Economics for business by David Begg and Damian ward (3rd edition) chapters 1-8 Chapter 1: Economics for

business.
1.1; What is economics? Economics is the social science that analyzes the production, the distribution and consumption of goods and services. It studies how individuals, firms, governments and economies deal with the problem of infinite wants and finite resources. Factors of production are the resources needed to make goods and services,: land, labor, capital and enterprise. - Land is where raw materials come from (e.g. oil, gas, base metals, wood etc.). - Labor is the ability to work. - Capital is composed by all the elements which take part in the production process (e.g. machinery, computers, offices, buildings etc.). - Enterprise is what brings land, labor and capital together and organizes them into business units that produce goods and services with the objective of making a profit. The production possibility frontier (PPF) is an important illustrative tool, showing the maximum number of products that can be produced by an economy with a given amount of resources. Figure 1 - PPF

Cars A C

75

50 25 X

25

50

75

Computers

The PPF shows how resources are finite. The maximum production possibility for a give country is limited, and choices have to be made in order to decide what and how much to produce (How many cars and how many computers for example). At any point on the PPF curve, the country is employing all of its resources to produce the best mix of goods and services to fit its needs. At point X not all the 1

resources are employed, thus there is a margin of improvement in terms of total output. Point Y represents a level of output which is not available yet but which might be achieved in the future (when more resources will be available). Opportunity costs are the benefits foregone from choosing the next best alternative. As noticeable in figure 1, the country will have to choose whether to produce more computers or cars. In case it produces more cars, the opportunity cost will consist in the foregone benefit of producing more computers instead. Ideally we try, when making decisions, to make the opportunity cost as low as possible. Macroeconomics is the study of how the whole economy works (e.g. at national level or the whole market for one product/service), while microeconomics is the study of how individuals make economic decisions within an economy. Macroeconomics deals with the performance, structure, behaviour and decision making of the whole economy. Microeconomics is concerned with how households and firms make decisions to allocate their limited resources. In a planned economy the government is the major owner of all the factors of production and decides how resources are allocated. In a market economy private individuals own the majority of the economic factors of production and the government plays no role in allocating the resources, which is done by the market itself without regulation. Most of the times is a mix of both (for example the healthcare system might be government based while the production of groceries will be decided by the firms in the groceries industry). In a mixed economy, the government and the private sector jointly solve economic problems. Market economies rely on a very quick and efficient communication of information that occurs through prices. Therefore the price system solves the problem of what should be produced and what not and the quantities. Gross domestic product (GDP) is a measure of overall economic activity within an economy. A way of measuring the planned side of an economy is to examine the size of government expenditure as a percentage of GDP. 1.2; Why study economics for business? The focus of economics is on the functioning of markets, and markets are very important for firms. First of all because the marketplace is where businesses sell their products and therefore where they make profits. Second, the market influences the costs of businesses: land, labour, capital and enterprise are all purchased through markets. Governments can also intervene in the markets, usually in order to benefit the whole society. Governments can either seek to boost revenues when the firms operate in the interest of the public or reduce them (increase costs) when the firms operates against the interests of society. Firms dont only operate within their regional or national environment, but rather in a very complex and massive global macroeconomic system. Its therefore important that businesses, in order to be 2

successful, understand how macroeconomic events and global change will impact on their current and future operations. 1.3; Appendix: the economists approach. Economists think about the world in terms of models or theories, stripping out the complexity of the real world in favour of a simple analysis of the central issues. Models or theories are frameworks for organizing how we think about an economic problem. Positive economics studies objective or scientific explanations of how the economy works. Normative economics offers recommendations based on personal value judgments. Thus positive economics statements rely upon data and facts, while normative economics statements are peoples opinion, and thus subjective statements. Diagrams provide a visual indication of the relationship between two variables. Variables can have either a positive or a negative relationship, the former meaning their values increase and decrease together, while with the latter the two variables move in opposite directions (with an increase in one there will be a decrease in the other one). The equation of a straight line is Y = a + bX. A quadratic is generally specified as Y = a + bX + cX The gradient is a measure of the slope of a line. One method of measuring the gradient of a line is to calculate the ratio between Y / X (the change of Y divided by the change of X). Another method involves the use of a simple mathematical function called differentiation. Differentiation is a means of understanding the gradient. The rule consist in X = nX. For example: 4 + X = 3X (all the constants become 0). Its important to business because if we want to discover the level of production that leads to minimum costs per unit, then we need a mathematical equation which links production and costs, differentiate, set to zero and solve to find the ideal level of production. Economists use two different types of data: time series and cross-sectional. Time series data are the measurements of one variable at different points in time. Cross-sectional data are the measurements of one variable at the same point in time but across different individuals. Panel data combines cross-sectional and time series data. A percentage measures the change in a variable as a fraction of 100.

Since percentages measure the rate of change in a variable, we need both the original and the new value of the variable to do so, with the help of the following formula: [(New value Original value) / Original value] x 100 For example, a companys share price was 2$ in 2008 and 6$ in 2010. The percentage change will be [(6-2)/2]x100 = 200, thus the share price increased by 200%. Index numbers are used to transform a data series into a series with a base value of 100. Why do we use index numbers? First because having a base value of 100, it is very easy to calculate the percentage change in the variable over time. Also, its very easy to make averages. The Retail Price Index is, for example, the average of many individual product price indices. Economists use two different ways to calculate averages: the arithmetic and the geometric means. Arithmetic means sum all the values and divides them by the number of values, creating an error when measuring growth since when doing so the base value changes all the time. This error can be avoided using the geometric mean. For example: Obserevations 2,2 2,3,4 Arithmetic mean (2+2)/2 = 2 (2+3+4)/3 = 3 Geometric mean (2x2) = 2 (2x3x4) = 2.88

The percentage increase between 3 and 4 is not the same as the percentage increase between 2 and 3, therefore arithmetic mean shows an error when calculating growth.

Chapter 2: Consumers in the marketplace.

2.1; Business problem: what is the best price? The best price is determined by the firms objectives, usually one of the following: Maximise profits Maximise market share Maximise total revenues

Though also non-commercial objectives are possible, such as improving the environment or being a socially responsible employer, these are the most common ones. It is generally not possible to for a firm to choose more than one of these objectives (theyre often in conflict with each other). 2.2; Introducing demand curves. In attempting to understand consumers behaviour, economists use a very simple construct known as the demand curve. The demand curve illustrates the relationship between price and quantity demanded of a particular product. The slope of the demand curve Qd is negative (downward sloping). Figure 1 Demand curve P 10 As the price falls, consumers are willing to demand greater amounts of the good and vice versa.

