© Economics Online 2011. 3 Alternative motives

© Economics Online 2011

Motives of firms

Revenue

Costs of production

Firm’s supply curve

Efficiency

Profits

Revenue maximisation

Profit maximisation

Natural monopoly

Price discrimination

Growth and mergers

Contestable markets

Regulation

Business economics

Sales maximisation

Oligopoly

Perfect competition

Monopolistic competition

Game theory

Monopoly


Motives of firms

© Economics Online 2011 3

Alternative motives

1. Profit maximisation Maximising profits means achieving the highest possible profit,

which is the excess of a firm’s revenue over its production costs. Profit maximisation is assumed to be the dominant motive of

private enterprise.2. Sales maximisation

To maximise sales means to sell as much quantity as possible, without making a loss.

This means producing an output where total revenue generated from sales just covers the total costs of production.

3. Sales revenue maximisation To maximise total revenue means achieving the maximum income

from selling products at particular prices.


Alternative motives

4. Market Share Market ‘share’ refers to the proportion of total market sales

achieved by a particular firm. This is a goal that is significant for firms operating in markets with

a few large competitors - called oligopolies. 5. Survival

Some firms take a short term view and simply want to survive - this is significant for new firms and those in competitive markets.

6. Shareholder value Shareholder ‘value’ is the remaining value of a business once all

debts have been paid.


7. Ethical/environmental objectives Trying to achieve an ‘ethical’ objective, such as being ‘carbon

neutral’.8. Satisficing

‘Satisficing’ means attempting to take into account a number of different objectives, without maximising any single one. Satisficing is regarded as a managerial objective, and will result in lower profits than when operating a profit maximising strategy.


Which motive?

The choice of motive depends upon a number of criteria, including:1. Who owns or manages the firm?

Owners may try to maximise profits while managers may try to maximise revenue.

2. How big the firm is? Small firms may simply hope to survive, whereas large firms may

wish to develop market share.3. What competitors are doing

If a dominant firm in a competitive market focuses on one goal, such as market share, this may become the focus of all firms.

4. The time period In the short run, simple goals such as survival may dominate,

while in the long run more challenging goals may dominate, such as maximising shareholder value.


Revenue


Types of revenue

Revenue is measured in three ways:1. Total revenue (TR)

1. The total flow of income to a firm from selling a given quantity of output at a given price.

2. The value of TR is found by multiplying price and quantity sold.2. Average revenue (AR)

1. Revenue per unit, which can be found by dividing TR by the quantity sold, Q.

2. AR is equivalent to the price of the product, where P x Q/Q = P.3. Marginal revenue (MR)

1. MR is the revenue generated from selling one extra unit of a good or service.

2. It can be both positive and negative.


Example

Consider the example of a firm which produces and sells DVD players.

If we know price and quantity demanded we can calculate TR and MR.

Price(£) Quantity (m) TR MR

100 1

90 2

80 3

70 4

60 5

50 6

40 7

30 8


100 1 100

90 2 180 80

80 3 240 60

70 4 280 40

60 5 300 20

50 6 300 0

40 7 280 -20

30 8 240 -40


Comments

As output increases, TR increases but at a decreasing rate.

When TR reaches its peak -is at a maximum - MR is zero.

When MR is positive, TR is rising, and when MR is negative, TR is falling.


100 1

90 2

80 3

70 4

60 5

50 6

40 7

30 8


100 1 100

90 2 180

80 3 240

70 4 280

60 5 300

50 6 300

40 7 280

30 8 240


100 1 100

90 2 180 80

80 3 240 60

70 4 280 40

60 5 300 20

50 6 300 0

40 7 280 -20

30 8 240 -40

Revenue

Quantity


Total revenue (TR) curve slopes upwards at a decreasing rate, reaches a maximum, then decreases.

Average revenue (AR) curve slopes downwards.

Marginal revenue (MR) curve slopes downwards at twice the rate of AR. When MR is 0, TR will be at maximum.

Total Revenue

MR

AR = D

Total, average and marginal revenue curves


The Principles of Production


Inputs – the factors of production

Fixed and variable factors In order to produce an output firms must purchase or hire

factors of production, which can be either fixed or variable. Fixed factors

Fixed factors are those which do not change as output changes.Typical fixed factors include a firm’s premises - offices and

factories - and capital equipment - machinery and tools. Variable factors

These do change with output – more are used when production increases, and less are used when production decreases.

Typical variable factors are the labour, energy and raw materials directly used in production.


Production time periods for a firm

There are four time periods in micro-economics:1. The very short run

A firm is said to be ‘in its very short run’ when the only way to increase output to the market is by using up existing stocks of inputs.

2. The short run In the short run the only way to increase output is by using more

variable factors, such as by hiring more workers. In the short run at least one factor of production is fixed.


Production time periods for a firm

3. The long run A firm enters its ‘long run’ when it increases its

scale of operations. Increasing scale means that none of the factors of production

are fixed - all are variable. 4. The very long run

A whole industry enters the ‘very long run’ when there is a significant change in the use of technology.


The law of diminishing returns


The laws of production in the short run

The law of diminishing marginal returns Economic theory predicts that:

If firms increase the number of variable factors they use, such as labour, while keeping one factor fixed, such as machinery, the extra output (‘returns’ or product) from each additional (marginal) unit of the variable factor must eventually diminish.

This is the ‘famous’ Law of Diminishing Returns.This states that, assuming one factor remains fixed, the marginal

output generated from adding new variable factors will not be constant – it will rise at first, reach a turning point, then eventually diminish.


Example of diminishing marginal returns

Consider the total output produced by workers and calculate:

1. Average product - product per worker.

2. Marginal product - the additional product from adding one extra worker.

Workers Total Product

Average Product

Marginal Product

1 6

2 14

3 28

4 36

5 40

6 42

7 42

8 40


Average Product

Marginal Product

1 6 6 6

2 14 7 8

3 28 9.3 14

4 36 9 8

5 40 8 4

6 42 7 2

7 42 6 0

8 40 5 -2


Diminishing returns

Productivity is low when only a few workers are employed.

However, it rises as each extra worker contributes more than the previous one.

Eventually marginal productivity begins to decline.

With the employment of seven workers marginal product is zero, and total product is at a maximum.


Average Product

Marginal Product

1 6 6 6

2 14 7 8

3 28 9.3 14

4 36 9 8

5 40 8 4

6 42 7 2

7 42 6 0

8 40 5 -2


Showing returns in the short run

The product curves The marginal returns

curve increases and then decreases.

With a small number of workers a division of labour cannot be employed. Marginal returns increase with specialisation and greater efficiency.

Eventually the effects of specialisation wear off.

Output

Inputs

Marginal Returns Average

Returns


Costs of production


Output Total Fixed Cost (£000)

Total Variable Cost (£)

Total Cost (£)

1

2

3

4

5

6

7

8

Costs of production

Fixed costsDo not vary with output,

such as rent, insurance, and depreciation.

Variable costs Do vary with output, such

as fuel, raw materials, and some labour costs.

Consider the following:The total fixed costs (TCF)

are £100,000.The total variable costs

(TVC) include the direct cost of labour and raw materials.



Total Cost (£)

1 100 50

2 100 80

3 100 100

4 100 110

5 100 150

6 100 220

7 100 350

8 100 640



Total Cost (£)

1 100 50 150

2 100 80 180

3 100 100 200

4 100 110 210

5 100 150 250

6 100 220 320

7 100 350 450

8 100 640 740

+ =

Cost Revenue

Quantity


Total cost curves

Total fixed cost (TFC) The curve is horizontal -

constant as output increases.

Total variable costs (TVC) This slopes up at an

increasing rate, reflecting the Law of Diminishing Returns.

Total costs The position of the TC

curve reflects fixed costs, and the gradient reflects variable costs.

Total Fixed Costs

Total Variable Costs

Total Costs


Average fixed costs

To find average fixed costs we divide total fixed costs by output.

As fixed cost is divided by an increasing output, average fixed costs will continue to fall.


Average fixed costs (£000)

1 100

2 100

3 100

4 100

5 100

6 100

7 100

8 100


Average fixed costs (£000)

1 100 100

2 100 50

3 100 33.3

4 100 25

5 100 20

6 100 16.6

7 100 14.3

8 100 12.5

TFC

Q

Cost Revenue

Quantity


Graph to show average fixed costs

Average fixed costs The Average Fixed

Cost (AFC) curve will slope down continuously, from left to right.

