Print Econs Unit 3 Final

8/3/2019 Print Econs Unit 3 Final

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Objectives

What motivates a firm?

a) Directors and Managers

Shareholders in a PLC will elect directors to look after their interests in thecompany. Directors appoint managers to manage and run the company.Owners influence decisions through the Annual General Meeting (AGM)

b) The workersThey dont the power to run the company, but collectively that may be ableto influence decisions through the trade unions, which may exert influenceover wages (and therefore costs), job losses, health and safety.

c) The consumersThey can influence the work of businesses through their demand patterns, ifa firm fails to provide goods that consumers demand they will eventuallycease trading as in the case of Rover Cars in 2005.

Short-run profit maximisation

Shareholders will be motivated by maximising their profits from the company- dividends.

However, not all firms are able to operate at a profit; some will be faced withmaking a loss.

Long-run profit maximisation

Keynesian economists believe that firms will seek to maximise their long runrather than their short-run profits. Firms will use cost plus pricing - the priceof the product is worked out by calculating the AC, when the firm isoperating at full capacity and adding a mark-up.

Short-run profit maximisation suggests that firms adjust price and output inresponse to changes in market conditions. However, most economists agreethat rapid price changes may affect a firms position in the market.Consumers dislike rapid price adjustments, and often view price cuts a signsof desperation and distress.

A firm might continue to operate in the SR even if it were making a loss. The

management would hope to be able to turn the business around and makeprofits in the long run.

Managerial theories

Some managers would seek to maximise sales rather than profits. Its oftenthe case that increased sales go hand in hand with increased salaries for topexecutives.

Other managers are motivated by factors, such as high salaries, the numberof people under their control, the power they can yield over investmentdecisions and the availability of fringe benefits. This idea originates from the

concept that managers in large firms will have enough discretion to pursuepolicies giving them personally most satisfaction.


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However, profit remains a shareholders best measure of success. Managersand directors are prone to shareholder revolts, and may even get voted outof office. Managers will profit satisfice, in other words, satisfy the demands ofshareholders. Once those demands have been met, managers would be freeto maximise their own rewards from the company.

Profit maximisation

Basic assumption is that all businesses will seek to maximise their profits. Profit maximisation is MC=MR.

Oligopoly is the one to which the objective of profit maximisation seemsleast applicable. As a result, other theories have been developed.

They often dont because:-Lack of knowledge of MC and MR.-Difficulty in predicting appropriate response when demand conditionschange.

-Internal bureaucracy resulting in X inefficiency, slow organisationalresponse to external change.-Divorce of ownership and control.-Social and other pressures.

Revenue maximisation

Baumol proposed a model of the form based on the principle that theprimary objective of the managers of a firm is to maximise sales revenue.

Revenue maximisation is MR=0.

The primary season, however, is seen to be that the salaries and status of

managers are more closely linked to sales revenue growth than profitmaximisation.


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The model still recognises the need to make profits, but its a constraint onmanagerial behaviour rather than an objective.

Minimum level of profit is required to satisfy shareholders, hence revenuemay be maximised subject to achieving this minimum profit level.

Managers may seek to maximise sales revenue for a variety of reasons:

-Consumers would view the firm with falling sales in a less favourable light.-Financial institutions may be less willing to lend to a firm with falling sales.-Falling sales may result in reduction in staffing levels including managers.

Sales maximisation

Sales maximisation is AC=AR.

The model assumes a separation between management and ownership anda sales market with a low level of competitive activity. It is also assumed thatmanagers relate their salaries and statues to the size of the firm.

Any growth in the size of the firm enhances their salaries and status withinthe firm. They therefore see the growth of the firm as one of their majorobjectives.

On the other hand they fear takeovers by other firms as this may result in a

loss of status and scope for salary increases. Takeover attempts are deemedto result from a depressed share valuation below the market valuation asjudged by the firm considering the takeover.

The main source of growth, through internal growth and diversification,depends upon a high level of retained profits for re-investment, however thiscreates a dilemma because a high level of retention implies a low level ofdividend payments to shareholders, which reduces the market valuation ofthe company.

The management is faced with a trade off situation between the dividendpolicy and retained profits and must seek the optimal balance between the

two.

A growth maximising management might choose to increase the size of thefirm up to the point where AC=AR so the firm will have expanded up to thepoint where normal profits are being made.

To increase the size beyond this point would result in the making of losses. Sales revenue maximisation the level of output would be greater and the

price lower than the under profit maximisation. If the minimum profit constraint were in excess of normal profit, the level of

output would have to be reduced. When dividends are low the share prices are low and takeover attempts are

likely.


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The firm only makes normal profit when TR=TC. It makes maximum revenue when the TR curve is at its highest. It makes maximum profit when the gap between TR and TC is at its greatest.Profit maximisation to revenue maximisation

Behavioural theories

Behavioural theories focus on internal decisions making structure of the firm.The aim is to understand this decision-making process rather than try tomake predictions about price and output.

A firms management will attempt to set itself minimal standards ofachievement intended only to ensure the firms survival and a level of profit,which is acceptable to shareholders.

Management attempts to achieve an acceptable level of performance for anumber of operational goals. These goals reflect the objective of differentgroups in the coalition and frequently conflict.

Businesses have little knowledge of their marginal costs and are nottherefore in a position to make optimal price and output decisions necessaryfor profit maximising theories.

Growth of firms

Birth and growth firms

During recession, more people have the initiative to start businesses sinceemployment opportunities are more restricted. In growth periods, risingdemand creates new opportunities for businesses.


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Level of entrepreneurial talent in a country will also influence the number ofbusinesses created, this will be influenced by attitudes to risk taking andlevel of education.

Technological development can be a spur to innovation and businesses startup, as can government incentives. People can claim unemployment benefit

in the first year. F irms which do survive will aim to grow for a number of reasons:

-No cost advantage to being small.-Supplying specialist markets with non-standard production.-Personal attention is valued.-Supplying larger companies.-Bulk buying with other firms to gain economies of scale.-Large firms may like them because they may disguise restrictive practices.

Why do firms grow?

Increase market share: They become a dominant firm in an industry.Larger firms find it easier and cheaper to raise finance. Larger firms likely tohave more opportunity to influence price within the market.

Benefit from greater profits: Aims to maximise profits and they canachieve this through expansion. Increased profits benefit shareholders whoreceive larger dividends.

Increase sales:Through larger brand recognition and more sales outlets. Increase EOS: Firm is able to exploit their increased size. It drives down

LRAC and approaches the minimum point on the LRAC curve and move closerto productive efficiency.

Gain power: Prevent potential takeovers by larger predator businesses. However, an important constraint can be lack of access to capital in order to

fund expansion or a lack of demand for the product produced. Larger firmschoose not to grow if they fear investigation or regulation by governmentbodies.

Internal and external growth

Firms can grow internally by reinvesting profits or externally by mergers ortakeovers.

Diversification

Conglomerate merger: Firms who merge with a company in a differentindustry.

Diversification can enable a firm to grow when the market in which it iscurrently operating its saturated; it enables the company to spread its risk.

However, the company may know nothing about the market it is entering

which poses a significant risk and different skills may be required (synergy -bringing together 2 businesses and getting more than original parts)


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Horizontal integration

It occurs when firms merge who are in the same industry at the same stageof production.

It can reduce the number of competitors in the market, increase the firmsmarket power and enable it to achieve economies of scale e.g. throughrationalising management.

Buying established brands may be an attractive option and cheaper thandeveloping brands you to achieve organic growth.

Vertical integration

Occurs when firms merge in the same industry but at different stages ofproduction.

Backwards-vertical merger - Firm takes over another firm whos at a prior

stage of production. Forwards-vertical merger - Involve taking over a firmwho is operating at subsequent stage of production. Vertical mergers can enable rationalisation in the production process and

ensure supplies of raw materials or access to markets. Firms may deny market access to a competitor creating barriers to entry. By

providing direct access to the customer, firms may be in a position to betterunderstand and meet customer needs. There may be scope for somemarketing economies of scale.

