Introduction to
Microeconomics
Study Guide
CONTENTS
Introduction
1 Introduction to Economics
2 The Market Mechanism
3 Elasticity
4 Costs of Production
5 Price Takers – Perfect competition
6 Price Makers – Monopoly
7 Imperfect competition
8 Labour Market
9 Market Failure – The Case for Government Intervention
10 Privatisation versus Nationalisation
AIMS
·
To teach students the basic principles of elementary
microeconomics
·
To develop student understanding of the relevance of
these principles in analyzing real world situations.
·
To introduce and develop essay writing skills.
1 INTRODUCTION TO ECONOMICS
1.1
THE ECONOMIC PROBLEM
What Is The Economic Problem ?
The scarcity of resources in relation to the calls made upon them imposes a choice on society as to the range of wants it wishes to satisfy. A decision to satisfy one set of wants necessarily means sacrificing some other set: this is what economists refer to as the opportunity cost of satisfying wants.
The basic economic problem is that of allocating scarce resources among
the competing and virtually limitless wants of individuals in a society.
The three basic questions that all nations have to decide in some way
are what goods and services to produce, how to produce them and for whom to
produce them. In order to do this
choices are made by households, firms and governments and these choices are
coordinated through markets for both goods and services and factors of
production.
The Distinction Between Micro and Macro Economics
Microeconomics is concerned with the behaviour of individual forms, industries, markets and consumers (or households). This branch deals with the problems of resource allocation, considers problems of income distribution and is chiefly interested in the determination of relative prices of goods and services.
Macroeconomics concerns itself with large aggregates, particularly for
the economy as a whole. It deals with
factors such as the determination of output and employment, the general price
level, spending and saving, total imports and export, the demand and supply of
money.
This course maintains the tradition and in the first semester we will
look at aspects of microeconomics, whilst the second semester will be concerned
with looking at the macro economy. It
should be pointed out that these two branches can never been completely
separated from each other as there are many linkages and overlaps between
them. The analysis of
unemployment, for example, draws on both micro and macro analysis.
Economic Methodology
Economic science seeks to understand the principles which determine the behaviour of households and firms and governments when they take decisions in the economy. It is made up of two components 1) careful and systematic observation and measurement 2) The development of a body of theory to direct and interpret observations. Thus an economic theory is a reliable generalization that enables up to predict the economic choices that people make and the economic effects of their choices. The term methodology refer to the way in which economists go about the study of the subject matter. There are broadly two approaches:
Positive economics is objective in that the validity of positive
statements such as what is, was or will be can be tested by reference to facts.
Normative economics is concerned with making suggestions about the ways
in which society is goal might be more efficiently realized. This involves economists in such ethical
questions as what should or ought to be.
For many years after the second world war
economics was dominated by the positive approach to the subject, but there is a
growing opposition to positivism and the hypo deductive methodology. There is an increasing recognition that
economics is a value laden subject.
Economists try to find economic principles by building models. The predictions of the models form the basis
of economic theories.
One of the simplest ways of constructing an
economic model is the use of production possibility frontiers. What follows are
examples of how these can be used to illustrate different economic situations.
Production possibility
frontier - diminishing returns
A production
possibility frontier will normally tend to be concave to the origin because of
diminishing returns to factors of production. In other words switching
resources from one use to another will lead to progressively smaller increases
in output of the other good.
Production possibility frontier – growth
(both goods)
An increase in the
level of resources (or the efficiency of the resources) will shift the
production possibility frontier outwards.
Production possibility
frontier – unemployment
Any point inside
the production possibility frontier indicates that there is unemployment or
under-employment of some resources. Points on the PPF indicate that resources
are being fully used and that an increase in the production of one good is only
possible by decreasing production of another.
Production possibility frontier - growth (one good)
An increase in the
level of resources (or the efficiency of the resources) for the production of
just one good will lead to the production possibility frontier shifting at just
one end.
Production possibility frontier - growth (both goods)
An increase in the
level of resources (or the efficiency of the resources) will shift the
production possibility frontier outwards.
1.2
RESOLVING THE
ECONOMIC PROBLEM
The basic economic problem can be resolved through a number of different economic systems. We will examine the extreme cases of the free market and command economies. In the real world, however, most economies are mixed to one degree or another.
A Free Market Economy
A free market economy is an economy where all economic decisions are
taken by individual households and firms.
Assumptions
·
Firms seek to maximize profits and households aim to
maximize utility
·
Workers seek to maximize their wages relative to the
human costs of working in a particular job.
The Price Mechanism (Adam
Smith’s Invisible Hand)
The system in a market economy whereby changes in price in response to
changes in demand and supply have the effect that demand equals supply.
Goods Market
·
Demand for a good rises creating a shortage
·
This causes the price of the good to rise choking
off the shortage and encouraging firms to produce more
Factor Market
·
The increase in the supply of the good causes an
increase in the demand for factors of producing used in making that good
·
This causes a shortage of those inputs and causes
the price to rise eliminating the shortage by choking off some of the demand
and encouraging the suppliers of inputs to supply more.
Assessment
·
Functions automatically, no need for costly and
complex bureaucracies. Can quickly adapt
to changing supply and demand decisions.
·
Markets are competitive, which not only keeps prices
down but is an incentive to firms to be efficient.
Adam Smith argued that the market mechanism ensured that an individual
pursuing private gain results in the social good.
Disadvantages
·
Competition between firms often limited,
the existence of monopolies or oligopolies results in higher prices and large
profits.
·
The market system is said to be efficient, but may
ignore the principal of equity. Power
and property may be unequally distributed.
·
Ignores social costs and benefits, therefore on the
one hand there may be practices which are socially undesirable, and on the
other some socially desirable goods would simply not be produced e.g. police
force.
·
Ethical objection, that a free market rewards self
interested behaviour.
The Command Economy
A centrally planned economy is an economy where all decisions are taken by central authorities.
Characterisitics
·
The allocation of resources between current
consumption and investment is planned.
·
At a microeconomic level the output of each industry
and firm is planned, along with the techniques used, the labour and resources
that will be used.
·
The distribution of output between different
consumers is planned.
Assessment
Advantages
·
Government could take an overall view of the economy
and direct the nations resources in accordance with
specific national goals.
·
High growth rates possible if the government
directed a large amount of resources into investment.
·
Unemployment could be avoided if government
carefully planned the allocation of resources.
·
National income could be distributed according to
need.
·
Social repercussions of consumption and production
can be taken into account.
Disadvantages
·
Costly to administer and cumbersome bureaucracy.
·
No system of prices.
As prices are set arbitrarily, rational decisions are hard as they do
not reflect scarcity.
·
Difficult to devise appropriate incentives to ensure
quality and motivation.
·
May involve loss of individual liberty as consumers
have little choice as to what to purchase.
·
Difficult to avoid shortages and surpluses.
Most economies fall some way between the two extremes. In a mixed economy the government may control
the following:
·
Relative prices of goods and inputs, by taxing or
subsidising them or direct price controls.
·
Relative incomes by the use of income taxes, welfare
payment or direct controls over wages, rent and profits.
·
Pattern of production or consumption by the use of
legislation, by the direct provision of goods, by taxes and subsidies of goods
and services provision.
·
Macroeconomic problems: inflation, unemployment,
lack of growth, balance of payments deficits, by the use of fiscal and monetary
policy, the direct control of prices and incomes and the control of the foreign
exchange rate.
Conclusion
The efficiency of the market as a way of allocating resources in a society underpins much of the content of microeconomics. It raises pertinent questions such as, should the health service be provided by the market. I will be elaborating on many of the ideas touched on in this lecture, such as perfect competition, market imperfection and market failure.
KEY CONCEPTS – you are advised to learn ALL of these
Scarcity
Production possibility curve
Resource allocation
Market mechanism
Centrally planned or command economy
Pur free market economy
Mixed economy
Microeconomics
Macroeconomics
2 THE MARKET MECHANISM
2.1
DEMAND
The Law of Demand
The quantity demanded is the amount of a good or service that consumers plan to buy in a given period.
