Edexcel A2 Economics

Unit 3 Business Economics & Economic Efficiency 7th Edition: September 2009

Author: Geoff Riley

Head of Economics, Eton College

- 2 -

tutor2u www.tutor2u.net

Edexcel A2 Economics – Unit 3: Business Economics & Economic Efficiency

I gratefully acknowledge the help of fellow EconoMax and Tutor2u Economics Blog authors Mark Johnston, Penny Brooks, Mark Johnston, Liz Veal, Mo Tanweer, Tom White and Bob Nutter for some of the ideas and arguments contained within this edition of the Edexcel Unit 3 course companion.

Geoff Riley

Contents 1.  Objectives ....................................................................................................................................................... 3 

2.  Company growth ........................................................................................................................................... 6 

3.  Revenue ........................................................................................................................................................ 11 

4.  Costs .............................................................................................................................................................. 14 

5.  Economies and diseconomies of Scale .................................................................................................... 23 

6.  Productive and allocative efficiency ....................................................................................................... 37 

7.  Normal and supernormal profit ............................................................................................................... 43 

8.  Profit Maximisation .................................................................................................................................... 44 

9.  Barriers to market entry and exit ............................................................................................................ 50 

10.  Market concentration ................................................................................................................................. 54 

11.  Perfect Competition ................................................................................................................................... 55 

12.  Monopoly ..................................................................................................................................................... 62 

13.  Monopsony .................................................................................................................................................. 76 

14.  Oligopoly ..................................................................................................................................................... 78 

15.  Monopolistic Competition .......................................................................................................................... 90 

16.  Contestable Markets .................................................................................................................................. 92 

17.  Government intervention to maintain competition in markets ............................................................ 96 

- 3 -

tutor2u www.tutor2u.net

1. Objectives

"There is one and only one social responsibility of business – to use its resources and engage in activities designed to increase its profits so long as it stays within the rules of the game, which is to say, engages in open and free competition without deception or fraud." Source: Milton Friedman

Is the quote from Milton Friedman relevant today? The standard theory of the firm assumes that businesses have enough information, market power and motivation to set prices that maximise profits. But this assumption is now criticised by economists who have studied the organisation and objectives of modern-day corporations. Not only do most businesses frequently move away from pure profit seeking behaviour, many are nor organised and set up in a way where profit is not the only objective.

There will always be a range of business objectives:

1. Profit maximisation

2. Revenue maximisation

3. Increasing and protecting market share

4. Surviving an economic downturn

5. Pursuing ethical business objectives

6. Providing a public service – see later sections on nationalised industries

Why might a business depart from profit maximisation?

There are numerous possible explanations. Some relate to the lack of accurate information required to set profit maximising prices. Others concentrate on the alternative objectives of businesses. We start first with the effects of imperfect information. It might be hard for a business to pinpoint precisely their profit maximising output, as they cannot accurately calculate marginal revenue and cost. Often the day-to-day pricing decisions of businesses are taken on the basis of “estimated demand conditions” or “rules of thumb”. Or a business might simply look to add a profit margin on top of their average cost – this is known as “cost-plus pricing”.

Secondly, most businesses are multi-product firms operating in a range of markets across countries and continents – as a result the volume of information that they have to handle can be vast. And they must keep track of the ever-changing preferences of consumers. The idea that there is a neat, single profit maximising price is redundant.

Behavioural Theories of the Firm

Behavioural economists believe that modern large-scale businesses are complex organizations made up various stakeholders. Stakeholders are defined as any groups who have a vested interest in the activity of a business. Examples might include:

o Managers employed by the firm

o Shareholders – people who have an equity stake in a business

o Customers

o The government and it’s agencies including local government

Each of these groups is likely to have different objectives or goals at points in time. The dominant group at any moment can give greater emphasis to their own objectives – for example price and output decisions may be taken at local level by managers – with shareholders taking only a distant and imperfectly informed view of the company’s performance and strategy.

If firms are likely to move away from pure profit maximising behaviour, what are the alternatives?

- 4 -

tutor2u www.tutor2u.net

1. Satisficing behaviour involves the owners setting minimum acceptable levels of achievement in terms of business revenue and profit.

2. Sales Revenue Maximisation

The objective of maximising sales revenue rather than profits was initially developed by the work of William Baumol whose work focused on the behaviour of manager-controlled businesses. Baumol argued that annual salaries and other perks might be closely correlated with total sales revenue rather than profits. Companies geared towards maximising revenue are likely to make frequent and extensive use of price discrimination as a means of extracting extra revenue and profit from consumers.

3. Managerial Satisfaction model

An alternative view was put forward by Oliver Williamson (1981), who developed the concept of managerial satisfaction (or managerial utility). This can be enhanced by raising sales revenue.

Price and output differs if the firm changes its objective from profit to revenue maximisation. Assuming that the firm’s costs remain the same, a firm will choose a lower price and supply a higher output when sales revenue maximisation is the main objective. The profit maximising price is P1 at output Q1 whilst the revenue maximising price is P2 at output Q2.

A change in the objectives of the business has an effect on welfare and in particular the balance between consumer and producer surplus. Consumer surplus is higher with sales revenue maximisation because output is higher and price is lower. Producer surplus is greater when profits are maximised.

Social Entrepreneurs

A social enterprise is a business that has social objectives whose profits are reinvested for that purpose in the business or the community, rather than being driven by the need to seek profit to satisfy investors. Social entrepreneurs are looking to achieve social and environmental aims over the long term.

Examples include

o Café Direct o Fair Trade o Traidcraft o Divine Chocolate

o The Eden Project o Fifteen Foundation (Jamie Oliver) o Housing Associations

Costs

Output (Q)

AC

AR (Demand)

MR

MC

Q1

P1

AC1

Profit Max at Price P1

P2

AC2

Q2

Revenue Max at Price P2

- 5 -

tutor2u www.tutor2u.net

o Micro-credit developed by the Grameen Bank

Case Studies in Social Entrepreneurship

An example from India

Devi Prasad Shetty strives to make sophisticated health care in India available to all irrespective of their economic situation or geographic location. Shetty has built a network of 39 telemedicine centres to reach out to patients in remote rural areas. Together, the network of hospitals performs 32 heart surgeries a day. Almost half the patients are children and babies. Sixty percent of the treatments are provided below cost or for free.

And one from the UK

Belu Water is a bottled water company that donates all of its profits to global clean water projects. The company uses carbon-neutral packaging in the form of a compostable bottle made from corn. Belu is the first carbon-neutral product being stocked at Tesco. Among its clean water projects, Belu has installed hand pumps and wells for 20,000 people in India and Mali, and it is also working on a rubbish-muncher to clean up the Thames. The company has a pledge that each bottle of mineral water sold will translate as clean water for one person for one month.

Source: Adapted from news reports, January 2008

Not for Profit Businesses

These are charities, community organisations that are run on commercial lines e.g. Network Rail:

o Network Rail took over the rail network in October 2002 o It’s stated purpose is to deliver a safe, reliable and efficient railway for Britain. o It is a company limited by guarantee – whose debts are secured by the government o Network Rail is a private company operating as a commercial business and regulated by the

Office of Rail Regulation o Network Rail is a "not-for-dividend" company - profits are invested in the railway network. o Train operating companies pay Network Rail for use of the rail infrastructure

Businesses required to main a loss-making service on social grounds

A good example here is the Royal Mail which is required to maintain a universal national postal delivery service throughout the UK for a uniform price. Household mail makes a loss, cross-subsidised by business mail – although this market is shrinking for the Royal Mail because of the introduction of fresh competition from Jan 2006. The Post Office Ltd is a subsidiary of the Royal Mail Group plc – it runs substantial losses on the network or rural post offices and has been under great pressure to close hundreds of offices to stem losses.

Suggestions for further reading on business objectives and business ownership

How effective is social enterprise? (BBC news, August 2008)

Making profit with a conscience (BBC news, March 2008)

Network Rail sees profit slide (BBC news, June 2009)

Putting ethics before business (Guardian, June 2009)

Social entrepreneurs – green and good (BBC news, October 2008)

Wind farm co-op raises thousands (BBC news, July 2008)

- 6 -

Tutor2u www.tutor2u.net

2. Company growth Why do firms seek to grow?

1. The profit motive: Businesses grow to achieve higher profits. The stimulus to achieve growth is often provided by the expectations placed on a business by the capital markets. The stock market valuation of a firm is influenced by expectations of future sales and profit streams so if a company achieves disappointing growth figures, this might be reflected in a fall in the share price. This opens up the risk of a hostile take-over and makes it more expensive for a quoted company to raise fresh capital by issuing new shares onto the market.

2. The cost motive: Economies of scale have the effect of increasing the productive capacity of the business and they help to raise profit margins.

3. The market power motive: Firms may wish to grow to increase their market dominance giving them increased pricing power in markets.

4. The risk motive: Growth might be motivated by a desire to diversify production so that falling sales in one market might be compensated by stronger demand in another market.

5. Managerial motives: Behavioural theories of the firm predict that business expansion might be accelerated by the decisions of managers whose aims and objectives might be different from those who are the major shareholders.

How do firms grow?

Organic growth

Organic growth is also known as internal growth and happens when a business expands its own operations rather than relying on takeovers and mergers. Organic growth might come about from:

• Expansion of existing production capacity through investment in new capital & technology

• Developing & launch of new products

• Growing a customer base through marketing

External growth

The fastest route for growth is through external growth – through mergers or contested take-overs. There are various forms of integration – explained below with some recent examples:

Horizontal integration: Horizontal integration occurs when two businesses in the same industry at the same stage of production become one – for example a merger between two car manufacturers or drinks suppliers. Recent examples of horizontal integration include:

• Nike and Umbro

• NTL and Telewest (new business eventually renamed as Virgin Media)

• AOL and Bebo

• Lloyds TSB (now Lloyds Banking Group) taking over HBOS

The advantages of horizontal integration include the following:

- 7 -

Tutor2u www.tutor2u.net

1. It increases the size of the business and allows for more internal economies of sale – lower long run average costs – improved profits and competitiveness

2. One large firm may need fewer workers, managers and premises than two – a process known as rationalization again designed to achieve cost savings

3. Mergers often justified by the existence of “synergies”

4. Creates a wider range of products - (diversification). Opportunities for economies of scope

5. Reduces competition by removing rivals – increases market share and pricing power

Vertical integration: Vertical Integration involves acquiring a business in the same industry but at different stages of the supply chain. Examples of vertical integration might include the following:

• Film distributors owning cinemas

• Brewers owning and operating pubs

• Tour operators / Charter Airlines / Travel Agents

• Crude oil exploration all the way through to refined product sale

• Record labels, record stations

• Sportswear manufacturers and retailers

• Drinks manufacturers integrating with bottling plants

Case Study: PepsiCo and Vertical Integration

PepsiCo, which owns the V-Water Tropicana and Gatorade brands has made a $6bn cash and stock offer for the Pepsi Bottling Group and PepsiAmericas. Pepsi already owns sizeable equity stakes in both of these huge bottling businesses - but it has taken advantage of the low stock market and a handy cash mountain to make a takeover bid. It is a classic case of backward vertical integration and PepsiCo expects the integration to cut costs by about $200m annually.

Source: Tutor2u blog, April 2009

The main advantages of vertical integration are:

1. Greater control of the supply chain – this helps to reduce costs and improve quality of inputs.

2. Improved access to important raw materials used in manufacturing.

3. Better control over retail distribution channels e.g. pub companies who can ensure that their beers and wines are sold in tenanted pubs and clubs.

Lateral Integration

This involves companies joining together that produce similar but related products. Examples include:

• eBay and Skype

• Google and You Tube

• Gillette and Proctor & Gamble

Other sources of monopoly power

Monopoly power also comes from owning patents and copyright protection or exclusive ownership of productive assets (e.g. De Beers – diamonds). Monopoly power can also come from winning bidding races for exclusive agreements – the best example of which is probably the monopoly on broadcasting live soccer games on TV owned by BSkyB as a result of winning auctions

- 8 -

Tutor2u www.tutor2u.net

organised by the Premier League. Their rival Setanta Sports went into administration in June 2009 and stopped broadcasting just a few days later.

The government and its agencies may also give monopoly power to some business through franchises and licences, for example the licence that Camelot has to operate the National Lottery. Monopoly power can come organically through internal growth where a firm takes advantage of economies of scale.

Case Study - Stobart Powers On

Undeterred by rising fuel costs and signs of an economic slowdown, Stobart Group the UK’s largest road haulier has continued to expand posting a 27% rise in revenues over the last year. The business now operates 1,800 trucks and 2,900 trailers and has worked at 81% capacity utilisation, up from 71% four years ago. Stobart has grown externally by merging with fellow haulier Westbury and acquiring O’Connor, the inland container terminal operator. Stobart has also purchased transport engineer WA Developments and has taken an option on buying Carlisle Airport. The business has a strategy of building a mutli-modal capability, mixing road, rail, sea and air transport. Following a capital investment programme, it now operates over 6 million square feet of high specification warehousing.

Source: Adapted from news reports, June 2008

Outsourcing

Over a third of UK companies now do some of their production work abroad, whilst 10% have over half of their manufacturing offshore in lower cost locations. Dyson is a high profile example of a company that has relocated production abroad to Malaysia, whilst keeping their research and design operations in the UK. Most recently we are witnessing a trend for service sector businesses to follow suit. In recent times we have seen Norwich Union, Abbey National, Tesco, British Airways and National Rail Enquiries all transfer parts of their operation overseas.

There are three main drivers promoting outsourcing as a business strategy:

(1) Technological change – Information, communication and telecommunication costs are falling - this makes it easier to outsource service and manufacturing operations to sub-contractors in other countries. Technological advances now promote "Just in time delivery" inventory strategies for the delivery of components and finished products and encourage the development of "virtual manufacturing". Communication costs are dropping sharply - the average price of a one minute international call was 74% lower in 2003 than in 1993.

(2) Increased competition in a low-inflation environment - which increases the pressure on businesses to achieve lower costs as a means of maintaining market share.

(3) Pressure from the financial markets for businesses to improve their profitability.

For many large businesses, there are cost advantages to be gained through doing business via a call centre located overseas. Outsourcing is not simply confined to service sector industries. Many manufacturing businesses are using outsourcing as a means of reducing their costs, providing greater flexibility of production levels at times of volatile demand and also in speeding up the time it takes to get their goods to market, especially new products.

Joint Ventures

Joint ventures occur when two or more businesses join together to pursue a common project or goal. This type of business agreement is becoming common especially as firms become aware of the potential of collaborative work in reaching a mutually agreed strategic target. Firms might come together for joint-research projects e.g. in sharing some of the fixed costs of research projects.

Good examples of joint ventures include:

• Sony Ericsson – a long standing mobile phone joint venture

- 9 -

Tutor2u www.tutor2u.net

• Google and NASA

• Hollywood studios joining together to fight internet piracy

• Hugo Boss and Proctor & Gamble

• Boeing and Lockheed

• MySpace and Skype

• Renault-Nissan’s joint venture with Indian firm Bajaj to produce a £1,276 car

• HMV launching a joint venture with Curzon Artificial Eye to set up in-store cinemas

• Cobra beer bought in a joint venture by Molson-Coors

Case Study: Travelodge teams up with Aldi in Joint Venture

Travelodge - which is owned by Dubai International Capital - has announced an fresh expansion plan which fits into its long-term aim to grow to over 70,000 rooms in nearly 1000 hotels by 2020 and to be the biggest hotel operator in London by the time the Olympics arrives in 2012. And as part of the organic growth strategy, Travelodge is teaming up with the discount food retailer Aldi to develop sites together into supermarkets and hotels. Notably two of the initial projects in this joint venture are in Middlesbrough (on Teesside) and in Newquay in Cornwall - both in regions where per capita incomes are substantially below the national average. Both businesses are taking advantage of the collapse in demand for commercial and residential property - which is freeing up land for others to invest in

Source: Tutor2u Economics Blog

Evaluation comments on mergers and takeovers

Many takeovers and mergers fail to achieve their aims.

1. Huge financial costs of funding takeovers including the burden of deals that have relied heavily on loan finance

2. The need to raise fresh equity through a rights issue to fund a deal which can have a negative impact on a company's share price. Over the three to five years after the deal on average, the share price of the acquiring company tends to drop.

3. Many mergers fail to enhance shareholder value because of clashes of corporate cultures and a failure to find the all-important "synergy gains“

4. With the benefit of hindsight we often see the ‘winners curse’ - i.e. companies paying over the odds to take control of a business and ending up with little real gain in the medium term. A good example would be the doomed takeover of ABM-AMRO by Royal Bank of Scotland.

5. Competition policy concerns can come into play especially when there is a risk of monopoly from vertical and horizontal integration

6. Integration often leads to sizeable job losses with important economic and social consequences for local areas.

7. Bad timing – mergers and takeovers that take place towards the end of a sustained economic boom can often turn out to be very damaging for both businesses. A good example occurred in the UK property market with Taylor Woodrow's merger with Wimpey in a £5bn all-shares deal sealed just as property prices were peaking. Since then house sales have collapsed due to the credit crunch and the merged business has suffered huge losses.

The survival of smaller businesses

Over time there is a clear trend towards larger scale businesses partly because of the pressures of competition; the need to achieve economies of scale and the effects of mergers and takeovers. However there are plenty of examples where businesses are de-merging and divesting themselves

- 10 -

Tutor2u www.tutor2u.net

of some of their existing assets. And even in industries where giant businesses dominate the market place, there is frequently room for smaller firms to compete and survive profitably.

1. Many smaller businesses act as a supplier / sub-contractor to larger enterprises

2. They might take advantage of a low price elasticity of demand and high income-elasticity of demand for specialist ‘niche’ goods and services.

3. Smaller businesses are often innovative, flexible and can avoid diseconomies of scale

Private equity

Private equity is the name given to a particular type of company ownership. Some businesses such as Tesco plc or British Petroleum plc are publicly-owned by outside investors who can buy and sell their shares on the stock market. In contrast, privately-owned firms are owned by groups of individuals or families and also by private equity funds. These funds raise capital from institutions such as pension funds and make investments in companies that they feel can be improved and achieve higher profits.

In recent years, private equity firms have acquired a string of businesses in the UK ranging from Birds-Eye frozen foods to Saga holidays, from Fitness First gyms to Madam Tussauds Group. Some commentators have called them ‘casino capitalists’ borrowing heavily to fund takeover bids and then engaging in severe asset stripping to realise the values of newly bought businesses. Defenders of private equity believe that they can provide a means by which inefficient management is removed and that takeovers can create many more jobs than they lose over the medium term.

Demergers

A demerger happens when a business spins off one or more of the businesses that it owns into a separate company – perhaps in the form of a management buy-out. A partial demerger means that the parent company retains a stake in the demerged business. The aim is to improve shareholder value by giving new management to chance to focus on a core business and to reduce levels of debt. Demergers can also result from government intervention - perhaps because the competition authorities want a business with a monopoly to be broken up to maintain competition.

Examples of recent demergers

1. Demerger of Cadbury's North American drinks business creating a new business called Dr Pepper Snapple Group (DPSG)

2. Severn Trent Water demerged its waste management business Biffa

3. Demerger of British Gas into the UK gas pipeline business Transco and an international oil and gas exploration company

4. Carphone Warehouse plans to demerge it’s Talk Talk broadband business

Suggestions for further reading on the growth of firms

Cadbury to go ahead with split (BBC news, August 2007)

Clubbing together to beat the big boys (BBC news, July 2008)

Co-op buys Somerfield for £1.57bn (BBC news, July 2008)

Hitachi to split businesses (BBC news, May 2009)

- 11 -

Tutor2u www.tutor2u.net

3. Revenue Revenue is the income generated from the sale of output in product markets.

o Average Revenue (AR) = Price per unit = total revenue / output

o Marginal Revenue (MR) = the change in revenue from selling one extra unit of output

The table below shows the demand for a product where there is a downward sloping demand curve.

Price per unit (average revenue)

Quantity Demanded (Qd)

Total Revenue (TR) (PxQ)

Marginal Revenue (MR)

£s units £s £s

400 220 88000

370 340 125800 315

340 460 156400 255

310 580 179800 195

280 700 196000 135

250 820 205000 75

220 940 206800 15

190 1060 201400 -45

Average and Marginal Revenue

In our example in the table, as price per unit falls, demand expands and total revenue rises although because average revenue falls as more units are sold, this causes marginal revenue to decline. Eventually marginal revenue becomes negative, a further fall in price (e.g. from £220 to £190) causes total revenue to fall.

Elasticity of Demand and Total Revenue

When a firm faces a perfectly elastic demand curve, then average revenue = marginal revenue

However, most businesses face a downward sloping demand curve! And because the price per unit must be cut to sell extra units, therefore MR lies below AR. In fact he MR curve will fall at twice the rate of the AR curve. You don’t have to prove this for the exams – but it is worth remembering that the marginal revenue curve has twice the slope of the AR curve!

Maximum total revenue occurs where marginal revenue is zero: no more revenue can be achieved from producing an extra unit of output. This point is directly underneath the mid-point of a linear demand curve.

- 12 -

Tutor2u www.tutor2u.net

Total revenue is shown by the area underneath the firm’s demand curve (average revenue curve).

Suggestions for further reading on business revenues

Premier league revenues rise despite downturn (BBC news, June 2009)

Revenue fears hit Vodafone shares (BBC news, July 2008)

Output (Q)

Revenue

Total Revenue (TR)

Marginal Revenue (MR)

Average Revenue (Demand) AR

Total revenue is maximised when

MR = 0

Price elasticity of demand = 1 at this

output

Ped >1 for a price fall along this length of AR

Costs

Output (Q)

Average revenue AR

Marginal revenue MR Q1

P1

Total revenue at price P1 where marginal revenue is zero

A rise in price to P2 causes a reduction in total revenue

P2

Q2

Total revenue at price P2

Total revenue (TR) refers to the amount of money received by a firm from selling a given level of output and is found by multiplying price (P) by output ie number of units sold

- 13 -

Tutor2u www.tutor2u.net

Stagecoach reports revenue rise (BBC news, June 2009)

- 14 -

Tutor2u www.tutor2u.net

4. Costs Introduction to production

We take it for granted that goods and services will be available for us to buy as and when we need them. But production and supplying to the market is often a complicated business.

Production Functions

The production function relates the quantity of factor inputs to the volume of output that result. We use three measures of production and productivity.

o Total product (or total output). In manufacturing industries such as motor vehicles and DVD players, it is straightforward to measure how much output is being produced. But in service or knowledge industries, where output is less “tangible” it is harder to measure productivity.

o Average product measures output per-worker-employed or output-per-unit of capital.

o Marginal product is the change in output from increasing the number of workers used by one person, or by adding one more machine to the production process in the short run.

The length of time required for the long run varies from sector to sector. In the nuclear power industry for example, it can take many years to commission new nuclear power plant and capacity. This is something the UK

government has to consider as it reviews our future sources of energy.

Short Run Production Function

The short run is a time period where at least one factor of production is in fixed supply. We normally assume that the quantity of plant and machinery is fixed and that production can be altered through changing variable inputs such as labour, raw materials and energy.

The time periods used in economics differ from one industry to another, for example, the short-run for the electricity generation industry or telecommunications differs from magazine publishing and local sandwich bars. If you are starting out in business with a new venture selling sandwiches and coffees to office workers, how long is your short run? And how long is your long run? The long run could be as short as a few days – enough time to lease a new van and a sandwich-making machine!

Diminishing Returns

In the short run, the law of diminishing returns states that as we add more units of a variable input to fixed amounts of land and capital, the change in total output will at first rise and then fall. Diminishing returns to labour occurs when marginal product of labour starts to fall. This means that total output will be increasing at a decreasing rate.

- 15 -

Tutor2u www.tutor2u.net

What might cause marginal product to fall? One explanation is that, beyond a certain point, new workers will not have as much capital equipment to work with so it becomes diluted among a larger workforce. An example is shown below.

We assume that there is a fixed supply of capital (20 units) available in the production process to which extra units of labour are added.

• Initially, marginal product is rising – e.g. the 4th worker adds 26 to output and the 5th worker adds 28 and the 6th worker increases output by 29.

• Marginal product then starts to fall. The 7th worker supplies 26 units and the 8th worker just 20 added units. At this point production demonstrates diminishing returns.

The Law of Diminishing Returns

Capital Input Labour Input Total Output Marginal Product Average Product of Labour

20 1 5 5

20 2 16 11 8

20 3 30 14 10

20 4 56 26 14

20 5 85 28 17

20 6 114 29 19

20 7 140 26 20

20 8 160 20 20

20 9 171 11 19

20 10 180 9 18

Average product rises as long as the marginal product is greater than the average – for example when the seventh worker is added the marginal gain in output is 26 and this drags the average up from 19 to 20 units. Once marginal product is below the average as it is with the ninth worker employed (where marginal product is only 11) then the average must decline.

Criticisms of the Law of Diminishing Returns

How realistic is this assumption of diminishing returns? Surely ambitious and successful businesses will do their level best to avoid such a problem emerging? It is now widely recognised that the effects of globalisation and the ability of trans-national businesses to source their inputs from more than one country and engage in transfers of business technology, makes diminishing returns less relevant as

Total Output (Q)

Units of Labour Employed (L)

(Q) Slope of the curve gives the marginal product of labour

Diminishing returns are apparent here – total output is rising but at a decreasing rate

- 16 -

Tutor2u www.tutor2u.net

a concept. Many businesses are multi-plant meaning that they operate factories in different locations – can switch output to meet changing demand.

