Theme 3: Business Behaviour and the Labour Market Flashcards
What are some reasons for why a firm would want to grow
1) To experience economies of scale and reduce costs
2) To gain a greater market share to influence prrices
3) More security and access to finance
What is the principle agent problem
Separation of ownership (who want to profit maximise) and leadership ( who may want to maximise their own benefits)
Also has an element of mroal hazard e.g. risky investment banker
What are the costs of the principle agent problem and issues linked to it
1) Agency costs-Principles may not be aware of how much a contract has been fufiled
2) Inefficiency - Enables agents to produce sub-optimal cost work
3) Cost of monitoring/incentives - solutions to overcome principle agent problem cost money
Salaries linked to revenue/growth. Lack of accountability. Info assymetry
What are some ways to overcome the principle agent problem
1) Tipping; reliance on tips may make waiters more aligned with owners
2) Share options part of salary; workers also benefit if company does well
3) Partner progression; workers are incentivised to align with shareholders to join company and also want to maintain company growth
What is Profit satisficing
- Owners set a minimum acceptable level of revenue and profit
What are cooperatives
- Co-ops are owned and run by their members, who can be customers, employees or groups of businesses
What is CSR
Coporate Social Responsibility
Why would a firm embrace CSR
- Altruism - being a good citizen
- Contracting Benefits - helps recruit,motivate and retain employees
- Customer related motivation - attract customers; brand postioning
- Lower production costs - packaging, energy useage
- Risk management - address potential legal/regulatory capture
Improved access to capital
What is outsourcing of public sector
Private sector businesses used to provide public sector work
What are arguments for out-sourcing
- competition can save the tax payer money
- Private sector businesses more likely to achieve efficiency improvemments and costs savings
- Also might be more innovative, less heirarchical and less prone to suffering from DEoS
What are arguments against out sourcing
- Business bidding to win contracts may sacrifice quality of service as a way of loweing their costs
- Doubts about some employmeny practices of service companies
- Contracting-out/outsourcing requires proper monitoring which itself invovles extra spending
What are the 2 main types of growth
organic and integration
What are advantages and disadvantages of Organic Growth
Advantages:
● 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 tending to leave after the change.
● The firm is able to keep control over their business.
Disadvantages:
● 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.
What are the 2 types of vertical integration
Forward and backward integration
What is vertical integration
Vertical integration is the integration of firms in the same industry but at different stages in the production process
What is the difference between vertical forward and backward integration
If the merger takes the firm back towards the supplier of a good, it is backwards integration.
Forward integration is when the firm is moving towards the eventual consumer of a good.
What are the advantages and disadvatages of forward and backward vertical integration
Advantages:
● 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 both can be reliable
● With backward integration, businesses can control the quality, delivery and price
● Forward integration secures retail outlets and can restrict access to these outlets for competitors.
Disadvantages:
● Firms may have no expertise in the industry they took over
What is horizontal integration
This is where firms in the same industry at the same stage of production integrate.
What are the advantages and disadvantages of horizontal integration
Advantages:
● 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.
Disadvantages:
● 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’.
What is a conglomerate integration
This is where firms in different industries with no obvious connections integrate. They can sometimes be linked by common raw materials/technology/outlets.
What are the advantages and disadavantages of congolomerate integration
Advantages:
● 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
● finance can be easily obtained and managers can be transferred from company to company within the firm.
Disadvantages:
● The problem with this is that firms are going into markets in which they have no expertise.
What are the constraints of business growth
● Size of the market: A market is limited to a certain size
● Access to finance: Firms use two main ways to finance growth: retained profits and loans.
● Owner objectives: Some owners may not want their business to grow any further
● Regulation: In some markets, the government may introduce regulation which prevents businesses from growing.
