Media.pearsoncmg.com Intl Ema Ema Uk He Nellis Prinbuseco 2 Guidance Notes 0273693115 Notes

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Guidance notes for Topics for Discussion

Contents

Chapters Pages

1. Business Economics: An Overview 2

2. The Analysis of Consumer Demand 11

3. The Analysis of Production Costs 17

4. Analysis of the Firm’s Supply Decision 26

5. Demand, Supply and Price Determination 33

6. Analysis of Perfectly Competitive Markets 41

7. Analysis of Monopoly Markets 48

8. Analysis of Monopolistically Competitive Markets 53

9. Oligopoly 59

10. Managerial Objectives and the Firm 68

11. Understanding Competitive Strategy 77

12. Understanding Pricing Strategies 87

13. Understanding the Market for Labour 95

14. Understanding the Market for Capital 106

15. Understanding the Market for Natural Resources 115

16. Government and Business 121

17. Business and Economic Forecasting 129

18. Business Economics – A Checklist for Managers 134

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CHAPTER 1

Business Economics: An Overview

Question 1

What do you understand by the ‘microeconomic environment’ and ‘macroeconomic environment’ of the firm? List some of the key issues, which the management should be aware of under both of these headings.

Guidance

• TheMicroeconomic Environment deals with:

• operation of the firm in its immediate market

• determination of prices

• the firm’s revenues, costs and employment levels etc.

• TheMacroeconomic Environment deals with:

• the general economic conditions of the wider economy of which each firm forms a part.

• Key issues under these headings:

(a) Microeconomic environment

• the factors that enter into price determination, notably market demand and supply.

• the factors that enter into the costs of production, notably the output produced, the costs of factor inputs (land, labour and capital), the scale of production and the efficiency with which the production process is managed.

(b) Macroeconomic environment

• the level of economic activity.

• the impact of macroeconomic policies involving decisions by government and the central bank.

• international developments including, for example, the impact of exchange rates and international trade.

Chapter references: pp. 1 – 2 and Figure 1.1.

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Question 2

Consider the main issues that the management might take into consideration when deciding how to allocate the firm’s resources.

Guidance

• Management has to decide what to produce, how to produce and for whom the different goods and services are to be supplied.

• Decisions will be driven by the following:

• objectives of the firm

• risk and uncertainty

• externalities

• demand in the marketplace

• availability of resources

• opportunity costs

• production costs including the prices of factor inputs

• the impact of technology

• time dimension (shortrun versus longrun).

Chapter references: pp. 3 – 13 and Figures 1.2 and 1.3.

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Question 3

What do you understand by the term ‘opportunity cost’? Give examples from the decision making of (a) a government policymaker, (b) a privatesector manager and (c) a publicsector manager.

Guidance

• Opportunity cost is what we forgo when we decide to use resources in one use as against another.

• Examples:

(a) government

• spending more on defence and less on healthcare

• increasing taxation and the consequent reduction of private consumer spending

• repairing a school roof and spending less on road repairs.

(b) privatesector manager

• investing more in new industrial buildings and therefore lower profits distributed

• investing in capital equipment as a substitute for manual workers

• expanding overseas rather than investing at home.

(c) publicsector manager

• employing more doctors and fewer nurses

• building a new municipal swimming pool instead of more municipal housing

• increasing refuse collection services instead of spending more on street cleaning.


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Question 4

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 more of one input (e.g. labour) to another input (e.g. capital or land) and then after some point the resulting increase in output becomes smaller and smaller.

• Examples:

• growing more and more crops from the same piece of land

• trying to produce output beyond the normal full capacity production level by simply supplying more and more workers

• increasing the number of banking staff in a branch without appropriate increases in computing facilities and physical office space

• trying to operate more and more trains with a given rail infrastructure

• the impact on educational attainment of excessively increasing the number of students that each teacher is responsible for.


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Question 5

What do you understand by the term ‘externalities’? When are they likely to be important?

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.

• They are likely to be important for several reasons, involving:

• costs: environmental effects, for example, pollution and noise

• benefits: the wider social impact of health and education spending; faster journey times because of measures, which reduce road congestion etc.

• An assessment of the relative costs and benefits will have implications for publicsector expenditure and taxation and the allocation of resources.

• Recognition of externalities is the focus of a branch of economics known as CostBenefit Analysis.

Chapter references: p. 13 and for discussion of CostBenefit Analysis see pp. 324 – 6, Chapter 14.

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Question 6

Compare and contrast the different forms of competition found in market economies. What are the possible implications for government economic policy?

Guidance

• Forms of market structure:

(a) Perfect competition

• very large number of small, independent buyers and sellers.

(b) Monopolistic competition

• very large number of producers supplying slightly differentiated goods and services to the market.

(c) Oligopoly

• a few, relatively large suppliers competing in the market on the basis of a wide range of marketing options including price.

(d) Monopoly

• a sole supplier of a goods or service to the market, which can choose either to set the selling price or to determine the quantity provided to the market.

For further information, comparing and contrasting these different forms of market structure, see Figure 1.4 in the book, p. 18.

• Implications for government economic policy involve:

• decisions regarding the optimal market structure for each industrial sector to maximise social welfare

• the decisions of firms under oligopoly and monopoly, which have obvious implications for competition policy including market dominance, mergers and takeovers and restrictive trade practices

• competition issues arising from advertising and branding, which may lead the government to introduce consumer protection measures including policy involving advertising standards.


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Question 7

What methods might be used to assess a firm’s competitive environment?

Guidance

• Assessing the firm’s external environment using, for example, a political, economic, social and technological (PEST) analysis.

• Assessing the competitive forces impacting on the firm using Porter’s Five Forces Model.

• An assessment of the firm’s competitive environment enables the firm to take stock of its strengths and weaknesses in an appropriate context.


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Question 8

How might a firm decide on the appropriate strategies to adopt to achieve and maintain a competitive advantage?

Guidance

• The firm will need to make an ‘honest’ assessment of its external environment and its internal resource capabilities.

• The firm needs to assess the market structure and the forms of competition it faces.

• One approach will be to complete PEST and Five Forces analyses followed by a strengths, weaknessess, opportunities and threats (SWOT) analysis.

• The firm will need to take account of its competitive ‘positioning’ in the marketplace – in particular, determining whether it is best to adopt one of the following strategies:

• cost leadership

• differentiation

• focus.


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Question 9

Select a company with which you are familiar. Conduct a detailed assessment of its competitive environment in terms of:

(a) A PEST analysis

(b) Porter’s Five Forces Model.

In the context of this assessment, conduct a SWOT analysis of the company.

Guidance

In addressing these tasks, there are a number of points to note to ensure that appropriate analyses are undertaken.

• PEST analysis:

• avoid producing long lists of every conceivable factor and events that just might impact on the firm

• focus on what you consider to be the key or most important factors and be prepared to defend their inclusion

• remember that a PEST analysis is seeking to detect trends in the external environment of the firm, which will lead to opportunities and threats.

• Porter’s Five Forces Model:

• the objective here is to identify the different forces impacting the competitive environment of the firm and hence profitability

• avoid lists, which simply identify existing rivals, customers, products etc.; the focus must be placed on the dynamics of the competitive environment

• seek to identify the relative importance or impact of each of the Five Forces on competition and profitability

• this will help focus in on the strategic decisions to be made.

• SWOT analysis:

• it is important to avoid generating long lists of strengths and weaknesses

• those identified should be relevant in the context of the opportunities and threats you discuss resulting from the PEST and Five Forces analyses.


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CHAPTER 2

The Analysis of Consumer Demand

Question 1

A marketing manager at the Ford Company in Belgium is preparing a briefing on consumer demand for a new model to be sold mainly in other parts of Europe. Consider the issues that this briefing should contain.

Guidance

• Consideration should be given to a wide range of factors, which are likely to impact upon the demand for the new model including the following:

• the ‘own price’ elasticity of demand

• the price of competing car models

• the price of complementary goods and services (including, for example, car insurance, road tax and fuel charges, etc.)

• the scale of advertising expenditure, which may be needed to build up the brand image

• the level and distribution of disposable incomes

• the importance of wealth effects and the implications for consumer demand including, for example, property values

• changes in consumers’ tastes and preferences

• the cost and availability of credit

• expectations concerning future price rises and availability of the new model

• population structure and trends.

• Particular attention should be devoted to an assessment of the extent to which these determinants of demand may change in the future, which may result in a shift in the demand curve for the new car model.

Chapter references: pp. 29 – 31, 36 – 38 and Figures 2.2, 2.3 and 2.4.

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Question 2

Draw what you consider may be the demand curve for this new model in say, the United Kingdom. Illustrate the effect of the following:

(a) a fall in the sterlingeuro exchange rate;

(b) a recession in the United Kingdom; and

(c) an increase in the price of Honda cars made in the United Kingdom.

Guidance

(a) A fall in the sterlingeuro exchange rate will make cars imported from Belgium (presumably priced in euros) more expensive for UK buyers. Hence, the UK demand curve will shift to the left.

(b) A recession in the United Kingdom will reduce demand in general, as a result of a lower level of national income – hence the UK demand curve will shift to the left.

(c) An increase in the price of a substitute – Honda cars – made in the United Kingdom will, ceteris paribus, result in Belgiummade cars becoming more price competitive – hence, the UK demand curve for Belgium cars should shift to the right.


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Question 3

Using the concept of consumer surplus, explain why a supplier might wish to charge more to one group of consumers than another.

Guidance

• The decision to charge more to one group of consumers than another involves an appreciation of price discrimination. If a supplier is able to charge each group on the basis of the highest price that each is willing to pay, this ensures that no consumer surplus remains. This gives rise to the notion of a discriminating monopolist whereby each group is charged a price that just equals the valuation, which they each place on each unit of the good consumed.

• In this way, the supplier will seek to maximise profits.

Chapter references: p. 33 – 36 and Figure 2.2.

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Question 4

Contrast the likely marketing strategies of:

(a) a food retailer selling via the Internet; and

(b) a fine wines retailer.

Explain the reasons for the differences based on the classification of goods outlined in this chapter.

Guidance

• The difference in marketing strategies will be dependent on several issues, primarily:

• the extent to which the demand for food and the demand for fine wines are sensitive to changes in prices and incomes

• the nature of the food being retailed: normal, inferior or Giffen products

• the importance of branding in the context of Veblen products (such as fine wines).

Chapter references: pp. 38 – 41.

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Question 5

A bus company operates two routes. On route 1, research suggests that the price elasticity is 0.8 and on the other route 1.3. The company has decided to revise fares upwards on both routes by 10% this year. Comment on the decision.

What alternative pricing strategy would you suggest?

Guidance

• In the case of route 1, an increase in fares of 10% will lead to an increase in overall revenue to the bus company. This follows because demand on this route is relatively price inelastic (i.e. is less than route 1 in absolute terms).

• 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.

• The bus company should consider dropping the price on route 2 since demand should rise proportionately more. However, this decision will depend upon how much spare capacity exists on the buses used on this route and other costs associated with this decision.

• Similarly, prices could be raised still further on route 1. However, the company must be made aware that the elasticity of demand is not constant – the value will differ at different price levels.

Chapter references: pp. 41 – 52 and Figures 2.5 – 2.8.

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Question 6

An international hotel chain calculates that this year demand for its accommodation in Kuala Lumpur will rise by 15%. The incomes of customers are estimated by the hotel management to be rising by around 10%.

(a) Assuming all other conditions of demand are unchanged, what do these figures suggest about the income elasticity of demand for the hotel accommodation?

(b) In practice, what other factors would need to be taken into consideration before accepting this income elasticity figure as the sole basis for estimating the hotel’s future demand?

Guidance

(a) A rise in demand in excess of a rise in income suggests that the demand for hotel accommodation is income elastic. In other words, as incomes rise, demand is set to rise at an even faster rate. This suggests that such accommodation is regarded as a luxury good.

(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, selfcatering apartments, etc.)

• the impact of exchange rate movements on the demand from foreign travellers

• other economic variables, such as the cost of borrowing, changes in share prices, property values, business and consumer confidence, etc.

• the general economic conditions.


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CHAPTER 3

The Analysis of Production Costs

Question 1

Explain the distinction between variable and fixed costs of production.

Guidance

• Consideration should be given to the types of inputs and the time period under review.

• Variable costs are those costs that vary as output varies. Fixed costs are those that do not vary with output. In the economic ‘shortrun’ production situation one or more factor inputs is fixed in supply, for example land or capital, whereas one or more inputs will be variable in supply, such as labour, in which case it is changes in the costs of the variable inputs that drives up the total costs of production. In the economic ‘longrun’ production situation all factor inputs are variable in supply so total costs are affected by the costs of employing additional units of all inputs.

• Marginal costs of production are calculated as an incremental change in the total costs 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 one or more fixed factor inputs) and ‘longrun marginal costs’ (that relate to changes in total costs where all inputs are variable in supply).

• Usually it will be easier to vary the quantity of labour employed than land and capital used; but in principle any factor of production could be either a variable factor or a fixed factor.


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Question 2

Using an appropriate diagram, discuss the relationship between marginal cost, averaged fixed cost, average variable cost and average total cost.

Guidance

• The appropriate diagram is Figure 3.5 from the book, which is based on the data in Table 3.3.

• The different types of production costs are related because:

• marginal cost is the incremental change in total cost as output varies

• marginal cost is affected by variable costs only

• average variable cost plus average fixed cost equals average total cost.

• Particular points to note about the relationship between the different cost curves are the following:

• average fixed cost (AFC) continuously declines and the area under the curve is always the same (and equals the total fixed cost)

• the marginal cost curve intersects the minimum points of the average variable cost (AVC) and average total cost curves (ATC)

• the vertical distance between the AVC and ATC curves is equal to the average fixed costs, hence as output rises the AVC and ATC curves move closer together.

Chapter references: pp. 69 – 74 and 78 – 80; Figure 3.5 and Table 3.3.

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Question 3

Using the discussion of costs included in this chapter and the discussion of demand in Chapter 2, explain the success of a large international motorcar manufacturer, such as Toyota.

Guidance

This question requires you to use the theory in Chapter 3 rather than simply regurgitate the theory. This is always more tricky, but also more interesting! It is a good test of the extent to which you really understand the theory.

The answer should include the following discussion:

• Economies of scale and learning or experience economies. Toyota produces large volumes 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, Toyota is an experienced vehicle manufacturer, which has learned how to produce cars most economically without unduly compromising on product quality (for example, Toyota uses production techniques that it has perfected over the years such as ‘justintime’ production, economising on the costs of holding stocks of materials, and ‘total quality management’, which through the organisation of vehicle design and the production process reduces vehicle defects.).

