Unit 3 Flashcards
Why do some Small Businesses tend to Remain Small?
Lack of finance for expansion
Fear of expansion
Avoiding diseconomies of scale- in a quickly grown firm there could be poor organisation, x-inefficiency, or having to higher wages
Providing niche products to maximise profit- due to more inelastic demand
Providing a more personal service
Acting as local monopolies
What are the Motives for the Growth of Firms?
To generate more profits
To benefit from economies of scale, meaning lower costs of production
To get more market power
Firms may want to diversify; so if sales drop in 1 market they can still generate sales
Senior managers may wish to grow, to control a larger business
What is the Principal-Agent Problem?
When the agent makes decisions for the principal, but the agent is inclined to act on their own interests, rather than those of the principle.
e.g. Shareholders and managers have different objectives which may conflict.
Can be linked to the theory of asymmetric information
What are Profit Organisations?
A profit organisation aims to maximise the financial benefit of its shareholders and owners.
The goal of the organisation is to earn Maximise Profits.
What are Not-For-Profit Organisations?
A not-for-profit organisation has a goal which aims to Maximise Social Welfare.
They can make profits, but they cannot be used for anything apart from this goal and the operation of the organisation.
What are Public Sector Organisations?
When the government has control of an industry.
There could be natural monopolies in the public sector- where only 1 firm may provide something, because it is insufficient to have multiple sets
Some public sectors yield strong positive externalities (e.g. public transport and education)
What are the Incentives of Public Sector Organisations?
Public sector industries have different objectives to private sector industries, which are mainly profit driven.
Social welfare may be a priority of a public sector industry. It could also lead to a fairer distribution of resources
What are Private Sector Organisations?
When a firm is left to the free market and private individuals
Benefits:
1) Firms have to produce the goods and services consumers want, which increases allocative efficiency and might mean goods and services are of a higher quality
2) Competition might also result in lower prices. This is because firms operating on the free market have a profit incentive, which public sector firms do not.
What are the Incentives of Private Sector Organisations?
Free market economists will argue the private sector gives firms incentives to operate efficiently, increasing economic welfare.
What is Limited Liability?
Investors (shareholders) and owners can only lose their investment in the business if it fails
They cannot be forced to sell their personal assets to pay off the business debts
What are Shares, and Who are Shareholders?
Shares: A small part of the business
Shareholders: Those who own shares
Who are Owners and Directors of a business?
Owners own the business to directors
Directors run the business. They give shares to the shareholders.
Why do PLC’s and Ltd’s like giving out shares?
Giving out shares to others is cheaper than asking the bank for money (The bank requires Interest)
What are Dividends?
When the shareholders get money for their shares.
If a business expands, the shares get more worth; the shareholders can sell it on for more money
What is Internal/Organic Growth?
When firms grow by expanding their production, output and sales from within the resources of the business.
E.g. research + development, investment in technology, production capacity
What are the advantages of internal growth?
Easier for the owner to manage and control the direction the business goes.
Relatively low risk
Firms grow by building on their own strengths, and using their own funds; which builds up less debt, making it more sustainable.
What are the Disadvantages of Internal Growth?
Growth can be very slow
Market share could fall if other firms grow quicker
No gains from integrating with another business
What is External/ Inorganic Growth?
When firms grow through merging with / acquiring / taking over another firm.
What are the Advantages of External Growth?
Quick to expand, as capacity already exists
Market share is instantly boosted, by the brand name + sales of the other firm
Share of expertise with other successful firms
What are the Disadvantages of External Growth?
Costly to purchase successful firms
Loans taken out to pay for the merger will have interest; opp cost
Problems with managing and controlling a much larger business
What is meant by a merger?
When the directors + shareholders of two firms agree to come together under one board of directors
What is meant by a takeover?
When one firm buys a majority of shares in another, and therefore has full management control.
What is backward vertical integration?
A firm higher up in the production process joins with a firm lower down in the production process.
What is forward vertical integration?
A firm lower down in the production process joins with a firm higher up in the production process.
What is horizontal integration?
Two competitors at the same stage in the production process join together
What is conglomerate integration?
A firm joins with another firm in a completely unrelated business.
What are the Advantages + Disadvantages of backwards vertical integration?
+: Offers reliable and better access to raw materials, so therefore greater control of supply, resulting in reducing costs and improving quality
-: Different cultures in businesses, and potentially diseconomies of scale
What are the Advantages + Disadvantages of forwards vertical integration?
+: Offers reliable and better access to raw materials, so therefore greater control of supply, resulting in reducing costs and improving quality
-: Different cultures in businesses, and potentially diseconomies of scale
What are the Advantages + Disadvantages of horizontal integration?
+ Reduces competition, as there’s one business instead of two
+ Substantial increases in market share
+ Benefits from economies of scale
- Different cultures in businesses, and potentially diseconomies of scale
What are the Advantages + Disadvantages of conglomerate integration?
+ Reduces risk by operating in different markets
+ Benefits from knowledge from the other market
- Requirement of different skills, and cultural differences
What are the Motives for the Growth of Firms?
To generate more profits
To benefit from economies of scale, meaning lower costs of production
To get more market power
Firms may want to diversify; so if sales drop in 1 market they can still generate sales
Senior managers may wish to grow, to control a larger business
What are the constraints on business growth?
- Size of the market
Small market- firms only access a limited consumer market, and so there’s limited opportunities for innovation and expansion - Access to finance
Smaller/ Newer firms are seen as more risky, and so get less loans. With insufficient credit, firms can’t invest + grow, nor innovate - Owner objectives
Owners’ objectives may be different- e.g. Maximising social welfare, maximising profits, environmental objectives, personal gain (reputation) - Regulation
Red tape can limit the quantity of output a firm produces. They also impose taxes (corporation tax, environmental laws + taxes)
What is Divorce of Ownership and Control?
Conflict between aims of owners and directors.
What is the Principle-Agent Problem?
Divorce of ownership creates the principle-agent problem.
The principle is the shareholder, and the agent in the manager and their divergent aims.
Shareholders own LTC/PLC, and wish to maximise profits to maximise their dividends. Managers may have different motives, such as wanting to increase sales at the expense of profit.
What is a Demerger?
When a company sells off some section of the business, and this forms a completely separate company
A demerger is usually carried out by distributing shares in the new business to the existing shareholders.
What are the reasons for demerging?
Lack of Synergies: A synergy is when creating a whole company is worth more than each company on its own. Without this, firms are likely to demerge because they will be worth more.
Growth of businesses at different rates: The faster growing part might be separated
Diseconomies of Scale: If the firm is so large that DoS start to occur, the firm may choose to split
Focused Companies: Firms may grow faster if they focus on a few markets, rather than several
Lack of resources: If firms can no longer invest the business due to a lack of a resources, they might sell off a part
Selling off parts of the firm can raise finance
What is the Impact of demergers on Businesses?
Firms can dispose of underperforming or loss-making parts of firm
More focus on their core activities
Firms can eliminate economies of scale
What is the Impact of demergers on Workers?
Workers’ roles may be shifted between the demerged firm and parent firm
There could be job cuts
Workers might become confused
Increased job security if loss-making parts of the firm are demerged
What is the Impact of demergers on Consumers?
The removal of diseconomies of scale means lower prices
If two firms in the same industry demerge, there is more choice for consumers
What is Revenue?
The income gained from the sales of goods + services, capital, etc. before any costs are deducted.
What is Total Revenue?
Price x Quantity Sold
When price is constant, TR is upwards sloping.
What is Average Revenue?
AR is the price each unit is sold for
TR / Quantity
What is the Relationship between PED to revenue concepts?
Price Takers: when demand is elastic, increasing price will reduce total revenue, and decreasing price will increase total revenue (AR = the demand curve)
Price Makers: when demand is inelastic, increasing price will increase total revenue, and decreasing price will decrease total revenue
What is Marginal Revenue?
