Theme 3 - ECONOMICS

  • Created by: iampriyal
  • Created on: 29-04-19 01:48

Why some firms tend to remain small and why others

Economies of scale relative to market size: Large firms might only experience small economies of scale compared to their size since the extent of economies of scale might be limited in that industry. This could make their costs higher than firms which choose to stay smaller. 

Diseconomies of scale: Larger firms could face high costs because they have grown too quickly. There could be poor organisation, x-inefficiency or because firms in large, formal markets tend to have to pay higher wages. 

Small firms as monopolists: Small firms could hold some degree of monopoly power since they provide a more personal, local service. Their opening hours might suit a small town, such as those of a corner shop. Small firms might also create a niche market, where they can use their relative price inelastic demand to charge higher prices.

Profit motive: By growing, firms get the opportunity to earn higher profits. Growing also allows firms to take advantage of economies of scale, providing they do not grow so large that they experience diseconomies of scale.

Owners: Managers of the firm might have the motive of larger bonuses, more holidays or more leisure time, which encourages them to expand the firm.

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Significance of the divorce of ownership from cont

The principal-agent problem can be linked to the theory of asymmetric information. This is when the agent makes decisions for the principal, but the agent is inclined to act in their own interests, rather than those of the principal. For example, shareholders and managers have different objectives which might conflict. Managers might choose to make a personal gain, such as a bonus, rather than maximise the dividends of the shareholders.

When the owner of a firm sells shares, they lose some of the control they had over the firm. This could result in conflicting objectives between different stakeholders in the firm. If the manager is particularly good, they might require higher wages to keep them in the firm. However, they also need to keep shareholders happy, since they are an important source of investment. It is not always possible to give both the manager a high salary and the shareholders large dividends since funds are limited. 

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Distinction between public and private sector orga

Public sector:

  • This is when the government has control of an industry, such as the NHS. 
  • There could be natural monopolies in the public sector. For example, only one firm will provide water because it is inefficient to have multiple sets of water pipes.
  • Some public sector industries yield strong positive externalities. For example, by using public transport, congestion and pollution are reduced.
  • Public sector industries have different objectives for private sector industries, which are mainly profit driven. Social welfare might be a priority of a public sector industry. It could also lead to a fairer distribution of resources. 

Private sector:

  • This is when a firm is left to the free market and private individuals. 
  • Free market economists will argue that the private sector gives firms incentives to operate efficiently, which increases economic welfare. Firms have to produce the goods and services consumers want, which increases allocative efficiency and might mean goods and services are of a higher quality. Competition might also result in lower prices. This is because firms operating on the free market have a profit incentive, which public sector firms do not. 
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Distinction between profit and not-for-profit orga

A profit organisation aims to maximise the financial benefit of its shareholders and owners. The goal of the organisation is to earn maximum profits.

A not-for-profit organisation has a goal which aims to maximise social welfare. They can make profits, but they cannot be used for anything apart from this goal and the operation of the organisation. 

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Organic growth

This is when firms grow by expanding their production through increasing output, widening their customer base, by developing a new product or by diversifying their range.

Advantages and disadvantages:

  • This is a long term strategy, and it is significantly slower than growing inorganically. This could mean competitors gain more market power by expanding in the meantime. It could also make shareholders unhappy if they want faster growth.
  •  Firms might rely on the strength of the market to grow, which could limit how much and how fast their can grow.
  • It is less risky than inorganic growth.
  • Firms grow by building upon their strengths and using their own funds, such as retained profits, to fund the growth. This means that the firm is not building up debt, and the growth is more sustainable.
  • Moreover, existing shareholders retain their control over the firm, which might reduce conflicts in objectives that are possible when there is a takeover.

Firms can grow inorganically through merging with, acquiring or taking over another firm.

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Forward and backward vertical integration

Vertical integration occurs when a firm merges with or takes over another firm in the same industry, but a different stage of production.

Forward vertical integration occurs when the firm integrates with another firm closer to the consumer. This involves taking over a distributor. For example, a coffee producer might buy the café where the coffee is sold.

Backward vertical integration occurs when a firm integrates with a firm closer to the producer. This involves gaining control of suppliers. For example, a coffee producer might buy a coffee farm.

Advantages and Disadvantages:

  • Firms can increase their efficiency, through gaining economies of scale, which could reduce their average costs. This could result in lower prices for consumers
  • Firms have more certainty over their production, with factors such as quality, quantity and price
  • The disadvantages associated with diseconomies of scale could be considered.
  • Vertical integration can create barriers to entry, which might discourage or limit the entrance of new firms.
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Horizontal integration

This is the merger of two firms in the same industry and the same stage of production. For example, if a car manufacturer merges with another car manufacturer, they will have horizontally integrated.

Advantages and disadvantages:

  • Firms can grow quickly, which can give them a competitive edge over other firms in the market. However, this could lead to monopoly power and there is the potential of lower inefficiency as a result.
  • There could be disagreements in the objectives of the two firms which merged.
  • Firms can increase output quickly, so they can take advantage of economies of scale.
  • The two firms will have expertise in the same industry, so the merged firm can gain advantages, such as in marketing.
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Conglomerate integration

This is the combining of two firms with no common connection. For example, Associated British Foods owns Primark and Patak’s, which produces curry pastes and pickles.

Advantages and disadvantages:

  • It can help both firms become stronger in the market than if they were individual.
  • The conglomerate can reach out to a wider customer base, and market competition could be reduced.
  • The advantages of economies of scale, and particularly risk bearing economies of scale, can be considered.
  • There is a risk of spreading the product range too thinly, and there might not be sufficient focus on each range. This might reduce quality and increase production costs.
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Constraints on business growth

Size of the market: A small market might only have limited opportunities for business expansion since firms can only access a limited consumer market and there might be limited opportunities for innovation and expansion. Larger markets, such as the market for mobile phones, have a much wider scope for innovation, and firms can take advantage of huge selling opportunities. 

Access to finance: Smaller and newer firms tend to be less able to get access to finance than larger, more established firms. This is because they are deemed riskier than established firms. Moreover, banks have become more risk-averse since the global financial crisis, which has limited the number and size of loans on the market. Without sufficient access to credit, firms cannot invest and grow, and firms cannot innovate as much.

