Theme 3 Content Flashcards
3.1 - Business Growth
How to small firms survive
3.1.1 - Sizes and types of firms
- Many small businesses act as a supplier or sub-contractor
- They might take advantage of low-price elasticity of demand (PED) and high income-elasticity (YED) for specialist ‘niche’ or ‘bespoke’ products that can be sold at a higher price with a larger profit margin per unit - by expanding you may lose the niche or bespoke aspect so reason to stay small
- Can avoid internal diseconomies of scale
- Lifestyle enterprises where owners are looking to satisfice not maximize profits
- Innovate, flexible and nimble in responding to changes in market demand
- Keep over-head costs low
- Benefit from external economies of scale
3.1 - Business Growth
What is the divorce of ownership from control?
- Large companies appoint directors rather than have owners run them, owners largely have nothing to do with day-to-day operations
- So there is a divorce of ownership from control
3.1 - Business Growth
What happens when there is a divorce of ownership from control
- The board of directors oversee the CEO and senior managers who actually run the firm
- This can result in a form of the principle agent problem where one group makes decisions on behalf of another
-> the CEO should put shareholders first
-> In practice, the agent almost always maximises their own benefit -> this could be through giving themselves large bonuses
3.1 - Business Growth
How to solve the divorce of ownership from control
- The shareholders do have control through the Annual General Meeting where they can vote people off and onto the board
- Alterately they have the opportunity to sell their shares too which can place pressure on the board if the price were to drop
3.1 - Business Growth
Why do firms want to grow?
- Economies of scale (Reduce costs so inc prof).
- Increased market influence (and over price)
- Increased market share (Inc. access to credit).
- Larger product range - more diverse / stable.
3.1 - Business Growth
Who controls private sector organisations?
Individuals
(For profit)
3.1 - Business Growth
Who controls public sector organisations?
Governmental bodies
(Not for profit)
3.1 - Business Growth
What are the constraints on growth?
[7]
- Owner’s Objectives.
- Type of product - e.g. winter gloves (seasonal).
- Market size - e.g. left-handed scissors.
- Bureacurcay, red tape and regulation - regular tax returns and health and safety requirements
- Access to finance
- Competition
- Skill shortages
3.1 - Business Growth
Through what kind of processes does organic growth of businesses occur?
Through internal processes. (relies on own resources)
3.1 - Business Growth
How is organic growth measured?
Through comparing sales/revenue year over year
3.1 - Business Growth
What are the benefits of organic growth
- Less risk -> Mergers go wrong all the time. In 2/3s of cases, the mergers make the firms less profitable (The Economist) They might suffer from
-> Diseconomies of scale
-> Cultural issues.
-> Communication problems. - No reduncy costs. - less wasted resources
- Less likely to recieve CMA attention
- Managable pace of growth
- The management know & understand every part of the business
- Builds on a businesses’ existing strengths (customer base)
3.1 - Business Growth
What are the disadvantages of organic growth
- Very slow - won’t please shareholders
- Might find it difficult to access finance if they do not have collateral.
- You might get bought out by a competitor
- Not suitable when trying to break into a foreign market
- Growth is very dependent on the growth of the overall market/consumer demand
- Not necessarily able to benefit from economies of scale
3.1 - Business Growth
What is vertical integration?
- Merging with a firm
- In the same industry
- But at a different stage in the production process.
3.1 - Business Growth
What is the difference between forwards and backwards vertical integration
- Forward vertical - moving closer to the customer. E.g. Luxotica purchasing Sunglass Hut.
- Backwards Vertical - Moving closer to the primary product E.g. Tesco and The Booker Group
3.1 - Business Growth
What are the advantages of forward vertical integration
- Creates a secure market for firms products
- Retailers profits now belong to the firm.
- Share information about consumer tastes/preferences
- Can offer better customer service and a more competitive price.
3.1 - Business Growth
What are the advantages of backwards vertical integration
[4]
- Suppliers profit now belongs to the retailer.
- Firm gets priority treatment for supplies and has more power to ensure quality - create brand loyalty.
- Can offer customers with more competitive prices - win win. E.g. Tesco-Booker.
- May be cost savings -> integrating with a supplier may increase efficiency
3.1 - Business Growth
What are the disadvantages of forward vertical integration
[5]
- Firms may not be experienced in running retail.
- Cultural issues/ diseconomies of scale
- Retailer may offer reduced choice to consumers and only stock the parent companies products.
- Firms often pay too much for firms
- Key workers may leave, loss of expertise
3.1 - Business Growth
What are the disadvantages of backwards vertical integration
- Suppliers may become complacent as there will always be a customer - x-ineffiency.
- Cultural issues/ diseconomies of scale.
- Firms often pay too much for firms
- Key workers may leave, loss of expertise
3.1 - Business Growth
What are the advantages of horizontal integration?
[5]
- Rapid increase in market share/Elimination of competitors
- Firms can specialise and rationalise
- Already has expertise in industry, merger likely to be successful
- Potential for economies of scale
- Revenue synergies – 1+1=3 extra benefits. Two companies’ combined can generate more sales than the sum of the two individually
3.1 - Business Growth
What are the disadvantages of horizontal integration?
[8]
- Time-consuming, high risk
- Potential loss of control for part of firm
- Integration challenges, such as cultural differences
- More scrutiny from the competition authorities – could be worried that competition will be substantial lessened. The authorities could stop the merger
- May divert management’s attention from core operations
- Overpaying
- Reduced flexibility – more people and process means the need for more transparency and so more legal accountability and red tape. Slower innovation and increased costs
3.1 - Business Growth
What is Conglomerate integration?
The integration of firms in different industries with no common connections.
3.1 - Business Growth
What are the advantages of conglomerate integration?
- Diversify to be less reliant on the success of one product - reduce risk - diversification of risk
- Opens a new market if growth is slow in existing markets. - New opportunities for growth
- Size of a conglomerate makes it easier to obtain finance
- Capitalizing on unrelated opportunities.
- Potential for higher returns in diverse markets.
- Parts of the new business may be sold for profit as they are duplicated in other parts of the conglomerate
3.1 - Business Growth
What are the disadvantages of Conglomerate Integration
[5]
- Possible lack of expertise in new products/industries
- Diseconomies of scale can quickly develop
- Usually results in job losses - loss of experienced workers
- Worker dissatisfaction due to unhappiness at the takeover can reduce productivity
- Overpaying
3.1 - Business Growth
What are the disadvantages of mergers and acquisitions for consumers
- However, larger firms may have more market power, making demand more inelastic. Firms can raise prices to achieve greater profits and revenues, at the expense of the consumer. Less consumer surplus.
- Any cost savings made by EOS may just be paid to shareholds or CEOs, rather than benefiting consumers.
- Might create diseconomies of scale or x-inefficiency
- Less choice
3.1 - Business Growth
What are the disadvantages of mergers and acquisistions for employees
- The initial merger may lead to job losses as the firm looks for cost savings - store closures.
- Duplicate staff members will be made redundant.
3.1 - Business Growth
What is a demerger?
When a company splits off
3.1 - Business Growth
Why can company value lead to demergers?
