Slides - Business - Tech - and Finance - C13 2

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FINANCIAL ANALYSIS DEPARTMENT
BUSINESS, TECHNOLOGY, AND FINANCE
CHAPTER 13: The economic

environment of business and finance
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Contents
1. Introduction to the economic environment
2. The macroeconomic environment
3. The market mechanism
4. Demand
5. Supply
6. The equilibrium price
7. Elasticity
8. Types of market structure
9. The failure of perfect competition
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Learning Objectives
Specify the signaling, rewarding, and allocating effects of the
price mechanism on business;
Specify the potential types of failure of the market
mechanism and their effects on business;
Identify the key macro-economic factors that affect
businesses
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Syllabus link
Business Strategy and Technology, Financial Management at the Professional
level & at the Advanced level
References are 6a, b,c
Assessment context
MCQ;
Straight tests of knowledge;
Applications of knowledge to a scenario
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1. Introduction to the economic environment

Economic environment of business and finance
The macroeconomic environment:
National influences: the business cycle; government policies (fiscal and
monetary policy, interest rates, exchange rates, inflation
Global influences: internationalization of trade, influence of regional
economic groups (EU, ASEAN), globalization of markets.
The micro economic environment:
How the market (or price) mechanism works?
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2.1. The national economy
Gross Domestic Product (GDP)
Definition
Formula
Importance
Limitation
Factors determining GDP
GDP & GNP & GNI
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Definition: The amount of national output by firms or government
agencies which produce goods and services in the national economy
The total monetary or market value of all the finished goods and services
produced within a country’s borders in a specific time period.
The total value added. (the final product)
The aggregate amount of income of the economy.
Must be a flow variable (restarted after a specific time period)
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Formula
Measuring spending: GDP = Consumer Spending (C) + Business Investment (I)
+ Government Spending (G) + (X-M)
Measuring income: National Income + Indirect business taxes & depreciation +
Net foreign factor income
National Income: Wages paid to labor; the rent earned by land; interest of capital;
the entrepreneur’s profit
Indirect taxes: sales taxes and property taxes
Net foreign factor income = Foreign payments in – Foreign payment out
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Importance: a measure of the economic activity in a country
An aggregate of personal incomes: the bigger this is, the more income
individual inhabitants will be earning on average;
More income means more spending by consumers (households); more
spending (not considering the effects of price rises) means that a higher output
of goods and services is required to produce;
Growth in GDP per head of population is an economic policy objectives. The
growth potential of an economy will depend on the amount of factors of
production available, and their productivity.
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The role of the government in the national economy
Producer: certain goods and services instead of privately-owned firms, and
public administration services, education and health services, the police force,
armed force, fire services and public transport.
Purchaser: It acts a the purchaser of final goods and services and add to total
consumption expenditure. National and local government obtain funds from the
firms or households of the economy in the form of taxation.
Investor: by purchasing capital goods, for example, building roads, schools and
hospitals.
It makes transfer payments from one section of economy to another.
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The role of the consumer in the national economy
Disposable income: Income available to individuals after payment of
personal taxes. It may be consumed or saved.
Factors affecting consumption by households:
Changes in disposable income, and the marginal propensity to consume: pay rises and
changes in tax rates. An increase in disposable income (from a pay rise, or a reduction in
tax rates) may increase consumption and have no effect on savings.
The marginal propensity to consume (MPC): How far an increase in disposable income is
allocated to consumption rather than saving. Marginal propensity is a component of
Keynesian macro theory; is calculated as the change in consumption divided by the
change in income.
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Changes in the distribution of wealth: Some sections of the population will
have a higher MPC than others so a redistribution of wealth might affect
consumption by taxing the rich and giving to the poor in the form of more
government allowances.
Government policy: Through taxation and and/or public spending.
The development of major new products: can create a significant increase in
spending by consumers who want to buy the goods and services.
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 Negative multiplier effect: when an initial withdrawal of spending from the economy leads to
knock-on effects and a bigger final fall in real GDP.
 Causes of negative multiplier effect:
 Fall in consumer spending
 Fall in investment
 Fall in exports
 Fall in government spending
 Tax- reducing disposable income
 Imports-spending flows abroad
 Save – household income saved rather than spent
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Coronavirus and negative multiplier effect
A decline in travel – leading to falling revenue for airlines and travel
companies
A decline in trade and firms running out of spare parts
A fall in confidence causing a decrease in travel and a decrease in investment
=> These effects all causes a fall in demand and lower economic growth.
However, they can exacerbated by a negative multiplier effect which affects
people not directly linked to the virus.
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Interest rates: Changes in interest rates will influence the amount of income
that households decide to save, and also the amount that they might elect to
borrow for spending. High interest rates will make saving more attractive
while low interest rates will reduce the cost of credit and will therefore
increase borrowing and levels of consumption.
