Theme 3 Flashcards
Business size can be measured by:
-Market share
-Profit (growth or absolute)
-Employees/ outlets
-Market power
-DIversification (risk spread)
Economies of scale
Refer to the cost advantage (average cost falling) experienced by a firm when it increases its level of output
Diseconomies of scale
Occur as average costs start to rise beyond a certain level of output
Principle- Agent problem
-Refers to the divorce of ownership between the principal and agent
- ie shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, such as a bonus, rather than maximise the dividends of the shareholder. (to fix this managers could be given shares in the business)
Public sector business
Controlled by the government e.g. schools, hospitals, libraries, (TAX)
Government (or state) has control of an industry, such as the NHS. Many industries in UK were nationalised after 1945 (railway, coal, electricity, steel)
A number of these were natural monopolies. For example, only one firm will provide water because it is inefficient to have multiple sets of water pipes.
Public sector industries have different objectives to private sector industries. Social welfare or industrial strategy might be a priority of a public sector industry.
Private sector business
Aim to make a profit, from small local businesses to large businesses
Free market economists will argue that the private sector gives firms incentives to operate efficiently, which increases economic welfare.
Firms have to produce the goods and services consumers want, which increases allocative efficiency and might mean goods and services are of a higher quality.
Competition might also result in lower prices. This is because firms operating on the free market have a profit incentive, which public sector firms do not.
Why do businesses grow
-Shareholder pressure
-Increase profit
-Increase market share
-New locations
-Survive
-Innovation
-Gap in market
-Achieve economies of scale
-Meet demand
-Managerial objectives like sales bonuses
-Synergy effects- new revenue streams
Organic Growth
Refers to a business growing gradually with their own resources
Methods of organic growth
-New customers- opening a new outlet or store
-New products- developing a new range of products
-New markets- - e.g. finding customers in a different location- Tesco tried to open in the USA, it was a flop
-Franchising- e.g. allowing other businesses to trade under your name (Subway, McDonald’s)
Organic Growth Advantages
-Lot less riskier than inorganic growth- cultures, practises, the way they do things are all established.
-Much cheaper than inorganic- can be financed through retained profit rather than borrowing or raising share capital.
-Retain Capital
-Less likley to experience diseconomies of scale
Organic Growth Disadvantages
-Slow pace of growth- might be hard to keep shareholders happy- they want high returns quick.
-May get left behind if rivals are all growing inorganically
-Cant tap into knowledge and expertise of other businesses as would be the case with inorganic growth.
Two Types of External Growth( inorganic)
-Merger- two businesses join together for mutual benefit.
-Takeover/ acquisition- one business acquires another along with all its assets. Can be hostile or voluntary.
Horizontal Integration
Merging or taking over a business at the same level of the supply chain, or in same industry at the same stage of production. It can create economies of scale and sharing expertise (synergies). For examples in 2019, The Walt Disney Company acquired 21st Century Fox’s entertainment assets in a deal that marked horizontal integration in the media and entertainment industry. The acquisition included film and television studios, cable and international TV businesses, and various other assets.
Forwards vertical Integration
Occurs when a company expands its operations by acquiring or controlling businesses that are closer to the end consumer or the distribution side of the supply chain. Allows businesses to determine how products are promoted and build relationships with consumers. For example : In 2017, Amazon, an e-commerce and technology giant, acquired Whole Foods Market, a high-end grocery store chain. This acquisition was a forward vertical integration move for Amazon, as it allowed the company to enter the brick-and-mortar retail space and expand its reach into the grocery industry.
Backwards vertical integration
With backward vertical integration, a company acquires or takes control of businesses positioned earlier in the production or supply chain.
By doing so, the company aims to ensure a stable and reliable source of raw materials, reduce dependency on external suppliers, and achieve cost savings through economies of scale.
It also means that business dont have to pay extra (profit margins) to suppliers.
For example, a car manufacturer may backward integrate by acquiring a steel manufacturer to secure a supply of steel for their car production.
For example, Nike owns its own factories, which gives it more control over the production of its shoes & apparel. Nike also owns its own retail stores, which gives it more control over the distribution of its shoes.
Tesla use forward and backwards vertical integration.
Conglomerate
A conglomerate has acquired many diversified businesses. It takes over businesses in a different market, spreading risk.
The world’s biggest conglomerates include businesses such as 3M in the United States, Siemens from Germany and Philips (Netherlands).
Samsung – the South Korean electronics giant - makes military hardware, apartments, ships and is also operates an amusement park.
Advantages of inorganic growth
-Greater profitability
-Market share and assets become larger
-Additional skills and expertise of new staff
-Easier to obtain capital when needed
Disadvantages of inorganic growth
-May be additional debt acquired
-Possibly large upfront cost
-Management challenges with integrating acquisitors
-More regulation (Asda/Sainsbury’s got stopped)
-Resistance to chnage
Vertical integration
Vertical integration is a business strategy where a company expands its operations by acquiring or controlling other businesses that are either upstream or downstream in the supply chain.
This means that a company integrates different stages of production or distribution within the same industry under its ownership.
The main goal is to gain more control over the entire value chain, from raw materials to the final product or service delivery.
There are two types of vertical integration – backward and forward
Adv of forward vertical integration
-Increased market power: A company can gain more control over distribution channels and access to final customers. This can increase market power and bargaining position with retailers or distributors.
-Enhanced control over distribution: Forward integration allows a company to have control over how its products are distributed and displayed to customers. This can lead to better brand representation, consistent messaging, and improved customer experiences.
-Profitability: By cutting out distributors, a company can capture a larger portion of the value chain, leading to higher profit margins on its products.
Benefits of vertical integration
-Control of the supply chain – this helps to reduce unit costs and improve the quality of inputs into the production (supply) process
-Improved access to key raw materials perhaps at the expense of rivals who must then pay more for them
-Better control over retail distribution channels + adding new channels to sales platforms to build business revenues
-Removing suppliers and taking market intelligence away from competitors which then helps to make a market less contestable (it increases a firm’s market power)
Drawbacks of vertical integration
-Mergers can often create new problems of communication and coordination within a bigger and more disparate firm. It can then lead to diseconomies of scale where the new bigger firm is more inefficient.
-Companies might lose the benefits of specialized expertise when they integrate various stages of the supply chain.
-In some cases, vertical integration may raise competition concerns, especially when a company gains significant control over an entire industry or market.
-With internal control over different stages, companies may become complacent and rely less on external innovation
Adv of Horizontal integration
-Exploit internal economies of scale (leading to lower LRAC) – lower average costs can lead to increased profits
-Cost savings from the rationalization of the business – this often this involves job losses in a bid to increase productivity.
-Create a wider range of products - (diversification) – this creates opportunities for economies of scope.
-Reduces competition by removing one or more key rivals – this increases market share and long-run pricing power.
-Buying a well-known brand can be cheaper in the long run than organically growing a brand and makes entry barriers higher for potential rivals
DisAdv of Horizontal Integration
-Reduced flexibility – the addition of more personnel and processes in the merged business means more legal accountability and extra red tape which can then slow down the rate of business innovation
-Risk of diseconomies of scale (which causes an increase in long run average cost) from the enlarged businesses especially if there are clashes of management style and corporate culture
-Risk of attracting scrutiny from competition authorities who might be worried that a merger might lead to a lessening of competition which could lead to higher prices and a decline in consumer welfare. For example, a merger between Sainsbury & Asda was blocked on competition grounds (2019)
Motivations for business growth
-Profit motive: Businesses grow to generate improved returns for shareholders. Share valuation is influenced by expectations of future revenues & profits
-Cost motive: Economies of scale increase the capacity of the business leading to lower average costs. This can help to raise profit margins.
-Market power motive: Firms may want market dominance giving them extra pricing power. Larger businesses can take advantage of monopsony power
-Risk motive: Diversification across products & markets can reduce investor risk
-Managerial motives: Managers with objectives tied to business growth often aim for rapid expansion
Mergers and takeovers are good for firms and economies- agree and disagree
For:
-Economies of scale
-Increase market share
-Increase sales and profits
-Brand name becomes established
-Reduced risk
Against:
-Deciding HQ location
-Job Cuts
-Business becomes too large/ monopoly
-Diseconmies of scale
Limits to business growth
-Regulatory Benefits
-Finding skilled staff
-Disruptive technologies
-Financial Constraints
-Size of potential markets
-Controlling costs of a growing business
Regulation and compliance costs
-Health and safety: businesses must adhere to regulations, which may involve purchasing safety equipment, conducting inspections, and providing training for employees
-UK’s General Data Protection Regulation (GDPR) has introduced strict data protection rules for businesses.
-Red tape and delayed planning - getting planning permission for new construction or development projects can be a lengthy and complex process
Competition from new technologies
-Many businesses in the UK have faced challenges from disruptive technologies that have fundamentally changed their industries:
1.London’s iconic black cab drivers faced significant challenges from the emergence of ride-hailing platforms like Uber and Lyft.
2.E-commerce has posed challenges to brick-and-mortar retailers
3.Banks have experienced disruption from fintech startups such as Monzo and Revolut offering innovative digital financial services.
4.Traditional media outlets, including newspapers have faced challenges from online platforms and social media
Financial constraints on business growth
-Limited Access to Capital and Debt – including difficulty in securing loans from banks, attracting venture capital, or accessing equity investment. Smaller businesses often face higher interest rates on loans
-Cash-flow issues - poor cash flow management can impede growth. If a business is struggling to collect payments from customers, has extended payment terms with suppliers, or faces seasonality in its sales.
