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
Costs of a natural monopoly
Can charge as high a price as they want due to no alternatives
Information gaps regarding price caps
Regulation in a natural monopoly
Profit maximisation is at far too low a quantity. Regulators require supply at P=MC - allocative efficiency. This is loss-making for the monopolist, so the government subsidises the subnormal profit
Pros of a monopoly
Dynamic efficiency
Greater economies of scale
Natural monopoly
Cross subsidisation (A cross-subsidy is a situation in which one group of customers or clients is charged a higher price for a product or service in order to subsidize a lower price for another group.)
Cons of a monopoly
Allocative inefficiency
Productive inefficiency
X inefficiency
Inequalities in necessity markets
Monopoly evaluation
TEND CROP
Type of good/service (luxury vs necessity)
EoS or DoS?
Natural monopoly
Dynamic efficiency?
Competition or threat thereof…
Regulation
Objective
Price discrimination
Pros of competitive markets
Allocative efficiency
Productive efficiency
X-efficiency
Jobs
Cons of competitive markets
Lack of dynamic efficiency
Lack of economies of scale
Cost cutting in dangerous areas
Creative destruction
Evaluation of competitive markets
Still dynamic efficiency?
Level of EoS
Natural monopoly
Where is cost cutting taking place?
–> role for regulation?
State vs dynamic efficiency
–> type of good/service
Characteristics of monopolistic competition
Many buyers and sellers
Slightly differentiated goods
Firms are price makers, but only slightly
Price elastic demand
Low barriers to entry and exit
Good information
Non-Price competition
Firms are profit maximisers
Examples of Monopolistic Competition
Taxis since Uber
Clothing
Restaurants
Hairdressers/salons
Hotels
Music Streaming
Coffee Shops
Bars/Nightclubs
Key Cutting and Shoe Repairs
Efficiency of Monopolistic Competition
X efficient
Allocatively, productively, and dynamically inefficient
BUT
More allocatively efficient than monopolies (some competition); variation might make inefficiency desirable over perfect competition.
More productively efficient than monopolies (must minimise costs); might be exploiting more economies of scale than perfect competition, or could just be byproduct of differentiation.
Dynamic efficiency could be part of competition e.g. clothes design
N-firm concentration ratio
The collective market share of the n largest firms in an industry
Characteristics of an oligopoly
Few firms dominate the market
–> high concentration ratio
Differentiated goods
–> firms are price makers
High barriers to entry/exit
Interdependence
–> price rigidity
Non-price competition
Profit maximisation not sole objective
Kinked demand curve
The demand curve for an oligopolist, which is based on the assumption that rivals will match a price decrease (inelastic) and will ignore a price increase (elastic)
No need to change price - vertical MR gap at existing price, so a shift of MC within the gap keeps it as the point of greatest profit
Results of oligopoly
Price wars: Repeatedly cutting prices to outcompete others
Predatory pricing: Pricing low to force competitors out of the market
Limit pricing: Pricing low to stop new firms from entering the market
Non-Price Competition
Promotion
Loyalty
Brand image
Attractive packaging
Higher quality
Oligopoly Game Theory
Prisoner’s dilemma: both make more money by lowering their prices –> both lower prices –> inelasticity makes them both earn less than if they both set prices high. Encourages collusion, but an incentive to cheat the agreement exists
Competitive oligopoly
Price or non-price competition
Factors promoting competitive oligopoly:
Large no. of firms (low concentration)
New market entry possible
One firm with significant cost advantage
Homogenous goods
Saturated market
Collusive oligopoly
Overt or tacit (price leadership)
Factors promoting collusive oligopoly:
Small no. of firms
Similar costs
High entry barriers
Ineffective competition policy
Consumer loyalty/inertia make cheating less likely
Characteristics of a contestable market
THREAT OF ENTRY
Low barriers to entry/exit
Large pool of potential entrants
Good information
Incumbent firms subject to ‘hit & run’ competition
Technology and contestability
Lower barriers to entry/exit (no need for physical firm)
Greater pool of potential entrants (more innovation to disrupt markets; find cheaper methods of production)
Improved information
Benefits of contestability
Movement towards limit price:
Allocative efficiency
Productive efficiency
X-efficiency
Job creation
Costs of contestability
Lack of dynamic efficiency
Cost cutting in dangerous areas
Creative destruction
Anti-competitive strategies
Evaluation of contestability
Length of contestability
Role of technology
Regulation
Dynamic efficiency
Government intervention to promote contestability
BMPSPC
Reduce barriers to entry (deregulation)
Monitor monopsonies to avoid price setting (2011: 9 supermarkets in the UK found to be fixing the price of milk/chees - Tesco alone fined £10mn)
Intervene to prevent anti-competitive pricing
Subsidise start-ups
Privatisation (profit motive –> efficiency –> lower costs –> lower prices)
Competitive tendering (but firms may cut costs in important areas to bid lower) e.g. used in movement of prisoners, hospital catering/cleaning, producing army tanks
Benefits of government intervention
Lower prices; higher consumer surplus
Higher quality
More competition –> more choice
More productive/allocative/dynamic efficiency
Drawbacks of government intervention
Government failure (regulatory capture; asymmetric information)
Who enacts competition policy?