Owner objectives: Owners might have different objectives. Some owners might aim to maximise profits, whilst others might a bigger personal gain in the form of bonuses and reputation. Therefore, some owners might not have business growth as an important objective. 

Regulation (red tape): It can limit the quantity of output that a firm produces. For example, environmental laws and taxes might result in firms only being able to produce a certain quantity before exceeding a pollution permit. Excessive taxes, such as a high rate of corporation tax, might discourage firms earning above a certain level of profit.

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Reasons for demergers

A demerger is when a large firm is separated into multiple smaller firms. For example, if Boots sold Halfords since it did not match their main activities.

  • Lack of synergies: A synergy is when creating a whole company is worth more than each company on its own. Without this, firms are likely to demerge because they will be worth more.
  • Growth: Each part of the firm could grow at different rates. The faster-growing part might be separated.
  • Diseconomies of scale: If the firm is so large that average costs rise with more output, the firm might choose to split.
  • Focussed companies: The firm might be able to grow faster if it focuses on a few markets, rather than several.
  • Resources: If a firm can no longer afford to invest the business, due to a lack of resources, they might sell off a part.
  • Finance: Selling off part of the firm can raise valuable finance, which could be better invested in a more profitable part of the firm. 
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Impact of demergers

Businesses

  • Firms can dispose of underperforming or loss-making parts of the firm. It allows the larger firm and the new, demerged firm to focus on their core activities. This allows them to adapt to their unique markets, whereas in a large firm, managers could find it hard to focus on each market.
  • The firm could make a profit by selling off a part of the firm. This can also be used as a source of finance, which will allow them to invest in other parts of the firm. 

Workers

  • Workers might become confused, and their roles might be shifted between the demerged firm and the parent firm. There could also be job cuts.

Consumers

  • The removal of diseconomies of scale could lead to lower prices for consumers. There could be a net welfare gain if the demerger results in a higher level of efficiency. If two firms in the same industry and the same stage of production demerge, such as two airlines, this would increase choice for the consumer.
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Profit maximisation

A firm’s profit is the difference between its total revenue (TR) and total costs (TC). A firm profit maximises when they are operating at the price and output which derives the greatest profit. Profit maximisation occurs where marginal cost (MC) = marginal revenue (MR). In other words, each extra unit produced gives no extra loss or no extra revenue.

Some firms choose to profit maximise because:

  • It provides greater wages and dividends for entrepreneurs
  • Retained profits are a cheap source of finance, which saves paying high-interest rates on loans
  • In the short run, the interests of the owners or shareholders are most important, since they aim to maximise their gain from the company.
  • Some firms might profit maximise in the long run since consumers do not like the rapid price changes in the short run, so this will provide a stable price and output.
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Revenue maximisation:

This occurs when MR = 0. In other words, each extra unit sold generates no extra revenue. 

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Sales maximisation

This is when the firm aims to sell as much of their goods and services as possible without making a loss. Not-for-profit organisations might work at this output and price. On a diagram, this is where average costs (AC) = average revenue (AR).

An example of sales maximising is Amazon’s Kindle launch. They sold as many Kindles as possible to gain market share, so they can earn more profits in the long run. It helps keep out and deter competitors. 

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Profit Satisficing

Another objective a firm might have is satisficing. A firm is profit satisficing when it is earning just enough profits to keep its shareholders happy.

Shareholders want profits since they earn dividends from them. Managers might not aim for high profits, because their personal reward from them is small compared to shareholders. Therefore, managers might choose to earn enough profits to keep shareholders happy, whilst still meeting their other objectives. This occurs where there is a divorce of ownership and control. 

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Formulae to calculate types of revenue

Total revenue:

  • Total revenue is calculated by price x quantity sold. 

Marginal revenue:

  • This is the extra revenue a firm earns from the sale of one extra unit. When marginal revenue is 0, the total revenue is maximised.
  • The point where MR = 0 on the revenue diagram is directly below the midpoint of the AR curve. This is in the middle of the demand curve and it is the point where PED = 1.

Average revenue:

  • Average revenue (AR) is the average receipt per unit. This is calculated by TR/quantity sold. In other words, this is the price each unit is sold for.
  • The AR curve is the firm’s demand curve. This is because the average revenue curve is the price of the good. 
  • In markets where firms are price takers, the AR curve is horizontal. This shows the perfectly elastic demand for their goods. In markets where firms are price makers, the AR curve is downward sloping
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PED and its relationship to revenue concepts

In markets where firms are price takers, the AR curve is horizontal. This is because the price received for the good is constant. This shows the perfectly elastic demand for their goods. AR= the demand curve, because AR is the price of the good, and the demand curve shows the relationship between price and quantity. Average revenue = marginal revenue.

If demand is elastic and price increases, the quantity demanded will fall. The effect on total revenue depends on how elastic the demand is. For example, if the price rose by 10% and demand decreased by 20%, then the elasticity of demand is +2. This means demand is very elastic and total revenue decreases. If prices rise by 10% and demand decreases by 1%, the price elasticity of demand is +0.1. Demand is relatively inelastic, and revenue increases.

Usually, the AR curve is downward sloping, because the price per unit is reduced as extra units are sold.

The price elasticity of demand changes as you move down a downward sloping demand curve.

The MR curve is twice as steep as the AR curve. The AR curve is a trend line. 

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Formulae to calculate types of costs

Total cost: Total costs = total variable costs + total fixed costs

Total fixed cost: In the short run, at least one factor of production cannot change. This means there are some fixed costs. Fixed costs do not vary with output. For example, rents, advertising and capital goods are fixed costs. They are indirect costs.

Total variable cost: In the long run, all factor inputs can change. This means all costs are variable. For example, the production process might move to a new factory or premises, which is not possible in the short run. Variable costs change with output. They are direct costs. For example, the cost of raw materials increases as output increases.

Average costs: Average (total) costs (ATC) = total costs / quantity produced.

  • ATC = AVC + AFC. Average fixed costs (AFC) = total fixed costs/quantity.
  • Average variable costs (AVC) = total variable costs/quantity.

Marginal cost: This is how much it costs to produce one extra unit of output. It is calculated by ∆TC÷∆Q. When a firm's total variable costs increase, both its marginal cost curve and average cost curve shift upwards. When a firm's total fixed costs increase, only its average cost curve shifts upwards. 