Qd2 5 10 15 20

Qd

Qd1 Q

2.3; Factors influencing demand. The demand curve shows a negative relationship between price and quantity demanded, but the willingness of consumers to purchase a certain product is affected by more factors than just price. These alternative factors are divided by economists in four broad categories: Price of substitutes and complements Consumer income Tastes and preferences Price expectations

Substitutes are rival products competing in the same marketplace (e.g., rice and pasta). Complements are products that purchased jointly (e.g., cars and petrol). To understand the effect of income upon demand, distinction between normal and inferior goods has to be made. Normal goods are demanded more when consumers income increases and less when income falls. Inferior goods are demanded more when income level fall and demanded less when income rises. Tastes and preferences reflect consumers attitudes towards a particular product. Over time these tastes and preferences are likely to change. Advertising plays a very important role in demand theory. First, it provides consumers with information about the products, making them aware that a new product is on the market, with its special features. Demand usually increases only just because buyers know the nature and availability of the product. Second, advertising is also about trying to change consumers tastes and preferences. Accordingly, advertising is also about informing the consumer about what they should buy. Whether advertising is providing information or developing consumers tastes and preferences (desires), the overriding aim is to shift the demand curve from Qd to Qd2 (as in figure 1). In terms of demand curves, if we expect to prices to fall in the future, then demand today will be reduced as people is willing to delay the purchase in order to save money. This will shift demand back to Qd2 (as in figure 1). Also opposite price expectations are possible, with prices believed to rise in the future leading to anticipated purchase (moving the demand curve to the right). Price expectations are beliefs about how prices in the future will differ from prices today. The law of demand states that, ceteris paribus (all other things being equal), if the price of a product falls, more will be demanded. Some consumers prefer products that have an element of exclusivity, and high prices ensure exclusivity along with signalling that the product is special. Therefore high prices sometimes attract a special group of consumers, shifting the demand curve to the right. These product are usually said to be status symbols. But everyone has limited resources, so the curve will be still downwards sloping. 2.4; Measuring the responsiveness of demand. Businesses need to know the impact of price changes on the quantity demanded. Elasticity is a measure of the responsiveness of demand to a change price. The elasticity of a product is determined by a number of factors: Number of substitutes Time

Definition of the market

As the number of substitutes increases, the more elastic will be demand. In the early periods of a new market, demand tends to be inelastic (due to fewer competitors and substitutes), but in the long term, as more products enter the market, demand is likely to become more elastic. In markets where the similarity between products is higher than in others, demand will be more elastic (its easier for consumers to switch to another and similar product). Mathematically economists can measure elasticity using the following formulae:

= %D/%P (percentage change in quantity demanded / percentage change in price) = (D/ P) x (P/D)

The value of for elasticity will lie between zero and infinity (0 < < ). D/ P

Elasticity value () 0 <1 =1 >1 =

Type of demand Perfectly inelastic Inelastic Unit elastic Elastic Perfectly elastic

0 0.5 1 2 Infinitely large

When demand is perfectly inelastic, quantity demanded will not be affected by any change in price. When demand is perfectly elastic, any change in price will hugely affect quantity demanded. When demand is unit elastic, quantity demanded will change equally to the change in price. Figure 2 Figure 3 Figure 2 = perfectly inelastic demand [=0] Figure 3 = perfectly elastic demand [=] 2.5; Income and cross-price elasticity. Income elasticity measures the responsiveness of demand to a change in income. Cross-price elasticity measures the responsiveness of demand to a change in the price of a substitute or complement.

Income elasticity (Y) = %D/%Y If Y < 1 the product is described as income inelastic, demand will change slower that the

income does, while if Y > 1 then the product is income elastic, and demand will change at a faster rate than income. Cross-price elasticity (XY) = %Dx/%Py
If products X and Y are substitutes or rivals, then, as the price of Y increases the demand for X will increase, so XY lies between zero and +. If X and Y are complements, then, as the price of Y increases, quantity demanded for X will decrease. XY lies between zero and -. 2.6; Business application: Pricing strategies I exploiting elasticitys. A rather simple approach to pricing is to simply take the cost of producing the product and add a mark-up. This system is called cost-plus pricing. The benefits of this approach lie in it being simple, you only need to know how much profit you want to add on the production expenses. Though, it fails to take into account the consumers willingness or unwillingness to buy the product. The best pricing method comprehends the understanding and utilization of price elasticity of demand. Total revenue is price multiplied by number of units sold. If demand is elastic, then dropping prices will raise total revenues; if demand is inelastic, price should be raised in order to increase total revenues. Changing the price involves the development of new pricing plans and the communication of price changes to retailers of the product. As a result, change can be costly and not always offset by improvements in revenues. Change can also represent a risk, since competitors could react to your price changes. Furthermore you may not fully understand the price elasticity of your product and therefore make a mistake when repricing it. If we wish to target unit elasticity (thats where revenues can be maximised), we need a measure of how far our current pricing is from this best price. To find the best price we need to gather data that will enable the demand curve for our product to be plotted and mathematically modelled. Once we have a demand curve, we can see the relationship between price and quantity and measure the elasticity of demand at various prices. Data is difficult to find and retailers are not willing to change prices just for the sake of experimenting and gathering data, therefore the job is usually given to market research companies. These will scanner data from large selections of retailers such as supermarkets across vast areas. For each price at which the product is sold, the market researchers also note down how many units of the product are sold at the tills.

By using econometrics, trend lines can be drew and analysed, providing information about the price elasticity of demand. Knowing that unit elasticity is what we are looking for, we will be able to move in that direction from the actual position along the curve. Successful products go through four phases of the product life cycle: introduction, growth, maturity and decline. Unsuccessful products usually dont pass the introduction phase. At each stage there is a different competitive environment and thus elasticities of demand. In the introduction stage an innovative product is likely to be unique and face few, if any, competitors. Therefore demand will be price inelastic, as the early adopters arent able to switch to another company or product easily. Firms could therefore set higher prices. In the growth phase competition increases, as companies that witnessed the success of the product in the introduction stage want to enter the market as well. Elasticity of demand rises and therefore prices start to decrease. To gain a dominant position in the marker prices should be cut, giving preference to increased market share rather than to maximise profits. At the maturity stage of the market competition is usually fierce, leading to higher price elasticity of demand. This is a reasonable base for aiming at sales maximisation strategies. High price elasticity means having little control over pricing, as competitive pressures force the price down. As the product enters the decline part of its life cycle, competition becomes lighter as companies exit a market where consumers are doing the same. Elasticity of demand will become more inelastic, which along with greater price stability will allow higher prices to be set. Therefore, throughout the product life cycle the pricing strategy has to be reactive to the changing competitive nature of the market. 2.7; Business application: Pricing strategies II extracting consumer surplus. Consumer surplus is the difference between the price charged for a product and the maximum price that the consumer would have been willing to pay. Consumer surpluses represent a benefit for consumers, but also missed profits for businesses. Price discrimination is the act of charging different prices to different consumers for an identical good or service. For price discrimination to be successful three elements must exist: The firm must have control over prices, thus an inelastic demand (having price-setting power) The firm must be able to distinguish the different groups of consumers that are willing to pay different prices The resale of the good must be prohibited

There are three different types/degrees of price discrimination.

