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Question

what is game theory

Answer 1

This examines the behaviour of firms considering how decisions of other firms affect their own choices. For example, if a firm in oligopoly cuts price, the outcome will largely depend on how other firms react, e.g. do other firms also follow suit (starting price war), or do they keep prices high? There are no guarantees in oligopoly.

Answer 2

One way of looking at oligopoly is through the kinked demand curve model, though this makes various assumptions, which may not match reality. * This model assumes firms seek to maximise profits. * If a firm increases price, then they will lose a large share of the market, because they become uncompetitive compared to other firms, and therefore demand is elastic for price increases. * If firms cut prices, then they would gain a big increase in market share. However, it is unlikely that firms will allow this. Therefore, other firms follow suit and cut prices as well. Therefore, demand is inelastic for a price cut. * This suggests that increasing or decreasing prices will lead to lower revenue and therefore prices will be rigid in oligopoly.

Answer 3

* The aim of advertising is to increase brand loyalty. If firms are successful, then consumers will wish to buy the product, even at a higher price. This will make demand more inelastic, and therefore increase profits. * Successful advertising can also create a barrier to entry, because a new firm may be unable to compete with an advertising budget of an incumbent firm, e.g. Cola market.

Answer 4

However, when the market price is high, there is a temptation to cheat. If Tesco cuts prices, whist Sainsbury has high prices, Tesco would make even more profit (£13m) but Sainsbury would make less (£2m). • Once a firm cuts prices, it encourages the other to cut prices and we end up with low prices and low profit.

Answer 5

1. A small number of firms. 2. A dominant firm who is able to have influence in setting the price. 3. Barriers to entry; this is important to stop other firms entering to take advantage of the high profits. 4. Effective communication and monitoring of output and costs, and effective punishment strategies for firms who cheat. 5. No effective government legislation, e.g. collusion is illegal in the UK, making it more difficult.

Answer 6

• Allocative inefficiency, because in monopoly, P > MC. • Productive inefficient, because output is not at lowest point on AC curve. • X-inefficient, because a monopolist has fewer incentives to cut costs; therefore AC curve is higher than it could be. • Less choice for consumers. • Quality of product could be worse, because there are fewer incentives for a monopolist to develop new products • Monopsony power. A monopoly may also have monopsony power, in employing workers and buying products. This means the firm can pay workers lower wages, and supermarkets can pay farmers lower prices.

Answer 7

* 1st Degree price discrimination. This is where the firm charges the maximum price that a consumer is willing to pay. This is very difficult in practice. * 2nd Degree price discrimination. This is when consumers are charged different prices according to how much they consume. For example, units of electricity become cheaper after higher levels of consumption. * 3rd Degree price discrimination. This is when consumers are grouped into two or more independent markets. For example, train companies offer discounts for people over 65 and to people travelling off-peak.

Answer 8

1. The firm must be a price maker, i.e. able to set prices. Price discrimination can only occur in imperfect competition (oligopoly or monopoly). 2. The firm must be able to separate the market into different sections and prevent resale, e.g. it must be impossible for an adult to use a child’s ticket. 3. There must be a different elasticity of demand for the different market sections, e.g. train firms can charge high prices at peak times because, in this period, demand for train travel is inelastic. 4. The cost of separating markets must be less than extra revenue gained. 5. It usually requires low or constant marginal cost.

Answer 9

1. Firm will be able to increase revenue. This may enable some firms, who may have otherwise have made a loss to stay in business, e.g. train companies need price discrimination to offer off-peak travel. 2. Research & development. Increased revenue can be used for research and development, which leads to better products for consumers. 3. Cheaper prices. Some consumers, often on lower incomes, will benefit from lower fares, e.g. pensioners can take advantage of cheaper fares on trains. 1. Higher prices. Some consumers will face higher prices, leading to allocative inefficiency and a loss of consumer surplus. 2. Inequality. Often those who benefit from lower prices may not be the poorest. For example, some old people may be quite rich, but the unemployed will have to pay the full adult fare. 3. Administration costs involved in separating the markets and implementing different prices.

Answer 10

A perfectly contestable market has the following three features: 1. Absence of sunk costs 2. Perfect information 3. Freedom to advertise and a legal right to enter the market.

Answer 11

* If there are low entry and exit costs, then firms can engage in hit and run tactics. This means that if an industry is making supernormal profits, then a firm can enter and take advantage of high prices. * If prices fall and the industry is no longer profitable, then the firm will leave. * Therefore, in a contestable market, a firm should be satisfied with normal profits, otherwise it would encourage hit and run tactics from other firms.

