Economics Theme 3 Revision

  • Created by: remybray
  • Created on: 10-10-17 11:12

Objectives of Firms

  • Firms are organisations often involving thousands of people directly, with millions of people indirectly invovled. 
  • Business objectives:
  • Profit maximisation - means achieving the highest possible profit for the risk taker. On a diagram, the level of output for profit maximisation is where MC=MR.
  • Higher profit means higher dividends for sharehodlers, more profit can be used to finance R&D, higher profit makes the firm less vulnerable to takeover and higher profit enables higher salaries for workers.
  • Profit satisficing - means a business is making enough profit to keep shareholders happy or it's sufficient for investors to maintain confidence in the management they appoint.
  • In many firms, there is a separation of ownership and control. Those who own the company (shareholders) often do not get involved in the day to day running of the company. This is a problem because although the owners may want to maximise profits, the managers have much less incentive to maximise profits because they do not get the same rewards (share dividends).
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Objectives of Firms

  • Therefore managers may create a minimum level of profit to keep the shareholders happy, but then maximise other objectives, such as enjoying work, getting on with other workers. (e.g. not sacking them) This is the problem of separation between owners and managers.
  • This 'principal-agent problem' can be overcome, to some extent, by giving managers share options and performance related pay although in some industries it is difficult to measure performance.
  • Sales maximisation - to maximise sales volume means to sell as many products as possible, without making a loss. This means the firm must produce an output where the total revenue generated from sales just covers the total costs of production. On a diagram, the level of output for sales maximisation is where AR=AC.
  • Firms often seek to increase their market share, even if it means less profit:
  • Increased market share increases monopoly power and may enable the firm to put up prices and make more profit in the long run.
  • Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries.
  • Increasing market share may force rivals out of business. Some firms may actually engage in predatory pricing which involves making a loss to force a rival out of business.
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Objectives of Firms

  • Revenue maximisation - means gaining the maximum possible revenue from selling a product. On a diagram, the level of output for revenue maximisation is where MR=0.
  • Private sector: Firms owned by individuals, it is the part of the national economy that is not under direct state control. Under a purely capitalist economy, everything would be privately owned.
  • Public sector: Firms that are owned by the state, it is the part of the economy that is under direct control of the government. Under a purely socialist economy, everything would be owned by the state.
  • Not-for-profit: is a type of organisation that does not earn profits for its owners. All of the money earned by a not for profit organisation is used in pursuing the organisation's objectives. These organisations use surplus revenues to further achieve its purpose/objectives, rather than distributing its surplus income to the organisation's shareholders as dividends.
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Reasons firms remain small

  • Niche markets - Small niche markets may have less competition and therefore be more profitable. Moving into a mass market may make competition more intense. Niche markets can have a more price inelastic demand; therefore firms can charge a bigger mark-up on the marginal cost of production. This enables the firm to be more profitable, despite lower volume.
  • Economies of scale are limited in some industries or there may be diseconomies of scales in expanding production
  • Tax breaks, VAT thresholds
  • Avoiding attention of potential buyers - the growth of the firm and its increased profits may lead to larger firms wishing to buy out the sole trader.
  • Minimum efficiency scales - some firms have already exploited all of their economies of scale, i.e. are producing at the most efficiently optimal point. If it were to expand, it would cause diseconomies of scale.
  • Lack of resources - the owners may lack knowledge, expertise and funds to expand.
  • Lack of motivation - expansion may result in increased rewards but perhaps the opportunity cost of lost leisure may be too much for a sole trader, and therefore the firm remains small. This is an example of satisficing, where a firm makes just enough profit to stay in business and then allows other objectives to take presedence.
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Reasons for growth of some firms

  • Profit motive - businesses grow to achieve higher profits and provide better returns for shareholders. The stock market valuation of a firm is influenced by expectations of future sales and profit streams so if a company achieves disappointing growth figures, this can be reflected in a fall in the share price. This opens up the risk of a hostile take-over and also makes it more expensive for a quoted company to raise fresh capital by issuing new shares
  • Cost motive - Economies of scale the long run increase the productive capacity of the business leading to lower average costs. They help to raise profit margins at a given market price
  • Market power motive - Firms may wish to increase market dominance giving them increased pricing power. This market power can be used as a barrier to the entry of new businesses in the long run. Larger businesses can build and take advantage of buying power (monopsony power)
  • Risk motive - Growth might be motivated by a desire to diversify production and/or sales so that falling sales in one market might be compensated by stronger demand in another sector. This is known as achieving economies of scope and is a feature of conglomerates.
  • Managerial motives - business expansion might be accelerated by senior and middle managers whose objectives differ from major shareholders.
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Organic growth

  • Organic growth involves expansion from within a business, for example by expanding the product range, or number of business units and location.
  • Organic growth builds on the business’ own capabilities and resources. For most businesses, this is the only expansion method used.
  • Organic growth involves strategies such as:
  • Developing new product ranges, launching existing products directly into new international markets (e.g. exporting), opening new business locations (either in the domestic marekt or overseas), investing in additional production capacity or new technology to allow increased output and sales volume.
  • Organic growth can come about from:
  • Increasing existing production capacity through investment in new capital & technology
  • Development & launch of new products
  • Finding new markets for example by exporting into emerging countries
  • Growing a customer base through marketing
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Organic growth

  • Advantages:
  • Less risk than external growth (e.g. takeovers)
  • Can be financed through internal funds (e.g. retained profits)
  • Builds on a business’ strengths (e.g. brands, customers)
  • Allows the business to grow at a more sensible rate
  • Disadvantages:
  • Growth achieved may be dependent on the growth of the overall market
  • Hard to build market share if business is already a leader
  • Slow growth - shareholders may prefer more rapid growth
  • Franchises (if used) can be hard to manage effectively
  • You may have limited resources for growing your own business
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Inorganic growth

  • Growing your business inroganically involves joining with another business through a merger or an acquisition.
  • Advantages:
  • Immediately expands your assets, your income and your market presence
  • You will have a stronger line of credit because of the combined value of the two businesses
  • You will benefit from the added expertise from personnel at the new business
  • Faster speed of access to new product or market areas
  • Increased market share / increased market power
  • Access internal economies of scale (perhaps by combining production capacity)
  • Secure better distribution channels / control of supplies
  • Acquire intangible assets (brands, patents, trademarks)
  • Overcome barriers to entry to target new markets
  • Defend a business against a takeover threat
  • Enter new segments of an existing market
  • To take advantage of deregulation in an industry / market
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Inorganic growth

