How is the opening up of trade and investment between, Exams of Business Ethics

Download How is the opening up of trade and investment between and more Exams Business Ethics in PDF only on Docsity! . Page . Chapter 5 How is the opening up of trade and investment between How is the opening up of trade and investment between eastern and western Europe likely to affect the location of industries within Europe that have (a) substantial economies of scale; (b) little or no economies of scale? Answer (a) Given that production will take place in only one or two plants, new plants will tend to be located near to the centre of the new enlarged market (i.e. further to the east than before in the case of western European companies). (b) Plants will still tend to be scattered round Europe, given that the customers are scattered. These effects will be the result of attempts to minimise transport costs and thus will be more significant the higher are transport costs per kilometre. Chapter 5 Answer With a vertical supply curve, price will be determined by demand. If demand is lower than anticipated, the price will have to be reduced if the trees or fresh foods are to be sold. Could the long run and the very long run ever be the same length of time? Answer Yes, if more advanced technology is already in existence but would require the purchase of new capital equipment for it to be used. What will the long-run and very long-run market supply curves for a product look like? How will the shape of the long-run curve depend on returns to scale? Answer The long-run curve will be more elastic than the short-run curve. If there are increasing returns to scale, the long-run supply curve will slope downwards (unless the effect is offset by external diseconomies of scale). The very-long run curve is difficult to identify. It is likely to slope downwards if improvements in technology result directly from a growth in the size of the industry. If, however, the advances in technology are the result of factors independent of the size of the industry (e.g. scientific advance), this would be shown by a vertical shift downwards of the long-run supply curve. Chapter 5 In the very long run, new isoquants will have to be drawn as factor productivity changes. An increase in productivity will shift the isoquants inwards towards the origin: less capital and labour will be required to produce any given level of output. Will this be a parallel inward shift of the isoquants? Explain. Answer Possibly but not necessarily. It depends on whether the advance in technology increases the productivity of both factors in the same proportion. What would the firm’s long-run total cost curve look like in each of these three cases? Answer (a) The long-run marginal cost curve would be falling (and below the LRAC curve) and thus the long-run total cost would be rising less and less steeply. (b) The long-run marginal cost curve would be rising (and above the LRAC curve) and thus the long- run total cost curve would be rising more and more steeply. (c) The long-run marginal cost curve would be horizontal and (equal to the LRAC curve) and thus the long-run total cost curve would be rising at a constant rate: i.e. it would be a straight line up from the origin. Will the envelope curve be tangential to the bottom of each of the short-run average cost curves? Explain why it should or should not be. Answer No. At the tangency points the two curves must have the same slope. Thus if the envelope curve is downward sloping, so too must the short-run average cost curve be downward sloping at the tangency point. Why might a firm operating with one plant achieve MEPS and yet not be large enough to achieve MES? (Clue: are all economies of scale achieved at plant level? Answer There may be economies of scale to be gained that do not relate to plant size but rather to the size of the organisation: for instance, marketing economies of scale and research and development economies of scale. Despite operating with a minimum cost plant, the firm may still not be large enough to achieve these other economies. . Why might a firm producing bricks have an MES which is only 0.2 per cent of total EU production and yet face little effective competition from other EU countries? Chapter 5 Answer Because bricks, being heavy and having relatively low value, are costly to transport. The effective market for bricks, therefore is a relatively local one. What would the isoquant map look like if there were (a) continuously increasing returns to scale; (b) continuously decreasing returns to scale? Answer (a) The isoquants would get progressively closer and closer together. (b) The isoquants would get progressively further and further apart. What would happen to the TR curve if the market price rose to £10? Try drawing it. Answer With a doubling in price from £5 to £10, the total revenue would double at each level of sales. The ‘curve’ would still be a straight line up from the origin, but twice as steep. Chapter 5 . Why are the figures for MR and MC entered in the spaces between the lines in Table Because marginal revenue (or cost) is the extra revenue (or cost) from moving from one quantity to another. Answer From the information for a firm given in the table below, construct a table like Table Q Q 0 1 2 3 4 5 6 7 P 12 11 10 9 8 7 6 5 TC 2 6 9 12 16 21 28 38 Use your table to draw diagrams like Figures 5.20 and 5.22. Use these two diagrams to show the profit- maximising output and the level of maximum profit. Confirm your findings by reference to the table you have constructed. Q (units ) P = AR (£) TR (£) MR (£) TC (£) AC (£) MC (£) T (£) A (£) 0 12 0 2 – –2 – 11 4 1 11 11 6 6.0 5 5.0 9 3 2 10 20 9 4.5 11 5.5 7 3 3 9 27 12 4.0 15 5.0 5 4 4 8 32 16 4.0 16 4.0 3 5 5 7 35 21 4.2 14 2.8 1 7 6 6 36 28 4.7 8 1.3 –1 10 7 5 35 38 5.4 –3 –0.4 Chapter 5 The curves will be a similar shape to those in Figures 5.20 and 5.20. The peak of the T curve will be at Q = 4. This will be the output where MR and MC intersect. Will the size of normal ‘profit’ vary with the general state of the economy? Answer Normal profit is the rate of profit that can be earned elsewhere (in industries involving a similar level of risk). When the economy is booming, profits will normally be higher than when the economy is in recession. Thus the ‘normal’ profit that must be earned in any one industry must be higher to prevent capital being attracted to other industries. Given the following equations: TR = 72Q – 2Q²; TC = 10 + 12Q + 4Q² Calculate the maximum profit output and the amount of profit at that output using both methods. Answer (a) T = 72Q – 2Q² – 10 – 12Q – 4Q = –10 + 60Q – 6Q² (1)  dT/dQ = 60 – 12Q Setting this equal to zero gives: 60 – 12Q = 0  12Q = 60  Q = 5 (b) MR = dTR/dQ = 72 – 4Q MC = dTC/dQ = 12 + 8Q Setting MR equal to MC gives: 72 – 4Q = 12 + 8Q  12Q = 60  Q = 5 Chapter 5 To find the level of maximum profit, we must substitute Q = 5 into equation (1). This gives: T = –10 + (60  5) – (6  5²) = –10 + 300 – 150 = £140 Chapter 6 (Why are some industries like bread baking and brewing relatively concentrated, in that a few firms produce a large proportion of total output (see Box 7.3 and Web case 7.5). and yet there are also many small producers? Answer The large firms may produce a fairly standardised product for a national market, sold through large outlets or large outlet chains. They have the advantage of economies of scale and can probably compete in terms of price. The small firms, on the other hand, may be able to produce a more specialist product and/or serve a particular local market. They may well compete more in terms of quality and variety than in terms of price. . Why do economists treat normal profit as a cost of production? Answer Because it is part of the opportunity cost of production. It is the profit sacrificed by not using the capital in some alternative use. What determines (a) the level and (b) the rate of normal profit for a particular firm? Answer It is easier to answer this in the reverse order. (b) The rate of normal profit is the rate of profit on capital that could be earned by the owner in some alternative industry (involving the same level of risks). (a) The level of normal profit depends on the total amount of capital employed. Will the industry supply be zero below a price of P Answer Once the price dips below a firm’s AVC curve, it will stop production. But only if all firms have the same AVC curve will the entire industry stop production. If some firms have a lower AVC curve than the firm illustrated in Figure 6.3 (b), then industry supply will not be zero at P5. Illustrate on a diagram similar to Figure 6.4 what would happen in the long-run if price were initially below PL. Answer The industry supply curve would initially be to the right of Se and average revenue would be below ARL. Firms would be making a loss. They would thus leave the industry. As they did so, the supply Chapter 6 curve would shift to the left until it reached Se. At that point, normal profits would be restored and firms would cease leaving the industry. . What other reasons can you think of why perfect competition is so rare? Answer • Information on revenue and costs, especially future revenue and costs, is imperfect. • Producers usually produce differentiated products, one from another. • There are frequently barriers to the entry of new firms. Why does the market for fresh vegetables approximate to perfect competition, whereas that for aircraft does not? Answer There are limited economies of scale in the production of fresh vegetables and therefore there are many producers. There are such substantial economies of scale in aircraft production, however, that the market is only large enough for a very limited number of producers, each of which, therefore, will have considerable market power. What advantages might a large established retailer have over a new e-commerce rival to suggest that the new e-commerce business is unlikely to have it all its own way? Answer • Customers are familiar with its products and services and may trust their quality. • Consumers may prefer to be able to ask advice from a sales assistant. • It may have sufficient market strength to match any lower prices offered by the e-commerce firm. • It may have sufficient market strength to force down prices from its suppliers. • Consumers may prefer to see and/or touch the products on display to assess their quality. • Consumers may prefer the ‘retail experience’ of going shopping. Chapter 6 As an illustration of the difficulty in identifying monopolies, try to decide which of the following are monopolies: British Telecom; your local evening newspaper; the village post office; a rival company; Interflora; the London Underground; ice creams in the cinema; Guinness; food sold in a university refectory; the board game ‘Monopoly’. Answer In some cases there is more obvious competition than in others. For example, with the growth of mobile phones and cable television companies supplying phone services too, British Telecom has lost its monopoly status for most customers. In other cases, such as ice creams in the cinema, village post offices and university refectories, there is likely to be a local monopoly. In all cases, the closeness of substitutes will very much depend on consumers’ perceptions. Try this brain teaser. A monopoly would be expected to face an inelastic demand. And yet, if it produces where MR = MC, MR must be positive, demand must therefore be elastic. Therefore the monopolist must face an elastic demand! Can you solve this conundrum? Answer Demand is elastic at the point where MR = MC. The reason is that MC must be positive and therefore MR must also be positive. But if MR is positive, demand must be elastic. Nevertheless, at any given price a monopoly will face a less elastic demand curve than a firm producing the same good under monopolistic competition or oligopoly. This enables it to raise price further before demand becomes elastic (and before the point is reached where MR = MC). On a diagram like Figure 6.9, by drawing in MR and MC curves, demonstrate that PL could be below the short-run profit-maximising price. Answer You will also need to draw an AR curve. If you look at Figure 6.8, you can see that the profit- maximising price will depend on the height of the MR and AR curves. With a ‘high’ AR curve, the profit-maximising position on this curve could well be above PL. What does this analysis assume about the price elasticity of demand for the new entrant (a) above PL; (b) below PL? Answer Chapter 6 (f) Low to moderate. The exit costs again will depend on the second-hand value of the equipment. (g) Relatively low if the ships can be transferred to other routes. Much higher if the company wishes to move out of shipping entirely and if the market for second-hand ships is depressed. . Make a list of those factors that determine the contestability of a particular air route. Answer • The number and severity of legal obstacles to the entry of new operators (the greater the obstacles, the less contestable the market). • The amount of government regulation preventing anti-competitive practices by existing operators (the greater the regulation, the more contestable the market). • The number of alternative routes that could be operated from the same airports (the more alternatives, the less the exit costs from any one route). • The degree of control of facilities at hub airports by existing operators (the greater the