The extra revenue gained from the sale of of one extra unit
Change in Revenue / Change in Quantity
What does Revenue look like for a Price Maker and Price Taker?
Price Taker:
Horizontal AR=MR=P=D curve
Upwards sloping TR curve
Price Maker:
Downwards sloping AR curve
Downwards sloping MR curve, crossing 0 at half the quantity of AR
Downwards parabola TR curve, reaching its highest when MR=0
What is Cost?
An expense which a business has to pay.
What is Fixed Cost?
Cost which doesn’t change, regardless to how much is produced.
What are some examples of fixed cost?
Rent, Salaries, Machines, Stationery, Advertising
What is variable cost?
Cost which varies with the level of output
What are some Examples of variable cost?
Utility Bills, Wages, Raw Materials, Packaging, Transportation
How are the factors of production like Over Time?
Short Run: At least one of the factors is in fixed supply
Long Run: Output can be changed- there are no fixed factors
Very Long Run: Technology changes
What is the law of Diminishing Marginal Returns?
Adding more units of a variable input to a fixed input increases product and reduces cost at first.
After a certain amount of input, the marginal increase in output becomes constant.
Eventually, an increase in input will lead to a fall in output/ increase in cost.
What is Average Cost, and how are the types of AC calculated?
The cost per unit of output.
ATC = TC / Q AVC = TVC / Q AFC = TFC / Q
Why does MC cut AC at its lowest point?
When MC < AC, AC falls.
When MC > AC, AC rises.
When MC = AC, AC doesn’t change.
At first, MC < AC, and thus AC falls until they meet. After that, MC > AC, and so AC rises.
What is Marginal Cost?
The additional cost of an additional unit of output is produced.
What does AC and MC look like on a diagram?
MC is a J-curve, and AC is a normal curve.
MC cuts AC at its lowest point.
Why is the MC curve a J-curve?
( i don’t think you have to learn this)
The MC curve is a reflection of the MP curve (via the x axis)
MP increases until DMR comes in. When this happens, each worker is less productive for most of the time, and so the MP falls, and thus MC rises.
What is the Minimum Efficient Scale?
The lowest point on the LRAC curve.
The most efficient level the curve stops falling, it tells us the minimum output required to fully exploit economies of scale.
What is an Evaluation point regarding Diseconomies of scale?
Depends on the Output:
If they’re performing before the minimum efficient scale, they’ll not reach diseconomies of scale
If they’re after the minimum efficient scale, they may be able to stay at that low cost for a while before the cost coming back up
Also: If fixed costs are too high, it will take them forever to get to the minimum efficient scale; yet alone diseconomies of scale
What does the LRAC curve look like, and why?
In the short run, firms want to lower their cost and avoid DMR, and will do this by expanding their capital. This shifts the SRAC curve to the right. Firms keep on doing this, to not be constrained to the amount of capital they have, and to avoid DMR
The LRAC curve enveloped the SRAC curves, where it is always equal to or lower than the SRAC curve.
SRAC falls at first, then rises due to DMR
LRAC falls at first, then rises due to economies of scale.
How is Marginal Cost Calculated?
Change in Cost / Change in Quantity
How is Total Cost Calculated?
TVC + TFC
TVC = VC x Quantity
What is meant by Economies of Scale?
When there’s a fall in the long run average cost of production as output rises.
What are Internal economies of scale?
This occurs within the firm as it expands production
What are the Types of Internal economies of scale?
Purchasing: Firms can get bulk-buying discounts
Risk-bearing: Firms can spread their risk by expanding into new markets
Marketing: Firms can divide their marketing budgets across larger outputs (e.g. dubbed adverts)
Financial: Banks are willing to give out cheaper loans to firms
Technical: Larger firms use smaller scale machinery + factories, which leads to lower costs of production per unit
Managerial: Firms can specialise, and divide their labour
What are External economies of scale?
These are achieves as the industry that the firm is operating in grows
What are the Types of External economies of scale?
Labour: Often a pool of skilled labour will develop in areas in which similar firms operate (e.g. Sillicone Valley)
Ancillary Services: Often support industries (e.g. suppliers) will develop in areas in which similar firms operate. The growth of tourism and travel agents has led to the growth in travel insurance.
Good Reputation: If a country or area builds up a good reputation for producing a good quality product, all the firms in the industry benefit from this.
Improved Infrastructure: The growth of an industry can encourage the government or the private sector to improve infrastructure that services the industry.
(e.g. growth of tourism in the UK has led to the expansion of UK airports
What are Diseconomies of Scale?
They occur when a business grows so large, the costs per unit increase.
What are some Causes of diseconomies of scale?
Diseconomies of scale occur for several reasons, but all as a result of the difficulties of managing a larger workforce:
Poor communication
Lack of motivation
Loss of direction and co-ordination
What does the economies/diseconomies of scale diagram look like?
It looks like a negative parabola
The left side is economies of scale, and the right side is diseconomies of scale.
What is the Minimum Efficient Scale?
The lowest point of the LRAC curve
This is where the optimum level of output is, since costs are lower and the economies of scale of production have been fully utilised
What are Network Economies of Scale?
These are gained from the expansion of ecommerce*.
Large online shops (eBay, Amazon, etc) can add extra goods and customers at a very low cost, but the revenue gained from this will be significantly larger
- commercial transactions conducted electronically on the internet
What is the Condition for Profit Maximisation?
Occurs when MC = MR
This is so that each extra unit produced gives no extra loss or extra revenue
What is Profit?
The difference between Total Revenue and Total Cost
It is the reward that entrepreneurs yield when they take risks
What is a Loss, Normal Profit and Supernormal Profit?
Normal Profit:
The minimum required to keep entrepreneurs supplying their enterprise.
It’s when TR = TC
It is considered to be a cost, and so included in the costs of production
Supernormal Profit:
The profit above normal profit
TR > TC
Loss:
When firms fail to cover their total costs
What is the Short Run and Long Run Shut Down point?
A firm which profit maximises continues to operate in the short run if P > AVC –
When shutting down, no variable costs are incurred by the firm. However, fixed costs have to be paid whether the firm shuts down or continues to produce. This means fixed costs are not considered when a decision to shut down is being made.
The shut-down point is P < AVC, when variable costs cannot be covered. This is at the lowest point on the AVC curve.
When a firm shuts down, it is a short run decision. This means production is only temporarily stopped.
However, in the long run, the firm can leave the industry. This will happen when TR < TC.
Where does the Shut Down Point occur in the short run?
The short-run shut-down point occurs when AVC=AR. Firms shut down when AVC > AR
AR>AVC: each additional unit sold will reduce the size of any losses and go towards covering fixed costs. The firm will be better off continuing to operate as they will be reducing the size of their losses.
Firms will shut down when AVC>AR because every additional unit sold will add to losses.
Where does the Shut Down Point occur in the long run?
The long-run shut-down point occurs when ATC=AR. Firms shut down when ATC > AR
If AR>ATC then each additional unit sold will add to profits. The firm will be better off continuing to operate.
Firms will shut down when
ATC>AR because every additional unit sold will add to losses.
What is meant by Efficiency?
How well a business will use their resources to produce goods + services
What is Static Efficiency?
Refers to how much output can be produced now from a given stock of resources and whether producers are charging a price to consumers that fairly reflects the costs of production
What is Allocative Efficiency?
Looks from the perspective of the consumer
Achieved when the value consumers place on a good or service (reflected in the price they’re willing to pay) equals the cost of the resources used up in production
AR / P = MC
(P=AR= Demand, MC = Supply)
What is Productive Efficiency?
About minimised cost and maximised output; exploiting all economies of scale
All resources are being used, and EoS are exploited. It occurs at the minimum point on the AC curve. It’s good to the consumer if the low cost is passed on to them as a low price
What is Dynamic Efficiency?
