Economics Flashcards
Microeconomics
economy
-consumers decide if buying
-firms decide prices
-allocate scarce resources efficiently
Macroeconomics
GDP
unemployment
inflation
6 main principles of economics (micro)
- Trade offs
- Rationality (perfectly inform, rank happiness/profit)
- Opportunity costs
- Incentives
- Trade = better off = specialisation = scarcity
- Allocate resources (scarce)
Rational maximisers
using info efficiently - generate behaviour determined
-efficient in production and consumption
-people act independently on basis of full info
transitive preferences (more is preferred to less)
utility
consumer satisfaction/happiness
useful to obtain predictions on behaviour
Neo-classical economics
assume believe in human rationality
-unbounded rationality - rationality = no bounds
3 choices regarding rationality
- optimism (tendency to overestimate –> rational = accurate unbiased info)
- loss aversion (pain in loss vs pleasure in gains = cognitive bias)
- framing (how info presented)
rationality assumption
more is always better
consumer choice theory
how make consumption decisions
theory behind economic demand curve
reactions to changes in price
aim = see rational consumers chose combination of goods = maximise utility
understanding demand helps in 4 ways
- estimate sales
- type /quantity of output
- price to charge
- effect of substitutes on sales
factors of demand
function of price income, tastes = expectations of future
- price (MOVEMENT)
- income
- preferences
- expectations
any other influence (SHIFT, RIGHT = INCREASE, LEFT = DECREASE)
R.I
L.D
consumer assumptions
-maximise utility
-rational economic agents = personal satisfaction
-choice = function of preferences and budget
2 tools to model consumer problem
- indifference curve
- budget constraint
indifference curve & features
-all possible combinations of 2 goods yield levels of satisfaction (combination of goods consumers are indifferent) - constant utility along curve
- slope downward (one increase other reduce preserve utility assume more is better)
- convex to origin - law of diminishing marginal utility
- more always better (further from origin = higher utility)
- curves cant intersect (2 lines = different utility levels - break law of transitive preferences)
marginal rate of substitution
magnitude of slope of indifference curve
rate at which person give up good measured on y-axis to gain additional unit of good on x-axis
remaining indifferent (total utility constant throughout curve)
marginal utility
incremental increase in utility that results from the consumption of one additional unit.
law of diminishing marginal utility
all else equal, as consumption increases, the marginal utility derived from each additional unit declines.
-extra consumption adds to utility but at diminishing rate
(assumption of utility theory)
budget constraint
show combination of goods consumers afford (income & price) range of choices affordable
(outside = unaffordable)
income = PARALLEL SHIFT
price = PIVOT
budget lines
quantity of 1 good on vertical axis
quantity of another on horizontal
shows consumption possibilities at given income and price
income types
- nominal (stays same)
- real (change - what money will buy at current price) - household income quantity of goods can be bought
consumer equilibrium
maximising utility given income and price of goods and services
types of goods
- inferior (demand drop income rise)
- normal (demand increase income rise)
optimal level of consumption
indifference curve os tangential to budget constraint
why consumers buy more when price decreases?
2 effects on demand
- substitution effect (swap to cheaper)
- income effect (buying power increased = buy more, real income rises)
6 determinants of demand
- price
- income
- price of related goods ( substitute// complements)
- tastes
- future expectation
- libertarian paternalism (nudges)
law of demand
quantity demand negative related to price
ceteris paribus - other influences = constant
-explain downward sloping demand curve
creative destruction
taste change over time
businesses shut and new emerge
libertarian paternalism
liberal - sense we think we are making choices
paternalistic - sense somebody already made choice
PED
responsiveness of QD to change in price
nature of relationship between price and quantity
% change in QD / % change in P
levels of elasticity
inelastic - steep (<1)
-0.5
large price change = small impact
move down curve
perfectly inelastic = vertical
elastic - shallow (>1)
-2
small price change = large impact
top of curve
perfectly elastic = horizontal
unitary = 1
marginal revenue
change in total revenue resulting from 1 unit increase
plotted at midpoint of output values
total rev maximised when selling extra unit = rev falls & selling 1 less = leaves revenue
cross price elasticity of demand
responsiveness of demand for 1 product to change in price of another
% change in quantity of good X demanded / % change in price of good Y
complements = -ve
substitutes = +ve
income elasticity of demand
responsiveness of demand to change in incomes
% change in quantity of good X demanded / by % change in income
normal = +ve
inferior = -ve
theory of producer choice
theory behind supply curve
-beyond certain output = costs rise more rapidly = producers need to be paid higher price = produce extra output = upward sloping
considerations of supply
- costs of production
- firms objective (profit? efficient least costly production methods - goods)
- production process
- factors of production
factors of production
land
labour
capital (physical - machines or human - training)
entrepreneurship
fixed = input cant be altered in quantity within given time period
variable = altered within given time period
technical efficiency
given level of output is done using the minimum amount of inputs (avoid waste) produce in least cost manner
production function 2 time frames
- short run (quantity of at least 1 factor of production is fixed -> capital = fixed, labour = variable =)
output is a function of L and K fixed capital - long run (can alter level of capital and labour to alter production - series of short run production processes
production in short run
- total product (TP)-> relationship between amount of labour used and output total amount produced
- marginal product (MP)-> change in total product resulting in 1 unit increase in variable factor all other factors are constant, MP to worker is extra output from hiring additional worker
- average product (AP) total product / quantity of input used - divide by units of labour = tells average productivity of workers
why does marginal product rise then fall?
