Economics for Business Assignment

Autumn 2011 (15%)

Wai Lam Au

Student Number: 11232915

COVER SHEET NEEDED

Wai Lam AU

Student Number: 11232915

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1) The ACCC chairman, Graeme Samuel, believes that the fuel market is characterised by a comfortable oligopoly. Consider the characteristics of different market structures and using information from the article, your knowledge of the industry and concepts from the lectures, briefly discuss whether you agree with Mr Samuels opinion and why. (3 marks)

Graeme Samuel states that the Australian fuel market can be viewed as a comfortable oligopoly. I agree with his opinion as the fuel market has characteristics which resonate with the traits of traditional oligopolies including barriers to entry and a small number of firms. The current fuel industry is a natural oligopoly since the few existing firms, including Caltex, Exxon Mobil, BHP Billiton and others, are able to satisfy market demand at the lowest possible price. This creates a natural barrier which prevents the ease of entry by other competitors. Graeme Samuel describes this as a comfortable oligopoly perhaps due to the strength of these barriers, the small likelihood of their corrosion and the resulting low-levels of competition. Moreover, the small number of competing firms and their proportionally large share of the market also resonate with the characteristics of an oligopoly. Within such a market structure, the interdependency of each companys actions affects the profits made by each firm. To reduce levels of interdependence and thus increase profit share, firms may legally or illegally form monopoly-like structures. Hence, in oligopolies, the temptation to cooperate or to collude through cartels arises. This cooperation is demonstrated in the article through the proposed acquisition of Exxon Mobil stations by Caltex. Thus interdependency and the temptation to collude results from the small number of competitors in oligopoly market structures. Both these elements of an oligopoly are reflected in the news article and support Graeme Samuels opinion of the fuel market as a comfortable oligopoly.

Wai Lam AU

Student Number: 11232915

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2) Briefly outline the role of the ACCC generally with regard trade practices law. What investigations has the ACCC undertaken in fuel markets? Interpret the ACCCs decision not to allow the Caltex takeover. What factors do you think were considered and why? (3 marks)

The Australian Competition and Consumer Commission (ACCC), in regards to trade practices law, is the agency responsible for overseeing national monopoly policy and protecting consumer and social interests. The role of ACCC works in conjunction with the Trade Practices Act 1974 which administers and regulates activities that restrict competition including price fixing, the misuse of market power, vertical restraints and mergers. The ACCC has conducted extensive analysis of competition in local retail fuel-markets concerning the number of competitors, pricing systems of fuel suppliers, traffic flow and other geographic features. The ACCC also analyses submissions from consumers, motoring groups and retail competitors in order to understand the nature of the Australian fuel market (ACCC 2009). In June 2007, the ACCC instigated an inquiry into the price of unleaded petrol (ACCC 2007) in which no obvious indication (Speedy 2009) of price fixing was evident. The ACCCs decision to oppose the Caltex takeover is based on the principles of the Trade Practices Act. Caltexs scheme to acquire 302 Mobil service stations had the potential to reduce competition in the oligopoly through increasing market share and thus forming a monopoly-like structure. Moreover, due to the merger, Caltex and Mobil would have the potential to raise and fix market fuel prices, which can be interpreted as a misuse of power. Most importantly, this potential pattern of action can threaten consumer interests in which the ACCC principle role is to protect.

Wai Lam AU

Student Number: 11232915

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3) Briefly outline the Prisoners Dilemma model of oligopoly. Within the context of this model explain what you think might have happened, and why, had Caltex been allowed to purchase the Mobil service stations. Use the idea of a Prisoners Dilemma with two petrol stations next to each other, one Mobil and one Caltex, and how they may have strategically interacted before and after the takeover. (5 marks) [200 words + diagram(s)]

The Prisoners Dilemma can be used to understand the price-fixing games and strategies in oligopolies. Within this dilemma involving two parties, there are four possible outcomes: both X and Y comply, X cheats and Y complies, Y cheats and X complies, or both cheat. In order to solve this dilemma, the Nash equilibrium must be found in which the each party takes the best possible action given the action of the opposite party. This model, and the respective pay-off matrix, can be applied to understand price-fixing in the fuel market and to predict the effects of Caltexs takeover. Exxon Mobils strategies Comply Cheat

$5m

$8m

Caltexs strategies

Comply

$5m

-$4m

-$4m Cheat

$0m

$8m

$0m Figure 1: The Pay-Off Matrix

The dominant strategy equilibrium, in which the best strategy of each party is the same regardless of the strategy of the other, is for both companies to cheat and make a zero economic profit. This would be the logical and safest strategy for each firm before the Caltex takeover. However, on a continual basis, firms would operate under a tit-for-tat strategy in which parties collude to generate profit but cheat if the other firm cheats in the previous period. This enacts a system of punishment in an otherwise cooperative equilibrium. However, if both firms were to collude in the price-fixing game, both would gain a profit of five million (refer to Figure 1). Through Caltexs takeover of Mobil stations, the ensuing cooperation between the merged firms would generate mutually higher profits. Hence, if the takeover was to take place, both firms will operate under a cooperative equilibrium in which they share the monopoly profit generated from continual compliance.