What are joint ventures
- Joint ventures occur when businesses join together to pursue a common project
- The businesses remain separate in legal terms
An example might be joint-research projects to share the fixed costs
Why do many mergers fail
- Huge financial costs of funding takeovers including deals that have relied on loan finance - this leaves a big debt overhang after the deal
- Integrating systems – companies might have very different technology systems that are expensive or impossible to marry e.g. eBay & Skype
- Share price: The need to raise fresh equity through a rights issue to fund a deal which can have a negative impact on a company’s share price
- Many mergers fail to enhance shareholder value because of clashes of corporate cultures, priorities and key personalities
- The enlarged business may suffer a loss of customers and also some of their most skilled workers post acquisition (a loss of human capital)
- Paying too much: With the benefit of hindsight we see the ‘winners curse’ - i.e. companies paying over the odds to take control of a business – this is particularly the case with takeovers driven by management ego
- Bad timing – mergers and takeovers that take place towards the end of a sustained boom can often turn out to be damaging for both businesses
What is a demerger
A demerger is a business strategy in which a single business is broken into two or more components
What are reasons for demergers
● Lack of synergies : managers are splitting their time between areas which are so different it could lead to diseconomies of scale
● Value of the company/share price: e the value of the separate parts of the company is worth more than the company combined.
● Focused companies: . By focusing on one area, managers can improve their skills and knowledge and become more successful.
What is the impact of demergers on workers
firms may need their own managers and leaders so people could get a promotion.
However, the goal of making the firm more efficient may result in job losses.
What is the impact of a demergers on business
a smaller core business may enable it to be more efficient and then lead to more innovation and surviving higher competition.
However, the smaller size of the business could lead to a loss of economies of scale and access to finance
What is the impact of demergers on consumers
may gain from innovation and efficiency, leading to better products and cheaper prices .
demerged firms may be less efficient through loss of economies of scale or raise prices/reduce quality or range of goods as they become motivated by profits.
What is profit maximisation and why would firms aim this
● 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
● This is at MC=MR
What is revenue maximisation and why would firms do this
● Baumol suggested managers are most interested in their level of revenue since this is what their salary depended on.
● Revenue maximisation is at MR=0
What is sales maximisation and why would firms do this
● Robin Marris suggested that managers aim to maximise the growth of their company above any other objective.
● Size is often linked to security
● Growth will also increase market share, and may push other firms out of business
- Sales maximisation is AC=AR
What are the limitations of profit maximisation
In the real world it is not so easy to know exactly your marginal revenue and marginal cost of last goods sold.
Many firms may have to seek profit maximisation through trial and error.
It is difficult to isolate the effect of changing price on demand. Demand may change due to many other factors apart from price.
Firms may also have other objectives and considerations.
What is revenue
Revenue is the money earned from the sale of goods and services
What is total revenue
● Total revenue (TR): The total amount of money coming into the business through the sale of goods and services. quantity x price
What is average revenue
Average revenue (AR): Demand is equal to AR: total revenue/output
What is marginal revenue
Marginal revenue (MR): The extra revenue that the firm earns from selling one more unit of production: total revenue from ‘N’ goods- total revenue from (N-1) goods OR change in total revenue change in output
How does a perfectly elastic demand curve affect revenue
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 that are sold, the higher the revenue made.
With imperfect competition, how do revenues change
D = AR
MR is 1/2 of Gradient of AR
and TR is dependent on MR elasticity
● If marginal revenue is positive , when the firm 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. After output Q, the demand curve is inelastic.
● When MR=0, TR is maximised and the demand curve is unitary elastic
What is seasonal revenues
Seasonality refers to fluctuations in output and sales revenue related to the seasonal of the year.
For most products there will be seasonal peaks and troughs in production and/or sales
What are fixed costs
Business expense that does not vary directly with the level of output
Examples:
* Business insurance
* Consulting fees
Rental fees
What are variable costs
costs that relate directly to the production or sale of a product
Examples:
Energy and fuel costs
Component parts
Packaging costs
What is TC (total cost) and TFC (Total fixed cost) and TVC (Total Variable Cost)
● Total cost (TC): The cost of producing a given level of output: fixed + variable costs
● Total fixed cost (TFC) : Costs that do not change with output and remain constant e.g. rent, machinery
● Total variable cost (TVC): Costs that change directly with output e.g. materials
What is ATC (Average Total Cost), AFC (Average Fixed Costs) and AVC (Average Variable Cost)
● Average (total) cost (ATC): total costs/ output
● Average fixed cost (AFC): total fixed cost/ output
● Average variable cost (AVC): total variable cost /output
What is marginal cost
Marginal cost (MC): The extra cost of producing one extra unit of a good
What is the short and long run
The short run is the length of time when at least one factor of production is fixed and cannot be changed; this varies massively with different types of production. The long run is when all factors of production become variable.
