ECONOMICS A2 LEVEL UNIT 3

BUSINESS ECONOMICS ANDTHE DISTRIBUTION OF INCOME

THE THEORY OF PRODUCTION

Production in the Short Run

Total Costs Fixed costs + variable costsFixed Costs Costs of production that do not vary as output changes

- Have to be paid regardless of production- Include rent and depreciation (fall in value of asset over life)

Variable Costs Costs of production that vary with output- Vary directly with output

Semi-Variable Costs

Costs with both fixed and variable element(EG: Landline telephone usage)

Short run Fixed costs and production scale remain sameLong run - All factors become variable

- Output scale can change

Marginal Returns

Marginal Product Output added by each extra unit of a factor (eg: worker)Average Product Total product÷Number of workersOptimal Output - Combination of fixed and variable factors

- Produces lowest average costProductive Efficiency Maximum output and minimum average cost

Marginal Returns in the Short Run

1. Increasing amount of variable factor are added to fixed factor

2. INCREASING MARGINAL RETURNSAddition of extra variable originally adds more output than previous variable

3. LAW OF DIMINISHING RETURNSAmount added to total product by each variable eventually decreases(EG: Due to overcrowding/overloading)

Average and Marginal Costs

Average Fixed Cost Total fixed costs ÷ Number of units of output producedAverage Variable Cost Total variable costs ÷ Number of units of output producedAverage Total Cost Total costs ÷ Number of units of output producedMarginal Cost Amount added to cost of production by next unit of output

- Marginal cost below average average cost falling- Marginal cost above average average cost rising- Marginal cost cuts average at its lowest point

Production in the Long Run

Firms can temporarily hold off problem of diminishing returns by:- Using larger premises- Specialisation

Growth without diminishing returns...- Requires different combination of variable and fixed factors- Will have separate ATC curve for each level of output- Assumes increasing returns to scale

Long Run Average Total Cost 1 Increasing Returns to Scale

(IE: Due to economies of scale)Increase in factor inputs more than proportionate increase in factor outputs

2 Constant Returns to Scale Increase in factor inputs proportional increase in factor outputs

3 Decreasing Returns to Scale(IE: Due to diseconomies of scale)

Increase in factor inputs less than proportionate increase in factor outputs

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Relationship between MES and size of domestic market may mean that economy can only support one firm at MES:- In this case a monopolistic structure is most efficient- Firms may have to export products to increase size of potential market

Relationship Between Short-Run and Long-Run Costs

Minimum Efficient Scale: MES (2)- Lowest point on LRATC curve- Long Run productive efficiency

- Firms at MES are more competitive- Output to meet MES depends on industry

- Firm producing at lowest point on SRATC is on LRATC- Scale of production increases unit costs likely to fall

Sudden Increase in Output- Originally at A- Movement along SRATC1- No longer at optimal output- Increase in unit costs to C

Increase in Scale of Production- Movement onto SRATC2- Movement down SRATC2- Decrease in unit costs- Reaches optimal output at BD

Some (smaller) firms may choose not to grow and overwork fixed factors due to:- Lack of finance- Inability to increase factory size- Fears that market growth is temporary

THE OBJECTIVES OF FIRMS

The Firm’s Revenues

Profits Total income/revenue for firm is greater than total costsTotal Revenue Price x Number of products sold

(Is equal to area under Quantity-Price curve)Average Revenue Total revenue ÷ Number soldMarginal Revenue Addition to revenue from the production of one extra unit

Revenues Dependant on Market

PERFECTLY COMPETITIVE MARKET IMPERFECT MARKET- Average revenue = price- Average and marginal revenue constant

- Average revenue = price- Average revenue > marginal revenue

Perfectly inelastic demand.

All units sold at one price.

Demand elastic up to a point.

More units sold as price falls.

Profit-Maximising Output

Revenue Cost ProfitUnit 1 £50 £20 £30Unit 2 £50 £30 £20Unit 3 £50 £50 £0Unit 4 £50 £80 £-30

The firm would produce Unit 3 as costs include ‘normal profit’.

The firm would not produce Unit 4 as they would lose money by producing it.

Normal Profit

Supernormal Profit More than that required to ensure supply of good- Incentive for firms to enter industry (allocation of scarce resources)- Indicate lack of competition

Normal Profit Amount required to keep factor employed in present activity in long run- Covers opportunity cost of all factors used in the process

Sub-normal Profit Less than that required to ensure supply of good- Oversupply and incorrect allocation of scarce resources

A Firm’s Objectives

Profit Maximisation Firm chooses level of output where MR = MC Can lead to lack of consideration of negative externalities

However, firms do not have all of the necessary information to make a rational choice in order to profit maximise. It could be expensive and time-consuming to seek profit maximisation.

Entrepreneur Individual who organises factors of production to make profitCorporation Private firm incorporated with The Registrar of CompaniesStakeholders Firms/organisations/individuals with interest in the firm

(EG: Employees, customers, national targets)

Public Limited Companies

1. PLCs are firms owned by a group of shareholders (shares can be traded)2. Shareholders have an Annual General Meeting where they make decisions:

a. They can elect directors who set corporate policiesb. They can discuss accounts and movements

3. Shareholders get financial returns is the firm is profitable (dividends)4. Activist shareholders want greater dividends and attempt to oppose management5. Firms cannot meet long-term objectives due to short-term shareholder pressures6. Some firms delist (remove their stock from stock exchange) to reduce pressure

FIRM OBJECTIVE THEORIESSatisficing Firm has satisfactory but not maximum profit:

- Reduces risk of activist shareholders- Reduces risk of hostile bid (shareholder takeover attempt)- Firms place more emphasis on job security/perks

