Theme 3 Flashcards
The size of firms in the UK?
Although production in the UK is dominate by large firms, there are many industries where small and medium-sized enterprises play a significant role.
Why do large firms exist?
Economies of scale and barriers to entry
Why might the costs of production for a large scale producer be higher than for a small company?
- It could be due to productive inefficiency - a large firm operating within its average cost curve boundary e.g. may be poorly organised in what they see as small unimportant segments of the market (called market niches)
- Or X-inefficiency may be present
- Average cost curve of a large producer may be higher in certain markets than for a small producer
How businesses grow?
Organically or internal growth
- firms increasing their output - increased investment or labour force
External growth through merger, amalgamation or takeover
- A merger or amalgamation is the joining together of two or more firms under common ownership
- A takeover implies that one company wishes to buy another company. May lead to hostile takeover when needs more than 50% of shares to win and the control.
Reasons for growth?
Profit maximising companies are motivated to grow in size for a number of reasons:
- may be able to exploit EOS
- more able to control its markets. Reduce competition and exploit market better
- be able to take more risk
5 different types of mergers?
Horizontal integration - merger of two firms in same industry at same stage of production
Vertical integration - in same industry but at different stages of production
Forward production integration - involves a supplier merging with one of its buyers
Backward vertical integration - involves a purchases buying one of its suppliers
Conglomerate integration - is the merging of two firms with no common interest
Whats a social enterprise?
Profits reinvested for social purposes
Whats a small - medium enterprise (SME)
Fewer than 250 employees - 99% of UK businesses
Whats a PLC?
A private sector business that trades it shares publicly on stock exchange with a minimum share capital of £50000
Whats a Ltd?
Shares are held privately and are not traded on the Stockmarket. Limited means that the amount investors have in share capital are only liable for the value of it.
Whats a partnership?
A business structure where partners share responsibility for the business (2-20)
Why small firms are likely to survive?
- Subcontracted by larger firms
- Provide niche goods and services that are highly price inelastic in demand, leading to high profits
- Can avoid diseconomies of scale
- Lifestyle enterprises - not profit maximising but profit satisfying (“enough”)
- Can be innovative and flexible in responding to changes in the market.
- Easy to sell online, eBay Etsy and amazon without incurring costs of having physical stores.
5 reasons why a firm may want to expand and grow?
- EOS (lower long run unit costs)
- Build and sustain your market power
- Improve shareholder returns from higher operation profits
- Reduce the risk of a hostile takeover
- Pursuit of managerial objectives
Whats a demerger?
why?
When a firm decides to split into separate firms
- Reduce risk of diseconomies of scale
- Raise money for shareholders
- Focus on streamline costs and improve profit margins
- diversify risk - focus on markets
What is profit maximising?
Profits are maximised at an output where marginal cost = marginal revenue
What is revenue maximisation?
Revenues are maximised at an output where marginal revenue = zero
What is sales maximisation?
Producing the largest amount possible consistent with earning normal profits
Whats satisfying behaviour?
Satisfying behaviour involves the owners of a business (shareholders) setting minimum acceptance levels of achievement in terms of revenue and profitability.
What is total revenue?
This is the total income a firm receives. Price x quantity
What is average revenue (AR)?
TR/Q
Marginal revenue (MR)?
The extra revenue gained from selling an extra unit of a good
Profit?
Total revenue (TR) - total costs (TC)
or
(AR-AC) x Q
Whats fixed costs?
The costs which don’t vary with changing output. Fixed costs stay the same even with relation to output.
What are variable costs?
Costs which depend on the output produced
What are total costs?
Fixed + variable costs
What are marginal costs?
marginal cost is the cost of producing an extra unit.
What are sunk costs?
Costs that have been incurred and cannot be recouped. e.g advertising after leaving the industry
ATC=
Average total cost = total cost / quantity
AVC=
Average variable cost = variable cost / quantity
MC=
Marginal cost
AFC=
Average fixed cost = fixed cost / quantity
TC=
variable costs + fixed costs
Why are short run cost curves u-shaped?