-diminishing marginal returns
-more workers added to fixed capital = each worker = less capital to be productive with = total product increases at decreasing rate and marginal product starts to fall
increasing marginal returns
initially marginal product rise
total product increase at increasing rate
due to specialisation (division of labour)
boost productivity of firm
law of diminishing returns
increasing amounts of variable factor used with given amount of fixed factor
point when additional unit of variable = less extra output than previous
MP of additional worker is less than MP of previous worker
average product vs marginal product
same relationship
marginal intersects average at highest point
marginal higher than average = average product increasing
output and costs concepts
- total costs
- marginal costs = change in total cost from 1 unit increase in output (labour - producing one extra unit) = change in TC/ change in output
- average cost
average costs vs marginal costs
-average fixed costs slope down as output increase fixed cost spread across larger output
-AVC = u shape due to specialisation increasing marginal returns, eventually increase due to law of diminishing marginal returns
marginal cost = u shaped benefits due to specialisation but then diminishing marginal returns
average costs vs marginal costs
-average fixed costs slope down as output increase fixed cost spread across larger output
-AVC = u shape due to specialisation increasing marginal returns, eventually increase due to law of diminishing marginal returns
marginal cost = u shaped benefits due to specialisation but then diminishing marginal returns
long run production
all costs variable
flatter = firm can increase output by increasing capital rather than workers
minimise production costs
altering size of capital stock = achieve least cost means of production
EOS/increasing returns to scale
3 reasons why occurs
proportional increase in all inputs under control of firm = greater & proportional increase in production
costs per unit of output fall as production scale increase
- specialisation/division of labour
- financial economics (lower interest rates)
- technical EOS (specialist/expensive machines)
constant returns to scale
occurs if proportional increase in all inputs = equal proportional increase in production
disEOS/decreasing returns to scale
3 reasons why occurs
proportional increase in inputs = less than proportional increase in production
costs per unit of output increase as production scale increase
- difficult managing large workforce (communication)
- less feedback/direction
- management problems (coordination = complex)
normal profits
assume average costs = include payment to entrepreneur reward for deploying factors of production
opportunity cost of providing the entrepreneurship factor of production
abnormal profit
economic profit
excess profit
supernormal
profits over level of normal profit
short run vs long run outcomes
short = increasing/diminishing marginal returns
long = returns to scale & EOS/dis EOS
accounting vs economic costs
accounting = monetary costs in books
economic = those costs plus opportunity costs
law of supply
higher price = greater quantity supplied (positive relationship)
upward sloping due to costs of production - shows higher price needed to cover costs of production (higher price = more profit)
as marginal costs increase = quantity produced increases
determinants of supply
- price of factors of production
- price of related goods
- expected future prices
- number of suppliers (increase in number of centres = increase quantity supplied at every price = increase supply)
- technology (advances = lower costs)
- libertarian paternalism
market competition levels
place of sale
competitive or anti-competitive
perfect competition - designed show equilibrium is generated and how markets operate if open to extreme competition
highlight shortcomings of less competitive
more competitive = more efficient at allocating scarce resources
market equilibrium
equilibrium: opposing forces balance (supplied = demanded) - one price. sometimes temporary disequilibrium too high or too low price
surplus (excess supply); too high supplied > demanded
shortage (excess demand); too low demanded > supplied
surplus
scaling back production
not sustainable price
firms drive down price to compete to sell excess
shortage
upward pressure on price
consumers compete against each other
increase production
interbank lending
bank only option
borrow from other banks during global financial crisis 2008
global financial crisis 2008
large mortgage banks = rely on wholesale money markets = funds = amount to borrow depends upon own market valuation (share price) and standard and poor’s credit agency rating –> aggressive mortgage lending practices by banks
US sub prime lending
fears of rising bad debts = institutional lenders to withhold funds from wholesale markets
credit crunch
shortage of funds = raises London inter bank offered rate = raises cost of borrowing for banks
going short
borrowing financial asset e.g. share
assumption it will fall in price
pay for borrowing the share and then sell at current market value with assumption it will fall in price when share price falls
