MANAGERIAL ECONOMICS - ASSINGMENT N0-2 - Dr. Aruna Shanthaarchchi

ANSWER ALL QUESTIONS - 15 MARKS - (20 marks for each)

Question 01

Case study 03

Oil production OPEC's oil shock32 OPEC has surprised the markets with an output cut of 900,000 barrels per day, to take effect at the beginning of November. Observers had expected the oil producers' cartel to hold its quotas steady because production in Iraq has been hit by sabotage. Before the regular meeting of the Organisation of Petroleum Exporting Countries (OPEC) in Vienna on Wednesday September 24th, most of the drama was provided by Hugo Chavez, the Venezuelan president, who opined that the Iraq representative should not have been at the get-together because he was an illegitimate stooge of American occupiers. If that is so, Ibrahim Bahr al-Uloum behaved very oddly. His bullish predictions that Iraq could produce at least 3.5m barrels per day (bpd) by 2005 seem to have been among the factors that persuaded the ten members of OPEC's quota system to approve a surprise production cut of 900,000 bpd, to 24.5m bpd. 116 DEMAND ANALYSIS The effect of the cut was to send oil prices sharply higher. Equities in America retreated on fears that a higher oil price could stymie the incipient economic recovery: the Dow Jones Industrial Average of 30 leading shares fell by 1.57% that day. In their official communique, OPEC's oil ministers pointed to their expectation of a 'contra-seasonal stock build-up' at the end of this year and the beginning of next year. Normally, oil stocks decline over the winter in the northern hemisphere, thanks to heavy use of heating oil. But this year, demand for oil, according to OPEC, will grow merely at its 'normal, seasonal' level, despite an improving world economy. OPEC expects supply to grow faster than demand, thanks to continued increases in production from Iraq and non-OPEC countries (of which Russia, the world's second-biggest oil exporter, is the most important). OPEC expects this supply-demand mismatch to translate into a stock increase of 600,000 bpd in the final quarter of this year. This contrasts with an estimated stock reduction of 500,000 bpd in the final quarter of 2001, and 1m bpd in the last quarter of 2002. Larry Goldstein, president of the Petroleum Industry Research Foundation, believes OPEC has got its sums wrong. In remarks to the Wall Street Journal, he said he thought stocks would be flat over the coming three months. Although the communique did not explicitly say so, OPEC members are keen to keep worldwide oil stocks below their ten-year average. That would give the cartel more power to determine the price. American oil stocks have been creeping up again after hitting 26-year lows earlier this year. America's energy secretary, Spencer Abraham, was clearly disappointed by OPEC's move, saying: 'Sustained global economic growth requires abundant supplies of energy. The US believes oil prices should be set by market forces in order to ensure adequate supplies.' America's opposition Democrats have been even more outspoken. Last month, they publicly rebuked Saudi Arabia, OPEC's (and