  • Disadvantages:
  • You will have to expand your management capabilities dramatically
  • You will suddenly have many more employees and more assets to monitor, use and dispose of
  • The focus of the second business can take over the vision you had when you started your business
  • May enter areas of the marketplace where you have no expertise
  • Grow too fast
  • Most mergers and acquisitions require financing, and you will have to service your debt from the growth you experienced with the merger or acquisition
  • If your calculations about increased income are inaccurate, you may find yourself strapped with a debt you have difficulty repaying
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Mergers and takeovers

  • Synergy is a key concept associated with external growth. 
  • Synergy happens when the value of two businesses brought together is higher than the sum of the value of the two individual businesses.
  • Cost synergy: where cost savings are achieved as a result of external growth
  • Revenue synergy: where additional revenues are achieved as a result of external growth

  • Why do so many takeovers and mergers/acquisitions fail to improve shareholder value?
  • Many takeovers and mergers fail to achieve their aims
  • Huge financial costs of funding takeovers inlcuding the burden of deals that have relied heavily on finance
  • Clashes of corporate cultures
  • Newly-integrated business may suffer a loss of key personnel and customers, some job positions will be duplicated and so redundancies will occur. This can damage their reputation and make customers feel like their brand has changed.
  • Bad timing - mergers and takeovers that take place towards the end of a sustained boom can often turn out to be damaging for both businesses.
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Horizontal integration

  • This is when two firms merge at the same stage of the same production process. 
  • e.g. when Kraft bought Cadbury in 2010
  • Advantages:
  • Production similarities - the firms have excellent knowledge of the market and have similar production processes
  • Increased market share
  • Economies of scale
  • Elimination of threatening competition
  • Remove risk of being bought out
  • Market knowledge - the employees working in the firm taken over have new ideas which can be easily applied to your own business, increasing innovation.
  • Disadvantages:
  • Culture clash
  • Focus of risk on a narrow range of goods or services
  • Diseconomies of scale
  • Job losses
  • Likely to attract the attention of competition authorities
  • Some assets might be sold off, which is wasteful
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Vertical integration

  • This is when firms merge in the same industry but at different stages of the production process.
  • Backward vertical integration - one firm buys another firm that is closer to the raw material stage of production
  • Forward vertical integration - means buying another firm in the same production process but closer to the customer
  • Advantages:
  • Lower prices - they are no longer buying supplies from people who are also trying to make profit
  • Control over raw materials means supply is guaranteed
  • Complete and total control - helps to ensure the image and success
  • Other firms might be prevented from getting the supplies
  • Disadvantages:
  • Flexibility is hindered  - might find it hard to adapt to changes in consumer demand
  • Must have a large amount of capital to invest
  • A loss of focus
  • Size - Principal-agent problem
  • Might not have specialist knowledge of production
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Conglomerate integration

  • This is when firms from different indsutries merge.
  • Advantages:
  • Diversification - spreading risk - less vulnerable to losses due to decline in sales in one sector or industry. Profitable areas can cross-subsidise loss-making areas. 
  • Different products do well at different parts of the business cycle
  • Investment opportunity 
  • Increases customer base of the company
  • Brands can become better recognised
  • Disadvantages:
  • Lack of expertise in new areas
  • Shift in focus - brands might become diluted
  • Difficult to merge cultural value, employees and skills
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Constraints on business growth:

  • SIze of the market 
  • Access to finance - risk of loaning to smaller firms
  • Owner objectives 
  • Heavy government regulation 

Demergers occur when firms sell off parts of the firm as a 'going concern', or a viable business in itself.

Reasons for demergers:

  • To focus on the core business, and perhaps develop that part to gain benefits of specialisation
  • To raise finance (by selling the shares in the new company)
  • To avoid diseconomies of scale
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Impacts of demergers

  • On businesses - allow focus on the core business, raising funds from selling parts of the business, and removing loss-making parts of the business. In the long term, there will be higher returns as cost savings are made.
  • On workers - increased job security if loss-making parts of the business are demerged, reduced conflict between cultures, increased focus on the business to enable it to be more profitable. May be some job losses and shift in roles between parent and demerged firm. Opportunities for managers of the newly demerged business.
  • On consumers - greater competition leads to lower prices. Possible lost economies of scale may lead to higher prices.
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Economies of scale

  • Economies of scale occur when the average costs per unit of output decrease with the increase in the scale of the output being produced by a firm in the long run.
  • Techincal economies - large scale producers can employ techniques that cannot be used by a small scale producer. Using computers and technology to replace employees. Able to transport bulk materials. Unit costs are lower.
  • Purchasing economies - bulk-buying from suppliers. Likely to get better deals. Can employ expert staff to negotitate the best deals.
  • Marketing economies - the cost of advertising is spread over a larger number of potential customers. Bulk buy adverts and negotiate a lower price with TV channels, etc. Employ most talented marketers.
  • Financial economies - larger firms have access to a wider range of credit and usually at a lower price. Lower interest rates - easier to borrow money. Easier to raise capital. Larger firms can issue shares on the stock market and do deals with lenders to borrow at cheaper rates. Safer bet for loans.
  • Managerial economies - more specialised management can be employed, saves business money because they are more efficient. Usually means higher profits.
  • Risk-bearing economies - large firms can afford to take risks with new products/services because other parts of the business are still profitable.
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Diseconomies of scale

  • Unwieldiness - large firms can become difficult to manage. When a firm is difficult to manage we say it is unwieldy; decisions may take longer to implement and the person making the decision may not have knowledge of the outcome.
  • Slowness - takes a long time to respond
  • Communication - too many layers of management
  • Lack of engagement - management may become very distant from the worker so workers may become less loyal to management and the purposes of the firm. 
  • Loss of management focus from core objectives - principal agent problem
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External economies of scale

  • Sometimes an industry as a whole grows, with the effect that the individual firms can benefit from this growth. 
  • In this situation, the LRAC curve of the firm moves downwards without any action by the firm itself as the industry grows.
  • Often associated with particular geographical areas:
  • Location, skilled labour, transport, reputation of area
  • Examples:
  • As businesses grow within an area, specialist skills begin to develop
  • Skilled pool of labour: located in or near a university town
  • Being close to other similar businesses who can work togehter with each other
  • Having specialist supplies and support services nearby
  • Better road and transport links develop as the area improves
  • Reputation of the area improves as it becomes knwon for a particular industry
  • Attracts other businesses
  • Development of R&D facilities in local universities
  • Investment in industry-related infrastructure
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Minimum efficient scale

  • This is a concept which shows the relationship between short-run average cost curves (SRAC) and long-run average cost curves (LRAC)
  • At the point where the average costs are at a minimum, the minimum efficient scale (MES) of output of a firm is reached.
  • The MES is the output for a business in the long run where the internal economies of scale have been fully exploited (lowest point of LRAC)
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Productive efficiency

  • Concerned with producing the maximum output of goods and services at the lowest cost. 
  • Occurs where a firm operates on the lowest point on the average cost (AC) curve.
  • This demonstrates that resources are being used in their most effective way in production (operating on the PPF curve). Producing any other way would raise costs per unit.
  • MC=AC because MC always crosses AC at its lowest point.

