A Level Economics MICRO

Paper
3 A level
Micro economics

Copyright: Tejvan Pettinger, Economicshelp.org 1st November 2015
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Table of Contents
Resource allocation ................................................................................................................... 3
Types of efficiency .................................................................................................................................. 3
Market Failure ............................................................................................................................. 5
Externalities and social efficiency .................................................................................................... 5
Negative externality ............................................................................................................................... 7
Positive externality ............................................................................................................................... 10
Cost-‐Benefit Analysis CBA ................................................................................................................. 11
Equi-‐marginal principle ..................................................................................................................... 13
Limitations of marginal utility theory .......................................................................................... 14
Indifference curves and budget lines ........................................................................................... 15
Budget line ............................................................................................................................................... 16
Income and substitution effect of a rise in price ..................................................................... 18
Costs of production .................................................................................................................. 20
Law of diminishing returns ............................................................................................................... 21
Economies of scale ................................................................................................................................ 23
Diseconomies of scale ......................................................................................................................... 24
Revenue ....................................................................................................................................... 25
Profit ............................................................................................................................................. 26
Profit maximisation .............................................................................................................................. 27
Market structures .................................................................................................................... 28
Perfect competition .............................................................................................................................. 28
Imperfect competition ........................................................................................................................ 31
Monopolistic competition ..................................................................................................... 32
Oligopoly ..................................................................................................................................... 34
The kinked demand curve model ................................................................................................... 34
Collusion .................................................................................................................................................... 37
Monopoly .................................................................................................................................... 39
Barriers to entry .................................................................................................................................... 41
Contestable markets ............................................................................................................... 42
Concentration ratios ............................................................................................................................ 43
Reasons for small firms ...................................................................................................................... 44
Mergers ...................................................................................................................................................... 44
Different objectives of a firm ............................................................................................... 46
Behavioural analysis ............................................................................................................................ 48
Price discrimination ............................................................................................................... 50
Government intervention to correct market failure ................................................... 53
Tax ............................................................................................................................................................... 53
Subsidy ....................................................................................................................................................... 55
Pollution permits ................................................................................................................................... 56
Equity and inequality .............................................................................................................. 60
Labour markets ........................................................................................................................ 63
Labour demand ...................................................................................................................................... 63
Supply of labour ..................................................................................................................................... 65
Wage determination in competitive markets ........................................................................... 66
Economic rent and transfer earnings ........................................................................................... 67
Market failure in labour markets ....................................................................................... 68
Monopsony ............................................................................................................................................... 68
Geographical immobilities ................................................................................................................ 69
Occupational immobilities – lack of skills .................................................................................. 69
Trades Unions ......................................................................................................................................... 70
National minimum wage ........................................................................................................ 72
Government Failure ................................................................................................................ 75

Resource allocation
Types of efficiency

1. Productive efficiency. Productive efficiency occurs when the economy is
on the production possibility frontier (PPF). It will also occur at the
lowest point on the firm’s SRAC curve.

2. Allocative efficiency. This occurs when goods and services are

distributed according to consumer preferences. This occurs at an output
where P=MC because, at this value, what the marginal benefit
consumers get is the same as the marginal cost.

3. X-‐efficiency. This occurs when firms’ actual costs are as low as potential.
A firm exhibits x-‐inefficiency if it lacks incentives to cut costs and so its
actual costs are higher than they could be.

4. Efficiencies of scale. This occurs when a firm produces on the lowest
point of its long run average cost, and therefore benefits fully from
economies of scale.

5. Dynamic efficiency. This refers to efficiency over time. For example, if
firms introduce new technology, it enables them to reduce costs over time
and their average cost curve will shift downwards. Dynamic efficiency is
also influenced by investment in human capital and investment in capital
and technology.

6. Pareto efficiency. This refers to a situation where you can not make
someone better off, without making someone worse off (This occurs on a
Production Possibility Frontier curve)

• Pareto efficiency occurs at point A or B
• D is pareto inefficient because you can produce more without any
opportunity cost.

Market Failure
Market failure occurs when there is an inefficient allocation of resources in a free
market.
Market failure can occur for various reasons.
• Externalities – a cost or benefit imposed on a third party, leading to
under or over-‐consumption.
• Information asymmetries – lack of complete knowledge by one party.
E.g. people may under-‐estimate the benefits of education (merit good) or
underestimate the costs of smoking (demerit good).
• Monopoly – When a firm has market power and can set higher prices.
• Immobilities – Geographical immobilities occur when it is difficult for
people or firms to move to another area.
• Public goods – Goods that are non-‐rival and non-‐excludable. They tend to
be under-‐provided or not provided in a free-‐market. Examples include
law and order, national defence and street lighting.
Externalities and social efficiency

Social benefit
• Social benefit is the total benefit to society.

• Social benefit = private benefit + external benefits.

• Social marginal benefit (SMB) = the additional benefit to society of
producing an extra unit.
• SMB = PMB (private marginal benefit) + XMB (external marginal benefit)
Example of social marginal benefit
Price Quantity PMB XMB SMB
10 4 10 4 14
8 6 8 4 12
6 8 6 4 10
4 10 4 4 8
2 12 2 4 6

Diagram of positive externality in consumption

In this case, the external marginal benefit (XMB) is constant at 4.
Therefore, the social marginal benefit (SMB) is always 4 greater than PMB.
Social cost
• Social cost is the total cost to society.

• Social Cost = private cost + external costs.

• Social marginal cost (SMC) = private marginal cost (PMC) + external

marginal cost (XMC)
Example of social cost
Price Quantity PMC XMC SMC
24 20 24 22 46
18 16 18 12 30
16 14 16 8 24
13 12 13 6 19
10 11 10 4 14
5 4 5 2 7
Social cost greater than private cost
Negative externality
A negative externality occurs when there is a cost imposed on a third party.
• For example, if a firm produces chemicals, the external cost is the
pollution that causes damage to the river and the lost earnings for
fishermen.
• If you drive into a town centre, the negative externality is the congestion
and pollution that affects other people in the town.
• With a negative externality, the social marginal cost is greater than the
private marginal cost.

Diagram of negative externality in production

• In a free market, the equilibrium will be at Q1, P1, where supply (S) =
demand (D).
• However, at Q1, the SMC is greater than the PMC.
• Q1 is socially inefficient because the SMC is greater than the SMB – this
illustrates an area of deadweight welfare loss.
• In this example, there is overconsumption of the good with negative
externalities.
• The socially efficient level of output would be at Q2, where SMC=SMB.
• Examples could include
o Overconsumption of cars driving into city centres at peak time,
causing congestion.
o Overconsumption of coal powered energy, which leads to excess
CO2 emissions and global warming.

Negative consumption externality
Negative externalities can also occur in consumption.
• For example, if we drive inefficient petrol cars, the consumption of petrol
causes excess CO2 emissions and pollution. This is a cost to the rest of
society. Other people will experience pollution and perhaps ill health
because of our decision to drive.
• If we drink alcohol to excess, we may turn up late to work on Monday
morning, leading to lower productivity and lower economic growth.

• With a negative consumption externality, the social marginal benefit is
less than your private marginal benefit.
• In a free market, the equilibrium will be at Q1 (D=S).
• But, the socially efficient level is at Q2 (where SMB = SMC).
• Therefore, in a free market, there is overconsumption of this good with a
negative consumption externality.

Positive externality
A positive externality in consumption occurs when there is a benefit to a third
party from your consumption.
• For example, if you cycle to work (rather than drive), other people benefit
from reduced congestion and pollution.
Diagram of positive externality in consumption

In a free market, the equilibrium will be at Q1, P1, where supply (S) = demand
(D).
• However, this is socially inefficient.

• At Q1, the SMB is greater than the SMC, leading to an area of deadweight
welfare loss.
• With a positive externality, there is under-‐consumption.
• Social efficiency occurs at Q2, where SMB=SMC.
Positive externality in production
• When producing a good causes a benefit to a third party.

• For example, if you keep bees, then a nearby apple farmer benefits
because your bees help to pollinate his apple trees.
Cost-‐Benefit Analysis CBA
This is a method used by governments to decide whether a project would be
beneficial for society. To undertake a CBA the procedure involves:
• All costs and benefits need to be identified. These include both monetary
and non-‐monetary costs and benefits.
• Also, future costs should be identified and calculated; this will involve
putting a net present value on these costs.
• A common monetary value needs to be placed on the various benefits.
Problems with using Cost-‐Benefit Analysis

1. Difficult to convert external benefits into a common monetary value,
e.g. it is difficult to agree on the value of a beautiful landscape.
2. CBA cannot effectively include the unpredictable.
3. Prices may be distorted by monopoly power or taxes.
4. Planning takes a long time and costs may change frequently.
5. Also revenues may be difficult to predict.
6. Difficult to choose a discount rate for future benefits and costs
7. With any project there will be winners and losers. Even if there is a
net gain to society, some people may lose out significantly. E.g.
building new rail link may offer overall benefit but people living next
to new railway may lose out.
Advantages of Cost-‐Benefit Analysis

• Offers wider benefits than private sector profit oriented approach. Cost
Benefit analysis can try to include external benefits and costs.
• No alternative. It is difficult to measure external costs, but there are few
better alternatives. The best solution is to improve methods of calculating
social costs and social benefits.
Cost-‐Benefit Analysis in Practise

e.g. High Speed Rail Link -‐ London Birmingham
Benefits include:
• Faster journey times.

• Meeting forecast rise in demand for rail travel.
• Reduce congestion on roads, lowering costs for business.
• Costs include
• Environmental impact on countryside.
• Money could be better spent on smaller scale projects which relieve
congestion at pinch points.
• Forecasts not guaranteed to occur.

Law of diminishing marginal utility
Marginal utility (MU) is the satisfaction that you gain from the last unit of
consumption. It is sometimes referred to as marginal benefit (MB)
• The first chocolate bar of the day is likely to give the highest utility. The
second chocolate bar usually gives less utility than the first.
• If you have already eaten three chocolate bars, you are unlikely to enjoy a
fourth. Therefore, the utility from the fourth chocolate bar is much less
than the first.
• As you consume more goods, the utility of the extra goods usually
declines. This is why the demand curve is downward sloping. You
wouldn’t want to pay as much for the fourth chocolate bar as the first.
• This is why an individual’s demand curve is downward sloping. They are
willing to pay lower prices for a higher quantity.

