Unit 1: Introduction to the Scope of Business Market Economics and Strategy
• Aims and Objectives:
• Consider the use of economics in the business environment;
• Understand the difference between the study of microeconomics and macroeconomics
• Understand the basic economic concerns of choice and how it relates to scarcity and opportunity cost
• Explain the advantages and disadvantages of different types of economic systems
Brief Introduction:
This unit introduces the economic study of business organisations and the markets in which they sell their goods and services. This is an introductory unit to bring you to understand the concepts of market economics and to introduce some basic economic tools. Within this unit various themes will be discussed that cover:
• Define market economic
• Difference between microeconomics and macroeconomics
• Classification of resources
• Generic model of business activity
• Main factors making up the micro and macro influences on the firm
• Advantages and disadvantages of different types of economic systems
Define market economic
Economics is the social science study of choices that individuals, businesses, governments and on a larger scale the choices entire societies make when they cope with scarcity and the incentives that influence and reconcile those choices. To define one needs to understand the economic questions that arise because we always want more than we can get, so we face scarcity, the inability to satisfy all our wants. Everyone faces scarcity because no one can satisfy all of his or her wants. Hence scarcity forces us to make choices over the available alternative. The choices we make depend on incentives, a reward that encourages a choice or a penalty that discourages a choice.
Difference between microeconomics and macroeconomics
Within economics there are two main branches:
1.Microeconomics: is the study of the choices that individuals and businesses make, and the way these choices interact in markets, and the influence of governments to determine the:
• Decisions and objectives of specific households and businesses. For instance, what determines household spending on different goods and services? How do firms in different industries organise the production of goods and services?
• Study of individual markets for goods and services – how are the prices and quantities traded determined?
2.Macroeconomics: is the study of the performance of the national economy and the global economy. Looking at the economy as whole, i.e. the entire circular-flow of income. Key macroeconomic issues are Gross Domestic Product (GDP – the total output of the economy), economic growth (the growth in GDP), inflation (changes in the general price level), unemployment (the numbers of people out of work) and the balance of payments (the surplus or deficit one nation has with its trading partners).
Classification of resources
A market is made up from various resources and in economics resources are defined as commodities, services, and other assets used to produce goods and services that meet human needs and wants, these are made up of the factors of production that populate the market economic and the circular flow of the economy as can be seen below in figure 1, the microeconomic areas are highlighted red:
Figure 1 – Circular flow of the Economy
Source: Ceyhun Elci
Within the definition of economics, classification of resources is the study of how society manages these scarce resources which are made up from the factors of production. These are categorised into resources such as: land, labour, capital and entrepreneurship, which are owned by households and are rented to firms/businesses for economic rent (e.g. wages and interest) for firms to undertake production for good and services for sale to households and others. Land includes all natural resources, including the site of production and the source of raw materials. Labour or human resources consist of human effort in the creation of products, paid through wages. Capital is the goods or means of production (machinery, buildings, and other infrastructure), which are used in the production of other goods and services, paid through interest. Entrepreneurs serve as managers, risk-takers, leaders, and visionaries and are usually the pioneers of growing the circular flow of the economy.
Generic model of business activity
Hence the business decisions incorporate the generic microeconomic choices in view of the business activity to decide:
• What goods and services are going to be produced?
• How are these goods and services going to be produced? What methods of production are going to be used?
• For whom are these goods going to be produced? Who is going to receive these goods and services? This depends upon how income and wealth are distributed in society.
Main factors making up the micro and macro influences on the firm
Micro and macro factors have an impact on the firm and business decision-making, these are both from internal and external influences on the firm these factors are categorised into:
• Microeconomic: the market, demand, competition, prices of products, labour, capital;
• Macroeconomic: overall economic situation, national expenditure, interest rates, and the exchange rate.
Advantages and disadvantages of different types of economic systems
Economic systems describe the way a country carries out the tasks of production and distribution in order to answer the three economic questions – what, how and for who. There are a variety of economic systems operating in the world but these can be categorised into:
• Planned- /Command- economies;
• Market economies; and
• Mixed economies – a combination of the two.
Figure 2 – Economic Systems Spectrum & Examples
Planned Economies
Planned economies also commonly referred to as command economies. Within these economies the government through a system of central planning decides the decisions of what to produce, how to produce and who gets what is produced. Planned economies are often, but not always, found in Communist countries – for instance, during World War II the UK was very much a planned economy. The key features of a planned economy are:
• Public ownership and control of resources. Most production is organised through state-owned (nationalised) industries.
