Business Economics Flashcards
Allocative efficiency
when society produces an appropriate amount of a good relative to consumer preferences (i.e. the allocation of resources maximise) (P = MC)
Allocative efficiency on a graph
P = MC
Barometric price leadership
When one firm’s price decision (caused by changes in the macroeconomic environment or market conditions in the industry) results in all other firms in the industry changing their prices by the same amount
Barriers to entry
Factors which make it hard for a new firm to join a market
Barriers to exit
Factors which make it hard for a firm to leave a market
Cartel
A formula collusive agreement between firms to limit competition by fixing price or output
Collusion
Collective agreements between firms that restrict competition (e.g. set output quotas, fix prices, limit product promotion, agree not to poach each other’s markets)
Competitive tendering
When the public sector calls for private firms to bid for a contract for a provision of a good or service
Concentration ratio
Market domination by the top ‘n’ firms in an industry
Consumer surplus
Difference between what a consumer pays and what they would be prepared to pay
Contestable market
When an entrant has access to all production techniques available to the incumbents, there is no brand loyalty; low entry and exit barriers and low sunk costs
Contracting out
Where the public sector places activities in the hands of a private firm and pays for its provision
Cost plus pricing
Setting a price based on average cost plus a % markup
Covert collusion
Where firms meet secretly to make price, output and tender decisions
Diseconomies of scale
Increase in the long run average cost when the scale of output increases
Economic of scale
Reduction in long run average cost when the scale of output increases
External economic of scale
Reduction in long run average cost experienced by firms in an industry when the whole industry expands
Fixed costs
Costs which do not change when output changes
Game theory
A method of modelling the strategic interaction between firms in an oligopoly (analysis of situations in which players are interdependent)
Hit-and-run competition
when a firm enters an industry to take advantage of temporarily high profits and quits once the profits have been exhausted
Horizontal integration
when two firms in the same industry at the same stage of production combine
Imperfect competition
the collective name for monopolistic competition and oligopoly
Lateral integration
when two firms in different industries combine
Limited liability
restriction of an owner’s loss in a business to the amount they have invested in it
Limit (entry) pricing
setting price with the intention of discouraging the entry of new firms
Long run
time period in which all factor inputs may be varied
Marginal cost
change in total cost when output changes by one unit
Marginal cost pricing
setting price equal to marginal cost
Marginal revenue
change in total revenue when sales change by one unit
Merger
The fusion of two or more companies into one
Minimum efficient scale (MES)
Lowest output level at which long run average cost is minimised
Monopolistic competition
A market structure in which there is a large number of firms producing a slightly differentiated product
Monopoly
Sole supplier
Monopsony
Sole buyer
Natural monopoly
An industry in which scale economies can be gained at any realistic output level
Non-price warfare
Trying to gain sales by focusing on factors other than price
Normal profit (2 meaning)
1) The profit that the firm could make by using its resources in their next best use (opportunity cost)
2) The minimum level of profit to keep a firm in the industry in the long run
Oligopoly
A market dominated by a few firms
Duopoly
A market dominated by 2 firms
Organic/internal growth
Growth from within the firm by expanding its current market or finding new markets
External growth
Integration of two or more formally separate firms, e.g. through a takeover
Perfect competition
A market structure containing no market imperfections
First degree price discrimination (perfect)
When a monopolist charges each consumer the maximum they are prepared to pay (captures the entire consumer surplus)
Predatory pricing
When a firm sets its price below its average variable cost to drive out competition
Price capping
Regulation which adjusts the utility’s prices according to a price cap index
Price discrimination
Charging different prices to different consumers for the same good (appropriating some of the consumer surplus)
Price maker
Firm has power to set its own price (i.e. faces a downward sloping demand curve)
Price taker
where firms must accept the market price (i.e. face a horizontal demand curve)
Pricipal-agent problem
conflict between the owners and the agents acting on their behalf
Private Finance Initiative (PFI)
a way of finding public infrastructure projects with private capital