Efficiency over a period of time. It focuses on changes in the amount of consumer choice available in markets, together with the quality of G+S available.
Supernormal Profit
Using supernormal Profit to reinvest back into the firm, which they can use to lower unit cost and venture into new areas
What is X Efficiency?
When there is no waste
Any Point on the AC Curve
Libenstein (1966) pointed to potential cost inefficiencies arising from a lack of effective competition within a market. Companies that face no or little real competition often allow their fixed costs to rise (e.g. Monopolies)
What is the Efficiency like in a Perfect Competition?
Short Run Profit: AE ✔️ PE ✖️
Short Run Loss: AE ✔️ PE ✖️
Long Run Equilibrium: AE ✔️. PE ✔️
What is the Efficiency like in a Monopolistic Competition?
Short Run Profit: AE ✖️ PE ✖️
Short Run Loss: AE ✖️ PE ✖️
Long Run Equilibrium: AE ✖️ PE ✖️
What is the Efficiency like in a Monopoly?
Short Run: AE ✖️ PE ✖️
Long Run Equilibrium: AE ✖️. PE ✖️. DE ✔️
What is the Efficiency like in an Oligopoly?
Short Run: AE ✖️ PE ✖️
Long Run Equilibrium: AE ✖️. PE ✖️. DE ✔️
What is the Level of competition in a prefect competition?
High
What are the types of goods which are produced in a perfect competition?
Homogenous
Are they price takers or price makers in a perfect competition?
Price Takers
What barriers to entry/exit are there in a perfect competition?
No barriers
What knowledge of prices do firms have?
Perfect knowledge
How many buyers + sellers are there in a perfect competition?
Many buyers and sellers, (none of whom is large enough to influence price)
What do firms in a perfect competition make in the short run?
Abnormal profit, or a Loss
What do firms make in the long run of a perfect competition?
Normal Profit
How do firms change from the short run to long run in a perfect competition?
Abnormal Profit: Gives an incentive to join the market, which increases supply.
Loss: Gives incentive to leave the market, reducing supply.
What are some examples of markets running in perfect competition?
Foreign Exchange Market
Market Stalls
What type of demand do firms in a perfect competition have?
Perfectly elastic
What does a diagram for a perfect competition look like?
Individual Firm: Elastic demand curve
Whole Market: Supply + Demand Curve, where the equilibrium is at the same price as the individual firm
What does the supply curve look like in a Perfect Competition?
In a perfectly competitive market, the supply curve for a firm is the marginal
cost curve above the average variable cost in the short run, and the average total cost in the long run.
What are the Similarities between Monopolistic Competition and Perfect Competition?
High Competition
Low Barriers to Entry
High Knowledge of Prices
Many Buyers + Sellers
What are the Differences between Monopolistic Competition and Perfect Competition?
MC are price makers, PC are price takers
MC has a downwards sloping demand curve, PC has an elastic curve
MC has slightly differentiated goods, PC has homogenous goods
What is Product Differentiation?
The process of distinguishing a product or service from others, to make it more attractive to a target market
What is Monopolistic Competition like in the Short Run?
Firms make Abnormal Profit, or Loss
What is Monopolistic Competition like in the Long Run?
Firms make Normal Profit
What are some Examples of Monopolistic Competition?
Restaurant business.
Hotels
Pubs
How does a Supernormal Profit making firm in a Monopolistic Competition go to Normal Profit in the Long Run?
In the long run, supernormal profits will be eroded because new firms will enter the market owing to lack of barriers to entry.
The entry of new firms will increase supply, shifting the average revenue curve downwards to the point where AR=AC, as in the diagram.
How does a Loss making firm in a Monopolistic Competition go to Normal Profit in the Long Run?
If the firm was making a loss, it would leave
the industry, reducing supply and shifting the AR curve upwards again to a
point where AR=AC
What does a Monopolistic Competition Diagram look like?
Short Run: https://s3-eu-west-1.amazonaws.com/tutor2u-media/subjects/economics/monopolistic_competition_short_run.png
Long Run: https://s3-eu-west-1.amazonaws.com/tutor2u-media/subjects/economics/monopolistic_competition_long_run.png
What is an Oligopoly?
A market dominated by a few producers, each of which has control over the market
What are the Characteristics of an Oligopoly?
- Supply is concentrated in the hands of relatively few firms
- Firms are interdependent, the actions of one firm affects others in the industry
- Goods may be homogenous or differentiated
- Firms often engage in non-price competition
- There are periodic aggressive price wars
- Firms may collude
- Prices are stable
What are some Examples of Oligopolies?
Energy suppliers Commercial banks Pharmaceutical retailers Mobile phones Soft drink manufacturers Supermarkets
What is meant by the Concentration Ratio?
The concentration ratio measures market share of the top ‘n’ firms in an industry
Shares can be by sales, employment, or any other indicators
How to calculate: Just add it up
What are the coefficients of the Concentration Ratio?
High number - the industry is highly concentrated, and dominated by a small number of firms
Low number - the industry is more highly competitive
What type of Demand Curve does an Oligopoly have?
Kinked Demand Curve
Used to illustrate the behaviour of firms in an oligopoly
It consists of 2 demand curves- elastic demand + inelastic demand
The square/rectangle underneath the equilibrium shows Total Revenue
What would happen if a firm in an Oligopoly Increased the Price of their product?
Elastic Curve:
A firm increases the price
Other firms’ rices haven’t changed
Those demanding that firm’s product will new switch to the substitutes
They lose market share (elastic demand- a price inc. will reduce a lot of demand)
What would happen if a firm in an Oligopoly Decreased the Price of their product?
Inelastic Curve:
A firm decreases the price
To prevent competition and loss in market share, the other firms decrease their prices (price war)
The firm’s revenues decrease (inelastic demand)
Why do prices tend to remain Stable in an Oligopoly?
Total revenue is maximise ‘at the kink’.
If price increases and demand is elastic, total revenue falls.
If price decreases and demand is inelastic, total revenue decreases.
As a result of the above, prices tend to remain stable as firms are reluctant to change prices up or down
What is meant by Collusion?
Collusion represents an attempt by firms to recognise their interdependence, and act together rather than compete.
It is a move towards joint profit maximisation
What is a Cartel?
A cartel is a formal agreement among competing firms
What are the Two Types of Collusion?
Overt Collusion
Tacit Collusion
What is Overt Collusion?
A price-fixing agreement with a producer cartel responsible for allocating output/supply within the market
What is Tacit Collusion?
A dominant firm is the price leader, and others follow
Are Cartels legal or illegal?
Illegal
Firms that operate a cartel can now be fined up to 10% of their UK turnover for up to 3 years
When is Collusion Easier?
Collusion is easier when..
There is only a small number firms in the industry (??)
The industry has substantial high barriers (??)
Firms output can be easily manipulated (??)
Total market demand not too variable
Low YED, Inelastic PED
What is Price Leadership?
Price leadership occurs when one firm changes their prices, and other firms follow.
Other firms are often forced into changing their prices too; otherwise they risk losing their market share.
The price leader is often the 1 judge to have the best knowledge of prevailing market conditions
This explains why there is price stability in an oligopoly
What is Game Theory?
Game theory refers to the interdependence between firms in an oligopoly.
It is used to predict the outcome of a decision made by one firm, when it has incomplete information about the other firm.
What is the Prisoner’s Dilemma?
A model based around two prisoners, who have the choice to either confess or deny a crime.
The consequences of the choice depends on what the other prisoner chooses.
The two prisoners are not allowed to communicate, but they can consider what the other person is likely to choose.
This relates to the characteristic of uncertainty in an oligopoly.
What is meant by the Dominant Strategy?
The dominant strategy is the option which is best, regardless of what the other person chooses.
This is for both prisoners to confess since this gives the minimum number of years that they have to spend in prison.
It is the most likely outcome.
What is meant by the Nash Equilibrium?