control, the less contestable the routes). • The more rapid the growth in passenger demand (the more contestable the market). Chapter 6 In the UK, train operators compete for franchises to run services on a particular route. The franchises are normally for 7, 10, 12 or 15 years. The franchise specifies prices and minimum levels of services (frequency, timing and quality). Would this be a good system to adopt in the airline market over particular routes? How is the airline market similar to/different from the rail market in this regard? Answer At the time of awarding the franchises there could be considerable competition from airlines and this would be in the interests of passengers. Once the franchises had been awarded, however, it could limit the entry of new carriers into the industry (such as low cost, no-frills airlines) and thus restrict possible competition. Most train routes are close to natural monopolies (though not entirely, as more than one train operator can use a particular line) and thus franchises are a particularly suitable way of making routes contestable. With airlines, however, there is scope for several airlines flying from particular airports and, for many destinations, for more than one airline to specific destinations from that airport. Nevertheless, take-off and landing slots are limited, as are slots for trains on particular lines, and thus the markets are similar, even if the airline industry is potentially more competitive. 22 Give some other examples of monopolistic competition. (Try looking through the Yellow Pages if you are stuck.) Answer Examples include: taxis, car hire, pubs, hotels and restaurants, insurance agents, estate agents, child minders, office equipment suppliers, double glazing installers, antique dealers, computer systems. Why may a food shop charge higher prices than supermarkets for ‘essential items’ and yet very similar prices for delicatessen items? Answer Because the demand for such essential items from a local food shop is likely to be less price- elastic than the demand for delicatessen items: if people run out of basic items, they will want to obtain them straight away rather than waiting until they visit the supermarket. Also the supermarkets may obtain bulk discount from their suppliers on basic items, but not on delicatessen items, where the turnover is much lower. . Which of these two items is a petrol station more likely to sell at a discount: (a) oil; (b) sweets? Why? Answer Oil (especially in large cans). The reason is that demand is more price elastic. People will be tempted to buy now, rather than waiting, if they see a reasonable discount (or a free gift). In the case of sweets, these are often an impulse buy and the price is very low anyway relative to the amount already spent on petrol. A penny or two price reduction will probably make very little difference to sales. Why does the LRMC curve cross the MRL curve directly below the tangency point of the LRAC and ARL curves? Answer Chapter 7 25 If this ‘fair’ solution were adopted, what effect would it have on the industry? Answer It would be likely to shift it upwards, given that additional output would not merely come from the most efficient producers, but rather from all producers in proportion to their market share. Also, over time, by protecting companies’ market share in this way, there would be less competition to adopt new more efficient techniques. ( . What are the barriers to entry in (a) brewing; (b) opening new pubs? Answer (a) Costs of plant for producing on a large scale; brand loyalty; advertising by the established firms; difficulty in finding outlets for the beer, given that most pubs are tied to a brewery and are required to sell only one ‘guest’ beer; ‘pressure’ from large breweries on pubs to stock their guest beers. (b) Market is already saturated in most areas; high cost of purchasing premises and fitting them out; fear of ‘unfair’ competition from existing pubs, most of which are tied to the large breweries. Do small independent brewers have any market advantages? Answer Yes. Beer, being heavy and bulky relative to value, is quite expensive to transport. Local brewers, by being near to their outlets are likely to have lower transport costs. On the demand side, there is often considerable loyalty for local ales. Draw a pair of diagrams like those in Figure 7.4. Illustrate what would happen if there were a rise in market demand and no rise in the costs of either the leader or the followers. Would there be an equal percentage increase in the output of both leader and followers? Answer The Dmarket curve would shift to the right. This would cause the Dleader curve also to shift to the right (now intersecting the vertical axis at the price where the Sall other firms curve crosses the new Dmarket curve). There would be a corresponding rightward shift in the leader’s MR curve, which would Chapter 7 26 cause the leader to increase output to where the new MR curve intersects with its MC curve, and to raise price to the point on its demand curve vertically above the new MR/MC intersection. Whether there would be an equal percentage increase in the output of both leader and followers depends on the shapes of the various curves and the initial market share of each. Chapter 7 27 Illustrate what was happening here on a demand and supply diagram. Remember that demand is highly inelastic and was increasing over time. Answer The initial demand and supply curves intersect at a price of $3 per barrel. The actions of OPEC in 1973/4 can be shown by a shift in the supply curve to the left, which, given the inelastic nature of the demand curve, causes price to rise substantially to over $12 per barrel. Then during the mid to late 1970s, the demand curve shifts to the right (demand was increasing over time), which combined with a slight movement back to the right of the supply curve, allowed sales (Q) to resume their pre 1973 level while price still remained above the $12 per barrel level. . What conditions facilitate the formation of a cartel? Which of these conditions were to be found in the oil market in (a) the early 1970s; (b) the mid-1980s; (c) 2000? Answer For the conditions that facilitate the formation of a cartel, see the list of factors favouring collusion on page 180. Taking the points in order as they appear on page 180: • There are relatively few oil producing countries (but more in the 1980s than in the 1970s). • The OPEC members meet openly to discuss pricing and quotas (in all three periods) • Production methods are relatively similar, although costs vary according to the accessibility of the oil. • The (final) product is very similar and there is an international price for each type of crude. • Saudi Arabia is the dominant