Under first-degree price discrimination each consumer is charged exactly what they are willing to pay for the good/service. It is very unlikely to happen because none is ever going to pay what he would be able to. Also quite complicated to manage. The most used application of this method is selling through biddings. The second-degree price discrimination consists instead in charging consumers different prices based on the amount of quantity purchased. Usually there is a fixed cost plus a variable cost that will depend on the amount purchased. For example telephone subscriptions. Consumers that are willing to spend more will buy at a higher fixed cost but receiving lower variable costs, while people that is not willing to pay as much will get the cheaper base cost but with higher variable costs. Third-degree price discrimination is when different groups of consumers are charged different prices. For example business class seats in flights. Another example could be the pay per view television subscriptions. Starting from a basis package of certain channels, the more channels you want the more you pay (e.g., sport channels, movie channels etcetera). This technique is called product debundling.

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Chapter 3: Firms in the marketplace

3.1; Business problem; managing fixed and variable costs. Fixed costs are constant, they remain the same whatever the level of output. Variable costs change or vary with the amount of production or demand. The biggest problem of fixed costs is not that they cost huge amounts of money, but that the nature of the cost does not change with the output and revenues. Variable costs have the advantage that they can easily be changed in relation to the revenues/production/demand. 3.2; The short and long run. The short run is a period of time of production is fixed, we tend to assume that capital is fixed and labor is variable. If demand changes in the short run, a company can easily employ or fire people to manage that demand, but if they need to expand because of the growing demand they cannot easily build a new office, therefore capital is fixed in the short run. But labor could also be fixed in the short run if a company works with contracts, like professional football players; they signed a 5-year contract so their labor is rather fixed than variable. The long run is a period of time when all factors of production are variable. We cannot really give a definition of how long the long run is, because it depends very much on the industry. In the internet industry the long run may be a week, while in the airplane manufacturing industry the long run may be ten years. 3.3; The nature of productivity and costs in the short run. Productivity in the short run. In assessing productivity, we need to distinguish between total product and marginal product. Total product is the total output produced by a firms workers. Marginal product is the addition to total product after employing one more unit of factor input (labor). Marginal always means one more. See table 3.1 on page 56 to get a good understanding of total product and marginal product. Task specialization helps to raise productivity because the total process is broken down into separate components, each worker then specializes in one task and becomes an expert in that task. The law of diminishing returns states that, as more of a variable factor of production, usually labor, is added to a fixed factor of production, usually capital, then at some point the returns to the variable factor will diminish. In other words; over-resourcing of capital (putting four people behind one cash desk) does not raise productivity/marginal product. Costs in the short run. In the short run, we have three types of costs; variable costs, fixed costs and total costs. Variable costs are costs associated with the use of variable factors of production, such as labor. Fixed costs are associated with the employment of fixed factors of production, like capital. Total costs are simply fixed costs plus variable costs. Average costs. We measure the costs per unit using average costs. To calculate the average costs we have to divide 11

the total costs by the number of units produced. You can subcategorize this by doing it for the variable and fixed costs. To calculate the marginal costs we have to divide the change in total costs by the change in output. If we make graphs with the lines of average costs and marginal costs, it should be noted that the marginal cost curve cuts through the minimum points of the average total and average variable cost curves. This is a mathematical relationship which is difficult to explain. 3.4; Output decisions in the short run. The price you sell your products for should always be related to your fixed and variable costs. If your price is lower than the average fixed costs but higher than the average variable costs you could still produce and sell and try to cover as much as possible of your fixed costs with the profit you made on the average variable costs. But if your price is lower than both average costs you shouldnt produce. If a company produces one more unit and the firm can receive a price that is equal to or greater than the marginal cost, then it can break even or earn a profit on the last unit. 3.5; Cost inefficiency. We only looked at the cost curve this far, but this does not give a clear view on how firms operate because one firm may be way more efficient than another firm. Cost inefficiencies lead to competitive disadvantages, so operating as near to the cost curve as possible is the best thing to do for companies. 3.6; The nature of productivity and costs in the long run. In the long run, both capital and labor are variable. Therefore, the law of diminishing returns does not determine the productivity of a firm in the long run. This is simply because there is no fixed capital in the long run to constrain productivity growth. So, in the long run, productivity and capital must be driven by something else; returns to scale. Increasing returns to scale exist when output grows at a faster rate than inputs. And the other way around of course. Constant returns to scale exist when inputs and outputs grow at the same rate. Economies of scale: production techniques. Economies of scale exist for a number of reasons. The greater the scale of operations/production, the more specialization is needed by workers, and the production uses mass-production techniques. Therefore, as firms change their level of scale, they also change their production process and longrun costs fall. Indivisibilities. This is about not being able to separate your fixed costs. E.g. if you have a jumbo jet that can carry 400 passengers, but you only find 300 passengers you cannot chop off the back of the plane to cut your costs. Increasing your scale by buying another plane which flies from the end point to a new point may give you the 100 passengers because they want to fly from the start point to the end point via the middle point. This is nothing more than spreading fixed costs. Geometric relationships. Volume is a measure of storage capacity. So, if you decide to create a tank to brew beer, and we 12

decide to double the volume of the tank, the material needed will not double in size. It becomes proportionately cheaper to build larger tanks than it does to build smaller tanks. Diseconomies of scale. Long-run average costs will eventually begin to rise because, as companies increase in size, they become more difficult to control and co-ordinate. More managerial input is required to run the business. Competitive issues. The lowest point on the long-run average total cost curve is defined as the minimum efficient scale. This is the output level at which long-run costs are at a minimum. The closer you are to the point of minimum efficient scale, the more competitive your operation is. In order to take advantage of this sort of economies of scale, a company might merge with another company. The new company will be bigger than the two separate parts and economies of scale can be realized. 3.7; Business application; linking pricing with cost structures. In every example given so far, fixed costs are a major component of total costs. We know that volume is crucial when fixed costs are high, because additional volume helps to spread the fixed costs over additional units of output. This lowers cost per unit sold, which ultimately lowers prices. From the demand theory we know that we can generate higher demand at lower prices. 3.8; Business application; footballers as sweaty assets. A common business term for making your fixed inputs work harder is to sweat the assets.