What is diminishing marginal productivity
● 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 short run. This will mean that the marginal cost of production will rise.
What is the shape of the AFC
● The average fixed cost curve (AFC) 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.
What is the shape of ATC
● The average total cost curve (AC/ATC) 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.
How is the AVC shaped
The average variable cost curve (AVC) is also U-Shaped, but it gets closer to ATC as output increases since AFC gets smaller.
How is MC curve shaped
● The marginal cost (MC) will also 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
Where does MC cut AC
The marginal cost 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.
Marginal costs can be rising whilst AC is still falling, as long as MC is still below AC.
Draw MC ATC AVC and AFC with imperfect competition
Why are SRAC and LRAC U shaped
Short run average cost (SRAC) curves because of the law of diminishing returns
Log run average cost (LRAC) curves because of economies and diseconomies of scale.
How are LRAC and SRAC related
LRAC is the envelope ffor all associated SRAC curves because the LRAC is either equal to or below the relevant SRAC
Draw SRAC’s and LRAC curves and explain the shape
Short run curves get diminishing marginal returns as some factors fixed
Long run curves all factors become variable and so the SRAC curve can be shifted, new SRAC curve will be lower since the firm can have economies of scale
This continues until the firm experiences constant returns to scale and eventually diseconomies of scale
What is the LRAC a boundary for
The long run average cost 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.
What is the LRAC a boundary for
The long run average cost 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.
What causes a movement or a shift along the LRAC curve
**Movement along the LRAC **is due to a change in output which changes the average cost 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.
What is the Minimum Efficient Scale
- 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.
What are economies of scale
Economies of scale are the advantages of large scale production that enable a large business to produce at a lower average cost than a smaller business
What are diseconomies of scale
the disadvantages that arise in large businesses that reduce efficiency and cause average costs to rise
What are constant returns to scale
firms increase inputs and receive an increase in output by the same percentage
What are internal economies of scale
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.
What are the 5 types of internal economies of scale
- Technical Economies
- Financial Economies
- Risk Bearing Economies
- Managerial Economies
- Marketing and purchasing economies
What are technical economies and some examples
- Economies that arise from improvements in the production process
- Specialisation
- Increased dimensiones; if you double the size of a container you increase the amount it can carry by more than double
- Indivisibilty of Capital; spme processes require huge capital
- Research and Development
What are financial economies
● Large firms have greater security because they have more assets so it is easier for them to obtain finance and interest rates will be lower due to lower risk. This makes investment more accessible.
What are risk bearing economies
● Large companies are able to 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.
What are managerial economies
● 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.
Staff represent an indivisibility and so small firms cannot employ specialist staff.
What are marketing and purchasing economies and some types
● Buying in bulk
● Specialisation: Like other areas, businesses can afford to take on specialist buyers and sellers who could be more efficient due to the extra time and knowledge.
●Distribution: Large firms are able to enjoy preferential rates from transport companies because they offer the company a lot of businesses.
What are external economies of scale
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.
What are the types of external economies of scale
- Labour
- Support Services
- Subsidies
Cluster effect
Transport links
Supportive legislation
How is labour an external economies of scale
● 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, for example Silicon Valley. This reduces the cost and time take to recruit.
● Another advantage for large industries is that local education and training providers are more likely to develop courses to prepare people to take up jobs in these businesses.
● Firms will be able to hire staff who have been trained by other businesses , which is cheaper and more efficient for the firm than training the workers themselves.
How is support services an external economy of scale
● 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.
What are some types of diseconomies of scale
- Workers
- Geography
- Change
- Price of materials
- Management
How can workers be a diseconomy of scale
- 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 their sense of belonging and have less personal commitment and identification with the business.
How can geography be a diseconomy of scale
● 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.
How can change be a diseconomy of scale
● It takes much longer and is much more difficult for a large firm to respond to change.
How can the price of materials be a diseconomy of scale
● an increase in demand 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.
How can management be a diseconomy of scale
● Coordination and control: As a business grows, it will become progressively more difficult to coordinate and keep control of all the different parts of the business.
● Communication: Within a large business, communication can be slow and also can lose accuracy
What are learning economies of scale
- Industry experience reduces LRAC
○ Workers may become more adapt and Managers schedule the production process more effectively.