member of OPEC: its dominance over the world market, however, waned from the mid-1980s as non-OPEC production increased and there was a world glut of oil. With a growing world economy in the late 1990s, Saudi Arabia’s influence grew again. • Entry barriers, however, have not been significant. This has allowed several non-OPEC members (e.g. Mexico, Norway and the UK) to break into the market. • The market is relatively stable in the short run (given the price and income inelasticity of demand). There has been a problem, however, of a decline in demand over the longer term. • Governments round the world have been relatively powerless to curb OPEC’s collusion, although from time to time (e.g. during the Gulf War) the USA has released oil from its huge stock piles to prevent excessive price increases. Chapter 7 30 between them, or simply ‘letting it be known’ that they would be willing to raise prices, providing that the other company did the same. The promise of the second company could be seen as credible if it had lower costs or greater financial backing than the first company. In such circumstances, the first company may be forced to give up its policy first. If they have similar costs and financial strength, then the threat is not credible. Give an example of decisions that two firms could make in sequence, each one affecting the other’s next decision. Answer Two supermarket chains are thinking of expanding into the small ‘metro’ stores segment of the market in a particular city that does not have any such stores. There is room in the market for only one in each of three suburbs, with the third having little prospect of making a profit in the short run. The first mover may succeed in gaining planning permission for the most profitable of the three. This will give the second an advantage in gaining planning permission in the second most profitable, given than the local authorities will want to maintain as much competition as possible. Both will have to consider, however, what they do about the third, which is only marginally profitable, but could help to develop the image of their other metro store in the city. They will also have to consider whether if the other company opened the third store this would deny them an opportunity of ever having a second metro store in the city: a store which could be profitable at some point in the future. Which of the following are examples of effective countervailing power? Answer (a) Tour operators purchasing seats on charter flights. (b) A large office hiring a photocopier from Rank Xerox. (c) Marks and Spencer buying clothes from a garment manufacturer. (d) A small village store (but the only one for miles around) buying food from a wholesaler. (a) and (c) are examples of effective countervailing power, because the individual purchasing firms are large relative to the total market for the product. Chapter 7 31 Could annoyance to the public ever rebound as a direct cost to the firm? Answer Yes. The government may be persuaded to tax advertising; local authorities may levy charges on companies for bill-boards. Also, on the demand side, consumers may be put off buying the product. Choose two products which are extensively advertised. Make out a case for and a case against these particular advertisements. Answer Check the particular products and the nature of the adverts against the list of points made on page 190. Which of the following markets do you think are contestable? (a) credit cards; (b) brewing; (c) petrol retailing; (d) insurance services; (e) compact discs? Answer The least contestable are credit cards and brewing, where the existing companies have considerable control over the market. Petrol retailing and insurance services (especially at the retail level) are relatively contestable because the barriers to entry are low. Exist costs are also relatively low (assuming that petrol stations can be sold easily). New producers of compact discs (the recording companies as opposed to the manufacturers of the basic discs on which recordings are made) face moderately high entry barriers in terms of recording contracts, economies of scale and influence over outlets, but there have been examples of new companies setting up, especially in more specialist parts of the market. . Look at each of the above questions. In each case decide whether price discrimination is being practised. If it is, is it sensible for train operators to do so? Is it discriminating between people with different price elasticities of demand? Answer Chapter 7 32 Price discrimination occurs when the same product or service (with the same marginal cost) is sold at different prices to different customers. Thus charging a different price for first and standard class, for seat reservation, for travel on different times of day, or on different days of the week, or at different times of the year are not examples of price discrimination, since (a) the service is different and (b) the marginal cost is not the same. On the other hand, charging a different price for children, students, old people, people travelling on single rather than return tickets and on day, ‘saver’ or period return tickets are examples of price discrimination since they allow travel on the same seat on the same train to different classes of people. . Are these various forms of price discrimination in the traveller’s interest? Answer If the lower-price fares are making travel possible for people who could otherwise not afford it, then clearly they are benefiting. For the people paying the higher-priced fares, then there are advantages and disadvantages. Clearly, they will not like paying more than they would in the absence of price discrimination, but given that at peak times some lines are operating to full capacity, the higher price may be necessary to prevent queuing or grossly overcrowded trains (though note, as explained in the answer to the last question, charging higher prices at peak times to everyone is strictly speaking not a form of price discrimination). Explain why, if the firm can practise first-degree price discrimination by selling every unit at the maximum price each consumer is prepared to pay, its revenue from selling 200 units will be the sum of both the shaded areas Answer Because the demand curve shows the maximum price consumers are prepared to pay for each additional unit purchased. Thus reading from left to right along Figure 7.11, the first unit can be sold at the price corresponding to Q = 1 on the demand curve; the second unit can be sold at the price corresponding to Q = 2 on the demand curve without affecting the price at which the first unit was sold, and so on for each unit. Thus in each case, the marginal revenue (not the average revenue) is given by the demand curve. When all these marginal revenues are added up (up to 200 units), this will give the area under the demand curve (both shaded areas), and being the sum of the marginal revenues, it must equal the total revenue from selling 200 units. 