Answer 12

1. Productive efficiency. Productive efficiency occurs when the economy is on the production possibility frontier (PPF). It will also occur at the lowest point on the firm’s SRAC curve. It means firms are producing this quantity for the minimum cost. 2. Allocative efficiency. This occurs when goods and services are distributed according to consumer preferences. This occurs at an output where P=MC because, at this value, what the marginal benefit consumers get is the same as the marginal cost. 3. X-efficiency. This occurs when firms’ actual costs are as low as potential. A firm exhibits x-inefficiency if it lacks incentives to cut costs and so its actual costs are higher than they could be. 4. Efficiencies of scale. This occurs when a firm produces on the lowest point of its long run average cost, and therefore benefits fully from economies of scale. 5. Dynamic efficiency. This refers to efficiency over time. For example, if firms introduce new technology, it enables them to reduce costs over time and their average cost curve will shift downwards. Dynamic efficiency is also influenced by investment in human capital and investment in capital and technology. 6. Static efficiency. This is concerned with efficiency at a particular point in time, and making the most of existing capital and technology. 7. Social efficiency. This includes all external costs and benefits. This occurs where social marginal cost = social marginal benefit.

Answer 13

* Wealth is a stock concept; it is the value of assets, such as savings, housing, and shares. * Income is the amount of money a person receives per time period, e.g. salary.

Answer 14

1. Inequality in wages and earnings growth. Workers with high levels of skills will be able to gain higher wages. However, those with few skills or qualifications will find themselves unemployed or in low paid jobs. Wage inequality can be affected by many things including: 2. Unemployment. High levels of structural and long-term unemployment are one of the biggest causes of poverty in the UK because the unemployed rely on government benefits, which are substantially less than wages. 3. Monopsony / monopoly. A powerful firm with monopsony power can pay low wages to workers and keep high profits for shareholders.

Answer 15

* Those with low income do not have any disposable income to save and increase wealth. * Those who are wealthy (e.g. own a house) can gain rentable income, which they can use to invest in the accumulation of more assets. * Wealth can be inherited, income cannot. * Taxes on income tend to be higher than taxes on wealth.

Answer 16

* Incentives play an important role in a free market. People need incentives to take risks and make the effort of setting up a business. Without the prospect of higher income, enterprise would be limited. Therefore a degree of inequality is needed in a free market economy. * Policies to reduce inequality may create disincentives to work, e.g. higher income tax may discourage working overtime. Benefits to the unemployed / low paid can discourage taking work (unemployment trap / poverty trap).

Answer 17

* Absolute poverty. This measures the number of people living below a certain income level which is necessary to be able to afford basic goods and services. * Relative poverty. This occurs when the income of a household is low compared to others; e.g. one definition of relative poverty is when a person has income below 50% of the national average. The Lorenz curve. This measures the degree of income inequality. The further the Lorenz curve is from the 45 degree line of perfect equality, the more inequality there is in society. Gini Coefficient This is a measure of inequality based on the Lorenz curve: • The Gini coefficient is area a / a+b. • The bigger area a is, the more inequality exists. • If Gini coefficient is 0 = perfect equality . • If Gini coefficient is 1.00 = perfect inequality.

Answer 18

Inequality in wages and earnings growth Unemployment Falling relative value of state benefit Regressive taxes

Answer 19

Progressive tax. Higher tax rates on high-income earners, e.g. top rate of income tax of 45%. HOWEVER may disincentive people to work Means-tested benefits. Welfare payments to those out of work or on low-incomes, e.g. unemployment benefits, housing benefits and tax credits – increase the income of the poorest in society. National Minimum Wage. Increasing wages of those in work and therefore helping to reduce wage inequality. Reduce unemployment. Supply side and demand side policies will help to reduce inequality caused by lack of work. Sustained economic growth. Increasing real GDP enables more wealth to ‘trickle down’ to low-income workers.

Answer 20

RATIONING EFFECT • If there is a shortage of the good, the price will tend to increase. • The higher price causes movement along the demand curve. Less is demanded at the higher price. This helps to ration the scarce demand. INCENTIVE EFFECT • If there was increased demand for a new good (like phone apps), this would push up the price. • This higher price makes the good more profitable. Therefore, it acts as an incentive for producers to increase production. SIGNALLING The price mechanism can provide a signal to firms and consumers. • If we see higher demand, prices will rise and this creates a signal to producers that there is high demand. • A high wage for certain types of work can signal to workers that firms need to fill these jobs.

Answer 21

Market failure occurs when there is an inefficient allocation of resources in a free market. • Complete market failure occurs when the market is missing, e.g. non- provision of public goods like justice and law and order. • Partial market failure occurs when there is a market for the good, but there is over or under consumption. For example, under-consumption of solar powered electricity which has positive externalities.

