AL Price System and the Microeconomy Flashcards
1
Q
The relationship of the law of diminishing marginal utility to derivation of an individual demand schedule
A
The demand curve is downward sloping showing the inverse relationship between price and quantity. The law of diminishing marginal utility states that as an extra unit of the good is consumed, the marginal utility falls therefore consumers are willing to pay less for the good
2
Q
The equi-marginal principle
A
This extends the law of diminishing marginal utility by explaining consumer behavior when distributing their income across different goods and services. Consumers allocate their incomes differently across goods and services in order to maximise their utility. Consumers allocate more income to the goods and services which derive greater utility
3
Q
Limitations of marginal utility theory
A
When making economic decisions, consumers aim to maximise their utility and firms aim to maximise profits
A consumers utility is the total satisfaction received from consuming a good or service
4
Q
The rational decision making model
A
Identify the problem
Find and identify the decision criteria
Weigh the criteria
Generate alternatives
Evaluate alternative options
Choose the best alternative
Carry out the decision
Evaluate the decision
5
Q
Limitations of the rational decision making model
A
This is not always the best or most realistic way for firms to make decisions. It might be fairer than making an intuitive decision but it takes significantly longer to decide which is not practical in a firm with strict time conditions
6
Q
The administrative man assumptions
A
The first alternative that is satisfactory is selected
The decision maker recognises that they perceive the world as simple
The decision maker recognises the need to be comfortable making decisions without considering every alternative
Decisions could be make by heuristics
7
Q
Heuristics
A
Simplify the decision making process to come to a reasonable decision. They are shortcuts to avoid taking too long to make the decision and they avoid the problem of having imperfect information or limited time
8
Q
Increases in price affecting the substitution and income effect
A
The good becomes more expensive than alternatives. This is the substitution effect and it assumes the same level of income. It measures how much a high price on a good causes the consumer to switch to substitutes.
Disposable income reduces which may lead to a fall in demand. This is the income effect.
These explain the downward sloping nature of the demand curve
9
Q
Fixed and variable factors of production
A
In the short run the scale of production is fixed (there is at least one fixed cost). In the long run the scale of production is flexible and can be changed. All costs are variable
10
Q
Marginal product
A
The marginal product of a factor is the extra output derived per extra unit of the factor employed. For labour it is the extra output per unit of labour employed
11
Q
Average product
A
The output per unit of income. This is output per worker over a period of time
12
Q
Total product
A
The total output produced by a number of units of factors over a period of time
13
Q
The law of diminishing returns
A
Diminishing returns only occur in the short run. The variable factor could be increased in the short run. Firms might employ more labour. Over time the labour will become less productive so the marginal return of the labour falls. An extra unit of labour adds less to the total output than the unit of labour before. Therefore total output still rises but it increases at a slower rate. This is linked to how productive labour is. The law assumes that firms have fixed factor resources in the short run and that the state of technology remains constant. The rise of out sourcing means that firms can cut their costs and their production can be flexible
14
Q
Average total costs
A
Total costs/quantity products
ATC = AVC +AFC
This is the cost per unit of output produced
15
Q
Average fixed costs
A
Total fixed costs/quantity
16
Q
Average variable costs
A
Total variable costs/quantity
17
Q
Marginal costs
A
How much it costs to produce one extra unit of output.
