Economics Mirco Y13

What is marginal revenue?

The change in total revenue as a result of changing the level of output by one unit

What is the law of diminishing returns?

As input of a variavle factor is increased, additional output produced by each additional unit of input falls, meaning SRAC increases, production process is contrained by the fixed factor.

What are the barriers to entry?

• High start up costs

• Legal barriers: a firm owning a patent to a particular design prevents other firms entering

• Economies of scale

• Brand names

• Ownership of raw materials

• Limit pricing: existing firm lowering prices so new firm makes a loss

• Predatory pricing: incumbent firm setting price below AVC to drive out rival firms

What are the barriers to exit?

• Sunk costs

• Contracts: legally obligated to to supply a product for a period of time

What is productive efficiency?

Where a firm operates at minimum LRAC, producing the maximum output possible from choosing an appropiate combination of inputs.

What is allocative efficiency?

Price = MC

What is dynamic efficiency?

When a firm invests sufficiently in R&D, leading to new production techniques and products.

What is X inefficiency?

Occurs when actual AC > attainable AC.

What is the principle agent problem?

Owners wanting to maximise profits where the managers may have a different objective. Principals delegate to agents who run things for them.

What is sales revenue maximisation?

• Managers salaries often linked to turnover rather than profits

• High expanding sales help attract external finance needed to fund investment

• To maximise it, firms would continue to produce more as long as additional output will increase rev

• When MR = 0

HOWEVER

• Principal agent problem is not inevitable

• Actions of agents could be closely monitored by owners to reduce asymmetric info

What is sales volume maximisation?

• Managers believing they will have increased career status from running large company

• Firms produce up the point where they would make a loss if they produced more output

• So where AC = AR

HOWEVER

• In practice managers are unlikely to be able to pursue turnover and competely ignore profits

• Would anger owners

What is growth maximisation?

• Firms may want to grow to increase market power = control price of product

• Done organically by external growth

HOWEVER

• Limit to how much firms can grow organically as it could lead to diseconomies of scale

How can alternative objectives contribute to increased profits in LR?

• Sales volume max: may develop e.o.s/market power that leads to profit max in LR, as firms outcompete rival firms and develop monopoly power = demand curve more inelastic

• Sales rev max: may help firms raise finance needed for capital investment, LR = lower costs

What is internal (orangic) growth?

When business finances expansion from within business.

What is external (inorganic) growth?

When the business finances expansion from outside of business.

What are the main methods of internal growth?

• Introducing new products: innovation and R&D

• Entering new markets: expanding overseas, changing marketing mix, using technology

What are the advantages/disadvantages of internal growth?

• Inexpensive

• Allows for business to expand on its existing strengths

• Can take a long time to achieve

• A lack customer demand

What are the main methods of external growth?

• Mergers: two businesses agree to join together. Majority shareholders of tw agree to share contol and ownership

• Takeovers: one business takes complete control by buying more than 50% of shares. A business selling shares to obtain finance is at risk of takeover. Hostile takeover occurs when one company buys more than 50% of shares without the wishes of target

What are the advantages/disadvantages of external growth?

• Reduces competition: increased market share = greater control on prices = more profit

• Gain new ideas from other businesses

• Quicker to grow

• Easier to break into new markets

• Two firms may have different objectives and targets

• Job losses as some employees made redundant

• Expensive/Risk of not happening

• Higher prices/less choice

What is horizontal integration and what are the +/-?

When two competitors join through a merger or takeover. The new business then becomes more competitve and increases its market share. This gives it more control.

• Removes a competitor from the market

• Opportunity for greater e.o.s

• Business gains a greater market

• Hostility and job losses may occur

• Changes within the business could impact negatively on consumer loyalty

• Can be expensive to purchase another company

What is forward vertical integration and what are the +/-?

When a business takes control with another that operates at a later stage in the supply chain.

• Guarantees an outlet to sell products

• Cuts out middle man leading to increased profits

• More control over pricing and product display

• Entering new markets may affect core activities as resources and expertise need to be shared

What is backward vertical integration and what are the +/-?

When a business takes control of a business earlier in the supply chain.

• Guarantees quality of inputs and supply of stock

• Cuts out middle man leading to increased profits

• More limit supplies to competitors

• Entering new markets may affect core activites as resources and expertise need to be shared

What is conglomerate integration and what are the +/-?

When businesses in unrelated markets join through a takeover/merger. Enables businesses to spread their risk over a wider range of products and services.

• Risk across different markets

• Targets new markets increasing customers base

• Business gains customers and assets from acquired business

• Experience/knowledge can be gained

• Entering new markets may affect core activites as resources and expertise need to be shared

• May not have knowledge required to successfully run the new business

What are the assumptions for perfect competition?

• Many small buyers and sellers

• No barriers to entry and exit

• Homogenous products

• Perfect knowledge

• Short run profit maximers

What are the efficiency implications for perfect competition?

