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Unit 3 Economics
Business Economics
Ross Bateman
Definitions
Evaluation

Unit Content:
3
...
1 - The Firm: Objectives, Costs & Revenues
The Objectives of Firms
Diminishing Returns, Product, Costs, Revenue & Profit
Returns to Scale & Economies of Scale
3
...
2 - Competitive Markets
Perfect Competition
3
...
3 - Concentrated Markets
Imperfect Competition / Oligopoly
Monopoly
Price Discrimination
Growth of Firms
Economic Welfare & Efficiency
Contestable Markets
3
...
4 - The Labour Market
Demand for & Supply of Labour
Determination of Wage Rates & Employment
Trade Unions & Monopsony
Minimum Wage
Wage Discrimination
Distribution of Income & Wealth
3
...
5 - Government Intervention in the Market
Market Failure
Government Failure
Competition Policy
Privatisation & Nationalisation
Regulation & Deregulation
Equity & Poverty

Unit 3 - Business Economics

Cost-Benefit Analysis (CBA)
Government Policies for Market Failure

3
...
1 - The Firm: Objectives, Costs & Revenues
The Objectives of Firms
Profit is where total revenue exceeds total cost
...

Profit Maximisation = Marginal Costs = Marginal Revenue, MC = MR
...

❖ Higher profit for a firm = Dividends, higher wages, R&D
...
Owners want
to maximise profit, whereas managers have less incentive to maximise profit because
their dividends are less than the owners
...

❖ Sales Maximisation: Helps to increase market share for a firm
...

❖ Growth Maximisation: Involves mergers and takeovers
...


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Unit 3 - Business Economics

Diminishing Returns, Product, Costs,
Revenue & Profit

Diminishing Returns

The concept of diminishing returns is a short-run
concept whereby the level of benefits or profits
gained is less than the money or energy invested
...

Short-run is defined as the time in which at least 1
of the factors of production is fixed
...

❖ Marginal Cost = The additional cost of an
extra unit of output
...

❖ Normal Profit = Where costs = revenue
...

❖ Abnormal Profit = Profit in excess of normal profit
...

❖ In an economy, profit is used to allocate resources, reward entrepreneurs, as a source
of finance for firms, and an incentive to reduce inefficiency
...

❖ The long-run is defined as when none of the factors of production are fixed
...

❖ Decreasing Returns to Scale = Occurs when the % change in output is less than the %
change in inputs
...

Returns to Scale & Economies of Scale

3
...
2 - Competitive Markets
Perfect Competition

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Unit 3 - Business Economics

SR: Perfect Competition

SR: Perfect Competition

LR: Perfect Competition

LR: Perfect Competition

Perfect Competition = A market structure in which there are a large number of buyers and
sellers selling a homogeneous product, in a market with no barriers to entry or exit
...

❖ Perfectly Competitive firms make normal profit in the long-run and abnormal profits
and losses in the short-run
...

❖ Equal consumer and producer

❖ Why should firms finance R&D when
there is perfect knowledge? Other
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Unit 3 - Business Economics

Perfect Competition Economic
Welfare

surplus, meaning good consumer
welfare
...

❖ Equitable that consumers pay a price
reflecting cost of producing the
goods
...
Lack of R&D
...

❖ No economies of scale to exploit
...

❖ Allocative and productive efficiency
...

Only form of competition existing in markets of
perfect competition is cost-cutting competition
...

Examples of PC: Agriculture, FOREX
...
3
...
Each firm possesses an
element of uniqueness, competing for the same customers
...

❖ Concentration Ratio = The proportion of the market share held by the dominant
firms
...


Oligopoly example: Tesco, Asda, Morrison’s, Sainsbury’s, Waitrose
...


Competitive Oligopoly

A Competitive Oligopoly is one where firms
pursue an independent strategy and compete
with each other but the firms are
interdependent
...

❖ Elastic demand = no firms follow = loss
...

In a competitive oligopoly it’s best for prices to
remain sticky
...

Oligopolies compete using price strategies:
❖ Predatory pricing: Selling such a low price that competitor cannot meet, forcing
them out of the market
...

❖ Price leadership: Firm that is leader of product market determines price
...

❖ Joint product development, reduced market uncertainty: raised consumer welfare
...

3 types of collusion:
❖ Overt = Open and public agreement to collude
...