Allocative efficiency

  • Occurs when goods and services are allocated according to consumer preferences.
  • Where the price equals the marginal cost of production, P=MC. It means that people are paying the exact amount it costs to produce the last unit. 
  • The price that consumers are willing to pay is equivalent to the marginal utility that they gain from consuming the good.
  • Where MC=AR (the price)
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  • When costs rise becuase there is no competition.
  • A lack of real competition may give a monopolist less of an incentive to invest in new ideas or consider consumer welfare. 
  • Even if the monopolist benefits from economies of scale, they will have little incentive to control production costs and X inefficiencies will mean that there will be no real cost savings.
  • To illustrate X-inefficiency on a diagram, the AC curve is drawn higher than it otherwise could be.
  • Occurs due to organisational slack, waste in production process, poor management

Dynamic efficiency

  • Ability to improve productivity over time, for example by innovating, investing in human capital or taking risks.
  • Is boosted by R&D spending and a faster pace of invention and innovation, investment in hte human capital of the workforce leading to gains in product quality, greater competition in markets and the transfer of knowledge and ideas across countries.
  • More likely to occur when a firm is making supernormal profits - able to invest more in R&D
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Evaluation of efficiency:

  • Increases employment if higher output required
  • Products and services reflect the demands of consumers
  • Prices will be lower if costs are lower
  • Reduces wastage of scarce resources (allocative)
  • Decreasing output could result in an increase in unemployment
  • Capital may become redundant
  • Capital-intensive production may replace labour (unemployment)
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Costs facing firms

  • Short run - the period over which a firm is free to vary the input of one of its factors of production (labour), but faces a fixed input of the other (capital)
  • Long run - the period over which the firm is able to vary the inputs of all its factors of production
  • Variable costs - costs that vary with the level of output e.g. operating costs, wages paid to staff
  • Fixed costs - costs that do not vary with the level of output, e.g. rent, salary
  • Sunk costs - short-run costs that cannot be recovered if the firm closes down
  • Total costs = total fixed costs + total variable costs
  • Total costs will increase as the firm increases the volume of production, because more of the variable input is needed to increase output. 
  • Average cost - total cost divided by the quantity produced
  • Marginal cost - the cost of producing an additional unit of output (change in total costs/change in output
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Costs facing firms

  • Short run - the period over which a firm is free to vary the input of one of its factors of production (labour), but faces a fixed input of the other (capital)
  • Long run - the period over which the firm is able to vary the inputs of all its factors of production
  • Variable costs - costs that vary with the level of output e.g. operating costs, wages paid to staff
  • Fixed costs - costs that do not vary with the level of output, e.g. rent, salary
  • Sunk costs - short-run costs that cannot be recovered if the firm closes down
  • Total costs = total fixed costs + total variable costs
  • Total costs will increase as the firm increases the volume of production, because more of the variable input is needed to increase output. 
  • Average cost - total cost divided by the quantity produced
  • Marginal cost - the cost of producing an additional unit of output (change in total costs/change in output
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Law of diminishing returns

  • Law of diminishing returns - a law stating that if a firm increases its inputs of one factor of production while holding inputs of the other factor fixed, it will eventually derive diminishing marginal returns from the variable factor
  • If the firm increases the amount of inputs of the variable factor (labour) while holding constant the input of the other factor (capital), it will gradually derive less additional output per unit of labour for each further increase.
  • It is a short-run concept, as it relies on the assumption that capital is fixed
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Types of profit

  • Normal profit - covers the opportunity cost of capital and is just sufficient to keep the firm in the market
  • It is the minimum level of profit necessary to keep a firm in that line of business.
  • It occurs where AR=AC where the quantity has been established from MC=MR.
  • This level of profit covers all the costs required to stay in business, plus a level of profit deeemed satisfactory to continue trading
  • Supernormal profit - refers to profits that exceed normal profit
  • Occurs where AR>AC
  • Means there is incentive for other firms to try and enter the industry
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Perfect competition

  • Number of firms: many
  • Freedom of entry: not restricted
  • Firm's influence over price: none
  • Nature of product: homogenous
  • This is a market where each individual firm is a price taker - no individual firm can influence the price of a product and the firm has to accept whatever price is set in the market as a whole.
  • This situation arises where there are many firms operating in a market, producing a product that is much the same whichever firm produces it, e.g. a market for carrots
  • Such markets are also typified by freedom of entry and exit 
  • Perfect competition - a form of market structure that produces allocative and productive efficiency in long-run equilibrium
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Perfect competition

The assumptions of the model of perfect competition are as follows:

  • Firms aim to maximise profits 
  • There are many participants (both buyers and sellers) - no individual trader is able to influence the market price. Limited economies of scale in the industry. If the minimum efficient scale is small relative to market demand, then no firm is likely to become so large that it will gain influence in the market.
  • The product homogeneous - no brand loyalty so no firm can charge a premium on its price.
  • There are no barriers to entry to or exit from the market 
  • There is perfect knowledge of market conditions - all participants in the market have perfect information about trading conditions in the market. Buyers always know the prices that firms are charging, and thus can buy the good at the cheapest possible price. Firms that try to charge a price above the market price will get no takers
  • There are no externalities - externalities are ruled out in order to explore the characterisitics of the perfect competition model.
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Perfect competition