• Productive - Y: firms operate at minimum of LRAC

• Allocative - Y: P = MC

• Dynamic - N: no incentive to invest in R&D as there is perfect knowledge so no SNP

• X - Y: firms have to operate at lowest attainable AC as they would go out of business

Whats the impact of consumer welfare in perfect competition?

• Price: highly competitive = consumers benefit from low prices = cannot exploit as they have no market power

• Choice: no choice as they are all selling homogenous products

• Quality: low as no incentive for innovation because of perfect knowledge, lack SNP

What are the assumptions for monopoly?

• Single seller of a good

• No substitutes for good

• High barriers to entry and exit

• SR profit maximisers

What are the efficiency implications for monopoly?

• Productive - N: deliberately restrict output below MES in order to keep prices high

• Allocative - N: firms exploit market power charging above MC, few resources are allocated to good as they restrict ouput to keep prices high

• Dynamic - ?: no incentive to invest in R&D as they control market, but they have SNP in order to keep market power high by increasing barriers to entry

• X - N: because lack of competitive pressures organisational slack may develop

Whats the impact of consumer welfare in monopoly?

• Low prices - N: firms have market power to exploit consumers, deliberately restrict output to do this. High barriers to entry enables firms to continue to charge high prices

• High quality products - N: firms have no incentive to improve quality of product as consumers have no choice, but could use SNP to innovate to keep barriers high

• High levels of choice - N: only one firm in market

What is a natural monopoly?

Occurs in an industry where there are such substantial e.o.s that only one firm is viable.

What are the advantages of a natural monopoly?

• Avoids wasteful duplication of resources: leading to lower costs = lower prices for consumers

• Nationalising: e.o.s can be enjoyed without expoiting consumers as firm is no longer profit maximiser

• Regulation: allocative efficiency achieved, setting pricing rule and subsididing difference between AC and AR

What are the disadvantages of a natural monopoly?

• Profit max firm: incentivised to restrict ouput = significant allocative inefficiency = consumers charged high prices

• X efficiency is likely to result when no profit incentive

• Gov needs sufficient info to know where to set pricing rule to regulate effectively. Still be inefficiency if regulation takes place, no incentive to keep costs down as they know profits will be limited

• Regulatory capture: regulator does not operate sufficiently independently of firm

What are the conditions for price discrimination?

• Firms must have market power

• Firm must have information about consumers willingness to pay

• Consumers must have limited ability to re sell product

What are the advantages of monopoly power?

• Monopolies make SNP which can be used by dynamically efficient

• Can price discriminate, no deadweight loss to society = reallocation of welfare

• Natural monopoly case its more efficient for there to be one firm in market

• Existence of domestic monopoly will enable to compete more effectively with large foreign girms in global market places

• Benefit from economies of scale

What are the disadvantages of monopoly power?

• Firms likely to use market power to exploit consumers by charging high prices and operating productively and allocatively inefficiently

• Gov can use competition policy to regulate monopoly firms, limiting power = forcing them to operate at allocatively efficient level of ouput - little incentive to be efficient = X inefficiency

• Price discrimination is unlikely

• Lack of competition may cause X inefficiency as they become complacent

What are the assumptions for monopolistic competition?

• Differentiated products

• Large no. of buyers and sellers

• No barriers to entry or exit

• SR maximiers

Why does a monopolistic competitive market make SNP in the SR?

• Initially equilibrium is at P1, Q1 and AR > AC = SNP

• Firms outside market observe SNP and no barriers to entry leads them to entering market

• Shifts supply to right from S1 to S2

• More firms in market and each individual recieves less demand

• Shifts AR and MR curve to left

• Continues to happen until SNP is eliminated

• New equilibrium of P1, Q1 where only normal profit exists

• Price decreases

What are the efficiency implications for monopolistic competition?

• Productive - N: output is too low

• Allocative - N: P>MC as unable to charge lower price due to high costs to produce differentiated good

• Dynamic - Y: come from differentiation so likely to be innovation, but without SNP is it possible?

• X - N: no space for slack

What are the advantages of monopolistic competition?

• Consumers enjoy wide range of choices

• Lots of innovation/quality improvements

• Cannot exploit consumers by making SNP as entry will increase and decrease price

What are the disadvantages of monopolistic competition?

• Product differentiation creates allocative and productive inefficiency

• Meaningful innovation may be limited by lack of profit

• Consumer pay high prices as a result of high costs

What is the market concentration ratio?

The % share of the market of a given no. of firms.

What are the assumptions for an oligopoly?

• High 3-5 firms market concentration ratio

• Firms are interdependent

• High barriers to entry and exit

• SR profit maximisers

What is collusion?

Where firms make agreements between each other over prices and/or output to maximise joint welfare.

What are the different types of collusion?