Why in the short run does marginal cost increase.
because of diminishing marginal returns
As capital is fixed, after a certain point, increasing extra workers leads to a declining productivity. Therefore, as you employ more workers the marginal cost increases.
What happens in long run costs curves and with consideration of EOS and DOS?
Due to EOS and DOS. if a firm has high fixed costs, increasing output will lead to lower average costs.
However, after a certain output, a firm may experience diseconomies of scale. This occurs where increased output leads to higher average costs. e.g communication in big-firms coordinate workers
What is the minimum efficient scale?
The minimum efficient scale is the scale of output where internal economies of scale have been fully exploited. The minimum point of output necessary to achieve the lowest A.C. on the LRAC. Productive efficiency achieved.
What is external economies of scale?
Occurs when a whole industry grows larger and firms benefit from lower long-run average costs. (positive external benefits of industrial expansion)
- supportive legislation
- transport links
- attract more labour
What is internal economies of scale?
Refers to how a firm gains lower average cost - from the increase in size of that particular firm
- technical
- specialisation
- bulk-buying
- financial economies
What is perfect competition?
Is a market structure where many firms offer a homogenous product. Because there is freedom of entry and exit and perfect information, firms will make normal profits and prices will be kept low by competitive pressures.
What are the 5 features of perfect competition?
- Many firms
- Freedom of entry and exit, this requires low sunk costs
- All firms produce an identical or homogenous product
- All firms are price takers, therefore the firms demand curve is perfectly elastic
- There is perfect information and knowledge
What are the 8 characteristics used to define a market ?
- Number and size of firms
- Barriers to entry and exit
- Sell a product or service - either homogenous or differentiated
- Short run or long run
- Price setting power (price takers or price makers)
- Knowledge - perfect or imperfect
- Profits - normal, abnormal and subnormal
- Scope for economies of scale
What is supernormal profit?
All excess profit a firm makes above the minimum return necessary to keep a firm in business
Total revenue - total costs and AR>AC
What are normal profits?
Firm makes sufficient revenue to cover its total costs and remain competitive in an industry
include opportunity cost when calculating
AR=AC
What are sub-normal profits?
Any profit less than where price is lower than average costs. If its making an economic loss than its likely to leave the market in the long run in search of higher expected returns. AR
What are the underlining assumptions in classical economics?
Firms seek to maximise profits (profit maximisers)
- MR=MC
- occurs at the biggest gap between total revenue and total costs
What is monopolistic competition?
Combines elements of monopoly and competitive markets. Is one with freedom of entry and exit, but firms can differentiate their products. Therefore they have an inelastic demand curve and so they can set price. However, because there is freedom of entry, supernormal profits will encourage more firms to enter the market leading to normal profits in the long run.
What are the characteristic of monopolistic competition?
- Many firms
- Freedom of entry and exit
- Firms produce differentiated products
- Firms have price inelastic demand; they are price makers because the good is highly differentiated
- Firms make normal profit in the long run but could make supernormal profits in the short run.
- Firms are allocatively efficient and productively efficient
Short run for monopolistic competition?
Long run for monopolistic competition?
The diagram is the same as for a monopoly. The firm maximises profit where MR=MC. This is at output Q1 and price p1, leading to supernormal profits
Demand curve shifts to the left due to new firms entering the market.
Efficiency when considering monopolistic competition in short and long run?
- Both allocatively inefficient - price set above marginal cost
- Both Productively inefficient - is not producing at the lowest point on AC curve
- Both dynamic efficiency - as possible for firms to have profit to invest in research and development
- X-inefficiency in long run - as possible for firm to face competitive pressures to cut costs and provide better products
What is productive efficiency?
Occurs where no additional (or maximum) output can be produced from the factor inputs available at the lowest possible average or unit cost. Thus, average costs are minimised.
