Theme 3

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3.1.1 Why do some firms remain small
* Niche market - demand for product specialised and limited
* Lack of economies of scale/avoid diseconomies of scale - firm has a small minimum efficient scale
* Owner objectives
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Why some firms want to grow
- Economies of scale - larger firms have lower costs per unit of output in LR
- Increased market share - larger firm has more market power - can control prices and retain consumer loyalty - competition reduced
- Economies of scope - larger less exposed to risks of smaller firms
- Psychological factors - more job satisfaction working for well-known brand
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The principle-agent problem
- Shareholders own most large businesses (principle) - appoint managers to control business on their behalf (agent)
- Shareholders want to maximise profit but managers may have different objectives - increase sales and revenue at expense of profit
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Private sector firms
- Have to make profit to survive - primary objective is to make profit
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Public sector firms
- Can survive without making profit as gov can make up any shortfall in revenues
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3.1.2 Organic (internal) growth
- Firms grow from within - buy new capital, take on more workers
- Advantages - low risk and easiest form of growth to manage
- Disadvantages - firm might not take on new ideas/people
- might get too specialised in areas becoming out of date
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External growth
- Firms grow by buying out other firms - merging or taking over
- Disadvantages - may get too large and hard to control (diseconomies of scale)
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Horizontal Integration
- Firms merge at same stage of production process
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Advantages of horizontal integration
- Economies of scale
- Increased market share
- Reduced competition
- Removes risk of being bought out
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Disadvantages of horizontal integration
- Focus of risk on narrow range of goods/services
- Diseconomies of scale
- Some workers may loose jobs - roles in new bigger firm duplicated
- Workers may have to move/travel
- Assets may be sold off - duplicated equipment
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Vertical Integration
- Firms merge at different stages of the production process
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Backward vertical integration
- One firm buys another that is closer to the raw material stage of production
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Advantages of backward vertical integration
- Control over raw materials - supply guaranteed
- Other firms prevented from getting supplies
- Supplier's mark up can become profit for buying the firm
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Disadvantages of backward vertical integration
- Firm might not need to buy all the supplies
- Might not have specialist knowledge of production
- Might find it hard to adapt to changes in consumer demand
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Forward vertical integration
- Buying a firm closer to the customer in the same stage of production
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Advantages of forward vertical integration
- Consumers will see firm's product at its best
- Consumer might not be distracted by competition
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Conglomerate integration or diversification
- Occurs when a firm buys another firm in a completely unrelated business
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Advantages of conglomerate business
- Spreads the risk - profitable areas can cross-subsidise loss-making areas
- Different products do well at different parts of business cycle
- Brands become better recognised
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Disadvantages of conglomerate business
- Lack of expertise in new areas
- Brands might become diluted
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Constraints on business growth
- Size of market - some firms could increase output but would have to drop price considerably or not find market at all
- Access to finance - since credit crisis 2008 - been hard for small/medium size businesses to borrow and other forms of finance limited
- Owner objectives such as control - some firms like to 'keep it in the family' - avoid employing people outside family - may make firm easier to manage and workers may have greater incentive/loyalty
- Heavy gov regulation
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3.1.3 Demergers
- Business decides to split into two separate firms
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Reasons for demergers
- To focus on core business - develop that part to gain benefits of specialisation
- Raise finance by selling shares in new company
- Avoid diseconomies of scale - merged firms can be difficult to manage if involve different activities or too large
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Impact of demergers
- On businesses - long term - higher returns/profits as cost savings made
- short term - financial cost of selling off one or more firms
- On workers - expected job losses due to process of rationalisation
- opportunities for managers of newly demerged business to increase sales
- new jobs created and increased job security - loss making parts of business removed
- On consumers - impact on consumer prices depends on intensity of competition and cost of economies of scale - higher unit costs in LR
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3.2.1 Profit maximisation
- MR\=MC
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Reasons for a firm to profit maximise
- SNP are used for reinvestment
- Dividends for shareholders
- Reward for entrepreneurship
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Disadvantages of profit maximisation
- Calculating MC and MR in real world is difficult
- Day to day decisions are taken on basis of estimated demand - firms may adapt cost plus pricing
- Consumers sensitive to fair/ethical prices
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Revenue maximisation
- MR\=0
- Firm cuts its prices down to the point where extra revenue received from selling another unit is balanced by the reduced price on items it is already selling
