economics questions Flashcards
open- AR>AC
closed- AR<AC
1) demand is low in January
2) P1- indifferent to shutting down and staying open because only cover AVC (staff) but loosing TFC which you would loose if you closed anyway
-Any price below this and you shut down because you are AR<AVC
3)In summer may have P2 but price is at P1 in jan because low demand so might as well close
cost tables and extra reading
When asked a question about why a firm is closed during a certain month, what graph do you use
open- AR>AC
closed- AR<AC (when price is at bottom of AVC or below it)
income effect and substitution effect
must have definition. All need is some examples and mitigations.
1. no claims discount if you comply and drive safely so could get money off insurance in future years
2. employer cannot monitor employee all the time/ piece rates is where you pay per piece of work; awards productivity
How is health insurance a moral hazard and suggest a way that problem could be mitigated
insured individuals take additional risks in because the terms of their health insurance coverage require the insurer to pay for all or some medical care.
solutions- co-pay schemes/ deductibles individuals to pay partially for the services they get. Also reflecting the price with accurate information. The decision to smoke cigarettes or go paragliding looks different when it means increased premiums.
How can big banks be a moral hazard
With the idea that a corporation is too big to fail; management of the company believes they will receive financial assistance to keep it going from the government- more willing to take risks to get profit. Governments cover their losses with bail outs
What is the 5 forces framework reference
Michael Porter’s (1978) 5 forces
to explore key factors that effect profitability, what work do you need to cite and write about
Michael Porter’s (1978) 5 forces (forces that effect profitability
5 forces
-threat new entry
-threat of substitutes
-power of buyers
-power of suppliers
-competition
How does threat of new entry explain why the industry is not profitable
relatively low barriers to entry. New companies can lease planes and airports and don’t even have to buy them/ new entrants are increasingly using regional airports at lower prices which steal customers. This has a downward effect on prices in the market- means all airlines now make less profit
5 forces
-threat new entry
-threat of substitutes
-power of buyers
-power of suppliers
-competition
How does threat of substitutes explain why the industry is not profitable
definition- functionally equivalent to what you’re offering
Cars/buses/ boats etc. Not much of a threat because they are not as good for long haul, so might not reduce profitability. However things like the Eurostar could steal customers and mean airlines have to compete with the train company or Channel ferries
5 forces
-threat new entry
-threat of substitutes
-power of buyers
-power of suppliers
-competition
How does threat of buyers explain why the industry is not profitable
climate conscious buyers/ Demand can be easily affected by events such as terrorism, political instabilities and natural disaster. Buyers will not want to travel to these places
-reputation for bad service- Long lines due to security cramped seating, poor service - the list of airline travelers’ complaints is a lengthy one. The perception that air travel is an ordeal makes it very difficult for airlines to charge the higher prices
5 forces
-threat new entry
-threat of substitutes
-power of buyers
-power of suppliers
-competition
How does power of suppliers explain why the industry is not profitable
very few suppliers of planes (Boeing and airbus) and oil. volatile to changes in oil prices and it means airlines cannot get cheaper planes from anywhere else
5 forces
-threat new entry
-threat of substitutes
-power of buyers
-power of suppliers
-competition
How does competition explain why the industry is not profitable
The competitive rivalry in the industry is Intense and increasing because of the presence of too many competitors in routes. low cost airlines drive profitability down to higher cost airlines because they price compete. Intensive price competition on particular routes, when LC airlines they take a lot of market share off more established airways. Profitability of these routes started to fall because the cheaper airlines overtook them
How would advertising increase buyers likeliness to buy the product
A rational consumer could say. ‘The more a company spends on advertising the more expensive it will be, therefore, heavily advertised goods must offer the worst value’
However, most consumers do not think like this. They think, if the firm can afford to spend a lot on advertising it must be good. Therefore, they trust the good to offer a minimum standard of service.