Can produce anywhere between A and C on the diagram.Social Responsibility

Firm pays regard to needs of stakeholders:- Reduce carbon footprint (amount of greenhouse gases)- Look after their staff (eg: perks, more holiday etc)- Corporate citizenship activities promoting sustainability

Sales Maximisation Theory

Managers want their firms to be as large as possible:- May maximise revenue even if marginal revenue is zero- Will increase sales in order to increase:

- Market share (percentage of market held by company)

- Market power (influence over quantity/price of goods sold)Organisational Theory

- Larger firms involve many people in decision-making- Larger firms are slower to react to changes in the market- Organisations pursue a number of goals

Cost Plus Pricing Firms follow a policy of non-maximisation by choice:- Firms sets price to average cost plus conventional mark up- Prices can be slow to react to changes in the market

Long-Run Profit Maximisation

Firms seek respectability and cannot keep making changes:- Menu costs prevent firms from making constant changes- Firms attempt to grow for the future

The Growth of Firms

Increasing profits can be achieved by:- Reducing costs (reaching minimum efficient scale/exploiting economies of scale)- Increasing market share (to gain dominant position in market)

Internal Growth

- Using profits/loans to finance expansion over time- Increasing number of fixed/variable factors within firm- Innovating (introducing new product/process) in order to increase customer base- Increasing geographic reach of organisation

Could be slow due to:- Market saturation- Strength of competition (prevents raising/maintaining of prices)- Lack of profit

External Growth

Takeover One firm is forced to accept a deal by which it is taken overMerger Agreed coming together of two firms

- Often fail to deliver expected benefits:o Cultural/leadership differenceso Poor communicationo Inability of companies to adapt to change

MERGER TYPESHorizontal integration Two firms at same stage of production combine

(Increases market power, reduces competition)Vertical integration:BACKWARDFORWARD

Two firms at different stages of production combine:Firm combines with firm at previous production stageFirm combines with firm at next production stage

Conglomerate merger Firms with no obvious connection combine (diversifying)Lateral merger Horizontal integration between businesses with similarities

CONSIDERATIONS FOR EXTERNAL GROWTHTime constraints External expansion is faster than internal expansionCost Cheaper to buy out another firm than to undertake investmentBrand - Old brands can only be acquired through takeover

- New brands take time and money to build upAsset stripping Predator can sell off firm’s assets for more than it pays for themManagerial Managers can increase incomes if they increase market share

Firms and Technological Change

Technical progress has three components:- Increased productivity- Existing outputs increase in quality- New goods/services become available

But change is limited by the rate of gross investment.

Invention Coming up with new ideaInnovation Putting invention to commercial use:

- Lower costs (increased dynamic efficiency new processes)- Increase range of products

TECHNOLOGICAL INVESTMENT1. Firm operating on LRATC12. New cost-cutting technology comes in3. Firm invests in new technology4. Firm now operates on LRATC25. Firm makes a saving of BC

Firms who do not invest cannot compete on price.

COMPETITIVE MARKETS AND PERFECT COMPETITION

Perfectly Competitive Markets

ASSUMPTIONS:- Large number of buyers and sellers:

o All product is soldo Firm is a price taker (has to accept price ruling in market)

- No firm/buyer is large enough to affect market price- Perfect market exists (buyers/sellers have perfect knowledge of product/prices)- Homogenous products (products all same regardless of who makes them)- Freedom of market entrance/exit all firms can make normal profits- Readily available information (everyone benefits from technological advances)

o BUT firms are unlikely to engage in research and development- Factors of production are perfectly mobile (can do anything anywhere)

Firms in Perfect Competition

- Individual firm has to accept equilibrium (X)- Firm will have no customers if above- Firm will not make maximum profit if below- Demand is perfectly elastic- Consumer/producer surpluses maximised- Allocative efficiency (optimum allocation of

scarce resources)

Firm Production

- Firms wishing to maximise profit/minimise loss produce where MR = MC- In this example, firms would produce at Y

Short-Run Profits

Total Revenue = Price x Units = XYTotal Cost = ATC x Output = ZYTotal Profit = XY – ZY = K

If K is positive it is supernormal profit.In a perfect market, other firms will enter the marketuntil all supernormal profits are competed away.

Market Response

1. Firms attracted to supernatural profits enter industry2. Increase in supply from S1 to S23. Fall in price to £Z4. Firm’s revenue curve shifts downward as price has fallen5. To maximise profits, firms must produce at W6. Any unit produced above W adds more to costs than to revenue

Total Revenue = Price x Units = ZWTotal Cost = ATC x Output = ZWTotal Profit = ZW – ZW = K = 0The long-term position for a firm ina perfect market is at K.

Normal Profit: ATC = AR

Long-Run Equilibrium and Efficiency

Firm is in equilibrium as it is making normal profit (AR = ATC).

Productively Efficient MR = MC (Optimum output)Allocatively Efficient MC of last unit = Price of last unitStatically Efficient Both productively and allocatively

efficient at a point in timeDynamic Efficiency Efficiency over time:

- New products/techniques- Increases economic growth

Unlikely with perfect competition, as no incentive for firms to invest in research and development.

- Firms in perfect competition not large enough to exploit economies of scale- Firms in perfect competition assumed to have efficient allocation of resources

BUT firms may cut costs by disposing of waste in way that create negative externalities

Firms Making Losses

Market operating at S1.Total Revenue = Price x Units = ZWTotal Cost = ATC x Output = QWTotal Profit = ZW – QW = NEGATIVE

Firms leave market. Supply shifts to S2.

Entering and Leaving the Industry

Total Revenue = Price x Units = YWTotal Cost = ATC x Output = XWTotal Profit = YW – XW = NEGATIVEThis situation cannot continue long-term.

Total Variable Costs = ZWTotal Fixed Cost = XW – ZW

If the firm shut immediately, all fixed costs would have to be paid out of the owner’s pocket. As the price is above the AVC, it pays the firm to continue production to offset some part of its fixed costs and close down slowly.