The dominant strategy is still higher than if both prisoners deny the crime.
However, if collusion is allowed in this dilemma, then both prisoners would deny. This is the Nash equilibrium.
A concept in game theory which describes the optimal strategy for all players, whilst taking into account what opponents have chosen.
(However: Even if both prisoners agree to deny, it would have an incentive to cheat and therefore confess, since this would reduce the potential sentence from 2 years to 1 year – this makes the Nash equilibrium unstable)
What is meant by Price Strategies?
When firms use the price of their product to influence market share.
It’s not very much used, as prices tend to be stable
What are the Types of Pricing Strategies?
Price Wars
Predatory Pricing
Limit Pricing
Psychological Pricing: Giving prices that end in 9; It’s psychologically seen as a separate, cheaper price. (eg 99p vs £1)
Price Skimming: Giving a high price at the launch of a product. Once the top end of the market (those willing to pay the most) has been ‘skimmed’, they lower their prices. iPhones tend to do this.
Price Penetration: Giving a low price initially, in order to gain market share/ customer base/ hope. This tends to occur when the business is targeting a mass market
Loss Leader: When a business sets the price below the cost of the product. This can attract customers to a store, where they will also buy additional products. Some firms sell the core product as a loss leader and make additional sales by selling accessories of the product
What is meant by Non-Price Strategies?
When firms don’t use the price of their product to influence market share. These aim to increase the loyalty to a brand, which makes demand for a good more price inelastic.
These strategies are mainly used within firms in an oligopoly
What are the Types of Non-Price Strategies?
Advertising and Marketing: Used to make their brand more known, and influence consumer preferences. However, it’s unknown how significant A+M is to each firm- if it’s ineffective, this leads to more sunk costs, which are unrecoverable
Customer service: e.g. Having more available delivery times, longer opening time, after sales service (guarantees + warranties, etc)
Differentiation of the product: e.g. Brand name, logo, catchphrases, unique selling point. If firms can increase brand loyalty, demand comes more price inelastic. This attracts + keeps customers, increasing market share.
Quality of products
What are the Benefits of Collusion?
- Industry standards could improve
(especially true in the pharmaceutical industry/ car safety technology; as firms can collaborate and improve on it.) - Excess profits could be used for investment, which might improve efficiency in the long run. It may also be used on dividends.
- It saves on duplicate research + development
- By inc. their size, firms can exploit economies of scale, leading to lower prices.
What are the Costs of Collusion?
- There’s a loss of consumer welfare (as prices are raised + output is reduced)
- Less competition means efficiency falls
- Reinforces the monopoly power of existing firms, making it hard for new firms to enter
- Lower quantities supplied leads to a loss of allocative efficiency.
What are Price Wars?
Price Wars occur when price cutting leads to retaliation and other firms cut prices, meaning the original firm again wants to cut prices.
+: The lower prices increase demand; Consumers benefit from low prices
-: All firms lose revenue.
What is Predatory Pricing?
Cutting prices below the average cost of production. (It can even go below AVC)
This is a short term measure only, and once other firms are forced out of the market they rise their prices back up
This is almost always illegal.
+: Forces firms out of the market
- :Illegal
- :Is it really worth it in the long term?
What is Limit Pricing?
It ensures the price of good is below that which a new firm entering the market would not be able to sustain. Potential firms are therefore unable to compete with existing firms.
- : The low profits received by that firm dissatisfying shareholder, since they receive lower dividends
What does the Oligopoly Diagram look like?
http://www.economicsonline.co.uk/Business%20economics%20graphs/Oligopoly-kinked-demand.png
What is a Natural Monopoly?
A firm who managed to enter the market first, and so have huge cost advantages.
What is a Monopoly?
A situation in which the market is dominated by one seller/producer.
(By law, it occurs when 1 firm has a market share of at least 25%)
Why do Natural Monopolies occur?
Costs are so expensive; it’s wasteful for others to join the market, duplicate it and be in business.
It’s also pointless, as the cost advantages are so high it can drive other competition out of the market
It just makes sense for one firm to be operating
What are the Assumptions/ Characteristics of a Monopoly?
Only one firm in the industry/country;
High barriers to entry, preventing new firms from entering the market
Short-run profit maximiser
Price Makers
What are some Examples of Natural Monopolies?
Rail Network
Water Utility
Gas Pipelines
All of these require huge fixed costs to run, and all are needed for the general consumption of society
What does a Monopoly look like in the Short Run?
It makes supernormal profit, because high barriers prevent new businesses from entering the market
What does a Natural Monopoly Diagram look like?
http://www.economicsonline.co.uk/Business%20economics%20graphs/Natural-monopoly-Basic.png
Due to ridiculously high fixed costs, it takes forever for firms to reach the minimum efficient scale
What does a Monopoly look like in the Long Run?
It makes supernormal profit, because high barriers prevent new businesses from entering the market
What happens when Naturally Monopolistic firms produce at a Low Quantity?
http://www.economicsonline.co.uk/Business%20economics%20graphs/Natural-monopoly-Basic.png
They get supernormal profit, but the quantity is quite restricted. This is hugely concerning for the government, because people who need their product to survive can no longer get it.
This then leads to regulation to produce an output at allocative efficiency (AR = LRMC)
This, however, is lower then LRAC, leading to loss. This loss is in fact huge due to the large quantity
The government starts to understand this, so they subsidise the firm so they won’t be in loss
What factors influence Monopoly Power?
Barriers to Entry
Number of Competitors
Advertising
Degree of Product Differentiation
What barriers to entry are there in a monopoly?
Patents Limit pricing Cost advantages Advertising + Marketing Research + Development expenditure Sunk Costs International Trade restrictions
How does advertising affect monopoly power?
Advertising can increase consumer loyalty, making demand price inelastic, and creating a barrier to entry
How does the degree of product differentiation affect monopoly power?
The more the product can be differentiated (through quality, pricing and branding), the easier it is to gain market share.
this is because the more unique the product seems, the fewer competitor the firm faces (a bit like a niche product)
What are the advantages to a monopoly?
- Abnormal profit means:
● finance for investment to maintain competitive edge
● reserves to overcome short-term difficulties and provide funds for research and development / invention and innovation - Cross-subsidisation (using profits from one sector to finance losses in another sector) may lead to an Increased Range of goods or services available to the consumer.
- Price discrimination may raise total revenue to a point that allows survival of a product or service. It is often said that economy-class flights are funded by those flying business and first class.
- Monopolists can take advantage of Economies of Scale, which means that average costs may still be lower than the most efficient average of a small competitive firm
- Monopolies could generate Export Revenue (e.g. Microsoft generates a lot of it for the US)
- High profits could be a source of government revenue through taxation
What are the disadvantages to a monopoly?
- Abnormal profit means:
● less incentive to be efficient and to develop new products
● efforts are directed to protect market dominance. - Monopolists avoid undesirable duplication of services and therefore a misallocation of resources
- Monopoly power means higher prices and lower output for domestic consumers.
- Monopolies may waste resources by undertaking cross-subsidisation, (using profits from one sector to finance losses in another sector).
- Monopolists may undertake price discrimination to raise producer surplus and reduce consumer surplus.
- Monopolies lead to a misallocation of resources by setting prices above marginal cost, so that price is above the opportunity cost of providing the good.
- Monopolists do not produce at the most efficient point of output (i.e. at the lowest point of the average cost curve).
What is meant by ‘Barriers to Entry’?
Barriers to entry are designed to block potential entrants from entering a market profitably.
They seek to protect the monopoly power of incumbent (existing) firms in an industry, and therefore maintain supernormal (monopoly) profits in the long run.
Barriers to entry have the effect of making a market less contestable.
What do Patents do?
Patents involve giving the firm the legal protection to produce a patented product for a number of years.
What is meant by ‘Cost Advantages’ as a barrier to entry?