To encourage higher demand, lower prices are needed.
Price Quantity Marginal utility (MU
12 9 12
9 12 9
6 16 6
3 19 3

Equi-‐marginal principle
The equi-‐marginal principle states that consumers will choose a combination of
goods to maximise their total utility. This will occur where
(Marginal Utility of A)/(Price of A) = (Marginal utility of B)/(Price of B)
• The consumer will consider both the marginal utility MU of goods and the
price.
• In effect the consumer is evaluating the MU/price or the marginal utility
of expenditure on each item of good.

Example 1: Marginal utility of Goods A and B
Units MU good A MU Good B

1 40 22
2 32 20
3 24 18
4 16 16
5 8 14
6 0 12

Suppose the price of good A and good B was £1. Then the optimum combination
of goods would be quantity of 4.
• Because 16/£1 = 16/£1

Example 2:
Suppose the price of good A is now £4 and the price of good B is £2.
Units MU A/ £4 MU B /2

1 10 11
2 8 10
3 6 9
4 4 8
5 2 7
6 0 6

In this case, the consumer is in equilibrium (maximising total utility) when
buying:
• 2 units of A (MU A/Price A = 8)

• 4 units of B (MU/ B / price B =8)
Limitations of marginal utility theory
• Difficulty of evaluating utility. When consumers purchase goods, they
may have a rough idea of how much utility the good will give, but often
they don’t – especially for new goods. In practical terms, consumers can’t
give a cardinal (numerical) value to utility
• Consumers are not always rational. For example, we often see over-‐
consumption of demerit goods (goods which give very low marginal
benefit). Or consumers may be influenced by advertising and purchase on
impulse.
• Numerous goods. In the real world, consumers have fluctuating income,
and innumerable goods to choose between. This makes even rough
calculations difficult.
• Many goods are related – the utility of a video recorder, depends on the
quality of video cassettes.
• Often goods can’t be split up into small portions, e.g. cars.
• Time. Consumers don’t have time to work out Marginal utility / price.
Behavioural economic models

Economic models, such as marginal utility theory assume consumers are rational.
But, in the real world, this is often not the case. There are various factors which
influence consumer behaviour.
• The amount of information they have.

• Limited time to make a decision.
• Limited ability to evaluate utility and usefulness.
• Power of habit and addiction, encourages overconsumption of demerit
goods.
• Default choices. We may use Google because it’s too much effort to choose
something else.
Framing.
This theory suggests that consumer patterns are heavily influenced by the way
they are presented. If goods are presented in a certain way, it can either
encourage us to buy or discourage us. For example:
• In the UK, packaging of cigarettes has been changed to display
consequences of throat cancer on the package. Recently cigarettes are
hidden from view – meaning consumers have to make an extra effort to
buy the good.
• Saying the cost of gym membership at £500 a year sounds a lot. But
saying it costs just £1.37 a day sounds more attractive to consumers.
• Related sales. Firms may position goods closely together to encourage
related sales, e.g. selling pastries with coffee.

Indifference curves and budget lines
An indifference curve is a line showing all the combinations of two goods which
give a consumer equal utility. In other words, the consumer would be indifferent
to these different combinations.
Example of indifference curve

Choice of goods with give consumer the same utility
Apples Bananas
22 17
14 20
10 26
9 41
7 80

Diminishing marginal utility and indifference curves

• The indifference curve is convex because of diminishing marginal utility.
When you have a certain number of bananas – that is all you want to eat
in a week.
• Extra bananas give very little utility, so you would give up a lot of bananas
to get something else.

Budget line
A budget line shows the combination of goods that can be afforded with your
current income.

If an apple costs £1 and a banana £2, the above budget line shows all the
combinations of the goods which can be bought with £40.
Optimal choice of goods for consumer

• Given a budget line of B1, the consumer will maximise utility where the
highest indifference curve is tangential to the budget line (20 Ap, 10 ban)
• Given current income – IC2 is unobtainable. IC3 is obtainable but gives
less utility than IC1.
Impact of lower price

If there is a fall in the price of bananas (from £2 to £1.50), we can now afford
more bananas with the same income. The budget line skewers to the right.

With lower prices, we can now consume at a higher indifference curve of IC2,
enabling more bananas and apples.
Income and substitution effect of a rise in price
When the price of a good rises. People buy less for two reasons:
1. Income effect
• This looks at the effect of a price increase on disposable income. If the
price of a good increases, then consumers will have relatively lower
disposable income. For example, if the price of petrol rises, consumers
may not be able to afford to drive as much, leading to lower demand.
2. Substitution effect
• This looks at the effect of a price increase compared to alternatives.
• If the price of petrol rises, then it is relatively cheaper to go by bus.

Using indifference curves to show different effects

• A rise in price changes the budget line. You can now buy less of good
Bananas. The budget curve shifts to B2
• Consumption falls from point A to point C (fall in Quantity of bananas
from Q3 to Q1
To find the substitution and income effects.
• We draw a new budget line parallel to B2 but tangential to the first
indifference curve.
• Being tangential to first indifference curve it enables the consumer to
obtain the same utility as before (as if there was no change in income.)
• By focusing on B-‐3, we are examining the effect of price change – ignoring
any income effect.
• The change from A to B (Q3 to Q2) is purely due to the substitution effect
and the relative price change.
Income effect
• However, income has fallen causing the consumer to choose from a lower
indifference curve I2. The change due to income is therefore b to C (Q2 to
Q1.)
• In this case of a normal good, the income and substitution effect reinforce
each other – both leading to lower demand.
Effect of rise in price for inferior good

• The substitution effect (using parallel budget line of B-‐3) causes a fall
from a to b.
• However, the income effect leads to an increase in demand (Q1 to Q2)
• This is because when income falls, the decline in income causes us to buy
more inferior goods because we can’t afford normal / luxury goods
anymore.
Costs of production
• Fixed costs: Costs that do not vary with output e.g. the cost of a factory.
• Variable costs: Costs that do vary with output; e.g. electricity and
materials.
• Total costs: Fixed + variable costs.
o Average Total Cost (ATC) = TC / Q
o Average Variable Cost (AVC)= VC / Q
o Average Fixed Costs (AFC)= FC / Q
Examples of costs

Q FC TC VC AVC = ATC =
VC/Q TC/Q
0 1000 1000 -‐ -‐
1 1000 1200 200 200 1200
2 1000 1300 300 150 650
3 1000 1550 550 183 516.67
4 1000 1900 900 225 475
Diagram of average costs

Law of diminishing returns
This occurs when employing extra workers leads to declining productivity.
• Total product (TP). This is the total output produced by all workers.
• Marginal product (MP). This is the output produced by an extra worker.
• Short run: In the short run, a firm can change a variable factor of
production (e.g. employ more workers) but, cannot change capital.
• Long run. The long run is a period of time where firms can change the
amount of capital, e.g. build a bigger factory.

Example of diminishing returns
Q of workers MP TP MC
1 2 2 10
2 4 6 5
3 6 12 3.3
4 8 20 2.4
5 10 30 2
6 8 38 2.4
7 5 43 4

• The first worker adds 2 goods. If a worker costs £20, the MC of those 2
units is 20/2 = 10.
• The 3rd worker adds 6 goods. The MC of those 6 units is 20/6 = 3.3.
• The 5th worker adds an extra 10 goods. The MC of these 10 is just 2.
• After the 5th worker, diminishing returns sets in, as the MP declines. As
extra workers produce less, the MC increases.
Diagram of diminishing returns

Diminishing returns explained

• Diminishing returns occur in the short run, when one factor is fixed, e.g.
capital.
• If the variable factor of production (labour) is increased, there comes a
point where it will become less productive.
• This is because if capital is fixed, extra workers will eventually get in each
other’s way, as they attempt to increase production.
• Consider a small café with limited space – 5 workers will start to get
crowded.
• When diminishing returns occurs, there will be a decreasing marginal
product (MP) and increasing marginal cost (MC).
• With diminishing returns we will see decreasing returns to scale.

Diminishing returns and marginal cost (MC)

• Because of diminishing returns, we get a SRAC (short run average cost),
which is U-‐shaped.
• The MC always cuts the SRAC at its lowest. When the marginal cost is
higher than average, SRAC will rise.
• When marginal cost is below average, the SRAC will fall.

Economies of scale
Economies of scale occur when long run average costs fall with increasing output.

In industries with economies of scale, we will become more efficient with higher
output, e.g. moving from Q1 to Q2 leads to lower average costs of P2. A bigger
firm will be liable to get improved returns to scale.
Relationship between SRAC and LRAC

In the short run, we get diminishing returns, but over time, we can increase
capital and shift from SRAC1 to SRAC2
Internal economies of scale
Internal economies of scale occur when an individual firm becomes more
efficient. Internal economies include:
1. Specialisation and division of labour. In large-‐scale operations,
workers can do more specific tasks. With little training, they can become
very proficient in their task and this enables greater efficiency. A good
example is an assembly line with many different jobs.
2. Bulk buying. If you buy a large quantity, then the average costs will be
lower.
3. Technical. When a firm benefits from increased scale of production. For
example, a large machine (e.g. blast furnace / combine harvester) would
be inefficient for small-‐scale production; for higher rates of production,
the firm gains a better rate of return.
4. Financial economies. A bigger firm can get a better rate of interest than
small firms.
5. Marketing. If a firm is undertaking a national advertising campaign, it
will be more efficient for large firms.
6. Risk bearing. Bigger firms are able to diversify into different areas. This
gives them a greater ability to avoid an economic downturn.

External economies of scale
This occurs when firms benefit from the whole industry getting bigger.
• For example, if the car industry gets bigger, all car firms will benefit from
better infrastructure, and access to specialised labour.
• This is why firms often concentrate in certain areas, e.g. technology firms
in Silicon Valley, and car firms in the West Midlands.
Diseconomies of scale

• This occurs when long run average costs start to rise with increased
output.
• Therefore, there will be decreasing returns to scale. As the firm gets
bigger it will become more inefficient.
Diseconomies of scale can occur for the following reasons:
1. Poor communication. In a large firm with many workers it can be
difficult to communicate and there may be high levels of bureaucracy.
2. Alienation. Working in a highly-‐specialised assembly line can be very
boring, and therefore workers become de-‐motivated.
3. Lack of control. When there are a large number of workers, it is easier to
escape with not working very hard and productivity could suffer as a
result.
4. External diseconomics of scale. When whole industries get too big and
suffer issues such as congestion and duplication of routes.
Revenue
• Total revenue (TR). This is the total income a firm receives. TR = price ×
quantity.
• Average revenue (AR) = TR / Q.
• Marginal revenue (MR). The extra revenue gained from selling an extra
unit of a good.

