Economics 9708/41 — May/June 2019

Background Concept

Imperfect competition refers to market structures where firms have some degree of market power, meaning they can influence price. This contrasts with perfect competition where firms are price takers. Key features of imperfect competition include barriers to entry, product differentiation, imperfect information, and the ability to set prices above marginal cost. Loyalty cards can contribute to these features by locking in customers and making it costly or difficult to switch.

Understanding the Question

The question asks for evidence from the article that loyalty cards make markets imperfectly competitive. You need to identify specific statements or data in the text that illustrate how loyalty cards reduce competition. The article mentions barriers to switching, high costs, confusion, and higher prices – all of which are characteristics of imperfect competition.

Approach

Read the article carefully and pick out phrases that directly relate to the features of imperfect competition. Focus on: barriers to entry (high investment cost), barriers to switching (loyalty reduces switching), imperfect information (confusing discounts), and the ability to raise prices (costs funded through higher prices). Present each piece of evidence clearly, linking it to the economic concept.

Step-by-Step Reasoning

1. Barriers to switching: The article says loyalty cards "may act as a constraint on free competition and prevent switching between brands." This directly reduces the contestability of the market, a key feature of imperfect competition.
2. Higher prices: It states "the costs of the scheme might be funded through higher prices." In a competitive market, firms cannot raise prices without losing customers; the ability to pass on costs indicates market power.
3. Barriers to entry: The article notes the substantial investment required – US$60m a year for one supermarket. This high fixed cost deters new entrants, protecting existing firms' market power.
4. Imperfect information: The incentives and discounts are described as "confusing and make it more difficult for the consumer to compare prices." Imperfect information reduces the effectiveness of price competition, another hallmark of imperfect competition.

Each of these points is directly from the text and illustrates a different aspect of imperfect competition.

Key Takeaways

• Always link evidence from the text to economic concepts.
• For questions asking for evidence, quote or paraphrase specific parts of the article.
• Understand the characteristics of imperfect competition: barriers to entry/exit, product differentiation, imperfect information, and price-setting ability.

Common Mistakes

• Simply listing features of imperfect competition without linking to the article.
• Misinterpreting the article: e.g., saying loyalty cards make markets more competitive because they offer discounts.
• Not providing enough specific evidence from the text.

Things to Be Careful About

• Ensure you are answering the question: it asks for evidence that loyalty cards make markets imperfectly competitive, not just evidence of imperfect competition in general.
• Use the article's own figures and phrases where possible (e.g., US$60m, "constraint on free competition").

Background Concept

Price elasticity of demand (PED) measures the responsiveness of quantity demanded to a change in price. It is calculated as % change in quantity demanded / % change in price. When demand is inelastic (PED < 1), a price increase leads to a smaller percentage fall in quantity, so total revenue rises. Utility theory explains consumer choice: consumers allocate spending to maximise total utility. Loyalty can be seen as an additional source of utility from a particular brand, making consumers less willing to switch when price changes.

Understanding the Question

The question asks you to analyse why a profit-maximising retailer would care about the link between utility, loyalty, and PED. The key is to recognise that loyalty makes demand less elastic, which gives the firm pricing power. You need to explain the chain: loyalty -> lower PED -> ability to raise price -> higher profit.

Approach

Start by defining PED and its relevance to revenue. Then explain how loyalty affects consumer utility and thus demand elasticity. Finally, link to profit maximisation: with lower PED, the firm can increase price and increase total revenue, and if costs are controlled, profit rises. Use the article's context of supermarkets and loyalty cards.

Step-by-Step Reasoning

1. Utility and loyalty: Loyalty cards provide discounts and rewards, which increase the utility consumers get from shopping at that retailer. This creates a psychological attachment, making consumers less likely to switch for a small price difference.
2. Effect on PED: Because loyal consumers are less responsive to price changes, the demand for the retailer's products becomes more inelastic. The article implies this by saying loyalty cards "prevent switching between brands."
3. Profit maximisation: A profit-maximising firm sets output where marginal revenue equals marginal cost. With inelastic demand, the firm can raise price above marginal cost and increase total revenue. If the loyalty scheme's costs are fixed or do not rise proportionally, profit increases.
4. Example: If a supermarket raises prices by 5% and loyal customers only reduce purchases by 2%, PED = -0.4 (inelastic). Total revenue rises. The supermarket can use the extra revenue to cover the cost of the loyalty scheme and still earn higher profit.

Key Takeaways

• Loyalty reduces price elasticity of demand.
• Firms with market power can raise prices to increase profit when demand is inelastic.
• Utility theory helps explain why loyalty affects demand elasticity.

Common Mistakes

• Forgetting to define PED or explain the relationship between PED and revenue.
• Not linking utility to loyalty explicitly.
• Assuming that lower PED always leads to higher profit without considering costs.

Things to Be Careful About

• The question says "analyse", so you need a developed chain of reasoning, not just a statement.
• Use the article's context: supermarkets, loyalty cards, discounts.
• Remember that profit maximisation requires considering both revenue and costs.

Background Concept

Effectiveness of loyalty cards can be measured by their ability to increase customer retention, sales, and profits. From an economic perspective, they aim to reduce price elasticity of demand and create barriers to switching. However, consumer behaviour is influenced by many factors beyond price, such as convenience, service, and habit. The article provides data on the relative importance of these factors.

