Theme 3 - Business Behaviour And The Labour Market

Question 1

What is monopolistic competition also known as ?

Answer 1

Imperfect competition

Question 2

Describe monopolistic competition.

Answer 2

There is a large number of small buyers and sellers.
No barriers to entry or exit.
Firms sell non-homogenous goods but have weak market power.
Firms are short run profit maximisers.

Question 3

Explain how firms hold a small amount of market power in monopolistic competition.

Answer 3

If a firm produces a product slightly different to that of its competitors then it holds a certain amount of market power. It can raise price without losing all its customers meaning that it is not a price taker. However because there are a large number of firms in the market producing close substitutes, it’s market power is said to be weak.

Question 4

Explain the demand curve in monopolistic competition.

Answer 4

Small changes in price are likely to lead to big changes in quantity demanded, making the curve price elastic. This is because customers can switch easily to close substitutes as there is a large number of small firms in the market. So the demand curve is downward sloping but elastic.

Question 5

Why do large firms exist?

Answer 5

Economies of scale may be significant.

Barriers to entry may exist which protect large firms from potential competitors.

Question 6

What is the principle agent problem and what is an example?

Answer 6

When one group, the agent, is making decisions on behalf of another group, the principal. E.g. divorce of ownership from control.

Question 7

What are public sector organisations?

Answer 7

Organisations that are owned and controlled by the state. Their purpose is to provide a service to the UK citizen.

Question 8

What are private sector organisations?

Answer 8

Organisations that are owned by individuals or companies and not the state. These aim to make a profit.

Question 9

What are not-for-profit organisations?

Answer 9

Private sector organisations that don’t have making a profit as a goal but use any profit or surplus they generate to support their aims.

Question 10

What is organic growth?

Answer 10

Organic growth is where the firm grows by increasing their output, e.g. increased investment or more labour.
Almost all growth of firms is organic.
E.g. Lego, they introduced new products like Lego friends and board games to expand their customer base.

Question 11

What are the advantages of organic growth?

Answer 11

• Integration is expensive, time-consuming and high risk, with evidence suggesting that the long-term share price of the company falls following integration.
• Firms often pay too much for takeovers and integration is often poorly managed with many key workers leaving after the change.
• The firm is able to keep control over their business.

Question 12

What are the disadvantages of organic growth?

Answer 12

• Sometimes another firm has a market or an asset which the company would be unable to gain through organic growth. For example, integration would allow a European company to expand into the Asian market which it has no expertise in.
• Organic growth may be too slow for directors who wish to maximise their salaries.
• It will be more difficult for firms to get new ideas.

Question 13

What is integration?

Answer 13

Integration is growth through amalgamation, merger or takeover. A merger or amalgamation is where two or more firms join under common ownership whilst a takeover is when one firm buys another.

Question 14

What is vertical integration?

Answer 14

Vertical integration is the integration of firms in the same industry but at different stages in the production process . If the merger takes the firm back towards the supplier of a good, it is backwards vertical integration. Forward vertical integration is when the firm is moving towards the eventual consumer of a good.
Tesco’s £3.7bn takeover of Booker in 2018 is an example of vertical integration. It has led to an increase in sales for Tesco.

Question 15

What are the advantages of vertical integration?

Answer 15

• There is increased potential for profit as the firm takes the potential profit from a larger part of the chain of production.
• There will be less risks as suppliers do not have to worry about buyers not buying their goods and buyers do not have to worry about suppliers not supplying the goods.
• With backward integration, businesses can control the quality of supplies and ensure delivery is reliable . Moreover, they don’t have to worry about being charged high prices for supplies, keeping costs low and allowing lower prices for consumers. This can increase competitiveness and sales.
• Forward integration secures retail outlets and can restrict access to these outlets for competitors.

Question 16

What are the disadvantages of vertical integration?

Answer 16

• Firms may have no expertise in the industry they took over, for example a car manufacturing company would have deep knowledge of car manufacturing but little knowledge of selling cars and vice versa.

Question 17

What is horizontal integration?

Answer 17

This is where firms in the same industry at the same stage of production integrate.

In 2015, AstraZeneca acquired ZS Pharma for $2.7bn. It gave them access to new compounds and was a long term deal intended to strengthen a specific sector of their business. Other well-known examples are Currys and PC Worlds and Arcadia, who own
Topshop, Evans, Dorothy Perkins etc.

Question 18

What are the advantages of horizontal integration?

Answer 18

• This helps to reduce competition as a competitor is taken out and increases market share, giving firms more power to influence markets.
• Firms will be able to specialise and rationalise , reducing the areas of the businesses which are duplicated.
• The business is able to grow in a market where it already has expertise , which is more likely to make the merger successful.

Question 19

What are the disadvantages of horizontal integration?

Answer 19

• The problem is that it will increase risk for the business as if that particular market fails, they have nothing to fall back on and will have invested a lot of money into that area. They are ‘placing all their eggs in one basket’.

Question 20

What is conglomerate integration?

Answer 20

This is where firms in different industries with no obvious connections integrate. They can sometimes be linked by common raw materials/technology/outlets.

Today, this is uncommon but it was popular in the 1960s and 1970s. General Electric was founded as a lighting business and is now involved in aircraft, water, oil and gas, financial services, healthcare, energy, aviation, rail and software. It is a successful model because they conduct extensive market research and remain as market leaders in relevant industries.

Question 21

What are the advantages of conglomerate integration?

Answer 21

• It is useful for firms where there may be no room for growth in the present market.
• The range of products reduces the risk for firms and if a whole industry fails, they will still survive due to the other parts of the business.
• It will make it easier for each individual part of the business to expand than if they were on their own as finance can be easily obtained and managers can be transferred from company to company within the firm.

Question 22

What are the disadvantages of conglomerate integration?

Answer 22

• The problem with this is that firms are going into markets in which they have no expertise. It can often be damaging for the business.

Question 23

What are the constraints of business growth?

Answer 23

Size of the market
Access to finance
Owner objectives
Regulation

Question 24

Explain how the size of the market is a constraint of business growth.

Answer 24

A market is limited to a certain size and so not all businesses
are able to mass produce because their goods would not be bought by consumers. This can happen no matter how big the market is, and there will always be limits on growth. In particular, niche markets (specific products that few people want) and
markets for luxury items or restricted prestige markets make it difficult for businesses to grow.

Question 25

Explain how access to finance is a constraint of business growth.

Answer 25

Firms use two main ways to finance growth: retained profits and
loans. If firms do not make enough profit or have to give out too much to shareholders, they will not be able to use retained profits to grow. Banks may be unwilling to lend firms money, particularly smaller businesses that they see as high risk. As a result, firms will be unable to grow as they can’t finance it.

Question 26

Explain how owner objectives are a constraint of business growth.

Answer 26

Some owners may not want their business to grow any further as
they are happy with their current profits and do not want the extra risk or work that comes with growth.

Question 27

Explain how regulation is a constraint of business growth.

Answer 27

In some markets, the government may introduce regulation which prevents businesses from growing. For example, the UK government regulates the number of pharmacies in a local area and an existing pharmacy can only expand by buying another company. Competition law, which prevents monopolies, can restrict growth as any merger which creates a company with more than a 25% market share can be forbidden from taking place.

Question 28

What are the business objectives?

Answer 28

Profit maximisation
Revenue maximisation
Sales maximisation
Satisficing

Question 29

What is the assumption with profit maximisation?

Answer 29

Neo-classical economics assumes that the interests of owners or shareholders are the most important and therefore the goal of firms is to profit maximise in the short run, in order to maximise owners’ returns.
By short-run profit maximising, firms can also generate funds for investment and to help them survive a slowdown during a recession.
For example, Apple and pharmaceutical companies are likely to profit maximise since they need the money to reinvest.

Question 30

Where do firms operate at to profit maximise?

Answer 30

In order to short run maximise, firms produce where MC=MR.

If they produce less than this, then producing more will increase profit since MR would be higher than MC so they’re making more in revenue than it costs to produce the good and so producing more would increase profit. If they produce more than this, they would be making a loss on the goods produced above the profit maximising point and so they should decrease production.

Question 31

Draw and explain a profit maximisation diagram.

Answer 31

Google answer

Question 32

What are the assumptions behind revenue maximisation?

Answer 32

William Baumol suggested managers are most interested in their level of revenue since this is what their salary depended on.
Even when their salary is not directly connected to sales revenue, they knew that a growth in revenue was always likely to be a positive for the business. It increases their prestige and is used as a justification to shareholders for managerial rewards.
A fall in revenue would be negative as it would not only reduce their salary but could signal the start of a downward spiral for the company. It could lead to a fall in staff and financial institutions may be worried and less willing to lend money.
As a result, many firms may aim to revenue maximise as long as they provide some profit for the owners.
Amazon follow an objective of revenue maximisation, with revenue nearing £120bn in 2015 but profit staying relatively stable. Their aim is to dominate the market.