buy back share lower price and return to owner
credit crunch/squeeze/crisis
sudden reduction in general availability of loans or credit or a sudden tightening of conditions required to obtain a loan
price ceiling
if set above equilibrium price = not binding market attains equilibrium price & quantity as if no ceiling
if set below = binding quantity demanded exceeds quantity supplied
price flow
minimum wage = price flaws only relevant if set above prevailing equilibrium market wage
min wage below equilibrium wage = not binding = no effect = market works = no minimum wage
min wage above equilibrium wage = binding quantity of labour supplied by workers exceeds the quantity demanded by employers = surplus of labour
surplus of labour
unemployment
quantity of labour hired at minimum wage is less than quantity that would be hired in an unregulated labour market
market structures
- perfect comp (infinite small firms, homogeneous product, most efficient)
- monopolistic comp (lots small firm differentiated product)
- oligopoly (few large selling homo or differentiated)
- monopoly (1 firm supply whole market)
competition levels
more competitive = more efficient allocation
optimal production level = price and level to profit maximise
profits determined by structure
perfect comp -> monopoly = increasing profit
benchmarks
applicable to actual situations
qualitative predictions = aid decision making
understand how competition breeds efficiency
perfect competition
homogenous & fully informed
free entry and exit
all identical cost structures (no cost adv)
price takers
price takers
cant influence price
horizontal demand curve (perfectly elastic) at market price nothing above or below = no incentives
demand curve - MR price doesn’t change with output = constant mkt demand curve = downward = general demand
marginal revenue
MR
change in total revenue results from 1 unit increase in quantity
profit maximising rule
MR > MC profits rise is output expand = increase output = add more to total revenue than total cost (extra rev exceeds extra costs to produce, expand = profits increase
MR = MC profits maximised no incentive to expand or reduce
abnormal profit
difference between revenue and costs
short run vs long run production and options for losses
- ceasing production (loss = fixed costs)
- continuing production at a loss (contributes to FC of production = minimise loss = optimal strategy)
short run - cant exit capital is fixed
long run - leave market
average firms revenue = average costs means ?
firm is making normal profit
zero economic profit but not zero accounting profit
costs curve include normal profit = opportunity cost of supplying entrepreneurship
fixed cost = combined yellow and grey if produce grey part is covered by revenue = producing is loss minimising
making a loss
fixed cost = costs if producing = indifferent to produce or not
shut down point
marginal cost curve = supply curve in perfect competition at any given price tells us what firm supplies
making a loss
fixed cost = costs if producing = indifferent to produce or not
shut down point
marginal cost curve = supply curve in perfect competition at any given price tells us what firm supplies
profit maximising vs loss
profit maximising level of output is where marginal costs = marginal revenue
loss -> average revenue is below average costs
long run = all costs are variable
average rev > average costs = abnormal profit
encourages entry into market in long run = increase supply
normal profit = demand curve touches bottom of long run average cost curve = no incentive
normal profit
enough to persuade firms to stay in the industry
not enough to persuade new firms to enter the industry
minimum return owner must make in order to prevent decision to close down
long run equilibrium
firms producing at most efficient output
price = MC (allocative efficiency)
production at bottom of AC (technical/productive efficiency)
types of efficiencies
economic = occurs when there is both technical and allocative
technical = goods produced in least costly way, operating when ATC is minimal
allocative = resources allocated to producing mix that society wants = supply price = marginal costs of production
monopoly
inefficient & least competition
high prices
large barriers to entry
differentiated product = loyalty
steep inelastic demand curve = no subs
gain status by low price or gov legislation
natural barrier to entry
most efficient number of firms is 1
industry is governed by downward sloping average cost curve
EOS over all output levels
natural monopoly
industry most efficient for production to be concentrated in single firm
monopoly = barriers to stop entry/exit (no difference between short and long)
firm demand curve = industry curve
inelastic
abnormal profit
not efficient outcome, allocative supply = demand no
technical firm produce at bottom of average cost curve no
higher prices lower output
demand curve same as industry
monopoly marginal revenue curve
falls at twice the rate of demand
outcomes of monopolistic market
high price
low production
economic profit
redistribution of welfare - consumers lose out, monopolists gain abnormal profit
is a monopoly desirable ?