Average Fixed Costs


Average variable costs

Average variable costsTo find average

variable costs total variable cost is divided by output.

Output Total Variable cost (£000)

Average Variable cost

(£000)

1 50

2 80

3 100

4 110

5 150

6 220

7 350

8 640

Output Total Variable cost (£000)

Average Variable cost

(£000)

1 50 50

2 80 40

3 100 33.3

4 110 27.5

5 150 30

6 220 36.7

7 350 50

8 640 80

TVC

Q

Cost Revenue

Quantity


Graph to show average variable costs

Average variable costs The AVC curve is ‘U’

shaped. AVC is ‘U’ shaped because of the Law of Variable Proportions, which explains the three phases of the curve:

1. Increasing returns followed by:

2. Constant returns, followed by:

3. Diminishing returns, which cause average costs to rise.

Average Variable Costs


Average total costs (average cost)

Average total costsTo find average total

costs (ATC, or AC) we must either divide total costs by output, or add AVC and AFC.

OutputAverage

Fixed Cost (£000)

Average Variable

Cost(£000)

Average Total Cost

(£000)

1 100 50

2 50 40

3 33.3 33.3

4 25 27.5

5 20 30

6 16.6 36.7

7 14.3 50

8 12.5 80

OutputAverage

Fixed Cost (£000)

Average Variable

Cost(£000)

Average Total Cost

(£000)

1 100 50 150

2 50 40 90

3 33.3 33.3 67

4 25 27.5 53

5 20 30 50

6 16.6 36.7 53

7 14.3 50 64

8 12.5 80 92

TC

Q

Cost Revenue

Quantity


Graph to show average total costs

Average total cost Average total cost (ATC)

can be found by adding average fixed costs (AFC) and average variable costs (AVC).

The ATC curve is ‘U’ shaped The ATC curve is also ‘U’

shaped because it takes its shape from the AVC curve.

Average Variable

Costs

Average Fixed Costs

Average Total Costs

Cost Revenue

Quantity


The areas for total costs

If we take a given level of output, Q, we can see the areas representing total variable costs and total fixed costs.

The two areas added together represent total costs.

AVC

ATC

Q

Total variable costs

Total fixed costs

Average variable costs x quantity = total

variable cost

Quantity

The greater the output the smaller the significance

of fixed costs

TVC

TFC


Marginal cost

To find marginal cost we need to find the cost of producing one extra unit of output.

This can be found by calculating the change in total cost when output is increased by one unit.

Marginal cost is derived solely from variable costs.

Output Total Cost (£000)

Marginal Cost (£000)

1 150

2 180

3 200

4 210

5 250

6 320

7 450

8 740

Output Total Cost (£000)

Marginal Cost (£000)

1 150

2 180 30

3 200 20

4 210 10

5 250 40

6 320 70

7 450 130

8 740 290

∆TC

∆Q

Cost Revenue

Quantity


The marginal cost curve

The marginal cost curve falls briefly at first, then rises.

Marginal Costs

Average Total Costs

Marginal cost (MC) cuts average total cost (ATC) at its lowest point on the ATC curve

Cost Revenue

Quantity


The relationship between ATC and MC

ATC and MC ATC and MC are

connected because they are derived from the same basic numerical data.

MC will always cut ATC from below.

When MC is below ATC, ATC will be falling, and when MC is above ATC, ATC will be rising.

Marginal Costs

Average Total Costs


Exercise A

1. Complete the missing figures.

2. What is profit maximising output?

3. What is sales revenue maximising output?

4. How efficient is the firm at profit maximisation?

Q P (£000)

Fixed cost

(£000)

Variable cost

Total cost ATC MC TR MR Profit

0 110 100

1 100 140

2 90 160

3 80 170

4 70 200

5 60 240

6 50 300

7 40 400

8 30 570


Answers (A)

Profit maximising Profits are maximised

at 4 units (supernormal profits are at £80,000).

Sales revenue maximising 6 units - in this case

there are zero super-normal profits.

Efficiency At profit max, ATC is

£50,000 – the lowest possible is £48,000 – there is a loss of productive efficiency.

The price, of £70,000, is greater than the marginal cost, of £30,000, hence there is

allocative inefficiency.

Q P (£000)

Fixed cost

(£000)

Variable cost


0 110 100 0 100 0 -100

1 100 100 40 140 140 40 100 100 -40

2 90 100 60 160 80 20 180 80 20

3 80 100 70 170 57 10 240 60 70

4 70 100 100 200 50 30 280 40 80

5 60 100 130 240 48 40 300 20 60

6 50 100 190 300 50 60 300 0 0

7 40 100 260 400 57 100 280 -20 -120

8 30 100 460 570 72 170 240 -40 -330


Exercise (B)

1. Complete all the missing figures and plot ATC, MC, AR and MR. (Do not plot the

figures for output 0 and 1). Figures are in £000s.

2. What is the profit maximising output?

3. What is sales revenue maximising output?

Q P Fixed cost

Variable cost


0 20 0 201 18 4 242 16 6 263 14 12 324 12 18 385 10 26 466 8 36 567 6 48 688 4 62 82


Answers (B)

2. The the profit maximising output is 4 units

3. Show the area representing super-normal profits.

4. The sales revenue maximising output is 5 units

5. Efficiency at profit maximising output:a. It is productively

inefficient (the lowest ATC is at output 5)

b. It is allocatively inefficient (at output 4 price is greater than marginal cost (P=12, MC =6)

Q P Fixed cost

Variable cost


0 20 20 0 20 0 -201 18 20 4 24 24 4 18 18 -62 16 20 6 26 13 2 32 14 63 14 20 12 32 10.6 6 42 10 104 12 20 18 38 9.5 6 48 6 105 10 20 26 46 9.2 8 50 2 46 8 20 36 56 9.3 10 48 -2 -87 6 20 48 68 9.7 12 42 -6 -268 4 20 62 82 10.1 14 32 -10 -50


The firm’s supply curve


The firm’s short run supply curve

If a firm cannot cover all its costs it will, clearly, go out of business, that is, shut down.

However, economic theory indicates that, in the short run, the firm does not need to cover all of its costs to carry on supplying?

In the short run the firm needs only to cover its variable costs – - if variable costs cannot be covered then no further output can be made.

In addition, fixed costs have already been paid for prior to any decision to supply.

However, this cannot continue indefinitely, and unless all costs are covered - the firm breaks even - the firm will eventually shut down.

Cost Revenue

Quantity


The firm’s supply curve

The decision to supply A firm’s decision to supply

is based on marginal cost. At a price lower than P1

(say, at P) and an output lower than Q1, Total Revenue (TR) will not cover Total Variable Cost (TVC) and the firm will shut down.

The firm’s supply curve, in the short run, is the MC curve above AVC, i.e., from P1 upwards.

Marginal Costs

ATC

AVC

Q

P

Q1

P1 Total variable cost

Total revenue


Efficiency


The importance of efficiency

Efficiency as an evaluative tool Efficiency is widely used in economics as a means of evaluating

the performance of firms, markets and whole economies. Efficiency can be static - relating to one firm or market at one

point in time – or dynamic – relating to one firm or one market over an extended period of time.

Static efficiency - allocative and productive efficiency Allocative efficiency occurs when the consumer pays a market

price which reflects the full marginal cost of production – the ‘condition’ for allocative efficiency for a firm is to produce an output where MC = P.

Productive efficiency occurs when the firm is producing at the lowest average total cost (ATC) of production - this also means that ATC = MC.

Cost Revenue

Quantity


Productive and allocative efficiency

Identifying static efficiency points

Productive efficiency occurs where ATC is at its lowest, and is equal to MC.

Allocative efficiency occurs where price equals marginal cost (P = MC).

MC

ATC

0 MR

AR = D

ATC = MC

P = MC


Dynamic efficiency

Dynamic efficiency Dynamic efficiency is associated with the Austrian Economist

Joseph Schumpeter and means technological progressiveness and innovation experienced by a firm or in a market over time.

Schumpeter showed that firms which are highly protected are more likely to undertake risky innovation, and generate dynamic efficiency.

There are two types of innovation1. Process innovation - applying new production techniques to an

existing product. 2. Product innovation - generating new or improved products.

Cost Revenue

Quantity


‘X’ inefficiency

‘X’ inefficiency is associated with management inefficiencies and arises when firms operate in uncompetitive markets. Managers have no incentive to keep costs as low as possible.

The effect of ‘x’ inefficiency is to push up average costs.