Price expectations. Expectations of price increases may increase current
consumption while expectations of price reductions may have the opposite
effect.
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The role of the saver in the national economy
Saving is the amount of income which is not consumed. The influences
which affect savings are very similar to those that affect consumption in
the inverse direction.
Income: a key determinant in the level of savings;
Interest rates and the cost of credit;
Long-term savings: A large amount of household savings goes into long-
term, contractual savings such as pension schemes.
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The role of investment by businesses in the national economy
Factors affecting investment:
The interest rate on capital (the price of money)
Expectations about the future and business confidence
The strength of consumer demand for goods
The opportunity cost of investment
The level of new technology to be invested in
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The impacts of high interest rate:
Firms will demand a higher return when appraising investments and so some
investments may not occur => restricting economic growth.
Individuals will be tempted to consume less of their income and save more,
so that they will invest more of their savings => to hold less cash and more
interest-bearing investment.
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The impacts of new technology:
A boost to investment:
If it reduces the unit costs of production via new methods of production
(such as robotics) then new technology will increase profitability. Firms
will invest in order to achieve lower costs and remain competitive.
If it leads to new types of good then new technology will stimulate
demand. Firms will invest to make the product and meet the consumer
demand.
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How to finance investment:
Private sector investment: REs, new issues of shares, or borrowing. However,
it depends on the economic situation.
Public sector investment: higher taxation or an increased deficit between
government income and expenditure (a higher Public Sector Net Cash
Requirement). This might force up interest rates in the capital markets and
crowd out private sector investment.
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2.2. The business/trade cycle
Business cycles/trade cycles: The continual sequence of rapid
growth in GDP, followed by a slow-down in growth and then a fall.
Growth then comes again, and when this has reached a peak, the
cycle turns once more.
Four main phases of the business cycle can distinguished
Recession (A)
Depression (B)
Recovery (C)
Boom (D)
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Recession:
Economic downturn is where the growth rate falls and may become
negative – leading to a fall in national output.
 It is a period of decline in general economic activity, typically defined
when an economy experiences a decrease in its GDP for two consecutive
quarters.
Business suffers a loss in sales revenue.
The knock-on effect of reducing inventory and cutting back on investment
might exacerbate the situation and add momentum to the recession.
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Recession:
Consumer demand falls
Investment projects already undertaken begin to look unprofitable
Orders are cut
Inventory levels are reduced
Business failure occur as firms find themselves unable to sell their goods
Production and employment fall
General price levels begin to fall
Business and consumer confidence diminish
Investment remains low
The economic outlook appears to be poor
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Depression: is a severe and prolonged downturn in economic activity.
A depression is commonly defined as an extreme recession that last
three or more years or results in a drop in annual GDP of at least 10%.
Depression and recession differ both in duration and the severity of
economic contraction.
The Great Depression lasted about 10 years and widely considered to
be the worst economic downturn in the history of the industrialized
world. It began shortly after the Black Thursday.
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2.2. The business/trade cycle The Great Depression
in 1929
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Recovery: Governments will try to limit the decline by boosting demand
in the economy as a whole.
The recovery is a phase that economic growth becomes positive and
growth rates pick up.
Output, employment, and income will all begin to rise
Business expectations will be more optimistic so new investment will be more
readily undertaken
The rising level of demand can be met through increased production by bringing
existing capacity into use and by hiring unemployed labor.
The average price level will remain constant or begin to rise slowly.
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Boom (upswing/upturn/a growth period): significant growth in
GDP;
Booms are often medium to long-term periods of economic growth,
and may eventually turn into a bubble. A bubble is when the boom
extends far beyond the fundamental growth trend in value where
buyers become irrationally exuberant.
The cyclical nature of the economy and markets generally mean that
periods of high-growth booms are followed by low-growth busts.
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During the boom:
Capacity and labor will become fully used => bottlenecks in some
industries
Further rises in demand will therefore be met by price rather than
production increases
Business will be profitable, with few firms facing losses
Expectations of the future may be very optimistic and the level of
investment expenditure high
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Avoiding the ‘boom’ and ‘bust’ cycle: Government generally seek
to stabilize the economic system:
In a recession they will try to boost overall demand
In a boom, they will try to keep dampen overall demand
through raising taxation or interest rates, and by reducing
public expenditure
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2.3. Inflation
Definition: An increase in price levels generally, and decline in the
purchasing power of money.
Deflation: Falling prices generally, which is normally associated
with low rates of growth and recession.
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2.3. Inflation
Why is inflation is a problem?
Redistribution of income and wealth: from suppliers to consumers
because outstanding amounts lose ‘real’ value with inflation. Moreover,
those with fixed income such as pensioners and low-paid, far worse than