Some parts maybe worth more than company combined
3.1 - Business Growth
Reasons for Demergers
- Reducing diseconomies of scale - smaller firm means less diseconomies of scale so possible increased profit
- Increased business focus
- Cultural differences
- Remove loss making divisions
- Increase liquidity & dividend payments
- Comply with the demands of the Competition Commission - due to high levels of market share
3.1 - Business Growth
Impacts of demerger on Businesses
- Opportunity for a more narrow focus on the core business
- Removing loss-making portions of the business
- Increased efficiency and lower costs/unit
- Increasing the annual profits for the year that the demerger occurred
- Removing some difficult cultural differences
- Long term – higher returns/operating profits
- Short term costs of selling the business especially if sold at low price
3.1 - Business Growth
Impacts of demerger on Employees
- Some workers may lose their jobs
- Reduced friction from cultural differences can help build better team dynamics
- Smaller workforce provides more opportunity for promotion
- Less complication in daily tasks due to more narrow focus
- Opportunity for managers of newly demerged business to assume new responsibilities
3.1 - Business Growth
Impact of demerger on consumers
- If successful, better quality products & customer service
- If successful, lower prices due to the firms new efficiencies
- If unsuccessful, a narrower product range & perhaps worse quality/customer service
- Impact on prices depends on the effect of a demerger on the intensity of industry competition
- Impact on prices depends on whether a demerger leads to fewer economies of scale being harnessed
3.2 - Business Objectives
What are the 3 possible business objectives?
- Profit maximisation. (Directors want this)
- Sales maximisation. (Organic growth)
- Revenue maximisation. (Managers want this)
3.2 - Business Objectives
Why do firms return to profit maximisation in the long run? (Keynes)
- Shareholder pressure to maximise profits - managers might be changed.
- Survival - firms might not be able to keep running with low profits. Needs to be money for reinvestment.
- A rival might have been removed
3.2 - Business Objectives
Why do firms maximise profits?
- Dividends to distribute to shareholders, CEOs and owners. - Pressure from shareholders as they vote on directors at annual general meetings (AGM)
- Bonuses to CEOs and Managers.
- Reinvestment into the firm - Research and development for future profits. - Business expansion
- Firm survival in a competitive atmosphere. - Owners do not want to fund losses, the bank may stop lending.
3.2 - Business Objectives
What happens if firms produce beyond profit maximising price?
The cost of producing one extra unit will exceed the revenue gained from one extra unit.
Results in higher costs and lower profits.
3.2 - Business Objectives
Where is revenue maximising point?
Marginal Revenue = 0. Any more than this and marginal revenue is less than 0 so revenue will start to fall.
3.2 - Business Objectives
Why might firms revenue maximise?
- To deter new entry (reduce price, increase quantity and market share) - Over time, rivals might leave the market, reducing competitive pressure and making demand more price inelastic.
- Avoid the CMA, which might invest for anti-competitive behaviour.
- Create brand loyalty, win customers
- Amazon follows an objective of revenue maximisation to dominate the market and create brand recognition
- The Principle agent problem - Managers are rewarded bonuses and incentives based on revenue they bring to the firm.
3.2 - Business Objectives
Where is sales maximisation?
- Selling as many units as possible whilst still making normal profit.
- AC=AR
3.2 - Business Objectives
Why might firms sale maximise?
- Avoid CMA attention
- Deter new entry - charge a limit price, as there are no supernormal profits to be made
- Start up and create brand awareness - Deliveroo, Uber
- Win more market share - more agressive than revenue maximisation. E.g. Aldi, Lidl.
- Build up monopoly power, price inelastic demand to raise prices in the future.
- Or force rivals out of the market.
3.2 - Business Objectives
What is profit satisficing? Where is it?
- A compromise between revenue maximisation and profit maximisation.
- Occurs between MC=MC and MR = 0.
3.2 - Business Objectives
Why might firms profit satisfice?
- Due to the principle agent problem, managers might make enough profits to satisfy owners happy whilst increasing their own benefit.
- Enough for higher bonuses but also enough for shareholders, who won’t remove managers.
- Win market share but have enough for shareholders.
- Avoid the CMA but have enough to reinvest
3.2 - Business Objectives
Where is the profit maximising point
MC=MR
3.2 - Business Objectives
Why can a firm survive, while making a loss, in the short-run?
- Managers could be satisficing, in a temporary market downturn.
- Losses may be cross-subsidised by profits in another sector.
3.3 - Revenues, costs and profits
At what point does MR begin to decrease?
When TR = 0.
3.3 - Revenues, costs and profits
Total revenue when price is constant?
3.3 - Revenues, costs and profits
Average and marginal revenue when price is constant?
3.3 - Revenues, costs and profits
Total revenue when price is falling
PED = 1 when TR is maximised and MR = 0
3.3 - Revenues, costs and profits
Average and marginal revenue when price is falling
- AR falls as price falls with increases in output
- MR falls twice as fast
- AR = D as it shows the average price received at each level of output
3.3 - Revenues, costs and profits
Give examples of fixed costs and variable costs.
- Fixed cost: printer
- Variable costs: ink + paper
3.3 - Revenues, costs and profits
Diagram showing the relationship between TC, TVC and TFC:
3.3 - Revenues, costs and profits
Why are Long run and short run cost curves shaped they way they are
SR - due to law of diminishing returns.
LR - due to EoS.
3.3 - Revenues, costs and profits
What happens to the AC and MC curve if costs decrease?
They always move as a pair.
AC shifts down, MC shifts out (to the right).
3.3 - Revenues, costs and profits
What is the minimum efficient scale?
The lowest quantity where AC stops decreasing. (Where all EoS have been utilised).
(Productive efficiency).
3.3 - Revenues, costs and profits
What are diseconomies of scale?
- Disadvantages that arise in large businesses that reduce efficiency and cause average costs to rise.
- Decreasing returns to scale - Δ% in output < Δ% in inputs
3.3 - Revenues, costs and profits
What are economies of scale
- Falling long run average cost as output increases in the long run
- Increasing returns to scale - Δ% in output > Δ% in inputs
3.3 - Revenues, costs and profits
What are constant returns to scale?
When a firm increases inputs and receives an increase in output by same percentage
3.3 - Revenues, costs and profits
What are external economies of scale?
Advantages which arise from the growth of the industry within which the firm operates, independent of the firm itself.
3.3 - Revenues, costs and profits
Types of interal economies of scale
- Technical - Gains productivity/efficiency from scaling up long-run production - specialisation, containerisation, learning by doing
- Marketing - A large firm can purchase factor inputs in bulk at lower prices if it has monopsony power
- Managerial - Division of labour where firms employ specialists –lower ac as productivity
- Financial - Larger, more established firms to be more credit worthy – better access to loans with more favorable rate
- Risk-bearing - Spreading the risk of failure by increasing number of products i.e. product diversification – which lowers failure and so lowers AC
- Networking - The marginal cost of adding one more user or customer to a network is close to zero - The long run cost-per-user diminishes
- Labour - Successful businesses in same areas find labour comes to that area - reduces cost and time taken. Staff from other businesses
3.3 - Revenues, costs and profits
Potential benefits to consumers from businesses utilizing economies of scale
- Lower prices leading to higher real incomes and increased consumer surplus
- Producer surplus has value – reinvested in capital spending and research & development
- Consumers as employees – higher real wages and profit shares
- Consumer benefits from network externalities
3.3 - Revenues, costs and profits
Evaluation of consumer benefits from economies of scale
- It is possible to question the extent to which EoS leads to lower prices – EoS can also reinforce market (monopoly power allowing dominant firms to raise prices to consumers perhaps using algorithms. Creates social costs
- Price is not the main metric for measuring consumer welfare – service quality and pace of innovation are also very important
3.3 - Revenues, costs and profits
Significance of economies of scale for firms
- Price competitiveness improving from cutting unit costs
- The extent of the economies of scale varies due to the minimum efficient scale compared to the size of the market
- Increased profits
- Good for share price
- Retained profits
- Less vulnerable to a hostile takeover bid
3.3 - Revenues, costs and profits
Diseconomies of scale - why do average costs rise
- Managerial Diseconomies: As firms become very large, the management structure can become overly complex and less efficient. Communication breakdowns and bureaucracy may increase, leading to higher costs.
