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UNIT 1: PRODUCTION AND ITS COSTS
Production is any economic activity that satisfies human wants
...

The long run is the period when all factor inputs are variable
...

Diseconomies of scale are the disadvantages of a firm increasing its scale or capacity which
lead to increasing long-run average costs
...

External diseconomies of scale are extra costs or disadvantages from outside economic forces
...
Therefore, as a variable factor of production is added to fixed factors of
production, the total product will increase, first at an increasing rate then at a decreasing rate
until eventually, total product falls
...


Fixed costs of production are the costs of production that do not vary as the level of output
changes
...
g
...


1

Variable costs of production are costs of production that vary directly with the level of output,
since more variable units are required to increase output
...
g
...


Total costs of production are the costs of production at any given level of output
...

Average Cost = Total Cost/Output

Marginal costs of production are the costs of producing an additional unit of output
...
MC is influenced by
variable costs since fixed costs are constant regardless of output
...
Marginal and average product curves rise
when marginal and average costs fall
...
The cost of producing the last unit rises
...


Breakeven point
This is the point at which a firm’s revenue just covers its costs of production
...
Knowing
its breakeven point, a business can work out how what volume of sales it needs to achieve to
cover its costs
...


3

The Long-Run Average Cost (LRAC) curve
This curve is U-shaped due to economies of scale, constant returns to scale and diseconomies
of scale
...
This is
depicted on the LRAC curve as the initial downward sloping part of the curve
...
The AC now remains constant even as the scale of production increases
and the level of output rises
...
This is what gives the LRAC curve its U-shape and is
illustrated below:

Internal Economies of Scale
These occur when average costs of production fall due to the growth in the scale of production
within a firm regardless of economic activities outside the firm
...
The main
internal economies of scale:
•

•

•

•

Technical economies- Larger firms can employ and combine more efficient specialised
machinery that should reduce the average costs of their production, giving them an advantage
over smaller firms because smaller firms cannot usually afford to employ such expensive but
highly productive units of capital
...
A more productive workforce, attained by splitting the production
process into many separate tasks, will reduce average costs
...
Also, larger firms can purchase their factor inputs on bulk at negotiated discount
prices
...
This will increase labour
productivity and reduce average costs
...


Internal Diseconomies of Scale
These occur when average costs of production increase due to the growth in the scale of
production within a firm regardless of economic activities outside the firm
...
The main
internal diseconomies of scale:
•

•
•
•

•
•

Managerial diseconomies- Monitoring the productivity of each worker in a large corporation is
both imperfect and costly
...
It is also
difficult to co-ordinate complicated production processes leading to break downs
...
Thus, industrial
relations may deteriorate and worker morale can suffer which reduces productivity
...

Increase in input costs- As a firm’s scale of production increases, so will its demand for
materials, labour, energy and transport
...
In such cases, firms might end up having to pay
more for some of their inputs
...
Control of outlying plants may become difficult
...


External Economies of Scale
These occur when average costs of production fall due to the growth of the size of the industry
in which the firm operates
...
Local colleges develop
courses of training geared to the particular needs of the industry
...
g
...
The
result is that firms, both large and small
...

Ancillary services- Ancillary industries are the firms which supply inputs to firms in a particular
industry
...
In
the UK, car manufacturing is concentrated in the Midlands, shoe manufacturing in North
Hampshire and more recently, computer software has been concentrated in the Thames Valley
...

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•

•

•
•

Commercial Facilities- Service industries like banking and insurance firms develop a special
knowledge of the needs of the industry in the areas they are located, leading to the provision of
specialised facilities
...

Co-operation- Regional specialisation encourages co-operation among firms
...
g
...
The
pottery firms in Stoke-on-Trent, the footwear firms in the East Midlands, and the cotton firms
in Lancashire have all set up research centres for their particular industries
...

Trade magazines- firms can take advantage of these to advertise cheaply and disseminate
information
...
g
...


External Diseconomies of Scale
These occur when average costs of production increase due to the growth of the size of the
industry in which the firm operates
...

Increased demand for raw materials may also bid up prices and cause costs to rise
...

Transportation costs may also rise because of increased congestion
...


Why has the significance of diseconomies of scale reduced?
•

Globalisation- Increased interdependence and trade between countries
...
UK firms can now access a
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•

•

•

•

•

•

worldwide market and as firms’ outputs increase, they can benefit from economies of scale
...
Businesses in the UK
can now take advantage of a vast pool of relatively cheap labour by either importing cheaper
labour into the UK or outsourcing production to low way economies both within and beyond
the EU
...
The improvements in technology, transport and communication that assist globalisation
have all impacted on firms’ costs
...
New internet-based companies have made significant inroads into the markets of
traditional firms in a variety of industries such as travel agencies, financial sevice providers and
gambling
...
Therefore, relatively small firms can now compete with large firms
without the need for expensive premises and associated high fixed costs
...
E-mailing is cheaper and quicker than
postal services and meetings can take place using video conferencing, hence, there has been a
consequential reduction in costs
...


Why do large firms exist?
Profit motive: This is probably the biggest reason why firms try to grow in size
...
However, when firms seek to grow, there is no guarantee that profits will increase
...