Average cost = total cost / output
MC=AC lowest point.
What is allocative efficiency?
Occurs where consumer satisfaction is maximised in the production of goods and services.
Be where quantity supplied will equal quantity demanded and P=MC
What is economic efficiency?
Occurs where we have allocative and productive efficiency at the same time.
What is static efficiency?
Occurs when all resources are being used in the most efficient manner at a point in time
What is dynamic efficiency?
Occurs where firms improve technology and production methods over a period of time. - improvement in social welfare, investment in human and non-human capital and technological change.
What are the features of an oligopolist market?
10 features..
- Few large firms
- High barriers to entry
- Product differentiation or homogenous
- Imperfect knowledge
- Price setters
- High concentration ratio
- Potential for collusion
- LR abnormal profits
- EOS
- Interdependence
Whats a pure oligopoly?
Small number of large firms control the entire market
Whats a realistic oligopoly?
Several large firms dominating a market
Duopoly?
Two firms that dominate and control the market
Oligopoly pricing strategies?
- Price wars - an intense form of competition where firms compete with each other to charge lower prices and therefore forcing the market price down
- price wars hurt competition firms but benefit consumers - Predatory pricing - strategy in which firms sell below the cost of production to induce the exit of a rival firm
- Limit pricing - undercut firms whilst still making a profit
Whats price leadership?
When one firm has a dominant position and firms with lower market shares follow the price changes of the leader.
What is collusion?
Takes place when rival companies cooperate for their mutual benefit.
What is a cartel?
Association of businesses or countries that collude to influence production levels and thus the market price.
Whats interdependence?
Where the decisions made by a business cannot be taken in isolation, it must consider likely reactions of other firms.
Kinked demand curve?
Assumes that a business faces a dual demand curve for its product based on the likely reactions of other firms.
Whats the prisoners dilemma?
Problem in game theory that demonstrates why two people might not cooperate even if in their best interests.
Whats the concentration ratio?
A measure of the total output produced in an industry by a given number of firms in the industry.
e.g. - four firm concentration ratio
add together the four firms market shares
20+15+10+5=50
Why firms want to collude?
As in oligopolies, there exists a high level of strategic independence between firms. So collusion can benefit firms as it can enable them to earn super-normal profits.
MAXIMISE PROFITS
- price war suits nobody - race to the bottom
- if guaranteed a certain price - firms could maximise profits collectively
DRIVE OUT COMPETITORS
- Existing firms agree to drop prices (predatory) making lower profit in s/r and able to absorb losses more so new entrants leave.
Whats overt collusion?
Formal and explicit co-operation and agreement between rival firms - leaves a paper trail
Done through production quotas so market price isn’t pushed down
Whats tacit collusion?
Firms follow a mutually beneficial co-operative strategy without explicitly agreeing to do so - hidden from the public eye
Done through price leadership - leader sets price - other firms tacitly copy leader and leader sets artificially high price which other firms follow so profits for all.
What factors need to be present the success of these cartels?
Overt…
- Perfect information - production levels seen by any other member - cheating can be seen
- Barriers to entry - production quota stabilised due to less disruption in the market reducing the profitability of hit and run entry
- Low demand changes - disruption of the market may lead to firms cheating
Why are cartels illegal?
Overt…
In most major economies, collusion and price fixing agreements are illegal. As people pay higher prices Reduces competition Restricts innovation Damages efficiency
Factors that can cause / encourage collusion?
- Similar products / standardised products
- Weak or ineffective regulation
- Fines are low in comparison to the gains
- High levels of communication
- Less firms / higher concentration ratio
- Low risk of new entrants / contest ability of market
- Brand loyalty
What happens when collusion breaks down?
- Market shrinks
- Enforcement of quotas and prices is difficult
- New entrants
- Whistle-blowing
- Trust
What are the costs of collusive behaviour?