Q P TR AR
1 10 10 10
2 9 18 9
3 8 24 8
4 7 28 7
5 6 30 6
6 5 30 5
7 4 28 4

The average revenue will always equal the price and this shows why the demand
curve is the same as the average revenue.

Profit

• Profit = Total revenue (TR) – Total costs (TC) or (AR – AC) × Q.
• Normal profit. This occurs when TR = TC. This is the breakeven point for
a firm. It is the minimum profit level necessary to keep the firm in the
industry in the long run.
• Supernormal profit. This occurs when TR > TC. This is profit above the
breakeven point.
• Operating profit. This occurs where AR >AVC. When average revenue is
greater than average variable cost, the firm is making a contribution
towards its fixed cost.
• Accounting profit. This is the total monetary revenue-‐ total costs. It is
also known as the book-‐keeping profit.
• Economic profit. This is the total revenue -‐ total monetary costs and
opportunity costs. In other words economic profit requires not just a
booking profit, but also to offer a better return than keeping the money in
the bank at 3% interest.

The role of profit in a market economy

1. Incentive. Profit gives entrepreneurs an incentive to set up businesses
and produce goods that are in demand.
2. Signal. Profit acts as a signal for enterprises that are in high demand.
Declining profit can provide a signal to reduce production.
3. Investment. Profit can be used to finance investment in research &
development – to help produce better products.
4. Tax. Governments place corporation tax on company profit to take a
percentage.

Profit maximisation
Profit maximisation will also occur at an output where MR = MC.

Why profit is maximised at MR=MC
• If MR > MC, total profit rises.

• If MR < MC, total profit falls.
• Profit is therefore maximised at Q = 5, where MR=MC.
• This diagram assumes that a firm can know its marginal cost and marginal
revenue. However, in the real world, they may not know exactly and make a
best approximation.

Market structures
Perfect competition
Perfect competition is a market structure where there are many firms and
competitive prices. Features of perfect competition include:
1. Many small firms.

2. Freedom of entry and exit; this will require low sunk costs.
3. All firms produce an identical or homogenous product.
4. All firms are price takers; therefore a firm’s demand curve is perfectly
elastic.
5. There is perfect information and knowledge for both consumers and
producers.

Examples of perfect competition include foreign exchange markets, many
agricultural markets and walking tourist guides around cities.
Diagram for perfect competition long run

This diagram shows perfect competition in the long run equilibrium.
• The diagram on the right shows the industry supply and demand; this sets
the market price of P1.
• Firms are price takers; their demand curve is perfectly elastic.
• Firms will maximise profits, where MR=MC (Q1).
• At this level of output Q1, firms make normal profits (AR=AC).
Efficiency of perfect competition

1. Allocative efficiency. This is because the long run equilibrium (Q1)
occurs where P = MC.
2. Productive efficiency. This is because firms produce at the lowest point
on the SRAC.
3. X-‐efficient. Competition between firms will act as a spur to increase
efficiency and make sure firms use the best combination of inputs.
4. Resources will not be wasted through advertising, because products are
homogenous.
Impact of higher demand in perfect competition

Perfect competition in short run

• If there is an increase in market demand (D2), there will be an increase in
the market price to P2.
• Therefore, the individual demand curve, and hence AR, will shift upwards.
• Firms will now maximise profits at Q2 (where MR=MC).
• This will cause firms to temporarily make supernormal profits (AR-‐AC) ×
Q2.
• However, there is perfect information, so other firms will know this
market has supernormal profits.
• There are no barriers to entry, so this will encourage new firms into the
market, until normal profits are made and prices fall back to P1.

Impact of higher costs in perfect competition

• If firms had a rise in AC, they would start to make a loss.
• But, if firms make a loss, they will close down, causing the market price to
rise until the industry is profitable again.
• Therefore, in the long run, firms in perfect competition will make normal
profits (AR=AC).
Disadvantages of perfect competition

1. No scope for economies of scale. This is because there are many small
firms producing relatively small amounts. Industries with high fixed costs
would be particularly unsuitable to perfect competition.
2. Undifferentiated products. These can be boring, giving little choice to
consumers.
3. Limited investment. Lack of supernormal profit will make investment in
R&D unlikely; this would be important in an industry such as
pharmaceuticals.
4. Limited incentives. With perfect knowledge, there is no incentive to
develop new technologies, because it would be shared with other
companies.
5. Externalities. If there are externalities in production or consumption,
there is likely to be market failure without government intervention.
How realistic is perfection competition?

• In the real world, it is hard to meet all the criteria, such as perfect
information and freedom of entry and exit.
• However, some markets come closer than others. Many markets can be
considered ‘competitive’, even if not quite matching perfect competition.
• These competitive markets with many firms will have a similar outcome
to perfect competition, i.e. low prices and low profits.
• In the real world, firms are often competing on issues, such as quality of
service, quality of product and extra features – rather than price.
Internet and competition

The internet has increased the number of industries which are closer to perfect
competition because:
• It is very easy to check prices (perfect information).

• The internet has helped to reduce costs of entering an industry; you don’t
need a big shop, but can spend a small amount on a website.
• Many firms are producing similar goods.
Internet and lack of competition

• However, the internet is not universally increasing competition. Some
firms have gained strong market power through dominating an aspect of
the internet, such as Google and Facebook.
• It would be difficult to challenge these firms, who have the benefit of
being the first to dominate (first mover).
• Some firms can gain patents on aspects of technology, e.g. patent on
Google search engine algorithm.

Imperfect competition
Imperfect competition is any market structure where firms have a degree of
market power. It is a market structure usually involving a small number of firms.
It includes:
• Monopolistic competition – firms producing differentiated product

• Oligopoly – an industry dominated by a few firms
• Monopoly – An industry dominated by one firm. (Market share of greater
than 25%)

Monopolistic competition
Monopolistic competition is a market structure with the following features:
• Many firms.
• Imperfect knowledge, but entrepreneurs can be aware if firms are making
supernormal profit to encourage entry.
• Freedom of entry and exit. Low barriers to entry.
• Similar goods, but with brand differentiation. For example, some
restaurants will gain a reputation for a certain quality of food.
Examples of monopolistic competition include restaurants, hairdressers and
clothing retailers.
Short run monopolistic competition

• Firms in monopolistic competition produce differentiated products; they
have an inelastic demand curve. This enables them to set a profit,
maximising price similar to monopoly.
• The firm maximises profit, where MR = MC. This leads to supernormal
profit, because AR > AC.
• They are allocatively inefficient (P>MC) and productively inefficient (not
lowest point on AC curve), in both the short run and long run.
Monopolistic competition -‐ long run

• In the long run, new firms are able to enter the market because there is
freedom of entry.
• As new firms enter, the demand curve for the initial firms shifts to the left,
until normal profit is made at P1 (where AR=AC).
Limitations of the model of monopolistic competition

• Some firms will be better at brand differentiation and therefore, in the
real world, will be able to make supernormal profit. New firms will not be
seen as a close substitute.
• There is considerable overlap with oligopoly. The main difference is that
the model of monopolistic competition assumes no barriers to entry. In
the real world, there are likely to be at least some barriers, even if just
through brand loyalty.
• It depends how you define a market. For example a restaurant considered
to be the best in a town, may have significant monopoly power. Takeaway
restaurants may be much more competitive, with lower profits.
• If a firm has strong brand loyalty (and inelastic demand curve) this in
itself is a barrier to entry.

Key difference with monopoly. In monopoly, there are barriers to entry. In
monopolistic competition, there are very few. Therefore, in the long run,
firms in monopolistic competition will make only normal profit.
Key difference with perfect competition. In monopolistic competition,

firms produce differentiated products and, therefore, they are not price
takers (perfectly elastic demand). They have inelastic demand.

Oligopoly
An oligopoly is an industry which is dominated by a few firms. One definition of
an oligopoly is a five firm concentration ratio of more than 50%.

Features of oligopoly include:
1. Interdependence of firms: firms will be affected by how other firms set
price and output.
2. Barriers to entry (but less than monopoly).
3. Differentiated products. Advertising and non-‐price competition are often
important in oligopoly.
How firms in oligopoly behave

There are three main possible ways for firms in oligopoly to compete:
1. Price competitive / price wars. An oligopoly where firms try to gain
market share and where prices and profits tends to be low.
2. Stable prices / focus on non-‐price competition. The kinked demand
curve suggests prices will be stable and firms focus on non-‐price
competition.
3. Higher prices / collusion. If there are barriers to entry, firms may try to
maximise price through increasing prices. This may involve collusion.
The behaviour of firms in oligopoly depends upon factors such as:
• The objectives of the firms, e.g. profit max or sales max.
• The degree of contestability, e.g. amount of barriers to entry.
• Government regulation, e.g. preventing collusion and price fixing.
• The nature of the industry, e.g. is the industry in growth phase or decline?
A declining industry may be more prone to price competition, as firms try
to retain sales.
Game theory
• This examines the behaviour of firms considering how decisions of other
firms affect their own choices. For example, if a firm in oligopoly cuts
price, the outcome will largely depend on how other firms react, e.g. do
other firms also follow suit (starting price war), or do they keep prices
high? There are no guarantees in oligopoly.
The kinked demand curve model

One way of looking at oligopoly is through the kinked demand curve model,
though this makes various assumptions, which may not match reality.
• This model assumes firms seek to maximise profits.

• If a firm increases price, then they will lose a large share of the market,
because they become uncompetitive compared to other firms, and
therefore demand is elastic for price increases.
• If firms cut prices, then they would gain a big increase in market share.
However, it is unlikely that firms will allow this. Therefore, other firms
follow suit and cut prices as well. Therefore, demand is inelastic for a
price cut.
• This suggests that increasing or decreasing prices will lead to lower
revenue and therefore prices will be rigid in oligopoly.

Diagram kinked demand curve model

This suggests that even variations in MC will not affect the price set.
Limitations of this model:
1. The model does not explain how prices were set in the first place.
2. Price stability may be due to other factors.
3. In the real world, firms often do cut or increase price.
4. Firms may not be profit maximisers, but seek increased market share,
even if it means less profit.
Non-‐price competition
If prices are rigid, and firms have little incentive to change prices, they will
concentrate on non-‐price competition. This occurs when firms seek to increase
revenue and sales by various methods, such as:
1. Advertising. This creates product differentiation and brand loyalty.
Advertising can also be used as a barrier to entry.
2. Product development. This could be an effort to improve the quality of
the product, such as mobile phones with more features.
3. Loyalty cards. A reason for customers to come back.
4. Quality of service. Increasing loyalty and making demand more inelastic,
through better quality goods.
5. Location. Better location for firms. For many products, such as
restaurants and cafes, location is everything. Unless you have a good
location, you will not pick up passing trade.