Question 33

Where do firms produce at when revenue maximising?

Answer 33

To revenue maximise, firms would produce where MR=0, since if marginal revenue is above 0 producing more would increase revenue.

Question 34

Draw and explain a revenue maximisation diagram.

Answer 34

Google answer

Question 35

What are the assumptions behind sales maximisation?

Answer 35

Robin Marris suggested that managers aim to maximise the growth of their company above any other objective. This is because their salary may be linked to the size of the company.
It is often easier for people to judge the level of growth achieved rather than the level of profit. This will increase the prestige of the business.
Size is often linked to security as it is believed large firms can survive rough periods much easier and are less likely to get into financial trouble overnight.
Growth will also increase market share, and may push other firms out of business. It will enable a firm to have more market power and more power over prices.
This tends to be a short term strategy, and in the long term firms are more likely to profit maximise.
Netflix and Spotify follow the objective of sales maximisation, as they are attempting to increase the size of their businesses.

Question 36

Where do firms produce at when sales maximising?

Answer 36

In order to sales maximise, the firm will want to get the highest level of sales possible without making a loss. They will want to ensure sufficient returns to keep the owners happy, so will aim for normal profits. As a result, they produce where AC=AR.

Question 37

Draw and explain a sales maximisation diagram.

Answer 37

Google answer

Question 38

What is the problem with sales and revenue maximisation?

Answer 38

The problem with both sales maximisation and revenue maximisation is that it necessitates a fall in price , which other firms may copy and so there may be no or little increase in revenue or sales: this is important in oligopoly. They also bring lower profits.

Question 39

What are the assumptions behind satisficing?

Answer 39

Due to the principal-agent problem, owners and directors will have different goals. Directors will want to maximise their own benefits but will need to make a certain amount of profit in order to keep their jobs, receive benefits and avoid criticism from shareholders/the press. Therefore, managers are likely to follow the objective of profit satisficing: they will make enough profit to keep owners happy whilst following other objectives and
not profit maximising. These other objectives are likely to be their own benefits, for example they may increase their own salaries which increases costs and therefore decreases profit.
The amount of profit needed will change year on year and will depend on the level of profit made by other firms: if everyone else is making a loss, and the firm only manages normal profit then this will be good enough for shareholders but if other
firms are making huge profits, shareholders too will expect huge profits.

Question 40

Explain the business aim of managerial utility maximisation.

Answer 40

Oliver Willamson said that managers will make decisions to maximise their own satisfaction. This will be dependent on their salary, the number of staff they control, their power over decision making and the other benefits they receive.

Question 41

Explain the business aim of marginal cost pricing/ allocative efficiency.

Answer 41

Firms, particularly nationalised industries, may want to aim to maximise social welfare, this will be done by producing where the value society places on the good is equal to the extra cost of producing that good, MC=AR. This achieves allocative efficiency.

Question 42

What is revenue?

Answer 42

Revenue is the money earned from the sale of goods and services.

Question 43

What is total revenue (TR)?

Answer 43

The total amount of money coming into the business through the sale of goods and services.
TR = Quantity * Price

Question 44

What is average revenue (AR)?

Answer 44

Demand is equal to average revenue, it is amount of money earned per individual unit or user.
AR = TR/ output

Question 45

What is marginal revenue?

Answer 45

The extra revenue that the firm earns from selling one more unit of production.
MR = change in TR/ change in output

Question 46

What firms experience a perfectly elastic demand curve when looking at revenue?

Answer 46

Firms in perfect competition, these firms have no price setting power, the price received by the firm for the good is constant and so MR = AR = D.
Their demand curve is horizontal, the TR curve is upward sloping because prices are constant and so the more goods sold, the higher the revenue made.

Draw a curve.

Question 47

What demand curve do firms in imperfect competition have?

Answer 47

For most goods the price decreases as output increases and there is a downward sloping demand curve and therefore a downward sloping AR curve. The demand curve and the AR curve are the same as it indicates the price that consumers are willing to pay for each quantity sold.
Firms with a downward sloping demand curve are firms that are in imperfect competition and so they have some price setting power.

Draw the curve

Question 48

Explain how MR influences the demand curve.

How does this explain a U-shaped TR curve?

Answer 48

For goods with a downward sloping demand curve, the elasticity of the curve is linked to marginal revenue.
If MR is positive, when the firms sells the product at a lower price, or when they increase output, total revenue still grows and so the demand curve is elastic.
If MR is negative, TR decreases as price decreases, or output increases, and so the demand curve is inelastic
When MR=0, TR is maximised and the demand curve is unitary elastic.

This explains why the TR curve is a U-shape, at first TR rises with output (when MR is positive) but it then begins to decline (when MR is negative).

Question 49

What is the opportunity cost of production?

Answer 49

The economic cost of production for a firm is the opportunity cost of production, the value that could have been generated had the resources been employed in their next best use.

Question 50

What are costs like in the SR?

What are costs like in the LR?

Answer 50

In the SR at least one factor of production is fixed and cannot be changed and so therefore some costs are fixed.
In the LR, all costs are variable.

Question 51

What is total cost?

Answer 51

The cost of producing a given level of output.

TC = FC + VC

Question 52

What is total fixed cost?

Answer 52

Costs that do not change with output and remain constant.

Question 53

What is total variable cost?

Answer 53

Costs that change directly with output.

Question 54

What is the formula for average total cost?

Answer 54

ATC = TC / Output

Question 55

What is the formula for average fixed cost?

Answer 55

AFC = TFC / Output

Question 56

What is the formula for average variable costs?

Answer 56

AVC = TVC / Output

Question 57

What is marginal cost?

Answer 57

The extra cost of producing one extra unit of a good.

MC = change in TC / change in output.

Question 58

What is diminishing marginal productivity?

Answer 58

Diminishing marginal productivity means that if a variable factor is increased when another factor is fixed, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit.

Marginal output will decrease as more inputs are added in the SR, this will mean that the marginal cost of production will rise.

Question 59

Describe the AFC curve.

Answer 59

The AFC curve starts high because the whole fixed costs are being divided by a small output. As output is increased, AFC falls as the same amount is divided by a larger number.

Draw the curve.

Question 60

Describe the ATC curve.

Answer 60

The ATC curve is U-shaped due to the law of diminishing marginal productivity. Costs initially fall as machinery is used more efficiently but as production continues to expand, efficiency falls as machinery is overused.

Question 61

Describe the AVC curve.

Answer 61

The AVC curve is also U-shaped, but gets closer to ATC as output increases since AFC gets smaller.

Question 62

Describe the MC curve.

Answer 62

The MC curve will be U-shaped due to the law of diminishing marginal productivity, it will initially fall as the machines are used more efficiently but will rise as production continues to rise.

The MC line will always cut the AC line at the lowest point on the AC curve: if MC is below Ac, then AC will continue to fall since producing one more costs less than the average so the average falls; but if MC is above AC, then AC will rise.
MC can be rising whilst Ac is still falling, as long as MC is still below AC.

Question 63

What is the relationship between short-run and long-run cost curves?
Draw them together.

Answer 63

SRAC curves are U-shaped because of the law of diminishing returns whilst LRAC curves are U-shaped because of economies and diseconomies of scale.
When a firm experiences economies of scale they see falling LRAC.
When a firm experiences diseconomies of scale their LRAC rise.

Question 64

What causes a shift in the LRAC curve?

What causes a movement in the LRAC curve?

Answer 64

The LRAC curve is a boundary representing the minimum level of average costs attainable at any given level of output. Points below the LRAC are unattainable and producing above the LRAC is inefficient.

Movement along the LRAC is due to a change in output which changes the AC of production due to internal economies/ diseconomies of scale.
A shift can occur due to external economies/ diseconomies, taxes or technology, which affects the cost of production for a given level of output.

Question 65

What is economies of scale?

Answer 65

Economies of scale are the advantages of large scale production that enables a large business to produce at a lower average cost than a smaller business. As a result, the firm is able to experience increasing returns to scale where an increase in inputs by a certain percentage will lead to a greater percentage in output.

Question 66

What is diseconomies of scale?

Answer 66

Diseconomies of scale are the disadvantages that arise in large businesses that reduce efficiency and cause average costs to rise. The firm experiences decreasing returns to scale, where output increases by a smaller percentage than inputs.

Question 67

What is constant returns to scale?

Answer 67

Constant returns to scale is where firms increase inputs and receive an increase in output by the same percentage.

Question 68

What is the minimum efficient scale?

Answer 68

The minimum efficient scale is the minimum level of output needed for a business to fully exploit economies of scale.
It is the point where the LRAC curve first levels off and when constant returns to scale is first met.