Motivations of managers and workers: Managers and workers may prefer to work for bigger
firms
...
However, worker morale may dictate that workers and managers
have little desire to see the firm grow as it would just increase their stress and responsibility
...

Economies of scale: A justification for many mergers, which lead to big increases in sizes of
firms
...
For example, the concentration of the airline and car industry because of the
economies of scale available
...
Despite the many
advantages of large scale production, there are a number of reasons why small firms continue
to survive
...
Consumers demand a wide variety of styles, patters
and designs
...
g
...
Firms in industries catering for such variety are
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•

•

•

•

•

confronted with the problem of short run and one-off types of production, therefore, they
cannot set up their capital and labour for specialised production
...
In such cases, the market for the products are likely
to be local
...
g
...

Personal services- Industries which provide a personal service are usually characterised by many
small firms
...
E
...
law, accountancy, architecture and hairdressing
...
Expensive sports cars, luxury
yachts and high-quality jewellery are examples of goods produced by small firms for very
restricted prestige markets
...
It is possible
for the industry’s total requirements of some particular component to be supplied by one
relatively small firm
...
E
...
farmers’ co-operatives allow farmers to obtain the benefits of bulk buying and the
collective ownership of large units of capitals
...

Initially, a firm is producing 300 units of output
...
In the short run, at least one factor input is fixed, and therefore, if the firm wishes to
increase output to 600 units the firm must move along the short run average costs curve to
point B
...
There could be an infinite number
of plant sizes and therefore an infinite number of SATC curves
...
Thus,
the LRAC curve is the envelope curve of the series of SRAC curves
...
This will occur on
the production possibility curve, where it is impossible to produce more goods without
producing fewer services
...
It is closely related to the concept of technical efficiency
...
e
...
An economy can
be productively efficient but not allocatively efficient
...
This is when the price of a product
equals the marginal cost of its production
...


•

Dynamic efficiency- This refers to efficiency over time, for example, a Ford factory in 1920
would be very efficient for the time period, but by comparison would now be inefficient
...


•

Pareto efficiency- This occurs when it is impossible to make one party better off without
making someone worse off
...
It is relate to
productive and allocative efficiency
...
Allocative- impossible to make someone better off without making someone else
worse off
...
Therefore, there is a net gain to society
...
Therefore, this is not a Pareto improvement
...


•

X inefficiency- This occurs when firms do not have incentives to cut costs, for example, a
monopoly which makes supernormal profits may have little incentive to get rid of surplus
labour
...
Also state control- a
nationalised firm owned by the government may face little or no incentive to try and make
profit
...
Examples: employing unnecessary
labour, lack of management control, and not finding the cheapest suppliers
...


Example Essay Questions
1
...
Critically examine the view that the advantages associated with large scale production
mean that small firms will become a thing of the past
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3
...

5
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7
...

9
...


11
...


13
...


- Same as number 1
Explain why the cost of supplying a litre of tap water is likely to be lower than the cost of
supplying a litre of bottled water
Evaluate the proposal to introduce water charges
Explain the relationship between a firm’s short run and long run average cost curves
- Define short run and long run
- Explain derivation of shape of AC curve
- Draw LRAC envelope curve
- Analyse diagram
Critically examine the view that firms can continue to grow without experiencing
diseconomies of scale
...

- Same as number 8
Explain the impact of economies and diseconomies of scale upon a firm’s long-run average
cost curve
- Same as number 6
Critically examine the view that advances in modern technology and improvements in
management techniques mean that firms can continue to grow without experiencing
diseconomies of scale
- Same as numbers 6 and 11
Explain the meaning of the terms short run and long run when referring to firms’ costs
Examine the factors which determine the shape of a firm’s long run average cost curve
- Same as 6,11 and 12
Evaluate the impact of the growth of internet usage and e-commerce on UK firms
- Same as 8 and 10

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UNIT 2: THE OBJECTIVES OF THE FIRM
The objectives of a firm are the goals which are set out by the people who lead or control the
organisation
...
This will usually mean that there will be higher
dividends for shareholders, more profit can be used to finance research and development,
the firm will be less vulnerable to takeover and workers will have higher salaries
...
In the
short run, as predicted by neo-classical theory of the firm, the main aim of private sector
business is to maximise profits
...

They point out that prices tend to be more stable than would be suggested by the theory
which claims that firms change output and price in accordance with changes in the MC and
MR
...
The assumption that firms will always aim to maximise profits
by equating marginal cost and marginal revenue lies at the core of the traditional
microeconomic analysis of firms’ behaviour and critics suggest that, most firms do not
equate MC and MR
...
This theory was developed in the 1950s by William Baumol
...
e
...
Shareholders
usually probably have no idea what maximum profits should be
...
This objective is usually favoured by
managers whose salaries are linked to sales revenue
...
A sales revenue maximising firm will expand output until MR is zero
and charge the highest price possible as indicated by the demand curve
...
If a firm pursues sales revenue
maximisation, it is likely to have a bigger share of the market than if it is profit maximised
...
e
...
For a firm, a higher market share will increase their
monopoly power and ability to be a price setter
...
The diagram below shows the output and price of a firm which wishes to maximise
sales subject to the constraint of making at least normal profits
...