Evaluate a pricing and non-‐pricing method for firms to increase profits
• A pricing strategy involves changing price to try and attract custom, e.g.
cutting price.
• Non price strategy is some aspect of quality, service which encourages
consumption, independent of price.
1. Non-‐pricing strategy -‐ advertising
The aim of advertising is to increase brand loyalty. If firms are successful, then
consumers will wish to buy the product, even at a higher price. Successful
advertising can make demand more inelastic, and therefore increase profits.
Successful advertising can also create a barrier to entry, because a new firm may
be unable to compete with an advertising budget of an incumbent firm, e.g. cola
market.
Evaluation
• It depends on the product. For example, advertising and brand loyalty
appear to be important for soft drinks and cars. However, it would be
relatively ineffective for a product like petrol, where people believe it is
homogenous and price will always remain the most important factor.
• It depends on the quality of advertising. Firms like Nike use top sports
stars to wear their products. This can make people wish to emulate their
heroes, but it can also backfire, e.g. Nike’s long-‐term sponsorship of Lance
Armstrong may diminish people’s view of Nike.
2. Pricing strategy – Price cuts
This involves undercutting rivals, through offering cheaper prices. If demand is
elastic and sensitive to price, this could lead to an increase in sales and an
increase in profits. This might work for a product like petrol and it worked
reasonably well with budget airlines, which were able to offer cheaper prices
than established national carriers.
Evaluation
• It depends how other firms react. If it starts a price war, with other firms
matching your price cut, it could lead to lower prices, as you have cheaper
prices but no increase in sales.
• It depends on the product. Supermarkets sell cheaper cola than Pepsi and
Coca Cola, but they are unable to take market share, because there is such
strong brand loyalty to the product.
Price wars
Firms may not seek to maximise profits but have other aims, such as increasing
market share and expanding the firm. This can explain why firms seek to reduce
prices and start price wars.
• Price wars are more likely in a recession, when demand is falling and
markets become more competitive.
• Price wars tend to be short-‐term because, otherwise, firms will make a
loss.
• Price wars are often selective, e.g. supermarkets have selective price
cuts on “loss leaders”. This can give a misleading impression of price
competition.
• Price wars can be in the public interest, but only if firms don’t get forced
out of business by the low prices.
Predatory pricing
• This occurs when a firm lowers prices in some sections of the market,
with the intent of forcing another firm out of business.
• To set price below cost, the firm will need to cross subsidise the market
from other profitable markets.
• Predatory pricing is against the public interest, because the dominant
firm can increase prices when its rival has left. There is legislation
which makes predatory pricing illegal.
Collusion
• Collusion occurs when firms agree to limit competition, by setting output
quotas and fixing prices.
• A cartel is a formal collusive agreement. For example, OPEC is a cartel of
the major oil producers.
• Tacit collusion is an unwritten agreement where firms observe informal
rules, such as not undercutting rivals. Tacit collusion often occurs if there
is government regulation against cartels and collusion.
• Overt collusion is where firms are open about their deals to set prices and
output.
• Through collusion, firms are able to maximise profits of the industry.
There will be a similar price and outcome to a monopolistic industry, with
firms effectively sharing the supernormal profits.
• Collusion is seen as against the public interest, because of higher prices
leading to allocative inefficiency. There is legislation against collusion and
cartels in the UK.
Breakdown of collusion
• However, when the market price is high, there is a temptation to cheat. If
Tesco cuts prices, whist Sainsbury has high prices, Tesco would make
even more profit (£13m) but Sainsbury would make less (£2m).
• Once a firm cuts prices, it encourages the other to cut prices and we end
up with low prices and low profit.
To keep prices high, there needs to be collusion, either overt or tacit. However,
this might be difficult, due to government regulation and other firms entering the
market.
Factors favouring collusion

1. A small number of firms.
2. A dominant firm who is able to have influence in setting the price.
3. Barriers to entry; this is important to stop other firms entering to take
advantage of the high profits.
4. Effective communication and monitoring of output and costs, and
effective punishment strategies for firms who cheat.
5. No effective government legislation, e.g. collusion is illegal in the UK,
making it more difficult.
Evaluation of collusion

• Collusion enables higher profits. However, if firms are found guilty of
collusion, they can be fined and so end up with lower profits.
• Collusion is unlikely to occur if they aim at sales maximisation.
• Firms may justify collusion on the grounds that it encourages stability,
and the higher profits can be used to finance investment, leading to better
products. However, under collusions, firms may become inefficient,
because it is easy to make profit and they don’t have to try hard.

Monopoly
• A pure monopoly occurs when there is only one firm in the industry.
• In the UK, a firm is said to have monopoly power if it has more than 25%
of the market share.
• A monopoly will have barriers to entry.

Diagram of monopoly

• A monopolist maximises profit, where MR = MC.
• Therefore, it sets price = P1 and quantity = Q1.
• Firm makes supernormal profit = (AR-‐ AC) × Q
• If the market was competitive, output would be Q2 and price P2 (normal
profit).
Disadvantages of monopoly

• Allocative inefficiency, because in monopoly, P > MC.
• Productive inefficient, because output is not at lowest point on AC curve.
• X-‐inefficient, because a monopolist has fewer incentives to cut costs;
therefore AC curve is higher than it could be.
• Less choice for consumers.
• Quality of product could be worse, because there are fewer incentives
for a monopolist to develop new products.
• Monopsony power. A monopoly may also have monopsony power, in
employing workers and buying products. This means the firm can pay
workers lower wages, and supermarkets can pay farmers lower prices.
Advantages of monopolies

1. Economies of scale. If the industry has high fixed costs and economies of
scale, then a large monopolist can bring benefits of lower average costs,
which lead to lower prices for consumers.

Increasing output from Q1 to Q2 leads to lower average costs (P1 to P2).
• Economies of scale will occur most often in industries with high fixed
costs, or scope for specialisation. For example, airlines and car
companies tend to have high-‐fixed costs and therefore there tends to
be only a small number of large firms.
• Note: Economies of scale may be so large that they outweigh
everything else, such as allocative and productive inefficiency.
2. Research and development. A monopolist can use its supernormal
profits, to invest in developing new products which may require high
investment. This is very important for industries, such as the
pharmaceutical industry where, without high profits, they would be
unable to develop new drugs.
3. International competition. A domestic monopoly may be necessary to
compete internationally. For example, Corus is the only steel producer in
the UK, but it faces competition from overseas competitors.
4. Monopolies may be efficient. A firm may gain monopoly power, because
it is efficient and innovative e.g. Google and Apple. A monopoly isn’t
necessarily inefficient; the opposite may be true.
Barriers to entry
These are factors that make it difficult for new firms to enter an industry.
1. High fixed costs. This enables the incumbent firm to benefit from
economies of scale. If a new firm entered the market, it would have higher
average costs and struggle to compete.
2. Vertical integration. This occurs when a firm has control over raw
materials and other supplies necessary for the good. For example, a new
airline may not be able to get landing slots at popular airports.
3. Legal monopoly. For example, a patent on an invention.
4. Advertising. Advertising creates strong brand loyalty to a particular firm,
making it difficult for others to enter.
5. Being the first firm in the industry. For example, Microsoft was the first
firm and therefore people usually buy Microsoft Office to obtain
compatibility with everyone else.
6. Predatory pricing. If an incumbent firm cuts price when a new firm
enters the market, it may be able to force the new firm out of business
and retain its monopoly power.
7. Geographical barriers. Some monopolies are based on having access to
particular locations, e.g. mines, or even motorway service stations.
8. Barriers to exit. If a firm has high costs to leave a market it may deter
entry. For example, if you have to spend a lot on research and
development, you can’t get this back when you leave industry.
Natural monopoly
A natural monopoly occurs when the most efficient number of firms in an
industry is one. This will occur if there are very significant economies of scale in
the industry.

In this example, if the industry demand is 10,000 then, if one firm produces
10,000 units, it can have average costs of £15. If two firms were producing 5,000
each, the average cost would be double (£30). The optimal number of firms is 2.
Contestable markets
• A contestable market is a market where there is free and costless entry
and exit. This requires low sunk costs.
• Sunk costs are costs that cannot be recovered when leaving the market,
e.g. expenditure on advertising is lost.
• In a contestable market, incumbent firms will always have the threat of
new firms entering the industry. Therefore, such a market will have a
competitive equilibrium, even if there are a small number of firms.
A perfectly contestable market has the following three features:
1. Absence of sunk costs
2. Perfect information
3. Freedom to advertise and a legal right to enter the market
Hit and run competition

• If there are low entry and exit costs, then firms can engage in hit and run
tactics. This means that if an industry is making supernormal profits, then
a firm can enter and take advantage of high prices.
• If prices fall and the industry is no longer profitable, then the firm will
leave.
• Therefore, in a contestable market, a firm should be satisfied with normal
profits, otherwise it would encourage hit and run tactics from other firms.
Contestable markets and the public interest

Contestable markets can bring the benefits of competitive markets such as:
• Lower prices.
• Increased incentives for firms to cut costs.
• Increased incentives for firms to respond to consumer preference.
• However, there could also be significant economies of scale, because the
theory of contestable markets doesn’t require there to be many firms.
Implications of contestable markets

• Policy makers should not just look at the degree of concentration, but also
the degree of contestability and how easy it is to enter the market.
• Regulators in the privatised industries have often focused on removing
barriers to entry, rather than breaking up big firms.
• It can be important to allow firms to share a distribution network, which
is a natural monopoly, e.g. consumers can buy gas from different
companies selling gas, whilst using the same national network of gas
pipes.

Concentration ratios
• A five-‐firm concentration ratio measures the market share of the five
biggest firms. A three-‐firm concentration ratio measures the combined
market share of the three biggest firms.