-High debt levels - excessive debt can become a constraint. High interest payments and principal repayments can limit a business’s ability to allocate funds to growth-oriented activities.
Size of market as a constraint on growth
-Businesses that rely on local customers in small towns or rural areas can face market size constraints
-Some businesses offer custom-made products tailored to individual customers’ preferences. Market size for such products might be limited due to the time and resources required to create each unique item
-Regional cultural products - Some cultural products are inherently limited by regional or cultural appeal such as traditional crafts & foods
-Market size might be constrained by high average prices which causes effective demand to be lower – example: unaffordable electric cars
Economies of scope
Occur where it is cheaper to produce a range of products rather than specialize in a handful of products.
E.g. Supermarkets
Diseconomies of scale
Occur when a business grows so large that the costs per unit increase. As output rises, it is not inevitable that unit costs will fall. Sometimes a business can get too big.
Economies of scale
- Economies of scale are cost advantages companies experience when production becomes efficient, as costs can be spread over a larger amount of goods.
- A business’s size is related to whether it can achieve an economy of scale-larger companies will have more cost savings and higher production levels.
- Economies of scale can be both internal and external. Internal economies are caused by factors within a single company while external factors affect the entire industry.
Internal economies of scale
Originate within the company, due to changes in how that company functions or produces goods.
Internal economies of scale happen when a company cuts costs internally, so they’re unique to that particular firm. This may be the result of the sheer size of a company or because of decisions from the firm’s management. There are different kinds of internal economies of scale. These include:
* Technical: large-scale machines or production processes that increase productivity
* Purchasing: discounts on cost due to purchasing in bulk
* Managerial: employing specialists to oversee and improve different parts of the production process
* Risk-Bearing: spreading risks out across multiple investors
* Financial: higher creditworthiness, which increases access to capital and more favourable interest rates
* Marketing: more advertising power spread out across a larger market, as well as a position in the market to negotiate
External Economies of Scale
Based on factors that affect the entire industry, rather than a single company.
External economies of scale, on the other hand, are achieved because of external factors, or factors that affect an entire industry. That means no one company controls costs on its own. These occur when there is a highly-skilled labour pool, subsidies and/or tax reductions, and partnerships and joint ventures-anything that can cut down on costs to many companies in a specific industry.
Economies and Diseconomies of Scale Graph
U shaped with axis x (output) and y (cost and revenue).
In downward of U- economies of scale as output increases and cost decreases. Upward slope is diseconomies of scale.
Demerger
When a large firm is separated into multiple smaller firms.
Reasons for demerging
-Lack of synergies- synergy is when creating a whole company is worth more than each company on its own. If this doesn’t exist, firms are likely to demerge because they will be worth more.
-Growth/Share Price- each part of the firm could grow at different rates. The faster-growing part might be separated. The growing firm can hold a stronger share price if demerged.
-Diseconomies of scale- If the firm is so large that average costs rise with more output, the firm might choose to split into smaller units.
-More focused companies- The firm might be able to grow faster if it focuses on fewer markets rather than lots of different markets/ sectors e.g. Dart group becoming Jet 2.
-Resources- If a firm is experiencing long term cash flow issues, they might sell off a part to raise cash. Selling off part of the firm can raise valuable finance, which could be better invested in a more profitable part of the firm.
Demergers Impact on Workers, Firms and Consumers
Impact on Workers:
-Demerged companies may need separate managers, which could lead to promotions.
-However, demergers aim to increase efficiency, which could result in job losses.
Impact on Firms:
-Focussing on a smaller demerged business may allow the business to be more innovative and efficient.
-However, could lose economies of scale.
Impact on Consumers:
-Consumers may gain from innovative businesses leading to better products.
-However due to firm losing economies of scale, prices might rise.
Business Objectives - Profit Maximisation
Traditionally firms wish to maximise profit. Normal profit (salaries and wages inc in total cost) covers the opportunity cost of remaining in the industry. This is included in the total cost faced by the firm. Profits above this are known as supernormal profits. If firms are in a position to choose ouput and price, they will produce where the difference between TR and TC is the greatest. This can be demonstrated on a TC/TR graph largest profit when largest gap between lines.
Business Objectives- Revenue Maximisation
Firms/Managers may decide to maximise their revenue as they have objectives to increase cashflow. Output will be set at the level where TR is the highest. This may result in them selling higher quantities than if they were profit maximising. MR=0
Business Objectives- Sales Maximisation
The objectives may be to maximise the volume of sales in order to meet growth targets. This may result in prices being lowered and output being set at breakeven point where TC=TR ( normal profit is included in the costs) AR=AC
Business Objectives- Long Run Profit Maximisation
Firms may choose to operate where they are making a loss if they believe in the long run this will gain them market share and higher profits e.g. Ryanair.
Behavioural Theories - in relation to objectives
-Satisficing- managers will run the firms to meet the minimal requirements of the shareholders. An illustration of the principal-agent problem.
-Bounded Rationality - Managers can only work with the knowledge they have and set objectives accordingly .e.g. they may not have been able to predict exchange rate/tax fluctuations.
-Corporate Social Responsibility (CSR) - firms meet objectives of environmental/social obligations.
Motivations for Revenue Maximisation
-Market Penetration and Expansion- In the early stages of a business or when entering a new market, focusing on revenue can help the company gain market share, build brand recognition and establish a customer base.
-Costs- higher output and revenue may enable the business to achieve economies of scale and enhance competitiveness over the long term.
-Attracting Investors and Financing- Businesses with strong revenue growth can be more attractive to investors and lenders.
-Business valuation and exit strategies- Businesses aiming to be acquired might focus on revenue growth to enhance their valuation.
-Business Survival- Cutting prices to increase revenue and improve cash flow can be an important way of surviving in an economic downturn.
Marginal Cost
The change in total cost for a business as a result of a one-unit change in output.
Change in TC / Change in Output (Q)
E.g. of low marginal cost - Online courses, Mass Production
E.g. of high marginal cost - Training staff, housing, aeroplanes, Specialised products such as suit tailors.
Why is Marginal Cost Important
- Businesses aiming to make profits need to have an indication of the marginal cost of supplying extra output. They can make higher profits, providing the marginal cost is less than the marginal revenue.
If the marginal cost of increasing output is low, then a firm might benefit from expanding their production because it will lead to a fall in the average (or unit) cost of supply.
Can Marginal Cost be hard to measure?
-Many firms engaged in mass production do not change their output in single units. They might produce ‘batches’ of extra output by adding more shifts to their factory productions.
-It is probably easier to measure marginal cost for ‘tangible output’ such as an extra barrel of oil or tonne of steel. Harder to accurately calculate the marginal cost of more people using a train service.
“Short Run” in Production
- In economics, short-run production refers to a period of time during which at least one factor of production (usually capital, such as machinery) remains fixed, while others can be varied.
- Variable factors might include labour and intermediate inputs
- This concept is central to understanding the relationship between inputs and outputs in the production process.
- The short run is characterized by the limited ability to adjust certain inputs, which leads to a constrained production (supply) capacity.
Law of Diminishing Returns
- The law of diminishing returns operates in the context of at least one fixed input and one variable input. The fixed input (usually capital) remains constant during the short run, while the variable input (usually labour) can be increased or decreased.
- The law of diminishing returns states that as more units of a variable input are added to a fixed input, after a certain point, the marginal product of the variable input will begin to decrease.
- In other words, the additional output produced by each additional unit of the variable input will start to decrease, ceteris paribus (i.e., with all other factors remaining constant)
Explaining the Law of Diminishing Returns
- Initially, as the farm adds more labour inputs, the total output of wheat increases rapidly.
After a certain point (in this case, after 4 - labour inputs), the total output starts to
increase at a diminishing rate. - Adding the 4th labour input only increases output by 10 bushels
- Adding the sixth labour input only increases output by 2 bushels
- Falling marginal product signifies diminishing returns.
When Diminishing Returns set in, the marginal product of labour starts to fall. When the marginal product of labour declines below existing average product then the average product of labour will fall .
Production vs Productivity
Production Measures the volume/ value of output in a given time period.
Productivity Measures the efficiency of factors of production in a given time period.Could be measured by output per person hour or output per person employed.
An Increase in production doesn’t automatically mean an increase in productivity.
How does diminishing returns affect cost
-The concept of diminishing returns is closely related to the marginal cost of supply which is the additional cost incurred by a producer when they increase their output by one unit.
-As diminishing returns set in, the marginal cost of supply will increase.
-This is because in order to produce more output, the producer needs to add more of the variable input (e.g. labour) which becomes less productive as more of it is added.
Characteristics of Perfect Competition
-Many Buyers/ Sellers
-Homogenous goods - all the same - all strawberries the same
-Firms are price takers- business has no option but to charge the ruling market price
-No barriers to entry/exit
-Perfect information
-Demand is perfectly elastic for firm in perfect competition, as firms are price takers so price remains the same.
Characteristics of Imperfect Competition
-Few Buyers/Sellers
-Differentiated goods
-Firms are price makers- business can influence price
-High barriers to entry/exit
-Imperfect Information
- Firms are price makers so will set high prices and then be governed by law of demand. MR is twice as steep, as when a firm is lowering its price its lowering the price on all products.
-Have some degree of pricing power and will face a downward sloping AR curve.
-Revenues are maximised at an output level where marginal revenue = 0. Marginal revenue is the change in total revenue from selling an extra unit (change in total revenue/ change in quantity) . The coefficient of PED when revenue is maximised is unity (1). Revenue maximisation occurs halfway down a linear demand curve.