35 What cost concepts are there other than those based on opportunity cost? Would the use of these concepts be likely to lead to an output greater or less than the profit-maximising one? Answer Historical costs and replacement costs. Given that these will generally be higher than opportunity costs in the case of equipment already owned by the firm, the firm is likely to produce less than the profit maximising output by using these other cost concepts. What advantages might a consumer gain from a large M- or H-form company? Answer Individual divisions or parts of the organisation may be more responsive to consumer wishes and better serve particular segments of the market. Make a list of six possible aims a manager of a high street department store might have. Identify some conflicts that might arise between these aims? Answer Six possible examples are: 1. To increase sales. 2. To seek promotion to a bigger store, head office or some other company. 3. To ensure that staff work efficiently. 4. To ensure that this season’s stocks are all sold by the end of the season (without having to make massive reductions at sale time). 5. To stock as full a range of products as possible. 6. To have an easy life. Conflicts could arise between (4) and (5), and between (6) and virtually any of the others. When are increased profits in the manager’s personal interest? Answer 36 Chapter 8 When they lead to an increased salary, to promotion, to greater prestige with colleagues and contacts outside the firm, to greater personal satisfaction, to a greater sense of job security, etc. . Do you carefully allocate your time between study and leisure? If not, why not? Answer You will have to answer this for yourself! If you don’t allocate your time carefully, the reason may be that you don’t like planning your time too much and prefer to take each day or hour as it comes; or it could be that you have learnt by experience what allocation best suits you and thus do not need to do detailed planning. (Why might it be difficult to refute a theory of long-run profit maximisation? Answer Because a firm could always claim that it was seeking to maximise profits by its various activities, even if in practice they turn out not to have been very successful. Also, a firm will be unable to predict the precise effects of its actions on costs and revenues, especially given that it will be unable to predict the long-term responses of its rivals and their effects ➢ (Box 8.3) 2. If a theory cannot in principle be refuted, is it a useful theory? No, not very – except that it may give useful pointers as to the types of effects that could be expected, were the theory to be true. It could thus alert people to what could occur. ➢ Draw a diagram with MC and MR curves. Mark the output (a) at which profits are maximised; (b) at which sales revenue is maximised. (a) Profits are maximised where MC = MR. (b) Sales revenue is maximised where MR = 0. Thus in Figure 5.22 on page 144 of the text, profits are maximised where Q = 3, and sales revenue is maximised between Q = 4 and Q = 5. (This can be confirmed from Table 5.10 on page 143.) Chapter 8 37 Page 202 ➢ Since advertising increases a firm’s costs, will prices necessarily be lower with sales revenue maximisation than with profit maximisation? No. If advertising could go on increasing total revenue substantially beyond the profit-maximising level of advertising, (and hence go on shifting the demand curve to the right), the effect could be to give a higher price. 204 ➢ Which of the three types of merger (horizontal, vertical and conglomerate) are most likely to lead to (a) reductions in average costs; (b) increased market power? (a) Horizontal: there is probably greater scope for rationalisation of production in fewer plants or for each plant to concentrate on a smaller range of products. Note that there is some scope for this with vertical mergers too (and possibly, to a limited extent, with conglomerate mergers). (b) Horizontal: this directly reduces the number of producers of the particular product(s). ➢ 1. Which of the above theories overlap and in what way? The motives given in the text are: 1) growth, 2) economies of scale, 3) monopoly power, 4) increased market valuation, 5) reduction in uncertainty, 6) opportunities that arise, 7) to resist takeovers, 8) defending another firm from an unwanted predator, 9) asset stripping, 10) empire building, 11) broadening the geographical base. (1) overlaps with (2), (3), (4), (5) and (10), depending on just why firms want to grow; (3) overlaps with (2), (5), (7), (10) and possibly (11), depending on the extent to which these others will increase monopoly power; (6) overlaps with all the others, depending on motives at the time. ➢ 2. Why, do you think, is it difficult to find adequate empirical support for any of them? Because motives are often complex and ill-defined, and because the decision makers may hide their motives. Also, given that the motives may well overlap, it is difficult to separate them. 205 ➢ (Box 8.4) 1. Why may a business favour borrowing, as a means of financing growth, over other sources of finance? It may be easier to raise finance through borrowing. Also, if the alternatives are a new issue of shares or financing growth from retained profit, then both could result in lower profits for existing shareholders and a lower share price, since the first would reduce the profits for distribution to shareholders and the second would create more shares to divide the profits between. Also, if a rapid growth in profits is expected, the cost of financing growth through borrowing would be constant (unless interest rates rose), whereas the cost of issuing extra shares would be a rapidly growing amount distributed to these new shares (and hence less to existing shareholders). ➢ (Box 8.4) 2. What are the strengths and weaknesses of diversification as a business growth strategy? A major advantage is that the firm becomes less reliant on one product and hence less vulnerable if the market for that product fluctuates. It is a way, therefore, of spreading risks. It is also advantageous to the firm if the market for its existing products is growing slowly or declining and if it is difficult to gain a bigger share of the market (either because of aggressive competition from Chapter 8 40 Page 207 ➢ How will competition between growth-maximising firms benefit the consumer? The firms may compete in terms of price or product specification in order to gain a bigger share of the market. Also the ‘competition for corporate control’ (i.e. the potential competition for the control of companies, by, say, rival take-over bids) will encourage firms to be efficient, both to help stave off predators and to help them in their bids to take over other companies. 