The five-‐firm concentration ratio of the UK supermarket share (2014) is:

1. Tesco 29%
2. Asda 17%
3. Sainsbury 16%
4. Morrison 11%
5. Co-‐op 6%

Total five-‐firm concentration ratio: 79%

• Note with 29% of market share, Tesco is considered a legal monopoly.
• In the UK, a firm is said to be legal monopoly (monopoly power) when it
has more than 25% of the market share).
• We would classify this market as an oligopoly because the market is
dominated by a few firms. There is a five firm concentration ratio of
greater than 50%.
• The three firm concentration ratio would be 62%

Reasons for small firms
Some firms remain small for a variety of reasons:
• Lack of ambition -‐ Some small family firms / sole traders may not want
to expand, because one shop is satisfactory for their needs. Not all firms
aim for profit maximisation or sales maximisation. People may feel
quality of life may be maximised by keeping a firm small and manageable.
• Too much competition -‐ Some markets are very competitive, making it
hard to increase market share.
• Choice -‐ In some markets, like clothes, there are many niche market
segments. Being the cheapest clothes producer is not enough, because
some consumers will never want to buy the cheapest clothes, preferring
the most exclusive.
• Government regulation -‐ Governments can intervene, to prevent the
growth of monopoly power. For example, the Competition Commission
would block a merger between Tesco and Waitrose.
• Lack of access to finance -‐ Many small firms may struggle to raise
finance for investment and expansion.
• Size of the market. -‐Many firms are limited by the market they are in.
Firms who produce niche products, such as clothes for very tall people,
will only have a small market. The only way to grow is to diversify into
related markets.
• Access to key locations -‐ A new airline may struggle to grow, because it
has difficulty getting landing slots at Heathrow airport. This is an example
of vertical constraints to growth.
• Legal barriers -‐ A legal patent may prevent other firms from entering a
certain market. For example, a drugs company may be unable to grow,
unless it can get the necessary patents.
• Tax incentives -‐ If a firm grows in size, it may lose the benefits of
remaining a small firm (e.g. lower corporation tax, VAT and grants from
government).
• Diseconomies of scale -‐ Increasing size may lead to higher average costs
and greater inefficiency, due to difficulties of managing a large firm.
Mergers
• Horizontal merger / horizontal integration. This occurs when two
firms at the same stage of production merge e.g. Guinness and Heineken,
two beer-‐brewing companies.
• Vertical merger / integration. When two firms at a different stage of
production merge. For example, a company who produces beer could buy
a chain of pubs to sell the beer.
• Forward vertical merger. This is when a firm acquires another firm at
the next stage of production, e.g. a firm like Ford which manufactures cars
could purchase a car sales room.
• Backward vertical merger. When a firm acquires another firm at a
previous stage of production, e.g. a clothes retailer buying a manufacturer
of clothes, or a beer producer buying a farm which produces hops
(ingredient used for brewing beer).
• Diversification. When an existing firm moves into a new market. For
example, Virgin Records, diversified into Virgin airways and Virgin trains.
Disadvantages of integration / mergers

If a merger leads to a significant increase in market share, either in local or
national markets, the new firm could exercise monopoly power.
The legal definition of a monopoly is a firm with more than 25% of the market. If
the firm has monopoly power, there could be the following disadvantages:
1. Higher prices leading to allocative inefficiency and a reduction in
consumer surplus.
2. Monopolies are more likely to be productively inefficient.
3. If there is less competition, complacency amongst firms can lead to lower
quality of products, less choice and less investment in new products.
4. The new firm can pay lower prices to suppliers (monopsony power).
5. Mergers can lead to job losses.
6. Motives for mergers may primarily be based on increasing prestige and
wages of workers concerned.
7. If the firm becomes too big, it may suffer from diseconomies of scale.

Potential benefits of mergers

1. Economies of scale. This occurs when a larger firm with increased output
can reduce average costs. This is important for industries with high fixed
costs.
2. Mergers can help firms compete on an international level.
3. Mergers may allow greater investment in R&D, because the new firm will
have more profit. This can lead to a better quality of goods for consumers.
Evaluation of mergers

The desirability of a merger will depend upon several factors, such as:
• Is there scope for economies of scale? What is the extent of fixed costs in
the industry?
• Will there be a significant reduction in competition?
• Is the market still contestable (is there freedom of entry and exit for other
firms)?
• The competition commission will look at each individual case and assess
its relative merits and demerits.

Different objectives of a firm
1. Profit maximisation
In economics, we usually assume firms aim to maximise total profits. The
benefits of maximising profit can include:
• Higher salaries for managers and workers.

• Higher dividends for shareholders.
• Encourages firm to be efficient and to keep looking at cutting costs.
• Higher profit enables more resources to invest in future projects and
safeguards the long-‐term success of the firm.
2. Revenue maximisation and elasticity

• When marginal revenue is positive, it means the firm is increasing its total
revenue.
• If MR is negative, then total revenue is decreasing. Therefore, revenue is
maximised when MR = 0.
Revenue and elasticity
• On a straight demand curve, the elasticity of demand varies. Initially, PED
is elastic. This is because the % change in QD is greater than the % change
in price.
• As price falls, revenue increases (MR>0) because demand is price elastic.
• However, later, the demand curve becomes inelastic. The % change in QD
is less than the % change in price. Here, a fall in price leads to a decline in
revenue, because demand is price inelastic.
• Where MR= 0, PED = 1 (unitary elasticity). At this point, changing price
doesn’t change total revenue; the % change in price is the same as the %
change in QD.
2. Sales maximisation
Firms may seek to increase their market share, even if it means less profit. This
could involve:
• Sales revenue maximisation – maximising total revenue (P*Q)
• Sales volume maximisation – selling as many units as possible – probably
selling goods as cheap as possible without making a loss.

A firm may pursue sales maximisation for various reasons:

• Increased market share increases their monopoly power and may enable
them to put up prices and make more profit in the long run.
• Managers prefer to work for bigger companies, as it tends to lead to
greater prestige and higher salaries.
3. Social / environmental concerns

A firm may incur extra expenses to choose products which don’t harm the
environment, or choose products not tested on animals.
• This can prove a good marketing strategy, e.g. for firms like the Body Shop.
• Organisations like the Co-‐op have a different structure to share profits
amongst consumers and workers.
4. Profit satisficing / divorce of ownership

• In many firms, there is separation of ownership and control.
• We get separation of ownership and control because owners may not
have time to run the day to day aspect of the business, but concentrate on
a small aspect, such as financing business or strategic planning.
• This is a problem because owners may want to maximise profits, but the
managers and workers have much less incentive to maximise profits.
• In this situation of separate ownership and control, managers may create
a minimum level of profit to keep the shareholders happy, but then
maximise other objectives, such as enjoying work and getting on with
staff.
• Profit satisficing is also known as principle/agent problem.
Trying to overcome profit satisficing
• To overcome the problem of profit satisficing, the firm can give workers
and managers performance-‐related pay and share options. This gives
workers an incentive to think like shareholders and maximise profits, and
it could overcome the x-‐inefficiency of workers without incentives.
• It depends on whether firms can give workers a reason to feel motivated
to work hard; this depends on several factors, such as corporate culture.

5. Social welfare
• Some businesses may be set up with aim of promoting social welfare. For
example, housing trusts and co-‐operatives.
6. Corporate social responsibility (CSR)

• This is a business model where the main stakeholders in a business are
considered – beyond the usual profit maximisation aims.
• For example, there may be concern for working conditions, and the
impact of the firm on the local community and environment.
7. Survival
• Some firms may just be concerned to survive. For example, build up
savings, reduce costs and just do enough to stay in business.
Behavioural analysis
Also the decision of firms may depend on how they interact with other firms.
Kinked demand curve (See oligopoly). This suggests that prices will be stable.
The prisoner’s dilemma and game theory

• The prisoner’s dilemma is a situation where two agents may not co-‐
operate – despite co-‐operation being in their best interests. It is an
example of game theory application.
• A simple example in economics could be two firms (Sainsbury and Tesco)
who have a choice to set high or low prices.
• If both firms set high prices, they make high profit (£9m each)
• If they compete with each other and set low prices, they will make just
£3m each.
Tesco
Sainsbury High Price Low Price
High Price T=£9, S=£9 T =£13, S = £2
Low Price T=£2, S =£13 T = £3, S = £3

Breakdown of collusion
• However, when the market price is high, there is a temptation to cheat. If
Tesco cut price, whist Sainsbury have high price, Tesco make even more
profit £13m, but Sainsbury make less £2m.
• Once a firm cuts price, it encourages the other to cut price and we end up
with low prices and low profit.
• To keep prices high, there needs to be collusion – either overt or tacit. But,
this might be difficult due to government regulation, and other firms
entering the market.

Diagram showing different objectives

• P1, Q1 – Profit maximisation -‐ because it is the output where MR=MC
• P2, Q2 – Revenue maximisation -‐ because it is the output where MR=0
• P3, Q3 – Marginal cost pricing -‐ P=MC (allocative efficiency)
• P4, Q4 – Sales maximisation -‐ The maximum sales a firm can make whilst
making normal production

Factors which influence choice of objectives
• Aims of owners. Some owners may be motivated by the prospect of
profit. Entrepreneurs may set up business hoping to secure their financial
future. Others may be more concerned with ideas of social welfare.
• Public opinion. Adverse publicity can encourage firms to take social
welfare more importantly, e.g. firms may suffer a backlash against ‘sweat
shops’ of cheap labour. This may encourage multi-‐nationals to promote
schemes for the betterment of developing countries.
• Social concern could increase profit. It could be argued that making
statements of social concern and giving some profit back to charity can
enhance a firm’s long-‐term reputation and become a good marketing
strategy. For example, companies with a reputation for tax avoidance can
suffer consumer boycotts.

Price discrimination

Price discrimination occurs when a firm charges a different price for the same
good to different groups of consumers.
• 1st Degree price discrimination. This is where the firm charges the
maximum price that a consumer is willing to pay. This is very difficult in
practice.
• 2nd Degree price discrimination. This is when consumers are charged
different prices according to how much they consume. For example, units
of electricity become cheaper after higher levels of consumption.
• 3rd Degree price discrimination. This is when consumers are grouped
into two or more independent markets. For example, train companies
offer discounts for people over 65 and to people travelling off-‐peak.
Conditions necessary for price discrimination

1. The firm must be a price maker, i.e. able to set prices. Price discrimination
can only occur in imperfect competition (oligopoly or monopoly).
2. The firm must be able to separate the market into different sections and
prevent resale, e.g. it must be impossible for an adult to use a child’s ticket.
3. There must be a different elasticity of demand for the different market
sections, e.g. train firms can charge high prices at peak times because, in
this period, demand for train travel is inelastic.
4. The cost of separating markets must be less than extra revenue gained.
5. It usually requires low or constant marginal cost.