Average cost(actual)

Average cost (lowest possible)


Profits


Profits

Types of profit The profit identity:

Total profits = total revenue (TR) – total costs (TC) Normal profit

When TR = TC, a firm is making normal profits, - the reward which is just sufficient to keep the entrepreneur supplying his or her enterprise – just covering opportunity cost.

Super-normal (abnormal) profit If a firm makes more than normal profit it is called super-normal

(or abnormal) profit (i.e. when TR>TC). The level of super-normal profits available is largely determined

by the level of competition in a market.


Profit maximisation


Profit maximisation

Maximum profits are achieved when: Total revenue (TR) is the greatest it can be above total costs (TC). To achieve this a firm must produce up to the point where

marginal revenue (MR) is equal to marginal cost (MC) . Profit maximisation also occurs when average revenue (AR) is at

the greatest it can be above average (unit) cost (ATC). N.B. Not all firms are profit maximisers .

Cost Revenue

Quantity


Diagram to show profit maximisation

Profit maximising output To maximise profits

firms need to produce up to the point where MR = MC.

Areas:

1. Total revenue = area OPAQ

2. Total cost = area 0CBQ

3. Therefore super-normal profits = area PABC

MC

ATC

Q

P

C

0

A

MR

AR = D

First, the cost curves go in

Next, the revenue curves

Profit maximisation output occurs where MC = MR

BSuper normal profits

Cost Revenue

Quantity


Why is profit maximisation at MC=MR?

If the firm produces at Q1: MR > MC, and the Q1st

unit generates a marginal profit – output should be increased.

At an output of Q2: MC > MR, and there is a

marginal loss - output should be reduced. Only at MC = MR will profit be maximised!

MC

ATC

Q Q2 Q10MR

AR = D

Profits could have been greater – there is

a loss of potential profits.

This area represents a loss of potential profits caused by

producing too much

Cost Revenue

Quantity


Competitiveness and profits

The fewer the firms the less competitive a market it is likely to be.

The effect of fewer firms is to:

1. Reduce elasticity of demand, creating steeper AR and MR curves.

2. Increase the level of supernormal profits for each firm.

MC

ATC

Q

P

C

0

A

B

MR

AR = D

More profit

Cost Revenue

Quantity


Total costs and total revenue

Profit maximisation can be also be found at the point where the gap between TR and TC is at its widest.

This is also where the gradient of both curves is identical.

If profits are shown separately they are maximised at the peak of the profits curve.

Q0

Total Revenue

Total Costs

+

-

Profits (profit function)

Normal profit

Maximum super-normal profit


Sales revenue maximisation

Cost Revenue

Quantity


Sales revenue maximisation

Maximising sales revenue A firm will maximise its

revenue when it produces up to the point where Marginal Revenue is zero.

This is also at the same level of output where PED = 1 - at the mid-point of the AR/demand curve.

MC

ATC

Q

P

0

MR

AR = D

TR


Sales maximisation

Cost Revenue

Quantity


Sales maximisation

Sales maximisation occurs at the point where sales volume is at its greatest, without making a loss.

To the right of Q, the firm will make a loss, and to the left of Q sales are not maximised.

Q

MC

ATC

Q

P

0

MRAR = D

AR = ATC

Cost Revenue

Quantity


Review questions

Identify the points, A - E:

1. Profit max2. Sales Revenue max3. Allocative efficiency4. Productive efficiency5. Sales max

MR

AR = D

ATC

Marginal Cost

E

A

B

C

D


Market structures


Introduction

What are market structures?The ‘structure’ of a market refers to the number of firms in the

market, their market shares, and other distinguishing features which affect the level of competition in the market.

Market structures are distinguished mainly by the level of ‘competition’ that exists between the firms in the particular market.

Competitive structure vs competitive behaviourAs well as look at market structures, modern theory also looks at

the behaviour (conduct) of firms, their performance, and the level of ‘contestability’ in the market.

A market might have an uncompetitive structure, with only a small number of firms competing, but the behaviour of firms might be highly competitive,


Market structures

Market structures, competition and concentration When competition is absent, the market is said to be concentrated.

There is a spectrum of structure, from ‘perfect’ competition to ‘pure’ monopoly.

Perfect Competition

Monopolistic Competition

Oligopoly

Monopoly

Duopoly

Maximum competition

Maximum concentration

These structures have varying degrees of competition and concentration.

The most extreme form of competition – very

large numbers of firms selling identical products

The most extreme form of concentration – only one

firm exists, selling a unique product.


Perfect competition


What is perfect competition?

Perfect competition means complete competition. It has the following characteristics:1. There is perfect knowledge by all participants – i.e. no

information failure or time lags.2. There are no barriers to entry into or out of the market.3. Firms produce homogeneous (identical) units of output.4. Each unit of input (such as units of labour) are also

homogeneous.5. There are a very large numbers of firms in the market.6. No single firm can influence the market price or market

conditions - the firm is said to be a price taker.7. Demand (AR) is infinite at any price – the AR curve is horizontal,

therefore AR = MR.


What is perfect competition?

8. Firms can only make normal profits in the long run. 9. There are assumed to be no externalities – no external costs or

benefits.10. There is no need for government regulation, except to make

markets more competitive.


The firm as a price taker

The single firm takes its price from the industry – it is a price taker.The industry is composed of all firms and each single firm must

charge this price – firms cannot diverge from market price, as shown below:

Price C/R

Q Q

The Industry The Single Firm

S

ATC

D

P

Q

AR = MRP

Q

MCThe industry sets the price that the firm must accept


Equilibrium in perfect competition

In the short runFirms under perfect competition can make super-normal profits.

In the long run New firms are attracted into the industry- there are no barriers, and

there is perfect knowledge. This drives down price and super-normal profits are eroded away!

Price Price

Q Q

Short Run Long Run

ATC

P

Q

AR = MRP

Q

MC

AR = MR

MC

ATC

Supernormal Profits Supernormal Profits

In the long run only normal

profits are made


Evaluation of perfect competition

The advantages of perfect competition1. Perfect knowledge means no information failure.2. No barriers to entry means existing firms cannot derive monopoly

power.3. Only normal profits made so producers cover their opportunity

cost, but consumers are not exploited.4. There is no need to incur advertising costs, because:

1. There is perfect knowledge2. Firms can sell all they can produce3. No product differentiation makes it hard to construct effective

advertising which only benefits the single firm


Evaluation of perfect competition

5. There is maximum possible consumer surplus and economic welfare.

6. There is maximum allocative and productive efficiency: P = MC , for allocative efficiency MC = ATC, for productive efficiency

7. There is maximum choice for consumers.


Evaluation cont…

But, is the model realistic? Very few markets or industries in the real world are perfectly

competitive. Most of the other assumptions, such as perfect knowledge and

no barriers to entry, are equally unrealistic.The assumption of no externalities is also unrealistic.

Although unrealistic, it is still a useful modelThe model is still very useful in two respects:

1. In terms of many primary markets, such as coffee, many of the assumptions are close to reality - such as producers being price takers and selling homogeneous units of output.

2. Even for other markets in manufacturing and services the model is a good yardstick by which economists and regulators can evaluate levels of competition that exist.





Monopolistic competition as a market structure was first identified in the 1930s.

It is defined as a single market involving a large number of independent competing firms, each one selling a slightly different good or service.

Independently owned high street restaurants are a typical example of firms operating under monopolistic competition.



The major assumptions of monopolistic competition are:1. Each firm makes independent decisions abut price and

output, based on its product, its market and its costs of production.

2. Knowledge is very ‘good’, but not perfect - for example, diners can view a menu before they order, but they cannot fully appreciate the meal until it is eaten.

3. There is freedom to enter or leave the market - there are no major barriers to entry or exit.



Products are differentiated – types of differentiation include:a. Physical product differentiation, where products are made

different by size, design, colour, shape, performance, features and so on.

b. Marketing differentiation, where the firm tries to differentiate its product by distinctive packaging and other promotional techniques.

c. ‘Human capital’ differentiation - also called ‘people ‘ or ‘service’ differentiation - where the firm creates differences through the skill of its employees, the level of training received, distinctive uniforms etc.

d. Differentiation through distribution, including distribution via mail order or through internet shopping

Cost Revenue

Quantity


The firm is a price maker

Price ‘making’ Unlike perfect

competition, firms can make (fix) their own price because they are selling a slightly different product from competitors.

This also means the demand curve will slope downwards.