Lower costs, perhaps through experience of being in the market for some time, allows the existing monopolist to cut prices and win price wars
What is Price Discrimination?
Price discrimination is when a firm charges different consumers different prices for an identical product, by exploiting the fact that different consumers have a differing willingness and ability to pay.
It happens in a monopoly.
What are some Ways to Split the Market?
Time (peak/off-peak)
Location (e.g. East London vs. Central London)
Income (high/low income)
Age (barbers)
Gender (car insurance is cheaper for females)
What are the Degrees of Price Discrimination?
First Degree Price Discrimination: occurs a firm charges each consumer the maximum price they are prepared to pay.
Second Degree Price Discrimination: when a different price is charged per unit according to how many units are purchased (e.g. petrol)
Third Degree Price Discrimination: involves charging prices to different groups of consumers who are separated into different markets
(You only need to know the third one <3)
What are the Conditions needed for Price Discrimination?
- Monopolists must face different demand curves from different groups of buyers (elasticity of demand must differ)
- Monopolists must be able to split the market into distinct groups of buyers
- Monopolists must be able to keep to market separate at relatively low cost to prevent selling between groups
What is the Price Discrimination Diagram?
http://www.economicshelp.org/wp-content/uploads/2012/11/n-price-discrimination1.jpg
What is the Output under Price Discrimination?
The 2 markets have different outputs
The whole market’s output is the sum of the 2 markets’ outputs.
What is the Price under Price Discrimination?
The price in the inelastic market would be higher than the elastic market
What are the Profits under Price Discrimination?
Profits from the 2 markets combined is higher than the whole market when a single price is charged.
What happens to Consumer Surplus under Price Discrimination?
In 3rd degree price discrimination the monopoly is extracting consumer surplus and turn it into extra supernormal profit
One group gets the product sold at a lower price, and another gets it sold at a higher price.
(Profit = (R-C) x Quantity)
http://www.digitaleconomist.org/monopoly_2_degree.gif
What are the Advantages of Price Discrimination?
Firms will be able to increase revenue. This will enable some firms to stay in businesses who otherwise would have made a loss.
(e.g. Price discrimination is important for train companies who differ prices depending on peak times)
Increased revenues can be used for research + development which benefit consumers
Some consumers will benefit from lower fares (e.g. elderly people and those who are poor)
What are the Disadvantages of Price Discrimination?
Some consumers will end up paying higher prices. These higher prices are likely to be allocatively inefficient, as P>MC
Those paying higher prices may not be the poorest (e.g. adults could be unemployed, OAPs well off)
There may be administration costs in separating the markets (extra paperwork required)
Profits from price discrimination could be used to finance predatory pricing (opp. cost)
What Evaluation points could be taken into account when discussing Price Discrimination?
1) How easily they can meet the conditions- It may be more difficult if:
More competition entered (increasing elasticity)
Is there any way the goods could be re-sold?
Can markets be kept geographically separate? (consider the internet)
2) The regulator may fine them
What is a (pure) Monopsony?
A monopsony is a firm which is the sole buyer of resources or suppliers.
There is a single buyer in the market.
What is meant by Monopsony Power?
A monopsonist has buying power in their market.
This buying power means that a monopsonist can exploit their bargaining power with a supplier to negotiate lower prices. The reduced cost of purchasing inputs increases their profit margins.
Many firms have some degree of monopsony power, which means firms have some control over their suppliers
A firm with monopsony power is able to negotiate lower prices, because their suppliers have nowhere else to sell to (there is only one buyer). They are also able to set the market price.
(suppliers accept it because the firm is well respected; and the quantity sold is huge- imagine McDonalds; big businesses can influence cheaper supply)
What are the assumptions about Monopsonies?
It is assumed that monopsonists are profit maximisers.
They aim to minimise costs by paying suppliers the lowest possible price.
Monopsonists will pay lower prices to suppliers than if the market was competitive but suppliers will also supply less to the market.
What are the Benefits of Monopsonies?
- Improved value for money; allowing an increase in productivity. Also, lower buying costs might be passed on to the customer in retail prices
- Lower input costs can raise profitability that can fund investment/ research +development
- The growth of the fair trade label and organisation is evidence of how pressure from consumers can lead to improved contracts and prices for farmers in developing countries – this increase in inome and profit will have important economic and social benefits of exporting industry
- Monopsony Power can give power to buyers in the face of monopoly supply or resources. For sample, cosmetic produces (e.g. L’Oreal) can charge very high prices for their products, but supermarkets good for supplies to cut their costs
What are the Costs of a Monopsony?
- Suppliers can be squeezed out of business - The price may be so low that they can’t cover their costs, forcing it out of the market
- Choice for consumers could be limited, as monopsony acts as a barrier to entry for new firms
- Higher profits from monopsonies can mean inequality - they make higher profit, new firms can’t compete as much, and so miss out on power
Who developed the Contestable Markets theory, and when?
William J. Baum, John Panzar + Robert Willig
1982
What is a Contestable Market?
A contestable market exists when an entrant has access to all production techniques available to the incumbents’customers, and entry decisions can be reversed without cost.
(They can exit and enters the market easily, and without cost)
What are the Assumptions of Contestable Markets?
Freedom of entry + to exit from the industry Low/No sunk costs Potential for hit and run competition Number of firms vary from one to many Firms compete and do not collude Firms profit maximise Goods may be homogeneous or branded Perfect knowledge of prices
Why is the Threat of Competition important in a Contestable Market?
Prices are kept competitive, and profits are low.
Even if they haven’t entered the market, the threat will make incumbent firms behave as if they were in competition
Why do firms want to Profit Maximise?
Keeps shareholders happy
Reinvestment opportunities
Greater efficiency - this lowers costs and lowers prices
What is Hit and Run Competition?
When a business enters the industry, takes the profit and gets out quickly (possibly because of the freedom of entry + exit)
What are the Implications of Contestable Markets?
In the long run, only normal profit is earned (due to so many businesses being in the market)
The ability to earn abnormal profit in the long run depends solely on barriers to entry + exit (how many firms are in the industry)
How do Contestable Markets benefit themselves, and the Public Interest?
Contestable markets can brig the benefits of competitive markets such as:
Lower prices
Increased incentives for firms to cut costs
Increased incentives for firms to respond to consumer preferences
The firm will be closer to allocative + productive efficiency than in a monopoly
There could also be significant economies of scale, because the theory of contestable markets doesn’t require there to be 1000s of firms.
What are some examples of low contestable markets?
Airlines
Banking
Energy Supplies
What is Contestability?
A measure of the ease with which firms can enter/exit an industry.
Focus is on the potential threat of competition, rather than actual competition
What is the Index of Contestability?
High Contestability: easier to enter + leave
Low Contestability: harder to enter + leave
What are the Signs of High Contestability?
Low levels of supernormal profits Low barriers to entry + exit Low concentration ratios Low sunk costs Low collusion levels, or other signs of oligopoly New firms entering/ leaving the market
Who are Stakeholders?
People influenced some way from the company
Owners (shareholders-want profit) managers (want more salary) workers (want breaks, high wages) consumers (want low prices) government (want revenue)
Are all contestable markets perfectly competitive?
Not all contestable markets are perfectly competitive
You can be contestable, but have a differentiated product
What is Profit Satisficing?
Satisficing is a mix of satisfy and sacrifice
It occurs due to divorce of ownership and control; and due to conflict between the stakeholders.
It’s important to profit satisfice, so everyone is happy
What is the Relationship between Sunk costs and Perfectly Contestable Markets?
Sunk costs are a barrier to contestability.
They are costs which cannot be recovered one they have been spent. For example, advertising incurs a sunk cost. A market with high sunk costs is less favourable to enter, because the risks associated with entering the market are high.
High sunk costs are likely to push a market towards a price and output that is similar to a monopoly.
What are the Types of Barriers to entry/exit in a Contestable Market?