Long Run Production - Returns to Scale

In the long run, all factors of production are variable. How the output of a business responds to a change in factor inputs is called returns to scale.

Numerical example of long run returns to scale

Units of Capital

Units of Labour

Total Output

% Change in Inputs

% Change in Output

Returns to Scale

20 150 3000

40 300 7500 100 150 Increasing

60 450 12000 50 60 Increasing

80 600 16000 33 33 Constant

100 750 18000 25 13 Decreasing

• In our example when we double the factor inputs from (150L + 20K) to (300L + 40K) then the percentage change in output is 150% - there are increasing returns to scale.

• In contrast, when the scale of production is changed from (600L + 80K0 to (750L + 100K) then the percentage change in output (13%) is less than the change in inputs (25%) implying a situation of decreasing returns to scale.

• Increasing returns to scale occur when the % change in output > % change in inputs

• Decreasing returns to scale occur when the % change in output < % change in inputs

• Constant returns to scale occur when the % change in output = % change in inputs

The nature of the returns to scale affects the shape of a business’s long run average cost curve.

Finding an optimal mix between labour and capital

In the long run businesses will be looking to find an optimal output that combines labour and capital in a way that maximises productivity and therefore reduces unit costs towards their lowest level. This may involve a process of capital-labour substitution where capital machinery and new technology replaces some of the labour input. In many industries over the years we have seen a rise in the capital intensity of production - good examples include farming, banking and retailing.

Calculating the costs of a firm

Next we look at production costs. In the short run, because at least one factor of production is fixed, output can be increased only by adding more variable factors.

Fixed costs

Fixed costs do not vary directly with the level of output

Most businesses operate with a significant fixed cost component. Examples of fixed costs include the rental costs of buildings; the costs of leasing or purchasing capital equipment such as plant and machinery; the annual business rate charged by local authorities; the costs of full-time contracted salaried staff; the costs of meeting interest payments on loans; the depreciation of fixed capital (due solely to age) and also the costs of business insurance.

- 17 -

Tutor2u www.tutor2u.net

Basically any business with significant capacity will have high fixed costs; perhaps the classic example is an airline with a large number of routes, or a vehicle manufacturer that spends millions of pounds building a new factory and installing expensive and bulky capital equipment.

Fixed costs are the overhead costs of a business.

Key points:

Total fixed costs (TFC) these remain constant as output increases

Average fixed cost (AFC) = total fixed costs divided by output

Average fixed costs must fall continuously as output increases because total fixed costs are being spread over a higher level of production. In industries where the ratio of fixed to variable costs is extremely high, there is great scope for a business to exploit lower fixed costs per unit if it can produce at a big enough size. Consider the Sony PS3 or the new iPhone where the fixed costs of developing the product are enormous, but these costs can be divided by millions of individual units sold across the world. Successful product launches and huge volume sales can make a huge difference to the average total costs of production.

Please note! A change in fixed costs has no effect on marginal costs. Marginal costs relate only to variable costs!

Variable Costs

Variable costs are costs that vary directly with output – when output is zero, variable costs will be zero but as production increases, total variable cost will rise.

Examples of variable costs include the costs of raw materials and components, the wages of part-time staff or employees paid by the hour, the costs of electricity and gas and the depreciation of capital inputs due to wear and tear.

Average variable cost (AVC) = total variable costs (TVC) /output (Q)

Average Total Cost (ATC or AC)

• Average total cost is the cost per unit produced

• Average total cost (ATC) = total cost (TC) / output (Q)

Marginal Cost

Marginal cost is the change in total costs from increasing output by one extra unit.

The marginal cost of supplying an extra unit of output is linked with the marginal productivity of labour. The law of diminishing returns implies that marginal cost will rise as output increases. Eventually, rising marginal cost will lead to a rise in average total cost. This happens when the rise in AVC is greater than the fall in AFC as output (Q) increases.

A numerical example of short run costs is shown in the table below. Fixed costs are assumed to be constant at £200. Variable costs increase as more output is produced.

Output (Q)

Total Fixed Costs (TFC)

Total Variable Costs (TVC)

Total Cost Average Cost Per Unit

Marginal Cost (the change in total cost

from a one unit change in output)

(TC= TFC + TVC)

(AC = TC/Q)

- 18 -

Tutor2u www.tutor2u.net

0 200 0 200

50 200 100 300 6 2

100 200 180 400 4 2

150 200 230 450 3 1

200 200 260 460 2.3 0.2

250 200 280 465 1.86 0.1

300 200 290 480 1.6 0.3

350 200 325 525 1.5 0.9

400 200 400 600 1.5 1.5

450 200 610 810 1.8 4.2

500 200 750 1050 2.1 4.8

• In our example, average cost per unit is minimised at a range of output - 350 and 400 units.

• Thereafter, because the marginal cost of production exceeds the previous average, so the average cost rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase in output has the effect of raising the cost per unit from 1.8 to 2.1).

An example of fixed and variable costs in equation format

If for example, the short-run total costs of a firm are given by the formula

SRTC = $(10 000 + 5X2) where X is the level of output.

• The firm’s total fixed costs are $10,000

• The firm’s average fixed costs are $10,000 / X

• If the level of output produced is 50 units, total costs will be $10,000 + $2,500 = $12,500

- 19 -

Tutor2u www.tutor2u.net

Case Study: The Marginal Cost of Oil

The marginal cost of oil is the expense of extracting an extra barrel of crude oil from below the ground. It is a widely held belief among economists who specialize in commodity prices that the long-run market price of something is determined fundamentally by the marginal cost of production. The resources that can be tapped at lowest cost are often done so first, and then as it becomes progressively harder to unearth such resources the market price must rise to provide an economic incentive to do so.

One problem is that, because oil is a non-renewable resource lying in geological structures that vary enormously in location, weather, depth and many other variables, the cost of extracting new supplies is hard to determine. Many OPEC countries – especially Saudi Arabia – have access to relatively cheap and elastic supplies of oil. But the same cannot be said of crude oil producers in Canada's tar sands and oil companies who have sunk huge amounts of money into exploiting the oil available in deep-water facilities off the west coast of Africa or in Brazil.

When the market value is much higher than marginal cost, oil producers extract a high level of producer surplus for each barrel that makes it to the oil refineries. The fact is that for many oil-exporting countries, the price for each barrel of crude oil extracted needs to be higher than the marginal cost of production for national governments to generate sufficient income to pay for ambitious public spending projects. So whereas the Saudi government can expect to balance its budget when world oil prices are hovering at around $55 per barrel, prices need to be closer to $70 a barrel for the Russian government to earn

enough oil revenues to pay for their state spending. And that figure rises to more than $95 a barrel for countries such as Iran and Venezuela.

Oil companies need to know that the price they can command in the market will be persistently above the marginal extraction cost in order to cover the fixed costs of production and the expected rate of profit demanded by shareholders.

Source: EconoMax, October 2008

US dollarsWorld Crude Oil Price - US Dollars Per Barrel

Source: Reuters EcoWin

03 04 05 06 07 08 090

10

20

30

40

50

60

70

80

90

100

110

120

130

140

150

US

dol

lars

per

bar

rel

0

10

20

30

40

50

60

70

80

90

100

110

120

130

140

150

Million barrels per day, source of data is the OECDWorld Oil Supply and Demand

World oil demand, millions of barrels per day World oil supply, millions of barrels per day

Source: OECD

86 88 90 92 94 96 98 00 02 04 06 08

milli

ons

55

60

65

70

75

80

85

90

Milli

on b

arre

ls p

er d

ay (m

illion

s)

55

60

65

70

75

80

85

90

- 20 -

Tutor2u www.tutor2u.net

Short Run Cost Curves

When diminishing returns set in (beyond output Q1) the marginal cost curve starts to rise. Average total cost continues to fall until output Q2 where the rise in average variable cost equates with the fall in average fixed cost. Output Q2 is the lowest point of the ATC curve for this business in the short run. This is known as the output of productive efficiency.

A change in variable costs

A rise in the variable costs of production – perhaps due to a rise in oil and gas prices or a rise in the national minimum wage - leads to an upward shift both in marginal and average total cost. The firm is not able to supply as much output at the same price. The effect is that of an inward shift in the supply curve of a business in a competitive market.

Costs

Output (Q)

Average Fixed Cost (AFC)

Average Variable Cost (AVC)

Average Total Cost (ATC)

Marginal Cost (MC)

If marginal cost is below average cost then average must be falling. Even if MC is rising, AC falls if MC <AC. For this reason, MC curve intersects the AC curve at the lowest point of the AC curve. Diminishing returns starts to occur when marginal cost starts to rise.

Q1 Q2

- 21 -

Tutor2u www.tutor2u.net

An increase in fixed costs has no effect on the variable costs of production. This means that only the average total cost curve shifts. There is no change on the marginal cost curve leading to no change in the profit maximising price and output of a business. The effects of an increase in the fixed or overhead costs of a business are shown in the diagram below.

Suggestions for background reading on changes in business costs

Dry cleaners facing rising costs (BBC news, June 2008)

Grain prices are squeezing bakers (BBC news, April 2008)

High costs fuel record loss for British Airways (BBC news, May 2009)

Costs

Output (Q)

AC1

MC AC2 (after rise in fixed costs)

Costs

Output (Q)

Average Variable Cost (AVC1)

Average Total Cost (ATC1)

Marginal Cost (MC1)

MC2 AC2

AVC2

- 22 -

Tutor2u www.tutor2u.net

Pub industry hit by rising costs (BBC news, September 2008)

- 23 -

Tutor2u www.tutor2u.net

5. Economies and diseconomies of Scale Economies of Scale

• Economies of scale are the cost advantages from expanding the scale of production in the long run. The effect is to reduce average costs over a range of output.

• These lower costs represent an improvement in productive efficiency and can give a business a competitive advantage in the market. They lead to lower prices and higher profits – a positive sum game for producers and consumers.

• We make no distinction between fixed and variable costs in the long run because all factors of production can be varied. As long as the long run average total cost (LRAC) is declining, economies of scale are being exploited.

Long Run Output (Units) Total Costs (£s) Long Run Average Cost (£ per unit)

1000 12000 12 2000 20000 10 5000 45000 9

10000 80000 8 20000 144000 7.2 50000 330000 6.6 100000 640000 6.4 500000 3000000 6

Returns to scale and costs in the long run

The table below shows how changes in the scale of production can, if increasing returns to scale are exploited, lead to lower long run average costs.

Factor Inputs Production Costs

(K) (La) (L) (Q) (TC) (TC/Q)

Capital Land Labour Output Total Cost Average Cost

Scale A 5 3 4 100 3256 32.6

Scale B 10 6 8 300 6512 21.7

Scale C 15 9 12 500 9768 19.5

Costs: Assume the cost of each unit of capital = £600, Land = £80 and Labour = £200

Because the % change in output exceeds the % change in factor inputs used, then, although total costs rise, the average cost per unit falls as the business expands from scale A to B to C.

Increasing Returns to Scale

Much of the new thinking in economics focuses on the increasing returns available to a company growing in size in the long run.

An example of this is the computer software business. The overhead costs of developing new software programs such as Microsoft Vista or computer games such as Halo 3 are huge - often running into hundreds of millions of dollars - but the marginal cost of producing one extra copy for sale is close to zero, perhaps just a few cents or pennies. If a company can establish itself in the market in providing a piece of software, positive feedback from consumers will expand the

- 24 -

Tutor2u www.tutor2u.net

installed customer base, raise demand and encourage the firm to increase production. Because the marginal cost is so low, the extra output reduces average costs creating economies of size.

Capacity utilization, fixed costs and profits

Lower costs normally mean higher profits and increasing financial returns for the shareholders. What is true for software developers is also important for telecoms companies, transport operators and music distributors. We find across many different markets that, when a high percentage of costs are fixed the higher the level of production the lower will be the average cost of production. Strong demand means that capacity utilization rates are high and this lowers the unit cost of supply.

Long Run Average Cost Curve

The long run average cost curve (LRAC) is also known as the ‘envelope curve’ and is usually drawn on the assumption of their being an infinite number of plant sizes – hence its smooth appearance in the next diagram below. The points of tangency between LRAC and SRAC curves do not occur at the minimum points of the SRAC curves except at the point where the minimum efficient scale (MES) is achieved.

If LRAC is falling when output is increasing then the firm is experiencing economies of scale. For example a doubling of factor inputs might lead to a more than doubling of output.

Conversely, When LRAC eventually starts to rise, the firm experiences diseconomies of scale, and, If LRAC is constant, then the firm is experiencing constant returns to scale

LRAC

SRAC1

SRAC2 SRAC3

Costs

AC1

AC2

AC3

Q2 Q3 Output (Q) Q1

- 25 -

Tutor2u www.tutor2u.net

Internal Economies of Scale (IEoS)

Internal economies of scale come from the long-term growth of the firm. Examples include:

1. Technical economies of scale:

a. Expensive capital inputs: Large-scale businesses can afford to invest in specialist capital machinery. For example, a supermarket might invest in database technology that improves stock control and reduces transportation and distribution costs.

b. Specialization of the workforce: Larger firms can split the production processes into separate tasks to boost productivity. Examples include the use of division of labour in the mass production of motor vehicles and in manufacturing electronic products.

c. The law of increased dimensions (or the “container principle”) This is linked to the cubic law where doubling the height and width of a tanker or building leads to a more than proportionate increase in the cubic capacity – the application of this law opens up the possibility of scale economies in distribution and freight industries and also in travel and leisure sectors with the emergence of super-cruisers such as P&O’s Ventura. Consider the new generation of super-tankers and the development of enormous passenger aircraft such as the Airbus 280 which is capable of carrying well over 500 passengers on long haul flights. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and warehousing. Amazon UK for example has invested in several huge warehouses at its central distribution points – capable of storing hundreds of thousands of items.

d. Learning by doing: There is growing evidence that industries learn-by-doing! The average costs of production decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale. Evidence across a wide range of industries into so-called “progress ratios”, or “experience curves” or “learning curve effects”, indicate that unit manufacturing costs typically fall by between 70% and 90% with each doubling of cumulative output. Businesses that expand their scale can achieve significant learning economies of scale.

2. Monopsony power: A large firm can purchase its factor inputs in bulk at discounted prices if it has monopsony (buying) power. A good example would be the ability of the electricity generators to negotiate lower prices when finalizing coal and gas supply contracts. The

Cost

(Per unit of output)

LRAC1

B

Economies of Scale

LRAC2

Learning

economies C

A

Output

- 26 -

Tutor2u www.tutor2u.net

national food retailers have monopsony power when purchasing their supplies from farmers and wine growers and in completing supply contracts from food processing businesses. Other controversial examples of the use of monopsony power include the prices paid by coffee roasters and other middlemen to coffee producers in some of the poorest parts of the world.

3. Managerial economies of scale: This is a form of division of labour where firms can employ specialists to supervise production systems. Better management; increased investment in human resources and the use of specialist equipment, such as networked computers can improve communication, raise productivity and thereby reduce unit costs.

4. Financial economies of scale: Larger firms are usually rated by the financial markets to be more ‘credit worthy’ and have access to credit with favourable rates of borrowing. In contrast, smaller firms often pay higher rates of interest on overdrafts and loans. Businesses quoted on the stock market can normally raise new financial capital more cheaply through the sale of equities to the capital market. The credit crunch has made raising finance harder for businesses of all sizes – bank overdraft and loan interest rates have increased across the board, but it remains true that larger corporations can still access credit at a cheaper cost.

5. Network economies of scale: There is growing interest in the concept of a network economy. Some networks and services have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them.

The container principle at work!

- 27 -

Tutor2u www.tutor2u.net

Network Economies of Scale

The power of networks is becoming increasingly recognized in the economics of long run costs, revenues and profits.

Many networks have huge potential for economies of scale. That is, as they are more widely used (or adopted), they become more valuable to the business that provides them. Good examples to use include online auction sites such as eBay, social networking sites, wireless service providers, air and rail transport networks and businesses such as Amazon.

In most cases, the marginal cost of adding one more user or customer to a network is close to zero, but the resulting financial benefits may be huge because each new user to the network can then interact, trade with all of the existing members or parts of the network.

Given the high fixed costs of establishing a network, the more users there are the lower are the fixed costs per unit. Thus as the network expands, not only are there potential gains from extra revenues, but the long run cost per user diminishes - an internal economy of scale.

In some cases an industry that requires a network to fulfill customer needs and wants across a country or region might be classified as a natural monopoly - an industry where long run average cost falls over a huge range of output and where the minimum efficient scale is a large percentage of market demand. Consider as examples the networks required by the major utilities such as water, gas, electricity and (fixed line) broadband suppliers. And perhaps businesses such as Network Rail and the Royal Mail might also claim to have aspects of a natural monopoly given the requirement for the former to maintain and improve a national rail infrastructure and, for the latter, to keep a universal postal service running to add postal addresses in the country - this is of course a loss-making aspect of their business model.

Where there are strong grounds for believing an industry is a natural monopoly, there might be a case for nationalizing and/or regulating the network element of the business but introducing competition into the actual service provision - e.g. franchise bids for train operating companies, and partial or complete deregulation of parcel and letter collection, sorting and delivery.

Source: Tutor2u Economics Blog

- 28 -

Tutor2u www.tutor2u.net

Economies of Scale – price, output and profits

Scale economies allow a supplier to move from SRAC1 to SRAC2. A profit maximising producer will produce at a higher output (Q2) and charge a lower price (P2) as a result – but the total abnormal profit is also much higher (compare the two shaded regions). Both consumer and producer surplus (welfare) has increased – there has been an improvement in economic welfare and economic efficiency – the key is whether cost savings are passed onto consumers!

External economies of scale (EEoS)

External economies of scale occur outside of a firm but within an industry. For example investment in a better transportation network servicing an industry will resulting in a decrease in costs for a company working within that industry. Another example is the development of research and development facilities in local universities that several businesses in an area can benefit from. Likewise, the relocation of component suppliers and other support businesses close to the centre of manufacturing are also an external cost saving. Agglomeration economies may also result resulting from the clustering of similar businesses in a distinct geographical location e.g. software businesses in Silicon Valley or investment banks in the City of London.

Case Study: Formula One and External Economies of Scale

Britain has a history of providing a base for some of the most successful teams in Formula One. McLaren are based in Woking but Renault, Honda, Williams and Red Bull are all clustered in the east Midlands. Partly this is an accident of history - namely the availability of disused airfields after the war. But the cluster of F1 teams is also a good example of the external economies of scale that can be generated when a group of producers develop and expand in a relatively small geographical area.

Most of the teams currently racing are based in the UK, along with their R&D operations. A whole network of industries, such as component suppliers, engineering and design firms, have sprung up in Britain, mostly in central England, to serve the sport both here and abroad. F1 also helps to support a far larger motorsport industry in the UK, for example rally car racing and all its associated industries. Estimates of the total number of jobs dependent on motorsport in the UK vary between 45,000 and 110,000. Geoff Goddard, professor in Motorsport Engineering Design at Oxford Brookes University, estimates that it accounts for 1 per cent of GDP, not insignificant when compared to car manufacturers, which represent about 5 per cent.

Source: Tutor2u Economics Blog

Costs

Output (Q)

SRAC1

SRAC2

AR (Demand)

MR

MC1

MC2

P1

P2

Q1 Q2

Profit at Price P1

Profit at Price P2

- 29 -

Tutor2u www.tutor2u.net

Economies of Scale – The Importance of Market Demand

The market structure of an industry is affected by the extent of economies of scale available to individual suppliers and by the total size of market demand. In many industries, it is possible for smaller firms to make a profit because the cost disadvantages they face are relatively small. Or because product differentiation allows a business to charge a price premium to consumers which more than covers their higher costs.

A good example is the retail market for furniture. The industry has some major players in each of its different segments (e.g. flat-pack and designer furniture) including the Swedish giant IKEA. However, much of the market is taken by smaller-scale suppliers with consumers willing to pay higher prices for bespoke furniture owing to the low price elasticity of demand for high-quality, hand crafted furniture products. Small-scale manufacturers can therefore extract the consumer surplus that is present when demand is estimated to have a low elasticity of demand.

Case Study: Mobile phone sales and economies of scale

The mobile phone handset industry is best described as an oligopoly. In the second quarter of 2008 the leading five manufacturers accounted for 83% of world sales.

Nokia 40.9

Samsung 15.3

Motorola 9.4

LG 9.3

Sony Ericsson 8.2

The global mobile phone market grew by 12.3 per cent year-on-year in the first half of 2008 with shipments reaching 584 million units - the economies of large-scale production in this kind of industry must be absolutely enormous. The power of the brand and the impact of achieving lower costs per unit are two of the key competitive drivers that impact on consumer preferences.

Source: Tutor2u Economics Blog

Economies of Scope

These are different from economies of scale! Economies of scope occur where it is cheaper to produce a range of products rather than specialize in just a handful of products. And they can be exploited when a business owns a resource that can be used more than once in different ways!

For example, in the increasingly competitive world of postal services and business logistics, the main service providers such as Royal Mail, UK Mail, Deutsche Post and the international parcel carriers including TNT, UPS, and FedEx are broadening the range of their services and making more better use of their existing collection, sorting and distribution networks to reduce costs and earn higher profits from higher-profit-margin and fast growing markets.

A company’s management structure, administration systems and marketing departments are capable of carrying out these functions for more than one product.

Expanding the product range to exploit the value of existing brands is a good way of exploiting economies of scope. Perhaps a good example of “brand extension” is the Easy Group under the control of Stelios where the distinctive Easy Group business model has been applied (with varying degrees of success) to a wide range of markets – easy Pizza, easy Cinema, easy Car rental, easy Bus and easy Hotel to name just a handful! Procter and Gamble is the largest consumer household products maker in the world. Its brands include Crest, Duracell, Gillette, Pantene, and Tide, to name just a few. Twenty four of its brands make over $1 billion in sales annually.

- 30 -

Tutor2u www.tutor2u.net

Another example of an economy of scope might be a restaurant that has catering facilities and uses it for multiple occasions – as a coffee shop during the day and as a supper-bar and jazz room in the evenings. Or a computing business can use its network and databases for many different uses.

Minimum Efficient Scale (MES)

The minimum efficient scale (MES) is the scale of production where the internal economies of scale have been fully exploited. The MES corresponds to the lowest point on the long run average cost curve and is also known as an output range over which a business achieves productive efficiency.

The MES is not a single output level – more likely we describe the minimum efficient scale as comprising a range of outputs where the firm achieves constant returns to scale and has reached the lowest feasible cost per unit.

The minimum efficient scale depends on the nature of costs of production in a specific industry.

In industries where the ratio of fixed to variable costs is high, there is plenty of scope for reducing unit cost by increasing the scale of output. This is likely to result in a concentrated market structure (e.g. an oligopoly, a duopoly or a monopoly) – indeed economies of scale may act as a barrier to entry because existing firms have achieved cost advantages and they then can force prices down in the event of new businesses coming in!

1. In contrast, there might be only limited opportunities for scale economies such that the MES turns out to be a small % of market demand. It is likely that the market will be competitive with many suppliers able to achieve the MES. An example might be a large number of hotels in a city centre or a cluster of restaurants in a town. Much depends on how we define the market!

2. With a natural monopoly, the long run average cost curve continues to fall over a huge range of output, suggesting that there may be room for perhaps one or two suppliers to fully exploit all of the available economies of scale when meeting market demand.

Costs

Revenues

Output (Q) MES Q2

LRAC

Increasing return to scale – economies of scale - falling LRAC

Decreasing returns – diseconomies of scale

- 31 -

Tutor2u www.tutor2u.net

Diseconomies of scale

“In automobiles as in many industries, economies of scale are technological, the diseconomies of scale human. Human factors in business are generally more influential than technological ones in determining the long run fate of a company.”

Source: John Kay, Financial Times, December 2008

Diseconomies are the result of decreasing returns to scale and lead to a rise in long run average cost

The potential diseconomies of scale a firm may experience relate to:

1. Control – monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly – this links to the concept of the principal-agent problem i.e. the difficulties of shareholders monitoring the performance of managers.

2. Co-ordination - it can be difficult to co-ordinate complicated production processes across several plants in different locations and countries. Achieving efficient flows of information in large businesses is expensive as is the cost of managing supply contracts with hundreds of suppliers at different points of an industry’s supply chain.

3. Co-operation - workers in large firms may develop a sense of alienation and loss of morale. If they do not consider themselves to be an integral part of the business, their productivity may fall leading to wastage of factor inputs and higher costs. Traditionally this has been seen as a problem experienced by the larger state sector businesses, examples being the Royal Mail and the Firefighters, the result being a poor and costly industrial relations performance. However, the problem is not concentrated solely in such industries. A good recent example of a bitter industrial relations dispute was between Gate Gourmet and its workers.

Avoiding diseconomies of scale

A number of economists are skeptical about diseconomies of scale. They believe that proper management techniques and appropriate incentives can do much to reduce the risk of industrial strife. Here are three of the reasons to doubt the persistence of diseconomies of scale:

1. Developments in human resource management (HRM). HRM is a horrible phrase to describe improvements that a business might make to procedures involving worker recruitment, training, promotion, retention and support of faculty and staff. This becomes critical to a business when the skilled workers it needs are in short supply. Recruitment and retention of the most productive and effective employees makes a sizeable difference to corporate performance in the long run.