- Damages consumer welfare
higher prices / lower consumer surplus
loss of allocative efficiency
hits lower income families - regressive impact - Absense of competition hits efficiency
x-inefficiecies leads to higher unit costs
less incentive to innovate / loss of dynamic efficiency
output quotas penalise firms who want to expand - Reinforces the cartels monopoly power
harder to new businesses to enter the market - reducing contest-ability
Potential benefits of collusion?
- General industry standards can bring social benefits
Pharmaceutical research
Car safety technology
Faster acceleration in developing new technologies - Fairer prices for producer cooperatives in lower middle income developing countries
Competing with powerful monopolistic cooperation
May help in reducing rates of extreme income poverty
-Profits have value - how are they made?
Capital investment projects
Research and development - leading to dynamic efficiency
Higher wages for employees - increased consumption
What are the three main assumptions for a monopoly?
- There is only one firm in the industry - the monopolist
- barriers to entry prevent new firms from entering the market
- the monopolist is a short run profit maximiser
Sources of monopoly power?
- Barriers to entry
the higher the barriers, the stronger the power - Product differentiation
the higher the degree of differentiation, the stronger the monopoly power
Problems of monopoly?
- Higher prices
- Allocative inefficiency - as monopoly results in deadweight welfare loss
- Productive inefficiency - as output dosent occur at lowest point on AC curve
- X-inefficient - as less incentive to cut prices
- Supernormal profit - unequal distribution of income in society
- Higher prices to suppliers - have little alternative to supply
- Diseconomies of scale - too big and difficult to coordinate
- Lack of incentives - (lack of competition) product innovation and develop better product
- Lack of choice
Advantages of monopoly?
- Economies of scale
- a monopoly can benefit from lower average costs which can lead to lower prices for consumers - Research and development
- Monopolies make supernormal profits which can be invested in R&D - A firm may gain monopoly power because it is most efficient
- as market dominance - comes from being innovative and meeting consumer demand rather than being x-inefficient - Global competition
- a domestic monopoly may face competition from abroad it can still face competitive pressures
Evaluation of monopolies?
- It depends on the industry - water needs a monopoly
- some industries need a lot of R&D - research drugs and aeroplanes
- A government may want to regulate monopolies to gain benefits of EOS, without the disadvantages of higher prices
What is price discrimination?
Price discrimination involves charging a different price to different groups of people for the same good.
Able to profit maximise.
Whats first degree price discrimination?
Involves charging consumers the maximum price that they are willing to pay. There will be no consumer surplus.
Whats second degree price discrimination?
Involves charging different prices depending upon the choices of consumers. (quantity, time period, collecting coupons)
It is also known as indirect price discrimination because the firm allows consumers to choose which price they will pay. Some choices are offered cheaper as they impose costs on the consumer.
Whats third degree price discrimination?
Group price discrimination
Involves charging different prices to different groups of people
- student discounts, senior citizen railcard, peak travel/off-peak travel a
- segmented by price elasticity of demand, income, age, sex
Whats product versioning?
One way that firms practise price discrimination is to offer slightly different products as a way to discriminate between consumers ability to pay. Priority boarding.
A form of indirect segmentation. By offering slightly different choices, the firm is able to separate consumers who are willing to pay higher prices.
What are the conditions necessary for price discrimination?
- Firm is a price maker - the firm must operate in imperfect competition; it must be a price maker with a downward sloping demand curve
- Separate markets - the firm must be able to separate markets and prevent resale
- Different elasticities of demand - different consumer groups must have elasticities of demand
- Low admin costs - must be relatively cheap to separate markets and implement price discrimination
- Ability to prevent re-sale - no secondary markets
Advantages of price discrimination?
- Firms will be able to increase revenue, Will enable some firms to stay in business who otherwise would have made a loss
- Increased investment. Increased revenues used for R&D which benefits consumers
- Lower prices for some
- Manages demand - encourage people to travel at unpopular times - helps avoid over-crowding and helps to spread demand subsidy - brings social benefits - brings people into marker
- Better use of spare capacity - environmental benefit
Disadvantages of price discrimination?