• Economies of scope: Toyota certainly benefits from producing a range of vehicles, which allows it to apportion certain common and joint costs across a wider number of vehicles, such as marketing costs and engine design costs.

• Toyota is a wellmanaged firm and therefore the reasonable expectation is that ‘Xinefficiencies’ will be minimised.

• Through economies of scale, learning economies and minimising Xinefficiencies, Toyota is able to produce vehicles that it can price competitively while still being able to generate profit. You should draw appropriate cost (and revenue diagrams, from Chapter 2) to illustrate your answer.

• You might also go on to discuss some other issues that impact on Toyota’s success, such as exchange rates, trade barriers, management training, and so on, but these issues, while relevant, go beyond the scope of Chapter 3.

Chapter references: pp. 81 – 98 and Figures 3.8 – 3.16.

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Question 4

The Meetoo Company produces shirts at a factory in Singapore. The shirts currently sell from 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? What other information might you need before reaching a decision.

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 factory at a loss, provided they can find the funding to do this.

• In some circumstances a firm’s 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. For example, it would not pay a soft drinks manufacturer to close down its bottling plant if there was no other or cheaper bottling facility available even if the bottling plant loses money, provided that the overall soft drinks business is profitable.

• Let us suppose that the factory belongs to profitoriented owners and there are no effects on other parts of a business to consider. Does it make sense to shut down production immediately and, if not, would it do so at any future time even if revenues and costs did not alter in the meantime? The answer to this question is ‘it all depends’!

• If the firm has already invested in plant or office space or other fixed factors of production and their cost cannot be recouped by resale of the facilities and capital equipment, such as at a ‘liquidation auction’, then it could pay the firm to continue in production until such time as the facilities and capital equipment need to be replaced. When investing in new capital equipment a profit maximising firm will want a reasonable expectation that its revenues will exceed its total costs (fixed and variable). But once the investment has taken place and the investment is what we call ‘sunk’, then the decision rule is: ‘do revenues exceed the variable costs of production?’. Provided that the variable costs, which are ‘avoidable costs’ if production does not occur, are covered then production is worthwhile to the firm. Any additional net revenues after meeting the variable costs can be put towards offsetting some of the fixed costs. The other way to look at this is that the loss would be greater to the firm if it shut down production in the shortrun.

• So with all of this in mind, what about the Singapore factory? The key to answering this question lies in the ‘contribution margin’, that is to say the difference between the selling price and the average variable costs of production (or variable costs per unit produced).

• The firm makes an overall loss on each shirt sold of $3, but if the firm were to shut down production it would still have to meet its fixed costs, which are equivalent to $4 per shirt currently sold. To calculate the total fixed costs we would need to know the number of shirts currently produced and this is not given in the question. But it is clear that the firm

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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 (and therefore earned no revenue) the loss would be higher (at $4 multiplied by the number of shirts currently sold).

• Another way of looking at this is to identify that by continuing to produce and sell the shirts at $15 the firm covers its average variable costs of $14 and makes a contribution towards the fixed costs of $1.

• It therefore does not appear to pay the firm to shut down production at present. On the face of it, however, it would not pay the firm to replace its fixed assets in the future. At that point in time, unless circumstances change, it would seem advisable for the firm to withdraw from the market.


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Question 5

Offscale, an office equipment supplier, has expanded its operations dramatically over the last 10 years. As sales rose at first unit costs fell and then levelled out. Now there are signs of rising costs. Investigation suggests that diseconomies of scale have set in. Offscale is still run by its founding director and two sons. Explain, using an appropriate diagram, what has been happening to costs over the last decade. Make suggestions as to what actions might be taken to prevent diseconomies of scale.

Guidance

• The answer is concerned with the shape of the longrun average cost curve and the effects of 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 production declined with greater output volume. Later it appears that the firm had rising unit costs of production; this is the evidence of decreasing returns to scale.

• The question suggests that diseconomies of scale are the problem. But costs may also be rising because of poor management of resources or Xinefficiency. In other words, the same resources with the same technology could produce the same output more cheaply with better 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, recognising its production methods.

• If Xinefficiency is the problem then reorganising production and improving the resource management would seem to be the solution.

Chapter references: pp. 81 – 87; Figures 3.8, 3.9 and 3.16.

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Question 6

Choose a firm in a sector with which you are familiar and consider the role of innovation within the firm in sustaining its competitive advantage.

Guidance

• The question allows you to choose the firm. This requires that you take an interest in the business and financial press or at least your local businesses.

• Innovation should improve competitiveness through new product offerings in the market and by driving down the costs of production – in both cases the firm’s competitiveness should be improved.

• Some firms, notably firms in industries with fast changes in technologies and products, need to invest heavily in R&D to sustain a constant stream of innovation. Innovation can take place in terms of new products or new and more efficient production processes for existing products.

• Innovation driven firms include Microsoft in the information technology (IT) sector, AT&T in telecommunications and Sony in consumer electronics. Another innovation driven industry is pharmaceuticals, but most industries have some innovation.

• Innovation in terms of new products will reinforce a ‘differentiation’ competitive strategy, while innovation in production processes may well be crucial to sustaining a ‘costfocused’ strategy (see the discussion in Chapter 11 on ‘strategic positioning’, pp. 221– 224).

• Innovation is different to ‘invention’. Innovation implies the use of new technologies and production methods in the production process. Invention proceeds innovation.

Chapter references: p. 82 on Research and development, pp. 86 – 87 and p. 91; Figure 3.10.

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Question 7

Assess the significance of new informationbased technology for the future of the retail banking industry. Illustrate your answer using appropriate cost diagrams.

Guidance

• The answer to this question draws on a number of the issues that you would have considered when answering Question 6. Consideration should be given to innovation involving the role of changes in IT in reducing costs of production.

• New IT should both reduce the costs of providing services (improve banking processes) and provide an opportunity to introduce new banking services to achieve a competitive advantage (e.g. Internet banking, telephone banking and more sophisticated electronic cash dispensers). In the future, who knows what new banking services may be introduced. New products increase the demand for banking services causing a shift in the demand curve for banking services.

• It is important, however, that IT not only allows banks to become more efficient at what they do now, but also allows them to extend and refine their product range.

• Those banks that invest in the most effectively used IT systems will reap the greatest competitive benefits in terms of both supply and demand curve effects.

• As costs are driven down and product innovation occurs it will become more difficult for banks to compete that lag behind in the introduction of IT.

• IT is expensive and therefore economies of scale may become more important in retail banking. This may lead to mergers and takeovers.

• New IT may alter the type of staff employed with an impact on relative wages.

Chapter references: pp. 86 – 89 and 97 – 98; Figures 3.8 and 3.10.

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Question 8

Using isoquant and isocost analysis discuss how the optimal combination of factor inputs employed by a firm should be decided.

Guidance

• The relevant material is in Appendix 3.1 to the book, pages 101−108. But before attempting to answer this question check that your course requires study of isoquant and isocost curve analysis, not all business economics courses do so.

• Isoquant curves map out levels of production obtainable from different combinations of factor inputs assuming that they are used efficiently.

• Isocost curves map out the costs of these factor inputs assuming different input prices.

• Each isoquant curve identifies a given level of output and every isocost curve a given level of expenditure on factor inputs.

• The most economic production occurs where output is maximised for any given expenditure on inputs. The result is an output and combination of factor inputs that cannot be improved on in the sense of obtaining a higher output from the given budget or expenditure on inputs.

Chapter reference: Appendix 3.1 and Figures A3.1 to A3.5.

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CHAPTER 4

Analysis of the Firm’s Supply Decision

Question 1

What factors enter into the decision of a carmanufacturing firm to launch a new model?

Guidance

• This question requires you to identify those matters that you might reasonably expect a car manufacturer to consider.

• Factors that we can expect include (a) the likely demand for the new model; (b) the existing competition; (c) expected new competition (competitors launching rival models); (d) forecast model design costs; (e) forecast production costs; (e) forecast marketing and distribution costs; (f) existing excess capacity.

• In other words, the manufacturer needs to take into account a range of matters that are 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 success of the launch, especially if the price elasticity of the cars is high.

• The firm will also need to consider the consequences of the launch timing. Would it pay to delay the launch, perhaps until after a competitor reveals its new vehicle? Is there an advantage in being ‘first to market’?

• The firm will also need to consider the most appropriate organisation of its ‘value chain’ to supply the vehicle.

Chapter references: this question calls on information from across the chapter and consolidates learning from the earlier chapters on demand, costs of production and supply.

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Question 2

Using the concept of ‘elasticity of supply’, explain why raw material prices often tend to be less stable than manufactured good prices.

Guidance

• Elasticity of supply is a measure of the responsiveness of supply to a change in price.

• 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). Where supply is price inelastic supply can be varied less easily in response to price changes.

• 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, raw materials often come from poorer countries that are less able to accommodate a 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 (though this will depend upon the particular production technology used).


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Question 3

Consider how a hotel owner would decide how to price hotel rooms:

(a) when deciding whether to build the hotel at the outset;

(b) having built the hotel, so as to ensure that the maximum number of rooms is occupied each evening.

Guidance

• Before building the hotel the owner will wish to set a room price that covers the total costs 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.

• Once the hotel is built, however, the owner has a ‘sunk cost’, the cost of the hotel building and facilities. In other words, there are fixed costs of production that will have to be met whether rooms are filled or not. In which case the hotel owner should be willing to accept a room price that at least covers the variable costs of providing the room (e.g. staffing costs, laundry and cleaning costs, heating and water costs and meals if provided). This is why you can often negotiate a lower price for a hotel room if you arrive at the hotel late in the day. The hotel owner is better off renting the room to you for the night at below full cost than leaving it empty. You do run the risk, however, that the hotel is already full and you are turned away!

• Another way of looking at this issue is in terms of elasticity of supply. Once the hotel is built, the total supply of rooms is perfectly inelastic.

• This pricing strategy makes sense provided that not too many potential customers are risk takers and do not book in advance, arrive late and try to bargain the room rate down. It is for this reason that some hotels will not offer a lower rate late in the day. They fear the impact on their overall revenues from bookings.

Chapter references: pp. 112 – 115; also see the discussion in Chapter 3 pages 78–80.

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Question 4

(a) Draw a value chain for a typical retail bank.

(b) Discuss where most value is likely to be created and why.

(c) Consider what are likely to be the main core competencies and distinctive capabilities that a retail bank will need to have to sustain competitive advantage.

Guidance

(a) The value chain shows where value is added at each stage of production and supply. A typical value chain for a manufacturing firm is provided in Figure 4.5 on page 118 of the 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. Although banks do not provide an after sales service in terms of, say, repair and warranty work, service is a key attribute of a successful retail bank. Indeed, professional services are built and sustained by providing consumers with a high quality of service.

(b) Therefore, value is most likely to be created in terms of providing service, including speedy, efficient and polite branch staff, smooth operating head office functions and innovation in financial products to attract and retain customers. For example, closing the branch network would certainly be disastrous unless some other avenue to customers is being used such as Internet and/or telephone banking. Most retail bank customers still depend on local branches.

(c) Core competencies are based on information or knowledge of financial products and their efficient and effective provision to retail customers. They are also based on the information 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 retail banking system. Another distinctive capability is innovation in financial services.

Chapter references: pp. 115 – 120 and 122 – 124; Figures 4.4 and 4.5.

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Question 5

On what basis might a housebuilding company decide whether to employ its own bricklayers, carpenters, plumbers etc., rather than using subcontracting firms?

Guidance

• Most building firms buy in these specialist services. One reason might be that they have insufficient work to justify employing their own fulltime staff. Generally the reason relates to the theory of transaction costs. For example, you might think that bricklaying is a core competence in building but this is not so. Large building companies are best viewed as contracting firms that contract to buy land and build homes and offices (in some cases they 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, such as estate agents).

• What drives the decision whether to outsource an activity or do it internally within the firm is transaction costs. The theory of contraction costs is concerned with the economics of the decision as to ‘the boundary of the firm’. Transaction costs include the costs of negotiating, 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 (perhaps through a tendering process), monitor the quality of the plumbing work provided 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 solution cannot be found).

• These transaction costs when contracting for building services need to be set against the costs of a firm employing its own bricklayers, carpenters, plumbers etc., which include the 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 management costs can be interpreted as a kind of ‘internal’ transaction cost.


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Question 6

Give examples of firms with which you are familiar, which are either:

(a) vertically integrated;

(b) horizontally integrated; or

(c) conglomerates.

Consider the merits of these forms of organising production with reference to the firms you have listed.

Guidance

• This question asks you to select your own examples.

• Vertical integration occurs where different stages in the supply or value chain are brought 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 (called ‘forward integration’).

• Horizontal integration involves mergers and takeovers between firms at the same stage of manufacture (e.g. a TV manufacturer buying the production facilities and brands of a rival TV manufacturer).

• Conglomerate mergers involve firms buying interests in unrelated industries and economic activities (e.g. a tobacco company purchasing a bank).


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Question 7

A local radio station is about to negotiate a renewal of its operating licence. Write a report for its management setting out the approach that the management should take to the contract renewal. The current operating costs of the station are $600m per annum, the annualised capital 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 operating licence. It is rumoured that the licensing authority intends to raise the annual licence fee to $70m per annum in the next franchise period. The station and its facilities were built five years ago at a cost of $900m, which is being written off on a straightline basis over a predicted tenyear life (i.e. $90m per annum). The annualised capital cost of $150m is composed of $90m depreciation and $60m in interest charges on loans incurred to finance the capital investment.

In writing your report, establish whether the radio station should seek a licence renewal if the rumoured new licence fee proves to be correct.

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 including a normal profit.

• 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 economic rent of $20m). If the licensing authority raises the licence fee to $70m per annum then clearly the station will start making an annual loss, 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 depreciation charge and the $60m interest charges whether the station operates then the loss by not operating (and hence receiving zero revenue) would be $150m. This is larger than the loss from operating ($50m) so the station should continue to operate.

• 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 actions for debt recovery from the station’s directors but more usually they will be protected provided that the firm has ‘limited liability’ status. Another possibility is that the station’s capital assets could be sold to an alternative owner for a sufficient sum to recoup the capital costs and repay the loans.

• Your report should cover these issues. You should also reflect on the possibility of making economies in operating costs and boosting revenues. How might this be done?