209 ➢ (Box 8.6) Are customers’ interests best served by profit-maximising firms, answerable primarily to shareholders, or by firms where various stakeholder groups are represented in decision taking? The answer depends on (a) the amount of competition faced by firms and (b) the degree to which customers’ (as opposed to other stakeholders’) interests are represented in any decision making. Generally, the more competitive the market, the more will profit-maximising firms be forced to take customers’ interests into account, in terms of both quality and price. In other words, competition is a good means of protecting consumers’ interests. With monopolists and powerful oligopolists, customers may be in a better position to exert pressure on the firm if they have some formal representation (e.g. consumers’ councils for gas and electricity), but their interests may well conflict with the interests of others, such as workers (where higher pay may result in higher prices) or environmentalists (who may want to restrict consumption) or suppliers (who may want to receive higher prices, which again could lead to higher prices). 211 ➢ Will this type of behaviour tend to lead to profit maximisation? Only if they are trying to outdo their rivals in terms of profit. ➢ Are satisficing firms more likely to suffer from X inefficiency (see Box 6.5) than firms which seek to maximise profit or sales revenue? Probably. They will be less anxious to increase labour productivity than maximising firms, and thus may continue with inefficient practices. 213 ➢ (Box 8.8) 1. Which of the following is more likely to be consistent with the aim of maximising profits: pricing on the basis of (a) cost per unit plus a variable percentage mark-up; (b) cost per unit plus a fixed percentage mark-up. Providing that the size of the mark-up is adjustable according to market conditions, either approach could lead to maximum profit. (b) is easier to implement, but (a) allows the firm to focus on the size of total profit (which is the object of profit maximisation) rather than on profit per unit. Chapter 8 41 ➢ (Box 8.8) 2. Explain the differences in the importance attached to the different factors leading to price increases from those leading to price reductions. The weighting suggests that firms react more to threats than opportunities. Thus a price reduction by rivals (a threat) is given a 36 per cent weighting, whereas a price increase by rivals (an opportunity – to raise prices) is given only a 16 per cent weighting. An increase in material costs (a threat to profits) is given a 64 per cent weighting, whereas a decrease in material costs (an opportunity for price cuts) is given only a 28 per cent weighting. A fall in demand (a threat) is given a 22 per cent weighting, whereas a rise in demand (an opportunity) is given only a 15 per cent weighting). It is similar with the last three factors in the lists. 214 ➢ 1. If the firm adjusts the size of its mark-up according to changes in demand and the actions of competitors, could its actions approximate to setting price and output where MC = MR? Yes. If demand conditions or the actions of competitors cause the firm to adjust its price in the belief that it would be profitable to do so, then the firm is effectively saying that the marginal revenue (gained) of the price change exceeds the marginal cost (incurred) (or the marginal revenue lost is less than the marginal cost saved). If the firm is a profit satisficer, however, then any price adjustment in response to demand changes or the actions of competitors may be to protect this satisfactory level of profit, rather than to gain maximum profit. Chapter 8 42 Page 214 ➢ 2. Some firms set their prices by adding a mark-up to average variable cost (the mark-up would be larger to include an element to cover fixed cost). Why might this make pricing easier for the firm? (See Box 5.6.) Because AVC is often relatively constant over fairly large ranges of output. Also, it is changes in AVC that will affect the profit-maximising output, not changes in AFC (changes in AFC do not affect MC), and thus basing the mark-up on AVC means that prices will only be changed when it is profitable. Chapter 4 45 111 ➢ Are there any Giffen goods that you consume? If not, could you conceive of any circumstances in which one or more items of your expenditure would become Giffen goods? It is unlikely that any of the goods you consume are Giffen goods. One possible exception may be goods where you have a specific budget for two or more items, where one item is much cheaper: e.g. fruit bought from a greengrocer. If, say, apples are initially much cheaper than bananas, you may be able to afford some of each. Then you find that apples have gone up in price, but are still cheaper than bananas. What do you do? By continuing to buy some of each fruit you may feel that you are not eating enough pieces of fruit to keep you healthy and so you substitute apples for bananas, thereby purchasing more apples than before (but probably less pieces of fruit than originally). 45 Chapter 5 Page 116 ➢ 1. How will the length of the short run for the shipping company depend on the state of the shipbuilding industry? If the shipbuilding industry is in recession, the short run (and the long run) may be shorter. It will take less time to acquire a new ship if there is no waiting list, or if there are already ships available to purchase (with perhaps only minimal modifications necessary). ➢ 2. Up to roughly how long is the short run in the following cases? (a) A mobile disco firm. (b) Electricity power generation. (c) A small grocery retailing business. (d) Superstore Hypermarkets Ltd’. In each case specify your assumptions. (a) Two or three days: the time necessary to acquire new equipment or DJs. (b) Two or more years: the time taken to plan and build a new power station. (c) Several weeks: the time taken to acquire additional premises. (d) One or two years: the time taken to plan and build a new store. 117 ➢ (Box 5.1) 1. Why might it be possible for there to be a zero marginal productivity of labour on many family farms in poor countries and yet for there to be just enough food for all the members of the family to survive? (Illustrate using MPP and APP curves.) Because the average physical product is sufficiently high to provide basic subsistence. In terms of Table 5.2 and Figure 5.2 on pages 122 and 125, if there were 7 family members working on the farm, the MPP would be zero, but the APP would be 6 tonnes of wheat per year. ➢ (Box 5.1) 2. The figures in the following table are based on the assumption that birth rates will fall faster than death rates. Under what circumstances might these forecasts underestimate the rate of growth of world population? 