Revenue
Revenue is any money that a business makes from selling its goods and services, whereas costs are anything that a business pays for. Businesses need revenue to ensure that they can maintain their day-to-day operations and pay any business costs they have.
Example of revenue for a florist shop:
selling flowers
: delivery charges
Examples of revenue for a web designer:
fee for designing a website
* fee for maintaining or updating a website
Revenue is worked out using a simple calculation:
Revenue = Selling price x Quantity
Average Revenue = total revenue/ quantity
Cost
A cost is anything that a business has to pay for. All businesses have costs that need to be paid regularly. Examples of costs for a business include rent, bills, and raw materials, staffing costs, petrol and postage.
Costs are split into three main categories: fixed, variable, and total
Fixed Cost
Fixed costs are costs for a business that do not change, no matter what the level of output for the business. They are usually fixed for at least a year and mean that a business will pay the same amount each week, month or year.
Examples of fixed costs include: Rent, Salaries and Advertising
Variable Cost
Variable costs are costs that change depending on the output of a business. These costs are dependent on how much a business produces or sells. If a business is producing or selling more, variable costs will rise. If a business is producing or selling less, variable costs will fall.
Examples of variable costs include: Raw Material, Postage, wages and petrol.
Total Cost
Total costs are the fixed and variable costs for the business added together, giving the total overall costs for the business. The calculation for total costs is:
Total costs = Fixed costs + Variable
Link between PED and TR
TR = P x Q , PED = % change in Q / % change in P.
Area under D = Total revenue
For inelastic demand - an increase in price will lead to an increase in total revenue. So assuming revenue maximising, a firm should increase price.
For elastic demand by increasing the price of an elastic good the TR will decrease so should decrease price to revenue maximise.
Factors of Production Costs
Capital- Interest repayments
Enterprise- Profit/ dividend payments
Land- Rent
Labour- Wages/ Salaries
Short and Long Run
Short Run - Some Factors fixed and cannot be increased/ reduced- usually land.
Long Run- Time taken to vary all factors of production
Short and Long run vary in all industries- could be difference of a day, month, year or several
Calculating costs
TC = TVC + TFC
AC= TC/Q
MC= Change in TC/ Change in Q
Economies of scale
In the long run, all costs are assumed to be variable.
Internal economies of scale are the unit cost advantages from a business expanding the scale of production in the long run.
They arise from the benefits of increasing returns to scale. Large-scale production often uses fewer inputs per unit of output.
Lower average costs are an improvement in productive efficiency and can give a business a competitive cost advantage.
Economies of scale can lead to lower prices for consumers and higher profits which is good news for shareholders.
Retailers such as Amazon can benefit from many internal economies of scale
Economies of scale help drive growth & profits in the global beer industry
Internal and External Economies of scale
Internal Economies of Scale: These arise from within the firm itself as it expands its own operations in the long run. They result from the firm’s own actions and decisions.
External Economies of Scale: These arise from factors outside the firm, often related to the industry or the business environment in which the firm operates. They are shared by multiple firms within an industry or geographic region.
Different types of Internal Economies of Scale
-Technical economies of scale
-Managerial economies of scale
-Purchasing economies of scale
-Financial economies of scale
-Risk-bearing economies of scale
Technical Economies of scale
Specialised Equipment: For example, a manufacturer of computer chips may be able to invest in cutting-edge semiconductor equipment that allows them to produce a larger quantity of chips with high precision, resulting in lower costs per chip.
Automated Production: Automation reduces the need for manual labour, minimizing errors, and increasing the speed of production.
Managerial Economies of Scale
This is a form of division of labour where firms employ specialists to supervise production systems.
Better management and increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity, and thereby reduce unit costs.
Financial Economies of Scale
Financial markets usually rate larger, more established firms to be more credit worthy and have access to loans with favourable rates of borrowing – they may borrow much more overall than a small firm and pay a lower rate of interest (although the bank still benefits because of the large amount borrowed)
Smaller firms often pay higher interest rate on overdrafts and loans. Whereas businesses listed on the stock market can normally raise new financial capital more cheaply through the sale of equities to the capital market.
Purchasing Economies of Scale
A large firm can purchase factor inputs in bulk at lower prices if it has monopsony power – we can call these purchasing economies.
Large food retailers have monopsony power when purchasing their supplies from farmers and wine growers and in completing supply contracts from food processing businesses.
Risk- Bearing Economies of Scale
Risk-bearing economies of scale can occur when larger businesses are better equipped to manage certain types of risks more efficiently than smaller ones.
This advantage arises from their size, and from product and market diversification to make their business more resilient.
Example: Insurance companies diversify their risk exposure across a wide range of policies and customers
Example: Amazon has since diversified into e-commerce, cloud computing (Amazon Web Services), digital streaming (Amazon Prime Video), and much more!
Internal Economies of Scale at Pure Gym
Purchasing power: Can use their monopsony power to negotiate lower prices from suppliers for things such as gym equipment, fitness gear, food and cleaning supplies.
Spreading fixed costs over many customers: Pure Gym must pay rent, utilities, and insurance regardless of how many members it has. As Pure Gym grows, this lowers the average cost per member.
Financial economies: Pure Gym can negotiate lower rates with commercial landlords, and (in theory) it can borrow money at lower interest rates.
Internal Economies of Scale at Hotel Chains
Bulk Purchasing - Larger hotel chains purchase supplies in bulk, such as linens, toiletries, and food items. Their monopsony power means they can negotiate lower prices and achieve cost savings not be possible for smaller “boutique” hotels.
Technology - Large hotel chains invest in centralized reservation systems, property management systems, and other IT infrastructure. By standardizing their technology across multiple locations, they can reduce costs and improve productive efficiency
Marketing and Branding - Large hotel chains can leverage their brand recognition and marketing budgets across multiple locations to drive demand and increase occupancy rates. Marketing is a fixed cost – consider Premier Inn’s TV advertising campaigns. Homogenous good- consumers know what they are getting;
Long Run Average Cost Curve
-The long run average cost curve (LRAC) is drawn on the assumption of their being an infinite number of plant sizes that a business can use
-If LRAC is falling when output is increasing, then the firm is experiencing economies of scale.
-For example, a doubling of factor inputs might lead to a more than doubling of output.
-Conversely, when LRAC eventually starts to rise then the firm experiences diseconomies of scale
-If LRAC is constant, the firm is experiencing constant returns to scale
External Economies of Scale
External economies of scale occur when the cost advantages of producing a good or service extend beyond an individual firm and benefit multiple firms within a specific industry or geographical area.
External economies of scale provide cost advantages to all firms within an industry or sector, not just to a single firm.
Often, external economies of scale are observed in clusters where businesses in the same industry are in proximity. For Example, Media City in Salford and Cambridge Science Park
Reasons for External Economies of scale
-Infrastructure Economies: If an industry cluster develops in a specific geographic area, firms can benefit from shared infrastructure, such as transportation networks, utilities, and specialized services.
-Knowledge and Labour Pool: In certain regions, there might be a concentration of skilled workers and a strong knowledge-sharing environment. Firms in these regions can tap into a well-trained labour force and easily access industry-specific knowledge. Business can benefit from the research activities of local / regional universities.
-Supplier Networks: Clusters of related businesses can lead to a strong supplier network. The automotive industry often sees this, as car manufacturers benefit from well-established networks of suppliers providing specialized components.
Examples of External Economies of Scale
Silicon Valley, California - a region in the San Francisco Bay Area known for its concentration of high-tech companies, startups, research institutions, and venture capital firms. The proximity of these entities fosters collaboration, knowledge sharing, and access to a highly skilled workforce.
Bangalore, India – Bangalore has become a global IT hub. The city’s concentration of IT companies, educational institutions, and technology parks has fostered an environment of collaboration and innovation.
UK Examples of Economies of Scale
Cambridge - Technology and Biotech: The city of Cambridge, particularly the area known as the “Cambridge Cluster” or “Silicon Fen,” is a hub for technology, biotech, and pharmaceutical companies.
Manchester - Creative and Media Industries: Manchester has a vibrant creative and media industry, with a focus on television, film, music, and digital media.
Sheffield - Advanced Manufacturing: Sheffield has a tradition in advanced manufacturing in industries such as aerospace, steel, and engineering
Dundee has developed a notable presence in the video game sector with a cluster of highly successful computer games companies based there.
Diseconomies of Scale
Diseconomies of scale are increases in the unit (average) cost of supply in the long run due to decreasing returns to scale.
Diseconomies of scale mean that a business has moved beyond their optimum size in the long run. Businesses are suffering from productive inefficiency perhaps because of organisational slack.
Breakdowns in communication may lead to the departure of highly skilled workers from a business – this a loss of human capital for the business
Businesses then might have to raise their prices to cover increased unit costs.
Lost cost competitiveness could lead to declining market share and a fall in the share price if the business is on the stock market.
Reasons for Diseconomies of Scale
-Higher Regulatory Costs for bigger businesses
-Office Politics/ Industrial Relations
-Risk Aversion among salaried staff
-Waste/ Inefficiency in large organisations
-Complexity and Coordination: As an organization grows, it may become more complex, with more (costly) layers of management.
-Bureaucracy: Larger organizations often develop bureaucratic structures to manage the increased complexity. Innovation may slow down as employees / managers become risk-averse.