Chapter references: the material in the chapter is generally relevant, as is the discussion in Chapter 3, pp. 78 – 80.

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CHAPTER 5

Demand, Supply and Price Determination

Question 1

The Organisation of Petroleum Exporting Countries (OPEC) cartel has just announced cuts in production levels, which are expected to drive up the spot price of a barrel of oil by 20% in the coming weeks. Using appropriate demand and supply diagrams, examine:

(a) The impact on the retail price of petrol.

(b) The likely impact on the electricitysupply market, bearing in mind that oil is an input into electricity generation as well as being a substitute source of energy.

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. For example, the more elastic is demand the larger the reduction in petrol demand that the price increase will provoke. In consequence, the petrol companies will absorb some of the effects of the crude oil price rise. The extent to which the petrol companies absorb the cost will depend upon the elasticity of supply. For example, the more inelastic the supply the less able will be the petrol companies to cutback output as demand declines.

• In practice, the demand for petrol tends to be price inelastic because vehicle users have no substitute fuel and petrol companies can alter the amount of refined petrol that they place on the market to some degree (though having large fixed costs they have to be careful not to increase their average total costs of supply sharply because of output reductions).

• You can illustrate the likely effect if you draw the demand curve with a steeper slope than the supply curve. The rise in the price of crude oil moves the supply curve for petrol at the pump to the left because it increases the costs of production. By identifying the new equilibrium price you can ascertain how far the price of petrol has increased to consumers. The petrol suppliers absorb the remainder of the cost increase.

• 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, the additional issue here is that if oil is the main alternative fuel to electricity, the companies should be able to pass on more of the cost to consumers because the price of the obvious substitute, fuel has also risen.

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• The diagram for electricity generation will also show a shift in the supply curve to the left because of higher production costs.


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Question 2

In today’s Budget statement by the Government, a new specific tax of $2 per unit has been levied on each bottle of wine sold. Assume that before the imposition of this new tax, the sale of wine was taxfree. A newsflash on television claims that ‘Tax causes wine prices to rise by $2 per bottle’. Evaluate this statement.

Guidance

• This answer to this question involves many of the features of the answer to Question 1.

• A tax increase raises the selling price and can be illustrated as a shift in the supply curve to the left.

• It is most unlikely, however, that consumers would bear the full tax imposition of $2 per unit. If stores raised the price by the full amount of the tax, they would see demand decline dependent upon the price elasticity of demand for wine. Only if demand elasticity was perfectly inelastic (a vertical demand curve) would the $2 price increase have no effect on wine sales. This is very unlikely.

• The result will be that some of the tax will be borne by the suppliers. The extent to which the tax is paid by customers or suppliers depends upon the price elasticity of demand and supply in the market.


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Question 3

Give examples of goods or services where the incidence of a sales tax is likely to fall primarily on:

(a) consumers;

(b) producers.

Guidance

• The theory relevant to answering Question 2 applies here.

• Consumers bear more of the tax the more their demand is price inelastic and the greater the elasticity of supply.

• Products where a sales tax is most likely to fall most heavily on consumers are those where there are few if any substitutes e.g. petrol, commuter rail fares.

• Products where a sales tax is most likely to fall most heavily on producers are those where consumers may have many acceptable substitutes and producers are unable to alter their supply significantly for some time e.g. a tax on cinema seats but not on theatre seats and other forms of entertainment.


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Question 4

Explain, using demand and supply analysis, why agricultural surpluses arise under the European Common Agricultural Policy (CAP) in which farmers receive large subsidies linked to production levels.

Guidance

• The European CAP has a number of components including purchasing 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 products above their competitive market clearing level.

• When the price is above the market equilibrium there will be excess supply. The response in a competitive market is for prices to fall. But the CAP removes much of the excess production from European markets thus retaining the higher price.

• The objective is to smooth out agricultural prices and provide a secure revenue flow to encourage investment in European farming. In years of abundant harvests, stocks are built up and released to the market in years of bad harvests.

• In practice, however, due to continuing political pressure from farming lobbies agricultural prices have tended to remain above their market clearing levels for considerable lengths of time. This has led to large stocks of some goods and in turn costly storage and in some cases their eventual destruction. More recently there has been action to reduce the output of farms through initiatives such as ‘set aside’ schemes, where farmers are subsidised to take land out of production.

• Your discussion should be based around a demand and supply analysis and the subject of the equilibrium price.

Chapter references: pp. 131 – 134 and 142 – 145 and Figure 5.1.

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Question 5

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? Assess this question with reference to the domestic housing market.

Guidance

• The free market is economically efficient when it is highly competitive. The result is both ‘allocative’ and ‘productive’ efficiency. That is to say no other allocation of the resources could improve economic welfare and the output is produced with the leastcost use of resources.

• These results depend, however, on the existing income and wealth distribution, which may be deemed inequitable. A different income and wealth distribution would lead to a different pattern of demand and supply and therefore a different welfare maximising allocation of resources.

• In addition, economic welfare will not necessarily be maximised in a free market if there are market imperfections, such as monopoly or externalities.

• The housing market is an interesting market to show your grasp of demand and supply and the economic welfare implications.

• Housing tends to be very inelastic in supply (at least in the shortrun). At the same time we all need somewhere to live, so housing in total (though not individual properties) has a very price inelastic demand. This applies whether we are discussing the market for house purchases or house rentals. Demand in both cases is not perfectly price inelastic because as 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 supply analysis, the operation of competitive markets and recognise that while economics may concentrate on the efficient use of resources it should not loose sight of the impact on social wellbeing.


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Question 6

During the past decade, microchip prices have fluctuated wildly on world markets, reflecting periods of excess demand followed by excess supply. Using appropriate diagrams, explain the impact of time lags in the production of microchips on price levels.

Guidance

• Figure 5.1 is the standard diagram illustrating excess demand. However, this question draws your attention to the role of time lags in production. That is to say that current supply cannot respond immediately to demand changes. When this is the case, supply is likely to be a function of past price.

• While it is common to discuss the ‘cobweb theory’ in relation to agricultural markets because supply can most obviously not respond immediately to price changes in farming, the analysis can be applied to any market where similar time lags apply. You should therefore use Figure 5.8 as the basis for much of your discussion.


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Question 7

Why would you expect the wholesale price of coffee in world markets to fluctuate more than the wholesale price of daily newspapers?

Guidance

• Some of the analysis is similar to that which applies to the previous question.

• Newspapers are printed daily or weekly and therefore supply can be very quickly adjusted to changes in demand provided that there is some spare printing capacity available. By contrast, coffee production cannot be altered quickly.

• In consequence, whereas newspaper production can be represented using the standard demand and supply diagram with demand and supply curves shifting smoothly to restore an equilibrium price when either the conditions of demand or supply change, coffee production follows a slower and less predictable movement to the longrun equilibrium price, as represented by cobweb theory.

Chapter references: pp. 131 – 136 and Figures 5.1, 5.2 and 5.3 and pp. 142 – 145 and Figures 5.8 and 5.9.

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CHAPTER 6

Analysis of Perfectly Competitive Markets

Question 1

(a) Give examples of markets that most closely equate to perfectly competitive ones.

(b) In what ways do they fall short of being ‘perfectly’ competitive?

Guidance

• Perfect competition demands very strict assumptions that are unlikely to be found in many if any markets in the real world. Markets that most closely equate to perfectly competitive ones are those in which there are very large numbers of buyers and suppliers, reasonably free entry and exit from the market and well informed consumers. It is in such markets that the purchase decision is driven by price.

• An example of this is a competitive stock market, as exists in major financial centres, such as New York, London and Tokyo. Here, a particular company’s share will trade at the same price at any given time. If it did not, then arbitragers would purchase the share at the lower price and resell it at the higher price for profit. This action would equalise the price. In other words, no one would buy a Microsoft share at $100 if an equivalent Microsoft share could be bought for $99.

• Other examples of very competitive markets driven by price are the markets for agricultural products, minerals and oil. This is why a price can be quoted daily for such products in the financial press, such as the price of ‘Brent crude’ oil.

• In all these markets the product is homogeneous.

• However, none of these markets need necessarily be perfectly competitive. All markets have some information imperfections including stock markets – otherwise how do we account for someone buying a stock just before it falls in price? (Remember that in perfect competition there is perfect information about the future.) Also, while there may be a large 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 also a relatively small number of international oil companies that account for most of the oil purchases.

• In other words, in real world markets the strict assumptions of perfect competition are not met.

Chapter references: pp.151 – 157; Figures 6.2 – 6.5.

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Question 2

If all products were sold in perfectly competitive markets, why may the allocation of resources be pareto optimal?

Guidance

• The start of this answer should set out clearly about what perfect competition is and define Pareto optimality and allocative efficiency.

• The answer should then go on to explain, why if all markets were perfectly competitive Pareto optimality results.

• You can conclude that it is this powerful result that leads economists to argue for competition in markets.

Chapter references: pp. 159.

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Question 3

Why would managers have no discretion in setting the prices of products or services in perfectly competitive markets?

Guidance

• Oddly as it may first sound, if markets were perfectly competitive there would be little for managers to do. Prices and outputs would be set given the competitive demand and supply conditions and firms would accept the going market price. There would be no role for marketing because all firms’ products are the same under perfect competition (there is no ‘branding’ of products, for example).

• After explaining this, you can go on to demonstrate your prowess in the theory of perfect competition by explaining the model and drawing the perfect competition diagrams for market equilibrium in the short and longrun.


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Question 4

(a) Why is it argued that a firm operating in a perfectly competitive market will produce at the technically optimum level of production in the longrun but not the shortrun?

(b) What does this imply about the efficient allocation of resources in perfectly competitive markets?

Guidance

• The technically optimum level of production is that at which production costs per unit are at their lowest. This is at the minimum point of the longrun average total cost curve.

• In answering the first part of this question you will need to show that you can distinguish 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 competition does not produce at the minimum point on its longrun average total cost curve, but it does so in the longrun.

• The implication of an efficient allocation of resources is straightforward. Efficient allocation requires that resources be allocated so that no alternative allocation would improve economic welfare. The resulting ‘allocative efficiency’ is known as ‘Pareto optimal’. Also, the resulting set of outputs must be produced at least cost or with ‘productive efficiency’. Under conditions of perfect competition, in the longrun both allocative and productive efficiency is achieved.

• It is not surprising, therefore, that economists favour competition.


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Question 5

If a market is perfectly competitive, what would be the effect of an increase in the demand for a good or service on the output and price:

(a) in the shortrun;

(b) in the longrun?

Guidance

• An increase in demand shifts the market demand curve to the right leading to a rise in price. For each individual firm in the perfectly competitive market, this means that the price and the demand curve it faces, rises. The result is supernormal profit.

• 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 supernormal profits. Each firm in the market will now face a lower price and demand curve.

• In answering this question you will need to be able to reproduce and explain the diagrams showing the market equilibrium in the shortrun and longrun.


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Question 6

‘A firm in perfect competition makes no economic profit in the longrun’. Discuss.

Guidance

• This question requires you to explain the difference between a normal profit and a supernormal profit.

• A normal profit has to be earned or the firm will leave the market, hence economists treat normal profit as another cost of production.

• By contrast, supernormal profit is an economic rent or excess profit above normal profit. It is this profit that is being referred to in the question as ‘economic profit’.

• Using the perfect competition diagrams illustrating the shortrun and longrun market equilibria, you should then explain how economic profit is competed away in the longrun through market entry by new suppliers.


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Question 7

(a) Explain why a firm in a perfectly competitive market may continue to produce even when losses are being made.

(b) Explain why such a situation cannot be sustained over a long time period.

Guidance

• This question is a little trickier than the previous questions and needs you to blend the knowledge gained from the reading in an earlier chapter about shutting down production in the short and longrun (pp. 71 – 75) with the perfect competition model set out in this chapter.

• Provided that a firm can at least cover its variable costs it will continue to produce in the 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, the firm must cover both its variable and fixed costs if it is to be profitable.

• You should explain this with relevant diagrams and discussion, using the references given below.

Chapter references: pp. 78 – 80 and Figure 3.7, and pp. 152 – 157 and Figure 6.3.

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CHAPTER 7

Analysis of Monopoly Markets

Question 1

Until the 1990s telecommunications companies such as Deutsche Telekom and France Telecom 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 productive efficiency?

Guidance

• An obvious starting point is to define allocative and productive efficiency.

• 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 means combining factors of production so as to maximise the output for given factor prices.

• There is no need to know much about the two companies mentioned in the question. But it is necessary to draw a diagram so that you can identify precisely where allocative efficiency occurs. The firms are monopolies, so the diagram needed is the standard monopoly diagram 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, a ‘deadweight loss’.

• The monopoly diagram is drawn on the assumption that the monopolist will not be productively inefficient. But you can amend the diagram to show productive inefficiency by raising the marginal and average cost curves on the diagram. This leads to an even lower profit maximising output. It does, however, also mean that profits are lowered because of the higher costs. Our expectation is, therefore, that a profit maximising monopolist will be allocatively inefficient but productively efficient.

• In practice, however, the lack of competition may lead a monopolist to be less focused on production efficiency; the result is that the monopolist then forgoes some profit for an ‘easy life’.

• The above discussion has not considered possible dynamic gains from a firm having a very high market share. These possible gains, that can easily be exaggerated, are discussed on pages 158 – 159.


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Question 2

In what ways might state ownership of a monopoly affect price and output decisions and why?

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 prices and therefore more consumer surplus.

• 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 economic criteria. In which case, the result will be productive inefficiency even if allocative efficiency is achieved.

• If in achieving wider social and political goals enterprises rely on state funding rather than user charges for some of their financing, then this will have implications for the level of taxation or levels of investment in other areas of public expenditure. Taxation moves prices from marginal supply costs and therefore can create allocative inefficiency elsewhere in the economy.

• It should be clear that a discussion of pricing and output under state ownership is complex and dependent upon the precise goals of government and the impact of government decisions on the wider economy.

• In developing this answer, you should be able to appreciate what impact privatisation of the enterprises is likely to have on price and output (at least in the absence of continued state regulation).


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Question 3

A firm intends to take over its only rival in the market and become the sole supplier:

(a) give reasons why the firm may be adopting this strategy;

(b) consider how the country’s competition authority is likely to assess the consequences of the takeover;

(c) for what reasons might the competition authority: (i) prohibit; (ii) allow the takeover to proceed?