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Chapter 4: Markets in action

4.1: Business problem: picking a winner. Volatility (fluctuations) in prices makes financial planning very difficult for business owners, they never know whether it is the right time to invest because of the changing environment. This problem is not just limited to investing, the wage or price at which you hire employees also depends on the market (demand and supply). Greater supply will increase competition and prices will fall, while higher demand by firms will lead to higher wages. Predicting what market prices are going to do can lead to a competitive advantage. 4.2: Bringing demand and supply together. A supply curve depicts a positive relationship between the price of a product and the firms willingness to supply the product. It has a positive slope; which is logical because the higher the price, the more you would be willing to supply. If a firm wishes to maximize its profits, then it has to be willing to supply additional units of output if the price it receives is greater than, or at least equal to, the marginal cost. Factors that lead to a shift in supply are; - More firms entering the market, which logically increases industry output and therefore the supply curve moves to the right. If firms close down the curve moves to the left because of less industry output. - If costs of labor, or other inputs, increase, profits must fall. As profits decrease, firms will be less willing to supply and so the supply curve will move to the left. When prices of inputs fall, making profits will be easier so more firms will be willing to supply and the supply curve moves to the right. - If a new technology is invented that enables firms to be more productive, then their costs will fall. This makes profits increase and firms are willing to supply more, therefore the supply curve moves to the right. Market equilibrium. Where demand and supply meet is known as the market equilibrium. This occurs at the price where consumers willingness to demand is exactly equal to firms willingness to supply. Any other combination of price and quantity that are not the equilibrium values are described as market disequilibria. If the market is in disequilibrium, then negotiations and resulting price changes will push the market towards its equilibrium position 4.3: Changes in supply and demand. Demands shifts to the right (increasing demand) is caused by: - For a normal good when income increases, for an inferior good when income decreases. - Following an increase in the price of a substitute. - Following a reduction in the price of a complement. - When tastes and preferences for this good improve. Demand shifts to the left (decreasing demand) is caused by: - For a normal good when income falls, for an inferior good when income rises. - Following a decrease in the price of a substitute. 14

- Following an increase in the price of a complement. - When tastes and preferences for this good deteriorate (become worse). Another important issue in changing demand are price expectations, these relate to views on future prices. If prices are going to rise in the future, then you will bring forward your consumption. Supply shifts to the right (increasing supply) is caused by: - If more firms enter the market. - If the costs of inputs, such as labor and raw materials, becomes cheaper. - If technological developments bring about productivity gains. Increased competition should lead to a drop in prices and more consumers taking up the product because of the lower prices. Supply shifts to the left (decreasing supply) is caused by: - If firms exit the market. - If the costs of inputs become expensive. Elasticity and changes in the equilibrium. Under inelastic supply we should expect that supply will not react strongly to a change in the price. Although prices may rice a lot, supply doesnt rise that much. By making the product scarce, or by engineering inelastic supply, the price in the market will rise. When demand is elastic, the increase in supply brings about a small change in the price. A small change in price means a big change in supply. The lesson learned from this is: if faced with inelastic demand for your product, do not increase your production capacity and thereby increase supply, because the price will drop quicker than output increases and your total revenues will fall. However, if you are faced with elastic demand, do consider increasing your capacity and supplying more to the market, as output grows at a faster rate than the declining price and so total revenues will rise. 4.4: Disequilibrium analysis. When supply exceeds demand, the market is said to be running a surplus. More is supplied than demanded. The only way to sell the excess stock is to begin discounting the price until everything is sold. The more unnecessary stock, the bigger the discount rates. The opposite situation is called a market shortage, in this case demand is bigger than the supply. Two responses are likely: firms may recognize the high demand for their products and raise the price or consumers may begin to bid up the price in order to gain access to the product. 4.5: Pooling and separating equilibrium. A separated equilibrium is where a market splits into two clearly identifiable sub-markets with separate supply and demand. This is not really a realistic example. Pooling equilibrium is a more realistic situation, this is a market where demand and supply for good and poor products pool into one demand and one supply. Good products cannot be differentiated from bad goods. Greshams law states that an increasing supply of bad products will drive out good products because good products are more expensive to make. In order to solve this problem good-product-suppliers

15

need to find a way of creating a separating equilibrium. The way to achieve this is to do something that bad-goods-suppliers cannot do, like a 12-month warranty. 4.6: Business application: marketing pop concerts a case of avoiding the equilibrium price. For certain luxury or very-demanded products the equilibrium price is not good. Take the example of a concert, if tickets are sold at the equilibrium price, it will only be just a sellout. If you then lower the price, more people will demand the tickets and therefore the concert will be sold out in a matter of hours. The importance of a sellout concert will be evidenced by the positive media attention. So selling for lower prices raises demand which makes a concert seems extremely demanded. This helps to reinforce the image of the celebrity in many ways; merchandising, CDs and media attention. 4.7: Business application: labor markets. Input markets are where factor inputs, such as land, labor, capital or entrepreneurship are traded.

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Chapter 5: Market structure and firm performance.

5.1; Business problem; where can you make profits? The answer is simple: in any market where consumers are willing to pay a price that exceeds your costs. Demand is elastic: if one shop drops its prices, students will flock to this shop. Demand is inelastic: whether a shop lowers or raises its prices, students will keep buying at that shop. 5.2; Profit maximization. Average revenue: the average price charged by the firm and is equal to the total revenue/quantity demanded: (PQ)/Q. Marginal revenue: is the change in revenue from selling one more unit. Profit maximization: the output level at which the firm generates the highest profit. Marginal profit: the profit made on the last unit and is equal to the marginal revenue (MC=MR) minus the marginal cost. If MC=MR, than MR-MC has to be 0.The firm maximizes profit when marginal profit = 0. When MR > MC, the firm is making a marginal profit. When, MR < MC they make a marginal loss. If demand increases for a product, the marginal revenue curve will shift to the right. This is because when the market price increases at all output levels, the firm will receive a higher price for each additional unit of output. In contrast, if demand for the product fell, then the marginal revenue curve would shift to the left. With lower marginal revenues, the profit maximizing output would be reduced. 5.3; The spectrum of market structures. Perfect competition: a highly competitive competitive marketplace. Monopoly: a marketplace supplied by only one competitor, so no competition exists. Imperfect competition: a highly competitive where firms may use product differentiation. Oligopoly: a market that consists of a small number of large players.

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Market structure: the economists general title for the major competitive structures of a particular marketplace.