the world's) leading producer, for reducing exports in August, thus causing an unpopular rise in American petrol prices. Some observers are also speculating that OPEC may be sneakily trying to shift its price target above the current $22-28 range (per barrel, for a basket of Middle Eastern crudes, which tend to trade a couple of dollars below West Texas crude). After all, the oil price has been well within that range for the past few months. Why cut production when current supply levels are achieving their aim? In fact, the oil price has stayed higher than many expected: it was widely expected to fall well below $20 per barrel after the end of the Iraq war. However, unrest in Nigeria, a big producer, and the continuing attacks on Iraq's oil facilities put paid to that. OPEC's fears about non-OPEC production may be well-founded. After decades of communism, the industry in Russia is ramping up output: so far this year, it has been pumping an average of 800,000 bpd more than last year. Oil and gas are the country's biggest exports, earning hard currency that is seen as a key ingredient of economic revival. Moreover, the oil industry is in private hands, so even if the government in Moscow wanted to put a lid on production, it has less influence over its oil companies than OPEC governments have over theirs. The president of OPEC, Abdullah bin Hamad al-Attiyah, told the Wall Street Journal that the cartel would not cut production below 24m bpd unless big oil exporters outside OPEC, including Mexico and Norway as well as Russia, were prepared to cut production too. OPEC's stance on Iraq is very different. Here, the cartel seems to be taking an overly rosy view. Iraq says it is currently producing around 1.8m bpd, well below the 2.5m bpd that it was pumping before the country was invaded in the spring (and even that was well below its potential, owing to years of sanctions). Moreover, exports, which are a crucial source of revenue for reconstruction, are still running at only about 500,000 bpd, compared with 2m bpd before the war. These have been seriously disrupted, and continue to be threatened by sabotage. Currently, oil is being exported mainly through the north: the southern ports on the Gulf coast are operating far below capacity. For those who take OPEC's optimistic view of Iraqi production at face value, the cartel's move should not have come as a surprise. But the sharp reaction from oil markets and stockmarkets suggests it did. Many speculators had sold oil in the futures market, or 'shorted' it, expecting the price to fall in the short term - they clearly weren't expecting a big cut in output quotas any time soon. According to the Commodity Futures Trading Commission, the American regulator for commodity futures markets, the increase in short positions over September was equivalent to 470,000 barrels of oil. OPEC's decision led to a scramble to 'cover' such positions by buying oil. Whether prices Demand theory 117 Summary 1 The term 'demand' can be used in many contexts, as in demand schedules, curves, equations, functions and quantity demanded. It is important to distinguish between these different meanings. 2 Graphs and equations can be drawn and written with either price or quantity as the dependent variable. 3 Coefficients in demand equations can have either graphical or economic interpretations. 4 Marginal effects and elasticities are two different ways of describing the effect of a variable on quantity demanded. 5 Indifference curve analysis can be used to determine the inverse relationship

between price and quantity demanded. 6 Price changes have two simultaneous effects on quantity demanded: an income effect and a substitution effect. The size and direction of these will determine the PED. 7 Although the basic neoclassical analytical framework and assumptions have certain limitations, the model is very versatile and is capable of being extended to apply to more complex situations. 8 There are a large number of factors which affect demand in reality; it is useful to distinguish between controllable and uncontrollable factors. 9 The concept of elasticity is vital in understanding and analysing demand relationships. 10 Theoretical considerations relating to the sign and size of elasticities must always be tested empirically. Review questions 1 Explain the problems for government policy if it tries to use supply-oriented policies rather than demand-oriented ones in trying to discourage the consumption of certain products. stay higher will depend on two key factors. Will OPEC members stick to their new quotas? (They have a history of cheating.) And will Iraqi militants continue to destroy their own country's wells and pipelines?

Questions

1. OPEC currently produces about 38 per cent of the world output of oil. Assuming the short-term price elasticity of demand is 0:28, estimate the effect of the output cut on the current price, stating any assumptions in your calculations.

2. Describe the factors currently driving the world demand for oil; why has the price not fallen below the $20 level as many expected?

3. Explain the effect of other non-OPEC producers on the cartel's output decisions.

Question 02

Case study 2:

The Oresund bridge A not-so-popular Nordic bridge31 It was not quite what the planners had in mind when Sweden and Denmark opened their expensive bridge across the Oresund strait in July. After an early boost from summer tourism, car crossings have fallen sharply, while trains now connecting Copenhagen, the Danish capital, and Malmo, Sweden's third city, are struggling to run on time. Many people think the costs of using the bridge are simply too high. And, from the point of view of Scandinavian solidarity, the traffic is embarrassingly one-sided: far more Swedes are going to Denmark than vice versa. So last week the authorities decided to knock almost 50% off the price of a one-way crossing for the last three months of this year. The two governments, which paid nearly $2 billion for the 16km (10-mile) state-owned bridge-cumtunnel, reckoned that, above all, it would strengthen economic ties across the strait and create, within a few years, one of the fastest-growing and richest regions in Europe. But ministers on both sides of the water, especially in Sweden, have been getting edgy about the bridge's teething problems. Last month Leif Pagrotsky, Sweden's trade minister, called for a tariff review: the cost of driving over the bridge, at SKr255 ($26.40) each way, was too high to help integrate the region's two bits. Businessmen have been complaining too. Novo Nordisk, a Danish drug firm which moved