those with significant earning power because the nominal amount of fixed
income stays the same but its purchasing power falls.
Balance of payment effects: If a country has a higher rate of inflation
than its major trading partners, it exports will become relatively expensive
and imports relatively cheap.
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2.3. Inflation
Price signaling and ‘noise’:
Inflation, especially high rate, can undermine the ability of price
mechanism to influence the allocation of resources in an economy.
Business confidence is undermined because planning and forecasting
are less accurate.
Inflation is often considered as ‘noise’ in an economy due to these
above reasons.
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2.3. Inflation
Wage bargaining: Wage demands increase in times of high inflation.
Waste of time to negotiate new wage rates rather than producing new
goods.
Consumer behavior: Keep goods leading to shortages for other people.
Consumers become more anxious to consume now rather than waiting
until costs rise => raise consumption and push price up even further.
A spiral that can contribute to hyper - inflation
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2.3. Inflation
How to measure Inflation in the UK?
Consumer Price Index (CPI): official measure based on EU HCIP (Harmonized
Consumer index prices). Includes taxes; excludes mortgage interest payments
and housing costs; includes some financial services not included in RPI.
CPIH = CPI with housing costs
CPIY = CPI less indirect taxes (VAT and excise duty)
CPT-CT = CPI with indirect taxes
Core inflation: small basket of goods
RPIJ = RPI (Retail Price Index)
Wage rate
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2.3. Inflation
Types of inflation
Demand pull: Price rises resulting from a persistent excess of demand
over supply in the economy as a whole. Supply cannot grow any further
when ‘full employment’ of factors of production is reached.
There are two main causes of demand pull inflation:
Fiscal: an increase in government spending or a reduction in taxes will
raise demand in the economy.
Credit: Extended credit leads to a rise in expenditure. Inflation is likely
accompanied by customers increasing their debt burdens.
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2.3. Inflation
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2.3. Inflation
Types of inflation
Cost push inflation: Prices rise resulting from an increase in the costs of
production of goods and services.
Some causes of cost push inflation:
Rising oil prices
Higher direct taxes (VAT)
Rising nominal wages
Rising food and energy prices
Devaluation – rising import prices ( increase the domestic price of imports => rising
cost of imports => increase inflation)
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2.4. Government objectives and policies
Monetary policy and aggregate demand
Interest rate: the relationship between interest rate and the
level of expenditure in the economy or the rate of inflation.
In the UK, the objective of monetary policy is to reduce the
rate of inflation to sustainable low level principally. It also helps
support consumer spending and to shorten the recession.
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Monetary policy and aggregate demand
A rise in interest rate will lead to:
The price of borrowing will rise
The spending will fall
The connection between interest rates and investment is not a stable and
predictable. Interest rate changes are only likely to affect the level of expenditure
after a considerable time lag.
The exchange rate for sterling will be higher
Capital inflows from sterling investments
A reduction of aggregate demand in the economy
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Fiscal policy and aggregate demand
Fiscal policy: The government’s policy on government spending, taxation
and borrowing.
Spending: Increased government spending increases the size of the
economy => expenditure and GDP increase;
Taxation: Increased taxation without increased government spending
reduces the size of the economy.
Borrowing: Public Sector Net Cash Requirement (PSNCR).
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Fiscal policy and aggregate demand
Increased borrowing and spending => expansionary fiscal stance
Increased taxation but no increase in spending (or decreased borrowing
and decreased spending) => contractionary fiscal stance
Increased taxation and spending => broadly neutral fiscal instance
(income diverted from one part of the economy to another)
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Supply-side macroeconomic problems
Macroeconomic demand – side intervention by Government using
monetary and fiscal policy may be harmful:
Demand management interventions are inflated in the long-run
High taxes act as a disincentive to economic activity
Political motivation leads to uncertainty and discourages the long-term
investment
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The main supply side macroeconomic policies are:
More involvement of the private sector
Reduction in taxes
Increasing flexibility in the labor market
Improving education and training to enhance the capacity of an economy
Increasing competition
Abolition of exchange controls and allowing the free movement of
capital
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3.1. What is a market?
A single geographical place where people meet to buy and sell
goods.
Buyers and Sellers who influence the market price.
Worldwide markets such as oil, wheat, cotton, and copper
Local markets such as housing market or market for second-hand
cars
Market mechanism: The interaction of demand and supply for a
particular item.
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3.1. What is a market?
Market: A situation in which potential buyers and potential sellers
(or ‘suppliers’) of an item (or ‘good’) come together for the
purpose of exchange.
Price of goods is determined by the interaction of demand and
supply.
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4. Demand
Demand: The quantity of a good that potential purchasers would
buy or attempt to buy, if the price of the good were at a certain
level.
 Demand curve: graphically shows the relationship between
demand for a good and the price of the good.
The demand curve is derived by estimating in a demand schedule
(how much of a good would be demanded at various hypothetical
market prices)
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4. Demand
Example: Suppose that the following demand schedule shows demand for biscuit
by one household over a period of one month.
Price per Kg ($) Quantity demanded at this price