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Derivation of short-run cost curves

The measure of the short run varies with industry. There is no standard. For example, the short run for the pharmaceutical industry is likely to be significantly longer than the short run for the retail industry. In the short run, there are some fixed costs. In the long run, all costs are variable. In the very long run, the state of technology can change, such as electronics.

The law of diminishing marginal productivity states that adding more units of a variable input to a fixed input increases output at first. However, after a certain number of inputs are added, the marginal increase in output becomes constant. Then, when there is an even greater input, the marginal increase in output starts to fall.

In other words, at some point in the production process, adding more inputs leads to a fall in marginal output. This could be due to labour becoming less efficient and less productive, for example. At this point, total costs start to increase.

As the output increases, the average variable cost curve tends towards the average total cost curve. This is because as output increases, the average fixed cost becomes increasingly small. This means the difference between the average variable cost curve and the average total cost curve becomes increasingly small. 

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Internal economies of scale

These occur when a firm becomes larger. Average costs of production fall as output increases.

Risk-bearing: When a firm becomes larger, it can expand its product range. Therefore, they can spread the cost of uncertainty. If one part is not successful, they have other parts to fall back on.

Financial: Banks are willing to lend loans more cheaply to larger firms because they are deemed less risky. Therefore, larger firms can take advantage of cheaper credit.

Managerial: Larger firms are more able to specialise and divide their labour. They can employ specialist managers and supervisors, which lowers average costs.

Technological: Larger firms can afford to invest in more advanced and productive machinery and capital, which will lower their average costs.

Marketing: Larger firms can divide their marketing budgets across larger outputs, so the average cost of advertising per unit is less than that of a smaller firm.

Purchasing: Larger firms can bulk-buy, which means each unit will cost them less. For example, supermarkets have more buying power, so they can negotiate better deals.

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Internal economies of scale

These occur when a firm becomes larger. Average costs of production fall as output increases.

Risk-bearing: When a firm becomes larger, it can expand its product range. Therefore, they can spread the cost of uncertainty. If one part is not successful, they have other parts to fall back on.

Financial: Banks are willing to lend loans more cheaply to larger firms because they are deemed less risky. Therefore, larger firms can take advantage of cheaper credit.

Managerial: Larger firms are more able to specialise and divide their labour. They can employ specialist managers and supervisors, which lowers average costs.

Technological: Larger firms can afford to invest in more advanced and productive machinery and capital, which will lower their average costs.

Marketing: Larger firms can divide their marketing budgets across larger outputs, so the average cost of advertising per unit is less than that of a smaller firm.

Purchasing: Larger firms can bulk-buy, which means each unit will cost them less. For example, supermarkets have more buying power, so they can negotiate better deals.

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External economies of scale

These occur within an industry when it gets larger.

For example, local roads might be improved, so transport costs for the local industries will fall.

Also, there might be more training facilities or more research and development, which will also lower average costs for firms in the local area. 

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Diseconomies of scale

These occur when output passes a certain point and average costs start to increase per extra unit of output produced.

REMEMBER THE 3 C's

Control: It becomes harder to monitor how productive the workforce is, as the firm becomes larger.

Coordination: It is harder and complicated to coordination every worker when there are thousands of employees.

Communication: Workers may start to feel alienated and excluded as the firm grows. This could lead to falls in productivity and increases in average costs, as they lose their motivation. 

 

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Profit maximisation

Profit is the difference between total revenue and total cost. It is the reward that entrepreneurs yield when they take risks.

Profit maximisation occurs when marginal cost = marginal revenue (MC = MR). This is so that each extra unit produced gives no extra loss or no extra revenue. 

Normal profit: Normal profit is the minimum reward required to keep entrepreneurs supplying their enterprise in the long run. It covers the opportunity cost of investing funds into the firm and not elsewhere. This is when total revenue = total costs (TR = TC). Normal profit is considered to be a cost, so it is included in the costs of production.

Supernormal profit: Supernormal profit (also called abnormal or economic profit) is the profit above normal profit. This exceeds the value of the opportunity cost of investing funds into the firm. This is when TR > TC.

Losses: A firm makes a loss when they fail to cover their total costs.

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Short-run and long-run shut down points

A firm which profit maximises continues to operate in the short run if P > AVC. This means firms continue to produce in the short run as long as variable costs are covered.

When shutting down, no variable costs are incurred by the firm. However, fixed costs have to be paid whether the firm shuts down or continues to produce. This means that fixed costs are not considered when a decision to shut down is being made.

The shut-down point is P < AVC when variable costs cannot be covered. This is at the lowest point on the AVC curve.

When a firm shuts down, it is a short run decision. This means production is only temporarily stopped. However, in the long run, the firm can leave the industry. This will happen when TR < TC. 

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Efficiency

Allocative efficiency: Allocative efficiency occurs when resources are distributed to the goods and services that consumers want. This maximises utility. It exists at P = MC, which means that consumers pay for the value of the marginal utility they derive from consuming the good or service. Free markets are considered to be allocatively efficient.

Productive efficiency: This is when firms produce at the lowest point on the short run or long run average cost curve. Since the MC curve cuts the AC curve at the lowest point, MC = AC is a point of productive efficiency. All points on the PPF curve are productively efficient. Allocative and productive efficiency are forms of static efficiency. 

Dynamic efficiency: This is when all resources are allocated efficiently over time, and the rate of innovation is at the optimum level, which leads to falling long-run average costs. The market is dynamically efficient if consumer needs and wants are met as time goes on. It is related to the rate of innovation, which might lead to lower costs of production in the future or the creation of new products. 

X-inefficiency: A firm is x-inefficient when it is producing within the AC boundary. Costs are higher than they would be with competition in the market. The point ‘X’ on the diagram shows x-inefficiency. 

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Characteristics of perfect competition

A perfectly competitive market has the following characteristics:

  • Many buyers and sellers
  • Sellers are price takers
  • Free entry to and exit from the market
  • Perfect knowledge
  • Homogeneous goods
  • Firms are short-run profit maximisers
  • Factors of production are perfectly mobile

In this market, price is determined by the interaction of demand and supply.

