ECONPLUSDAL THEME 3 Flashcards
Short run
When there is at least one fixed factor of production
Law of Diminishing Returns
In the short run, when variable factors of production are added to a stock of fixed factors of production, total/marginal product will initially rise and then fall.
Rise: Labour productivity is increasing (specialisation/DoL takes place; stops underutilisation of fixed factors of production)
Fall: Labour productivity is decreasing (fixed factors of production constrain production)
Long Run
When all factors of production are variable
Explicit costs
Fixed costs - do not vary with output e.g. rent, salaries, interest on loans, advertising, business rates
Variable costs - vary with output e.g. wages, utility bills, raw material costs, transport costs
Implicit costs
Opportunity costs
Returns to scale
% change of output relative to % change of input
Increasing returns to scale
When long-run average total cost declines as output increases due to economies of scale
Decreasing returns to scale
When long-run average total cost increases as output increases due to diseconomies of scale
Minimum efficient scale
The level of output at which all economies of scale are exhausted. The point on the LRAC curve where increasing returns to scale end, and constant returns begin
Economies of scale
A reduction in LRAC as output increases
Types of economies of scale
Internal: Really Fun Mums Try Making Pies
Risk Bearing
Financial
Managerial
Technical
Marketing
Purchasing
External:
Better transport infrastructure
Component suppliers move closer
R&D firms move closer
e.g. motorsport valley UK; Silicon Valley; Biomedical science in Cambridge (Astra Zeneca relocted HQ there)
Diseconomies of scale
An increase in LRAC as output increases
Types of diseconomies of scale
3Cs and an M
Control
Communication
Coordination
Motivation
Characteristics of perfect competition
Many buyers and sellers
Homogeneous goods
Firms are price takers
No barriers to entry and exit
Perfect information
Firms are profit maximisers
Allocative, Productive, X efficiency
No dynamic efficiency
Accounting Profit
Total Revenue - Total Costs (explicit only)
Economic Profit
Total revenue minus total cost (includes explicit and implicit costs)
Normal profit
0 economic profit
Supernormal profit
Any economic profit above normal profit - also known as abnormal profit
Subnormal profit
Negative economic profit
Profit maximisation
MR=MC
Can use COST PLUS PRICING but fails against competition
draw diagram
Reasons for profit maximisation
Allows reinvestment
Provides high dividends for shareholders
Lower costs and lower prices for consumers
Reward for Entrepreneurship
Reasons against profit maximisation
Knowledge of MR=MC
Greater scrutiny
Key stakeholders harmed (leads to satisficing instead)
Non-profit organisation e.g. NSPCC
Other objectives more appropriate
Profit satisficing
Between MR=MC and AR=AC
Sacrificing profit to satisfy as many key stakeholders as possible
Stakeholders affected by profit satisficing
Shareholders
Managers
Beneficiaries:
Consumers
Workers/TUs
Government
Environment groups
Revenue maximisation
draw diagram
MR=0
Reasons for revenue maximisation
Economies of scale (more Q than profit max)
Predatory pricing (lower price than profit max)
Principle Agent Problem
Perishable product
Principle Agent Problem
Divorce between ownership and control
Shareholders own a business and appoint directors and managers to run it on their behalf
SHAREHOLDERS AND MANAGERS WILL HAVE DIFFERENT OBJECTIVES
Shareholders want to maximize profits to maximize their dividends, whereas managers might have different motives, such as wanting to increase sales and revenue at the expense of profits
This divorce of ownership creates the principal-agent problem. The principal is the shareholder and the agent is the manager responsible for day to day running of the business
Often there can be conflict between shareholders and managers, as managers may increase costs to benefit the business at the expense of profits
Sales/growth maximisation
AC=AR
Reasons for sales maximisation
Economies of scale
Limit pricing
Principle agent problem
Flood the market
Why Firms Want to Grow
1) Profits - to generate more profits to give shareholders a better return (dividends)
2) Costs - to benefit from economies of scale, resulting in lower unit costs of production
3) Market power - to become a more dominant force in their market; if a firm dominates the market it can increase its prices e.g. Etisalat/du
4) Reducing risk - firms might want to diversify so that if sales drop in one market they have another market to generate sales e.g. Virgin
5) Managerial motives - senior managers may wish to grow in order to control a larger business
Why some firms prefer to stay small
1) Lack of finance for expansion
2) Avoiding diseconomies of scale (unit costs increase)
3) Regulation (red tape)
4) Offering a more personal service as they get to know customers and their needs; acting as suppliers; and acting as local monopolies at specific times e.g. local newsagents
Constraints on Business Growth
Government regulation preventing mergers or takeovers (CMA) - These may be disapproved as the government may feel that they might form a monopoly
Access to finance - Firms may not have enough money to takeover a business
Size of the market - If the market is very small it may be difficult for businesses to gain more market share in the market as there are simply not a lot of customers in the market
Growth may not be an objective of the owners. Other objectives could be ethical, profit satisficers etc.