The Short-Run Supply Curve for a Firm in Perfect Competition

Any reduction in price from Z will force the firm out of the industry immediately as it will be unable to cover its variable costs.

Some firms expecting future price rises may choose to enter the market as price rises above variable cost.

The Structural Performance and Conduct Model

STRUCTURAL PERFORMANCE AND CONDUCT MODELIndividual performance depends ultimately on the industry structure where the variables in the model are:Structure - Number and size of buyers and sellers

- Degree of product differentiation- Level of barriers to entry

Conduct Activities of:- Buyers (their position of power)- Sellers (use of productive capacity, pricing policies, R&D)

Performance Welfare Maximisation:- Resources achieving highest value output for economy

Structure of perfect competition should lead to optimal allocation of resources. Other market forms can be subjected to this analytical model and their outcomes judged relative to the outcome under perfect competition.

To get close to a perfect market, governments may introduce competition policies.

CONCENTRATED MARKETS: THEORY OF MONOPOLY

Monopoly

Assumptions of monopoly:- Output of industry all produced by single firm- Barriers to entry (obstacles prevent new firms entering market)

Legal Monopoly Firm with 25%+ of market share

Profit Maximisation

Monopoly producing when MC = MR, thus making maximum profits.This occurs at price X.

Total Revenue = Price x Units = XZTotal Cost = ATC x Output = YZTotal Profit = XZ – YZ = POSITIVE = SUPERNORMAL

Monopoly is not producing at lowest level of ATC.Monopoly is not productively efficient.Monopoly is X-inefficient (not reducing costs to lowest level).This is because it has no incentive to reduce costs to the minimum.

Sources of Monopoly Power

Patent Laws Grant of temporary monopoly rights over new productNationalisation - Taking firm/industry into public ownership

- Government prohibits competition by lawLimit Pricing - Incumbent (existing) firm exploits economies of scale

- Sets price so low that other firms cannot enter industryFixed Costs - Incumbent creates expensive fixed costs

- These costs are often sunk (irretrievable)(EG: Massive advertising campaign)

Product Differentiation Way of distinguishing product from competitors.Control of Raw Materials - Firm has control of raw materials forcing prices up

- Firm buys prime retail outlet sites

Range of Monopoly Outputs

A MR = MC (Profit maximising)B MR = 0 (Revenue maximising)C MC = AR (Allocative efficiency)

Marginal cost pricingD ATC = AR (Normal profits)

Average cost pricingNatural Monopoly

Natural Monopoly Most efficient for production to occur in one firm:- High capital cost to set up- Duplication unnecessary and wasteful- Minimum efficient scale occurs at extremely high output level

PROFIT MAXIMISATION- Monopoly should produce at Q1- Monopoly makes profits of RPXV

BUT authorities likely to use price controls

ALLOCATIVE EFFICIENCY- Monopoly should produce at Q2- Monopoly would make loss of AB- Government would have to subsidise

The Consumer and Producer Surplus

Monopoly and Efficiency

Perfectly Competitive Market (Ignore MR)

Price: PC Quantity: QC (optimum levels)Consumer Surplus: EFG

Monopolised IndustryMonopoly equates MR and MC to maximise profit.Price: PM (more) Quantity: QM (less)Consumer Surplus: EHI (smaller)

Monopoly does not produce more than QM as MC > MR. This would diminish profits.

- Marginal cost of producing last unit: QMJ- Price last unit sold for: QMI (considerably more)

Consumer Surplus

ABC Amount paid less than amount would have been prepared to pay

Producer Surplus

ACE Amount charged more than amount would have been prepared to charge

Dead-weight loss KJG Reduction in consumer and producer surplus when output is restricted to less than the optimum level

Monopoly and Dynamic Efficiency

- Monopoly benefitting from economies of scale- Marginal cost curve shifted right to MC1- Output now J (greater than competitive output)- Price falls to K (lower than competitive price)- Monopolistic situation benefits consumers

NOTE: Monopoly still not allocatively efficient as price of last unit (JZ) is greater than cost (JX).

The Minimum Efficient Scale

- MES not until high levels of output (A) in some industries- With monopoly, firms producing less (eg: B) unable to compete- Competitive market situation would lead to higher prices- In this situation, a monopoly would be preferable

Innovation

Monopolists responsible for economic growth:- High profits- Can afford to spend money on R&D and innovation- Would otherwise face competition from new more innovative firms- Innovation leads to economic growth

PRICE DISCRIMINATION

Price Discrimination Identical good/service sold to different customers at different prices for reasons not associated with costs(EG: to reduce consumer surplus and thus increase profit)

CONDITIONS FOR PRICE DISCRIMINATIONControl - Vendor can control what is offered

- No competing firms who could sell at lower pricePrevention of Resale - Resale prevented from one buyer to another

- Traders cannot buy in cheaper market and sell in dearerVarying Elasticity - Different elasticities of demand

- Some buyers prepared to pay more than others

METHODS OF PRICE DISCRIMINATIONGeographical - Different prices in different countries/regionsTime - Different prices at different times (eg: train tickets)

- Different elasticity of good/service at different timeCustomer Age - Different prices for different customers (eg: child fare)

TYPES OF PRICE DISCRIMINATIONFIRST DEGREE SECOND DEGREE THIRD DEGREEDiscriminating firm can charge separate price to each individual customer

Discriminating firm can charge separate price to different customer groups

Discriminating firm can charge separate price in different countries

- Sell where MR = MC

- Demand elastic abroad- Lower price abroad

Profit is shaded area:A + B > C:More profit with price discrimination.

Ability to make max profit.Each unit at max price.

Different prices for different blocks of consumption.