Market structures

Imperfect competition Financial and commodity markets

Perfect Competition Small service sectors, bars, restaurants

Oligopoly

Monopoly

Supermarkets and banking

Microsoft and the Beckhams

Perfect competition: Many buyers and sellers Firms have no market power Homogeneous products No barriers to exit* or entry Perfect information

* Exit barriers make exit from a market by existing competitors difficult. Perfect competition is characterised by a set price. The curve will show two strokes crossing each other somewhere in the middle. Pricetaker: a firm who accepts the market price. Accounting profits: are revenues less raw material costs, wages and depreciation. Differences between accountants view and economists view see figure 5.10 page 107. Economic profits: are revenues less the costs of all factors of production. Normal economic profits: are equal to the average rate of return which can be gained in the economy. Supernormal profits: are financial returns greater than normal profits. The market equilibrium (The state of equilibrium that exists when the opposing market forces of demand and supply exactly offset each other and there is no inherent tendency for change. Once achieved, a market equilibrium persists unless or until it is disrupted by an outside force. A market 18

equilibrium is indicated by equilibrium price and equilibrium quantity.) can be influenced by entry and exit of competitors in the market or by change in demand. Productive efficiency: means that the firm is operating at the minimum point on its long-run average cost curve. Moreover, in long-run equilibrium the firm is charging a price that is equal to the marginal cost. This means that the firm is also allocatively efficient. Allocative efficiency: occurs when price equals marginal cost, or P = MC. 5.5; Monopoly. The UK competition authorities define a monopoly to exist if one firm controls more than 25 per cent of the market. Monopolies tend to exist because of barriers to entry. An high entry barrier can be caused by licences or patents. A natural monopoly: exists if scale economies lead to only one firm in the market: the produce enough to fulfil the total needs in a market. Creative destruction: occurs when a new entrant outcompetes incumbent companies by virtue of being innovative. Rent-seeking behaviour: the pursuit of supernormal profits. An economic rents is a payment in excess of the minimum price at which a good or service will be supplied. See table 5.4, page 116 for the key comparisons of perfect competition and monopoly. 5.6; Business application; understanding the forces of competition. The five forces of Porter model is strongly related to perfect competition. For every force a manager need to assess the following: Bargaining power of suppliers: - Number of suppliers - Differentiation of outputs - Ratio of input supply price to the output price Bargaining power of customers: - Number of buyers - Number of substitutes available to buyers - Price sensitivity of buyers Threat of entry: - Existence of entry barriers - Capital entry requirements - Access to distribution - Threat of retaliation Threat of substitutes: Price of substitutes 19

- Differentiation of substitutes Strategy and rivalry: Number of firms Exit barriers Rate of industry growth

If a company has a weak understanding, or lack of control over its competitive forces, then profits will plummet. In contrast, if the firm can understand and manage the forces of competition that it faces, then it has a better change of becoming monopoly. 5.7; Business application; oops were in the wrong box the case of the airline industry. Figure 5.19 on page 119.

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Chapter 6: Strategic rivalry.

6.1; Business problem; will rivals always compete? strategic interdependence: exists when the actions of one firm will have implications for its rivals. Oligopoly: a marketplace with a small number of large players such as banking, supermarkets and the media. Monopolistic competition: a highly competitive market where firms may use product differentiation. For the most part it is the same as perfect competition except for the existence of product differentiation. There are many examples of monopolistic competition and the all must relate to differentiation in some form or other. Bars can be differentiated by location, or thing they sell. Shops can be differentiated by distance, papers has to be sold in local shops, while people would drive an hour to get food. The monopolistic long-run equilibrium has some important features. First, the tangency equilibrium results in average costs being above minimum average costs. tangency equilibrium: occurs when the firms average revenue line just touches the firms average total cost line. In comparison with perfect competition, long-run equilibrium in monopolistic competition does not result in firms operating at minimum average total costs. Therefore, monopolistic competition is not productively efficient. In long-run equilibrium, firms in monopolistic competition have some monopoly power because price exceeds marginal costs. In perfect competition, freedom of entry and exit ensures that in long-run equilibrium price, average cost and marginal cost are equal. There is no market power in perfect competition. Firms in perfect competition are indifferent between serving a new customer and turning them away. This is because the revenue from one more sale is always higher than the costs. (P > MC). Characteristics of monopolistic competition: product differentiation few opportunities for economies of scale zero economic profits yet, some power over pricing

6.3; Oligopoly theory. An oligopoly is a market with a small number of large players. Unlike in perfect competition, each firm has a significant share of the total market and therefore faces a downward-sloping demand curve for its products. Firms in oligopolies are price-setters as opposed to price takes. Oligopolies are often referred to as highly concentrated industries, implying that competition is concentrated in a small number of competitors. A simple measure of concentration is the N-firm concentration ratio, which is a measure of the total market share attributed to the N largest firms. 21

N-firm concentration ratio (CR): a measure of the industry output controlled by the industrys N largest firms. So, the percentage of the market, owned by the N largest firms. For example: jumbo (17%), albert heijn (23%) and super de boer (18%)are the 3 largest firms in the market, then the three-firm concentration ratio is: 58%. Entry barriers: represent an obstacle to a firms ability to enter a industry. The costs for a firm can be exogenously or endogenously determined. Our natural entry barriers are concerned with exogenous costs: means external, outside. These costs are outside the control of a firm. This doesnt mean that these costs are uncontrollable; rather, the firm does not influence the price of labour, machines, raw materials and the production technology used. The level of costs associated with a particular industry, as we saw with monopolies, can create an entry barrier. In order to enter and compete in a industry its essential to build up a plant that is at least as big as the MES (minimum efficient scale). For example, if we have 50 million customers and the MES is 10 million units per year, then we might reasonably expect 50m/10m = 5 firms in the market. If we consider supermarkets, it is easy to see why natural entry barriers may exist. The big players in the supermarket industry have in excess of 500 stores each. So the MES must be around 500 stores. So, it is the natural, or exogenous, cost characteristics, coupled with the market size that leads to a natural entry barrier and the creation of an oligopoly. What happens if the MES it not very big compared with the market size? Entry is easier and aids competition. Consider the case of soft drink manufactures. If you wish to enter the soft drinks market, then you need to buy a bottling plant, a factory to house in and a warehouse and maybe some trucks. These costs wont exceed the 5million. This is for many companies not a huge amount of money. So, the MES is not big and, therefore the entry barrier into the market is limited. So, as a firm inside the market, how do you prevent entry? Easy; you change the cost characteristics of the industry and make the MES bigger, or, as the economist would say, you endogenize the cost function. If costs are endogenized, the firms inside the industry have strategically influenced the level and nature of costs. Sunk cost: is an expenditure that cannot be regained when exiting the market. Contestable market: a market where firms can enter and exit the market freely. This exists when there are no sunk costs. 6.4; Oligopoly theory: competition among the big ones. A cartel is when all companies in a oligopoly co-operate and act as one monopolist, as this generates the highest level of profits. Collusion is likely to fail when there is: - a large number of firms - product differentiation - instability in demand and costs 6.5; Competition among rivals. A kinked demand curve shows that price rises will not be matched by rivals, but price reductions will be. Thats why this curve is often used to explain the pricing behaviour of competing petrol stations. 22