Q

P

0

AR = D

P1

Q1

If the firm reduces price, quantity

demanded will increase


Equilibrium under monopolistic competition In the long run

Firms are attracted into the industry if there are short-run super-normal profits. Demand becomes more elastic and shifts to the left, driving down price until super-normal profits are eroded away.

The firm prefers the short run and will try to ‘stay in it’ by innovation and further product differentiation!

Price Price

Q Q

Short Run Long Run

ATCP

Q

AR

P

Q

MC

AR

MC

ATC

MR

Supernormal Profits

Supernormal Profits


Assumptions cont…

4. Firms are price makers and are faced with a downward sloping demand curve. The firm makes a unique product and can charge a higher or lower price than its rivals and do not have to ‘take it’ from the industry as a whole, though the industry price may be a guideline or a constraint.

5. Firms usually have to engage in advertising on a on a local basis.

6. Firms are assumed to be profit maximisers - maximising profits is assumed to be the main goal because firms tend to be smaller enterprises with the entrepreneur actively involved in managing the business.

7. There are usually a large numbers of independent firms competing in the market.


Examples of monopolistic competition

Monopolistically competitive firms are most common in industries where differentiation is easy to undertake, such as in:

The restaurant businessHotels, pubsGeneral specialist retailing and consumer services, such as

hairdressing The survival of small firms

The existence of monopolistic competition partly explains the survival of small firms in modern economies.


Evaluation of monopolistic competition

The advantages of monopolistic competition1. There are no significant barriers to entry so markets are

relatively contestable.2. Differentiation creates diversity, choice and utility.3. The market is more efficient than monopoly, but less efficient

than perfect competition - less allocative and productive efficiency.

4. However, they may be dynamically efficient - innovative in terms of new production processes or new products.


Evaluation of monopolistic competition

The disadvantages of monopolistic competition1. Some differentiation creates waste, such as excess packaging.2. As the diagram illustrates, there is allocative inefficiency in both

the long and short run – assuming profit maximisation - price is above marginal cost (P>MC).

3. Advertising can be considered wasteful, though most is ‘informative’ rather than ‘persuasive’ .

4. There is a tendency for excess capacity – firms can never fully exploit their fixed factors, such as machinery, because mass production is difficult.

As a model?As a model monopolistic competition is much more ‘realistic’ than

perfect competition. Many familiar and commonplace markets could be said to fit very closely to this model.


Oligopoly


Oligopoly

What is an oligopoly?An oligopoly is a firm with only a few competitors.A market in which a few firms dominate is said to be highly

concentrated. Oligopolies are identified using ‘concentration ratios’ .

A concentration ratio shows the proportion of total market share controlled by a given number of firms.

A hypothetical example – If the following are the market shares of the largest few firms; firm A = 45%, B = 25%, C = 22%, D = 5%, E = 2%, F = 1%, the 4-firm concentration ratio is:

97%.


Oligopoly

The Herfindahl – Hirschman Index (H-H)This is an alternative method of measuring ‘concentration’ and

for tracking changes in the level of concentration following mergers. The formula is (H–H) = X2 + Y2 + Z2; where X, Y and Z is the % of the top three firm’s market shares.

Question – calculate the H-H index for the following hypothetical drinks market:

‘Fizzy’, with 45% ‘Juicy’ with 15% ‘Thirsty’ with 22% ‘Burpy’ with 6%


Oligopoly, mergers and concentration

Answer:2734 - This is a very high figure - the highest figure possible is

10,000 for a pure monopoly (1002 + 02 + 02). If the index is below 500 the market is not considered highly concentrated, while an index above 1500 indicates a highly concentrated market – the larger the figure the higher the concentration.

Question - what will be new index if Juicy and Thirsty merge?Answer:

3430Hence the merger has made the market more concentrated.Mergers between oligopolists increase concentration and

‘monopoly power’ and are likely to be the subject of regulation .


Assumptions and characteristics

1. Interdependence, which means firms cannot act independently of each other.

2. Importance of strategy - strategy is very important to oligopolists. Because firms cannot act independently they must anticipate the

likely response of a rival to any given change in their price or in their non-price activity. In other words they need to plan ahead, and work out a range of possible options based on how they think rivals might react.

Game theory can be applied to illustrate the importance of strategy.Oligopolists have to make important strategic decisions, such as:

1. Whether to compete or collude with rivals.2. Whether to raise or lower price, or keep price constant.3. Whether to be the first to implement a new tactic or to wait and see

what rivals do – i.e. having a ‘1st-mover’ or ‘2nd-mover’ strategic advantage.


Barriers to entry

3. Barriers to entry Natural entry barriers include:

1. Economies of large scale production.2. Ownership or control of a key scarce resource.3. High set-up costs.4. High R&D costs, which are also often a sunk cost.

Artificial barriers include:1. Predatory pricing - a firm may try to push prices low enough to force

rivals out of the market.2. Limit pricing - with limit pricing the incumbent firm sets a low price

and a high output so than entrants cannot make a profit at that price – usually, setting a price just below the average total costs (ATC) of potential entrants.


Barriers to entry

3. Predatory acquisition - this involves taking over a potential rival.4. Advertising - advertising is another sunk cost, and the more that is

spent by incumbent firms the greater the deterrent to new entrants.

5. A strong brand - this creates loyalty, locks-in existing customers and deters entry.

6. Loyalty schemes (such as Tesco’s Club Card) - such schemes help oligopolists retain customer loyalty and deter entrants who need to gain market share.

7. Exclusive contracts, patents and licences - these make entry difficult as they favour existing firms who have won the contracts or own the licenses.

8. Vertical integration - this can ‘tie up’ the supply chain and make life tough for potential entrants, such as a manufacturer having its own retail outlets, such as a brewer owning its own pubs


Collusion

4. Possibility of collusion or competition Another key feature of oligopolistic markets is that firms may

attempt to collude, rather than compete. Types of collusion

1. Overt collusion occurs when there is no attempt to hide agreements.

2. Covert collusion occurs when firms try to hide the results of their collusion, usually to avoid detection by regulators.

3. Tacit collusion occurs when firms ‘act together’ (‘in concert’) but nothing is formally or even informally agreed.

If firms do collude and their behaviour can be proved to be anti-competitive they are likely to be subject to regulation.

If competing, there is a preference for non-price competition to avoid price wars.


Assumptions cont…

5. Price stickiness There is a tendency for the prices of goods and services

provided by oligopolists to be stable over time.


Examples of oligopolies

ExamplesOligopolies are common

in the airline industry, banking, brewing, soft-drinks, supermarkets, and music production.

In the UK music industry, supply is highly concentrated, with a 4-firm concentration ratio of around 75%.

Uni-versal33%

EMI16%

Sony-BMG16%

Warner10%

Others25%

UK Music industry market shares (2008)


Pricing strategies of oligopolies

Oligopolies may pursue the following pricing strategies:1. Predatory pricing to ‘squeeze’ rivals.2. They may also operate a limit pricing strategy to deter entrants.

Limit pricing is also called entry forestalling price.3. They may collude with rivals and raise price together (but this

may attract new entrants).4. They often employ cost-plus pricing – this is a simple pricing

method where average costs are calculated and a fixed mark-up is added to cover fixed costs and contribute to a profit.


Non-price strategies

Non-price competition1. Trying to improve quality and after sales servicing, such as

offering extended guarantees.2. Expenditure on advertising, sponsorship and product placement

to build strong brand. Building a brand is an important strategy for most oligopolies.

3. Sales promotion, such as ‘buy-one-get-one-free’ (BOGOF).4. Loyalty schemes, such as Sainsbury’s ‘Nectar Card’.


Non-price strategies

Each strategy can be evaluated in terms of:1. How successful is it likely to be?2. Can rivals copy the strategy?3. Will the firms get a first mover advantage?4. How expensive is it to introduce the strategy? If the cost of

implementation is greater than the pay-off, clearly it will be rejected.

5. How long will it take to work? A strategy that takes five years to generate a pay-off may be rejected in favour of a strategy with a quicker pay-off.


Pricing decisions


Game theory

Pricing strategies can be looked at in terms of game theory. A game has three important features:

Pay-offs , such as win, lose, draw Strategies - planning ahead based on the expected move of an

opponent rather than simply reacting to events Rules , such as agreeing who moves first

Games can be zero-sum games – e.g. player 1 gains 10, and player 2 loses 10 (+10, -10), or:

Non zero-sum games – e.g. player 1 gains 10 and player 2 gains 5. Game theory can be applied to oligopoly because these features

are often present.