Question 69

Define internal economies of scale.

List them.

Answer 69

An internal economy of scale is an advantage that a firm is able to enjoy because of a growth in the firm, independent of anything happening to other firms or the industry in general.

• Technical economies
• Financial economies
• Risk bearing economies
• Managerial economies
• Marketing and purchasing economies

Question 70

Explain technical economies as an internal economy of scale.

Answer 70

These arise as a result of what happens to the production process.

• Specialisation = large firms can appoint specialist workers and machines that can do their jobs more quickly and better.
• Balanced teams of machines = large firms can afford every kind of machine for each stage of production, this ensures they run each machine at its optimal level.
• Increased dimensions = increasing the dimensions of any structure will lead to a proportionately larger increase in capacity.
• Indivisibility of capital = some processes require huge items of machinery and investment that make it only possible for them to be produced on a large scale.
• Research and development = often only large firms can afford to carry out large scale research and development, which means they are able to gain advantage over competitors.

Question 71

Explain financial economies as an internal economy of scale.

Answer 71

Large firms have greater security because they have more assets and are therefore less likely to be forced out of business overnight. As a result it is easier for them to obtain finance and interest rates will be lower due to lower risk, this makes investment more accessible.

Question 72

Explain risk bearing economies as an internal economy of scale.

Answer 72

Large companies can operate in a range of different markets, producing different products which means that if one area of business fails, their whole business will not collapse.

Question 73

Explain managerial economies as an internal economy of scale.

Answer 73

Large companies can afford to appoint specialist managers in every field, who are specialised and so have greater knowledge and are able to do their job better.

Question 74

Explain marketing and purchasing economies as an internal economy of scale.

Answer 74

• Buying in bulk = large firms are able to buy in large numbers and so may be able to buy their raw materials at a cheaper price than competitors.
• Specialisation = big businesses can afford to take on specialist buyers and sellers who could be more efficient due to extra knowledge.
• Distribution = large firms are able to enjoy preferential rates from transports companies because they offer the company a lot of businesses. They will be transporting in large batches which means that they can transport in full, large transporters which are cheaper per item than half-full or small transporters. Large businesses can also establish regional distribution centres which enables them to reduce transport costs by using large transporters over long distances, storing goods in the distribution centre and using smaller transport to take stock to individual shops.

Question 75

Describe what external economies of scale are.

List them.

Answer 75

An external economy of scale is an advantage which arises from the growth of the industry within which the firm operates, independent to the firm itself. These cause the LRAC curve to shift downwards.

• Labour
• Support services

Question 76

Explain labour as an external economy of scale.

Answer 76

Businesses established in an area with other successful firms from the same industry find that labour tends to come to that area if they want a job in that industry, e.g. Silicon Valley. This reduces the cost and time taken to recruit.
Local education and training providers are more likely to develop courses to prepare people to take up jobs in these businesses.
Firms can hire staff who have been trained by other businesses, which is cheaper and more efficient for the firm than training workers themselves.

Question 77

Explain support services as an external economy of scale.

Answer 77

Businesses who provide products or services for large businesses will naturally move to the area where those businesses are based, which reduces transport cost/time delays for the business.

Question 78

What are some diseconomies of scale?

Answer 78

• Workers = In a large business, people can think their efforts go unnoticed and have less chance of promotion so lose motivation and work less hard. They can also lose sense of belonging and have less personal commitment and identification with the business.
• Geography = A firm may have to transport finished products huge distances and firms may find it harder to control parts of the business which is miles away.
• Change = It takes longer and is more difficult for large firms to respond to change.
• Prices of materials = As business grows so does their demand for raw materials and equipment. This can cause prices to rise and therefore increase production costs. This could also occur if the whole industry increases and so firms bid up prices.
• Management = As business grows it becomes more difficult to coordinate and keep control of all the different parts of the business. This could lead to poorer quality of work and business decisions that don’t work well together. Communication can also be slow and lose accuracy because of the distance and the number of people it has to be passed through.

Question 79

What is profit?

Answer 79

The difference between revenue and costs.

Question 80

Where is profit maximised?

Answer 80

Profit is maximised when TR and TC are furthest apart, with TR above TC.
It also occurs when MC=MR because producing one more adds more to revenues than it does to cost, producing that must have increased profit.

Question 81

What is normal profit?

Answer 81

Normal profit is the return that is sufficient to keep the factors of production committed to the business. Costs include the level of profit needed to keep the producer in the market and to cover the opportunity cost. Therefore, if the firm covers its costs it earns normal profit.
This is at the point where AC=AR or TC=TR.

Question 82

What is supernormal profit?

Answer 82

If the profit is greater than normal profit, the firm is earning supernormal profit or abnormal profit.
This occurs where AR>AC or TR>TC.

Question 83

What is a loss

Answer 83

A loss is where the firm fails to cover its costs.

This is where AR

Question 84

What are the SR and LR shut-down points?

Answer 84

If AVCAR then producing more goods will increase the loss, as a result firms should leave the industry immediately.

In the LR, firms need 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 VC. Hence, the short run shut-down point is where AVC=AR.

Draw a diagram.

Question 85

What is efficiency?

What are the types of efficiency?

Answer 85

Efficiency can be used to judge how well the market allocates resources, and the relationship between scarce inputs and outputs. 
Allocative efficiency
Productive efficiency
Dynamic efficiency
X-inefficiency

Question 86

What is allocative efficiency?

Answer 86

This is achieved when resources are used to produce goods and service which consumers want and value most highly and when social welfare is maximised.
It will occur when the value to society from consumption is equal to the marginal cost of production, where P = MC.

Question 87

What is productive efficiency?

Answer 87

When products are produced at the lowest average cost so the fewest resources are used to produce each product.
The minimum resources are used to produce the maximum output.
This can only exist if firms produce at the bottom of the AC curve, in the short run this is where MC = AC.
It is only possibly if there is technical efficiency, where a given output is produced with minimum inputs (not all technically efficient firms are productively efficient).

Question 88

What is dynamic efficiency?

Answer 88

This is achieved when resources are allocated efficiently over
time. It is concerned with investment, which brings new products and new production techniques. The alternative is static efficiency: efficiency at a set point in time.
Allocative and productive efficiency are examples of static efficiency. Dynamic efficiency will be achieved in markets where competition encourages innovation but where there are differences in products and copyright/patent laws. Supernormal profit is required to provide firms with the incentive to invest and the ability to do so.

Question 89

What is X-inefficiency?

Answer 89

If a firm fails to minimise its average costs at a given level of output, it is X-inefficient and there is organisational slack. This is a specific type of productive inefficiency as it occurs when they fail to minimise their cost for that specific output.
It often occurs where there is a lack of competition so firms have little incentive to cut costs.

Question 90

What is an oligopoly?

What are the characteristics of an oligopoly?

Answer 90

Oligopoly is where there are a few firms that dominate the market and have the majority of market share, although this does not mean there won’t be other firms in the market. There are four key characteristics of oligopoly:

• products are generally differentiated
• supply in the industry must be concentrated in the hands of a relatively small number of firms, meaning there is a high concentration ratio
• firms must be interdependent (so the actions of one firm will directly affect another)
• there are barriers to entry.

Question 91

What is the kinked demand theory in relation to oligopoly?

Answer 91

In oligopoly, there is a kinked demand curve. If a firm raises its price, other firms will not follow since they know their comparatively lower price means they are more competitive. On the other hand, if a firm lowers its price, other firms will follow since they want to remain competitive.
The kink in demand means that there is a gap in the MR curve and so a rise or fall in costs or demand is likely to have no impact on price or output, because of this, prices in oligopolistic markets tend to be stable. The problem with the kinked demand curve theory is that it assumes that there is an initial price set within the market and does not explain why this price was set. However, it does explain why prices tend to be stable.

Draw a diagram.

Question 92

What is N-firm concentration ratios?

Answer 92

The concentration of supply in the industry can be indicated by the concentration ratio which measures the percentage of the total market that a particular number of firms have.
E.g. the 3 firm concentration ratio shows the percentage of the total market held by the three biggest firms.
It is worked out by adding the percentages of market share for the firms or using the formula: total sales of n firms/ total size of market * 100.

Question 93

What is collusion?

Answer 93

Collusion is when firms make collective agreements that reduce competition . When firms don’t collude, this is a competitive oligopoly. The UK energy market is an oligopoly that is suspected of collusion.

Question 94

Why do firms in an oligopoly collude?