- Separation of markets- Individual bargains- Need understanding of

how much customer prepared to pay

1. Up to Z sold at A2. Beyond Z sold at B

No price discrimination: all sold at B less profit.

Consequences of Price Discrimination

ADVANTAGES FOR PRICE DISCRIMINATORIncome Redistribution - Income redistributed from consumers to producersProfits - Increased profits as ability to sell at maximum priceLarger Output Single Price Monopoly: Increase in output lower price

Discriminating Monopoly: Does not have to lower price

EFFECTS OF PRICE DISCRIMINATION ON CONSUMERSLoss of Welfare Consumer surplus disappears under first degree discriminationInequitable Some consumers have to pay more than others unfairReinvestment Profit reinvestment could lead to lower future costs and pricesFairer Lower prices for poorer citizens enable them to buy more

CONCENTRATED MARKETS: THE THEORY OF OLIGOPOLY

Structure of the Market

Oligopoly A few large firms have the majority of the market shareConcentration Ratio Proportion of the market share held by dominant firms

EG: 5:80 (five large firms have 80% market share)

Barriers to Entry

Predatory pricing Setting a price that would bankrupt competitor firmAdvertising Large firm large output low marketing average costMultiplicity of brands - Some customers regularly switch brands

- Larger firms can afford to run multiple brands- Larger firms pick up more brand-switching customers

Integration Combining with other firms (easier for larger firms)- Can control supply of resources/distribution- Can benefit from economies of scale

Non-price competition Techniques persuading customers to buy (non-price)EG: BOGOF, loyalty cards (affordable for large firms)

Branding Makes demand more inelastic- More affordable for larger companies

R&D Larger firms can afford more R&D:- More efficient production techniques lower prices- Greater variety of products (innovation)

Competitive Oligopoly

Interdependent Actions by one firm have impact on revenue of other firmsPrice War Firms competitively lower prices to increase market share:

1. One firm lowers price to increase market share2. Other firms lower prices to compete3. Decreased revenues for all firms in market

Reactive Behaviour Action taken by firms in response to change in competitorBrand Loyalty Measure indicating degree of consumer loyalty:

- More brand loyalty more inelastic demand

Non-Price Competition

Oligopolists avoid losing revenue through price wars by competing on areas other than price:-- In-store advertising/marketing- Loyalty cards- Increased range of services

- In-store chemists and post offices- Home delivery services- Discounted petrol at hypermarkets- Extension of opening hours

Kinked Demand Curve

Kinked Demand Curve

Analysis of reasons for oligopoly price stability:

- Demand elastic above Y (loss of revenue)- Demand inelastic below Y (price war)

SO firms leave their prices at Y

Different parts of kinked demand curvehave different marginal revenue curves:

- MC curve fluctuates between K and V- No reason for firm to change output from Z

Discontinuous Marginal Revenue Curve

Discontinuous Marginal Revenue Curve

Region over which change in marginal costs will not lead to change in firm’s price/output

- Marginal cost curve can shift between MC1 and MC2- This has no impact on output/price

- Shift from MC1 to MC2 decreases profits- Shift from MC2 to MC1 increases profits

- Oligopolists likely to attempt to reduce marginal costs

ISSUES WITH DISCONTINOUS MARGINAL REVENUE CURVE THEORY- No explanation for how original price was reached- Only deals with price competition not non-price competition- Ignores effects of limited price competition (eg: discounts, interest free credit etc)- Assumes reaction by competing firms no guarantee they will compete this way- Large/strong firm may ignore model and lower price beyond kink

Game Theory

Game Theory Analysis of how game’s players react to changing circumstancesZero Sum Game Gain by one player matched by loss by another player

- Competitive oligopoly assumed to be zero sum game- Parties are risk adverse

Risk Averse No party takes action that might promote retaliatory activity

Competing or Colluding

Nash Equilibrium

A firm’s best strategy is to maintain its present behaviour, given the behaviour of other firms.

Competing - Prisoner’s Dilemma(A does best if increases output to more than B without B changing)

- Both parties fear other party will make more profit- Both parties increase output (optimal preventative strategy)- Non-cooperative equilibrium reached (Nash)FIRMS BENEFIT FROM COLLUDING RATHER THAN COMPETING

Colluding Firms cooperate in pricing and output policies:FORMAL COLLUSION (Firms ensure MC=MR)(Often illegal as against competition policy)

INFORMAL COLLUSION

Cartel makes restrictive agreements in order to increase joint profits.

Conditions of successful cartels:- Major producers must all be cartel members- Market isolated from suppliers outside cartel- High barriers to entry to prevent competition- All producers must agree not to defect- Cartels selling homogenous products have

more success

Outcomes for producers in cartels:- Increased profit for inelastic products- Increase is non-price competition- Increased profit increased investment

Outcomes for consumers:- Increased price of products- Increased price of products made using

original product- Reduction of consumer surplus- Increased non-price competition

Price leader establishes market price that other firms follow.

Forms of price leadership:

- Dominant firm in industry changes price and all other firms follow

- Barometric price leadership (small firm’s price changes are accepted as they are adroit to interpreting market conditions)

- Parallel pricing identical prices and price movements maintained in industry

- Tacit collusion: firms reach agreement over pricing

Pricing Techniques

Two forms of pricing are common in oligopoly:TRANSFER PRICING COST PLUS PRICINGMNCs alter costs and prices to benefit from different tax levels in different countries.

- Overstate costs in high-tax countries- Sell products to subsidiaries cheaply- Sell products in low-tax countries- Declare profits in low-tax countries- Minimise tax bill- Maximise profits

- Easier for large firms in oligopolies to reach MES- Easiest to use cost plus pricing when at MES:

o Costs constant A and Bo Some output fluctuation allowedo Prices remain constanto Prevents menu

costs.