❖ Tacit = Firms act together, but there is no formal / informal agreement
...

Oligopolistic firms realise that price war is self-defeating for all firms - firms may agree to
indulge in non-price competition: Marketing, Product Differentiation & Design, and
competing on quality
...
The monopoly restricts
output and raises prices, generating abnormal
profits
...
(If you have
40% or more)

Monopoly

There are very high barriers to entry in monopolies that’s how the monopolies abnormal profits are
protected
...

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Unit 3 - Business Economics

Sources of monopoly power:
❖ Natural monopoly: Only room for one firm benefiting to the full from economies of
scale
...

❖ Geographical causes: Only firm existing in an area
...

❖ Advertising: New firms cannot afford minimum level of advertising required and used
by incumbent firms = barrier to entry
...

Advantages of a Monopoly

Disadvantages of a Monopoly

Monopoly Productive Efficiency

❖ If EoS exist, monopoly may be more
productively efficient than PC
...

❖ Dynamically efficient, profits protect
barriers to entry, R&D present
...


❖ Productively and allocatively
inefficient
...

❖ Restricted output, higher prices
...


In diagram, not room for more than one firm to benefit from full economies of scale
...

There is a loss of consumer surplus in a monopoly
...
If monopoly raises prices from P1 to P2, it gains
consumer surplus P1P2CD
...

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Unit 3 - Business Economics

Deadweight welfare loss represented by both
triangles
...


Monopoly Economic Welfare

Government intervention to correct monopolies:
Nationalisation, Regulation & Competition Policy
...

❖ Nationalisation is advantageous as government can make sure market is efficient,
and consumers are prevented from exploitation
...

Rate of return regulation can be used for monopolies, this limits price increases
...

❖ Disadvantages include danger of regulatory capture, where regulators become soft
on the firm and allow them to make abnormal profits, and also firms may not make
enough profit for investment
...

First Degree Price Discrimination
Customers prepared to pay more are charged a
higher price than those who are only willing to pay
a lower price
...
Firm charges different price for
every unit consumed
...

Third degree price discrimination: Charging
different price to different consumer groups, e
...

cinema goers
...

Conditions for firms to be able to price discriminate:
❖ Firm must be price maker with downward sloping demand
...

❖ Markets / consumer groups must have different elasticities of demand
...

❖ Positive externalities: improves social
welfare and equity to those who are
charged lower prices
...

❖ Inequitable: those who pay higher
prices may not be the poorest, e
...

OAP’s
...

❖ Growth = The process of increasing in size by generating more revenue by increased
sales
...

❖ Internal Growth: When a business expands existing operations
...
Innovation and creativity is central to organic growth
...

➢ Safer than external growth, maintains existing management style
...

❖ External Growth: Occurs when firms join together, either through mergers or
takeovers
...
g
...

■ Vertical: Firms merge at different stages of production, either vertically
forward or backward
...

■ Conglomerate: Firms merge with no obvious connection in order to
diversify, e
...
car producer and a travel agency
...

❖ Quick and fast
...


Disadvantages of External Growth
❖ Lack of competition, could result in a
private monopoly
...


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Unit 3 - Business Economics

Economic Welfare

Economic Welfare

Consumer surplus = derived whenever the price a
consumer actually pays is less than they are
prepared to pay
...

Contestable Markets
Contestable Markets are competitive markets in
which firms face real and potential competition
...

❖ Number of firms is not important, what matters is the absence of barriers to entry
and exit, and the level of sunk costs
...
They are a barrier to entry, lower the sunk costs = more
contestable the
market is
...

3 conditions must be evident for market contestability:
❖ Ability / legal right to use best available technology
...

❖ The relative absence of sunk costs
...
Possible when entry & exit costs are
low and when incumbent firms are charging high
prices relative to cost
...

❖ Productive Efficiency = where MC = AC
...

❖ Allocative Efficiency = where MC = AR
...

❖ X-Inefficiency = Where there's a lack of effective / real competition in a market or
industry meaning that average costs are higher than what they would be with
competition
...
Introduction of new technology and
working practises to reduce costs over time
...
Monopolies can be
dynamically efficient
...

Dynamic Efficiency

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Unit 3 - Business Economics

3
...
4 - The Labour Market
Demand for and Supply of Labour
Derived demand is demand for a good / service which is the consequence of the demand
for something else
...
If MRP of labour increases, demand for
labour increases as labour is worth more due to
increased productivity
...