Change in TC/change in quantity
18
Q
Total costs
A
How much it costs of produce a given level of output. An increase in output results in an increase in total costs
TC = TVC +TFC
19
Q
Total fixed cost
A
In the short run at least one factor of production cannot change. This means there are some fixed costs. Fixed costs do not vary with output. They are indirect costs
20
Q
Total variable cost
A
In the long run all factor inputs can change. This means all costs are variable. Variable costs change with output. They are direct costs
21
Q
Short run average costs
A
In the short run there are some fixed costs. After a certain number of inputs are added the marginal increase of output becomes constant. Then when there is an even greater input the marginal increase in output starts to fall (fall in marginal output). This could be due to labour becoming less efficient and less productive. Total costs start to increase. Marginal costs rise with increase diminishing returns. MC, ATC and AVC rise with diminishing returns. AFC falls with increase output. The lowest points on the curve are the points where diminishing marginal productivity sets in. The MC curve cuts through the lowest points on the ATC and AVC curves
22
Q
Returns to scale
A
Refers to the change in output of a firm after an increase in factor inputs. Returns to scale increases when the output increases by a greater proportion to the increase in inputs. Decreasing returns to scale are linked to diseconomies of scale since it occurs when the firm becomes less productive. Constant returns to scale are when output increases by the same amount that input increases by
23
Q
Long run average cost
A
The point of lowest LRAC is the minimum efficient scale where the optimum level of output is since costs are lowest. If fixed costs are high average costs are lowered as output increases. AC increases with diseconomies of scale. This is on the LRAC curve since economies of scale are only applicable in the long run. Initially average costs fall since firms can take advantages of economies of scale so average costs are falling as output increases. After the optimum level of output there AC is lowest, they rise due to diseconomies of scale. The lowest LRAC is the minimum efficient scale where the optimum level of output is since costs are lowest and economies of scale have been fully utilised
24
Q
Internal economies of scale
A
Occur when a firm becomes larger. Average costs of production fall as output increases
Risk bearing
Financial
Managerial
Technological
Marketing
Purchasing
25
Network economies of scale
Gained from the expansion of ecommerce
26
External economies of scale
Occur within the industry
27
Diseconomies of scale
Occur when output passes a certain point and average costs start to increase per extra unit of output produced
Control
Coordination
Communication
28
The relationship between returns to scale and economies of diseconomies of scale
Returns to scale increases when the output increases by a greater proportion to the increase in inputs. This occurs where there are economies of scale and factor inputs become more productive. If more input leads to less output there are decreasing returns to scale which is linked to diseconomies of scale since it occurs when factor inputs become less productive
29
Total revenue
Price times quantity sold
This is the revenue received from the sale of a given level of output
30
Average revenue
The average receipt per unit
TR / quantity sold
31
Marginal revenue
The extra revenue earned from the sale of one extra unit. It is the difference between total revenue at different levels of output
32
Profit
The difference between total revenue and total costs
33
Characteristics of perfect competition
Many buyers and sellers
Seller are price takers
Free entry to and exit from the market
Prefect knowledge
Homogenous goods
Firms are short run profit maximisers
Factors of production are perfectly mobile
34
Competitive markets profit
Price is determined by the interaction of demand and supply. Profits are likely to be lower than a market with only a few large firms. This is because each firm in a competitive market has a very small market share. Therefore their market power is very small. If the firms make a profit new firms will enter to market due to low barriers to entry because the market seems profitable. The new firms will increase supply in the market which lowers the average price. This means that the existing firms profits will be competed away
35
Profit maximising equilibrium in the short run and long run
In the short run firms can make supernormal profits. In the long run where profits are competed away only normal profits are made. It is assumed that firms are short run profit maximisers. In the long run competitive pressure ensures equilibrium is established. The supernormal profits have been competed away so firms only make normal profits. Equilibrium at P = MC means firms produce at a new output in the long run
36
Advantages of a perfectly competitive market
In the long run there is a lower price. P = MC so there is allocative efficiently
Since firms produce at the bottom of the AC curve there is productive efficiency
The supernormal profits produced in the short run might increase dynamic efficiency through investment
37
Disadvantages of a perfectly competitive market
In the long run dynamic efficiency might be limited due to the lack of supernormal profits
Since firms are small there are few or no economies of scale
The assumptions of the model rarely apply in real life. In reality, branding, product differentiation, adverts and positive and negative externalities mean that competition is imperfect
38
Characteristics of monopolies
Profit maximisation. A monopolist earns supernormal profits in both the short run and the long run
Sole seller in a market (pure monopoly)
High barriers to entry
Price maker
Price discrimination
39
Factors influencing monopoly power
Barriers to entry
- Economies of scale
- Limit pricing
- Owning a resource
- Sunk costs
- Brand loyalty
- Set up costs