-Cultural and Organisational Issues: As organisations grow, maintaining a cohesive culture and shared values can become more challenging. This can impact employee morale, motivation, and have a damaging effect on labour productivity.
Allocative Efficiency
Reached when no one can be made better off without making someone the worse off. Also known as Pareto efficiency/ optimality. Occurs when the value that the consumers place on a product ( reflected in the price they are willing and able to pay) equals the marginal cost of factor resources used up in production. The condition required for allocative efficiency in a market is that Price = Marginal Cost Of Supply.
-Maximises total consumer welfare (economic welfare maximised), Consumer and producer surplus maximised.
Price = Marginal Cost of Supply
Productive efficiency
Refers to a state where a company is producing goods or services at lowest possible average cost, using fewest possible resources. This means that a company can produce to maximum output with the given inputs, without any waste or inefficiencies. In other words the company is using resources in the most efficient way possible. Productive efficiency is achieved at an output that minimizes the unit cost (AC) of production. Productive efficiency where AC = MC.
Market Structure Characteristics
-Number of firms in a market
-Degree of power of each firm- market concentration- power concentrated
-Barriers to entry/exit - legal etc
-Knowledge/ Information- perfect knowledge- every firm has access to the same information.
-Product Homogeneity/ branding- products differentiated from competition- easier to control
-Profit Levels.
Perfect Competition -> Pure Monopoly
Perfect competition-> monopolistic competition -> oligopoly -> Duopoly -> Monopoly -> Pure Monopoly
as go left gets more competitive ( fewer imperfections)
as go right gets less competitive (greater degree of imperfections)
Perfect Competition Assumptions
A model of an extreme market structure, based on certain assumptions.
Basic Assumptions:
-Homogenous products (they are all perfect substitutes)
-All Firms have equal access to factors of production
-Many buyers + sellers (no monopoly or monopsony power)
-Sellers must act independently (there is no price collusion)
-Free (costless) entry and exit to the market
-Perfectly elastic demand curve for each individual firm
-Perfect knowledge/ info from buyers/ sellers about prices and quality of what is being sold.
-Profit maximisation is assumed as the default objective of firms - (MC=MR) and consumers are assumed to be utility maximisers when making purchasing decisions.
Industry and Firm MC/AC/D/S graphs
-Market price is set in the market
-The market price comes over to the firm and the firm has a perfectly elastic demand curve
-The individual firms supply curve is represented by the MC curve
-The firm will produce at the profit maximisation point (MC=MR)
-In the long run firms will make normal profits (AC=AR)
Abnormal Losses in the SR - graph
-Firms are making abnormal losses
-Because of no exit barriers some firms start to leave the market
-As firms leave the market supply shifts to the left, causing price to rise
-This continues until we attain normal profits in the long run
Abnormal Profits in the SR - graph
-Firms are making abnormal profits
-perfect knowledge- evreyone knows abnormal profits
-Because of no entrance barriers some firms start to enter the market
-As firms enter the market supply shifts to the right, causing prices to fall.
-This continues until we attain normal profits in the long run.
Monopoly Characteristics
- Number and Size of firms that make up the industry- One large dominant firm.
-Control over price or output- Price makers- choose price
-Freedom of entry and exit from the industry- huge barriers, difficult to get in/out
-Nature of the product (degree of homogeneity)- highly differentiated, price inelastic, few substitutes.
-Diogromatic representation- very price inelastic (not perfect)
Pure Monopoly Assumptions
-Single seller of goods/service.
-No substitutes for the good.
-There are barriers to entry into the market.
Pure Monopoly
Where only one producer exists in the industry. In reality, rarely exists - always some form of substitute available.
Monopoly exists therefore where one firm dominates the market.
Firms may be investigated for example of monopoly power when market share exceeds 25%. In 2019, Asda + Sainsburies were going to merge, giving 32% market share, not allowed to happen.
Origins of Monopoly
-Natural Monopoly- usually on a network or grid… wastefull to duplicate.
-Geographical factors - where a country or climate is the only source of supply of a raw material… quite rare. However, consider a single grocery store in an isolated village.
-Government-created monopolies - now sold off
-Through growth of the firm, amalgamation, merger or take over.
-Through acquiring a patent or license
-Through legal means - Royal charter, nationalisation, wholly owned plc.
Monopoly Diagrams
Revenue Maximisation at MR=0.
Abnormal profit at P1abP2
If the market is competitive, then it will be allocatively efficient. Where Demand = Supply. Therefore in a monopoly the consumer faces a higher price (P, rather than P3). The Quantity available to the consumer is lower ( Q* rather than Q1). But because Q restricted to Q* we contract along supply curve to P1.
If the market was competitive we would see P3Q1 therefore consumer surplus of CeP3 and producer surplus of P3eo. At Q* consumer surplus is CaP1 and a consumer loss of consumer surplus of P1aeP3. Original producer surplus of P3eo and new producer surplus of P1afo. Dead weight loss of aef.
Price Discrimination
Price Discrimination occurs when a firm charges a different price to a different group of consumers for an identical good or service, for reasons not associated with the cost of supply.
Price Discrimination occurs in all imperfectly competitive markets.
It is most common in monopolies and oligopoly.
Requires a supplier to have some pricing power.
It has potentially important welfare and distribution effects.
Aims of price discrimination
-Increased Revenue- extracting consumer surplus and turning it into increased producer surplus for the seller.
-Higher profits- Total profit will rise providing the marginal profit from selling to extra consumers is positive.
-Using spare capacity- can help a business make more efficient use of their supply capacity.
3rd Degree Price Discrimination
Charging different prices to groups of people with different price elasticity of demand (PED).
Examples of 3rd Degree price discrimination
-Cinema pricing- Ticket prices vary by age, time of film showing and (in some cases) by location of the cinema.
-Student discount- many venues offer price discounts for students who have a more price-sensitive demand.
-Car insurance- price walking- long-standing customers faced higher prices when renewing their policies.
Conditions for using price discrimination
-Monopolists have “market power” - the ability to set prices without worrying about competition.
-The groups being discriminated between must have a different PED.
-There must be a way of stopping arbitrage opportunities that arise from consumers buying cheap, and selling to those who have been charged a higher price.
Negative effects on consumer welfare
-Higher prices for many people reduces their consumer surplus - an example is “dual pricing” in insurance where loyal customers were charged more than new customers. This form of pricing exploits imperfect information in the market and consumer inertia.
-Price discrimination reinforces monopoly power of firms which can then lead to higher prices in the long run and a loss of allocative efficiency.
-Algorithms increase the potential to discriminate between consumers- there is now widespread use of artificial intelligence-driven price discrimination leading to certain groups in society consistently paying more (such as online hotel bookings).
-Multi-purchase or volume discount purchasing favours higher-income, larger families at the expense of single people. It can encourage food waste, which creates external costs.
Arguments supporting price discrimination
-It makes fuller use of spare capacity leading to less waste. There are potential environmental benefits from this- an example, less food waste.
-Helps generate extra cash flow for businesses which can ensure survival during a recession- this supports jobs and maintains choice for consumers.
-Can fund cross-subsidy of goods and services - premium prices for some can fund discounts for other groups living on lower incomes (consider means-tested college fees). It can allow the continuation of loss-making services such as rural bus & train routes.
-Higher monopoly profits can finance investment & research and development spending which then drives improved dynamic efficiency in the long run.
-Can be seen as a progressive policy - an example, charging different prices for drugs such as vaccines between advanced and developing nations.
Natural Monopoly
A market structure where a single firm can produce a particular product or service at a lower average cost than multiple firms could.
In other words, it is more efficient for one firm to be the sole provider of a specific good or service due to economies of scale.
A natural monopoly arises when economies of scale are so pronounced that the average cost of production decreases as the firm produces more output.
Given the potential for monopolistic abuse in natural monopolies, many governments regulate them to ensure fair pricing, quality of service and accessibility for consumers to help maintain consumer welfare.
Examples of a natural monopoly
-Web search engine
-Messaging platform
-Air traffic control
-London Underground
-Rail Network
-Energy grid
Natural Monopoly - Costs
Natural monopoly occurs when the most efficient number of firms in the industry is one. A Natural Monopoly will typically have high fixed costs and low marginal costs meaning that it might be inefficient to have many firms each providing the same product. Long run average cost continues to fall over a big range of output.
The shape of LRAC - for natural monopoly can mean that it is tough for smaller challenger firms to enter the market profitably. But it might be possible to successfully enter the market at the retail level providing ‘final mile services’ to customers.
-For example - Electricity and gas distribution -as distinct from retail distribution services from energy businesses such as Ovo energy or Octopus
Full Natural Monopoly Diagram
-Assumes that the firm in a natural monopoly is aiming to maximise profits
-Important to understand the nature of costs for a natural monopoly. There are likely to be substantial economies of scale which in theory- can help improve consumer welfare if reflected in lower price.
Monopolistic Competition
A market that shares the same characteristics of monopoly and some of perfect competition.
There are many firms producing similar, but not identical products.
For example:
-Sandwich bars
-Hairdressers
-Takeaway restraunts
-Care homes
-Taxi companies
Key Characteristics of Monopolistic Competition
-There are many producers and many consumers in a market- the concentration ratio is low and they act independently.
-The barriers to entry and exit into and out of the market are low
-The firms are short run profit maximisers.
-Consumers see that there are non-price differences among the competitors’ products .i.e. there is products differentiation.
-Producers have come control over price- they are ‘price makers’ rather than ‘price takers’.
