Theme 3 revision PDF

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Summary of key elements of Theme 3 Economics...

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Advantages of vertical integration: Where a company takes over a different stage of the production process, either forward vertically or backwards vertically 1. Control of the supply chain which can mean reduced costs and improvements in the quality of the production process. 2. Improved access to key raw materials at the expense of competitors who may not have this comparative advantage. 3. Better control over retail distribution 4. Removing suppliers and crucial information from competitors which helps make the market less contestability Advantages of horizontal integration: where a company takes over a company at the same stage of the production process 1. Increases the size of the business which can lead to benefits such as internal economies of scale 2. One larger merged firm may need fewer workers and premises than two, a process known as rationalisation which leads to cost savings in the long run. 3. Creates a wider range of products, diversification leads to economies of scope. 4. Reduces competition by removing industry rival, increasing market share and pricing power

Reasons firms will remain small       

cost of expansion legal barriers niche-market business avoiding diseconomies of scale lower corporation tax/vat liability access to finance objectives other than profit maximisation

Principal-agent problem: The larger a firm becomes the greater the gap between the owners (shareholders) and the managers. This can be dealt with by using shared ownership schemes, long term contracts, and long term stock commitments

Barriers to entry: 1. 2. 3. 4. 5. 6.

Legal barriers Economies of scale Limit pricing R&D Advertising activity Sunk costs

Monopoly and competition Perfect competition: The situation in which buyers and sellers are so numerous and well informed that market power is absent and the market price is beyond the control of individual buyers/sellers. In a market where AR > AC there is an incentive to join the market because this will allow firms to make supernormal profits. This incentivises an increasing number of firms to enter into the market which pushes the price down. This means that AR = AC meaning that firms will now only earn normal profits and therefore there is no reason to join the market. A monopoly is able to earn supernormal profits in the long run when operating where MR = MC because they are protected by barriers to entry and therefore their abnormal profit is protected from other firms being able to join the market and take this gain.

Price discrimination Price discrimination is the process by which a firm charges different prices to different groups of consumers for reasons not associated with costs. Not possible in a market with perfect competition as firms are price takers not price makers. Conditions for price discrimination: 1. Must be able to identify and separate different groups 2. Groups must have different price elasticities 3. Must have price setting power (market power)

In the inelastic market the area of revenue is PX0Q. in the elastic market the area of revenue is P1X10Q1. Total revenue is therefore (PX0Q + P1X10Q1). Profit is (PX0Q + P1X10Q1) – (P2X20Q2). Any additional revenue must be profit because the costs remain constant.

Efficiency Productive efficiency occurs when the level of output is at the lowest point on the long run average cost curve. X-efficiency is achieved when the marginal cost curve and average cost curve are as low as possible

Allocative efficiency: is achieved when the price is equal to the marginal cost of producing it. P(AR) = MC. If P > MC the value that people place on a good is greater than the social cost and therefore signals to producers to increase the output of that good. If P < MC then people value the good or service less than the cost to society. This therefore should signal to producers to produce less of a good or service. Monopoly: Not productively or allocative efficient Short Run Competition: Allocative efficient as P = MC Long Run Competition: Both productively and allocatively efficient.

Market Structure – Perfect competition       

Many buyers and sellers Sellers are price takers No barriers to entry/exit Perfect knowledge Homogenous goods Short run profit maximises Factors of production perfectly mobile

Advantages

Disadvantages

In the long run there is a lower price P=MC so allocative efficiency

In the long run, dynamic efficiency might be limited due to the lack of supernormal profits. No or few economies of scale

Productive efficiency forms produce at bottom of AC curve Supernormal profits in short run can increase dynamic efficiency

Model is rarely applied in real life

Market Structure – Monopolistic Competition      

Firms sell non-homogenous products due to branding (product differentiation) Lots of close substitutes No barriers to entry/exit from the market Downward sloping demand curve meaning they can raise price without losing all of their customers. Buyers/sellers have imperfect information In long run firms enter market because attraction by profits that firms are making, firms products become more elastic therefore leading to only normal profits in the long run.

Advantages

Disadvantages

Consumers get wider variety of choice

In long run dynamic efficiency affected by lack of supernormal profit

More realistic than perfect competition Short run supernormal profit can

increase dynamic efficiency through investments Allocative inefficient P > MC Productively inefficiency

Market Structure – Oligopoly     

Dominated by a few producers A high three-firm concentration ratio Few firms selling similar products differentiated by branding Barriers to entry. Firms are able to earn profits in long run because of these barriers protecting profit. Interdependence of firms

Collusive and non-collusive behaviour occurs when firms work to achieve a certain objective, e.g. higher profits by fixing prices Overt collusion: formal agreement made between firms to set prices. This is illegal Cartel: Group of two/more firms that agree to control price and limit output. E.g. OPEC Tacit collusion: where firms agree to follow the prices set by a leading firms. Advantages of Collusion

Disadvantages of Collusion

Industry standard can improve as firms can collaborate on technology Excess profits can be used for investment to improve efficiency in long run

Loss of consumer welfare as prices raised and output falls Absence of competition leads to less efficiency.

Saves on duplicate R &D Exploit economies of scale leading to lower prices

Reinforces monopoly power of exists firms Lower Q supplied leads to loss of Allocative Efficiency

Nash equilibrium: Optimal strategy for all players.

Price competition:

 Price Wars: firms constantly cutting prices below that of its competitors.  Predatory pricing: (illegal) price goods/services below their average costs to drive firms out of the industry. Short run losses made  Limit pricing: Firms discourage the entry of new firms into the market Non-price competition:

    

Brand loyalty schemes. E.g. loyalty cards Improvements in customer service. Longer opening hours Special offers Advertising and marketing Brand differentiation

Market Structure – Monopoly  Profit maximisation (long and short run supernormal profits)  Sole seller in market  High barriers

 Price maker  Price discrimination UK monopoly is when one firm has 25% of the market share. Monopoly power: Barriers to entry: economies of scale, limit pricing, owning a resource, sun costs, brand loyalty, set-up costs

Advantages

Disadvantages

Monopolies earn significant supernormal profits so they may invest more into R & D. Yield positive externalities. Firms innovate with protected ideas High profits can be source of government tax revenue. Monopolies can generate a source of export revenue.

Higher prices suggest higher prices, profits and inefficiency.

Monopolies can exploit consumer by charging higher prices Monopolies have no incentive to become more efficient due to lack

Can exploit economies of scale

of competitive pressure. Consumers do not have as much choice in a monopoly

Market Structure – Natural Monopoly  A situation where it is most efficient for production to be concentrated in a single firm.

Market– Monopsony  Monopsony is a single buyer in a market  Monopsonists are profit maximisers  Can negotiate lower prices because suppliers have nowhere else to sell to.  Firms with monopsony power are able to set the market price. Advantages

Disadvantages

Negotiate lower prices for goods Led to producers’, e.g. farmers, than can free up spending on other losing profits. things.

Consumers can receive lower prices as well

Employees are likely to lose out with lower wages. Workers may become unproductive if wages are low...