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Reasons for firms to revenue maximise
- If a firm is going to have to dispose stock, costs aren't relevant
- Wishes to deter profitable entry of new firms - maintain more market power
- Ensure the business remains competitively priced in competitive market
- Gain more benefit from economies of scale
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Sales maximisation
- AR \= AC
- Firm sells as much as possible so that is at least makes normal profit
- Might increase market share and get rid of competitors by cutting price
- SR policy - in LR firm might return to profit max
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Reasons for firms to sales maximise
- Increased market share increases firms monopoly power and enables them to increase prices - make profit in LR
- Avoid attraction of competition authorities
- Avoid attracting other firms into market
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Satisficing
- Making enough profit to keep shareholders happy, after which managers can aim for other objectives
- Characteristics of the manager will be reflected in objectives of the firm
- Firms may wish to keep profits down to avoid being taken over - managers may gain satisfaction from being in control
- Some firms aim to make just enough profit to keep shareholders happy then pursue other objectives
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3.3.1 Revenue
- Amount of money received from selling goods and services
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Total revenue
- price x quantity
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Price maker
- Firm that has to cut its price in order to sell more
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Price taker
- Has to offer its product at the same price as everyone else
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Average revenue
- Price the firm receives per unit sold
- TR/Q \= P
- AR \= P
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Marginal revenue
- % change in TR/ % change in Q
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3.3.2 Costs in the short run
- At least one factor of production is fixed
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Fixed costs
- A cost that doesn't change with output e.g rent
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Variable costs
- A cost that changes with output e.g raw materials
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Total costs
- Fixed costs + variable costs
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Average fixed costs
- TFC/Q
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Average variable costs
- TVC/Q
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Average costs
- TC/Q
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Marginal costs
- Additional cost to the firm of making one more unit of output
- % change in TC/ % change in Q
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The law of diminishing marginal returns
- As more variable factors are added to a fixed factor, the increase in output will eventually fall
- Only applicable in the SR when at least one factor of production is fixed
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3.3.3 Costs in the long run
- All factors of production are variable
- As theres no fixed costs, there can't be law of diminishing returns
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Economies of scale
- Occur when average costs per output fall as scale of output increases
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Managerial economies
- Both large and small firms have just one person at top
- While manager of bigger firm may earn more, there is likely to be duplicated costs when two smaller firms combine to become one big one
- Larger firms can afford better managers - higher profits and long-term sustainability
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Financial economies
- Larger firms have access to wider range of credit than smaller firms and at lower price
- Large firms can issue shares on stock market and do deals to borrow at cheaper rates
- Often seen as safer bet for loans - more assets that can be sold to pay off debt
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Commercial economies
- Large firms can bulk buy from their suppliers
- As they buy a large amount at steady rate - better deals
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Technical economies
- Doubling dimensions of an object increases volume by 8 times - larger warehouse/shop can carry much more
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Marketing economies
- As firm grows bigger, cost of advertising spread out over large number of potential customers
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Minimum efficient scale
- At the point where LRAC are at their minimum, the minimum efficient scale of output of firm is reached
- No further economies of scale can be achieved beyond this point
- Affects number of firms that can operate in market and structure of markets
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Diseconomies of scale
- Occurs when average unit costs of production increase beyond certain level of output
- Unwieldiness - large firms can become difficult to manage - decisions take longer to implement and person making decision may not have required knowledge
- Slowness - takes large firm long time to respond in many cases
- X-inefficiency - lack of comp for large firm may mean costs are allowed to rise
- Lack of communication
- Lack of engagement - management may become distant from worker - workers become less loyal - more absenteeism
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External economies of scale
- Sometimes industry as whole grows - individual firms can benefit from this growth
- However, as industry grows, external diseconomies of scale may set in - difficult for firms to be notices
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3.3.4 Profit
- Reward for risk taking
- Revenue - costs
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Profit max
- Occurs at the output level where supernormal profits are at their greatest
- When MC \= MR, no more profit can be made - MP \= 0
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Normal profit
- The minimum necessary to keep risk-taking resources in their current use
- Occurs when AC\=AR or TC\=TR
- Doesn't act as signal for other firms to enter or leave market
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Supernormal profit
- Profit above the minimum required to stay in business
- It is the difference between TR and TC