What are some advantages and disadvantages of advertising
disadvantages-
1.Cost of advertising doesn’t improve the product but leads to higher prices for consumers
2.needs regulating to prevent firms from making false claims
advantages-
1.High barriers to entry (cola and Pepsi) difficult for new entrants
2. Consumers like buying goods where they feel they can rely on a minimum standard
3.generate more sales and enhance brand loyalty
What are the advantages and disadvantages of price discrimination (charging different prices for different people)
advantages:
-firms increased revenue (train companies who offer different prices for peak and off peak
-Lower prices for some
-Manages demand airlines use cheaper early morning flights to avoid over-crowding and helps to spread out demand
disadvantages:
-Higher prices for some
-Potentially unfair For example, adults paying full price could be unemployed, senior citizens can be very well off
-Decline in consumer surplus Price discrimination enables a transfers money from consumers to firms – contributing to increased inequality
In markets where the marginal cost of an extra sale is very low, the firm has an incentive to use price discrimination to sell all the tickets. What is an example of this happening in practice
Airline tickets very low just before their date. Once the company is due to fly the MC of an extra passenger will be very low. Therefore this justifies selling the remaining tickets at a low price.
For goods and services, demand peaks at particular times. Why should prices be higher during peak times
MC=high during peak periods because of capacity constraints. Prices should be higher during peak periods.
(D1 is peak period) The firm sets MC = MR for each period.
-It is also efficient; the sum of producer and consumer’s surplus is greater because prices are closer to MC
Question on HQ good vs LQ good. Two firms, Post and Kellogg have got a new cereal, which it would sell for $3 a box. Assume the MC of making cereal is zero, so the $3 is all profit. Each company knows that if it spends $10 million on advertising, it will get 1 million consumers to try its new cereal. And each company knows that if consumers like the cereal, they will buy it not once but many times. Post is lower quality than Kelloggs. What should each company do in regards to advertising.
Post-advertising would sell one box to each of I million consumers, but customers would not buy again. It is not worth paying $10 million in advertising to get only $3 million in sales. It does not bother to advertise. It sends its cooks back to the drawing board to find another recipe
Kellogs- Advertising is profitable here because Kellogg has a good product that consumers will buy repeatedly.
-the content of the advertisement is irrelevant. Kellogg signals the quality of its product by its willingness to spend money on advertising
What is the limiting profitability factor in the photographic film industry such as Kodak and Fuji
threat of substitues- digital photography/ coping with the substitute product becomes the number 1 strategic focus
threat of entry- why are entrants who are diversifying from other markets more threatening
new entrants always put pressure on price, but existing companies can leverage existing capabilities and cash flows to shake up competition (apple into music distribution, Pepsi into bottled water market)
Advice for incumbent companies when the threat of entry is high/ low entry barriers
threat of entry puts a cap on industry profit potential.
-incumbents must hold down prices or boost investment (modernising) to deter entrants
The coffee industry has low barriers to entry and therefore a high threat of entry. Starbucks in an incumbent firm; what is its best strategy to compete with new entrants
-invest aggressively into modernising stores and menus
-try and hold down prices
What is right about the profitability of an industry when the threat of entry is high
keeps profitability low; it is the threat of entry that holds down profitability wether the entry happens or not
What makes an industry have high barriers to entry/ policies a firm may introduce to create high barriers
-large companies have economies of scale/ can spread fixed costs over more units/ lower price per unit
-customer switching costs
-sunk costs
-expected retaliation from incumbent firms (will they seem likely to cut prices especially if high fixed costs to fill excess capacity)
Why does a supplier having multiple industries to supply to increase its ‘supplier power’
If it doesn’t depend heavily on 1 industry for revenue, it will charge max profitability in each one. However, If one industry accounts for a large portion of its supply, it will want to protect that industry through reasonable pricing
How will these factors increase a ‘suppliers power’
-no substitute for supplier
-supplier supplying to multiple industries
1)no substitues- Pilots union for example has lots of supplier power over airlines as there is no good alternative to a well trained pilot in a cockpit
2)multiple industries- If it doesn’t depend heavily on 1 industry for revenue, it will charge max profitability in each one. However, If one industry accounts for a large portion of its supply, it will want to protect that industry through reasonable pricing
What are Michael Porter’s (1978) 5 forces
How is ‘buyers power’ high if
-few switching costs
-The industries products are standardised or not differenciated
-low switching costs: no loyalty to one brand
-standardised products: if buyers believe they can find an equivalent product, they will play one vendor against another
define a substitute
a product/service that consumers see as essentially the same or similar-enough to another product
With high threat of substitutes, industry profitability suffers; It puts a ceiling on prices. How are the industries of long distance telephone wires and video rental outlets struggling
profitability suffers when the substitute has better relative value so cheaper and is better trade off
long distance wires-inexpensive internet based phone services such as Skype
video rental- cheaper and more convenient Netflix and prime/ video on demand services online
Under what conditions are firm likely to price compete
-products are nearly identical and there is low switching cost between them (airlines, supermarkets)
-the product is perishable: temptation to cut prices and sell product while it still has value (fruit or computers that go out of date)
Why would more distinguishing uni grade levels be a better thing (ranking in a 2.1 bracket)
creates market pooling where If so many students get an 2.1, it is difficult for employers to distinguish between HP and LP workers.