In a competitive market, profits are likely to be lower than a market with only a few large firms. This is because each firm in a competitive market has a very small market share. Therefore, their market power is very small. If the firms make a profit, new firms will enter the market, due to low barriers to entry, because the market seems profitable. The new firms will increase supply in the market, which lowers the average price. This means that existing firms’ profits will compete away.

In the short run, firms can make supernormal profits. In the long run, only normal profits are made.

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Advantages and disadvantages of a perfectly compet

Advantages

  • In the long run, there is a lower price. P =MC, so there is allocative efficiency.
  • Since firms produce at the bottom of the AC curve, there is productive efficiency.
  • The supernormal profits produced in the short run might increase dynamic efficiency through investment. 

Disadvantages

  • In the long run, dynamic efficiency might be limited due to the lack of supernormal profits.
  • Since firms are small, there are few or no economies of scale.
  • The assumptions of the model rarely apply in real life. In reality, branding, product differentiation, adverts and positive and negative externalities, mean that competition is imperfect. 
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Monopolistic competition

Characteristics of monopolistically competitive markets:

  • A monopolistically competitive market has imperfect competition. Firms are short-run profit maximisers.
  • Firms sell non-homogeneous products due to branding (there is product differentiation). However, there are a lot of relatively close substitutes. This makes the XED of the goods and services sold high.
  • The model is based on the assumption that there are a large number of buyers and sellers, which are relatively small and act independently.
  • Each seller has the same degree of market power as other sellers, but their market power is relatively weak.
  • There are no barriers to entry to and exit from the market. Since firms have a downward sloping demand curve, they can raise their price without losing all of their customers. This is because firms have some degree of price-setting power.
  • Buyers and sellers in a monopolistically competitive market have imperfect information.
  • Examples of monopolistic competition include hairdressers and regional plumbers. 

In the short run, firms profit maximise at the point MC = MR. Therefore, firms in a monopolistically competitive market can earn supernormal profits in the short run.

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Advantages and disadvantages of monopolistic compe

Advantages

  • Firms are allocatively inefficient in the short and long run (P > MC)
  • Since firms do not fully exploit their factors, there is excess capacity in the market. This makes firms productively inefficient.
  • The model of monopolistic competition is more realistic than perfect competition.
  • The supernormal profits produced in the short run might increase dynamic efficiency through investment. 

 Disadvantages

  • In the long run, dynamic efficiency might be limited due to the lack of supernormal profits.
  • Firms are not as efficient as those in a perfectly competitive market. In a monopolistically competitive market, firms have x-inefficiency, since they have little incentive to minimise their costs. 
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Oligopoly

Characteristics of an oligopoly:

  • High barriers to entry and exit: There are high barriers of entry to and exit from an oligopoly. This makes the market less competitive.
  • High concentration ratio: In an oligopoly, only a few firms supply the majority of the market. For example, in the UK the supermarket industry is an oligopoly. The high concentration ratio makes the market less competitive.
  • The interdependence of firms: Firms are interdependent in an oligopoly. This means that the actions of one firm affect another firm’s behaviour.
  • Product differentiation: Firms differentiate their products from other firms using branding. 

Concentration Ratio

The concentration ratio of a market is the combined market share of the top few firms in a market. 

  • If the 4 firm concentration ratio was calculated, the market share of the 4 largest supermarkets would be added together: 28.4% + 17.1% + 16.4% + 10.9% = 72.8%.
  • The higher the concentration ratio, the less competitive the market, since fewer firms are supplying the bulk of the market.
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Reasons for collusive and non-collusive behaviour

Collusive behaviour occurs if firms agree to work together on something. For example, they might choose to set a price or fix the quantity of output they produce, which minimises the competitive pressure they face.

Collusion leads to a lower consumer surplus, higher prices and greater profits for the firms colluding.

Firms in an oligopoly have a strong incentive to collude. By making agreements, they can maximise their own benefits and restrict their output, to cause the market price to increase. This deters new entrants and is anti-competitive.

Collusion is more likely to happen where there are only a few firms, they face similar costs, there are high entry barriers, it is not easy to be caught and there is ineffective competition policy. Moreover, there should be consumer inertia. All of these factors make the market stable.

Non-collusive behaviour occurs when the firms are competing. This establishes a competitive oligopoly. This is more likely to occur where there are several firms, one firm has a significant cost advantage, products are homogeneous and the market is saturated. Firms grow by taking market share from rivals. 

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Overt and tacit collusion, cartels and price leade

Collusion can be overt or tacit.

  • Overt collusion is when a formal agreement is made between firms. It works best when there are only a few dominant firms, so one does not refuse. It is illegal in the EU, the US and several other countries. For example, it is often suspected that fuel companies partake in overt collusion. This could be in the form of price fixing, which maximises their joint profits, cuts the cost of the competition, such as by preventing firms using wasteful advertising, and reduces uncertainty
  • A cartel is a group of two or more firms which have agreed to control prices, limit output, or prevent the entrance of new firms into the market. A famous example of a cartel is OPEC, which fixed their output of oil. This was possible since they controlled over 70% of the supply of oil in the world. This reduces uncertainty for firms, which would otherwise exist without a cartel.
  • Cartels can lead to higher prices for consumers and restricted outputs. Some cartels might involve dividing the market up, so firms agree not to compete in each other’s markets.
  • Price leadership occurs when one firm changes its prices, and other firms follow. This firm is usually the dominant firm in the market. Other firms are often forced into changing their prices too, otherwise, they risk losing their market share. This explains why there is price stability in an oligopoly; other firms risk losing market share if they do not follow the price change.
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Game theory

  • Game theory is related to the concept of interdependence between firms in an oligopoly. It is used to predict the outcome of a decision made by one firm, when it has incomplete information about the other firm.
  • It can be explained using the Prisoner’s Dilemma, which is a model based around two prisoners, who have the choice to either confess or deny a crime. The consequences of the choice depend on what the other prisoner chooses. 
  • The two prisoners are not allowed to communicate, but they can consider what the other prisoner is likely to choose. This relates to the characteristic of uncertainty in an oligopoly.
  • The dominant strategy is the option which is best, regardless of what the other person chooses. This is for both prisoners to confess since this gives the minimum number of years that they have to spend in prison. It is the most likely outcome.
  • This is still higher than if both prisoners deny the crime, however. If collusion is allowed in this dilemma, then both prisoners would deny. This is the Nash equilibrium.
  • However, even if both prisoners agree to deny, each one has an incentive to cheat and therefore confess, since this could reduce their potential sentence from 2 years to 1 year. This makes them Nash equilibrium is unstable.
  • It essentially sums up the interdependence between firms when making decisions in an oligopoly
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Types of price competition

Price wars: This involves firms constantly cutting their prices below that of its competitors. Their competitors then lower their prices to match. Further price cuts by one firm will lead to more and more firms cutting their prices. An example of this is the UK supermarket industry 

Predatory pricing: This is illegal. It involves firms setting low prices to drive out firms already in the industry. In the short run, it leads to them making losses. As firms leave, the remaining firms raise their prices slowly to regain their revenue. They price their goods and services below their average costs. 