Profits may increase by merging profit margins at each stage of production. Costs may decrease for e.g. it now has a guaranteed market and could

reduce sales force. Greater quality control over inputs may give a non-price advantage. However, disadvantages include an over-dependency on one market, a lack

of specialist knowledge in the new areas to improve efficiency and potentialfor diseconomies of scale e.g. managerial. The competition authorities mayinvestigate if barriers to entry have been erected or monopoly poweracquired. The firm may also face substantial costs in funding themerger/takeover, which may take many years of cost savings to recoup.

Alliances

Cooperation between companies for a joint venture. E.g. Star Alliance within

air transport creates a greater route network and more attractive air milesscheme than individual companies could achieve on their own.

It provides a competitive advantage over non-members.

Demergers

Large corporations have since been moving towards a focus on their coreactivities and therefore selling off some assets.

Demergers can occur if a firm feels it is suffering from diseconomies of scale. Firms may also demerge if they feel that some parts of the business do not

have any synergy with the core parts of the business, in other words, if they

do not bring any benefits to the whole organisation.


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Firms may demerge in order to raise finance to invest in their core activitiesor to reduce their debt servicing costs.

Revenue

Price Demand Total RevenueMarginal RevenueAverage Revenue10 0 0 0 09 1 9 9 98 2 16 7 87 3 21 5 76 4 24 3 65 5 25 1 54 6 24 -1 43 7 21 -3 32 8 16 -5 21 9 9 -7 1

A positive MR, a decrease in the price results in an increase in revenue,hence elastic ped.

A negative MR, a decrease in the price results in a decrease in revenue,hence inelastic ped.

When MR=0, ped = -1.

Marginal revenue

The addition to TR of selling one more unit of output. The MR curve starts in the same place as the AR curve and crosses the x-

axis halfway between the origin and the point which AR would touch the x-axis.

Average revenue

AR = Total revenue/Quantity The revenue per unit sold.

Total revenue

TR = Price X Quantity It can also be found by the area under the marginal revenue curve.


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As the demand curve slopes downwards, price has to be reduced in order tosell more of a product, as a result, total revenue doesnt rise indefinitely.

When MR is positive, TR is rising. When MR is negative, TR is falling. The TR curve starts at the origin; since revenue is 0 when quantity sold is 0.

Deriving AR and MR from the TR curve

MR is shown by the gradient of TR, AR is shown by the gradient of the ray tothe point under consideration.

Short run

Short run: Period of time when one factor of input to the production processis fixed. Labour and raw materials are variable inputs. Capital is a fixed input. In the short run, a firm can only increase its output by combining increasing

qualities of a variable factor with a certain amount of fixed factor.

Marginal product

Marginal product: The addition to output produced by an extra unit ofoutput.

Marginal product: Change in total output/Change in the level of inputs


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Law of diminishing marginal returns

The law of diminishing returns states that as increasing quantities of avariable input are combined with a fixed input, the marginal product of thatvariable input will decline.

Average product

Average product:The quantity of output per unit of input. Average product: Total product/Number of workers Average product tells you how much on average each of the current workers

produce.

What if a firm can sell as much of its product as it wants withoutlowering the price?

Demand would be perfectly elastic at the ruling market price. Since the firm does not have to lower price to increase demand, then

marginal revenue will be constant and the same as the market price.

Costs

Total cost (TC)

Total cost is the cost of all resources necessary to produce any particularlevel of output.

Total cost always rises with output because to obtain more output requiresmore input i.e. factors of production - land, labour, capital and enterprise.

TC = FC + VC

Fixed cost (FC)

Fixed costs are also called indirect costs. Costs that do not vary with output. The costs remain constant whether the firm is producing or not e.g. rent. Such costs have to be paid even when output is zero.Variable cost (VC)

Variable costs are also called direct costs. As a firm produces more output, so it needs more labour, raw materials and

power. Variable costs are those, which vary with output. They are zero when output is zero and rise directly with output.


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Average cost (AC)

Average cost is the total cost divided by the number of units of thecommodity produced.

It is the cost per unit of output. AC= AFC + AVC.

Average total cost (ATC or AC)

AC = TC/Q The curve is described as elongated U shape. Optimum level of output - the most efficient level of output - is where ATC is

at minimum.

Average fixed costs (AFC)

AFC = FC/Q The curve declines continuously with output in the short run as fixed costs

are spread over a greater number of units of output. Fixed cost is positive so never touches the quantity axis.

Average variable costs (AVC)

AVC = VC/Q The curve falls initially then rises due to the operation of the law of

diminishing returns.


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Returns to scale

Increasing returns to scale: When a proportionate increase in all factorsof production leads to a more than proportionate increase in output.

Decreasing returns to scale: When a proportionate increase in all factorsof production leads to a less than proportionate increase in output. Constant returns to scale: When a proportionate increase in all factors of

production leads to a proportionate increase in output.

Economies of scale

Economies of scale: A fall in the long run average cost (LRAC) of abusiness as a result of an increase in size (unit cost decrease)

Diminishing marginal unit cost - Each extra unit we produce cost us less. Internal economies of scale: Falling average costs of production which

occur in the long-run as a firm increases its scale of production, they occurindependently of what is happening elsewhere in the industry (e.g. labourspecialising)

External economies of scale: Rising average costs of production whichoccur in the long-run as a firm increases its scale of production, they occurindependently of what is happening elsewhere in the industry (e.g. bulkbuying)

Rationalisation: Consolidating organisational structural to increaseeconomic efficiency and lay off redundancies.

As the industry grows, other businesses set up to service the industry, whichcan result in lower costs e.g. locating near to the industry and reducing

transport costs. In the long run no factors of production are fixed so LRAC is made up from

lots of SRAC. Internal and diseconomies of scale cause movements along the LRAC curve,

whereas external economies and diseconomies of scale cause the wholeLRAC curve to shift.

Industrial economies of scale

Increased specialisation

The production of larger outputs gives firms greater opportunities to applythe principles of division of labour and specialisation.

In the larger firm the production process can be broken down into manymore separate operations, workers can be employed on more specialisedtasks and the continuous use of highly specialised equipment becomespossible.

This will lead to higher productivity and lower costs per unit of output.

Indivisibility

Some types of capital equipment can only be employed efficiently in units of

a minimum size, and this minimum may well be too large for the small firms.


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More generally the lower limit is an economic one: smaller versions of theequipment could be made but their usefulness would not justify their cost.

Such indivisibility means that firms with small outputs cannot takeadvantage of some highly specialised equipment.

Stock economies

A large plant can operate with smaller stocks in proportion to sales than thesmaller firm.

Variations in orders from individual customers and unexpected changes incustomers demands will tend to offset each other when total sales are verylarge.

Costs per unit will be lower as a result.

Firms economies of scale

Technical

A research department must be of a certain size in order to work effectively. To the small firm this minimum effective size may represent a level of

expenditure too large to justify any possible returns. The large firms, the expenditure may be relatively small because the cost is

spread over a large output, allowing the firm to invest more heavily in R&D. This is important in those industries where the rate of change is rapid and

these sectors of the economy tend to be dominated by giant firms.

Their growth leads to greater research efforts, which lead to thedevelopment of new products and the establishment of new sources ofcompetitive advantage.

M arketing economies

The larger the firm, the more likely it is to be able to buy its inputs in bulk.Bulk buying enables the large enterprise to negotiate discounts fromsuppliers and be able to dictate its requirements with regard to quality anddelivery much more effectively than the smaller firm. By placing large ordersfor particular lines bulk buyers also enable suppliers to take advantage of

long runs - this will reduce the cost of supplies. The large firm will be able to employ specialist buyers. Expert buyers have

the knowledge and skill that enables them to buy the right materials at theright time at the right price.

The selling costs per unit will generally be much lower. In selling, the largerfirm can afford to employ experts whose specialised skills can give it greateconomic advantages.

Packaging costs per unit will be lower in larger firms.

Managerial economies


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The number of managers needed by a firm does not normally increase at thesame rate as output if the firms output doubles this does not mean it needstwice as many managers. This lowers the cost of management per unit.

Workers in small firms may have to undertake a range of tasks but as a firmgrows it is more likely to be able to appoint managers to specialise in

particular areas and to be able to afford to recruit experienced specialists.This can lead to better decision-making and increased efficiency.