1 29/3
2 8
3 25/4
4 9/2
5 8/3
6 1
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4. Demand
What factors determine demand?
Within the control of the business: Seven Ps
Price - Product
Marketing research - Price
Product research and development - Promotion
Advertising - Place
Sales promotion - People
Training and organization of sales force - Processes
Effectiveness of distribution - Physical evidence
After-sales service
Granting of credit to customers
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4. Demand
Outside the control of the business:
Price of substitute goods (items to which the consumer will switch if the
price changes)
Price of complementary goods (items which the consumer buys as a result
of buying the goods, such as blades for razors)
Consumers’ income
Fashion and expectations
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4. Demand
Price: the higher the price, the lower will be the quantity
demanded. This dependence of demand on price applies to all
goods and services.
The demand law: How the quantity demanded will change in
response to a change in price provided that all other factors
affecting demand are unchanged.
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4. Demand
Impact of price on the demand curve: A movement along the demand curve
Impact of other factors on the demand curve: A shift of a demand curve
Substitute goods are goods that are alternative to each other, so that an
increase in the demand for one is likely to cause a decrease in the demand for
another.
Rival brands of the same commodity, like Coca-Cola and Pepsi
Tea and coffee
Bus rides and car rides
Some different forms of entertainment
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4. Demand
Complements: are goods that tend to be bought and used together, so that
an increase in the demand for one is likely to cause an increase in the
demand for the other. Examples of complement are:
Cups and saucers
Holidays and travel insurance
Cars and the components and raw materials that go into their manufacture
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4. Demand
Income levels: normal and inferior goods
A rise in income may increase demand for a particular good => These
goods are called normal goods (necessary goods).
Demand for a particular good may rise with income up to a certain point
but then falls as income rises beyond that point => These goods are called
inferior goods.
Remember that normal goods or inferior goods not refer to the quality of
a good. It means the relationship between demand and income.
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4. Demand
Income distribution
What do you think might be the demand for swimming pools among a
population of five households enjoying total annual income of $ 1
million, if the distribution of income is either as under assumption 1 or
as under assumption 2?
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4. Demand
Income distribution
Household Annual income Annual income
Assumption 1 Assumption 2
1 950,000 200,000
2 12,000 200,000
3 13,000 200,000
4 13,000 200,000
5 12,000 200,000
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4. Demand
Fashion and expectations
A change in fashion will alter the demand for a product.
Expectations will alter the demand for a product.
Fear of war, the effect of strikes
Prices are expected to fall => purchasing might be postponed
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4. Demand
Shifts of the demand curve to the right:
Taste shift to greater popularity
Population likely to buy rises
Income rises (for a normal good)
Price of substitutes rises
Price of complements falls
Future expectations encourage buying
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4. Demand
Shifts of the demand curve to the left:
Taste shift to less popularity
Population likely to buy drops
Income drops (for a normal good)
Price of substitutes falls
Price of complements rises
Future expectations discourage buying
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5. Supply
What is meant by ‘supply’?
Supply: the quantity of a good that existing suppliers or would-be
suppliers would want to produce for the market at a given price.