- Coordination and Control Problems: Larger firms often struggle to maintain effective control and coordination among various departments and divisions, leading to inefficiencies and higher costs.
- Worker Alienation: In very large organizations, employees may feel disconnected from the company’s goals and values, which can result in lower productivity and higher turnover rates.
- Communication Challenges: With an increase in size, communication becomes more challenging, leading to misunderstandings and errors that can increase costs.
3.3 - Revenues, costs and profits
When can firms making subnormal profits survive?
- In the SR - cross subsidise
- In the LR, cannot survive - firm will leave market reducing supply + increasing price
3.3 - Revenues, costs and profits
What is the shut-down condition for firms? Represent this on a diagram:
Where AR = AVC.
3.3 - Revenues, costs and profits
What is supernormal profit, where does it occur and what does the graph look like
The profit above normal profit
Occurs when AR>AC
3.3 - Revenues, costs and profits
What is subnormal profit, where does it occur and what does the graph look like
Is a loss - not sustainable - will lead to firm shutting down in the long run
Occurs when AC>AR
3.3 - Revenues, costs and profits
What is normal profit, where does it occur and what does the graph look like
Normal profit is the minimum level of profit required to keep a firm in the industry. It is the profit that covers all explicit and implicit costs of production but provides no extra income above those costs
AR=AC
3.4 - Market structures
What is achieved at allocative efficiency?
The maximisation of net social benefit / society surplus.
3.4 - Market structures
What is Allocative efficiency?
When resources are distributed perfectly to the wants and needs of society.
3.4 - Market structures
What is allocative efficiency also known as?
Pareto efficiency
3.4 - Market structures
Allocative efficiency is when goods and services are distributed according to
Consumer preference
3.4 - Market structures
Where is the allocative efficient point?
Maximise social welfare by having price at marginal cost. p=mc
MC=AR
3.4 - Market structures
What is productive efficiency?
When the minimum resources are used in the production process.
3.4 - Market structures
Where does productive efficiency take place?
At the bottom of the AC curve.
Where AC = MC.
3.4 - Market structures
What is a good evaluation point for a non-productively efficient firm?
Are they dynamically efficient + raising costs in R+D to achieve this?
(As this would raise costs, causing lack of productive efficiency, but would be beneficial in the LR)
3.4 - Market structures
When talking about productive efficiency, what is the main linked development we can use?
Economies of Scale
3.4 - Market structures
What is dynamic efficiency?
Dynamic efficiency refers to the ability of an economy to innovate and adapt over time. It involves the long-term competitiveness and growth potential of an economy. Dynamic efficiency is linked to innovation, technological progress, and the ability to adapt to changing circumstances.
3.4 - Market structures
How can dynamic efficency be achieved by a firm
By achieving supernormal profits first, and then reinvesting these profits into research and development to try and lower costs. Thus being dynamically efficient
3.4 - Market structures
What is X-efficiency?
When there is sufficient competition in the market to rationalise organisational slack.
3.4 - Market structures
Where, on a diagram does minimisation of organisational slack occur?
At the bottom of the AC curve.
(Productive Effiency AKA minimum efficient scale, occurs at AC = MC).
3.4 - Market structures
Where does X-efficiency occur?
Only occurs in non-competitive markets.
(e.g. perfect competition, as infinite sellers = sufficient competition to force a firm to rationalise costs).
3.4 - Market structures
What happens to a firms profit if they become X-inefficient?
They are reduced, a firm making normal profits would start making a loss.
3.4 - Market structures
What is X-inefficiency?
X-inefficiency exists when an organisation incurs higher costs than are necessary to produce any given output
3.4 - Market structures
Where can X-Inefficiency occur?
Only in non-competitive markets, needs supernormal profits to occur.
(in PC, Supernormal profits cannot be made).
3.4 - Market structures
In perfect competition, why is the demand curve perfectly elastic?
Firms are price takers
They can only charge the market price
3.4 - Market structures
What are the (5) characteristics of perfect competition?
- Homogenous products – all products are the same, perfect substitutes
- All firms have equal access to factors of production
- Large number of buyers & sellers. All sellers act independently
- Free (costless) entry into and exit from the market
- Perfect knowledge/perfect information for buyers/sellers
- Profit maximization is assumed as the key objective of the firm
3.4 - Market structures
What type of efficiencies does perfect competition possess?
- Firms will be allocatively efficient P=MC
- Firms will be productively efficient. Lowest point on AC curve. (maybe not in the short run if there are super or sub normal profits being made)
- Firms have to remain efficient otherwise they will go out of business. (X-efficiency)
- Firms are unlikely to be dynamically efficient because they have no profits to invest in research and development, and all products are homogenous so little innovation possible
3.4 - Market structures
Evaluations of the assumptions of Perfect Competition
- Dominance in real world markets of differentiated/branded products
- Impossible to avoid search/transaction costs even with the spread of digital/web technology
- Rare for entry and exit in an industry to be costless
3.4 - Market structures
What happens if there are supernormal profits in perfect competition and what does it look like?
New firms join ↑ comp.: incentivised and there are no barriers.
The new firms joining increase supply, which reduces market price.
In the LR, firms make normal profit.
3.4 - Market structures
What does perfect competition diagram look like in the long run
3.4 - Market structures
What happens if there are subnormal profits in the short run
Then firms will leave the market as they are making a loss, leading to shift of market supply so increase in price until normal profits are made for the remaining firms
3.4 - Market structures
What are the assumptions of monopolistic competition
- Many buyers and many sellers
- Differentiated products
- Non-price competition
- Low-to no barriers to entry and exit
- Limited price control
- Imperfect information
3.4 - Market structures
How can products be differentiated (non price competition)
- Product quality
- Product performance – processing speed, reliability
- Branding
- Functionality
- Provenance of a product – where it has come from, environmental footprint
- Quality of after-sales service for customers – e.g. product guarantees
3.4 - Market structures
What are the affects of an indirect tax on monopolistic competition?
Increase in costs.
AC shifts up, MC shifts inwards.
(This is also true for oligopoly, monopoly).
3.4 - Market structures
Draw the diagram for monopolistic competition supernormal profits in the short run
3.4 - Market structures
What happens to supernormal profits in monopolistic competition in the long run?
Supernormal profits are eroded away - new firms entry the market due to lack of barriers to entry.
Increases overall market supply and decreases demand for each firm.
Until the point where AR = AC.
In the long run, a monopolistically competitive firm can make neither supernormal profits nor losses.
3.4 - Market structures
Is monopolistic competition allocatively efficient?
NO
They have market power to charge above P=MC.
3.4 - Market structures
Is monopolistic competition productively efficient
A monopolistically competitive firm is not productively efficient because it does not produce at the minimum of its average cost curve.
3.4 - Market structures
What are the 6 characteristics of an oligopoly?
- Few sellers - High concentration ratio - rule of thumb - C5 ratio of >60%
- High barriers to entry and exit (sunk costs, brand loyalty, EOS)
- Imperfect information
- Differentiated products
- Price makers but also price rigidity
- INTERDEPENDENCE OF FIRMS
3.4 - Market structures
What are some examples of oligopolistic industries?
- Banking - HSBC, LLoyds, Barclays, Santander
- Supermarkets - Tesco, Asda, Sainsburys, Morrisons
- Cafes - Starbucks, Costa, Pret
- Cinemas - Odeon, Vue
- Petrol retailers
- House developers
3.4 - Market structures
Why is the demand curved kinked in oligopoly?