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Losses
- Occurs when a firms total costs exceed revenues - TC\>TR
- Firm doesn't automatically shut down when making a loss
- Point where P \= AVC or below \= shut down point
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3.4.1 Efficiencies
- Efficiency measures how well resources are used to help satisfy changes in wants and needs
- Static efficiencies (at point of time) - productive, x-inefficiency, allocative
- Over time - dynamic efficiency
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Productive efficiency
- Concerned with producing goods/services with the optimal combination of inputs to produce maximum output for minimal costs
- Producers are minimising wastage of resources
- Occurs where firm operates on lowest average cost - lowest point of average cost curve
- However, little incentive for firm to operate at productive efficiency and no incentive to lower price this far
- Occurs where price \= MC \= AC as MC always closes AC at lowest point
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X-inefficiency
- Occurs when firm isn't producing at lowest possible cost for given level
- Happens when costs rise because there is no comp
- Main causes:
- monopoly power
- state control
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Allocative efficiency
- Occurs where P \= MC of production
- Means people are paying exact amount it costs to produce the last unit
- If people are prepared to pay more than it costs to produce last unit it would be better in terms of consumer satisfaction to produce more units - consumers prepared to pay more than cost to society
- However, if consumer satisfaction is less than cost of making unit, production should be cut back
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Dynamic efficiency
- Concerned with whether resources are used efficiently over time
- Measures a firms ability to improve productivity over time such as by innovating, investing in humans capital or taking risks
- Focuses on changes on amount of consumer choice available in markets together with quality of goods/services available
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Overview of market structures
- Concentration ratio - measures market share of nth largest firms
- E.g 3 firm ratio - market share of 3 largest firms
- Don't include 'others' in calculation
- Highly concentrated - few large firms - dominate market
- Low concentration - many small firms/market share diluted
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3.4.2 Perfect competition characteristics
- Many buyers and sellers - can't influence price - price takers
- No barriers to entry or exit
- Perfect knowledge
- All firms aim to maximise profit - MR\=MC
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Firms making a loss
- Firms will start leaving industry, prices will rise, output will rise for the individual firm as there's fewer firms in market
- Allows MC to rise as MR rises
- Firm may not shut down straight away - perfectly competitive firm will have fixed costs in SR
- If the firm more than covers its AVC, we can say its making a contribution to FC of production
- If it can't cover its AVC, its better to shut down straight away
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3.4.3 Characteristics of monopolistic competition
- Some price setting power - price makers - AR curve downwards sloping
- Many buyers and sellers
- Low barriers to entry/exit
- All firms aim to maximise profit - MR \= MC
- Imperfect knowledge - asymmetric info
- Type of product - similar but differentiated
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3.4.4 Oligopoly assumptions
- Few firms dominate market
- High barriers to entry/exit
- Firms aim for profit max - MR \= MC
- Firm faces downward-sloping demand curve
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3.4.4 Oligopoly
- Imperfect competitive industry with high level of market concentration
- Rule of thumb - oligopoly exists when top five firms or fewer in market account for more than 60% total market sales
- There is strategic interdependence - meaning one firms output and price decisions are influenced by likely behaviour of competitors
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Competition in Oligopolies
- With only few firms dominating, firms tend to avoid price comp
- Non price competition
- Use kink demand curve to show why prices are sticky and price comp seen as futile
- Non price comp key to market share and profitability
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Pricing strategies
- Sales max pricing
- Price wars
- Limit pricing
- Rev max pricing
- Price discrimination
- Predatory pricing
- Price leadership
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Non pricing strategies
- Quality and innovation
- Free gifts
- Product development
- After care/customer service/ warranties
- Packaging
- Advertising
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Pricing strategies - predatory pricing
- Involves cutting prices below average cost of production
- Short term measure only and once other firms have been forced out of market the firm raises prices again
- Almost always illegal
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Pricing strategies - price wars
- Occur when price cutting leads to retaliation and other firms cut prices - original firm again want to cut prices to increase their sales
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Pricing strategies - limit pricing
- Involves cutting price to point where new possible entrants or newly entered high cost firms can't compete
- The incumbent firm can sustain this position in long term as it has lower costs
- May or may not be illegal - depends on specific case
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Pricing strategies - price leadership
- In some markets dominant firm acts to change prices and others will follow
- As if other firms try to make changes this could set off price war or other sorts of retaliation
- Large firm becomes established leader
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Pricing strategies - non-price competition
- When firms take action to compete without changing price
- May be through advertising, loyalty cards, free gifts
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Evaluation of strategies
- How successful is it likely to be?
- Will rivals be able to copy strategy?
- Will firms get a 1st - mover advantage?
- How expensive is it to introduce the strategy? - if cost of implementation is greater than pay off - will be rejected
- How long will it take to work?