Privatisation
transfer of assets from public to private sector
Producer surplus
difference between the price received by a firm and the minimum price for which it would have been prepared to sell the good
Product differentiation
making a product different from the competition
Product proliferation
when one company introduces new brands in the same product lines trying to capture each and every market segment for that product line
Productive efficiency
Producing at lowest average cost (MC = AC)
Prodcutive efficiency on a graph
MC = AR
Profit maximisation
Output level yielding largest profits (MC = MR)
Profit maximisation on a graph
MC = MR
Public private partnership
An arrangement by which a government service or private business venture is funded and operated through a partnership of government and private sector
Regulatory capture
Where the regulator comes to identify with the interests of the firm it regulates, becoming its champion not its watchdog (regulator starts to serve the interests of the monopolists rather than limit their power)
Relevant market
A market to be investigated under competition law, meaning no major substituted are omitted
Sales maximisation
Highest output level without making a loss (AC = AR)
Sales maximisation on a graph
AC = AR
Satisficing
Non-maximising behaviour
Short tun
Time period in which at least one factor of production must be fixed
Sunk costs
Costs that cannot be recovered once a firm leaves an industry (e.g. advertising)
Surplus/supernormal/abnormal profit
Profit in excess of normal profit
Tacit collusion
Implicit cooperation (when firms collude without any formal agreement having been reached and where there is no explicit communication between firms and strategies)
Takeover
When one firm becomes the owner of another firm (external growth)
Variable costs
Costs which change with output
Vertical integration
When two firms combine in the same industry at different production stages
X-inefficiency
Managerial or operations slack resulting in average cost being high that it needs to be
Economic cost =
Money cost + imputed cost
Imputed cost
The opportunity cost of factors of production (i.e. what they could have generated elsewhere)
‘Peer to peer’ (P2P) lending
Individuals and organisation directly lend money to small businesses
How can the size of a firm be measured?
1) Sales turnover
2) Numbers employed
3) Market share
4) Stock market value
5) Value of its assets
What is the difference between a private and public limited company?
A private company’s shared cannot be sold without permission whereas a PLC’s shares are traded openly
Why are firms motivated to grow?
1) Exploit economies of scale
2) Gain a greater degree of market power
3) Risk management through product diversification
4) Expand into markets where there are major growth prospects
Why do small firms still exist?
1) Minimum efficient scale of production is low in many industries
2) Some specialist or niche markets exist that large companies don’t want to supply
3) Co-operatives allow small businesses to gain the advantages of bulk buying whilst retaining their independence
4) Large firms may allow smaller firms to exist to disguise their monopoly power
5) Many family owned businesses are not prepared to take the risk of expansion
What are the potential disadvantages of growth?
1) Diseconomies of scale
2) Customers payed less personal attention
3) A firm may have insufficient working capital to meet their increased financial commitments (Overtrading)
Forward-vertical integration
When a firm joins with another firm at the next stage of the production or distribution process
Backwards-vertical integration
When a firm joins with another firm at the previous stage of the production or distribution process
Conglomerate
A firm that owns a large number of diversified businesses
Lateral integration
When companies join together that produce similar but related products
Economies of scope
occur where it is cheaper to produce a range of products rather than specialize in a handful of products
Joint venture
When two or more firms enter into an agreement to combine resources for a specific business undertaking
How does the Herfindahl Index work?
Calculates market concentration by squaring the percentage market share of each firm in the market and summing these number
What numbers generated by the Herfindahl Index signify…
a) a pure monopoly
b) perfect competition
a) 10,000
b) 10 or less
What are the advantages of external growth for a firm?
1) Acquisition of market power
2) Economies of scale
3) Diversification
How does diversification provide firms with greater risk-bearing capabilities?
1) Lateral integration makes firms better able to withstand a slump in any one market
2) Horizontal integration can give firms more geographical and brand diversification
What are the advantages of vertical integration to a firm?