- Because firms are interdependent
- Increasing price will lead to loss of revenue, as consumers can go to competitiors, who keep their price the same
- Decreasing price will also lead to loss of revenue, as competitors will also lower their prices
- Therefore there is no incentive to change prices, prices stabalise at P1Q1 (price rigidity)
3.4 - Market structures
What are the 2 diagrams for an oligopoly?
- When considering demand - use kinked demand
- When considering costs - use imperfect competition with supernormal profits
3.4 - Market structures
What happens if a firm in oligopoly decides to raise the price they charge consumers?
They lose revenue
If one firm increses its prices, competitors will not follow as they can attract the firms consumers by having a lower price.
3.4 - Market structures
What happens if a firm in oligopoly decides to decrease the price that they charge consumers?
They will lose revenue as competitors also lower prices.
This starts a price war which is bad for the revenue of all firms
Firms instead engage in non price competition
E.g. Waitrose profits fell 24% in 2015 due to price war
3.4 - Market structures
How might supermarkets attract new customers without decreasing price (non price competiton)
- Loyalty programmes (Tesco Clubcard)
- Complementary goods (Costco offer free samples)
- High quality products (product differentiation) - waitrose, M&S
- High quality customer service.
3.4 - Market structures
How might airlines attract new customers without decreasing price (non price competiton)
Loyalty programmes and upgrades
High quality food/service and luxury seating
3.4 - Market structures
Why do firms engage in non-price competition
- Attract new customers without starting a price war
- To increase brand loyalty - more inelastic demand.
- Interdependence
To increase overall profits
3.4 - Market structures
How might firms engage in non-price competition? What are the 5
- Product differentiation - improve quality and product range
- Large scale advertising and improved branding (makes product more attractive but might incur sunk costs)
- Improved quality of customer service - longer opening hours, locations
- Loyalty programmes and special offers
- Firms might merge instead of competing (more eos and market share) (Shift MR AR to the right)
3.4 - Market structures
What are the disadvantages of non price competition?
- Expensive - Opportunity costs of advertising, product development, improving service.
- Can be copied by rivals - E.g. Sainsbury’s introducced a new nectar card
- Won’t work if customers are already loyal to other brands
- A merger might be blocked by the CMA (above 25% of market share)
3.4 - Market structures
What is predatory pricing used for?
Predatory pricing is used to eliminate existing competitors
3.4 - Market structures
How do firms predatory price?
By setting price below AVC to drive out competitors. (P2)
Prices are increased once competitors are removed (due to losses from lost consumers)
Profits increase for the original firm.
3.4 - Market structures
What happens to other firms when a firm predatory prices?
Drives the market price down.
Other firms cannot sustain the losses (no build up of savings) and leave.
3.4 - Market structures
Why do firms predatory price?
Driving out competitors means there are less competitive.
The firm builds up monopoly power and demand becomes more inelastic
Then they can raise prices and achieve higher supernormal profits in the long run.
3.4 - Market structures
What are the problems with predatory pricing?
- Predatory pricing is illegal - if competition authorities find evidence, could be fined 10% of worldwide revenue (Aberdeen journals were fined £1.3 million in 2001 for trying to eliminate competitors, Uber Faced legal action in San Francisco)
- Depends on elasticities - demand will have to be elastic for consumers to switch.
- The predatory firm will have to withstand losses - might also reach below shut down point
3.4 - Market structures
Why do firms limit price?
If there is a threat of entry, they do this to
To discourage new entry to the market, that could potentially compete away profits.
Ensures long run inelastic demand and supernroaml profits.
3.4 - Market structures
How do firms limit price?
- They set the price at sales maximising price, below the AC of potential new entrants, who have not yet built up any Economies of Scale.
- No new firms will enter as they will incur losses.
- In the long run, demand is more inelastic for the incumbent firms. Higher prices in future.
3.4 - Market structures
What are the problems with limit pricing?
Loss of profits - less money for investment.
Customers will be unhappy if prices rise later
Potential anti-trust investigation
3.4 - Market structures
Why might it be hard for the CMA to stop predatory and limit pricing?
- Both are very difficult to prove. (Asymmetric information)
- Fines may not be high enough to deter firms from using these stratergies
- Investigations take a long time (time lag). CMA does not have enough resources
- Regulatory capture
3.4 - Market structures
Are oligopolies efficient?
No - they charge above allocatively efficent price. There is a deadweight loss.
3.4 - Market structures
What is price leadership?
When a leading firm sets a price and other firms follow the price to avoid starting a price war.
3.4 - Market structures
What is tacit collusion?
- When there is no formal collusion, but it is implied. An ‘understanding’ between firms.
- For example, in the supermarket industry, firms know that competing reduces revenues for all
- E.g. Price leadership
3.4 - Market structures
What is overt collusion?
When firms have a formal agreement to market share or price fix
3.4 - Market structures
How many construction firms have been found by the CMA to be rigging bids?
10 construction firms have been found by the CMA to be rigging bids.
They were fined a total of £60million In 2023.
They were involved in offering public services like asbestos removal.
3.4 - Market structures
What is bid rigging? How do the firms bid rig? What is the example.
- Discussing prices with competitors for a contract - the agree a minimum price. (Cover bidding)
- Often firms agree to not bid for a certain contract, so that they can earn the highest possible price fromt he government
- In 2023, CMA found ten contruction companies were colluding to rig bids for public sector works. They were fined a combined £60m.
3.4 - Market structures
What is market sharing?
- When two or more firms agree not to compete for each other’s costumers
- Sometimes by location - ‘carving up the market’
3.4 - Market structures
What is price fixing?
When firms agree to all charge higher prices, in order to avoid competiting and maximise industry profits
3.4 - Market structures
Why do firms collude in oligopoly
- TO MAXIMISE INDUSTRY PROFITS AND REVENUES by making demand more inelastic.
- Firms that work together act like a monopoly and exploit consumers for higher profits.
- Avoids a price war and competition
- Easy to co-ordinate in an oligopoly as there are few firms
- Oligopolies have high barriers to entry, which stops other firms from competing.
- Collusion is hard to prove.
- There is an incentive to collude - e.g. pass on higher costs.
- Investment could be used to erect new barriers
3.4 - Market structures
Why might oligopoly be a bad thing for firms?
X-inefficiency due to a lack of competitive pressure
3.4 - Market structures
Why might oligopoly be a good thing?
- Dynamic efficiency - money for investment and lowering LRAC
- Economies of scale - larger firm means lower long run average costs
- Depends on barriers to entry - if there is a threat of new entry then firms will be incentivised to keep prices down for avoid profits being competed away. If they collide to fix prices high then potential entrants will have a larger incentive to enter
- Depends on how many firms - if there are many firms in the industry it is likely that the agreement will break down and firms will charge low prices
3.4 - Market structures
How much were Asda and Sainbsury’s fined for price fixing? What year was this in?
- In 2007, Asda and Sainsbury’s and other surpermarkets were fined £116m after they were found price fixing the price of milk, cheese and butter.
- Passing on price rises to consumers
- The scandal cost consumers £270m
3.4 - Market structures
What happened to Morrison’s position in the ‘big four’
- Was recently overtaken by Aldi
- Shoppers are trying to save money amid plummeting living standards.
- Suggests that oligopoly can be disrupted by new entrants
3.4 - Market structures
Which chain of convinience stores did Morrisons take over in 2022?
- McColls
- The CMA said that there were competition concerns in only a small number of areas.
- But, they allowed it to go through. £190m rescue deal as McColl’s went into administration
3.4 - Market structures
How much was BA fined in 2007?
- In 2007, British Airways was fined by the office for fair trading £270m for illegal price-fixing arrangements with Virgin on long haul flights.
- The two companies met to agree and collude on the extra price of fuel surcharges in response to rising oil prices.