Diagram of price discrimination

This diagram shows how a profit-‐maximising firm can use price discrimination
to charge different prices to different segments.
• We assume marginal cost is the same for both groups.

• Market A has an inelastic demand; therefore, the price is higher, than
market B, where demand is more elastic.
Advantages of price discrimination

1. Firm will be able to increase revenue. This may enable some firms, who
may have otherwise have made a loss to stay in business, e.g. train
companies need price discrimination to offer off-‐peak travel.
2. Research & development. Increased revenue can be used for research
and development, which leads to better products for consumers.
3. Cheaper prices. Some consumers, often on lower incomes, will benefit
from lower fares, e.g. pensioners can take advantage of cheaper fares on
trains.
Disadvantages of price discrimination

1. Higher prices. Some consumers will face higher prices, leading to
allocative inefficiency and a loss of consumer surplus.
2. Inequality. Often those who benefit from lower prices may not be the
poorest. For example, some old people may be quite rich, but the
unemployed will have to pay the full adult fare.
3. Administration costs involved in separating the markets and
implementing different prices.
Common examples of 3rd degree price discrimination
• Student discounts. Many shops offer 10% discount to students. This is
because students have limited income and are more likely to be sensitive
to price. It is relatively easy to separate the market, e.g. check students
have a student card.
• Buy in advance. If you are able to buy train tickets in advance, you can
often have a big discount on original price. This is because people
planning ahead have more time to choose means of travel, and will be
more sensitive to price.
Limit pricing

• This occurs when a firm sets price sufficiently low to deter entry.
• For example, if a monopolist set a very high price, he would maximise
his profits but new firms may be encouraged to enter because of the
level of profit.
• Limit pricing would involve firms reducing prices -‐ making less profit,
but setting prices sufficiently low to deter new firms entering; this
enables them to maintain their monopoly position.
• The firm may create enough spare capacity to create a credible threat
to increase supply to deal with new firms.

Price leadership

• This can occur in an oligopoly where one firm has a significant market
share. If this dominant firm changes price, it will have a big impact on the
market, and will often encourage other firms to follow suit.

• For example, if OPEC cut supply to increase oil prices, they will tend to
have big impact on oil prices.

Government intervention to correct market failure
Tax
• Tax shifts the supply curve to the left and makes the good more expensive.
This will reduce demand.
• The government can use tax for demerit goods and goods with negative
externalities.
Diagram specific tax

• A specific tax places a certain per unit tax on the good. It is the same
whatever the price, for example, tobacco duty or alcohol excise duty.
• In this case the specific tax is £15, and it reduces the quantity from Q1 to
Q2.
• The price rises from £52 to £60.
• A specific tax can be used to make consumers pay the full social cost of
demerit goods, such as alcohol and tobacco.
Ad valorem tax

An ad valorem tax places a certain percentage on the good. For example, VAT in
the UK is 20%. The higher the price of the good, the more tax is paid.
Tax to overcome market failure

• The ideal tax would be equal to the external marginal cost.
• This makes consumers pay the full social marginal cost.
• Tax shifts the supply curve to S2 and reduces demand to Q2, which is the
socially efficient level (SMC=SMB).
Advantages of taxes
• Raises revenue for the government to spend on alternatives.
• Internalises the externality (tax makes people pay the full social cost).
• Creates incentives in the long-‐term to encourage firms to reduce pollution
or provide alternatives.
• Tax can also alter consumer behaviour in the long-‐term. For example,
higher petrol tax may encourage consumers to buy a bicycle.
Evaluation of taxes

• If demand is inelastic, tax will only have a minimal effect in reducing
demand. This may occur if there are no alternatives to the good e.g. oil.
• High taxes may encourage tax evasion, e.g. cigarette tax encourages
cigarettes to be smuggled on the black market.
• High specific taxes will be regressive. They take a higher percentage of
income from the poor than high-‐income earners.
• There may be administration costs in implementing new taxes, e.g. it
would be difficult to implement a congestion charge for small cities.
• It can be difficult to measure the external cost and how much tax should
be increased.
Subsidy
The aim of subsidies is to encourage consumption of goods which are
underprovided / under-‐consumed in a free market.

• In this example, the free market equilibrium is at Q1, P1 (S=D).
• A subsidy of P0-‐P2 shifts the supply curve to S2 and reduces price to P2.
• At this price, the quantity demanded is Q2. This is a socially efficient level
because at Q2, SMB=SMC.
Evaluation of subsidies

• Cost to the government. Subsidies will be expensive and will require
higher taxes on other goods.
• If demand is inelastic, a subsidy will be ineffective in increasing demand.
For example, a subsidy on train travel may be ineffective if it is a poor
substitute to driving a car.
• A firm that receives a subsidy is more likely to be inefficient, as they
become reliant on the government subsidy. Subsidies may keep inefficient
firms in business.
• There may be government failure, e.g. the government has poor
information about who to subsidise.
• Subsidies may be most effective if combined with other policies, e.g. tax
on driving and subsidies to reduce cost of buses.
Pollution permits
These involve giving firms a legal right to pollute a certain amount, e.g. 100 units
of carbon dioxide per year.
• If the firm produces less pollution, it can sell its permits to other firms.
• However, if it produces more pollution, it has to buy permits from other
firms.
• There will be a market for pollution permits. If firms pollute a lot, there
will be low supply and high demand; therefore the price will be high for
permits.
• Therefore, there is a financial incentive for firms to cut pollution.
Problems of pollution permits

• Difficult to know how many permits to give in the first instance.
• It may be difficult to accurately measure pollution levels. There is an
incentive for firms to hide pollution.
• In most markets, it requires global co-‐operation to make it effective,
otherwise the industry will move to countries with lower environmental
legislation. Also, pollution is very much a global problem requiring global
solutions.
• High administration costs of measuring pollution and enforcing permits.

Information provision
The government may seek to overcome market failure through providing
information about certain goods.
• For example, the government may run campaigns to warn about the
health dangers of tobacco and alcohol. These are demerit goods, where
people may not know the costs of consumption.
• Providing information can help overcome information asymmetries.
• The government can try ‘nudge’ consumer behaviour. E.g. discourage
cigarette consumption by making packets look unattractive.
Evaluation
• Government advertising campaigns will cost money and require higher

taxes.
• There is no guarantee people will listen or take note of government
campaigns. Young people may choose to ignore campaigns about the
dangers of alcohol because they enjoy a sense of rebelliousness.
• However, over time, people have become aware of the dangers of tobacco
and long-‐term smoking rates have been falling.
Regulation
To overcome market failure, the government may use laws and regulations to
prohibit certain behaviour.
• For example, rather than try and tax cocaine to make people pay the full
social cost, they may just prohibit its production and consumption.
Evaluation
• Regulation is simple and can be effective in preventing damaging goods
and services from being produced. However, sometimes no pollution is
not the most efficient level of production in society.
• It depends on the enforceability. For example, when the US prohibited
alcohol, it was very hard to enforce. People kept drinking but organised
crime became more powerful and more successful because illegal alcohol
was in high demand.
State provision of public services

For some merit goods and public goods, the most efficient solution for market
failure is for the government to provide services directly.
Advantages of state provision
• It ensures everyone has access to this important merit good and provides
greater equality in society.
• A national health service may be able to benefit from economies of scale,
leading to lower average costs than small independent hospitals.
• For services like health and education, workers do not need the same
profit motive of a private manufacturing firm. Therefore, there is less
likely to be government failure due to a lack of incentives.
• Public goods like law and order may not be provided at all in a free
market.
• It is difficult to introduce a profit motive into public services such as
health care; for example, it is not practical to give performance related
pay to nurses / doctors. Also, the private sector may cut costs by reducing
the quality of service, e.g. cutting back on cleaning.
However
• State provision of public services could lead to higher levels of
bureaucracy and government failure through lack of incentives in the
public sector.
Nationalisation
When industries are nationalised (owned by government), prices and output
decisions can be set by government bodies, e.g. setting gas prices to be in the
social interest and ensure affordability.
• However, there is a problem of government failure, e.g. not knowing what
prices to set.
Privatisation
This is when state owned assets are sold to the private sector. The argument is
that the private sector will have a profit incentive to cut costs and become more
efficient. This may lead to lower prices.
• However, the problem with privatisation is that you may create private
monopolies, who end up charging higher prices because there is a lack of
competition.
Deregulation
This involves removing barriers to new firms entering a market. Deregulation
often occurs with privatisation – to try and increase competition in privatised
industries.
• However, the problem is that some natural monopolies can be difficult to
make more contestable. It is hard to increase competition when there are
very high economies of scale.

Regulation of monopolies
Governments can prevent mergers, but some firms are already monopolies or
have significant monopoly power (e.g. privatised monopolies, such as gas,
electricity, trains). In this case, there needs to be regulation of monopoly firms.
This includes:
1. Regulate prices -‐ prevent excessive price increases.

2. Profit regulation – Look at the profitability of firms. If it is excessive
compared to similar firms, it is a sign the firm is abusing monopoly
power.
3. Monitor quality of service, performance targets, and investment
levels
4. Encourage competition – removing barriers to entry.
Price-‐cap regulation
• Regulators have the power to limit price increases or order firms to cut
prices by a certain amount.
• This is done through CPI – X (or RPI-‐X). This means that firms have to cut
prices by an amount x after taking inflation into account.
• In certain industries like water, regulators use CPI + K. Where K is the
amount they can increase prices to fund necessary capital investment.

Advantages of RPI – X regulation
1. The system provides an incentive for firms to increase efficiency.
2. Different prices can be set depending upon the circumstance of the
industry, therefore the system is flexible.
3. The regulator should be independent of the government and the firm and
can therefore act in the interests of the consumer.
4. If the information the regulator has is good then they can increase
allocative efficiency by setting prices close to marginal cost.

Disadvantages of the RPI -‐ X system
1. Regulators have often underestimated the potential cost savings of firms,
therefore x has been too low and regulation too soft. This has allowed
firms to increase their profits at the expense of consumers.
2. Regulators have been accused of regulatory capture. This occurs when
the firm persuades the regulator to look favourably upon the industry; if
the firm can control the information the firm receives, this is easier to do.
3. On the other hand, if regulators become too strict with the firm it may
hamper investment. Firms may be reluctant to invest if they fear the
regulator will make them cut prices.
4. Regulators need to look at more than just price. For example, they should
consider performance targets and quality of service.