COMPETITION POLICY AND CONTESTABLE MARKETS

Imperfect Competition and Competition Policy

- Imperfect competition considered to imply productive/allocative inefficiency- Not true theoretically if monopolistic firms encouraged to be dynamically efficient

Competition Policy

Methods that UK government and EU authorities use in order to increase market efficiency covering:- Monopolies- Mergers- Restrictive Trade Practices- Promotion of new competition (encouraging contestable markets)

DEPARTMENT OF TRADE AND INDUSTRYGovernment department responsible for British industry reported to by:Office of Fair Trading

Government organisation responsible for implementing aspects of competition policy. It monitors:- Concentration ratio- Evidence of price discrimination/leadership- Merger/takeover activity (risk of monopolies/dominant firms)- Ratios of advertising expenditure to sales- Profit margins- Ratio of capital employed to sales turnover

If firms are found to exploit the dominant market position against the public interest (public right not to be exploited by monopolies) they are reported to the competition commission.

Competition Commission

Government organisation responsible for implementing policy relating to monopolies:- Outlaws abuse of dominant market position (40%+ market share)- Monopolies cannot restrict output to generate supernormal profits

Competition commission approaches to deal with monopoly abuse:- Compulsory breaking up- Price controls- Taxes on excess profits- Nationalisation (state control of firms)- Privatisation (sales of government-owned assets to private sector)- Deregulation

RESTRICTIVE TRADE PRACTICESMethods firms use to reduce competition/reinforce dominance including:Discriminatory prices Offering discounts if buyers purchase other productsResale price maintenance (RPM) Selling price fixed to prevent price competitionRefusal to supply outlets Retailers not agreeing to RPM not sold toFull-time forcing Firms wishing to sell product must stock entire range

Public Ownership

REASONS FOR NATIONALISATION:Economies of Scale Reduced prices would not be achieved in contestable marketNatural Monopoly Firms can gain continuous economies of scaleProvision Ensures provision of some necessary low-profit products

Privatisation

FORMS OF PRIVATISATIONDeregulation Removal of restrictions on provision of good/serviceSale of local authority assets Assets can be expensive to run and are thus soldCompetitive service tendering Introducing competition into market for provision of

public services (eg: refusing to collect rubbish)Franchising/licensing Different companies work in various regions

PRIVATISATION ADVANTAGES PRIVATISATION DISADVANTAGESEfficient as greater incentive to be productive Profit-led companies restrict outputRaises short-term government revenue Private firms often ignore externalitiesMore competition (breaks up monopolies) Vital loss-making services closedCapitalism enterprise culture innovation Reduced investment for long-term

(firms more focussed on short term)

Public-Private Partnerships and the Private Finance Initiative

Public-Private Partnerships (PPP)

Partnerships between public and private sector to provide public services (EG: contracting out)

Private Finance Initiative Form of PPP in which private firms take on bulk of work- Government decides on required service- Government seeks bids from private companies- Private companies build, finance and run projects- Draws on expertise of private companies

Regulation and Deregulation of Markets

REGULATION DEREGULATIONRules/controls restricting market freedom Removing government control from marketSelf-regulationGroup of firms regulate themselves through use of professional regulation

External regulationExternal agency enforces rules/controls- Reduces negative externalities- Deter abuse of monopoly power- Protect consumer rights

- Promotes competition efficiency- More firms less restriction on output

- Reduces unnecessary costs caused by ‘red tape’ put in place by governments

- Reduces regulatory capture (regulatory agencies influenced by firms)

Contestable Markets

Theory of Contestable Markets

In a contestable market:- High levels of competition:

o No one firm has significant market shareo Hit and run entry allowed

- No barriers to entry or exito Incumbent firms cannot exploit huge MESo No sunk costs

- Firms maximise short-run profits (produce at MC=MR)- Firms produce homogeneous or heterogeneous good- Perfect knowledge in market

Hit and Run Entry Firms enter market, cream some supernormal profit, exitGoodwill Value of firm in excess of asset value including:

- Reputation/brand- Trade contacts and general expertise

MONOPOLY/OLIGOPOLY FIRMS WILL MAKE NORMAL PROFITS IN LONG RUN1. Monopoly operates in industry making profit X2. Industry becomes contestable3. Monopoly fears competition4. Monopoly reduces price from MP to CP (ATC = AR)5. Monopoly now makes just normal profits6. Firms unable to make supernormal profits and compete7. New entrants deterred

MONOPOLY/OLIGOPOLY FIRMS FORCED TO BE EFFICIENT:1. Monopoly not producing at lowest point on ATC2. New firms enter market producing at most efficient output level3. New firms can price goods more competitively

Reality of Contestable Markets

ISSUES WITH THEORY OF CONTESTABLE MARKETSSunk Costs Impossible to eliminate sunk costs in some industriesTechnological Expertise Incumbent firms have better knowledge of industry technologySupply Chain New entrants take time to establish place in supply chainEntry Barriers Entry barriers can be extremely difficult to removeENTRANT BARRIERS:- Economic conditions- Competitor’s reaction- Market conditions- Govt regulations

INNOCENT BARRIERSPart of nature of industry:- Economies of scale- Large MES

Without these, firms may:- Accept competition- Attempt to invent barriers

STRATEGIC BARRIERSDeliberate and may include:- Hostile takeovers- Product differentiation- Predatory pricing- Limit pricing- Creation of brand loyalty- Increased advertising

Benefits of Contestable Markets

- Threat of competition prevents firms from raising prices too high- Firm can benefit from economies of scale without increasing consumer price- Reduced need for government interference (eg: with windfall profit taxes)

Criticisms of Contestable Market Theory

Limited Application - Sunk costs may be extremely high- Unachievable economies of scale for newcomers

Technical Knowledge - Incumbent firms have advanced technical knowledge- May be impossible for firms to enter without knowledge

Incumbent Patents - Patents prevent competition on specific goods- Efficient incumbent firms do not share results of R&D