In large firms, specialist managers can be fully utilised, but it is doubtful f thesmaller firm could find enough specialised work to keep them fully occupied.

Risk-bearing economies

Many large firms are able to reduce the risks of trading by means of a policyof diversification. They manufacture either a variety of models of a particularproduct or a variety of products.

A fall in demand for any one of its products may not mean serious trouble forthe firm; it may well be cancelled out by a rise in demand for one or more ofthe other products.

A small firm is likely to be specialising on one product, any fall in demand forwhich may have serious consequences. Small firm with a restricted market ismore vulnerable to changes in market conditions.

The larger firm is likely to have a diversified market structure, selling in anumber of different regions or countries.

In the national market, demand fluctuations between regions may offset oneanother; a sudden fall in demand in the home market might be balanced bya rise in the demand overseas. As a result, demand is more stable andpredictable and the firm odes not need to hold as much stock for thepurpose of meeting unforeseen increasing in demand this reducesstockholding costs.

Financial economies

The large firm is well known and has several financial advantages. It makes

them a more credit-worthy borrower. Its greater selling potential and largerassets provide the lenders with greater security and make it possible forthem to provide loans at lower rates of interest than would be charged to thesmaller firm.

The larger firm has more access to finance and it may approach a widevariety of other financial institutions as well as taking advantage of thehighly developed market in the issuing of new shares and debentures.

Smaller firms will have to pay a higher risk premium to cover the great riskof bankruptcy.

Government bond is when you lend money to the government. Corporate bond is when you lend to businesses.

Diseconomies of scale


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Diseconomies of scale occur when a firm becomes too large and its long rununit costs increases. E.g. it may experience managerial problems such aspoor labour relations.

External diseconomies of scale: Rising costs that arise not from an

increase in the size of the firm itself but from an increase in the size of theindustry in which the firm operates.

Internal diseconomies of scale

Management problems

1) Coordination: Large organisations must be subdivided into many specialistdepartments. As these departments multiply and grow in size, the task ofcoordinating their activities becomes more and more difficult. Efficiency islikely to fall as a result.

2) Control: Management consists of two basic activities - the taking ofdecisions and seeing that these decisions are carried out. This latter functionis that of control. The large firm usually has an impressive hierarchy ofauthority, the problem of seeing that everyone is doing what they aresupposed to be doing, and doing it well is a very difficult task. Efficiency islikely to fall as a result.

3) Communication: The transfer of information and commerce is a two-wayprocess. Subordinates must be able to feed back their difficulties andproblems. There must not only be a vertical line of communication,information must also move laterally, because one section of the firm mustknow what the other sections are doing. Keeping everyone informed of what

is required of them and of what is happening elsewhere in the firm becomesincreasingly difficult as a firm grows in size. Slower and less effectivecommunication leads to a reduction in efficiency.

4) Motivation:The attitude of workers to management is of critical importanceto the efficient operation of the enterprise, and the cultivation of a spirit ofwilling co-operation appears to become more and more difficult as the firmbecomes larger. It is not easy to make any individual worker in a labour forceof thousands feel that they are an important part of the firm and people lowdown the pyramid of control often lack an identification of interest with thefirm and regard it with apathy and hostility. As the gap between the top andbottom grows, employees may increasingly feel alienated. Less motivatedworkers will be less productive and leading to a rise in unit costs.

Prices of inputs

As the scale of production increases, the firm will increase its demands formaterials, labour, energy and transport. It may be difficult to obtainincreased supplies of some of these factors. In such cases a firm attemptingto increase the scale of its production may find itself bidding up the prices ofsome of its inputs, leading to an increase in costs per unit of output.

External economies of scale


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1) Labour: The concentration of similar firms in any one area leads to thecreation of a local labour force skilled in the various techniques used in theindustry. Local schools or colleges may develop special courses or vocationaltraining geared to the particular needs of the industry, thereby reducingfirms training costs.

2) Disintegration: When an industry is heavily localised there is a tendencyfor individual firms to specialise in a single process or in the manufacture ofa single component. This development allows firms collectively to achievemany of the economies of scale. Each individual firm may obtain itscomponents and other requirements at relatively low cost because theypurchase in bulk for the purpose of mass production for the whole industry.

3) Cooperation: Regional specialisation encourages cooperation andcollaboration among the firms. Research centres may be established as jointventures by the firms in heavily localised industries. Cost per unit is likely tofall as a result of such activity.

4) Specialised markets: When an industry is large enough specialised placesand facilities to bring buyers and sellers into contact may be developed.

External diseconomies of scale

1) Labour shortages: A shortage of labour with appropriate skills maydevelop so that firms in this industry may find themselves bidding up wagesas they try to attract more labour.

2) Raw material prices: Increase demand for raw materials bid up prices andcosts rise.

3) Land prices: If the industry is heavily localised, land for expansion willbecome increasingly scarce and hence more expensive both to purchase andto rent.

4) Transport costs: Transport costs may also rise because of increasedcongestion in the local area caused by the development of the industry.

Other reasons why the LRAC curve might shift

Raw materials: If the costs of raw materials required in the industry rosethen there would be a shift upward in the LRAC curve. If the raw materialsfell in price, the LRAC curve would shift downwards.

Wage costs: A fall in the wage rates in the industry would reduce firmscosts and lead to a downward shift in the LRAC curve, while a rise in wage

rates would increase firms costs and cause the LRAC curve to shift upwards. Taxation: If the government imposes a tax upon industry, costs will rise,shifting the LRAC curve of each firm upwards.

Technology: The LRAC curve is drawn on the assumption that the state oftechnology remains constant. The introduction of new technology, which ismore efficient than the old, will reduce average costs and push the LRACcurve downwards.

Productive and allocative efficiency

Productive efficiency


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Productive efficiency occurs if it produces at the minimum of the AC curve orMC=AC.

Only long run perfect competition achieves productive efficiency.

However, in some cases, monopoly firms can make substantial economies ofscale. This results in them producing on a lower AC than the perfectlycompetitive firm.

Thus, despite being the perfectly competitive firm being productivelyefficient, it is not able to achieve the same low level of AC as the monopoly. An economy is productively efficient when it is operating on its PPF.

Allocative efficiency

Allocative efficiency is achieved when p=MC (welfare maximisation point) Perfect competition achieves allocative efficiency, in both short run and long

run.


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In industries which are natural monopolies where the minimum efficientscale is beyond the market demand curve, there are problems in pursuing ap=MC strategy. If the firm sets p=MC then it will make a loss, since AR(price) is below AC and lead to subnormal profits.

Governments may not allow natural monopolies to pursuit a profit

maximising strategy, they may nationalise the industry and operate a two-part tariff. One part of the tariff will set a price equal to marginal cost, thesecond part will be fixed access charge which will enable the industry toavoid a loss. The system was criticised as it encouraged X-inefficiency andmany monopolies were privatised with regulators to prevent abuse ofmonopoly power.

Dynamic efficiency

Dynamic efficiency occurs when resources are allocated efficiently over aperiod of time.

A lack of dynamic efficiency occurs when firms fail to take into account theentire long term costs and benefits of an action. Where benefits areuncertain over long periods of time, firms may choose to ignore them, whichmay result in under-investment.

X-inefficiency

X-Inefficiency decreases the minimisation of cost that occurs under theconditions of competition.

It is argued that it is a necessary corollary of profit maximisation that a firmachieves X-inefficiency. However, under conditions of monopoly or oligopoly

the firm is protected from competition and the firm may be under pressureto be X-inefficiency. It this is so it will lead to an upward shirt in the costcurves that would add to the adverse effects of a monopoly.

Organisation knows its not making the most profit but do nothing. E.g. Keeping facilities that will keep employees on site so schools lets

teachers use the gym.

Profit

Normal profit: The profit required to retain a firm in the industry and theprofit that a firm could earn by using its resources. It is the minimum amountof returns the firm expect to get in order to stay in production.

Supernormal profit: Profit in excess to retain a firm in the industry. If a firm does not make at least normal profit it will leave the industry. A firm which is producing where AC=AR is making only normal profit only. Subnormal profit: Profit that implies the firm is making a loss, which will

induce firms to reorganise the use of their current resources which couldmean leaving the industry in search for better profits elsewhere.