When the price of a good rises the quantity
demanded will fall. There are two
reasons for this law:
·
The Income Effect means that the people’s income
will be reduced and therefore they buy less or the good.
·
The Substitution Effect means that as the good is
more expenses relative to other goods, people will switch to buying other
goods.
The Demand Curve
The market demand schedule shows the total demand by consumers at each
price over a given time period.
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Other Determinants of Demand
1.
The price of related goods
2.
Income
3.
Expected future prices
4.
Population
5.
Preferences
Movements Along and Shifts in the Demand Curve
A movement along the demand curve occurs as a result of a change in price. A shift in demand is when a change in a determinant other than price causes demand to all or rise, in this case the whole demand curve will shift to the left or right.
|
When price changes, the consumer will move along the
demand curve. This may be a contraction in demand (less demand because price
has risen) or an extension in demand (more demand because price has fallen). |
Contraction in Demand – Under “Movement along same demand schedule”
Shift diagrams, left and right
2.2
SUPPLY
The quantity supplied is the amount of a good that producers plan to sell in a given period of time.
Supply Curve
Shifts and movements in supply.
Contraction in supply
Extensions in supply
When the price of a good rises the quantity
supplied will also rise. There are three
reasons for this:
·
As more is supplied, producers will find beyond a
certain output costs rise more rapidly. (This
will be explained in detail when the costs of production are examined). Thus if higher output involves higher costs
of production, producers will need to get a higher price in order to persuade
them to produce extra output.
·
The higher the price, the more profitable it becomes
to produce. Firms will produce more by
switching production from producing less profitable goods.
·
In time a higher price will attract new producers to
the market and total market supply thus rise (Diagram 2.3).
Other Determinants of Supply
1. Prices of factors of production
2.
Prices of related goods
3.
Expected future prices
4.
The number of suppliers
5.
Technology
Movements Along and Shifts in the Supply Curve
The effect of change in price is illustrated by a movement along the supply curve. If a determinant other than price changes the whole supply curve will shift left or right.
2.3
PRICE
DETERMINATION
The determination of equilibrium price and output can be shown by using demand and supply curves. Equilibrium is the point at which the two curves intersect.
At any price above the equilibrium price there will be a surplus as
supply will exceed demand. The price
will fall in order to clear the market.
At any price below the equilibrium price there will be an excess
demand. The shortage will bid the price
upwards.
Market Equilibrium (pl)
KEY CONCEPTS – you are advised to learn ALL of these
Demand
Determinants of demand
Shifts in demand
Movements along demand curve
Supply
Shifts in supply
Movements along supply curve
Equilibrium
Shortage
Surplus
3
ELASTICITY
3.1
PRICE ELASTICITY
OF DEMAND
Price Elasticity of Demand is the responsiveness of quantity demanded to a change in price.
PED = percentage change in
the quantity demanded
percentage change in price
Normally we would expect n to have a negative sign since either price
or quantity in the equation above will be a minus figure.
The Value
Ignoring the sign and concentrating on a value of the figure, tells us
whether demand or supply is elastic or inelastic.
Elastic (n > 1) where a change in the price
causes a proportionately larger change in demand.
Inelastic (n < 1) where a change in the price
causes a proportionately smaller change in demand.
Unit elasticity ( = 1) where demand changes by
the same amount as the price.
Examples
Calculate the price elasticity of demand in the following examples:
1.
When the price of salt increases by 50% the quantity
demanded falls by 5%.
PED = 5%/50% = -0.1.
2.
When the cost of mortgages goes up by 5% the
quantity demanded falls by 15%.
PED = 15%/15% = -0.3.
3.
When the price of sports shoes goes up by 10% the
quantity demanded falls by 5%.
PED = 10%/5% = -2.0.
4.
When the price of Reeboks increases by 10% demand
falls by 15%.
PED = 15%/10% =
-1.5.
Factors Affecting The Price Elasticity of Demand
1.
The ease of substitution of another good or service.
2.
The proportion of income spent on a good.
3.
Whether the good is s necessity or a luxury.
4.
The period of time since the price change.
Applications
1.
Pricing strategy of firms
The total sales revenue (TR) is price times quantity (TR = PxQ).
Elastic demand
P rises, Q falls disproportionately, TR falls
P falls, Q rises disproportionately, TR rises
Inelastic demand
P rises, Q falls proportionately less, TR
rises
P falls, Q rises proportionately less, TR
falls
2.
Advertising Strategy
It is in the interests of firms to try to make demand inelastic by
creating brand loyalty and reducing substitutes.
3.
Government Taxation
It helps to explain why the government tax goods with price inelastic
demand such as alcohol and cigarettes rather than goods with elastic demand.
**All
diagrams here***
3.2
INCOME ELASTICITY
OF DEMAND
Income elasticity is the responsiveness of demand for a commodity to
changes in income.
YED = percentage change in the quantity demanded
percentage change in income
Income elastic n
> 1
Income inelastic n
between 1 and 0
(normal good)
negative income elasticity n < 0
inferior good
Factors Affecting Income Elasticity of Demand
1.
Degree of necessity of a good
2.
The rate at which the desire for a good is satisfied
as consumption increases.
3.
The level of income of consumers
Applications
Income elasticity is an important concept of firms in considering the size of the market for this product, in response to changes in national Income over the long term and short term fluctuations in the economy.
*Income Elasticity Diagrams, if there*
3.3
CROSS ELASTICITY
OF DEMAND
This is the responsiveness of demand for one good to a change in the
price of another.
CEDab
= percentage change in
quantity demanded of Good A
percentage change in the price of Good B
This relationship will be positive if the goods are substitutes and
negative if the good are complements.
Applications
Provides a measure for firms of the extent to which their goods are substitutes for other goods, and therefore indicates the degree of competition in the market.
3.4
PRICE ELASTICITY
OF SUPPLY
PES = percentage change in
quantity supplied
percentage
change in price
Factors Affecting Elasticity of Supply
1.
Spare Capacity
2.
Time lags
Supply elasticities are usually positive with values greater than zero.
Supply Diagrams, if there
Applications
1. Rising prices when there is insufficient spare capacity in the economy to respond to an increase in demand.
2. Inelasticity of supply in the short run
contributes to understanding why the price of primary products tends to be more
volatile than the price of manufactured goods.
KEY CONCEPTS – you are advised to learn ALL of these
You need to know the definition and the formulae in all cases
Price elasticity of demand
Income elasticity of demand
Cross elasticity of demand
Price elasticity of supply
Time lags
4 COSTS OF PRODUCTION
The theory of production and costs provides an analysis of how price signals should be translated into effective production decision, so that not only are markets provided with what they demand but also production is by the least cost method.
Market constrains are technology constraints limit the amount of profit
a firm can make. Most firms are in
business to make the most profit possible bearing in mind these two constraints
and they attempt to do so by maximizing output and/or minimizing cost.
Firms in wishing to alter its total product (i.e. the total quantity
produced) are constrained by limited factors of production. In the short run they may be able to only
alter one input, for example it may take several months or years to obtain a
new machine that makes the production process more efficient, but in the
meantime they can increase the amount of labour used. The new machine may come on stream in the
long run, which is a period of time when all input can be varied. With increased labour and new machinery,
production cannot go on increasing indefinitely and firms are subject to the
law of diminishing returns.
The Law of Diminishing Returns
This underpins the short run production function. The Law of Diminishing Returns states that as
successive increases in a variable factor are added to other fixed factors of
production, such as capital, there will be a point beyond which the extra or
marginal product will decline.
Diminishing
Returns
5.1
SHORT RUN COSTS
OF PRODUCTION
The short run is a period of time over which at least one factor of protion is fixed, the calendar time will vary from firm to firm.
All firms are subject to costs which can be split up into fixed and
variable costs as follows:
Fixed Costs are fixed in the short run e.g. rent, interest.
Variable costs vary with output e.g. raw materials, components, labour.