Competition and Markets Authority
Overlooks regulatory bodies (ORR, CAA, OFCOM, OFWAT, OFGEM)
European Competition Commission (EU)
What are the aims of competition policy?
PROTECT PUBLIC INTEREST
Prevent excessive/predatory/limit pricing
Promote competition
Ensure quality, standards and choice
Regulate natural monopolies/Ensure effective privatisation of natural monopolies
Promote technological innovation
When will a merger be investigated?
If it results in a 25% market share or more
If it has a combined turnover above £70mn
Investigation does not mean it will be blocked (Lloyds and TSB merged - market share of 35%)
Examples: Asda/Sainsbury; Just Eat/Hungryhouse; Ladbrokes/Coral - had to sell 400 shops)
When will competition authorities intervene?
Antitrust & cartel agreements
Investigate mergers
Liberalise concentrated markets
Monitor state aid control
Methods of monopoly regulation
ACTING AS A SURROGATE FOR COMPETITION
Price regulation (RPI, RPI-X, RPI+K) BUT level of X/K?; Cost; Incentive to keep reducing RPI-X; Regulatory capture
Quality control/Performance targets e.g. Trains, Gas/Electricity, NHS unintended consequences; ‘game the system’
Profit control covering costs and adding % return on capital employed BUT Asymmetric information; incentive to raise costs; incentive to over-employ capital
Windfall taxes on profit BUT Worsen monopoly outcomes; tax evasion/avoidance; less innovation; under-reporting of profit
Merger policy; privatisation; deregulation; reducing trade barriers
Evaluation of monopoly regulation
GOVERNMENT FAILURE:
Level of information
Costs vs benefits
Regulatory capture
Benefits of monopoly
Benefits of Price capping
Appropriate way to prevent natural monopolies or dominant firms from making excessive profits at the expense of consumers
Allows cuts in price levels - increase consumer surplus
Improve productive efficiency out of necessity (suitable when RPI+K is used)
Drawbacks of Price Capping
Job losses as firms cut costs to make profit
Asymmetric information –> cap too high
Lower profits to reinvest
Benefits of profit regulation
Encourages lowering prices - higher consumer surplus
May mean lower costs for businesses using the product or service e.g. lower electricity prices if energy market regulated
Drawbacks of profit regulation
Asymmetric information –> difficult to understand business costs and rates of return –> can fudge the numbers?
Little incentive for monopolists to minimise costs (won’t gain profit) –> productive inefficiency
May employ too much capital to enjoy return
Advantages of privatisation
Allocative efficiency up
X inefficiency down
Efficiency incentive which drives dynamic efficiency
Disadvantages of privatisation
Limited competition –> productive and allocative inefficiency
Loss making services cut even if socially desirable
Loss of natural monopoly and loss of economies of scale benefits –> productive inefficiency
Evaluation of privatisation
The level of competition post privatisation
Level of government regulation
Advantages of deregulation
More firms will increase consumer choice –> incentive for firms to be allocatively efficient
Productive and X efficiency rise
More dynamic efficiency
Disadvantages of deregulation
Loss of natural monopoly (AC up, productive efficiency down, wasteful duplication of resources –> allocative inefficiency)
Formation of oligopolies and local monopolies
Evaluation of deregulation
Short run vs long run
Height of other barriers to entry
Level of government regulation against anti-competitive behavior
Advantages of nationalisation
Greater economies of scale
More focus on service provision (allocative efficiency)
Less likely to be market failures arising from externalities
Public sector can be a vehicle for macro-economic control
Disadvantages of nationalisation
Diseconomies of scale
Lack of incentive to minimise costs
Complacent & wasteful production (X-inefficiency)
Lack of supernormal profit
Highly expensive and a burden on the tax payer
Higher prices due to low competition
Greater risk of moral hazard
Political priorities override commercial issues
Evaluation of nationalisation
Funding vs delivery of key public services
PPPs better?