Guidance

• In answering the first part of this question, takeovers can occur for a number of reasons. On the one hand, the combined firm may expect to achieve cost savings through sharing the labour force, buildings and capital equipment. It may also plan to combine sales forces and marketing expenditures to boost joint sales. In other words, the firm anticipates efficiency gains with economic benefits. On the other hand, the motivation may be simply to monopolise the market, leading to higher prices, lower output and lower consumer choice.

• The response of a competition authority will, therefore, be dependent upon which of these two sets of motivations for the takeover it suspects to be dominant. In arriving at its decision it will need to (a) define the product market to assess the degree of demandside substitution (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, thereby making the price increase unsustainable?).

• If the authority should decide that the result of the takeover is likely to be the abuse of a dominant position in the market place or a significant reduction in competition it is likely to rule against the takeover. This will be the obvious conclusion if there is likely to be limited demandside or supplyside substitution.

Chapter references: pp. 166 – 172 and Figure 7.2 (you may also like to consult pp. 358 – 361 in Chapter 16 on Competition Policy).

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Question 4

Mail services in most countries, are provided by a single supplier (which is often stateowned). Why is it important to define the market carefully before deciding whether these suppliers are monopolists in their own territories?

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.

• The question is concerned with the definition of a ‘monopoly’. Technically, a monopolist is the sole supplier of a good or service. But this sort of definition implies that the ‘market’ is clearly defined, which is rarely the case. For example, a firm may have a monopoly of normal postal deliveries, but are premium services part of the same market or are they in a 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 according to the prices charged.

• 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. In which case, the share of the market that the postal service supplies shrinks.

• It should be clear, therefore, that the wider the appropriate market definition the less likely it 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 Guidance Notes to Question 3 above).

Chapter references: pp. 165 – 166 and 172 – 174.

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Question 5

In the United States of America, steel workers supported by their employers successfully lobby 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 (if any) between the behaviour of US steel workers and the behaviour of firms that collude to fix prices to consumers? Should we adopt the same analytical process to judge both situations?

Guidance

• Import controls on steel protect the production of steel in the United States and, therefore, the jobs of steel workers. In so far as the result is to raise prices to consumers and restrict choice, there will be a welfare loss. In this sense, the result involves a transfer of income from consumers of steel (and steel products) in the United States to steel workers in terms of wages and their employers in terms of profits.

• 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 would support the workers is because of a fear of job losses and the wider social welfare implications.

• In the sense that the workers and their employers are rent seeking, their behaviour and that of colluding firms is similar. The result is lower output, higher prices and a loss of social 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 economic rent at the expense of consumers.

• It is for this reason that some might be uncomfortable using the same analytical technique of 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 collusion similarly raise prices and can impact adversely on social welfare.


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CHAPTER 8

Analysis of Monopolistically Competitive Markets

Question 1

(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 monopolistically competitive.

Guidance

• Like the other theoretical models of markets discussed in the book, monopolistic competition occurs under a number of strict conditions or assumptions. There must be a large number of firms competing in the market and each has only an insignificantly small share of the market. This means that each firm is a 'price taker', accepting the going market price set by market demand and supply. Each firm is assumed to have the same or very similar costs of production. There is free entry and exit from the market and the firms produce similar (though not identical) products.

• So, we are looking for very competitive markets with large numbers of competing firms and involving some limited degree of product differentiation. Examples might include takeaway food restaurants, if there are a lot in your neighbourhood and they are little differentiated; high street hairdressers where consumers are choosing between them on price; taxis if there are large numbers competing; and plumbing firms.

• In practice, these markets may not be good examples of monopolistic competition. In particular, consumers tend to differentiate between takeaway food restaurants with some (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 plumbing services can exceed the supply, leading to reduced competition.

Chapter reference: p. 179.

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Question 2

To what extent do managers have discretion when setting prices in monopolistically competitive markets?

Guidance

• Managers in monopolistically competitive markets have no discretion and must be price takers. This follows from the assumptions underlying the monopolistic competition model (summarised in the Guidance Notes to Question 1 above) and particularly the very limited product differentiation. Consumers buy on price and firms must price at the going market price.


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Question 3

(a) Consider the role of marketing and advertising in monopolistically competitive markets.

(b) Why will firms tend to allocate resources to the development of a brand strategy?

Guidance

• The lack of product differentiation in monopolistically competitive markets makes, in principle, marketing and advertising problematic. Where consumers treat products readily as substitutes, a firm advertising and marketing its product will tend to stimulate the sales of its competitors’ products too. This can be expected to limit the incentive for any individual firm to spend on marketing and advertising.

• At the same time, however, if a firm can develop brand loyalty amongst consumers it can then move away from having to compete under the conditions of monopolistic competition. Brand loyalty reduces the willingness of consumers to switch to competitors’ products even when prices are lower.

• A firm can, therefore, be expected to try to develop a brand promotion strategy to reduce consumer switching; which is the same thing as saying that a brand promotion strategy reduces the (positive) crossprice elasticity of demand between the firm’s product and its competitors’ products.

Chapter reference: pp. 183 – 184.

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Question 4

What are the economic welfare costs associated with monopolistic competition?

Guidance

• When assessing the economic welfare costs, perfect competition is the obvious comparison. Under perfect competition in the longrun both allocative and productive efficiency occur. In other words, P=MC (allocative efficiency) and production occurs where average total cost (ATC) is minimised (production efficiency). By contrast, under monopolistic competition in the longrun P>MC and ATC are not minimised. The result is higher prices and higher average costs of production.

• However, perfect competition is a theoretical extreme.


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Question 5

Discuss the role of advertising in a monopolistically competitive industry. In what sense might advertising expenditure by a particular firm in the industry be wasteful?

Guidance

• The answer is similar to that for Question 3 above, which you should refer to.

• Advertising expenditure uses up economic resources and therefore has an opportunity (economic) cost. While informative advertising that improves consumer choice may be an efficient use of resources, in the sense that the resources would not lead to a higher economic welfare if used elsewhere in the economy, other forms of advertising may be less easy to defend.


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Question 6

Compare and contrast the shortrun and longrun equilibrium facing a firm under conditions of monopolistic competition.

Guidance

• The shortrun involves a period in which firms cannot enter (or exit) the market. Therefore, supernormal profits can be earned.

• In the longrun, these profits will be competed away by market entry. In the longrun, firms in monopolistic competition earn only a normal profit.

• Answering this question requires drawing the appropriate shortrun and longrun market equilibrium diagrams and explaining the different price, output and profit consequences.


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CHAPTER 9

Oligopoly

Question 1

Ollipolly is a company producing business magazines, which has one main rival in the market, Polliolly. Ollipolly has 45% of the market and Polliolly, 55%.

(a) What type of market does Ollipolly operate in?

(b) What competitive strategy would you suggest to the board of Ollipolly to improve: (i) its market share; and (ii) its profitability?

(c) Would it be in the interests of the two companies to merge or for one to acquire the other?

Guidance

• (a) Ollipolly operates in a particular type of oligopolistic market where the market is shared between two firms. This is called a duopoly market.

• (b) As in all oligopolistic markets, in formulating a competitive strategy there needs to be 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 would be Polliolly’s response? If it matched the price cut the market shares might not change. Moreover, the price elasticity of demand determines the total revenue earned by both firms (if demand is elastic then the total revenue earned from sales by both firms would rise, whereas if demand was price inelastic the total sales revenue would decline following a price reduction).

• The kinked demand curve could be used to show the possible effect of a price reduction. You could also answer the question using a game theoretic analysis.

• The impact on profitability depends on what happens to revenue and costs of production as price and output change. In general, reducing price is a higher risk strategy than other marketing initiatives, such as advertising and developing a strong brand because it is easier for the rival firm to match quickly.

• Your answer should therefore explore the likely responses in the market to different marketing initiatives. Another possibility would be to try and reduce the costs of production, which could result in a price advantage in the market or a higher profit. You should explore how this might be achieved – will it require new investment?

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• (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 competition authorities would stand aside and allow this to happen!

Chapter reference: material throughout the chapter.

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Question 2

With reference to the Prisoner’s Dilemma, explain why collusion is often a feature of oligopoly markets.

Guidance

• The Prisoner’s Dilemma is concerned with the dilemma that a prisoner faces when being questioned by the police and cannot communicate with an accomplice. Should the prisoner confess or not? The answer depends upon whether the accomplice confesses.

• This Dilemma, which is a classic of game theory, is endemic in oligopoly markets. Firms changing prices, considering advertising campaigns, investing etc., could do so with more confidence of the outcome if they knew how their competitor firms would react.

• Collusion between firms is equivalent to the prisoners communicating secretly and agreeing a joint strategy that maximises their utility. If firms are colluded perfectly (i.e. there was no uncertainty and no cheating), then they could act as a monopolist and increase price, reduce output and increase their (joint) profit.

• It should now be clear why competition law makes such collusion, e.g. in the form of cartels, illegal. They are not in the public interest.


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Question 3

Identify two oligopolistic industries and compare and contrast the ways in which the firms in these industries compete. Explain the reasons for any differences in competitive behaviour that you identify.

Guidance

• The firms are likely to act so as to try and increase product differentiation. In other words, they will wish to reduce the (positive) crossprice elasticity of demand between their product and competitors’ substitutes. By doing so, they gain some monopoly power and can make supernormal profits (economic rent).

• One of the firms may be a price leader.

• You should therefore be looking at the firms’ marketing strategies and product mix. Differences in competitive behaviour will reflect differences in product mix, any differences in production costs and any differences in management strategies (e.g. their goals in terms of longrun or shortrun profit maximisation). In some industries government policy may also impact on the strategy adopted through prohibitions, taxes and subsidies, exchange rate policy etc.


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Question 4

Using the kinked demand curve model, identify why oligopoly markets may be subject to relative price stability, interspersed with periods of aggressive price wars.

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 competitors also reduce price.

• The result is an incentive for firms to maintain price stability. However, if one firm were to reduce its price this would trigger price reductions. If the first firm were to cut its price again to seek competitive advantage, its competitors can be expected to respond once more with price cuts. The result would be a price war.


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Question 5

Explain why nonprice competition is often found in oligopolistic markets.

Guidance

• The answer to this question is similar to that for Question 4, which you should refer to again.

• Because price reductions can lead to price wars that lead to all firms suffering lower profits, other forms of marketing become more attractive. These forms of marketing are generally aimed at building up brand loyalty e.g. through advertising. The result is to reduce the (positive) crossprice elasticity of demand of the firm’s product. If fully successful, the ultimate outcome would be that the firm would become, in effect, a monopolist; that is to say its product would no longer be viewed by consumers as having any close substitutes.

• In practice, marketing is unlikely to be so successful and the crossprice elasticity with other firms’ products will remain above zero, if diminished by marketing.


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Question 6

Joe and David own the only two restaurants in a village. They have reached a secret agreement that they will each serve smaller portions of food to increase their profit margins. Under what circumstances is the agreement likely to:

(a) hold;

(b) break down?

Guidance

• Joe and David are in a duopoly market for restaurant meals (assuming consumers are unwilling to travel outside the village to obtain their meals). By colluding, they can act like a monopolist and maximise their joint profits.

• However, while this outcome is attractive to Joe and David, there must be trust between them. Should Joe cheat and not reduce the portions customers will presumably switch away from David’s restaurant.

• 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 term advantage. Therefore, the agreement might well hold. It would be more problematic if the agreement was less easy to police.

• Nevertheless, Joe might consider that by pointing to David’s much smaller portions (‘what a mean guy!’) he will win longterm consumer loyalty and David will lose out. In other words, even where an agreement is easy to police for conformance, if one of the parties to the agreement would see longterm damage to its competitor’s reputation (or brand) by cheating, cheating could be the dominant strategy.

• You should develop this line of argument based on the lessons from game theory set out in the chapter and highlight the importance of trust, reputation and policing in collusive agreements. You can also bring into your answer the time period of the agreement and the issue of finite versus infinite games.


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Question 7

Assume that hotel Y is considering four possible strategies to increase its occupancy rate. These strategies are as follows:

(a) to reduce price overall by10%

(b) to increase advertising expenditure by 30%

(c) to offer enhanced facilities to its guests

(d) to enter into a new agency agreement with a travel promotion company.

The company considers that it is very likely that its competitors will respond with similar deals. The question provides a payoff matrix to analyse.

(i) Which of the four strategies should hotel Y adopt if it follows a maximax rule?

(ii) Which of the four strategies should hotel Y adopt if it follows a maximin rule?

(iii)Under what circumstances is the hotel management likely to adopt a maximin over a maximax strategy?

Guidance

• This game theory question is answered by careful scrutiny of the payoff matrix given in the question.

• (i) The hotel should adopt strategy (b) on a maximax rule because the payoff is maximised at the level 120. The other strategies have caused maximum payoffs of 20, 50 and 30.

• (ii) The hotel should adopt strategy (c) if it follows a maximin rule because the lowest pay off is 10 from the strategy. The other strategies reach lower payoffs of 5, 10 and 0.

• (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 (unconcerned about the level of risk).


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Question 8

How should competition authorities react to the announcement of a cartel arrangement between a country’s largest breweries to maintain beer prices and allocate regional markets amongst them? Would your answer be different if the national breweries faced intense competitive pressure from imported beers?

Guidance

• Operating this cartel in the absence of alternative beers to consumers from importers seems clearly to be against the public interest.

• 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 economic rents, there would still be some ‘deadweight loss’. Deadweight loss is discussed in Chapter 7, which deals with monopoly markets.

• The existence of imported beers makes the outcome less easy to identify precisely. If the volume and scope of imported beers was to be such that consumers retained considerable choice and the decision to raise prices by the domestic breweries failed to hold, as consumers switched to the imported beers, then the cartel is obviously less damaging to social welfare. Indeed, in these circumstances we would expect the cartel to quickly collapse, as it would no longer be in the interests of any of the domestic brewers.

• However, the danger exists that the importers might be enticed to, overtly or covertly join the cartel and thereby raise the joint profits. Then the outcome is clearly not in the public interest.


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CHAPTER 1 0

Managerial Objectives and the Firm

Question 1

Is profit maximisation a satisfactory assumption when modelling the behaviour of firms? Explain your answer.

Guidance

• Different approaches could be adopted to answering this question and the one below is our 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, but it may be far from being descriptively satisfactory.

• The time period needs to be clarified. No one could expect a firm to consistently maximise 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 prejudice longrun sales).