Concentration Ratios
The n firm concentration ratio is the market share of the n largest firms in the market.
Monopolistic Competition - Graph
Long Run equilibrium diagram for monopolistic competition, profit maximisation at MC = MR, LREQ equals normal profit. AR = AC at Q star. AC is tangential to AR at Q star. AC cutting MC at lowest point
Monopolistic Competition - Productive efficiency
- No- Since at Qm rather than Qo, not where MC=AC.
-There is a market shortage
-They are also not maximising their economies of scale
Monopolistic Competition - Allocative efficeincy
-No, since Pm > Mc
-In a truly competitive market, the Po would exist - so there is a misuse of the consumer surplus- consumers are overcharged, and firms produce under their capacity.
Monopolistic Competition - Dynamic efficiency
-There are profits for product development
-There is an incentive for the companies to invest in R&D and new ideas…. As the product is always being developed.
-So yes- there is an incentive to be dynamically efficient.
Oligopoly Characteristics
-Few Firms will dominate the market (fight for market share)
-Interdependent
-High concentration Ratio
-Differentiated goods, so price makers
-High barriers to entry and exit
-Profit maximisation is not the sole objective
Example of Oligopoly
Groceries - top five firms have over 60% of the market share
-Tesco, Sainsbury’s, Asda, Morrisons, Aldi
Assumptions of Oligopoly diagram
-Other firms will not follow the price rise
-Other firms will follow a price fall
Oligopoly - collusion
An Oligopoly can lead to a temptation to collude:
-OPEC (Organisation of the Petroleum Exporting Countries)
-In this type of overt, collusion firms typically agree to limit their output in order to raise prices
-OPEC attempts to manipulate the world price of oil by restricting supply
Concentration Ratios of Market Structures
0% - No concentration - Perfect Competition
1%-50% - Low concentration - Monopolistic Competition
51%-80% - Medium Concentration - Monopolistic Competition/ Oligopoly
81%-100% - High Concentration - Oligopoly/ Monopoly
Two main types of oligopoly
Competitive:
-Engage in price wars or non price competition
-When there are lots of firms in market (low concentration)
-Low barriers so firms attracted to super normal profits
-Offer a range of similar goods
-More like a competitive market
(all relative to oligopoly)
Collusive
-Can be overt (publicly) or tactic (discreetly)
-Fix prices high to reduce competition and maximise profits
-Fit the output to keep supply at a certain level
-Higher barriers to entry
-Ineffective competition policy
-Small number of firms dominating (3-4)
Consumers might still be loyal regardless or they might not know or care.
Collusion Advantages
-Excess profits could be reinvested to improve dynamic efficiency in the long run (or higher dividends)
-Firms can collaborate on technology and improve their goods/services
-Saves on duplicate research
-Increase in size so economies of scale - lower prices
Collusion Disadvantages
-Less consumer welfare as prices are raised and output reduced
-Efficiency falls as less competition which would increase average costs
-Makes it tougher for new firms to enter
Game Theory
Game theory - related to the concept of interdependence between firms in an oligopoly.
Firms will eventually end up at the Nash Equilibrium unless they collude, but there is an incentive to cheat to both get higher profits.
Cartel
A formal agreement between firms to fix prices, output, or other market conditions
Price fixing
An agreement among competitors to set prices at a certain level.
The German Beer Price Fixing Case
In 2014, several major German Breweries were fined by the Federal Cartel Office for price-fixing agreements. This case provides a real-world example of collusion in an oligopolistic market. Four of the country’s largest breweries were fined €106.5m (£89m) for price-fixing. The talks resulted in a Germany-wide rise of €5-€7 per hundred litres for barrelled beer, and €1 per crate of bottled beer. The Cartel Office said the brewer AB InBev, whose brands Beck’s, Franziskaner and Hasseroeder were under particular investigation, and the retailer REWE Zentral escaped fines because they co-operated from early on in the investigation. Linking to the prisoner dilemma, by cooperating.
Game Theory - Prisoner Dilemma
The Prisoner’s Dilemma is a classic game theory scenario that demonstrates how cooperation can be difficult to achieve even when it is in everyone’s best interest.
Oligopoly competition: The Prisoner’s Dilemma can be used to model oligopoly competition, where a small number of firms dominate in a market. In this context, each firm has an incentive to maximize its profits, but if all firms do so, it can lead to a suboptimal outcome for the industry as a whole. The Prisoner’s Dilemma provides a framework for understanding how firms can coordinate their actions perhaps through tacit collusion to achieve a better outcome.
Tactic Collusion
In economics, tacit collusion refers to a situation where firms in an industry coordinate their behavior and set prices at a level that maximizes their joint profits, without any explicit communication or agreement between them, mutual understanding.
Unlike explicit collusion, where firms engage in illegal behavior such as price fixing or market allocation, tacit collusion is not illegal and is often difficult to prove. In a tacitly collusive industry, firms may engage in a variety of behaviors that allow them to coordinate their actions without communicating directly with one another. For example, they may adopt similar pricing strategies, match each other’s price changes, or limit their production to avoid price wars.
Tacit collusion is often seen in industries with a small number of large firms, where there are high barriers to entry and the market is not very competitive. In such industries, firms may have an incentive to coordinate their behavior in order to avoid the uncertainty and risk associated with aggressive competition.
The effects of tacit collusion on consumers can be significant, as it can lead to higher prices and reduced choice in the market. Regulators and antitrust authorities may monitor industries for signs of tacit collusion and take action to prevent or punish collusive behavior if it is found to be harming consumers.
Monopsony
-A monopsony is a single buyer in a market. For example, Network Rail for track maintenance and the government for teachers.
-Profit Maximisers
-Can negotiate lower prices with suppliers
-They set market prices
For example
- Nuclear Arms - only the government who buys
- NHS - the world’s largest employer
The monopsony gains higher profits by being able to buy at lower prices. This increases the funding for research and development and leads to more returns for shareholders.
They achieve purchasing economies of scale, which will lower costs and increase profits.
The NHS has monopsony power when buying drugs from pharmaceutical companies, can negotiate lower prices. These additional profits can be reinvested.
Benefits of Monopsony
The benefits of monopsony to firms and consumers include:
- Higher profits of monopsony can be used to invest and innovate.
- Monopsony power can give power to buyers in the face of monopoly supply of resources. For example, cosmetic producers such as L’Oréal can charge very high prices for their products but supermarkets can force their suppliers to cut their costs.
Benefits to Firms:
-Monopsony power allows the buyer to negotiate lower prices for inputs, benefiting the firm by reducing production costs. Increasing Profits.
Benefits to Consumers:
-Consumers may benefit from lower prices for the final goods or services produced by the monopsony, as lower input costs can translate into lower prices for consumers.
-However, if the monopsony drives suppliers out of business or reduces the quality of inputs, it could result in limited product variety and potentially higher prices in the long run.
Benefits to Employees:
-Employees may benefit from a monopsony’s presence if it offers competitive wages and working conditions due to its ability to negotiate lower input costs.
-However, in cases where the monopsony uses its power to depress wages, it can lead to lower incomes and reduced job opportunities for workers.
Benefits to Suppliers:
-Suppliers may benefit from the stability and reliability of a monopsony as a consistent buyer.
-However, they may face pressure to accept lower prices, reduced profit margins, and less bargaining power.
Negatives of Monopsony
The costs of monopsony to firms and consumers include:
* Suppliers can be squeezed out of business.
* Choice for consumers could be limited, as monopsony acts as a barrier to entry for new firms.
* Higher profits of monopsony can mean inequality.
* Firms might be investigated by the competition authorities.
*If the monopsony exploits its market power excessively, it can harm suppliers, potentially leading to reduced supply, lower product quality, or the exit of smaller suppliers from the market.
Examples of Monopsony power in Milk Prices
Where there is a single buyer (or a small number of buyers) in the market - Large milk processors and supermarkets (roughly 80% of milk sold through retailers) can act as monopsonists, driving down prices they pay to farmers due to their dominant position.
In 2015 there was a 25% drop in price British farmers were paid for milk, forcing many farmers to sell milk for less than it cost produce. Despite cost of producing milk increasing (due to feed costs, energy prices and labour), the price farmers receive has remained low.
Overall, the demand for milk is relatively inelastic because it’s a staple product. Consumers’ price sensitivity is low, meaning they will still purchase milk even if prices rise. However, the cost pressures on farmers are a significant issue because their supply costs are less flexible. This has led to many dairy farmers in the UK facing financial hardship, leading to calls for better support for farmers, including potential policy changes, subsidies, or fairer pricing structures.
Demand Curve for Labour
Shows how many workers will be hired at any given wage rate over a period of time
Labour is a derived demand (derived from the production of goods/services)
Labour demand shifts
-Change in demand for final product or change in price of final product - if demand for cars decreases (or price increases), then labour will shift left as need less workers to produce cars
-Changes in labour productivity- If labour becomes more productive i.e through training/qualifications then demand would shift right.
-Change in price of capital - Capital is a substitute for labour, so if price of capital decreases. Demand for labour would decrease.
Elasticity of labour demand
Measures the responsiveness of labour demanded given a change in the wage rate
Factors affecting the wage elasticity of demand for labour
SECT
-Ease and cost of factor Substitution - Labour demand is more elastic when a firm can substitute easily and cheaply between labour and capital.
-Price Elasticity of demand for the final product - Can a firm pass higher labour costs to consumers at higher prices? If demand is inelastic, higher costs can be passed on.
