Question

Hutchinson Whampoa, owner of Three, UK's fastest growing mobile network, has started exclusive talks to buy Telefónica's O2 for \(£ 10.25\) billion. This has caused price-rise concerns among British phone users. Source: The Financial Times, January 23,2015 a. If the prices of telecom services rise because of the deal, how will this influence the supply of telecom services? b. Given your answer to part (a), explain why Hutchison Whampoa can afford to raise mobile tariffs? c. What can you say about the price elasticity of demand for services in the UK telecoms market with respect to the deal between Hutchinson Whampoa and Telefónica?

Short answer

Part (a): Supply likely increases. Part (b): Less competition allows price increases. Part (c): Demand is likely inelastic.

Step-by-step solution

Understanding the Market Effect - Part (a)

If prices of telecom services rise due to the deal, suppliers might see it as an opportunity to increase their profits. Therefore, the supply of telecom services is likely to increase, as providers are incentivized to produce more when prices are higher.

Analyzing Hutchison Whampoa's Motivation - Part (b)

Given that the supply of telecom services is likely to increase, Hutchison Whampoa can afford to raise tariffs because fewer competitors in the market can lead to less price competition. With less competition, they can set higher prices without losing many customers.

Evaluating Price Elasticity of Demand - Part (c)

The ability of Hutchison Whampoa to raise prices and still retain customers suggests that the price elasticity of demand for telecom services in the UK is likely inelastic. This means that demand for telecom services does not significantly decrease when prices go up, likely due to the essential nature of the services.

Key concepts

Price Elasticity of Demand

The concept of price elasticity of demand explores how the quantity demanded of a good or service responds to changes in its price. In simpler terms, it measures how sensitive consumers are to price changes.
For instance, if a small price increase leads to a large decrease in the quantity demanded, the product is said to be price elastic. On the other hand, if the quantity demanded changes very little with a price rise, the product has inelastic demand.
In the context of Hutchinson Whampoa's acquisition of Telefónica’s O2, the demand for telecom services in the UK is found to be inelastic. This means that even if Hutchinson Whampoa raises the prices, customers will still continue to use their services.
This inelasticity is usually because telecom services are essential in daily life. People rely on mobile networks for communication, work, and access to information. Therefore, a price increase won't cause a significant drop in the number of users.
To summarize, the price elasticity of demand helps businesses like Hutchinson Whampoa understand that they can increase prices with minimal impact on their customer base, especially for essential services like telecom.

Supply and Demand

Supply and demand are fundamental concepts in economics. Supply refers to the quantity of a good or service that producers are willing and able to offer at different price levels, while demand is the quantity that consumers are willing and able to purchase at various prices.
In our exercise, if telecom service prices rise due to Hutchinson Whampoa’s buyout of O2, this likely means people are willing to pay more for these services. Providers see a chance to make more profit and thus will increase the supply of telecom services.
However, with increased supply and fewer competitors, the monopoly or reduced market competition allows Hutchinson Whampoa to control the market better. This means they can afford to raise their prices and still retain a considerable number of customers.
In essence, when supply increases due to higher prices, and competition decreases, companies can set higher prices without significant fear of losing customers. This dynamic is vital in understanding market behaviors and predicting how changes like mergers affect market equilibrium.

Market Competition

Market competition refers to the presence of multiple firms in a market that vie for the same group of consumers. Higher competition usually leads to better prices and services for consumers as companies strive to attract customers.
With Hutchinson Whampoa’s exclusive talks to purchase O2, a significant competitor is removed from the UK telecom market. This reduction in competition allows Hutchinson Whampoa to potentially dominate the market.
When competition is minimal, companies have more power to set prices, as consumers have fewer alternatives to switch to. This can lead to higher prices and potentially lower-quality service as the pressure to outperform competitors diminishes.
Therefore, market competition is crucial in ensuring that consumers have choices and fair prices. Mergers like the one in our exercise can lead to a less competitive market, giving larger companies like Hutchinson Whampoa an upper hand, but at the possible expense of consumers.