• The profit maximisation assumption is predicated in the belief that firms will know how to profit maximise. The model assumes perfect information. In fact, the firm may not have sufficient information about consumer demand and marginal production costs to maximise profit exactly.

• The question talks about the ‘behaviour of firms’ and economists often talk about ‘the firm raising prices’, ‘the firm reducing its output’ and so on. In fact, it is the management within the firm that makes such decisions. It is from this perspective that some would see the Cyert and March ‘behaviouralist’ approach and similar approaches as more satisfactory than a profit maximisation assumption when modelling firms' behaviour. These models look at the decisionmaking process within firms.

• However, in a very competitive market it is difficult to see how a firm could survive in the longrun unless it seeks to maximise profit.

• Firms not in the private sector to make profit, e.g. voluntary firms, such as charities and public sector firms, may choose to pursue some other objective than profit.


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Question 2

What do you understand by the term ‘the growth of managerial capitalism’?

Guidance

• This question is concerned with the division between ownership and control in modern corporations or with corporate governance. Modern corporations contain a principal–agent relationship, with shareholders as the principal and senior management as the agent.

• It is the movement away from ownercontrolled businesses towards shareholder corporations with share ownership widely spread that is associated with managerial capitalism

• Given the principal–agent relationship, it is possible that management might not pursue the interests of shareholders (maximum profit) but rather its own interests (managerial utility). This would lead to prices and outputs that are not consistent with profit maximisation (MC=MR); for example, where the firm pursues sales revenue maximisation (MC>MR).


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Question 3

Give examples of ‘principal–agent’ relationships in economic transactions and discuss their importance when analysing business decisions.

Guidance

• The answer to this question builds on the answer to the previous one, which you should read first.

• Where a principal–agent relationship exists business decisions may not be compatible with strict profit maximisation. This means a different output and the price will be chosen.

• Examples exist in privatesector corporations and in government, as explained on page 197. However, a principal–agent relationship will exist in any economic transaction where one person or agent acts on behalf of another, e.g. when you use a solicitor to pursue a legal claim on your behalf.

Chapter reference: pp. 211 – 215 and Figure 10.1.

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Question 4

Using an appropriate diagram, show the effect of a higher minimum profit constraint on a sales revenue maximising firm. To what extent will the competitiveness of the capital market affect where the minimum profit constraint lies?

Guidance

• The appropriate diagram is Figure 10.3 on page 217.

• Raising the minimum profit constraint shifts the horizontal minimum profit constraint line upwards and closer towards the maximum profit level. As a consequence, output falls and price will rise (given a downward sloping demand curve). This is likely to affect, in turn, the level of employment in the firm.

• Owners of the firm (shareholders in private sector corporations) can be expected to prefer the maximum profit output to any other. If the capital market is very competitive and investors are perfectly informed, investment funds will move away from firms that are not maximising profits to those that do. In which case, firms will not be able to attract and retain capital and remain in business unless profits are maximised. Even where perfect information does not exist (the reality), it is to be expected that a competitive capital market will restrain management from pursuing sales over profits. This is the same as a movement upwards in the minimum profit constraint line.


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Question 5

In what circumstances is Williamson’s managerial theory of the firm likely to be most applicable? Under what principal–agent relationships is it likely to be found?

Guidance

• Williamson’s 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 principal–agent relationship in corporations (see the answers to Questions 1 and 2).

• It is most likely to be found or be most applicable where agents (management) can pursue their own goals rather than those of the principals (owners). In practice, management’s freedom to pursue its own goals is constrained by the product market (the more competitive, 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. threat of takeover). Also, agents can be expected to provide incentives to management to pursue profit using profit bonuses, performancerelated pay, shareoption schemes etc.

• 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. Williamson’s theory is likely to be particularly relevant, therefore, to stateowned activities.


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Question 6

To what extent do ‘behavioural theories’ of the firm provide a more useful insight into the behaviour of firms than the other theories reviewed in this chapter? Consider the argument that while the behavioural approach is descriptively attractive, it does not lend itself to predicting accurately pricing and output decisions.

Guidance

• Behavioural theories are concerned with behaviour within firms and with the process of decisionmaking. By contrast, the other theories in the chapter assume a particular kind of behaviour will occur (e.g. profit maximisation, sales revenue maximisation).

• Behavioural theories provide, therefore, an approach that appears to be more descriptively relevant when discussing the behaviour of firms. To illustrate this you should outline the theory put forward by Cyert and March.

• 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 trying to predict how firms in a particular market will behave in terms of setting price and output. This is because each firm can be expected to have its own peculiar behaviour and decisionmaking processes.

• The other models in the chapter do have the advantage of being able to predict price and output, given certain stated conditions.

Chapter references: pp. 223 – 224 and p. 226.

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Question 7

Distinguish between corporate governance and business ethics.

Guidance

• Corporate governance is concerned with the principal–agent relationship in corporations or the division of ownership and control.

• Business ethics is concerned with the nature of decisions made by and within firms.

• The two may be linked in the sense that a particular form of corporate governance may lead to a particular form of business behaviour. For example, if the corporate governance regime leads the management to pursue maximum profit above all else this then will affect management’s attitude to redundancies, environmental externalities and so on, which it may treat as unfortunate necessities in the pursuit of profit.

Chapter references: pp. 208 – 215 and pp. 225 – 226.

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Question 8

Discuss whether a firm interested in maximising shareholder value should be concerned with ethical issues.

Guidance

• Shareholder value is a reflection of the share price. In a competitive capital market, the share price should reflect the stock market’s expectations about longterm (discounted) profitability.

• A firm maximising shareholder value might, therefore, be expected to take a sceptical view of business ethics if they impact adversely on profitability.

• However, this is not necessarily the case. The firm’s management may decide that being ‘ethically sound’ promotes the company’s image amongst both consumers and investors. It might consider that while an unethical action could raise profits today, there would be an adverse impact over the longer term. The firm might consider that if it took an unethical decision the government could respond by regulating its future activities at great cost.

• In other words, management needs to make a judgement concerning the extent to which it will maximise shareholder value by acting ‘ethically’.


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Question 9

Identify a company, which argues that it pursues an ethically based corporate strategy.

(a) What are the ethically based aspects of the strategy?

(b) What are the costs and benefits to the company arising from this strategy?

(c) What are the costs and benefits to other stakeholder groups, including society in general, arising from this strategy?

(d) To what extent could it be argued that this ethical strategy is merely marketing hype?

Guidance

• Your answer will, of course, depend upon the company you choose.

• (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 will be more controversial (e.g. is making surplus labour redundant in an economic recession ethical or not? Is undertaking product testing using animals ethical even if as a result damage to humans is avoided?).

• (b) The costs will be those financial outlays that have to be met to operate ethically and revenues foregone by so operating. Benefits will be in the form of increased consumer and investor goodwill arising from the actions.

• (c) To discuss the effect on other stakeholder groups requires you to determine the stakeholders or those with an interest in the decisions made by the firm.

• (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 deeply held view that it is right to act ethically.


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CHAPTER 1 1

Understanding Competitive Strategy

Question 1

Select an organisation with which you are familiar and prepare a detailed report to help the management establish an appropriate competitive strategy for the next few years.

Guidance

• This question requires you to apply knowledge of Chapter 11 and the earlier chapters of the book.

• The choice of organisation to discuss is yours; but the features you are likely to want to cover are the following:

• the mission and objectives of the firm;

• the firm’s external environment and expected changes;

• the firm’s strategic positioning;

• the internal resource capabilities of the firm; and

• the firm’s value chain.

• Useful approaches you can apply are the political, economic, social and technological (PEST) and strengths, weaknesses, opportunities and threats (SWOT) frameworks and perhaps the FiveForces model.

• You might also wish to look at core competencies and distinctive capabilities.

Chapter references: material throughout the chapter.

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Question 2

Conduct a FiveForces analysis of the retail food industry in your home country. Assess the impact of each of the Five Forces on the industry’s profitability over the next five years.

Guidance

• It is a general rule from economics that the less the competition in a market the more scope there is for firms to make higher profits.

• The FiveForces model looks not only at rivalry or competition within the product market but at the competitive power of buyers and suppliers and the competitive threat from substitute products and services and new market entrants.

• Your analysis of the retail food industry in your country should therefore look at a number of key factors:

• the degree of competition between the existing retailers, including their relative market shares;

• the degree to which buyers can switch between the firms;

• the extent to which suppliers to the retailers have market power; and

• the extent to which new forms of food retailing (e.g. Internet shopping) and new market entrants (e.g. overseas retailers entering the domestic market) might impact on the overall competitive environment.


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Question 3

What do you understand by the term ‘Porter’s generic strategies’? Critically appraise Porter’s arguments concerning generic strategies.

Guidance

• Porter’s generic strategies are concerned with the positioning in the market place to gain competitive advantage.

• Porter suggested two main strategies:

• low cost; and

• product differentiation.

You should explain the differences and then go on to discuss the issue of focus.

• A major criticism of Porter’s 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, differentiation may involve heavy investment in R&D and brand building through extensive marketing and this weighs against minimising the costs of production. Nevertheless, some firms, such as supermarkets argue that they must address both strategies to be seen by their consumers as providing value for money.


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Question 4

To what extent is strategic change within firms determined more by the organisation’s internal culture and politics than by the external environment?

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 maintaining a ‘strategic fit’.

• At the same time, studies have shown that some firms are more able to change and adapt successfully than other firms and some firms are better at managing change at certain stages in their evolution than at other stages. This suggests that the quality of the internal responses within the firm is critical. This conclusion draws attention to the firm’s internal resource capabilities (e.g. management talent, human resources, information technology (IT) etc.) and behaviour and attitude in firms. Behaviour and attitude is shaped by what some call the firm’s ‘culture’.

• Equally, change involves winners and losers within the firm. Some may gain promotion and status while others loose out. It is to be expected, therefore, that the internal change process and decisionmaking within the firm will be highly emotional and political.


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Question 5

What PEST factors are most likely to cause turbulence in the internal environment of the following industries?

(a) International passenger airline travel.

(b) Oil exploration.

(c) Global management consultancy.

(d) Global telecommunications.

Guidance

• This question requires you to undertake a PEST analysis for each sector. The issues you highlight in the answer will vary across the four industries mentioned.

• Under international passenger airline travel, for example, details of trends concerning the following might enter into your analysis:

• Political: international terrorism; government to government air travel agreements

• Economic: oil prices (a major airline cost); liberalisation of airline markets to promote competition; privatisation of airlines; access to airports (landing slots) and airport pricing policies; rising real incomes

• Social: opposition to aircraft noise; environmental opposition to new runways; increased interest in international travel

• Technological: new aircraft leading to safer and cheaper travel; new air traffic management systems permitting more flights per hour; safer all weather landing aids.

Chapter reference: p. 233 (also see Chapter 1, pp. 19 – 20).

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Question 6

Undertake a forcefield mapping for a firm with which you are familiar, detailing the key internal drivers and restrainers, which it is likely to face in the context of management’s attempts to increase profitability.

Guidance

• A forcefield mapping is a simple method of bringing together the factors that you consider will promote change and the factors that you consider will impede change in the firm.

• Examples of typical forces for and against change are shown in Figure 11.7, p.228. The forces you identify will depend upon the firm you are studying.


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Question 7

Consider the limitations of the classical approach to strategy. To what extent does the idea of emergent strategies improve our understanding of the competitive process?

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 stages or steps leading to an optimal outcome in terms of competitive advantage.

• More recent times have seen a recognition that strategy formulation and implementation in firms is generally a combination of planning and emergent outcomes (incremental responses to changes in the external environment), where cause and effect relationships are not always clear.

• In this ‘processualist’ approach to strategy, strategy is not a combination of clear steps but rather an iterative process involving learning and adaptation.

• There are other approaches to strategy, in addition to the classical and processualist views, which are covered on dedicated strategic management courses.


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Question 8

It is often said that the ‘dot com’ bubble burst at the start of this millennium. Using the tools and concepts set out in this chapter, prepare some reasoned arguments to explain why the strategies of many ‘dot com’ companies were misconceived.

Guidance

• The enthusiasm to establish and invest in dot com companies developed in the second half of the 1990s. As in the case of other speculative investment bubbles in the past, back to the 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 associated with excessive investment. By the year 2000, it was evident that the market was not expanding quickly enough to absorb the goods and services of the very large number of dot com companies that had been setup.

• Mistakes in strategy relate to misunderstanding the time lags between demand and supply responses and misunderstanding the difference between the technological ability to provide a service and the likely consumer demand for that service. Many forecasts of the scale of consumer shopping on the Internet, for example, were greatly overoptimistic.

• 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 their resource base including management capabilities.

• The forms of analysis you might use to develop your answer include the FiveForces model, PEST and SWOT analyses.


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Question 9

Critically appraise Porter’s ‘diamond’ as an explanation of competitive advantage in the global economy.

Guidance

• Porter’s diamond is an attempt to identify those factors that enter into an explanation of why some nations appear to have industries that are more competitive than in other countries; an example is Japan until the 1990s.

• 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 produced at lowest cost, which can be sold competitively in the international market.

• The approach extends Porter’s FiveForces Model to the international arena to explain the competitive advantage of nations.

• However, the model has been heavily criticised because it seems to conflict with the ‘law of 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 will be dominant in some forms of production and will trade with countries that are specialising in other product areas.

• Economists, therefore, are happy to talk about the competitive advantage of firms but not the competitive advantage of nations.

Chapter references: pp. 243 – 245 (for the law of comparative advantage see our companion text on macroeconomics, The Principles of Macroeconomics, FT/Prentice Hall (2004), Chapter 13).

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Question 10

Why may the ‘structureconductperformance' (SCP) model be inadequate as a tool for determining the level of profitability across industries?

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 therefore their performance, especially in terms of profits earned.

• 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, monopolistic competition and some oligopoly models, which relate conduct and performance to market structure, in practice competitive strategy is not entirely determined by the structure of the market. For example, two firms operating in the same market might 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, with management possessing some discretion over pricing, outputs etc.


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CHAPTER 1 2

Understanding Pricing Strategies

Question 1

What are the three main functions of price in a market economy?

Guidance

• Price multiplied by the quantity sold determines the firm’s total revenue and therefore affects its profitability.

• Price rations demand (if goods and services were not priced then demand would vastly outstrip supply). Price is considered more efficient and possibly more equitable as a method of supply rationing than the alternatives of either queues (first come first served) or allocation by politicians and bureaucrats.

• Prices act as a signal in a market economy that supply exceeds demand and production should be cutback (falling prices) or that demand exceeds supply and production should be expanded (rising prices).