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Game theory
- Study of strategies used to make decisions
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Pay off matrix
- Two-firm, two-outcome model
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Dominant strategy
- Unique best strategy regardless other players actions
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Nash equilibrium
- All players pursuing their best possible strategy given the strategies of all other players
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3.4.4 Collusion
- Occurs when firms operate together or collaborate to limit comp and divide market
- Two types:
- overt collusion - operating together openly - occurs if firm sends message to another firm about its prices/decisions - illegal
- tacit collusion - unspoken - illegal but hard to control
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Why do firms collude?
- Remove cost of comp e.g marketing
- Interdependence - joint profit max - act together to maximise profits (use pay-off matrix to illustrate this)
- Successful collusion can increase SNP - increase producer surplus - increase shareholder value - increase share prices
- snp can also be used to R&D - dynamic efficiency
- Reduce uncertainty in market
- Protect market share/ dominance in market against rivals
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Collusion in a market is easier to achieve when:
- There are small number of firms in industry and barriers to entry protect monopoly power of existing firms in LR
- Market demand isn't too variable of cyclical
- Demand fairly price inelastic so that a higher cartel price increases total rev to suppliers - easier when product is viewed as necessity
- Each firms output can be easily monitored - enables cartel to more easily control total supply and identify firms who are cheating on output quotas
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Possible break downs of cartels
- Several factors can create problems within collusive agreement between suppliers:
- Enforcement problems - cartel aims to restrict production max profits - but each individual seller finds it profitable to expand production - may become difficult for cartel to enforce its output quotas - disputes about how to share profits
- other firms may opt to take free ride - producing close to but just under cartel price
- Falling market demand creates excess capacity in industry and puts pressure on individual firms to discount prices to maintain rev - collapse of coffee export cartel 2001
- Successful entry of non cartel firms into industry undermines cartels control of market - e.g emergency of online retailers in book industry led to Net Book agreement 1995
- Exposure of illegal price fixing by regulators
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3.4.5 Monopoly assumptions
- One firm in market
- High barriers to entry/exit
- Firms aim to profit max
- Firms face downward sloping demand curve
- Imperfect info
- Differentiated (monopoly power)
- Price maker
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Price discrimination
- When a firm charges different prices to different consumers for reasons that don't reflect cost differences
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conditions of price discrimination
- Some degree of monopoly power with barriers to entry
- Separate target market into two different sub categories with differing elasticities - inelastic and elastic
- Prevent arbitrage (re selling) and cost of preventing this must be lower than increase in rev
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Advantages of price discrimination
- Increase rev and make SNP - can use this increased rev to cross-subsidise - consumers more choice
- Allows them to manage demand
- Some consumer benefit from lower prices (elastic) - increase consumer surplus
- Increased SNP can be used for R&D / investment - dynamic efficiency
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Disadvantages of price discrimination
- Costs to administer/ prevent arbitrage
- Some consumers pay higher prices - decrease consumer surplus - lower income groups may have to pay higher price
- May not reinvest SNP / could just give to shareholders
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What is a natural monopoly?
- For NM, LRAC curve falls continuously over range of output - result may be that theres only room for one firm in market to fully exploit EoS available
- Key point is that it is characterised by increasing returns to scale at all levels of output - LRAC will drift lower as production expands
- LRAC is falling as LR marginal cost is below LRAC
- may only be room for one supplier to reach minimum efficient scale and achieve productive efficiency
- Example - Royal Mail postal distribution network - collection/sorting/delivery
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Benefits of monopolies for consumers
- Innovation - may bring new ideas and take risk of new ideas not working
- R&D - large firms more able to plough back large sums into this high risk enterprise - research more often then not leads to failure
- Investment - large scale firms can invest - confident
- Cross-subsidisation may lead to increased range of goods/services
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Benefits of monopolies
- SNP means:
- finance for investment to maintain competitive edge
- Monopoly power means:
- powers to match large overseas organisations - help keep jobs within country and improve bop
- Price discrimination may raise total rev to point which allows survival of product
- Monopolists can take advantage of EoS - AC may still be lower than the most efficient average of a small competitive firm
- Can avoid duplication of services - misallocation of resources
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Benefits of monopolies for governments
- Large firms may pay higher rates of cooperation tax - more profit monopoly makes, more firm will pay in tax
- May have competitors outside country - monopoly power helps keep jobs within country and improves bop
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Benefits of monopolies for workers
- May offer better job security
- Higher profits for firm may mean higher bonuses for workers
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Benefits of monopolies for other firms such as suppliers
- Can offer secure outlet for suppliers
- Firms that buy from monopolies may be more likely to have constant quality - not worth taking risks with quality - too much to lose