Answer 94

If firms compete, they know lowering prices to gain new customers is likely to cause other firms to lower their prices;. However, if they work together, they could maximise industry profits. Collusion reduces the uncertainty firms face and reduces the fear of engaging in competitive price cutting or advertising, which will reduce industry profits.
Despite this, firms may decide to be a non-collusive oligopoly since collusion is illegal and due to the risks of collusion , such as other firms breaking the cartel or prices being set where they don’t want it. A firm with a strong business model and something that sets it apart from other firms will not want to collude if they feel they can increase market share and/or charge higher prices than competitors.
Collusion between firms works best when: there are a few firms which are all well known to each other; the firms are not secretive about costs and production methods and the costs and production methods are similar; they produce similar products;
there is a dominant firm which the others are happy to follow; the market is relatively stable; and there are high barriers to entry.

Question 95

What are the two main types of collusion?

Explain them.

Answer 95

When firms engage in collusion, they may agree on prices, market share or advertising expenditure. There are two main types of collusion: overt and tacit collusion. Overt collusion is when firms come to a formal agreement whilst tacit collusion means there is no formal agreement.

Question 96

What is a cartel?

How can they operate?

Answer 96

A formal collusive agreement is called a cartel, which is a group of firms who enter into agreement to mutually set prices. The rules will be laid out in a formal document which may be legally enforced and fines will be charged for firms who break these rules.

There are two ways a cartel could operate: agree on a price for the goods and then compete freely using non-price competition to maximise their market share; or agree to divide up the market according to the present market share of each business.

Question 97

What is a problem with cartels?

Answer 97

The problem with any cartel is that no firm is likely to set their prices/output at the level they would not ideally choose and there is constant temptation to break the cartel. The more successful the cartel, the greater the incentive to break it; it is
important for firms to be the first to break it and not the firm who is left to deal with the after effects.

Question 98

What can be involved in tacit collusion?

Answer 98

Since collusion is illegal, firms may be involved in tacit collusion such as price leadership and barometric firm.
Price leadership is where one firm has advantages due to its size or costs and becomes the dominant firm. Other firms will tend to follow this firm because they would be fearful of taking on the firm on in any form of price war. As a result, the dominant firm will decide the price and allow the other firms to supply as much as
they wish at this price.
Barometric firm price leadership is where a firm develops a reputation for being good at predicting the next move in the industry and other firms decide to follow their leader.
Other examples could be unwritten rules about keeping advertising low or not trying to take each other’s customers.

Question 99

What is game theory in oligopolies?

Answer 99

Game theory explores the reactions of one player to changes in strategy by another player. The aim is to examine the best strategy a firm can adopt for each assumption about its rival’s behaviour and it provides insight into interdependent decision making that occurs in competitive markets.

Question 100

How does game theory work?

Answer 100

There are two strategies the firm could take: a maximin policy or a maximax. The maximin policy involves firms working out the strategy where the worst possible outcome is the least bad. Alternatively, the maximax policy involves firms working out the policy with the best possible outcome.
If the maximin and maximax strategies end up with the same solution, this is called the dominant strategy. However, dominant strategies aren’t that common in real life and the best strategy for a firm tends to depend on what the other firm does.
In some cases, there is a Nash Equilibrium where neither player is able to improve their position and has optimised their outcome based on the other players expected decision. They have no incentive to change behaviour, unless someone else changes theirs.

Question 101

What are the types of price competition that oligopolies can use?

Answer 101

Price wars
Predatory pricing
Limit pricing

Question 102

Explain price wars as a type of price competition for oligopolies.

Answer 102

These occur in markets where non-price competition is weak ; where goods have weak brands and consumers are price conscious. They also occur when it is difficult to collude.
A price war will drive prices down to levels where firms are frequently making losses. 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.
It lowers industry profits.
Supermarkets are one example of an industry using heavy price wars, with firms desperately trying to offer lower prices than their rivals.

Question 103

Explain predatory pricing as a type of price competition for oligopolies.

Answer 103

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.

Question 104

Explain limit pricing as a type of price competition for oligopolies.

Answer 104

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.

Question 105

What are some pricing strategies that oligopolies can use?

Explain them.

Answer 105

• Cost plus pricing = Where firms work out their AC and add a percentage increase, which determines the level of profit they make. The size of this increase will depend on the level of competition and barriers to entry. The problem is that it does not consider the market.
• Psychological pricing = Where firms use the non-rounded prices to give an impression that the price is cheaper than it is. The aim is for consumers to feel they can afford the good and so be encourage to buy it.
• Market led pricing = Firms setting prices by looking at prices charged by competition. They price their good close to other firms, since if it was higher people would not buy it and if it was lower then they could be losing profit. The problem is that there is no consideration of costs.
• Price skimming = When a product is initially launched, firms can set very high prices to cover research and development. Once the product is no longer the newest or best, the price will be lowered. Mainly used by technology firms.
• Penetration pricing = When a product is first introduced, the firm will set prices low to encourage people to use it for the first time, after trying the product firms increase the price in hopes that people continue to buy as they like it.

Question 106

What is non-price competition for oligopolies?

Describe them.

Answer 106

An oligopolistic market tends to have a lot of non-price competition due to the fact that prices are relatively stable. They spend a long time and a lot of money on advertising and promotions, for example the Tesco club-card or the computers for schools scheme. The soft drink market is one good example of a market with high levels of non-price competition.

• Advertising = creates awareness of the company/product and persuades purchasing. Can increase sales and market share which in the long run increases profits. Can also make demand 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 for 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 = Will encourage loyalty amongst customers and give the business a positive reputation.
• Product development = Investing in product development will give a competitive advantage over rivals. However, this is often expensive and firms need money before, only large firms will be able to do large scale advertising and there is no guarantee it will be successful.

Question 107

How are oligopolies efficient?

Answer 107

Firms in an oligopoly market will be statically inefficient since they are not productively or allocatively efficient.
They are likely to be dynamically efficient, they make supernormal profits so have funds to invest and an incentive to invest due to competition.
They will be able to exploit economies of scale which lowers costs.

Question 108

What is a pure monopoly?

Answer 108

Pure monopoly exists where one firm is the sole seller of a product in a market.
The closest example is Google which owns 88% of the market.

Question 109

What are the characteristics of monopoly?

Answer 109

• more than 25% of the market
• short run profit maximising
• high barriers to entry
• price maker
• price discrimination

Question 110

Explain the demand curve for a monopolist.

Draw the curve and describe it.

Answer 110

The demand curve for a monopolist will be the demand curve for the product (since the monopoly firm is the industry itself). It will be downward sloping, since even though the firm is a monopolist, people can still choose whether to buy the good or not. Profit maximising is at MC=MR, so this is the output they will produce at.
Since there is a monopoly, the firm may be able to earn supernormal profits or a loss in the long run as there is no freedom of entry and exit to the market.

Question 111

What is third degree price discrimination in monopolies?

Answer 111

This is when monopolists charge different prices to different people for the same good or service . There are different examples of where this can occur: different times of the day, for example peak and off-peak train times; different prices in different places, such as between London and smaller towns; and between different incomes, for example discounts for elderly people.
In order for price discrimination to occur: the firm must be able to clearly separate the market into groups of buyers; the customers must have different elasticities of demand; and they must be able to control supply and prevent buyers from the
expensive market from buying in the cheaper market.

Question 112

Draw the diagrams for the different markets (inelastic and elastic) for price discrimination in monopolies?
Explain why monopolies price discriminate.

Answer 112

Diagram in pg. 15 in PMT 3.4.5
The firm produces where MC=MR in each market. Therefore, in the inelastic market they produce at Q1P1 and make supernormal profit of the orange area; in the elastic market they produce at Q2P2 and make supernormal profit of the purple area; and in the combined market they produce at Q3P3 and make supernormal profit of the yellow area. This shows that by price discriminating and having two separate markets, the inelastic market and the
elastic market, rather than a combined market, the firm can make higher profits. The orange area plus the purple area is larger than the yellow area.

Question 113

What are the costs and benefits to price discrimination?

Answer 113

• Firms benefit since they are able to increase their profits. This can go into research and development, improving dynamic efficiency.
• Those in the elastic market gain as they are able to pay a lower price than they otherwise would; they benefit from cross subsidisation. These consumers may have been unable to access the good if it were not for the price discrimination and so this may increase equality.
• Consumers lose some of their consumer surplus to the producers and some consumers have to pay a higher price.

Question 114

What is a natural monopoly?

Answer 114

Some companies are said to be natural monopolies. In these industries, the economies of scale are so large that even a single producer is not able to fully exploit all of them . These are decreasing cost industries. There are no pure natural
monopolies in real life, but some examples include the National Grid, Royal Mail and National Rail.

Question 115

Draw the diagram for a natural monopoly.

Answer 115

Google answer.

Question 116

Why is there no competition for natural monopolies?