• While management and accountants may be mainly concerned with the first of these three roles, economists tend to be as much concerned with the latter two.


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Question 2

Citibank has appointed you as a consultant to help in its reconsideration of its charging policy for current (cheque) accounts. You are required to set out the principles of the different approaches to pricing that the bank might adopt.

Guidance

• Current accounts are ‘normal’ goods and we can expect consumers to be influenced in their choice of a bank by the price of the cheque account on offer. The price is the interest rate paid on cheque account deposits, but might also be reflected in the provision of free banking services. The position of the demand curve will be influenced by the price of substitutes, tastes etc., in the usual way. Quality of service, including the availability of bank branches at which cheques can be cashed, can also be expected to influence the consumer’s choice of bank.

• Pricing decisions start with demand and supply. But you would also need to assess the bank’s 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 share even at the cost of shortterm profits.

• You would also need to consider the wider ‘marketing mix’ alongside price.

• You will need to think about how the bank should ‘position’ itself best; for example, is the cheque account on offer in some way distinct in the market place?

• You would also need to assess the nature of the market in which the bank operates: is it highly competitive, oligopolistic or even a monopoly? The latter is most unlikely because we know there are many banks that compete for cheque account consumers.

• In other words, there are lots of issues you can bring into the answer of this question, that draw on your knowledge of pricing strategies. It is a general rule from economics that the less the competition in a market the more scope there is for firms to make higher profits.


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Question 3

Tophols Travel Company has decided to preserve its profit margin on the holidays it sells by passing on to consumers the full cost of a rise in the airfares it pays. Every holiday will bear an equal markup to cover the extra airfare costs. Advise the company of the possible impact of this policy.

Guidance

• The company is facing a rise in its costs and wants to pass this on in full to its customers. But its decision shows an ignorance of the principles of demand and supply. The demand curve for holidays can be expected to be downward sloping and probably will be elastic especially over the longerrun. Raising price reduces demand and if the elasticity is greater than the value of one, the revenue received will decline by minus one.

• Moreover, the application of an equal markup, while administratively easy and seemingly 'fair', totally ignores the different elasticities of demand across the different holidays it sells. To minimise the loss of sales revenues from raising prices the company would be advised to raise price by a ratio that is inverse to the elasticity of demand. In other words, the firm should apply the highest increase where demand is the most price inelastic and the lowest increase where demand is the most price elastic. This is known in economics as the 'Ramsey pricing rule'.

• However, other considerations may enter into the pricing strategy to prevent the full application of this rule; for example, those with very inelastic demands may be those that have already booked and would find it costly to switch companies, but the company may not wish to alienate these customers and loose their repeat business.


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Question 4

When DVD players were first launched in the market in the 1990s they were priced much higher than today. How do you explain this? Does it always make sense to price a new product initially at a high price and then reduce the price later?

Guidance

• There are two broad reasons why a firm may wish to charge a high price for a new product in the market:

• the first reason relates to competition. If the firm is first to enter the market with the product it may decide to earn a higher profit margin until the competition develops. This implies a ‘skimming policy’;

• 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 costs quickly.

• In the case of DVDs, both reasons probably applied.

• It does not always make sense to apply a ‘skimming policy’, however, for several reasons:

• a high price attracts competitors;

• consumers may react adversely to later price reductions (particularly those who paid the earlier higher price) thus damaging the company’s image with consumers; and

• the resulting higher price slows down the growth of sales and this can be disadvantageous where there are economies to be gained from largescale production.


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Question 5

Explain why: (a) an electricity generator may charge a lower price for units of electricity after 11pm at night and before 7 am in the morning; (b) an airline charges substantially more to fly 'first class' and 'business class' compared with 'economy class'.

Guidance

• This question is essentially asking you to differentiate the reason for different prices when: (a) costs of production differ; and (b) there is simple price discrimination.

• 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 should be born by the peak users. Putting this another way, once the generating plant is built 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 stations that would be needed solely to meet the off peak demand.

• Moreover, by charging less for offpeak electricity, this creates an incentive for consumers 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 therefore increase economic efficiency.

• By contrast, the airline case is much closer to what economists call pure price discrimination. The cost of service to firstclass and businessclass travellers is higher than the cost of service to economyclass travellers. First class and business class may get privileged check in facilities at the airport, superior food and drink on the flight and greater legroom between seats etc. However, this additional cost of production cannot, in itself, justify the extent of the price differences between firstclass, businessclass and economy tickets.

• Much of the price difference is explained by the different elasticities of demand. Firstclass and businessclass travellers may have their flights paid for by their companies or for other reasons be less price sensitive than economy class customers. They may have to travel at particular times, whereas economy class customers may have more discretion as to when they fly.

• To reflect the different price elasticities, prices are set higher where demand is less price elastic.

Chapter references: pp. 268 – 273 and Figure 12.6 and pp. 276 – 278 and Figure 12.8.

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Question 6

A water company is currently operating at a loss. It calculates that one way of removing the loss is to raise its charge per cubic metre for water consumed and its fixed connection charge both by 30%. Consider the case for adopting equal or different increases in the volume and connection charges.

Guidance

• Once again, this question relates to elasticity of demand in pricing decisions. It also relates to the fact that water companies, like other businesses, have fixed costs and variable costs. 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 plants etc., are variable costs of water supply.

• If the charge is raised by 30% for connection and supply volume the impact will depend on the following:

• if consumers of water are metered they can be expected to reduce the volume of water they use;

• the extent of the reduction will depend upon consumers’ price elasticity;

• the extent to which the water company will welcome this reduction in demand depends upon its cost structure. Remember that the company will save variable costs but the fixed costs remain (at least in the shortrun, which in water supply could be many years because water system assets tend to have long lives).

• Therefore, if price elasticity were high and costs were largely fixed, raising the volume charge could lead to a large fall in revenue with only a small compensating fall in the costs of providing the water.

• 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, and therefore the elasticity of demand to stay connected is very low, some may do so simply because they are no longer able to afford to stay connected. We can expect that 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 product fundamental to civilised life.

Chapter references: pp. 259 – 260 and pp. 278 – 279.

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Question 7

Give three examples of thirddegree price discrimination, highlighting in each case why price discrimination is possible and the degree to which it is sustainable.

Guidance

• Successful price discrimination requires different price elasticities of demand in different markets and an inability to arbitrage profitably between the markets (i.e. buy in the lower priced market and resell in the higher priced one).

• Examples of markets where thirddegree price discrimination may occur are as follows:

• air travel (see the Guidance Notes to Question 5 above);

• the supply of motor cars in different national markets; and

• hotel prices (lower prices for corporate bookings).


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Question 8

Why is it possible for European motor manufacturers to sell their car models at different prices in different European countries?

Guidance

• The vehicles could be differently specified with extra features in some markets that justify the higher selling prices.

• However, it is difficult to believe that this explanation, put forward by the vehicle manufacturers, is sufficient.

• Although the European Union is supposed to be a single trading market, some barriers to trade in vehicles still exist. In particular, it is claimed that manufacturers put pressure on motor dealers in lowprice markets to refrain from selling cars to consumers from higher price markets in Europe. This strategy is made easier to operate where the consumers come from the United Kingdom, which requires righthand drive cars.

• In other words, the failure of a complete single market to operate allows the manufacturers to retain what appears to be a degree of price discrimination across the markets of the EU member states.


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CHAPTER 1 3

Understanding the Market for Labour

Question 1

What do you understand by the terms ‘the marginal value product (MVP)’ and the ‘marginal revenue product (MRP)’ of labour?

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 marginal physical product, (MPP)) and the impact of selling that output on the firm’s total revenue.

• Marginal value product (MVP) is the term we use to describe this contribution under conditions of perfect competition, where price (P) (and therefore, MR) is constant. In which 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, we describe the contribution as the marginal revenue product (MRP) where:

MRP = MPP × MR.

Chapter reference: pp. 286 – 290 and Figures 13.1 – 13.3.

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Question 2

How does the calculation of MVP and MRP differ?

Guidance

• The difference relates to the fact that the MR is not constant as output changes except under conditions of perfect competition (also, see Guidance Notes to Question 1 above).

Chapter reference: pp. 286 – 290 and Figures 13.1 – 13.3.

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Question 3

Using marginal productivity theory, explain why a profitmaximising firm will employ fewer people when the wage that has to be paid rises, everything else being equal.

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 employer’s pension contributions and social security contributions can be included as part of the wage to labour). Clearly if the wage (the MC) of employing an extra worker exceeds that worker’s contribution to the revenue of the firm (MRP or MVP) then, logically, the profit maximising firm will not employ that worker. Similarly, provided that the wage is less than the MRP (or MVP) the worker will be employed. Hence, the optimal employment level is where the wage (MC of employment) equals the MRP (or MVP).

• It follows, therefore, that everything else being or remaining equal, when the wage rises the level of employment will fall.

• The ‘everything else being equal’ condition is important because it could be that at the time the wage rises (for whatever reason) the productivity of labour (MPP) and/or the price of the product (P and therefore MR) rise. In such circumstances, the effects on costs and revenues might cancel out leaving employment the same. It is even possible that the revenue effect could exceed the costside effect of the higher wage, leaving employment higher after the wage rise. This should not be interpreted, however, as suggesting that wage rises have no effect on employment because in the absence of the wage increase, with higher productivity or output price, the firm would have employed even more, additional workers. The wage rise has, therefore, depressed employment.

Chapter reference: material throughout the chapter, but especially pp. 295 – 299 and Figure 13.7.

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Question 4

How can an understanding of the elasticity of supply of labour help a manager to determine wages and other terms of employment?

Guidance

• The elasticity of supply of labour is a measurement of the responsiveness of the supply of labour to a change in the wage paid and is measured as: the percentage change in the supply of labour divided by the percentage change in the wage rate.

• Correctly, the wage here is the real wage and not simply an increase in wage to offset the national inflation rate, which leaves real or relative wages in the economy unaffected.

• It is useful for managers to have at least some broad estimate of the elasticity of supply of the labour they employ. This is so because managers then have a better understanding of the 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 incentive to recruit a given number of additional employees, than if the elasticity is high.

• Restrictions on the supply of labour into an occupation (e.g. due to qualification requirements or professional membership) will reduce the elasticity.

• Across the economy as a whole elasticity of supply is likely to be lower, the lower the national unemployment rate.


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Question 5

Under what circumstances are trade unions most likely to be able to obtain wage increases?

Guidance

• Trade unions are more likely to obtain wage increases where their bargaining power is high and employers are less inclined to fight the proposed increases.

• 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, and hence the employer’s ability to replace striking union members, the more powerful the union is likely to be. This is also the case if the employer has limited scope to substitute capital for the labour, which may now be more expensive.

• Employers are less likely to fight the wage increase where: (a) the industry is in imperfect competition and much of the additional wage costs can be passed on to consumers through price increases; (b) the industry currently earns supernormal profits, so that the additional costs can be absorbed by the firm; (c) the employer is currently a monopsonist and therefore pays an average wage that is less than the MRP of labour; (d) where the firm is supported by state subsidies; (e) labour costs are only a small part of total costs so the effect on the firm’s total costs of a higher wage is small; and (f) there is scope for offsetting increases in labour productivity.


100

Question 6

Consider the impact on employment of adopting a ‘national minimum wage’, which exceeds the competitive market equilibrium wage rate.

Guidance

• If the national minimum wage for lower paid workers were below their competitive wage rate it would be ineffective.

• If it were above that rate, in principle we would expect the employment of some low paid workers to decline because the new wage would exceed their MRP.

• However, this conclusion assumes that currently these workers are being paid their MRP. It also assumes that employers could not make offsetting increases in the productivity of labour through organising production better. It has also been suggested that a higher wage might motivate workers thereby increasing their productivity or reducing their tendency to ‘slack’ at work.


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Question 7

Why might an employer and employee be willing to share the costs associated with the employee studying for a professional qualification such as the Master of Business Administration (MBA)?

Guidance

• The MBA should raise the MRP of those who study for it by increasing their business skills. They will be in higher demand and be able to obtain higher wages.

• It is obvious, therefore, why the employee might wish to invest in studying for an MBA (which has an opportunity cost in terms of lost earnings during the period of study as well as the cost of the course fees, etc.). It is, perhaps, less obvious why employers sometimes sponsor their employees to study for the MBA and pay all or some of the costs.

• The employer could rationalise this action on the grounds that on returning from the MBA the employee will be more productive and profitable to the firm.

• However, the employer faces the dilemma that the employee may not return to the company at the end of the course, but instead seek employment elsewhere for a higher wage. Indeed, logically this should occur because the current employer, to recoup the MBA costs incurred, will need to pay a wage less than the returning employee’s MRP. A new employer, who has not incurred these costs, can afford to offer the employee a wage up to the employee’s 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 unscrupulous employers.

• Because the employer may not, therefore, be able to guarantee reimbursement of any MBA costs incurred, employers are likely to treat ‘investing’ in an employee’s MBA as high risk and refuse to fund it. In some Western countries MBA students sponsored by employers, especially in full, are dwindling in number.

• On the other hand, the employer could continue to fund MBA studies as a method of recruiting and retaining employees. In effect, then, the employee is accepting a somewhat lower wage than the employer could otherwise have paid in return for being allowed to study for an MBA during their employment.

• The exception to the above reasoning would be if: (a) the employer could reasonably expect a high proportion of MBA graduates sponsored to return to the firm; or (b) the incentive of MBA study increased employment and motivation at work and resulted in a higher level of productivity (and hence a higher MRP) before the employee embarked on the studies.


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Question 8

What are the likely implications of labour immigration on wage rates and employment levels? Consider these implications with respect to the immigration of highly educated and skilled labour in contrast with those with minimal education and skill levels.

Guidance

• Immigration increases the supply of labour and increases the elasticity of supply of particular types of labour.

• This should result in lower wages and higher employment levels, provided that the labour market is competitive. Restrictions on the competitive labour market, such as strong trade unions, could limit the downward impact on wages, but this would lead to higher unemployment.

• The level of skills and education of immigrants is important to an understanding of where in 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 likely to result in unemployment if there is an existing shortage of doctors.

• The answer should be tackled in terms of the supply and demand for labour in the economy as a whole and at the individual occupation levels and in terms of the elasticity of demand and supply for particular types of labour.


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Question 9

The government has just announced a 5% decrease in tax for all employees. Using an appropriate diagram, consider the impact of this tax change on the labour market, particularly with respect to those on low wages compared with those at the top end of the pay scale.