Definitions
Total cost (TC) = total fixed cost (TFC) + total variable cost (TVC)
Average total cost (ATC) = total cost = TC = TFC+TVC
Q
Q Q
Average fixed cost (AFC) = total fixed cost
= TFC
output Q
Average variable cost (AVC) = total variable cost = TVC
output Q
Marginal cost is the increase in total cost resulting from a unit
increase in output:
Marginal cost (MC) = change in total cost = r TC
change in
output r Q
Note: as total fixed costs do not change, it is only affected by
changes in variable costs therefore:
Marginal cost (MC) = r TVC
r Q
Table
4.2
Diagram 4.2
Diagram that shows total fixed costs, total variable costs, and total
costs.
5.2
COSTS OF
PRODUCTION IN THE LONG RUN
The Long Run Total Cost
Curve
This describes the cost of producing each output level when the firm is
able to adjust all inputs optimally, in other words in the long run all costs
are variable and it depends on the firm’s production function.
Returns to Scale
Constant – the percentage
increase in output = the percentage increase in inputs.
Increasing – the percentage
increase in output > the percentage increase in inputs.
Decreasing – the percentage
increase in output < the percentage increase in inputs.
Diagram 4.3
Diagram that shows economies of scale, diseconomies
of scale and constant costs.
Plant Economies of Scale or Technical Economies of Scale
1.
Specialisation
and divisions of labour. Workers and
managers can be employed who have specific skills in particular areas.
2.
Indivisibilities. Some inputs are a minimum size. If there are two types of machines, one
producing 6 units per day and one 4 units per day. A minimum of twelve units would have to be
produced, with two producing machines and three packaging machines if all
machines are to be fully utilized.
3.
The Container
principle. Any capital equipment that
contains things (blast furnaces, pipes, vats, lorries)
tend to cost less per unit of output the larger the size.
4.
Greater
efficiency of large machines. Only one
worker may be required to operate the machine.
5.
Multi stage
production. A large factory will be able to
take a product through several stages of its manufacture.
Other Economies of Scale
include:
Organisational economies
Research and development
Spreading Risk
Financial economies
Diseconomies of Scale
When firms get beyond a certain size, costs per unit of output may start to increase. There are several reasons for these diseconomies of scale.
Management problems of coordination.
Workers’ motivation may decrease and industrial relations may
deteriorate.
Complex interdependencies of mass production may lead to disruption if
there are any hold ups in any particular part of the firm.
External Economies
There has been a revival of interest in
Marshallian industrial districts. It is
argued by some economists and economic geographers that there are substantial
benefits to be gained from firms in the same area of production clustering together. They may benefit from the presence of
suppliers, distributors, a skilled labour market, specialist
research and development institutions.
Areas frequently quoted as examples are the Emilia Romagna area of
KEY CONCEPTS – you are advised to learn ALL of these
Fixed costs
Variable costs
Law of diminishing returns
Long run
Short run
Economies of scale
Diseconomies of scale
5
PRICE TAKERS –
PERFECT COMPETITION
5.1
ALTERNATIVE
MARKET STRUCTURES
The market structure under which a firm operates will determine its
behaviour. Firms under perfect
competition will behave differently from firms which are monopolies. This behaviour or conduct will in turn affect
the firm’s performance, profits, prices and efficiency. Economists thus see a casual chain running
from market structure to the performance of that industry.
Table 5.1
Features
of the Four Market Structures
|
Type of market |
Number of Firms |
Freedom of entry |
Nature of product |
Examples |
Implication for demand curve for firm |
|
Perfect competiton |
Very many |
Unrestricted |
Homogeneous (undifferentiated) |
Cabbages, carrots (these approximate to perfect competition) |
Horizontal. The firm is a
price taker. |
|
Monopolistic competition |
Many/several |
Unrestricted |
Differentiated |
Plumbers, restaurants |
Downward sloping, but relatively elastic. The firm has some control over price |
|
Oligopoly |
Few |
Restricted |
1. Undifferentiated or 2. Differentiated |
1. Cement 2. Cars electrical appliances |
Downward sloping, relatively inelastic but depends on reactions of
rivals to a price change |
|
Monopoly |
One |
Restricted or completely blocked |
Unique |
British Gas (in many parts of |
Downward sloping, more inelastic than oligopoly. The firm has considerable control over
price |
5.2
PERFECT
COMPETITION
Perfect competition is considered as the ideal or the standard against which everything is judged. Perfect competition is characterised as having:
Many buyers and sellers. Nobody has power over the market.
Perfect knowledge by all parties. Customers know that all products are the same. Advertising cannot persuade them otherwise.
Any seller has only a very small portion of the market. Again, suppliers cannot put pressure on the market.
Firms can sell as much as they want, but at the price ruling. Thus sellers have no control over market price. They are price takers, not price makers.
All firms produce the same product, and all products are perfect substitutes for each other.
There is no advertising.
There is freedom of entry and exit from the market. Sunk costs are few, if any. Firms can, and will come and go as they wish. Potential losses are zero, or very small.
Companies in perfect competition in the long-run are both productively and allocatively efficient.
Equilibrium under perfect competition
In perfect competition, the market is the sum of all of the individual firms. The market is modelled by the standard market diagram (demand and supply) and the firm is modelled by the cost model (standard average and marginal cost curves). The firm as a price taker simply 'takes' and charges the market price (P* in figure 1 below). This price represents their average and marginal revenue curve. Onto this we superimpose the marginal and average cost curves and this gives us the equilibrium of the firm.
Figure 1 Equilibrium of the firm and industry in perfect competition
Firms in equilibrium in perfect competition will make just normal profit. This level of profit is just enough to keep them in the industry and since profits are adequate they have no incentive to leave.
Normal profits
Normal profit is the level of profit that is required for a firm to keep the resources they are using in their current use. In other words it is enough profit to keep them in the industry. Anything in excess of normal profits is called abnormal or supernormal profits.
Any profit above normal profit is a 'bonus' for the firms, as it is more then they need to keep them in the industry. We call this supernormal (or abnormal) profit. However, this supernormal profit will be a signal to other firms and will attract more firms into the industry. If firms are making consistently below normal profits then they will choose to leave the industry.
What does this mean for prices and competition? Consider the following case.
A firm enters a perfectly competitive market with a product. It sells Q1 units of its product at price P1. It is able to make supernormal profits at this stage. It sells at P1 but has a cost of only C. It makes SNP's of P1 - C per unit sold. This is shown below.
Figure 2 Firm in perfect competition making supernormal profit
Competition is perfect. New firms enter the market. Supply increases (the supply curve shifts to the right - S2 in figure 3 below) and prices fall. The original firm has to lower its price or it will sell nothing. It charges P2 (the same as the market price) and so now sells only Q2. The market size expands from Q1 to Q2. Look at the modified diagram below.
Figure 3 The impact on a market of supernormal profit
The presence of SNP's has attracted more firms to the market and this led to the price falling. The supernormal profits were competed away and equilibrium was reached where only normal profit was earned. Each of the firms will now be in long run equilibrium earning only normal profit. The long run equilibrium is where MC = MR = AC = AR. This can be seen in figure 4 below.
Figure 4 Long run equilibrium in perfect competition
The falling prices put pressure on the less efficient firms. They may be forced to close and transfer their assets elsewhere.
Short-run losses
A firm with high costs may face a short-term loss-making situation during this process. It is not at risk in the short-run provided price at least covers its variable cost. Its fixed costs are prepaid, so it has breathing time. This is shown below. The price, P*, covers variable costs and some fixed costs. A loss of C - P* is made, but they have breathing time.
Figure 5 Short-run losses
The firm will have to get more efficient, or others will have to leave the industry so that prices may rise. If this happens in the short-run the market will be back in equilibrium, no firm will make SNP's and no firm will be making a loss. The market will settle down with no firms making losses and no firm making SNP's. It will be in equilibrium, as shown earlier. Look at the diagram again, you must know it and be able to explain its development.
Figure 6 Long-run equilibrium of firm and industry in perfect competition
So, perfect competition is a model of an efficient form of competition. Efficient firms face well informed consumers. Only normal profits are made, so prices are not excessive. Resources are used effectively and efficiently.
Allocative Efficiency.
Do perfectly competitively industries exist?