Role of regulation?
Competition in private sector
Size and objective of private sector firms
Merger
The joining together of two or more firms under common ownership
Horizontal Integration
When businesses in the same sector merge e.g. secondary sector
Vertical Integration
When businesses in different sectors merge e.g. a business in the secondary sector and a business in the tertiary sector
Forward Vertical Integration
When a business merges with a business in the next sector e.g. secondary takes over tertiary
Backwards Vertical Integration
When a business merges with a business in the previous sector e.g. secondary sector merges with primary sector
Conglomerate
A merging of two firms in different industries e.g. a tobacco company buying an insurance company
Advantages of a Horizontal Merger
May allow reductions in average costs due to economies of scale.
Can reduce competition in the market by taking out a competitor.
It can allow one firm to buy unique assets owned by another part of the world.
It allows a business to grow in a market where it already has knowledge and expertise. This is likely to make the merger more successful.
Spreading risk.
Disadvantages of a Horizontal Merger
Often pay too much for the firm they are buying.
Integration of the two firms is too often poorly managed and many of the key workers may leave following the acquisition could lead to a loss of jobs due to duplication of jobs.
Different cultures in businesses (culture clash).
Diseconomies of scale.
Advantages of a Backward Vertical Merger
May be cost savings - integrating a supplier into the firm may make the firm more efficient.
May reduce risk e.g. A supplier might have a technology that it could offer to rival firms and give them a competitive advantage. A supplier might unexpectedly refuse to sell its product to the firm.
Better access to raw materials.
Disadvantages of a Vertical Merger
May have little expertise in the industry.
Firms often pay too much for the firm they take over, and the share price falls.
There can be difficulties in merging the two firms together into one firm. Either the costs of creating a single firm from two separate firms are too great or the two firms fail to integrate, but costs rise because extra layers of management are needed to control the new, larger firm.
Many of the key workers in the firm that has been taken over may leave, taking with them much of the expertise that made it successful.
Diseconomies of scale.
Culture clash.
Advantages of a Forwards Vertical Merger
May be cost savings - integrating a buyer into the firm may make the firm more efficient; economies of scale.
May reduce risk e.g. a buyer could decide to buy from another firm.
Could give a firm more control over its market e.g. if a firm owned another firm that bought its products, it could decide at what price to sell the product and in what markets. It could better control branding of the products.
Have a place to sell their product.
Advantages of a Conglomerate
Reduces risk - buying another firm operating in a completely different market means that a firm is not so dependent on the ups and downs of one market.
A conglomerate may find it easier to expand compared to a situation where the companies and operations were independent. Size gives a conglomerate more options to obtain finance to expand the business. Successful senior managers can be transferred from company to company depending on their need.
Could be an opportunity for asset stripping. Some companies specialise in buying other companies which they see as having more valuable individual assets than the buying price of the company.
Disadvantages of a Conglomerate
Firms do not have expertise in the market into which they buy.
Asset stripping benefits the stripper; hurts workers (lose jobs), customers (lose products), and local economies (lost jobs; derelict industrial sites).
Often pay too much for the firm they are buying.
Integration of the two firms is too often poorly managed and many of the key workers may leave following the acquisition.
Diseconomies of scale.
Culture clash
Competition and Markets Authority (CMA)
An independent, non-ministerial government department, which works to promote competition between providers so that customers benefit.