Answer 116

It would be pointless to encourage competition since it would raise average costs for the industry. If any new firm enters the market, they will be easily priced out as their costs will be so much higher. This raises questions for competition policy and nationalisation.
Natural monopolies tend to be found in industries with very high fixed costs , such as railways. In order to run one train you would need to invest billions in track, tunnels, bridges and stations whilst running extra trains represents a much smaller
relative increase in costs, meaning average costs will decrease drastically.

Question 117

How efficient are natural monopolies?

Answer 117

These firms are neither allocative nor productively efficient as there is no minimum on the AC curve and at allocative efficiency there would be a loss.

Question 118

What are the costs and benefits of monopolies for firms?

Answer 118

• Monopolists have the potential to make huge profits for their shareholders through profit maximisation.
• The existence of supernormal profits means firms will have finance for investments and will be able to build up reserves to overcome short term difficulties.
• Firms with monopoly power will be able to compete against large overseas organisations.
• Large firms will be able to maximise economies of scale, reducing costs and increasing profit further.
• However, firms may not always choose to profit maximise because of X-inefficiencies, sales or revenue maximising, profit satisficing or contestability leading to limit pricing. In the long run, the lack of competition may mean that firms become complacent and so they may not make maximum profits.

Question 119

What are the costs and benefits of monopolies for employees?

Answer 119

• Monopolists produce at lower outputs, so will employ fewer workers.
• However, the inefficiency of the monopoly may mean employees receive higher wages, particularly directors and senior managers. Profit satisficing or sales/revenue maximising may mean output is higher and so more employees are employed.

Question 120

What are the costs and benefits of monopolies for suppliers?

Answer 120

• 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.

Question 121

What are the costs and benefits of monopolies for consumers?

Answer 121

• With a natural monopoly, consumers tend to be better off than if there was competition.
• When firms enjoy economies of scale , they will be more efficient and customers will enjoy a higher consumer surplus.
• Monopolists may produce an increased range of goods or services due to cross subsidisation.
• The use of price discrimination will allow for survival of a product or service , and benefits some customers (those in the cheap market) whilst is negative for others. For example, it is said that economy class flights are funded by business class flights
• Consumers may pay higher prices and see a poorer quality service , due to a lack of competition.
• There is less choice for consumers, since there is only one firm producing the good.

Question 122

How are monopolists efficient?

Answer 122

A monopoly is productively inefficient, since they don’t produce at MC=AC. They are also not allocative efficient as P>MC.
Since a monopolist is likely to make supernormal profits, they will be dynamically efficient. However, if there is no competition, they may have no incentive to invest.
Monopolists may suffer from X-inefficiency because of the lack of competition.
Alternatively, a large monopolist may enjoy large economies of scale which allow AC to fall. If these fall by a large enough amount, then consumer surplus will grow larger than would exist in perfect competition.
Schumpeter argued that monopolies will have large retained profits and will be able to exploit new products or production techniques without worrying about competitors. This would make them more productively efficient, as costs are lower, more
allocative efficient, as there are new products in the market, and dynamically efficient.
Also, monopolists avoid undesirable duplication of services and prevent a misallocation of resources. Cross subsidisation may waste resources since profits from one sector finance losses in another, whilst instead they should just stop production of this good.

Question 123

What are monopolies like in the long run?

Answer 123

There are few permanent monopolies since supernormal profits give an incentive for other firms to break down the monopoly through a process of creative destruction. Some suggest a monopoly, or the possibility of having a monopoly, is good in the short run as it provides incentive to invest and innovate which is good for both the company and the economy. The bad aspects of monopoly are more likely to become true in the long run as
firms can simply enjoy the benefits and become complacent. The effects of a monopoly will depend on the industry : in industries with high fixed costs, the gains from economies of scale will be higher.

Question 124

What is contestability/ a contestable market?

Answer 124

A contestable market is one with a high threat of new entrants, which keeps firms producing at a competitive level. Even in a monopoly, a firm may be forced to be efficient due to the potential of new entrants to the market. Any attempt to make a huge profit will mean other businesses will be attracted to the industry.

Question 125

What are the characteristics of contestable markets?

Answer 125

• Perfect knowledge, if firms are making abnormal profits others will enter.
• Freedom on entry and exit
• Relative absence of sunk costs
• Low product loyalty
• Firms are short run profit maximisers and do not collude with each other.

E.g. the taxi industry with the introduction of Uber, the hotel market with AirBnB, fast food with five guys.

Question 126

Why do firms enter in contestable markets?

What profit do they make?

Answer 126

In a contestable market, firms will enter the market if they see other firms are making huge profits. They will remain in the market until competition prevents them from making a profit. This will take away profit from the original firms, and could even force them out of business. The only way to prevent this is by using limit pricing, which reduces the incentive for firms to enter the market.
In a perfectly contestable market, firms will only be able to make normal profits and produce where AC=AR because new firms will enter the market if price was any higher and firms were making supernormal profits.

Question 127

How are firms in a contestable market efficient?

Answer 127

Firms are likely to be productive and allocative efficient. If they are not producing at the lowest point on their AC curve (i.e. not productively efficient), new firms can enter the market and undercut them by offering lower prices. Due to this, and the fact they can only make normal profits in the long run, they must also be allocative efficient. Since they can only make normal profits AC=AR, and since they produce at the lowest point on their AC curve AC=MC. Therefore, AC=MC=AR, so the value to society is equal to the cost.

Question 128

What barriers to entry and exit do contestable markets have?

Answer 128

Some barriers are natural barriers, sometimes called innocent entry barriers. These include natural monopolies and high entry/sunk costs. However, others are put in place by existing firms in the industry. They include patents and copyrights as well as high levels of advertising and branding. Both the costs to entry and exit must be high for the market to have low contestability, since if entry costs are high but the firm is able to make profit once in business and not lose much of this profit if they leave, then the market is still contestable.

• Legal barriers can prevent new firms from entering an industry. Laws are put in place which make it more difficult for firms to enter the market, or explicitly mean they cannot enter. For example, patents and exclusive rights to production (such as with television) mean other firms cannot enter the market. Some industries, such as the taxi industry, gain market licences to operate.
• Marketing barriers, high levels of advertising build up consumer loyalty, so demand becomes more price inelastic, and consumers are less likely to try other brands. Sometimes a brand can become associated with a product, such as ‘Hoover’ with vacuum cleaners. New firms entering the industry are unlikely to have the funds to undertake large scale advertising so struggle to compete with the incumbent firms. This may also be a barrier to exit, since losing a brand and consumer loyalty will be a cost of leaving the market.
• The pricing decisions of incumbent firms can be a barrier to entry. Predatory pricing means prices are so low that firms are driven out of the market, and so it would be extremely difficult for new firms to enter. Limit pricing discourages the entry of other firms as prices are set at a level to prevent new entrants. Some firms might employ anti-competitive practices, such as refusing to supply retailers which stock competitors.
• Some industries have high capital start up costs , for example buying the machinery necessary to begin production. Sunk costs may also be high.
• Economies of scale mean that new firms are unable to produce on the same AC curve as large, incumbent firms. If they were to enter the industry, their costs would be higher and so prices would be higher and they would be unable to compete.
• Barriers to exit prevent firms from leaving a market quickly and cheaply. They include the cost to write off assets, pay leases and make workers redundant.

Question 129

What is a sunk cost?

Answer 129

A sunk cost is a fixed cost that a business cannot recover if it leaves the industry. It includes property (if the lease is longer than it is actually used for), machinery and equipment that cannot be resold, and advertising.
All businesses will face sunk costs because even if things are resold it is generally for a lower price.

Question 130

What is the relation to sunk costs and contestability?

Answer 130

The degree of contestability is measured by the extent to which the gains from market entry for a firm exceed the costs of entering the market . A market with no sunk costs and no barriers to entry and exit is a perfectly contestable market. The more contestable a market, the more unstable it will be as there can be regular hit
and run competition.
In reality, no market is likely to be perfectly contestable as there is always likely to be some sunk cost.

Question 131

How have some firms become more contestable?

Answer 131

• Aldi and Lidl changed the structure of supermarkets by offering much lower prices and increasing market share.
• The deregulation of markets has allowed a reduction of some barriers to entry in some industries such as telecommunications and postal services. Moreover, competition policy has meant firms can no longer use predatory pricing and cartels so markets are more contestable.
• The European single market has opened up new markets for firms and so these firms can enter into the market, making them more contestable.
• Globalisation has increased contestability since foreign firms can enter domestic markets.
• Changes in technology has reduced entry costs as capital is more mobile. The rise of internet shopping means that firms no longer have to find retailers for their products and can easily enter the market and sell goods online.

Question 132

What does the demand curve for labour show?

Answer 132

The demand curve for labour shows the quantity of labour that employers would wish to hire at each possible wage rate.

Question 133

How is the demand for labour determined?