• Each firm is given production targets and allocated labour and other resources by the central planners.
• Distribution of output is often through some form of state-rationing system. Where goods and services are sold in markets, planners often set the prices.
There are a number of advantages of planned economic system:
• Output decisions can be coordinated across industries, and production organised to explicitly meet the needs of the population. Karl Marx described market coordination as anarchic, and Lenin argued that the entire country would be best run as if it were a large post office;
• Economic plans usually intertwine social and economic objectives. Therefore, command economies were characterised by lower inequality, lower unemployment with the provision of benefits usually administered through state owned enterprises.
However there are also disadvantages of a planned economic system, which include the following:
• Central planning decisions require a huge amount of information – production may get caught up in large bureaucracies;
• Few incentives to improve efficiency:
o No profit motive
o State owned enterprises face no domestic competition and are protected from foreign competition by trade barriers;
o Managers have few incentives to over fulfil production targets, as this will result in the following year’s production targets from being ratcheted upwards;
o Soft budget constraints, firms do not need to make profits, and are supported by state subsidies and granted preferential credit from state-owned banks;
o Shortages and bottlenecks in the production system encouraged hoarding of resources and large stocks. The inventory to output ratio in the former USSR was typically double that in the USA;
o Political interference, managers would often be more concerned about following political rather than enterprise objectives;
o Production targets are poorly focused. For example, volume targets for:
• Coal (tons) provide no incentive to purify
• Steel (tons) produced steel that was too heavy
• Glass (square meters) produced glass that was too thin and brittle
Value targets encouraged the production of goods with higher costs of production
• Little freedom and choice for consumers: the classic example is in the former USSR when there was a shortage of shoes but a surplus of rubber, hence the shoe market was subsequently flooded with rubber shoes
• Black markets: shortages of goods and administered prices set at low levels encourage the creation of black markets
The main problem in planned economies is the relative inefficiency of the system of production.
Market Economies
Market economies is when society attempts to deal with the basic economic problems by allowing free play to what are known as market forces. The market economy system is also known as the ‘free enterprise’, ‘laissez-faire’ or ‘capitalism’ system. In a pure market economy there is essentially no role for the government as all the economic decisions – what, how and for whom – are answered by the market mechanism.
The main features of a market economy are:
• Private property: citizens have the right to own and dispose of assets, and are entitled to any income generated from those assets;
• Freedom of choice and enterprise: consumers are free to buy the goods and services they want (consumer sovereignty) and entrepreneurs are free to organise capital and labour and form their own enterprises;
• Self-interest: people and firms follow their own self-interest – in pursuit of welfare and profits;
• Competition: there are no barriers to engaging in economic activity;
• Markets and prices: the key feature of the market economy. All resources are allocated by prices.
The main advantages of a market economy are:
• Economic freedoms;
• Incentives and competition encourage improvements in efficiency and quality and innovation;
• There is no need to coordinate activity as prices signal information. For example, shortages of food would see prices rise which would give producers greater incentive to increase production.
However, market economies are also subject to a number of problems/disadvantages:
• Inequality: the market allocates according to prices, so those with more wealth have more control over goods and services.
• Instability: markets can be volatile, for example financial markets. Market economies are also subject to economic cycles;
• Market failures: markets can only reflect private costs and benefits, so may not deliver socially optimal outcomes. For example, markets take no account of pollution and congestion, may fail to provide public goods such as national defence (due to the free-rider problem), and large firms with market power may exploit their position to increase profits (monopoly power).
Mixed Economies
Mixed economies are primarily market economies, but the economic system acknowledges the shortcomings of the market mechanism and provides a role for government in the way of:
• Creating a framework of rules to preventing restrictive practises and enforcing property rights;
• Supplementing the price system by correcting market failures;
• Redistributing income; and
• Playing a role in stabilising the economy;
The mixed economic system defines the environment in which businesses operate in the UK. That is they rely on markets for the purchasing of resources (labour and capital) and for the selling of their goods and services. However, the environment is also shaped by government interventions in the market mechanism.
End of Unit Activity
Having read the chapter and the supplementary notes, you should consider the following:
Develop an explanation with fellow students as to why the problem of scarcity means that society has to make the following economic choices and do the choices change in view of differing economic systems:
a.What goods and services to produce
b.How to produce these goods and services
c.Who will receive these goods and services
Evaluate your views of scarcity in view of the above 3 systems and devise your views of scarcity in the context of discussing what, how and who goods and services are produced and received.