Firms exercise the demand for labour, whereas
households are the supply for labour
...
g
...

❖ Rise in consumer demand for a product,
meaning increased demand for labour because labour is in derived demand
...
g
...

❖ Productivity (MRP): if output per worker
increases, this makes labour more
MRP of Labour
attractive
...

❖ MRP = Extra value of output arising from
hiring an additional labour unit
...

❖ MRP = MP x MR
...

❖ When there is a higher MC, the firm
employs fewer workers
...

❖ Economically Inactive = Percentage of population not in/seeking work
...

Labour supply curve is upward sloping because,
as wages rise, this creates an incentive for more
workers to work
...
Because it’s
the cost of adding an extra worker for the
employer
...

❖ Non-monetary factors: Convenience,
status, promotion prospects, job security
and working conditions
...

Factors influencing supply to a particular firm:
❖ Training: Can make job more attractive, more supply
...

❖ Unemployment: If low, hard to find skilled labour, less supply
...

❖ Wage: Higher wages, more attractive, more
supply
...
For then onwards,
people substitute work time for leisure time, as
they can work less hours for the same money
...

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Unit 3 - Business Economics

❖ Substitution effect: individuals work more hours as opportunity cost of leisure
increases
...


Economic Rent

Economic Rent: Payment received by factor of
production above that needed to keep it in its
present occupation
...

In a perfectly competitive labour market, there
will be many firms with perfect information
about wages and job conditions, firms offering
Perfectly Competitive Labour
Market

Perfectly Competitive Labour
Market

identical jobs
and many
workers with
same skills
...

In perfect competition, firms are wage takers, because low wages = no supply
...

Firm maximises profits by employing at Q1 where MRP = MC
...
They
want to raise wages, and they do this by limiting
supply of labour
...

In the diagram, (in a competitive market), the
trade union acts as the monopoly supply of
labour
...
If an
employer wishes to hire more labour than Q3, they would need to increase wages above
WR2
...

❖ However, trade unions can raise both employment and wages when they negotiate
for higher pay
...
Increased demand for
output creates increased demand for labour and results in higher pay and
employment
...

Monopsonies are wage makers
...
With a
monopson, if they are not influenced by a trade
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Unit 3 - Business Economics

union, they pay wage where MRP = MCL
...


Finally, you can also have the
introduction of a trade union within a
monopsonistic market
...

Then, W1 and Q1 are monopsony
wages with no trade unions in place
...

The new ACL (LSC) is WR2XS
...
This is
because the monopsonist must offer a
higher wage in order to persuade additional workers to supply labour
...
Upward
sloping line ZV shows MCL of increasing employment above L2
...


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Unit 3 - Business Economics

Minimum Wage
National Minimum Wage: Minimum wage rate that
must, by law, be paid to employees
...

❖ The idea is that the poorest people are paid
more, reducing the gap between the rich and
the poor, and reducing relative poverty
...

❖ However, the introduction of a minimum
wage could mean firms have less funds to
use to innovate, cost-push inflation as firms costs of production rise and increasing
unemployment could occur due to firms reducing the number of workers they
employ because of having to pay them higher wages
...

❖ Elastic supply: When firms raise wage, it will get a lot more people applying
...

Reasons for wage differentials:
❖ Relative Bargaining Power = Trade Unions good at increasing wage
...

❖ Esteem = Respected
...
Also, people discriminate on the basis of
ethnic origin
...

There are 2 types of discrimination, positive and negative:
❖ Positive discrimination is where groups of workers are treated more favourably than
others, this type of discrimination can be good because it offsets negative, but it’s
bad because it is inequitable
...

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Unit 3 - Business Economics

Distribution of Income and Wealth
❖ Wealth = A stock of valuable assets
...

❖ Income = A flow of money to a factor of production
...

Distribution of Income & Wealth = How income is shared out between the factors of
production, and how wealth is shared out between the population
...

❖ Non-marketable Wealth = Wealth specific to a person, can’t be transferred
...


Wealth
Sources: Inheritance (assets accumulated
over generations), Saving (over long-term),
Entrepreneurship (Self-made wealth) &
Chance
...


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Unit 3 - Business Economics

Government policies to redistribute income:
❖ Progressive Taxation: More taxation paid as
income increases
...