Understanding the Question

The question asks you to consider whether there is conflicting evidence in the article about the effectiveness of loyalty cards that offer price discounts. You need to identify statements that support the idea that they are effective and statements that suggest they are not, and then reach a conclusion about the conflict.

Approach

First, find evidence that loyalty cards are effective: the article says retailers use them to attract customers with promotions, and they gather data to target offers. Then find evidence against: price is not the most important factor, most consumers are not loyal to one card, and habit/low involvement reduce loyalty. Present both sides and then conclude that there is indeed a conflict.

Step-by-Step Reasoning

1. Evidence for effectiveness:

   • "Retailers recognise that price has an importance in consumers’ choice. Many supermarkets use loyalty cards to attract customers with promotions and price reductions." This suggests that price discounts can attract customers.
   • "Companies who have invested in card schemes use them as a means to gather data on customers... can direct future offers to their wants." This implies that targeted promotions can be effective.

2. Evidence against effectiveness:

   • The article provides a table of factors influencing choice: one-stop shopping (43%), good service (22%), price (18%), coffee shop (12%), help with packing (6%). Loyalty cards are not even listed, suggesting they are less important than these factors.
   • "Only about 10% are loyal to one particular card." This indicates that most consumers are not strongly attached to a single card.
   • "When the consumer has a low involvement in research or a low emotional attachment to the product, there will be little loyalty." This suggests that for many purchases, loyalty is weak.

3. Conclusion: The evidence is conflicting. On one hand, cards can be a tool for targeted discounts and data collection. On the other hand, price is not the primary driver of choice, and most consumers are not deeply loyal. Therefore, the effectiveness of loyalty cards is limited and context-dependent.

Key Takeaways

• When asked to consider conflicting evidence, present both sides clearly.
• Use specific data and quotes from the article to support each side.
• A conclusion should resolve the conflict, even if it is that the evidence is mixed.

Common Mistakes

• Only presenting one side of the evidence.
• Not using the article's data (e.g., percentages) to support arguments.
• Failing to reach a conclusion or giving a vague conclusion.

Things to Be Careful About

• The question says "consider whether there is conflicting evidence", so you must explicitly state that there is a conflict.
• Use the article's own figures and phrases to strengthen your answer.
• The conclusion should be justified by the evidence presented.

Background Concept

Indifference curve theory is a model of consumer choice that assumes consumers have preferences over bundles of goods. An indifference curve shows all combinations of two goods that give the consumer the same level of satisfaction (utility). The consumer's objective is to reach the highest possible indifference curve given their budget constraint. The theory relies on several assumptions about rationality: preferences are complete (the consumer can compare any two bundles), transitive (if A is preferred to B and B to C, then A is preferred to C), and non-satiated (more is preferred to less). The consumer is assumed to have perfect information and the ability to calculate the optimal choice.

Understanding the Question

The question asks you to discuss how the idea of rationality is used in indifference curve theory. You need to explain the role of rationality in the model, i.e., the assumptions about consumer behaviour that make the model work. Then you should discuss the limitations of these assumptions, using the article's points about habit and low involvement.

Approach

Start by explaining the key rationality assumptions in indifference curve theory: complete and transitive preferences, utility maximisation, and the ability to compare marginal rates of substitution with prices. Then discuss how these assumptions are used to derive the demand curve and predict consumer behaviour. Finally, evaluate the realism of these assumptions, referencing the article's evidence that many purchases are based on habit and low involvement, which contradicts rational choice.

Step-by-Step Reasoning

1. Rationality assumptions in indifference curve theory:

   • Consumers have complete preferences: they can rank any two bundles.
   • Preferences are transitive: consistent ordering.
   • Consumers are utility maximisers: they choose the bundle on the highest indifference curve affordable given their budget.
   • They have perfect information about prices and their own preferences.
   • They make decisions by equating the marginal rate of substitution (MRS) to the price ratio.

2. How rationality is used:

   • The shape of indifference curves (convex to origin) reflects diminishing marginal rate of substitution, which is a rational response to scarcity.
   • The budget line represents the constraint, and the consumer rationally chooses the tangency point where MRS = price ratio.
   • This rational choice framework allows economists to derive demand curves and predict responses to price changes.

3. Limitations and real-world behaviour:

   • The article states: "many purchases are based on habit and consumer research is imprecise." This contradicts the assumption of rational, well-informed decision-making.
   • "When the consumer has a low involvement in research or a low emotional attachment to the product, there will be little loyalty." This suggests that consumers do not always engage in the careful calculation assumed by the theory.
   • Behavioural economics shows that consumers often use heuristics, are influenced by framing, and exhibit biases.

4. Conclusion: Rationality is central to indifference curve theory, but its assumptions are often violated in practice. The theory provides a useful benchmark but must be applied with caution, especially when analysing real-world consumer behaviour like loyalty card usage.

Key Takeaways

• Indifference curve theory assumes rational, utility-maximising consumers with consistent preferences.
• The model uses rationality to derive demand curves and predict choices.
• Real-world behaviour often deviates from rationality due to habit, limited information, and emotional factors.

Common Mistakes

• Describing indifference curves without linking to rationality.
• Forgetting to discuss limitations or only describing the theory.
• Not using the article's evidence to support the discussion of limitations.

Things to Be Careful About

• The question says "discuss", so you need both explanation and evaluation.
• Ensure you explicitly state how rationality is used in the theory (e.g., to derive the optimal choice).
• Use the article's points about habit and low involvement to critique the rationality assumption.