no direct competition- no incentive to reduce average costs
monopolistic set own price consumers cant compare
efficiency concerns:
price not equal marginal costs (allocative)
dont produce at bottom of long run average costs = capacity (productive)
consumer and producer surplus
consumer - total amount in excess of market price consumers would have been willing to pay (shown by demand curve)
producer - total amount of revenue in excess of marginal costs of production firm gets at market price
perfect comp = total surplus and total welfare = maximised
governments promote competition
anti bodies = seek out abuse of monopoly power
anti-competitive conduct (excessive, predatory pricing, collusion)
power to fine
prevent mergers = stop very concentrated market structures emerging
benefits of monopoly
provide future resources for investment/innovation
reward innovation (innovation in terms of developing new products = widens consumer choice and aids economic growth) - innovation in new production process = lower average costs of production
monopolistic competition
some degree of market and some discretion on price
product diff = quality, price, marketing
freedom of entry of new firms
combined perfect comp and monopoly
same conditions of perf comp but products are differentiated
only normal profit in long run due to free entry and exit
efficiency concerns
oligopoly
few firms share large proportion of industry
mutual interdependence
between firms means any independent actions 1 firm takes = impact performance of rival firms in market
must consider strategic decision making
oligopolists 2 directions
- interpedendence of firms = collude and act like monopoly = joint maximise industry profits
- mutual interdependence
3 oligopoly models
- kinked demand curve
- cournot model
- prisoners dilemma model associated with game theory
kinked demand curve model
-price increases from prevailing market price = not followed by competitors (no motivation to do so, competitors decide to keep as will gain customers, oligopolistic firm looses customers)
-price reductions from prevailing market price = matched by competitors = otherwise competitors lose market share, oligopolistic firm won’t gain significant customers
-leads to reduction in profits = demand curve not perfectly elastic = KINKED
kinked demand curve and marginal revenue
kinked demand = discontinuous at its kink and then marginal revenue curve is discontinuous too
-MR slopes away from demand curve as rev increases due to selling extra unit of output but falls as price attained is now lower for every unit sold
profit maximising level of output MC=MR
problems with kinked demand
price stability - due to other factors ?
model lacks empirical observation
help explain price stability = not explain price setting
cournot oligopoly
focuses upon output decisions of firms as key strategic variable
compete on amount produced decide independently compete on quantity of goods sold
assumptions of the cournot oligopoly
- 2 firms
- homogeneous product
- equal marginal costs of production
cournot conjecture
conjecture - opinion firmed on the basis of incomplete info) firm calculates optimal output assuming rival will not change output from previous period
residual demand curve
amount of demand left for a firm once other firm has sold its output
production of 2nd supplier in cournot model depends on 2 concepts
- cournot conjecture
- residual demand curve
reaction functions
reaction curves or best response functions
tells us what 1 firms optimal (profit maximising) level of production is for every level of output of its rival
-output of first firm is sensitive to second output of each firm affects others perception about extent of residual demand curve
cournot equilibrium
when the 2 lines cross
neither firm has an incentive to adjust their output as both are playing their best response given rivals actions
combined profits = less than If monopoly (as oligopoly = higher output lower price)
monopoly = Q1M or Q2M
perfect comp = Q1PC or Q2PC
only normal profits with perfect competition = so won’t chose
greater under monopoly less under perfect competition
game theory
allows us to explore implications of self interested (strategic) behaviour where individual decision making entities are interdependent
-understanding driver of individual decision making focus on equilibrium outcomes
-possibility firms might find it optimal to collude with each other to enhance own and joint profit
prisoners dilema
each either confess or deny involvement
independent decision no collusion
real world:
1. stick to implicit agreement to charge high monopoly prices for soft drinks
2. cheating on agreement and cut price = steal rival market share
Nash equilibrium
point where competitor is pursuing best possible (dominant strategy) given likely strategies of other competitors in game
no sole incentive for either competitor to move away from point
collusion & 2 types
co-operative behaviour
e.g. price fix, control output, agression towards each other non price variables
- overt (explicit) written agreement
- tactic (implicit) mutually recognises through repeated interaction that cooperation is rewarded by higher profits
collusion in practice
-repeated interaction - cheats in 1 round = punished later = value future profits highly sustainable collusion reputation for co-operation develops
triggers 1. grim trigger (cheat once never cooperate again) 2. tit for tat (cheated last round you cheat this round)
traditional Neo-classical theory of markets
assumes market participants have complete/perfect info about underlying economic variables
-buyers and sellers = both perfectly informed about quality of goods being sold
information in markets
-many models assume consumers & firms = same info
-consumers = knew competitors price
-firms = access to sam tech
-no adv = equilibrium outcomes
-free entry and exit
same price
reality = asymmetric
asymmetric information
one side of transaction knows less than other
= economic inefficiency
- adverse selection - ex-ante = based on forecasts rather than actual results
- moral hazard - one side take actions other side cant observe ex-post = based on actual results not forecast
market for lemons
good and reliable = peach
unreliable = lemon
cant tell the difference hidden info
greshams law
circulating currency consisting of both ‘good’ and ‘bad’ money both forms are required to be accepted at equal value under legal tender law
-quickly dominated by bad money as people hand over bad coins and keep good
-bad money will drive out good money
adverse selection
asymmetric info problem = adverse selection
ex-ante one cant distinguish between quality of competing goods
e.g. workers (productive?), insurance (risk?) consumer durables (quality?)