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Strategies to increase profits

In order to increase profitability a firm needs to increase revenue or cutcosts.

Increasing revenue will lead to a rightward shift in AR and hence MR, soincreasing the profit maximisation point and price. The AR curve can be shifted rightwards y actions such as advertising.

However, this is likely to incur costs, hence the increase in supernormalprofit will be in reality lower.

Cutting fixed costs will result in a fall in the ATC curve from AC1 to AC2, soincreasing supernormal profit from the yellow area to blue area.

Cutting price would lead to a movement along the curve. Fixed costs include security, cleaning and insurance. It may be possible for a

firm to contract out some non-core function to another specialist companyenabling FC to be reduced. However, if existing workers have to be maderedundant, there will be a short-term increase in costs before the benefit ofincreased supernormal profit is realised.

Lower fixed costs lead to lower average costs and marginal cost is constant. Lower variable costs lead to lower average costs and lower marginal cost.

Cutting variable costs will result in a fall in the ATC curve from AC1 to AC2and a fall from MC from MC1 to MC2, so increasing supernormal profit fromthe blue plus purple area to the blue plus yellow area.

Variable costs are those that vary with output e.g. labour and raw materials. Firms may introduce machinery or change working practices in order to raise

productivity. If machinery is purchased this will result in an initial cost, which

will mean that the increase in supernormal profit is not as large as predictedin the diagram below.


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Decrease in variable cost will lower average costs and lower marginal cost.

Profit maximisation

The profit maximum output is when MC=MR and results in an increase inprofit.

Profit is the area where MR exceeds MC.

What barriers exist to firms entering and leaving markets?

Market structure

Number of characteristics that determine the market structure

The size and number of firms in the market. The ease or difficulty with which these new firms might enter the market The extent to which goods in the market are similar (homogeneity) The extent of knowledge shared by firms in the market The extent to which the actions of one firm will affect another firm

(interdependence)

The number of firms in an industry

1) Monopoly: It exists where there is only one supplier in the market (morethan 25% of market share)


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2) Oligopoly: It exists in a market dominated by a few large producersalongside a large number of small and relatively unimportant firms. They actagainst the publics interest.

3) Perfect competition or Monopolistic competition: There are largenumber of small firms, none of which are large enough to influence price.

Large number of buyers and sellers and price is set by cost.

Barriers to entry

Market structures are affected by the ease with which new entrants canaccess the market.

Firms that are in an industry, which is unlikely to experience many newentrants, may behave differently to those operating in an industry, which haslow barriers to entry.

Product homogeneity and branding

In industries such as gas and oil extraction, the product is essentially thesame whoever produces it. These identical goods are known as homogenousgoods. This means that no producer has a monopoly over production.

Firms find it easier to maximise profits if they are able to differentiate theirproduct by creating brand loyalty and reducing the elasticity of demand forgood. This creates barriers to entry reducing the competitiveness of themarket.

Knowledge

Buyers and sellers are said to have perfect knowledge if they are fullyinformed about price and output. If one producer puts its prices up, then thatproducer will lose all its customers because they will buy the good fromelsewhere in the industry.

Perfect knowledge is when information is freely available; t is up to firms andconsumers to access this. Imperfect knowledge exists where there arepatents protecting a particular process. Individual firms may not be aware ofall the new innovations to be introduced.

A lack of information acts as a barrier to entry, preventing firms fromentering the market.

Interrelationships within markets

Firms may be independent of each other; the actions of one firm will have nosignificant impact on any other firm in the industry.

If firms are interdependent then the actions of one firm will have an impacton others.

Barriers to entry

Barriers to entry are obstacles that deter potential competitors from enteringthe industry.

Economies of scale


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Existing firms may be able to make higher profits and set lower prices thannew entrants. The additional profit could be spent on product developmentto keep them one step ahead of potential new entrants.

In some industries, economies of scale are very large and this will deter a

new firm from entering the market, as it is likely to produce less and havehigher average costs than the existing firms, making it difficult to compete.

Limit pricing

A situation where an established firm tries to forestall new entry in asituation typically where economies of scale exist.

The existing firm will set a price below the AC of new entrants in order toreduce its profit.

It can be practiced in order to prevent reference to a regulator or theCompetition commission, or to the make the market less attractive to new

entrants, particularly where the market is contestable. Limit pricing is attractive where there are economies of scale to be made, a

new entrant is unlikely to be able to benefit from these initially, so setting alow price will make a new entrant unviable in the sort run and the industryunattractive.

Predatory pricing

A situation where a firm is prepared to deliberately make a loss in the shortrun with the aim of driving a rival out of the market.

In the long run this will enable the firm to raise its price more than it has

previously been reduced, it can lead to a price war.

Sunk costs

These are unrecoverable costs when a firm exits the industry. If a firm has high sunk costs this may discourage them from exiting the

industry. Advertising is an example of a sunk cost, since its a fixed cost; it increases

the AC more at lower levels of output, than higher levels of output. This cancreate a barrier to entry.

In order to be noticed within the market place, a new entrant would have to

undertake a similar level of advertising to existing firms. This gives it a significantly higher break even point than the existing firm,

particularly as the new entrant is unlikely to capture the same level ofmarket share as the existing firm.

Start-up costs

Some industries such as car manufacturing require a large initial capitalinvestment to start production. Potential competitors may find it difficult toraise this amount of capital and will be unable to enter the industry. Thisallows the firms in the industry to continue earning profits in the long run.

Legal barriers


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This is the strongest restriction against the entry of new firms where the lawoperates to prevent the emergence of competing firms.

Patents: The production process or the product itself may be protected by apatent. The inventor of the product or production process is given exclusive

production rights for a given time period - often up to 20 years - preventingthem from having the invention copied and by protecting him from thethreat of competition. E.g. Medicine.

Nationalism: When industries have been nationalised it has created state-owned monopolies. It is mostly government owned and had a monopolyposition.

Licenses: It is illegal to enter without a licence provided by the government.Licenses are often limited in supply and not granted often, it becomes verydifficult for new firms to break into the industry and existing firms are able toearn long-run monopoly profits.

Marketing barriers

Advertising: If existing firms spend heavily on advertising and marketingand command a high degree of consumer loyalty, it is extremely difficult forpotential competitors to break into the market. New firms would have tospend a huge amount on marketing if they were to compete effectively,attract consumers and establish themselves in the industry. Such marketingcould be expensive.

Brand proliferation: A way for a new firm to establish themselves is to fill amarket niche - a gap in the market, which is unserved by existing firms.However, existing firms can make entry more difficult through brand

proliferation - giving customers an apparent abundance of choice byproviding a wide range of similar products but with slightly differentcharacteristics and closing any market niches that new entrants mightexploit.

Transport costs

Geographical proximity may offer a degree of protection to local firms andact as a barrier to entry against potential competitors because transportcosts, journey times and the general inconvenience of travelling longerdistances makes it more difficult for new firms to attract customers.

Restrictive practices

A manufacturer may refuse to sell its goods to a retailer which stocks theproducts of a competitor firm, making it more difficult for new firms toestablish themselves in the market. Alternatively, a manufacturer mayrefuse to supply one of its products to a retailer unless the retailer purchasesits whole range of goods.

Barriers to exit

Sunk costs


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Employment law: You cant fire someone due to redundancy payments andbusinesses tend to close down because its cheaper.

Long leases: Makes closing hard because you pay rent for a long period.

Market concentration

A five firm concentration of 65% means that the largest five firms in theindustry are responsible for selling 65% of all the products sold in themarket.

Market concentration can also be measured by calculating the percentage ofoutput or employment accounted for by the largest firms.

A high concentration ratio indicates that a few large firms dominate theindustry, suggesting an oligopolistic market structure.

Low concentration ratios suggest more competitive market structures suchas monopolistic competition.

Perfect competition Perfect competition describes a market where there is a high degree of

competition. Always allocatively efficient and productively efficient in the long run.

Conditions/Assumptions

1) There must be many buyers and sellers in the market, none of who islarge enough to influence price. Buyers and sellers are price takers. Thesellers accept the price as given and adjust their output to the market price.