The Prisoner’s dilemma

The Prisoner's Dilemma is a classic, non zero-sum, game which illustrates the choices facing two suspects.

The scenario Robin and Tom are prisoners: They have been arrested for a petty crime, of which there is

good evidence of their guilt – if found guilty they will receive a 2 year sentence.

During the interview the police officer becomes suspicious that the two prisoners are also guilty of a serious crime, but is not sure he has any evidence.

Robin and Tom are placed in separate rooms and cannot communicate with each other. The police officer tries to get them to confess to the serious crime by offering them some options, with possible pay-offs.


The options Each is told that if they both confess to the serious crime they

will receive a sentence of 3 years. However, each is also told that if he confesses and his partner

does not, then he will get a light sentence of 1 year, and his partner will get 8 years.

They know that if they both deny the serious offence they are certain to be found guilty of the lesser offence, and will get a 2 year sentence.


Game theory

Pricing strategies can be looked at in terms of game theory. A game has three important features:

Pay-offs , such as win, lose, draw Strategies - planning ahead based on the expected move of an

opponent rather than simply reacting to events Rules , such as agreeing who moves first

Games can be zero-sum games – e.g. player 1 gains 10, and player 2 loses 10 (+10, -10), or:

Non zero-sum games – e.g. player 1 gains 10 and player 2 gains 5. Game theory can be applied to oligopoly because these features

are often present.


Choice of strategy The choice of strategy will depend upon the specific pay-offs,

which depends upon the actions of competitors, and the firm’s ability to predict or control these actions.

Raising price or lowering price could lead to a small beneficial pay-off, but both strategies can lead to large losses, which could be potentially disastrous. In short, changing price too often is too risky a strategy.

Another important decision is which style of ‘game’ to play – to compete or co-operate and collude.

Game theory predicts that: There is a tendency for cartels to form because co-operation is

likely to be highly rewarding. Co-operation reduces the uncertainty associated with the

mutual interdependence of rivals in an oligopolistic market.


Prisoner’s dilemma

TOM

ROBIN

Confess

Deny

Confess

Deny

The pay-off in games can be represented in a pay-off matrix.

A (Robin) gets 3 years

B (Tom) gets 3 years






B (Tom) gets 1 year

The dominant strategy - which is one that gives the best pay-off no matter what the other player chooses, is to confess.

If Tom denies, Robin should confess, and if Tom confesses, Robin should confess.


Advertising decisions

Virgin

BA

Raise Hold

Raise

Hold

The following hypothetical pay-off matrix shows the profits for two airlines, BA and Virgin, if they choose to increase spending on advertising (raise) or hold current spending (hold).

BA gets £20m

Virgin gets £30m

BA gets £60m

Virgin gets £20m

BA gets £40m

Virgin gets £10m

Virgin gets £40m

BA gets £30mNash Equilibrium

BA raises, and gets £20m, Virgin raises, and gets £30m

BA raises, and gets £60m, Virgin holds, and gets £20m

BA holds, and gets £30m, Virgin raises, and gets £40m

BA holds, and gets £40m, Virgin holds, and gets £10m

Summary

Virgin’s dominant strategy is clearly to raise spending – it would be better off whatever BA does. Assuming BA knows this, it will hold its spending, and gain £30. Neither party has an incentive to move. This is a ‘Nash equilibrium’

BA raises, and gets £20m, Virgin raises, and gets £30m

BA raises, and gets £60m, Virgin holds, and gets £20m

BA holds, and gets £30m, Virgin raises, and gets £40m

BA holds, and gets £40m, Virgin holds, and gets £10m

Nash equilibrium exists when each player’s strategy is the best available, given the other players’ strategies.

A dominant strategy is one that gives the best pay-off no matter what the other player chooses.


Equilibrium – Cartels, and collusion

Y OIL

X OIL

Raise Hold

Raise

Hold

X gets £30m

Y gets £30m

X gets £10m

Y gets £60m

X gets £25m

Y gets £25mY gets £10m

X gets £60m

Nash Equilibrium

X OIL raises, and gets £30m, Y OIL raises, and gets £30m

X OIL raises, and gets £10m, Y OIL holds, and gets £60m

X OIL holds, and gets £60m, Y OIL raises, and gets £10m

X OIL holds, and gets £25m, Y OIL holds, and gets £25m

Summary

However, if they reach an agreement to form a cartel and collude, they can agree to raise price together, and increase revenues, from £25m to £30m. This only works with a price agreement.

Nash equilibrium exists when each player’s strategy is the best available, given the other players’ strategies.

The dominant strategy is to hold prices steady.

The revenue for two petroleum producers, X Oil and Y Oil, if they choose to increase their prices, or keep them the same. Currently, they achieve revenues of £25m per year each. PED for oil is assumed to be inelastic.


Maximin and Maximax strategies

B GAS

A GAS

Raise Lower

Raise

Lower

A gets £120m

B gets £120m

A gets £50m

B gets £130m

A gets £100m

B gets £100mB gets £50m

A gets £130m

Nash Equilibrium

Maximax for A = Best of the bestIf A raises, the best is £120 If A lowers, the best is £130Therefore best of best is £130, also got through lowering.

Maximin for A = Best of the worstIf A raises, the worst is £50 If A lowers, the worst is £100Therefore best of worst is £100, got through lowering.

If a firm uses a maximin strategy, it looks to make a choice that achieves the best of the worst outcomes. Choosing a maximax strategy means choosing the best of the best outcome. Consider two GAS suppliers who can either raise price or lower price in an attempt to increase profits.

A dominant strategy is also one where the maximin and maximax are the same – in this case to lower price – it is also Nash equilibrium, which exists when each player’s strategy is the best available, given the other players’ strategies.


Other strategies

A tit-for-tat strategy is one where players co-operate – e.g., to raise price together, in the first instance, and then always copy their rival’s previous move. This is clearly anti-competitive, and would result in legal action if discovered.


Game theory and oligopoly

Game theory provides many insights into the behaviour of oligopolists. For example, it indicates that generating rules for behaviour reduces risk, such as: Employing a simple cost-plus pricing method which is shared by

all participants – common where oligopolists share similar costs, as with petrol retailing.

Implicitly agreeing a price leader - in the oil example, firm X OIL may aggressively lead and raise price, with Y OIL passively following, even though Y OIL would be better off holding.

Supermarkets implicitly agreeing some lines where price cutting will take place, such as bread or baked beans, but keeping price constant for most lines.

Generally keeping prices stable to avoid price retaliation.


Non-price competition

For many reasons, explained through game theory, oligopolists may to prefer non-price competition, including: Free gifts Quality of service Opening hours After-sales service (e.g. 24 hour help-lines) Advertising Special promotions Building the brand Loyalty schemes (e.g. Nectar Card)

Cost Revenue

Quantity


Price stickiness

Q

P

0

AR = D

The kinked demand curve can also be used to illustrate the interdependence of oligopolists.

For the oligopolist, once a price has been determined, it will hold because firms cannot pursue independent strategies.

What will rivals do if a firm raises its price?

If an airline, like British Airways (BA) raises the price of its tickets to New York, rivals will not follow suit and BA will lose revenue - the demand curve is relatively elastic.

P1

Q1

Cost Revenue

Quantity


Price stickiness cont…

Q

P

0

AR = D

What will rivals do if it lowers its price?

If BA lowers its price, rivals would have to follow suit and drop their prices.

BA will lose sales revenue and market share.

The demand curve is relatively inelastic in this context.

P1

Q1

P2

Q2

Cost Revenue

Quantity


The Kinked Demand Curve

Q

P

0

AR = D

The reaction of rivals depends on whether price is raised or lowered. The response, and elasticity of demand and gradient of the demand curve will be also be different.

The demand curve will be kinked, at the current price.

At price P, and output Q, revenue will be maximised.

P1

Q1

P2

Q2

A

Cost Revenue

Quantity


The Kinked Demand Curve cont…

Q

P

0

AR = D

Maximising profits Profits are always

maximised when MC=MR. So long as MC cuts MR in its vertical portion then profit max is still at P.

If MC changes, then price still sticks at P.

Even when MC moves out of the vertical portion, the effect on price is minimal.

However, consumers do not get the benefit of any cost reduction!

P1

Q1

P2

Q2

Marginal Cost


Cartels What are cartels?

Cartels are designed to protect the interests of members by co-operating rather than competing.

However, consumers may suffer higher prices or hidden prices, lower output and restricted choice or other uncompetitive behaviour.