Limit pricing: This is not necessarily illegal. Low prices discourage the entry of other firms, so there are low profits. It ensures the price of a good is below that which a new firm entering the market would be able to sustain. Potential firms are therefore unable to compete with existing firms. This can be evaluated by considering how the low profits of existing firms might dissatisfy shareholders since they receive lower dividends

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Types of non-price competition

These aim to increase the loyalty to a brand, which makes the demand for a good more price inelastic.

For example, firms might improve the quality of their customer service, such as having more available delivery times. They might keep their shops open for longer, so consumers can visit when it is convenient.

Special offers, such as buy one get one free, free gifts, or loyalty cards might be used to attract consumers and increase demand.

Advertising and marketing might be used to make their brand more known and influence consumer preferences. However, it is difficult to know what the effect of increased advertising spending will be. For some firms, it might be ineffective. This would make them incur large sunk costs, which are unrecoverable.

Brands are used to differentiate between products. If firms can increase brand loyalty, demand becomes more price inelastic. Increasing brand loyalty means firms can attract and keep customers, which can increase their market share. 

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Monopolies

Monopolies can be characterised by:

  • Profit maximisation: A monopolist earns supernormal profits in both the short run and the long run.
  • Sole seller in a market (a pure monopoly)
  • High barriers to entry
  • Price maker
  • Price discrimination

In the UK, when one firm dominates the market with more than 25% market share, the firm has monopoly power. 

Monopoly power can be gained when there are multiple suppliers. If two large firms in an oligopoly (several large sellers) have greater than 25% market share, they are said to have monopoly power.

There are very few examples of pure monopolies, but several firms have monopoly power.

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Examples of barriers to entry which can maintain m

  • Economies of scale: As firms grow larger, the average cost of production falls because of economies of scale. This means existing large firms have a cost advantage over new entrants to the market.
  • Limit pricing: This involves the existing firm setting the price of their good below the production costs of new entrants, to make sure new firms cannot enter profitably.
  • Owning a resource: Early entrants to a market can establish their monopoly power by gaining control of a resource. 
  • Sunk costs: If unrecoverable costs, such as advertising, are high in an industry, then new firms will be deterred from entering the market.
  • Brand loyalty: If consumers are very loyal to a brand, which can be increased with advertising, it is difficult for new firms to gain market share.
  • Set-up costs: If it is expensive to establish the firm, then new firms will be unlikely to enter the market.
  • The number of competitors: The fewer the number of firms, the lower the barriers to entry, and the harder it is to gain a large market share.
  • Advertising: Advertising can increase consumer loyalty, making demand price inelastic, and creating a barrier to entry.
  • The degree of product differentiation: The more the product can be differentiated, through quality, pricing and branding, the easier it is to gain market share. 
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Third degree price discrimination

Price discrimination occurs in a monopoly, when the monopolist decides to charge different groups of consumers different prices, for the same good or service. This is not for cost reasons.

Usually, demand curves of different elasticities exist with each group of consumers. This allows the market to be split and different prices to be charged. It must not cost the monopolist much to split the market; otherwise, it will not be financially worthwhile. 

By charging different prices, the monopolist can maximise their overall profits. 

Third-degree price discrimination is when different groups of consumers are charged a different price for the same good or service. For example, the higher price at peak times on trains is a form of third-degree price discrimination, because generally, a different group of consumers use trains at peak times, than off-peak times. 

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Costs and benefits of a monopoly (Consumers)

Costs

  • Usually, price discrimination results in a loss of consumer surplus. Since         P > MC, there is a loss of allocative efficiency.
  • It strengthens the monopoly power of firms, which could result in higher prices in the long run for consumers. 

Benefits 

  • Consumers could benefit from a net welfare gain as a result of cross-subsidisation, if they receive a lower price.
  • Some consumers, who were previously excluded by high prices might now be able to benefit from the good or service. For example, drug companies might charge consumers with higher incomes more for the same drugs, so that the less well-off can also access the drugs at a lower price. This can yield positive externalities. 
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Costs and benefits of a monopoly (Suppliers)

Costs

  • If it is used as a predatory pricing method, the firm could face investigation by the Competition and Markets Authority.
  • It might cost the firm to divide the market, which limits the benefits they could gain. 

Benefits 

  • Producers make better use of spare capacity.
  • The higher supernormal profits, which result from price discrimination, could help stimulate investment.
  • If more profits are made in one market, a different market which makes losses could be cross-subsidised, especially if it yields social benefits. This will limit or prevent job losses, which might result from the closure of the loss-making market. 
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Natural monopoly

A natural monopoly arises when there are high fixed costs, usually in the form of infrastructure. For example, water and gas pipes, electricity cables and rail networks are expensive forms of infrastructure. In these industries, natural monopolies supply the services. The costs of infrastructure are a form of sunk costs since the costs are not recoverable if the firm decided to leave the market. This makes barriers of entry to and exit from the market high.

It is considered inefficient to duplicate this infrastructure by trying to make the market more competitive. This is because resources would be wasted. 

