Unit 4 January 2003 Answers

Section A

Question 1

(a) (i) Using the information provided define what is meant by vertical integration.

When firms at different stages of the production line merge, for example a tour operator merging with an airline, travel agent or hotelier.

(a) (ii) Explain one motive for a firm such as Airtours to become more vertically integrated.

Airtours may be motivated to pursue vertical integration to control the supply in their market, such as tickets for airlines. This will lead to an increase in profitability as the firm will then be able to overcharge its competitors for use of their services.

The firm will also lower the costs of production by reducing duplication and taking advantage of economies of scale, again leading to an increase in profits. The firm may also be able to increase its market share by offering lower prices to consumers and overcharging rivals for use of their services attracting more customers to the firm and so increasing profits.

(b) (i) State two features an economist would consider to classify the market structure of any industry.

Two from...

(b) (ii) Comment on the extent to which the tour operators' industry is an oligopoly.

Four large firms dominate the market with a four-firm market share of 74%. There are high barriers to entry in the form of brand loyalty and that the larger firms are able to take advantage of economies of scale.

There is lots of product differentiation and firms aim to attract customers through non-price competition. In the market there are also a large number of small firms supplying to niche markets.

However there have been price wars in the past where large firms have competed on price and there is good information in the market, neither of which are characteristics of an oligopoly.

To conclude the market is an oligopoly to a greater extent demonstrating many of the qualities of an oligopoly with only minor characteristics not typical of an oligopoly.

(c) Using examples from the article, explain two ways in which large tour operators prevent their industry from becoming more contestable.

A contestable market is a market with low/no barriers to entry and from which there is costless exit, there are no sunk costs associated with a perfectly contestable market.

Vertical integration can be used by large tour operators to control the supply to the market and overcharge rival firms for using this supply. In the package holiday market this may include a tour operator buying hotels or buying an airline as a form of backward integration and buying a travel agent to ensure their holidays are sold at travel agents. This makes the market less contestable as it increases smaller firms sunk costs.

Large firms can also take advantage of economies of scale to lower their costs of production and so offer consumers the same product at a lower price forcing smaller firms who are unable to lower their costs to the same level out of the market.

(d) Discuss the implications for consumer of this industry becoming increasingly dominated by a small number of large firms.

Large firms can benefit from economies of scale and so have lower average costs of production. The firm can choose to benefit consumer by lowering their price. Alternatively the firm may choose to invest the supernormal profits they make to fund research and development projects and so improve choice for the consumer.

Firms may have promotions such as children for free or at a reduced rate to gain a greater market share which will benefit the consumer in the short run as they get the same product for a lower price, however in the long run firms may be able to exploit the consumer from the dominant position they obtain.

However large firms can abuse their position by offering consumers less choice and less specialised holidays. There is the possibility that the larger firms may take over the smaller firms supplying to a niche market and the niche market may be supplied a generic product, which is not beneficial to the consumer.

Large firms can also use economies of scale as a barrier to entry so fewer firms will enter the market leading to a reduced consumer surplus, which is not beneficial to the consumer.

In order to avoid price competition with the few firms left in the industry there is a high possibility of collusion, possibly forming a cartel. This would allow the firms to set high prices for consumers and reduce the quality of holidays made available to consumers.

In reality an informal collusion is made in the holiday market with Airtours being the price leader (with 23% market share, according to the case study). In a market like this much non-price competition will lead to firms spending money on advertising to affect consumer tastes and preferences so the consumer may end up with a holiday they did not want.

Section B

No answers are available for questions 2, 3, or 4.

Tips

For questions in the style of part d, aim to comment on prices/price setting/quality of goods/variety of holidays. Talk about how dominance may be beneficial as firms invest their supernormal profits, obtained by taking advantage of economies of scale, into research and development. Also mention how dominance can be harmful to the consumer through exploitation in the form of a higher price and reduced consumer surplus.

Homework

June 2004, from section B of the paper, question 2, parts a and b. Whilst in the exam you can answer this question on any of the four markets studied for homework write your answer as applied to the air travel market. Re-read Anderton photocopies and Cramp photocopies as appropriate to help with this.

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