  • As the firm is a price taker, it faces a perfectly elastic demand curve for its product. P1 is the price set in the market, and the firm cannot sell at any other price.
  • If it tries to set above P1, it will sell nothing, as buyers are fully aware of the market price and will not buy at a higher price. The firm can sell as much output as it likes at that going price - which means there is no incentive to set a price below P1.
  • The short-run marginal cost curve represents the firm's short-run supply curve: in other words, it shows the quantity of output that the firm would supply at any given price.
  • If the price falls below short-run average variable cost, the firm's best decision will be to exit from the market, as it will be better off just incurring its fixed costs.
  • If firms in this market are making profits above opportunity cost, the market is generating more profits than other markets in the economy. This will prove attractive to other firms, which will seek to enter the market - and the assumption is that there are no barriers to prevent them from doing so.
  • This process of entry will continue for as long as firms are making supernormal profits. However, as more firms join the market, the position of the industry supply curve shifts to the right.
  • At some point the price will have fallen to such an extent that firms are no longer making supernormal profits, and the market will then stabilise.
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Perfect competition

  • In the long-run, firms no longer have any incentive to enter or to exit the market. The market is in equilibrium, with demand equal to supply at the going price. The typical firm sets marginal revenue equal to marginal cost to maximise profits, and just makes normal profits

Efficiency under perfect competition

  • For an individual market, productive efficiency is reached when a firm operates at the minimum point of its long-run average cost curve. Under perfect competition, this is indeed a feature of the long-run equilibrium position. So productive efficiency is achieved in the long run - but not in the short run, when a firm need not be operating at minimum average cost.
  • For an individual market, allocative efficiency is achieved when price is set equal to marginal cost. The process by which supernormal profits are competed away through the entry of new firms into the market ensures that price is equal to marginal cost within a perfectly competitive market in long-run equilibrium. So allocative efficiency is also achieved. Firms also set price equal to marginal cost even in the short run, so allocative efficiency is a feature of perfect competition in both the short run and the long run.
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  • Monopoly - a form of market structure in which there is only one seller of a good or service
  • The assumptions of the monopoly model are as follows:
  • There is a single seller of a good
  • There are no substitutes for the good, either actual or potential
  • There are barriers to entry into the market
  • The firm aims to profit maximise
  • The firm is a price maker
  • For the monopolist, the demand curve may be regarded as showing average revenue and slopes downwards.
  • Unlike a firm under perfect competition, the monopolist has some influence over price, and can make decisions regarding price as well as output.
  • As with the firm under perfect competition, a monopolist aiming to maximise profits will choose to produce at the level of output at which MR equals MC.
  • This choice allowed the monopolist to make supernormal profits.
  • Other firms may see that the monopoly firm is making healthy supernormal profits but the existence of barriers to entry will prevent those profits from being competed away, as would happen in a perfectly competitive market.
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  • If a monopoly experiences an increase in the demand for its product (the demand curve shifts to the right), the MR curve will also shift, as this has a fixed relationship with the demand curve. 
  • After the increase in demand, the monopoly chooses to produce MR=MC, and now sets a higher price, making higher profits.
  • Natural monopoly - monopoly that arises in an industry in which there are such substantial economies of scale that only one firm is viable
  • A monopoly is neither productively or allocatively efficient.
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Price discrimination

  • First degree price discrimination - a situation arising in a market whereby a monopoly firm is able to charge each consumer a different price
  • Second degree price discrimination - charging a different price for different quantities
  • Third degree price discrimination - a situation in which a firm is able to charge groups of consumers a different price for the same product
  • There are 4 conditions under which a firm may be able to price discriminate:
  • The firm must have market power and price setting powers - therefore price discrimination is not possible by a firm in a perfectly competitive market
  • The firm must have information about consumers and their willingness to pay - and there must be identifiable differences between consumers (or groups of consumers)
  • There must be barriers to prevent consumers from different market segments buying from each other - the firm must be able to prevent 'consumer switching' - a process whereby consumers, who have purchased a product at a lower price, are able to resell it to those consumers who would have otherwise paid the expensive price. The act of buying from one market cheaply and selling in another market at a higher price is known as arbitrage.
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Price discrimination

  • There must be a different price elasticity of demand for each group of consumers - the firm is then able to charge a higher price to the group with a more price inelastic demand and a lower price to the group with a more elastic demand. By adopting such a strategy, the firm can increase total revenue and profits (i.e. achieve a higher level of producer surplus). To profit maximise, the firm will seek to set MR=MC in each separate market.
  • Advantages of price discrimination:
  • Some consumers are brought to the market that might otherwise have been priced out. Higher total output than just MC=MR
  • Profits may finance innovation and R&D
  • Profits may help cross-subsidise other activities
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Monopolistic competition

  • Monopolistic competition - a market that shares some characteristics of monopoly and some of perfect competition. The model describes a market in which there are many firms producing similar, but not identical, products. E.g. travel agents, hairdressers or fast-food outlets.
  • The assumptions of monopolistic competition are as follows:
  • There are many producers and consumers in a market - the concentration ratio is low
  • Consumers perceive that there are non-price differences among the competitors' products, i.e. there is product differentiation - this allows firms to build up brand loyalty among their regular customers, which gives them some influence over price.
  • There are no or low barriers to entry and exit into and out of the market - firms are able to join the market if they observe that existing firms are making supernormal profits
  • Producers have some control over price - they are 'price makers' rather than 'price takers' - but less so than monopolies, therefore the demand curve is more elastic than a monopoly, but more inelasitc than perfect competition
  • Monopolistic firms are profit maximisers
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Monopolistic competition

  • Demand is relatively elastic in monopolistic competition because each firm faces competition from a large number of very close substitutes offered by rival firms. However, demand is not perfectly elastic because the output of each firm is slightly different from that of other firms and can 'make the price' to some extent, unlike the price-takers in perfect competition. Monopolistically competitive goods are close substitutes, but not perfect substitutes.
  • In the short run, the diagram is essentially the same as it is for a monopoly, with the demand curve (MR) being more elastic. 
  • The assumption of free entry into the market means that the supernormal profits being made will attract new firms into the market. The new firms will produce differentiated products and this will have 2 important effects on demand for the representative firm's product:
  • The new firms will attract some customers away from this firm, so that its demand curve will tend to shift left
  • As there are now more substitutes for the original product, the demand curve will become more elastic
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Monopolistic competition

