Notesale: Turn your study into money

Document Preview

Extracts from the notes are below, to see the PDF you'll receive please use the links above

---

Objectives of firms
1
...
Keep shareholders happy – high dividends
b
...
Greater efficiency, lower costs, lower prices – to profit maximise, the firm will be
efficient to minimise its total costs
BUT




Knowledge of MR = MC ? – difficult for a firm to know it’s MR
Greater risk of investigations – greater profits leads authorities to be suspicious
Other objectives
o Profit satisficing – (satisfy and sacrifice)
 Divorce of ownership & control
 Difference in objectives :
o Difference between who runs and who owns the business
o Managers might care more about size of business to get higher
salaries, rather than profit maximising
o Workers might want vacations
o Consumers want lower prices
 Thus profit maximising might not work as optimum level of profit that
satisfies all stakeholders may need to be considered/used instead
 Conflict between what stakeholders want – stakeholders – anyone who is
influenced in some way, by what the company does
 e
...
owners – tend to be shareholders – have a share in the business but
, managers, workers, consumers, government etc…
2
...
Revenue maximising – MR = 0 (where MR intersects x-axis)
a
...
Price charged will drop and quantity will go up
i
...
As quantity increases and firm grows in size, might benefit slightly from
economies of scale
4
...
Producing and selling as much as possible
i
...
Break even
iii
...

 A firm might want to use other objectives, (revenue max / breakeven)
o Often because of conflict between short and long term goals
 E
...
In long term, a firm might want to profit maximise, however in order to do
so, in the short term it needs to drive out competition/ they want growth –
sales maximisation
Barriers to entry (sources of monopoly power)
Barrier to entry – something that prevents a new firm from entering the industry
Barrier to exit – something that prevents a firm from leaving the industry
1
...
Very high cost of starting up
b
...
Strategic – anti-competitive practices
a
...
Statutory – legal barriers (licenses, patents, regulations, health and safety standards etc…)
Types of barriers to entry:
1
...
New firms can’t compete with large firms that are benefiting from economies of scale
2
...
g
...
Legal barriers (licenses, patents, regulations, health and safety standards etc…)
4
...
Easier for larger firms to do so than smaller firms
b
...
Sunk costs
a
...
g
...
Again, specific to industry
6
...
g
...
Re-sale of assets – if high cost of assets that will lose a lot of value once you want to sell them if
you leave
2
...
Costs for ending licence agreements/contracts – high price if want to end a contract early – e
...

rent
Efficiency
Allocative – are resources being allocated at a point where consumer satisfaction is maximised



Demand = Supply
For firms: where P (AR) = MC

Productive – firms maximising production and minimising their costs, exploiting all economies of scale in
doing so



Minimum point on AC curve (point B)
Potentially also good for consumers if lower costs are passed on via higher prices

Dynamic – occurs over time – supernormal profits made by a firm



If a monopoly is making supernormal profits,
Can be reinvested in firm – unit costs will be lowered

X efficiency – occurs at any point on AC (e
...
point B or C)


Costs
and
revenue

X inefficiency – e
...
producing at point A where costs are much
higher than could have been if the firm was efficient and
produced at point B instead

AC

A
C
P

B

Q

Output

Perfect competition
1
...

3
...

5
...
If decreases price all other firms
will follow and they will just be selling the same but at a lower price
...
Price drops and
AR = ATC, normal profits are thus
made
...
Price increases and AR = ATC,
normal profits are thus made in the
long run
...

2
...

4
...


One single supplier
Unique products – firms are price makers
High entry/exit barriers
Imperfect information
Firms  profit maximisers

In monopolies:





Allocative efficiency – no, P > MC
Productive efficiency – no, not producing at P = lowest point of AC
Dynamic efficiency – yes, if reinvests supernormal profits
X efficiency – no, producing at A, which is not on AC curve

A

Natural monopoly
e
...
rail network, water utility companies, gas network etc…

1
...
E
...
cost of pipe network to transfer water around the country
2
...
Firm already in market has possibility to exploit huge economies of scale due to this






Natural monopoly wants to profit maximise and produce where MR = MC
As good is needed for the population, government intervenes to make the natural monopoly
allocatively efficient  quantity increases and produce where AR = MC  supply = demand –
socially optimal but natural monopoly makes a loss
Subsidy given that is equal to the loss so normal profits made

Price discrimination
One consumer is sold the good at a price and another consumer is sold the same good at a different
price
...
Have some degree of price making power
2
...
If a consumer is paying at a lower price, can the firm stop the consumer from selling that
good at a higher price
b
...
g
...
There must be consumer groups with varying elasticities of demand

Degrees (types) of price discrimination:
1
...
Second degree – excess capacity at a lower price – e
...
a plane might have seats left, or a
stadium hasn’t sold all of its tickets – sell the tickets at a lower price
Costs
and
MC
In order to sell all of its excess capacity,
revenue
firm charges a lower price where MC =
P1
A
AR and it is making normal profits, until it
D
P2
C
reaches full capacity
...
Third degree – when there are different elasticities of demand for different types of consumers
e
...
peak and off peak travel

Peak





Off-peak

Travellers that travel in peak times pay a higher price than travellers that travel in off-peak times
Elasticities of demand are being exploited – maximises profits in both market segments
Cannot charge same price for peak and off peak as at price for peak there is no demand in the
off-peak market segment

Price discrimination




Consumer surplus suffers in most cases – in second degree, there is some consumer surplus
Charge as high as possible to maximise firms’ profits
However, for third degree, profits made in one market may lead firm to lower prices in other
market, which can be beneficial to consumers
Perfect Competition vs Monopoly
Good:
D
...
L of
consumer surplus

1
...
May be in contestable market – might mean lower
prices and greater quantities
3
...