1) Cost savings are made through cutting out profit margins at intermediate stages of production
2) Can act as a barrier to entry making markets less contestable
Why is integration potentially damaging to an economy?
1) Confers a degree of monopoly power
2) Post merger rationalisation often leads to a direct loss of jobs
Why does integration sometimes receive government encouragement?
1) Domestic firms made need to be large to compete internationally
2) Sometimes in the public interest (e.g. Lloyds Bank takeover of HBOS)
Why do demergers take place?
1) Problems of diseconomies of scale - mainly managerial
2) Changes in the market conditions
3) Technical change
4) Pressure from shareholders
What dictates the shape of a firm’s SRAC curve?
1) The law of increasing/diminishing returns to a variable factor of production
2) Minimum point will be the maximum point on the average product curve (where MP = AP)
What is the difference between diminishing returns and economies of scale?
1) Diminishing returns is a relationship between input factors in the SR (when at least one is fixed)
2) Returns to scale is a concept which analyses what happens when all factor inputs rise
What dictates the shape of a firm’s LRAC curve?
Returns to scale (economies and diseconomies of scale)
Optimum factor combination
The best combination of fixed and variable factors in terms of output per variable factor (e.g. 1:3 signifies that maximum average return to variable factor occurs when there are 3 of them)
What is the minimum point on the marginal cost curve associated with?
The highest point on the marginal product curve
What is the minimum point on the average variable cost curve associated with?
The highest point on the average product curve
Which curves will a change in fixed costs shift?
1) The average cost curve
2) NOT the marginal cost or the average variable cost curves
Which curves will a change in fixed costs shift?
The average cost and marginal cost curves
What do all points on the LRAC curve for a firm show?
The least cost or minimum attainable average cost of production for any given output
What is the assumption in basic micro-economic theory of a firm?
Firms will always choose the least-cost method of production in the long-run (and hence move along the LRAC curve if this is possible)
What is happening if a firm is experiencing economies of scale?
It will be experiencing increasing returns to scale
What happens between the point when a firm experiences economies of scale and diseconomies of scale?
Constant returns to scale
Technical economies of scale
Increases in productivity arising from the process of production when the scale of a firm’s operations increases
Types of technical economies of scale
1) Specialisation
2) Indivisibilities
3) Linkage of processes
4) Economies of increased dimensions
Indivisibilities
1) Capital equipment with high productivity is usually expensive and cannot be scaled down below a certain level of production
2) At low levels of output these indivisible units of capital equipment would be under-utilised and the firm would be operating with excess capacity
3) It is only at high levels of output that a firm will be able to afford these large pieces of capital equipment
Law of increased dimensions
1) Increasing the height and width of a building (e.g. storage warehouse) leads to a more than proportionate in crease in the storage capacity of that building
2) Applies mainly to industries involved in distribution and transportation
Marketing economies of scale
A large firm can spread its advertising and marketing budget over a large output and it can purchase its inputs in bulk at negotiated discounted prices
Financial economies of scale
Large firms can obtain more favourable repayment terms and lower rates of interest on loans because…
1) They have a higher credit rating
2) They are considered lower risk as have an established reputation and more collateral security
Managerial economies of scale
1) A large firm can employ specialist managers and departments to deal with key functional areas
2) Expertise of specialist personnel can help to make the organisation run more efficiently at a higher level of productivity
Research economies of scale
Large firms have the resources to commit themselves to major research programmes in search of new products
Risk-bearing economies of scale
1) Some investments are very expensive and perhaps risky
2) Only a large firm will be able and willing to undertake the necessary investment
Why do diseconomies of scale occur?
Large firms can eventually become difficult to manage causing productivity to fall since…
1) ineffective flow of information between parts of the company resulting in slow and ineffective decision making
2) workers suffer from a disconnect with management
3) principal agent problem
External economies of concentration
When a number of firms making the same product locate close together…
1) the local labour force is geared up to the skill requirements of the industry (e.g. local colleges often run courses targeted at employment in industry)
2) specialist support firms are attracted to the area to provide parts or specialist services
3) local government may improve transport links in the area
External diseconomies of scale
the disadvantages that arise due to high levels of production as a result of an increase in the number of firms in an industry - particularly if concentrate in teh same geographical area
Why do external diseconomies of scale arise?