  • In the long-run, as a result of low barriers to entry, firms enter the market and take advantage of the supernormal profits. Eventually therefore, this shifts the firm's demand curve (MR) to the left. The AC curve will also be pushed up.
  • In the long-run, the firm operates where MC=MR, but also AC=AR, and the firm is just making normal profits. There is thus no incentive for more firms to join the market.
  • Neither of the conditions for productive or allocative efficiency are met with this long-run diagram.
  • n-firm concentration ratio - a measure of the market share of the largest n firms in an industry
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  • Oligopoly - a market with a few sellers, in which each firm must take account of the behaviour and likely behaviour of rival firms in the industry
  • The firms are therefore interdependent.
  • The kinked demand curve model revolves around how a firm perceives its demand curve. One problem that arises is that a firm cannot readily observe its demand curve with any degree of certainty, so it must form expectations about how consumers will react to a price change.
  • If the firm increases the price, it will lose customers because rivals are not expected to react, and will continue to sell at the old price. On the other hand, if the firm reduces price, it will face intense competition from rivals, and will be unlikely to gain many customers. Its best strategy may thus be do nothing.
  • Game theory - a method of modelling the strategic interaction between firms in an oligopoly
  • Dominant strategy - a situation in game theory where a player's best strategy is independent of those chosen by others
  • Nash equilibrium - a situation occuring within a game when each player's chosen strategy maximises payoffs given the other player's choice, so that no player has an incentive to alter behaviour
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  • Cartel - an agreement between firms on price and output with the intention of maximising their joint profits
  • Collusion can bring high joint profits, but there is always the temptation for each of the member firms to cheat and try to sneak some additional market share at the expense of the other firm(s) in the cartel.
  • In the UK the operation of a cartel is illegal under the UK Competition Act, under which the Competition and Markets Authority (CMA) is empowered to fine firms up to 10% of their turnover for each year the cartel is found to be in operation.
  • Overt collusion - a situation in which firms openly work together to agree on prices or market shares
  • Tacit collusion - a situation occurring when firms refrain from competing on price, but without communication or formal agreement between them
  • One way in which this may happen is through price leadership.
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  • Monopsony - a market in which there is a single buyer of a good, service or factor of production
  • A single 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.
  • There may be towns in which there is a single large employer that employs a significant proportion of the local labour force.
  • It is possible that the sheer buying power of the large chains of supermarkets would leave the relatively fragmented suppliers in a weak bargaining position. The supermarkets would then be able to keep their costs down by using their bargaining strength.
  • The supermarkets gain from establishing regular low-cost suppliers, the consumers gain from lower prices, and the suppliers gain from knwoing they have a regular buyer for their products. However, this supposes that the buyers do not exploit their market power to reach unreasonable deals with their suppliers. There may also be knock-on effects for other parts of the grocery sector, as small retailers may find it difficult to obtain produce at a price that allows them to remain profitable. This may result in a lessening of consumer choice.
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Price competition

  • Price Wars
  • Competition characterised by the repeated cutting of prices below those of competitors.
  • One competitor will lower its price, then others will lower their prices to match. If one of them reduces their price again, a new round of reductions starts.
  • In the short term, price wars are good for buyers, who can take advantage of lower prices. Often they are not good for the companies involved because the lower prices reduce profit margins and can threaten their survival.
  • In the medium to long term, price wars can be good for the dominant firms in the industry. Typically, the smaller, more marginal firms cannot compete and must close. The remaining firms absorb the market share of those that have closed. The real losers, then, are the marginal firms and their investors. In the long term, the consumer may lose too. With fewer firms in the industry, prices tend to increase, sometimes higher than before the price war started.
  • In oligopoly markets prices can become 'sticky' because if the price rises, competitors will not follow the rise (see kinked demand curve). So the merchant will lose its market share to its competitors on lower prices. But if the price falls, other players will merchants will follow suit if they can. At some point, merchants find that they cannot gain profit if they cut the price further— so the sticky price remains.
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Price competition

  • Predatory pricing - an anti-competitive strategy in which a firm sets price below average variable cost in an attempt to force a rival or rivals out of the market and achieve market dominance
  • This is because if a firm was failing to cover average variable costs, its strategy should be to close down immediately (shut-down point)
  • It would seem that consumers have much to gain from such strategies through the resulting lower prices. However, a predator that is successful in driving out the opposition is likely to recoup its losses by putting prices back up to profit-maximising levels thereafter, so the benefit to consumers is short lived
  • In some cases, the very threat of predatory pricing may be sufficient to deter entry by new firms. The existing firms could do this by making it known that they had surplus capacity, so that they would be able to increase output very quickly in order to drive down the price.
  • A new firm may reckon that, if the exisitng firm finds it worth sacrificing profits in the short run, the rewards of dominating the market must be worth fighting for. It may therefore decide to sacrifice short-term profit in order to enter the market - especially if it is diversifying from other markets and has resources at its disposal.
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Price competition

  • Limit price - the highest price than an existing firm can set without enabling new firms to enter the market and make a profit
  • This assumes that the incumbent firm has some sort of cost advantage over potential entrants, e.g. economies of scale
  • If the existing firm has been in the market for some time, it will have gone through a process of learning by doing, and therefore will have a lower average cost curve than the potential entrant. This makes it more likely that limit pricing can be used.
  • Thus, by setting a price below the profit-maximising level, the original firm is able to maintain its market position in the longer run. This could be a reason for avoiding making too high a level of supernormal profits in the short run, in order to make profits in the longer term.
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  • Contestable market  - a market in which the existing firm makes only normal profit, as it cannot set a higher price without attracting entry, owing to the absence of barriers to entry and sunk costs
  • Contestability looks at how easy it is for firms to enter an industry. A highly contestable market is one that is open to actual (firms actually have entered the market) or potentail (firms having entered, but the threat of doing exists) competition.
  • Some key conditions for a highly contestable market:
  • Size of entry barriers:
  • Absence of sunk costs
  • Access to technology
  • Low consumer loyalty
  • Sunk costs refer to costs that a firm incurs in setting up a business and which cannot be recovered if the firm exits the market.
  • New firms in the market must have no competitive disadvantage compared with the incumbent firms - they must have access to the same technology, and there must be no significant learning-by-doing effects.
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  • Under these conditions, the incumbent firm cannot set a price that is higher than the average cost, because as soon as it does it will open up the possibility of hit-and-run entry by new firms, which can enter the market and compete away the supernormal profits. Firms must set price equal to average cost, so that there are no supernormal profits to act as an incentive for entry.
  • Firms are likely to be efficient - for fear that inefficiency will prompt the entry of new firms.
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Non-price competition