2. Performance related pay schemes (PRP) can provide financial incentives for the workforce leading to an improvement in industrial relations and higher productivity. Another aim of PRP is for businesses to reward and hang onto their most efficient workers. The John Lewis Partnership is often cited as an example of how a business can empower its employees by giving them a stake in the financial success of the organization.

3. Increasingly companies are engaging in out-sourcing of manufacturing and distribution as they seek to supply to ever-distant markets. Out-sourcing is a tried and tested way of reducing costs whilst retaining control over production although there may be a price to pay in terms of the impact on the job security of workers whose functions might be outsourced overseas.

- 32 -

Tutor2u www.tutor2u.net

Case Study: Amazon – Economies of Scale and Scope

Increased dimensions: Firstly, the company invested in enormous warehouses to stock its inventory of books, DVDs, computer peripherals. This allows it to benefit from the law of increased dimension.

Buying power: Amazon has significant monopsony power when it purchases books directly from publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit margin.

Learning by doing and first-mover advantage: Amazon is benefiting from learning by doing having been one of the first major players in the online retail sector. The unit costs of production tend to decline in real terms as a result of production experience as businesses cut waste and find the most productive means of producing output on a bigger scale

Pre-Orders - Amazon use a pre-order system for customers that allows it to capture early demand and improve stock (or inventory) forecasting.

Less invested capital: As an online retailer, Amazon avoids the need for retail stores – one advantage is that it has lower invested capital in the business and it frees up resources for customer fulfillment and investment in new technology – Amazon distributes to over 200 countries.

Shifting stock at speed: Amazon has a much faster stock velocity – measured by the number of weeks an item remains in stock. For Amazon this is half that of a physical store – and the benefit is a reduction in obsolescence loss (the value of unsold stock is estimated to decline by 30% per year)

Economies of scale help to give Amazon a significant cost advantage. The business is also looking to create economies of scope from marketing and broadening the range of products available through the Amazon brand. Among the innovative business ideas under development we can identify:

• Merchants@/Marketplace which gives independent (third party) sellers the opportunity to sell their products through the Amazon platform

• Amazon Enterprise Solutions – where Amazon provides e-commerce technology for a range of partners such as Marks and Spencer, Lacoste, Mothercare and Timex

• CreateSpace – a new self-publishing platform for books, music and video

• Amazon Kindle – a portable reader that wirelessly downloads books, blogs, magazines and newspapers to a high-resolution electronic paper display that looks and reads like real paper,

Amazon now sells nearly one fifth of the books bought in the UK each year.

Technological Change, Costs and Supply in the Long-run

What is innovation?

- 33 -

Tutor2u www.tutor2u.net

The Oxford English Dictionary defines innovation as “making changes to something established”. Invention, by contrast, is the act of “coming upon or finding: discovery”. Innovations frequently disrupt the way that businesses do things and may have been doing so for years. Many well-established businesses have come under pressure from innovative challenger brands and products.

Product innovation is a driving dynamic in most markets – consider for example how important innovation is in these markets:

o Telecommunications

o Pharmaceuticals

o Transport

o Audio-visual products

o Green energy and transport

o Farming (important at this time given the global food crisis)

Product innovation is often associated with small, subtle changes to the characteristics and performance of a product.

New markets and “synergy demand”:

Product innovation creates new markets, especially when new technology creates radically different products for consumers. Innovation is also a source of synergy demand. For example, the British ‘challenger-brand’ King of Shaves launched a new razor (the Azor) in 2008 and its success has generated extra demand for its range of shaving oils and gels.

Sustaining and disruptive innovations

Many new products are similar to existing ones on the market – companies are often satisfied with “sustaining innovations” rather than “disruptive innovations” which have the power to upset the status quo and make serious inroads into the market share of well-established businesses. Joseph Alois Schumpeter famously made reference to innovation creating “gales of creative destruction”.

Examples of disruptive innovations:

o Emergence of the low-cost airlines following a radically different business model – this has had a huge effect on national scheduled airline carriers such as British Airways.

o Consider online music download businesses such as iTunes and Spotify

o Voice over Internet Protocol VoIP such as Skype versus traditional telephone and mobile phone service providers.

Innovation and dynamic efficiency

Dynamic efficiency occurs over time. It focuses on changes in consumer choice available in a market together with the quality/performance of goods and services that we buy. Innovation can stimulate improvements in dynamic efficiency, always providing that the innovations that come to market are appropriate in satisfying our changing needs and wants.

- 34 -

Tutor2u www.tutor2u.net

Innovation as a barrier to entry

Innovative behaviour can be an important barrier to entry in markets. Firstly because some the property rights embedded in product innovations might be protected by patent laws. There is nearly always a “first mover advantage” for successful innovators that gives them scope to exploit some monopoly power in a market. Set against this argument is that view that high rates of innovation reduce barriers to entry because they challenge existing market power enjoyed by well-established businesses.

Process innovation

Process innovations involve changes to the way in which production takes place, be it on the factory floor, business logistics or innovative behaviour in managing employees in the workplace. The effects can be both on a firm’s cost structure (i.e. the ratio of fixed to variable costs) as well as the balance of factor inputs used in production (i.e. labour and capital).

Cost reducing innovations cause an outward shift in market supply and they provide the scope for businesses to enjoy higher profit margins with a given level of demand. Process innovation should also lead to a more efficient use of resources.

The diagram above uses cost and revenue curves to show the effect of driving down production costs from SRAC1 to SRAC2 – leading to lower prices and a higher output. You could also use this diagram to show the gains in producer and consumer surplus that come from cost-reducing innovation and technological change. Consumers stand to gain from such innovation in that they should be able to expect lower prices. This increases their real incomes.

Costs

Output (Q)

SRAC1

SRAC3

AR (Demand)

MR

MC1

MC2

P1

P2

Q1 Q2

Profit at Price P1

Profit at Price P2

- 35 -

Tutor2u www.tutor2u.net

Case Study: IPods, Innovation and Market Structures

Apple’s iPod was launched in 2001 and in that time Apple has sold more than 180 million units. Despite the entry of Microsoft’s Zune digital media player (launched in 2006, and manufactured by Japan’s Toshiba) and existing players produced by the likes of Sony, Creative and Samsung, the Apple iPod continues to enjoy a market share of more than eighty per cent.

The early generations of the iPod largely created a new market rather than displacing an existing one. And Apple’s strategy since then has been to innovate and deliver new products to the market that appeal to a new group of consumers. Indeed there are those who claim that Apple has built up a vertical monopoly in this market based around the success of the iPod, iPod Shuffle, iTouch, iPod Nano with Apples iTunes software, the iTunes Music Store platform, and the FairPlay digital rights management system (DRM). Until recently, DRM acted as a barrier to entry in the market because it prevented consumers who had purchased songs through iTunes from using them on digital players other than Apple’s own products.

In January 2009 Apple made agreements with the big music labels to offer music free of DRM protection. As the Times reported in January 2009 “DRM-protected songs prevent music being copied — an option insisted on by recording studios — meaning that iTunes tracks could be played only on Apple products such as iPods.” iPod’s market position has been further reinforced by a mini-economy of accessories that have been released onto the market - from docking stations to headphones.

An oligopoly is a market dominated by a few producers, each of which has some control over the market. However, oligopoly is best defined by the conduct (or behaviour) of firms within a market rather than its market structure. In an oligopoly we frequently see:

1/ Periods of intense price competition between rival brands

2/ Investment in research and development to speed up product and process innovation

3/ An emphasis on non-price competition as a way of gaining and protecting market share

4/ Entry and exit barriers that limit the number of businesses that can operate profitably in the market

The iPod fits fairly neatly into this type of market structure because of

(i) The use of patented technologies such as digital rights management to protect Apple’s position

(ii) Encouraging developers to bring out new applications for products such as the iTouch

(iii) Exploitation of large economies of scale that brings down the unit costs of production

(iv) Occasional price wars as the main suppliers compete for market share

(v) Strong focus on the brand and on new generations of digital media players with new features / extra functionality / stronger design and improved portability

The success of the iPhone raises questions about the future of the iPod! Is there still a distinct need for a personal digital media player when all of its features are offered by the iPhone? The fiercest battle is now in the smart phone market where Apple faces tough competition from Nokia and Research in Motion, the manufacturer of the Blackberry.

Source: Tutor2u Economics Blog

- 36 -

Tutor2u www.tutor2u.net

Government Policy and Innovation

Supply-side strategies are usually linked directly with attempts to promote more innovative behaviour. Indeed the focus of government policy is firmly focused on improvements in the microeconomics of markets.

Which policies might encourage more innovation?

o Tax credits / capital investment allowances.

o Policies to encourage small business creation and entrepreneurship.

o Toughening up of competition policy to expose cartel behaviour, but to allow and promote joint ventures to fund research and development.

o Lower corporation taxes to encourage innovative foreign companies to establish in Britain.

o Increased funding for research in our universities.

Important developments:

1. Increasingly most innovation is done by smaller firms and by entrepreneurs– indeed multinational corporations are now out-sourcing their research and development spending to small businesses at home and overseas – much is being shifted to cheaper locations “offshore”—in India and Russia. See this article on entrepreneurship in the Economist.

2. Innovation is now a continuous process – in part because the length of the product cycle is getting shorter as innovations are rapidly copied by competitors, pushing down profit margins and (according to a recent article in the economist) “transforming today's consumer sensation into tomorrow's commonplace commodity” – a good example of this is the introduction of two major competitors to the anti-impotence drug Viagra!

3. Innovation is not something left to chance – the most successful firms are those that pursue innovation in a systematic fashion – it becomes part of their corporate culture.

4. Demand innovation is becoming more important: In many markets, demand is either stable or in decline. The response is to go for “demand innovation” - discovering fresh demand from consumers and adapting an existing product to meet them – the toy industry is a classic example of this.

5. The 2009 recession may well prove to be a stimulus to innovation; many of the successful ‘new’ products of today were developed and tested during the last recession.

Suggestions for further reading on the economics of innovation and technological change

Britain’s brilliant ideas boom (Money Programme, November 2007)

Video games make history in 2007 (BBC news, December 2007)

The technology of teaching (BBC news, March 2008)

Innovation is transforming NHS care (BBC news, July 2008)

The many faces of innovation (The Economist, July 2008)

Jam boy is Scotland’s top innovator (BBC news, December 2008)

Moment of change – energy innovation (BBC Worldwide, Jan 2009)

Innovating out of a recession (BBC news video, April 2009)

Innovation firms buck the economic downturn (BBC news, July 2009)

- 37 -

Tutor2u www.tutor2u.net

6. Productive and allocative efficiency Efficiency is about a society making optimal use of scarce resources to satisfy wants & needs.

There are several meanings of efficiency but they all link to how well a market allocates our scarce resources to satisfy consumers. Normally the market mechanism is good at allocating these inputs, but there are occasions when the market can fail.

Allocative efficiency

Allocative efficiency is concerned with whether the resources we have available are actually used to produce the goods and services that we want and which we place the greatest value on. Allocative efficiency is reached when no one can be made better off without making someone else worse off.

Allocative efficiency occurs when the value that consumers place on a good or service (reflected in the price they are willing and able to pay) equals the cost of the resources used up in production. The condition required for allocative efficiency is that price = marginal cost.

In the diagram above, the market is in equilibrium at price P1 and output Q1. At this point, the total area of consumer and producer surplus is maximised. If for example, suppliers were able to restrict output to Q2 and hike the market price up to P2, sellers would gain extra producer surplus by widening their profit margins, but there also would be an even greater loss of consumer surplus. Thus P2 is not an allocative efficient allocation of resources for this market whereas P1, the market equilibrium price is deemed to be allocative efficient.

We will see when we study the economics of monopoly that when businesses have ‘pricing power’ in their own markets, they may increase their profit margins to squeeze some extra profit from consumers (they are turning consumer surplus into producer surplus). This has an effect on allocative efficiency for if a monopoly supplier can select a price well above the costs of supply, consumers will suffer a reduction in their welfare. Have you ever felt ripped off buying sandwiches from a motorway service station? The producer has become better off but someone else (aka the consumer) has become worse off.

Using the production possibility frontier to show allocative efficiency

Costs

Revenues

Output (Q)

Demand

Supply

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

Consumer Surplus (CS)

Producer Surplus (PS)

Q2

P2

- 38 -

Tutor2u www.tutor2u.net

Pareto defined allocative efficiency as a position “where no one could be made better off without making someone else at least as worth off.”

This can be illustrated using a production possibility frontier – all points that lie on the PPF are allocatively efficient because we cannot produce more of one product without affecting the amount of all other products available. In the diagram below, the combination of output shown by Point A is allocatively efficient as is the combination shown at point B – but at the output combination X we can increase production of both goods by making fuller use of existing resources or increasing efficiency.

If an economy is operating within the productive possibility frontier there will be an under-utilisation of resources causing output of goods and services to be lower than is feasible. In this sense unemployment is a waste of scare resources; indeed the hours lost through jobless workers can never be recovered – unemployment can be very costly from both an economic and social viewpoint.

If every market in the economy is a competitive free market, the resulting equilibrium throughout the economy will be Pareto-efficient.

Productive Efficiency

Productive efficiency refers to a firm's costs of production. It is achieved when the output is produced at minimum average total cost (ATC) i.e. when a firm is exploiting economies of scale. Productive efficiency also exists when producers minimise the wastage of resources in their production processes.

Dynamic Efficiency

Dynamic efficiency occurs over time and it focuses on changes in the amount of consumer choice available in markets together with the quality of goods and services available.

Social Efficiency

Output of Consumer Goods

Output of Capital Goods

C2

C1

X2 X1

A

B

X

Innovation as a source of dynamic efficiency

Dynamic efficiency is improved when businesses bring to the market goods and services that are innovative and high quality and which offer consumers greater choice.

- 39 -

Tutor2u www.tutor2u.net

The socially efficient level of output and or consumption occurs when marginal social benefit = marginal social cost. At this point we maximise social welfare. The existence of negative and positive externalities means that the private optimum level of consumption or production often differs from the social optimum leading to some form of market failure and a loss of social welfare.

In the diagram below the socially optimum level of output occurs where the social cost of production (i.e. the private cost of the producer plus the external costs arising from externality effects) equals demand (a reflection of private benefit from consumption.

A private producer who opts to ignore the negative production externalities might choose to maximise their own profits at point A. This divergence between private and social costs of production can lead to market failure.

Consumer and producer surplus explained

• Consumer surplus is the difference between the total amount that consumers are willing and able to pay for a good or service (indicated by the demand curve) and the total amount that they actually pay (the market price).

• Producer surplus is the difference between what producers are willing and able to supply a good for and the price they actually receive. The level of producer surplus is shown by the area above the supply curve and below the market price.

Output (Q)

Demand = Private Marginal Benefit = Social Marginal Benefit

Private Marginal Cost (Supply)

Q1

Costs

Revenues

Marginal Social Cost

Q2

External Cost P1

P2

- 40 -

Tutor2u www.tutor2u.net

Economic efficiency

Economic efficiency is achieved when an output of goods and services is produced making the most efficient use of our scarce resources and when that output best meets the needs and wants and consumers and is priced at a price that fairly reflects the value of resources used up in production.

1. If in an economy, no one can be made better off without making someone else worse off, the conditions for allocative efficiency have been met.

2. If in an economy, production of goods and services takes place at minimum of feasible average cost, the conditions for productive efficiency have been met.

Price

Quantity

Demand

Supply

P1

Q1

Equilibrium Point Consumer

Surplus

Producer Surplus

- 41 -

Tutor2u www.tutor2u.net

Case Study: Radiohead - Paying the price you are willing to pay

Radiohead's new album In Rainbows was released to a wave of publicity largely surrounding their innovative pricing strategy. Fans were invited to name their own price for the downloadable mp3 files and in the event, nearly two-thirds of down loaders paid nothing. Indeed Internet monitoring company Comscore found that only 38% of down loaders willingly paid to do so and the average price paid for the album was £2.90. One person in ten was willing to pay between £3.80 and £5.71 for the album.

Source: Adapted from news reports

Price discrimination and consumer & producer surplus

Price discrimination occurs when a firm charges a different price to different groups of consumers for an identical good or service, for reasons not associated with the costs of supply. Is price discrimination something that economists should be supporting in terms of the behaviour of businesses and final outcomes in different markets?

Pure (1st degree) discrimination

With 1st degree price discrimination the firm is able to perfectly segment the market so that the consumer surplus is removed and turned into producer surplus. Thus there is a clear transfer of welfare from consumers to producers. This is shown in the next diagram.

Costs

Revenues

Output (Q)

Market Demand

Supply in a competitive market

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

P2

Q2

Net Loss of Economic Welfare from price P2 raised above the equilibrium price

Allocative efficiency in a competitive market

At the competitive market equilibrium price and output, we maximise consumer and producer surplus. No one can be made better off without making someone else worse off – this is known as the condition required for a Pareto optimal allocation of resources

Allocative efficient price and output at the market equilibrium

- 42 -

Tutor2u www.tutor2u.net

Third degree (or multi-market) price discrimination involves charging different prices for the same product in different segments of the market. The key is that third degree discrimination is linked directly to consumers’ willingness and ability to pay for a good or service. It means that the prices charged may bear little or no relation to the cost of production. Clearly the price elasticity of demand is the key factor determining the pricing decision for producers for each part of the market.

The market is usually separated in two ways: by time or by geography. For example, exporters may charge a higher price in overseas markets if demand is found to be more inelastic than it is in home markets. There is more consumer surplus to be exploited when demand is insensitive to price changes.

Market A Market B

MC=AC

QuantityQuantity

Price Price

Pa

Pb

MRa

MRb ARb

ARa

Profit from selling to market A – with a relatively elastic demand – and charging a lower price

Demand in segment B of the market is relatively inelastic. A higher unit price is charged

MC=AC

QbQa

Consumer surplus at Price Pa Consumer surplus at Price Pa

Quantity of Output (Q)

Price (P)

AR (Market Demand) MR

P1

Average Cost = Marginal Cost

Q1

P2

P4

Q3 Q2

Equilibrium output with perfect price discrimination – the monopolist will sell an extra unit providing that the next unit adds as much to revenue as it does to cost

P3

P5

Q4 Q5

Consumer surplus is turned into extra revenue for the producer = additional producer surplus (higher profits)

- 43 -

Tutor2u www.tutor2u.net

7. Normal and supernormal profit The Nature of Profit

Profit measures the return to risk when committing scarce resources to a market or industry. Entrepreneurs take risks for which they require an adequate rate of return. The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is likely to demand. Economists distinguish between different types of profit – explained below:

1. Normal profit - is the minimum level of profit required to keep factors of production in their current use in the long run. Normal profits reflect the opportunity cost of using funds to finance a business. If you decide to put £200,000 of your savings into a new business, those funds could have earned a low-risk rate of return by being saved in a bank account. You might therefore use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment in order to keep going in the long run! Because we treat normal profit as an opportunity cost of investing financial capital in a business, we include an estimate for normal profit in the average total cost curve, thus, if the firm covers its AC then it is making normal profits.

2. Sub-normal profit - is any profit less than normal profit (where price < average cost)

3. Abnormal profit - is any profit achieved in excess of normal profit - also known as supernormal profit. When firms are making abnormal profits, there is an incentive for other producers to enter a market to try to acquire some of this profit. Abnormal profit persists in the long run in imperfectly competitive markets such as oligopoly and monopoly where firms can successfully block the entry of new firms. We will come to this later when we consider barriers to entry in monopoly.

Calculating economic profit

Consider the following example:

The table shows data for an owner-managed firm for a particular year.

• Total revenue £320,000

• Raw material costs £30,000

• Wages and salaries £85,000

• Interest paid on bank loan £30,000

• Salary that the owner could have earned elsewhere £32,000

• Interest forgone on owner's capital invested in the business £20,000

In a simple accounting sense, the business has total revenue of £320,000 and costs of £145,000 giving an accounting profit of £175,000. But the firm’s profit according to an economist should take into account the opportunity cost of the capital invested in the business and the income that the owner could have earned elsewhere. Taking these two items into account we find that the economic profit is £123,000.

- 44 -

Tutor2u www.tutor2u.net

8. Profit Maximisation Profits are maximised when marginal revenue = marginal cost

Price Per Unit (AR) (£)

Demand / Output (units)

Total Revenue (TR)

(£)

Marginal Revenue (MR)

(£)

Total Cost (TC)

(£)

Marginal Cost (MC)

(£)

Profit (£)

50 33 1650 2000 -350

48 39 1872 37 2120 20 -248

46 45 2070 33 2222 17 -152

44 51 2244 29 2312 15 -68

42 57 2394 25 2384 12 10

40 63 2520 21 2444 10 76

38 69 2622 17 2480 6 142

36 75 2700 13 2534 9 166

34 81 2754 9 2612 13 142

Consider the example in the table above. As price per unit declines, so demand expands. Total revenue rises but at a decreasing rate as shown by the column showing marginal revenue. Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units. Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas marginal cost is £9 per unit. Profits increase from £142 to £166.

But once marginal cost is greater than marginal revenue, total profits are falling. Indeed the firm makes a loss if it increases output to 93 units.

As long as marginal revenue is greater than marginal cost, total profits will be increasing (or losses decreasing). The profit maximisation output occurs when marginal revenue = marginal cost.

In the next diagram we introduce average revenue and average cost curves into the diagram so that, having found the profit maximising output (where MR=MC), we can then find (i) the profit maximising price (using the demand curve) and then (ii) the cost per unit.

• The difference between price and average cost marks the profit margin per unit of output.

Profits are decreasing when MR < MC

Marginal Revenue

Marginal Cost

Q1

Revenue

And Cost

Output (Q)

Profits are increasing when MR > MC

- 45 -

Tutor2u www.tutor2u.net

• Total profit is shown by the shaded area and equals the profit margin multiplied by output

The short run supply decision - the shut-down point

A business needs to make at least normal profit in the long run to justify remaining in an industry but in the short run a firm will continue to produce as long as total revenue covers total variable costs or price per unit > or equal to average variable cost (AR = AVC). This is referred to as the shutdown price.

The reason for this is as follows. A business’s fixed costs must be paid regardless of the level of output. If we make an assumption that these costs cannot be recovered if the firm shuts down then the loss per unit would be greater if the firm were to shut down, provided variable costs are covered.

Consider the cost and revenue curves facing a business in the short run in the diagram above.

Costs

Revenue

Output (Q)

SRAC

AR (Demand)

MR

SRMC

Q1

P1

AC1

Supernormal profits at Price P1 and output Q1

AC2

Q2

Normal profit at Q2 where AR = AC

Costs,

Revenues

Output (Q) Q1

MC

AVC

AR

MR

P1

AC1 A

B

C

P1 is below average variable cost

P2

ATC

- 46 -

Tutor2u www.tutor2u.net

Average revenue (AR) and marginal revenue curves (MR) lies below average cost across the full range of output, so whatever output produced, the business faces making a loss.

At P1 and Q1 (where marginal revenue equals marginal cost), the firm would shut down as price is less than AVC. The loss per unit of producing is vertical distance AC.

If the firm shuts down production the loss per unit will equal the fixed cost per unit AB.

In the short-run, provided that the price is greater than or equal to P2, the business can justify continuing to produce in the short run.

Case Study: Northern Foods decides to mothball a factory

Northern Foods, which supplies Marks and Spencer, is to mothball a factory making ready-meals because it is no longer economical. They said that, whilst the plant had been profitable in recent years it was no longer generating enough money to give an adequate return to shareholders. Some analysts have argued that the decision might be due to the effects of the monopsony power of Marks and Spencer which has demanded discounts of up to 6% from its top suppliers including Northern Foods.

Source: Adapted from news reports, May 2008

Case Study: Bitter blow for beer drinkers as pubs call last orders

It is a bitter blow for the licensed trade but 1.2 million fewer pints of beer are being drunk every day in Britain this year compared to last and over forty pubs a week are calling last orders for the final time. The British Beer & Pub Association blames mounting costs - including pub rents, wages and higher wholesale prices for beers and other drinks - together with sinking sales due to falling consumer confidence, higher beer prices and impact of the smoking ban. But the biggest villains of the peace according to the pubs are the major supermarkets whose cheap beer has created a significant price wedge between the cost of drinking at home or having a few jars down the local.

Source: Tutor2u economics blog, May 2009

Recession and factory closures

The concept of the shutdown point has become topical this year due to the recession. Many manufacturing businesses have opted to close down loss-making production plants and retailers have announced the closure of retail outlets in a bid to cut their losses. Some of the plant closures have been temporary, for example some high-profile car manufacturers mothballed their factories and reduced the number of shifts. But for other businesses, the downturn has brought about an end to trading. Over the last year we have seen the demise of a large number of well-known retail businesses including Zaavi, Coffee Republic, Woolworths and MFI.

Aluminium plant closes with loss of 400 jobs (BBC news, March 2009)

Downturn causes chemical plant to close (BBC news, January 2009)

Factory closures as production moves to Eastern Europe (BBC news, April 2009)

Mysterious death of the petrol station (BBC news, March 2008)

Plastics plant closure leads to job losses (BBC news, June 2009)

Sanyo to shutdown TV monitor plant (BBC news, January 2009)

- 47 -

Tutor2u www.tutor2u.net

Deriving the Firm’s Supply Curve in the Short Run

• In the short run, the supply curve for a business operating in a competitive market is the marginal cost curve above average variable cost.