The greater the economies of scale a firm exploits, the less likely a new firm will enter the market
Legal barriers (e.g. patents and exclusive rights)
Predatory Pricing
Limit Pricing
Some firms may employ Anti-Competitive Practices (e..g refusing to supply retailers which stock competitors)
Brand Proliferation (e.g. the many brands of laundry soaps are provided by only a few large conglomerates- which disguises consumers from actual market concentration)
The cost of making workers redundant may discourage firms from leaving an industry
What is meant by Behavioural Economics?
Behavioural Economics is a field of economics which looks directly at the way human behaviour and decision-making is modelled. It refers to how individuals react and make decisions when there are changes in the economy.
Why don’t firms choose Profit Maximisation?
- They don’t know where MC = MR is
- Divorce between ownership and control may lead to other objectives (managerial aims) - conflict of interest
- Firms could be aiming for profit maximisation in the long run
What is Sales Maximisation?
The maximum level of output that can be produced without making a loss
AC = AR
Why do firms Sales Maximise?
Long term strategy to gain market share
Deters new entrants who have higher costs - puts off new potential competition
What is Revenue Maximisation?
The maximum level of output that can be produced, before total revenue starts to fall
MR = 0
Why do firms Revenue Maximise?
Managers may wish to max revenue to satisfy managerial aims (e.g. bigger perks, bigger bonuses, move to headquarters, etc)
What is Satisficing Behaviour?
This is when managers may behave in a certain way for a quiet life and therefore do not push for the profit maximising position
They do enough to keep shareholders off their backs (keep them satisfied). This is called satisficing behaviour, or profit satisficing because managers produce Satisfactory Profits, rather than maximum profits
What is Derived Demand?
Demand from one thing comes from demand of another thing
Labour is derived demand; e.g. Restaurants + Chefs
Who Supplies/ Demands for Labour?
Businesses demand labour
Workers supply labour
What Factors affect demand for labour?
Technology/Machinery (as a substitute)
Gov. Regulations (e.g. min wage, laws, ease to hire, etc.)
Demand for Final Product
What Factors affect supply of labour?
Social Trends (more supply for certain sectors, etc)
Retirement Age
Availability of Benefits
Income Tax
What is Wage Elasticity of Labour Demand?
A measurement of responsiveness of demand of labour when wages change
A change in the demand for labour in response to the change in the cost of wages
What factors affect wage elasticity of labour demand?
Proportion of Labour Costs to Total Cost
Ease + Cost of Substitutes
PED for Product Being Made
Time Period to Look for Alternatives
Why is the Labour Market a Market Failure?
30 million are in the UK workforce, and 2.5 million are unemployed
If resources were allocated efficiently, everyone would be employed
What is Geographical Immobility of Labour?
Geographical immobility refers to barriers people moving from one area to another to find work.
What are the reasons for geographical immobility?
Family + Social Ties
Lack of Employment Info
Costs (esp. into London)
How can Geographical Immobility of Labour be Corrected?
Reforms to Housing Market: improve supply and reduce cost of rented properties
Specific subsidies for people moving into areas with labour shortages
Encourage part ownership
What is Occupational Immobility of labour?
Occupational immobility occurs when there are barriers to the mobility of factors of production between different sectors of the economy; leading to these factors remaining unemployed, or being used in ways that are not efficient.
What are the reasons for Occupational Immobility?
Structural Unemployment
mismatch of employees’ skills, and employers skill requirements
How can Occupational Immobility be corrected?
More spending on Higher Education
Subsidise provision of Vocational Training
Invest in Training Schemes for the Unemployed to boost human capital
What is the aim of Competition Policy?
To promote competition, make markets work better, and contribute towards improved efficiency in individual markets and enhance competitiveness of UK businesses within the European Union single market.
What do competition policies aim to Ensure?
Wider consumer choice
Technological innovation, which promotes dynamic efficiency
Effective price competition between suppliers
What are the 4 Key Pillars of competition policy in the UK and EU?
Antitrust + Cartels: involves the elimination of agreements that seek to restrict competition, including price-fixing and other abuses dominant firms
Market liberalisation: Introducing fresh competition in previously monopolistic sectors
State aid control: state aid measures (e.g. subsidies) to ensure that such measures do not distort competition in the single market
Merger control: involves the investigation of mergers and take-overs between firms (e.g. a merger between two large groups which would result in market domination)
Who are the Competition Regulators for the UK economy?
The Competition Markets Authority (CMA) is responsible for strengthening business competition and preventing + reducing anti-competitiveness.
They began fully operating on April 1 2014; when it assumed many of the functions of the previously existing Competition Commission (CC) and Office of Fair Trading (OFT), which were abolished.
The European Union Competition Commission is another important body for the U.K. economy.
What are Other Roles of Competition Regulators?
To monitor and regulate prices:
They aim to ensure that companies do not exploit their monopoly power by charging excessive prices (e.g. The EU Competition Commission put a maximum price on phones ‘roaming’ charges)
Monitoring Standards of Customer Service: Companies that fail to meet specified service standards can be fined, or have their franchise/license taken away
Opening up Markets;: encourages competition by removing barriers to entry. A key task for the regulator is to fix a fair access price for firms wanting to use the existing infrastructure (Dominating firms are forced to allow others to use its infrastructure network)
Being the Surrogate Competitor: Regulation can act as a form of surrogate competition, – attempting to ensure that prices, profits and service quality are similar to what could be achieved in competitive markets
What are the Barriers to Entry?
Economies of Scale
High start up costs/ capital costs
Legal Barriers (patents, licenses, healthy + safety services, etc)
Branding and Advertising
Sunk Costs (costs that aren’t recoverable when a firm shuts down or changes. You can’t get the money back or sell it on)
Anti-Competitive Practices (eg predatory prices)
What Power do Regulators have?
The OFT and CC can impose fines, enforce the break up of a monopoly, force the sale of an asset, force the dominant firm in the industry to allow others to use its infrastructure network, and put company directors/managers in prison.
Any business found to be a member of a cartel can be fined up to 10% of its worldwide turnover. Any serious types of cartel found can result in a criminal conviction
What are the Barriers to Exit?
Re-Sale of Assets (if you can’t get your money back, etc)
Redundancy Costs (costly to pay for redundant workers)
Costs for Ending License Agreements (e.g. Rent. Thing of it like leaving before your mobile contract ends)
Why does Collusive behaviour occur?
Collusive behaviour occurs if firms agree to work together on something. For example, they might choose to set a price or fix the quantity of output they produce, which minimises the competitive pressure they face.
What are the two Types of Oligopolies?
Competitive Oligopoly
Collusive Oligopoly
Why does Non-Collusive Behaviour occur?
Non-collusive behaviour occurs when the firms are competing. This establishes a competitive oligopoly.
What is the Breakeven Point?
The break even point for a firm is the level of output sufficient for revenue to cover all its costs.
At the break-even price, the firm neither makes a loss or profit.
The break-even price occurs where AR = ATC
What are some examples of Industries where Monopsony power exists/persists?
- Electricity Generators can negotiate lower prices for coal + gas supply
- Leading supermarkets have oligopsony power when it comes to purchasing products from businesses at earlier stages of the supply chain (meat + poultry farmers, milk producers, etc.)
- Low-cost airlines get a favourable price when purchasing a new fleet of aircraft
- Amazon’s buying power in the retail book market- it gets a better price than booksellers; giving it a competitive advantage
- The increasing buying power of countries - e.g. China - securing deals to buy mineral deposits from other countries (often LEDCs in Africa)
What are the Factors that promote a Competitive Oligopoly?
High numbers of firms
New market entry is possible
One firm with significant cost advantages
Homogeneous goods
Saturated market (A lot of price wars and price competition)
What are Sunk Costs?
They are costs which cannot be recovered one they have been spent. For example, advertising incurs a sunk cost.
