Economics in Action 1: real world decision-making

BT monopoly not in interests of a competitive telecoms market, the UK economy or users

By David McConnell

From Mr David McConnell. 

Sir, Ben Verwaayen, BT Group's chief executive, seems to be suggesting that the only way BT can make an adequate return is if it remains a near-monopoly provider (Letters, October 6). This may be an appealing idea to BT and its shareholders, but it most certainly is not in the interests of a competitive telecommunications market, the UK economy or consumers. 

A healthy UK telecoms market depends not on a single provider being profitable but on there being sufficient competition from a number of players, each with equal access to the monopoly's assets (assets owned not through investment and risk but paid for by taxpayers before BT was privatised 20 years ago). 

A healthy market that encourages innovation from a range of network and service providers will give consumers a wider choice of improved and keenly priced communication services. UK Competitive Telecommunications Association members believe that the best way to achieve a genuinely competitive market is by establishing a genuinely level playing field where all players have the same opportunities and play by the same set of rules. 

What is important is that a level playing field is achieved, an objective that even BT now seems willing to address. Successful implementation of equivalence will deliver the benefits of breaking up BT but without the potential attendant disruption. It will also, crucially, avoid perpetuating a market dominated by a single company. 

David McConnell, Chairman, UK Competitive Telecommunications Association, London WC1B 4HP. Copyright the Financial Times Limited 2008

Answer the following question using diagrammatic analysis, and illustrate aspects of your analysis with reference to the FT letter from David McConnell on BT (British Telecom). 

1.      Explain how the economic analysis of monopoly shows that firms can gain from a monopoly position?

2.      Explain how a comparative analysis of monopoly and perfect competition shows that consumers are likely to be worse off if competition in a market is reduced?

Economics in Action 2: real world decision-making

Apple Computer in the Mid 90s

Between 1991 and 1994, Apple Computer engaged in a holding action in the desktop market dominated by PCs using Intel chips and running Microsoft’s operating system.

In 1994, Apple’s flagship model, the Power Mac, sold roughly 10,000 units per month at an average price of $3,000 per unit. At the time, Apple claimed about a 9% market share of the desktop market (down from greater than 15% in the 1980s).

By the end of 1995, Apple had witnessed a dramatic shift in the competitive environment. In the preceding 18 months, Intel had cut the prices of its top-performing Pentium chip by some 40%. Consequently, Apple’s two largest competitors, Compaq and IBM, reduced average PC prices by 15%. Mail-order retailer Dell continued to gain market share via aggressive pricing. At the same time, Microsoft introduced Windows 95, finally offering the PC world the look and feel of the Mac interface. Many software developers began producing applications only for the Windows operating system or delaying development of Macintosh applications until months after Windows versions had been shipped. Overall, fewer users were switching from PCs to Macs.

Apple’s top managers grappled with the appropriate pricing response to these competitive events. Driven by the speedy new PowerPC chip, the Power Mac offered capabilities and a user-interface that compared favourably to those of PCs. Analysts expected that Apple could stay competitive by matching its rivals’ price cuts. However, John Sculley, Apple’s CEO, was adamant about retaining a 50% gross profit margin and maintaining premium prices. He was confident that Apple would remain strong in key market segments – the home PC market, the education market, and desktop publishing.

(Source: Based on J. Carlton, “Apple’s Choice: Preserve Profits or Cut Prices,” The Wall Street Journal, February 22, 1996, p. B1)

Answer the following Questions

1. What effect (if any) did the events of 1995 have on the demand curve for Power Macs?

Should Apple preserve its profit margins or instead cut prices?

2. a) In 1994, the marginal cost of producing the Power Mac was about $1,500 per unit, and a rough estimate of the monthly demand curve was:  P = 4,500 - .15Q. At the time, what was Apple's optimal output and pricing policy?

b) By the end of 1995, some analysts estimated that the Power Mac's user value (relative to rival PCs) had fallen by as much as $600 per unit. What does this mean for Apple's new demand curve at end-of-year 1995? How much would sales fall if Apple held to its 1994 price? Assuming a marginal cost reduction to $1,350 per unit, what output and price policy should Apple now adopt?

1. *The Coolidge Corporation is the only producer of a particular type of laser.

The demand curve for its product is

QD= 8,300 - 2.1P and its total cost function is TC = 2,200 + 480Q + 20Q2 where P is price (in dollars), TC is total cost (in dollars), and Q is monthly output.

a. Derive an expression for the firm's marginal revenue curve.

b. To maximize profit, how many lasers should the firm produce and sell per month?

c. If this number were produced and sold, what would be the firm's monthly profit?

2. *Suppose that an industry is characterized as follows:

C = 100 + 2q2 each firm's total cost function

P = 90 - 2Q industry demand curve

a. If there is only one firm in the industry, find the monopoly price, quantity, and level of profit.

b. Find the price, quantity, and level of profit if the industry is competitive.

c. Graphically illustrate the demand curve, marginal revenue curve, marginal cost curve, and average cost curve. Identify the difference between the profit level of the monopoly and the profit level of the competitive industry in two different ways. Verify that the two are numerically equivalent.

3. *Dayan's Doorstops, Inc. (DD) is a monopolist in the doorstop industry. Its cost is

C = 100 - 5Q + Q2, and demand is P = 55 - 2Q.

a. What price should DD set to maximize profit? What output does the firm Produce? How much profit and consumer surplus does DD generate?

b. What would output be if DD acted like a perfect competitor and set MC = P? What profit and consumer surplus would then be generated?

c. What is the deadweight loss from monopoly power in part (a)?

 4. *The Auto Company has a small plant that produces speedometers exclusively. Its annual fixed costs are $30,000, and its variable costs are $10 per unit. It can sell a speedometer for $25.

a. How many speedometers must the company sell to break even?

b. What is the break-even revenue?

c. The company sold 3,000 units last year. What was its profit?

d. Next year's fixed costs are expected to rise to $37,500. What will be the Break-even quantity?

e. If the company will sell the number of units obtained in part d and wants to maintain the same profit as last year, what will its new price have to be?