Return to Blackboard to access the unit 1 wiki and expand on ideas about scarcity as your collaborate the concepts of scarcity and how its impact society. You should aim to considering; listing your own wants and needs, as this will help your identify the concerns of satisfying all.
In preparation for the wiki, the tutor will deliver a session, on blackboard, on using wikis at the start of the week for unit 1.
At the end of the unit your tutor will provide formative feedback on view of the wiki contributions made.
Unit 2: Economic Problems & Market Failure
Aims and Objectives:
• Understand the economic problem and how it relates to scarcity and opportunity cost;
• Gain an understanding and acknowledge the use of the production possibility curve;
• Develop an understanding of various economic tools related to the economic problem and achieving efficiency;
• Consider the factors of market concerns and government intervention, in view of coordinating economic activities.
Brief Introduction:
The prior unit introduced the economic reality that needs exceed the resources available to satisfy them – hence we face scarcity. This unit will expand and reinforced the central themes of core economic model surrounding the economic problem. The production possibilities frontier (PPF) is developed and used to illustrate the concepts of trade-off and opportunity cost expansion for efficiency. This unit examines various themes that cover:
• Basic economic problems
• Scarcity and opportunity cost
• Economic choices
• Production possibility curve
• Transformation curve
• Production efficiency
• Economic Coordination
• Externalities
• Market failure
• Government intervention
• Moral hazard
• Asymmetric information
• Choice through Capital Accumulation
• Choice through Specialization and Trade
Basic Economic Problems
Households and people have insatiable wants, but resources are limited. This means that:
• Not everything can be produced; and
• Not everybody can have everything they want.
Due to the problem of scarcity, society has to make choices; hence the basic economic problem is to decide:
1. What to produce?
2. How to produce?
3. Who gets what is produced?
4. Scarcity and Opportunity Cost
5. Because economics is involved with dealing with scarce resources it has come to be known as the ‘dismal science’. This term was attributed to Thomas Carlyle, who gave economics this nickname as a response to the writings of Thomas Malthus – who grimly predicted that starvation would result as projected population growth exceeded the rate of increase in the food supply. As resources are scarce, every choice has a cost in terms of what could otherwise have been done. Economists refer to this as the “opportunity cost” of any decision or activity and are defined as the value of the next best alternative forgone (that is not chosen). It is the sacrifice related to the second best choice available to someone, or group, who has picked among several mutually exclusive choices. Value does not necessarily need to be defined in terms of money.
Economic Choices
Therefore the economic choice is the opportunity cost which is the relationship between scarcity and choice. In economics the view is that rational views are considered in determining the opportunity cost. And these can be grouped into differing opportunity costs for instance the economic choice and:
• Opportunity costs in consumption; which is expressed in terms of anything, which is of value. For example, an individual might decide to use a period of vacation time for travel rather than to do household repairs. The opportunity cost of the trip could be said to be the forgone home renovation;
• Opportunity costs in production; here the choice may be assessed in the decision-making process of production. For example, if the workers on a farm can produce either one million kilos of wheat or two million kilos of barley, then the opportunity cost of producing one kilo of wheat is the two kilos of barley forgone (assuming the production possibilities frontier is linear, discussed below). Firms would make rational decisions by weighing the sacrifices involved. Which can take 2 forms:
o Explicit costs; are opportunity costs that involve direct monetary payment by producers. The opportunity cost of the factors of production not already owned by a producer is the price that the producer has to pay for them.
o Implicit costs; are the opportunity costs in factors of production that a producer already owns. They are equivalent to what the factors could earn for the firm in alternative uses, either operated within the firm or rent out to other firms.
Production Possibility Frontier/Curve
Production possibility graphs show the various combinations of amounts of two commodities that could be produced using the same fixed total amount of each of the factors of production. It is linked to the opportunity costs, which at the societal level can be simply represented by using a production possibility frontier (PPF). Which shows, given the resources available to a country, the different combinations of goods and services it can feasibly produce. It also shows the opportunity cost of production – that is what has to be forgone if it is decided to produce more of a particular good or service.
For instance, suppose a country can either produce manufactured goods or agricultural goods. If it allocates all its labour to the factory, then it would produce a quantity of 200 of manufactured products, but zero agricultural output.