Therefore, causes unemployment
...
Encourages a person's
assets to be invested, otherwise they will be
taxed
...


The Laffer Curve

Trickle-down Effect = The highly wealthy contribute to the good of society
...
3
...

Complete and Partial market failure, complete results in a missing market
...

Causes of market failure:
❖ Negative Externalities (Production / Consumption)
❖ Positive Externalities (Production / Consumption)
❖ Public Goods
❖ Merit & Demerit Goods
❖ Income Inequality
❖ Information Failure
❖ Monopolies
❖ Immobility of Factors of Production
Private Goods = Excludable, Rivalry, Rejectable
...

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Unit 3 - Business Economics

The difference between a pure public good and a quasi public good is that a pure public
good is associated with the free-rider problem
...

Absence of property rights & imperfect information can also lead to market failure:
❖ Imperfect information leads to market failure as people make poor decisions (overconsuming demerit goods and under consuming merit goods) due to not possessing
the relevant info, some even ignore the social & private costs / benefits
...
Common
property resources are free to use because it’s too expensive or physically impossible
to establish legal boundaries over them
...


Negative Externalities (Production
& Consumption)

Positive Externalities (Production
& Consumption)

Public Goods

Merit Goods

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Unit 3 - Business Economics

Demerit Goods

There are 4 types of environmental market failure:
❖ Resource Depletion: Negative externalities affecting the future generations as the
3rd party
...

❖ Public Good aspects of the environment: Air is public good, no incentive to look after
polluted air
...
g
...

There are 2 interventions used to correct environmental market failure: Tax & Tradeable
Pollution Permits:
❖ Tax output of industrialised nations and use the revenue to compensate citizens for
revenue loss (tax hypothecation)
...

➢ Incentivises firms to reduce emissions and encourages polluter pays principle
...

Environmental market failure has negative externalities (negative third party effects)
because nobody owns the environment, and distributional effects (global warming affects
those in LEDC’s more through flooding and droughts)
...

❖ Policy Myopia = Government act in the short-term with elections in mind to stay in
power, they ignore the long term effects of policies
...

❖ Law of Unintended Consequences = Effects will be unleashed which the policymakers would not have initially anticipated
...

❖ Regulatory Capture = Regulatory agencies created by government can be ‘captured’
by the industries or firms they are intended to oversee or regulate
...


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Unit 3 - Business Economics

Competition Policy
Competition Policy is government policies to prevent and reduce the abuse of monopoly
power, they are intended to make goods markets more competitive
...
Enables exploitation
with higher profits at expense of consumers
...

❖ Abuse of Market Power = If a firm has more than 40% market share, it has market
power
...

❖ Some mergers may not be in the public interest and are investigated
...
They use these things to monitor anti-competitive business behaviour
...

Responses by the CMA:
❖ Monopoly Busting - Break up monopolies
...

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Unit 3 - Business Economics

❖

❖
❖

❖
❖

Immediately prevents the exploitation by monopolies, but no guarantee the new
firms won’t just collude again
...
Means firms can’t exploit consumers, rise in consumer surplus, but demand
will exceed supply and could lead to the use of black markets
...
Higher
government revenue to improve consumer welfare, no gain in consumer surplus
...
Protects consumers from being charged too high prices, but hard to
determine an acceptable fine for businesses
...

Public Ownership of Monopoly - Nationalised businesses act in public interest
...

Deregulation - Removes artificial barriers to entry to allow for increased competition
...

Investigation will take place if the merger leads to a SLC (Substantial Lessening of
Competition)
...
g
...

❖ Privatisation = Transfer of government owned assets to the private sector, e
...
Royal
Mail
...
g
...
Ultimately, the
taxpayer pays for the service
...
Creating internal markets, one part of state-owned enterprise charges a price
to another part of same enterprise for service it provides, e
...
education
...

❖ Deregulation = Removal of regulation from markets, promotes competition and
contestability & removes ‘red-tape’
...

However, monopolies may not be
more efficient
...
However, once sold, the
gov
...

❖ Lack of Political Interference =
Nationalised companies have political
pressure & may think in short-term
for elections
...

❖ Closure of loss making services =
Privatised businesses may cut off the
loss making services, loss of
consumer welfare consequently
...


Disadvantages of Nationalisation
❖ Inefficiency due to no profit motives
and no targets set by government
...