  • This may be regarded as a 'safer' option by firms - it is potentially less damaging to revenue than a price war, and the advertising etc. carried out by firms may increase the overall size of the market.
  • Due to the risks of price wars, oligopolists tend to focus on non-price competition:
  • Product differentiation
  • Large scale advertising - if the firms in an industry typically spend heavily on advertising, it will be more difficult for new firms to become established, as they too will need to advertise widely in order to attract customers. 
  • Heavy marketing
  • Brand names - firms may spend heavily on achieving a well-known brand image that will ensure customer loyalty. Hence they invest a lot in the design and packaging of their merchandise.
  • Packaging
  • Free gifts/competitions/sponsorships
  • Excellent customer service
  • Loyalty cards
  • After-sales service
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Demand for labour

  • Derived demand - demand for a good or service not for its own sake, but for what it produces, e.g. labour is demanded for the output that it produces
  • Given that the demand for labour is a derived demand, the first factor that will determine the demand for labour is the output that labour produces. Given the law of diminishing returns, the additional output produced by labour as more labour is deployed is expected to diminish, other things remaining equal. This is because capital becomes relatively scarcer as the amount of labour increases without a corresponding increase in capital.
  • Marginal physical product of labour (MPP) - the additional quantity of output produced by an additional unit of labour input (the number of units that an additional worker produces). In the short-run, it will fall as each new worker is employed.
  • Marginal revenue product of labour (MRP) - the additional revenue received by a firm as it increases output by using an additional unit of labour, i.e. the MPP multiplied by the marginal revenue received by the firm.
  • Therefore if each additional worker contributes less and less output, then when these goods are sold, it also means that each employee will contribute less and less revenue to the firm. It makes sense then that as the quantity of labour increases, the wage that the firm is willing to pay will fall.
  • If the firm is operating under perfect competition, then marginal revenue and price are the same and MRP is MPP mulitplied by price. 
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Demand for labour

Factors affecting the position of the demand for labour curve

  • The productivity (output per worker) may change - if labour becomes more productive for some reason, then this will lead to an increase in the demand for labour. E.g. if a new technological advance raises the productivity of labour, it will also affect the position of the labour demand curve. Employers will be prepared to pay more to workers who are more productive.
  • The price of what is produced may change - because the demand for labour is a derived demand, a change in the revenue that the firm receives from selling the output that labour produces wll affect the demand for labour. If the MRP increases, employers will be willing to pay more for labour.
  • Demand for product being produced - as the demand for labour is a derived demand, a rise in the level of consumer demand for a product will mean that a business needs to take on more workers.
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Demand for labour

Wage elasticity of the demand for labour

  • Availability of substitutes - one significant effect on the elasticity of demand for labour is the extent to which other factors of production, such as capital, can be substituted for labour in the production process. If capital or some other factor can be readily substituted for labour, then an increase in the wage rate will induce the firm to reduce its demand for labourby relatively more than if there were no substitute for labour. 
  • Proportion of labour cost to total cost - the share of labour costs in the firm's total costs is important in determining the elasticity of demand for labour. When labour is a highly significant share of total costs, firms tend to be sensitive to changes in the cost of labour.
  • Time - capital will tend to be inflexible in the short run. Therefore, if a firm faces an increase in wages, it may have little flexibility in substituting towards capital in the short run, so the demand for labour may be relatively inelastic. However, in the longer term the firm will be able to adjust the factors of production towards a different overall balance. Therefore, the elasticity of demand for labour is likely to be higher in the long run.
  • Elasticity of demand for product being made - the elasticity of demand for labour in an industry is directly correlated with the elasticity of demand for the product itself.
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Supply of labour

  • We might expect to see an upward-sloping labour supply curve. The reason for this is that more people will tend to offer themselves for work when the wage is relatively high. 
  • An increase in the wage rate paid to workers in an industry will have 2 effects:
  • It will tend to attract more workers into that industry, thereby increasing labour supply
  • For existing workers an increase in the wage rate may have ambiguous effects.
  • A number of factors may influence the position of the labour supply curve:
  • An increase in the rate of unemployment benefits - if the government increased income tax or increased the level of JSA, then this would mean people were less incentivised to enter the labour market and start looking for work.
  • An increase in the rate of immigration to a country - if there are more people, there are more workers willing to work at a given wage rate (supply shifts to the right)
  • Expectations - If people expect to receive a poor pension and to live longer then they will work for longer and so labour shifts to the right. If people perceive that the macroeconomy is uncertain and that their jobs are insecure, people may wish to work more whilst they are employed in order to earn enough to save for a 'rainy day', so there will be more people willing to work at a given wage rate.
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Supply of labour

  • Working conditions - if the conditions or wages in other industries fall, then other industries may see an increase in supply as workers seek to enter new industries.
  • Changes in preferences or income - if the cost of living for people rises (inflation), then supply may shift to the right (increase) as people need to work more at a given wage rate in order to purchase everyday goods and services. Additionally, as incomes increase, people may want to enjoy more of their leisure time. E.g. if some people in the economy feel well off and have lots of disposable income, it is likely that supply will shift to the left (decrease) as thye do not feel the desire to work so much at a given wage rate. This is an A* concept and can be demonstrated on the backward bending supply curve, which shows the supply for an individual worker. The worker will continue to work more and more hours for a higher wage, up until the point where the curve begins to bend backwards. As the wage continues to rise, the income effect may gradually become stronger, so that at some wage level the worker will choose to supply less labour and will demand more leisure.
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Supply of labour

Wage elasticity of supply

  • The elasticity of supply of labour is a measure of the responsiveness of the quanity of labour to changes in the wage rate. There are several factors that may influence the elasticity of labour supply - in other words, to what extent an increase in the wage rate in a labour market will encourage an increase in the supply of labour.
  • The extent of unemployment and underemployment - The higher the level of unemployment, the higher the elasticity is likely to be. However, there are also likely to be obstacles to flexibility in labour supply. E.g. if the unemployed workers available for work may not have the skills needed for the vacancies available, so that training may be needed. Or if the workers available live in areas remote from where the vacancies are.
  • Time - labour supply may be relatively inelastic in the short-run. Labour supply will likely be more elastic in the long run, as more people may be attracted into high-paid occupations, industries or regions. Also, firms may shift their locations to where labour is more plentiful.
  • Availability of suitable labour in other industries - if an industry can recruit workers relatively easily from other industries (if there is a large pool of unskilled workers), then labour supply will be more elastic. For other occupations, such as teachers, there is a limited number of workers with appropriate qualifications so supply is more inelastic.
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Wage determination