Formation of cartels Industrial cartels may be created when a few large producers get

together to co-operate regarding aspects of the market they operate in. Cartels represent a type of ‘overt’ collusion.

Once formed, cartels can fix prices to avoid price competition, or can restrict output to an agreed limit or set rules governing the behaviour of members.


Cartels When are cartels most powerful?

When there are high barriers to entry into the market or industry, and when all members can be policed by a dominant member.

Cartel-like behaviourSome firms may act as though there is a cartel - ‘cartel-like’

behaviour - even though there is no formal cartel, and this may be subject to investigation by the regulators - this is an example of tacit collusion.

As predicted by game theory, cartels rely on members agreeing.


EU’s largest fine imposed on electronics cartel

The Siemens led electronic equipment cartel In January 2007 the European Commission imposed a record

fine of £500m on 11 European power equipment firms, led by the German firm Siemens.

The Commission argued that Siemens, along with 10 other firms, had ‘carved-up’ the European power equipment market between 1988 and 2004. The market had been carved-up along geographical lines and through a quota system.

One of the cartel members, ABB, had escaped a fine because it had been a whistle blower and provided important evidence to the Commission.


Evaluation of oligopolies

The disadvantages of oligopoliesOligopolies can be criticised on a number of obvious grounds,

including:1. High concentration reduces consumer choice.2. Cartel-like behaviour reduces competition.3. Firms can be prevented from entering a market because of

deliberate barriers.4. There is a potential loss of economic welfare.5. They may be allocatively and productively inefficient.


Evaluation of oligopolies

The advantages of oligopoliesHowever, oligopolies may provide the following benefits:1. Oligopolies may adopt a highly competitive strategy, in which

case they can generate similar benefits to more competitive market structures, such as lower prices.

2. They may be highly dynamically efficient.3. Price stickiness may bring advantages to consumers and the

macro-economy – it helps consumers plan ahead and stabilises their expenditure, which may help stabilise the trade cycle.


Monopoly


Monopoly and monopoly power

What are monopolies? A pure monopoly is a single supplier in a market - for the

purposes of regulation, ‘monopoly power’ exists when a single firm controls 25% or more of a particular market.

A complex monopoly is said to exist whenever firms tacitly collude, and act as if they are a single firm, operating similar or identical price and non-price policies.


Monopolies are formed when:1. A firm has exclusive ownership of a scarce resource, such as

Microsoft owning the ‘Windows’ brand.2. Governments grant a firm monopoly status, such as The Post

Office, in which case it is called a ‘statutory monopoly’.3. Producers have patents or copyright giving them exclusive

rights to sell a good or service, such as a song writer having a monopoly over their own material.

4. Firms merge, or are acquired, to create a monopoly.

Cost Revenue

Quantity


The monopoly diagram Monopoly profits

With no close substitutes the monopolist can derive super-normal profits in the long run.

A monopolist with no substitutes would be able to derive the greatest monopoly power!

MC

ATC

Q

P

C

0

AA

BB

MR

AR = D

There is no distinction between the short and

long run – the pure monopolist can make

supernormal profits into the long run


‘Natural’ monopolies

What is a ‘natural’ monopoly?A ‘natural’ monopoly is a special type of monopoly which arises

when there are very high fixed costs of distribution, such as cables, pipelines, grids and track.

These costs are also sunk costs, and they deter entry and exit.Trying to improve competition by encouraging new entrants into

the market creates a potential loss of efficiency. The efficiency loss to society would exist if the new entrant had to

duplicate all the fixed factors, the infrastructure.


‘Natural’ monopolies

Natural monopolies and economies of scaleWith natural monopolies economies of scale are very significant.

If the incumbent has derived considerable economies of scale by developing its supply and distribution network over a long period of time it is unlikely that new firms can exploit their own economies of scale.

Indeed the incumbent may have reached or exceeded minimum efficient scale, which is the lowest level of output at which all scale economies are exploited.


Public utilities

Natural monopolies are common in markets for ‘essential services’ that require an expensive infrastructure to deliver the good or service, as in the case of water supply, electricity and gas supply and other industries known as public utilities.

Because there is the potential in these industries to exploit monopoly power governments tend to nationalise and/or heavily regulate them.

Regulators If public utilities are privately owned, as in the UK, since

privatisation during the 1980s, they usually have their own special regulator to ensure that they do not exploit their monopoly status.

Examples of regulators in the UK include OFGEM, the energy regulator, OFCOM, the telecoms and media regulator.


Rail transport as a natural monopoly

Railways are a good example of a natural monopoly The very high costs of laying track and building a network, let alone

the costs of buying or leasing the trains, would prohibit, or deter, the entry of a competitor.

To society, the costs associated with building and running a rival network to that of the incumbent would be wasteful.

Avoiding wasteful duplication The best way to ensure competition, without the need to duplicate

all the infrastructure, is to allow new train operators to use the existing track – hence competition has been introduced, without duplication of costs.

This approach is the general one adopted to deal with the problem of privatising natural monopolies and encouraging more competition, such as with telecoms, electricity and gas.

Cost Revenue

Quantity


The natural monopoly diagram

Continuous economies of scale ATC keeps falling because of

continuous economies of scale – MC is always below ATC.

If unregulated natural monopolies are likely to make excessive super-normal profits and be inefficient.

But forcing them to be allocatively efficient means they make losses! MC

ATC

Q

P

C

0

AA

BB

MR

AR = D

LOSSES

With natural monopolies, minimum efficient scale (MES) can only be achieved by a single firm – MES means the situation when the available economies of scale in

the whole industry have been used up, and none are available for other firms , hence

no firms will enter.

SNP


Pricing of natural monopolies

Dealing with losses A public utility’s losses could be dealt with in a number of ways,

including:1. Subsidies from the Government.2. Price discrimination - revenue could be increased by charging

some consumers a different price than others, i.e. price discrimination.

3. A ‘two part’ tariff - consumers could be charged a fixed fee to enter the network, and then charged a separate price for the extra marginal units consumed. For example, to avoid making loses, water companies could charge consumers:1. A fixed (standing) charge for being able to use water, paid monthly

or quarterly, plus:2. A charge per unit consumed, measured through meters installed in

homes.


Evaluation of monopolies

The advantages of monopolies1. They can benefit from economies of scale, and may be ‘natural’

monopolies.2. They can earn a country large export revenues.3. According to Joseph Schumpeter, monopolies will eventually be

replaced by more efficient firms through ‘creative destruction’.4. It has been consistently argued by some economists that

monopoly power is required to generate dynamic efficiency, because: High profit levels boost investment in R&D Innovation is more likely in large enterprises and this may lead to

lower costs than in competitive markets. A firm needs a dominant position to bear the risks associated with innovation

Firms need to be able to protect their intellectual property (ideas) by establishing barriers to entry – otherwise there will be a ‘free rider’ problem

Cost Revenue

Quantity


Dynamic efficiency Assumptions

In a perfectly competitive market supply and demand will equate.

However, monopolies are protected from competition.

If super-normal profits are invested in new technology, costs are reduced and the supply curve is to the right of the industry supply curve. The result is lower price and higher output.

Monopolist’s supply curve

(MC)

ATC

Q1

P1

Q

P

0MR

AR = D

Supply curve if industry is

competitive


Evaluation of monopolies

The disadvantages of monopoly to the consumer1. Restricting output onto the market.2. Charging a higher price than in a more competitive market.3. Reducing consumer surplus and economic welfare.4. Restricting choice for consumers.5. Reducing consumer sovereignty.


Welfare loss Higher prices

Because the monopolist is the only supplier, it tries to maximise profits – producing where MR = MC, and it can charge a higher price (P1) than in a more competitive market (at P).

Less consumer surplus This results in a loss of

consumer surplus: P, P1, A, B

Producer surplus was: P,B,Z

It is now: P1, A, D, Z

The overall (net) loss of economic welfare is:

A B D

Q

Price

P

Q

Demand curve (AR)

Q1

P1

C

Supply Curve (MC)

A

B

D

MR

Z


The wider and external costs of monopolies

Monopolies can also lead to:1. A less competitive economy in the global market-place.2. A less efficient economy;

Less productively efficient Less allocatively efficient More ‘X’ inefficient - i.e. the loss of management efficiency

associated with markets where competition is limited or absent.

3. Less employment in the economy, as higher prices lead to lower output and less need to employ labour.


Remedies for monopoly power


The remedies for monopoly power

Why regulate? It is generally believed that the costs to society from the

existence of monopoly power are greater than the benefits, and that monopolies should be regulated.

