Answers to in-text Questions in Chapter 6

Page
155 Give one more example in each category.
Perfect competition: grains; foreign exchange.
Monopolistic competition: taxis; van hire.
Oligopoly: (homogeneous) white sugar; (differentiated) beer; banks.
Monopoly: National Grid Company (electricity transmission); local bus company on specific routes.
Would you expect builders and restaurateurs to have the same degree of control over price?
Other things being equal, restaurateurs are likely to produce a more differentiated product/service than
general builders (as opposed to specialist builders), and are thus likely to face a less elastic demand. This
gives them more control over price. Note, however, that the control over price depends on the degree of
competition a firm faces. If, therefore, there were only a few builders in a given town, but many
restaurants, the above arguments may not hold.
156 1. It is sometimes claimed that the market for various stocks and shares is perfectly competitive, or
nearly so. Take the case of the market for shares in a large company like Ford. Go through each of the 4
assumptions above and see if they apply in this case. (Dont be misled by assumption (1). The firm in
this case is not Ford itself.)
[Note that the market in this case is for Ford shares not for the products of Ford itself.]
Most aspects of the four assumptions of perfect competition apply.
a) There is a very large number of shareholders (although there are some large institutional shareholders.)
b) People are free to buy Ford shares.
c) All Ford ordinary shares are the same.
d) Buyers and sellers know the current share price, but they have imperfect knowledge of future share
prices. This gives rise to speculation in stocks and shares.
2. Is the market for gold perfectly competitive?
Nearly. It is similar to the market for Ford shares. There are many buyers and sellers of gold, who are thus
price takers, but who have imperfect knowledge of future gold prices. Also, countries with large gold stocks
(e.g. the USA) could influence the price by large-scale selling (or buying). [Note also that the price would
have to refer to a weighted average of the price in all major currencies to take account of exchange rate
fluctuations.]
157 (Box 6.1) What are the advantages and disadvantages of using a 5-firm concentration ratio rather than a
10-firm, 3-firm or even a 1-firm ratio?
The fewer the number of firms used in the ratio, the more useful it is for seeing just how powerful the largest
firms are. The problem with only including one or two firms in the ratio, however, is that it will not pick up
the significance of the medium-to-large firms. For example, if we look at the 3-firm ratio for two industries,
and if in both cases the three largest firms have a 50 per cent market share, but in one industry the next
largest three firms have 45 per cent of the market (a highly concentrated industry), but in the other industry
the next three largest firms have only 5 per cent of the market (an industry with many competing firms), the
3-firm ratio will not pick up this difference. Clearly, this problem is more acute when using a 2-firm or a 1firm ratio.
The more the firms used in the ratio, the more useful it is for seeing whether the industry is moderately
competitive or very competitive. It will not, however, show whether the industry is dominated by just one or
two firms. For example, the 10-firm ratio for two industries may be 90 per cent. But if in one case there
are 10 firms of roughly equal size, all with a market share of approximately 9 per cent, then this will be a
much more competitive industry than the other one, if that other one is dominated by one large firm which
has an 85 per cent market share.
A more complete picture would be given of an industry if more than one ratio were used: perhaps a 1firm, a 2-firm, a 5-firm and a 10-firm ratio.

Answers to questions in Economics (4th edition) by John Sloman

Page
157 (Box 6.1) Why are some industries like bread baking and brewing relatively concentrated, in that a few
firms produce a large proportion of total output (see Boxes 7.3 and 7.4). and yet there are also many
small producers?
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.
158 1. Why do economists treat normal profit as a cost of production?
Because it is part of the opportunity cost of production. It is the profit sacrificed by not using the capital in
some alternative use.
2. What determines (a) the level and (b) the rate of normal profit for a particular firm?
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.
160 Will the industry supply be zero below a price of P5 in Figure 6.3?
Once the price dips below a firms 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.
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 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.
161 1.

What other reasons can you think of why perfect competition is so rare?
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.

2. Why does the market for fresh vegetables approximate to perfect competition, whereas that for
aircraft does not?
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.
163 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.
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.