Long run profit maximisation states that firms are more interested in long run profits than
short run profits and suggests that firms use cost plus pricing strategies
...
The price and therefore, profit aimed for, are based on the long run costs of
the firm
...
For example, by investing heavily in new capacity, firms may make a loss in the
short run to enable higher profits in the future
...
Changes in demand are met by changes
in output, not price
...

Managerial utility- In managerial theories of the firm, it is argued that there is a divorce of
ownership and control
...
Therefore, although shareholders wish to see profits maximised, managers,
as workers, will attempt to maximise their own rewards
...
For instance, a manager may be more
interested in which company car he or she will get, whether there is time to play gold on a
Wednesday afternoon, or whether there is an extra £1 million available for the budget, than
whether the firm has maximised its profits at the end of the financial year
...
Managers must be seen to be efficient enough
to justify their positions and salaries thus managers make enough profit to satisfy
shareholders
...
Managers also recognise that a reduction of
profits may have a negative effect on the company’s share price
...


The Principal-Agent Problem
This occurs when the principal delegates an action to another individual (agent), but the principal
does not have full information about how the agent will behave
...
For example, a shareholder (principal) wants to maximise profits for his firm
...
However, due to agency costs, the shareholder
cannot fully know how hard the agent is working and to what the contract is being fulfilled
...

The principal-agent problem can lead to market failure because the agent pursues his own selfinterest rather than that of the principal and the business may be run inefficiently
...


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It can also cause adverse selection- poor choices based on asymmetric information
...
For example, a lazy worker gets
a job because the employer doesn’t know he is lazy
...
This is an example of a moral hazard
...
This encourages the banker to make risky investments
...
This has, in the past, led to major banking collapses, such as rogue trader Nick Leeson
and Barings Bank in 1995
...
Principals may be reluctant to enter into a contract at all for the fear
that they will not know what is going on
...
If a
mutually beneficial transaction doesn’t occur at all, this would be a significant welfare loss
...

Examples of the principal-agent problem: Shareholders and managers of a company, landlords
and tenants and sub-contracting your essay or other school work
...
The main
stakeholders of a business are the shareholders who own shares in the company, employees who
are workers employed by the company, customers who buy and use the products the firm
makes, suppliers who sell raw materials to the firm, the local are affected by the business and
the local environmental impact of the business
...
This might in turn, increase productivity
...
If suppliers go out of
business, firms will lose in the long run
...

Negative publicity, e
...
firms using child labour, can lead to boycotts of firms
...
The John Lewis partnership
is more like a co-operative where workers (members) are given a share in the profits
...
Public sector professions in the UK
include doctors, police, teachers and civil servants
...


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Profit incentive

Bureaucracy

Public Sector

Private Sector

Profit motive is often absent;
therefore, government bodies
have a greater tendency to be
overstaffed and inefficient
...


For political reasons, it is
sometimes more difficult to get rid
of surplus workers in the public
sector than the private sector, so
they are more likely to employ
surplus workers in unproductive
jobs
...


Crowding out

If the public sector grows, then this is reducing resources for the private
sector
...
Therefore, if government spending can be reduced, it
will free up resources for more efficient private sector growth and job
creation
...


Government
spending that
could
discourage
productivity

Some government spending can discourage productivity e
...
welfare
benefits can reduce the incentive to work and encourage economic
inactivity
...
g
...


Public goods

The government needs to provide
nearly all goods with the
characteristics of public goods e
...

street cleaning, military, police and
the judicial system
...


The government needs to
intervene, through public services
such as health and education
...


Goods with positive externalities will
be under-consumed in a free market
...


Merit goods
with positive
externalities

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Macroeconomic
stability

In a recession, public sector jobs
act as a stabilizer- limiting the rise
in unemployment
...
M
...


Private sector jobs are more volatile
regarding the economic cycle
...


Conclusion:
Both the public and private sector have a role to play
...
Reducing
the scope of government spending could create more private sector opportunities for
investment and job creation
...
Also, the private sector needs a
stable micro-economy which the government has a role to provide
...


15

UNIT 3: THE GROWTH OF FIRMS
Firms grow in different ways
...
In this case, the firm increases its
production and sales independently of the actions of other firms
...

External growth/Growth by integration is growth by joining with other firms by mergers or
acquisitions
...
Another term for this is amalgamation and it occurs when the Boards of
Directors of the two companies, with the support of their respective shareholders, agree to
merge their two companies
...
This may
be a hostile or voluntary acquisition
...
g
...
A
hostile acquisition bid occurs whenever one company attempts to acquire another without
the approval of the target company’s board of directors
...

- Backward vertical integration- This is when the merger impetus is towards the source of
supplies
...
It is often
carried out so that the firm may exercise a much greater control over the quality and quantity
of its supplies
...