Guidance

• Taxes on employees take the form of income tax and social security contributions.

• These taxes may reduce the incentive to work by reducing the employee’s posttax income. There will be an incentive to substitute leisure time for work time (leisure now has a lower opportunity cost in terms of posttax wages lost). However, because employees now earn effectively less due to the tax in any given work period, they may actually work longer to make up for the lost earnings (known as an income effect). The substitution effect and income effect of taxes on employment therefore point in opposite directions regarding the likely impact of a tax on incentives to work.

• In practice, empirical studies of the impact of taxation on work have been similarly inconclusive, but with some evidence that incentives to work are more adversely affected amongst very low and very highincome groups. This makes sense because lowincome earners may find that following a tax increase they would be better off not working and rely instead on state welfare benefits. For higher income groups, a higher tax is not so likely to 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 might expect the substitution effect of the tax change to exceed the income effect.

• Turning to the precise question, which is concerned with a tax reduction, the effect is likely 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 because the opportunity cost of leisure time is increased.

• The precise result will, of course, depend on the nature of the tax reduction. Does it fall equally on all employees? Being a percentage tax cut, the benefits are greater, the higher the income earned.

• These various effects can be reflected in a demand and supply of labour diagram.


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Question 10

Jubilee Products

Number of employees Total output of products Price per unit ($) of products in the market

100 5,000 8.00

101 5,100 6.50

102 5,250 5.70

103 5,350 5.50

104 5,400 5.45

105 5,420 5.43

106 5,430 5.42

The wage rate paid is $550 per week (there are no other employment costs).

From the above data, using MRP theory, determine the number of workers Jubilee Products should employ at the going wage rate.

Guidance

• The table below shows the calculations related to the question:

Number of employees

Total output of products

Marginal Physical Product (MPP)

× Price

(per unit)

$

= Marginal Value Product

(MVP)

$

100 5,000 — × — —

101 5,100 100 × 6.50 = 650.0

102 5,250 150 × 5.70 = 855.0

103 5,350 100 × 5.50 = 550.0

104 5,400 50 × 5.45 = 272.5

105 5,420 20 × 5.43 = 108.6

106 5,430 10 × 5.42 = 54.2

105

• With the wage rate set at £550 per week, the firm should employ 103 workers, i.e. where the MRP equates to the wage rate.

Chapter references: pp. 288 – 290 and table as produced above.

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CHAPTER 1 4

Understanding the Market for Capital

Question 1

Using an appropriate diagram, explain how a profitmaximising firm should decide on the level of its capital investment when the firm:

(a) is in a perfectly competitive capital market;

(b) has monopsony power in the buying or hiring of capital equipment.

Guidance

• A profitmaximising firm will consider both the cost and benefit from employing additional units of capital. More specifically, the firm will demand additional capital up to the point where the marginal cost of capital equals its marginal revenue product.

• In a perfectly competitive market, the firm’s demand for capital is so small that it buys or hires capital at its going market price.

• In a monopsony, market the firm is the sole buyer of a particular capital and the price it pays will vary with the amount employed.

• The relevant diagrams are Figures 14.1 and 14.2.


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Question 2

Strong Steels is deciding whether to invest in a new strip rolling mill. Advise on the approach the firm should adopt in appraising the possible investment.

Guidance

• Assuming that Strong Steels attempts to maximise profits it will need to take account of the expected return from the investment and the cost of investing. Only if the expected return is at least equal to the cost of investing will the investment be deemed worthy of undertaking. Even then it is the expected return that is taken into account as actual returns are unknown. This is why all investment is risky.

• Because investment returns occur in the future they will need discounting to present 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 discount the cash flows over the life of the investment.

• Figure 14.3 provides an overview of the process. Pages 317 – 321 discuss discounting and contrast it with a ‘payback period’ method of investment decisionmaking.

• The firm will also need to calculate its cost of capital (funds raising). This is usually undertaken using a weighted average cost of capital (WACC) model (see pages 322 − 323).


108

Question 3

After considering your report, Strong Steels has decided not to invest in the new mill because the payback period is 7 years. The company has a policy of investing only when the payback period is 4 years or less. The strip rolling mill would have an expected life of at least 15 years. Comment on this decision.

Guidance

• The payback method of investment appraisal is used widely and can be a useful crosscheck on the results from using discounted cash flow (DCF) techniques. However, the payback period method is inferior to the DCF approach because it does not take into account possible positive cash flows (returns) after the end of the payback period.

• The mill would last 15 years but Strong Steels has chosen to consider only the returns for the first 4 years. Hence, what might seem an unprofitable investment taking the first 4 years into account could have been profitable if the entire life of the asset had been considered.

• The longer the payback period and the higher the discount rate (hence the lower the DCF in later years) the closer the two methods converge.

• Also, some firms might feel that although an asset has a projected long life (e.g. 15 years), there is a high risk that the asset could become obsolescent due to technological change well before the theoretical limit of its life. Hence, they ignore possible cash flows beyond, say, 4 years. This may be the case in Strong Steels.

• Nevertheless, it would be sensible for Strong Steels to use the DCF method before deciding whether to invest.


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Question 4

Explain the difference between the ‘net present value (NPV)’ and the ‘internal rate of return’ methods of investment appraisal.

Guidance

• Both are DCF methods.

• The NPV method uses a discount rate (usually established in relation to the cost of capital) to discount future cash flows, with the investment decision depending upon whether the discounted sum is positive or negative.

• The internal rate of return method sets a discount rate (or interest rate) that equates the present value of a project’s net cash flow to the initial investment. This rate can then be compared with the firm’s cost of capital or the rate it uses to decide whether an investment is worthwhile (sometimes known as the ‘hurdle rate’), which may be higher to reflect risk (see the Guidance Notes to Question 5 below).


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Question 5

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.

• This might be calculated as the WACC, which reflects the combined cost of equity and debt financing.

• Because of the inherent uncertainty in investing in projects that have a long life, firms may decide to add a risk premium to the WACC. The discount rate is then above the WACC – this is a very common approach. (Note that this risk premium is different to the risk premium that exists on equity financing and debt taken into account in the WACC. This risk 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 calculating the WACC).


111

Question 6

Suppose that an investment project is expected to yield net cash over the next five years of $100m (year 1), $95m (year 2), $75m (year 3), $50m (year 4) and $80m (year 5). The initial cost of the project is $250m. At the end of the fifth year the investment has no residual value.

(a) What is the payback period?

(b) Calculate the NPV (assume a discount rate of 10%).

(c) Calculate the internal rate of return.

Guidance

• (a) The payback period is 3 years (technically, slightly less than 3 years). It will be seen that the initial cost of the project ($250m) is recouped within 3 years ($100m + $95m + $75m).

• (b) Given the formula shown on page 320, the NPV is calculated as:

[ ]

1 2 3 4 5 $100m $95m $75m $50m $80m NPV $250m (1+0.1) (1+0.1) (1+0.1) (1+0.1) (1+0.1)

$90.91m + $78.51m + $56.35m + $34.15m + $49.67m $250m

= $309.59m $250m

= $59.59m

= + + + −

= −

−

(c) Given the formula shown on page 327, we must compute the value of the internal rate of return (r), which reduces the NPV of the future cash flows to the cost of the initial investment ($250m).

In other words:

1 2 3 4 5 $100m $95m $75m $50m $80m $250m = 0 (1+r) (1+r) (1+r) (1+r) (1+r)

+ + + + −

The value of the internal rate of return (r), in this case is 20%.


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Question 7

How should a firm decide upon its weighted average cost of capital (WACC) and how does the WACC enter into NPV calculations?

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. Where the firm uses its own funds (‘ploughed back’ profits) because these could have earned a return if used elsewhere (e.g. invested in government bonds) an ‘opportunity cost’ interest rate can be imputed.

• Assuming a firm raises 20% of its funds for investing through new equity and 80% from loan financing, the relative costs of these funds will be weighted 0.2 and 0.8 respectively in obtaining the WACC.

• The WACC then forms the basis for the discount rate used in NPV calculations. However, because of the inherent uncertainty in investing in projects that have a long life, firms may decide to add a risk premium to the WACC. The discount rate is then above the WACC – this is very common. (Again, as we noted earlier on Question 5, this risk premium is different to the risk premium that exists on equity financing and debt taken into account in the WACC. This risk 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 calculating the WACC).


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Question 8

The government is deciding whether to build a new rail link between two expanding regions. The aim is to move traffic from the roads, but building the link will mean demolishing 200 homes at the cost of $120m and will cost a total of $1.2bn to complete. Public works schemes have a discount rate of 10%. Expected rail receipts are put at $100m per annum over the next 10 years (the assumed life of the investment before major reinvestment will be needed). It would appear that the investment is not worthwhile. Do you agree?

Guidance

• The present value of the future rail receipts, over the 10year period, is given by:

1 2 3 10 $100m $100m $100m $100m $614.46m (1 0.1) (1 0.1) (1 0.1) (1 0.1)

+ + + • • • • • • + = + + + +

• From this figure we must deduct the cost of the project, given at £1.2bn.

• The result is a negative NPV figure of $585.54m.

• This suggests that the project is not worth undertaking on financial grounds.

• 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 benefits as well as the private ones (the rail revenues). It should also take into account any social costs of the rail link (such as additional noise and disruption during construction). The loss of the 200 homes will be reflected in the total cost ($1.2bn) and does not need to be considered separately providing that the $120m includes adequate compensation for those affected by the loss of their homes.

• Pages 324 – 326 explain how the costbenefit analysismight by undertaken by government.


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Question 9

Does costbenefit analysis have any part to play in privatesector investment decisions? Explain your answer.

Guidance

• In one sense, the private sector does undertake costbenefit analysis when appraising possible investments. It compares the costs with the benefits when calculating cash flows and returns.

• However, the private firm can be expected to ignore external costs and benefits because they do not impact on its expenditures and receipts.

• Costbenefit analysis, in the sense of looking at all internal and external costs and benefits, is something usually associated with government investment appraisal. Governments should be concerned with externalities.

• Nevertheless, because of ‘green’ pressures and the like, some firms do now appraise their investments taking into account at least some of the likely externalities.


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CHAPTER 1 5

Understanding the Market for Natural Resources

Question 1

‘House price rises are caused by greedy landowners’. Discuss.

Guidance

• Suppliers can only get a price for something if there is a demand for it. Landowners are no different. The price they obtain for their land when sold to house builders reflects the demand for it. Hence, and as David Ricardo explained two centuries ago in his study of the price of corn, the price of land reflects the high price of corn or, in our case, the price of housing that can be built on the land.

• It is for this reason that we talk about land as earning an economic rent, i.e. a return above its opportunity cost or transfer earnings.


116

Question 2

Consider the case for the imposition of a development land tax by government. (Development land tax is a tax on the value of land used for development, e.g. house building or industrial use.)

Guidance

• The answer follows logically from the answer to Question 1. If land earns an economic rent (a return above its opportunity cost or transfer earnings – i.e. what it could earn in its next best use) then this can be taxed away without affecting the incentive to keep the land in its current use. For example, if land has a transfer price of $1000 per acre and currently earns $1200 per acre, it would be possible to tax away up to $200 per acre of the earnings without leading the land to be withdrawn from its current use.

• This is the argument behind applying a development land tax to tax away for public benefit the economic rents of landowners.


117

Question 3

Will taxation of economic rents affect the allocation of resources?

Guidance

• Logically, if economic rents are earnings above transfer earnings then taxing them will not affect the allocation of resources.

• However, if by accident or design the tax becomes excessive and exceeds the economic rent then the allocation of resources will be affected.


118

Question 4

Discuss the case for using pollution permits rather than prohibitions on new production to limit the environmental damage from the production of goods and services.

Guidance

• Prohibitions or bans prevent firms from doing something, irrespective of the precise social costs and social benefits, which may result from their activities.

• By contrast, pollution permits place the onus on firms to decide. Pollution permits are issued by government and permit a particular type of pollution (e.g. waste water pollution) up to a stated level. Producers would have an incentive to curb pollution voluntarily because any pollution permits unused or underused could be sold to firms that had exceeded their allocation of permits.

• Pollution permits, unlike prohibitions, work by using price signals and are therefore usually preferred by economists.


119

Question 5

What issues are likely to be considered when an environmental audit is conducted by:

(a) government;

(b) a profitmaximising firm?

Guidance

• Government should take into account not only the private costs and benefits (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] and lives saved [benefit]).

• The private firm undertaking an environmental audit might take into account some of the more obvious environmental effects of their schemes but might ignore others. This will depend upon the depth of the environmental audit.


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Question 6

Consider the role of property rights in a discussion of environmental issues.

Guidance

• Property rights are the rights to benefit from utilisation and transfer of property.

• In general, people look after their own private property better than public property. This is evident, for example, in what is known as the ‘tragedy of the commons’. When land is held in common for grazing or cultivation each individual’s actions may have little effect on the overall result. For example, if 100 farmers use an area of common land for grazing purposes, each farmer’s 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 grazing even though collectively it is in the interests of all the farmers to prevent damage to the land.

• The same thinking can be applied to environmental issues. Although I know that using my car is environmentally damaging, this has no effect on my decision to use my car because 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 property rights in the shoals of fish.

• Where property rights exist, economic agents have an incentive to maintain, protect and enhance their property. The individual farmer will protect his/her fields from overfarming because of the impact on the future value of the land. If property rights can be attached to shoals of fish (as in salmon farms) then owners have an incentive not to overfish and wipe out their fish stocks.


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CHAPTER 1 6

Government and Business

Question 1

In what ways do governments impact on business decisionmaking today?

Guidance

• Governments impact on business decisionmaking in a number of ways resulting from decisions concerning taxation and subsidies, industrial and environmental policy, regional and competition policy as well as macroeconomic policy decisions.

• Taxes and subsidies affect decisions by firms to produce and to employ factor inputs.

• Industrial policy and environmental regulations impact on production and sales directly.

• Governments define and protect private property rights through legislation, the police and the courts. Without this protection commerce could not flourish.

• Governments affect business through regional policy and competition policy.

• Governments manage the macro economy through public expenditure and tax changes, therefore influencing the level of economic activity.


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Question 2

Under what circumstances might governments improve economic welfare by interfering in market transactions? What forms might government intervention take?

Guidance

• Governments can improve economic welfare where there is ‘market failure’; that is to say, the market fails to allocate resources so as to maximise social welfare.