Answer 22

Externalities Information asymmetries Monopoly Immobilities Public goods Inequality

Answer 23

* Non-rivalry. When a good is consumed, it doesn’t reduce the amount available for others, e.g. street lighting. * Non- excludability. This occurs when it is not possible to provide a good without it being possible for others to enjoy, e.g. national defence. * Examples include law and order, national defense, and street lighting. Public goods suffer from the free-rider problem • The free rider problem means that people can enjoy the goods without paying for it. Therefore, there is no incentive for firms to provide goods because it is difficult to charge consumers for using it. • The consumer can enjoy it for free. • Public goods usually require the government to provide the good directly and pay for it out of general taxation. Exam tip: Be careful - not all goods provided by the public sector (government) are public goods. • For example, the NHS is provided by the public sector (government). But, it is not a public good, because resources are limited (waiting lists), so there is rivalry and excludability. If you see a doctor, no one else can. • The NHS would be considered a merit good. People may underestimate the benefits of getting vaccinations and a healthy workforce has positive externalities.

Answer 24

A private good is a good where the benefits accrue to the individual and others are prevented from consuming it. • The private good is rivalrous and excludable. If you eat an apple, no one else can eat it. If you walk under a street light, many other people can. That is why a street light is a public good.

Answer 25

A merit good occurs where people may underestimate or be unaware of the benefits of consuming a good. * For example, students may underestimate the benefits of studying and therefore leave school early. Or people may be reluctant to get a vaccination from diseases. * Merit goods often have a positive externality as well. * Merit goods are under-consumed in a free market.

Answer 26

A demerit good occurs where people under-estimate or ignore the costs of consuming a good. • For example, people may not be aware of the dangers of smoking. • Demerit goods often have negative externalities as well (e.g. passive smoking effect to others). • Demerit goods are over-consumed in a free market.

Answer 27

Geographical immobility occurs when it is difficult for labour and capital to move to different areas. For example, there may be unemployment in the north, and jobs available in the south, but workers may struggle to move because of: • Difficulty of getting housing the south, • Family ties to the north, and / or • Poor information about available jobs. Occupational immobilities occur when labour lacks the relevant skills for a particular job. • For example, an unemployed coal miner may struggle to get a job as computer technician due to lack of training. This leads to structural unemployment.

Answer 28

If demand is very inelastic, tax will only have a minimal effect in reducing demand. This may occur if there are no alternatives to the good, e.g. petrol, tobacco. High taxes may encourage tax evasion, e.g. cigarette tax encourages cigarettes to be smuggled on the black market. High specific taxes will be regressive. They take a higher percentage of income from the poor than high-income earners. It can be difficult to measure the external cost and how much tax should be increased.

Answer 29

Cost to the government. Subsidies will be expensive and will require higher taxes on other goods. If demand is inelastic, a subsidy will be ineffective in increasing demand. For example, a subsidy on train travel may be ineffective if it is a poor substitute to driving a car. A firm that receives a subsidy is more likely to be inefficient, as they become reliant on the government subsidy. Subsidies may keep inefficient firms in business. There may be government failure, e.g. the government has poor information about who to subsidise. Subsidies may be most effective if combined with other policies, e.g. tax on driving and using money to provide alternatives to driving into town, e.g. cheaper buses.

Answer 30

The problem of a maximum price is that if the price is set below the equilibrium, we get a shortage. • At Max Price, demand is greater than supply (Q3-Q1). This leads to waiting lists and encourages a black market. • The extent of the shortage depends on the elasticity of demand and supply. If supply is inelastic, there will be little reduction in availability. • Note: If the maximum price was placed above the equilibrium, it would have no effect.

Answer 31

• Difficult to know how many permits to give in the first instance. • It may be difficult to accurately measure pollution levels. There is an incentive for firms to hide pollution. • In most markets, it requires global co-operation to make it effective, otherwise the industry will move to countries with lower environmental legislation. Also, pollution is very much a global problem requiring global solutions. • High administration costs of measuring pollution and enforcing permits.

Answer 32

* Government advertising campaigns will cost money and require higher taxes. * There is no guarantee people will listen or take note of government campaigns. Young people may choose to ignore campaigns about the dangers of alcohol because they enjoy a sense of rebelliousness. * However, over time, people have become aware of the dangers of tobacco and long-term smoking rates have been falling.

Answer 33

Regulation is simple and can be effective in preventing damaging goods and services from being produced. However, sometimes no pollution is not the most efficient level of production in society. • It depends on the enforceability. For example, when the US prohibited alcohol, it was very hard to enforce. People kept drinking but organised crime became more powerful and more successful because illegal alcohol was in high demand.

Answer 34

1. Lack of incentives working for the government 2. Unintended consequences 3. Lack of information 4. Administration costs