Equity and inequality
Policies to reduce inequality could include:

1. Means tested benefits

Means tested benefits involve transfer payments to those on low incomes. For
example, universal tax credit, income support, child benefit.
A transfer payment means giving money without recompense of service / good.

Advantages of means tested benefits:

• They allow money to be targeted to those who need it most. e.g. family tax
credit or pension credit.
• It is cheaper than universal benefits and reduces the burden on the tax
payer.
• Benefits are an essential source of income for those in the lowest income
deciles.

Problem with means tested benefits

1. Poverty trap. Means tested benefits may create a disincentive to earn a
higher wage, because if you do get a higher paid job you will lose at least
some of your benefits and pay more tax. This is known as “the benefit trap”
or the “poverty trap”.
2. The poverty trap occurs where people on low incomes are discouraged
from working extra hours or getting a higher paid job because any extra
income they earn will be taken away in lost benefits and higher taxes.
• To avoid the poverty trap the government can grade benefits
so that there isn’t an immediate cut off point. (e.g. government
tax credits to those in work)
3. Some relatively poor may fall just outside the qualifying limit for means
tested benefits.
4. Also not everyone entitled to means tested benefit will collect them
because of ignorance or difficulties in applying.
5. Means tested benefits are often unpopular because people are stigmatised
as being poor.
6. In recent years, the welfare state has faced increased demands due to
demographic factors leading to more calls for means tested benefits.

2. Progressive Taxes

• Increasing progressive taxes, such as the higher rate of income tax from
40% to 50%, will take more income from those on high income levels.
This enables cuts in regressive taxes and / or increased benefits which
help increase the income of the poor. This can be an effective way for
reducing relative poverty.
• However, critics argue higher income taxes create a disincentive to work,
leading to less output. This is because higher tax makes work less
attractive and reduces the opportunity cost of leisure. Therefore people
work less and enjoy more leisure. This is known as the substitution effect.
• However the impact of higher taxes on disincentives depends. Higher tax
reduces incomes and this may encourage people to work more, to
maintain their income. (This is known as the income effect)
• Evidence suggests that higher income tax has little incentive on the
supply of labour, suggesting labour supply is relatively inelastic. However,
it also depends at what level income tax is set. There is certainly a level
where higher income tax will reduce incentives to work.

Negative income tax

This is a form of progressive income tax where people earning below a certain
amount get additional benefits from the government. It is a way of guaranteeing
a minimum basic income.

• However, it can lead to disincentive effects of earning more.

Capital gains tax and inheritance tax.

Capital gains tax an inheritance tax can help to redistribute wealth (stock of
assets / money). Taxes on wealth tend to be relatively lower.
3. Reduce unemployment

Unemployment is a major cause of poverty because the unemployed have little
income, relying on state benefits. Unemployment can be reduced through both
supply side and demand side policies (see notes on Unemployment for more
detail)

4. National minimum wage / living wage

Another policy to reduce income inequality is a statutory minimum wage, e.g. in
UK £6.70 an hour (Oct 2015-‐16). This helps increase the income of the low paid.

• However, if set too high, a minimum wage could cause unemployment

Measuring Poverty
The Lorenz curve. This measures the degree of income inequality. The further
the Lorenz curve is from the 45 degree line of perfect equality, the more
inequality there is in society.

In this diagram the

poorest 50% of the
population have 27%
of total income.
This means the

richest 50% have
73% of total income.

2. Gini Coefficient This is a measure of inequality based on the Lorenz curve:
• The Gini coefficient is area a / a+b.

• The bigger area ‘a’ is, the more inequality exists.
• A Gini coefficient of 0 = perfect equality.
• A Gini coefficient of 1.00 = perfect inequality.
In the 1980s, the UK saw a significant rise in income inequality, which has been
maintained in the past two decades.
Intergenerational inequality
In recent years, the UK has seen more wealth inequality and intergenerational
inequality. This is because:
• Rising house prices have increased wealth of home-‐owners (who tend to
be older)
• Rising house prices have prevented young people buying – meaning they
have to rent, which doesn’t enable increased wealth in long-‐term.
• Wealth can be inherited. It depends on parents.
• Wealth attracts less tax. Inheritance tax has been cut, so many
homeowners don't’ pay tax on inheritance.
Labour markets
Labour market terminology
• Labour productivity – output per worker in a certain period of time.
• Unit labour costs – average cost per worker, including wages, taxes and
insurance.
• Human capital – the skills and educational attainments of workers.
• Nominal wages = monetary amount of wages for a worker
• Real wages = nominal wages – inflation, e.g. if nominal wages rise 7%,
but inflation is 2.5% -‐ real wages rise 4.5%
Factors affecting labour productivity

• Wage rate. A higher wage may make workers more motivated to work
hard. If wages are low, they may be less worried about losing their jobs.
• Technology. Improved technology will enable workers to be more
productive and produce more in the same amount of time.
• Management. Good working relationships and management can inspire
workers to work harder. Poor labour relations can lead to lower
productivity.
• Education and skills. If labour becomes better educated and gains
valuable skills, they can increase their productivity.
• Flexibility of workers. Can workers take on different tasks to avoid
bottlenecks.
Factors that affect unit labour costs

• Nominal wage rates. Wages are the biggest component of unit labour
costs
• Taxes on labour, e.g. employer national insurance contributions
• Statutory maternity / paternity paid leave. Firms have to pay benefits to
workers on maternity leave.
Labour demand
• Labour is a derived demand. This means that demand for labour
depends on the demand for the goods they produce. If there is more
demand for going to restaurants, then there will be more demand for
catering staff.
• The demand for labour will be determined by the workers’ marginal
revenue product (MRP). This is the value that a worker can give a firm.
• Marginal revenue product (MRP) = MPP × MR. MRP is effectively the
increase in revenue a firm gains from employing an extra worker.
• Marginal physical product (MPP). This is the increase in output that an
extra worker produces.
• Marginal revenue (MR). This is the revenue that a firm gains from
selling the last unit of output. It is related to the price.
Factors that determine demand for labour

• Productivity (MPP) of workers – higher productivity = higher demand.
• Demand for the good. If there is high demand for watching footballers,
clubs will be willing to pay higher wages, because there is more money in
the sport. Footballers will have a high MRP.
• Substitutes to labour. In some production processes, firms could
substitute workers for machines (e.g. assembly lines).
• Wages. Higher wages cause a movement along the demand curve.
• Non-‐wage costs. This includes paying national insurance, health
insurance, and potential redundancy pay.
Higher demand for labour (curve shifting to the right) could be due to:
• Economic growth causing more demand for the product, e.g. with greater
demand for tourism, there will be increased demand for taxi drivers.
• Higher productivity of workers – leading to higher MPP, e.g. better
technology.
• Changes in tastes and fashion causing more demand for the good.
Increased popularity of coffee shops leads to increased demand for
baristas.
Elasticity of demand for labour

The elasticity of demand for labour measures how responsive demand for labour
is after a change in wages. Elasticity of demand for labour depends on:
• How essential is the worker? Can labour be substituted for capital? For
example, with automated checkouts, workers can be substituted for
machines and labour demand will be more elastic.
• Number of people with qualifications and skills. If only a small
number of workers have qualifications, demand will be more inelastic.
• Time period. In the short term, demand for labour will be inelastic.
However, over time, it becomes easier to substitute labour for capital, so
demand becomes more elastic.
• Proportion of wage costs. If labour is a high % of total wage costs, the
firm will be more sensitive to a rise in wages.
Workers with inelastic demand are hard to replace. Therefore, they tend to have
greater bargaining strength and can demand higher wages.

Supply of labour
• Higher wages usually encourage a worker to supply more labour, because
work is more attractive compared to leisure.
• Substitution effect of a rise in wages. Workers will tend to substitute
income for leisure, because leisure now has a higher opportunity cost.
This effect leads to more hours being worked as wages rise.
• Income effect of a rise in wages. This effect involves workers working
fewer hours when wages increase. This is because workers can get a
higher target income by working fewer hours.

Backward bending
supply curve

After a certain point,

higher wages may lead
to lower labour supply
because workers can
reach their target
income with fewer
hours.

Different workers will have different preferences. A worker with little expenses
may find the income effect soon dominates and higher wages encourage him to
work less and choose more leisure time.
Market supply of labour depends upon:

1. Wage rate. Higher wages cause a movement along the supply curve.
2. The number of qualified people and the difficulty of getting
qualifications. If there were more people qualified to be lawyers, the
supply curve would shift to the right.
3. The non-‐wage benefits (non-‐pecuniary) benefits of a job. This includes
status, job security, danger of job, how enjoyable the job is, the length of
holidays and other fringe benefits. E.g. if tube drivers have to start
working nights, it may reduce supply of workers because it becomes a
less attractive job.
4. Population / demographics. Net immigration into the UK has increased
the supply of nurses, cleaners, and other service sector workers.

Wage determination in competitive markets
• The equilibrium wage rate in the industry is set by the meeting point of
the industry supply and industry demand curves (We).
• In a competitive market, firms are wage takers (We) because if they set
lower wages workers would not accept the wage.

• Because firms are wages takers, the supply curve is perfectly elastic,
therefore the wage = AC = MC.
• The firm will maximise profits by employing at Q1, where MRP = MC.

Diagram: comparison of wages in different industries

In diagram on left, elastic supply and demand lead to lower wages
In diagram on right, inelastic supply and demand lead to higher wages.

Low wage job
• In the diagram on the left, supply and demand are both elastic. This could
be an unskilled job such as a cleaner or retail assistant.
o Many people have sufficient qualifications to be a cleaner,
therefore supply is elastic.
o Also, demand is relatively elastic, because cleaners have a low MRP.
High wage job
• On the right, supply and demand are inelastic, leading to a higher wages.
o This could be a lawyer, where the number of qualified lawyers is
limited.
o Demand for lawyers is likely to be high and inelastic, because a
successful lawyer could make a big difference to the profit of a
company. Therefore, they have a high MRP.
Economic rent and transfer earnings

• Transfer earnings are the minimum wage that a worker needs in order to
make him take a job.
• Economic rent is anything above the transfer earnings.
If a worker would be willing to work as a cleaner for £7 an hour – but he got paid
£10 an hour then his economic rent would be £3.
Market failure in labour markets
Monopsony
This occurs when there is just one buyer of labour in a market, or if the firm has
substantial market power in employing workers.
Diagram of Monopsony
• The marginal cost of employing one more worker will be higher than the
average cost. This is because, to employ one extra worker, the firm has to
increase the wages of all workers.
• Therefore, MC is steeper than AC.
• To maximise the level of profit, the firm employs Q2 of workers where
MC = D (MRP).
• Therefore, in a monopsony, the firm only has to pay a wage of W2. This is
less than the competitive wage of W1.
• The monopsony also employs fewer workers than a competitive market.
• Lack of information, and difficulties in switching jobs, gives many firms a
degree of monopsony power.