No 'perfect' perfectly competitive industries exist. Ironically, one of the closest today is probably the market for shares. However, as we mentioned before it is still an important model as it provides a benchmark of what we, as economists, regard as ideal and allows us to judge other industries against the 'ideal'. This should help us formulate appropriate policies to improve uncompetitive
Perfect Competition and the Public Interest
Advantages
·
Price equals marginal cost. Given that price equals marginal utility (how
much satisfaction a consumer places on a good), marginal utility will equal
marginal costs. This it is argued is
optimal.
·
If a firm is less efficient than other firms it will
make less than normal profit and be driven out of business. If it is more efficient it will earn
supernormal profits. Thus competition
will act as a spur to efficiency.
·
The desire to earn supernormal profits and to avoid
making a loss, will encourage the development of new technology.
·
The lack of advertising (all goods are homogenous)
will lower firms costs.
·
The long run equilibrium is at the bottom of the
firm’s long run average cost curve therefore will produce at the lowest cost
output.
·
Consumer gains from lower prices, since not only are
costs low, but there are no long run supernormal profits.
·
If consumer tastes change the price change will lead
to the form to respond.
These last two points are said to lead to consumer sovereignty. Consumers through the market decode what, and
how much is produced.
Disadvantages
·
Even though firms may have the technology to develop
new technology they may not be able to afford the necessary research and development. May be afraid that if their rivals copy them
the investment would have been a waste of money.
·
Perfectly competitive industries produce
undifferentiated products. This lack of
variety may be seen as a disadvantage to the consumer.
This occurs when no resources are wasted – when no one can be made
better off without making someone else worse off. Three conditions must be satisfied to achieve
allocative efficiency:
Obstacles to Efficiency
The two main obstacles to efficiency are:
External costs and benefits and the existence of
monopoly.
Thus we have seen how a firm in a perfectly competitive market chooses
its profit maximizing output. We have
seen how the actions of all firms combine to determine a market supply. We have seen how a competitive industry
operates in the short run, we have studied the dynamic
forces and move such a market to along run equilibrium. The model of perfect competition allows us to
understand important features of real world markets even though many markets do
not approximate this model.
KEY CONCEPTS – you are advised to learn ALL of these
Perfect competition
Price taker
Short run under perfect competition
Long run under perfect competition
Normal profit
Supernormal profit
Profit maximization under perfect competition
Long run equilibrium
Close down point
Allocative efficiency
1
PRICE MAKERS – MONOPOLY
What Is A Monopoly
An industry where there is a single supplier of a good or service that has no close substitutes and in which there is a barrier preventing new firms from entering is a monopoly. In practice the boundaries of an industry are arbitrary, and the determination of monopolies is along and costly business for institutions such as the Monopolies and Mergers Commission.
Barriers To
Entry
·
Legal barriers e.g. law, licence or patent
restrictions.
·
Natural monopoly e.g. a unique source of supply of a
raw material or economies of scale.
·
Economies of scale.
·
Production differentiation and brand loyalty.
·
Ownership of wholesale and retail outlets.
·
Mergers and takeovers.
·
Aggressive tactics and intimidation
Demand and Revenue
Since in a monopoly there is only one firm, the demand curve facing the firm is the demand curve facing the industry.
Table 6.1
Price Total
haircuts demanded Total revenue Marginal revenue
Ł per
haircut (per hour) (TR = P X Q)
10 0 0
……………..
9
9 1 9
……………..
7
8 2 16
…………….. 5
7 3 21
……………. 3
6 4 24
…………… 1
5 5 25
…………… -1
4 6 24
…………… -3
3 7 21
…………… -5
2 8 16
…………… -7
1 9 9
…………… -9
1 10
It is important to notice that the marginal revenue curve is below the
demand curve (average revenue). Why is
marginal revenue less than price?
Because when the price is lowered to sell one more unit, there are two
opposite effects on revenue. The lower
price results in a revenue loss but the increased quantity results in a revenue
gain. Over the range 0 to 5 haircuts
marginal revenue is positive. When more
than 5 haircuts are sold marginal revenue becomes negative.
When marginal revenue is positive total revenue is increasing. When marginal revenue is negative total revenue is declining. When marginal revenue is zero total revenue is at a maximum.
Revenue and Elasticity
We have already established a connection between elasticity of demand and the effect of a change in price on total revenue. If demand is elastic total revenue increases when the price falls. If demand is inelastic, total revenue decreases when price falls. The output range over which total revenue increases when price decreases is the same as that over marginal revenue is positive. Thus the output range over which MR is positive is also the output range over which demand is elastic.
Diagram 6.1 AR and MR Curves for Firm Facing a Downward Sloping
Demand
Curve
This relationship has an important application which is that a profit maximizing monopoly never produce an output in the inelastic range or the demand curve. But exactly what price and quantity does a profit maximizing monopoly firms choose?
Equilibrium price and output
Although the monopolist is a price maker and can choose which price to charge, it is still constrained by the demand curve.
A monopolist (like a perfectly competitive firm) will maximize profits
where MR = MC. The economic profit is
shown by the shaded area.
Diagram 6.2 Profit Maximisation Under a Monopoly
Monopoly and the Public Interest
Disadvantages of monopoly
·
Higher price and lower output than under perfect
competition (Diagram 6.3)
·
Possibility of higher cost curves due to lack of competition
(x-inefficiency)
·
Less innovative.
Diagram 6.3
Advantages of monopoly:
·
Economies of scale and scope.
·
Possibility of lower cost curves due to more
research and development
·
Innovation and newer products.
Monopolists and Price Discrimination
Price discrimination is the practice of charging some customers a
higher price than others for an identical good.
British Rail is an example of this with higher prices for commuters and off-peak
discounts for students and elderly people.
Price discrimination increases a monopolist’s profits by increasing its
revenue. Three conditions are necessary.
1.
The firm must be a price setter.
2.
Markets must be separate, with no leakages. That is consumers in the low price market
must be able to resell the good or service in the higher priced market.
3.
Demand elasticity must differ in each market. The firm will charge a higher price in the
market where demand is less elastic, and thus less price
sensitive.
Case Study – Car Prices in the European Union
The discriminating monopolist divides sales between the two markets. In the combined market it equates MR with MC, this would given an output of 25,000 cars at a price of Ł3250, giving a total revenue of Ł81.25m. However by equating MR and MC in the separate markets it increases total revenue while keeping costs the same. In Market A 15,000 cars are sold at Ł3000, total revenue Ł45m. and in Market B 10,000 cars are sold at Ł4000, total revenue Ł40,. Total revenue Ł85m. an increase of Ł3.75m on the combined market price.
Diagram 6.4
Combined market = Ł3,250 X 25,000 = Ł81.25 million
Market A = Ł3000 X 15,000 = $45 million
Market B = Ł4000 X 10,000 = Ł40 million
Original revenue = Ł81.25 million New
revenue with price discrimination = Ł85 million
Comparing Monopoly and Competition
·
Monopoly charges a higher price and produces a lower
quantity than under competition.
·
Monopoly prevents some of the gains from trade so is
less efficient than competition.
·
Monopoly reallocates surplus from the consumer to
the producer.
·
Monopoly may be more efficient than competition
where economies of scale or scope are available.
Theory of Contestable Markets
Recently some economists have suggested that what is crucial in determining price and output is not whether an industry is actually a monopoly or competitive, but whether the treat of competition exists.
A market is said to be perfectly contestable when the costs of entry
and exit by potential rivals are zero, and when such entry can be made
rapidly. In such cases the possibility
of earning economic profits attracts new firms to enter, thus driving profits
down to a normal level. The theory
argues that the threat of this happening, will ensure
that firms already in the market will a) keep prices down so that it just makes
normal profit, and b) produces as efficiently as possible taking advantage of
economies of scale and new technology.
If the existing firm did not do this, entry would take place and
potential competition would become actual competition.
There are two main bodies concerned with the operation of monopoly and merger policy; the Office of Fair Trading (OFT) and Competition Commission (CC).
The CC is an advisory body which investigates suspected abused of
monopoly power or proposed mergers. This
includes investigating:
·
Any single firm whose current market share is 25 per
cent of the national or local market. Or
two firms whose joint share is 25 per cent or more.