What is Agglomeration economies
Businesses in similar industries tend to cluster together and attract an influx of skilled talent which then provides human capital to expanding businesses.
What are economies of scope
Economies of scope happen when it is cheaper to produce a range of products rather than specialize in a limited number……Amazon
How would you evaluate economies of scale
- The nature of production / technology requirements will influence the size of MES relative to market demand
- Economies of scale may run out at a certain point but constant returns to scale means that unit cost will be stable
- Many economies depend on businesses achieving a high rate of capacity utilisation – this lowers the fixed cost per unit
What are the conditions for profit maximisation
- Profit is maximised when TR and TC are furthest apart (TR>TC)
- Also occurs at MC=MR
What happens if MR crosses MC twice
Sometimes, MR and MC may cross at two points and thus the profit maximising point is where marginal cost rises as it crosses the MR line.
What is normal profit and where does it occur
● Normal profit is the return that is sufficient to keep the factors of production committed to the business .
In economics, 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. **
Where does a loss occur in economics
AR<AC
If a business is making a loss in the short run, when should it shut down
When AVC>AR as producing more goods will increase the loss
If AVC<AR then firms should continue production as each good produces a revenue to help cover the loss
If a business is making a loss in the long run when should it shut down
Firm must make at least normal profits of AC=AR
(also cover fixed costs)
What is the short run shut down price
AVC=AR
(don’t need to cover fixed costs in short run)
Should this firm keep producing in short run, and long run
- AVC cost is only C2 so AR>AVC so can produce in SR
- IN LR needs AC=AR so will have to shut down
What is the evaluation of profit maximisation
- In the real world it is more difficult to maximise profits because firms do not have access to costs and MR data easily; ends up being prediction
- Principle agent problem; profit satisficing
- ESG considerations, other strategies
What is the evaluation of the shutdown price
- The firm may not close down at price of less than shutdown
- if they expect the** fall in demand to be temporary** and they are hopeful they can cut costs. A firm will try to avoid shutting down because it will lose market share and long term customers
What are factors that affect profitability
- Market Share
- Brand Image
- Competition
- Costs
- Exchange rate
- Economic Growth
Allocative efficiency
When resources are allocated to the best interests of society, when
there is maximum social welfare and maximum utility; P=MC
Asymmetric
information
Where one party has more information than the other, leading to
market failure and causing problems for regulators
Average cost/average
total cost (AC/ATC)
The cost of production per unit
total costs/
quantity produced
Average revenue (AR)
The price each unit is sold for
TR/quantity sold
Bilateral monopoly
Where there is only one buyer and one seller in the market
Cartels
A formal collusive agreement where firms enter into an agreement to
mutually set prices
Collusion
Occurs when firms agree to work together, for example by setting a
price or fixing the quantity they produce
Competition policy
Government action to increase competition in markets
Competitive tendering
When the government contracts out the provision of a good or service
and invites firms to bid for the contract
Conglomerate
integration
The merger of firms with no common connection
Constant returns to
scale
Output increases by the same proportion that the inputs increase by
Contestable market
When there is the threat of new entrants into the market, forcing firms to be efficient
Decreasing returns to
scale
An increase in inputs by a certain proportion will lead to output
increasing by a smaller proportion
Demergers
A single business is broken into two or more businesses to operate on
their own, to be sold or to be dissolved
Deregulation
The removal of legal barriers to allow private enterprises to compete
in a previously protected market
Derived demand
The demand for one good is linked to the demand for a related good
Diminishing marginal
productivity
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; after a certain point, marginal
output falls
Diseconomies of scale
The disadvantages that arise in large businesses that reduce
efficiency and cause average costs to rise
Divorce of ownership
from control
Firms are owned by shareholders, who have little say in the day to
day running of the business, and controlled by managers; this leads to the principal-agent problem
Dynamic efficiency
Efficiency in the long run; concerned with new technology and
increases in productivity which causes efficiency to increase over a
period of time
Economies of scale
The advantages of large scale production that enable a large
business to produce at a lower average cost than a smaller business
External economies of
scale
An advantage which arises from the growth of the industry within
which the firm operates, independent of the firm itself
Fixed cost
constant costs whatever the amount of goods produced
For-profit business
A business whose main aim is to make money
Game theory
Used to predict the outcome of a decision made by one firm, when it
has incomplete information about the other firm
Geographical mobility
of labour