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Monopsony

Characteristics and conditions for a monopsony to operate:

  • A monopsony is a single buyer in a market. For example, Network Rail for track maintenance and the government for teachers are examples of a monopsony. Moreover, supermarkets have monopsony power when buying produce from farmers, which means they are able to negotiate low prices.
  • It is assumed that monopsonists are profit maximisers.
  • A firm with monopsony power is able to negotiate lower prices because their suppliers have nowhere else to sell to (there is only one buyer).
  • Firms with monopsony power are able to set the market price. 
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Costs and benefits of a monopsony

Costs

  • It is the monopsony power of supermarkets that has led to many farmers losing profits. Farmers lose out to supermarket price wars, because supermarkets keep negotiating lower prices from farmers, in order to lower their own prices and compete with other supermarkets. Supplying firms are unlikely to make more than normal profit.
  • Employees are likely to lose out with lower wages. For example, those trained to be coal miners had little choice of who to work for. This meant their labour could be exploited by the employer. However, now this has been offset with the power of trade unions, which are able to negotiate higher wages and good working conditions.
  • Workers might become unproductive if wages are low.

Benefits

  • The NHS has monopsony power when buying drugs from pharmaceutical companies. They are able to negotiate lower prices for the drugs. This saves money which can be invested elsewhere, such as in R&D. Moreover, the NHS can then cover more treatments within their budget.
  • By lowering the price paid to suppliers, consumers might receive lower prices.
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Contestability

Characteristics of contestable markets:

  • Contestable markets face actual and potential competition.
  • Entrants to contestable markets have free access to production techniques and technology.
  • There are no significant entry or exit barriers to the industry. For example, there will be no sunk costs in a contestable market.
  • There is low consumer loyalty.
  • The number of firms in the market varies.

Implications of contestable markets for the behaviour of firms:

  • If markets are contestable, firms are more likely to be allocatively efficient. In the long run, firms operate at the bottom of the average cost curve. This makes them productively efficient.
  • The threat of new entrants affects firms just as much as existing competitors. Due to the low barriers to entry which provide easy access to the market, firms are wary of new entrants entering the market, taking supernormal profits, and then leaving. This is known as hit and run.
  • There could be supernormal profits in the short run and only normal profits in the long run. In the short run, new firms can enter and take advantage of supernormal profits. However, in practice, firms can only earn normal profits in the short run. Without SNP there is no incentive.
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Types of barrier to entry and exit

Barriers to entry aim to block new entrants to the market. it increases producer surplus and reduces contestability. 

The greater the economies of scale that a firm exploits, the less likely it is that a new firm will enter the market. This is because they would produce comparatively expensively, so they cannot compete. 

  • Legal barriers: These can act as a barrier to entry. For example, patents and exclusive rights to production (such as with television) mean other firms cannot enter the market. 
  • Consumer loyalty and branding: This can make a market less contestable. This is since demand becomes more price inelastic, and consumers are less likely to try other brands.
  • Predatory pricing: This involves firms setting low prices to drive out firms already in the industry. In the short run, it leads to them making losses
  • Limit pricingThis discourages the entry of other firms. It ensures the price of a good is below that which a new firm entering the market would be able to sustain
  • The cost of making workers redundant: This might discourage firms from leaving an industry
  • Losing a brand and consumer loyalty: This is hard to put a monetary value on but is still considered a cost of leaving the market
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Sunk costs and the degree of contestability

There are different degrees of contestability across markets. All markets have the potential to be contestable, but it depends on what kind of costs firms face, and how loyal consumers are. No markets are perfectly contestable, markets generally have some degree of contestability.

It is hard to judge the degree of contestability since in reality there will be some costs to entry and exit.

An application point of contestability could be the bus industry, which the government helps to make more contestable. Also, the budget airline industry could be seen as having some degree of contestability, if firms rent planes for a few years and then sell them. Ryanair entered the market cheaply by choosing less popular landing slots. In recessions, however, the market is less profitable.

Sunk costs are a barrier to contestability. They are costs which cannot be recovered once they have been spent. For example, advertising incurs a sunk cost. A market with high sunk costs is less favourable to enter because the risks associated with entering the market are high.

High sunk costs are likely to push a market towards a price and output that is similar to a monopoly. 

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Demand for labour

The labour market is a factor market. The supply of labour is determined by those who want to be employed (the employees), whilst the demand for labour is from employers.

Labour is a derived demand. This means that the demand for labour comes from the demand for what it produces. For example, the demand for people who make cars is derived from the demand for cars. With no demand for cars, there will be no demand for car manufacturers.

Demand is related to how productive labour is and how much the product is demanded. The elasticity of demand for labour is linked to how price elastic the demand for the product is.

The wage rate will lead to movements along the supply and demand curves for labour. All other factors will shift the curves. 

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The demand for labour is affected by...

The wage rate: The downward sloping demand curve shows the inverse relationship between how much the worker is paid and the number of workers employed. When wages get higher, firms might consider switching production to capital, which might be cheaper and more productive than labour.

Demand for products: Since the demand for labour is derived from the demand for products, the higher the demand for the products, the higher the demand for labour.

The productivity of labour: The more productive workers are, the higher the demand for them. This can be increased with education and training, and by using technology.

How profitable the firm is: The higher the profits of the firm, the more labour they can afford to employ.

The number of firms in the market: This determines how many buyers of labour there is. If there is only one employer, for example, the NHS, the demand for labour is lower than if there are many employers, such as in the supermarket industry. The lower demand for labour can mean wages are lower, so trade unions try to encourage higher wages.

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Supply of labour and what affects it

The supply of labour is calculated by the number of workers willing and able to work at the current wage rate, multiplied by the number of hours they can work.

The supply of labour is affected by: 

  • The wage rate: The upward sloping supply curve shows the proportional relationship between how much the worker is paid and the number of workers willing and able to work.
  • Demographics of the population: The more people there who are able and willing to work, the higher the supply of labour. This changes with retirement and school leaving ages, the number of university students and immigration.
  • Advantages of work: This can influence how much people prefer to work, and is linked to non-monetary advantages. If the cost of working is lower, so families can afford childcare, people are more likely to work.
  • Leisure time: Leisure is a substitute for work, which is why part-time work and early retirements are attractive options for some people
  • Trade unions: These could attract workers to the labour market because they know their employment rights will be defended.
  • Taxes and benefits: If taxes are too high and benefits are too generous, people might be more inclined to withdraw from the labour market.
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Market failure in labour markets

The geographical and occupational mobility of labour: 

The mobility of labour is the ability of workers to change between jobs.