  • The real wage rate (takes into account inflation) is determined by where the demand and supply of labour meet. The impact that a movement in demand or supply would have upon the wage rate will depend upon their relative elasticities.
  • A manager of a company is likely to be paid more than a cleaner for the same company. The MRP of the manager is likely to be higher. Their education, skills and work experience are likely to provide greater value to the company than the cleaner's. The supply of managers is lower than the supply of cleaners. Most workers in the workforce could be a cleaner, but only a few have sufficient qualities to be managers. A combination of greater demand and less supply lead to hgiher wage rates for managers.
  • Similarly, surgeons are in relatively inelastic supply. The education required to become a surgeon is long and demanding, and essential for entry into the occupation. Furthermore, not everyone is cut out to be a surgeon, as this is a field that requires certain innate abilities and talents. This implies that the supply of surgeons is limited, and does not vary a great deal with the wage rate. Once an individual has trained as a surgeon, there may be few alternative occupations to which they could transfer. On the other hand, the training programme for butchers is less arduous and a wider range of people are suitable for employment in this occupation. Labour supply is thus likely to be more elastic. There are also other occupations into which butchers can transfer.
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Labour mobility

Geographic mobility

  • Geographical immobility of labour is when workers find it difficult to move from one area to another. 
  • There are a number of reasons to explain why workers may not be freely mobile between different parts of the country. This will cause problems for the labour market if the available jobs and available workers are not located in the same area.
  • A key issue involves the costs that are entailed in moving to a new job in a new region. These could be considerable in social terms - people do not want to move away from their friends and relatives, or to leave the area that they know. Parents may not wish to disrupt their children's education. 
  • There are also strong economic considerations. The relatively high rate of owner-occupied housing in the UK means that workers who are owner-occupiers may need a strong inducement to move to another part of the country on search of jobs. Differences in house prices in different parts of the country add further to the problem.
  • There may also be information problems, in that it may be more difficult to find out about job availability in other areas. The internet may have reduced the costs of job search to some extent, but it is still easier to find jobs in the local area, where the reputation of firms is better known to locals.
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Labour mobility

  • Where both partners in a relationship are working, this may also make it more difficult to find jobs further afield, and there is some evidence that females tend to be less mobile geographically than males.

Occupational mobility

  • The difficulty that people face in moving between occupations is an important source of labour market inflexibility, and may result in structural unemployment.
  • Over time, it is to be expected that the pattern of consumer demand will change and if the pattern of economic activity is to change in response, it is important that some sectors of the economy decline to enable others to expand.
  • As the UK economy has moved away from manufacturing towards service sector activities, people have needed to be occupationally mobile to find work.
  • There are costs involved for workers switching between occupations. Firms may be expected to underprovide training to their workers because of the free-rider problem. There may therefore be a need for some government interention to ensure that training is provided in order to combat the problem of structral unemployment.
  • Workers may not hae the information to enable them to judge the benefits from occupational mobility. E.g. job satisfaction
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Government intervention in labour market

  • Unemployment benefits - if unemployment benefit is provided at too high a level, it may inhibit labour force participation, in that some workers may opt to live on unemployment benefit rather than take up low-skilled employment. In such a situation, a reduction in unemployment benefit may induce an increase in labour supply. It is important that unemployment benefit is not reduced to such a level that workers are unwilling to leave their jobs to search for better ones, as this may inhibit the flexibility of the labour market
  • Incentive effects - there are dangers in making the tax system too progressive. There may come a point at which marginal tax rates are so high that a large proportion of additonal income is taxed away, reducing incentives for individuals to supply additional effort or labour. 
  • Minimum wage - it is intended to protect workers against exploitation by the small minority of bad employers and aims to improve incentives to work by ensuring that 'work pays', thereby tackling the problem of voluntary unemployment. It aims to alleviate poverty by raising the standard of living of the poorest groups in society. It can be said that a NMW is causing an increase in unemployment because of its effects on the demand for labour.
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Policies to improve labour flexibility

  • Training, skills and information - The 1997 Labour government launched a package of policy measures knwon as the New Deal, which were aimed at reducing long-term unemployment. Such measures are designed to improve the flexibility of the labour market, by providing unemployed workers with information and skills training. 
  • Trade union reform - by negotiating for a wage that is above the equilibrium level, trade unions may trade off higher wages for lower levels of employment. The potential disruption caused by strike action can also impede the workings of a labour market.
  • Regional policy - there have always been differences in average incomes and in unemployment rates between the various regions of the UK. Housing markets limit the mobility of workers, and it is costly for firms to relocate their activities. The regions most affected have been those that specialised in industries that subsequently went into decline. 
  • Technology and unemployment - if firms invest in technology and expand the capital stock, this affects the marginal revenue product of labour and hence the demand for labour. What if new industries absorb less labour than is discarded by the old declining industries? It is important that the workers released from the declining sectors have (or can obtain) the skills that are needed fro them to be absorbed into expanding sectors.
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Government intervention to promote competition

  • Competition policy - a set of measures designed to promote competition in markets and protect consumers in order to enhance the efficiency of markets
  • A key focus of such legislation has been monopoly, as economic analysis highlighted the allocative inefficiency that can arise in a monopoly market if the firm sets out to maximise profit.
  • There is an underlying belief that competition induces firms to eliminate X-inefficiency as well as encouraging better resource allocation.
  • Under monopoly the single firm finds that it can extract consumer surplus by using its market power, and as a result the market performs less well. This point of view leads to a distrust of monopoly. Mergers that lead to higher concentration in a market will always lead to allocative inefficiency in the market's performance.
  • The first issue concerns the assumption that cost conditions will be the same under perfect competition as under monopoly. However, there are many reasons to expect economies of scale in a number of economic activities. If this assumption is correct, then a monopoly firm will face lower cost conditions than would apply under perfect competition.
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Government intervention to promote competition