- Higher prices for some
- Decline in consumer surplus - enables a transfer of money from consumers to firms - contributing to increased inequality - turned into producer surplus (profit)
- Potentially unfair - exploits consumers - majority still more than marginal cost
- Administration costs - in separating the markets, which could lead to higher prices
- Predatory pricing - profit could be used to finance it
- Reinforces monopoly power
Price discrimination - rail network as an example?
Advance fares using companies like Trainline offer generous discounts compared to buying a ticket on the day. Off peak fares and suburban services work out cheaper than peak journeys into city centres. Season tickets are also regulated separately directly by the government as opposed to the the Office of road and rent.
The government attributes the rise in fares to be necessary to finance the improvements in provision realised by projects such as crossrail. Overall, however, rail journeys are increasingly being paid by the consumer as opposed to the tax payer.
Whats a monopsony?
A monopsony occurs when a firm has market power in employing factors of production (e.g.labour)
Means there’s one buyer and many sellers
It often refers to the monopsony employer - who has market power in hiring workers.
This is a similar concept to monopoly where there is one seller and many buyers
Bargaining power is therefore in the buyer as they can choose who to buy from which means they can negotiate lower prices and increase profit margins (purchasing EOS) and suppliers can be exploited.
Monopsony in labour markets?
If there is only one main employer of labour, then they have market power in setting wages and choosing how many workers to employ. e.g. government police, nurses…
Profit maximisation for a monopsony?
- The marginal cost of employing one more worker will be higher than the average cost because to employ one extra worker the firm has to increase the wages of all workers.
- to maximise the level of profit, the firm employs Q2 of workers where the marginal cost of labour equals the marginal revenue product MRP=D
- in a competitive labour market, the firm would be a wage taker. If they tried to pay only W2, workers would go to other firms willing to pay a higher wage.
Minimum wage in monopsony?
It could increase wages without causing unemployment.
A monopsony pays a wage of W2 and employs Q2
If a minimum wage was placed equal to w1, it would increase employment to Q1.
A minimum wage of w3 would keep employment at q2
Problems of monopsony in labour markets?
- Monopsony can lead to lower wages for workers. This increases inequalities in society.
- Workers are paid less than their marginal revenue product
- Firms with monopsony power often have a degree of monopoly selling power. This enables them to make high profits at the expense of workers and consumers.
- Firms with monopsony power may also care less about working conditions because workers don’t have many alternatives to the main firm.
Monopsony in product markets examples?
- Supermarkets - food from farmers
2. Amazon and books
Benefits to firms from monopsony power?
- Allows firms to achieve Purchasing EOS leading to lower long run average costs
- Lower purchase costs bring about higher abnormal profits and ultimately increased returns for shareholders
- Extra profit (producer surplus) might then be used to fund capital investment or R&D to improve efficiency
Potential benefits of monopsony for consumers?
and drawbacks..?
- consumers gain from lower prices - increasing real incomes and consumer surplus
- Improved value for money - e.g. NHS using bargaining power for lower prices
- Lower incomes of those employed - lower profits
- May be faced with less choice or higher prices in l/r
- Lower wages - lower real incomes
Evaluation of monopsony?
- Some suppliers may leave the market if monopsony power leads to losses being made. Reducing the amount of consumer choice.
- Lower supply prices might cut the profits available for innovation. Reduces product quality / mass production might have environmental issues / raise ethical issues.
Whats a contestable market?
Occurs when there is freedom of entry and exit into the market. Low sunk costs. Freedom of entry and exit. So threat of new entry means prices are close to competitive equilibrium and profits low-otherwise new firms enter.
Arguments for intervention?
- Protect jobs
- Protect the consumer
- Economic environment
- British ownership
Arguments against intervention?