Options available to regulators include:1. Setting price controls and formulae (price capping). This means

forcing the monopolist to charge a specific price. For example, in the UK the RPI – ‘X’ formula has been widely used

to regulate the prices of the privatised utilities. In the formula, the RPI (Retail Price Index) represents the current average inflation rate, and ‘X’ is a figure which is set at the expected efficiency gain which the regulator believes would have existed had the firm operated in a competitive market.



1. Prohibiting mergers and acquisitions (M&A)2. Breaking-up the monopoly - such as forcing Microsoft to split

into two separate businesses – one for the operating system and one for software sales.

3. Bringing the monopoly under public control – nationalisation.4. Forcing firms to un-bundle their products.

Bundling means selling a number of products together in a single bundle, such as Microsoft selling PowerPoint, Access, Excel and Word as one product rather than separate ones.

Un-bundling makes it easier for new firms to enter the market .



5. Introducing yardstick competition, such as setting punctuality targets for British Rail based on the highly efficient Bullet trains of Japan. It is also possible to split up a service into regional sections to compare the performance of one region against another. This is applied in the UK to both water and rail.





What is price discrimination? Price discrimination is

charging a different price for the same good or service.

First degree This occurs when a firm

charges a different price for every unit consumed.

The firm is able to extract the consumer surplus for itself

In practice ‘first degree’ discrimination is very difficult.

Q

Price

P1

Q1

Demand curve (AR)

Q

P

A

B

Supply

The firm has ‘captured’ the consumer surplus for itself


Second and third degree discrimination Second degree

Second degree price discrimination means charging a different price for different quantities, such as quantity discounts on foreign holidays.

Third degree Third degree price discrimination means charging a different

price to different consumer groups, such as with: 1. Rail and underground – commuters and casual travellers.2. Rail and cinemas – adult and child.3. Gas, electricity, and telephone - peak users and off-peak users.


The conditions for discrimination

The necessary conditions for price discrimination1. The firm must be able to identify different market segments.2. Different segments must have different price elasticities (PEDs).3. Markets must be kept separate by time, physical distance and

nature of use.4. There can be no seepage between the two markets.5. The firm must have some degree of monopoly power.

Output

Cost & revenue

Output

Cost & revenue

Output

Cost & revenue


AR1MR1

AR2

MR2

AR3

MR3

Price discrimination is an effective profit maximising strategy if submarkets with different elasticities can be identified

Assuming there are no additional costs associated with separating the market

And ATC is constant, and therefore equal to MC, profits will be

maximised where MC cuts MR

Inelastic market

Elasticmarket

Combined market

ATC = MC

P1

P2

P3

High price

One priceSNP1

SNP2SNP3

Markets can be separated in a number of ways:

PEAK OFF PEAKADULT CHILDDOMESTIC FOREIGNOFFICE HOME

If the profits from the two separated sub-markets (SNP1 + SNP2 are greater than the single, un-separated market

(SNP3) then discrimination will maximise profits


Low price


Growth of firms

Cost Revenue

Quantity


Economies and diseconomies of scale

The ‘standard’ long run cost curve is assumed to be ‘U’ shaped, reflecting economies and diseconomies of scale.

LRAC

Economies of scale Diseconomies

of scale

Diseconomies of scaleare the extra costs associated with becoming ‘too’ large

Economies of scaleare savings that are made when a firm increases its scale

Expansion of firm


Types of economies of scale

1. Technical economies These are the cost savings a firm makes as it gets larger because it can

employ large scale mechanical processes and machinery.2. Purchasing economies

Larger firms can buy in bulk and achieve purchasing discounts.3. Administrative savings

Large firms can spread their administrative and management costs across all their plants, departments, divisions or subsidiaries.

4. Financial savings Large firms can borrow money more cheaply than small firms.

5. Risk bearing economies Large firms can bear business risks more effectively than smaller firms.


Types of economies of scale

1. Technical economies These are the cost savings a firm makes as it gets larger because it

can employ large scale mechanical processes and machinery.2. Purchasing economies

Larger firms can buy in bulk and achieve purchasing discounts.3. Administrative savings

Large firms can spread their administrative and management costs across all their plants, departments, divisions or subsidiaries.

4. Financial savings Large firms can borrow money more cheaply than small firms.

5. Risk bearing economies Large firms can bear business risks more effectively than smaller

firms.


Examples of diseconomies of scale

Economic theory also predicts that a firm can become less efficient if it becomes too large – the additional costs of becoming too large are called diseconomies of scale. Examples of diseconomies include:

1. Information failure Larger firms find it difficult to maintain an effective flow of

information between departments, divisions or between head office and subsidiaries.

Time lags in the flow of information can also create problems in terms of the speed of response to changing market conditions.

2. Co-ordination problems A large firm, with many departments and divisions, may find it

much harder to co-ordinate its operations than a smaller firm.



3. ‘X’ inefficiency ‘X’ inefficiency is the loss of management efficiency that occurs

when firms become large and operate in uncompetitive markets, such as: Over-paying for resources, such as paying managers salaries

higher than needed to secure their services. Not bothering to cut back on unnecessary costs.

4. Low motivation Workers in large firms may experience a lack of motivation

which can result in lower productivity, as measured by output per worker.



5. The ‘principal-agent’ problem Because of the size and complexity of most large firms the

owners often have to delegate decision making to appointed managers, which can lead to inefficiencies, including increased bureaucracy.

Cost Revenue

Quantity


Minimum efficient scale (MES)

This is the scale at which LRAC first become their lowest.

It can also be seen as the point at which all or most economies of scale are exhausted. LRAC

MES

EC ONO MI ESOF

SC A L E


How do firms grow?Firms grow in two ways – by internal expansion or through integration.1. Internal expansion

For internal growth the firm will need to generate sufficient profits to enable it to purchase new assets, such as new technology.

Internal expansion is also called organic growth. The importance of branding - one of the most common internal

growth strategies is to build the firm’s brand. Building a brand has many advantages. For example, once the brand is established less advertising is needed to launch new products.


Integration

2. Vertical integration Firms merging at different stages of production. There are two

types of vertical integration – backwards and forwards. Backwards - This means firms merging with another firm ‘nearer

to the source’ of the product, such as a vehicle manufacturer buying a steel manufacturer.

Forwards - This means firms merging to move ‘nearer to the consumer’, such as a vehicle manufacturer buying a chain of car showrooms.

3. Horizontal integration Firms merging at the same stage of production - for example,

two vehicle manufacturers integrating.4. Lateral integration

Firms merging with others that trade in different markets. This is also called conglomerate or diversified integration.


Integration

Multi-nationals Many firms grow through integrating with overseas firms – this

is increasingly common in the global economy. Mergers and acquisitions account for a large share of FDI.


Evaluation of mergers

Advantages of mergers1. Economies of scale.2. With vertical integration there are savings in terms of not paying

‘3rd party’ profits. 3. Economies of scope - using the fixed assets of one firm to produce

output for the other firm.4. Unexpected synergies - unexpected benefits when firms merge.5. Rationalisation - being able to dispose of unprofitable aspects of

the business.6. Sharing knowledge - each firm can benefit from the knowledge and

experience acquired by the other. With vertical integration information asymmetries can be reduced or removed.


Evaluation of mergers

7. Protect from take-over - merging sends out a signal to other firms not to attempt a take-over bid.

8. More spending on R&D - firms that merge may be able to allocate more funds to Research and Development (R&D) and generate new products.


Evaluation of mergers cont…

Disadvantages of mergers1. Increased concentration and lower competition .2. Diseconomies of scale - firms that merge may experience

diseconomies such as difficulties with co-ordination and control.3. Higher prices - with less competition, the merged firm may find it

easier to raise price.4. Restricted output - there may be proportionately less output

from the merged firm.5. Loss of jobs - rationalisation is likely to lead to lost jobs.6. Reduced choice - consumers may suffer from reduced choice

following a merger of two close competitors.7. Increased barriers and less contestability.


Bank mergers

Why are bank mergers common? Like all firms, banks can derive considerable benefits from

merging, including deriving economies of scale. However, in addition there are considerable benefits to financial

institutions from merging rather than expanding organically. Over time banks will have built up a range of low, medium and

high risk borrowers. To expand organically, a bank may have to take on higher risk customers. However, if a bank acquires another bank, it will not need to increase its average risk level because it will acquire a range of customers of all risks, rather than only high risk ones.


Contestable markets


Contestable markets What are ‘contestable’ markets?