Answer 133

The demand for labour is determined by marginal revenue product (MRP), the extra revenue generated by an individual worker. The higher the MRP, the higher the demand for workers.

Question 134

How is the demand curve for labour drawn?

Why is it like this?

Answer 134

The law of diminishing marginal productivity means that increasing the number of workers, whilst all other factors are fixed, is likely to increase MRP at first but then cause it to decline. The demand for labour is assumed to be downward sloping because in the long run all factors of production vary so high wage rates encourage businesses to use machinery instead of workers and in the short run firms have fixed levels of capital and so diminishing marginal productivity means that adding extra workers gives a lower return so to employ these workers, the wage rate has to fall.

Question 135

What is the formula for marginal revenue product?

Answer 135

MRP = marginal output * price

or the difference in TR.

Question 136

How is labour derived demand?

Answer 136

Firms hire workers in order to produce goods to meet their aim, usually of making a profit. Therefore, the demand for labour is derived demand as it is derived from demand for the product the labour produces. Businesses only want the worker for as long as people are willing and able to buy the product they produce.

Question 137

What are the factors influencing demand for labour?

Answer 137

• Wage rates = as wage rates increase, demand for labour contacts since the MRP of labour must be higher for it to be worthwhile employing more people, so less are employed.
• Demand for the product = : Since labour is a derived demand, if there is no demand for the product, there is no demand for the labour. Firms won’t employ people if the goods they make aren’t going to be sold and make a profit. An increase in demand for the product leads to an increase in demand for labour. This is linked to the concept of MRP: an increase in output or price of a good will increase demand for the labour that produces that good.
• Price of other factors of production = If machinery and equipment becomes cheap, people will switch machinery for labour and therefore the demand for labour will fall.
• Wages in other countries = If wages are lower in other countries, people will be employed in other countries as it represents lower costs.
• Technology = Improvements in computers and technology means that many jobs have been lost with the work being done by machines. This means that there is less demand for labour, but demand for labour in technological based industries is increasing. By 2040, about 47% of jobs could be lost to technology.
• Regulation = High regulation within the labour market is likely to discourage firms from hiring since it can be very costly and time-consuming so this will reduce demand for labour in these areas. France is a country that used to have high levels of labour regulation and this is something the new president, Emmanuel Macron, is trying to change.
• State of economy = In a recession demand for products is low and thus there is reduced demand for labour.

Question 138

What is the price elasticity of demand for labour?

Answer 138

This is the responsiveness of the quantity demanded of labour to the wage rate.

Question 139

What are the factors affecting the PED of labour?

Answer 139

It is directly correlated to the price elasticity of demand for the product the labour produces. If the good is elastic, then a rise in wages and hence a rise in prices for consumers will have a large impact on the quantity the business sells. This will mean that the business will reduce the number of people it employs, in order to help it make a profit.
It is affected by the proportion of wages to the total cost of production : if wages are a huge proportion of costs, then an increase in wages will increase costs massively and so there will be a large fall in demand for labour hence it will be elastic.
If there are many substitutes, such as machinery and labour in other countries, then the demand will be elastic. This means high skilled jobs tend to be more inelastic than low skilled jobs as the labour cannot be easily replaced.
Time also plays a role. In the long run, it is more elastic as machinery can be developed and jobs can be moved whilst in the short run firms have to employ workers and redundancy payments can be expensive.

Question 140

What does the supply of labour curve show?

Answer 140

The supply of labour curve shows the ability and willingness of people to make themselves available to work at different wage rates.

Question 141

What are the factors influencing supply of labour?

Answer 141

• Wages = an increase in wages will lead to an increase in hours worked at first but beyond a certain point, it will lead to a decrease in hours worked. At this point the firm cam recruit new workers to increase hours worked.
• Population and distribution of age = : A high population will mean there is a large supply of labour. The distribution of age is important as there needs to be many people of high working age to ensure there is lots of labour. Migration plays a role in
  determining the workforce, since many migrants are of working age and come to the UK to work.
• Non-monetary benefits = Supply of labour will increase if there is high job satisfaction, for example in vocational jobs. Some jobs offer perks such as free private healthcare etc. which will increase supply. Factors such as holiday, hours of work, flexibility and opportunities for promotion also play a significant part.
• Education = More educated workers means there is a higher
  supply of workers. This is particularly important for some industries which require qualifications. Occupations which require high levels of education may suffer from lower supply of labour compared to low skilled jobs.
• Trade unions = : Trade unions may be able to restrict the supply of labour by introducing barriers to entry, for example you have to have a degree for teaching.
• Wages and conditions of other jobs = : If many jobs in a local area are considered to be unpleasant and offer low wages, then supply for alternatives will be higher.
• Legislation = The government rules can affect supply of labour, for example school leaving age and the retirement age.

Question 142

Explain how there is market failure in the labour market.

Answer 142

Labour can suffer from either occupational or geographical immobility.
They can suffer from occupational immobility where workers find it difficult to move from one job to another because of a lack of transferable skills. It is particularly difficult in the short term when workers need to get new training but in the long run it may only be possible at a high cost.
Moreover, they can suffer from geographical immobility where they find it difficult to move from one place to another due to the cost of movement, family etc.
Immobility can mean that there can be excess supply of labour in one area/occupation and excess demand in another. Even if wages are higher where there is excess demand, people will be unable to leave where there is excess supply to get a job in that area/occupation because of their immobility. The UK suffers from a severe skills shortage and this could cost £90bn a year following Brexit. There are four million too few high skilled people but six million too many low skilled people. Engineering is one industry suffering particularly badly from skills shortages.

Question 143

What is the elasticity of supply of the labour market?

Answer 143

This is the responsiveness of supply to a change in wage rates.

Question 144

What factors affect the elasticity of supply in the labour market?

Answer 144

It will depend on the level of qualifications and training since if there is a high level of qualifications necessary for the job, people will not easily be able to take up the job so the supply of labour will be inelastic.
Similarly, it can depend upon the availability of suitable labour in other industries, for example if a company can ‘poach’ workers from other industries, then it will be more elastic.
Moreover, it depends on time as in the long run supply of labour will be more elastic as people will have time to train. If the job is vocational, it will be inelastic since even if wages fall people won’t leave the job.
High tax rates and welfare benefits can reduce incentives meaning a lower supply,
High levels of unemployment make supply more elastic as the firm can increase workers without having to raise wage rates significantly.

Question 145

How are wages determined?

Answer 145

For the highest paid workers, there will be a low supply and a high MRP. The immobility of labour means that there may be excess
supply in one area/occupation, causing low wages, and not enough workers in another, meaning high wages. The lower the elasticity of supply/demand, the greater the change in the real wage rate and the smaller the change in employment as a result of a change in demand/supply for labour. The effect will also depend on the size of the shift.

Question 146

How are wages determined in perfect competition?

Answer 146

In a perfectly competitive labour market, we make the same assumptions as in a perfectly competitive product market. Therefore, wages are determined purely by demand and supply and all workers are paid the same. If workers were not paid the same, they would simply move somewhere else where the wage rate in the industry was higher. For example, a waiter in Liverpool would move to be a waiter in Portsmouth if the wage rate was higher. This would reduce supply and lead to an increase in wages in Liverpool, and increase supply and lead to a fall in wages in Portsmouth.

Draw a diagram

Question 147

How are wages determined in an imperfectly competitive market?

Answer 147

In an imperfectly competitive market, wages will not always be set where demand equals supply.

Monopsony (draw diagram)
In 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. Compared to a perfectly competitive market, they employ less people at a lower wage rate.

Monopoly (draw diagram)
The existence of trade unions means they can operate as the only seller of labour. There are two ways they could increase wages. Firstly, they could set barriers of entry which would reduce supply. Teachers’ unions lobbied for a rule which means that all teachers must have degrees . Alternatively, they could set wages at a specific wage and ensure workers are not prepared to work for less, creating a kinked supply curve. Supply is perfectly elastic up to output of QS and if the company wanted to employ more than this, they would have to increase wages further. The firm will employ where supply is equal to demand. Both of these methods will lead to higher wages but cause a fall in employment from the perfectly competitive equilibrium.

Bilateral monopoly (draw diagram)
= both monopoly and monopsony in a labour market
Refer to pg. 9 on PMT 3.5 for diagram and explanation.

Question 148

What are some issues with the labour market?