The ease and speed at which labour can move from one area to
another
Horizontal integration
The merger of firms in the same industry at the same stage of
production
Increasing returns to
scale
An increase in inputs by a certain proportion will lead to an increase in
output by a larger proportion
Interdependent
The actions of one firm directly affects another firm
Internal economies of
scale
An advantage that a firm is able to enjoy because of growth in the
firm, independent of anything happening to other firms or the industry in general
Limit pricing
When firms set prices low in order to prevent new entrants; used in
contestable markets
Loss
When revenue does not cover costs
Marginal cost
The additional cost of producing one extra unit of good
Marginal revenue
The additional revenue gained by selling one extra unit of good
Maximum wage
A ceiling wage which people cannot earn above
Minimum efficient
scale
The lowest level of output necessary to fully exploit economies of
scale
Minimum wage
A floor wage which people cannot earn below
Monopolistic
competition
Where there are a large number of buyers and sellers who are
relatively small and act independently, selling non-homogeneous
goods
Monopoly
A single seller in the market
Monopsony
A single buyer in the market
N-firm concentration
ratio
The percentage of market share held by the ‘n’ biggest firms
Nationalisation
When a private sector company or industry is brought under state
control, to be owned and managed by the government
Natural monopoly
Where economies of scale are so large that not even a single
producer is able to fully exploit them; it is more efficient for there to be a monopoly than many sellers
Non-collusive
oligopoly
When firms in an oligopoly compete against each other, rather than
making agreements to reduce competition
Non-price competition
When firms compete on factors other than price, for example
customer service or quality; they aim to increase the loyalty to the
brand which makes demand more inelastic
Normal profit
The minimum reward required to keep entrepreneurs supplying their
enterprise, the return sufficient to keep the factors of production
committed to the business; TC=TR
Not-for-profit business
Where firms are run in order to maximise social welfare and help
individuals and groups; any profit they do make is used to support
their aims
Occupational mobility
of labour
The ease and speed at which labour can move from one type of job to
another
Oligopoly
Where a few firms dominate the market and have the majority of
market share, they act interdependently
Organic growth
Where firms grow by increasing their output
Overt collusion
Collusion where firms come to a formal agreement, for example a
cartel
Perfect competition
A market with many buyers and sellers selling homogenous goods
with perfect information and freedom of entry and exit
Perfectly contestable
market
A market with no barriers to entry, where a new firm can easily enter
and compete against incumbent firms completely equally
Predatory pricing
When a large, established firm is threatened by new entrants so sets
such a low price that other firms make losses and are driven out the
market
Price leadership
Where one firm sets prices and other firms tend to follow this firm as they are fearful of engaging in a price war
Price wars
Where firms continuously drive prices down to the point where they
are frequently making losses and firms are forced to leave
Principal-agent
problem
Where the agent makes decisions on behalf of the principal; the agent
should maximise the benefits of the principal but have the temptation
of maximising their own benefits
Private sector
The part of the economy that is owned and run by individuals or
groups of individuals
Privatisation
The sale of government equity in nationalised industries or other firms to private investors
Productive efficiency
When resources are used to give the maximum possible output at the
lowest possible cost; MC=AC
Profit maximisation
When firms produce at a point which derives the greatest profit;
MC=MR
Profit satisficing
When a firm earn just enough profit to keep its shareholders happy
Public sector
The part of the economy that is owned or controlled by local or central government
Regulatory capture
When regulators become more empathetic and are able to ‘see things from the firm’s perspective’, which removes impartiality and weakens their ability to regulate
Revenue maximisation
When firms produce at a point which derives the greatest revenue;
MR=0
Sales maximisation
When firms produce at a point where they sell as many of their goods
and services as possible without making a loss; AR=AC
Static efficiency
The level of efficiency at one point in time
Sunk cost
Costs that cannot be recovered once they have been spent
Supernormal profit
The profit above normal profit, TR>TC
Tacit collusion
Collusion where there is no formal agreement, such as price
leadership
Third degree price
discrimination
When monopolists charge different prices to different groups for the
same good or service
Total cost
The cost to produce a given level of output
total variable costs+total fixed costs
Total revenue
Revenue generated from the sale of a given level of output
price x quantity sold
Variable cost
Costs which change with output
Vertical integration
When a firm merges or takes over another firm in the same industry,
but at a different stage of production
What is **allocative efficiency **
when the value to society from consumption is equal to the marginal cost of production, where P=MC.