·
Any proposed merger that would result in a firm
having assets of 30 million, or a 25 per cent share of the market.
The OFT investigates and reports on any anti-competitive
practices. These were specified by the
1980 Competition Act as the following:
·
Price discrimination.
·
Predatory pricing (selling below cost to drive out
competitors).
·
Vertical price squeezing (where a vertically
integrated firm which controls the supply of a good charges a higher price for
that input to competitors).
·
Tie in sales (where the firm controlling the supply
of a first product insists that its customers buy a second product from it
rather than its rivals.
·
Selective distribution: where a firm is prepared to
supply only certain retail outlets.
Assessing
Monopoly Policy
·
Too often the CC has been ready to accept a firms
assurances and there has been too little follow up to ensure that firm has done
what it said
·
Minister can accept or reject the CCs findings
·
Out of thousands of possible cases for investigation
only some 160 have been referred to CC since 1948.
Merger policy
The vast majority over (97 per cent) of proposed mergers have not been referred to the CC. A major criticism that the policy has not been tough enough, with many mergers not referred which should have been. Many studies show that mergers have not been in the public interest with anti competitive effects outweighing those that economies of scale may have produced.
SEMINAR QUESTIONS
1. Explain why the marginal revenue curve lies below the average revenue curve for a monopolist.
2.
Why will a monopolist chose not to produce in the
range or output where the demand curve is inelastic?
3.
Answer the following questions in relation to
Diagram 6.5.
(i)
At what price will the monopolist sell the product?
(ii)
What is the average cost per unit of output at the
selling price?
(iii)
Which area represents the monopolist total profit?
(iv)
What is the optimum level out output?
(v)
What is the highest possible level of price the
monopolist could charge and still break even?
(vi)
What level of output corresponds to the perfectly
competitive level of output?
Diagram 6.5
KEY CONCEPTS – you are advised to learn ALL of these
Monopolist
Barriers to market entry
Downward sloping demand curve
Revenue and elasticity
Profit maximizing price and output
Monopoly and public interest
Monopoly and competition compared
Contestable markets
Monopoly and merger legislation
2 IMPERFECT COMPETITON
2.1
MONOPOLISTIC
COMPETITON
Assumptions
·
Quite a large
number of firms. Each firm has an
insignificantly small share of the market.
·
·
Freedom of entry. Any firm can set up business in this market.
·
Product
differentiation. Each firm produces a different
product or service different from its rivals.
Therefore each firm faces a downward sloping demand curve.
Examples: Petrol stations, restaurants, hairdressers
and builders are all examples of monopolistic competition. A typical competition. A typical feature is that there is only one
firm in a particular location. There may
be many chip shops in town but only one in a particular street. People may be prepared to pay high prices
than go elsewhere.
Short
Run – Output and Price
Profits are maximized where
MC = MR.
AR and MR are more elastic
than for a monopolist.
Profits depend on the
strength of demand, the position and elasticity of the demand curve.
Long
Run – Output and Price
·
Firms will enter the industry attracted by economic
profits.
·
Demand will fall and AR will shift to the left.
·
Long run equilibrium is where only normal profits
are being made.
·
Demand (AR) will be tangential to the firm’s long
run average cost curve.
Diagram 7.1 Equilibrium Under Monopolistic Competition
Limitations of Model
·
Imperfect information
·
Difficulties in deriving the demand curve for the
industry as a whole
·
Size and cost structure mean that normal and
supernormal profits can be made in the long run by firms in the same industry.
·
The simple model concentrates on price and output,
however in practice the firm will need to decide the variety of the product and
advertising.
Monopolistic Competition and the Public Interest
·
Monopolistically competitive firms,
may have higher costs than perfectly competitive firms, but consumers gain from
greater diversity.
·
Monopolistically competitive firms may have fewer
economies of scale and conduct less research and development, but competition
may keep prices lower than under monopoly.
2.2
OLIGOPOLY
Definition
Oligopoly is defined as an industry in which there are a few firms.
·
By a few it is meant that the number of firms should
be sufficiently small for there to be conscious interdependence, with each firm
aware that its future prospects , depend not only on
its own policies, but also those of its rivals.
·
An industry is defined as a group of firms where the
firms products are close substitutes for one another, that is have a high and
positive cross elasticity of demand.
Measurement
The rise of oligopolies can be charted in a number of ways.
1.
The Size distribution of firms. This is measured in terms of output,
employment or turnover.
2.
Concentration ratios. This shows the proportion of output accounted
for by the five largest firms.
3.
Advertising expenditure. This is an indirect method of gauging the
rise of oligopoly markets and the tendency towards product differentiation.
Competition and Collusion
Oligopolies are pulled in two different directions.
·
The interdependence of firms makes them wish to
collude with each other. By behaving as
a monopoly they could maximize industry profits.
·
On the other hand they will be tempted to compete
with their rivals to gain a bigger share of industry profits.
2.3
COLLUSIVE
OLIGOPOLY
When a oligopoly
is non-collusive the firm uses guesswork and calculation to handle the
uncertainty of its rivals reactions.
However another way of handling uncertainty in markets which are
interdependent is by some form of central co-ordination. One form of collusion is to form a
cartel. A cartel is the establishment of
some central body with responsibility for setting the industry price and
output. They are against the law in most
countries including
When firms engage in collusion they may agree on prices, market share, advertising expenditure etc.
The cartel will maximize profits if it behaves as monopoly.
The total market demand curve is shown with the corresponding market MR
curve. The cartel’s marginal cost curve
(MC) is the horizontal sum of the MC curves of its members. Profits are maximized at Q1 where MC =
MR. The cartel must therefore set a
price of P1 at which Q1 will be demanded.
Having agreed on the cartel price the members may then compete against
each other using non-price competition to gain a bigger share of Q1 as is
possible or they may somehow decide to share the market between them.
Diagram 7.2 Profit Maximising Cartel
Tacit collusion – Price leadership
As we saw in the previous chapter cartel are
effectively prohibited in the
Dominant firm
price leadership. Where firms
(the followers) choose the same price as that set by a dominant firm in the
industry (the leader).
Barometric price
leadership. Where the
price leader is the one whose prices are believed to reflect market conditions
in the most satisfactory way. This may
be a smaller firm.
Average cost pricing. Where a firm sets its price
by adding a certain percentage on top of the average costs.
Breakdown of collusion
Cartels can be vulnerable to pressures.
For example, the International Transport Association (IATA) the cartel
for international airlines sought to set prices for each route. During the 1970s it was seriously weakened by
price cutting competition from non-member airlines. It was further weakened by the world
recession with lower incomes causing weak demand for air travel (with a high
income elasticity of demand) to fall dramatically. In order to fill seats they began to compete
amongst themselves.
2.4
NON COLLUSIVE
OLIGOPOLY
The Kinked Demand Curve Theory
Output and Price of Oligopolies
The central theory of market theory is to predict how firms will set prices and outputs. In oligopoly where there are a few firms and product differentiation, there is not the precision as with perfect competition and monopoly.
The Kinked Demand Curve
The most popular theory of the
oligopolist this theory of the kinked demand curve proposed by Hall and Hitch
in the
If the firm raises it price above a certain level
If the firm were to reduce its price rivals would follow suit in order
to protect its market share. Thus a
reduction in price to P1 would bring about only a small increase in quantity
demanded. Thus the firm would expect its
demand curve to be relatively inelastic for reduction in price.
Overall the firm will believe its demand curve to be kinked at the
current price
Diagram 7.3 Kinked Demand Curve Under Oligopoly
Price cutting as a strategy tends to lead to a competitive downward spiral
in firms prices and price wars which in turn leads of a fall in revenue. Oligopolistic firms tend to prefer to engage
in non-price competition.
The Problems with the Kinked Demand Curve
·
The theory does not explain how oligopolists
se the initial price, only why the price might be stable.
·
The stickiness of price may have little to do with
rival firms reaction patterns but with the
administrative expense of changing price.
6.6
Oligopoly and the
Public Interest
If oligopolists act together collusively and jointly maximize profits then the same disadvantages as those experienced under a monopoly will be experienced.