• In the long run, a firm must make a normal profit, so when price = average total cost, this is the break-even point. It will therefore shut down at any price below this in the long run.

• As a result the long run supply curve will be the marginal cost curve above average total cost.

The concept of a ‘supply curve’ is inappropriate when dealing with monopoly because a monopoly is a price-maker, not a “passive” price-taker, and can thus select the price and output combination on the demand curve so as to maximise profits where marginal revenue = marginal cost.

Changes in demand and the profit maximising price and output

A change in demand and/or production costs will lead to a change in the profit maximising price and output. In exams you may often be asked to analyse how changes in demand and costs affect the equilibrium output for a business. Make sure that you are confident in drawing these diagrams and you can produce them quickly and accurately under exam conditions.

In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 (assuming that short run costs of production remain unchanged). The increase in demand causes a rise in the market price from P1 to P2 (consumers are now willing and able to buy more at a given price perhaps because of a rise in their real incomes or a fall in interest rates which has increased their purchasing power) and an expansion of supply (the shift in AR and MR is a signal to firms to move along their marginal cost curve and raise output). Total profits have increased.

Costs

Output (Q)

AC

AR1 (Demand)

MR1

MC

Q1

P1

AC1

Profit Max at Price P1

P2

AC2

Q2

Profit Max at Price P2

AR2

MR2

A rise in demand (a shift in AR and MR) causes an expansion of supply, a higher profit maximising price and an increase in supernormal profits

- 48 -

Tutor2u www.tutor2u.net

The Functions of Profit in a Market Economy

Profits serve a variety of purposes to businesses in a market-based economic system

1. Finance for investment Retained profits are source of finance for companies undertaking investment. The alternatives such as issuing new shares (equity) or bonds may not be attractive depending on the state of the financial markets especially in the aftermath of the credit crunch.

2. Market entry: Rising profits send signals to other producers within a market. When existing firms are earning supernormal profits, this signals that profitable entry may be possible. In contestable markets, we would see a rise in market supply and lower prices. But in a monopoly, the dominant firm(s) may be able to protect their position through barriers to entry.

3. Demand for factor resources: Scarce factor resources tend to flow where the expected rate of return or profit is highest. In an industry where demand is strong more land, labour and capital are then committed to that sector. Equally in a recession, national output, employment, incomes and investment all fall leading to a squeeze on profit margins and attempts by businesses to cut costs and preserve their market position. In a flexible labour market, a fall in demand can quickly lead to a reduction in investment and cut-backs in labour demand.

4. Signals about the health of the economy: The profits made by businesses throughout the economy provide important signals about the health of the macroeconomy. Rising profits might reflect improvements in supply-side performance (e.g. higher productivity or lower costs through innovation). Strong profits are also the result of high levels of demand from domestic and overseas markets. In contrast, a string of profit warnings from businesses could be a lead indicator of a macroeconomic downturn.

Real GDP Growth (Top) and Net rate of return on capital employed (Bottom)Business Profits and the Economic Cycle

Source: CBI Manufacturing Survey

99 00 01 02 03 04 05 06 07 08

milli

ons

6

8

10

12

14

16

18

Rat

e of

retu

rn (%

) (m

illion

s)

6

8

10

12

14

16

18

Manufacturing

Service Sector Industries

-5-4-3-2-1012345

% c

hang

e in

GD

P

-5-4-3-2-1012345

- 49 -

Tutor2u www.tutor2u.net

Steps to higher profits

In an ideal world, running a business would be easy! You come up with an innovative idea, create a new product or service so popular you can’t stop people from buying it. Word spreads and, before you know it, sales and profits are growing. In reality, few businesses are able to sit back and watch the profits roll in. Creating and increasing profitability depends on doing a hundred little things better than the existing competition. So what are the best ways for a business to increase its profitability?

Method 1: Grow the “Top Line”

Every business and every market is different. But for most businesses, the best long-term way to improve profitability is to increase sales (also known as “turnover”). This is for four main reasons:

1. If a business has a high gross profit margin, every extra sale is profitable. Once your turnover reaches the break-even level then each additional sale adds to profits.

2. Acquiring new customers is made easier by greater market presence and reputation. As you grow, unit costs are reduced through economies of scale.

3. If your customers tend to be loyal, the value of each new customer lays not just in the immediate sale, but in future sales as well. The cost of selling to existing customers is always lower than the cost of acquiring new customers.

4. Defending a market share against competitors is easier than defending high profit margins.

Many businesses operate in what are called “low growth” markets - where expansion only comes by taking a bigger share of the available demand. Low growth markets tend to be in markets where income elasticity of demand is low, so that as the real incomes of consumers increase, there is little positive effect on market demand.

Method 2: Keep Costs under Control

If a business has a low gross profit margin, reducing direct costs increases the profit on each sale. Eliminating overheads has an immediate impact on profit. Every business can increase profitability by reducing hidden costs. Hidden costs include the costs of employing inappropriate people since poor recruitment can lead to lower quality, increased training costs and ultimately redundancy costs.

Suggestions for further reading on profits

The recession has hit profits in many businesses and industries, but not every business suffers a slump in profitability during an economic downturn. Here is a selection of recent news articles on the profitability of businesses in different markets and industries and how changes in demand and costs affect prices and profits.

Burger King Profits grow strongly (BBC news, April 2009)

Dominos delivers strong profits (BBC news, February 2009)

Downturn hits sports giant Nike (BBC news, June 2009)

Honda profits slump as sales fall (BBC news, April 2009)

PC maker Dell’s profits slump (BBC news, May 2009)

Profits fall at Gregg’s bakeries (BBC news, March 2009)

Profits up at frozen food retailer (BBC news, June 2009)

Ryanair reports first annual loss (BBC news, June 2009)

Setanta goes into administration (BBC news, June 2009)

- 50 -

Tutor2u www.tutor2u.net

9. Barriers to market entry and exit Barriers to entry are designed to block potential entrants from entering a market profitably. They seek to protect the power of existing firms and maintain supernormal profits and increase producer surplus. These barriers have the effect of making a market less contestable - they are also important because they determine the extent to which well-established firms can price above marginal and average cost in the long run.

The 1982 Nobel Prize winning economist George Stigler defined an entry barrier as “A cost of producing which must be borne by a firm which seeks to enter an industry but is not borne by businesses already in the industry”.

Another Economist, George Bain defined entry barriers as “The extent to which established firms elevate their selling prices above average cost without inducing rivals to enter an industry”.

The Bain interpretation of entry barriers emphasises the asymmetry in costs that often exists between the incumbent firm and the potential entrant. If the existing businesses have managed to exploit economies of scale and developed a cost advantage, this might be used to cut prices if and when new suppliers enter the market. This is a move away from short-run profit maximisation objectives – but it is designed to inflict losses on new firms and protect a dominant position in the long run. The monopolist might then revert back to profit maximization once a new entrant has been sent packing!

Another way of categorising entry barriers is summarised below

o Structural barriers (also known as ‘innocent’ entry barriers) – arising from differences in production costs.

o Strategic barriers (see the notes below on strategic entry deterrence).

o Statutory barriers – these are entry barriers given force of law (e.g. patent protection of franchises such as the National Lottery or television and radio broadcasting licences).

Entry barriers exist when costs are higher for an entrant than for the incumbent firms. This is shown in the next diagram.

The incumbent monopolist has achieved economies of scale so that that its own LRAC and LRMC are lower than that of a potential entrant. If the monopolist maintains a profit maximising price of P1, a market entrant could achieve above normal profits since its costs are lower than the prevailing price. At any price below Pe the potential entrant will make a loss – and entry can be blockaded.

- 51 -

Tutor2u www.tutor2u.net

Theory of Early Mover or First Mover Advantage

Sometimes there are sizeable advantages to being first into a market – first-movers can establish themselves, build a customer base and make life difficult for new firms on the scene. The first-mover idea is summarised thus:

Grow first & become larger Achieve economies of scale Bigger business generates the resources to do more innovation More innovation leads to better products and lower costs Catalyst to grow bigger Eventually no entrant can compete Later entrants may be forced to exit the market

Barriers to Exit – (Sunk Costs)

Whilst textbooks tend to concentrate on the costs of entering a market, often it is the financial implications of leaving an industry that act as one of the most important barriers – hence we need to consider exit costs. A good example of these is the presence of sunk costs.

Sunk costs cannot be recovered if a business decides to leave an industry. Examples include:

o Capital inputs that are specific to an industry and which have little or no resale value.

o Money spent on advertising, marketing and research and development projects which cannot be carried forward into another market or industry.

When sunk costs are high, a market becomes less contestable. High sunk costs act as a barrier to entry of new firms because they risk making huge losses if they decide to leave a market. In contrast, markets such as fast-food restaurants, sandwich bars, hairdressing salons and local antiques markets have low sunk costs so the barriers to exit are low.

o Asset-write-offs – e.g. the expense associated with writing-off items of plant and machinery, stocks and the goodwill of a brand

o Closure costs including redundancy costs, contract contingencies with suppliers and the penalty costs from ending leasing arrangements for property

o The loss of business reputation and goodwill - a decision to leave a market can seriously affect goodwill among previous customers, not least those who have bought a product which is then withdrawn and for which replacement parts become difficult or impossible to obtain.

LRAC = LRMC (Existing Monopolist)

Monopoly Demand (AR)

MR

Q1

Revenue

Cost and Profit

Output (Q)

P1

Pc

Qc

B

A

C

AC = MC (Potential Entrant into the market)

D

- 52 -

Tutor2u www.tutor2u.net

o A market downturn may be perceived as temporary and could be overcome when the economic or business cycle turns and conditions become more favourable

Strategic Entry Deterrence

Strategic entry deterrence involves any move by existing firms to reinforce their position against other firms of potential rivals. There are plenty of examples of this – including the following:

o Hostile takeovers and acquisitions – taking a stake in a rival firm or buying it up!

o Product differentiation through brand proliferation (i.e. investment in developing new products and spending on marketing and advertising to reinforce consumer / brand loyalty).

o Capacity expansions to achieve lower unit costs from exploiting internal economies of scale.

o Predatory pricing: Predatory behaviour is defined as a dominant company sustaining losses in the short run with the knowledge it will be able to recoup them once the competition is forced to exit, and is in breach of the Competition Act 1998. We return to this in the chapter on oligopoly and cartels.

Strategic barriers may be deemed anti-competitive by the British and EU competition authorities - The EU Competition Commission has been active in recent years in building cases against European businesses that have engaged in anti-competitive practices including price fixing cartels.

Case Study: Allegations of predatory pricing in the Cardiff bus market

Cardiff's main bus company has been accused of "predatory behaviour" in an investigation by the Office of Fair Trading (OFT). The OFT found that the Cardiff Bus Company, which carries an estimated 80,000 people each weekday in Cardiff, used its dominant position to run its no frills services with revenues so far below costs that it was impossible for its competitor (2Travel plc) to remain in the market. Cardiff Bus denied it had infringed competition law.

Sources: News reports and the Office of Fair Trading

Case Study: Borders v Amazon

Borders bookstore has broken away from Amazon after seven years to launch its own standalone website. Borders.com will have a total of 2 million books and DVDs in its inventory. In addition, in an agreement with Alibris, Borders will now offer about 60 million used books for sale. The site also features a link to its cobranded e-bookstore with Sony and has the ability to download digital audio either in DRM or DRM-free formats. The success or failure of the attempt by Borders to break the stranglehold of Amazon in the battle for market share in the UK will be an interesting test case of the scale of barriers to entry and the power of first mover advantage.

Source: Tutor2u blog, June 2008

Despite the inevitability of entry and exit barriers markets are constantly evolving and we often do witness the entry of new suppliers even when one or more firms have a clear position of market power. Entry can occur in a variety of ways:

1. A takeover from outside the industry (sometimes known as the “Trojan-horse route” to by-pass any structural entry barriers that might exist within an industry.)

2. A transfer of brand names from one sector of the economy to another (for example the diversification practiced by both EasyGroup, Virgin and Stagecoach in recent years.)

3. Increasing competition from overseas – i.e. the liberalisation of markets around the world

- 53 -

Tutor2u www.tutor2u.net

Case Study – Competition in the UK Energy Market The UK energy market for electricity and gas is in theory competitive and not in need of any robust price regulation. However, industry analysts and the regulator of the energy sector OFGEM have become concerned that the big six firms are not serving their customers nor operating as a competitive market. The UK’s energy oligopoly is made up of British Gas, EDF, N power, E.ON, Scottish Power and Scottish and Southern Energy (SSE). The suspicions of the regulator, OFGEM, were initially aroused when all six companies raised their prices by similar amounts within a short period of time early in 2008. The companies claimed this was not evidence of a cartel as they faced similar rises in costs due to the rise in the wholesale price of gas. A highly concentrated market, selling a homogeneous product with price inelastic demand, has all the ingredients for the formation of a successful cartel. Although an investigation by OFGEM found no evidence of collusion by the six firms, it is quite possible that the market is an example of a complex monopoly. Hence the firms may thus not be competing effectively and be engaging in tacit collusion or a form of price leadership. Thus there may have been no evidence of meetings between the firms, nor an exchange of sensitive information, but nonetheless there is not a fully functioning competitive market. In addition, the probe by OFGEM was concerned about the practice of possible price discrimination against some consumers. The regulator found that dual fuel customers (those who buy both gas and electricity from the same supplier) were getting their energy cheaper than those customers who bought just one source of energy from a supplier. As parts of the UK don’t have access to mains supply gas this is arguably unfair to some consumers with up to 4.3 million losing out. Similarly, those customers who pay for their energy by direct debit from their bank account pay less than those who use pre-payment meters. Is this a form of price discrimination? In a sense it is, because different customers are being charged more than others for the same product. However, it can be argued that the cost of running the pre-payment meter scheme is higher than the direct debit scheme. Unfortunately it is mainly lower income households that use pre-payment meters and there is a feeling among consumer groups and some MPs that they are being treated unfairly. Further concerns by the regulator about the UK energy market relate to doorstep and telephone selling by energy companies trying to get customers to switch to new suppliers. Often customers are allegedly persuaded to switch their energy company having not been given all the facts of their new terms of supply. As a result they can end up paying more and are the victims of asymmetric information. However, some customers stick with energy suppliers despite the fact that they can better terms with another firm. They simply cannot be bothered to take the time to investigate other competitors and are suffering from customer inertia. Arguably switching supplier should be made easier. Consumers groups such as Consumer Focus feel that the energy market should be fully investigated by the Competition Commission as it has greater powers than the regulator, OFGEM. OFGEM have warned the energy companies to put their house in order or they will do just that. With the UK’s energy policy complicated by the nuclear issue, renewable energy and meeting CO2 emissions targets there is much food for thought for energy suppliers, the regulator and the government.

Source: Robert Nutter, EconoMax January 2009

Suggestions for further reading:

Pre-pay meter users due a rebate (BBC news, June 2009)

Energy bills are unfair to some (BBC news, October 2008)

OFGEM to publish energy findings (BBC news, October 2008)

- 54 -

Tutor2u www.tutor2u.net

10. Market concentration What do we mean by market concentration?

When we focus on industries where one or more firms have market power we often use the term concentration ratio. This measures the market share of the top ‘n’ firms in the industry. Share can be by sales, employment or any other relevant indicator. The value of ‘n’ is often five, but may be three or any other small number. If the top ‘n’ firms gain a greater market share the industry is said to have become more highly concentrated. Our example below is taken from the June 2008 figures for market share in the UK food retail sector.

• The 3 firm concentration ratio is measured at 63.9%

• The 5 firm concentration ratio is measured at 83.4%

• This market structure suggests an oligopoly – but each of the businesses has ‘market power’ in the sense that each has control over the products it sells and the prices it charges.

• The data is for the national economy – local and regional concentration ratios might be different – e.g. the local monopoly power enjoyed by one or more businesses. The UK competition authorities are aware of this when they investigate markets.

MARKET SHARE (%)

CUMULATIVE MARKET SHARE (%)

Tesco 31.2 31.2 Asda (Wal-Mart) 16.8 48.0 Sainsbury’s 15.9 63.9 Morrisons (Safeways) 11.4 75.3 Co-operative (Somerfield) 8.1 83.4 Waitrose 3.9 87.3 Aldi 2.9 90.2 Lidl 2.3 92.5 Iceland 1.7 94.2

1. A pure monopolist in an industry is a single seller. It is quite rare for a firm to have a pure monopoly – except when the industry is state-owned and has a legally protected monopoly. The Royal Mail used to have a statutory monopoly on delivering household mail. But this is now changing fast as the industry has been opened up to fresh competition.

2. A working monopoly: A working monopoly is any firm with greater than 25% of the industries' total sales. In practice, there are many markets where businesses enjoy some degree of monopoly power even if they do not have a twenty-five per cent market share.

3. A dominant firm is a firm that has at least forty per cent of their given market.

- 55 -

Tutor2u www.tutor2u.net

11. Perfect Competition

Perfect competition – a pure market

Perfect competition describes a market structure whose assumptions are strong and therefore unlikely to exist in most real-world markets. Economists have become more interested in pure competition partly because of the growth of e-commerce as a means of buying and selling goods and services. And also because of the popularity of auctions as a device for allocating scarce resources among competing ends.

Assumptions for a perfectly competitive market

1. Many sellers each of whom produce a low percentage of market output and cannot influence the prevailing market price.

2. Many individual buyers, none has any control over the market price

3. Perfect freedom of entry and exit from the industry. Firms face no sunk costs and entry and exit from the market is feasible in the long run. This assumption means that all firms in a perfectly competitive market make normal profits in the long run.

4. Homogeneous products are supplied to the markets that are perfect substitutes. This leads to each firms being “price takers” with a perfectly elastic demand curve for their product.

5. Perfect knowledge – consumers have all readily available information about prices and products from competing suppliers and can access this at zero cost – in other words, there are few transactions costs involved in searching for the required information about prices. Likewise sellers have perfect knowledge about their competitors.

6. Perfectly mobile factors of production – land, labour and capital can be switched in response to changing market conditions, prices and incentives.

7. No externalities arising from production and/or consumption.

The real world of imperfect competition!

It is often said that perfect competition is a market structure that belongs to out-dated textbooks and is not worthy of study! Clearly the assumptions of pure competition do not hold in the vast majority of real-world markets, for example, some suppliers may exert control over the amount of goods and services supplied and exploit their monopoly power.

On the demand-side, some consumers may have monopsony power against their suppliers because they purchase a high percentage of total demand. Think for example about the buying power wielded by the major supermarkets when it comes to sourcing food and drink from food processing

- 56 -

Tutor2u www.tutor2u.net

businesses and farmers. The Competition Commission has recently been involved in lengthy and detailed investigations into the market power of the major supermarkets.

In addition, there are nearly always some barriers to the contestability of a market and far from being homogeneous; most markets are full of heterogeneous products due to product differentiation – in other words, products are made different to attract separate groups of consumers.

Consumers have imperfect information and their preferences and choices can be influenced by the effects of persuasive marketing and advertising. In every industry we can find examples of asymmetric information where the seller knows more about quality of good than buyer – a frequently quoted example is the market for second-hand cars! The real world is one in which negative and positive externalities from both production and consumption are numerous – both of which can lead to a divergence between private and social costs and benefits. Finally there may be imperfect competition in related markets such as the market for key raw materials, labour and capital goods.

Adding all of these points together, it seems that we can come close to a world of perfect competition but in practice there are nearly always barriers to pure competition. That said there are examples of markets which are highly competitive and which display many, if not all, of the requirements needed for perfect competition. In the example below we look at the global market for currencies.

Currency markets - taking us closer to perfect competition

• The global foreign exchange market is where all buying and selling of world currencies takes place. There is 24-hour trading, 5 days a week.

• Trading volume in the Forex market is around $3 trillion per day – equivalent to the annual GDP of France! 31% of global trading takes place in London alone.

• Most trading in currencies is ‘speculative.’

The main players in the currency markets are as follows:

• Banks both as “market makers” dealing in currencies and also as end-users demanding currency for their own operations.

• Hedge funds and other institutions (e.g. funds invested by asset managers, pension funds).

• Central Banks (including occasional currency intervention in the market when they buy and sell to manipulate an exchange rate in a particular direction).

• Corporations (for example airlines and energy companies who may use the currency market for defensive ‘hedging’ of exposures to risk such as volatile oil and gas prices.)

• Private investors and people remitting money earned overseas to their country of origin / market speculators trading in currencies for their own gain / tourists going on holiday and people traveling around the world on business.

Why does a currency market come close to perfect competition?

• Homogenous output: The "goods" traded in the foreign exchange markets are homogenous - a US dollar is a dollar and a euro is a euro whether someone is trading it in London, New York or Tokyo.

• Many buyers and sellers meet openly to determine prices: There are large numbers of buyers and sellers - each of the major banks has a foreign exchange trading floor which helps to "make the market". Indeed there are so many sellers operating around the world

- 57 -

Tutor2u www.tutor2u.net

that the currency exchanges are open for business twenty-four hours a day. No one agent in the currency market can, on their own influence price on a persistent basis - all are ‘price takers’. According to Forex_Broker.net "The intensity and quantity of buyers and sellers ready for deals doesn't allow separate big participants to move the market in joint effort in their own interests on a long-term basis."

• Currency values are determined solely by market demand and supply factors.

• High quality real-time information and low transactions costs: Most buyers or sellers are well informed with access to real-time market information and background research analysis on the factors driving the prices of each individual currency. Technological progress has made more information immediately available at a fraction of the cost of just a few years ago. This is not to say that information is cheap - an annual subscription to a Bloomberg or a Reuter’s news terminal will cost several thousand dollars. But the market is rich with information and transactions costs for each batch of currency bought and sold has come down.

• Seeking the best price: The buyers and sellers in foreign exchange only deal with those who offer the best prices. Technology allows them to find the best price quickly.

What are the limitations of currency trading as an example of a competitive market?

• Firstly the market can be influenced by official intervention via buying and selling of currencies by governments or central banks operating on their behalf. There is a huge debate about the actual impact of intervention by policy-makers in the currency markets.

• Secondly there are high fixed costs involved in a bank or other financial institution when establishing a new trading platform for currencies. They need the capital equipment to trade effectively; the skilled labour to employ as currency traders and researchers. Some of these costs may be counted as sunk costs – hard to recover if a decision is made to leave the market.

Despite these limitations, the foreign currency markets take us reasonably close to a world of perfect competition. Much the same can be said for trading in the equities and bond markets and also the ever expanding range of future markets for financial investments and internationally traded commodities. Other examples of competitive markets can be found on a local scale – for example a local farmers’ market where there might be a number of farmers offering their produce for sale.

The internet and perfect competition

Advances in internet technology have made some markets more competitive. It has certainly reduced the barriers to entry for firms wanting to compete with well-established businesses – for example specialist toy retailers are better able to battle for market share with the dominant retailers such as ToysRUs and Wal-Mart.

One of the most important aspects of the internet is the ability of consumers to find information about prices for many goods and services. There are an enormous number of price comparison sites in the UK covering everything from digital cameras to package holidays, car insurance to CDs and jewellery.

That said the price comparison web sites themselves have come under criticism in recent times. For example the sites offering to compare hundreds of different motor insurance policies or mortgage products draw information from the insurance and mortgage brokers but might use limiting

- 58 -

Tutor2u www.tutor2u.net

assumptions about the different types of consumers looking for the best price – the result is a range of prices facing the consumer that don’t accurately reflect their precise needs – and consumers may only realise this when, for example, they make a claim on an insurance policy bought over the internet which turns out not to provide the specific cover they needed.

And in the market for price comparison sites there is monopoly power too! Moneysupermarket.com currently has around 40% of the overall comparison site market, with Confused.com its nearest rival with a share of about 10%.

Price and output in the short run under perfect competition

In the short run, the interaction between demand and supply determines the “market-clearing” price. A price P1 is established and output Q1 is produced. This price is taken by each firm. The average revenue curve is their individual demand curve.

Since the market price is constant for each unit sold, the AR curve also becomes the marginal revenue curve (MR) for a firm in perfect competition.

For the firm, the profit maximising output is at Q2 where MC=MR. This output generates a total revenue (P1 x Q2). Since total revenue exceeds total cost, the firm in our example is making abnormal (economic) profits.

This is not necessarily the case for all firms in the industry since it depends on the position of their short run cost curves. Some firms may be experiencing sub-normal profits if average costs exceed the price – and total costs will be greater than total revenue.

Output (Q) Output (Q)

Market Demand and Supply Individual Firm’s Costs and Revenues Price (P) Price (P)

Market Demand

Market Supply

P1

Q1

AR (Demand) = MR

MC (Supply)

AC

P1

AC1

Q2

- 59 -

Tutor2u www.tutor2u.net

Short run losses

The adjustment to the long-run equilibrium in perfect competition

If most firms are making abnormal profits in the short run, this encourages the entry of new firms into the industry, which will cause an outward shift in market supply forcing down the ruling price.

The increase in supply will eventually reduce the price until price = long run average cost. At this point, each firm in the industry is making normal profit. Other things remaining the same, there is no further incentive for movement of firms in and out of the industry and a long-run equilibrium has been established. This is shown in the next diagram.