- Forward vertical integration- This is when the movement is towards the market outlets
...
Reasons for this
include the desire to secure an adequate number of market outlets, raise the standards or
said outlets or a counter action if a major competitor has made a move to take over the
outlets
...
Apeejay grew tea in their Indian plantation and buying Typhoo
who blends and packages tea should result in benefits associated with forward vertical
integration
...
This is the most common type of
merger in recent years
...
g
...
This form of integration occurs for various reasons:
-

Market domination
Allows greater specialisation
Economies of scale
It may be a defensive move to counter expansion by rival firms
...


16

Conglomerate integration - The merger of firms which produce goods or services that are not
directly related to one another, i
...
the firms are from different industries and have no common
interest
...
g
...
Such mergers are
less common than they were in the 1960s and 1970s, and could occur for various reasons:
- Diversification of output to reduce the risks of trading
...
A steel
manufacturer, for instance, will do exceptionally well in a boom but will be hit hard in a
recession
...

- There may be a little scope for further growth in the markets for their existing products
...
Also, cheaper supplies (raw
materials for production), may become accessible
...
Furthermore, the
expansion of output in the case of horizontal integration offers potential for lower long run
average costs from a wide range of sources (technical, managerial, financial)
...
In the case of vertical
integration, cost savings are made through cutting out profit margins at intermediate stages of
production
...
The value of a brand name is included on the balance
sheet as an asset
...
Mergers, particularly horizontal mergers,
increase the firms’ market share and therefore increase their power to influence price
...
These factors help to spread risk
...

• Asset stripping- This is buying a company and selling it off in bits to make a profit
...


Problems caused by Integration
• Increased monopoly power may lead to consumer exploitation
...
The Leeds-Halifax merger in
1995, for example, resulted in the closure of some branches, particularly where the two
societies had branches near each other
...


17

UNIT 4: MEASURING MARKETS
Sales Volume Vs
...
E
...
if 200 pencils are sold for £2 each, then the sales
volume is 200 pencils
...
E
...
if 200 pencils are
sold for £2 each, then the sales value is £400
...
Calculated by:
• Taking a company’s sales revenue and dividing it by the total value of sales in that market
...

Why is it difficult to accurately measure market share and size?
• It is difficult to determine what market a firm belongs to
...
g
...
Streamlining firms into specific markets is difficult,
therefore it is difficult to accurately measure market share and size
...
To illustrate this, consider the likely market share for Marks and Spencer
...
This is because Marks and Spencer is
likely to sell significantly less groceries than firms such as ASDA
...

• Geographical boundaries- need to consider whether the market you are measuring is the local
market, the regional market or the national market
...
4%, its market share may be significantly larger in some
smaller geographical areas
...

• Measuring the market share of large companies such as Tesco is very difficult due to the sheer
volume of sales that need to be measured and the fact that it is a moving target
...
This is because a firm that produces in a market but has other sources of
income may grow not because of that market-related good, but another
...
g
...
Also, it is difficult to know why a market has grown
...
g
...

Also, is growth based on sales value or sales volume? Determining which to base growth
measurement on is difficult
...
Large number of buyers and sellers, none of which wield enough market power to influence
price
...
The large number of buyers and sellers act independently i
...

they do not collude
...
All firms produce a homogenous product- the products are identical and cannot be
distinguished between each other through advertising, branding or any other form of product
differentiation
...
Freedom of entry and exit- In the long run, there are no barriers to entry and exit of firms in the
market
...

4
...

5
...
Consumers are free to trade wherever they can get the lowest priceregardless of distance
...
Firms aim to maximise profits
...
The
market price of the product will then fall and supernormal profits competed away
...
This is the long run equilibrium position for a perfectly competitive
firm
...

Productive efficiency is achieved when production costs are minimised i
...
the firm produces on the
lowest point on the AC curve
...
Therefore,
a perfectly competitive firm is productively efficient in the long run
...
This is when resources are allocated and
distributed so that it would be impossible to reallocate or redistribute to make someone better off
without making someone else worse off
...
To maximise
profits, a perfectly competitive firm will produce where MC=MR
...


In the real world…
Perfect competition does not exist in the real world as there is no real-world industry which
possesses all the characteristics of the perfectly competitive market structure, however, there are
some markets that mostly imitate it e
...
the foreign exchange market, the market for agricultural
produce and the share market on the stock exchange
...
Although some foreign exchange platforms are
comparatively large, none of them wield significant market power
...
There is no difference between currency notes in
different foreign exchange stores
...
However, the
FCA [Financial Conduct Authority] started regulating the industry in 2009, which means that a
license is now required to open a foreign exchange business and the process is a lot more
convoluted than it was before
...
Since exchange rates do not vary at the same time, it is possible to say that consumers
in the foreign exchange market have perfect knowledge
...

Market for agricultural produce:
Many buyers and sellers, none of which can individually influence market price- There are many
small farmers and many purchasers of agricultural products
...

20

Homogenous products- Although there are differences in the quality of agricultural products and a
standardised grading of products, for practical purposes milk or gain that meet certain basic
standards are likely to be homogenous
...
However, farm produce can be packaged, branded and advertised- therefore enabling
discernment between the products of different farms
...

However, the capital required for efficient and advanced farming or licensing requirements could
be a barrier
...
g
...
However, this
knowledge cannot be described as perfect as perfect knowledge is unrealistic and unattainable
...