Since car drivers can always drive on to the next filling station, each petrol station has a number of nearby competitors. If one increases the prices, then the rest will hold prices to attract drivers. The demand curve has a different shape above and below the current market prices: 1. The firm raises its price, rivals will keep their prices constant. The firm will, therefore, lose customers when it raises prices. As a result, demand above the current market price is elastic. 2. In contrast, if a firm reduces its prices, all rivals will match the price reduction. The firm will not gain more demand by reducing prices. Demand below the current market price is therefore inelastic. 6.6; Game theory. The game theory seeks to understand whether strategic interaction will lead to competition or cooperation between rivals. To understand why competing, rather than co-operating, with a rival is preferable we need to understand the importance of the nash equilibrium. The nash equilibrium occurs when each player does what is best for themselves, given what their rivals may do in response. A dominant strategy is a players best respond, whatever its rival decides. In a single-period game, the game is only played once. In a repeated game, the game is played a number of times. A credible commitment or threat has to be one that is optimal to carry out. 6.7; Game theory extensions: reaction functions. Residual demand is equal to the market demand less the amount produced by the firms rivals. In a Cournot model each firm threats its rivals output as a given. A reaction function shows that a firms profitmaximizing output varies with the output decision of its rival. A first-mover advantage ensures that the firm which makes its strategic decision first gains a profitable advantage over its rivals. A Stackelberg model is similar to the output approach of Cournot, but firms do not make strategic decision simultaneously. 6.8; Auction theory. There are four types of auction formats: the English auction (bids begin low and are increased incrementally until no other bidder is willing to raise the bid. The Dutch auction (prices start high and are gradually reduced until a bidder accepts the price and wins the auction). The first price sealed-bid auction (bidders must submit a single bid, usually in writing). Second-price sealed-bid auction (a variation on the first price sealed-bid auction. Again, bids are submitted in writing, but the highest bidder pays the price of the second highest bid. Private values means each bidder has a private, subjective, value of an items worth. Common values means the value of the item is identical for all bidders, but each bidder may form a different assessment of the items worth. 23

The revenue equivalence theorem states that under private values each auction format will generate the same level of revenue for the seller. The winners curse is where a winning bid exceeds the true value of the sold item.

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Chapter 7: Growth strategies.

7.1; Business problem: how should companies grow? Different types of growth: 1. Organic growth The simple growth over time. In a market with rapidly expanding demand, organic growth can be very sustainable. But strong competition can reduce growth, competition can cut prices and volumes. 2. Horizontal growth Merging two similar companies is referred to as horizontal growth, thus occurs when a company develops or grows activities at the same stage of the production process. Advantages can be increased sales, achievement of economics of scales and decreased operation costs. Diversification The expansion of variety by product and geography would be considered diversification . There is a difference between unrelated and related diversification. The separation of those two can be very difficult; a supermarket operating in groceries, food, electronics and banks can appear unrelated, but can equally be considered as different aspects of the retail market. Growing in diversified way can mean an offset of risks as non-food sales may grow more than food sales. 3. Vertical growth Means taking over the vertical chains of production. The chain consist of sourcing, producing and distributing. A company might prefer vertical integration for the reason of having more control on the value chain (quality, security). 7.2; Reasons for growth. If a firm is a profit maximize, growth can be pursuit for revenue or costs improvements. 7.3 Horizontal growth. Horizontal growth can occur in different ways for example: organic growth by buying more assets (airline buying more airplanes). A firm can also consider acquisition and merger. In either case, the company grows by merging its activities with those of an existing operator. Merger: Generally involves 2 companies agreeing by mutual consent to merge their existing operations. Acquisition: Involves one firm purchasing another firm, This might occur by mutual consent or in a hostile takeover, where the manager might try to resist the takeover. Horizontal growth and revenue In Chapter 2 elasticity of demand was examined. We can state that in case of inelasticity, dropping prices will not lead to an incline in revenue, but raising prices do. In a case of elastic, dropping prices rather than rising prices will lead to increased revenue. Reducing competition

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In the case of merger and acquisition, at least 1 competitor will disappear, so competition will be reduced. This leads to a reduction of substitutes, so likely the elasticity of demand is reduced as well. Leaving less chance of price wars. If we now also consider perfect competition, oligopoly and monopoly, we can reinforce the arguments above. Under perfect competition with a large number of competitors, prices and profits are lowest. Under monopoly, prices and profits are highest. Under oligopoly, consolidation in the industry can lead to greater cooperation to reduce competition and even to the forming of cartels. Exploiting market growth The incentives from revenue and horizontal growth emanates from two main sources: first, a reduction in the number of competitors and, therefore reducing elasticity, making price raises easier and price wars less likely and second, to take advantage of customer growth opportunities in the market. Horizontal growth and costs First, it is said that merger/acquisition leads to a reduction of long-run average costs and benefit from economies of scale; As two companies come together you only need one CEO, one department for Marketing and so on. This is called the principle of Rationalization. However, it is possible that a firm becomes too big which leads to diseconomies of scale, problems of control and co-ordination. This leads to reduced productivity, which in turn leads to increased long-run average costs. Second, an alternative cost reason for horizontal expansion is the benefit to be had from the learning curve. The learning curve says: As cumulative output increases, average cost fall. For an example of the learning curve, see page 158 of the book. 7.4 Vertical growth. Location benefits For the steel industry for example melting plants are often located near steel rollers. Rolling steel means it has to be heated, steel still heated from the melting process, can be more easily processed then if they had to be cooled down, transported and heated again for being processed. Problems from monopoly It is possible that materials might be supplies by a monopoly. In which the price of materials is high. A simple solution is to buy the supplier. Transaction costs Transaction costs are the costs associated with organizing the transaction of goods or services. If a contract is established for the supply of goods or services, time of negotiating and lawyers establishing the actual contract are both listed as transaction costs. Economist highlight a number of factors that are likely to lead to higher transaction costs, these factors are all related to the degree to which the contract or agreement can be declared complete. Under a complete contract, all of the aspects of the contractual arrangement are fully specified.