Alternatively, if the entire workforce was sent to the fields it can have a quantity of 100 of agricultural output, but the idle factory would mean no manufactured goods were made. Below the possible combinations of each type of good this country could produce, see visualised in the PPF.
Figure 3 – Production Possibility Frontier
Transformation curve
The slope of the production–possibility frontier (PPF) at any given point is called the marginal rate of transformation (MRT), giving the transformation curve. The slope defines the rate at which production of one good can be redirected (by re-allocation of production resources) into production of the other. It is also called the (marginal) ‘opportunity cost’ of a commodity, that is, it is the opportunity cost of X in terms of Y at the margin. It measures how much of good Y is given up for one more quantity of good X or vice versa. The shape of a PPF is commonly drawn as concave from the origin to represent increasing opportunity cost with increased output of a good as seen above. Thus, MRT increases in absolute size as one moves from the top left of the PPF to the bottom right of the PPF.
Production efficiency
If an economy is producing a combination of goods inside the PPF (point a), it implies that by simply using resources more efficiently could increase output. The combinations of goods that lie above the PPF (point x) though are unobtainable, as fully utilising available resources will only move the economy onto the PPF but not beyond. For a country to obtain these combinations they would require an outward shift in the PPF, which can only be achieved through an improvement in technology to become more production efficient. Quite often this is achieved by advanced countries that are operating on or near the PPF, so growth can only be achieved by innovating and developing new technologies. However, countries that are operating within the current global PPF can grow quickly by converging towards the PPF through the adoption of existing technology and the efficient mobilisation of resources. This may explain why growth is much faster in emerging market economies, especially in Asia, as they catch up to the PPFs of advanced economies. Allocative efficiency occurs only when marginal benefit equals marginal cost.
Economic Coordination
A firm is an economic entity that hires factors of production and organises its factors to produce and sell goods and services, while a market is an arrangement that enables buyers and sellers to get information and to do business with one another. Hence, firms and markets can move along the PPF, which means they will always have a trade-off involved in diverting economic resources from the production of one thing to another. The economy may gain one thing but at the opportunity cost of losing something else.
Externalities
These are cost or benefit which results from an activity or transaction and which affects an otherwise uninvolved party that did not consider they would incur the cost or benefit. These fall into 2 categories:
• Negative: or so called ‘external cost’ or ‘external diseconomies’ are actions of a product on consumers that imposes a negative side effect on a third party; it results is a ‘social cost’.
• Positive: or so-called, beneficial externalities, external benefits, external economies, or Merit goods are actions that can lead to broader society benefits in the form of greater economic productivity, lower unemployment rate, greater household mobility and higher rates of political participation.
The economic actions of externalities can be analysed and illustrated through a standard supply and demand diagram if the externality can be valued in terms of money.
Market failure
This is a concept that describes the misallocation or inefficient allocation of goods and services by a free market. That is, there exists another conceivable outcome where a market participant may be made better off without making someone else worse-off. Hence, it contrives the view and outcome of Pareto optimal. Market failures can occur when individuals’ pursue activities for a pure self-interest hence they may not be efficient as a means for the whole society. With increased power by managers in large corporations (seen in the financial banking crisis) agents (managers for example) can gain market power, that allows them to block other mutually beneficial gains from economic activities from occurring. This usually leads to inefficiencies due to imperfect competition, and which can take many different forms, such as monopolies, monopsonies or monopolistic competition. The results are that output falls below the quantity at which the marginal social benefit is equal to the marginal social cost of the last quantity of produce and can lead to negative externalities.
Government Intervention
Are any action taken by a government of political positioned institutions in a market economy or market-based mixed economy in an effort to impact the economy beyond the basic regulation, with the aim of political or economic objectives, such as promoting economic growth, increasing employment, raising wages, raising or reducing prices, promoting equality, managing the money supply and interest rates, increasing profits, or addressing market failures in most cases (as was seen with the financial banking crisis where governments intervened with bailouts).
There are varied views of the effects of government economic interventionism, with the:
• Libertarians and other advocates of free market or laissez-faire economics of the views that any government intervention as harmful, due to the fallacy of central planning, the law of unintended consequences, and other considerations; while
• Modern liberals are more inclined to support the agenda, seeing state economic interventionism as an important means of achieving wealth redistribution and/or other social engineering goals; and
• Marxists views are towards the extreme end of the modern liberal movement, stating that intervention is a necessary part of government welfare programs in the context of a mixed economy.