We are assuming in the diagram above that there has been no shift in market demand. The effect of increased supply is to force down the price and cause an expansion along the market demand curve.

Output (Q) Output (Q)

Market Demand and Supply Individual Firm’s Costs and RevenuesPrice (P) Price (P)

Market Demand

Market Supply

(MS)

P1

Q1

AR1 = MR1

MC (Supply)

AC

P1

Q3

P2 P2

AR2 = MR2

Q2

MS2

P2

Long run equilibrium

output

Output (Q) Industry Output (Q)

Market Demand and Supply Individual Firm’s Costs and Revenues Price (P) Price (P)

MD1

Market Supply

P1

Q1

AR = MR

MC (Supply)

AC

P1

Q2

MD2

P2

AR2 (Demand) = MR2

AC2

- 60 -

Tutor2u www.tutor2u.net

But for each supplier, the price they “take” is now lower and it is this that drives down the level of profit made towards normal profit equilibrium.

In an exam question you may be asked to trace and analyse what might happen if

1. There was a change in market demand (e.g. arising from changes in the relative prices of substitute products or complements.)

2. There was a cost-reducing innovation affecting all firms in the market or an external shock that increases the variable costs of all producers.

Adam Smith on Competition

“The natural price or the price of free competition ... is the lowest which can be taken. [It] is the lowest which the sellers can commonly afford to take, and at the same time continue their business.”

Source: Adam Smith, the Wealth of Nations (1776), Book I, Chapter VII

Characteristics of competitive markets

The common characteristics of markets that are considered to be “competitive” are:

• Lower prices because of many competing firms. The cross-price elasticity of demand for one product will be high suggesting that consumers are prepared to switch their demand to the most competitively priced products in the marketplace.

• Low barriers to entry – the entry of new firms provides competition and ensures prices are kept low in the long run.

• Lower total profits and profit margins than in markets which dominated by a few firms.

• Greater entrepreneurial activity – the Austrian school of economics argues that competition is a process. For competition to be improved and sustained there needs to be a genuine desire on behalf of entrepreneurs to innovate and to invent to drive markets forward and create what Joseph Schumpeter called the “gales of creative destruction”.

• Economic efficiency – competition will ensure that firms move towards productive efficiency. The threat of competition should lead to a faster rate of technological diffusion, as firms have to be responsive to the changing needs of consumers. This is known as dynamic efficiency.

The importance of non-price competition

In competitive markets, non-price competition can be crucial in winning sales and protecting or enhancing market share.

Perfect competition and efficiency

Perfect competition can be used as a yardstick to compare with other market structures because it displays high levels of economic efficiency.

1. Allocative efficiency: In both the short and long run we find that price is equal to marginal cost (P=MC) and thus allocative efficiency is achieved. At the ruling price, consumer and producer surplus are maximised. No one can be made better off without making some other agent at least as worse off – i.e. we achieve a Pareto optimum allocation of resources.

- 61 -

Tutor2u www.tutor2u.net

2. Productive efficiency: Productive efficiency occurs when the equilibrium output is supplied at minimum average cost. This is attained in the long run for a competitive market. Firms with high unit costs may not be able to justify remaining in the industry as the market price is driven down by the forces of competition.

3. Dynamic efficiency: We assume that a perfectly competitive market produces homogeneous products – in other words, there is little scope for innovation designed purely to make products differentiated from each other and allow a supplier to develop and then exploit a competitive advantage in the market to establish some monopoly power.

Some economists claim that perfect competition is not a good market structure for high levels of research and development spending and the resulting product and process innovations. Indeed it may be the case that monopolistic or oligopolistic markets are more effective long term in creating the environment for research and innovation to flourish. A cost-reducing innovation from one producer will, under the assumption of perfect information, be immediately and without cost transferred to all of the other suppliers.

That said a contestable market provides the discipline on firms to keep their costs under control, to seek to minimise wastage of scarce resources and to refrain from exploiting the consumer by setting high prices and enjoying high profit margins. In this sense, competition can stimulate improvements in both static and dynamic efficiency over time.

The long run of perfect competition, therefore, exhibits optimal levels of economic efficiency. But for this to be achieved all of the conditions of perfect competition must hold – including in related markets. When the assumptions are dropped, we move into a world of imperfect competition with all of the potential that exists for various forms of market failure.

Suggestions for further reading on aspects of competitive markets

Betting on perfect competition (Tutor2u blog, October 2008)

Blog articles on competitive markets

Consumers in danger of being misled by price comparison sites (Independent, October 2007)

Tesco adds to contestability in digital downloads (Tutor2u blog, April 2008)

Costs

Revenues

Output (Q)

AR (Demand)

MC (Supply)

P1

Q1

Consumer Surplus (CS)

Producer Surplus (PS)

P2

Q2

Net Loss of Economic Welfare from price P2 raised above marginal cost

Market equilibrium output where demand = supply and where price = marginal cost of production

- 62 -

Tutor2u www.tutor2u.net

12. Monopoly A pure monopolist is a single seller in an industry – in this case, the firm is the industry – and it can take market demand as its own demand curve. The firm is a price maker but a monopoly cannot charge a price that the consumers in the market will not bear. In this sense, the price elasticity of the demand curve acts as a constraint on the pricing-power of the monopolist.

Assuming that the monopolist aims to maximise profits (where MR=MC), we establish a short run price and output equilibrium as shown in the diagram below.

The profit-maximising level of output is at Q1 at a price P1. This will generate total revenue equal to OP1aQ1, but the total cost will be OAC1aQ. As total revenue exceeds total costs the firm makes abnormal (supernormal) profits equal to P1baAC1.

The effect of a rise in costs on monopoly price and profits

AC

Monopoly demand (AR) = market demand

MR

MC

Q1

Monopoly Profit at Price P1

Revenue

Cost and Profit

Output (Q)

P1

AC1

Short run price and output under a pure monopoly – the average revenue curve is assumed to be the market demand curve. A pure monopoly is a single seller of a product in a given market. The firm is the industry and has a 100% market share

b

a

- 63 -

Tutor2u www.tutor2u.net

The rise in price from P1 to P2 helps the monopolist to absorb some of the rise in costs, but the net effect is a reduction in profits and a contraction in output from Q1 to Q2. The extent to which a business can pass on a rise in costs depends on the price elasticity of demand – ‘pricing power’ is greatest when demand is price inelastic, i.e. consumers are not price-sensitive.

Price Discrimination

In our study of the theory of the firm we have assumed so far that a business charges a single price for its products, naturally the reality is different!

Most businesses charge different prices to different groups of consumers for the same good or service! This is price discrimination. Businesses could make more money if they treated everyone as individuals and charged them the price they are willing to pay. But doing this involves a cost – so they have to find the right pricing strategy for each part of the market they serve – their revenues should rise, but marketing costs will also increase.

It is important that you understand what price discrimination is, the conditions required for it to happen and also some of the economic and social consequences of this type of pricing tactic.

What is price discrimination?

Price discrimination occurs when a business charges a different price to different groups of consumers for the same good or service, for reasons not associated with costs.

It is important to stress that charging different prices for similar goods is not pure price discrimination. Product differentiation – gives a supplier greater control over price and the potential to charge consumers a premium price because of actual or perceived differences in the quality or performance of a good or service.

Conditions necessary for price discrimination to work

Essentially there are two main conditions required for discriminatory pricing:

o Differences in price elasticity of demand: There must be a different price elasticity of demand for each group of consumers. The firm is then able to charge a higher price to the group with a more price inelastic demand and a lower price to the group with a more elastic demand. By adopting such a strategy, the firm can increase total revenue and profits (i.e.

AC1

Monopoly Demand (AR)

MR

MC1

Q1

Monopoly Profit at Price P1

Revenue

Cost and Profit

Output (Q)

P1

AC1

AC2

MC2

Q2

P2

AC2

Monopoly Profit at Price P2

- 64 -

Tutor2u www.tutor2u.net

achieve a higher level of producer surplus). To profit maximise, the firm will seek to set marginal revenue = to marginal cost in each separate (segmented) market.

o Barriers to prevent consumers switching from one supplier to another: The firm must be able to prevent “consumer switching” – a process whereby consumers who have purchased a product at a lower price are able to re-sell it to those consumers who would have otherwise paid the expensive price. This can be done in a number of ways, – and is probably easier to achieve with the provision of a unique service such as a haircut, dental treatment or a consultation with a doctor rather than with the exchange of tangible goods such as a meal in a restaurant.

o Switching might be prevented by selling a product to consumers at unique moments in time – for example with the use of airline tickets for a specific flight that cannot be resold under any circumstances or cheaper rail tickets that are valid for a specific rail service.

o Software businesses such as Microsoft often offer heavy price discounts for educational users. Office 2007 for example was made available at a 90% discount for students in the summer of 2009. But educational purchasers must provide evidence that they are students.

Examples of price discrimination

(a) Perfect Price Discrimination – or charging whatever the market will bear

Sometimes known as optimal pricing, with perfect price discrimination, the firm separates the market into each individual consumer and charges them the price they are willing and able to pay. If successful, the firm can extract the entire consumer surplus that lies underneath the demand curve and turn it into extra revenue or producer surplus. This is hard to achieve unless a business has full information on every consumer’s individual preferences and willingness to pay. The transactions costs involved in finding out through market research what each buyer is prepared to pay is the main barrier to a businesses engaging in this form of price discrimination.

If the monopolist can perfectly segment the market, then the average revenue curve becomes the marginal revenue curve for the firm. The monopolist will continue to sell extra units as long as the extra revenue exceeds the marginal cost of production.

In reality, most suppliers and consumers prefer to work with price lists and menus from which trade can take place rather than having to negotiate a price for each unit of a product bought and sold.

Second Degree Price Discrimination

This involves businesses selling off packages or blocks of a product deemed to be surplus capacity at lower prices than the previously published or advertised price. Price tends to fall as the quantity bought increases.

Examples of this can be found in the hotel industry where spare rooms are sold on a last minute standby basis. In these types of industry, the fixed costs of production are high. At the same time the marginal or variable costs are small and predictable. If there are unsold rooms, it is often in the hotel’s best interest to offload any spare capacity at a discount prices, providing that the cheaper price that adds to revenue at least covers the marginal cost of each unit.

There is nearly always some supplementary profit to be made from this strategy. Firms may be quite happy to accept a smaller profit margin if it means that they manage to steal an advantage on their rival firms.

Early-bird discounts – extra cash flow

- 65 -

Tutor2u www.tutor2u.net

Customers booking early with carriers such as EasyJet or RyanAir will normally find lower prices if they are prepared to book early. This gives the airline the advantage of knowing how full their flights are likely to be and is a source of cash flow prior to the flight taking off. Closer to the time of the scheduled service the price rises, on the justification that consumer’s demand for a flight becomes inelastic. People who book late often regard travel to their intended destination as a necessity and they are likely to be willing and able to pay a much higher price.

Peak and Off-Peak Pricing

Peak and off-peak pricing and is common in the telecommunications industry, leisure retailing and in the travel sector. For example, telephone and electricity companies separate markets by time: There are three rates for telephone calls: a daytime peak rate, and an off peak evening rate and a cheaper weekend rate. Electricity suppliers also offer cheaper off-peak electricity during the night.

At off-peak times, there is plenty of spare capacity and marginal costs of production are low (the supply curve is elastic) whereas at peak times when demand is high, short run supply becomes relatively inelastic as the supplier reaches capacity constraints. A combination of higher demand and rising costs forces up the profit maximising price.

Third Degree (Multi-Market) Price Discrimination

This is the most frequently found form of price discrimination and involves charging different prices for the same product in different segments of the market. The key is that third degree discrimination is linked directly to consumers’ willingness and ability to pay for a good or service. It means that the prices charged may bear little or no relation to the cost of production.

Supply (Marginal Cost)

Off-Peak Demand

Peak Demand

MR Off-Peak MR Peak

Output Off-Peak Output Peak

Price, Cost

Output

P1

P2

- 66 -

Tutor2u www.tutor2u.net

The market is usually separated in two ways: by time or by geography. For example, exporters may charge a higher price in overseas markets if demand is estimated to be more inelastic than it is in home markets.

In the peak market the firm will produce where MRa = MC and charge price Pa, and in the off-peak market the firm will produce where MRb = MC and charge price Pb. Consumers with an inelastic demand will pay a higher price (Pa) than those with an elastic demand who will be charged Pb.

The internet and price discrimination

The rapid expansion of e-commerce using the internet is giving manufacturers unprecedented opportunities to experiment with different forms of price discrimination. Consumers on the net often provide suppliers with a huge amount of information about themselves and their buying habits that then give sellers scope for discriminatory pricing. For example Dell Computer charges different prices for the same computer on its web pages, depending on whether the buyer is a state or local government, or a small business.

Two Part Pricing Tariffs

Another pricing policy is to set a two-part tariff for consumers. A fixed fee is charged and then a supplementary “variable” charge based on the number of units consumed. There are plenty of examples of this including taxi fares, amusement park entrance charges and the fixed charges set by the utilities (gas, water and electricity). Price discrimination can come from varying the fixed charge to different segments of the market and in varying the charges on marginal units consumed (e.g. discrimination by time).

Product-line pricing

Product line pricing occurs when there are many closely connected complementary products that consumers may be enticed to buy. It is frequently observed that a producer may manufacture many related products. They may choose to charge one low price for the core product (accepting a lower mark-up or profit on cost) as a means of attracting customers to the components / accessories that have a much higher mark-up or profit margin.

Market A Market B

MC=AC

Quantity Quantity

Price Price

Pa

Pb

MRa MRb ARb

ARa

Profit from selling to market A – with a relatively elastic demand – and charging a lower price

Demand in segment B of the market is relatively inelastic. A higher unit price is charged

MC=AC

Qb Qa

MC=AC

- 67 -

Tutor2u www.tutor2u.net

Good examples include manufacturers of cars, cameras, razors and games consoles. Indeed discriminatory pricing techniques may take the form of offering the core product as a “loss-leader” (i.e. priced below average cost) to induce consumers to then buy the complementary products once they have been “captured”. Consider the cost of computer games consoles or Mach3 Razors contrasted with the prices of the games software and the replacement blades!

Case Study: Weddings and price discrimination

Mentioning that you need a room or a location for a wedding reception / party can add hundreds of pounds to charges. People are paying over the odds because the demand for wedding services is price inelastic. Bride and groom want everything to be perfect on their special day and many venues will simply hike up the charge for the hire of a room for a wedding by several hundred pounds, or a photographer will raise fees for an all-day event.

Why should it cost so much more to host a lunch reception following a wedding compared to exactly the same room, meal for a corporate lunch or funeral wake? This is price discrimination at work. The average cost of a British wedding set to rise to nearly £18,500. And research from home insurer Churchill has found that British wedding guests spend £13.8 billion attending weddings every year. Weddings can be an expensive business for all concerned!

Source: News reports

Consequences of Price Discrimination

Who gains and who loses out from persistent and pervasive price targeting by businesses? To what extent does price discrimination help to achieve an efficient allocation of resources? There are many arguments on both sides of the coin – indeed the impact of price discrimination on welfare seems bound to be ambiguous.

Impact on consumer welfare

Consumer surplus is reduced in most cases - representing a loss of welfare. For the majority of buyers, the price charged is well above the marginal cost of supply.

However some consumers who can now buy the product at a lower price may benefit. Lower-income consumers may be “priced into the market” if the supplier is willing and able to charge them less. Good examples might include legal and medical services where charges are dependent on income levels. Greater access to these services may yield external benefits (positive externalities) that then affect social welfare and equity. Drugs companies might justify selling their products at inflated prices in countries where incomes are higher because they can then sell the same drugs to patients in poorer countries.

Producer surplus and the use of profit

Price discrimination benefits businesses through higher profits. A discriminating monopoly is extracting consumer surplus and turning it into supernormal profit. Price discrimination also might be used as a predatory pricing tactic to harm competition at the supplier’s level and increase a firm’s market power.

A counter argument to this is that price discrimination might be a way of making a market more contestable. For example, the low cost airlines have been hugely successful by using price discrimination to fill their planes.

Profits made in one market may allow firms to cross-subsidise loss-making activities/services that have important social benefits. For example money made on commuter rail or bus services may allow transport companies to support loss-making rural or night-time services. Without the ability to price discriminate, these services may have to be withdrawn and jobs might suffer.

- 68 -

Tutor2u www.tutor2u.net

In many cases, aggressive price discrimination is a means of business survival during a recession. An increase in total output resulting from selling extra units at a lower price might help a monopoly to exploit economies of scale thereby reducing long run average costs.

Suggestions for further reading on the economics of price discrimination

Price discrimination is a highly common tactic in all kinds of markets – here is a selection of articles that cover the issue. The key evaluation issue is the question of who gains and who (if anyone) loses from such pricing strategies. And whether government intervention is justified?

Fair Trade or Foul (Tim Harford, April 2008)

Positive price discrimination at South Africa 2010 (Tutor2u blog, March 2009)

Price discrimination for Big Macs (Tutor2u blog, June 2008)

Price gouging in Edinburgh (Tutor2u blog, August 2008)

Blog articles on price discrimination

Monopoly and Economic Efficiency

In this section we evaluate the costs and benefits of businesses with industry muscle or monopoly pricing power in markets. The standard case against monopolistic businesses is no longer straightforward. Markets are changing all of the time and so are the conditions in which businesses must operate regardless of whether they have any noticeable market power.

When a company lowers its price, is that genuine competition that benefits consumers or an attempt to monopolise the market? If a company gains market share, is that a result of improved efficiency or merely a competitive threat in the long run? When a company develops innovative products that competitors cannot easily duplicate, is that monopolization? If several companies look to limit excess output because of difficult trading conditions – is this necessarily collusive behaviour that competition policy should look to stop?

The economic case against monopoly

The conventional argument against market power is that monopolists can earn abnormal (supernormal) profits at the expense of efficiency and the welfare of consumers and society.

The monopoly price is assumed to be higher than both marginal and average costs leading to a loss of allocative efficiency and a failure of the market. The monopolist is extracting a price from consumers that is above the cost of resources used in making the product and, consumers’ needs and wants are not being satisfied, as the product is being under-consumed.

The higher average cost if there are inefficiencies in production means that the firm is not making optimum use of scarce resources. Under these conditions, there may be a case for government intervention for example through competition policy or market deregulation.

- 69 -

Tutor2u www.tutor2u.net

X Inefficiencies under Monopoly

The lack of competition may give a monopolist less incentive to invest in new ideas. It can be argued that even if the monopolist benefits from economies of scale, they have little incentive to control their costs and 'X' inefficiencies will mean that there will be no real cost savings compared to a competitive market.

A competitive industry will produce in the long run where market demand = market supply. Consider the diagrams below. Equilibrium output and price is at Q1 and Pcomp on the left hand diagram and Pcomp and Q1 on the right hand diagram. At this point, Price = MC and the industry meets the conditions for allocative efficiency.

If the industry is then taken over by a monopolist (not necessarily immediately!) the profit-maximising point (MC=MR) is at price Pmon and output Q2. The monopolist is able to charge a higher price restrict total output and thereby reduce welfare because the rise in price to Pmon reduces consumer surplus. Some of this reduction in welfare is a pure transfer to the producer through higher profits, but some of the loss is not reassigned to any other agent. This is known as the deadweight welfare loss or the social cost of monopoly and is equal to the area ABC.

Output (Q)

Competitive Market Pure Monopoly

Price (P) Price (P)

Market Supply

Market Demand

Market Supply

Monopoly Demand

Q1 Q1

MR

P comp

P mon

Q2

- 70 -

Tutor2u www.tutor2u.net

A similar result is seen in the next diagram which makes the assumption of constant long-run average and marginal costs under both competition and monopoly. The deadweight loss of welfare under monopoly (whose profit maximising price is P1 and Q1) is shown by the triangle ABC. The competitive price and output is Pc and Qc respectively.

Potential Benefits from Monopoly

A high market concentration does not always signal the absence of competition; sometimes it can reflect the success of firms in providing better quality products, more efficiently, than their rivals

One difficulty in assessing the welfare consequences of monopoly, duopoly or oligopoly lies in defining precisely what a market constitutes! In nearly every industry a market is segmented into different products, and globalization makes it difficult to gauge the degree of monopoly power.

What are the main advantages of a market dominated by a few sellers?

Economies of Scale

Output (Q)

Competitive Market Pure Monopoly Price (P)

Market Supply

Market Demand

Market Supply

Monopoly Demand

Q1 Q1

MR

P comp

P mon

Q2

Net loss of consumer surplus

Net loss of producer surplus

B

C

D

A

LRAC = LRMC

Monopoly Demand (AR)

MR

Q1

Monopoly Profit at Price P1

Revenue

Cost and Profit

Output (Q)

P1

Pc

Qc

B

A

C

Price (P)

- 71 -

Tutor2u www.tutor2u.net

A monopolist might be better placed to exploit increasing returns to scale leasing to an equilibrium that gives a higher output and a lower price than under competitive conditions. This is illustrated in the next diagram, where we assume that the monopolist is able to drive marginal costs lower in the long run, finding an equilibrium output of Q2 and pricing below the competitive price.

Monopoly Profits, Research and Development and Dynamic Efficiency

As firms are able to earn abnormal profits in the long run there may be a faster rate of technological development that will reduce costs and produce better quality items for consumers.

Monopoly power can be good for innovation. Despite the fact that the market leadership of firms like Microsoft, Toyota, GlaxoSmithKline and Sony is often criticised, investment in research and development (R&D) can be beneficial to society because they expand the technological frontier and open new ways to prosperity. Many innovations are developed by firms with patents on the ‘leading-edge’ technologies.

Baumol – Oligopoly and Innovation

William Baumol an economist from Princeton University published a book titled “The Free Market Innovation Machine” in which he argued that the structure that fosters productive innovation best is oligopoly. The Baumol hypothesis is that oligopolists compete by making their products differ slightly from their rivals. Highly innovative firms are often quick to license new technology or to become members of technology-sharing consortia. (The UK digital boom, BBC news, August 2007)

Natural Monopoly

There are several interpretations of what a natural monopoly us

1. It occurs when one large business can supply the entire market at a lower price than two or more smaller ones

2. A natural monopoly is a situation in which there cannot be more than one efficient provider of a good. In this situation, competition might actually increase costs and prices

3. It is an industry where the minimum efficient scale is a large share of market demand such there is room for only one firm to fully exploit all of the available internal economies of scale

4. An industry where the long run average cost curve falls continuously as output expands

Output (Q)

Competitive Market Pure Monopoly

Price (P) Price (P)

Market Supply

Market Demand

Competitive Supply (MC)

Monopoly Demand

Q1 Q1

MR

P comp P mon

Q2

Monopoly Supply with

Scale Economies

- 72 -

Tutor2u www.tutor2u.net

The key point is that a natural monopoly is characterized by increasing returns to scale at all levels of output – thus the long run cost per unit (LRAC) will drift lower as production expands. LRAC is falling because long run marginal cost is below LRAC. This can be illustrated in the diagram above:

There may be room only for one supplier to fully exploit economies of scale, reach the minimum efficient scale and achieve productive efficiency.

Examples

Because there is no single definition of a natural monopoly, none of the examples below are purely national monopolies – their cost structure does take them close to a common-sense interpretation:

1. British Telecom building and maintaining the UK telecommunications network for the broadband industry – especially the ‘final mile’ copper wiring from the local exchanges to each household

2. The Royal Mail’s postal distribution network – collection / sorting / delivery

3. Camelot operating the national network for the UK lottery

4. National Rail owning, maintaining and leasing out the UK rail network

5. National Grid, which owns and operates the National Grid high-voltage electricity transmission network in England and Wales. Since April 1, 2005 it also operates the electricity transmission network in Scotland. Owns and operates the gas transmission network (from terminals to distributors).

6. London Underground, Tyne and Wear Metro

A natural monopoly does not mean that there is only one business operating in the market or that only one firm can survive in the long run. Indeed there may be many smaller businesses operating profitably in smaller ‘niche’ segments of a market (however that is defined).

Possible conflicts between efficiency and welfare

It is often said that a natural monopoly raises difficult questions for competition policy because

Costs

Output

LRAC

LRMC

SRAC1

SRAC2

- 73 -

Tutor2u www.tutor2u.net

• On the one hand – it is more productively efficient for there to be one dominant provider of a national infrastructure e.g. a rail network or electricity generating system

• Natural monopolies often require enormous investment spending to maintain and improve the networks

• On the other hand – businesses monopoly power (huge barriers to entry) might be tempted to exploit that power by raising prices and making huge supernormal profits – damaging consumer welfare

The profit-maximizing price is P1 at an output of Q1. Price is well above the marginal cost of supply and high supernormal profits are made – but output is high too and there is still a sizeable amount of consumer surplus because of the internal economies of scale that have brought down the unit cost for all consumers. (We are ignoring the possibility of price discrimination here).

Options for competition policy in industries that resemble a natural monopoly

1. Nationalization: Bringing some of these industries into state ownership

a. Network Rail is a not-for-profit business (formerly Railtrack plc) – taken back into public ownership in 2001

b. National Air Traffic Services – currently owned by the UK government (49%); The Airline Group (42%) which is a consortium of British Airways, bmi, easyJet, Monarch Airlines, Thomas Cook Airlines, Thomsonfly and Virgin Atlantic; BAA (4%); and NATS employees (5%).