1) Local labour becomes scarce and firms have to offer higher wages to attract new workers
2) Land and factory space can become scarce and rents begin to rise
3) Local roads become congested and so transport costs rise
Economies of scope
Efficiencies associated with the range of products available from a firm
Compare the gradient of the MR curve with the AR curve
The MR curve is twice as steep as the AR curve
At which section of the TR curve is demand elastic?
When the gradient is positive (i.e. before peak)
At which section of the TR curve is demand inelastic?
When the gradient is negative (i.e. after peak)
At which point on the TR curve does demand have unitary elasticity?
When TR is maximised (i.e. at the peak)
At what point is TR maximised?
When MR crosses the x-axis
Why might firms not change their price rapidly in response to changes in market conditions?
1) Consumers may dislike price changes - if so in the LR profits might be enhanced by a maintenance of stable prices
2) So firms will only change prices if it becomes clear that the market conditions will persist in the LR
Managerial theories of the firm
Assume that managers control the company and managers may have their own agenda (e.g. enjoying an easy life)
Why would a firm persue revenue maximisation over profit maximisation?
likely to have a bigger share of the market
At what point on a graph is revenue maximised?
When MR crosses the x-axis
At what point on a graph are sales maximised (provided at least normal profits are made)?
AC = AR
Who proposed a behavioural theory of the firm and what does he say?
1) Herbert Simon argues that decision-making within a company is the result of interaction between many competing groups within the firm
2) Hence, ‘satisficing’ takes place as compromises deemed as satisfactory are made
3) This situation carries on until firm faces more difficult trading conditions and hence must reduce x-inefficiency
Who developed the contestable market approach and what does he say?
William Baumol says it does not matter whether an industry is highly concentrated as long as firms are free to enter and leave the market without making losses
What are the characteristics of perfect competition?
1) Many buyers and sellers
2) All firms and consumers enjoy perfect knowledge of market conditions
3) Homogenous products
4) No barriers to entry or exit
Are firms in perfect competition price-makers or takers?
Price-takers so any attempt to raise prices will lead to a complete substitution away from the firm’s product
What is the disadvantage of perfect competition?
1) There is no incentive for technological change as any idea or process introduced by one firm would be immediately available to all the other
2) Hence, there would be no way for the firm to recover its research costs
What profit do firms in perfect competition make in the LR?
Normal profit
On what condition will a firm continue to operate in the SR despite making losses?
If the price of the product is greater than the firms variable costs as this allows them to make a contribution towards their fixed costs
Shut down price
The minimum price a business needs to justify remaining in the market in the short run (i.e. MC = AVC)
What does perfect competition result in?
1) A productively and allocatively efficient market
2) X-efficient firms
When does a monopoly exist from a legal standpoint and why?
When a firm (or a cartel) enjoys a market share of over 25% - this is enough to confer substantial control over prices
What are the characteristics of a monopoly?
1) Only one firm
2) High enough barriers to entry to prohibit new entry in both SR and LR
3) Exit barriers
What kind of barriers to entry may exist for firms seeking to enter a market?
1) Capital costs and expertise
2) Economies of scale
3) Legal restrictions
4) Control of a scarce resource or input
5) Information asymmetry
6) Advertising
7) Brand proliferation
What types of legal restrictions exist that prevent firms from entering a market?
1) Patents
What does a patent do?
Give legal protection to inventions by firms or individuals meaning that the owner of the patent has the right to stop anyone from making or using the invention without the owner’s permission (essentially a right to stop competition for a limited period)
Structural barriers to entry
Not deliberately erected by existing firms
Behavioural barriers to entry
Erected by firms to deliberately prevent the entry of a new firm
Examples of structural barriers to entry
Start-up costs and economies of scale
Examples of behavioural barriers to entry
Limit pricing and refusal to allow access to a scarce raw material supply
‘Zombie’ firm
A firm that stays in an industry because they can cover their variable costs and make a contribution to fixed costs (carry on due to huge exit costs)
How can exit barriers serve as a barrier to entry?
