Theme 3

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3.1.1 Why do some firms remain small

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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  • might get too specialised in areas becoming out of date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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  • 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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  • 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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  • 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

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