HKDSE Econ - CH11-13 (Short-run and long-run production, Intergration and expansion of firms)

MUST ALSO REVISE NOTES

Production

The process of turning input into output

Variable factors

Factors which quantity changes when output changes

Fixed factors

Factors which quantity remains unchanged when output changes

Total product

Total amount of output produced at a certain level of employment of factors

Average product

Total product / number of variable factor

Marginal product

Change in total product

Law of diminishing marginal returns

When a variable factor is added continuously to a given amount of a fixed factor, the marginal product will eventually diminish, holding technology constant.

Marking scheme to support law of diminishing marginal returns

• X is a fixed factor as its quantity remains constant when the output changes

• Y is a variabl factor, so it is a short-run production

• The MP decreases from A to B when the Cth unit of factor is put to use

Marking scheme to not support law of diminishing marginal returns

• The quantity of X and Y both increase when the output changes. There are no fixed factors in the production. It is a short-run production

• The MP does not diminish when the output increases

Total cost

Total variable cost + total fixed cost

Marginal cost

Change in TC = Change in TVC

Marginal revenue

Average revenue = Price when constant

Profit maximisation condition

P = MR = MC, where the seller is a price-taker in perfect competition

Effect of profit maximisation when P increases

MR increases → profit maximisation output increases → total revenue increases

Effect of profit maximisation when fixed cost increases

• No change in variable cost → no change in MC → profit maximiation output remains unchanged

• Total cost increases → total profit decreases

Effect of profit maximisation when variable cost increases

• MC increases → profit maximisation output decreases

• TC uncertain → profit uncertain

Average fixed cost

Keeps decreasing, but larger than or equal to 0

Average variable cost

Increases initially and eventually decreases

Optimum scale of production

• AC / MC minimised

• Use of factors minimised

1. Definition of economies of scale / diseconomies of scale

2. Firms (blank) from EoS / DoS

1. Advantages / disadvnatages associated with long-run production that increase / decrease the average long-run cost of production

2. Enjoy / suffer

How can production scale be expanded?

By increasing production output

• Internal economies: increase in production scale of the firm

• External economies: increase in production scale of other firms / entire industry

Internal EoS

• Financial economies: lower borrowing costs / less collaterals

• Marketing economies: advertising costs / extra services provided to customers spread over a larger output

• Managerial economies: wider scope of specialisation → improves managerial efficiency and productivity

• Research and development economies: research expenses spread over a larger output → develop technologies to decrease cost

• Technical economies: more output → capital goods / machinery can be utilised more fully and efficiently

• Purchasing economies: purchase raw materials in bulk → obtain discounts

• Risk diversitifcation economies: diversify products / markets to reduce risk

External EoS

• Managerial economies: more talented workers are attracted to the industry and trained

• Marketing economies: Firms may benefit from the advertisement of other firms promoting similar products → create trends to attract customers

• More supporting services: transport and communication networks are better developed

• Technical economies: lower prices for backup services

• Purchasing economies: larger industries have more bargaining power to purchase materials earlier than smaller industries

Internal DoS

• Financial economies: large outstanding loans → increase in borrowing costs

  • Banks face higher risk when a large sum of money is borrowed again and again → increase interest rate to compensate for higher risk

• Marketing economies: market becomes saturated → marketing costs increase

• Managerial economies: too large in scale

External DoS

• Purchasing economies: excessive expansion in production output bids up prices of raw materials / inputs

• Increase in transport costs: over-concentration of business activities leads to traffic congestion

• Technical economies: firms providing backup services also suffer from DoS → increase price

Internal integration vs external integration / expansion

Internal: within a firm’s own capacity → opening more branches / introducing more products
External: combine with another firm

General motives of integration

• Make use of established brand’s goodwill to decrease advertising costs

• Enjoy economies of scale to reduce average cost

• Better use / reduce duplicates of faciltiies and resources (synergy effect)

Vertical forward integration

Expand to a business in the later stage of prodcution / that provides market outlets for produts

• Obtain market information through market outlets

• Ensure steady supply of market outlet of products

• Reduce transaction cost

• Develop relationship with customers

Vertical backward integration

Expand to a business in the preceding stage of production / that provides inputs or raw materials for production

• Ensure steady supply of inputs to prevent risk of disruption to production due to inadequate supply of input

Horizontal integration

Expand to a business selling similar / the same produts

• Increase market share / market power by influencing market price

• Reduce competition, eg avoiding price wars

Lateral integration

Expand to a business selling similar but not competitive products

• Reduce risk through diversification (use profits of one business to cover the loss of the other)

Conglomerate integration

Expand to a business in a completely unrelated industry

• Reduce risk through diversification (use profits of one business to cover the loss of the other)

Perfect vs imperfect competiiton

Buyer / sellers have perfect / imperfect information on the market

Market

A set of arrangements that allow a transaction to take place

• Buyer

• Seller

• Product

• Price

• P competition (eg. discounts)

• Non-P competition (eg. gifts / advertisements / improve product quality)

Price-taker

• Firms lose all customers when they set price different from other sellers

• No influence on market price

Price-searcher

• Buyers / sellers are not fully informed on every aspect of the market

• Market information involves cost to obtain

Characteristics of perfect competition

• Many sellers

• Free entry

• Homogenous product

• Perfect market information

• Price-taker

Behaviour of sellers in perfect competition

• No non-P comp (sellers can sell whatever Q they want at the same P)

• P comp (not expected to do so)

• P changes when D / S change

• MC same for all individual sellers (profit maximisation: MC=MR=R)

Characteristics of monopolistic competition

• Many sellers

• Free entry

• Heterogenous products

• Imperfect market information

• Price-searchers (seller can determine price on their own)

Behaviour of sellers in monopolistic competition

P competition and non-P competition

Characteristics of oligopoly

• Many sellers but with several dominant sellers

• Free or restricted entry

• Homogenous or heterogenous products

• Imperfect market information

• Price searcher:

  • Sell heterogenous products

  • Customers favour certain brands

  • Hold significant market share

Behaviour of sellers in oligopoly

• P competition and non-P competition

• Interdependent / price leadership

  • Consider the reaction of competitors when making business decisions (will follow competitors if they lower P) → keep lowering prices → leads to price wars (lowering P below the cost of production to increase market share)

  • Price tends to be rigid (agree on same / similar P) → non-P competition

Characteristic of monopolistic competition

• One seller (no close substitutes)

• Restricted entry

• Heterogenous (eg electricity) or homogenous (eg 1st class in MTR) products

• Imperfect market information

• Price-searcher (set P to maximise profit)

Behaviour of sellers in monopoly

• Face P copmetition and non-P competition from

  • Sellers of substitutes

  • Producers using similar production process / resources

  • Competition to be the only seller (eg. licenses)

• Business risk from inefficient operation

Sources of monopoly power

• Natural monpooly (high set-up costs → EoS decrease AC → no room for second producer)

• Government provision of strategic goods

• Ownership of patent / copyright (right of an inventor to buy / sell / produce their product)

• Ownership of essential technologies (eg. possession of superior raw materials)

• Sole ownership of franchise (license to operate in a particular trade / business)

• Collusion / integration with firms (collaborating with firms to increase joint profits eg. cartels)