Geographical immobilities
Workers and firms can find it difficult to move, because of geographical
immobilities. For example, because of high living costs, it may be difficult for
workers to buy / rent a house in London. Therefore, there can be labour
shortages in London, but high unemployment in depressed areas.

Government policies to deal with geographical immobilities
1. Building new houses in popular areas. However, this is difficult to do,
because of limited space in places like the South East and London. It
would also require huge house-‐building programmes to bring prices
down.
2. Subsidies to encourage firms to move to depressed areas. However,
firms may be reluctant to relocate to the north, even with subsidies,
because of limited infrastructure, which makes business harder.
3. Wage bonuses for expensive areas. The government could pay a wage
bonus for those living in London and other areas of high house prices.
However, this would become a very expensive way of dealing with the
problem.
Occupational immobilities
• Often, vacancies remain unfilled because unemployed workers have
inadequate skills to take on the jobs. This leads to occupational
immobilities and structural unemployment.
• The UK has many vacancies in jobs, such as HGV drivers. This is partly due
to the UK not valuing practical vocational jobs as much as ‘academic
qualifications’.
• A shortage of skills may be more common in an economy facing rapid
technological and social change.
Government policies to deal with skills shortages

1. Government provision of education and training. This is important
with the greater focus on vocational skills needed by the economy.
• However, it is expensive and there is a concern that people may not
want to undertake government training schemes, though the
government could make training schemes a requirement of receiving
benefits.
2. Government subsidies to firms who provide training schemes. This
helps to overcome government failure, as the firm is likely to have better
knowledge of the skills that industry really needs.
• But the government still needs to evaluate which firms would be good
to support.

Trades Unions
Trade unions represent workers. They can seek to:
• Increase wages for workers through collective bargaining.

• Try to improve working conditions and safety of the work place.
• Help implement new working practises which leads to higher
productivity.
Impact of trade unions depends on
• Union density. If 90% + of workforce are in the union, they will have
more bargaining power to increase wages.
• Type of job. If many workers are in the same position (e.g. coal miners)
they have more collective influence. If the workforce is more diverse,
working at different times (e.g. service sector), they have less power.
• Impact of strike. If the job is critical to the firm or economy, threats of
strikes have more power, e.g. tube drivers can have a big impact on
London; if teachers go on strike it is less influential in the short term.
Impact of trade union in competitive labour market

This increase in wages will cause a fall in employment. Thus, in competitive
labour markets, trades unions can cause unemployment.

Trades Unions could increase wages to W2. This would reduce demand to Q2.
The level of unemployment would be Q3-‐Q2.
However the impact of a trade union depends upon:
• Elasticity of demand for labour. If demand is inelastic, higher wages will
have little impact on reducing demand for labour.
• Unions could bargain for higher wages in return for increasing labour
productivity. If MRP of workers increases, firms can afford higher wages.

Trade unions and monopsony
If a firm has monopsony power, it will be paying a lower wage of W2, and
employing just Q2.

• If a trade union bargains for a higher wage (of W3), there will be no fall in
employment. Demand will still be Q2.

National minimum wage
With the decline of trade unions, the national minimum wage has become more
significant for dealing with issues of low pay.
• From October 2015, the national minimum wage will be £6.70 an hour for
workers aged over 21. There are lower rates for young workers.
• The government has indicated it will significantly increase the minimum
wage for adult workers to £9 an hour by 2020.
• This is an attempt to match the living wage – a level deemed necessary to
deal with current living costs.
Issues with a minimum wage

Potential unemployment
• A minimum wage above the equilibrium could cause unemployment of

Q3-‐Q1. This is because the minimum wage of W2 reduces demand for
workers to Q1.
• This is particularly a concern for some industries where wages are a high
percentage of costs, e.g. hairdressers or service sector workers, such as
cleaners.
• A substantial rise in the minimum wage will be more likely to cause
unemployment in low wage regions, such as the north. It will have less
impact in London and the south.

Minimum wage and monopsony
• A minimum wage could counter-‐act the effect of a monopsony employer,
an employer who pays lower wages and employs fewer workers.

• A monopsony is able to pay a wage of W2 and employ Q2.
• If the NMW increased wages to NMW 1, the demand for labour would stay
at Q2 and not cause any fall in employment.
• If the NMW was set at level W1, demand for labour would actually
increase to Q1.
Do firms in the UK have monopsony power?

• Some jobs, like firemen, only have a government employer, so that is a
classic example of a monopsony.
• In theory, many service sector workers are free to choose employers but,
in practice, it is difficult to switch jobs. There are many costs and
uncertainties in applying for a job with higher pay.
• Therefore, arguably, many firms in the UK have a degree of monopsony
power, though it will depend on the industry and skillset of the workers.
National Minimum Wage and elasticity of demand and supply
• If demand for labour is inelastic, a national minimum wage would cause
little, if any, fall in demand for labour.
• For example, if wages increase for the whole service sector industry, they
can pass the wage costs on to consumers.

National minimum wage and elasticity of demand and supply

• In this case, a NMW only causes a very small fall in demand for labour,
from Q1 to Q2.
2. Regional variations. A minimum wage may be insufficient to provide a living
wage in London because of higher living costs. But, in the north, employers may
not be able to afford it.
To what extent are wages determined by MRP theory?

MRP and supply of labour provide a good starting point for wage determination.
But, in the real world, other factors can determine wages, including:
• Discrimination. Firms may not be rational, but pay some workers
different wages on the grounds of age, race, or gender. Alternatively, firms
may be unwilling to employ / promote people of certain sex or ethnic
minority.
• Difficulty of measuring MRP. Many workers do not produce a
quantifiable product, e.g. with nurses, teachers and doctors it is hard to
measure how hard they work.
• Regional labour markets. In the UK, many labour markets are highly
regional. In London, it is expensive to live, and there are more job
vacancies. Firms often need to pay higher wages in London to attract
workers.
• Different aims of workers. Some workers may not aim at wage
maximisation – or progressing in their career. Some workers may prefer
more leisure time or take out time from work for family reasons.
Government failure
• Government failure occurs when government intervention in the economy
causes a net welfare loss.
• People also refer to government failure when government efforts to
overcome market failure do not succeed.
Causes of government failure

1. Lack of incentives working for the government. Government bodies do not
have the same profit motives of private companies. Therefore managers and
workers may feel no incentive to work hard or cut costs. The result can be
government agencies that are inefficient, with higher costs and not producing
what people need.
2. Unintended consequences Often government intervention tries to solve one
problem, but another problem is created. For example:
• Minimum prices in agriculture were an attempt to stabilise farmers’
incomes. However, the unintended consequence of guaranteed minimum
prices was that it encouraged over-‐production. Farmers used chemicals to
maximise yields – knowing the government would buy any surplus. This
proved expensive and inefficient.
• By increasing taxes on tobacco, the government made it more
profitable for people to smuggle cigarettes from Europe.
• A maximum price on renting property could lead to a decline in
available housing for renting – worsening the housing crisis rather than
helping.
• Higher income tax may discourage people from working.
3. Lack of information. Government bodies can suffer from a lack of knowledge
about how to intervene, just as we can get a lack of information in a free market.
• For example, it can be difficult for a government body to calculate the net
external costs of a new airport or nuclear power.
• Governments may fail to predict future trends, e.g. the impact of
minimum prices on incentives in the long-‐term.
4. Administration costs. Any government intervention is likely to have some
administration costs and bureaucracy.
Can government failure be overcome?

• Governments can try to give civil servants and public sector workers
performance related pay.
• Many areas of government spending are non-‐profit making industries,
and people are motivated by desire to offer quality of care / service (e.g.
doctors, teachers).

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Types of efficiency

2. Allocative efficiency. This occurs when goods and services are

Externalities and social efficiency

• Social benefit is the total benefit to society.

Price Quantity PMB XMB SMB

• Social cost is the total cost to society.

• Social marginal cost (SMC) = private marginal cost (PMC) + external

Price Quantity PMC XMC SMC

• However, this is socially inefficient.

• When producing a good causes a benefit to a third party.

Problems with using Cost-­‐Benefit Analysis

Advantages of Cost-­‐Benefit Analysis

Cost-­‐Benefit Analysis in Practise

• Faster journey times.

Price Quantity Marginal utility (MU

Example 1: Marginal utility of Goods A and B

Units MU good A MU Good B

• Because 16/£1 = 16/£1

Units MU A/ £4 MU B /2

• 2 units of A (MU A/Price A = 8)

Behavioural economic models

• The amount of information they have.

Example of indifference curve

Diminishing marginal utility and indifference curves

Optimal choice of goods for consumer

Using indifference curves to show different effects

Effect of rise in price for inferior good

Examples of costs

0 1000 1000 -­‐ -­‐

1 1000 1200 200 200 1200

2 1000 1300 300 150 650

3 1000 1550 550 183 516.67

4 1000 1900 900 225 475

Diagram of average costs

Diagram of diminishing returns

Relationship between SRAC and LRAC

Diseconomies of scale

The role of profit in a market economy

• If MR > MC, total profit rises.

1. Many small firms.

Impact of higher demand in perfect competition

Impact of higher costs in perfect competition

Disadvantages of perfect competition

How realistic is perfection competition?

Internet and competition

• It is very easy to check prices (perfect information).

Internet and lack of competition

• Monopolistic competition – firms producing differentiated product

Short run monopolistic competition

Limitations of the model of monopolistic competition

Key difference with perfect competition. In monopolistic competition,

How firms in oligopoly behave

The kinked demand curve model

• This model assumes firms seek to maximise profits.

Factors favouring collusion

Evaluation of collusion

Disadvantages of monopoly

Advantages of monopolies

Problems with using Cost-‐Benefit Analysis

Advantages of Cost-‐Benefit Analysis

Cost-‐Benefit Analysis in Practise

0 1000 1000 -‐ -‐

1. Regulate prices -‐ prevent excessive price increases.