·
Depending on the size of the oligopoly there may be
less scope for economies of scale to mitigate the effects of market power.
·
Oligopolists are likely to engage in much more
extensive advertising which increases the demand of the product.
·
Countervailing power may exist. For example, when the buyer of the goods is
also a big firm they may prevent prices from being pushed up.
Advertising and the Public Interest
Under perfect competition and monopoly advertising is pointless. Under imperfect competition advertising is
often a major means of competing.
Supporters of advertising claim:
·
Advertising provides information on new products
·
It is necessary to introduce new products
·
Aids development by emphasizing special features
·
May encourage price competition
·
Increases sales and enables economies of scale
Critics suggest that advertising imposes serious costs on the consumer
and society.
·
Consumers do not have perfect knowledge and may be
misled
·
Creates wants and therefore increases scarcity
·
Waste of valuable resources which have an
opportunity cost
·
Increases the price paid by the consumer
·
Creates a barrier to the entry of new firms
·
May impose a cost of society by being annoying
tasteless and unsightly
SEMINAR QUESTIONS
1. Look at Diagram 7.4 below.
(i)
Identify Curves I, II, III and IV.
(ii)
What is the long run equilibrium price and quantity
2. Why is advertising expenditure a measure of the rise of oligopoly?
3.In what ways to the following industries
differentiate their product: cars, banks petrol stations, supermarkets.
KEY CONCEPTS – you are advised to learn ALL of these
Monopolistic Competition
Oligopoly
Oligopoly – measurement of
Collusive Oligopoly
Cartels
Joint profit maximization
Tacit collusion
Price leadership
Non collusive oligopoly
Kinked demand curve
3 LABOUR MARKET
INTRODUCTION – FACTOR MARKETS
In a market economy not only
goods but the factors or production which go towards the making of those goods
are also no sale. Indeed in many cases
the same commodity could be regarded as a factor of production or a consumer
good satisfying final demand depending upon the use to which it is put. Thus a hi-fi system which is bought and
installed in someone’s home is a consumer good; the same hi-fi system installed
in a shop or a pub is properly thought of as a factor of production since its
purpose is to contribute to the output and profits of that firm however
measured. The principal factors of
production: land, labour, and capital each have markets and therefore prices
generally referred to as: rent, wages
and interest.
The demand for factors of
production is normally referred to as ‘derived’ demand, which is to say that
the factor is not wanted for itself but rather for what it can contribute to
final output. The supply clearly comes
from individuals who own factors of production.
Typically in the case of land and capital its ownership is concentrated
in a relatively small group while labour (the ability to do useful work) may
well be the only factor of production that many households own. In order to convert the ownership of a factor
into an income it is necessary, of course, to enter the factor market.
In this lecture we look at
labour markets and briefly at the market for land. In the next lecture we will examine returns
to capital in more detail.
LABOUR
MARKETS
The price (wages) in the labour market depends, like any other price, on the demand and supply. Traditional analysis relates the demand of potential employers to the marginal revenue product (MRP) which measures the employers evaluation of the impact of an additional worker on the firm’s total revenue.
8.1
WAGE
DETERMINATION UNDER PERFECT COMPETITION
The
Supply of Labour
The supply of labour is offered by households and the traditional assumption is that more work will be offered for higher wages. However, it has long be recognized that for some individuals or groups or workers higher wages might lead to a reduction in hours of work offered, the worker in effect taking the higher real income as leisure preference. The outcome would be a ‘backward bending’ labour supply curve.
Diagram 8.1
The Demand for Labour
Under competitive conditions MRP equals MPP (marginal physical product) times price, since each additional unit produced by the marginal worker can be sold at a given price. Under monopoly conditions MRP will be less than MPP times price since additional units, could only be sold if the price of the product as a whole were reduced.
Labour Output Marginal product Marginal Value Wage rate Extra
Input (Goods) of labour (MPL x Ł500) (Ł) profit (Ł)
(workers)
0
0
0.8
1 0.8 400 300 100
1.0
2 1.8 500 300 200
2.3
3 3.1 600 300 350
1.2
4 4.3 600 300 300
1.1
5 5.4 550 300 250
0.9
6 6.3 450 300 150
0.7
7 7.0 350 300 50
0.5
8 7.5 250 300 -50
Firm’s Employment Rule
Employ workers up to point where Wage = Marginal Revenue Product
The firm sells output for a given price and hires labour at the given
wage Wo. Marginal
productivity makes the MRP curve slope downwards. Below L* extra employment adds more to
revenue than labour costs. Above L*
extra employment adds more to revenue than labour costs.
8.2
WAGE
DETERMINATION IN IMPERFECT MARKETS
In the real world few markets correspond to perfect markets:
·
Firms have market power in selling goods, they may be operating under conditions of monopoly,
oligopoly or perfect competition.
·
Firms may have market power in employing
labour. This situation is called
monopsony. When there are just a few
employers it is called a oligopsony.
·
Workers may have market power as members of unions.
·
A monopolist employer faces a monopolist union. This is called a bilateral monopoly.
We examine one of these situations.
Labour with Market Power
(union monopoly)
Diagram 8.3
If unions force the wage rate up from W1 to W2 employment will fall from Q1 to Q2 and there will be a surplus of people (Q3-Q2) wishing to work in this industry for whom no jobs are available.
This model suggests that wages can only be increased at the expense of
employment, unless productivity is increased.
This is called a productivity deal and would shift the MRP curve to the
right.
8.3
TRANSFER EARNING
AND ECONOMIC RENT
Transfer earnings are what a factor must earn to prevent it from moving to an alternative use (To persuade people to stay in their current job equivalent to economic profit for a firm).
Mary Jones manager of store earns Ł20,000.
She could earn Ł15,000 in another job and would transfer if her salary
were cut below Ł15,000.
Take the market for nurses.
At each higher wage the new nurses attracted are getting just enough to
persuade them into the profession. The
wage for them is entirely transfer earnings.
But nurses already in the profession will be getting economic rent, as
they are now getting more than the minimum to keep them in the profession.
Workers economic rent is the difference between the actual wage rate
and the point of the supply curve at which they entered the market.
The more inelastic the supply curve, the greater will be the proportion
that is economic rent. The bigger the
wage increase necessary to attract new workers the more economic rent existing
workers will get.
If we take an individual with “unique talent” there is a totally
inelastic demand curve. As a result his
income is determined entirely by demand and is entirely economic rent.
Diagram 8.4
Other Labour Market
Influences
The market for labour is such a significant one, both in its impact on the value of goods and services and the source of economic welfare for households that a vast amount of economic literature has been devoted to its analysis. In answer to the question why do some individuals/groups earn more than others a number of elaborations on the basic market model have been offered:
1. Earnings differences might relate to
differences in skill (which will affect the firm’s calculations of MRP) and
these skill differentials may relate to differences in education and
training. Alternatively some economists
have argued that education (e.g. the English public school system) simply
represents a form of screening which allows higher paid jobs to be offered to
those who have similar backgrounds, accents, etc.
2. Earnings differentials may well relate to trade union/trade association membership.
3. Discrimination
on the grounds of age, sex, race, disability, etc may explain significant
amounts of earnings differentials. In
the
8.4 THE LAND MARKET
“Land” in economies refers to natural resources and so would include,
in addition to physical space, climate, raw materials, mineral extractions and
fishing rights etc. The market for the
use of these resources again can be analysed in terms of greater productivity
and so a shop in Hatfield’s Galleria would attract a lower rent than one in,
say
SEMINAR QUESTIONS
1. The diagrams below show the local market for plasterers. Which of the two curves would shift and in which direction as a result of each of the following changes?
·
A deterioration in the working conditions of
plasterers
·
A decrease in the prices of plasterers
·
A decrease in the demand for new houses
·
An increased demand for plasterers in other parts of
the country
·
Increased wages in other parts of the building trade
2. A fashion model could earn Ł80 per week as a gardener, Ł160 per week
working on a building site or Ł240 as a lorry driver. As a model he earns Ł320 per week. Assuming he likes all four jobs, what is his economic
rent for being a fashion model?