The number of competitors
Advertising
The degree of product differentiation
40
Profit maximising equilibrium
A monopolist earns supernormal profits in both the short run and the long run. This is where MC = MR. Since the firm is the sole supplier the firms cost and revenue curve is the same as the industries. Firms are price makers in a monopoly. P>MC due to profit maximisation which occurs at MC = MR so there is allocative inefficiency in a monopoly. AR .AC so there are supernormal profits
41
Disadvantages of monopoly
The basic model suggests that higher prices and profits an inefficiency may result in a misallocation of resources compared to the outcome in a competitive market
Monopolies could exploit the consumer by charging them higher prices. The good is under consumed so consumer needs and wants are not fully met. This loss of allocative efficiency is market failure
Monopolies have no incentive to become more efficient because they have few or no competitors so production costs are high
Loss of consumer surplus and a gain of producer surplus
Consumers do not get as much choice in a monopoly as they do in a competitive market
42
Advantages of monopoly
Can earn significant supernormal profits so might invest in R&D. This can yield positive externalities and make them more dynamically efficient in the long run leading to more invention and innovation
Firms will innovate if they can protect their ideas which is more likely where there are high barriers to entry
If there is a natural monopoly it might be more efficient for only one firm to produce since duplicating infrastructure might be wasteful
Monopolies could generate export revenue
Monopolies can exploit economies of scale so they have lower average costs of production
High profits could be a source of government revenue through taxation
43
Natural monopoly
An industry which is most efficient when only one firm produced the good or service rather than several
44
Characteristics of monopolistically competitive markets
Imperfect competition and short run profit maximisers
Firms sell non-homogenous products due to branding but there are a lot of relatively close substitutes (high XED)
Based on the assumption that there are a large number of small and independent buyers and sellers
Compete with non-price competition
No barriers to entry and exit
Firms can raise price without losing all customers due t come degree of pricing power
Imperfect information
45
Profit maximising equilibrium in the short run and long run
In the short run firms profit maximise at MC = MR. In the long run new firms enter since they are attracted by supernormal profits. This makes demand more price elastic which shifts AR to the left so only normal profits can be made. Firms can try and stay in the short run by differentiating their products and innovating
46
Advantages of monopolistically competitive markets
Firms are allocatively inefficient in the short and long run
Firms do not fully exploit their factors so there is excess capacity in the market. This makes firms productively inefficient in the short and long run
Consumers get a wide variety of choice
The model is more realistic than perfect competition
The supernormal profits produced in the short run might increase dynamic efficiency through investment
47
Disadvantages of monopolistically competitive markets
In the long run dynamic efficiency may be limited due to the lack of supernormal profits
Firms are not as efficient as those in a perfectly competitive market. Firms have x-inefficiency since they have little incentive to minimise their costs
48
Characteristics of an oligopoly
High barriers to entry and exit
High concentration ratio
Interdependence of firms
Product differentiation
49
Oligopoly as a market structure and a behaviour
Firms can either operate in a market which is oligopolistic or several firms can display oligopolistic behaviour. Firms which display oligopolistic behaviour might be interdependent, have stable prices, collude or have non-price competition
50
Calculation of concentration ratios and their significance
The combined market share of the top few firms in a market. The higher the concentration ratio, the less competitive the market since fewer firms are supplying the bulk of the market
51
Collusive oligopoly
Occurs if firms agree to work together such as setting a price or fixing the quantity of output they produce which minimises the competitive pressure they face. Leads to lower consumer surplus, higher prices and greater profits for the firms. Can allow oligopolists to act as a monopolist and maximise their joint profits. Firms in an oligopoly have a strong incentive to collude which deters new entrants and is anti-competitive. More likely with only a few firms with similar costs, high entry barriers, not easy to be caught and ineffective competition policies. There should be consumer inertia
52
Non-collusive behaviour
Occurs when the firms are competing. This establishes a competitive oligopoly. This is more likely to occur where there are several firms one firm has a significant cost advantage, products are homogenous and the market is saturated. Firms grow by taking market share from rivals
53
Overt collusion
When a formal agreement is made between firms. It works best when there are only a few dominant firms so one does not refuse. Often illegal
54
Tacit collusion
Occurs when there is no formal agreement but collusion is implied
55
The difference between cooperation and collusion
Cooperation is allowed in the market while collusion is not. Collusion is usually with poor intention whilst cooperation will be beneficial. Collusion generally refers to market variables such as quantity produced, price per unit and marketing expenditure. Cooperation might refer to how a firm is organised and how production is managed
56
The kinked demand curve model