A contestable market is one with zero entry and exit costs. This means there are no barriers to entry and no barriers to exit – such as ‘sunk costs’ and contractual agreements.

The existence - or absence - of sunk costs and economies of scale are the two most important determinants of contestability. ‘Natural’ monopolies are the least contestable markets because of extremely high barriers to entry and exit.

Asymmetric information is also a key barrier to entry – incumbents may know much more about the industry than potential entrant.

With no barriers to entry into a market, the threat of entry is enough to keep incumbents ‘on their toes’ and to act as if it there is competition.

Potential entrants can operate a hit and run strategy.


Hit and run strategy

Super-normal profit

Incumbent

High price Low output

Potential entrant

HIT RUN

Potential entrant

Potential entrant

Inefficient

Low price High output

Normal profit Efficient

BARR

IERS

BARR

IERS

Existing market

Cost Revenue

Quantity


Evaluation of contestable markets

The theory of contestable markets is an alternative to traditional theory.

‘Perfectly’ contestable markets can deliver the benefits of perfect competition, but without the need for a large number of firms.

Firms are forced to keep excess profits to a minimum, and move towards sales maximisation.

MC

ATC

Q

P

0

A

MR

AR = D


Regulation


Regulation - alternative approaches

Classical theory The Classical view can be summarised as - monopolies are inevitably

‘bad’, and mergers are likely to lead to monopoly power, reduced competition and a misallocation of scarce resources.

Regulators should be tough on monopolies and mergers.The modern, pragmatic, approach

The ‘modern’ view is much more pragmatic, and can be summarised as - monopolies and mergers should be judged on a case by case approach, and not automatically heavily regulated.

Monopolies can create benefits as well as costs, such as the benefits of economies of scale, innovation, and export earnings.


The Competition Act 1998, and the Enterprise Act 2002

The Competition Act 1998 The Competition Act 1998 prohibits a number of activities by

firms, including:1. The formation and operation of cartels.2. Abuse of a firm’s dominant position on a national or local level.3. Concerted practice - firms colluding instead of competing – such

as: Fixing prices, or raising price together, or fixing output. ‘Carving up’ a market.


The Competition Act 1998, and the Enterprise Act 2002

The Enterprise Act 2002 The main provisions of the Act were:1. Assessment of mergers to be less influenced by politicians.2. New powers to regulators to investigate abuse, such as using

surveillance.3. Criminalisation of cartels.4. Disqualification of directors for breach of the competition rules5. Consumer groups can complain about uncompetitive practices.


The regulatory structure in the UK

Regulation in the UK Regulating firms and promoting competition is undertaken in

the UK by:1. The Office of Fair Trading (OFT) - the OFT looks at ‘unfair’

trading, especially the privatised utilities, through its sub-offices – OFTEL, OFGEM, OFWAT, OFCOM etc – it is the main ‘referring body’.

2. The Department for Business, Innovation and Skills (BIS) – this is the government department in charge of UK competition policy.

3. The Competition Commission - the Competition Commission is the main independent investigatory body.


The OFT

The OFT’s main objectives are:1. To identify and put right trading practices which are against the

consumer’s interests.2. To regulate the provision of consumer credit.3. To investigate anti-competitive practices.4. To investigate abuse of market power and cartel-like behaviour.5. To help promote market structures which encourage

competitive behaviour. It can impose fines when necessary.

The sub-offices The OFT’s sub-offices were specifically established to regulate

the privatised utilities and to encourage competition.


Examples of price fixing Football shirts

In August 2003 the OFT imposed one of its biggest fines for price fixing by football shirt makers and retailers - price fixing is an example of ‘concerted practice’. The fines of £18m were spread between: Shirt makers Umbro (£6.6m) Sportswear sellers JJB Sports (£8.4m) Soccer Club Manchester United (£1.7m)


BIS

The Department for Business, Innovation and Skills (BIS) was created in 2009.

The main objectives of BIS are: To promote free and fair markets, with increased competition To increase productivity and improve skills To promote science and innovation, and promote the commercial

exploitation of knowledge To improve economic performance of the UK regions, and to

reduce the gap in growth rates between the regions


Competition Commission

The Competition Commission In terms of mergers, the Commission must assess whether a

merger will significantly reduce competition. After investigating it may recommend that the merger goes ahead, is prohibited, or is allowed to go ahead, but with modifications.

The Competition Commission and abuses of dominance In the case of ‘abuse of dominance’ the Commission can fine

an offender up to 10% of turnover - sales revenue - for a maximum of three years.


Regulating the privatised utilities

Nationalisation Between the 1930s and 1950s most of the public utilities in the

UK were taken over by the state via a process called nationalisation.

The main motive for this was to ensure a co-ordinated approach to production and supply.

However, by the late 1970s it was becoming apparent that these utilities were suffering because:1. They were being managed inefficiently and suffered from ‘X’

inefficiency.2. They had no ability to raise capital on the open market and had to

compete with other government spending departments. As a result during the 1980s many industries owned by the state

were sold off to the private sector via privatisation.


Missing contestability

Privatisation and regulation The major privatisations in the UK were gas, electricity, oil,

telecoms and coal. However, many of the privatised utilities are also natural

monopolies. With a natural monopoly the role of the regulator is to act as a

‘surrogate’ competitor to the privatised natural monopoly, therefore adding contestability to the market.


UK Regulator’s options

Regulators have a number of options, including:1. Setting price controls and formulae .2. Limiting profits to normal profits.3. Imposing a windfall tax on abnormal profits.4. Introducing yardstick competition - which means setting targets

based on ‘best practice’ from similar industries in the UK or abroad.

5. Bringing down barriers to entry - such as forcing the incumbent to allow potential rivals to have access their network or infrastructure - unbundling their infrastructure.

6. Prohibiting further mergers and acquisitions (M&A) - to stop the level of concentration in the industry increasing.


Regulation options cont…

7. Bringing them back under public control (re-nationalisation) - which would force them to move from profit maximisation to sales maximisation.

8. Allowing self regulation. Certain industries may be allowed to self regulate by establishing a code of conduct by which industry members agree to abide. Critics argue that self regulation is unlikely to provide sufficient incentive for firms to behave responsibly.


Evaluation of competition policy

Increasing powers Since the Competition Act (1998) and the Enterprise Act (2002)

regulators have had more power to act against abuses of monopoly power.

However:1. Very few mergers are actually investigated each year. 2. Despite heavy fines, secret (covert) collusion is difficult to prove

– new powers have been given to the regulators to undertake covert surveillance of firms to establish whether collusion is taking place.


Evaluation of competition policy

3. Tacit collusion is almost impossible to prove - statistical techniques could be used to establish correlations between price movements in ‘theory’ and in practice.

4. The problem of cheating or finding loopholes – such as getting round the regulations by moving into an adjacent market - for example, a large grocery retailer moving into the ‘convenience’ store market.

5. A major criticism is that single markets are inadequately defined. For example, are ‘convenience stores’ the same market as ‘grocery’ stores - Tesco have 6% of the convenience food market as well as 26% of the grocery market!


European Competition Policy

The European Commission ensures that European competition policy is implemented.

The legislation is contained in Article 101 of the Treaty on the Functioning of the European Union (1958)

The main areas of legislation include: Anti-trust Mergers Cartels State aid


Antitrust

Antitrust legislation covers two key areas:1. Agreements between two or more firms which restrict

competition, such as price fixing or market sharing (carving-up)

2. Abuse of dominant position, such as attempting to push a rival out of a market by predatory pricing

Since 2004, national regulators (i.e. UK) are empowered to apply the EU rules

The rules apply to trade between member states in the common market


Mergers

If a merger is above a particular threshold it may be examined solely by the Commission (combined worldwide sales of €5bn, and €250m within the common market)

The merger may be restricted or prevented if it impedes competition significantly and therefore adversely affects consumers

Parties may agree to take particular steps to mitigate the reduced competition, and therefore avoid prohibition – e.g. to license technology to another company


Cartels

Cartels are illegal under EU competition law Because cartels are ‘hidden from view’ the Commission offers an

incentive of ‘no-fine’ for the first member of a cartel to provide information (i.e. become a whistle-blower).


State aid

In general terms, EU Treaty law forbids national governments from giving unfair assistance to its industries – such as through subsidies.

However, there are some exceptions, including ‘development aid’ for particularly poor regions, or where the social benefits of aid with not distort the operation of the single market. For example, areas with very high unemployment.

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© Economics Online 2011. 3 Alternative motives