3. What factors affect the labour market for teachers? How might the labour market for English and
Economics teachers be different?
4.Given that a wage above the
equilibrium reduces employment, why is there a case for a minimum wage?
KEY CONCEPTS – you are advised to learn ALL of these
Factor markets
Supply of labour under perfect competition
Demand for labour under perfect competition
Marginal physical product
Marginal revenue product
Imperfect labour markets
Monopsony
Trade unions
Economic rent
Transfer earnings
Rent
4
FIRMS IN ACTION
4.1
INVESTMENT IN
THEORY AND PRACTISE
Most developed economies contain relatively sophisticated capital markets
but in essence their operation is much the same as any other market. There is a demand for capital by firms in
order to purchase plant and machinery, which in turn through an estimation of
its marginal productivity should increase the revenue and profit of the company
(it is common to talk of capital as both the ‘real’ purchases of machinery and
equipment and also the finance borrowed from the banking sector in order to buy
the equipment).
Discounting Theories
When making the decision to buy it is essential that estimated future
returns are discounted to give a present value.
The supply of capital comes from savers (either households or firms)
and is assumed to be positively related to the rate of interest. The capital market therefore relates the
supply and demand of funds available for loan to the current rate of
interest. There are, of course, many
rates of interest in a developed economy, depending on the nature of the loan:
length of time, security, etc. However
they all tend to move up and down in concert and so it is convenient to think
of a simplified model of one interest rate that clears the market.
Discounting to Present Value
Compound interest means that Ł100 at a rate of 10 per cent is worth Ł110
in one years time and Ł121 in two years time. If we turn this idea around we can say that
Ł110 in one years time is Ł100 today. This is the principle beyond discounting a
future flow of returns to a present value.
Formula: 
P = Present value A =
Future flow I = Market rate of
interest n = number of years
Example
A firm is considering buying a machine which costs Ł3000. It is predicted that
it will give a flow of revenue from the goods it produces as follows:
(Year 1) Ł900 + (year 2) Ł800+ (year 3) Ł700+ (year 4) Ł600+ (Year 5) Ł500 = Ł3500.
This flow or revenue appears to be greater than the initial cost of
buying the machinery. But if this flow
is discounted at a rate of interest of 10 per cent a different picture emerges:
Ł900 + Ł800 + Ł700 + Ł600 + Ł500 =
1.10 (1.10)2 (1.10)3 (1.10)4 (1.10)5
Ł181 + Ł661 + Ł526 + Ł410 + Ł310 =
Ł2736
Non discounting Methods
·
Average rate of return
·
Pay back period
4.2
Alternative
Maximising Theories
·
Problems with traditional theory
·
Alternative aims
-
Long run profit maximization
-
Sales revenue maximization
-
Growth survival
·
Behavioural theories of the firm
.
5
MARKET FAILURE –
THE CASE FOR GOVERNMENT INTERVENTION
Adam Smith (1776) suggested the people by pursuing their own interests are led by ‘and invisible hand’ to promote the interests of society. If there is an invisible hand and markets allocate resources efficiently so that consumer wants are met at minimum cost, why should governments intervene in the economy? The general argument of government intervention is that of market failure, which will be examined in the lecture. In the second half we will discuss a practical application of some of these ideas in the form of Cost Benefit Analysis which has been used to aid decision making in the public sector.
5.1
MARKET FAILURE
Market failure is the inability of an unregulated market to achieve
allocative efficiency in certain circumstances.
There are various reasons why allocative efficiency may not be achieved
and these are:
1.
Public goods
2.
Immobility of Factors and time lags in Response
3.
Imperfect information
4.
Monopolies and cartels
5.
Externalities
1.
Public Goods
Certain goods and services would not be provided without the
intervention of the government. We
cannot perhaps imagine this country without a legal system, defence forces,
schools, roads and health services but all of these goods and services are
provided largely by the government although there are elements now of the
private sector in each category.
A pure public good is a good or service which is consumed by everyone
and from which no-one can be excluded, defence is a good example. It has two characteristics, non-rivalry i.e.
one person’s consumption of the good does not reduce the amount available for
someone else and non-excludability i.e. no-one can be excluded from consumption
of the good.
This brings in the problem of free riders, which is someone who
consumes a good or service without paying for it. This problem arises with public goods because
why should one person pay when everybody else will contribute to the cost. If everyone took this attitude the good would
not be provided hence the need for government intervention.
·
Public good. A good or service which has the features of
non rivalry; and non excludability and as a result would not be provided by the
free market.
·
Non-rivalry. Where the consumption of a good or service by
one person will not prevent others for enjoying it.
·
Non-excludability. Where it is not possible to provide a good or
service to one person without it thereby being available for others to enjoy.
2. Immobility of Factors and Time Lags in Response
Even under perfect competition factors may be slow to respond to changes
in demand and supply conditions. Labour
is often geographically and occupationally immobile. This can lead to unemployment, one the one
hand and high wages for those in sectors or rising demand, In the meantime other changes will
occur. Thus the economy is in a
continuous state of disequilibrium and the long run never comes.
3. Imperfect Information
It is assumed under perfect competition that consumers have perfect
knowledge about prices and products.
Whilst this may be the case if a vacuum cleaner is being purchased and
magazines such as Which exist to help people make an
informed choice. In the case of health
care full information is much more difficult and the consequences of purchasing
the wrong service are much more serious.
4. Inequality
One major criticism of the free market is the problem of inequality. Optimality is achieved representing the efficient allocation of resources for any given distribution of income.
5. Market Power
We have already explored in some detail the way in which the conditions for perfect competition rarely exist and many sectors are dominated by oligopolies.
6.
Externalities
An externality is said to exist when the production or consumption of a good directly affects businesses or consumers not involved in the buying or selling of it and when those spillover effects are not reflected in market prices.
5.2
SHOULD HEALTH
CARE BE LEFT TO THE MARKET
Advocates of free health care argue that there are a number of fundamental objections to relying on a market system to allocate health care for the following reasons:
·
Equity.
Because income in unequally distributed some people will be able to
afford better treatment than others. On
the grounds of equity health care should be free, at least for poor people.
·
Difficulty for people predicting their future
medical needs. There is great
uncertainty about people’s future medical needs. Medical insurance is one way round this, but
what about the problem of equity. Would
the premiums be high for some people?
·
Externalities.
Health care generates a number of benefits external to the patient. Curtailment of infectious diseases benefits
everybody. Employers benefit from having
a healthy workforce.
·
Patient Ignorance.
The consumer (the patients) may have poor knowledge. You rely on the doctor, the supplier of
treatment. Some patients may be advised
to take a more expensive treatment than is necessary.
·
Oligopoly. If
doctors and hospitals operated in the free market as profit maximisers, they
may act as an oligopoly and collude to fix standard prices to protect their
incomes.
5.3
Externalities in
More Detail
External
benefits. Benefits from production (or consumption)
experienced by people other than the producer (or consumer).
External costs. Costs of
production (or consumption) borne by people other than
the producer (or consumer).
Social costs. Private cost plus
externalities in production.
Social benefits. Private benefit plus
externalities in consumption.
External costs of production
(MSC > MC)
When a chemical firm dumps waste in a river or pollutes the air the community bears an additional cost.
Diagram 10.1 shows that the
socially optimum output for the firm would be Q2 where P = MSC. The firm however, produces Q1 which is more
than the optimum. Thus external costs
lead to overproducing from society’s point of view.
External benefits of
production (MSC < MC)
If a bus company spends money on training drivers who when leave to work for haulage or coach companies, the costs of these companies are reduced as they do not have to train drivers. Society has benefited from their training although the bus company has not.
External costs of
consumption (MSB > MB)
When people use their cars other people suffer from exhaust fumes,
congestion and noise. These negative
externalities make the marginal social benefit of using cars less than the
marginal private benefit (i.e. marginal utility). Diagram
10.2 shows the marginal utility (reflected in the demand curve) and price
to the consumer of using a car. The
distance traveled by the motorist will be Q1 miles where MU (D) = P. The social optimum, however, would be less
than this, namely Q2, where the MSB = P.