Illustrates the feature of price stability in an oligopoly. It assumes other firms have an asymmetric reaction to a price change by another firm. It is an illustration of interdependence between firms. The first part shows a relatively price elastic demand curve. The second part shows a relatively inelastic demand curve. When firms deviate from the rigid, equilibrium price and quantity they enter the different demand elasticities
57
Cartels
A group of two or more firms which have agreed to control price, limit output or prevent the entrance of new firms into the market. Can lead to higher prices for consumers and restricted outputs. Some cartels might involve dividing the market up so firms agree not to compete in each others markets
58
Price leadership
Occurs when one firm changes their prices and other firms follow. This is usually the dominant firms in the market. Other firms are often forced into changing their prices too otherwise they risk losing their market share. This explains why there is price stability in an oligopoly. Other firms risk losing market share if they do not follow the price change. The price leader is often the one judge to have the best knowledge of prevailing market conditions
59
Price wars
A type of price competition which involves firms constantly cutting their prices below that of its competitors. Their competitors then lower their prices to match. Further price cuts by one firm will lead to more and more firms cutting their prices
60
Non-price competition
Aims to increase the loyalty to a bran which makes demand for a good more price inelastic. For some firms advertising will be ineffective which would make them incur large sunk costs. If firms can increase brand loyalty demand becomes more price inelastic
61
Barriers to entry
Firms might try to drive competitors out of the industry in order to increase their own market share. Barriers to entry are designed to prevent new firms entering the market profitability. This increases producer surplus
62
Game theory
Related to the concept of interdependence between firms in an oligopoly. It is used to predict the outcome of a decision made by one firm when it has incomplete information about the other firms
63
Prisoners Dilemma
A model based on the consequences of a choice being dependent on what the other chooses. It relates to the characteristic of uncertainty in an oligopoly. The dominant strategy is the best option regardless of what the other chooses. It is the most likely outcome. If collusion is allowed, both would deny and the outcome would be better for both
64
Nash equilibrium
Described the optimal strategy for all players whilst taking into account what opponents have chosen. They cannot improve their position given the choice of the other. Each also has an incentive to cheat making the Nash equilibrium unstable. It sums up the interdependence between firms when making decisions in an oligopoly
65
Disadvantages of oligopoly
Suggests that higher prices and profits and inefficiency may result in a misallocation of resources compared to the outcome in a competitive market
If firms collude there is a loss of consumer welfare since prices are raised and output is reduced
Collusion could reinforce monopoly power of existing firms making it hard for the entry of new firms. The absence of competition mans efficiency fall which increases average costs
66
Advantages of oligopoly
Can earn supernormal profits so might invest in R&D which can yield positive externalities and make the monopoly more dynamically efficient in the long run
Firms are more likely to innovate if they can protect their ideas which is more likely with high barriers to entry
Higher profits could be a source of government revenue
Industry standards could improve because firms can collaborate on technology and improve it.
Can exploit economies of scale so have lower average costs of production
67
Characteristics of contestable markets
Face actual and potential competition
Entrants to contestable markets have free access to production techniques and technology
No significant entry or exit barriers
Low consumer loyalty
Number of firms in the market varies
68
Implications of contestable markets for the behaviour of firms
Firms are more likely to be allocatively efficient. In the long run firms operate at lowest average costs making them productively efficient. The threat of new entrants affects firms and existing competitors. Due to low barriers firms are wary of new entrants taking supernormal profits then leaving the market. Highly contestable markets are like perfect competition. There could be supernormal profits in the short run and only normal profits in the long run but in practice firms can only earn normal profits in the short run because it is the only way to prevent potential competition
69
Predatory pricing
Involves firms setting low prices to drive out firms already in the industry. In the short run it leads to them making losses. As firms leave the remaining firms raise their prices slowly to regain their revenue. They price their goods and services below their average costs which reduces contestability
70
Limit pricing
Discourages the entry of other firms. It ensures the price of a good is below that which a new firm entering the market would be able to sustain. Potential firms are therefore unable to compete with existing firms
71
Types of barrier to entry and exit
Economies of scale
Legal barriers
Consumer loyalty and branding
Predatory pricing
Limit pricing
Anti-competitive practices
Vertical integration
bran proliferation
Cost of making workers redundant
72
Degree of contestability
All markets have the potential to be contestable but it depends on types of costs and consumer loyalty. No markets are perfectly contestable. It is hard to judge the degree of contestability since in reality there will be some costs to entry and exit
73
Sunk costs and contestability
A barrier to contestability. They are costs which cannot be recovered once they have been spent. A market with high sunk costs is less favourable to enter because the risks associated with entering the market are high. High sunk costs are likely to push a market towards a price and output that is similar to a monopoly
74
How can the size of firms be determined?