2) There is freedom of entry and exit to the industry. Firms must be able

to establish themselves in the industry quickly. Free mobility of firms ensuresthat the number of firms in the industry can always remain large andcompetition remains tough.

3) Buyers and sellers possess perfect knowledge of prices. Thus if oneproducer charges higher prices than its competitors for a good, consumerswill buy from elsewhere in the market and demand will fall to zero.

4) Firms produce a homogenous product. All firms are producing and sellingproducts that are accepted by buyers as identical, there are no imaginarydifferences such as brand names and trademarks. These ensure that no firmcan increase or decrease the price of its product above or below the marketprice without serious effect on its sales.

There are only a few industries in the world, which approximate to his modelsuch as the foreign exchange market. There are a large number of foreignexchange dealers supplying the market, none of which is large enough toinfluence the exchange rate. It is relatively easy to establish a bureau-de-change and thus enter the industry, as easy to leave. A foreign exchangedealer will know the market determined exchange rate. Currencies arehomogenous - US dollars are indistinguishable from other US dollars sold byanother bureau-de-change.

Demand and revenue


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Perfect competition assumes that there are a large number of suppliers inthe market.

A firm can expand output or reduce output without influencing price. A bureau de change cannot put up the exchange rate for US dollars and

expect to sell anything. It may decide to lower the exchange rate, but there

is no gain by doing this, as the foreign exchange dealer may sell all hisoutput at the original higher price.

The demand curve is horizontal (perfectly elastic) and is also the firmsaverage and marginal revenue curves. If a firm sells all its output at themarket price, then this price must be the average price or revenue.

In addition if a firm sells an extra, it will receive the same price for eachadditional unit as it did for each preceding unit sold, and therefore marginalrevenue will be the same as average revenue.

Demand curve is perfectly elastic because the firm is a price taker, AR =MR= Price.

Short run equilibrium

In perfect competition firms are profit maximisers. Firms will produce where marginal cost is equal to marginal revenue

(MC=MR) The price the firm charges are determined by the market because the

individual firm is too small to influence price and is a price taker. Firms in the short run are making supernormal profits, new firms will enter

the industry, increasing market supply and thus reducing price. In this diagram the horizontal average revenue curve is shown to be above

the average total cost at the point where MC=MR. It achieves allocative efficiency but not productive efficiency.

Short-run firm making losses

The firm makes a loss at equilibrium, profit maximising where MC=MR. If production is unprofitable, firms will leave the industry, reducing marker

supply and increasing price. The price charged per unit of output (p2) islower than average total cost (p1) and hence the firm makes a loss.


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When there are too many firms you get subnormal profit.

Long run

If a firm were making super normal profits in the short-run, other firms wouldenter the industry eager to share these high profits.

They would be able to do this, as there are not barriers to entry in perfectcompetition.

The entry of new firms stimulates an increase in supply from s1 to s2establishing a price just low enough for firms to make normal profits.

Long-run equilibrium position of a firm facing short-term super normal profits

If a firm were making losses, in the long run, some firms would leave the

industry, as there are no barriers to exit. As result of these departures totalsupply would fall from s1 to s2.

Firms would continue to leave the industry until the whole industry returns toprofitability.

When the supply curve is at s1 the firm is making a loss. At s2 the supply curve is high enough to make normal profits.

Long-run equilibrium position of a firm in an industry facing short-term losses

In the long run, competition ensures equilibrium occurs where the firm neithermakes the super normal profits or losses.

This means in equilibrium average cost equals average revenue.


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Equilibrium for the firm

In the long run in perfect competition, super-normal profits are competedaway. This occurs because competitor firms are free to enter the market andhave perfect knowledge of the existing firms production methods.

AC=AR because no supernormal profits are made. Since products are identical, consumers are not loyal to existing suppliers. As new firms enter the market, the supply curve shifts right and market price

decreases.

Supply curves

In the perfectly competitive market, the supply curve of the firm is themarginal cost curve above the average variable cost in the short run and theaverage total cost in the long run.

Marginal cost of production (i.e. the change in total cost resulting from thesale of one more unit) represents the lowest price a firm would be prepared tosupply an extra unit of output.

In the short run a firm will not necessarily shut down if it is making a loss. It will remain open as long as it covers the average variable cost. The firm will stop supplying if average revenue or price is less than average

variable cost. In the long run, the firm will only continue to supply if all costs are covered.

Therefore the minimum long run shut down point is the minimum point of theATC curve.

In the short run the firm may produce at a temporary loss if it believes that itwill be profitable in the long run.

If unprofitable they can shut down in which case the loss will be equal to fixedcosts.

It is only worth producing if variable costs are covered.

Anything in excess of these variable costs contributes to fixed costs andmakes the firm better off producing than not producing.


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Hence the short run shut down point is the minimum point of AVC. Shut down point for firms in PC is imperfect knowledge and firms make only

normal profit.

P1 shows the minimum shut down point in the long run, while p2 shows theminimum shut down price in the short run.

Evaluation of perfect competition

Although perfect competition achieves productive and allocative efficiency inthe long run, it is not an ideal market structure as it downs not provide thesupernormal profit necessary for investment and research and developmentto take place.

This model is useful, in that it provides a yardstick to assess how competitiveother market structures are.

Monopoly

Assumptions

A monopoly is assumed to:-Be the only firm in the industry.-Have high barriers to entry preventing new firms from entering the market.-Be short run profit maximisers.

The legal definition of a monopoly used by the Competition Commission iswhen a firm has more than 25% share f the market.

In the UK, gas, electricity and water supply, telecommunications and therailway track are natural monopolies because economies of scale are so largethat any new entrant would find it impossible to match the costs and prices of

the established firm. Some monopolies such as the water companies have considerable monopoly

power because there are no good substitutes for their product. A monopoly is able to maintain its position as the sole supplier of a good or

service because it is able to establish higher barriers to entry. In practice governments define monopoly as 25% market share and will

investigate and regulate firms through the Competition Commission. This isnecessary because of the potential abuse of monopoly power.

They are productively and allocatively efficient.

Revenue curves

The monopolist faces a downward sloping demand curve.


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The monopolist can therefore only set the level of price or output. If it wishes to sell more units it must lower price or if it wishes to increase

price then it must reduce output as shown below (price maker) The monopolist cannot set both price and quantity because it cannot control

demand.

Price = AR as the downward-sloping demand curve shows the relationshipbetween price per unit and quantity is the average revenue curve.

If AR is falling, marginal revenue must be falling too and at a faster rate. Thedownward sloping demand curve shows us that if the firm wants to sell moreunits, it must cut its price. However, it will have to cut its price not just on theextra unit it sells but on all the unit it sells. It cannot charge a higher price tosome consumers than others.

The monopolists AR and MR curves

Sources of monopoly power

These come largely through barriers to entry to a market. There is also the natural monopoly case where there are such substantial

economies of scale that there is only room for one firm in the market.

Equilibrium output (short run and long run) A monopolist is assumed to profit maximised, it aims to achieve an output

equal to the point where MC=MR. The monopolist may produce in the short run even if it is making a loss, as

long as it covers its variable costs. It will close down in the short run if itcannot cover its variable costs. In the long run, a monopolist will need tocover all its costs of production and cease production if average cost isgreater than average revenue in the long run.

The monopolist can earn supernormal profit in the long-run because barriersto entry prevent new firms from entering the industry and competing such

profits away. The diagram below shows:


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-The equilibrium profit maximising level of output at q1 where MC=MR.-The monopolist s able to supply q1 at a price of p1.-Supernormal profits of the shaded area will be made. The supernormal profitper unit is the difference between the average revenue received (p1) and theaverage cost of c1.

The price is determined by establishing the output level where MC=MR andthen identifying the average revenue for this - i.e. the monopolist sets priceusing the AR.

The shaded are shows the supernormal profit, this remains in the long runsince barriers to entry prevent new entrants joining the market andcompeting it away.

A monopolists total revenue curve

Total revenue will rise when marginal revenue is positive. As marginal

revenue falls, total revenue increases at a slower rate. Total revenue ismaximised when marginal revenue is zero. When marginal revenue isnegative total revenue will fall. Total revenue is zero if average revenue, theprice received per unit of output, is zero too.