What are the Evaluation points to a Competitive Oligopoly?
All points involving efficiency and economies of scale within a Perfectly Competitive firm
What are the Benefits of Behavioural Economics?
By integrating economics with psychology, economists can benefit from the experience psychology has in examining our behaviour. Many psychologists are teaming up with economists in an attempt to study human beings in the economic forum, the most recent team being the 2002 noble prize winners Daniel Kahneman + Vernon Smith.
For the first time, lab experiments are being used to provide serious empirical data for economists to study. These experimental economists use techniques borrowed from psychology to test human studies within a controlled environment. As methodology improves, such experiments are slowly going more credibility within the economic academia
What are the factors promoting a Collusive Oligopoly?
They use Overt or Tacit Collusion (price leadership)
Small number of firms
Similar costs
High entry barriers
Ineffective competition policy
Consumer loyalty
Consumer inertia
(These two link to cheating – it doesn’t matter what you do if you don’t have these two things)
Why are Cartels Unstable?
Firms can cheat on any agreement, and there’s always the threat of being caught by competition authorities.
What are the Evaluation points to a Collusive Oligopoly?
All points involving efficiency and economies of scale within a Monopoly
How can firms continue to run in the short run?
Firms continue to produce in the short run as long as variable costs are covered.
What are Regulatory Bodies?
They are specialised regulators looking over specific industries and the companies operating within them. They work beneath the CMA and report to the CMA.
ORR CAA OFCOM OFWAT OFGEM
What are some Examples of Very Competitive Markets?
Fast Food
Cars
What are some Examples Of businesses with Monopoly Power?
Google Search
London Underground (natural)
Merlin Attractions
Durex (both global and UK)
What are some Examples of Diminishing Marginal Returns?
Factories
Farming
What are some Exemplar industries with Economies of Scale?
Supermarkets
Airlines
Online Retail
Pharmaceuticals
What are some Exemplar Profit Maximising Firms?
Apple
Pharmaceuticals
Electrical Goods
What are some Exemplar Sales Maximising Firms?
Costa (UK)
Amazon
Netflix
Spotify
This helps increase brand loyalty
What are some Exemplar Corporate Social Responsibilities (making everything ethical)?
Disney
Starbucks
Microsoft
Body Shop
What are some Examples of Monopoly Regulations?
RPI: Trains
RPI-X: Airports
RPI+K: Water
Performance Targets: GPs, Ambulances, Trains
Mergers: Betting Shops, Ferry Crossing, Just Eat/Hungry House
Privatisation: Rail, Royal Mail
Deregulations: Bus, Airlines
What are Some Exemplar Industries with a Decreased Demand for Labour?
Air Traffic Controls
Retail Workers
What are Some Exemplar Industries with an Increased Demand for Labour?
App/Software Developers
What are Some Exemplar Industries with a Wage Elastic Demand for Labour?
Call Centre Workers
What are Some Exemplar Industries with a Wage Inelastic Demand for Labour?
Premier League Footballers
Cleaners
What are Some Exemplar Industries with a Decreased Supply for Labour?
Hotel Receptionists
Vets
What are Some Exemplar Industries with an Increased Supply for Labour?
Nurses
Holiday Reps
What are Some Exemplar Industries with a Wage Inelastic Supply for Labour?
Teachers
Nurses
Chefs
Doctors
What are Some Exemplar Industries with a Wage Elastic Supply for Labour?
Waitresses
Hairdressers
Cleaners
What is the Minimum Wage?
£7.50 an hour for over 25 years old
What is the Living Wage?
£8.45 an hour
£9.75 an hour (in London)
What is the UK Gini Coefficient?
0.34
What are some Policies to Redistribute Income?
Tax Wealth- taxing the rich, and corporation tax (Labour)
Transfer Payments (Labour)
More spending on Education and Health (both parties)
Higher minimum wage (both parties)
What are the 4 Types of Government Intervention (unit 3)?
Government intervention to…
Control Monopolies
Control Mergers
Promotes Competition + Contestability
Protect Employees + Suppliers
How can Monopolies be Regulated/Controlled?
Price Regulation
Quality Control/Performance Targets
Profit Control covering costs and adding % return on capital employed
Windfall Taxes on profit
What is RPI?
RPI is the rate of inflation.
If everyone’s income rises, and the firms products rise as well, this can be seen as fair because they’re covering their costs.
However, it can go stricter.
What is RPI-X?
Restricts levels by which firms can increase their prices below RPI, whilst X represents a percentage.
Why do firms like RPI-X?
A firms incentive is to cut costs as low as possible below X.
This allows firms to raise price by RPI-X, but the costs have been cut more, giving a larger profit margin
Therefore, there’s strong incentives for RPI-X.
What is RPI(+/-)K?
Seen a lot in the water industry.
K represents a % whereby enough profits can be made to allow for capital investment
RPI+K: RPI price increases on their own won’t generate high enough profit to sustain big capital inestments in a company
RPI-K: Prices don’t need to rise above RPI; they can rise below RPI, giving enough profit for firms to make to allow for capital investment
What is the Price Capping Diagram?
https://www.tutor2u.net/_legacy/blog/files//mob_price_cap_2.jpg
What are the Problems with Price Regulation?
It depends on the level of x/k; and asymmetric information can lead to bodies regulating it at a value that harms all firms
Regulating is very costly and time consuming
Regulatory Capture- those in the firm become close w/ regulators, and influence their decision as a result
How do Quality Control/Performance Targets control Monopolies?
Found in trains, gas + electricity, NHS, etc.
They have to reach certain targets, or are allowed a certain amount of failure, etc.
What are the Problems of Quality Control/Performance Targets controlling Monopolies?
Unintended Consequences: shortcuts may be taken to ensure targets are met, meaning the quality of service is reduced
‘Gaming the System’- the adapt to the system and change things to avoid exceeding rules, which results in inefficient service
How does Profit Regulation control Monopolies?
Regulatory bodies may give a greater rate of return (which reflect high profit it will bring) if they employ more capital
Using the equation whereby costs are going to be covered, but also adding a % rate of return on capital employed.
We know that capital employed on investment is risky and costly; but it looks at paying the costs now to ensure high productivity and hopefully high profits in the future
What are the Problems with Profit Regulation to control monopolies?
Asymmetric Information: They may not give the correct rate of return and harm firms
Incentive to increase costs, as they will always be covered
Incentive to Over-Employ Capital in order to get higher returns
How do Windfall Taxes on Profit control Monopolies?
They don’t re-invest as much money into things that will further dominate their firm; nor can they benefit from as much economies of scale
What are the Problems with Taxes on Profit to control monopolies?
Worsens monopoly outcomes
Tax exemption/evidence
Less innovation
Under-reporting of profit
What are the Evaluation points about Monopoly Control?
Level of information
Costs / Benefits of Regulation - the taxpayers pay for all regulation, which is expensive
Regulatory Capture
Benefits of a Monopoly that are now controlled
These all lead to Government Failure
What are the Merger Controls?
If a merger between companies creates a market share greater than 25%, competition authorities can investigate and do 1 of 2:
- Break up the merger if it goes heavily against public interest
- If they create monopoly outcomes in certain locations, they can force them to sell off their stores in those locations to promote competition
How can Competition + Contestability be Promoted?
o privatisation
o deregulation
o enhancing competition between firms through promotion of small business
o competitive tendering for government contracts
What is Privatisation?
The transfer of ownership of a firm/industry, from the public sector to the private sector
What happens in Publicly Owned Firms?
Publicly owned firms are owned by the government, and will act in the best interests of the consumers.
Prices tend to be low and output tends to be high, and they may not know how to make profits
What does Privatisation Cover?
Contracting out services
Competitive tendering
Public Private Partnerships (PPP)
How may Privatisation involve contracting out services?
A government pays a private firm to carry out work on its behalf
How may Privatisation involve competitive tendering?