2
...

4
...


Many buyers and sellers, each relatively small
...

Firms are short run profit maximisers
...

Firms do not produce homogenous products- Although products are similar, there are
deliberate attempts to differentiate products usually through branding and advertisement
...
Firms are price makers as they each have weak elements of monopoly power
...
This will increase supply, reducing the demand for each firm,
causing a leftwards shift in their demand curves
...
The firm will produce where AC=AR because
competitive pressures mean that a firm can neither make a loss nor earn supernormal profits
...
A “double coincidence” will
thereby occur as the level of output will align with the points “MC=MR” and “AC=AR”
...

The firm is not producing at minimum AC because of advertising expenditure required for branding,
output is lower than minimum AC (not optimal output) because there are too many firms in the
industry
...

The firm is also not producing where P=MC, rather, where P>MC as the product is overpriced
...

However, it could be dynamically efficient as firms have profit to invest in research and
development
...


In the real world…
Monopolistic competition has been described as ‘perfect competition with a real-world face’
...
Examples are restaurants, clothing, Tv programmes and hairdressers
...
There are relatively low
barriers to entry in setting up a new restaurant
...
Product differentiation is a key element of the business
...
There are relatively low
barriers to entry in setting up a new clothing line
...

TV programmes – globalisation has increased the diversity of tv programmes from networks around
the world
...

However,
• Some firms will be better at brand differentiation and therefore, in the real world, they will be
able to make supernormal profit
...

• There is considerable overlap with oligopoly – except the model of monopolistic competition
assumes no barriers to entry
...
A new firm can’t easily capture the brand loyalty
...


22

Oligopoly
Main characteristics:
1
...

3
...


The market is dominated by a few large firms each with a large concentration ratio
...

Firms are price makers
Firms are interdependent- The decisions, outcomes of decisions and profit level will depend
on the decisions of other firms in the industry
...

5
...
Products may be differentiated- cars or newspapers (imperfect oligopoly) or homogenouscement or sugar (perfect oligopoly)
...
Price rigidity/stickiness
8
...
If a business raises price and others leave their prices constant, then we can expect quite a
large substitution effect making demand relatively price elastic
...

According to the CMA (Competition Markets Authority), an oligopolistic market is one which has a
4-firm concentration ratio more than 60%
...
However, they realise that it is unlikely that one
of their competitors will go out of business, and that if they are not careful, their attempts to
compete could backfire through the instigation of price wars, leading to lower profits all round
...
As a result, we often find a considerable level of price rigidity or
“stickiness” in oligopolistic markets as firms agree not to compete on price
...
With the original cost situation, the firm will produce where MC1=MR, output is
0X and charge price 0P
...
g
...
However, the firm will continue will produce output 0X for price 0P
...

The kink stays at the same price 0P because this is the price above which none of the
23

oligopolistic firms can go without losing customers
...
Profit maximising output is where MC=MR
...

The assumption is that firms in an oligopoly are looking to protect and maintain their market share
and that rival firms are unlikely to match another's price increase but may match a price fall i
...
rival
firms within an oligopoly react asymmetrically to a change in the price of another firm
...
Others will leave their prices constant and then, we can expect
quite a large substitution effect making demand relatively price elastic
...

On the other hand, the more inelastic part of the kinked demand curve illustrates a situation
whereby a business reduces its price but other firms follow suit
...
Cutting prices when demand is inelastic leads to a
fall in revenue with little or no effect on market share
...
The MR slopes twice as steeply as
the AR with a break in MR directly beneath the kink in the AR curve
...

24

Collusive behaviour in oligopolies
Collusion occurs when firms in an oligopoly work together to reduce uncertainty in the market
...
This is illegal in the UK and EU
...

Price fixing is where all firms in the market try and control supply to achieve a “monopoly” like
situation
...
This is most likely
when the market is dominated by a few large firms, demand is inelastic, market demand doesn’t
fluctuate and the output of each firm can easily be quantified
...

Tacit collusion is where companies are engaging in behaviours which minimise the response of
competitors
...


Non-collusive behaviour in oligopolies
When firms do not collude, they compete
...
This
refers to all forms of competition other than through the price mechanism to influence demand and
build brand recognition
...

Non- price competition can occur for various reasons:
• Oligopolistic firms may reject price competition because it can result in costly price wars and
where the cost structure of the industry is such that short term prices could be forced down to
very low levels, they engage in non-price competition
...
Thus, the best and
sometimes, only way to attract customers is to make the products different or brand them
differently
...
This is typical in the clothing industry; therefore, clothing retailers will
compete in these areas rather than price
...

• There is a possibility of collusion
...
This is a key feature of oligopolistic
industries
...
It is for this reason that oligopolistic firms are constantly considering the behaviour of their
competitors when making their own economic decisions
...

Government policies to deal with oligopolies
When the existence of oligopolies begins to have negative effects, the Competition and Market
Authority (CMA) is forced to evoke measures controlling their activities
...
g
...

- This leads to increased competition by encouraging firms to act competitively rather than
colluding whilst still maintaining existing economies of scale and with it all positive effects
of oligopolies (and act as a deterrent to other oligopolistic firms
...