Firms may not try to enter an industry in the first place if they know it is difficult to leave
What are the conditions required for price discrimination?
1) Different price-elasticities in sub-markets
2) The sub-markets can be kept separate
Second degree price discrimination
When the monopolist price discriminated according to the volume of purchase by a particular customer (popular amongst firms with spare capacity)
Third degree price discrimination
When the monopolist splits customers into two or more separate groups
How can price discrimination benefit consumers?
Certain consumers would not have bought the product unless they were offered a special low price
Why might it be worthwhile for a monopolist to advertise?
1) Helps maintain barriers to entry
2) Can increase demand for a good if brand image is improved
Benefits of a monopoly
1) Abnormal profits allow for investment and R&D
2) Cross subsidisation of markets may lead to an increased range of goods or services available to consumers
3) Need for economies of scale to compete with large overseas competitors in the global market
4) Access economies of scale
5) Avoids the problems of duplication and wasteful advertising
6) Some industries are natural monopolies
Disadvantages of a monopoly
1) Reduced consumer output compared to a perfectly competitive market
2) Abnormal profit can mean little incentive to be efficient or develop new products
3) Resources can be wasted by cross-subsidisation (facilitates predatory and limit pricing)
4) May engage in price discrimination
5) Allocatively and productively inefficient and likely to carry X-inefficiency
6) Potentially less variety and choice for consumers
Limit pricing
When a firm sets a low enough price to deter new entrants from coming into its market
Characteristics of monopolistic competition
Similar to perfect competition except that products are non-homogenous (i.e. there is product differentiation)
What demand curve does a firm in monopolistic competition face?
Downward sloping (but more elastic than in monopoly or oligopoly) - a rise in prices will not cause the firm to suffer a complete substitution away from its product due to brand loyalty
Examples of monopolistic competition
1) Hairdressers
2) Taxi firms
Profits in monopolistic competition
1) Supernormal profits can be made in the SR
2) Normal profits made in LR
What are the two theories about duopolies?
1) Cournot model states that the firms choose the quantity to produce and price their good accordingly (P>MC)
2) Bertrand model states that firms choose prices and produce at the corresponding quantity (P=MC)
Characteristics of an oligopoly
1) High market concentration
2) Firms are interdependent
3) Barriers to entry and exit
How is the Herfindahl Index calculated?
Squaring the market shares of all the firms (e.g. 20% market share = 0.2 x 0.2) and adding them together - closer the result is to 1 the closer the market is to a monopoly
Who proposed the theory of kinked demand?
Sweezy
What reasons have been proposed to explain the price rigidity seen in oligopolies?
1) Demand is kinked
2) Supply curves are more L-shaped than U-shaped
Kinked demand model of an oligopoly
Firms will not cut prices as it is unlikely to enjoy much of a boost in demand as competitors will follow suit, while any firm raising its price will suffer a great loss of business, as competitors are unlikely to follow suit
Problems with the kinked demand model of an oligopoly
1) There is no explanation of how the original price was arrived at
2) Model ignores non-price competition
3) Likely that there will be a much wider range of reactions by firms
Why would an L-shaped supply curve lead to greater price rigidity?