• Formal: formal agreements made on how to act collectively (illegal anti comp. behaviour)

• Informal (tacit): avoid getting caught by regulators, e.g. price leadership

• Strategic alliance: firms working together more loosely, not strict form of collusion

What are the efficiency implications of oligopoly?

• Productive - N: deliberately restrict output to keep prices high

• Allocative - N: firms collude to keep price above allocative efficient level

• Dynamic - Y: SNP, funds to engage in significant non price competition

• X - N: price and output stays same even when they have different costs, so X inefficiency may develop

What are the advantages of an oligopoly?

• If collusion breaks down, consumers will benefit from price wars due to interdependence

• Likely to be significant innovation as firms enjoy market power through non price comp.

• Benefit from economies of scale

• Can innovate

• Product differentitation and choice - non price factors

What are the disadvantages of an oligopoly?

• Price rigidity

• High barriers to entry

• Limited choice - products may be similar

What are price wars?

• Firms make SNP so tempted to break collusive agreement by lowering price

• Want to steeal market share from rivals

• Other firm cut price to avoid losing market share

• Lead to prices spiralling downwards

What is price rigidity?

• Prices tend to remain stable via collusion due to threat of price watrs

• Price remain unchanged even cost of production changes

• Rise in costs are absorbed by SNP

What is the game theory?

When firms is deciding to cut price or not it needs to consider outcome of possible responses from rival firms.

How is a market contestable?

• No barriers to entry or exit

• No sunk costs

• Are not in a competitive disadvantage compared with incumbent firms - no brand loyalty

• Access to same technology

• No prospect of incumbent firm limit pricing to discourage entry of new firms

What are the advantages of a contestable market?

• Prices will be lower than in profit max. monopoly

• Threat of new comp. provides incentive to invest in R&D, improving product quality and dynamic efficiency

• Closer to allocative efficiency as more consumer wants are met

• Closer to productive efficiency as firms are not restricing output

• Firms are X efficienct and cant afford to slack or there will be entry

• Potential job creation as more output is produced

What are the disadvantages of a contestable market?

• Perfect contestable market is unlikely, some sunk costs

• Firms get away with making SNP in SR and exploit consumers

• No investment in R&d as firms only make normal profit

• Firms may act anti competitively by merging or spending lots in advertising so market is no longer contestable

What is derived demand?

Demand for labour is dependent on demand for product. Only demanded because of what it can produce and what output can be sold for.

What is marginal revenue product of labour?

Change in firms TR as a result of employing one more worker.

MPPL x MR

What is marginal physical product of labour?

Change in total output that resukts from employing one more worker.

How can a firm make more profits using labour markets?

• MRP > MCL: employing additional worker as change in TR as a result of employing next unit of labour is greater

• MCL > MRP: make workers redundant as change in TC as a result of employing last unit of labour is greater

• MCL = MRPL: profit maximising level of emp., no need to increase or decrease emp.

What is the elasticity of demand for labour?

% change in quantity of labour demanded / % change in wage rate

What are the factors that determine the wage elasticity of demand for labour?

• PED for g/s produced: product inelastic = wage inelastic, high costs = pass costs onto consumers, little reduction in d&d = quantity of labour decreases less than prop.

• Proportion of wage costs to TC

• Ease with which labour can be substituted

• Elasticity of supply of complementary factors

• Time period

What are the factors that determine labour supply?

• Wage rate

• Opportunity to work overtime

• Possibility of bonuses

• Pension schemes

• Convenience and flexibility of hours

• Status

• Promotion chances

• Flexibility of location

• Qualifications and skills

• Job security

• Pleasantness of job

• Holidays

• Perks and fringe benefits

• Quantity and quality of training on offer

• Recent performance of firm

• Posession of a rare ability

What is the elasticity of supply of labour?

% change in quantity of labour supplied / % change in wage rate

What are the factors of the elasticity of supply of labour?

• Qualifications and skills required

• Length of training

• Mobility of labour

• Time period

• Vocationalism

• Availability of workers: more wage inelastic whilst in high unemp. labour supply

What is a monopsonist?

Firm that is only buyer of certain type of labour.

Why are monopsonists wage makers?

• They influence wage rate

• MCL>ACL as when firm wants to employ more workers they have to raise wage rate for all previous workers employed

What are trade unions?

Labour organisation that seek to promote interest of members

They negotiate:

• Pay

• Improved working conditions

• Security of employment

What is a bilateral monopoly?

Where unions negotiate with monopsonies over wage rates.

What are some wage differentials?

• Skilled workers earn more than unskilled workers

• Older workers earn more than younger workers

• Full time earn more than part timers

• Men earn more than women

• Ethnic minorities tend to earn lower wages

What are the advantages for government intervention in the labour market?

• Reduces poverty

• Can reduce male/female wage

• Increased motivation = increased productivity = increased profits

• Provides incentive to work

What are the disadvantages for government intervention in the labour market?

• Unemployment

• Increased costs for companies = higher prices and fall in profit

• Wage price spiral