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Aspects of a contract Complexity - Is an obvious factor. For example sand is an uncomplicated product whilst lecturing is complicated. As the product becomes more complex, the more incomplete the contract becomes. As the contract becomes more incomplete, the higher are the cost of transaction Uncertainty Also affect the ability to write a complete contract. In the case of a bag of sand, the certainty is high, for example in changing situations (changing weather) the bag remains the same. Whilst a lecturer can be subjected to changing theory. Monitoring The more simple and certain the contract is, the more easy it is to monitor the contract. Again compare the bag of sand and the lecturer. The delivery of a bag of sand is easy, assessing whether the lecturer did a good job is less easy. Enforcement In the case of an incomplete contract it is more difficult to enforce. Nexus of contracts Is a collection of interrelated contractual relationships, where the firm represents a nexus/central point, at which all these interrelated contractual relationships are managed in the pursuit of profit. Transaction costs and vertical growth When will a firm grow or shrink along its vertical axis? The firm will grow when it needs to reduce its transaction costs by making use of its hierarchy or managerial structure to control its transactions. On the other side firms will shrink when it beliefs that it is possible to use the market to reduce transaction costs. Vertical growth: strategic considerations An important transaction problem is the hold-up problem, which is the renegotiation of contracts and is linked to asset specificity. A specific asset has a specific use; a general asset has many uses. 7.5 Diversified growth. Diversification involves a company expanding into related or unrelated markets. This may occur for a number of reasons, but a strong costs reason centres on the concept of economies of scope. Which is said to exist if the costs of producing two or more outputs jointly is less than the costs of producing the outputs separately. Cost (A) + Cost (B) > Cost (A+B) Diversification and risk reduction Diversification can reduce a companys exposure to risk. By being active in more than 1 market, the risks are spread in case of threats of new entrants, recession or falling back sales. On the other hand the profit of a company will rise if one of the markets its being active in faces fall of costs or increased sales. In order for this to be true the various operations must form a diversified portfolio of business activities, which means it contains a mix of uncorrelated business operations. 7.6 Evidence on mergers.

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To examine how mergers of all types improve firm-level performance, economist have used a variety of techniques. These techniques have included stock market studies, financial ratio analysis and case studies. Stock market studies investigate whether shareholders from the buying firm or the acquired target firm gain most. Most commonly acquired forms gain most. Financial and accounting examine merger activity within similar industry. Case studies examines specific mergers and look for firmspecific example of merger benefits. 7.7 Business application: horizontal growth by merger. Merger is attractive in times of recession as well as in a growing economy. In a recession firms hope to benefit from economies of scale and be more cost-efficient. Whilst in a situation of a growing economy firms see options to merge as a means of exploiting growth while achieving economies of scale. 7.8 Business application: vertical growth moving with the value. A common feature of business firms is change. The consequence of changes is that the value added in each stage of the vertical chain of production also changes. As costs fall, or revenues rise, then one part of the value chain becomes more valuable. Similarly as costs rise, or revenues fall, then another part of the value chain becomes less valuable.

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Chapter 8: Governing business.

8.1 Business problem: managing managers. Within all of us there is an element of Homer Simpson (actually stated in the book!). We appear to do a lot but often have more willingness to do little. Recognizable are frequent coffee breaks, toilet visits or even pub visits in work time! This is called the principal-agent problem. Basically a principal is a person who hires an agent to undertake work on their behalf. Principal can suffer from 2 profound problems; the interests of the agents and the principal differs and principals can have difficulties monitoring the agents work. The principal expects when he hires the agent that the agent will, as he has promised, increase profit. If he does not, moral hazard-type behaviour is the case. This occurs when someone agrees to undertake a certain set of actions but then, once a contractual arrangement has been agreed, behaves in a different manner. The costs of this behaviour are more generally termed as agency costs, meaning it reflects reductions in value to principals from using agents to undertake work on their behalf. 8.2 Profit maximization and the separation of ownership from control. Earlier it was stated that firms are profit maximizers, trying to bring MC (marginal costs) and MR (marginal revenue) into an equilibrium. But this is very complex since raw materials prices change, companies are likely to sell more than 1 product and output prices could change. So, they are never sure what the maximum profit is. Aside from this practical problems of trying to equate MC and MR, there are strong reasons why a firm might pursue objectives different than profit maximization. Crucially it is often the case that the individuals who manage a firm are different from the individuals who own the firm. Separation of ownership from control exists where the shareholders, who own the company, are a different set of individuals from the managers that control the business on a dayto-day basis. Managerial objectives Economist have proposed a number of alternative theories relating to the objectives that managers might pursue. Consumption of perquisites So, rather than work hard for the companys owners, managers would rather indulge themselves in the purchase of expensive cars, jets and lavish expense accounts that can be used to dine clients (and friends). So managers try to express dominance and success. Sales maximization An alternative hypothesis recognizes that the measurement of profit can be subjective. How much will the firm decide to depreciate its assets and what provision for bad debts will it charge to the profit and loss statement this year? So managers might decide the maximize sales. Often mistaken is that people think that profit increases as revenue increases, this is not true giving the fact of diseconomies of scale and the law of diminishing returns. Growth maximization The final hypothesis is that managers will seek to maximize growth, rather than profit. It is no 29

surprise that the pay of top directors is linked to the size of the company. Other intentions can be having an competitive advantage, economies of scale and increased power over pricing. Behavioural theories Behavioural theories of the firm are based on how individuals actually behave inside firms. Goal setting Organizations are complex environments represented by a mixture of interest groups, including managers, workers, consumers and trade unions. Even within managers there are sub-groups such as marketing managers, account managers and production managers. If for instance the marketing manager gets to the top of the company, extra money will flow to the marketing department. So different people represent different goals. Target setting Regardless of which goals or objectives predominate, the complexity of the environment will mean that measures and targets are difficult to set. How much should sales increase? 10% or 20%. It has to determined what is realistic. And set a maximum level of growth and a acceptable level of growth. Herbert Simons invented the concepts of satisficing, which is the attainment of acceptable levels of performance. For example 10% growth is acceptable and 20% is maximum. But the establishment of the maximum growth is difficult, it could be 20%, 25% or even 50%. And, failure to meet a goal creates tension between the group who sets the goal and the people pursuing them, so its maybe better to set a realistic goal. Thus, separation of ownership from control provide managers with the incentive to pursue any of the above objectives. 8.3 Principal agent theory. Agency costs between managers and shareholders If 1 person owns a company he is manager but also shareholder. If the firm would generate 100.000 euro in profit, but the owner decides to buy a 30.000 car for the money. The owner still receives 70.000 + 30.000 = 100.00. But when he decides to sell half of the companies stake because the company has grown, this changes. The profit is 100.000 and the owner buys the car of 30.000 that means that both the original owner and the new stakeholder can only divide 70.000 among them. This means that the new stakeholder does not receives 50.000 but 35.000. Compare this the original owner who still receives the car, he receives 30.000 + 35.000 = 65.000. Therefore, the value of a share in the company is 35.000 and not 50.000. The reduction in the companys value from employing an agent to manage the company is an example of an agency cost. The agency cost in this example is 50.000 35.000 = 15.000. This arises from the fact that the original owner his different interest than the new shareholder and because the original owner is not monitored. So, it is possible to use the companys money to satisfy the owners interest at the expense of the remaining owner. Agency costs between workers and managers Agency costs do not only occur between managers and owners of the company, but also between managers and workers. For example, if a manager hires shelf packers to work for him in a supermarket there are two ways of payment. First, piece rates, lets say 0.20 for every piece he puts 30