The geographical immobility of the factors of production refers to the obstacles which prevent the factors of production moving between areas. For example, labour might find it hard to find work due to family and social ties, the financial costs involved with moving, imperfect market knowledge on work and the regional variations in house prices and living costs across the UK.

The occupational immobility of the factors of production refers to the obstacles which prevent the factors of production changing their use. For example, labour might find it difficult to change the occupation. This occurred in the UK with the collapse of the mining industry, when workers did not have transferable skills to find other work. The causes include insufficient education, training and skills. 

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Wage determination

Labour market equilibrium: The labour market is a factor market.

The supply of labour is determined by those who want to be employed (the employees), whilst the demand for labour is from employers. Labour market equilibrium is determined where the supply of labour and the demand for labour meet.

This determines the equilibrium price of labour, i.e. the wage rate.

An increase in the supply of labour would lead to a shift right.

A decrease in the supply of labour would lead to a shift left.

However, in the real labour market, wages are not as flexible. Keynes coined the phrase ‘sticky wages’.

Wages in an economy do not adjust to changes in demand. The minimum wage makes wages sticky and means that during a recession, rather than lowering the wages of several workers, a few workers might be sacked instead. 

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Current labour market issues

Wage differentials:

Sometimes, even in the same job, workers can be paid different amounts. This is due to Skills, Qualifications and training, Pay gaps and Gender.

The impact of migration on labour markets: 

  • There could be more competition to get a job due to the rise in the size of the working population. Migrants tend to be of working age, and many are looking for a job. 
  • There could be more competition to get a job due to the rise in the size of the working population. Migrants tend to be of working age, and many are looking for a job. o Migrants tend to bring high-quality skills to the domestic workforce, which can increase productivity and increase the skillset of the labour market

Unemployment: 

  • Unemployment is a problem since, if consumers are unemployed, they have less disposable income and their standard of living may fall as a result. 
  • If the unemployment rate increases, the government may have to spend more on JSA, which incurs an opportunity cost because the money could have been invested elsewhere.

 

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Minimum wages

The National Minimum Wage is an example of a minimum price.

  • The minimum wage has to be set above the free market price, just like other minimum prices, otherwise, it would be ineffective. 
  • There has been no evidence of a rise in unemployment with a rise in the NMW so far in the UK. Some firms say this is because the NMW is still relatively low.
  • The NMW will yield the positive externalities of a decent wage, which will increase the standard of living of the poorest, and provide an incentive for people to work.
  • It could make it harder for young people to find a job because of their lack of experience might not be valuable to firms who are paying more for their labour.
  • The government might make more tax revenue, due to more people earning higher wages.
  • A higher wage could make the country less competitive on a global scale since they cannot compete with countries that have lower wages. 
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Maximum wage

A maximum wage is also known as a wage ceiling, and it limits how much income someone can earn.

  • It can be used as a means to redistribute wealth more equitably in society.
  • In theory, a maximum wage should limit inflation, since wages (and therefore consumer demand) is limited. Maximum wages must be set below the free market equilibrium wage to be effective.
  • One criticism of a maximum wage is that it could be a disincentive to innovate, and workers might opt for less demanding work. 
  • Maximum wages control the market wage, but this could lead to government failure if they misjudge where the optimum wage should be.
  • It can lead to a more equal distribution of wealth in society. 
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Public sector wage setting

The public sector is the compilation of industries owned by the government.

In the UK, public sector pay is higher than the private sector, in raw terms. Between 2008 and 2010, public sector pay grew (4.5%) relative to the private sector (1%). Women in the public sector were paid about 8% more than those in the private sector between 2013 and 2014.

Across the country, public sector pay is more equal than private sector pay.

About half of government spending goes towards public sector pay. 

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Policies to tackle labour market immobility

The flexibility of the labour market is how willing and able labour is to respond to changes in the conditions of the market. It is important for labour to be able to adjust to changes in demand, and it is vital for the supply-side of the economy.

  • Trade union power: If trade unions are pushing for higher wages, the labour market is likely to be more flexible. Trade unions can also increase job security. If trade unions limit the rights of a worker to strike, there could be a decline in flexibility.
  • Regulation: The more freedom firms have to hire and fire workers and the more freedom workers have in terms of their rights, the more flexible the labour market. 
  • Welfare payments and income tax rates: The reward for working should be high. If welfare payments are generous and income tax rates are high, labour market flexibility is likely to be lower.
  • Training: More widely available training opportunities and a more skilled workforce makes the labour market more flexible. The quality and price of education should be improved, so more people can afford a good education.
  • Infrastructure: Improving infrastructure might help the geographical immobility of labour, since it becomes easier to move around the country.
  • Housing: If housing became more affordable, then people might be more able to move around the country for work, which improves the geographical mobility of labour.
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The significance of the elasticity of demand of la

The wage rate and level of employment are affected by shifting the demand curve differently, depending on how elastic the other curve is.

If labour demand is inelastic, because there are few or no substitutes, strikes will increase the wage rate but not affect the employment rate significantly. Where there is an inelastic demand for labour, a lower supply will lead to a higher increase in the wage rate.

The elasticity of demand for labour measures how responsive the demand for labour is when the market wage rate changes. This is affected by:

  • How much labour costs as a proportion of total costs: The higher the cost of labour as a proportion of total costs, the more elastic the demand. Labour costs are high as a proportion of total costs in the services.
  • Ease of substitution: The easier it is to substitute factors, the more elastic the demand for labour because firms can easily to switch to cheaper forms of production, such as capital.
  • The PED of the product: This also affects labour. The more price elastic the product, the more price elastic the demand for labour
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The significance of the elasticity of supply of la

The wage rate and level of employment is affected by shifting the supply curve differently, depending on how elastic the other curve is. 

The elasticity of supply of labour is the responsiveness of the quantity of labour supplied to a change in the wage rate. This is affected by:

  • The skills of the workforce: Skilled jobs have lower elasticities than unskilled jobs because it is more difficult to attract workers, since only a few have the necessary skills.
  • Length of training: The longer the training period for a job, the lower the elasticity of labour supply.
  • Sense of vocation: Some jobs have rewards which are not financial, such as teaching. These will have inelastic supplies.
  • Time period: In the short run, the supply of labour is more inelastic than in the long run. 
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Government intervention to control mergers

The Competition and Markets Authority (CMA) is the main competition regulator in the UK. The key aims for competition policy are to promote competition and ensure markets are efficient.