2
...

4
...
W
...

2
...

4
...
Slight product differentiation –
e
...
different brands of chocolate etc…
2
...
Low barriers to entry/exit
4
...
Firms – profit maximisers
6
...


AR

MR
Allocative efficiency – P > MC so no allocative efficiency
Productive efficiency – Not operating at min point of AC so no productive efficiency
Dynamic efficiency – No, at least not in long run as no supernormal profits are made

AC

Output

Oligopolies
1
...
g
...
High barriers to entry/exit
3
...
Interdependence – any time a firm makes
a decision, it must consider the likely reaction
of its rivals  Price rigidity
5
...
Firms  profit max/ look for greater market share
Competitive oligopoly  Price wars



Terrible for firm
Good for consumer

Competitive oligopoly  Non-price competition



Service quality, discounts etc…
Much more common as not detrimental to firm



Above price P, demand is relatively elastic as if a firm decides to raise its price, competitors will
not follow and consumers will move away from the firm that raised its price
Below price P, demand is relatively inelastic as if a firm lowers its price, other firms are going to
follow, or even try to undermine with lower prices – only leads to a massive price fall and
decrease in profits without a great change in market share
MR is cut and continued down because MR from the first part of the kinked demand does not
match MR from the second part of the kinked demand at the quantity Q
If MC increases, as long as it is within the vertical section (line from Q going up), there will be no
price change
Game theory
Firm A – figures on left
Firm B – figures on right







Firm B

90p

£2M , £2M

£1M , £2
...
2M , £1M

£1
...
5M

 As both firms could be making £2M by both
pricing £1, this may lead to collusion
 Price leadership (strongest firm) may control
prices
 Tacit collusion – agree to not engage in price
wars

Contestable markets
When there is a potential threat of there being
competition – of competitors entering the market
...
Absence of entry/exit barriers
(especially sunk costs) – increases threat
of entry
2
...
Perfect information
4
...

Point where AR = ATC called entry limit price – price which will limit new entry – normal profits
won’t provide incentive for other firms to get in

Good
1
...
Allocative and potentially productive efficiency
3
...
No supernormal profits made
2
...


Privatisation
When government run organisations or state run activity is sold to the private sector
...
Lead to increase in allocative efficiency
a
...
X inefficiency decreases
a
...
Efficiency incentive which drives dynamic
efficiency
a
...
W
...


1
...
Loss making services cut even if socially desirable
3
...
Private firms don’t take into account positive and negative externalities
Depends on:
1
...
Level of government regulation – high = more competitive markets , low = more monopolies /
oligopolies + regulation can be used to force firms to take externalities into account

Deregulation
When governments reduce legal barriers to entry in a given industry – incentivises more firms to enter –
promotes competition – promotes efficiency
...
More firms will increase consumer choice 
incentive for firms to be allocatively efficient
2
...
Great incentive for firms to
minimise costs to maximise profit
b
...
Waste is minimised
3
...
Profits, even if not supernormal,
can be reinvested in business
Disadvantages
1
...
Higher average costs
b
...
Economies of scale benefits lost
c
...
Formation of oligopolies and local monopolies
a
...
W
...


Depends on:
1
...
If oligopolies and monopolies fall, chances are in long run, contestability will fall – thus
failure of policy
2
...
If other barriers to entry are still very high, firms might not have the incentive to enter
the market
3
...
To regulate against anti-competitive behaviour to prevent oligopolies and monopolies
from forming

Cost Benefit Analysis (CBA)
Decision making tool accounting for the social costs (private & external) and the social benefits (private
& external) of a project over time, to establish a net present value
...




If net present value is positive, then funding the project is the most efficient – net benefit to
society
If it is negative, then funding the project would be allocatively inefficient – net cost to society

How it works
1
...
Value judgements made as to which costs/benefits to include
3
...
Some, such as negative externalities are difficult to put a monetary value on
4
...
E
...
if loss of lives expected during a project, weight that cost very highly
b
...
g
...
Discount rate used to attain NPV (NPVB – NPVC)  NPV = net present value
a
...
Sensitivity analysis conducted
a
...
g
...
If sensitivity analysis gives very close values, then this tells that the CBA is
subject to lots of different assumptions and forecasts – makes you think twice
about going ahead with the project
...
Identification – how can you identify all the costs and benefits – what if you didn’t include some
of them
2
...
Appropriate discount rate – a slightly wrong discount rate can alter NPV value significantly
4
...
g
...
Cost – large (opportunity) costs
6
...
Subjectivity of weights/probabilities – are they appropriate



---