2. Price controls

a. For many of the major utilities, the government introduced industry regulators to oversee these businesses when they were privatized in the 1980s and early 1990s

b. For many years utility businesses such as British Telecom and British Gas were subject to price capping– most of these have now finished although some remain – for more details – see this link

3. Introducing competition into the industry -this has been a favoured policy

Costs

Output

LRAC

LRMC

SRAC1

SRAC2

AR

MR

Q1

P1

C1

- 74 -

Tutor2u www.tutor2u.net

a. Basically involves separating out infrastructure from the final service to the consumer – for example:

i. British Telecom was eventually forced to open-up local telecom exchanges and allow rivals to install equipment (‘unbundling the local loop’) – who then sell services such as broadband to households – competitors pay BT an access charge designed to give BT a 10% rate of return from running the network.

ii. National Rail runs the network – but train-operating companies have to bid for the franchise to run passenger services – and the industry regulator can take their franchise away if the quality of service isn’t good enough. The government took the East Coast line into public ownership in July 2009 following the financial problems facing National Express.

iii. Camelot has successfully bid to operate the National Lottery until 2017

SPEW

Here is a good way to remember some of the issues we have covered regarding monopoly, efficiency and economic welfare

Service - does the lack of competition affect the quality of service to consumers?

Prices - how high are prices compared to competitive / contestable market

Efficiency - productive, allocative and dynamic

Welfare - what are the overall welfare outcomes? Is there a net loss of welfare in markets dominated by businesses with monopoly power?

Acknowledged source: Ruth Tarrant

- 75 -

Tutor2u www.tutor2u.net

Case Study: BAA’s Monopoly Heads for the Departure Gate

Reviled by airlines complaining of high charges and poor service and lambasted by passengers furious about lost luggage and interminable delays, British Airports Authority (BBA) the owner and manager of Heathrow, Gatwick, Stansted, Glasgow, Edinburgh, Aberdeen and Southampton has come under huge criticism from passengers, airlines and other stakeholders. These seven airports account for 90% of the air passengers using South East and East Anglian airports and 84% of Scottish air passengers. BAA racked up revenues of over £2bn in 2007 and an operating profit of close to £400m.

Nearly half of BAA's income came from charges - including landing fees paid by airlines. Over a quarter comes from their retail division and nine per cent comes from property income. One per cent of income flows from other traffic charges – for example a charge of £4.48 each time they use the Heathrow Taxi System. Add in the profits from expensive airport car parking, profits from their stake in Heathrow Express, bureau de change businesses and duty free, it is not hard to see how BAA is able to generate monopoly profits.

The airlines have complained about the quality of service and the cost of operating at BAA's airports. British Airways claimed that "BAA’s record at Heathrow has been lamentable and common ownership is the root cause of the failure to expand Heathrow’s runway capacity.” Ryanair is reported as saying that "“Heathrow is a mess, passengers continue to be stuck in long security queues at Stansted and Gatwick’s development is being held back by this over charging monopoly.”

BAA has countered with the claim that "common ownership has yielded benefits for consumers and remains the best structure for the efficient operation of airports – the most important issue for passengers.” BAA argues that it has “invested in major new facilities” and that the major problem is that UK airport terminals are already running at maximum capacity. A second strand of defence from BAA is that the airports they run now have been starved of investment in the past and this affects their current performance. They claim that regulatory control from the Civil Aviation Authority (CAA) is damaging. BAA is committed to investing more than £9.5bn upgrading the three airports over the next 10 years. But the CAA is proposing to lower the cap on investment returns, to 6.2 per cent from 7.75 per cent, a disincentive to go ahead with capital projects?

A counter argument is BAA has an effective rather than a natural monopoly and that BAA gains more from the spillover effects that flow from passenger demand exceeding the capacity at Heathrow. Airlines and their passengers are more or less forced to switch to Gatwick and/or Stansted because Heathrow is completely chocker! Monopoly power can lead to X-inefficiencies, higher prices and lower levels of innovation. The passenger experience deteriorates but there is little that they can do about it.

In March 2009, the Competition Commission told BAA that it must sell Gatwick and Stansted airports and either Edinburgh or Glasgow airport. The report argued that "Under separate ownership, the airport operators including BAA will have a greater incentive to be far more responsive to their customers, both airlines and passengers."

Source: Geoff Riley, EconoMax and Tutor2u blogs

BAA told to sell three airports (BBC news)

Competition Commission report on BAA

- 76 -

Tutor2u www.tutor2u.net

13. Monopsony Monopsony is an important idea in economics but not often discussed in the media – indeed there were only six references to it in the Financial Times between 2003 and 2009! But for economists wanting to understand changes in the balance of power between buyers and sellers in different markets and how this affects prices, profit margins and incentives, it is important to have an understanding of monopsony and its effects. At A2 level you will not be expected to use diagrams to show the impact of monopsony power in product markets.

What is monopsony power?

A monopsonist has buying power in their market. This buying power means that a monopsonist can exploit their bargaining power with a supplier to negotiate lower prices. The reduced cost of purchasing inputs increases their profit margins. Monopsony exists in both product and labour markets – in this chapter we focus on buying power in the markets for goods and services.

Examples of industries where monopsony power exists and persists:

1. Electricity generators can negotiate lower prices for coal and gas supply contracts’

2. The major food retailers have power when purchasing supplies from meat and poultry farmers, milk producers, wine growers and other suppliers. Tesco, Sainsbury, Wal-Mart-Asda and Cooperative-Somerfield have oligopsony power when it comes to purchasing products from businesses at earlier stages of the supply-chain.

3. A car-rental firm seeking a contract to a manufacturer to supply new cars for their fleet

4. Low-cost airlines getting a favourable price when purchasing a new fleet of aircraft

5. British Sugar buys almost the entire sugar beet crop produced in the UK year

6. Amazon’s buying power in the retail book market – it gets a better price than other booksellers and this gives it a significant competitive advantage.

7. The increasing buying power of countries – for example China – in securing deals to buy mineral deposits from other countries – often in less developed nations in Africa.

8. The government is a major buyer e.g. in military procurement – and might be able to use this bargaining power when confirming contracts for new military equipment and supplies. The National Health Service is another example of a dominant buyer – in this case as a purchaser of prescription drugs from the pharmaceutical companies.

Case Studies on Monopsony Power – The Milk Industry

Dividing the spoils

“Supermarkets use their gigantic size and bargaining power to capture almost all of the profit from the milk industry, leaving farmers with a tiny proportion of the total: equal to only half a pence for each litre of milk.” That is the central finding of new research by Drs Howard Smith and John Thanassoulis presented at the Royal Economic Society’s 2008 annual conference. Farmers are in the weakest position, only able to secure 0.5 pence per litre, or about 3% of the total supply chain profits from liquid milk.”

The research suggests that dairy farmers might help to counter-balance the power of the supermarkets by strengthening farmers’ cooperatives. This is already happening in many parts of the country. But fundamentally the retailers will always hold the whip hand in pricing negotiations and contract agreements. The danger is that the market failure due to excessive monopsony power will lead to many more milk farmers leaving the industry, thereby increasing the demand for imported milk.

Is the buying power of dairies such as Robert Wiseman and Dairy Crest, who then sell much of their processed milk to large supermarkets such as Tesco and Asda, resulting in a fair deal for the small-scale dairy farmer – the price taker? When a market has a sole buyer, a monopsony, prices are depressed by the buying power

- 77 -

Tutor2u www.tutor2u.net

of the only outlet for the producers. Arguably the dairy farmer has lost out to the combined buying power of the dairies and the supermarkets.

Source: Tutor2u Economics Blog, March 2008 and Robert Nutter, EconoMax, November 2006

Collapse of a Dairy Cooperative

Dairy Farmers of Britain (DFOB), which is responsible for 10% of UK milk production, has gone into administration. DFOB is an agricultural cooperative with 1,800 member farmers who supply over one billion litres of milk a year, but in recent months DFOB has not been able to pay its farmer members an economical milk price, which has resulted in members tendering their resignations in large number. A key blow was DFOB losing the milk contract from Co-operative supermarkets. Many diary farmers continue to receive a price for their milk that is less than the cost of production and a sizeable number have decided to leave the industry.

The price of milk

61p - cost to farmer to produce four pints

58p - paid to farmer by milk processor

£1.07 - paid to processor by supermarket

£1.45 - cost to customer to buy four pints from supermarket

Source: Adapted from news reports, June 2009

Monopsony power is often given a bad press! We read of ‘greedy supermarkets’ abusing their buying power to force down profit margins for suppliers and enjoy higher returns for themselves. In evaluation it is important to remember some of the possible advantages from monopsony power:

1. Improved value for money – for example the UK national health service can use its bargaining power to drive down the prices of routine drugs used in NHS treatments and ultimately this means that cost savings allow for more treatments within the NHS budget.

2. Producer surplus has a value as well as consumer surplus – lower input costs will raise profitability that might be used to fund capital investment and research.

3. A monopsonist can act as a useful counter-weight to the selling power of a monopolist e.g. the NHS versus the global pharmaceutical companies.

4. In most supply chain relationships – for example between supermarkets and their suppliers – the long term sustainability of an industry requires that both benefit – if there are no mutually beneficial gains from trade, ultimately trade and exchange will break down.

5. The growth of the Fair Trade label and organisation is evidence of how pressure from consumers can lead to improved contracts and prices for farmers in developing countries. For example if tea producers in Rwanda get a stronger price for their output, the increased income and profit will have important economic and social benefits for the exporting industry and the wider economy.

Suggestions for further reading on the economics of monopsony power

Beet farmers look for better price to sweeten the pill (Tutor2u blog, August 2008)

Bookstores – clubbing together to beat the big boys (BBC news, July 2008)

Milk prices report sparks call for fair trade rules in UK (Wales online, March 2008)

Rio Tinto and Nippon Steel agree big cut in iron ore prices (Tutor2u blog, May 2009)

Tate and Lyle sugar to be FairTrade (BBC news, February 2008)

- 78 -

Tutor2u www.tutor2u.net

14. Oligopoly What is an oligopoly?

An oligopoly is a market dominated by a few producers. An oligopoly is an industry where there is a high level of market concentration. Examples of markets that can be described as oligopolies include the markets for petrol in the UK, soft drinks producers and the major high street banks. Another example is the global market for sports footwear – 60% of which is held by Nike and Adidas.

However, oligopoly is best defined by the conduct (or behaviour) of firms within a market.

The concentration ratio measures the extent to which a market or industry is dominated by a few leading firms. A rule of thumb is that an oligopoly exists when the top five firms in the market account for more than 60% of total market sales.

Characteristics of an oligopoly

There is no single theory of price and output under conditions of oligopoly. If a price war breaks out, oligopolists may choose produce and price much as a highly competitive industry would; whereas at other times they act like a pure monopoly.

An oligopoly usually exhibits the following features:

1. Product branding: Each firm in the market is selling a branded product.

2. Entry barriers: Entry barriers maintain supernormal profits for the dominant firms. It is possible for many smaller firms to operate on the periphery of an oligopolistic market, but none of them is large enough to have any significant effect on prices and output

3. Inter-dependent decision-making: Inter-dependence means that firms must take into account the likely reactions of their rivals to any change in price, output or forms of non-price competition.

4. Non-price competition: Non-price competition is a consistent feature of the competitive strategies of oligopolistic firms.

Duopoly

Duopoly is a form of oligopoly.

In its purest form two firms control all of the market, but in reality the term duopoly is used to describe any market where two firms dominate with a significant market share. There are many examples of duopoly; including Coca-Cola and Pepsi (soft drinks), Unilever and Proctor & Gamble (detergents), Bloomberg and Reuters (Financial information services), Sotheby’s and Christie’s (auctioneers of antiques/paintings), Standard and Poor’s and Moody’s (credit rating agencies), BSkyB and ESPN (live Premiership football), and Airbus and Boeing (aircraft manufacturers).

In these markets entry barriers are high although there are usually smaller players in the market surviving successfully. The high entry barriers in duopolies are usually based on one or more of the following: brand loyalty, product differentiation and huge research economies of scale.

Kinked Demand Curve Model of Oligopoly

- 79 -

Tutor2u www.tutor2u.net

The kinked demand curve model assumes that a business might face a dual demand curve for its product based on the likely reactions of other firms to a change in its price or another variable. The common assumption is that firms in an oligopoly are looking to protect and maintain their market share and that rival firms are unlikely to match another’s price increase but may match a price fall. I.e. rival firms within an oligopoly react asymmetrically to a change in the price of another firm.

• If a business raises price and others leave their prices constant, then we can expect quite a large substitution effect making demand relatively price elastic. The business would then lose market share and expect to see a fall in its total revenue.

• If a business reduces its price but other firms decide to follow suit, the relative price change is smaller and demand would be inelastic. Cutting prices when demand is inelastic also leads to a fall in total revenue with little or no effect on market share.

The kinked demand curve model makes a prediction that a business might reach a stable profit-maximising equilibrium at price P1 and output Q1 and have little incentive to alter prices.

The kinked demand curve model predicts there will be periods of relative price stability under an oligopoly with businesses focusing on non-price competition as a means of reinforcing their market position and increasing their supernormal profits. Short-lived price wars between rival firms can still happen under the kinked demand curve model. During a price war, firms in the market are seeking to snatch a short term advantage and win over some extra market share.

Recent examples of price wars include the major UK supermarkets, price discounting of computers in China and a price war between cross channel speed ferry services. Price competition is frequently seen in the telecommunications industry.

Changes in costs using the kinked demand curve analysis

Assume we start out at P1 and Q1:

Will a firm benefit from raising price above P1?

Will it benefit from cutting price below P1?

Raising price above P1

Demand is relatively elastic because other firms do not match a price rise

Firm loses market share and some total revenue

Reducing price below P1

Demand is relatively inelastic

Little gain in market share – other firms have followed suit in cutting prices

Total revenue may still fall

Costs

Revenues

Output (Q)

P1

Q1 MR

AR

- 80 -

Tutor2u www.tutor2u.net

One prediction of the kinked demand curve model is that changes in variable costs might not lead to a rise or fall in the profit maximising price and output. This is shown in the next diagram where it is assumed that a rise in costs such as energy and raw material prices leads to an upward shift in the marginal cost curve from MC1 to MC2. Despite this shift, the equilibrium price and output remains at Q1. It would take another hike in costs to MC3 for the price to alter.

There is limited real-world evidence for the kinked demand curve model. The theory can be criticised for not explaining why firms start out at the equilibrium price and quantity. That said it is one possible model of how firms in an oligopoly might behave if they have to consider the likely responses of their rivals.

The importance of non-price competition under oligopoly

Non-price competition assumes increased importance in oligopolistic markets. This involves advertising and marketing strategies to increase demand and develop brand loyalty among consumers. Businesses will use other policies to increase market share:

o Better quality of service including guaranteed delivery times for consumers and low-cost servicing agreements.

o Longer opening hours for retailers, 24 hour online customer support.

o Discounts on product upgrades when they become available in the market.

o Contractual relationships with suppliers - for example the system of tied houses for pubs and contractual agreements with franchises (offering exclusive distribution agreements). For example, Apple has signed exclusive distribution agreements with T-Mobile of Germany, Orange in France and O2 in the UK for the iPhone. The agreements give Apple 10 percent of sales from phone calls and data transfers made over the devices.

Advertising spending runs in millions of pounds for many firms. Some simply apply a profit maximising rule to their marketing strategies. A promotional campaign is profitable if the marginal

Output (Q)

P1

Q1 MR

AR

MC1

MC2

MC3

Increase in marginal cost from MC1 to MC2 does not lead to a change in the profit maximising price and output

P2

Q2

Increase in marginal cost from MC2 to MC3 does lead to a change in output and price

Price (P)

- 81 -

Tutor2u www.tutor2u.net

revenue from any extra sales exceeds the cost of the advertising campaign and marginal costs of producing an increase in output. However, it is not always easy to measure accurately the incremental sales arising from a specific advertising campaign. Other businesses see advertising simply as a way of increasing sales revenue. If persuasive advertising leads to an outward shift in demand, consumers are willing to pay more for each unit consumed. This increases the potential consumer surplus that a business might extract.

Relatively high spending on marketing is important for new business start-ups and for firms trying to break into an existing market where there is consumer or brand loyalty to the existing products in

Collusion in Oligopoly

Collusive behaviour is thought to be a common feature of many oligopolistic markets. In this section we look at different forms of collusion starting with tacit collusion based around price leadership.

Tacit collusion

Price leadership refers to a situation where prices and price changes established by a dominant firm, or a firm are usually accepted by others and which other firms in the industry adopt and follow. When price leadership is adopted to facilitate tacit (or silent) collusion, the price leader will generally tend to set a price high enough that the least cost-efficient firm in the market may earn some return above the competitive level.

We see examples of this with the major mortgage lenders and petrol retailers where many suppliers follow the pricing strategies of leading firms. If most firms in a market are moving prices in the same direction, it can take some time for relative price differences to emerge which might cause consumers to switch their demand.

Firms who market to consumers that they are “never knowingly undersold” or who claim to be monitoring and matching the cheapest price in a given geographical area are essentially engaged in tacit collusion. Does the consumer really benefit from this? Tim Harford’s article “Match me if you Can” in February 2007 is especially worth reading on this pricing strategy.

Tacit collusion occurs where firms undertake actions that are likely to minimise a competitive response, e.g. avoiding price cutting or not attacking each other’s market

It is often observed that when a market is dominated by a few large firms, there is always the potential for businesses to seek to reduce uncertainty and engage in some form of collusive behaviour. When this happens the existing firms engage in price fixing cartels. This behaviour is deemed illegal by UK and European competition law. But it is hard to prove that a group of firms have deliberately joined together to raise prices.

Explicit Price Fixing

Collusion is often explained by a desire to achieve joint-profit maximisation within a market or prevent price and revenue instability in an industry. Price fixing represents an attempt by suppliers to control supply and fix price at a level close to the level we would expect from a monopoly.

To collude on price, producers must be able to exert some control over market supply. In the diagram below a producer cartel is assumed to fix the cartel price at price Pm. The distribution of the cartel output may be allocated on the basis of an output quota system or another process of negotiation.

Although the cartel as a whole is maximising profits, the individual firm’s output quota is unlikely to be at their profit maximising point. For any one firm, expanding output and selling at a price that slightly undercuts the cartel price can achieve extra profits! Unfortunately if one firm does this, it is in each firm’s interests to do exactly the same and, if all firms break the terms of their cartel agreement, the result will be excess supply in the market and a sharp fall in the price. Under these circumstances, a cartel agreement can break down.

- 82 -

Tutor2u www.tutor2u.net

Collusion in a market or industry is easier to achieve when:

1. There are only a small number of firms in the industry and barriers to entry protect the monopoly power of existing firms in the long run.

2. Market demand is not too variable (or cyclical) i.e. it is reasonably predictable and not subject to violent fluctuations which may lead to excess demand or excess supply.

3. Demand is fairly inelastic with respect to price so that a higher cartel price increases the total revenue to suppliers – this is easier when the product is viewed as a necessity.

4. Each firm’s output can be easily monitored (this is important!) – This enables the cartel more easily to control total supply and identify firms who are cheating on output quotas.

5. Incomplete information about motivation of other firms may induce tacit collusion.

Possible break-downs of cartels

Most cartel arrangements experience difficulties and tensions and some cartels collapse completely. Several factors can create problems within a collusive agreement between suppliers:

1. Enforcement problems: The cartel aims to restrict production to maximize total profits of members. But each individual seller finds it profitable to expand production. It may become difficult for the cartel to enforce its output quotas and there may be disputes about how to share out the profits. Other firms – not members of the cartel – may opt to take a free ride by producing close to but just under the cartel price.

2. Falling market demand creates excess capacity in the industry and puts pressure on individual firms to discount prices to maintain their revenue. There are good recent examples of this in commodity markets including the collapse of the coffee export cartel.

3. The successful entry of non-cartel firms into the industry undermines a cartel’s control of the market – e.g. the emergence of online retailers in the book industry in the mid 1990s led ultimately to the end of the Net Book Agreement in 1995.

4. The exposure of illegal price fixing by market regulators such as UK Office of Fair Trading and the European Competition Commission

Individual Firm inside the Cartel Industry Costs and Revenues

Firms Output Industry Output

MC (industry)

Demand

MR

MC

AC

Quota Industry

Output (Qm)

Pm (cartel) Pm (cartel)

Price Price

- 83 -

Tutor2u www.tutor2u.net

Exposure of cartels within the European Union and the USA

Case Study: No smoke without fire – cigarette price fixing

A tobacco manufacturer and five retailers have been told to pay the biggest collective penalty yet imposed for price-rigging after admitting their role in efforts to boost the cost of cigarettes. The six companies agreed to pay £132m to settle the charges with Gallaher, one of two tobacco manufacturers involved in the case, shouldering the lion’s share of the burden after agreeing to pay £93m. The Times reports that “The six companies fined made prompt admissions of illicit competition practices in return for lenient fines.” - another example of game theory and the prisoners dilemma in action!

Source: Tutor2u economics blog, July 2008

In recent years, the European Union, UK and USA competition authorities have uncovered a substantial number of price-fixing agreements. Some of the most prominent examples can be explored by using the links below:

• Airlines fined $504m in US air-cargo price fixing probe (2008) • BA given massive fine for fuel surcharge price fixing (2007) • Chemicals price fixing cartel (2006) • Copper price fixing cartel (2006) • Dutch brewing cartel (2007) • Europe fines glassmakers record €1.4bn (2009) • How arch rivals colluded to hike up cost of air travel (2007) • Law broken on pricing by tobacco firms (2008) • Paraffin mafia is fined Euro 535m (2009) • Plastics bags cartel (2005) • Quantas admits cargo price fixing (2009) • Rubber cartel (2007) • Sotheby’s fined £12m for price fixing (2002) • Supermarkets fined £116m for dairy price-fixing (2007) • LCD flat-screen makers charged with price fixing (2009)

More recent articles on collusion are available from the Tutor2u blog.

Oligopoly and Game Theory

The Monty Hall problem

Suppose you’re on a game show, and you’re given the choice of three doors. Behind one door is a car, behind the others, goats. You pick a door, say number 1, and the host, who knows what’s behind the doors, opens another door, and say number 3, which has a goat. He says to you, “Do you want to pick door number 2?” Is it to your advantage to switch your choice of doors?

Possible answer to the Monty Hall problem

Game Theory

Game theory is mainly concerned with predicting the outcome of games of strategy in which the participants (for example two or more businesses competing in a market) have incomplete information about the others' intentions.

Game theory analysis has direct relevance to the study of the conduct and behaviour of firms in oligopolistic markets – for example the decisions that firms must take over pricing, and how much money to invest in research and development spending. Costly research projects represent a risk for any business – but if one firm invests in R&D, can a rival firm decide not to follow? They might lose

- 84 -

Tutor2u www.tutor2u.net

the competitive edge in the market and suffer a long term decline in market share and profitability. The dominant strategy for both firms is probably to go ahead with R&D spending. If they do not and the other firm does, then their profits fall and they lose market share. However, there are only a limited number of patents available to be won and if all of the leading firms in a market spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one firm opts to proceed.

The Prisoners’ Dilemma

The classic example of game theory is the Prisoners’ Dilemma, a situation where two prisoners are being questioned over their guilt or innocence of a crime. They have a simple choice, either to confess to the crime (thereby implicating their accomplice) and accept the consequences, or to deny all involvement and hope that their partner does likewise.

Confess or keep quiet? The Prisoner’s Dilemma is a classic example of basic game theory in action!

The “pay-off” is measured in terms of years in prison arising from their choices and this is summarised in the table below. No communication is permitted between the two suspects – in other words, each must make an independent decision, but clearly they will take into account the likely behaviour of the other when under interrogation.

“When I am getting ready to reason with a man I spend one-third of my time thinking about myself and what I am going to say, and two-thirds thinking about him and what he is going to say.”

Source: Abraham Lincoln

Here is an example of the Prisoners’ Dilemma:

Two prisoners are held in a separate room and cannot communicate They are both suspected of a crime They can either confess or they can deny the crime Payoffs shown in the matrix are years in prison from their chosen course of action

Prisoner A

Confess

Deny Prisoner B

Confess (3 years, 3 years) (1 year, 10 years)

Deny (10 years, 1 year) (2 years, 2 years)

What is the best strategy for each prisoner? Equilibrium happens when each player takes decisions which maximise the outcome for them given the actions of the other player in the game. In our example of the Prisoners’ Dilemma, the dominant strategy for each player is to confess since this is a course of action likely to minimise the average number of years they might expect to remain in prison. But if both prisoners choose to confess, their “pay-off” i.e. 3 years each in prison is higher than if they both choose to deny any involvement in the crime.

That said, even if both prisoners chose to deny the crime (and indeed could communicate to agree this course of action), then each prisoner has an incentive to cheat on any agreement and confess, thereby reducing their own spell in custody.

- 85 -

Tutor2u www.tutor2u.net

The equilibrium in the Prisoners’ Dilemma occurs when each player takes the best possible action for themselves given the action of the other player. The dominant strategy is each prisoners’ unique best strategy regardless of the other players’ action Best strategy? Confess? A bad outcome! – Both prisoners could do better by both denying – but once collusion sets in, each prisoner has an incentive to cheat!