Economies of scale relative to market size
Diseconomies of scale
Small firms and monopolists
Profit motive
Market power
Diversification
Owners
75
Diversification
A type of organic growth which is also international growth. This is when firms grow by expanding their production through increasing output widening their customer base by developing a new product or by diversifying their range. Firms might use market penetration to sell more of their products to existing consumers. They might also invest in R&D, technology or production capacity. This will allow sales to increase and the volume of output to expand
76
Disadvantages of diversification
Long term strategy and slower than growing inorganically meaning competitors gain more market power by expanding in the meantime
Firms might rely on the strength of the market to grow which could limit how much and how fast they can grow
77
Advantages of diversification
Less risky then inorganic growth
Firms grow by building upon their strengths and using their own funds to fund growth. The firms is not building up debt and the growth is more sustainable
Existing shareholders retain their control over the firms which might reduce conflicts in objectives that are possible in a takeover
78
Vertical integration
Occurs when a firm merges with or takes over another firm in the same industry but a different stage of production
79
Forward vertical integration
Occurs when the firms integration with another firm closer to the consumer. Involves taking over a distributor
80
Backward vertical integration
Occurs when a firm integrates with a firm closer to the producer. This involves gaining control of suppliers
81
Advantages of vertical integration
Can increase efficiency through gaining economies of scale which could reduce average costs and result in lower prices for consumers
Firms can fain more control of the market. Backwards can mean that firms can control the price they pay for supplies and could raise the price for other firms giving them a cost advantage
Firms have more certainty over their production
82
Disadvantages of vertical integration
Disadvantages associated with diseconomies of scale
Can create barriers to entry which might discourage or limit the entrance of new firms leading to a less efficient market since the firm has little incentive to reduce average costs when market share is high
83
Horizontal integration
The merger of two firm in the same industry and the same stable of production
84
Advantages and disadvantages of horizontal integration
Firms can grow quickly which can give them a competitive edge but could lead to monopoly power and there is the potential of inefficiency
Could be disagreements in the objectives of the merging firms
Firms can increase output quickly so can take advantage of economies of scale
Will have expertise in the same industry so the merged firm can gain advantages
85
Conglomerate integration
The combining of two firms with no common connection
86
Advantages of conglomerate integration
Can help both firms become stronger in the market
Can reach out to a wider customer base and market competition could be reduce
Advantages of economies of scale and rise bearing
87
Disadvantages of conglomerate integration
Risk of spreading the product range too thinly and there might not be sufficient focus on each range. This might reduce quality and increase production costs
88
Size of the market constraint on business growth
A small market might only have limited opportunities for business expansion since firms can only access a limited consumer market and there might be limited opportunities for innovation and expansion. Larger markets have a much wider scope for innovation and firms can take advantage of large selling opportunities
89
Access to finance constraint on business growth
Smaller and newer firms tend to be less able to get access to finance than larger more established firms. This is because they are deemed riskier than established firms. Banks have become more risk aware since the financial crisis which has limited the number and size of loans on the market. Without sufficient access to credit firms cannot invest and grow and firms cannot innovate as much
90
Owner objectives constraint on business growth
Owners might have different objectives. Some owners might aim to maximise profits while others might see a bigger personal gain in the form of bonuses and reputation instead of growth
91
Regulation constraint on business growth
Can limit the quantity of output that a firm produces or discourage firms earning above a certain level of profit. This might limit the size that a firm choose or is able to grow to
92
Traditional profit maximising objective of a firm
Profit is an important objective which models assume is the main. Profit is the difference between TR and TC. Firms break even when TR=TC. A firms profit maximises when they are operating at the price and output which derives the greatest profit. Profit maximisation occurs when MC=MR. Profits increase when MR>MC. Profits decrease when MC>MR
93
Why firms choose to profit maximise
Provides greater wages and dividends for entrepreneurs
Retained profits are a cheap source of finance which saves paying high interest rates on loans
In the short run the interests of the owners or shareholders are most important since they aim to maximise their gain from the company
Some firms might profit maximise in the long run since consumers do not like rapid price changes in the short run so this will provide a stable price and output