Answer 148

-Skills shortages: The UK suffers from geographical and occupational immobility, which means that even if there are enough engineers, there aren’t enough engineers in certain areas.
-Young workers: Workers who join the workforce during recessions tend to receive lower lifetime earnings than those who enter the labour force in better times. Youth unemployment can be a particular issue; during hard times, firms are unlikely to employ new workers but are reluctant to let go of their current workers and so the young struggle to get a job.
-Retirement: Rising life expectancy and an increase in the number of people reaching retirement age, as the ‘baby boomers’ reach retirement, has negative effects on the
government budget. Pensioners now makeup over 50% of welfare spending. The retirement age will have to continue to rise and the government is trying to encourage people to save for their own pensions.
-Wage inequality: Over time, those on the highest wages have seen their wages grow by a bigger percentage than those on the lowest wages. This is a contentious issue and raises questions over relative poverty and the level of redistribution
required.
-Zero-hour contracts: There has been a rise in zero-hour contracts and this causes problems for employees who do not know how much they will earn a week and receive little notice of when they will be required to work.
-The ‘Gig economy”: Many more people are now self-employed and undertake short term contracts, working for companies such as Uber and Deliveroo. There are concerns over the rights of these workers and the unreliability of their pay each week.
-Migration: Many people suggest that migration causes a fall in wages but it allows employers to recruit from a larger pool of workers and helps to fill skills shortages.
There are also issues over the correct level of unemployment, underemployment, the minimum wage, conditions in work etc.

Question 149

How can the government intervene in the labour market?

Answer 149

National minimum wage
Maximum wages
Public sector wage setting
Tackling immobility

Question 150

What has the government done with national minimum wage?

Answer 150

Labour introduced the National Minimum Wage in April 1999 to raise people out of poverty and decent minimum standards in the workplace. It changes every April, all workers over school leaving age receive their minimum wage and a failure to pay employees can lead to the firm being fined. The National Living Wage has been introduced for over 25 year olds, and the government pledge for it to be £9 by 2020.

Question 151

What are the arguments for national minimum wage?

Answer 151

• The wage is able to reduce poverty as it mainly impacts the lowest wages and ensures that these people have enough to live on.
• It can reduce male/female wage differentials as women are more likely to take up lower paid jobs (because they are vocational, offer more flexible hours etc.) and so a minimum wage is able to decrease the gaps between men and women.
• It may make employees less likely to leave their job as they feel more loyal to the businesses, which will decrease labour turnover, and therefore recruitment and training costs. This will increase profit but is a weak argument since if they are offered a higher wage elsewhere, then they will leave.
• There could also be a more content workforce who will be more motivated and, thus making the business more productive and increasing its profits. However, this assumes all people are motivated by money and this is not necessarily the case.
• Moreover, a minimum wage provides an incentive to work and prevents the ‘unemployment trap’, when benefits are higher than the wage people would otherwise receive.
• It ensures everyone receives a fair wage, and is not exploited by being drastically underpaid.

Question 152

What are the arguments against the national minimum wage?

Answer 152

• The most notable negative consequence is the potential loss of jobs in the industry (or unemployment on a macro level).
• Moreover, the minimum wage will raise costs for the companies and so may increase their prices, which is liking to lead to a fall in profit.
• Another negative impact could be the wage spiral as individuals will try to protect wage differentials between them and the lowest price workers. An increase in the wage of the lowest paid will mean that others expect theirs to rise too. This will reduce profit and further reduce competitiveness.
• There is no consideration of regional differences , and so this, alongside the fact many people on minimum wages are secondary earners, means the minimum wage may be ineffective at reducing poverty.

Question 153

How effective is the national minimum wage?

Answer 153

The impact of any minimum wage will depend on where it is set, and whether this is above or below the current wage. The level of job losses is dependent on the elasticity of supply and demand. If both are relatively elastic, there will be large job losses but if both are relatively inelastic, the losses will be small.

Question 154

What are the macroeconomic effects of minimum wages?

Answer 154

• can reduce inequality
• will lead to a rise in AD since the poorest people see a rise in income and they have a high MPC, this leads to economic growth and employment.
• public finances will worsen as the government employs many people on the minimum wage.
• rise in business costs will lead to a reduction in competitiveness which will negatively affect the trade balance and reduce the net trade component of AD. It will also increase SRAS, causing inflation in the short term.

Question 155

How can the government use maximum wages in the labour market?

Answer 155

Minimum wages are fairly common but few places set maximum wages. Some people suggest there should be a maximum wage for chief executives or a maximum pay ratio compared to the lowest wage earners. The government can set maximum pay limits for public sector workers in order to keep public sector
spending down. It will help to reduce inequality.
The introduction of maximum wages will lead to excess demand within the industry, since people may not put themselves forward for the job if they don’t think the salary matches the stress and responsibilities or they know they could get higher wages abroad. The UK may suffer from a loss of the best workers , which will reduce the quality of businesses and decrease competitiveness.

Question 156

What is the impact of maximum wages on the labour market?

Answer 156

The impact of this depends on the elasticities of supply and demand: inelastic means there will be little impact. It is argued that supply and demand for the highest paid workers, such as chief executives, is very inelastic since there is a small supply of chief executives and firms only need one chief executive so their cost is a very small part of total costs. This could mean maximum wages will have almost no effect on the market, other than causing a reduction in wages.

Question 157

How can the government use public sector wage setting in the labour market?

Answer 157

Since trade unions in the UK are weak, in the short run, the government can effectively make whatever wage decisions it decides in order to improve the budget.
Between 2010 and 2015, public sector workers experienced a pay freeze. This put downward pressure on private sector wages since few people were likely to leave the private sector for the public sector and private sector employers could use this as evidence to limit pay rises for their workers.
However, in the long run, if private sector workers receive pay rises and public sector workers don’t, people will move from the public sector to the private sector and this will force the government to increase public sector wages in order to expand
supply.
As a result, the wages of public and private sector workers tend to rise by the same percentage over a long period of time but in the short term they can rise by different rates.

Question 158

How can the government tackle geographical immobility in the labour market?

Answer 158

They could improve the supply of houses and reduce the price of properties making it easier for people to move. They could make renting cheaper to help people working in temporary jobs.

• They could improve transport links which will allow people to work further away from where they live and if they do move, it will be easier for them to visit family and get to job interviews.
• National advertising could be used so people know about jobs all over the country.
• The government could introduce subsidies on houses, taxes etc. in areas where there are labour shortages to encourage people to move to the area and take up jobs.
• One action taken has been to move public agencies out of London, for example the DVLA was moved to Swansea . Although this doesn’t improve the mobility of labour, it helps to prevent excess demand for labour in one place and excess supply in another.

Question 159

How can the government tackle occupational mobility of labour in the labour market?

Answer 159

They can improve occupational mobility of labour, through education. This will help to make the workforce more employable and better at a wider range of jobs:

• Vocational training can be increased, particularly for younger students.
• They could encourage further study, such as university or technical courses at college. They have been encouraging engineering degrees.
• They could encourage greater spending on training within work.
• Education could be targeted at improving skills shortages and helping with job applications, for example interview skills.

They could also encourage flexible work patterns which will allow more parents to work. On top of this, discrimination in the labour market could be reduced and employers who take on unemployed individuals from groups with above average
unemployment rates could be subsidised.

Question 160

What is the competition and markets authority?

What do they do?

Answer 160

The Competition and Markets Authority (CMA) work to promote competition for the benefit of consumers and investigate mergers and breaches of UK and EU competition law, enforce consumer protection law and bring criminal cases against individuals who participate in cartels. They are able impose financial penalties, prevent mergers taking place and force businesses to reverse actions already taken.

• They control mergers
• The control monopolies
• They promote competition and contestability
• They protect suppliers and employees

Question 161

How do they CMA control mergers?

Answer 161

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.
Tesco’s takeover of Booker was allowed as the CMA believed the impact on competition would not be too high since supermarkets are in a hypercompetitive industry. However, the European Commission blocked the merger of Ryanair & Aerlingus in 2010 as they would control more than than 80% of all Europe flights from Ireland.

Question 162

How do the CMA control monopolies?

Answer 162

Holding a dominant position in an industry is not wrong in itself but if the firm exploits this to stifle competition, they are deemed to be anti-competitive. Monopolies are allocative and
productively inefficient and so it can be argued that they need to be controlled. Most of this regulation occurs for utilities, which are natural monopoles.
They control through:
- price regulation
- profit regulation
- quality standards
- performance targets

Question 163

How do the CMA control monopolies through price regulation?

Answer 163

Regulators can set price controls to force monopolists to charge a price below profit maximising price, using the RPI-X formula. X represents the expected efficiency gains of the firms and the aim is to ensure firms pass on their efficiency gains to consumers. This is used in the airport industry.
Arguably, a better system is ‘RPI-X+K’, where K represents the level of investment. This is used in the water industry and has allowed investment of £130bn. 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.
The problem is that it is difficult to know where to set X due to rapid improvement in technology and because any information on what the efficiency gains will be have to come from the firm, who could easily lie as there is asymmetric information. As a result, there may be sudden price falls or rebates for customers, for example the water industry was forced to cut prices by 10% in 2000.
Moreover, maximum prices could be set where the price is equal to the MSC, ensuring monopolies are allocative efficient. However, it is difficult for governments to know where they should set the price as they do not know the exact allocative efficient output. It can also increase dynamic inefficiency as firms are unable to maximise profit so may not invest.