Limit Pricing - Prices lowered beyond original competitive level- Newcomers unable to compete and forced to leave

Application of the Nash Equilibrium to a Contestable Market

SITUATIONS WHICH WILL NOT OCCUR:1. Monopoly in market with monopoly price (high)2. New firm enters and monopoly makes economic loss

1. Monopoly in market with monopoly price2. New firm does not enter and monopoly makes massive profit

1. Monopoly in market with competitive price (low)2. New firm enters and both make economic loss

SITUATION WHICH OCCURS:1. Monopoly in market with competitive price [the Nash equilibrium for this game]2. New firm does not enter and monopoly makes normal profit

THE LABOUR MARKET: DEMAND AND SUPPLY

Demand for Labour

Derived Demand for Labour

Demand for labour arises from demand for output it produces:1. Rise in demand for good X2. Rise in demand for workers who produce good X

Aggregate Demand Total demand for labour depends on level of economic activity:- Growing economy + confidence rising employment- Fall in national output + underconfidence unemployment

Individual Firm’s Demand

Number of workers a firm employs dependant on:- Price of labour- Productivity- Price of alternative factors of production- Supplementary labour costs (eg: National Insurance)

Marginal Productivity Theory

Marginal Productivity Theory Demand for workers depends on their MRPEquilibrium occurs when MRP=MCL

Marginal Labour Cost (MCL) Marginal cost of taking on additional labour unitMarginal RevenueProduct (MRP)

Value of output arising from hiring additional labour unit

MP x MR = MRPMP: Worker’s marginal product MR: Marginal revenue

Marginal Product of Labour Change in total output arising from hiring one more worker

Perfect competition is assumed:- Price of output does not change if firm sells more- Firms can recruit workers at constant wage rate

Marginal Revenue Product of Labour Curve

MRP curve of labour = demand curve for labour

Firm demands quantity of labour at which MCL=MRP

Wage Rate: W1 Quantity: Q1Wage Rate: W2 Quantity: Q2

Shifts in the Demand Curve for Labour

- Demand curve for labour shifts right if MRP of labour increases- MRP of labour increases if MP or MR increase- This could occur if there is an increase in productivity

The Elasticity of Demand for Labour

Elasticity ofDemand for Labour

Responsiveness of quantity demanded of labour to change in wage rate

Elasticity of Demand for Labour = % change in quantity of labour demanded % change in wage rate

FACTORS THAT DETERMINE ELASTICITY OF DEMAND FOR LABOURTime Period Elasticity of demand higher in long run:

- Easier to substitute labour for machinery in long run- In short run, workers may have contracts

Substitutes More substitutes for labour higher elasticityPED for Product - Inelastic demand for product, inelastic demand for labour

- Elastic demand for product, elastic demand for labourProportion of Labour Cost to Total Cost

Larger proportion of labour cost to total cost higher elasticityBECAUSE increase on wage bill has significant effect on costsHigh proportion + Increased wage rates = Left shift of supply

Supply of Labour

Participation/Activity Rate Percentage of population of working age in work/actively seeking work (75% in UK woo!)

Economically Inactive Percentage of population not in/seeking work

Supply of Labour to a Particular Occupation

PEOPLE ARE ATTRACTED TO JOBS BY:Monetary Factors Non-Monetary FactorsFinancial rewards to occupation Non-financial reward to particular occupation- Wage- Commission- Bonuses

More people want to do a job with a higher wage rate.

- Convenience and flexibility- Status (people attracted to jobs with status)- Promotion prospects- Job security- Working conditions- Holiday/leisure time- Perks/fringe benefits- Job satisfaction

Net Advantage(Adam Smith)

Overall rewards to particular occupation:- Monetary and non-monetary

Lower supply of workers when no non-monetary advantages, so they are paid higher wage by firms who want them.

Supply of Labour to a Particular Firm

FACTORS INFLUENCING SUPPLY OF LABOUR TO PARTICULAR FIRMS:In addition to factors influencing supply of labour to particular occupation.Training Firm offering high quantity/quality of training is more attractiveLocation Firms in cities/with transport links have greater supply of labourUnemployment Harder to find skilled labour when unemployment is lowOvertime Firms offering opportunity for overtime have higher labour supplyWage Higher wage rate likely to attract new workers into

the industry, increasing supply of labour to particular firm.

Elasticity of Supply of Labour

Elasticity ofSupply of Labour

Responsiveness of quantity supplied of labour to change in wage rate

Elasticity of Supply of Labour = % change in quantity of labour supplied % change in wage rate

FACTORS THAT DETERMINE ELASTICITY OF SUPPLY OF LABOURSkills Required Lower elasticity of labour supply for skilled jobsTraining Length Lower elasticity of labour supply for jobs with long trainingVocational Jobs with non-financial rewards (eg: teaching, nursing) tend to

have a more inelastic labour supplyTime Period Labour more elastic in long run (training period for job)

Individual Supply of Labour

Backward-bending Supply Curve for Labour

Workers prefer to work fewer hours as their income increases above a certain level

NOTE: Opportunity cost of an hour working

Income effect (of wage increase) Can work fewer hours for same paySubstitution effect (of wage increase) Individuals work more hours as

opportunity cost of leisure increases

THE LABOUR MARKET: WAGE DETERMINATION

Wage Determination

Demand and Supply

Wages influenced by demand and supply:1. Rise in demand for worker type2. Right shift of demand curve (D1 to D2)3. Extension of supply curve4. Rise in wage rate (W1 to W2)

Economic Rent and Transfer Earning

Transfer earnings

- Minimum payment needed to keep FoP in its present use- What FoP could earn in next best alternative use

Economic rent

Payment received by FoP above that needed to keep it in its present occupation:- Larger when supply is inelastic- Smaller when supply is elastic