-Labour Costs as a % of total costs - When labour expenses are a high % of total costs, labour demand is more wage elastic.
-Time period - In the long run it is easier for firms to switch factor inputs e.g. bring more capital in prehaps replacing labour.
Individual labour supply curve
-Key choice for individuals is between work and leisure
-The supply curve is backward bending for the individual
As wages go up, hours worked will increase until the target income is met. From that point, as the wage rate goes up, hours worked decrease. Causing backward bend.
Income Effect
Income effect (Positive and Negative)- As wages go up, incomes rise at the same time.
* The positive income effect we work more as wages go up to increase income.
* The negative income effect states that as wages go up we actually work less due to our target income being met
* Because our wages have gone up and we reach a certain “target income” we work less to enjoy leisure time etc.
Substitution effect
As wages rise, the opportunity cost of leisure time increases providing an incentive to work.
Industry Supply Curve
-If wage goes down then a contraction of supply occurs
-If wage goes up, then an extension of supply occurs
If in perfect competition, firms are wage takers (no control over the wage rate). AC=MC=S. So the market has set the wage rate.
In a monopsony, monopsonies are the sole buyer of workers so they set the wages here.
AC of labour = S
MC of labour - x2 steep
Factors which affect supply of labour
-Wage rate/ value of leisure time
-Migration
-Training
-Trade unions
-Benefits and taxes
-Non-monetary benefits
Factors which affect supply of labour - Wage on offer in substitute occupations
-If higher wages in another job - workers will leave and supply will shift left (quantity decreases and wage increases)
Factors which affect supply of labour - Barriers to entry
-If barriers to entry are reduced- ie remove skills tests for teachers or lower qualifications for medical school - then supply shifts right (quantity increases and wage decreases)
Factors which affect supply of labour - Non-Monetary benefits/fringe benefits
-If lots of fringe benefits such as company cars, health insurance, working conditions, flexibility with overtime. Then supply shifts right (quantity increases and wage decreases)
Factors which affect supply of labour - Improvement in occupational mobility of labour
-More people become qualified/skilled
-They are occupationally mobile
-Supply shifts right(quantity increases and wage decreases)
Factors which affect supply of labour - Improvement in geographical mobility of labour
-If it becomes easier to move to different parts of the country
-Permanently or through improved infrastructure
-They are geographically mobile
-Supply shifts right (quantity increases and wage decreases)
Factors which affect supply of labour - Size of working population
-If economically active groups increase, then more labour can be supplied. Supply shifts right (quantity increases and wage decreases)
Policies to improve the mobility of labour
To reduce occupational immobility:
-Invest in training schemes for the unemployed to boost their human capital to equip them with new skills and skills that can be transferred from one occupation to another.
-Subsidise the provision of vocational training by private sector firms to raise the skills level
To reduce geographical immobility:
-Reforms to the housing market designed to improve the supply and reduce the price of rented properties and to increase the supply of affordable properties.
-Specific subsidies for people moving into areas where there are shortages of labour – for example teachers and workers in the National Health Services
-Better transport infrastructure- such as HS2.
Wage elasticity of labour supply
Measures the responsiveness of labour supplied given a change in the wage rate.
Factors affecting wage elasticity of labour supply
-Nature of skill required - ie length of training period - Doctors~7 years. Even if firms increase wages by a lot, there might not be enough supply of there well qualified workers
-Nature of the Job - ie teaching - teachers are not just in it for the money
-Time- Jobs have notice periods attached to them, so in the short run are inelastic, in long run elastic
Wage determination - in perfectly competitive markets
-Many workers/employees
-Labour is homogenous
-Perfect information
-Firms are wage takers
-No barriers to entry
Shifts in demand and supply of labour
Shift in Demand:
-During a recession, workers would be let go
-Demand for labour would decrease
-Wages would decrease to W1
Shift in Supply:
-If the retirement age increases or there is a decrease in school leaving age
-This would keep more workers in the market (increase in supply)
-Wage rate would decrease
Shifts in the wage rate
- The price of the good or service:
- The higher the price of the good or service, the more profitable it is for firms to produce it, and the more labour they will demand.
- Productivity of labour:
- The more productive workers are, the more output they can produce per hour, and the more labour firms will demand.
- The cost and availability of substitutes:
- If there are good substitutes for labour, such as capital or automation, firms will be less likely to demand labour.
- The level of technology:
- The higher the level of technology, the more productive workers can be, and the more labour firms will demand.
- The level of government regulation:
- The more regulations there are on businesses, the more costly it is for them to operate, and the less labour they will demand.
- The level of economic activity:
- The higher the level of economic activity, the more goods and services are being produced, and the more labour firms will demand.
Limitations to Shift in wage rate - NMW
-In the real labour market, its not as straightforward as this due to the national minimum wage
-Rather than lowering all wages (due to decreased demand for increased supply), some workers would be sacked
-Known as sticky wages
This leads to a fall in employment rate, however depends on what level the wage is set at and the elasticity of labour demand.
Benefits of the Minimum wage
- Reduced Poverty and Inequality:
-A minimum wage can help lift low-wage workers out of poverty, reducing income inequality.
-It can provide a basic standard of living for workers and their families. - Increased Consumer Spending:
-Higher wages can lead to increased consumer spending, boosting economic growth.
-Low-wage workers tend to have a high propensity to consume, meaning they are likely to spend any extra income. - Improved Worker Morale and Productivity:
-A higher minimum wage can improve worker morale and motivation, leading to increased productivity.
- It can also reduce employee turnover, which can be costly for businesses.
-Opportunity cost of losing job is now higher so work harder, could increase productivity and profits (wage efficiency theory) - Reduced Government Welfare Spending:
- A minimum wage can reduce the need for government welfare programs, as workers earn enough to support themselves.
-This can lead to fiscal savings for the government
Costs of the Minimum wage
- Job Losses:
-A minimum wage can lead to job losses, especially for low-skilled workers.
-Businesses may respond to higher labour costs by reducing their workforce. - Increased Prices:
-Businesses may pass on the increased labour costs to consumers in the form of higher prices.
-This can lead to inflation and reduce consumer purchasing power. - Reduced Competitiveness:
-A high minimum wage can make businesses less competitive, especially in global markets.
-This can lead to job losses in export-oriented industries. - Discouraged Investment:
-The prospect of higher labour costs can discourage businesses from investing in new ventures or expanding existing ones.
-This can stifle economic growth.
Maximum wage
-Relatively uncommon
-In the 1970s, the UK government set maximum wage increases at workers could receive in an attempt to control inflation
-More recently, there have been calls for maximum wages for CEOs. Their wages seem to rise a lot quicker than the workers
Current issues in the labour market
-Youth unemployment
-skills shortages
-Changes in retirement and schooling age
-Temporary, flexible and zero-hour contracts - (zero hour don’t receive same benefits of permanent jobs, pensions/sick pay/holiday, however this is part of reason why attractive for employers) as well as not being guaranteed work. In 2022, nearly 1 million workers were on zero-hour contracts which is more than five times the number in 2000
Wage differentials refer to being paid different amounts even in the same job:
-Qualifications - Degree earn more than those with just A levels
-Gender - more career breaks for women
-Discrimination - gender, age, race
-Zero-hour contracts
-Gig economy - uber
% difference in full time earnings between men and women
South Korea - 37%
UK - 17.5%
New Zealand - 5.6%
Current issues in the labour market - Skills Shortages
Creates challenges - Decreased productivity, increased recruitment costs (smaller pool), increased labour costs, not at full productive capacity.
Govt schemes such as T levels can give more industry focused education (But fewer than 3% of 16 year olds enroll in T-Levels, with almost a third of those enrolled in 2022 giving up).
Some of the many labour markets experiencing shortages include nursing, engineering, pharmacies, secondary teaching, and graphic design
Current issues in the labour market - Youth unemployment
This means that there is excess supply of labour for 16-24 year olds, so there is a misallocation of resources in the labour market .
Unemployment for 16-24 year olds in April 2022 was at 10.8% compared to the general unemployment rate of 3.8%
This means that it is nearly three times as likely for a young person to be unemployed
Where possible employers prefer to hire workers with more experience as it can lead to higher productivity
The education or skills gap is another reason for youth unemployment. Young people leave school without the skills that employers require
This has negative effects of underemployment (taking minimum wage jobs), lower living standards (lower incomes) and a higher cost to the government (universal credit).
This has a larger effect on the economy due to the lower consumption
Current issues in the labour market - Migration affect on the labour market
-Increased supply of labour
-Increased competition for jobs, could bring in skills/ increase productivity, especially in a country that operates a points-based system which identifies skills gaps and only allows people who can fill these gaps to enter.
-Could lower wages even more (for lowest paid jobs), good for businesses potentially. However the increase in population could lead to an increased demand for goods and thus labour, causing wages to go back up.
-Also majority of immigrants are young males, this means are less likely to need to use healthcare or education so not putting pressure on public services, will also contribute to tax, so net benefit on society.
Government intervention in labour market- Public Sector wages
-The public sector in developed economies employs millions of workers
-The government therefore has a major influence on wage rates both for public sector and private workers
-In the UK public sector workers had a pay freeze between 2010 and 2015 as they sought to reduce public spending
-This can result in shortages in public sector workers (leave to work in the private sector)
-Between 2008-2010, public sector pay grew (4.5%) relative to private sector.
-Women in the private sector were paid around 8% more than those in private, 2013-14.
