P T E R 1 8

BusinessEconomics AChecklistforManagers
Question1
Setoutaneconomicstrategyforasmallscalefoodretailerthreatenedbythepossibleentryinto itsmarketofacompetitor,whichispartofalargenationalchainofsupermarkets.

Guidance
The smallscale food retailer will have to develop a strategy, which differentiates its productsandservicesfroma newand largercompetitor,which is part ofa large national chain. The retailer may consider opening for longer hours as well as providing a more personal service, which may include home delivery. It may also consider stocking a range of productsthatonewouldnotnormallyexpecttofindinalargesupermarketalthoughthis is becoming less likely as supermarkets expand their own range of products (to include items,suchasnewspapers,flowers,readytoeatmealsetc.). Thesmallretailerwillfindlifeverydifficultifitdecidestocompeteonpricealonebecause the larger competitor will have much greater bargaining power with wholesalers and suppliers.Atthesametime,thesmallretailerwilllosebusinessifitisnotreasonablypriced andcompetitive. Chapterreference:materialthroughoutthechapter.

134

Question2
Isitsensibleforafirmtoreacttonewcompetitionbyreducingprice?Justifyyourviews.

Guidance
Cuttingpricecan,undercertainconditions,beanappropriatestrategybut it is often not a strategythatcanbesustained. A price reduction may deter new firms from entering the market referred to as an enterlimitingorentrylimitingstrategy. However,cuttingpriceisunlikelytobeasensiblereactionwhennewcompetitorsbecome established players. This stems from the kinked demand curve argument related to oligopoly.Inotherwords,apricecutislikelytobeduplicatedbycompetitorsresultingin anoverallreductionintotalrevenue. Apricecutcould,however,beimplementedaspartofawiderstrategytoincreasemarket sharelinkedperhapstosomepromotionalexpendituretoincreasetheoveralldemandin themarketplace. Pricecutscouldalsobeselective,creatinglossleaderswhileattractingmorecustomersto otherproductsandservicesonoffer. Chapterreference:materialthroughoutthechapter.

135

Question3
Wheniscostcuttingnotasustainable,longtermcompetitivestrategy?

Guidance
Costcuttingisnotasustainablelongtermcompetitivestrategyunlesspricecoversallcosts ofproductionfixedandvariable.Ifpricefallsbelowthetotalcostofproductionthenthe firmshouldshutdowninthelongterm. In addition, cutting cost may have an impact on marketing, R&D and training budgets as wellasonstaffmorale allofwhicharelikelytobedamagingtothebusiness. Cost cutting, therefore, must be combined with some fundamental changes in corporate strategyifthecompanyistosurviveandmustnotbeseenasanendinitself. Chapterreference:materialthroughoutthechapter.

136

Question4
Whatnonpricestrategiesshouldbeconsideredasareactiontonewcompetition?

Guidance
Nonprice strategies may involve a wide range of options depending on the nature of the productorserviceandtheindustrysector. Productorservicedifferentiationisoneofthemostcommonnonpricestrategies.Thismay involve improved or additional features (such as extended warranties on cars). It is important that the buyer regards such features as having value otherwise the strategy is unlikelytosucceed. An advertising strategy may be launched to enhance brand recognition and brand value. Ifsuccessful,thismayevenmakeitpossibleforthefirmtoraiseprice! Bundlingcouldbeadoptedasastrategywherebytwoormoreproductsaresoldtogether forexample,freefabricsoftenerwithalargepacketofdetergent.Thisisacommonstrategy inmanysegmentsoftheretailingsector,whichmaybepreferredto apricewar. Couponsmaybegivenawaywithproductsorservicestoattractdemand.Aswithbundling, there will be a cost involved for the firm, but this may be a more attractive strategy than enteringintodirectpricecompetition. Chapterreferences:materialthroughoutthechapter.

137

Question5
Takinganindustrywithwhichyouarefamiliar(theoneyouworkinoroneyouhavestudied), setoutthekeyeconomicvariablesthatyoufeeldeterminebusinesssuccess.

Guidance
The impact of economic variables on any industry will depend on a number of factors. Astartingpoint,therefore,wouldbetoaddressthefollowingquestions: doestheindustryhaveaninternationaldimension,orisitsolelyadomesticactivity? istheindustryintheprivatesectororstateownedsector? istheindustryintheservicesectorormanufacturingsector?

The list of economicvariables that shouldbeconsideredcouldbeconsiderable.However, themostimportantonesarelikelytoinvolve: economicgrowth interestrates(domesticallyandinternationally) inflation(ofprices,wages,rawmaterialsetc.) unemployment(nationallyandsectorally) exchangerates consumerspending corporateinvestmentexpenditure governmentexpenditureandtaxation.

It is important to understand how changes in the economic environment and expected officialpolicyresponsesarelikelytoimpactontheindustry.Thiswillenablemanagement toplanaheadandtakethenecessarystepseithertoavoideconomiccrisesortobenefitfrom economicupturns. Chapterreferences:materialthroughoutthechapter.

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Question6
Dothesameforaparticularfirminthisindustry,andindicatethemainfuturecompetitivethreats andactionsthemanagementshouldtake.

Guidance
The reader should refer to Chapter 11, pages 217 220 for a detailed list of questions, whichshouldbeaddressed.Thefirmshouldconsiderthethreatswhichitfacesarisingatthe industrylevelintermsof: thebargainingpowerofbuyers thebargainingpowerofsuppliers thethreatfrompotentialnewentrantsintothemarket thethreatfromsubstituteproductsorservices thedegreeofcompetition(rivalry)inthemarket.

Possibleactionswilldependonthenatureoftheproductorserviceandthestructureofthe industry. The firm may choose to be a lowcost producer or may adopt a product differentiation strategy(fordetails,seepp.221 222). Chapterreferences:materialthroughoutthechapterandChapter11.

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Question7
In the case of this firm, indicate the main future threats that are likely to come from the macroeconomicenvironment.

Guidance
SeetheGuidanceNotesforQuestion8,Chapter16. Futurethreatscouldcomefrommanydevelopments,dependingonthenatureoftheproduct orserviceandthestructureoftheindustry. Ingeneral,threatsfromthemacroeconomicenvironmentarelikelytoinvolve: thepossibilityofamajorrecession changesinconsumerspendinglevelsandpatterns externalshocks(suchasoilpricehikesandtradewars) inflationary pressures, which may lead to an increase in shortterm interest rates and henceariseinborrowingcosts adownturninbusinessandconsumerconfidence stockmarketinstability. Thelistisfarfromexhaustive.Itisimportantthereforeforfirmstobeawareofdevelopments inthewiderbusinessandeconomicenvironmenttobeforewarnedaboutthepossibilityand impactofthreats. Bydefinition,threatsemergingfromdevelopmentsinthemacroeconomicenvironmentare beyondthecontroloftheindividualfirmbutrecognition of earlywarnings,will givethe firmtimetomakeadjustmentstoitsactivitiesincludingprice,capacity,investmentdecisions etc. Chapterreferences:materialthroughoutthechapter.

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