- Between 2004 and 2006, surcharges on air tickets rose from £5 to £60 per ticket. The £270m fine compares to an annual profit of £611m for BA. BBC link on collusion.
- Virgin was granted ‘leniency’ for reporting the collusion
3.4 - Market structures
Draw the payoff matrix for oligopoly (Game theory)
3.4 - Market structures
What is defection?
When one firm does not honour the collusion agreement
3.4 - Market structures
How do other firms despond to defection?
Other firms will retaliate by also lowering prices and starting a price war.
After this, firms agree to start a cartel and the game starts again
3.4 - Market structures
What are the problems with forming a cartel?
- Large fines from CMA - 10% of Worldwide revenue
- Collusion won’t be effective if there are substitutes for the good
- If new firms can enter the market, then the cartel firms will lose revenue. Barriers to entry must be kept high.
- Raising prices could reduce revenue if demand is price elastic.
- Demand needs to be inelastic to encourage a cartel
3.4 - Market structures
How does the CMA discourage cartels?
- Fines of up to 10% of worldwide revenue
- Shareholders will sack managers if caught.
- Prison sentences for directors.
- Bad for reputation and can lose them business.
- Fines are reduced for firms that co-operate and admit to collusion. CMA granted ‘leniancy’ for Virgin airlines for whistleblowing
3.4 - Market structures
What are the problems for the CMA with preventing cartels?
- Fines - very profitable firms will be bale to afford fines or pass them on to consumers. The benefit of collusion probably outweighs the fine.
- Resources - the CMA has very limited time and resources to investigate.
- Asymmetric information - firms can claim that they charge the same price due to similar costs. The CMA won’t know
- Time lag - investigations take a long time
- Regulatory capture/bribery.
3.4 - Market structures
What are the disadvantages to joining a cartel?
- Firms become complacent - X-inefficiency
- Extra profit paid out as dividends
- Competitors outside the cartel may innovate and gain market share. Penetrate the market
- Consumers move away from firms in the cartel to cheaper substitutes.
3.4 - Market structures
What happens to average costs if an industry experiences external economies of scale (diagram)
Average costs fall for all firms (spillover effect)
3.4 - Market structures
Why do external economies of scale occur?
- Cluster effect - If firms locate in a similar area, this makes it more efficient for suppliers to meet a larger base of purchasers.
- Skilled labour - If industry develops in a particular region it will encourage skilled labour to seek work in the region (Bankers in the City, Silicon Valley in San Francisco)
- Transport links - Will be developed to lower costs of operating. E.g. government builds railways to support indsutrial areas.
- Supportive legislation - If it becomes important then legislation will treat it favourably
3.4 - Market structures
Give the 6 main barriers to entry and exit?
- Anti competitive practicies by incumbents - predatory and limit pricing.
- Economies of scale
- brand loyalty
- Legally imposed barriers - patents
- Sunk costs - E.g. Advertising.
- High start up costs
3.4 - Market structures
What is game theory?
The exploration of how the reactions of one player changes the strategy of the others.
3.4 - Market structures
What are the 2 things a firm needs to collude?
- Weak regulation in the market
- Good info. about competitors
3.4 - Market structures
In game theory, what is the dominant strategy
When one option is always the best, no matter the other firms’ behaviour
3.4 - Market structures
In game theory, what is nash equilibrium?
When neither player is unable to improve their position.
3.4 - Market structures
What is game theory related to?
The concept of interdependence between firms in an oligopoly
3.4 - Market structures
What is collusion?
A collective agreement to reduce competition.
3.4 - Market structures
What is the effect of collusion on consumer surplus?
- Reduces CS, higher price
- Maximisation of profits in the LR for colluding firms
3.4 - Market structures
Give some negatives of collusion:
Lower Quantity prod. + higher price = loss of AE.
Reinforces monopoly power ↑ barriers to entry.
Absence of competition = loss of efficiency (potential X-inefficiency).
3.4 - Market structures
Give benefits of collusion:
- Saves on duplicate R+D.
- Collaboration on tech. ↑ standards.
- ↑ size, ↑ EoS
- Excess π may increase efficiency in LR - dynamic.
3.4 - Market structures
What is a good example of a cartel?
OPEC - controls 70% of worlds oil supply + fixes output.
3.4 - Market structures
What is (third degree) price discrimination?
When different groups of consumers are charged different prices for the same g/s.
E.g. higher P for peak gym membership.
Adult + child cinema tickets.
3.4 - Market structures
What does (third degree) price discrimination allow a firm to do?
To maximise their overall profits.
3.4 - Market structures
Evaluate a loss of consumer surplus due to (third degree) price discrimination:
Drug companies charging people on higher incomes more may allow losses to be made to those on lower incomes to access drugs at a cheaper price. (Yielding positive externalities in the LR - more peope have access to PCE).
3.4 - Market structures
What are the three types of collusion?
- Bid Rigging
- Price fixing
- Market sharing - Common with construction companies.
3.4 - Market structures
What does non-collusive behaviour do?
Firms will increase market share but face reduced profits (as they sales max).
Means firms compete on price, lower prices = lower profits, could mean limit pricing.
3.4 - Market structures
What happens in a non-collusive oligopoly?
When firms in an oligopoly compete.
(Rather than making agreements to reduce competition).
3.4 - Market structures
What is the key aim of collusion?
To maximise joint profits
(However, there is always an incentive to cheat on collusive agreement, due to game theory)
3.4 - Market structures
What can collusion do to share prices?
Less uncertainty over levels of retained profits, increases share prices, increased capital base (dynamic efficiency)
3.4 - Market structures
What are collusive legal agreements on the ‘research side’?
Research joint ventures between firms. Could lead to better quality products in the market.
(Not all forms of collusion are bad).
3.4 - Market structures
What is a real world example of where collusion is beneficial?
EU introduced R&D Block Exemption Regulation. (For research joint ventures).
(As collusion in research can bring product improvements).
3.4 - Market structures
What is a non-collusive oligopoly?
Firms in an oligopoly compete against each other, rather than making agreements to reduce competition.
3.4 - Market structures
What do price wars do? When do they occur?
Drive prices down.
When firms have weak brands and consumers are price conscious
3.4 - Market structures
What is a natural monopoly?
- Some industries have very high fixed costs, due to infrastructure
- Once the fixed cost is paid, there are few other expenses.
- E,g. the cost of having an extra passanger is very small.
- This means that their marginal costs are very low.
- Duplication and competition in natural monopoly is wasteful
E.g. Thames water, National rail, British Telecoms.
3.4 - Market structures
What does the diagram for natural monopoly look like?
- Once the fixed cost is paid, AC is constantly falling
- Very low marginal costs
- The more passengers on the train, the lower the costs of production per passenger
- The larged fixed cost is spread between more people/units of output
- One large firm is best
3.4 - Market structures
Why is competition so detrimental to consumers in markets with natural monopolies?
- Because, if you have multiple firms all operating at C1Q1, then you have unnecessary and wasteful duplication.
- It is better to have one large firm at Q2, - lower costs and therefore prices.
- If we had competition and had smaller firms producing at Q1, costs and prices would be higher.
- We need one firm which is suffienctly large enough to exploit the economies of scale available
E.g. several train tracks would not bring any benefits
3.4 - Market structures
Monopolies charge high prices due to market power (allocative inefficiency) and high costs (x-inefficiency), and offer poor quality and services. How could governments regulate natural monopolies to prevent this?