Question 164

How do the CMA control monopolies through profit regulation?

Answer 164

In the USA, ‘rate of return’ regulation is used where prices are set to allow coverage of operating costs and to earn a ‘fair’ rate of return on capital invested, based on typical rates of return in a competitive market.
This aims to encourage investment and prevents firms from setting high prices. However, it gives firms an incentive to employ too much capital in order to increase their profits.
It is also criticised since a reduction in costs will not improve the firm’s situation and so there is little incentive to be efficient . As with ‘RPI-X’ it also means that regulators need sufficient knowledge of the industry and so will suffer from asymmetric information.

Question 165

How do the CMA control monopolies through quality standards?

Answer 165

Monopolists will only produce high quality goods if this is the best way to maximise profits. The government can introduce quality standards, which will ensure that firms do not exploit their customers by offering poor quality.
For example, the Post Office has to deliver letters on a daily basis to all areas and electricity generators are forced to have enough capacity to prevent blackouts.
The problem is that it requires political will and understanding to introduce.

Question 166

How do the CMA control monopolies through performance targets?

Answer 166

Regulators can introduce yardstick competition, such as setting punctuality targets for train operating companies based on the best-performing European train operators. It is also possible to split up a service into regional sectors to compare the performance of one region against another; this is used in the water industry.
They could set targets over price, quality, consumer choice and costs of production. It will help firms to improve their service and lead to gains for customers.
The problem is that firms will resist the introduction of targets, so again it requires political will and understanding. They will also attempt to find ways to meet targets without actually improving , for example changing train timetables to prevent trains officially arriving late.
Other firms will fail to meet their performance targets and so there will be no improvements. Network Rail failed to deliver on the performance targets for their long distance sector in 2013-14. The government need to ensure that fines and other deterrents are strong enough that firms at least work to ensure targets are met.

Question 167

What are types of regulation for monopolists?

Answer 167

• Windfall taxes = taxes imposed after the event has occurred e.g. extremely high profits. It can discourage monopolists from making excessive profits and/ or encourage them to reinvest them. However, it is not a long term solution and firms may begin to underreport their profits.
• Breaking up the monopolists = the government can split up the monopolist into competing units, which should lower prices and profits and greater consumer choice. However, this may cause a loss of economies of scale and mean that prices rise. There is likely to be little impact of splitting a monopoly up into two firms and lobby groups will make this very hard for the government to do.
• Subsidies = subsidising monopolies may help achieve allocative efficiency. This will reduce their MC and encourage them to produce where the cost to society (MC) is equal to the value society places on it (P). Taxing the monopolists can then regain some money. This will be very politically unpopular and requires knowledge of costs and revenue curves and knowing where the allocative efficient output would be.
• Self-regulation = governments won’t have to pass legislation and industries can police themselves rather than having to pay workers to enforce regulation. However, this tends to be a weak way of regulating firms as firms will aim to minimise the amount of changes they have to make and continue to maximise profit.
• reducing barriers to entry and using merger policy will prevent monopolies being formal in the first place. Nationalisation can help to protect consumers in the case of a natural monopoly, whilst privatisation can help to increase efficiency.

Question 168

How can the government promote competition through promotion of small business?

Answer 168

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.
The Red Tape Challenge aims to decrease regulation, particularly for small businesses. There are also schemes, such as the Enterprise Investment Schemes and Seed Enterprise Investment Scheme, which provide tax relief for people who buy shares in small companies to help them grow.

Question 169

How can the government promote competition through deregulation?

Answer 169

This is the removal of legal barriers to entry to a previously protected market to allow private enterprises to compete. This will increase efficiency in the market by allowing greater competition as more firms can enter and conduct more activities than they could before. The Deregulation Act of 2015 aims to continue deregulation.
The government can also privatise industries, which will allow for competition in the market.
However, it can have some negative effects, leading to poor business behaviour. Licenses for specific industries are necessary to ensure standards are upheld. Some have argued that the deregulation of financial markets was a major contributor to the
financial crisis in 2008.

Question 170

How can the government promote competition through competitive tendering?

Answer 170

The government has to provide certain goods and services because they are merit or public goods but this does not mean that the state has to be the producer of all these goods and services. Goods, such as the sheets in NHS hospitals, are produced by the private sector and then bought by the public sector.
A similar thing can be done with services; the government can contract out the provision of a good or service to private companies e.g. private firms could be employed to run hospitals. These are called Private Finance Initiatives (PFI)
Competition can be introduced into the market as the government will request competitive tenders by drawing up a specification for the good or service and inviting private firms to bid for the contract to deliver it. The firm offering the lowest price wins
the contract, subject to quality guarantees.
This helps to minimise costs for the government and ensures efficiency by allowing for competition in the market. The private sector will have more experience running the projects, so it is likely they will be better managed.
However, it may not always be the most cost effective way and the process of collecting bids is costly and time-consuming . The private sector may not aim to maximise social welfare in the same way the government would and could use cost-cutting methods that reduce quality.

Question 171

How can the government protect suppliers and employees through restrictions on monopsony power?

Answer 171

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.

Question 172

How can the government protect suppliers and employees through workers’ rights?

Answer 172

The government protects employees through health and safety laws, employment contracts, redundancy processes, maximum hours at work and the right to be in a trade union. The government can also encourage firms to draw up codes of
conduct relating to employment practice. The problem is that if workers’ rights are too strong, employers will be unwilling to
take on new workers due to the extra cost of employing these workers.

Question 173

What is privatisation?

Answer 173

Privatisation is the sale of government equity in nationalised industries or other firms to private investors. The aim is to revitalise inefficient industries but can sometimes lead to higher prices and poor services.

Question 174

What is nationalisation?

Answer 174

Nationalisation is when a private sector company or industry is brought under state control, to be owned and managed by the government.

Question 175

What are the advantages and disadvantages of privatisation?

Answer 175

● It encourages greater competition, which reduces X-inefficiency and ensures low prices and high quality as firms realise they need to be competitive.
● Managers become more accountable, since they know poor performance will mean a fall in share prices and/or shareholders wanting them to be replaced.
● In both the long and short run, it can reduce the public sector net cash requirement (PSNCR) as the initial sale of shares raises revenue for the government and they no longer have to cover any of the firm’s losses.
● It reduces government interference which some see as a benefit in itself. This also means that firms can invest with greater certainty , instead of worrying about change when a government is elected every 5 years.
● An ideological argument is that it puts utilities into the hands of the people , since they can own shares. Workers will be more motivated as they know their hard-work will be rewarded by high dividends.
● On the other hand, when there are natural monopolies it may be fairer for the government to own the firm since they won’t abuse their monopoly position.
● Some people argue that industries such as electricity, water and transport are important because they directly affect the success of other industries, and so therefore it makes more sense for the government to own them in order to coordinate
them properly.
● There are problems over externalities and inequality.
● Some argue that it negatively affects that the PSNCR as firms are under-priced when they are sold and the government no long receives a firm’s profit.

Between 1994 and 1997, the railway industry was privatised. This has seen a rise in passenger satisfaction and a growth in investment. Season tickets have risen with inflation but standard single fairs have risen by 200%.

Question 176

What are the advantages and disadvantages of nationalisation?

Answer 176

● Investment is needed for the long term , but in a private company investment is only short term as shareholders will see no benefit from long term investment. This may lead to a poor quality of service.
● In the case of a natural monopoly, it is better for monopoly to be run by the state as they aim to maximise social welfare rather than a private business who will maximise profits.
● The government will consider externalities.
● The government will guarantee a minimum level of service for people who suffer the risk of being cut off from the service, due to the lack of potential profit from providing for them.
● Some say it would be dangerous to allow key strategic industries to fall into private hands as this could have disastrous effects for the country.
● However, nationalised industries suffer from the principal-agent problem and moral hazard, as managers know that any loss they make will be covered by the government.
● They will experience X-inefficiency and this could cause higher prices for consumers, especially since the industry will become a monopoly.
● They will be influenced by government’s decisions and the government may not have enough money to invest.

Post WWII brought high levels of nationalisation and this is known as the ‘golden age, a period of high growth before a period of stagflation that led to privatisation of these same industries. It became apparent that they suffered from high losses and were X-inefficient.

The NHS is a nationalised industry which suffers from a lack of funding and a lack of competition, both of which lead to poor quality. They also suffer from uncertainty as spending on the NHS changes every five years with the new government; this causes problems and is something Jeremy Hunt has tried to change.