46 Chapter 3 A faster decline in the death rate as a result of new advances in medicine allowing people to live longer. A slower growth in living standards in developing countries causing people to continue choosing to have large families so that they will have offspring to look after them in their old age. 119 ➢ (Box 5.2) How would you advise the baker as to whether he should (a) employ four assistants on a Saturday; (b) extend his shop, thereby allowing more customers to be served on a Saturday? (a) If maximising profit is the sole aim, then he should employ a fourth assistant if the extra revenue from the extra customers that this assistant can serve is greater than the costs of employing the assistant. (b) Only if the extra revenue from the extra customers will more than cover the costs of the extension plus the extra staffing. ➢ 1. What is the significance of the slope of the line ac in the top part of Figure 5.1? It gives the level of APP at point c. The reason is that the slope of a line from the origin to the TPP curve gives TPP/Lb. Note that since the line from the origin to the TPP curve is steepest at point c, point c represents the quantity of labour where APP is at a maximum (as the lower part of the diagram confirms). ➢ 2. Given that there is a fixed supply of land in the world, what implications can you draw from Figure 5.1 about the effects of an increase in world population for food output per head? Other things being equal, diminishing returns would cause food output per head to decline (a declining MPP and APP of labour). This, however, would be offset (partly, completely or more than completely) by improvements in agricultural technology and by increased amounts of capital devoted to agriculture: this would have the effect of shifting the APP curve upwards. (See Box 5.1.) Chapter 3 49 Page . Chapter 3 50 . 51 . Do you ever purchase things irrationally? If so, what are they and why is your behaviour irrational? Answer A good example is things you purchase impulsively, when in fact you do have time to reflect on whether you really want them. It is not a question of ignorance but a lack of care. Your behaviour is irrational because the marginal benefit of a bit of extra care would exceed the marginal effort involved. . If you buy something in the shop on the corner when you know that the same item could have been bought more cheaply two miles up the road in the supermarket, is your behaviour irrational? Explain. Answer Not necessarily. If you could not have anticipated wanting the item and if it would cost you time and effort and maybe money (e.g. petrol) to go to the supermarket, then your behaviour is rational. Your behaviour a few days previously would have be irrational, however, if, when making out your weekly shopping list for the supermarket, a moment’s thought could have saved you having to make the subsequent trip to the shop on the corner. Are there any goods or services where consumers do not experience diminishing marginal utility? Answer Virtually none, if the time period is short enough. If, however, we are referring to a long time period, such as a year, then initially as more of an item is consumed people may start ‘getting more of a taste for it’ and thus experience increasing marginal utility. But even with such items, eventually, as consumption increases, diminishing marginal utility will be experienced. If Darren were to consume more and more crisps would his total utility ever (a) fall to zero; (b) become negative? Explain. Answer Yes, both. If he went on eating more and more, eventually he would feel more dissatisfied than if he had never eaten any in the first place. He might actually be physically sick! Chapter 4 54 MU diamonds MU water How would marginal utility and market demand be affected by a rise in the price of a complementary good? Answer Marginal utility and market demand would fall (shift to the left). The rise in the price of the complement would cause less of it to be consumed. This would therefore reduce the marginal utility of the other good. For example, if the price of lettuce goes up and as a result we consume less lettuce, the marginal utility of mayonnaise will fall. MU, P Pd Pw Qd Qw Quantity of water The diagram illustrates a person’s MU curves of water and diamonds. Assume that Quantity of diamonds diamonds are more expensive than water. Show how the MU of diamonds will be greater than the MU of water. Show also how the TU of diamonds will be less than the TU of water. See Diagram 4.2 opposite. Imagine that you are going out for the evening with a group of friends. How would you decide where to go? Would this decision-making process be described as ‘rational’ behaviour? Answer You would probably discuss it and try to reach a consensus view. The benefits to you (and to other group members) would probably be maximised in this way. Whether these benefits would be seen as purely ‘selfish’ on the part of the members of the group, or whether people have more genuinely unselfish approach, will depend on the individuals involved. Define ‘risk’ and ‘uncertainty’. Answer Risk: when an outcome may or may not occur, but its probability of occurring is known. Uncertainty: when an outcome may or may not occur and its probability of occurring is not known. Give some examples of gambling (or risk taking in general) where the odds are (a) unfavourable; (b) fair; (c) favourable. Answer Chapter 4 55 (a) Betting on the horses; firms launching a new product in a market that is already virtually saturated and where the firm does not bother to advertise. (b) Gambling on a private game of cards which is a game of pure chance; deciding which of two alternative brands to buy when they both cost the same and you have no idea which you will like the best. (c) The buying and selling of shares on the stock exchange by dealers who are skilled in predicting share price movements; not taking an umbrella when the forecast is that it will not rain (weather forecasts are right more often than they are wrong!); an employer taking on a new manager who has excellent references. (Note that in the cases of (a) and (c) the actual odds may not be known, only that they are unfavourable or favourable.) Which gamble would you be more likely to accept, a 60:40 chance of gaining or losing £10 000, or a 40:60 chance of gaining or losing £1? Explain why. Answer Most people would probably prefer the 40:60 chance of gaining or losing £1. The reason is that, given the diminishing marginal utility of income, the benefit of gaining £10 000 may be considerably less than the costs of losing £10 000, and this may be more than enough to deter people, despite the fact that the chances of winning are 60:40. Do you think that this provides a moral argument for redistributing income from the rich to the poor? Does it prove that income should be so redistributed? Answer Arguments like this are frequently used to justify redistributing income and form part of people’s moral code. Most people would argue that the rich ought to pay more in taxes than the poor and that the poor ought to receive more state benefits than the rich. The argument is frequently expressed in terms of a pound being worth more to a poor person than a rich person. It does not prove that income should be so redistributed, however, unless you argue (a) that the government ought to increase total utility in society and (b) that it is possible to compare the utility gained by poor people with that lost by rich people – something that is virtually impossible to do. (What details does an insurance company require to know before it will insure a person to drive a car? Answer Chapter 4 56 Age; sex; occupation; accident record; number of years that a licence has been held; motoring convictions; model and value of the car; age of the car; details of other drivers. Chapter 4 59 Page 104 ➢ 2. What will happen to the budget line if the consumer’s income doubles and the price of both X and Y double? It will not move. Exactly the same quantities can be purchased as before. Money income has risen, but real income has remained the same. 106 ➢ 1. The income–consumption curve in Figure 4.13 is drawn as positively sloped at low levels of income. Why? Because for those on a low level of income the good is not yet in the category of an inferior good. Take the case of inexpensive margarine. Those on very low incomes may economise on their use of it (along with all other products), but as they earn a little more, so they can afford to spread it a little thicker or use it more frequently (the income–consumption curve is positive). Only when their income rises more substantially do they substitute better quality margarines or butter. ➢ 2. Show the effect of a rise in income on the demand for X and Y where this time Y is the inferior good and X is the normal good. Is the income–consumption curve positively or negatively sloped? The curve will slope upwards at first, but become less and less steep. It will then peak at the point where Y becomes an inferior good, and will thereafter slope downwards (i.e. have a negative slope). ➢ Illustrate on an indifference diagram the effects of the following: (a) A rise in the price of good X (assuming no change in the price of Y). (b) A fall in the price of good Y (assuming no change in the price of X). (a) The budget line will pivot inwards (e.g. from B2 to B1 in Figure 4.14, causing a fall in consumption from point k to point j). (b) The budget line would pivot outward on the point where the budget line crosses the horizontal axis. It is likely that the new tangency point with an indifference curve will represent an increase in the consumption of both goods. Diagram 4.3 below can be used to illustrate this. Assume the budget line pivots outwards from B2 to B1. The optimum consumption point will move from point c to a. 107 ➢ As quantity demanded increases from Q1 to Q2 in Figure 4.15 the expenditure on all other goods decreases. (Point b is lower than point a.) This means, therefore, that the person’s total expenditure on X has correspondingly increased. What, then, can we say about the person’s price elasticity of demand for X between points a and b? What can we say about the price elasticity of demand between points b and c and points c and d? Chapter 4 60 Between a and b the demand for X is price elastic: a fall in the price of X leads to an increase in expenditure on it. Between b and c price elasticity is equal to (minus) one: a fall in the price of X leads to no change in expenditure. Between c and d demand for X is price inelastic: a fall in price leads to a reduction in expenditure on X (and hence an increase in expenditure on the total of all other goods). ➢ Illustrate on two separate indifference diagrams the income and substitution effects of the following (a) A decrease in the price of good X (and no change in the price of good Y). (b) An increase in the price of good Y (and no change in the price of good X) See Diagram 4.3 on the next page. In each case the substitution effect is shown by a movement from point a to point b and the substitution effect is shown by a movement from point b to point c. 109 ➢ (Box 4.6) 1. If Judy earned more than Warren, show how much income she would redistribute to him if (a) she cared somewhat for him; (b) she loved him ‘as herself’. Draw her indifference curve in each of these two cases. Assuming that their joint income remained the same as before (i.e. that Judy earned more but Warren earned less), then, if each spent their own income entirely on themselves, they would consume at a point high up along the line YTYT: e.g. at a point between f and eJ. (a) If she cared somewhat for Warren, her optimum point would be somewhere like eJ. Her indifference map would be north-west of Warren’s, with the tangency point to her highest possible indifference curve at eJ. (b) If she loved him ‘as herself’, the optimum point would be at eE. Chapter 4 61 Page (a) Decrease in price of X (b) Increase in price of Y Diagram 4.3 109 ➢ (Box 4.6) 2. In the case where they both love each other ‘as themselves’, will their two sets of indifference curves be identical? It depends on what precisely is meant by ‘loving each other as themselves’. Even if the optimum point for both Warren and Judy were at eE, the slope of their indifference curves may be very different at points other than along the line of equality OE. In other words they may gain a different individual utility from an unequal distribution of income. 110 ➢ (Box 4.7) 1. Make a list of the characteristics of shoes. Which are ‘objective’ and which are ‘subjective’? Objective: size, durability, colour, material. Subjective: brand image, the appearance (pleasurable or unpleasurable), comfort. ➢ (Box 4.7) 2. If two houses had identical characteristics, except that one was near a noisy airport and the other in a quiet location, and if the market price of the first house was £80 000 and the second was £100000, how would that help us to put a value on the characteristic of peace and quiet? It would suggest that purchasers are prepared to pay an extra £20 000 for peace and quiet (see Chapter 11, section 4, on cost–benefit analysis).