Supply curve: show the quantity suppliers are willing to produce
at different price levels. It is an upward sloping curve from left to
right.
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5. Supply
What factors influence supply?
The price obtainable for the good
The prices of other goods
The price of related goods
The cost of making the good
Changes in technology
Other factors
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5. Supply
The effect of time on supply and demand
In the short-run both supply and demand are relatively
unresponsive to changes in price, as compared to the long run.
In the case of supply, changes in quantity of a good supplied often
require the laying off or hiring of new workers, or installation of
new machinery.
In the case of demand, it takes time for consumers to adjust their
buying patterns.
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Price signals and incentives
Businesses’ supply decisions will be influenced by both demand and
supply considerations
Market demand conditions influence the price that a supplier will get for
its output. Prices act as signals to suppliers, and changes in prices should
stimulate a response from a supplier to change its production quantities.
Supply is also influenced by production costs and profits. The objective of
maximizing profits provides the incentive for suppliers to respond to
change in price or cost by changing their product quantities.
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What is the equilibrium price?
Equilibrium price: The price of a good at which the volume demanded by
consumers and the volume businesses are willing to supply are the same.
The forces of supply and demand push a market to its equilibrium price and
quantity.
If there is no change in the determinant of supply and demand, the
equilibrium price will rule the market and will remain stable.
If the equilibrium price does not rule, the market is disequilibrium, but
supply and demand will push prices towards the equilibrium price.
Shifts in the supply curve or demand curve because of determinants other
than price will change the equilibrium price and quantity.
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Adjustments to equilibrium
Increase in consumer incomes: rise in market price & rise in quantity
supplied
Product becomes unfashionable: Fall in market price & Fall in quantity
supplied
Improvement in production technology: Fall in market price & Rise in
quantity supplied
Rise in factor costs: Rise in market price & Fall in quantity supplied
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Price regulation
Government might introduce regulations either:
To set a maximum price for a good: the ceiling price
To set a minimum price for a good: the floor price
If the maximum price is higher than equilibrium price, it existence will have
no effect at all on the operation of market force.
If the maximum price is lower than the equilibrium price would be, there will
be an excess of demand over supply. There might be an existence of the
black market.
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7. Elasticity
Price elasticity of demand (PED)
Definition: The extent of a change in demand given a change in price
PED = %Change in quantity of demanded/% Change in price
PED might be positive
PED less than 1 => inelastic demand
PED more than 1 => elastic demand
PED = 1 unit elasticity
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7. Elasticity
Elastic and inelastic demand
Where demand is inelastic, the quantity demanded changes by a smaller
percentage than the percentage change in price.
Where demand is elastic, demand changes by a larger percentage than
the percentage change in price.
Which of the following goods have elastic demands and inelastic
demand?
Gasoline; college textbooks; coffee; airline tickets; concert tickets; soft
drinks; medical procedure.
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7. Elasticity
Inelastic demand Elastic demand
Gasoline Gas from a particular station
Traditional textbooks New textbook distribution channel
Specialty Coffee Drinks Black Coffee
Concert tickets Airline Tickets
Medical procedure Soft drinks