Demerger
When a business sells off one or more of the businesses that it owns into a separate company
Reasons for Demergers
- Cultural differences
- Creating more focused firms
- Protecting the value of the firm
- Reducing the risk of diseconomies of scale
- Raising money from asset sales and return to shareholders
- To meet requirements of competition authority regulators (CMA 0 Competition and Markets Authority)
Business Benefits of a Demerger
- Allowing focus on the core business
- Raising funds from selling parts of the business
- Removing loss-making parts of the business
- Avoids clash of cultures
Worker Benefits of a Demerger
- Increased job security if loss-making parts of the business are demerged
- Reduced conflict between cultures
- Could negotiate higher wages
Consumer Benefits of a Demerger
- Greater competition leads to lower prices
- More focused businesses are able to better meet consumer needs as quality may be better
Monopsony
Only one buyer of a good in a market e.g. Network Rail/track maintenance
Has buyer power
Impacts of a monopsony on itself
+Lower costs…
+More profit
+Allows more investment
-Potential fines
-Suppliers might have to lower quality of their goods
Impacts of a monopsony on the suppliers
+Encourages efficiency
+Could eventually become a monopoly
-Less revenue
-Might have to leave the market
Impacts of a monopsony on consumers
+Lower prices may be passed on
-Lower quality of goods
Impacts of a monopsony on its employees
+Profits may be passed on to them
-Might invest in automation e.g. self-checkout
-May question employer’s ethics
Impacts of a monopsony on the suppliers’ employees
+None
-Revenue falls so might need to cut costs (lower wages, redundancies)
Factors impacting demand for labour
Demand for goods and services (labour is a derived demand)
Price of capital (machinery) –> capital labour substitution
Economic climate
Productivity of workers
Factors that impact the supply of labour
Wage rate (pecuniary benefits) - short term: wages up –> supply up, but eventually will fall (no point in money if no time to spend it) - work is an inferior good
Income tax
Non-pecuniary benefits
Trade union presence
Social trends e.g. immigration, emigration (brain drain), demographics
Market failure in the labour market
Geographical immobility of labour (expensive/hard to move/commute; high house prices; don’t want to move away from family/friends)
Occupational immobility of labour (lack skills e.g. due to structural changes) - short term difficult, but long term people can retrain
Policies to improve labour mobility & incentives
Occupational mobility: subsidize uni fees; better funding for workplace training; teaching new skills e.g. coding; expand apprenticeships/internships
Geographical mobility: HS2; rise in house-building; regional policy to create new jobs
Incentives: subsidise childcare; higher NMW/LW; cut income tax; welfare reforms
Benefits of a minimum wage
Reduces poverty
Improve incentives to work
Higher disposable income for poor workers (higher mpc)
Promotes equality among workers
Drawbacks of a minimum wage
Unemployment
Higher variable costs –> lower profit –> less investment; redundancy
Makes UK businesses internationally uncompetitive
Higher costs –> higher prices/inflation –> lower real incomes
Less investment –> less dynamic efficiency
National Living Wage
Rising at least until 2020
Min wage >25 y/o
Higher than min wage; increases faster
By 2020, will be 60% median earnings (£9)
Workers on min/living wage triples 2015-20
Min wage lower than France/Australia; higher than USA
Firms could react by investment (training/automation), job cuts, higher prices etc.
Responses: Waitrose stopped paying Sunday/overtime rates for new workers; Caffe Nero eliminated free lunch
Benefits of a maximum wage
Corbyn suggested it would be an effective way of reducing inequality
Will lower costs –> Profits up –> investment –> dynamic efficiency
Costs of a maximum wage
Brain drain
Can be circumvented e.g. dividends, bonuses
Not much money saved for multi-billion dollar companies
Tax evasion (Laffer curve)
Highest pay reflects highest responsibility; incentive for entrepreneurship
Labour market issues
Skills shortages (immobility of labour)
Young workers struggle to break into the workforce (last in, first out etc.)
Retirement (rising life expectancy –> pensions make up over 50% of welfare spending)
Wage inequality (highest wages grow faster)
Zero-hour contracts
Gig economy (difficult to get mortgage; no holiday pay)
Migration –> lower wages
Factors affecting elasticity of demand for labour
COST
Costs (proportion in business)
Output’s PED - can price be increased instead?
Substitutes (machinery?)
Time
Elasticity of supply of labour
Time to acquire skills to enter the market, so inelastic in the short run, but elastic in the long run
May be inelastic if they can recruit from overseas
Specialisation
The concentration of production ona narrow range of goods and services