- Agencies can prove to be overly zealous in their prosecution of innocent firms
...

• Forcibly breaking up oligopolies by means of privatisation (forcing firms to split into smaller
private ones) or nationalisation (In the past, BBC)
...
Can be good
(Nationalisation of National Grid) but also bad
...
E
...
US vs
...

Microsoft trying to split Internet Explorer from Windows
...

- Ultimately, any interference of the sort with the market mechanism will lead to a distortion
from the natural equilibrium point, for better or for worse
...
Any interference always prone to the law of unintended consequences
...
This includes the removal of red-tape costs and legal barriers to entry e
...
Royal Mail
revoked the status of legal monopoly
...
As a result, consumers benefit from all positive
effects of the former
...

However,
- A regulatory capture can occur
...

- Agencies can act overzealous and prevent mergers where they shouldn’t
26

Oligopolistic firms and Efficiency
Oligopolistic firms seek to profit maximise and we assume that rivals don’t react to price rises but
react to price falls
...

Depending on the cost and revenue situation of an oligopoly, it will either be productively efficient
but not allocatively efficient, or neither
...

Furthermore, some oligopolies are better off that way e
...
the airline industry
...


In the real world…
Common industries overshadowed by oligopolies are the Grocery Store/Supermarket Industry,
Cable Television Services, Entertainment Industries (Music and Film), Airline Industry, Mass Media,
Pharmaceuticals, Computer & Software Industry, Cellular Phone Services, Smart Phone and
Computer Operating Systems, Oil and Gas and the Auto Industry
...

Give relevant examples and relate to these points:
1
...

3
...

5
...


The market is dominated by a few large firms each with a large concentration ratio
...

Firms are price makers
Products may be differentiated- imperfect oligopoly or homogenous - perfect oligopoly
...
e
...
The legal definition of a monopoly, according to the CMA is when a firm has a
minimum of 25% of the share of the market
...
The industry is best suited to a single
supplier as this avoids the wasteful duplication of scarce resources
...

2
...

4
...
This
may be an inherent feature of the industry itself such as prohibitively high capital requirement or
significant economies of scale which may prevent small firms from effectively competing with
27

larger, well entrenched rivals
...

• Innocent barriers- These occur inevitably e
...
cost advantages
...

• Capital costs- Where existing firms are already operating on a vast scale, making use of
indivisible units of capital and enjoying extensive technical economies of scale, entry costs are
very high and only large firms can afford to pay them
...
g
...
High sunk costs represent a high cost of failure; therefore, they are a barrier
to entry
...

• Natural cost advantages- Producers possess superior/unique factors e
...
site or location that
reduce their costs
...

• Legal barriers- Patents give exclusive production rights for a given period to the inventor of a
certain product
...
This enables them to gain returns on their enormous research costs without the fear
of being copied by competitors
...
In some industries,
earning a license to produce is tedious and the licenses are rarely authorized
...
For example, in the case of retail development, the refusal of
planning permission for new outlets can create legal protection for existing suppliers
...
Advertising and brand names
with a high degree of customer loyalty may prove a difficult obstacle for new firms to overcome
...

• Brand proliferation- If existing firms provide a wide range of similar products but with slightly
different characteristics, new firms will find it harder to find a niche in the market
...

• Expertise- For example, firms may find it hard to break into the oil business because large
amounts of expertise are needed to compete with existing oil companies
...
For example, The De Beers Syndicate in South Africa enjoyed sole access to what was
almost the only land on which diamonds could be mined, although the syndicate’s dominance
has recently been threatened by new sources in Russia and Angola
...
g
...
Predatory pricing is
charging a lower price than competitors so that one or more of them will be driven out of the
market, then increasing the price again
...
Unless the new entrants have new
ideas or can exploit a new market segment, they are likely to fall
...
This involves deliberately setting low prices to deter potential rivals
...

• Barriers to exit- In some industries, there are significant costs when a firm decides to leave
...
The US steel industry was in this
position in the late 1990s as it was unable to shut inefficient plants down
...


Equilibrium position:
A monopolist will produce where MC=MR to maximise profits, at output 0X
...
The firm will earn supernormal
profits
...
Monopoly power is the ability to earn
long run supernormal profits
...
Firms will engage in price discrimination to increase the
revenue they receive for their goods and in turn, increase their profits
...

Conditions for price discrimination:
1
...
Perfectly
competitive firms are not able to practice price discrimination since they are price takers
...
Price discrimination requires the firm to be able to split the total market into distinct groups or
(in the case of perfect price discrimination) into individual consumers
...
Buyers in different markets must have different levels of willingness to pay as price
discrimination is only effective if the individual consumers or distinct groups have a different
willingness to pay for the product
...


29

4
...

Types of Price Discrimination
First degree price discrimination: First degree price discrimination (otherwise known as perfect
price discrimination) occurs when a firm charges each consumer the maximum price that he or she
is willing to pay for each unit
...
Perfect price discrimination is very difficult to practice because it requires the firm to have
perfect information on each customer’s willingness to pay
...
It is the job of the salesperson to
make a judgement about the likely maximum price that each consumer will be willing and able to
pay
...
This is illustrated in the diagrams below
...
As a result, the total revenue the firm receives is equal to the
shaded area CBQ1O
...