What is productive efficiency
firms produce at the bottom of the AC curve, in the short run this is where MC=AC, has to be technically efficient
What is **dynamic efficiency **
his is achieved when resources are allocated efficiently over time. It is concerned with investment,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.
What is static efficiency
oncerned with the most efficient combination of existing resources at a given point in time.
Allocative + prod effieiencies
What is a x-inefficiency
If a firm fails to minimise its average costs at a given level of output, it is X-inefficient and there is organisational slack. It often occurs where there is a lack of competition so firms have little incentive to cut costs.
What are the 2 types of dynamic efficiency
- Cost Reducing Innovation
- Creative Destruction
What makes up cost reducing innovation
* Product innovation
○ Small-scale and frequent subtle changes to the characteristics and performance of a good or a service
* Process innovation
○ Changes to the way in which production takes place or is organised
○ Changes in business models and pricing strategies
Innovation has demand and supply-side effects in markets and the economy as a whole
What is social efficiency
- The socially efficient level of output and/or consumption occurs when marginal social benefit (MSB) = marginal social cost (MSC)
What are the impacts of Monopoly allocative inefficiency
- The monopolist will seek to extract a price from consumers above the cost of resources used in making the product.
Higher prices mean that consumers’ needs and wants are not being satisfied, as the product is being under-consumed.
Higher prices cause a loss of consumer surplus & welfare and will disproportionately affect lower income families.
What effiencies does Perfect Competition have
- Allocative efficiency: In both the short and long run, price is equal to marginal cost (P=MC)
- Productive efficiency: in the long run
so static efficiency
Dynamic efficiency: no room to innovate because homogeneity or enough for R+D
● Competition should keep costs, and therefore prices, low. However, firms will be unable to benefit from economies of scale and this may mean costs are higher than they otherwise could be.
What efficiencies does Monopolistic Competition have
- Prices are above marginal cost – meaning that the equilibrium is not allocatively efficient
- Saturation of the market may lead to businesses being unable to exploit fully economies of scale - causing average cost to be higher – therefore not productively efficient
- Debate over the social costs of packaging and negative externalities is linked to monopolistic competition
Monopolistic competition associated with extensive consumer choice and innovation – good for dynamic efficiency
Do takeovers boost economic efficiency
- Economies of scale from horizontal integration (productive efficiency)
- Higher supernormal profits leads to increased R&D spending and more innovation (dynamic efficiency)
Firms with monopoly power still face competition in contestable markets (allocatively efficient prices)
Do takeovers boost economic efficiency
- Increased market power can lead to X-inefficiency (managerial slack, waste)
- Risks of diseconomies of scale (rising long run AC)
- Many takeovers fail to achieve forecast cost gains
Growing number of de-mergers points to limited impact of takeovers on overall economic efficiency
Economic case against monopolies
- Prices are higher than under competitive conditions
Leads to a loss of allocative efficiency (price > MC)
**Regressive effects **on lower-income households - Absence of genuine market competition may lead to production inefficiencies
○ X-Inefficiencies such as wasteful production and advertising spending
○ Higher prices can limit the final output in a market and lead to fewer economies of scale being exploited - Protected markets – perhaps less drive to innovate
Monopoly may get too big – diseconomies of scale
What is the economic case for monopoly
High market concentration does not always signal absence of competition; can reflect the success of firms in providing better-quality products, more efficiently, than their rivals.
- Profits used to fund investment & research
- Natural monopoly – economies of scale
- Domestic monopoly faces global competition
- Monopolistic firms can be regulated – i.e. industry regulator acting as a proxy consumer
- Price discrimination may help some consumers (cross-subsidisation)
What did Schumpeter argue about monopolies and creative destruction
· Schumpeter argued that firms have a very real incentive to invest in R and D,
· He stated that firms would fear Creative Destruction. Where new firms enter the market with technological advancement a force out existing firms. Incumbents fear this.