ACADEMY OF FINANCE
ICAEW – CFAB
7. Elasticity
Special values of price elasticity of demand
Demand is perfectly inelastic: PED = 0. This is the case where the demand
curve is a vertical straight line.
Demand is perfect elastic: PED = . This is the case where the demand
curve is a horizontal straight line.
Unit elasticity of demand. PED = 1. The percentage change in quantity
demanded is equal to the percentage change in price. Demand changes
proportionately to a price change.
ACADEMY OF FINANCE
ICAEW – CFAB
7. Elasticity
What is the significance of price elasticity of demand?
When demand is elastic, an increase in price will result in a fall in the
quantity demanded such that total expenditure will fail.
Demand inelasticity above zero means an increase in price will still result
in a fall in quantity demanded but total expenditure will rise.
With unit elasticity, expenditure will stay constant given a change in price.
ACADEMY OF FINANCE
ICAEW – CFAB
7. Elasticity
Positive price elasticities of demand: Giffen goods and Veblen
goods
Giffen goods: The rise in price will reduce consumers’ real incomes, and
will therefore affect their ability to buy goods and services.
Robert Giffen observed that this income effect could be so great for
certain basic goods that the demand curve may be upward sloping. The
price elasticity of demand would be positive.
Veblen goods: The demand curve for a good might also slope upwards if
it is bought for purpose of ostentation, so having a higher price tag makes
the good more desirable to consumers and thus increase demand =>
conspicuous consumption.
ACADEMY OF FINANCE
ICAEW – CFAB
7. Elasticity
Factors influencing price elasticity of demand for good
Availability of substitutes
The time horizon
Competitors’ pricing
Luxuries and necessities
Percentage of income spent on a good
Habit-forming goods
ACADEMY OF FINANCE
ICAEW – CFAB
7. Elasticity
Income elasticity of demand
Income elasticity of demand: An indication of the responsiveness of
demand to change in household incomes.
Income elasticity of demand =
Income elasticity is greater than 1=> income elastic. Usually luxury goods.
0< income elasticity < 1 => income inelastic. Normal goods.
Negative income elasticity => inferior goods.
ACADEMY OF FINANCE
ICAEW – CFAB
7. Elasticity
Cross elasticity of demand
Definition: A measure of the responsiveness of demand for one good to
changes in price of another good.
Cross elasticity of demand =
If the two goods are substitutes, cross elasticity of demand will be
positive.
If two goods are complements, cross elasticity of demand will be
negative.
If two goods are unrelated goods, cross elasticity of demand will be zero.
ACADEMY OF FINANCE
ICAEW – CFAB
7. Elasticity
Price elasticity
Definition: A measure of the responsiveness of supply to change in price.
Price elasticity of supply =
Where the supply of goods is fixed whatever price is offered, supply is
perfectly inelastic and the elasticity of supply is zero. The supply curve is a
vertical straight line.
Where the supply of goods varies proportionately with the price => there is
unit elasticity of supply.
Where the producers will supply any amount at a given price but none at all
at a slightly lower price => Perfectly elasticity. The supply curve is a
horizontal straight line.
ACADEMY OF FINANCE
ICAEW – CFAB
7. Elasticity
Elasticity of supply and time
The market period: supply is fixed
The short run: suppliers can produce larger quantities only if they are not
already operating at full capacity; they can reduce output fairly quickly by
means of lay-offs and redundancies.
The long run: New suppliers can enter the industry in the long run. There
is time to build new factories and machines, and time for old ones to be
closed down.
ACADEMY OF FINANCE
ICAEW – CFAB