Chapter 6
Page
165 Try this brain teaser. A monopoly would be expected to face an inelastic demand. After all, there are no
direct substitutes. 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?
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).
1. 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.
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.
2. What does this analysis assume about the price elasticity of demand for the new entrant (a) above PL;
(b) below PL?
Above PL, demand will be relatively elastic because the existing firm will not put its price above PL. In
other words, if the new entrant raised its price above PL, it would lose a lot of sales to the existing firm.
Below PL, however, demand is likely to be much less elastic. If the new entrant did try to cut its price
below PL, hoping to survive long enough to capture a significant share of the market and gain economies of
scale, the existing firm would probably reduce its price too in order to drive the new entrant out of business;
the new entrant would not, therefore, gain many sales from the existing firm. The demand curve would thus
be kinked at the limit price set by the existing firm (see the section on kinked demand curves on pages 188
9).
167 (Box 6.3) 1. In what respects might Microsofts behaviour be deemed to be: (a) against the public
interest; (b) in the public interest?
(a) Prices are likely to be higher, given the lack of competition; there may be less product development,
because potential competitors fear Microsofts power to block their entry to the market, or drive them
from it if they do succeed in entering; less choice for consumers.
(b) By developing products that are in general use round the world, it is more convenient for businesses
and their employees, who do not have to learn different sets of programmes or have problems with
incompatibility of programmes; monopoly profits can lead to high levels of investment and product
development, which can help to reduce prices over the longer term.
(Box 6.3) 2. In December 1998, America Online (AOL) announced it was to acquire Netscape
Communications, and to form an alliance with Sun Microsystems. The state of South Carolina
subsequently dropped its anti-trust suit against Microsoft, stating that the forces of competition are
working. Bill Gates remarked on hearing news of the merger, Its hard to believe that the Government
can still press their case with a straight face. Three of the biggest competitors are banking together and
yet the Government is still trying to slow us down. Should the AOLNetscape merger alter attitudes
towards the recent business practices of Microsoft?
To the extent that these other companies can use their joint market power to compete with Microsoft, then it
is probably in the consumers interests. But these competitors will not provide competition across the range
of Microsofts products. In the case of the Windows operating system and Microsoft Office products,
Microsoft has the advantage of an established network of users, and this gives Microsoft a huge market
advantage.

Answers to questions in Economics (4th edition) by John Sloman

Page
167 (Box 6.3) 3. The problem with being locked-in to a product or technology is only a problem if such a
product can be clearly shown to be inferior to an alternative. What difficulties might there be in
establishing such as case?
If potential competitors have been prevented from developing superior products or technology, then those
products or technology are not available to be compared with the existing products or technology! You are
trying to compare an existing situation with a hypothetical one. Even if the competitors do have a product
on the market, its inferiority may be a practical one rather than an intrinsic one namely that it is
incompatible with the market leaders products or technology.
168 If the shares in a monopoly (such as a water company) were very widely distributed among the
population, would the shareholders necessarily want the firm to use its monopoly power to make larger
profits?
If the water company raised its charges and thereby made a larger profit, shareholders would gain from
larger dividends, but as consumers of water would lose from having to pay the higher charges. Except in
the case of shareholders with only a few water shares, however, the gain is likely to outweigh the loss.
Nevertheless, with shares very widely distributed, the average net gain would be only very small, and the
wider the distribution, the more shareholders there would be who would suffer a net loss from the higher
charges.
169 (Box 6.4) 1. How might you measure X inefficiency?
The proportion by which actual output falls short of that which it is estimated could be produced if all inputs
were fully and effectively used. Alternatively you could measure it in cost terms: i.e. the amount by which
average costs exceed the level at which all inputs were fully and effectively used.
(Box 6.4) 2. Another type of inefficiency is productive inefficiency. What do you think this is? (Clue: it
has to do with the proportions in which factors are used).
Productive inefficiency occurs when the cost of producing a particular level of output could be reduced by
combining the factors of production in different proportions.
171 (Box 6.5) 1. Make a list of those factors that determine the contestability of a particular air route.
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).
(Box 6.5) 2. Are there any advantages to the traveller of the government allocating routes?
It depends on the objectives of the government. If the government is aiming to increase competition and
allocates routes to several different carriers then the consumer will be likely to benefit more than if the
government effectively protects a monopoly (or oligopoly) by allocating routes to only one or two carriers.

Chapter 6
Page
172 In which of the following industries are exit costs likely to be low: (a) steel production; (b) market
gardening; (c) nuclear power generation; (d) specialist financial advisory services; (e) production of a
new drug; (f) mobile discos; (g) car ferry operators? Are these exit costs dependent on how narrowly
the industry is defined?
(a) High. The plant cannot be used for other purposes.
(b) Relatively low. The industry is not very capital intensive, and the various tools and equipment could be
sold or transferred to producing other crops.
(c) Very high. The plant cannot be used for other purposes and decommissioning costs are very high.
(d) Low. The capital costs are low and offices can be sold.
(e) Low to moderate. It is likely that a pharmaceutical company can relatively easily switch to producing
alternative drugs. Substantial exit costs are only likely to arise if the company is committed to a longterm research and development programme or if equipment is not transferable to producing alternative
drugs.
(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.
Give some other examples of hit-and-run competition.
Ice cream vendors on a beach in a heat wave; a plastics company manufacturing a batch of cheap moulded
sledges in a snowy spell.