The AVC is horizontal for a significant band of output so cost-plus pricing strategy or profit-markup strategy will produce constant prices
Nash equilibrium
The position resulting from both players making their optimal decision, maximising their minimum pay-off (i.e. ‘maximin’)
Dominant strategy
The best strategy for a player in a game regardless of the strategy of other players
Prisoner’s dilemma
A game where, given that neither player knows the strategy of the other player, the optimum strategy for each player leads to a worse situation than if they had known the strategy of the other player and been able to co-operate and co-ordinate their strategies
Example of tacit/informal collusion
Price leadership
Overt/formal collusion
When firms make agreements amongst themselves to restrict competition
Example of overt/formal collusion
Cartels
Market conduct
The behaviour of firms
Marketing mix
A mixture of elements which form a coherent strategy designed to create demand for a product and profits for a firm (4 P’s - product, price, promotion and place)
Price agreement
A type of formal collusion where two or more firms arrange to fix prices of their product
Price follower
A firm which sets its price by reference to the prices set by the price leader in a market
Price war
A situation where several firms in a market repeatedly lower their prices and other firms in the market set their prices in relationship to the price leader
Under which conditions is collusion between firms more likely?
1) There are few firms in an industry
2) Firms have similar costs and methods of production
3) Products are homogeneous
4) Products have price inelastic demand
5) The laws against collusion in a country are weak and ineffective
What market share does a dominant firm have?
c.40%
Why do firms use dominant firm price leadership?
Offers all firms the advantage of certainty
1) Dominant firm is able to set the price
2) The remaining firms know that they will be able to supply as much as they wish at the price set
Dominant firm price leadership
Firms set the same price as an established price leader (i.e. the ‘dominant firm’ in the market)
Why do firms engage in barometric price leadership?
1) It is formally or informally agreed that all firms will follow (exactly or approximately) the changes of the price of a firm which can forecast better than the others the future developments in the market
2) The firm chosen as the leader is considered as a barometer, reflecting the changes in economic environment
Customer intertia
When customers fail to make the effort to switch to different suppliers despite the potential for lower prices or higher quality products
Problems with marginal cost pricing
1) MC pricing fails to take into account changes in demand which affect the MC
2) MC can be hard to identify in integrated systems of production
3) MC pricing may cause an industry with decreasing LR costs to encounter financial deficits
4) Achieves Pareto efficiency but may fail to include externalities in this
5) If marginal costs are rising sharply and demand is high a firm will make abnormal profits
What is a barometric firm?
A firm which from past behaviour has established the reputation of a good forecaster of economic changes
What are the three broad aims of non-price competition?
1) Expanding the total market
2) Expanding the individual firm’s share of the market
3) Fostering brand loyalty
What will a successful advertising campaign do?
1) Shift the demand curve to the right
2) Decrease the elasticity of demand
Blockaded entry
When a firm is protected by a legal monopoly (e.g. National Lottery)
‘Hit and run competition’
When a firm temporarily enters a market and then leaves when supernormal profits are exhausted
Technical efficiency
When any given output is produced with the minimum quantity of inputs (i.e. any point on the LR average cost curve)
What is the relationship between the PPF and allocative and productive efficiency?
1) All points on the frontier are productively efficient
2) Only one point is allocatively efficient
When does P=MC not secure the attainment of allocative efficiency?
When externalities are present
Distributive efficiency
When goods are distributed precisely to those consumers who need them most and in an equitable way
Dynamic efficiency
When resources are allocated efficiently over time (innovation and investment will reduce the LR average cost curve)
Static efficiency
When resources are allocated efficiently at a point in time
Pareto efficiency
When it is not possible to reallocate resources so as to improve the utility of one person without reducing the utility of another
Theory of second best
1) If price is higher than marginal cost in one industry it is not efficient for the price to equal marginal cost in all other industries
2) This would encourage over consumption of the cheaper goods priced at marginal cost
Who defends monopolies and how?
Schumpeter who argues that monopoly profits provide funds for research and development (Dynamic efficiency)
Monopsony
When there is a single buyer of a product or factor of production
Oligopsony
When there are a few large buyers of a product or factor of production
Countervailing power
The balancing of the power of one group by another group
What is the difference between invention and innovation?
1) Invention is about discovering a new product, or finding new ways of making products
2) Innovation involves bringing this new idea to the market (turning invention into a product that will deliver sales and profit)
Why are some inventions never developed commercially?