* They invest therefore in R and D and this is likely to come in the **form of the product/process. **
What does investment in the product result in (quality)
· Scarce resources are effectively allocated to meet consumer needs and wants.
· Consumers utility is met/improved and although consumers may face higher prices one could argue this level of product development and meeting the consumers’ needs is not possible in a competitive market due the absence of abnormal profit in the long run.
What does investment in the process result in (cost)
Investment in production-invention or innovation.
Investment in process is an example of technological EOS and the impact of tech improvement will drive down average and marginal cost. This can be shown. (see diagram)
What are the 4 key characteristics of a perfectly competitive market
1.There must be many buyers and sellers. This means that no one will be able to influence the market
2. freedom of entry and exit from the industry
3. There must be** perfect knowledge**
4. Homogenous products
Why must there be freedom of entry and exit for a perfectly competitive market
when a business is making profits anyone can enter that market and start producing that product for themselves.
As a result, business are unable to make SNP in the long run and if they are making losses they are able to leave. In the long run, they make normal profits.
Why must there be perfect information for a perfectly competitive market
This enables firms to know when other firms are making profits which will attract them to join the market. Moreover, all firms have the same costs as they can use the same production techniques.
It also means that any attempt to raise prices above the level determined by the market will lead to no sales, as customers will be aware they can buy the same good for a lower price and firms know there is no point lowering the price as they will sell all their goods at the higher price determined by the market.
Why must there be homogeneity for a perfectly competitive market
it means if a firm raises it price above the competitors’ no one will buy it and they will not gain from lowering their price because they can sell all of your product at the same price as everyone else.
Explain the kinked demand curve theory
· At P1 if one firm increased their price, other firms would not follow suits. Consumers would buy from the other firms therefore the firms raising price would face a PED elastic response on the AR curve would lose a large share of the market, revenue and likely profit
· If one firms cut price then they could gain a big increase in market share, however it is unlikely that firms will allow this. Therefore, other firms follow suit and cut price as well. Therefore demand will only increase by a small amount: Demand is inelastic for a price cut and revenue would fall for all firms
· This model suggests price will be rigid because there is no incentive for firms to change the price, they are risk averse.
Use a Game Theory matrix to explain why oligopolies have stable prices
What does the prisoners dilema show about the Nash Equilibrium
Draw a Cartel Firm’s SNP when staying within the quota of output
Draw the incentive to cheat shown by a Cartel Firm’s SNP
Draw a monopoly market
Draw a diagram for 3rd degree price discrimination based on separation by PED
The diagram shows the seperate markets for separate groups: those with inelastic demand and those with elastic demand. Assumption of constant cost
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.
Draw a diagram for 3rd degree price discrimination based on separation by PED
The diagram shows the seperate markets for separate groups: those with inelastic demand and those with elastic demand. Assumption of constant cost
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.
Draw a natural monopoly
Draw the Williamson trade off and describe the areas of DWL, falls in consumer surplus, gains in producer surplus
Analyse this diagram
- As a profit maximiser the monopoly will restrict output to Q1 in order to achieve MC=MR.
- Consumers suffer through a lack of choice but also high prices reducing surplus to [5,6,7].
- Producer benefits by capturing surplus from the consumer, a transfer in welfare [1,2,11,12]. Total producer surplus is now [1,2,13,14].
- The monopoly is not allocatively efficient as P≠MC, This creates a welfare loss of [8,9,10] made up of lost consumer and producer surplus.
- The firm is not productively efficient it doesn’t not produce at the lowest point of the AC curve
- there is likely to be a degree of x-inefficiency. This results in higher AC, higher prices and poor service.
- The monopoly does not fully exploit its EoS on the graph as it does not produce at the MES point since it restricts output.
What is 1st Degree Price Discrimination (Perfect Price Discrimination)
- Each consumer in theory is charged the maximum they individually are willing to pay so extracts all consumer surplus.
- In reality, this is an unrealistic theory as consumers are unlikely to reveal their true preferences
What is third degree price discrimination (direct price discrimination)
This involves charging different prices to different groups of people
Analyse this diagram
- As a profit maximiser the monopoly will restrict output to Q1 in order to achieve MC=MR.
- Consumers suffer through a lack of choice but also high prices reducing surplus to [5,6,7].