  • A second important issue concerns contestability. If barriers to entry into the market are weak, and if the sunk costs of entry and exit are low, the monopoly firm will need to temper its actions to avoid potential entry. Thus, in judging a market situation, the degree of contestability is important. If the market is perfectly contestable, then the monopoly firm cannot set a price above average cost without allowing hit-and-run entry. 
  • Oligopolies also need careful attention because of the danger that they will collude, and act as if they were a joint monopoly. Government authorities may therefore be wary of markets in which concentration ratios are high. For this reason, it is important to examine whether a concentrated market is always and necessarily an anti-competitive market.
  • Another significant issue is that a firm that comes to dominate a domestic market may still face competition in the broader global market. This may be especially significant within the Single European Market. Some economists believe that the government should allow such firms to dominate the domestic market in order that they can become 'national champions' in the global market. This has been especially apparent in the airline industry, where some national airlines are heavily subsidised by their national governments in order to allow them to compete internationally. 
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Government intervention to promote competition

Government intervention to promote competition and contestability:

  • enhancing competition between firms through promotion of small business
  • deregulation
  • competitive tendering for government contracts
  • privatisation

The impact of government intervention on:

  • prices
  • profit
  • efficiency
  • quality
  • choice
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Government intervention to promote competition

Merger and anti-competitive behaviour policy

  • From April 2014, the conduct of competition policy has been entrusted to the Competition and Markets Authority (CMA). The CMA investigates mergers and anti-competitive practices in markets. The main functions of the CMA are:
  • Investigating mergers which could potentially give rise to a substantial lessening of competition (SLC)
  • Investigating markets to assess particular markets in which there are suspected competition problems
  • Antitrust enforcement by investigating possible breaches of UK or EU prohibitions against anti-competitive agreements and the abuse of a dominant position
  • Criminal cartels - the CMA is able to bring criminal proceedings against individuals who commit the cartel offence
  • Consumer protection
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Government intervention to promote competition

Merger and anti-competitive behaviour policy

  • From April 2014, the conduct of competition policy has been entrusted to the Competition and Markets Authority (CMA). The CMA investigates mergers and anti-competitive practices in markets. The main functions of the CMA are:
  • Investigating mergers which could potentially give rise to a substantial lessening of competition (SLC)
  • Investigating markets to assess particular markets in which there are suspected competition problems
  • Antitrust enforcement by investigating possible breaches of UK or EU prohibitions against anti-competitive agreements and the abuse of a dominant position
  • Criminal cartels - the CMA is able to bring criminal proceedings against individuals who commit the cartel offence
  • Consumer protection
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Government intervention to promote competition

  • Competition authorities will investigate larger mergers that will significantly reduce competition in the market and have power to prevent mergers from goigng ahead.
  • Illegal activities between firms that seek to limit competition come in several forms:
  • Creation of a cartel that colludes to fix high prices and/or allocating customers between themselves
  • Refusal to supply a product to a customer unless the customer buys other products at a high price
  • Predatory and limit pricing - both illegal methods of removing and restricting competitors
  • Such practices are quite common still because firms believe they will not be found out or prosecuted. Also, if the fine for engaging in anti-competition practices is a fraction of the extra profit that can be made from such practices, then there is a strong financial incentive for firms to engage in illegal activities. 
  • Strengthening laws, prosecuting offenders more and imposing larger fines therefore can increase competition in an industry
  • It is also often difficult for authorities to prove that collusion has taken place, so increasing funding and resources for competition authorities would likely reduce anti-competitive behaviour and increase competition within markets.
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Government intervention to promote competition


  • If a monopoly is state owned, the firm can be privatised. This means it is sold off to the pirvate sector and is no longer owned by the government. Free market economists would argue that privatisation and the pursuit of profit will increase efficiency. It is likely to reduce costs in the pursuit of profit maximisation - something which a government owned firm would not be seeking to achieve. The privatised monopolist will then offer lower prices to consumers and a better quality product.
  • Contracting out - a situation in which the public sector places activities in the hands of a private firm and pays for the provision. E.g. waste disposal
  • Competitive tendering - a process by which the public sector calls for private firms to bid for a contract to provide a good or service. 
  • Public-private partnership (PPP) - an arrangement by which a government service or private business venture is funded and operated through a partnership of government and the private sector. The most common partnership model is the Private Finance Initiative (PFI). 
  • Some economists may argue that private sector monopolies will always damage the interests of their customers because they charge too high prices and produce too little. A nationalised monopolist will be able to operate for the benefit of customers.
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Government intervention to promote competition


  • This is the process of removing government controls from markets.
  • The government may allow private firms to compete in a market, which is currently supplied by a state monopoly.
  • The government may lift regulations which prevent competition between private firms.
  • The government may also lift regulations when an industry is privatised
  • Deregulation attempts to improve economic efficiency through the promotion of competition. It is argued that this will lower costs (greater productive efficiency) whilst reducing prices and increasing output (increasing allocative efficiency). 
  • A problem with deregulation is that it encourages 'creaming' of markets (firms only providing services in the most profitable areas of the market).

Encouraging the growth of small businesses

  • Providing training, advice and grants to potential new entrepreneurs. Governments can also encourage the growth of existing small business by giving tax incentives or subsidies. The UK rate of corporation tax is 1% lower than for large businesses.
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Government intervention to promote competition

Government intervention to protect suppliers

  • They can pass anti-monopsony laws which make certain practices illegal 
  • They can appoint an independent regulator which has powers to force monopsonists to change their buying practices through a code of practice, possibly with the threat of large fines
  • They can encourage monopsonists to regulate themselves, drawing up their own code of practice - the weakest option as monopsonists will likely draw up a code of practice which allows them to continue to exploit their suppliers

Government intervention to protect employees

  • Profit maximising firms wish to pay the lowest possible wage, give as few benefits as possible and spend as little as possible on the working environment
  • Legal protection - legislation on health and safety at work, employment contracts, maximum hours at work, redundancy procedures and the right to belong to a trade union
  • Trade unions give their members significant protection from employers.
  • Government can encourage firms to draw up codes of conduct relating to employment practices
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Government intervention to promote competition

Regulation of privatised industries

  • Railway systems, water or gas supply and electricity generation are all examples of natural monopolies. In the past, one response to this situation would have been to nationalise the industry (take it into state ownership), since no private sector firm would be prepared to operate at a loss, and the government would not allow firms running such natural monopolies to act as profit-maximising monopolists making supernormal profits.
  • Where it was not possible, or feasible, to encourage competition, regulation was seen as the solution. 
  • Regulatory capture - a situation in which the regulator of an industry comes to represent the industry's interests rather than regulating it
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