its Scandinavian marketing activities to Malmo to take advantage of 'the bridge effect', has been urging Danish staff to limit their trips to Malmo by working more from home. Ikea, a Swedish furniture chain with headquarters in Denmark, has banned its employees from using the bridge altogether when travelling on company business, and has told them to make their crossings - more cheaply if a lot more slowly - by ferry. The people managing the bridge consortium say they always expected a dip in car traffic from a Demand theory 115 summer peak of 20,000 vehicles a day. But they admit that the current daily flow of 6,000 vehicles or so must increase if the bridge is to pay its way in the long run. So they are about to launch a new advertising campaign. And they are still upbeat about the overall trend: commercial traffic is indeed going up. The trains have carried more than 1m passengers since the service began in July. Certainly, the bridge is having some effect. Many more Swedes are visiting the art galleries and cafe s of Copenhagen; more Danes are nipping northwards over the strait. Some 75% more people crossed the strait in the first two months after the bridge's opening than during the same period a year before. Other links are being forged too. Malmo's Sydsvenska Dagbladet and Copenhagen's Berlingske Tidende newspapers now produce a joint Oresund supplement every day, while cross-border ventures in health, education and information technology have begun to bear fruit. Joint cultural ventures are also under way. And how about linking eastern Denmark more directly with Germany's Baltic Sea coastline, enabling Danes to go by train from their capital to Berlin in, say, three hours? Despite the Danes' nej to the euro, it is still a fair bet that this last much-talked-about project will, within ten years or so, be undertaken.

Questions

1 Explain why the demand for the bridge is likely to be price-elastic.

2 If the Swedish government estimates that the price elasticity is -1.4, calculate the effect on traffic using the bridge, stating any assumptions.

3 Why is the calculation above not likely to give an accurate forecast for the long term?

Question 03

Case study 03

Microsoft - increasing or diminishing returns? In some industries, securing the adoption of an industry standard that is favourable to one's own product is an enormous advantage. It can involve marketing efforts that grow more productive the larger the product's market share. Microsoft's Windows is an excellent example.2 The more customers adopt Windows, the more applications are introduced by independent software developers, and the more applications that are introduced the greater the chance for further adoptions. With other products the market can quickly exhibit diminishing returns to promotional

expenditure, as it becomes saturated. However, with the adoption of new industry standards, or a new technology, increasing returns can persist.3 Microsoft is therefore willing to spend huge amounts on promotion and marketing to gain this advantage and dominate the industry. Many would claim that this is a restrictive practice, and that this has justified the recent anti-trust suit against the company. The competitive aspects of this situation will be examined in Chapter 12, but at this point there is another side to the situation regarding returns that should be considered. Microsoft introduced Office 2000, a program that includes Word, Excel, PowerPoint and Access, to general retail customers in December 1999. It represented a considerable advance over the previous package, Office 97, by allowing much more interaction with the Internet. It also allows easier collaborative work for firms using an intranet. Thus many larger firms have been willing to buy upgrades and pay the price of around $230. Production theory 191 However, there is limited scope for users to take advantage of these improvements. Office 97 was already so full of features that most customers could not begin to exhaust its possibilities. It has been estimated that with Word 97 even adventurous users were unlikely to use more than a quarter of all its capabilities. In this respect Microsoft is a victim of the law of diminishing returns.4 Smaller businesses and home users may not be too impressed with the further capabilities of Office 2000. Given the enormous costs of developing upgrades to the package, the question is where does Microsoft go from here. It is speculated that the next version, Office 2003, may incorporate a speech-recognition program, making keyboard and mouse redundant. At the moment such programs require a considerable investment in time and effort from the user to train the computer to interpret their commands accurately, as well as the considerable investment by the software producer in developing the package.

Questions

1 Is it possible for a firm to experience both increasing and diminishing returns at the same time?

2 What other firms, in other industries, might be in similar situations to Microsoft, and in what respects?

3 What is the nature of the fixed factor that is causing the law of diminishing returns in Microsoft's case?

4 Are there any ways in which Microsoft can reduce the undesirable effects of the law of diminishing returns?