solving the lemons problem
higher quality = signal true worth
-warranties, brand name, licensing
-credit references, education
signalling job market signalling
solve lemons problem if cost of attaining signal significantly differs between sellers
asymmetric info = employers cant tell difference between high and low productivity = pay all the same wage
high = underpaid = won’t work
low = overpaid = will work
only low productivity workers are hired
2 roles of education
- improves human capital
- signal of higher productivity (higher wage, differentiate)
-wage offers bs education
Lower levels of education = lower wage
2 scenarios of job market signalling
- pooling equilibrium: costs of attaining level of education too high relative to rewards= no-one undertake or too low - all will undertake
- separating (signalling) equilibrium: high productive individuals = less costly to undertake education// costs of attaining too high vs rewards for low-productive workers refrain vs low enough to induce high productive workers to undertake = separating equilibrium exists
benefits to workers of educational signalling
cost of attaining education is higher for the less productive workers therefore steeper ray
net benefits for low productive workers are BD which is less than not undertaking any education which would be A0 (zero cost and lower wage)
reducing education costs can lead to pooling
cost of acquiring qualification fall
less productive workers = benefit increase as distance BE is greater than AO = acquire qualification
-degree of labour market pooling and then less differential in the wage as the wage rate will fall
requiring a greater signal may have costs without benefits
pursuing higher education = greater costs = may not lead to greater benefits for the higher productive workers as benefits fall to B’F’
how firms differentiate between equally qualified
- raise entry requirements
- recruit from top unis
- interview centres
- short term contracts
moral hazard
arises where ex-post agents have less incentive to deliver on contract and/or develop tendency to take risk as costs could incur not felt by party taking risk
solutions- incentive = exclusion clauses
principal agent problem
one party, agent, acts on behalf of other party called principal
agent = usually more info than principal as principal cant completely monitor agent agent have incentive to act inappropriately if interest of agent and principal aren’t aligned = gives rise to opportunism
opportunism
- work place - shirk (solution = piece rates, monitoring)
- external contracts - not deliver on quality/time (financial rewards for compliance)
advertising
public promotion (individual, firm, gov) of a particular product/service offered for consumption by economic agents
-consumer focused - private firms wanting product purchase
-gov bodies - public info
higher advertising intensity depends on 3 factors
- degree of competition in market
-oligopolists tend to compete on advertising, product differentiation and R&D rather than price - durability of product (dont rely on advertising for significant purchases often durable goods = expensive = use other promotions, less durable = cheaper = perishable = encourage purchase
- brand proliferation
-brand loyalty, excessive advertising to entice away from rivals and maintain own brand awareness intenser advertising
expected relationship between advertising intensity and market concentration
inverted U
lower market concentration = each nominal portion of market = low advertising price is the competitive weapon
more concentrated markets = oligopolistic firm avoid price comp = more advertising
-does start to decrease in intensity as realise aggressive advertising will not increase market share campaigns are matched by rivals, advertising = eats into profits
impact of advertising on demand
total revenue = green
advertising expenditure relatively inelastic in respect to demand
on right = demand more sensitive/elastic to advertising expenditure
more impact of advertising = greater advertising elasticity of demand
how does advertising improve a firms market position
successful advertising = more sales
-shift demand curve to high (extent of shift - depend on persuasiveness and susceptibility of consumers)
-marginal gain in sales from advertising expenditure = greater the more sensitive (Elastic) the demand curve is
-advertising elasticity of demand
advertising elasticity of demand
the extent to which the advertising campaign shifts demand curve to the right
impact of advertising on brand loyalty
enhances it
shifts curve to right & alters the slope = steeper = firm charge higher prices = reduce price elasticity of demand = more inelastic
more market power and price discretion
impact of advertising on brand loyalty
enhances it
shifts curve to right & alters the slope = steeper = firm charge higher prices = reduce price elasticity of demand = more inelastic
more market power and price discretion
greater discretion over price
rice in price from Pa to Pb = lose some sales but total revenue sales will increase as firm receives higher price per unit sold
advertising as a signal of quality
different types of good with different qualities
ex-ante = consumers cant distinguish between all firms get the same market price
avoid this problem = spend more on advertising of lower quality = burning money = secure higher price and repeat purchase
advertising as an entry deterrent
- enhance market power of incumbent firms = brand loyalty = difficult to steal market share
- EOS (favours incumbent firms)
- raises set up costs and sunk costs
economies of scales
average cost of advertising per unit of output
lower for large established firms
sunk cost
investment cost that cant be recovered even if firm subsequently leave the market
raise entry barriers
types of goods
influence advertising style
1. search (consumer establish quality by inspection before purchase)
- experience (consume product to determine quality) - adverts important (images)