At the top of the demand curve, demand is price elastic because a fall in priceleads to a rise in revenue. At the point where marginal revenue is zero andtotal revenue is maximised, price elasticity of demand must be unity, since achange in price has no effect on revenue. At the bottom of the demand curve,demand must be price inelastic because a fall in price leads to a fall inrevenue.

Loss making monopolist

A monopolist may decide to remain operational whilst it makes a loss in theshort-run as long as it is covering its variable costs and making a contributionto its fixed costs.

The monopolists may feel that in the long run super-normal profits might beachieved.


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A dvantag es and disadvantages of a monopoly

Advantages DisadvantagesSupernormal profit means finance forinvestment to maintain competitive edgeand reserves to overcome short-termdifficulties and provide funds for researchand development.

Supernormal profit means less incentiveto be efficient and to develop newproducts and efforts are directed toprotect market dominance.

Monopoly power means powers to match largeoverseas organisations.

Monopoly power means higher pricesand lower output for domesticconsumers.

Cross-subsidisation may lead to an

increased range of goods or servicesavailable to consumer.

Monopolies may waste resources by

undertaking cross-subsidisation, usingprofits from one sector to finance lossesin another.

Price discrimination may raise totalrevenue to a point, which allows survivalof a product or service. E.g. economy classflights are funded by those flying businessand first class.

Monopolists may undertake pricediscrimination to raise producer surplusand reduce consumer surplus.

Monopolists can take advantage ofeconomies of scale, which means thataverage costs may still be lower than the

most efficient average of a smallcompetitive firm.

Monopolists do not produce at the mostefficient point of output (i.e. at thelowest point of the average cost curve)

There are few permanent monopolies.Supernormal profits act as an incentive tobreak down the monopoly through aprocess of creative destruction (i.e.undermining the monopoly throughproduct development and innovation)

Monopolies lead to a misallocation ofresources by setting prices abovemarginal cost, so that price is above theopportunity cost of providing the good.

Monopolists avoid undesirable duplicationof services and a misallocation ofresources.

Monopolists can be complacent anddevelop inefficiencies.


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Nationalised industries

In industries which are natural monopolies where the minimum efficientscale is beyond market demand curve, there are particular problems in

pursuing a p=mc strategy. If the firm sets p=mc then it will make a loss because with a continually

falling AC curve, MC is below the AC curve, therefore setting p=mc results ina loss, since AR is blow AC.

P


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Since the monopoly makes some EOS, it has a lower cost curve than the PCfirm.

Monopoly acts against the consumer interest and results into a net welfareloss for society and consumers pay in excess of MC and resourcesmisallocated in monopolists industry.

Theres a debate over whether PC or monopoly produces the greatest levelof innovation. Schumpeters theory Creative Distribution argues thatmonopoly creates innovation and supernormal profits can fund them.Innovation is more likely under monopoly since barriers to entre mean thatto enter a market firms have to innovate developing new products andmethods and this would result in one monopoly replacing another.

Firms in PC may innovate to keep up with competition and to take advantageof a rise in profits, however, lack of barriers to entry means any benefit frominnovation is short run.

Monopolies are likely to have the funds available to spend on research anddevelopment, since there are no barriers to entry; monopoly profits resultingfrom innovation are protected. However, they may choose not to innovate ifthey see no competition.

In the diagram above, due to substantial economies of scale it transfers fromperfect competition to monopoly and there is a net welfare gain. Theconsumer gains the yellow area as price decreases and increase in consumersurplus. The blue area is supernormal profits as it is able to produce at alower AC due to EOS.

In the diagram above, the industry transfers from PC to monopoly andtheres a loss of consumer surplus shown by the purple plus green area. Thegreen area is deadweight loss and the purple area is producer surplus. The

blue area is supernormal profit. Since the blue area is greater than the greenarea there is a net welfare gain.


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However, monopoly results in X inefficiency -failure to minimisecosts/organisational slack and creating an efficiency loss.

However, since the welfare gain goes to the producer at the expense of theconsumer, this might not be considered socially desirable.

Other costs of monopoly

Resource cost of obtaining and maintaining a monopoly firm. Some monopolies are created by the government. In order to win a franchise; firms will devote resources to the bid, it could be

argued that these are wasted. Money might be spent on hospitality but ifsold to highest bidder, resources would not be diverted to hospitality andmoney might be used in a more productive way.

However, sale of TV franchises demonstrates that companies paying thehighest figures may have to reduce programming costs and quality ofprogramming may suffer, which is not in the public interest.

The conditions necessary for price discrimination in monopoly

Definition

Price discrimination occurs when a firm charges different prices to differentconsumer groups for the same product.

The price differential is not associated with different costs of production. E.g. children pay less in the cinema for the same service.

Conditions required for price discrimination to work

1) There must be different price elasticity of demand for the product from eachgroup of consumers - This allows the firm to extract consumer surplus byvarying the price leading to additional revenue and profit. Lower the pricewhere ped is elastic so TR increases and gain in consumer surplus. Raise theprice here ped is inelastic so TR increases so loss of consumer surplus.

2) Firms must be able to prevent market seepage (arbitrage) - Consumerspaying the lower price have an opportunity to re-sell to those who would becharged a higher price. Its easier in the provision of services rather thangoods by the nature of the product. E.g. Rail companies employ inspectors toprevent seepage between off peak and peak travellers.

3) The costs of separating the market must be less than the additional revenuegained and selling to different sub groups or market segments must not beprohibitive - Monopolist must have control over the sale of the product withprice setting power.

First-degree discrimination

The firm separates the whole market into each individual consumer andcharges them the price they are willing to pay (indicated by the demandcurve)

Firms will sell an output up to the point where AR=MC. Beyond this point theprice consumers are willing to pay is less than the marginal cost ofproduction making additional output unviable.


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Perfect PD allows the monopolist to extract every last bit of consumersurplus from each buyer and consumer is charged a price exactly equal towhat hes willing to pay.

Every consumer is charged a different price and the maximum they arewilling to pay.

Examples of first degree PD include bargaining in street markets and antiquefairs.

First degree PD can be beneficial in enabling a firm to make a profit wherenone was available without PD. This can enable a good or service to beproduced, which is valued by consumers. Firms only lower the price to thelast customer when PD.

Second-degree price discrimination

This type of price discrimination is based on the amount sold. This is oftenseen in industrial processes, where a firm can be rewarded for the quantity ofa product that it buys.

Third degree price discrimination

Occur when the monopolist groups the customers into different markets andcharges different prices to different markets but the same price for all withinthe same market.

The monopolist is able to divide his customers into 2 or more groups,charging a different price to each group. A higher price is charged in themarket with less elastic demand.

Assuming a constant marginal cost for supplying to each group ofconsumers, the firm aims to charge a profit maximising price to each.

Consumers with an inelastic demand for the product will pay a higher pricethan those with an elastic demand. The elasticity of demand reflects the

willingness to pay for the good or service. Diagrams demonstrate thatinelastic market is charged more than elastic market.


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Price discrimination for producers

The most profitable system of discriminatory prices will provide higher totalrevenues to the firm than the profit maximising single price, leading tohigher profits.

PD enables larger output and internal EOS to be reaped, leading to lower ACand higher profits eventually.

Is price discrimination in the interests of consumers?

Consumer surplus is reduced in most cases representing a loss of consumerwelfare. In the third degree in an elastic market some is removed. All isremoved in the first degree.

Some consumers who can buy the product at a lower price may benefit.Previously they may have been excluded from consuming it. Some marketswhere the price is reduced will get additional consumer surplus.

Price is greater than marginal cost and therefore firms are not achievingallocative efficiency (p=mc) - not in the interest of consumers. Price discrimination is in the interest of firms who achieve higher profits.

Producer surplus is greater so societys welfare rise and at the expense ofconsumers.

Allow firms to cross subsidise loss-making activities that have importantsocial benefits.

Poor are able to consume the good for which consumption is impossible athigher uniform prices. The group of consumers with high demand elasticityare able to enjoy the good at lower price whilst those with low demandelasticity do not mind paying a higher price.