There is not a large enough market to make a profit from it (i.e. cannot be ‘scaled up’)
Process innovation
When a new production technique is applied to an existing product (leads to increases in productivity and lower costs per unit)
Production innovation
When firms create a new product or improve an existing product (leads to increased sales and profits)
Who introduced the term creative destruction?
Joseph Schumpter
Creative destruction
The incessant product and process innovation mechanism by which new production units replace outdated ones (new innovations replace old ones)
In the long run what does creative destruction account for?
Over 50% of productivity growth
What drives the process of creative destruction?
The copying of new innovations which causes profit margins to become low and hence creates an incentive to seek out new innovations
Are more contestable markets likely to invest in new technology more or less?
1) If there is a constant threat of entry new firms may spend more on investing in new technology in order to gain an advantage over potential entrants
2) BUT firms in a contestable market may only be making normal profits so have no resources to invest in new technology
3) High barriers to entry could encourage firms to invest in new technology since an increase in profits will not attract new entrants, which would dilute the benefits of new products and processes
4) Firms in non-contestable markets likely to be earning abnormal profits giving them resources to invest in new technology
What forms can privatisation take?
1) Sale of state owned shares in companies
2) Contracting out of services previously provided by the state, under the process of compulsory competitive tendering
3) Sale of individual state assets
4) Deregulation
Internal market
A system in which goods and services are sold by the provider to a range of purchasers within the same organisation, who compete to establish the price of the product
What are the aims of privatisation?
1) Improving efficiency (profit goal created drive to eliminate X-inefficiency)
2) Improving the quality and range of services (profit goal and ‘discipline of the market’ lead to this)
3) Lower prices (from competition)
4) Widening of share ownership (increase productivity of labour force through them becoming shareholders)
5) Revenue rising (one-off boost to government revenue and concomitant reduction in gov. borrowing)
6) The creation of companies who, disciplined by the market, would become strong enough to be world leaders, competing on an international scale (e.g. British Gas, National Grid and British Telecom)
What is the achievement of the goals of privatisation heavily dependent on?
Complementary measures to introduce competition (Ceteris Paribus the privatisation of a state monopoly creates a private monopoly)
What may inhibit competition from working in spite of firms best efforts?
Customer inertia
How do regulators stimulate the effects of competition?
Price caps and quality standards
How do regulators encourage competition?
Ease the entry of new products and prevent privatised firms erecting of maintaining barriers to entry
What are the types of regulation?
1) RPI-X
2) Licencing/Franchising
3) Rate of return regulation
40 Yardstick competition
RPI-X regulation
Permitted price increases are determined by the percentage rise in the retail price index (RPI) minus the reduction in price brought about by expected efficiency gains in an industry
Problems with RPI-X regulation
1) Difficult to set a figure for X
- If X is too high then the company will have insufficient funds to invest and the standard service will fall leading to dynamic inefficiency
- If X is too low excessive profits will be earned
2) Difficult to decide how long the X factor should be set for
- If too long then changes in market conditions cannot be taken into account
- If too short there is not enough time for companies to plan ahead with long term investments
RPI+Y regulation
Firms can increase their prices by inflation plus any additional costs that are out of the control of the firms in the sector (hence they are permitted to be passed on to consumers)
Licencing/franchising regulation
Granting licenses or franchises to firms and giving them significant monopoly power (normally for 7-10 years)
Rate of return regulation
Regulator sets what it thinks is a ‘normal’ rate of return on the capital employed in the business and the government taxes any profit above this ‘normal’ rate at 100%
Problems with rate of return regulation
1) No incentive for firms to be efficient beyond a certain level (higher investment and attempts to raise productivity are not incentivised)
2) Encourages firms to overvalue their assets
Yardstick competition
When the regulator uses the performance of the best performing firms in an industry to set price and customer service standards
When is yardstick competition often used
When the firms are regionally separate and there may be no direct competition
Problem with yardstick competition
Geographical, climatic and geological differences between regions make price comparisons subjective