Second degree price discrimination: Second degree price discrimination involves establishing a
pricing structure based on the quantity of goods purchased, with those purchasing higher quantities
benefiting from lower prices
...
Examples of second degree price discrimination include
discounts for bulk energy use, variations in prices for different sized cereals boxes and supersized
portions at fast food restaurants
...
A price of P1 is charged if a consumer
purchases quantity Q1
...
The firm will not reduce price below P3 since this
price represents the marginal cost of production
...
By engaging in second degree price discrimination the firm can convert the
shaded area P1CFDEP3 from consumer surplus into additional revenue
...


30

Third degree price discrimination: Third degree price discrimination occurs when a firm separates
its customers into two or more distinct segments, with each segment having a different price
elasticity of demand
...
This is illustrated
in the diagrams below:

In the first diagram, the firm charges a common price of £5 to all consumers
...
If the firm can separate its
market into two distinct groups based on different price elasticities, then it should be able to earn
higher revenue
...

At a price of £6, 60 of the original 100 consumers will continue to purchase the product; therefore,
the firm will gain £360 revenue from this market segment
...
Therefore, the revenue received from this market
segment is equal to £320 (£4 X 80)
...


31

The impact of price discrimination on economic welfare:
Price discrimination is often criticised because it transfers welfare away from consumers toward
firms
...

However, price discrimination can also lead to some consumers, (those with relatively elastic
demand) paying a lower price
...
In some
cases, individuals, who would have previously been unable to consume the good, will be priced into
the market and would therefore, gain welfare
...

It could also be argued that since the firm can sell more goods by discriminating, it will have more
scope to exploit economies of scale
...

Furthermore, some economists point out that much of the criticism of price discrimination is based
on static analysis
...

Monopolies and Efficiency
The profit maximising monopolist produces where MC=MR
...
This is because a monopolist is the
sole supplier and therefore, wields enough market power to be a price maker
...
Scarce resources are also being wasted as
production is not occurring at the lowest average cost i
...
the monopolist is productively inefficient
...

Some economists also argue that if the merged firm becomes so powerful that it faces little
competition there will be no incentive to invest in research and development and therefore, it will
also reduce dynamic efficiency
...
The term is used to describe the process by which former
dominant companies or technologies are pushed out of the market by new
innovative and dynamic ideas or entrepreneurs
...

• Schumpeter was an economist of the Austrian School which advocated a laissez-faire approach
to economic policy
...

• Schumpeter argued that long-wave cycles were caused by a step change in technology or a
significant innovation
...


32

Consequently, “creative destruction" describes the process of industrial transformation, from a
competitive to a monopolistic market and then back to a competitive one
...


In the real world…
Monopolies do exist, as natural monopolies occur in industries where not even a single producer is
able to fully exploit the potential economies of scale
...
In such a situation, it is only economically practical to
have one supplier of the service
...
Having two or three gas mains would be a
wasteful duplication of resources
...

This generally occurs in industries where the fixed costs of production are so high that it is not
profitable for a second firm to enter and compete
...

2
...

4
...

Large pool of potential entrants
...

Incumbent firms are vulnerable to firms that come into the market, make the best of the
supernormal profits available, and then leave
...
Firms are short-run profit maximisers, producing where MC=MR
...
Goods may be homogenous or branded
...
Perfect knowledge in and of the industry exists
...
However, only
normal profits can be earned in the long run because there are no barriers to entry
...


Efficiency:
In the long run, firms in a contestable market must be productively efficient
...
This is
due to the freedom of entry and exit
...
They only earn normal
profits, so AC=AR (P)
...
Therefore, AR(P)=MC
...


In the real world…
The theory of contestable markets is often seen as an alternative to the traditional, Neo-classical,
theory of the firm
...


Price and Non-Price Competition
Price Competition exists when producers compete based on price; by developing different price
strategies to beat the competition
...

For example, Coca-Cola and Pepsi are close competitors, thus, they often engage in price wars
...

Non-price Competition focuses on the factors that affect demand other than the price of the
product
...
Thus,
producers focus on these factors to increase the sale of products
...


Pricing strategies available to firms with market power
Price discrimination- read notes on price discrimination
...
This works well when the firm
faces homogeneous demand for its product (i
...
when all consumers have similar demand for the
product)
...

Peak-load pricing- pricing strategy in which higher prices are charged during peak hours than during
off-peak
...


34

UNIT 6: COMPETITION POLICY
Benefits of competition to the economy
The competitiveness of British business is a key driver of innovation, productivity and the efficient
functioning of the modern economy
...

Conventional economic theory shows that firms that enjoy market power can deliberately maximise
their profits by raising prices and restricting production
...
All businesses need to re-evaluate their prices from time to time, and their
executives will naturally be more reluctant to raise their prices if they will as a result lose significant
business to competitors
...
e
...