Monopolistic competition

Imperfect competition

Perfect competition assumes that there are many small firms and all goodsare homogenous, and in monopoly it is assumed there is only one supplier.

Competition is imperfect because firms sell products, which are nothomogenous.

E.g. Toothpaste market and Indian restaurants.

Assumptions

1) There are a large number of small firms.2) There are low barriers to entry or exit.3) Firms produce similar but differentiated products.

Producers are similar but differentiated in terms of packaging, colour, design,specification, marketing or price from rival products.

This results in brand loyalty and downwards-sloping demand curve. Supernormal profits are competed away in the long run. However, advertising can create differentiation is wasteful and leads to

higher average cost than necessary. However, the need to compete may


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result in less X inefficiency than under monopoly. Inefficiency is when thefirm knows about it but doesnt do anything about it.

The downward sloping demand curve

Firms producing a product, which is slightly different from their rivals, willhave a certain amount of market power. They will be able to raise pricewithout losing all of their customers to those firms who have maintainedstable prices. Therefore the firms demand curve is downward sloping.

It is not a price-taker because there are a large number of firms producingclose substitutes; its market power is likely to be relatively weak.

Short run

The shaded area shows super normal profit - this will disappear in the longrun as firms are free to enter and exit the market, no barriers to entry and

perfect knowledge. It is neither productive nor allocative efficient. (P>mc) Not producing on the minimum point of the AC curve.

Long run

The firm will produce where MC=MR so as to profit maximise. In the diagramabove, this means that it will produce at an output level of Q1. It will chargea price based on its demand or average revenue curve, P1.

In the long run the firm will not be able to obtain supernormal profits,because new firms will enter the industry if they see profits to be made

exploiting the 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. If the firm were making a loss, firms would leave the industry, reducing

supply and shifting the AR curve upwards again to a point where averagerevenue is equal to average cost. Therefore in the long run amonopolistically competitive fir can make neither supernormal profits norlosses.

Not productive or allocative efficient.


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1) Draw AC.2) Draw AR (tangent)3) Mark off P and Q.4) Draw MR.5) MC must pass through where Q=MR and minimum of PC.

PC VC MC

Differentiation results in smaller quantity produced and slightly higher AR.

Oligopoly

An industry dominated by a few large producers supplying either an identicalor differentiated product. There is a high concentration ratio and firms areinterdependent.

The small number of firms ensures interdependence, where each firm isaware that its future prospects depend not only on its own policies but alsothose of its rivals.

The industry may be competitive or collusive. They keep prices stable - they know that the actions of one firm will impact

on the other firms in the industry, in other words they are interdependent. If one firm were to raise its prices then others would not follow and because

the goods traded are similar, customers will move to the lower cost option.

If a firm were to lower prices then other firms would follow suit and a pricewar would result, with no real gain for any of the firms in the industry.


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Instead, oligopoly firms will tend to work together through collusiveagreements, whether they are tacit or overt or engage in non-pricecompetition.

Collusion is where firms agree on prices, market share, output andadvertising expenditure.

Non-price competition can take the form of advertising, issuing of loyaltycards, branding, packaging, and other measures to reduce the closeness ofsubstitutes.

P1 is the stable market price. Above P1, the firm believes that if it raises itsprice, the competitors will not follow suit and it will lose market share;therefore demand is price elastic above p1. At prices below p1 the firmbelieves that lowering its prices will result in competitor firms lowering theirprices; therefore demand is price inelastic below p1. This results in the kink

in the AR curve and the subsequent hole in the MR curve. Any MC curvethat passes through the hole in the MR is compatible with q1, p1 as profitmaximisation.

Non-price competition (competitive oligopoly)

Oligopolies demonstrate the features of a stable market price (kinkeddemand curve) and firms compete in ways other than by price.

They wish to avoid a damaging price war and do not reduce prices to capturemarket share for fear or sparking a price war, which can result in a loss ofrevenue for all participants (although gains for the consumer)

There are many ways of increasing sales through non-price competitivenessincluding: advertising and marketing, extended opening hours, extendedguarantees on the product, loyalty cards, home delivery or discounted petrol.

Cartels (collusive oligopoly)

Oligopolies have the incentive to collude to behave as a monopoly, sincecollusion reduces uncertainty and risk. It will include behaviour such asagreeing production levels, in order to maximise prices and profits for thecartel as a whole.

A formal collusive agreement s called a cartel, it refers to a group of firmsthat agree to coordinate their production and pricing decisions so that theyact as a single firm to earn monopoly profits.


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For a cartel to be successful, producers must control supply to maintain anartificially high price. Collusion is easier when there are a relatively smallnumber of producers in the market, and a large number of customers,market demand is not too variable, possible to prevent new firms fromentering the industry and the individuals firms output can be monitored

easily by the cartel. The cartel will not wants its members to be undercut, and risk losing market

share. To maintain the cartel, members should have similar costs, otherwise some

will benefit more than others from the price set, and firms must have similarobjectives to bind them together and must not cheat.

A cartel provides an incentive to cheat for individual members, particularly ifthey feel that their output quotas have been set too low. It is in the interestsof an individual firm to break the agreed quota and over-produce. Since theother members will have restricted output, any one members additionaloutput will not depress market price to its previous level, the cheatingmember will benefit from a higher price and higher output, thus receivingsubstantially increased profits and greater market share.

Once one firm over producers, the market prices start to fall, all firms havethe incentive to break the agreement. In these circumstances its hard tohold the cartel together.

Cartels are unstable, often illegal and governments do not like markets thisway.

Cartels always collapse and there are a number of pressures leading to this.It is in the short-term interest of members to cheat, tension is created duringeconomic downturn when demand falls.

Other problems include the entry of non-cartel member firms into theindustry reducing the percentage of the market controlled by the cartel,discovery of price fixing agreements by governments or regulators.

E.g. OPEC, European steel producers and International Coffee Agreement(ICA)

Collusive oligopoly

Firms prefer to collude because: It reduces uncertainty due tointerdependent firms in the market, it avoids the high costs of non-pricecompetition, it avoids the situation of price cutting that leads to less revenue

for all and profits would be even higher compared to the competitivesituation.

Firms collude by agreeing to limit competition among them. They may fixprices, set output quotas and agree on market share.

Collusion between firms is easier if: Their production and average costs aresimilar, they produce similar products and can easily agree on price, there isa dominant firm and there is no government regulation prohibiting collusion.

Price leadership in oligopoly (tacit collusion)


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When one firm has a dominant position in the market, it may take the lead inprice setting.

Firms with a lower market share simply adopt the price set by the leader. This is a type of tacit collusion where firms in the market observe each

others behaviour closely and do not compete on price, even if they do not

communicate with each other. Firms tacitly collude by watching each others prices to avoid price wards.

Game theory

Can be used by economists to predict how firms will react in a number ofgiven scenarios.

It is used when dealing with oligopoly to explain why firms may collude andwhy they may later decide to abandon any agreement to collude.

Prisoners dilemma

Marias pleaInnocent GuiltyJuans plea Innocent Maria Light sentence Maria Go free

Juan Light sentence Juan Severe sentenceGuilty Maria Severe sentenceMaria Medium sentence

Juan Go free Juan Medium sentence

This example explains why oligopolistic firms would prefer to collude ratherthan compete, also they are highly interdependent on each other - theyconsider the competitive response of the other firms to their actions beforedeciding on the course of action to undertake.

It illustrates that different strategies can be in the best interest of the firmdepending on whether it colludes or competes. Nash equilibrium - Occurs when each players chosen strategy maximise

pay-offs given the other players choice, so that no player has an incentive toalter behaviour.

Assumptions:-Model assumes a zero sum game (a winner and loser)-Prisoners have been kept separate and do not know what each is doing, butthey know the outcome of each action.

What should they do?

Confess - If one of them confesses they should get a light sentence, but asthey cannot trust each other and cant be sure that the other party has notconfessed (which would result in a severe sentence for each prisoner whodid not confess), they would act selfishly therefore both confessing to get thebest solution for themselves. They tend to both confess.