- Competitiveness
- Foreign direct investment - create jobs
- Strategic interests
- Can other countries do a better job?
What does government intervention want?
Seeks to alleviate market failure in order to protect the interests fo consumers (consumer welfare) and society as a whole.
What are the takes which governments can intervene in markets?
- Price regulation - regulate price set by monopolies to protect consumers from being exploited
- Profit regulation - decide whether they are excessive or not due to the absence of competition
- Quality standards - consumers not being exploited
- Performance targets - minimum standards are met
- Promote competition and contest ability
- Competition between firms through promotion of small business
- Deregulation - economic efficiency
- Privatisation
- Nationalisation
- Monosposny power
What is game theory?
Mathematical models that attempt to study and explain strategic interactions between rational decision-makers.
Basic concepts involved in game theory?
4 elements…
Players - identity of decision-makers
Rules - the rules that bind the game
Outcomes - the options available to each player
Payoffs - the end result that each player receives
Rationality - all players in the game act rationally and in accordance with the maximisation principle
Common knowledge - all players have equal knowledge of the rules of the game and the players involved
Assumptions involved in game theory?
Rationality - all players in the game act rationally and in accordance with the maximisation principle
Common knowledge - all players have equal knowledge of the rules of the game and the players involved
What is the payoff matrix?
A table that represents the final outcomes of any game theoretic situation
2x2 payoff matrix - analyse simple scenrarios
What is the prisoner's dilemma? Set-up... Decisions... Dilemma... Results...
Two individuals are caught committing a crime and are put into prison and questioned.
the prisoners are locked in separate cells and are individually questioned in separate rooms
In the question room, each prisoner is given a choice by the investigators.
Either confess (betray) - incentivised with the promise of a lower sentence
Stay silent (loyality) - provides police with little evidence for crime
Dilemma - their prison sentence depends not just on what they say, but on what the other prisoner says.
Prison sentence… decisions lead to worse off or better off.
Whats the dominant strategy in game theory?
rational
For both prisoners to confess as that generates the best outcome regardless of what the other prisoner does.
though if both don’t confess, could be better off but runs risk…
Whats demand for labour?
Is derived demand> Depends on demand for the product the worker is producing.
Whats marginal revenue product of labour?
equation…
Whats MPP?
Demand for labour depends for labour depends on the marginal revenue product of a worker.
MRP=MPPxMR
Marginal physical product (productivity of a worker)
The extra revenue a firm gains from employing an extra worker. It depends on a worker productivity (PPP) and the Marginal Revenue (MR) of the costs of goods sold.
Wage determination in competitive labour markets?
- industry wage is determined by supply and demand for labour
- an individual firm in a perfectly competitive labour market is a wage taker. Therefore, its supply curve is elastic.
- the firm maximises profits where MRP of workers equals the marginal cost of employing them (at Q1)
What is supply of labour? - factors
- Substitution in effect of a rise in wages.
- with higher wages, workers will give greater value to working the leisure. With work more profitable, there is a higher opportunity cost of not working. Effect causes more hours to be worked as wages rise. - Income effect of a rise in wages.
- when an increase in wages causes workers to work fewer hours. This is because workers can get a higher income by working fewer hours. Therefore they may work less. Therefore, after wage rise, workers may work less because they can get their target income with fewer hours spent working.
Market supply of labour depends on…
5 factors…
- Number of qualified people (supply elasticities)
- Diffculty of getting qualifications (supply elasticities)
- Non-wage benefit of a job
- The wages and conditions of other jobs
- Demographic changes and immigration
Advantages of trade unions?
- protect and improve real incomes
- appeal for better working conditions
- protect against unfair dismissal
- provide job security
- collective bargaining
- industrial action
Arguments for trade unions?
- employment levels protected or increased
- efficient wage theory
- keynesian theory
Arguments against trade unions?
- real wage unemployment
- profits and employment reduced
- prevent flexibility in labour market
- encourage cost-push inflation