- Price capping
- Profit capping/controls (rate of return regulation)
- Quality/performance targets
3.4 - Market structures
How does a price cap work
- Sets price at allocatively efficient point (P2) instead of profit max (P1) - increse consumer surplus
- Rail - Price increases restricted to RPI-X . RPI is the rate of inflation and X is the % of expected efficiency savings
3.4 - Market structures
What are the advantages of price capping natural monopolies?
- X-inefficiency cannot be passed on through price rises - any x inefficiency will reduce profits, if it cannot be passed on to the consumer
- Incentive to be more efficient - cutting costs by more than X% target means more profit
- Lower consumer prices
3.4 - Market structures
What are the problems with the kinked demand curve?
- Products are different - price is not the only factor which consumers take into consideration
- In the real world, prices do change.
- Firms may not seek to maximise profits, but prefer to increase market share and so be willing to cut prices, even with inelastic demand.
- Some firms may have very strong brand loyalty and be able to increase the price without demand being very price elastic.
- The model doesn’t suggest how prices were arrived at in the first place
3.4 - Market structures
Why do we get different PEDs in the Kinked demand curve diagram
Interdependence means: when a single firm raises their price, there is a big change in Qd of original firm. (As other firms won’t react).
When a single firm drops their price, everyone drops price ∴ there will be a small change in Qd of original firm.
3.4 - Market structures
What are the disadvantages of price capping
- Price cap could be set too low due to regulatory capture and prices then rise too quickly.
- Rail fares are up 35% between 2008 and 2016 - Asymmetric informatoin - Regulator does not know where P=MC is or what efficiency savings could be made
- Could be too strict and prevent the firm from making enough profit for investment.
3.4 - Market structures
What are Rate of Returns regulations
- A Profit cap -
- Involves a regulator setting a maximum % of profit that the monopolist can earn - anything above is taxed at 100%.
- It is calculated as a % of total asset spending (machines, buildings, equipment etc) in the firm
- Usually introduced in industries were supernormal profits are considered excessive. May be necessary where little competition exists or where collusion ins possible.
3.4 - Market structures
What does the diagram for rate of returns regulations look like?
Firms will have to switch from profit maximisation to sales or revenue maximsation to reduce profit - increase consumer surplus and allocative efficiency to meet the cap
3.4 - Market structures
What are the disadvantages of rate of return regulations
- No incentive to cut costs as profits won’t rise (X-inefficiency) - higher costs and prices.
- Less money to reinvest - Reduces dynamic efficiency. Encourages
- Regulatory capture - Cap might be set too high, no effect, customers still exploited.
- Asymmetric information - Firms may overstate the value of the investment in the firm to increase permitted profits.
3.4 - Market structures
How do performance targets work?
- The regulatory body will set performance targets relating to customer service, quality etc.
- Ofcom gives Royal Mail a target of delivering 93% of first class post the next day.
- Were fined £1.5 million for missing it in 2018
- The office for road and rail gives Network Rail a target for 90% of trains in the UK to be on time
* £2m fine for delayed upgrades to London Bridge Station
3.4 - Market structures
What are the problems with performance targets
- Fines might not be high enough (regulatory capture)
- Firms could lie about performance (asymmetric information)
3.4 - Market structures
How does nationalisation work?
- Most natural monopolies (rail, water, energy, post) are privately owned in the UK
- The government could nationalise them (buy them from their private owners and run them not for profit)
3.4 - Market structures
How is a natural monopoly different from other industries?
- A natural monopoly is a special case where one large businesses can supply the enture market at a lower unit cost than with multiple providers
- This is because of the nature of costs in a natural monopoly industry. Typically rhere are very high fixed costs and low marginal costs
- For example, the supply of water or electricity to houses and businesses invovled building a big network infrastructure
- As a result, fixed costs are enormous but the marginal cost of adding an extra user is very low
- Therefore, the average total cost will continue to fall as extra users are added to the network. This is an internal economy of scale
- This means that long run average cost (LRAC) may fall across all ranges of output. Only one firm might reach the minimum efficient scale
3.4 - Market structures
What are the advantages of nationalisation of natural monopolies?
- Exploit Economies of Scale
- Run at allocatively efficient point - lower prices and increased consumer surplus
- Better service
- More investment - not run for profit so extra revenue can be reinvested into the firm.
- More tax revenue - government will have an income steam.
- Democratic - electorate can scrutinise government perfomace
3.4 - Market structures
What are the disadvantages of nationalising natural monopolies
- X- inefficiency - no competition or profit motives. Encourages profligacy and wasteful spending. Costs rise
- Principal agent problem
- Opportunity cost of using taxpayer’ money - expensive to buy firms
- Government run firms in the UK have made heavy losses and require taxpayer subsidies
3.4 - Market structures
What is the definition of price discrimination? (Third degree)
- When the monopolist decides to charge different groups of consumers different prices, for the same good or service.
- Demand curves of different elasticities exist with each group of consumers
* Market can be split and different prices can be charged. - A market with an elastic demand curve will have a lower price.
- A market with an inelastic demand curve will have a higher price
3.4 - Market structures
What is second degree price discrimination?
- When firms charge different prices depending on the quantity consumed or the timing of the purchase.
- Ryanair and EasyJet will charge a lower price depending on if you travel at peak or off peak hours.
- Gives airlines the advantage of knowing demand for the flight based on the time - can adjust the price accordingly.
- Airlines tend to raise their prices closer to the flight.
3.4 - Market structures
What are some examples of third degree price discrimination?
- Any student discount - unidays, student beans
- National rail services
- Segregate the market using rail cards
- Impossible for consumers to sell train tickets off to others because it is attached to ID.
- Cinema concession.
- Gym membership.
3.4 - Market structures
What are the benefits of price discrimination to consumers?
- Consumers could benefit from a net welfare gain as a result of cross subsidisation, if they recieve a lower price.
- Some consumers, who were previously excluded by high prices, might now be able to benefit from the good or service. For example, drug companies might charge consumers with higher incomes more for the same drugs, so that the less well-off can also access the drugs at a lower price. This can yield positive externalities.
3.4 - Market structures
What are the disadvantages of price discrimination for consumers
- Usually, price discrimination results in a loss of consumer surplus. Since P>MC, there is a loss of allocative efficiency.
- Consumers in the inelastic market are charged more than before. - decline in consumer surplus. Unfair. Loss of allocative efficiency.
- Some groups might not be inelastic because they are wealthier but because it is a necessity - e.g. peak time train travel. Unfair
3.4 - Market structures
What are the advantages of price discrimination for producers
- Producers make better use of spare capacity.
- The higher supernormal profits might be used for dynamic efficiency.
- Manages demand - encourage people to travel at unpopular times to spread out demand.
3.4 - Market structures
What are the disadvantages of price discrimination for producers
- If it is used as a predatory pricing method, the firm could face investigation by the Competition and Markets Authority
- Costs of enforcing (admin costs) might exceed the benefit. Ad
- Arbitrage (selling between groups). (buyer from lower priced group selling at a higher price than they bought for)
3.4 - Market structures
What are the 6 conditions of price discrimination?
- Firm is a price maker -
- Seperate markets - Firm can identify and seperate markets.
- Different elasticities of demand
- Low admin costs for the price discrimination
- Prevention of arbitrage
- Same costs of production for both markets.
For evaluation, question if these are realistic ambitions
3.4 - Market structures
Price discrimination diagram
- However, price discrimination allows the firm to set different prices for segment A (inelastic demand) and segment B (elastic demand)
- Because demand is price inelastic, segment (A) will have a higher profit maximising price (P1)
- In segment (B) demand is price elastic, so the profit maximising price is lower.