Moral hazard & Asymmetric information
This occurs when the behaviour of one party may change in detriment from one to another after a transaction has taken place, for example insurance of a product. Moral hazard can be divided into two types when it involves asymmetric information, which is when one party of a transaction has relevant information that the other party or parties are not pertinent too. The moral hazards with asymmetric information are:
• Ex-ante moral hazard where a change in behaviour occurs prior to the outcome of the random event; whereas
• Ex-post involves changes to behaviour after the outcome.
End of Unit Activity
Having read the chapter, you should consider blogging about your views of the following question:
Using the following table that describes the production possibility frontier for a simple economy answer the following questions:
Good A 8 7 6 5 4 3 2 1 0
Good B 0 2.2 4 5 5.6 6.1 6.5 6.8 7
a.Plot the above PPF. And consider if the economy is producing at an efficient level of output at the following combinations of goods:
i) Good A = 5, Good B= 5.6
ii) Good A = 2, Good B = 6.5
iii) Good A = 7, Good B = 1.5
b.Calculate the opportunity cost [in terms of Good B forgone] for each extra unit of Good A produced. What does this tell us about the shape of the PPF? Explain your answer.
c.Show what happens to the PPF if there is:
i)30% growth in Good A only
ii)30% growth in Good B only
iii)30% growth in both Good A and Good B
d.Explain what happens to the opportunity cost of an extra unit of Good A [in terms of Good B forgone] in each case.
Return to Blackboard to access your blog and expand on this topic and evaluate the PPF.
In preparation for the blog, the tutors will set-up the blog and provide a session via content on blackboard, on familiarising students with blogs at the start of the week for unit 2.
At the end of the unit your tutor will read your blogs to provide a formative overview on your understanding of PPFs and economic problems, the blogs will be developed over the term of the module to help develop your learning leading up to your blackboard tests in unit 6 and 9.
Unit 3: The Market Firm
Aims and Objectives:
• Understand why firms exist
• Develop views to identify the advantages and disadvantages of different types of firms
• Analyse the reasons for the growth and decline of firms
• Develop an understanding of the characteristics of firms and industries in view of growth factors.
Brief Introduction:
The module so far has looked at the markets in which businesses sell their goods and services to households. Here we move on from this, and look at business organisations themselves. Specifically, this unit is interested in why firms exist, the advantages and disadvantages of different types of firms, and how and why firms grow. The growth of firms is an important issue, both for the economy as a whole and the way in which businesses can produce goods and services and supply markets. This will be examined and discussed in this unit through the themes of:
• Theory of the firm
• Types of business organisations and their characteristics (legal entity & problems)
• Objectives firms may pursue
• Existence of firms
• Ways in which companies are organised – the growth and decline of firms
Theory of the Firm
One of the most basic, traditional premises involving firms is that they seek to maximise current profits. This belief has served as the foundation of many economic theories and subsequent market economics based managerial decisions. However, as it can be surmised not all organisations seek this objective in isolation. One instance is the maximisation of short-term profits that often comes at the sacrifice of long-term profits and sustainability. It would be difficult to argue that most firms seek to operate for only a short time, so it is obvious that this theory has some shortcomings. It has generally been accepted that firms seek to create a balance of short- and long-term profitability so that the creation of wealth or value is maximised. This has become known as the theory of the firm, which has a very useful equation that represents how the value of a firm can be expressed as:
The formula, demonstrates how activities within the firm can be improved, how efficiencies can be increased, and how risks can be lowered in order to increase overall value. It would not be wise to assume that firms are free to make whatever decisions they please and that they have full control over the level of wealth that can be created. There are numerous internal and external constraints on the operations of a firm that will not allow for full and complete optimisation. Government regulations, limitations on resource availability, and legal constraints all force firms to have a lower ceiling when aiming to maximise wealth.
Types of business organisations and their characteristics (legal entity & problems)
There are four basic types of organisational structures, each defined by who actually owns the firm:
1. Sole proprietorships – is a firm, which is owned by one person, but it does not necessarily mean it is simply a one-person business, as the sole proprietor can hire other people to work for them. These businesses are generally small scale and do not require much capital (machinery and equipment). Typical examples include plumbers, electricians and a whole host of personal services such as child carers, pet sitters, hairdressers and financial advisers. Sole proprietors are treated as self-employed individuals so profits are taxed as labour income.