What is some advice for cinema ticket pricing
-price discrimination- discount on Monday and Tuesday/ pensioner specials on Monday afternoons/
-peak pricing (graph) MC=high during peak periods because of capacity constraints. Prices should be higher during peak periods.
(D1 is peak period) The firm sets MC = MR for each period. D2 price at off peak
-based on local competition: do not charge higher than what locals are charging as customers will go to the cheapest
You sell widgets and another store over the road sells the exact same ones. You want to figure out what price to sell your widgets at, what strategy explains this dilemma
prisoners dilema and collusion-
-you both end up charging very low prices. All of potential profit to be made from widgets has gone up in smoke
-you could collude or offer low prices and steal market share. Both stores have this choice, and will mostly always choose not to as they will always ‘cheat’
-Why take the chance and offer a high price in the unlikely senario that the other store will do the same and you will both make high profits. Both are more likely to go with the low prices
substitution effect and income effect of rising the price of diamonds
there will be little substitution effect because there are no alternatives to diamonds. However, a higher price of diamonds will lower demand because of the income effect
For a worker there is a choice in work and leisure. What is the income and substituion effect of raising wages
sub effect- work has a higher awards so workers will swap leisure time for working
income effect- workers have more income
Income and substitution effect for interest rates and saving
Higher interest rates increase income from saving. Therefore, this gives consumers more income to spend, and spending may rise (income effect)
Higher interest rates make saving more attractive than spending, reducing consumer spending (substitution effect)
Compare monopoly to perfect competition with a graph, and explain why a monopoly is not allocatively or productive efficient
productive efficient- produce bottom of AC curve, but monopoly doesn’t so there is excess capacity (low customer welfare as people are paying more for less product
allocative efficient- P=MC but on this graph price is above MC
Diagram relationship between monopoly AC and Demand curve to show how monopolies can make abnormal profit
abnormal profit between a and b, by AR>AC
Reasons against monopolies/ how are monopolies not allocative efficient or productive efficient
1.not allocative efficient (don’t produce at bottom of ATC curve)
2.can set market prices higher than in a competitive market- so costumers are losing out.
3.productive inefficiency- excess capacity exists/ do not produce at bottom of AC curves so firms could have produced more of the good and sold it in the market
What is a benefit to a monopoly
could reinvest abnormal profits into infrastructure/ into innovation
-innovation could widen consumer choice and aid economic growth
-innovation in new production processes could lead to lower average costs of production
How does collusion benefit the businesses colluding
price fixing can eliminate/reduce competition while also leading to even higher barriers to entry
What sanctions would you give businesses that have colluded
1.a fine that was bigger than the profits made otherwise that would just encourage them to collude again
2.governments strictly monitor the markets
3.whistleblower has low punishment
Where is the price set in perfect competition
P=MC
How can abnormal profit be competed away
-firms enter the market and cause a surplus and prices to go down.