3.4 - Market structures
What are the main aims on price discrimination
- Increasing total revenue by turning consumer surplus into producer surplus
- Increase total profit
- Generate cash flow
- Increase market share and build customer loyalty
- Make use of spare production capacity
- Reduce the amount of waste
3.4 - Market structures
Analyse how consumers may benefit from price discrimination
- Price discrimination is the charging of different prices to different groups of consumers on the basis of variations in people’s ability to pay
- One way that some consumers may benfit comes from third degree discrimination pricing based on age or income
- E.g. a bus company may charge students a lower price. Students typically have lower income so their demand is more price elastic
- This means that student passengers get a discounted ticket price which has the effect of increasing their real purchasing power
- As a result, they can afford to travel more regularly within their budget constraint. It might make attending college more affordable
- The consequence can be an increase in consumer surplus which is one measure of economic welfare from market activity
3.4 - Market structures
What is the economic case against monopolies
-
Prices are higher than they would be under competitive conditions
- Leads to a loss of allocative efficiency as monopoly has price greater than MC
- Higher prices –> regressive impact - Absence of genuine competition leads to production inefficiencies such as X inefficiencies
- Higher prices can limit output to fewer economies of scale
- Protected markets to less drive to innovate
- Monopolies may get too big – causing more diseconomies of scale - rising long run AC
Be able to compare different market structures in terms of efficiences
3.4 - Market structures
Economic and Social Case Justifying Monopolies
- Profits can be used to fund investment & research which then improves dynamic efficiency
- Natural monopoly allows for applications of large economies of scale which leads to lower prices. Therefore having one firm e.g. Network Rail, can lead to technical economies of scale and more R&D
- Domestic monopoly businesses often face tough global competition (a key aspect of globalisation)
- Monopolistic firms can be regulated with an industry regulator acting as a “proxy consumer”
- Price discrimination may help some consumers if charged a lower price than the usual monopoly price
3.4 - Market structures
Applications for Monopoly Power
Google controls 90% of the UK search advertising market, worth over £7bn and Facebook around half of the display advertising market. This monopoly power raises concerns about their ability to push up prices for consumers and act as a barrier to entry for new competitors
3.4 - Market structures
Welfare Case against Price Discrimination
- Exploitation of the consumer – most consumers still pay more than the marginal cost of supply
- Extraction of consumer surplus which is turned into higher producer surplus/supernormal profits
- Possible use of discrimination as a limit pricing tactic and therefore creates a barrier to entry to rival firms
- Ultimately, if successful, price discrimination reinforces the monopoly power of existing firms (not always a bad thing)
3.4 - Market structures
Arguments in Support of Price Discrimination
- Potential for cross subsidy of activities that bring social benefits, for example, pharmaceutical companies charging lower prices for drugs in lower & middle-income countries
- Making better use of spare capacity – this can have environmental benefits such as less waste
- It brings new consumers into market – who would otherwise be excluded by a normal higher price
- Use of monopoly profit for research – this is a stimulus to innovation/dynamic efficiency gains
3.4 - Market structures
General evaluation points on price discrimination include
- The impact depends on the extent to which price discrimination is used for socially beneficial purposes or purely to increase profit
- The impact depends on how businesses subsequently choose to use their higher revenues and profits
- It is difficult in practice to agree on a ‘fair price’ - it is a matter of perspective and may involve value judgements
3.4 - Market structures
Evaluating monopoly power
- Natural monopoly – it might be more productively efficient to have a monopoly supplier
- Competition in the supply chain – possible to introduce competition at different stages of the supply chain via competitive tendering and the use of franchises
- “In theory…. But in practice”: Some economists argue that it is best to judge a monopoly on a case by case basis using an evidence-based approach to how a monopoly actually behaves in the market
- Contestability – the threat of entry into a market can be a powerful influence on firms with monopoly power
- Definition of the market – a business might have monopoly power in the domestic market but face significant international competition
3.4 - Market structures
What is the definition of a monopoly (according to the CMA)
Legal monopoly has over 25% of market share
E.g. Apple, microsoft, spotify, amazon
3.4 - Market structures
What is a pure monopoly?
A firm that has 100% of market share
E.g. TFL
3.4 - Market structures
What are the 4 assumptions about monopolies?
- Profit maximisers - MR=MR.
* They make supernormal profits in the long and short run - Price makers and market power P>MC
- High barriers to entry (Brand loyalty, some economies of scale, regulation, sunk costs, bilateral monopoly).
- Productive and allocative inefficent
3.4 - Market structures
What is the benefits to producers holding monopoly power?
- Exploit more economies of scale
- Supernormal profits can be reinvested in dynamic efficiency which lowers costs further or improves product quality, increasing demand and future profits.
- Market power and ability to charge P > MC; allocative inefficency
3.4 - Market structures
What are the problems for producers holding monopoly power?
- Likely to suffer from X-inefficiency due to a lack of competitive pressure/organisational slack-higher costs and lower profits.
- Not productively efficient as output is limited to where MC=MR.
- CMA investigations (fined up to 10% of WW revenue, breaking the firm up, negative press)
3.4 - Market structures
What are the benefits to consumers from monopoly power?
- Dynamic efficiency. High quality.
- Whilst they aren’t productively efficient, they have some economies of scale - passed on to consumer, lower lr prices.
- Consumer surplus
3.4 - Market Structures
What are the problems for consumers due to monopoly power?
- Higher prices than in perfect competition (allocative inefficiency)
- Costs of extra X-inefficiency may be passed on through higher prices
What does the natural monopoly theory assume that we could criticise
- It assumes that there are no diseconomies of scale.
- You are never going to run into increasing costs due to managerial issues.
- E.g. British Rail became excessively bureaucratic and inefficient which is why it was sold of by the Major government
Why is competition in a natural monopoly a bad thing?
- Because, if you have multiple firms all operating at C1Q1, then you have unnecessary and wasteful duplication.
- Low output for each firms means higher costs, higher prices, not profitable.
Why is it better for natural monopolies to operate at C2Q2?
- It means that they can exploit all available economies of scale.
- Lower prices and costs
- Higher profitability
3.4 - Market Structures
Why might natural monopolies be bad for the consumer?
- Because, they have the ability to exploit the consumer.
- No other alternatives means inelastic demand - they have the market power to increase prices and force consumers to charge a higher price.
3.4 - Market Structures
What is a government monopoly?
- When a government has a monopoly, and they ban competition.
- For example, British airway.
- After state monopolies are privatised, they are opened up to competition.
3.4 - Market Structures
When was Royal Mail deregulated?
When was it privatised?
In 2006, they allowed other companies process mail.
In 2013, they opened it up to privatisation.
3.4 - Market Structures
What is a monopsony? Provide an example:
A single buyer in a market
The govt. for teachers
3.4 - Market Structures
Problems with government intervention to limit monopsony power
- Lack of resources - Groceries code adjudicator has 4 employees.
- Time lag- Recognition lag, decision lag, implimentation lag, effect lag. Takes a long time to investigate and accuse.
- Asymmetric information - GCA does not have full info on how suppliers are being treated. Many suppliers do not complain out of fear of losing partnerships.
- Effect - Firms can afford fines - The co op was fined 1.3million, but made 50million in profit
- Regulatory capture - GCA may become excessively sympathetic towards firms they are supposed to be regulating. May issue only warnings instead of fines.
- Minimum prices create excess supply/ subsidy inefficiency
3.4 - Market Structures
Give an example of a firm with monopsony power being able to negotiate lower price
Supermarkets buying produce from farmers, negotiate lower prices (as they’re the sole buyer).
3.4 - Market Structures
Why is a firm with monopsony power able to negotiate lower prices?
Their suppliers have nowhere else to sell to. (There is only one buyer)
3.4 - Market Structures
What type of influence over price does a monopsony have?