❖ Government focuses on increasing
welfare rather than profit
...


Regulation & Deregulation
❖ Regulation = Government legislation and laws in a particular market designed to
correct market failure
...


Advantages of Deregulation
❖ Increased Competition = Makes
market more contestable, removes
barriers to entry
...

This means they can spend
elsewhere
...


Disadvantages of Deregulation
❖ Unintended Consequences = Firms
may act more risky leading to missing
market / market failure
...

❖ May not work = Entry barriers like
technical knowledge are difficult to
remove, will take long time
...

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Unit 3 - Business Economics

Main incentive of deregulation ties in with the contestable market theory
...

Deregulation may be a method of regulatory capture, and agencies may act in the firm’s
best interest rather
than the public interest
...

Equality = Goods and services are distributed the
same, equally, concerned with quantity
...

There are 2 types of equity:
❖ Horizontal Equity = Fair treatment of people
whose circumstances are the same
...

2 ways of measuring equality: Lorenz Curve & Gini
Coefficient:
❖ Lorenz Curve shows the % of income earned
by the % of the population
...

❖ Gini Coefficient = Measures area between the Lorenz Curve and the line of perfect
equality as a ratio of total area under the line
...
Inequality can be useful in creating incentives, and thus efficiency, e
...

Absolute Poverty = Poverty below a set level, below $1/day
...

Poverty Trap = When individuals are no better off following a pay increase due to increasing
tax paid and withdrawing benefits
...
Pensions
do not rise in line with the standards of living
...
Recent cap on
unemployment benefits means even more poverty
...
The unwaged are
absolutely poor
...

❖ Framework:
1
...

2
...

3
...

a
...
MSC = MPC + MEC
4
...

5
...
(NET MSB = MSB - MSC)
6
...

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Unit 3 - Business Economics

Advantages of CBA
❖ Detailed research means that all
aspects are thoroughly research
before anything happens
...

❖ Mostly prevents unintended
consequences as so thoroughly done
...

❖ High administrative cost to perform a
CBA
...


❖ Evaluation of CBA = The value of the information from the CBA increases if:
➢ It’s conducted under an independent body
...

➢ If it states where assumptions have been made
...

❖ Regulation directly influences the quantity
of the externality that a firm or household
can generate
...
Quantity controls
would be more appropriate rather than
banning a good, e
...
pollution permits
...

Government calculates monetary value of
the negative externality
...
Polluter pays principle
...

❖ Regulation can make the generation of positive externalities compulsory
...

❖ Subsidies are money paid by the government to firms undertaking certain activities,
usually to make the good cheaper so consumption increases
...

❖ Public Goods
Best solutions are government provision and privatisation (contractualisation)
...
The government provides
the goods at zero price and then funds the provision of the goods through taxation
...
Also, if
government provides all public goods, they can benefit from economies of scale
...

Contractualisation involves putting services out to private tender, e
...
road cleaning
and waste disposal
...
Also, marketisation
can be used
...
g
...


❖ Income Inequality & Poverty
Best solutions are progressive taxation, transfers to the poor, minimum wage and training
and education schemes
...
This helps to redistribute income, not wealth
...

❖ Transfers to the poor = Income paid by the state to benefit recipients and financed
from taxation
...
g
...
Opportunity cost involved
...
Reduces poverty by reducing gap between rich and poor and increases
productivity (efficient wage theory)
...

❖ Training and education schemes may be introduced by the government aimed at low
income households, giving them better skills and making them more employable
...

❖ Information Failure
Best solution is improving information provision
...
Consumers either do not know about or ignore true costs and benefits
of their actions to themselves and society
...

❖ The CMA (Competition and Markets Authority) are in charge of regulating markets
and ensuring competition, and so would be the ones to enforce policies involving
monopolies and oligopolistic markets
...
If a monopoly is
nationalised, it will act in the public interest, and the government can invest and fund
the project
...

❖ Deregulation = Typically used for monopolies as it makes markets more competitive
and contestable
...
But governments have to monitor the
market and enforcement costs may be high, and may have unintended
consequences
...

❖ Environmental Market Failure
Best solutions are extending property rights, taxation & information provision
...

❖ Property rights confer legal ownership or control to a good
...

❖ By taxing the output of industrialised nations, the revenue can be used to
compensate citizens for their revenue loss from the environment
...


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