Economic Rent = Total Earnings – Transfer Earnings

Trade Unions

Trade Union Organisation of workers who join together to further own interestsTrade Union Mark-Up

Addition to wages secured by members of trade union, compared to what they would earn without union

- Trade union acts as monopoly seller of labour- Trade union drives wages up from W1 to W2- This creates new supply curve W2A- Labour employed falls from Q1 to Q2- Some unemployment- OR increase productivity of members and shift MRP right

Employers with Labour Market Power

Monopsonist

Single dominant buyer (eg: of labour) so can set wage rate- Increase wage rate to employ more (so MCL > ALC) because

must increase all workers’ wages

Total Earnings WQAEconomic Rent WABTransfer Earnings ABQ

Monopsony in a Market Without Trade Unions

Competitive Market Outcome:Equilibrium wage: WCLevel of employment: QC

Monopsony not influenced by trade unions:Equilibrium wage: W1Level of employment: Q1

Monopsony in a Market With Trade Unions

Monopsony influenced by trade unions:- Trade union sets wage rate at W2- Kinked line W2AB is labour supply curve and ACL- MCL is double-kinked line W2ABE

As long as monopsonist employs labour force smaller than or equal to Q2, MCL = ACL=W2.- Beyond Q2, monopsonist has to offer higher wage

o This is represented by CE

- Under monopsony conditions, trade union increases wages and employment

- Closer union’s target wage is to competitive equilibrium (WC): higher employment

Wage Differentials

Wage Differentials Differences in wage arising between individuals, occupations, industries, firms and regions

Demand and Supply

High Demand Low DemandHigh (elastic) Supply Central wage Lowest wageLow (inelastic) Supply Highest wage Central wage

Higher marginal revenue productivity: higher wage.

OTHER REASONS FOR WAGE DIFFERENTIALSRelative BargainingStrength

- Those in strong trade unions tend to have higher pay- Those not in trade unions tend to have lower pay

Government Policy - National minimum wage- Increased public spending in areas

Esteem - More difficult occupations held in high public esteem have perceived higher MRP higher value higher wages

Wage Differentials Between Different Groups

Skilled/Unskilled - Higher demand for skilled workers ( higher pay)- Skilled workers have higher MRP ( higher pay)

Male/Female - More part-time women ( lower pay)- Negative discrimination undervalued MRP ( lower pay)- Break from career ladder to have children ( lower pay)

Part-time/Full-time - Higher supply of those willing to work part-time ( lower pay)- More likely to be in trade union if full-time ( higher pay)

Ethnic Origin - Qualifications of ethnic minorities often lower ( lower pay)- Many ethnic minorities work in catering ( lower pay)- Negative discrimination ( lower pay)

Discrimination in the Labour Market

Labour MarketFailure

Free market fails to achieve efficient allocation of resources in labour market

Discrimination Groups of workers treated differently to other workers in same job:- Form of Labour Market Failure

Negative Discrimination

NegativeDiscrimination

Group of workers treated less favourably than others:

- Increased labour supply to non-discriminating firms

- Reduced demand for workers discriminated against:o Workers may struggle to find worko Workers may take jobs they are overqualified for

- Reduced labour supply for discriminating firms:o Fewer workers to choose fromo Higher production costs (passed onto consumer)o Damaged international competitiveness

- Government time and money spent monitoring discrimination

Positive Discrimination

Positive Discrimination

Group of workers treated more favourably than others:- Positive government discrimination to offset negative discrimination

- Employers perceive MRP of particular groups of workers to be greater than it actually is

- Workers gain higher wages than others of similar ability

THE DISTRIBUTION OF INCOME AND WEALTH

Wealth

Wealth Stock of valuable assetsEG: Pension rights, property, shares, art, bank deposits, cash

Marketable wealth Wealth that can be transferred to others- Proportion of wealth held in property fluctuates over time

Non-marketablewealth

Wealth that cannot be transferred to others- Specific to certain individual (eg: life assurance)

Distributionof wealth

How wealth is shared out between population- Wealthiest 1% in UK own about a quarter of total wealth- Wealthiest 50% in UK own over 90% of total wealth

Richer: Older, white, male

Sources of Wealth

Inheritance - Main source of wealth- Property accumulated over generations (self-perpetuating)

Saving - Easier for high income earnersEntrepreneurship - Increasing source of wealth (self-made through risk)Chance - Lottery, premium bonds

Wealth Inequality

Inheritance - Stocks of wealth (estates, titles) passed through familiesMarriage - Rich people often marry rich people

- Wealth remains within small group of peopleIncomeInequality

- High earners better able to save and earn interest- Higher earners have access to higher-interest saving accounts

Chance - Successful business start-up- Lottery, premium bonds

Income

Income Flow of money to factor of production- May include wages, state benefits, pensions

Distribution of Income How income is shared out between factors of production

Functional Distribution of Income

Lorenz Curve Diagrammatic representation of distribution of income and wealth:

Horizontal axis: cumulative percentage of populationVertical axis: cumulative percentage of income earned

45° line of perfect equality (top 8% earn 8% of income)- More inequality: further Lorenz curve from this line

Gini Coefficient Statistical measure of the degree of inequality of income or wealth:Ratio of area between perfect equality line and Lorenz curve [A/(A+B)]

Distribution of Household Income in the UK

Causes of Income Inequality Between Households

Wealth Inequality - Wealthier households earn income from dividends/interestHousehold Composition - Different numbers of people in employmentLevel of Skills/Qualifications - More skilled people likely to earn moreDifferences in Earnings - Some workers earn more than others (see Chapter 8)

Reasons for Geographical Income Inequality

- Industrial structure (some areas have more low-paid manufacturing jobs)- Unemployment rates- Proportion of population claiming benefits- Qualification/skills of labour force in relation to employment opportunities- Higher living costs in some areas higher incomes