• The main advantages of this business type are:
o Full control over the business
o Full share of profits provides strong incentives
o Flexible and easy to set up
• However, there are also a number of disadvantages, including:
o Limited access to finance and unlimited liability, meaning that personal assets (e.g. houses, cars) can be claimed by creditors should the business be unable to pay back its debts
o Uncertain income, instability and lack of continuity. The firm will most-likely end if the sole-proprietor dies, retires or changes occupation.
2. Partnership – is an ownership by 2 or more people and laid out in a partnership agreement is a simple extension of a sole proprietor business, so unsurprisingly shares many of the same advantages and disadvantages. Ownership of the company is divided between two or more individuals. The partnership agreement is a legal document that stipulates the rights and responsibilities of the partners, including how each is remunerated. Common examples of partnership firms are solicitors (and other types of lawyers), accountants and estate agents.
• Compared to sole proprietors there are two main advantages to a partnership:
o More opportunities to specialise and delegate than sole proprietor. For example, solicitors may have different areas of expertise, which enables a partnership to cover a wider range of business areas.
o Greater capital: the availability of finance and ability to borrow is likely to increase with the size of the partnership
• However, partnerships suffer from similar disadvantages:
o Unlimited liability: personal assets are at risk should the company be unable to repay its debts
o Lack of continuity: the partnership agreement is dissolved if one partner dies or leaves
o Disputes between partners may occur, especially over the distribution of profits
3. Limited companies – are firms that owned by shareholders, who then appoint a board of directors to run or manage the company.
• The main advantages of a limited company are:
o Raise money by selling shares in the business
o Limited liability – the exposure of anybody who invests in the company through buying shares is limited to the value of the investment alone. Should the company fail then creditors cannot claim personal assets.
o Separate legal entity – meaning the business can continue to exist even if workers/owners change.
• Because of the legal standing of limited companies, and especially because liability is now limited, it is easier for these types of firms to raise capital funds by attracting investors. However, this comes at the cost of:
o Company accounts have to be made public and audited
o Fees must be paid to incorporate and register at Companies House
o More complicated tax regime, profits are subject to corporation tax rather than income tax
There are two basic types of this company:
i) Private Limited company – where the shares are not openly traded.
ii) Public Limited companies – where shares can be easily bought or sold on a stock exchange
4. Cooperatives – are businesses owned by a specific group, (e.g. workers or the consumers). They are a limited liability company that can organise for profit or not for profit. A cooperative has members rather than shareholders who have the decision-making authority. Cooperatives are typically consumer or worker based.
Objectives firms may pursue
Apart from maximising profit as stated by the theory of the firm there are various other objectives the firm aims to pursue, which include:
1. Profit satisficing – means a sufficient level, as many firms are separated in ownership and control (shareholders do not often get involved in the day to day running of the company), it creates a problem because although the owners may want to maximise profits, the managers have much less incentive to maximise profits because they do not get the same rewards, (share dividends). Hence, managers may create a minimum level of profit to keep the shareholders happy, but then maximise other objectives, such as enjoying work, getting on with other workers, this is known as the principle agent problem.
2. Sales maximisation – firms may seek to increase their market share rather than profits, even if it means less profit. This could occur for various reasons:
a. Increased market share increases monopoly power and may enable the firm to put up prices and make more profit in the long run;
b. Managers prefer to work for bigger companies as it leads to greater prestige and higher salaries;
c. Increasing market share may force rivals out of business.
3. Growth maximisation – similar to sales maximisation but may involve mergers and takeovers. Here the firm may be willing to make lower levels of profit in order to increase its size and gain more market share.
4. Long Run Profit maximisation – in some instance firms may sacrifice short term profits in order to increase profits in the long run.
5. Social/Environmental concerns – firms may incur extra expenses to choose products, which don’t harm the environment or products that are not tested on animals. For public relations and firm prestige, or for local community/charitable concerns.
6. Cooperatives – firms may have completely different objectives to typical firms (Plc. or Ltd., the common firms). A cooperative is run to maximise the welfare of all stakeholders – especially workers. Any profit the cooperative makes will be shared amongst all members.
Existence of Firms
A firm is basically a devise for creating long-term contracts when short-term contracts are too bothersome. Firms exist as the most efficient way of coordinating economic activity; internally they operate as a managed/planned economy. The size, scope and boundary of firms are therefore determined by the gains from internalising transactions and not relying on the market. This however does not mean that firms should grow very large and internalise all transactions. This is because the management and organisation of firms also imposes transaction costs and these tend to get larger as the firm gets larger, which limits the overall size that the firm will grow to.