Price setting power (as they’re the only firm buying)
3.4 - Market Structures
How is monopsony power an example of an internal EoS?
It should lower LRAC (purchasing EoS).
3.4 - Market Structures
What effect does Monopsony power have on consumer welfare
- A monopsony has buying or bargaining power. For example, retailers have power when purchasing supplies from farmers
- This means that a monopsony (in theory) can use their purchasing power to negotiate lower prices for raw materials & other inputs
- As a result, their variable costs of production will be lower and this will lead to a decrease in marginal and average total costs
- If the monopsony is a profit-maximising firm, then a fall in AR and MC (ceteris paribus) will lead to lower equilibrium price
- In this way, final consumers may benefit from lower prices which will increase their consumer surplus and economic welfare
- This assumes that the price paid by the consumer is the main determinant of their welfare. This may not tbe the case in reality
3.4 - Market Structures
Benefits of monopsony for Firms
- Monopsony allows firms to achieve purchasing economies of scale leading to lower average costs
- Lower purchase costs bring about higher profits and increased returns to shareholders
- The extra profit might be used to find capital investment or research and development
3.4 - Market Structures
Costs of Monopsony to Firms
- May experience some reputational damage for the way they treat their suppliers - supplier may be driven out of business
- The continual price pressure on suppliers often results in conflict, which can be difficult to manage
- In the long-run, they may drive their suppliers out of business, causing supply chain issues
3.4 - Market Structures
Benefits of monopsony for employees
The higher profits often result in higher wages for the monopsonist’s employees
Lower cost of raw materials might mean more room to pay staff
3.4 - Market Structures
Costs of monopsony to employees
Employees may find it difficult to reconcile their ethics/values with the way suppliers are treated
Benefits of Monopsony for Consumers
- Consumers gain from lower prices – for example, supermarkets can negotiate better prices from food and drink manufacturers and other household products that are then passed on to consumers
- Improved value for money – for example, the NHS can use its bargaining power to cut the prices of drugs used in treatments. Cost savings allow for more treatments within the NHS budget
- Allocative efficiency and increased consumer surplus
3.4 - Market Structures
Costs of Monopsony for Consumers
The quality of the product may decrease as suppliers attempt to cut their own costs in response to the price pressure from the monopsonist
3.4 - Market Structures
Benefits of Monopsony for Suppliers
- Supplying to a large well-known monopoly may enhance the supplier’s reputation and open up new opportunities
- Supplying to a large, well-known monopoly may provide an opportunity to increase sales volume
- When the supplier has market power as a monopolist it can counteract the monopsonist.
- Might make efficiency savings or create a co-operative
3.4 - Market Structures
Costs of Monopsony for Suppliers
- Businesses may use their buying power to squeeze lower prices out of suppliers. This reduces the profits of firms in the supply chain and causes lower incomes
- Consumers might be faced with less choice or higher prices in long run if some suppliers leave the market (may be forced to due to lower profits)
- The monopsonist may exploit its market power by paying less or later.
3.4 - Market Structures
What is a contestable market?
- No barriers to entry or exit, no sunk costs, and all firms have access to the same technology
- If a market is contestable, the threat of a new firm entering means that incumbent firms lower their prices.
- New firms don’t have to enter , just the threat of entry is enough.
- Contestability measures how easy it is to enter/exit and how existing firms change their behaviour as a result.
3.4 - Market Structures
What are the four conditions of a contestable market?
- No barriers to entry or exit: barriers to entry are low or non-existent and there are no sunk costs. This allows firms to easily join or leave the market
- No competitive disadvantages on entry: new firms are able to setup and immediately compete with existing firms and have access to the same technology
- Perfect information: There is no proprietary knowledge that would limit competition (e.g. patents)
- Hit-and-run competition: Short-run supernormal profit acts as a profit signalling mechanism and new firms easily enter the market, extract profit, then leave
3.4 - Market Structures
What are some examples of contestable markets?
- Web based platforms makes industries more contestable
- No physical premises. Costs a lot less to set up a business.
- Low marketing costs
- Challenger firms can enter - Monzo, N26, Starling
- Taxi services - Bolt, Uber, Ola.
- Selling products online - Amazon, eBay.
- Takeaways - Deliveroo, ubereats.
- Food retailing – Lild and Aldi
- Hotel/room sharing market – Airbnb
- Retail energy market – Octopus
- Easy to access consumers through internet and smart phone apps - less need for marketing.
3.4 - Market Structures
Conditions required for market contestability
- A pool of new businesses who are willing, able and ready to enter the market
- No significant entry or exit costs – lowers the risk of entry
- Equal access to available industry technologies (includes the relative absence of patent protection)
- High rates of customer switching – we assume relatively low brand loyalty among buyers
3.4 - Market Structures
How do contestable markets help keep prices low?
The threat of entry is sufficient to keep prices down to a competitive equilibrium + profits low (to reduce the incentive to enter).
(Usually firm moves from profit max and limit pricing occurs).
3.4 - Market Structures
Where do firms in a highly contestable market produce?
At AC=AR
- If a market is highly contestable, new firms will be tempted to enter the market and compete for the supernormal profit.
- This is ‘hit and run’ entry - entering to compete for supernormal profits and later leaving the market.
- The threat of competition lowers the price and increases output
- This is a key evaluation to monopolies.
3.4 - Market Structures
What does contestability measure?
- Meausres how easy it is for new firms to enter or exit
- Is there a threat of competition? Can new firms enter the market?
3.4 - Market Structures
Where do firms produce if the market is not contestable?
Firms will operate profit maximising price
3.4 - Market Structures
What do firms do if a market is contestable?
- They lower their prices to sales maximising price.
- They are only earning normal profits.
- So firms have no incentive to enter
3.4 - Market Structures
Some key exam points for contestability
- Threat of entry affects the day-to-day behaviour (conduct) of firms whether or not a firm actually enters
- Firms making supernormal profits are vulnerable to “hit and run” competition
- This then means that they are likely to behave more competitively pricing lower and not necessarily earning higher supernormal profits, to discourage new firms from entering
- A highly contestable market may resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition
- Competition polices such as liberalisation of a market that help to open an industry to new suppliers or persuade consumers to switch in greater numbers help to increase contestability
3.4 - Market Structures
Analyse how firms might be affected by increased contestability
- A contestable market exists when there is freedom of entry and exit into an industry and there are limited or no sunk costs of production
- In the absense of actual competition or threat of a rival entering a market, an uregulated firm could maximise profit where MC=MR
- But it a market becomes more contestable - e.g. through a policy of liveralization then competitve pressures will keep prices down
- Instead of profit maximising, existing firms would have an incentive to cut prices perhaps to a level where normal profit is made
- This is at an ouput where price (AR)=MC. Firms are making enough profit to stay in the market without attracting rivals
- Actual and threatened competition intensifies incentives for businesses to control their unit costs by avoiding any X-inefficiencies
3.4 - Market Structures
How can incumbent firms make life difficult for new entratns
- Hostile takeovers and acquisitions – taking a stake in a rival firm or buying it up completely
- Product differentiation – Through brand proliferation (developing new products and spending on marketing and advertising to reinforce brand loyalty) - decrease PED and increase loyalty
- Capacity expansions – designed to achieve lower unit costs from exploiting internal economies of scale (purchasing, technical)
- Predatory pricing – this happens when a dominant company sustains losses in the short run in the knowledge it can recoup them and raise prices if competition is forced to exit – Illegal
3.4 - Market Structures
What is a perfectly contestable market?
A market with no barriers to entry
(where a new firm can easily enter and compete against incumbent firms completely equally)
3.4 - Market Structures
A more contestable market is likely to be more
Allocatively efficient