Types of Government Intervention to Reduce Income Inequality

Taxation - Progressive taxation redistributes income more evenlyMonetary Benefits - Means-tested benefits redistribute income more evenly

- Universal benefits are available for everybodyDirect Provision of Goods and Services

- Free at point of consumption (funded through taxation)- Give all citizens equality of opportunity

Legislation and Labour Market Policy

- Introduction of national minimum wage- Anti-discrimination legislation- Government subsidisation of training

Poverty

Absolute Poverty

Individual/household income insufficient for them to afford necessities- Worldwide: Less than $1.25 per day- Rare in UK and MEDCs

Relative Poverty

People are poor in comparison to others- In UK: Disposable income less than 60% of UK median

Targets for the Eradication of Poverty

- Increase in proportion of working-age people with a qualification- Improving literacy/numeracy at age 11- Reducing proportion of elderly people unable to heat homes properly- Reducing number of low-income households- Reducing homelessness- Reducing number of children in workless households

Poverty Audit Assessment of government performance in eradicating poverty

Groups More Likely to Suffer from Poverty

- Elderly- Disabled

- Sick- Single-parents

- Unemployed- Ethnic minorities

Causes of Poverty

Unemployment Lower income so more chance of povertyLow Wages Unskilled workers often earn lessSickness and Disability Dependency on sickness/disability incomes gives

people relatively low incomesOld Age State benefits major source of income for elderlyPoverty Trap[DISINCENTIVE]

Individuals are no better off following a pay increase because tax paid increases/benefits are withdrawn

Imperfect Information People unaware of entitlements to benefits

Government Policy Measures to Tackle Poverty

National Minimum Wage Statutory minimum wage introduced to boost earnings of low paidAND increases aggregate demand increasing demand for labourBUT increases firms’ costs of production unemploymentBUT creates an excess of supply unemployment

Progressive Income Tax Reduces extent of poverty trapTackling Unemployment Unemployment is major cause of povertyTraining/Education Increase worker productivity and thus long-term job prospectsTrickle-down Effects Encouraging rich to spend to stimulate economy for benefit of all

BUT would not benefit all groups experiencing povertyIncreasing Benefits Increases incomes of unemployed

BUT increases voluntary unemploymentTax Credits Creates incentives for people to work

AND does not increase voluntary unemployment

GOVERNMENT INTERVENTION IN THE MARKET

Market Failure

Free market fails to achieve efficient allocation of resources:- Negative externalities (underpriced goods/services)- Positive externalities (overpriced goods/services)- Public goods (not produced)- Merit goods (underproduced)- Demerit goods (overproduced)- Imperfect information (goods over/under consumed)- Monopolies (overpriced goods)- Immobility of factors of production (wastage)- Equity issues (poverty, inequality)

Leads to:- Productive inefficiency

o Firms not producing at minimum possible ATC- Allocative inefficiency

o Resources not being used to produce goods wanted by consumersGovernment Intervention

Governments may intervene to correct market failure:- Government legalisation and regulation- State provision of goods and services- Fiscal Policy intervention (eg: indirect taxes and subsidies)- Improving quality and availability of information available

Government Failure

Government intervention does not improve allocation of resources:- Political self-interest- Policy myopia (short-term solution)- Imperfect information- Unintended consequences- Regulatory capture (those who set regulations influenced by large firms)

Environmental Market Failure

Negative Externalities

Negative spillover effects to third parties not involved in production/consumption

- Social costs > Private costs- Profit-maximising firm only takes into account own costs- Free market equilibrium price less than social equilibrium- Allocative inefficiency Welfare Loss (shaded area)

DistributionalEffects

Environmental externalities often do not affect those who create them:- Global warming affects those in LEDCs more (flooding/drought)- PROPOSED SOLUTION: Impose tax on output of industrialised nations and

use revenue to compensate citizens for their revenue loss

Government Intervention to Correct Market Failure

Environmental Taxation

- Tax placed on good or service with negative impact on environmentEG: Fuel duty, air passenger duty, landfill tax, Congestion charges

- Tax is value of distance between MSC and MPC (BC)- Production levels move towards social optimum- Revenues raised from taxation fund environment clean-up

- BUT: Difficult to put accurate monetary value on environment- BUT: Difficult to achieve target reduction in pollution (don’t know how firms

will react to changing demand and supply unknown elasticities)- BUT: Inelastic demand raises revenues but will not reduce output much- BUT: Imposing tax on demerit goods (cigarettes) could be regressive- BUT: Increased environmental taxes reduces international competitiveness

Pollution Regulation

- Government could set pollution quota- Firms which do not conform to the monitor are fined (revenue)

BUT: Pollution monitoring systems are expensiveExtending Property Rights

- Tragedy of commons (overexploitation of un-owned natural resources)EG: Overfishing

- Government could set up pollution permits/emissions trading/carbon trading

- Firms who emit more pollution will have higher costs less competitive- This encourages firms to be more environmentally friendly

Kyto Protocol Agreement made at global summit meeting to cut world carbon emissions

Cost-Benefit Analysis (CBA)

Cost-Benefit Analysis (CBA)

Investment appraisal technique that takes into account all private and external costs and benefits of an economic decision- Used by governments in evaluating investment projects

Framework of CBA:1. Identify all relevant costs and benefits arising out of project- Divide costs and benefits into private and external costs/benefits2. Place monetary value of costs/benefits (shadow prices)3. Use statistical forecasting techniques to estimate long-term costs/benefits4. Compare social costs and social benefits- Project goes ahead if social benefits > social costs

Limitations:- CBA may not reflect distributional impacts of investment projects

EG: External costs may be localised, external benefits may be widespread- CBA may be ignored due to project objections from pressure groups- Very difficult to place value on environment/human life etc