Policies to tackle labour market immobility
-Trade union power
-Rate of Universal Credit/ welfare
-Housing affordability
-Infrastructure - HS2 would improve labour supply
Trade Union - Pros
Protection/Job Security
-Protecting and improving the real living standards /
real wages of their members
-Protecting workers against unfair dismissal (i.e.
upholding employment rights)
-Promoting improvements in working conditions,
work-life balance & related health and safety issues
-Promoting better workplace training and education,
i.e. the accumulation of human capital
-Protection of pension rights for union members
Collective bargaining
-As negotiating as a collective, gives increased power, could lead to increase in wages or benefits or working conditions. BUT If wages rise faster than productivity, then firms will see a rise in unit costs and this can negatively affect profits and eventually lead to less jobs.
Worker Representation:
-Grievance Handling: They help workers address grievances, resolve workplace conflicts, and enforce employment rights.
-Legal Support: Unions provide legal assistance to members facing discrimination, wrongful termination, or other workplace issues.
Unions will have more success in raising wages for their members if the demand for labour is relatively wage inelastic
* Unions are more influential when they represent a high % of all workers in a given industry/occupation
* Pay might also rise if unions and employers agree a pay deal based on better productivity
-Unions can act as a counter to the monopsony power of employers who may pay lower wages and spend less
on worker training. BUT A monopsony employer does not always pay lower wages than they need to. Many employers understand the positive link between pay and productivity.
-Unions can help to prevent structural unemployment by campaigning against job losses caused for example by import dumping. BUT Unions may impede competitiveness if they seek to block the use of technologies that replace some workers with robots.
Trade Unions - Cons
-Limited individual bargaining power - reduces Standards of living and job satisfaction
-Trade Unions may bid for employers to pay a premium wage (or “wage mark-up”) above the normal competitive market wage. This might lead to an excess supply of labour and a contraction of total employment.
Long term decline of Trade Unions
There has been a long-term decline in union
Falling trade union density in the UK membership. Membership is ageing and is focused in public sector occupations
* Factors behind trade union decline:
1. Impact of legislation that has reduced/removed many of their powers to engage in industrial action
2. Rise in flexible labour markets e.g. with short term contracts, zero hours, part time working, self-employment
3. De-industrialisation - there are fewer jobs in industries where unions tended to be stronger - e.g. less jobs in heavy manufacturing and many more in services
4. Impact of globalisation which has reduced the bargaining power of employees - growing monopsony power of large MNCS
Government intervention to control monopolies - Price regulation
-Refers to limiting prices (maximum price) e.g. a firm can only increase prices at the rate of RPI next year
or RPI-X (which is a certain % based on how efficient they are)
It gives an incentive for firms to be as efficient as possible as if they can lower costs by more than X they will enjoy increased profit. It prevents excessive prices
and ensures that gains are passed onto the consumer
or RPI - X + K ( which is based on the investment they make)
Aim is to make prices more allocative efficient
However
If firms keep getting more efficient, government will just keep increasing the value of X which can act as a disincentive
Also cost to admin this
Govt may introduce price at allocatively efficient point, to maximise social benefit. Increases CS.
Government intervention to control monopolies - Quality control/ performance targets
-The government can introduce quality standards, which will ensure that firms do not exploit their customers by offering poor quality.It will help firms to improve their service and lead to gains for customers.
-e.g. train- to reduce delays every hour
NHS - to see X amount of patients an hour
Gas/Electric - can’t cut of if elderly cannot pay on time.
However could lead to unintended consequences:
-Doctors could rush seeing patients
-May game the system- e.g. extend train journey times to minimise delays or reduce amount of trains running.
Government intervention to control monopolies - Profit Regulation
-Windfall tax - A higher tax levied by the government on specific industries when they experience unexpected and above-average profits, for example, monopolists when they make extremely high profits.
-However, this could just lead to increases in price as supply shifts left or under-reporting of profit. Could lead to tax evasion (apple, starbucks and many more) and less R&D into innovation and reducing dynamic efficiency as less profit.
Why competition is good
- Lower prices: Businesses are forced to lower prices to attract customers in a competitive market, benefiting consumers.
- Better quality: To stand out, companies must improve product quality and features to compete effectively.
- Innovation: Competition encourages businesses to develop new products and services to stay ahead
- Greater choice: Consumers have a wider range of products and services to choose from
- Economic growth: Competition drives efficiency and productivity, contributing to overall economic growth
Why competition can be bad
- Price wars: Extreme competition can lead to destructive price wars where companies sell products below cost to gain market share, potentially harming all businesses involved
- Unfair practices: Companies may resort to unethical practices to gain an edge, like predatory pricing or aggressive marketing tactics. For example in 2019 the big 4 accountancy firms were accused of anti competitive pricing, deliberatlely under pricing audit work to make it harder for challenger firms to compete.
- Market instability: Rapid shifts in market dynamics due to intense competition can create uncertainty for businesses
- Small business struggles: Smaller businesses may find it difficult to compete against larger, more established companies with greater resources
What can the government do to promote competition - Deregulation
-Deregulation- refers to the government reducing legal barriers to entry. Creates an incentive to enter leading to increased competition.
More choice for consumers/ consumer surplus
Allocative and productive efficiency
However:
-Could lead to the formation of oligopolies and local monopolies - increased prices
-Depends on SR vs LR - in the LR, it could lead to less Allocative/productive efficiency if the formation of oligopolies
-There might be other high barriers to entry, not just regulation
What can the government do to promote competition - Privitisation and promotion of small businesses
-Privatisation- refers to state-run firms sold off to the private sector. Private markets main incentive is profit so will drive down costs and increased efficiency due to competition. Leads to Allocative/Productive efficiency, lowering prices and reduce PSNCR (public sector net cash requirements) as no longer have to cover losses.
However:
-Depends on level of competition in the market/ wont instantly be loads of firms entering as soon as market is privatised
-Loss making services will be cut even if socially desirable
-Loss of natural monopolies and their EonS
-UK doesn’t have many State-run companies to sell off anyways.
-Promotion of small businesses- The government can give training and grants to new entrepreneurs and encourage small businesses through tax incentives or subsidies . This will increase competition since there will be more firms within the market, and will offer a chance for more firms to join.
● It increases innovation and efficiency , since new firms are likely to provide new products and incumbent firms will no longer be able to be X-inefficient.
Government intervention to protect suppliers and employees - Nationalisation and restrictions on monopoly power
-The process of taking an industry into public ownership
Potential for greater EonS/ allocative efficiency.
Less likely to be market failure from externalities ( as the government aims to maximise welfare rather than profit). A profit-maximising monopoly will not be allocatively efficient, a nationalised firm is more likely to move towards allocative efficiency.
However:
-Could lead to diseconomies of scale
-Lack of incentive - to minimize costs/ less productive efficiency, X-inefficiencies
-Wasteful production
-No supernormal profits to tax
-Burden on taxpayer if making a loss,
-Rise of moral hazards as MPs may put their self-interests first
-Principal agent problem
-Monopsony power by firms - Monopsonists are able to exploit suppliers by reducing prices. The government can
prevent these by passing anti-monopsony laws which make certain practices illegal
and can introduce an independent regulator who will force monopsonists to buy
fairly.
-Fines can be put in place for those who exploit their power and minimum prices
may be introduced to ensure suppliers are paid a fair amount. Self-regulation can
also be used, but this is weak.
-Workers rights and laws also in place to protect employees (health and safety, max hours and contracts). Problem is that if workers’ rights are too strong then costs high and less employment.
Should Railways be nationalised
Yes- currently inefficient under private ownership, high fares , quality of trains/reliability still below standards, lack of competition in market anyways (cant choose which company you travel on). Nationalisation can divert all profits back into.
However, Possible to improve the contest ability of the industry without a transfer of ownership e..g by allowing more open access operators to run train services. Even if all profits made on the railways were reinvested in the railways, it would still require subsidy from the taxpayer and there has been substantial investment in new rolling stock by private.
No- Would cost billions to revert to nationalized system
However, the government subsidises railways for the most part anyways and spends billions in investment and maintenance into railways.
PED and revenue
With a graph with a n shaped TR curve and a AR and MR curve with MR=0 at same Q as the peak of TR.
-If marginal revenue is positive, when the firm sells the product at a lower price (or increase output), total revenue grows and so demand curve is elastic.
-If MR negative, TR is decreases as price decreases (or output increases) and so the demand curve is inelastic.
-When MR=0 TR is maximised and demand curve is unitary elastic.
Short-run and long-run shut-down points
-When a business is making a loss it may not be the best decision to shut down straight away, it depends on the average variable cost.
-If AVC<AR then firms should continue to produce. Each god they make will generate more revenue than it costs for them to make it, and so this will help them to reduce the size of the loss by covering some of its fixed cost. In this case, they should only shut down when their fixed cost increases e.g. when machinery needs to be replaced, when lease is up etc.
-However, if AVC>AR then producing more goods will increase the loss. As a result they should leave the industry immediately.
-In the LR, the firm needs to make at least normal profit for them to stay in the industry. However in the SR they should produce as long as their revenue covers their variable costs. Hence the short run shut down point is where AVC=AR
-Firms tend to produce on the SR point even though it does not affect their losses as they do not want to let go of their workers or let customers down.
Types of price competition
Price war -Occur when non-price competition is weak, or when difficult to collude
-A price war will drive prices down to levels where firms are frequently making losses. Lowers industry profits. In the short term, firms will continue to produce if their AVC is below AR but in the long run, they will leave the market and prices will have to rise since supply falls
Predatory pricing:
● This occurs when an established firm is threatened by a new entrant or if one firm feels that another is gaining too much market share.