- credence (cant determine quality even after consumption) - averts = hybrid of persuasiveness/info
benefits and costs of advertising
benefits: provides info
1. price/location
2. expand market size space to enter
3. signal of quality
costs:
1. persuade/manipulate
2. entry barrier (sunk cost)
3. wasteful expenditure
substitution effect (work for leisure)
wages rise = cost of leisure time increases (opportunity cost)
higher wages = tend to want to work longer hours
certain point = target income = satisfied = backward bending supply curve
trade off between work and leisure time
price discrimination
charging different prices for same service to customers who have different willingness to pay
-profitably extend market and ensure more consumers are being served
-market segmentation (cater for different consumer types)
-firms have some power over buyers to allow varying in prices
-instance of non-uniform pricing = consumers charged different prices for same good or charged different price for good depending on amount purchased
forms of market segmentation
price discrimination
product differentiation
product differentiation
sell different versions (varying degrees of quality) of good to customers who can self-select product they desire
necessary conditions for price discrimination
-degree of market power
-different willingness
-know valuation of good = charge right price
-markets firm charges different prices must be separate
arbitrage
potential for a customer in a low price market to sell on to customers int he high price market
first degree (perfect) price discrimination
-selling different price to each customer
-judge maximum buyer is willing & extract all consumer surplus
-assume constant marginal and average costs
-charge different prices along the demand curve
-carry on until MR =MC stop as beyond this point MC> MR
-competitive output produced
consumer surplus
amount in excess of price paid that a customer would willingly pay if necessary to consume units purchased
effect on total revenue selling an extra unit under uniform pricing
- increase due to another unit to sales at positive price
- reduction due to receiving slightly lower price on all other units
-MR curve twice the slope of linear demand curve
-under perfect price discrimination second of these effects is eliminated D = MR
competitive output
MC = price
second degree price discrimination
-firms selling at different prices depending on how much of the good customer buys
quantity discount
profits maximised when MC =MR at the output Qu and price Pu therefore the profit is the yellow shaded area
blue areas are the extra profits generated through 2nd price discrimination instead of uniform price which is the yellow area
uniform price
price where MC =MR
third degree price discrimination
-identify groups with different sensitivities to variations in price - separate based on relative price elasticity of demand & charge accordingly
-optimal non discriminating price
-mechanisms to stop price sensitive group reselling to price insensitive group
kinked demand curve
generates a discontinuous MR curve
kinks in the opposite direction to the kinked demand curve model for oligopoly
price discrimination and welfare
total welfare greater under price discrimination than under monopoly pricing
-firm welfare = higher = make greater abnormal profit
-consumer welfare = lower under price discrimination
-paying different prices, more customers are served under price discrimination - competitive output produced
product differentiation
non price variables firms use to compete on
capture and expand market share and maximise profit
make consumers perceive its different
through:
1. expenditure on R&D/advertising
2. patents/laws of copyright & trademark
product differentiation allows firms to
set apart from rivals - ‘market niche’
different versions of good = segment the market
not mutually exclusive = achieve both simultaneously
types of product differentiation
- horizontal (differ but physical attributes are similar qualities) - competing firms, firms own products)
- vertical (real physical differences in quality - costs and prices) competing firms or own products
successful segmentation
- consumers = clear preference over characteristics
- key determinant of which good consumer will buy
-identify and develop accordingly
preferences modelled
using indifference curves
prefers being on higher indifference curve B and C are indifferent but both are preferable to A
affordability
depends on price and income
affordable set is bounded along a-c-b
if all sellers raise prices = choice boundary shifts inwards = but same shape
price of 1 product rises alone = shape of affordable boundary changes
solving the consumer choice problem
combine budget constraints with indifference curves
introducing new products
-typically carries a fixed cost of development
-Firms require segments to be composed of a sufficiently large number of consumers so that revenues earned from introducing new products/packages covers this cost
market segmentation enables firms to
-increase sales revenue
-reduce product space available for competitors
-enhance brand reputation
-establish degreee of monopoly power
-variety of products = reduce PED & create barrier to entry = degree of monopoly power = supernormal profits (abnormal)
incumbent firms
businesses already established in market/indsutry,
adv - loyal customer base, internal EOS =average costs are lower
new entry into market
- set up new legal entity
- brings new productive capacity into market
-if the new legal entity doesnt hold = investment in extra capacity by existing producers
-if the new capacity doesnt occur = takeover or merger existing industry assets are consolidated in new legal entity
why does entry matter
new capacity = downward pressure on industry prices
-reduce barriers = competition
perfect competition
horizontal demand curve –
prices are determined by the market forces of demand and supply
firms = price takers.