• 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 where governments could improve social welfare is where the competitive market produces a distribution of income and wealth that is considered suboptimal on social grounds.

• 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 increases social welfare (see the Guidance Notes to Question 7 below).


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Question 3

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 people to go to university. This results from a belief that a competitive market would under supply higher education because of the cost of private fees.

• A subsidy reduces the charge to the user of higher education and therefore increases demand for it (see Figure 16.2). Consequently, the subsidy attempts to equate more closely the marginal cost of higher education with the marginal social benefit from consuming it. Social benefits arise in terms of the likelihood that someone who has benefited from higher education will be less likely to draw on state welfare payments later in life, may be less likely to resort to crime to fund their lifestyle and less likely to be a burden on the social services. Equally, the economy benefits from a higher skilled and more flexible workforce; benefits not necessarily fully captured in the wages paid.

• However, the subsidy could be excessive leading to an oversupply of higher education and a net loss of social welfare. Government subsidies have to be paid for out of taxation, imposing a cost on the economy.


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Question 4

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

Guidance

• Industrial policy is state intervention in the economy to alter the development of industries from what would occur in competitive private markets.

• Accelerative industrial policies aim to speed up industrial restructuring.

• Decelerative industrial policies aim to slow down industrial restructuring.

• Corporate strategies are affected because businesses will develop their strategic plans in the context of their knowledge about the government’s intentions for industries. For example, if it is known that government favours more investment in a particular sector, and may be willing to support this with favourable tax treatment or subsidies, then investing will seem more attractive. At the same time, knowledge that the government is keen to see an industry replaced sends signals that government is unlikely to intervene to protect the industry from market pressures.


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Question 5

What are the key features of competition policy in your country?

Guidance

• Competition policy is government policy aimed at preventing monopoly abuse either in the form of market dominance by one firm or collectively by firms operating cartels and other restrictive practices.

• Competition law varies in detail across countries but usually consists of laws against restrictions on both market dominance and restrictive practices. Many countries also have legislation to restrict mergers that might lead to market dominance.

• Critics would argue that normally monopoly power is competed away by market forces and therefore government involvement is unnecessary. Also, they would argue that government intervention through competition policy is economically costly and prevents economically beneficial mergers and trading agreements between firms.


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Question 6

Comment on the likely impact of regional policy on business strategy.

Guidance

• Regional policy involves government intervention in the economy through taxation, subsidies and planning laws to encourage firms to invest in particular areas of the country, normally those where unemployment levels are above the national average.

• Location decisions in business strategy are affected. It may prove impossible to establish a production site in the most preferred area of the country (e.g. that which makes most sense in terms of the firm’s private costs and benefits). Another area of the country might now seem more attractive as a location because of the government subsidies and tax benefits.

• It should be noted that regional policy distorts privatesector investment decisions and this can prove damaging if firms locate to areas where they cannot produce the output cost effectively over the longrun and especially once the government’s fiscal incentives end.


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Question 7

What do you understand by ‘state failure’? When is state failure most likely to arise?

Guidance

• State failure occurs when government intervention in the economy lowers rather than raises social welfare. This occurs where the economic costs of state intervention exceed the economic benefits.

• This is most likely to occur where state intervention distorts market forces significantly, undermines enterprise and competition, and slows economic growth. This could occur either because politicians pursue their own or sectional interests rather than the public interest or they lack the necessary information to know what is in the public interest. In other words, state intervention is associated with both incentives and information deficiencies.


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Question 8

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, on the business.

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 or likely to impact on the firm and its market.

• Government policy can impact on all four factors in the firm’s environment: political, economic, social and technological, as discussed in the chapter.

• 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 comprehensive but merely indicative of some of the key aspects, which are likely to arise.


Expected new product developments from the company’s R&D activities

Competitors’ developments

Assessments of ‘state of the art’ developments

THE BUSINESS

TECHNOLOGICAL TRENDS

ECONOMIC TRENDS

POLITICAL TRENDS

SOCIAL TRENDS Economic growth

Consumer spending Government spending Interest rates Exchange rates Money supply Investment

Change in societal values Demographic changes New lifestyles Attitudes to work and leisure

Political alignments Legislation Businessgovernment relations

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CHAPTER 1 7

Business and Economic Forecasting

Question 1

What factors are likely to affect the market for houses and the determination of house prices:

(a) nationally over time; and

(b) locally at a point in time?

Guidance

• In both cases house prices will reflect the demand and supply of housing. House prices fall when there is an excess supply of houses for sale and rise when there is an excess demand.

• Over time, house prices are affected by changes in demand and supply conditions, such as 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. For example, a change in social attitudes that leads to a preference for owned over rented housing will increase the demand for houses for purchase, as will more divorces that lead to more single person households.

• House prices locally, at a point in time, are affected by local demographic and social factors and by issues, such as local economic development that draws in new employers leading to a larger workforce. Local house prices will also reflect the existence of acceptable substitutes, notably rented 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, including relevant variables to reflect demand and supply patterns geographically.


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Question 2

You have been asked to write a report on the future of the market for men’s clothing by a major clothing manufacturer.

(a) Outline briefly the structure that the report will take, highlighting the main steps of the final analysis.

(b) What factors do you consider will be the most important in determining future sales of the company’s product?

Guidance

• The report is concerned with the market for men’s clothing and therefore with factors which affect or are likely to affect the demand for and the supply of men’s clothing.

• The size of the market (the number of men!) is merely a starting point because the market is affected by numerous other factors, such as fashion and incomes.

• You should start by trying to specify the demand function for men’s clothing.

• Similarly, supply is affected by the price of men’s 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 men’s clothing. Another important factor relates to the number and quality of retail outlets for men’s clothing.

• You should attempt to specify the supply function for men’s clothing.

• 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 important demand and supply considerations in the market based around your demand and supply analysis.

• From this discussion you should be able to deduce what factors you consider to be the most important in determining the future sales of the company’s product.


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Question 3

You have been appointed by the board of an upmarket cosmetics producer to prepare a report concerning a new product launch. Briefly describe, how you would assess:

(a) the launch price of the product;

(b) future sales, shortterm and longterm;

(c) the likely reaction of competitors;

(d) profitability of the new product.

You have also been instructed to identify different ways in which the new product may be test marketed, justifying clearly your preferred method.

Guidance

• The price chosen at the launch of the product will be determined by factors, such as the costs of production, but also by (a) the competitiveness of the market, and (b) the firm’s strategy.

• We can safely assume that the cosmetics market is not perfectly competitive and therefore the firm has discretion when setting its price. There are broadly two opposite pricing strategies that could be adopted and both, depending on the market and the firm’s strategy, could be valid.

• 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 other pricing strategy involves ‘promotional’ or ‘penetration pricing’, which involves pricing relatively low (at cost or lower, such as at or slightly above variable cost) with a view to winning the maximum market share. The high market share might then provide an effective barrier to competitors thinking of entering the industry later.

• Neither of these strategies is immune from problems and, in particular, both imply a later change in price. For example, the promotional strategy may not be profitable unless prices can be raised later. There may be no guarantee of this, especially if the market is contestable.

• Future sales in the shortterm and the longterm can be estimated using some of the techniques laid out in this chapter. Note that the results are ‘estimates’, which might diverge from the actuals, especially if the modelling process is defective. It is particularly difficult to forecast sales for a completely new product because there is no historic evidence on which to call.

• The response of competitors will depend on the barriers to entry into the industry, which could be legal (e.g. patent protection) or strategic (e.g. the firm’s marketing strategy). The likely response of competitors will influence the initial pricing policy adopted.

• 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

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necessitate high marketing expenditure to draw it to the attention of consumers. This in turn will influence the decision on the initial pricing strategy adopted by affecting supply costs.

• Before the product launch information can be obtained on the likely response of consumers to particular types of marketing, including pricing, through consumer surveys and market experiments. The chapter outlines a number of possible methods for collecting information on consumer demand.

Chapter reference: see especially pp. 368 – 373 and Chapter 12 on pricing strategies.

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Question 4

Samuel Goldwyn once stated ‘Never make forecasts, especially about the future’. Discuss the pitfalls involved in making business forecasts. How are these pitfalls best avoided?

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 statistical analysis of the data. Nevertheless, it is important to recognise that forecasts can be wrong even when undertaken using sophisticated econometric modelling. But when undertaken carefully and thoroughly, statistical analysis should provide more reliable results than ‘hunches’.

• Although there is insufficient space in one chapter to discuss statistical forecasting methods in detail, the chapter does provide pointers to some of the more important factors that need to be considered.

• 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 sales or proxies for them).

• Secondly, it is important to collect relevant and reliable data on the variables identified (remember the adage: ‘rubbish in, rubbish out’!).

• Thirdly, the relationship between the variables will need to be estimated based on the data and the reliability of the estimates will need to be assessed. Are the results reliable? There are some standard diagnostic tests relating to the reliability of the entire equation and the individual coefficient values. These are based on the statistical measure of what is known as the ‘standard error’. When forecasting prices it will also be important to control for the socalled ‘identification problem’ (see pp. 378 – 380).

• We all need to take a view about the future if we are to run our lives successfully, and this is particularly true of businesses and governments. Forecasting the future will always be hazardous, yet, turning Samuel Goldwyn’s comment on its head, how can we flourish without forecasting the future?

Chapter references: material throughout the chapter but particularly pp. 373 – 386.

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CHAPTER 1 8

Business Economics – A Checklist for Managers

Question 1

Set out an economic strategy for a smallscale food retailer threatened by the possible entry into its market of a competitor, which is part of a large national chain of supermarkets.

Guidance

• The smallscale food retailer will have to develop a strategy, which differentiates its products and services from a new and larger competitor, which is part of a 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 products that one would not normally expect to find in a large supermarket – although this is becoming less likely as supermarkets expand their own range of products (to include items, such as newspapers, flowers, readytoeat meals etc.).

• The small retailer will find life very difficult if it decides to compete on price alone because the larger competitor will have much greater bargaining power with wholesalers and suppliers. At the same time, the small retailer will lose business if it is not reasonably priced and competitive.


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Question 2

Is it sensible for a firm to react to new competition by reducing price? Justify your views.

Guidance

• Cutting price can, under certain conditions, be an appropriate strategy but it is often not a strategy that can be sustained.

• A price reduction may deter new firms from entering the market – referred to as an ‘enterlimiting’ or ‘entrylimiting’ strategy.

• However, cutting price is unlikely to be a sensible reaction when new competitors become established players. This stems from the ‘kinked demand curve’ argument related to oligopoly. In other words, a price cut is likely to be duplicated by competitors resulting in an overall reduction in total revenue.

• A price cut could, however, be implemented as part of a wider strategy to increase market share – linked perhaps to some promotional expenditure to increase the overall demand in the market place.

• Price cuts could also be selective, creating lossleaders while attracting more customers to other products and services on offer.


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Question 3

When is costcutting not a sustainable, longterm competitive strategy?

Guidance

• Cost cutting is not a sustainable longterm competitive strategy unless price covers all costs of production – fixed and variable. If price falls below the total cost of production then the firm should shut down in the longterm.

• In addition, cutting cost may have an impact on marketing, R&D and training budgets as well as on staff morale – all of which are likely to be damaging to the business.

• Cost cutting, therefore, must be combined with some fundamental changes in corporate strategy if the company is to survive and must not be seen as an end in itself.


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Question 4

What nonprice strategies should be considered as a reaction to new competition?

Guidance

• Nonprice strategies may involve a wide range of options depending on the nature of the product or service and the industry sector.

• Product or service differentiation is one of the most common nonprice strategies. This may 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 unlikely to succeed.

• An advertising strategy may be launched to enhance brand recognition and brand value. If successful, this may even make it possible for the firm to raise price!

• ‘Bundling’ could be adopted as a strategy whereby two or more products are sold together – for example, free fabric softener with a large packet of detergent. This is a common strategy in many segments of the retailing sector, which may be preferred to a price war.

• Coupons may be given away with products or services to attract demand. As with bundling, there will be a cost involved for the firm, but this may be a more attractive strategy than entering into direct price competition.


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Question 5

Taking an industry with which you are familiar (the one you work in or one you have studied), set out the key economic variables that you feel determine business success.

Guidance

• The impact of economic variables on any industry will depend on a number of factors. A starting point, therefore, would be to address the following questions:

• does the industry have an international dimension, or is it solely a domestic activity?

• is the industry in the private sector or stateowned sector?

• is the industry in the service sector or manufacturing sector?

• The list of economic variables that should be considered could be considerable. However, the most important ones are likely to involve:

• economic growth

• interest rates (domestically and internationally)

• inflation (of prices, wages, raw materials etc.)

• unemployment (nationally and sectorally)

• exchange rates

• consumer spending

• corporate investment expenditure

• government expenditure and taxation.

• It is important to understand how changes in the economic environment and expected official policy responses are likely to impact on the industry. This will enable management to plan ahead and take the necessary steps either to avoid economic crises or to benefit from economic upturns.


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Question 6

Do the same for a particular firm in this industry, and indicate the main future competitive threats and actions the management should take.

Guidance

• The reader should refer to Chapter 11, pages 217 – 220 for a detailed list of questions, which should be addressed. The firm should consider the threats which it faces arising at the industry level in terms of:

• the bargaining power of buyers

• the bargaining power of suppliers

• the threat from potential new entrants into the market

• the threat from substitute products or services

• the degree of competition (rivalry) in the market.

• Possible actions will depend on the nature of the product or service and the structure of the industry.

• The firm may choose to be a lowcost producer or may adopt a product differentiation strategy (for details, see pp. 221 – 222).

Chapter references: material throughout the chapter and Chapter 11.

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Question 7

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

Guidance

• See the Guidance Notes for Question 8, Chapter 16.

• Future threats could come from many developments, depending on the nature of the product or service and the structure of the industry.

• In general, threats from the macroeconomic environment are likely to involve:

• the possibility of a major recession

• changes in consumer spending levels and patterns

• external shocks (such as oil price hikes and trade wars)

• inflationary pressures, which may lead to an increase in shortterm interest rates and hence a rise in borrowing costs

• a downturn in business and consumer confidence

• stock market instability.

• The list is far from exhaustive. It is important therefore for firms to be aware of developments in the wider business and economic environment to be forewarned about the possibility and impact of threats.

• By definition, threats emerging from developments in the macroeconomic environment are beyond the control of the individual firm – but recognition of early warnings, will give the firm time to make adjustments to its activities including price, capacity, investment decisions etc.


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