● The established firm will set such a low price that other firms are unable to make a profit and so will be driven out the market. The existing firm is then able to put their price back up.
● This is illegal and only works when one firm is large enough to be able to have low prices and sustain losses .
Limit pricing :
● In order to prevent new entrants , firms will set prices low (the limit price). The price needs to be high enough for them to make at least normal profit but low enough to discourage any other firm from entering the market.
● The greater the barriers to entry, the higher the limit price. It is mainly used in contestable markets.
● The drawback of this is that it means firms cannot make profits as high as they would be otherwise be able to.
Non-price competition
Typically in an oligopolistic market
● Advertising: This creates an awareness of the company/product and can persuade a customer to purchase the product. If advertising is successful, it can increase sales and market share for a business which in the long run can increase profits. Advertising can also make the demand for a product/service more inelastic. ● Loyalty cards: These encourage repeat purchases by rewarding customers for their loyalty. They also provide firms with lots of data on consumers’ buying habits, which the firm can use to increase sales.
● Branding: A successful brand can help increase loyalty and repeat purchases for a business. People will trust the brand and the quality it represents so will more likely keep buying from them. An established brand should find it easier to release new
products.
- Quality: A firm that is known or good quality may be able to charge higher prices, and is likely to have strong brand loyalty. They are likely to have good reputation and benefit from positive recommendations,
● Customer service: This will encourage loyalty amongst customers and give the business a more positive reputation.
● Product development: A business that invests in product development will have a competitive advantage over rivals. If they’re the first firm to release a new product, they would see an increase in sales and this is likely to help with branding. The problem with these methods is that they are often expensive and so firms need the money before they are able to undertake the competition. Similarly, only large firms will be able to do large scale advertising, research and development etc.. There is no guarantee that it will be successful
Monopoly costs and benefits to firms, employees, suppliers and consumers
Firms
-Can make huge profits for shareholders
-Means firms have finance for investments and for ST difficulties
-Able to maximise economies of scale
-However, may choose not to profit maximise:
X-inefficiencies, profit satisficing, contestability.
-In the LR a lack of competition may mean firms become complacent and dont maximise profit.
Employees
-produce lower output so employ less
-However inefficiency of monopoly may mean employees recieve higher wages, particularly directors and senior managers. Profit satisficing or sales/revenue maximisation may mean output is higher so more employed
Suppliers
-For suppliers, the impact of a monopolist will depend on the extent to which the monopolist is also a monopsonist . If the monopolist buys all or most of the suppliers’ goods (so is a monopsonist), it will reduce the suppliers’ profits as the monopolist will decrease prices
Consumers
-With a natural monopoly consumers tend to be better off than if there was comptition
-When firms enjoy economies of scale, they will be more efficient and consumers will enjoy a higher CS
-Use of price discrimination will allow for survival of a product or service and benefits some consumers
-Consumers may pay higher prices for poorer quality good/service due to lack of competition
-Less choice
Monoposony in the labour market
n a monopsony market, there is only one buyer of the labour. In this situation, businesses
know that if they want to increase their labour force they will have to increase the wage they
offer and, just like with monopsony product markets,an increase in the wage for one
increases the wage for all. Therefore, the MC curve is above the supply curve (AC) of labour
because it costs more to employ an additional worker than the average cost of labour. A firm
will determine how many workers to employ where the cost of employing them is equal to
the value of that worker to the company. They employ where MC=D at Q1 and at this output,
they will pay their workers W1 (determined by the S curve). Compared to a perfectly
competitive market (which would produce at W2Q2), they employ less people at a lower
wage rate
Government intervention to control mergers
● In the UK, mergers are assessed in terms of the specific circumstances of each case, considering whether there will be a substantial lessening of competition (SLC). The CMA will consider the likely competitive situation if the merger goes ahead
compared to if it does not, and the merger will be approved if its potential benefits are greater than its cost.
● A merger is investigated if it will result in market share greater than 25% or if it meets the turnover test of a combined turnover of £70 million or more.
● The aim of preventing two large companies merging is so they do not exploit their
customers by raising price, offering poorer quality service and reducing choice. It
can prevent firms from gaining monopoly power.
● However, the problem is that very few mergers are investigated each year. The
CMA can suffer from regulatory capture and may not have all the information
necessary to make a decision.
Sainsbury’s and Asda 2019, would have taken 32% MS.
Impacts of government intervention
-Governments are able to prevent monopolies charging excessive prices and aim
to limit their profit. They try to ensure that consumers pay fair prices, receive a
good quality service and have a lot of choice through different methods of
regulation and target setting. High regulation may force some firms out of the
industry, which would reduce choice.
● They can increase efficiency in a market by increasing competition and
contestability. By regulating prices, they ensure a business keeps their costs low and
so prevent X-inefficiency. They try to increase dynamic efficiency by encouraging
investment. However, if the government regulates too strongly, they can push costs
up and led to inefficiency.
● If the government runs a business, in theory, they should reduce prices and
increase quality as they aim to benefit consumers. A public sector business is likely
to be allocative efficient, as they aim to maximise social welfare. They will see lower
costs due to economies of scale . However, the government may suffer from
X-inefficiency as they have no incentive to be efficient due to the lack of
competition. This may push up prices and reduce the quality of a good; the private
sector may have expertise and knowledge which the government might not have.
The government are likely to offer less choice, since there is only one company
producing the good.
● Government intervention on the whole tends to be limited because of the political
power of large firms and industries as a whole. They are able to lobby the
government and set up pressure groups.
Limits to government intervention
Regulatory capture:
● This occurs when the regulator is captured by the firm/industry they are regulating.
The fact that the regulator will often meet with the firm’s employees will mean they
become more empathetic and able to ‘ see things from their perspective’ , which
will remove impartiality and weakens their ability to regulate.
● Large corporations can invest huge amounts in learning how to play the system and
in gaining the support of their regulator. It also is likely that the regulator will have
worked in the sector for many years, as these people will have experience and
knowledge of the industry. As a result, they will have personal connections with
those that they are regulating and this makes it difficult for them to be unbiased.
● This is an example of government failure , and argues that government regulation is
not the most effective method of achieving competition and efficiency.
● One example is the alleged capture of HMRC by Vodafone, who negotiated a tax
reduction from £7bn to £1bn in 2009-10 .
Asymmetric information:
● This is where regulatory bodies have to use information provided to them by the
industries when setting price targets etc. It is in the industry’s best interest to
maximise their profits and so may provide inaccurate or limited information, meaning
regulators are unable to set correct targets, prices etc.
● As a result, government failure may occur if regulation such as RPI-X or quality
standards are not set correctly. The government will be unable to regulate the
companies accurately.
Contestable market Characteristics
-Low barriers to entry and exit
-Perfect information
-No sunk costs- costs that cannot be recovered once incurred, means that they can exit the market without suffering substantial financial losses, makes market more contestable
-No collusion- less likely due to ease of entry and exit, firms know that if they try to raise prices or restrict output, new competitors can quickly enter and undercut them
Examples include ride-sharing services and fast food chains, who can enter the market with minimal infrastructure and compete with established brands.
Implications of contestable markets for the behavior of firms
-Price competition- firms in contestable markets tend to engage in intense price competition since they know that new entrants will undercut their prices if they attempt to charge excessive prices
-Efficiency and Innovation: Firms have an incentive to operate efficiently and innovate to maintain a competitive edge. In a contestable market, the threat of new entrants drives firms to continually improve their products and processes.
-Short-Term Focus: Firms may have a short-term focus on maximizing profits since they are aware that the market conditions can change rapidly with the entry of new competitors.
-No Monopoly Power: Contestable markets discourage firms from attempting to establish and maintain monopoly power since any attempt to do so is likely to be short-lived.
Types of barriers to entry and exit
-Economies of scale - firms can produce at lower average costs due to economies of scale to deter new entrants, as newcomers may struggle to compete with established firms cost advantage
-Capital Requirements: High startup and capital investment costs can be a significant barrier to entry, especially in industries requiring expensive equipment or infrastructure.
-Government Regulation: Regulatory barriers, such as licensing requirements or safety standards, can limit entry into certain markets.
-Access to Distribution Channels: Difficulty in accessing distribution channels or securing shelf space can act as a barrier, particularly in industries with established distribution networks.
-Brand Loyalty: Established brands with strong customer loyalty can deter new entrants from gaining market share.
-Network Effects: In industries where the value of a product or service increases with the number of users (network effects), it can be challenging for new entrants to compete with established networks.
-Patents and Intellectual Property: Firms with strong patent protection or proprietary technology can create barriers to entry by preventing others from using their innovations.
Sunk costs and the degree of contestability
Sunk costs are costs that have already been incurred and cannot be recovered. The presence of sunk costs can affect the degree of contestability in a market. In a contestable market:
-Low Sunk Costs: When firms have minimal sunk costs, it becomes easier for them to exit the market if conditions become unprofitable. This enhances the contestability of the market, as firms are not financially tied to the industry.
-High Sunk Costs: If firms have significant sunk costs, such as substantial investments in specialized equipment or infrastructure, they are less likely to exit the market quickly. High sunk costs can reduce the degree of contestability because firms may continue to operate even when they are not earning a profit, hoping to recoup their initial investments.
In summary, low sunk costs contribute to a more contestable market by allowing firms to enter and exit more easily, while high sunk costs can reduce contestability by trapping firms in the market even when they are unprofitable.