Wai Lam AU

Student Number: 11232915

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4) An issue which has led to complaints against fuel retailers is the fact that prices follow a weekly cycle. For example, prices are often higher on Saturdays and lower on Tuesdays. Suppose you are a petrol retailer and are presenting an argument to the ACCC that this is perfectly reasonable and does not reflect collusion. You have collected the demand information shown in the table below and can show you have a constant marginal cost of $0.90/litre. Show that a profit maximising firm would charge a higher price on Saturday than Tuesday. Illustrate with a diagram. Why might demand systematically differ across days of the week? (4 marks) [200 words + diagram(s)]

Figure 2: Marginal revenue on Saturday and Tuesday

In order to illustrate that the prices of petrol are higher on Tuesdays than Saturdays, we must derive the information needed to sketch the price vs. output graph. As a result, the above values of marginal revenue for Saturday and Tuesday were calculated (Figure 2). These values were plotted on the following figure to form the respective curves (Figure 3) : the marginal cost curve (constant value of $ 0.9/litre), the marginal revenue curve for both Saturday and Tuesday, and the firms demand curve.

Wai Lam AU

Student Number: 11232915

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Key:
Marginal revenue (Saturday): Marginal revenue (Tuesday): Demand curve for the firms output:

Figure 3: Marginal revenue curve for Saturday and Tuesday, marginal cost curve and demand curve For the petrol retailer to maximise profit, the output in which marginal cost equals to marginal revenue must be determined. On each day of the week, the quantity in which MC equals MR is produced, but retailed at the price that is determined by the respective red demand curve. Therefore, the price is set at PT on Tuesday and, similarly, Ps on Saturday. Referring to Figure 3, the price on Saturday(Ps) is greater than fuel price on Tuesday (PT) as required. Thus, it is due to the relationship between marginal revenue, marginal cost and demand that price of fuel differs over the week. This fluctuation of price is a reasonable and natural reflection of the changes in demand, and thus is not a result of price-fixing or collusion. The quantity of fuel demanded differs systematically across the week due to the fluctuations of petrol prices across week. This demonstrates and satisfies the Law of Demand which states that with all other factors remaining constant, only changes in price will affect the quantity demanded. Demand changes only when factors outside of price changes including variation of preferences, increased use of the car on weekends Wai Lam AU

Student Number: 11232915

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Reference List
Speedy, B. 2009, Julian Segal says Caltex to maintain strategy, as ACCC opposes Mobil bid, The Australian (Business), 2 December, viewed 2 May 2011 < http://www.theaustralian.com.au/business/industry-sectors/julian-segal-says-caltex-to-maintain-strategyas-accc-opposes-mobil-bid/story-e6frg9h6-1225806209943>

Australian Competition and Consumer Commission 2007, Inquiry into the price of unleaded petrol: Petrol inquiry issues paper 28 June 07, Australian Competition and Consumer Commission, viewed 4 May 2011, <http://www.accc.gov.au/content/index.phtml/itemId/790921>

Australian Competition and Consumer Commission 2009, ACCC to oppose the acquisition of Mobil retail assets by Caltex (Release # NR 296/09), Australian Competition and Consumer Commission, viewed
2 May 2011, <http://www.accc.gov.au/content/index.phtml/itemId/904296/fromItemId/855279>

Wai Lam AU

Student Number: 11232915

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3.3 0 3.0

Price (dollars per litre)

2.0 1.70

PS

PT
1.0 0.90

MC

Saturday demand
0.10 Tuesday demand

Quantity (thousands litres/day)

Saturday Price Marginal Revenue ($/Litre)

Tuesday Price Marginal Revenue ($/Litre)

3.30 2.50 1.70 0.90 0.10 -0.7 -1.5

1.70 1.30 0.90 0.50 0.10 - 0.30 -0.70

Wai Lam AU

Student Number: 11232915

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