on the shelf and second an hour rate of 5 per hour. The employer paid by the hour, can sit around and do nothing, but still earn 5 euro, in contrast to the employer paid per piece. He needs to put at least 25 products on the shelf in an hour to earn 5 euro an hour. So, paying per piece could be a way to reduce agency costs. Piece rates is used when the output is easy to verify, like with car sellers, they receive a commission for every car they sell. But how do you verify the output of a manager? Monitoring workers, good communication, investment decisions and so on. How do you align the owners interest with the managers interest? We need an alternative way to reduce agency costs. Stock options could provide a solution to reducing agency costs. 8.4 Business application: Stock options and the reduction of agency costs. In order to reduce agency costs, managers could offer the option of buying stocks in the future for a price agreed in the past. So, if the managers performance is good and the price of a share raises the manager can get I better price for his share, raising his income. But how effective are stock options as a solution to agency costs? 1. If a manager owns 30.000 a year, he gets that salary whether the company performs well or not. If he is offered stock options, he will earn 20.000 + stock options. So, if the company underperforms he will lose money. Meaning the risk of stock options could be unattractive to managers. 2. The managers performance is linked to the shares price, but what if the share price is influenced by other things? Like the degree of competition or a policy by the government. 3. It could also be the case, the managers works hard but other managers not, so his effort does not means extra pay because of the other managers. 4. A manager with stock options will only be interested in raising the companys share price, but what if shareholders want more than just a high share price? 5. Finally, managers behaviour should be verifiable, in some cases managers kept liabilities of the balance sheet to inflate the shares price and in other cases expenses were capitalized and reported as assets, rather than sent to the profit and loss account as an expense. So, it seemed the company was doing well and managers cashed in on stock option. Therefore, performance contracts can help to resolve the principal-agent problem, but only if: - workers accept the contracts; greater reward for higher risks - there is a link between worker effort and the performance measures - the performance can be co-ordinated across a number of objectives - workers cannot unduly influence the measure But owners have to be careful with rewards, as they can attract bad managers or bad media attention Performance pay and the public sector A current trend is to introduce performance pay in the public sector. Paying care doctors a fixed salary plus a performance element which is linked to a certain healthcare indices. The key, as with performance contracts in the private sector, is to ensure that workers can respond to the incentives 31

and do not divert the effort of employees away from other important value-adding activities. For example, a dentist the extraction of a tooth attracts the same reward as a extensive root canal work. The root canal work is more beneficial to the patient, but the extraction is more easy to perform for a dentist. The important learning point is that markets, prices and incentives direct the allocation of resources; and this is equally important in the private and public sectors. 8.5 regulation of businesses. We have examined the governance of managers by shareholders. We will also show that , in other ways, markets can act against the interest of consumers or even the public. Not surprisingly, the interest of firms and wider society differ. Polluting the environment, rather than cleaning factory emissions, is a cheap alternative for a profit maximizing firm. At the heart of most economists understanding is that an economy characterized by perfectly competitive markets is Pareto-efficient, means that no one within an economy can be made better off without making some other people worse off. Therefore, the wellbeing of society is at a maximum. 8.6 Externalities. Externalities are the effects of consumption, or production, on third parties. If production, or consumption, by one group improves the wellbeing of third parties, then a positive externality has occurred. If it reduces the wellbeing of third parties it is a negative externality. The cost of a private firm of producing a particular output is the marginal private cost, this includes cost of raw materials, labour and machinery. MSC, marginal social cost, refer to the cost to society for producing one extra good. MSC > MPC: The equilibrium of the firm is with a bigger quantity and the society would want to decrease the output. Which means the firm will choose a level of output that is greater than society demands. The firm does not recognize the pollution costs MSC < MPC: Society find it more desirable to produce more output than the company does. MPB: Marginal private benefit, is the benefit to the individual from consuming one more unit of output> MSB: Marginal social benefit, is the benefit to society from the consumption of on more unit of output MPB > MSB: The optimal benefit for society is where MSP meets MSC, but in the case of MPB > MSB implies that one individual benefits more from consumption than society demands. MPB < MSB: Society gains more benefit than a private individual from consumption. Examples could be education and vaccination. 8.7 Dealing with externalities. Taxation and subsidy The problem with an externality is that the pricing mechanism does not impose the costs, or benefits, on the correct individuals. If a firm pollutes the environment, the whole of the society bear with that. 32

So, a way has to be found to internalize the costs. A way of doing that is with extra taxation and that works like this. The maximum profit of a firm, which pollutes, 2000 outputs. In this situation marginal private benefit and marginal private cost are equal. A taxation means extra costs for firms, the height of the taxation forced the firms price to rise and the demand to decrease. In such a way were marginal social benefit and marginal social cost are in a equilibrium. For example, cigarettes in the original situation cost 2 euro in equilibrium and the quantity was 50, but after tax raises of 0,80 euro, the demand curve changed. Demand decreased.

Subsidies Subsidies are payments made to producers, by the government, which leads to a reduction in the market price. This leads to a increase of demand. Basically, it is the same like the previous example only reversed. Subsidies are mend to increase output, taxation to decrease output. 8.8 Market power and competition policy. Earlier we compared a monopoly with perfect competition and argued that in case of a monopoly the price is higher and the output lower. Now, with the introduction of Pareto-efficiency, we show that in societys perspective, monopoly is not a desired market structure. To analyze this use figure 8.5 in your book on page 193, as I was unable to find an image representing this on the internet. consumer surplus: The difference between the price consumers are willing to pay and the price they actually pay Producer surplus: The difference between the price a firm wants to sell its products for and the price they actually sell at Dead-weight loss: Loss of welfare to society resulting from the existence of monopoly Creative destruction: Enables a firm to overcome the entry barriers of an existing monopoly. With creative innovation destroying the existing monopoly Competition policy In the UK, the Director General of Fair trading supervises company behaviour and, where fit, can refer individual companies to the Competition Commission, they investigate whether a monopoly, or potential monopoly, significantly affects competition. 8.9 Business application: Carbon trading.

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Carbon dioxide, a greenhouse gas, is a by-product of burning fossil fuels such as oil and coal. Burning fossil fuels for energy creates greenhouse gasses, so this is an example of a negative externality. The marginal private cost of producing electricity does not reflect the full marginal cost, which also includes the effect of environment pollution. Environmental and growth economist examine the rising production of greenhouse gases using an environmentally-adapted Kuznet-curve. The environmental Kuznet-curve shows an n-shaped relationship between the production of greenhouse gases and GDP per capita. As an economy grows and GDP per capita rises, then a greater use of fossil fuels production results in the rising production of detrimental greenhouse gases. Once an economy reaches a certain size and affluence, then there is likely to be sufficient wealth and technical expertise to address the use of fossil fuels and the generation of greenhouse gases. Therefore, in advanced high GDP per capita economies the production of greenhouse gasses starts to decline. In order to reduce greenhouse gases. The first is a license to pollute and the second is permits to emit pollutants.

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