Market structure: a description of the number of buyers and sellers in
a market for a particular good, and their relative bargaining power.
Perfect competition
Many small (in value) buyers and sellers which, individually, cannot influence the
market price
No barriers to entry or exit, so businesses are free to enter or leave the market
as they wish
Perfect information such that production methods and cost structure are
identical
Homogeneous products
No collusion between buyers or sellers
ACADEMY OF FINANCE
ICAEW – CFAB

Consequences of perfect competition:
Suppliers are price takers
All suppliers only earn normal profits
There is a single selling price
In practice, perfect competition is often seen as an ideal state because:
Barriers of entry
Asymmetric information
Goods are differentiated
There may be collusion
ACADEMY OF FINANCE
ICAEW – CFAB

Monopoly
One supplier (or one dominant supplier)
Many buyers
Entry barriers:
Patent protection
Access to unique resources
Unique talent
Public sector monopoly
Size domination of market
ACADEMY OF FINANCE
ICAEW – CFAB

Consequences of monopoly:
Businesses can either set the selling price or determine the quantity
supplied
Monopolists can earn greater than normal profits
Monopolists can be further classified as follows:
A pure monopoly
An actual monopoly
A government franchise monopoly
A natural monopoly
ACADEMY OF FINANCE
ICAEW – CFAB

Monopolistic competition:
Many buyers and sellers (as in perfect competition)
Some differentiation between products
Branding of products to achieve this differentiation
Some (but not total) customer loyalty
Few barriers to entry
Significant advertising in many cases
ACADEMY OF FINANCE
ICAEW – CFAB

Oligopoly:
A few large sellers but many (often small buyers)
Product differentiation
A high degree of mutual interdependency
Consequences:
Businesses compete through non-price competition
Price cuts are generally copied by competitors
Price increases are not always copied
ACADEMY OF FINANCE
ICAEW – CFAB

Duopoly:
Two dominant suppliers who between them control prices
A temptation for the suppliers act in collusion
=> High price and limited competition
ACADEMY OF FINANCE
ICAEW – CFAB

Is perfect competition the best structure?
Advocates of the free market
Free markets are efficient
Free markets are impersonal
Allocation of economic resources: Allocative efficiency and Productive
efficiency
In reality, these assumptions of the free market are often invalid => The
free market often fails to allocate resources efficiently.
ACADEMY OF FINANCE
ICAEW – CFAB

Market failure
Definition: A situation in which a free market mechanism fails to
produce the most efficient (the ‘optimum’) allocation of resources.
The causes of market failure:
Market imperfection with one, or a few, suppliers exerting market power
Externalities
The existence of public goods and benefits that are gained by third parties
Economies of scale. Large-scale production leads to reduction in cost per
unit, which are not matched by price reductions. This leads to above-normal
profits and enables large companies to dominate small companies.
ACADEMY OF FINANCE
ICAEW – CFAB

Market imperfection
Monopoly
Monopsony buyers
Information asymmetry
The slow response of the price mechanism to changes in demand creates
some short-run inefficiency in resource allocation
ACADEMY OF FINANCE
ICAEW – CFAB

Externalities
Definition: The difference between the private and the social costs, or
benefits, arising from an activity.
A cost or benefit which the market mechanism fails to take into account
because the market responds to purely private signals. One activity might
produce both harmful and beneficial externalities.
There are instances when either:
Suppliers or buyers do things which give benefit to others, but no rewards to
themselves;
Suppliers or buyers do things which are harmful to others, but at no cost to
themselves.
ACADEMY OF FINANCE
ICAEW – CFAB

Public goods
Definition: Public goods are things whose production is organized by the
government.
National defence
Policing
ACADEMY OF FINANCE
ICAEW – CFAB

Economies of scale
Definition: Economies of scale refers to the cost advantages experienced
by a company when it increases its level of output.
Reasons:
Internal economies: economies arising within the business from the
organization of production;
External economies: economies attained by businesses because of the
growth of the industry as a whole.
ACADEMY OF FINANCE
ICAEW – CFAB

Internal economies of scale: arise from the more effective use of available
resources, and from increased specialization, when production capacity is
enlarged.
Specialization of labor
Division of labor
Large and more specialized machinery
Dimensional economies of scale
Buying economies
Indivisibility of operations
Holding inventory
ACADEMY OF FINANCE
ICAEW – CFAB

External economies of scale: occur as an industry grows in size.
A large skilled labor force
Specialized ancillary industry
Large consumer market: internal economies of scale dominates
Ancillary services: external economies of scale dominates

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ACADEMY OF FINANCE

CHAPTER 13: The economic

1. Introduction to the economic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

2. The macroeconomic environment

3. The market mechanism

3. The market mechanism

Price per Kg ($) Quantity demanded at this price

6. The equilibrium price

6. The equilibrium price

6. The equilibrium price

6. The equilibrium price

Gasoline Gas from a particular station

Traditional textbooks New textbook distribution channel

Specialty Coffee Drinks Black Coffee

Concert tickets Airline Tickets

Medical procedure Soft drinks

8. Types of market structure