firm tries to charge more than the prevailing market price, consumers will not be willing to buy from that firm
contestable market
companies with few rivals behave in competitive manner when market they operate in has week barriers to entry as long as barriers are low if only 1 or 2 firms in market price = average costs (perfect comp)
incumbents = no advantage
barrier to entry/exit
anything that prevents new firms entering or costlessly exiting market and thus allowing incumbent firms to charge higher prices and make higher profits than under perfect competition
4 main areas of barriers to entry
- absolute cost advantages
- EOS
- product differentiation
- barriers to exit
absolute cost advantages
incumbents - lower av costs than rivals (cheap/superior tech cheaper capital = inv)
-become vertical integrated = raise cost of capital for new entrant
-force retailers to do full line forcing
vertically integrated firms
conduct several stages of production process within the firm
full line forcing
incumbents force retailers to buy full product line
less available retail space for competitor
control distribution channel
EOS
large vol cheap low av cost per unit
eOS in advertising expenditure = deter entry
natural monopoly = entire industry output provided by 1 firm at lowest costs
product differentiation
loyalty
wary of new products = quality?
high value = less inclined to experiment and importance of differentiation
segment the market = reduce space
barriers to exit
anything restricting ability of incumbent firms to redeploy assets from 1 market to another
(entry could be risky)
forms of barriers to exit
- ownership of specialised and durable assets
- fixed costs of exit
- strategic considerations
- government barriers
ownership of specialised and durable assets
highly specific
sunk costs
cant convert to cash on exit
low resale value = optimal to remain in market
sunk costs
costs associated with being involved in particular industry or line of work largely irrecoverable if exit industry
fixed costs of exit
labour settlements
relocation/retraining
accountancy fees
contract breaking
loss of productivity & worker morale
strategic considerations
line of business constitutes part of wider business strategy than pulling out
-loss of purchasing power/bulk buying
-loss of use of shared facilities (production synergies) - decrease EOS
-inability to meet needs of customers
gov barriers
exit some circumstances - difficult/prohibited by gov = keen to preserve local employment
link to FDI = inducements to firms to locate in regions
cant exit quick if find economic circumstances different from expectations
tenure
conditions under which land/buildings are held occupied
innocent vs strategic entry deterrence
preserve profits (Actual and rivals)
-incumbents create conditions where excess profits are sustainable by creating barriers to entry = consistent with or part of ordinary profit = maximise behaviour
innocent –> create extra loyalty = more hurdles = barriers raised
strategic –> incur extra costs in short run = permit continued above normal profit in long run (inter-temporal substitution of profits)
types of entry deterrence:
- joint cost raising
- investment in excess capacity
- predatory pricing
joint cost raising
(incumbents incur extra costs themselves = force potential entrants to incur costs = non-optimal to enter) dirty tricks (convince unsafe), raising switching costs (reward scheme), increase input costs (raw materials, skilled workers), costs of product improvements (standard in industry)
investment in excess capacity
entry occurs = fight price war = see off new entrants
undercutting to force new out
excess capacity = increase operations = operate below capacity (costly) = signal of aggressive intent of incumbent
predatory pricing
incumbent lower price below cost to drive out rivals/new entrant & raise when exit occurred/threat of re-entry receded
incur loss in short run make excessive profits in Long run = build up reputation of tough competitor
P<AC (short run losses)
P> AC (long run abnormal profit)
predatory pricing
incumbent lower price below cost to drive out rivals/new entrant & raise when exit occurred/threat of re-entry receded
incur loss in short run make excessive profits in Long run = build up reputation of tough competitor
P<AC (short run losses)
P> AC (long run abnormal profit)
conditions for predation
high degree of strategic interdependence
deep pockets
welfare (social consumers benefits from low prices in short run lose out in long run price raised)
corporate strategy
choice of strategy at level of corporation, strategic orientation determined at headquarters
-decisions relating to units that make up corporation
-broad strategic decisions relating to HR policy and practice, culture etc
business unit strategy
choice of strategy at level of individual business units
-make appropriate strategic decisions given market environment faced by business unit
-decisions like pricing, advertising, product characteristic made by firms on market by market basis
empirics themes
- some more profitable industries (average rates higher)