Prisoner A

Confess

Deny Prisoner B

Confess (3 years, 3 years) (1 year, 10 years)

Deny (10 years, 1 year) (2 years, 2 years)

Applying the Prisoner’s Dilemma to business decisions

Game theory examples usually revolve around the pay-offs that come from making different decisions. One arrangement of possible payoffs is as follows:

T refers to the temptation to defect

R refers to the reward for mutual cooperation between players

P refers to the punishment for mutual defection

S refers to the sucker’s payoff

In the classic prisoner’s dilemma the reward to defecting is greater than mutual cooperation which itself brings a higher reward than mutual defection which itself is better than the sucker’s pay-off. And critically, the reward for two players cooperating with each other is higher than the average reward from defection and the sucker’s pay-off.

Consider this example of a simple pricing game: The values in the table refer to the profits that flow from making a particular decision.

Firm B’s output

High output Low output

Firm A’s output High output £5m, £5m £12m, £4m Low output £4m, £12m £10m, £10m

Display of payoffs: row first, column second e.g. if Firm A chooses a high output and Firm B opts for a low output, Firm A wins £12m and Firm B wins £4m.

In this game the reward to both firms choosing to limit supply and thereby keep the price relatively high is that they each earn £10m. But choosing to defect from this strategy and increase output can cause a rise in market supply, lower prices and lower profits - £5m each if both choose to do so.

- 86 -

Tutor2u www.tutor2u.net

A dominant strategy is a strategy that is best irrespective of the other player’s choice. In this case the dominant strategy is competition between the firms.

Game theory analysis has direct relevance to our study of the behaviour of businesses in oligopolistic markets – for example the decisions that firms must take over pricing of products, and also how much money to invest in research and development. Costly research projects represent a risk for any business – but if one firm invests in R&D, can another rival firm decide not to follow? They might lose the competitive edge in the market and suffer a decline in market share and profitability.

The dominant strategy for both firms is probably to go ahead with R&D spending. However, there are only a limited number of patents available to be won and if all of the leading firms in a market spend heavily on R&D, this may ultimately yield a lower total rate of return than if only one firm opts to proceed.

The Prisoners’ Dilemma can help to explain the break down of price-fixing agreements between producers which can lead to the out-break of price wars among suppliers, the break-down of other joint ventures between producers and also the collapse of free-trade agreements between countries when one or more countries decides that protectionist strategies are in their own best interest.

The key point is that game theory provides an insight into the interdependent decision-making that lies at the heart of the interaction between businesses in a competitive market.

Case Study: Claims of Price Rigging in the Food Industry

There is plenty for the consumer to feel irked about as the cost of food, petrol and other essential basics seems to race ahead of the general rate of inflation. Yet now it seems there is a conspiracy among some large companies to fix the price of other goods we buy, such as toothpaste and shampoo.

There is currently an OFT investigation into the pricing behaviour of some big name companies - Proctor and Gamble, Coca-Cola, Kimberly-Clark, GlaxoSmithKline and Unilever. The leading supermarkets – Tesco, Sainsbury, Asda and Morrisons have also received visits by OFT investigators. What these large companies have in common is that economists would classify them as oligopolies (industries where there are a small number of large firms). These businesses can behave in the following ways as economic theory predicts:

• Prices are sticky – by expecting the worst, firms are most likely to choose non-price competition. If a firm is considering a price rise, the worst outcome would be if the other firms in the industry do not increase their prices, causing the firm to lose business. Therefore the firm will be reluctant to raise prices. If a firm is considering reducing its price, the worst outcome is if all the other firms also choose to cut prices. The firm will not gain market share, but will end up with less revenue. Therefore the firm will be reluctant to decrease its price, all other things being equal. So firms will, instead, use methods of non-price competition such as ‘buy one, get one free’, ‘3 for 2’ offers, free gifts, loyalty points, etc. Firms are likely to spend large amounts on advertising designed to establish brand loyalty.

• Price wars – sometimes an oligopoly will make an aggressive move to try and win market share. The big name supermarkets do this from time to time. One firm cuts prices significantly and others follow or undercut so as not to lose their share. This can be a good outcome for consumers, but does not appear to be happening at present.

• Collusion – this is where the firms choose to act together to ‘fix’ prices and can be illegal. However, some collusive behaviour is hard to pin down, which is why an OFT investigation is

- 87 -

Tutor2u www.tutor2u.net

going ahead. If costs of production increase, it is not unreasonable to expect all firms in the industry to respond with an increase in price, but there appears to be some evidence, for example, that supermarkets have used rising costs as an excuse to inflate their prices to increase profit margins.

If it does transpire that some of the best known companies have been acting illegally by price fixing, this will look very bad for them at a time when consumers are already feeling the pinch.

Source: Liz Veal, EconoMax, June 2008

Case Study: Prisoner's Dilemma and Climate Change Negotiations

Can repeated games of the prisoner’s dilemma help climate negotiations?

With 2012 signalling the expiry date of the Kyoto Protocol, there is an urgent need for a successor treaty to tackle the ever-increasing global emissions problem. The main issue with tackling climate change is the cost to countries of implementing it. To be successful it will need profound transformation of energy and transport organisations, and changes in the behaviours of billions of consumers. The Stern Review admitted that it will likely cost 1% of GDP –even though it doesn’t seem much, it is double the amount currently spent on development aid worldwide.

• The USA sees a cap on carbon emissions as a threat to competitiveness, and hence to its global supremacy;

• The developing world denounces any calls for a cap on emissions as an effort by former colonial powers to hold back development;

• Europe has been making encouraging though patchy progress towards targets, driven mainly by a one-off switch from coal to gas.

The issue here is how countries can expect to make cuts in emissions when their economic competitors refuse. This in turn leads to the Tragedy of the Commons which occurs when a group’s individual incentive lead them to take actions which, overall, lead to negative consequences for all group members.

A country that refuses to act, whilst the other cooperates, will experience a free-rider benefit - enjoying the advantage of limited climate change without the cost. On the flip side, any country that imposes limits, when its competitors do not, incurs not just the cost of limiting its own emissions, but also a further cost in terms of reduced competitiveness

The dynamics of the prisoner’s dilemma do change if participants know that they will be playing the game more than once. In 1984 an American political scientist at the University of Michigan, Robert Axelrod, argued that if you play the game repeatedly you are likely to see emerging is cooperative rather than defective actions. He identified four elements to a successful strategy which is this case can be applied to climate negotiations:

1. Be Nice – sign up to unilateral cuts in emissions, as deep as your economy and financing capacity allows.

2. Be Retaliatory – single out countries that have not commenced action and, in collaboration, find ways of pressurising them until they do so.

- 88 -

Tutor2u www.tutor2u.net

3. Be Forgiving - when non-compliant countries come onboard give them generous applause; signal that good behaviour will be rewarded with even deeper cuts in your own emissions.

4. Be Clear - let everyone know in advance exactly how you are going to behave – that you will work with them if they take action on emissions, and that you will retaliate if they do not.

Repeated Prisoner’s Dilemma provides valuable insight into how countries should act away from the negotiating table and over the longer term. Ultimately, for the planet’s sake, one hopes that everyone will play the game

Source: Mark Johnston, EconoMax, December 2007

John Maynard Keynes’ “The Beauty Contest”:

“...professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest.

We have reached the third degree where we devote our intelligences to anticipating what average opinion expects the average opinion to be.”

Source: J.M. Keynes; General Theory, p.156, 1936

Suggestions for further reading on game theory

Game theory resources (US based site) www.gametheory.net/

Game theory society (US based site) www.gametheorysociety.org/

Prisoners Dilemma and a Big Brother Housemates Game! http://www.paulspages.co.uk/hmd/

Do economists need brains? (The Economist, July 2008)

Game of co-operation and betrayal

Game theory and the Dark Knight (Pure Pedantry Blog, July 2008)

Game theory could save the world (Telegraph, July 2008)

Reaping rewards for cheating (Sydney Morning Herald, July 2008)

Supermarket petrol price cuts (BBC news, July 2008)

Under the hammer – auctions and game theory (Tim Harford, May 2007)

World Cup Game Theory (Tim Harford, Slate, July 2006)

World trade talks collapse over tariff protection (Guardian, July 2008)

Suggestions for further reading on oligopoly

Call to investigate energy 'oligopolies' (Guardian, May 2008)

Collapse of the DOHA trade negotiations – free trade versus protectionism (BBC news, July 2008)

Comfortable power oligopoly ripping off customers (The Times, May 2008)

- 89 -

Tutor2u www.tutor2u.net

OPEC cartel’s empty tool kit (Fortune Magazine, July 2008)

School uniform price war (BBC news, August 2008)

Thai cartel idea outrages rice consumers (Times, May 2008)

Wake up to old-fashioned power of new oligopolies (Financial Times, February 2006)

Why do cartels often collapse? (Tutor2u blog, May 2009)

- 90 -

Tutor2u www.tutor2u.net

15. Monopolistic Competition

Monopolistic competition is a form of imperfect competition and can be found in many real world markets ranging from clusters of sandwich bars and coffee stores in a busy town centre to pizza delivery businesses in a city or hairdressers in a local area. Small-scale nurseries and care homes for older people might also fit into the market structure known as monopolistic competition.

The assumptions of monopolistic competition are as follows - as you check through them, look to see the differences between this mark structure and perfect competition.

1. There are many producers and many consumers in a market - the concentration ratio is low

2. Consumers perceive that there are non-price differences among the competitors' products i.e. there is product differentiation

3. Producers have some control over price - they are “price makers” rather than “price takers.”

4. The barriers to entry and exit into and out of the market are low

In the short run the profits made by businesses competing in this type of market structure can be at any level - in our example above the business is making supernormal profits indicated by the shaded area. One of the predictions of the model is that high levels of abnormal profit will attract new suppliers and new products into the market the effect of which might be to reduce the demand for existing products and reduce profits down towards normal profit equilibrium.

Strong brand loyalty can have the effect of making demand less sensitive to price.

AC1

P1

MR

AR

Price and Cost

Quantity of Output

AC

MC

Q1

- 91 -

Tutor2u www.tutor2u.net

The long run equilibrium may be as shown in our second diagram shown below - with normal profits being made. The reality is that a stable equilibrium is never reached - new products come and go all of the time, some do better than others. Existing products within a market will typically go through a product life cycle that affects the volume and growth of sales.

One of the implications of monopolistic competition is that an inefficient outcome is reached. Prices are above marginal cost and saturation of the market may lead to businesses being unable to exploit fully the internal economies of scale - causing average cost to be higher than if less firms and products were supplying the market. Critics of heavy spending on marketing and advertising argue that much of this spending is wasted and is an inefficient use of scarce resources. The debate over the environmental impact of packaging is linked strongly to this aspect of monopolistic competition.

Case Study: Competition in the market for nursery education

In August 2007 Nord Anglia decided to sell its market-leading nursery operation for less than half the price it paid to build the business. Nord Anglia sold its 88 kindergartens to Busy Bees, an Australian-owned company, for £31.2 million. It blamed over-capacity in the nursery market and the lack of economies of scale as the main reasons for the disposal. In 2006, Nord Anglia made a loss of £3.5 million on its nursery operation, on turnover of £47.1 million. For Busy Bees, the acquisition catapulted the business into the number one position in the nursery market, giving it a total of 134 nurseries across the UK. John Woodward, the entrepreneur who founded Busy Bees with a single site 25 years ago wants to make Busy Bees into a “major childcare brand”.

The UK nursery market is worth around £500 million and is currently highly fragmented, with some 85% of operations being “mom and pop” style individual sites. The total number of private nurseries is around 15,000. One problem facing all nursery operators is that the business is labour-intensive. One member of staff is needed to look after every three babies or seven toddlers. Nursery staff costs are around 60% of revenue. To be sustainable, a nursery has to be at least 60% full in each of its ten sessions in a week, although many customers choose not to use a nursery for a full week.

Source: Business Café, September 2007

P2 = AC2

MR

AR

Price and Cost

Quantity of Output

AC

MC

Q2

- 92 -

Tutor2u www.tutor2u.net

16. Contestable Markets What is a contestable market?

William Baumol defined contestable markets as existing where

“An entrant has access to all production techniques available to the incumbents, is not prohibited from wooing the incumbent’s customers, and entry decisions can be reversed without cost.”

For a contestable market to exist there must be low barriers to entry and exit so new suppliers can come into a market to provide fresh competition. For a perfectly contestable market, entry into and exit out must be costless

No market is perfectly contestable but virtually every market is contestable to some degree even when it appears that the monopoly position of a dominant seller is unassailable. This can have implications for the behaviour (conduct) of existing firms and then affects the performance of a market in terms of allocative, productive and dynamic efficiency.

Contestable markets and perfect competition - the differences

Contestable markets are different from perfect competitive markets. For example, it is feasible in a contestable market for one firm to have price-setting power and for firms in a market to produce a differentiated product.

There are three main conditions for pure market contestability:

o Perfect information and the ability and/or the right of all suppliers to make use of the best available production technology in the market.

o The freedom to market / advertise and enter a market with a competing product.

o The absence of sunk costs – this reduces the risks of coming into a market.

Sunk costs – a barrier to contestability

Barriers to market contestability exist when there are sunk costs. These are costs that have been committed by a business cannot be recovered once a firm has entered the industry.

The Increasing Contestability of Markets

One feature of the British and European economy in recent years has been an increase in the number of markets and industries that are genuinely contestable. Several factors explain this development:

1. Entrepreneurial Zeal: It is often the case that markets become more competitive because of the persistence of entrepreneurs who simply do not accept that the existing market structure is a given. A new supplier may have the advantage of product innovation or a more competitive business model based on different pricing strategies. A good example of this is the battle that King of Shaves is having as the challenger brand to companies such as Gillette and Wilkinson Sword.

2. The recession – an economic downturn can have the effect of opening up markets to new businesses. An example was the demise of Setanta Sports in the summer of 2009 which went into administration after failing to reach a break even target for the number of subscribers. Within days of Setanta closing down its programming in the UK, US sports channel ESPN (owned by the Walt Disney Corporation) was able to purchase the rights to show a number of live Premiership games and to launch a new sports channel in August 2009. The recession has also led to an increase in market share for a number of discount food retailers such as Aldi and Lidl – taking away some of the market share of the dominant food retailers.

3. De-regulation of markets – De-regulation involves the opening up of markets to competition by reducing some of the statutory barriers to entry that exist. Good examples

- 93 -

Tutor2u www.tutor2u.net

of recent deregulation include the liberalisation of telecommunications and postal services as part of the European Union competition initiatives. And also the Open Skies initiative in aviation that is aimed at opening up trans-Atlantic air travel.

4. Competition Policy: Tougher competition laws acting against predatory behaviour by existing firms are designed to make markets more contestable. In both the UK and the EU this has included tougher rules against price fixing cartels.

5. The EU Single Market: The development of the Single European Market has opened up the markets for member nations. A good example of this is home and car insurance and also the entry of Western European clothes retailers onto the UK high streets and shopping malls.

6. Technological Change: New technology has brought down some of the entry costs in some markets leading to an increase in capital mobility. A huge investment in open source software is changing the contestability of the market for web browsers; there is no fierce competition between Microsoft’s Internet Explorer, Chrome (Google), Firefox (Mozilla) and Safari (Apple).

7. Technological spill over can see the emergence of products that imitate the characteristics of the products of the incumbent firms. Just a few years after the launch of Viagra, the anti-impotence drug, Levitra, the first market rival to the hugely profitable Viagra, is now being manufactured by the German firm, Bayer AG, and marketed by British firm GlaxoSmithKline.

Case Studies in Market Contestability

The Global Credit and Debit Card Market

Visa and their main rival MasterCard are locked in a fierce battle for market share. Currently Visa has 55% of the world’s payments cards and a 59% slice of total transactions. MasterCard has 36% of cards and 31% of the value of transactions. Simple maths tells us that this is a good example of a duopoly – there are other players notably American Express and Diners Club, but they are in a completely different league. If anything, Visa and MasterCard’s main competitors are cash and cheques!

The key to understanding this level of market dominance is the concept of a platform (or network) economy of scale. The fixed costs of building, maintaining and expanding a payments system are enormous but the marginal costs of adding one more user to the system are, in contrast, tiny

Over the years, Visa has built a large retail payments network with commercial relationships with nearly 17,000 financial institutions and 30 million retail outlets – making it easily the world’s biggest payments system. There are over 1.5 billion Visa cards in issue and around 1 billion transactions are made annually. Visa has more cards in circulation than all the major competitors combined and their cards are accepted in 170 countries or territories. In Western Europe alone, nearly 350 million Visa cards are now in circulation. 11.4% of consumer spending at point of sale in Europe is with a Visa card. At Christmas in 2007, the Visa network was handling 7,400 messages per second and their system has a capacity to cope with upwards of 12,000 before reaching a ceiling.

The Visa brand has been extended in many different ways to exploit economies of scope - from basic ATM cash cards, through to debit and credit cards targeted at different segments of the payments market. Take your choice from Visa Classic, Visa Gold, Visa Platinum, Visa Infinite, Visa Electron, PLUS and Visa Travellers Cheques and V-Pay!

Because of the investment in infrastructure and the internal economies of scale from adding more merchant outlets and extra customers, Visa estimates that the average cost per transaction has fallen by nearly a half over the last five years – this is a hugely important competitive advantage for the business going forward

Of course this has not stopped regular accusations that Visa has engaged in anti-competitive practices as a barrier to entry in a highly profitable global industry. In 2007, American Express claimed that Visa and others had prevented 20,000 US banks from using Amex credit card products. Earlier this year, American Express accepted a payment of £1bn from Visa to settle the dispute and have Visa dropped as a defendant in the anti-trust case. Other critics of Visa and MasterCard claim that the high charges for using cards represent a ‘tax on consumption’ that hit the poorest hardest.

- 94 -

Tutor2u www.tutor2u.net

And this year a cluster of leading European banks including Commerzbank, Deutsche Bank, Société Générale and BNP Paribas has been giving serious consideration to setting up a rival network to Visa and MasterCard. Can they overcome the barriers to entry and make a profitable entry into this market?

Source: EconoMax, May 2008

Smart-phones - a contestable market

As the market for high-end mobiles gets ever more crowded, which should you pick?” The market space has become evermore congested as the likes of Apple, Microsoft, Research in Motion and Symbian (developers of the software that run most of Nokia’s smart-phones) compete with each other for a share of the lucrative corporate and personal sector market.

It is a market where performance, functionality, speed and reliability of access, look and feel of the hardware and the length of battery life are all important non-price factors influencing consumer preferences. Price is significant and smart-phone manufacturers are fully aware of the need to attract heat-seekers or ‘early adopters’ – consumers who are willing to pay a premium price for being among the first to be seen using a new piece of kit.

Despite the obvious barriers to entry for new participants, the smart-phone market is increasingly contestable even though it is dominated by a handful of major players. The increasing use of open-source software has helped to make the battle for market dominance a more intense affair.

Source: Tutor2u economics blog, December 2008

How does the threat of competition affect a firm’s behaviour?

How might the contestability of a market affect the conduct and performance of businesses? It is worth emphasising in essays and data questions that it is the actual behaviour of agents in the market that is more important that a simple picture of market share.

In the diagram above a pure monopoly might price at P1 – the profit maximising equilibrium. If a market is contestable, there is downward pressure on price, because the presence supernormal profits signals for new firms to enter the market and if the existing monopolist is producing at too high a price or has allowed their average total costs to drift higher, entrants can undercut the monopolist and some of the abnormal profit will be competed away. Normal profit equilibrium occurs when average revenue equals average total cost (at output Q2 and price P2). A lower price and higher output causes an increase in consumer surplus.

Costs

Revenues

Output (Q)

AC

AR (Monopoly)

MR

MC

Q1

P1

Profit Max at Price P1

P2

Q2

- 95 -

Tutor2u www.tutor2u.net

When markets are contestable – we expect to see lower profit margins than when a monopoly operates without competition. Indeed the threat of competition may be just as powerful an influence on the behaviour of the existing firms in a market than the actual entry of new businesses.

If a market is contestable, industry structure and firm behaviour is determined by the threat of competition - 'hit-and-run' entry. The market will resemble perfect competition, regardless of the number of firms, since incumbents behave as if there were intense competition.

Case Study: Latte Battle taken up by McDonalds

The competition for market share in the retail coffee market is a classic example of a contestable market. Starbucks has enjoyed super-charged growth in recent years but there are grounds for thinking that it may have become too big and is suffering from diseconomies of scale. There is a growing challenge from Dunkin Donuts and also from McDonalds which is investing heavily in up-market coffee machines which will dispense ground coffee and sold by McDonald’s baristas across their 14,000 North American outlets. A key part of their strategy will be to sell brewed coffee up to sixty cents cheaper than Starbucks for an equivalent size of cup and these lower prices will come from a lower cost base.

As the Wall Street journal reports; 'McDonald's process is more automated. It uses a single machine to make all the components of each drink. Espresso is brewed using beans with a darker roast that are more finely ground than those for drip coffee, resulting in a concentrated form that's usually mixed with hot milk to make lattes and cappuccinos. McDonald's has three flavours it adds to its espresso drinks, a significantly narrower line-up than Starbucks, which boasts thousands of drink combinations.

Starbucks has seen its share price fall steeply in recent years. The business has been hit by the severe recession in the US economy and many of their newly opened stores that Starbucks have failed to make a profit. Today, about 80% of the orders purchased at US-based Starbucks outlets are consumed outside the store.

Source: Tutor2u Economics Blog, February 2008

Suggestions for further reading on contestable markets

Renault-Nissan joins the race to produce a $2500 car (Tutor2u blog, May 2008)

Sony in danger of losing game crown to Nintendo (The Times, July 2008)

Laser treatment deregulation fear (BBC news, February 2008)

HD DVD defeat hits Toshiba profit (BBC news, March 2008)

London tailors face low-cost rival (BBC news, March 2008)

Console makers in three-way shoot-out (Independent, October 2008)

Recession helps discount stores (BBC news, November 2008)

Aldi moves into the holiday market (BBC news, Jan 2009)

Farmers seeking organic holiday (BBC news, Jan 2009)

World’s cheapest car goes on sale (BBC news, April 2009)

King of Shaves takes on Wilkinette (Tutor2u blog, June 2009)

ESPN to launch UK sports channel (BBC news, July 2009)

Google to launch rival operating system (BBC news, July 2009)

Google launches internet browser (BBC news, September 2009)

- 96 -

Tutor2u www.tutor2u.net

17. Government intervention to maintain competition in markets Competition policy

The aim of competition policy is promote competition; make markets work better and contribute towards improved efficiency in individual markets and enhanced competitiveness of UK businesses within the European Union single market. Competition policy aims to ensure

o Wider consumer choice

o Technological innovation which promotes dynamic efficiency

o Effective price competition between suppliers

There are four key pillars of competition policy in the UK and in the European Union

1. Antitrust & cartels: This involves the elimination of agreements that seek to restrict competition including price-fixing and other abuses by firms who hold a dominant market position (defined as having a market share in excess of forty per cent).

2. Market liberalisation: Liberalisation involves introducing fresh competition in previously monopolistic sectors such as energy supply, postal services, mobile telecommunications and air transport.

3. State aid control: Competition policy analyses examples of state aid measures to ensure that such measures do not distort competition in the Single Market

4. Merger control: This involves the investigation of mergers and take-overs between firms (e.g. a merger between two large groups which would result in their dominating the market).

The Regulators

Regulators are the rule-enforcers and they are appointed by the government to oversee how a market works and the outcomes that result for both producers and consumers. Examples of regulators include the Office of Fair Trading and the Competition Commission. The European Union Competition Commission is also an important body for the UK economy.

What do the regulators regulate?

1. Prices: Regulators aim to ensure that companies do not exploit monopoly power by charging excessive prices. They look at evidence of pricing behaviour and also the rates of return on capital employed to see if there is evidence of ‘profiteering.’ Recently the EU Competition Commission made a ruling on the ‘roaming’ charges of mobile phone operators in the EU and helped to enforce a new maximum price on such charges.

2. Standards of customer service: Companies that fail to meet specified service standards can be fined or have their franchise / licence taken away. The regulator may also require that unprofitable services are maintained in the wider public interest e.g. BT keeping phone booths open in rural areas and inner cities; the Royal Mail is still required by law to provide a uniform delivery service at least once a day to all postal addresses in the UK

3. Opening up markets: The aim here is to encourage competition by removing barriers to entry. This might be achieved by forcing the dominant firm in the industry to allow others to use its infrastructure network. A key task for the regulator is to fix a fair access price for firms wanting to use the existing infrastructure. Fair both to the existing firms and also potential challengers.

4. Regulation can act as a form of surrogate competition – attempting to ensure that prices, profits and service quality are similar to what could be achieved in competitive markets.

- 97 -

Tutor2u www.tutor2u.net

In a nut shell the role of competition authorities around the world is to protect the public interest, particularly against firms abusing their dominant positions

Anti-Trust Policy - Abuses of a Dominant Market Position

A firm holds a dominant position if its power enables it to operate within the market without taking account of the reaction of its competitors or of intermediate or final consumers.

Competition authorities consider a firm’s market share, whether there are credible competitors, whether the business has ownership and control of its own distribution network (achieved through vertical integration) and whether it has favourable access to raw materials.