- Producer benefits by capturing surplus from the consumer, a transfer in welfare [1,2,11,12]. Total producer surplus is now [1,2,13,14].
- The monopoly is not allocatively efficient as P≠MC, This creates a welfare loss of [8,9,10] made up of lost consumer and producer surplus.
- The firm is not productively efficient it doesn’t not produce at the lowest point of the AC curve
- there is likely to be a degree of x-inefficiency. This results in higher AC, higher prices and poor service.
- The monopoly does not fully exploit its EoS on the graph as it does not produce at the MES point since it restricts output.
What is 1st Degree Price Discrimination (Perfect Price Discrimination)
- Each consumer in theory is charged the maximum they individually are willing to pay so extracts all consumer surplus.
- In reality, this is an unrealistic theory as consumers are unlikely to reveal their true preferences
What is third degree price discrimination (direct price discrimination)
This involves charging different prices to different groups of people
Draw a predatory pricing diagram
Draw a limit pricing diagram
Draw a monopsony diagram
They will produce where the cost to them (MC) is equal to the value they get (AR). Hence, they will produce where MC=D.
Draw the effect of contestability
· There is downward pressure on prices because high prices and profits act as incentives for new producers to compete away monopoly profit.
· Normal profit will occur AC=AR (link to alternative objectives)
· An improvement in c/s and welfare will occur.
Draw the effect of both the substitution effect and the income effect
Backwards bending supply curve
How does the average and marginal cost of labour interact with employment
f a firm can employ each additional worker at the same wage rate, then the average and marginal cost of labour will be the same
If the firm has to pay higher wages to attract more workers, then the average cost of labour rises and the marginal cost of labour will be above ACL. This is since raising wages for one worker means raising wages for workers
What is a perfectly competitive labour market
- Same assumptions as perfect competition in products
- 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.
*
How does a monopsony employ workers
They will employ to where:
Cost of employment (MC) = Value of worker to company (MRP/D)
At this quantity they will then use their monospony power to push the wages down to a wage determined by the Supply curve
Compared to a perfectly competitive market they employ less people at a lower wage
How do monopolies in labour markets (TUs) increase wages
1) They could set **barriers of entry **which would reduce supply. Teachers’ unions lobbied for a rule which means that all teachers must have degrees .
2) Alternatively, they could set wages at a specific wage and ensure workers are not prepared to work for less, creating a kinked supply curve as seen in the diagram (the grey line). 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, at QDW2. Both of these methods will lead to higher wages but cause a fall in employment from the perfectly competitive equilibrium of Q1W1.
Explain the steps to arrive at a wage rate and draw a diagram for a bilateral monopoly
- The firm is a monopsonist and wants to employ at Q2W2.
- However, the union may decide to set a minimum wage at W1 and ensure that there is no one willing to work below this price, creating a kinked supply curve. The new MC and AC curves are the purple curves.
- The wage that is set will depend on the relative bargaining strength of both .
- In a time of economic recession and unemployment the unions may have less bargaining power and wage is most likely to be down at W1. In times of full employment, they may have the power to influence and wages could be at W3 .
What is the current minimum wage
What is efficiency wage theory and draw the graph
increasing wages can lead to increased labour productivity because workers feel more motivated to work with higher pay.
Therefore if firms increase wages – some or all of the higher wage costs will be recouped through increased staff retention and higher labour productivity.
Draw the effect of a productivity deal
Diagram shows that as MRP rises, more workers could now be employed at the TU wage, contrary to the opinion that the TU will increase wage rate at the expense of employment.
This should protect against redundancy
Explain why MC=AC=Ls
TU now enters a monopsony market and through collective bargaining now raises the wage to w/pTU.
The agreed wage becomes the standard for the industry/firm, therefore MC = AC = LS.
This is because the cost of employing the next worker is the same as the previous, meaning MC is constant and so is AC.
Explain why the firm won’t employ past Q(tu)
At this wage, QTU workers are prepared to work and the monopsony is happy to employ as MC is below MRP. If the monopsony wished to employ beyond the LS curve kink, a higher wage would have to be offered.
In offering a higher wage, all previous workers would have to be paid more and MC would discontinue and go above MRP. Therefore, the firm would not employ beyond QTU.