Organic growth
A firm increasing its size internally e.g. increasing sales or expanding the workforce
Inorganic Growth
A firm increasing externally e.g. merger/takeover
Other business objectives
Survival –> brand loyalty
Public sector organisations (P=MC - allocative efficiency)
Corporate social responsibility (CSRs) - The Body Shop doesn’t test products on animals
Barriers to Entry
Any obstacle that prevents a new firm entering a market
Types of Barriers to Entry
LLOYD’S TSB
Legal (Patents; licences; red tape; standards/regulations; insurance)
Technical (Start-up costs; sunk costs; economies of scale; natural monopoly)
Strategic (predatory pricing; limit pricing; heavy advertising)
Brand Loyalty
Barriers to exit
Any obstacle that prevents a firm leaving a market
Types of barriers to exit
Undervaluation of assets
Redundancy costs
Penalties for leaving contracts early
Sunk costs
Allocative efficiency
Where resources follow consumer demand
Where society surplus is maximised
Where net social benefit is maximised
D=S; MSB=MSC, AR=P=MC
Productive efficiency
When a firm is operating at the lower point on their AC curve
Full exploitation of economies of scale
X efficiency
Minimising waste
Production on the AC curve
Happens for monopolies and public sector firms
Dynamic efficiency
Re-investment of LR supernormal profit
Shutdown point
Short term: lowest point of the AVC curve
Long term: lowest point of the ATC curve
Break even condition
AR=AC
Characteristics of a monopoly
One seller dominating the market (pure monopoly or monopoly power)
Differentiated products
Firm is a price maker
High barriers to entry/exit
Imperfect information
Firm is a profit maximiser
Dynamic efficiency
Allocatively, productively, x inefficient
Price discrimination
Where a firm charge different prices to different consumers for an identical good/service with no differences in costs of production
Conditions for price discrimination
Price making ability
Information to separate the market
Prevent re-sale (market seepage)
1st degree price discrimination
Practice of charging each customer the price they are willing to pay. All consumer surplus turned into monopoly profit
2nd degree price discrimination
Practice of charging different prices per unit for different quantities of the same good or service
3rd degree price discrimination
Practice of dividing consumers into two or more groups, one with elastic demand and one with inelastic demand
Pros of price discrimination
Dynamic efficiency
Economies of scale
Some consumers benefit
Cross subsidisation
Dynamic efficiency
Economies of scale
Some consumers benefit
Cross subsidisation
ALLOCATIVE INEFFICIENCY
Inequalities
Anti-competitive pricing
Characteristics of a natural monopoly
Huge fixed costs
Enormous potential for economies of scale (LRAC slopes down for ages)
Rational for 1 firm to supply the entire market - competition is undesirable
Competition would result in a wasteful duplication of resources and non-exploitation of full economies of scale –> Allocative & Productive inefficiency
Benefits of a natural monopoly
Gains in productive efficiency due to massive scale
Can be regulated to achieve allocative efficiency