The theory of the firm might explain the rise of vast and very diversified business groups in emerging markets (e.g. Tata in India). Due to a relative lack of laws and institutions protecting market participants, markets may not operate efficiently, which puts costs on firms that go to the markets. Therefore established industry groups will emerge to counter the high transactions costs involved in using the market and it makes sense to extend this over a large and diversified product range.
Ways in which companies are organised – the growth and decline of firms
Firms are organised in various ways in which they grow, hence they fall in two aspects in view of the growth of firms, these two aspects and type and direction, both have subsets, which are:
1.Type of growth, which is split into 2 further subsets:
Organic [internal] growth – a firm grows by expanding its existing structure, by either:
• Increasing its customer base – selling the same product to more people; or
• Higher output per customer – selling a larger range of products to the same customer bas
Organic growth is recognised as having several advantages:
• The process can be guided by existing management team, building on the strengths and best practises of the company
• There are no clashes in culture from trying to integrate two different firms/management structures together
• It May be cheaper than an acquisition. When buying another firm a premium over its market value may have to be offered in order to encourage a sufficient number of its shareholders to sell their shares.
• However, on the negative side: establishing new products, brands and markets takes longer than buying an established business, and given that success is not guaranteed it is also riskier.
Inorganic [external] growth – are undertaken through either mergers and/or acquisitions of another company:
• Mergers; occur when two firms agree to go forward as a single new company rather than remain separately owned and operated. This is known as a merger of equals – e.g. the 1999 merger of Glaxo Wellcome and SmithKline Beecham to GlaxoSmithKline.
• Acquisitions [takeovers]; are when one business purchases another. This may not necessarily be 100% of the company but perhaps just a controlling stake, i.e. over 50% of the shares; they occur either by buying the shares, and therefore the control of the target company; or buying the assets of the target company. Offering cash to shareholders or new shares in the combined company usually funds acquisitions. Some acquisitions can be ‘friendly’ or ‘hostile’, depending on how the bid is perceived by the target company’s board of directors and shareholders. When friendly the companies cooperate and negotiate the terms of the takeover. While when hostile the target board is not brought in on the negotiations, but hostile takeovers usually become friendly once the management accepts that the takeover is likely to happen, in which case the better option is to negotiate terms rather than continue to fight.
2.Direction of growth, which is further split into 3 subsets:
Vertical integration – is when there is common ownership of production along a product’s supply chain:
• Backward vertical integration – when a firm takes control of some of the inputs used in the production of its products.
• Forward vertical integration – when it controls the markets for where its products are sold [distribution centres, retailers, or just the next firm along the production chain].
The main advantages to a firm from expanding vertically are:
• Lower transactions costs, e.g. search and negotiation costs
• It is easier to coordinate production along the supply chain and introduce new technologies at each stage of production
• Less uncertainty over supplies and markets, i.e. fewer bottlenecks
• Control over suppliers and markets can be used to restrict competitors
However, there may also be some disadvantages to expanding the firm in this way:
• Harder to switch to other suppliers/buyers if technology or markets change
• Weaker motivation for good performance as competition is diminished
• Where vertical integration may reduce competition it might become subject o regulation [anti-trust].
Horizontal integration – is when a firm expands horizontally at the same stage of production.
There are several advantages to growing horizontally:
• Economies of scale – larger production reduces average costs
• Economies of scope – sell a broader range of products and reduce risk of relying on one particular brand.
• Increased market power – the new firm controls a larger share of the market and may be able to use that position to limit completion and gain larger profits
There are however, two possible disadvantages:
• Diseconomies of scale – the larger firm may become difficult to manage, with it difficult to integrate the different parts of each firm and also with the possibility of culture clashes between management styles and worker practises. As a result average costs of production might actually increase, and not decrease.
• Regulation – if the new firm is likely to control a large proportion of the market then regulators may act in order to stop exploitation of consumers. For example, the regulator may only allow the merger to proceed if certain parts of the business are sold off in order to maintain competition in the industry.
• Conglomerate – is when the firm expands into a completely unrelated product market, hence they are involved in the production of two or more entirely different products. The main reason for a firm to grow into an unrelated product market is to take advantage of economies of scope. This means it can use its existing brand names and infrastructure in order to enter and be competitive in new product markets [i.e. Cost[A] + Cost[B] > Cost [A+B], so one firms can produce goods A and B together at a cheaper price than two firms producing the same goods separately].