- favourable environments
- similar activities different profit rates
defining a market & potential problems
competing products
geographical area
competitors
problems:
wrong identification = poor strategy formulation
narrow = overlook broad = irrelevant analysis
porters 5 forces
- threat of new entrants
- threat of substitutes
- bargaining power of suppliers
- bargaining power of buyers
- intensity and form of industry rivalry
threat of new entrants
a. Barriers to entry = difficult for new firms to enter
b.Advantages for incumbents over entrants e.g. loyal customer base restricts demand facing a new firm
c.Barriers are low, new firms attracted into profitable industries = adds capacity to industry and drives down prices
d. Main barriers brand loyalty, EOS, control of inputs/distribution channels, high capital requirements, strategic action by incumbents
e. Any of these are significant = reduced threat and prosperity of market is enhanced
threat of substitutes
functionally equivalent
fall outside of intial market definition adopted
fall in prices of existing substitutes or intro of new sub threaten profit of industry
bargaining power of suppliers and buyers
supply chain and firms position in it
impact profit
suppliers = up prices = profit fall
buyers strong = drive down price = industry prices fall
bargaining power enhance = few sub or if switching = costly
intensity and form of industry rivalry
intese = comp = reduce profit
intense: many firms, slow growth, lack of differentiation, high fixed costs = sell volume
try collude
2 ways of gaining long term competitive advantage
- low cost
- differentiation
otherwise stuck in the middle
differentiation strategy
extra benefits
extra costs - recoup in prices
only works if able to charge
higher prices
-identify sources of value
-willing to incur higher costs
-communication of differentiation to consumers
low cost strategy
basic product = low price = reduce quality versus differentiated goods
undercut in market sell volume = key to low cost if EOS benefit from lower average cost
higher margins = reduce cost by more than price reduction
focus strategy
subset of differentiation or low cost concentrate on particular buyer group
low cost = compete against market cost leader
differentiated = exploit small customer or particular specialisation more innovative than larger firms
which strategy to chose
- Choice is determined by profit drivers in environment
- Cost leadership = price strategy = raise sales volumes by lowering prices and enhance margins by lowering costs
- Price strategies = viable when market is sensitive to price (market PED = elastic)
- Price reductions = attract extra sales volumes = EOS = lower costs
- Price strategies can be poorer as customers are less concerned with price (cheap good = small proportion of income = addictive = no close substitutes = necessity)
- Demand is inherently less influenced by price = differentiation is good way of attracting new customers and holding onto current
critical perspectives of porter
- Externally oriented, market driven, outside in perspective on strategy formation – says little about internal organisation of firm
- Firms analyse their environments and position themselves with respect to the important competitive threats
- Relegates importance of firm specific resources, capabilities, competencies (inside out strategies perspectives) 4. Qualitatively based tool – difficult to quantify impact on industry profitability
specific issues of porter
generic strategies a route to competitive advantage? (strategies that others cant imitate)
framework preclude possibility of uncovering an innovate strategy ? (constrained world, redefine way of thinking)
is being stuck in middle bad? (hybrid strategies)
government where do they fit ?
Lancaster’s characteristics model
firms seek to identify key characteristics of a product they think matters to consumers
-discover characteristics through market research
horizontal differentiation arises
no real differences in quality of competing products
real price
value in terms of some other good, service, or bundle of goods
comparisons of different goods at same moments in time
substitution effect
substitute toward the relatively cheaper good and away from the relatively more expensive
cost curves vs product curves
cost curves are just inverse of product curves
increasing marginal returns = specialisation & divisionof labour = MP increase addition of extra worker contribute more to output and cost less = marginal returns and marginal costs of production is falling
diminishing marginal returns = ,ore and more use same capital, less to be productive with addition of extra = generates smaller increments of output, marginal product falls and marginal costs rise
price floor - minimum wage
minimum wages are called price floors
minimum wage only relevant if set above prevailing equilibrium market wage
-if minimum wage set below equilibrium wage = not binding and no effect market works as if no minimum wage
-if minimum wage set above equilibrium wage = binding quantity of labour supplied exceeds quantity demanded = surplus = unemployment