94
Normal profit
The minimum reward required to keep entrepreneurs supplying their enterprise. It covers the opportunity cost of investing funds into the firm and not elsewhere. This is when TR=TC. Considered to be a cost so it is included in the costs of production
95
Supernormal profit
The profit above normal profit. This exceeds the value of opportunity cost of investing funds into the firms. This is when TR>TC
96
PED and total revenue
TR=PxQ
If a good has an inelastic demand the firm can raise its price and quantity sold will not fall significantly. This will increase total revenue. If a good has an elastic demand and the firm raises its price, quantity sold will fall. This will reduce total revenue
97
Survival objective of firms
Some firms especially new firms entering competitive markets might aim to simply survive in the market. This is a short term view. During periods of economic decline when consumer spending falls firms might have survival as their objective until there is economic growth again. Firms might aim to sell as much as possible to keep their market position even if it is at a loss in the short run
98
Growth objective of a firm
Some firms might aim to increase the size of their firm. This could be to take advantage of economies of scale. This would lower their average costs in the long run and make them more profitable. Firms might grow by expanding their product range of by merging or taking over existing firms. Large firms are also more able to participate in research and development which might make them more competitive and efficient in the long run
99
Increasing market share objective of a firm
This helps increase the change of surviving in the market and it can be achieved by maximising sales.
100
Quality objective of a firm
Firms might aim to increase their competitiveness by improving their quality. Firms might consider improving their customer service or the quality of the good they produce. This could be achieved through innovation. If firms can gain a reputation for high quality goods, they could charge higher prices since consumers might be willing to pay more for them
101
Maximising sales revenue objective of a firm
Revenue maximisation when MR=0. Each extra unit sold generate no extra revenue.
102
Sales maximisation objective of a firm
When the firm aims to sell as much of their goods and services as possible without making a loss. AC=AR.
103
Other objectives of firms
Society
Environmental
Ethical where there are philanthropic owners
Managerial for personal gains
Worker welfare
104
The satisficing principle
A firm is profit satisficing when it is earning just enough profits to keep its shareholders happy. Shareholders want profits since they earn dividends from them. Managers might not aim for high profits because their personal reward from them is small compared to shareholders. Therefore managers might choose to earn enough profits to keep shareholders happy while still meeting their other objectives. This occurs where there is a divorce of ownership and control
105
Principal agent problem
When the agent makes decisions for the principal but the agent is inclined to act in their own interests rather than those of the principal. When an owner of a firm sells shares they lose some of the control they had over a firm resulting in conflicting objectives between different stakeholders in the firm. When a manager sells their shares shareholders gain more control over the decisions of the firm putting pressure on the management or to try and get higher dividends
106
Price discrimination
Occurs in a monopoly when the monopolist decides to charge different groups of consumers different prices for the same good or service. Usually demand curves of different elasticities exist with each group of consumers which allows the market to split and different prices to be charged. It must not cost the monopolist much to split the market. A market with elastic demand will have a lower price
107
First degree price discrimination
When each consumer is charged a different price
108
Second degree price discrimination
When prices are different according to the volume purchased
109
Third degree price discrimination
When different groups of consumers are charged a different price for the same good or service
110
Costs to consumers of price discrimination
Results in a loss of consumer surplus. Since P>MC there is a loss of allocative efficiency
Strengthens the monopoly power of firms which could result in higher prices in the long run for consumers
111
Costs to producers of price discrimination
If used as a predatory pricing method the firm could face investigation
It might cost the firm to divide the market which limits the benefits they could gain
112
Benefits to consumers of price discrimination
Could benefit from a net welfare gain as a result of cross subsidisation if they receive a lower price
Some consumers who were previously excluded by high prices might now be able to benefit from the good or service which can yield positive externalities
113
Benefits to producers of price discrimination
Make better use of spare capacity
Higher supernormal profits could stimulate investment
If more profits are made in one market a different market which makes losses could be cross subsidised especially if it yields social benefits. This will limit or prevent job losses which might result from the closure of the loss making market