-profit maximising when MC=MR (P1)
-normal profits when pricing at bottom of ATC
Plot TC, TVC and TFC on a graph of cost to run per day vs output
equation for MC
Describe the shape of all of these curves. Graph for company chaining labour on fixed capital
MC- initially decreases due to specialisation. Then DMR and increases because more and more workers needed to produce one unit of output
ATC = AVC +AFC
AVC- As output increases more and more labour is needed to produce 1 extra unit due to DMR
AFC- When output increases, the firm spreads its total fixed costs over a larger output, so its average fixed cost decreases
What are the columns for a table to show this graph
What is a marginal revenue graph (can also plot AP on this)
MR= increases due to increasing marginal return, then decreases due to DMR
What is the equation for PED
PED=2 is elastic, a 10% pay cut results in
20% increase in quantity demanded
Graph for total product vs labour
On the line = technologically efficient
Draw a long run average cost curve and label. Give reasons for IRS and DRS
internal IRS- result of firm/ managers/purchasing economies (bulk)/ financial economies (low interest loans)
external IRS- government railroads/ technology/ agglomeration/ more efficient labour
DRS- difficulty managing/ loss direction or communication/ asymmetric information
How does a diagram show a shortage and surplus of a good when the price of it changes
price 1= surplus. price is too high. customers want Q1 but suppliers have Q2
price 2= shortage. price too low. customers want Q2 but suppliers have Q1
Show a government price cap causing a shortage
demand exceeds supply
Why does AVC have a U shape
DMR
supply and demand graphs for perfect completion
conditions for perfect comp and examples of industries
- homogenous good/ perfect substitutes
- cannot price compete
- everyone is perfectly informed
4.free entry and exit
oat, wheat, milk
Use diagrams to show what price to set to get abnormal profit, and then normal profit in perfect competition
-abnormal profit/ maximising= P=MC
-normal profit at bottom of ATC
-anything below ATC is a loss but as long as making above AVC, then the firm should stay open
What does a monopoly MR curve look like
falls twice the rate
What does an oligopoly MR curve look like
What is monopolistic competition
everything same as perfect comp, except firms produce different products not the same
Why can oligopolies not price compete
Above P, will loose significant customers because other firms will not have followed suit
Below P- competitors match low price and so company will not gain significant amount of customers
Example for collusive outcome and Nash equilibrium for Pepsi and cola
Example for collusive outcome and Nash equilibrium for Pepsi and cola
What are some ways of collusion in practice usually in oligopolies
- price fixing- meeting and deciding on a set price to maximise profits
- all lowering prices to drive smaller competitors out
- price matching- “if you find a lower price for this product we will match it”- warning other firms not to lower price because both firms will loose out
- information via trade/ journals- colluding groups may have the opportunity to gain advantages through the sharing of private/preliminary information with one another. This financial collusion can allow the parties to enter and exit trades before the shared information is publicly available
What would be the HH index for this
0= perfect comp
5,000= duopoly
10,000= pure monopoly
This still suggests an oligopoly
Why is asymmetric information bad
end up with a market where only low quality goods are traded
leads to economic inefficiency/ in perfect comp all competitors have same information
There are two type of asymmetric information. What is adverse selection and what is moral hazard
adverse selection- one side of the transaction knows about themselves which the other side does not (buying a faulty car/ car insurance/ you are not going to say you are a bad driver/ degree courses how do you know which will give u best opp)
moral hazard- one side can take actions the other side cannot observe (insurance company cannot see the way you drive)
In the context of asymmetric information, How do higher quality goods signal their true worth in the product market/financial market/ labour market
high quality goods can give warranties (iPhone) because they know the return rate on their product is low. Low quality goods cannot because their product is bad and they will loose money
A levels is a signal of HP
pooling equilibrium
-A levels are supposed to signal HP to cause a separating equillbirum in worker’s wages (pay HP workers more).
-pooling equillbirum- employers cannot tell difference between HP and LP so end up paying the same
-A levels loose its value of signalling a HP
-difficult for uni administration to distinguish between HP/LP
adverse selection- One side of a transaction knows about herself, but the other side does not
-could cause a LP to go to uni which is inefficient for them
b
-raise entry requirements for jobs
-recruit only from top universities
-rigorous interviews
-offer short term contracts to assess productivity
-check GCSE grades
What are market segmentation strategies and what are the conditions to implement it successfully
Price Discrimination: imperfect comp
-Degree of Market Power/Downward Sloping Demand Curve
-Different Consumer Groups Willingness to pay (Different PeD)
-Markets must be separate (no opportunity for re-sale) ‘tie’ the product to consumer (e.g. student card
Product Differentiation:
-Market has different segments of consumers with different preferences over a product (preference segments)
-Firms can develop different versions of the product to cater for different consumer groups
-Ensure Revenues from differentiated products cover the costs of their development
What are the advantages of market segmentation
- increase revenue
2.reduce product space available for new competitors - establish degree market monopoly power
- enhance brand reputation
What are the different price discrimination (market segmentation)
1st price- estimating what the highest willing price to pay and charging that/ no customer surplus
2nd- bulk buying getting unlimited data for £20 and using lots of data is cheaper per GB than getting limited data and using less
3rd- identifying groups of consumers with different sensitivities to variations in price
separates consumers into different groups based on their relative price elasticity (buisness travellers less concerned with plane ticket than students)
What are some product differenciatons (market segmentation)
-market niche
-offer different versions of their product/service
-make product to be percieved as different as those in the market (Evian water)
-Short/Long tours (vertical product differentiation)
Personal tours (vertical product differentiation)
Theme tours; buildings/gardens/ghost tours (horizontal product differentiation)
What are some examples of 3rd price discrimination (charging different rates for different people)
-family tickets
-student or OAP tickets
-lower prices at off peak
How do firms differenciate their products?