External benefits of
consumption (MSB > MB)
When people travel by train rather than by car other people benefit by there being less congestion and exhaust and fewer accidents. Thus the marginal social benefit of rail travel is greater than the marginal private benefit.
10.4 FORMS OF INTERVENTION
Changes in property rights
One cause of market failure in the limited nature of property rights. One solution may be to extend property rights to define who owns property, what use it can be put to, the rights other people have over it and how it may be transferred. Individuals may be able to prevent other people imposing costs on them.
Taxes and subsidies
Assume a chemical firm in the course of production pollutes the atmosphere. In the Diagram 10.3 below the firm produces Q1 where P = MC, but takes no account of the external costs imposed on society. If the government imposes a tax on production equal to the marginal pollution cost the firm will internalize the externality. The firm will now maximize profits at Q2, which is the socially optimum output where MSB = MSC.
Diagram 10.3
Using
taxes to correct a distortion
5.4
COST BENEFIT
ANALYSIS
Cost benefit analysis is a procedure for making long run decisions such as whether to build a university or where to build an airport. It attempts to evaluate the social costs and benefits of proposed investment projects as a guide to the desirability of particular projects. CBA differs from ordinary investment in that the latter only considers private costs and benefits.
·
Procedure
·
Identifying costs and benefits
·
Measurement of costs and benefits
·
Risk and uncertainty
·
Discounting future costs and benefits
·
Distributional consequences
6
THE FIRM, THE SINGLE MARKET AND
Mergers, Economies of Scale and Market Power
6.1
THE SINGLE MARKET
The Removal of Non-Tariff Barriers
Tariffs and quantitiative restrictions such as quotas have, at least in
theory, long been eliminated in the EU. The
Single Market Act 1992 is to eliminate remaining non-tariff
barriers which includes removing:
·
Cost increasing barriers – delays at customs,
collection of statistics or verification of technical regulations.
·
Market entry restrictions. The main example here is state procurement,
where the government favour domestic suppliers.
·
Market distorting subsidies and practices. Barriers that distort the market so as to
give domestic producers an unfair advantage.
The Cecchini Report
This report is the result of 27 volumes of research by economists and management consultants, which argues that there will be substantial gains from the completion of the internal European market which they estimate at 210 billion ECU. They suggest that benefits are grouped in the following categories:
1.
Trade creation.
Costs and prices are likely to fall as countries produce those goods or
services they are most efficient in.
2.
Economies of scale.
Industries on a European basis can exploit economies of scale. The EU is the largest industrialized market
in the developed world.
3.
Static and dynamic effects. Greater competition in both the short and
long run. In the short run this would
being profits down and encourage reducing costs and in the long run there would
be greater innovation and restructuring.
The Paradox
There is, however, one major contradiction in the Cecchini report. On the one hand the Report foresees increased competition leader to power prices and thereby increasing consumer welfare, on the other however this is to be achieved through restructuring where economies of scale will be achieved through mergers increasing the market power of larger firms. In order to examine this apparent paradox we need to look at some of the empirical evidence on economies of scale and mergers more closely.
6.2
THE EVIDENCE FOR
ECONOMIES OF SCALE
·
A comparative study of results from various EU
countries concerning full legal mergers, (Mueller 1980) draws the conclusion that
tests to identify economies of scale as a possible objective for merger proved
that it was not significant. The size of
the acquiring firm was often already greater than the minimum optimum scale.
·
A further weakness in the Commission evidence is cited
as being that the conclusions on the Minimum Efficient Scale and economies of
scale are drawn from Pratten’s work in the 1960s. On updating his research he gives a cautious
warning that economies of scale are elusive and that the long run average costs
curve only slopes very gently to the right.
·
Further in the Commission Report (1988) itself
contradictory evidence emerges as to the scope for economies of scale in
financial services.
·
According to Mueller (1989) post-merger
profitability suggested little or no effect on the profitability of the merging
firm in the three to five years following.
Finally he found that the cost of changes to the organization were often
greater than the benefits.
The evidence ranging from empirical studies to econometric models leads
to the conclusion that there is no real trade off between efficiency gains from
mergers and an increase in monopoly power since the net efficiency are not there.
6.3
OTHER ASPECTS OF
SQUARING MERGERS AND COMPETITION POLICY
The New Industry Structure
Which Follows Mergers
Jacquemin argues that a crucial aspect of horizontal merger is the response of non-participant firms to any output reductions by merging parties. If the non-participating firms reduce output, the merger even though profitable will reduce welfare. On the other hand if non-participating firms with large mark ups respond by expanding output in response to mergers, significant gains in welfare may be provided.
The International Dimension
The international dimension is a crucial
factor for evaluating the impact of European mergers. Competition from imports limits the market
power of domestic producers. Therefore
mergers in industries that are less open are more dangerous for competition
than mergers in relatively closed industries.
There have been accusations that
The Role of Mergers In High Technology Industries
The Cecchini Report argues that the Community lags behind its competitors in industrial activities which are characterized by strong growth in demand and high technological content and are therefore R & D intensive. It argues that the fragmentation of the Community industry constitutes a serious handicap to these industrial markets, and that the critical mass of spending on research requires the active co-operation, if not integration of European firms to realize these economies of scale, and match expenditure in this area by the US and Japan.
It is suggested that mergers or joint ventures would increase resources
available and encourage the undertaking of risky and/or ambitious projects,
cutting duplication and encouraging the transfer of technology, and speeding up
the innovative process. Even if there is
a static loss due to concentration there is a dynamic gain in the long
run. The existence of such a trade off
is questionable, in that evidence suggests that R & D is not characterised
by substantial economies of scale and that monopoly power in the long run can
be expected to inhibit R & D and technological advance. The rapid rise in the number of mergers has
been less in high growth and high technology sectors.
Are Economies of Scale A Motive For Merger?
Not only is there little evidence to support the existence of international economies of scale, but there is little evidence to suggest that these are a primary motivation. In a survey quoted y Davis (1991) economies of scale as a merger motive is only given in 7% of cases. The Hill Samuel Bank case studies of ten European mergers found that the most important reasons offered were the exploitation of distribution links, international branding, technology or skills transfer, suggesting that the overwhelming motive for mergers is access to new markets.
11.4 TRENDS IN MERGER
ACTIVITY
·
An examination of the structure and pattern of
merger activity in the past decade, disputes the Cecchini prediction of
widespread mergers between European firms to increase competitiveness through
the realization of economies of scale.
·
Between 1983 and 1987 the number of mergers per year
increased approximately three fold. The
data however, suggests a rather perverse increase in the number of national
mergers as 1992 approached. A similar
but less pronounced pattern occurred in the service sector, which may reflect
the fact that barriers to entry in this sector are greater than
manufacturing. Sectorally chemical,
electrical and mechanical engineering and food accounted for 60% of all
mergers, which appears to be out of line with the Cecchini Report.
·
The most striking feature of European mergers is the
number of mergers and their value between different countries with the
·
SEMINAR QUESTONS
1. Distinguish between and give examples of: static/technical economies, learning economies, economies of scope.
2.
Suggest reasons why mergers have tended to be higher
in manufacturing rather than the service sector.
3.
What sort of barriers still exist
between mergers in different countries.
To what extent do these explain why the
4.
What problems do you think exist in controlling and
implementing competition policy in
7
PRIVATISATION
VERSUS NATIONALISATION
The lecture will briefly outline the main arguments. A case study approach will be taken in the lecture
and seminar in order to highlight some of the topical debates.
1.1
OUTLINE OF THE
MAIN ARGUMENTS
Arguments For Public Ownership : Market
Failure
·
Natural Monopoly
·
High capital costs/Barriers to entry
·
Lack of investment
·
Planning and co-ordination of industry
·
Externalities
·
Lame ducks
·
Management of the Economy
Arguments For Privatisation
·
Increases Efficiency
·
Reduced Interference
·
Reduction of the PSBR
·
Increased ownership/popular capitalism
Arguments Against Privatisation
·
Natural monopoly
·
Insufficient regulation
·
Public interest
·
Valuation of shares