They also protect consumer interests by keeping prices low and widening consumer choice.

The competition authorities investigate potential mergers between two large firms, if they would dominate the market by merging.

If the merger (or takeover) is deemed to create a larger firm with monopoly power, it is likely to be prevented. 

Example:

Recently, after months of deliberation, the CMA concluded that the merger of two of the top 5 supermarkets, Asda and Sainsbury's, would be a great detriment to customers when it comes to experience, price and choice despite claims that the merger would lower prices and increase choice due to economies of scale. 

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Government intervention to control monopolies

Governments intervene in the market to control monopolies and prevent the abuse of monopoly power. This is because of the potential for market failure, and loss of consumer surplus, that can result from a monopoly exploiting the market.

The transfer of wealth from consumers to producers is not necessarily considered to be an economic problem. However, the reduction in overall economic welfare that results from monopoly power is a disadvantage. 

  • Price regulation: Governments can prevent monopolies from charging consumers excessive prices, which might result in a loss of allocative efficiency. For example, they might use RPI-X, which is a form of price capping. 
  • Profit regulation: Governments can control the profits that firms earn by ensuring they are not excessive. In the UK, firms have to pay corporation on any profits they earn.
  • Quality standards: Additionally, regulators can observe the quality of the goods and services of the firm. 
  • Performance targets: The government sets targets on organisations, such as schools, to ensure a minimum target is being met. This aims to regulate its quality. 
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Promotion of competition through Small Businesses

The UK government has established the ‘Red Tape Challenge’, which aims to simplify regulation for businesses. It is especially aimed at small businesses. This aims to make it cheaper and easier to meet environmental targets and create new jobs.

Small and Medium Sized Enterprises (SMEs) are important for creating a competitive market. They create jobs, stimulate innovation and investment and promote a competitive environment.

Governments aim to improve access to finance and reduce barriers to entry, which will make it easier for smaller firms to enter the market. 

Schumpeter, an economist, proposed the idea of ‘creative destruction’. This is the idea that new entrepreneurs are innovative, which challenges existing firms. The more productive firms then grow, whilst the least productive are forced to leave the market. This results in an expansion of the economy’s productive potential. 

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Deregulation and privatisation

Deregulation is the act of reducing how much an industry is regulated. It reduces government power and enhances competition. 

By deregulating or privatising the public sector, firms can compete in a competitive market, which should also help improve economic efficiency. 

Excessive regulation is also called ‘red tape’. It can limit the quantity of output that a firm produces. 

Privatisation means that assets are transferred from the public sector to the private sector. In other words, the government sells a firm so that it is no longer in their control. The firm is left to the free market and private individuals. 

Free market economists will argue that the private sector gives firms incentives to operate efficiently, which increases economic welfare. This is because firms operating on the free market have a profit incentive, which firms which are nationalised do not. 

However, firms which profit maximise in a competitive market might compromise on quality. Also by selling the asset to the private sector, revenue is raised for the government. However, this is only a one-off payment. 

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Competitive tendering for government contracts

The government provides some goods and services because they are public or merit goods and they are underprovided in the free market. The government could contract out this provision, so that private firms operate things such as roads or hospital.

The firm which offers the lowest price and best quality of provision wins the government contract. This saves the government money since the public sector can be bureaucratic and inefficient. The private sector has an incentive to reduce their costs since they operate in a competitive market.

It also frees the government of maintenance, since the private sector might have the expertise and knowledge to fulfil the project and maintain the infrastructure.

This can be evaluated by considering how the private sector might not meet the specification of the contract. Moreover, the private sector firm might try and cut costs by lowering wages, and they are less likely to have social welfare as a priority

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Restrictions on monopsony power of firms

It is the monopsony power of supermarkets that has led to many farmers losing profits. Farmers lose out to supermarket price wars because supermarkets keep negotiating lower prices from farmers, in order to lower their own prices and compete with other supermarkets. Supplying firms are unlikely to make more than normal profit.

Governments can regulate this to ensure that farmers are receiving a fair deal. For example, farmers in the UK might receive grants and subsidies to support their production. The CMA might investigate supermarket buying power to ensure they are not abusing their monopsony power. 

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Nationalisation

This occurs when private sector assets are sold to the public sector. In other words, the government gains control of an industry, so it is no longer in the hands of private firms.

The railway industry in the UK was nationalised after 1945.

By nationalising an industry, natural monopolies are created. This is because it is inefficient to have multiple sets of water pipes, for example. Therefore, only one firm provides water.

Some nationalised industries yield strong positive externalities. For example, by using public transport, congestion and pollution are reduced.

Nationalised industries have different objectives to privatised industries, which are mainly profit driven.

Social welfare might be a priority of a nationalised industry. 

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The impact of government intervention on...

Prices

  • Governments can prevent monopolies from charging consumers excessive prices, which might result in a loss of allocative efficiency.
  • This can make services from utility companies, such as water, gas and electricity more affordable, which is especially beneficial to low and fixed income households. 

Profit

  • If governments impose strict price caps, investment could be limited, since the amount of profit that a firm makes is restricted.
  • However, the recent fall in UK corporation tax from 21% to 20% will help firms keep more profits. 

Quality

  • Governments can ensure firms are meeting minimum targets, which ensures firms focus on increasing social welfare. However, firms which profit maximise might compromise on quality. 
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Limits to government intervention

Regulatory capture

  • There is a risk of regulatory capture. This is when regulators start acting in the interests of the company, due to impartial information, rather than in consumer interests.
  • This information disadvantage is a problem for regulators. 

Asymmetric information

  • The problem of asymmetric information can make it hard to determine what level a price cap should be imposed at.
  • It is hard to determine government policies when intervening where there is market failure since the extent to which the market fails involves a value judgement. For example, it is hard to decide what the cost of pollution to society is. Different individuals will put a different value on it, depending on their own experiences with pollution, such as how polluted their home town is.
  • Without sufficient information, governments could make poor decisions and it could lead to a waste of scarce resources. 
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