Holding a dominant position is not wrong if it is the result of the firm's own competitiveness against other businesses! But if the firm exploits this power to stifle competition, this is deemed to be an anti-competitive practice.

Anti-competitive practices are designed to limit the degree of competition inside a market.

Examples of anti-competitive practices

1. Predatory pricing also known as ‘destroyer pricing’ happens when one or more firms deliberately sets prices below average cost to incur losses for a sufficiently long period of time to eliminate or deter entry by a competitor – and then tries to recoup the losses by raising prices above the level that would ordinarily exist in a competitive market.

2. Vertical restraint in the market: This can happen in a number of ways:

a. Exclusive dealing: This occurs when a retailer undertakes to sell only one manufacturers product. These may be supported with long-term contracts that “lock-in” a retailer to a supplier and can only be terminated by the retailer at high financial cost. Distribution agreements may seek to prevent instances of parallel trade between EU countries (e.g. from lower-priced to higher priced countries).

b. Territorial exclusivity: This exists when a particular retailer is given the sole rights to sell the products of a manufacturer in a specified area.

c. Quantity discounts: Where retailers receive larger price discounts the more of a given manufacturer's product they sell - this gives them an incentive to push one manufacturer's products at the expense of another's.

d. A refusal to supply: Where a retailer is forced to stock the complete range of a manufacturer's products or else he receives none at all, or where supply may be delayed to the disadvantage of a retailer.

3. Collusive practices: These might include agreements on market sharing, price-fixing and agreements on the types of goods to be produced.

Price Fixing – The role of the Office of Fair Trading

UK competition law now prohibits almost any attempt to fix prices - for example, you cannot

o Agree prices with your competitors or agree to share markets or limit production to raise prices.

o Impose minimum prices on different distributors such as shops.

o Agree with your competitors what purchase price you will offer your suppliers.

o Cut prices below cost in order to force a weaker competitor out of the market.

- 98 -

Tutor2u www.tutor2u.net

Case Study: Cartels and the law in the UK

Cartels are a particularly damaging form of anti-competitive behaviour - taking action against them is one of the OFT's priorities. Under the Competition Act 1998 and Article 81 of the EU Treaty, cartels are prohibited. Any business found to be a member of a cartel could be fined up to 10 per cent of its worldwide turnover. In addition, the Enterprise Act 2002 makes it a criminal offence for individuals to dishonestly take part in the most serious types of cartels. Anyone convicted of the offence could receive a maximum of five years imprisonment and/or an unlimited fine.

Source: adapted from the OFT web site

There have been many examples of allegations of and investigations in price fixing and other forms of collusive behaviour in UK and European markets in recent years. They all provide interesting evidence of how the competition authorities both in the UK and in the European Union are using their enhanced powers under new competition laws to investigate possible instances of price fixing or anti-competitive behaviour.

Some collusive behaviour is tolerated / encouraged

Not all instances of collusive behaviour are deemed to be illegal by the European Union Competition Authorities. Practices are not prohibited if the respective agreements "contribute to improving the production or distribution of goods or to promoting technical progress in a market.”

o Development of improved industry standards /technical standards of production and safety which eventually benefit the consumer.

o Research joint-ventures and know-how agreements which seek to promote innovative and inventive behaviour in a market.

Market Liberalization

The main principle of EU Competition Policy is that consumer welfare is best served by introducing competition in markets where monopoly power exists. Frequently, these monopolies have been in network industries for example transport, energy and telecommunications. In these sectors, a distinction must be made between the infrastructure and the services provided directly to consumers using this infrastructure.

While it is often difficult to establish a second, competing infrastructure, for reasons linked to investment costs and efficiency (i.e. the natural monopoly arguments linked to economies of scale and a high minimum efficient scale) it is possible and desirable to create competitive conditions in respect of the services provided.

The European Commission has developed the concept of separating infrastructure from commercial activities. The infrastructure is thus the vehicle of competition.

State Aid in Markets

The argument for monitoring state aid given to private and state businesses by member Government is that by giving certain firms or products favoured treatment to the detriment of other firms or products, state aid disrupts normal competitive forces. Under the current European state aid rules, a company can be rescued once. However, any restructuring aid offered by a national government must be approved as being part of a feasible and coherent plan to restore the firm’s long-term viability. Government aid designed to boost research and development, regional economic development and the promotion of small businesses is normally permitted.

Here are some recent examples of the state aid /state subsidy issue in the news. They nearly always relate to industries and businesses either suffering short-term losses whose future is under threat or those struggling to cope and adjust to long-term economic decline. The effects of the credit crunch and subsequent recession have brought state aid firmly back into the spotlight especially as many governments have decided to offer rescue and other support packages for strategic industries.

- 99 -

Tutor2u www.tutor2u.net

In theory the EU commission must approve and/or endorse any application by the government of a member state to offer financial help to national businesses where such assistance impacts on businesses in other EU countries. During the summer of 2009 there has been an avalanche of commission endorsements ranging from government funding to recapitalize distressed banks, to state financial support to rebuild export-credit insurance (a key area badly hit by the credit crunch), from state aid for research and development in developing new aerospace engines to increased regional aid budgets for investment schemes in economically depressed regions of the EU.

Report rules out state aid for the UK fishing industry (BBC news, July 2008)

Merkel offers state aid for Opel (BBC news, March 2009)

Merger Policy in the UK and the European Union

Corporate restructuring is a fact of life. There is a natural tendency for markets to consolidate over take through a process of horizontal and vertical integration. The main issue for competition policy is whether a proposed merger or takeover between two businesses is thought to lead to a substantial lessening of competitive pressures in the market and risks leading to a level of market concentration when collusive behaviour might become a reality.

When companies combine via a merger, an acquisition or the creation of a joint venture, this generally has a positive impact on markets: firms usually become more efficient, competition intensifies and the final consumer will benefit from higher-quality goods at fairer prices.

However, mergers which create or strengthen a dominant market position can, after investigation, be prohibited in order to prevent ensuing abuses. Acquiring a dominant position by buying out competitors is in contravention of EU competition law.

Companies are usually able to address the competition problems, normally by offering to divest (sell or off-load) part of their businesses. In December 2007, the UK Competition Commission announced that the broadcaster BSkyB would be forced to sell some of its 17.9% stake in ITV.

Further reading on competition policy

Ferry competition study concluded (BBC news, June 2009)

Inquiry into Ticketmaster merger (BBC news, June 2009)

Grocery inquiry – success or failure (BBC news, April 2008)

Case study: EU competition commission enforces price cap on mobile phone charges

The EU Competition Commission has enforced a price cap on the cost of sending text messages when abroad and has introduced a maximum charge for receiving and making a phone call. The main argument from the competition authorities was that the market for domestic phone calls and for EU phone calls are comparable and thus the marked price differentials for domestic versus foreign phone calls was not justified; and was an abuse of market dominance. At a time when both external and internal economies of scale were lowering the unit costs of domestic phone calls, international roaming charges remained high. The EU Commission has had to balance the desire for competition with the need to avoid over-regulation. Vodafone made a pre-emptive strike ahead of the likely regulation in roaming charges, by saying it would cut the cost of using other companies’ networks when abroad by at least 40 per cent; it has since announced an end to roaming charges. Whilst the EU regulator is there to ensure competition if it over-regulates, it will end up stifling competition, and this balancing act is not always an easy one to maintain.

Under the new limits there is a single tariff covering all 27 EU member states - bringing the maximum charge for making a call while abroad down to 37p per minute. Receiving calls now costs a maximum of 17p per minute. Sending a text message from another country inside the EU will cost no more than 10p. Data transfer prices have also fallen, with one megabyte of data now costing 85p. The limits exclude tax

Source: adapted from the Tutor2u economics blog, June 2009 (author: Mo Tanweer)

- 100 -

Tutor2u www.tutor2u.net

Privatisation and Nationalisation – The Mixed Economy

What is privatisation?

Privatisation means the transfer of assets from the public (government) sector to the private sector. In the UK the process has led to a sizeable reduction in the size of the public sector of the economy. State-owned enterprises now contribute less than 2 per cent of GDP and less than 1.5% of total employment. Privatisation has become a common feature of microeconomic reforms throughout the world not least in the transition economies of Eastern Europe as they have made progress towards becoming fully-fledged market economies. But over the last two years privatisation in the UK economy has given way to a new wave of nationalisation including some high profile banks, building societies and transport services.

Major privatisations

The major privatisations in the UK over the last thirty years have occurred with the following businesses (the year of privatisation is in parenthesis).

o Associated British Ports (1983) o British Aerospace (1980) – eventually

merged with Marconi Electronic Systems

o British Airports Authority (1986) – subsequently bought by Grupo Ferrovial in 2006

o British Airways (1987) o British Coal (1994) – in 1994, UK

Coal’s assets were merged with RJB Mining to form UK Coal plc

o British Gas (1986) - In 1997 British Gas plc de-merged Centrica plc and renamed itself BG plc (later BG Group plc). in Britain it is used by Centrica, while in the rest of the world it is used by BG Group

o British Petroleum - In August 1998, British Petroleum merged with the Amoco Corporation (Amoco), forming "BP Amoco."

o British Rail (privatised in stages between 1994 and 1997) – created Railtrack – it was renationalised in 2002.

o British Steel (1988) – British Steel merged with the Dutch steel producer Koninklijke Hoogovens to form Corus Group on 6 October 1999. Corus was bought by Indian steel firm Tata in 2007.

o British Telecom (1984) o National Power and PowerGen (1990)

- 1990 the Central Electricity Generating Board was split into three generating companies (Powergen, National Power and Nuclear Electric plc.) and electricity transmission company, National Grid Company.

o Regional water companies

The early examples of privatisation such as the sale of British Telecom to the private sector in 1984 represented a simple transfer of ownership as shares were offered for sale via the stock market. More recently the privatisation process has become more complex. The focus has switched to breaking up existing statutory monopoly power through a process of deregulation and liberalisation of markets – basically designed to introduce competition where once monopoly power was well established.

Market forces have been introduced in social services, the NHS and in higher education.

The public sector of the UK economy

What is best provided by the market? And what might be more appropriately provided by the government sector of the economy? Privatisation has radically changed the public or government sector of the economy although since the current Labour government came to power, there has been a huge rise in total public sector employment, in part the result of a large rise in government spending on the national health services. The following businesses remain part of the public sector:

o British Nuclear Fuels plc - an international company, owned by the British government, concerned with nuclear power.

- 101 -

Tutor2u www.tutor2u.net

o Network Rail - Network Rail is a "not for dividend" company that owns the fixed assets of the UK railway system that formerly belonged to British Rail, the now-defunct British state-owned railway operator. Network Rail owns the infrastructure itself, railway tracks, signals, tunnels, bridges, level crossings and most stations, but not the rolling stock. Network Rail took over ownership by buying Railtrack plc, which was in "Railway Administration", for £500 million from Railtrack Group plc.

o East Coast Rail Line. In June 2009 – see the short case study below

o The Royal Mail - Royal Mail has been a state-owned company since 1969 and remains a public limited company wholly owned by the UK government. The Royal Maul is regulated by PostComm which has the power to grant licences to new competitors entering the deregulated market for household and business mail services. The market was opened up to full competition in January 2006. The Royal Mail retains a universal service commitment.

o The Tote – a betting business that remains in state ownership and has done since it was created by an act of parliament in 1928. The government has announced plans to privatise the business but this has not yet been completed in part because of difficult stock market conditions following the credit crunch and the recession.

o Northern Rock - In the autumn of 2007 the government announced the nationalisation of Northern Rock - all shares in the business were handed over to the Treasury. The main justification for the decision was that Northern Rock's business model had failed but that the economic and social consequences of allowing the business to go bust were too severe - hence the need for government intervention. Weeks earlier Northern Rock ran into a financial crisis which led to the first run on a major UK bank since the nineteenth century. It was forced to ask the Bank of England for emergency funding. With nationalisation, the debts of the bank were taken onto the public sector finances. These loans and guarantees were estimated to be worth more than £50bn. In the months since the nationalisation, Northern Rock has been downsizing its activities, reducing the size of its mortgage loans book and making several thousand employees redundant.

o Bradford and Bingley - In September 2008 the UK government nationalised Bradford and Bingley - it took control of the bank's £50bn mortgages and loans, while B&B's £20bn savings unit and branches was bought by Spain's Santander.

o Royal Bank of Scotland: On the 13 October 2008 the UK government announced its plan to save the Royal Bank of Scotland from failing. It agreed a bail out of the bank in return for taking a seventy per cent stake in the business. The government also has a 43 per cent stake in Lloyds Banking Group.

The pendulum seems to be moving back from the idea that all of the public sector is ripe was privatisation – when it comes to the public-private sector mix, it is likely that the UK will move towards different ownership models for different industries and decided on a case-by-case basis.

- 102 -

Tutor2u www.tutor2u.net

Case Study: The East Coast Rail Line is Nationalised

The profitable East Coast rail line north of Newcastle heading into Northumberland towards Berwick upon Tweed is one of the most glorious on the entire British rail network. There are stunning views looking out to Holy Island, Bamburgh Castle and the village of Alnmouth. And as trains pull out of Durham there is a fantastic panorama featuring Durham Cathedral, a view to take the breath away whatever the weather. Even the most hardened commuter is tempted away from their laptop to soak up the view. It is unlikely that senior executives at National Express will be in the mood to savour these delights since the government is taking the East Coast rail line that runs from London to Edinburgh into public ownership.

National Express has struggled with falling revenues and higher costs that have contributed to rising losses on the line. In effect the nationalisation prevents National Express from re-entering the market when new franchises become available and there is the chance that the government will also strip the operator of its East Anglia and C2C services operating out of Liverpool Street and Fenchurch Street stations.

The rail franchise also has suffered greatly from the huge financial commitments it made to the government when bidding successfully to operate the line and has a £1.2bn debt pile. Under the terms of the franchise agreement, National Express is required to pay the government £1.4bn to run the East Coast line until 2015, with the amount rising steeply from £85m in 2008 to £395m this year. In order to meet its targets, the franchise requires passenger revenue growth of about 10% per year, but turnover has been affected by the recession which has cut the volume of business travel and prompted many to trade-down from first class to standard class travel. In this sense National Express is no different to the problems facing airlines such as British Airways whose premium passengers have long been a key source of revenue. They have been criticised for their high walk-on fares, indeed a business that charges £266 for a Newcastle-London peak return journey and still cannot balance the books perhaps deserves to be dumped by the government?

National Express is bound by the terms of a bankers covenant that limits the amount that they can borrow to no more than 3.5 times its earnings before interest, tax, depreciation and amortisation (EBITDA). As a result the business is expected to raise fresh capital by a rights issue to existing shareholders, little wonder that the share price has fallen sharply in recent months. It has already been the subject of a takeover bid from rival transport operator First Group. Here is another example of the winners’ curse – where an auction leads to the winning bidder paying more than was viable to secure the franchise.

The government has refused to renegotiate the terms of the licence. The Department for Transport (DfT) will take control of the franchise towards the end of 2009, putting it into a public company specially created by the department. It will then put the contract out to tender again to the private sector at the end of next year. The government may have to wait until macroeconomic conditions improve to find a buyer for the East Coast franchise; the expectation is that public ownership will last for about a year. The government wanted to send a message to other businesses in the sector that they are keen to avoid moral hazard - no operator is too big to lose their franchise.

Since rail privatisation in 1994, train lines have been operated using a franchise policy through which the government effectively outsources the operation of 19 British rail routes to privately owned companies. On most franchises, it gives operators a multimillion pound subsidy to help pay charges for using the tracks, which are levied by the state-owned Network Rail, who run Britain's tracks, signals and stations. Among the remaining train operating companies, First Group, Stagecoach/Virgin, Go-Ahead and Arriva now dominate train operating company landscape. How long will it take before we arrive back at a pre-privatisation situation with just one national train operating company and one business (Network Rail) managing the network?

For National Express the failure of the business to make the East Coast line a success will damage their reputation - it is a timely example of the exit costs linked to entering a market.

Source: Tutor2u Economics Blog, June 2009

National Express

- 103 -

Tutor2u www.tutor2u.net

Privatisation – good or bad for economic efficiency?

Supporters of privatisation believe that the private sector and the discipline of free market forces are a better incentive for businesses to be run efficiently and thereby achieve improvements in economic welfare.

Privatisation was also seen as a way of reducing trade union power, widening share ownership and increasing investment, as privatised businesses were now free to raise finance through the stock market. Privatisation was regarded as an important supply-side policy designed to drive competition and improve productive and dynamic efficiency.

Opponents of privatisation argued that state owned enterprises had already faced competition when part of the public sector and that in several instances the transfer of ownership merely replaced a public sector monopoly with a private sector monopoly that then required regulation.

There were criticisms that state assets were sold off by the government at too low a price and that the consequences of privatisation has been a decrease in investment and large scale reductions in employment as privatised businesses have sought to cut their operating costs.

Deregulation of markets

Deregulation involves opening up markets and encouraging the entry of new suppliers. Examples of this in the UK include the opening up of markets for bus services, household energy supplies, the liberalisation of household mail services and financial deregulation affecting both banks and building societies.

The expansion of the European Single Market has accelerated the process of market liberalisation. The Single Market seeks to promote four freedoms – namely the free movement of goods, services, financial capital and labour. In the long term we can expect to see the microeconomic effects of the EU Single Market working their way through many British markets and the general expectation is that competitive pressures for all businesses working inside the European Union will continue to intensify.

Product market liberalisation involves breaking down barriers to entry in industries and making them more contestable. The aim is to boost market supply, bring down prices for consumers, and encourage an increase in competition, investment and productivity leading to a rise in economic efficiency. In the long term, if product markets become more competitive and investment flows into these industries, there are macroeconomic implications for example an increase in an economy’s underlying trend rate of economic growth which might contribute to an improvement in average standards of living.

Utility regulators

Utility regulators oversee the activities of companies privatised over the last two decades. These former state-owned utilities are regulated to ensure that they do not exploit their monopoly position. In the long run, the thrust of regulation has been to encourage competition by easing the entry of new suppliers and making markets more contestable.

o Ofwat – (water services regulation authority) – Ofwat is the body responsible for economic regulation of the privatised water and sewerage industry in England and Wales. Key issues for Ofwat at the moment include the threats of water shortages, the problems of leaks and rising water bills.

o Financial Services Authority – oversees banking and other financial industries, heavily criticised for its role in allowing excessive lending and risk taking by the banks which ultimately led to the global credit crisis and subsequent recession.

o Ofcom - The Office of Communications is the UK's communications regulator

- 104 -

Tutor2u www.tutor2u.net

o Ofgem - The Office of Gas and Electricity Markets is the government regulator for the electricity and downstream natural gas markets in Great Britain. Its primary duty is to “promote choice and value for all gas and electricity customers".

o Office of the Rail Regulator – ORR is the UK government's agency for regulation of the country's railway network.

Price Capping for the Utilities

Price capping has been a feature of regulation in recent years – although this is now being phased out as most utility markets become more competitive. Inn reality, setting a price cap, the industry regulator usually has in mind a “satisfactory rate of return on capital employed” for each business.

Basics of price capping

Price capping is an alternative to rate-of-return regulation, in which utility businesses are allowed to achieve a given rate of return (or rate of profit) on capital. In the UK, price capping has been known as "RPI-X". This takes the rate of inflation, measured by the Consumer Price Index and subtracts expected efficiency savings X. In the water industry, the formula is "RPI - X + K", where K is based on capital investment requirements designed to improve water quality and meet EU water quality standards. This has meant increases in the real cost of water bills for millions of households in the UK.

Price capping has meant in most cases that average prices for consumers have fallen in real terms although this has not been the case for all privatised industries. The assumption is that productivity growth will help to accommodate the price caps. Profits for utilities can rise providing that efficiency levels improve (i.e. firms are able to bring down their unit labour costs)

Advantages

o Capping is an appropriate way to curtail the monopoly power of “natural monopolies”.

o Cuts in the real price levels are good for household and industrial consumers (leading to an increase in consumer surplus and higher real living standards in the long run).

o Price capping helps to stimulate improvements in productive efficiency because lower costs are needed to increase a producer’s total profits.

o The price capping system is a useful tool for controlling consumer price inflation in the UK.

Disadvantages

o Price caps have led to large numbers of job losses in the utility industries.

o Setting different price capping regimes for each industry distorts the price mechanism.

Case Studies on Price Capping

Yell and price capping

Price capping is still used in the market for telephone directories where Yell has a dominant position in the market. In June 2006 it was announced that Yell would still be subject to a price capping formula because of the relative absence of competition in the industry. According to the Competition Commission report, "Yell continues to hold a powerful position in this market and competition is not working effectively. Prices are capped at the moment and without this price cap, advertisers would pay more than in a well-functioning market. At present, Yell is subject to a yearly price cap of RPI less 6% - so at the moment, the real cost of advertising rates are falling year-on-year.

- 105 -

Tutor2u www.tutor2u.net

Case Study: Post Comm approves a rise in the price of stamps

The price of both first and second-class stamps has increased by 3 pence. A first-class stamp now costs 39p for standard letters weighing up to 100g. A second-class stamp now costs 30p for a letter of the same weight. For large letters, the price of a first-class stamp has gone up by 9p to 61p while a second-class stamp has raised 5p to 47p. The price increases were within the price limits set by the regulator, Postcomm. Despite higher prices, the delivery of stamped mail remains a loss-making business for Royal Mail.

Source: Adapted from news reports, April 2009

Changing Role of the Utility Regulators

Gradually the main utility regulators have withdrawn from price regulation because of the increased competition in the market. The main focus of the regulatory authorities is now to provide improved price information for consumers to make prices of different suppliers more transparent.

The authorities also keep a close eye on anti-competitive behaviour.

In telecommunications, one key decision made eventually by Ofcom was to enforce unbundling of the local loop. In the UK this has meant opening up the telephone exchanges owned by British Telecom and allowing broadband businesses to put in their own equipment and then supply broadband services in direct competition with BT to households. The vast majority of households are within one mile of their local telephone exchange. Although local look unbundling has taken time to become widespread, it has been one factor behind the rapid expansion of market supply in broadband that is revolutionising the UK telecommunications market.

One of the consequences of the greater level of competition in the telecommunications industry in the UK is that in July 2006, Ofcom withdrew all price capping controls on British Telecom.

The debate over water prices

Index of prices, January 1987=100Water and other charges

RPI: housing: water & other charges (Jan 1987=100) RPI: All items retail prices index (January 1987=100)

Source: Reuters EcoWin

87 88 89 90 91 92 93 94 95 96 97 98 99 00 01 02 03 04 05 06 07 08 09

100

150

200

250

300

350

400

450

1987

=100

100

150

200

250

300

350

400

450

All Items Retail Price Index

Water Charges

- 106 -

Tutor2u www.tutor2u.net

When water was privatised in 1989, the average household bill was about £219. In 2006, it was £303 - up 38%. Since the last price review in 2004, the average bill has gone up 10% and is expected to rise about 20% plus inflation between 2005 and 2010.

The subsequent profits declared by the water industry have prompted an outcry that shareholders are benefiting at the expense of customers. The problem has been exacerbated by PR disasters such as Thames Water's handling of the drought last summer and an imposition of a hosepipe ban while the company's pipes leaked millions of litres a day into the ground.

Water companies argue that the increases are needed for large-scale investment such as mending burst pipes to meet leakage targets and improving waste disposal. The water industry invests more capital in maintenance than all other utilities combined. Since privatisation, the sector has invested over £50bn - half of that is down to meeting European Union directives. In 2004, it agreed with the regulator to spend a further £16.8bn to 2010. Given that last year alone 3.6bn litres of water leaked from UK pipes every day, it would appear that the money is needed.

Water bills could rise by 17% over five years (BBC news, June 2009)

Water metres and consumer welfare (BBC news, March 2009)

Source: Adapted from newspaper reports, March 2007

Case Study: Is there a future for NHS dentistry?

In 2006 the government introduced a series of reforms for NHS dentists which included the scrapping of system of registration whereby dentists had a list of patients. A chronic shortage of dentists operating within the NHS led to huge queues of people outside practices where a new NHS dentist had become available.

Under the terms of the new contract dentists were paid to carry out a set number of courses of treatment in the hope that this would give them more time to spend with patients and an improvement in preventative dentistry. But many dentists decided not to sign the contract and left the NHS to pursue a career in the private sector. As a result demand for NHS dental care is still outstripping supply and patients are struggling to get access in some places.

It costs the taxpayer £175,000 to train a dentist. If dentists receive training and then leave to work in private practice, the NHS suffers from the free-rider problem. It has been suggested that newly qualified dentists should have to serve a five year term within the NHS before having the freedom to move into the private sector. Average earnings for NHS dentists stood at just over £96,000 in 2007. For the top-earning dentists who own their own practice average income rose is £172,494.

Source: Tutor2u Economics Blog

Suggestions for further reading on privatisation and nationalisation

Guardian special reports on the Northern Rock

Have we reached the end of Thatcher’s privatisation dream? (Guardian, July 2009)

Call for sell-off of the Royal Mail (BBC news, May 2008)

Argentina renationalises airline (BBC news, July 2008)

NHS dentists turning private (BBC news, July 2008)

NHS runs like a supermarket war (BBC news, July 2008)

B&B nationalisation is confirmed (BBC news, September 2008)

Irish bank set to be nationalised (BBC news, January 2009)

Venezuela in bank nationalisation (BBC news, May 2009)