Private firms bid/compete to gain a contract to provide a service for the government.
This firms will complete on the price and quality of the service offered
How may Privatisation involve Public Private Ownerships?
A private firm works with the government to build a service for the public
An example of a PPP is a Private Finance Initiation (PFI)
A private firm is contacted by the government to run a project
In the UK, some hospitals/schools are built by a private firm, then the government leases the buildings from the firm (usually for a long period of time)
What are the Advantages of Privatisation?
Increased competition means improved efficiency, lower X inefficiency
Lower taxes in the short run
(The government won’t pay for the new facility immediately)
What are the a Disadvantages of Privatisation?
A privatised public monopoly is likely to become a private monopoly, so extra measures (e.g. the regulation) need to be taken to avoid this
Privatised firms means more focus on reducing cost and profits, instead of focusing on safety and quality
PFIs mean taxes for future generations
What is meant by Regulation?
Rules that are enforced by authority (e.g. a government); and they are usually back with legislation
What is meant by Deregulation?
Removes/ reduces regulation. It removes some barriers to entry to increase competition (particularly at monopolistic market) and tackle market failure
What are the Advantages of Deregulation?
Improves resource allocation removing regulation makes the market more contestable, so new firms are more likely to enter the market
The increased rate of competition means prices go down closer to MC, and output increases
Improves efficiency
What are the Disadvantages of Deregulations?
It’s difficult to deregulate some natural monopolies – these require large infrastructures (e.g. The water industry needs a pipe network). These infrastructures are expensive to build and maintain; and there’s only a need for one of them
Deregulation can’t fix of the market failures, such as negative externalities, consumer inertia or immobile factors of production
What would happen if Deregulation + Privatisation occur together?
Deregulation can be used alongside privatisation of a public monopoly to prevent the privatised firm from becoming a private monopoly
Privatising can remove legal barriers to entry, and the regulation removes further barriers to entry
How can Regulation Encourage the use of Renewable Energy?
The government has introduced Renewable Obligation Certificates (RCOs) to encourage the use of power generated from renewable energy sources
Energy suppliers are given a set minimum percentage of power that must come from renewable sources
Company who generate the renewable energy issued with ROCs which link to the amount of renewable energy they’ve generated. They then sell these certificates on to suppliers
Suppliers that fall short of the target % have to pay a financial penalty. The money raised from those penalties is distributed between the suppliers who did reach the target
How can ‘enhancing competitions between firms through promotion of small business’ promote competition + contestability?
Small and Medium Sized Enterprises (SMEs) are important for creating a competitive market. They create jobs, stimulate innovation and investment and promote a competitive environment.
Governments aim to improve access to finance and reduce barriers to entry, which will make it easier for smaller firms to enter the market.
What is the ‘Red Tape Challenge’?
The UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses.
It is especially aimed towards small businesses. This aims to make it cheaper + easier to meet environmental targets and create new jobs.
What is Creative Destruction?
Schumpter, an economist, proposed the idea of ‘creative destruction’ - the idea that new entrepreneurs are innovative, which challenges existing firms.
The more productive firms then grow, whilst the least productive are forced to leave the market. This results in an expansion of the economy’s productive potential.
How can Competitive Tendering promote competition + contestability?
The government provides some goods and services because they are public or merit goods, and they are underprovided in the free market. The government could contract out this provision, so that private firms operate things such as roads or hospital.
The firm which offers the lowest price and best quality of provision wins the government contract. This saves the government money, since the public sector can be bureaucratic and inefficient.
The private sector has an incentive to reduce their costs, since they operate in a competitive market.It also frees the government of maintenance, since the private sector might have the expertise and knowledge to fulfil the project and maintain the infrastructure.
This can be evaluated by considering how the private sector might not meet the specification of the contract.
Moreover, the private sector firm might try and cut costs by lowering wages, and they are less likely to have social welfare as a priority.
How can Suppliers + Employees are promoted?
Restrictions of Monopsony Power on Firms
Nationalisation
How can restrictions of monopsony power of firms protect suppliers + employees?
Monopsony power of supermarkets lead to negotiating lower prices, meaning many farmers lose profits. In supermarket price wars, supermarkets keep negotiating lower prices from farmers, to lower their own prices.
Supplying firms are unlikely to make more than normal profit.
Governments can regulate this to ensure that farmers are receiving a fair deal.
For example, farmers in the UK might receive grants and subsidies to support their production. The CMA might investigate supermarket buying power to ensure they are not abusing their monopsony power.
How can Nationalisation protect suppliers + employees?
This occurs when private sector assets are sold to the public sector. In other words, the government gains control of an industry, so it is no longer in the hands of private firms.
The railway industry in the UK was nationalised after 1945.
By nationalising an industry, natural monopolies are created. This is because it is inefficient to have multiple sets of water pipes, for example. Therefore, only one firm provides water.
Some nationalised industries yield strong positive externalities. For example, by using public transport, congestion and pollution are reduced.Nationalised industries have different objectives to privatised industries, which are mainly profit driven. Social welfare might be a priority of a nationalised industry.
The diagram shows where nationalised and privatised firms operate. Privatised firms operate at Q1 P1, which is the profit maximising level of output and price. A nationalised firm is more likely to operate at Q2 P2, which is the allocatively efficient level of output (AR=MC).
What is the Impact of Government Intervention on Price?
Governments can prevent monopolies charging consumers excessive prices, which might result in a loss of allocative efficiency.
This can make services from utility companies, such as water, gas and electricity more affordable, which is especially beneficial to low and fixed income households.
Limiting how much a firm can increase its prices by also encourages the firm to become more efficient. This is so that they can lower their costs and increase their profit margins.
If corporation tax is high, firms might pass the extra cost onto consumers, resulting in higher prices, rather than losing their own profits.
What is the Impact of Government Intervention on Profit?
If governments impose strict price caps, investment could be limited, since the amount of profit that a firm makes is restricted.
However, the recent fall in UK corporation tax from 21% to 20% will help firms keep more profits. The size of the fall can be evaluated- is 1% a significant fall?
What is the Impact of Government Intervention on Efficiency?
Public Firms are more Efficient:
Private sector firms are more likely to operate at the profit maximising level of output and price. A public sector firm is more likely to operate at the allocatively efficient level of output (AR=MC).
Therefore, government intervention might lead to an increase in economic efficiency, since the objectives change from profit maximisation to maximising social efficiency.
Private Firms are More Efficient:
Free market economists argue that by operating in a competitive environment, firms have an incentive to become efficient.
This is because they are forced to lower their average costs in order to profit maximise. This makes private sector firms more productively efficient.
They might also argue that private sector firms have to produce the goods and services that consumers want in order to keep earning profits. This might increase allocative efficiency.
What is the Impact of Government Intervention on Quality?
Governments can ensure firms are meeting minimum targets, which ensures firms focus on increasing social welfare.
For example, firms in the gas and electricity markets are regulated to ensure vulnerable groups, such as the elderly, are kept warm during colder months.
Firms which profit maximise might compromise on quality.
However, if private sector firms have the expertise and knowledge which the government might not have, then they might be able to produce goods and services of a higher quality.
What is the Impact of Government Intervention on Choice?
If governments regulate monopolies and encourage the start-up and growth of SMEs, consumer choice in the market widens, since there are more firms competing.
A stringent price ceiling might force some suppliers out of the markets, which reduces the quantity supplied and narrows choice for consumers.
If governments can reduce the price of a good or service, it could allow those on low and fixed incomes to access goods and services they previously could not afford to.
What are the Limits to Government Intervention?
Asymmetric Information
Regulatory Capture
What is Consumer Inertia?
Customers just tend to put up with poor service and results, as long as it doesn’t get too bad.
How do you show Total Revenue on an oligopoly diagram?
The square/rectangle underneath the equilibrium shows Total Revenue