-advertising (fixed cost so must balance this out with sales)
-patents/copyright make it difficult for rivals to imitate
diagram for 3rd degree price differenciaton/ selling the same product in different markets one at a lower price than the other (arbitrage- buying and selling in different markets)
Both sell where MR=MC (green line hits blue line)
sell a higher price in the inelastic market than the elastic one
combined profits= blue area
Diagram for if 3rd degree price differentiation fails
1.initially same as inelastic, At point when elasticity starts to set in the demand curve becomes elastic ( second pink line)
2.In the combined market the firm will charge P*
3. Also shows how more profits are made under discrimination (blue area is bigger than yellow)
Diagram for 2nd degree price differenciaton (bulk buying)
person 1 buys quantity 0-Q1 and pays P1, to person 3 who buys Q2-Q3 will pay P3
blue shaded areas are additional profits added to the yellow area which is profit under uniform pricing
What is overt and tacit collusion
overt-formal and explicit co-operation and agreements take place between rival firms
tacit-
Graph to show where companies set their price and quantity under uniform pricing
price where MC=MR
vertical vs horizontal product differenciation
horizontal- for things that serve basically the same purpose (eg textbooks and mortgages) (santander off different types of mortgages)
vertical- real physical differences/ can be between firms or within the same firm (e.g) BMW is better than anther car, seats can be better or worse in the same stadium
Why would the club need a relatively large group of ‘suzies’ in order to actually create a third package
potentially large fixed cost to introduce new packages (might need to build new seats our pay chefs) so revenue earned must outbalance new fixed costs
What are 4 main barriers of entry to a market
4 barriers of exit
What are ways to deter another firm from entry
joint cost rising- increases rivals costs to make their business unprofitable (also raises the cost of the firm doing it)
-dirty tricks-convincing customers rivals products are unsafe
-raising switching costs-introduce consumer reward schemes(clubcard)
-prodcut improvement- pharmaceutical companies lobby for tighter restrictions/standards
production probability frontier
Explain collusion
attempt to disrupt the market’s equilibrium. Companies which would typically compete against one another; conspire to work together to gain an unfair market advantage
Does price subsidising for the consumer by the government work? Does the government need to import more
-every measure that reduces the incentives for domestic savings means a higher need for imports. This then puts more pressure on the price Europe faces on the global market
for consumers who can now pay less- only a transfer (from the government to households), not a net loss to society
-demand will fall less than expected. Consumers gifted cheaper gas by their governments will be less inclined to turn down their thermostats or take shorter hot showers
-This means that Europe will have to import more than it would have done if consumers had been forced to pay higher energy prices
What is the circle of price caps
Any price subsidy will lead to higher import prices, but this means that the price paid by the consumer falls less than anticipated- The increase in import prices then induces policymakers to increase the subsidy. Any attempt to cap the domestic price could thus set in motion a chain of ever higher spot prices and higher subsidy rates to keep consumers’ costs down.
EU-wide subsidies could have such a strong impact on import prices that ultimately increase consumer prices anyway because the increase in the import price essentially overwhelms the subsidy. It becomes a vicious circle
What to do about the energy crisis instead of price caps
governments should subsidise gas savings, for example, by paying households for consuming less this winter than last winter
OR
-to offer households a price cap only for a limited basic amount per capita and charge the full market price for any quantities consumed above this level.
Why does is the UK more susceptible to price spikes in energy than other EU countries
relies more heavily on gas than its European neighbours because it has less nuclear and renewable energy
The UK also does not have as much capacity to store gas, forcing it to buy on short-term markets where there is greater volatility in prices