A reduction in the number of competitors can have another pernicious effect as firms then fail to
reduce their prices when they could do so, because they know that such a reduction would quickly
be matched by their competitors
...


The CMA
The CMA is the UK's primary competition and consumer authority
...
From April 2014, it took over the functions
of the Competition Commission
...
They look at evidence of pricing behaviour and the
rates of return on capital employed to see if there is evidence of 'profiteering
...
When setting price caps, regulators need
to decide how much profit companies should be allowed to earn in exchange for the risks they are
asked to take
...
The regulator may also require that unprofitable
services are maintained in the wider public interest e
...
BT keeping phone booths open in rural
areas and inner cities; the Royal Mail is still required by law to provide a uniform delivery service at
least once a day to all postal addresses in the UK
Opening markets: The aim here is to encourage competition by removing or lowering barriers to
entry
...
A key task for the regulator is to fix a fair access price for firms wanting to
use the existing infrastructure
...
A good
example to use here is the attempt in the UK to introduce more competition into the banking
industry by encouraging the entry of challenger banks to compete against the large established
commercial banking businesses
...
Fear of action by OFT and other regulators may prevent anticompetitive behaviour (i
...

there will be a deterrent effect)
Protecting the public interest: The key role of competition authorities around the world including
the European Union is to protect the public interest, particularly against firms abusing their
dominant positions
...
For instance, in the summer of 2014, the Competition and Markets Authority (CMA)
recommended a full competition inquiry into UK retail banks claiming that the market for current
accounts was not sufficiently competitive to work in the consumers' interest
...
Dumping, where a company sells a product in a competitive market at a loss
...

2
...

3
...

4
...
g
...
Dividing territories, an agreement by two companies to stay out of each other's way and reduce
competition in the agreed-upon territories
...
Limit pricing, where the price is set by a monopolist at a level intended to discourage entry into a
market
...
Tying, where products that aren't naturally related must be purchased together
...
Resale price maintenance, where resellers are not allowed to set prices independently
...
Religious / minority group doctrine, where businesses must apply tribute to a significant
(normally religious) part of the community to engage in trade with that community
...
g
...
Absorption of a competitor or competing technology, where the powerful firm effectively coopts or swallows its competitor rather than see it either compete directly or be absorbed by
another firm
...
Subsidies from government which allow a firm to function without being profitable, giving them
an advantage over competition or effectively barring competition
12
...
Protectionism, tariffs and quotas which give firms insulation from competitive forces
14
...

15
...


36

Government intervention in market dominance and anti-competitive practices:
Privatisation
Benefits of privatisation
1
...
If you work for a government run industry, managers
do not usually share in any profits
...
Since privatisation, companies such as BT, and British
Airways have shown degrees of improved efficiency and higher profitability
...
Lack of political interference: It is argued governments make poor economic managers
...
For example, a
state enterprise may employ surplus workers which is inefficient
...
Therefore, stateowned enterprises often employ too many workers increasing inefficiency
...
Such short-term view may cause them to be unwilling
to invest in infrastructure improvements which will benefit the firm in the long term because they
are more concerned about projects that give a benefit before the election
...
Shareholders: It is argued that a private firm has pressure from shareholders to perform
efficiently
...
A state-owned firm
doesn’t have this pressure and so it is easier for them to be inefficient
...
Increased competition: Often privatisation of state-owned monopolies occurs alongside
deregulation – i
...
policies to allow more firms to enter the industry and increase the
competitiveness of the market
...
For example, there is now more competition in telecoms and
distribution of gas and electricity
...
E
...
there is no competition in tap water because it is a natural monopoly
...

Disadvantages of privatisation
1
...
For example, tap water has very significant fixed costs so there is no scope for
having competition amongst several firms
...
Therefore, it is better to
have a public monopoly rather than a private monopoly which can exploit the consumer
...
Public interest: There are many industries which perform an important public service, e
...
, health
care, education and public transport
...
For example, in the case of health care, it is feared privatising
health care would mean a greater priority is given to profit rather than patient care
...
When
doctors treat patients, they are unlikely to try harder if they get a bonus
...
Government loses out on potential dividends: Many of the privatised companies in the UK are
quite profitable
...

37

4
...
Such firms need regulating to prevent abuse of monopoly
power
...

5
...
This led to areas where it was unclear who had
responsibility
...
The existence of different rail companies has increased the complexity of rail tickets
...
Short-termism of firms: As well as the government being motivated by short term pressures, this
is something private firms may do as well
...
For example, the UK is suffering from a lack
of investment in new energy sources; the privatised companies are trying to make use of existing
plants rather than invest in new ones
...
An industry like telecoms is a typical industry
where the incentive of profit can help increase efficiency
...
It depends on the quality of
regulation
...


Government intervention in market dominance and anti-competitive practices:
Nationalisation
Benefits of nationalisation
1
...

2
...

3
...

4
...

5
...

6
...
g
...

7
...

Disadvantages of nationalisation
1
...

2
...

3
...

4
...

5
...
Lack of profit motive will reduce funds available for reinvestment, innovation and dynamic
efficiency
...
Decisions and strategies can be influences by elections and other political motives and not
necessarily efficiency or the country’s best interest

---