Not confess - If they trust each other and be sure of each others responsethis would be the best option. By not confessing both prisoners would get alight sentence.

Maximax - maximising the maximum benefit for the individual would meanthat they should confess and get a light sentence, but if one could be trusted

not to confess, both will get a light sentence.


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Maximin - Minimum benefit where the prisoners will tend to because theycant trust each other and get a severe sentence.

Dominant strategy - Same policy is suggested by different strategies. Thisis a dominant strategy game because both strategies encourage a cut inprice.

Nash equilibrium - Position resulting from everyone making his or heroptimal decision.

What determines the behaviour of firms?

Behaviour of firms in different market structures

The structure-conduct performance model argues that oligopoly andmonopoly charge high prices and results in supernormal profits, basic marketconditions determines the structure of a market which in turn will determinefirm conduct and performance.

Markets that are highly concentrated are able to set high prices or engage in

anti competitive practices that result in supernormal profits and efficiencylosses.

However, the model has been criticised by the contestable market approach.

1) Objectives: We assume that firms will seek to profit maximise, in monopolyand oligopoly they may pursue other objectives.

2) Non-price competition: Firms in oligopolistic competition may engage innon-price competition that is a key feature of oligopoly, where stable pricesencourage non-price competition, often through advertising. They mayengage in predatory pricing where they put price below the cost to drive thecompetitors out of the market. Limit pricing is when they price to restrict

profit to restrict firms entering.3) Interdependence: They take into account the likely reactions of others

when deciding on pricing and output. In PC and MC, firms are independent.Only in oligopoly this occurs.

4) Collusion: May occur in oligopoly where firms cooperate to restrict outputand raise prices. In a monopoly collusion is not possible but defined as a 25%market share, it can occur. Competition is a feature of PC and MC.

Assessing the performance of firms in different market structures

1) Price: PC will deliver the lowest possible average costs (productive

efficiency), where significant economies of scale exist; monopoly may in factprovide a lower price to the consumer, proving the most efficiency. This canbe linked with a discussion of consumer surplus, which will be greatest whereprice is lowest.

2) Profit levels: In PC and MC, firms make only normal profit in the LR, while inoligopoly and monopoly supernormal profit can be made in the LR. However,high levels of sunk costs can reduce profits significantly in the long run (e.g.advertising and infrastructure costs) Sunk costs may have to be covered inthe long run.

3) Efficiency: Firms in PC achieve productive and allocative efficiency in the

long run. However, productive and allocative efficiency and example of staticefficiency is efficiency at a particular point in time. Dynamic efficiency is


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concerned with whether resources are used efficiently over time. Innovationmay result in falling AC and monopolies may encourage productive efficiencyover time. Monopoly can be dynamic efficiency if it drives its AC down.

4) Innovation: No agreement on which market structure delivers innovationmost effectively, Schumpeter argues it is monopoly.

5) Consumer choice: In PC it offers the consumers the greatest choice, whilemonopoly offers the least. However, since all products are identical in PC, itis not much of a choice. Oligopoly may provide considerable choices.

6) Perfect knowledge: PC provides perfect knowledge and consumers canmake informed choices. In other market structures they may be the victimsof persuasive advertising, and make less rational purchasing decisions thatoffer them lower levels of benefit or satisfaction.

Monopsony

Monopsony occurs when there is a single buyer of a good. The buyer may be able to exert substantial influence over the suppliers of

the good when drawing up contracts on the price and quality of goods. Thispower may be especially strong when the sellers are relatively small andnumerous.

E.g. In supermarkets the sheer buying power of the large chains would leavethe relatively fragmented suppliers in a weak bargaining position, thesupermarkets would then be able to keep their costs down by using theirbargaining strength.

In the labour markets monopsony would occur where there are a largenumber of employees, but one dominant employer whose employment

decisions directly affect the wage rate. The dominant employer is themonopsonist. This situation is most likely to occur where a large single plantlike a steel mill.

When labour is mobile, the number of potential employers increases and thelabour market ceases to be monopsonistic.

The labour demand curve (DL) shows the firms marginal revenue product oflabour (MRP) at each level of employment. The labour market supply curve(SL) shows the quantity of labour supplied at each wage rate.

In order to attract an extra unit of labour the firm must offer a higher wage

rate to all units of labour employed. The marginal cost of employing an


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additional unit of labour (MCL) will be greater than the wage rate at eachlevel of employment.

Monopsony employers can keep wage levels down and the quantityemployed down, as its not a competitive market.

Monopsonist employment in a government is healthcare or education.

Competition

Contestable markets

If a market is contestable, the firms within the industry will behave in acompetitive way.

A contestable market is when it has low sunk costs and low barriers to enter. This means new firms can quickly enter an industry when they seesupernormal profits being made and exploit these before leaving theindustry. This is known as hit and run profit.

It will be very competitive regardless of how many firms are in the industry. The firms in the industry will take care not to price themselves out of the

market. Close regulation of monopoly firms in contestable markets are required to

ensure appropriate competition. Lack of regulation may result in predatorypricing.

Firms could offer favourable terms to suppliers who did not handle theproducts of competitors. High levels of advertising and publicity or researchand development may deter new entrants since it adds significantly to fixedcosts.

Contestability

When an entrant has access to all production techniques available to theincumbents, is not prohibited from wooing the incumbents customers, andentry decisions can be reversed without cost.

Three conditions:-Perfect information and the right to use the best available technology.-Freedom to advertise and being legally free to enter the market.-Absence of sunk costs.

Sunk costs are those which a firm incurs in setting up and running a business

which are irrecoverable to the owners of the firm should it decide to leavethat particular industry or go banking. (E.g. advertising and equipment)


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If an industry is contestable than incumbent firms may be forced to act as ifthey are in competition and be satisfied with making only normal profitsbecause of the threat of hit and run tactics.

Any firm making supernormal profits would be opening up opportunities fornew entrants to come into the market, undercut existing prices and take the

profit for themselves.

Evaluating the theory of contestable markets

No market is perfectly contestable (i.e. zero sunk costs) - the degree ofcontestability.

To test the theory (i.e. the absence of sunk costs restrains the activities ofincumbent monopolists) would require a great deal of information about thecost structure of the incumbents. Its not usually available.

Controversy about whether the threat of hit and run competition is sufficientto make incumbent firms go weak at the knees.

Finding out cost structures of incumbent firms is difficult because theinformation is commercially sensitive - so difficult to judge whether the firmis pricing at competitive levels or not.

Diagram for contestable markets

If the firm produces at Q1 and prices at P1 it will make supernormal profits

and new entrants will be attracted in. Contestable market is when AC=AR. Because of the costless entry and exit new firms will arrive and take away

the incumbent firms market share unless price is reduced to where the firmis making normal profit (P2)

In terms of the objectives of firms, contestability may force the incumbentaway from profit maximising to a sales maximising strategy more in line withthe interests of consumers.

The degree of contestability should determine the extent of the pricereduction.

Factors to consider when assessing the degree of contestability withina market


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Technological change: New entrants may be committed to capitalexpenditure based on out-dated technology. This is acute in highly capital-intensive industries.

Natural monopoly aspects: Some industries have high levels of non-

recoupable and non-relocatable infrastructure expenditure (e.g. sunk costs)High levels of capital expenditure are not in themselves proof of lowcontestability.

High level of advertising expenditure and branding: If the market hasvery strong bands than a new entrant would have to spend heavily onmarketing their new product. If the product fails such expenditure cannot beclawed back. This would include advertising (sunk cost) and the design ofpackaging.

Limit pricing: If the incumbent firms establish a reputation for limit pricingthen potential new entrants may feel they are guaranteed losses should theyrisk entering the industry.

Information asymmetry: The theory that the firm tends to assume thatthere is symmetrical information available to both potential new entrantsand to incumbents. However, there may in realist be an imbalance. There isan invisible barrier to entry, if the incumbent has better information aboutthe way the industry works than the potential new entrant will takeexpensive time for new entrants to acquire this know-how.

Possession of exclusive rights to raw materials or distributionfacilities: Potential new entrant will find it difficult to acquire raw materialsnecessary to begin producing.

Investment costs: Specialised equipment may be difficult to sell secondha

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