However, there are also two motivations for conglomerates:
• Growth opportunities in other industries if opportunities for growth in existing markets are limited
• Diversification: risk reduction by reducing dependence of certain markets/products
While there are a number of problems with conglomerates:
• Lack of focus
• Organisational morass [difficult to manage]
• Trade at a discount because it is less than the sum of its parts
End of Unit Activity
Having read the chapter, you should consider discussing your views of the following with your fellow student colleagues:
1. Discuss your views of what you consider the role the firm to be and what role the firms play in the market economy to increase economic growth of a nation?
2. Then consider what you view as the advantages and disadvantages of sole traders and partnerships as against public companies as a means of organising a business, developing on any 2 advantages and disadvantages?
3. Also within your discussion examine and mention your thoughts around the relationships firms play in the innovation, entrepreneurship, and growth of the firms and what is the rational for integration?
Return to Blackboard to access the discussion board and expand on the discussion questions.
In preparation for the discussion for this unit within the discussion board, the tutor will provide guidelines to familiarise students with discussion boards at the start of the week for unit 3.
At the end of the unit your tutor will read your discussions to provide a formative feedback on the collaborative learning achieved via the discussion session, the tutor will engage in the discussion sessions during unit 3 to enhance the debate.
Unit 4: Markets, Prices: Demand and Supply
Aims and Objectives:
• Develop an understanding of the law of demand and the factors that determine the position of the demand curve
• Develop an understanding of the relationship between prices and supply of goods and services and the factors that can lead to a shift in the supply curve
• Understand how demand and supply interact in a market to establish equilibrium prices and quantities
• Be able to apply demand and supply analysis to market situations
Brief Introduction:
Demand and supply lies at the heart of the principle of market economics, for instance markets are where the forces of demand and supply come together to set prices for goods and services. Demand and supply curves provide a deeper understanding of the choices that people and firms make. This may be determined by prices that provide:
• a signals to producers (what is produced and how it is produced); and
• allocate goods and services to those who are able and willing to pay
Demand and supply can be applied to a large number of situations to explain changes in the prices and the quantities of goods and services produced. This will be looked at in this unit through various themes that will cover:
• Law of demand and factors
• Perverse demand curves
• Law of supply, and relationship between prices
• Market Equilibrium
• Excess Demand
• Excess Supply
• Factors that can lead to a shift in the demand and supply curve
• Market demand and supply analysis
Law of demand and factors
In a market-based economy, the interaction of demand and supply in determines the prices of goods and services and the quantity produced and consumed. Any change in demand and supply can lead to changes in the price of the good or service and in the quantity produced and consumed.
The price of a good or service affects the quantity people plan to buy. The quantity demanded of a good or service is the amount that consumers plan to buy during a given time period at a particular price. The law of demand states that other things remaining the same (ceteris paribus), other things including incomes, tastes and preferences, population and the price of other related goods and services. The higher the price of a good the smaller is the quantity demanded, and the lower the price of a good the greater the quantity demanded. Hence, the demand curve is downward sloping curve that shows how much of a particular good or service is demanded at each price. As the demand curve slopes downwards, the quantity demanded increases as the price falls (see Figure 4).
Figure 4 – Demand Curve
Source: Ceyhun Elci
As figure 4 illustrates, as the price falls from P1 to P2, the quantity demanded increases from Q1 to Q2. If the price falls further to P3 then there is a further increase in quantity demanded to Q3. Increases in prices would have the opposite effect on quantity demanded. This inverse relationship between demand and price is because of:
• Substitution effects: as goods and services become cheaper consumers transfer their demand away from alternatives/competitors to that particular good or service.
• Income effects: a fall in prices means that consumers can now afford to buy more goods and services given the same level of income.
The increase in demand caused by a fall in price is called an extension in demand. A fall in demand causes by a rise in price is called a contraction in demand. Also the demand curve is a willingness-to-pay curve – for each quantity, the price along the demand curve is the highest price a consumer is willing to pay for that unit of output, which means that a demand curve is a marginal benefit curve
Perverse Demand Curves
A demand curve that slopes upwards is often called ‘perverse’ as it implies the demand for good or service increases as its price rises. This is in contradiction to the law of demand, which implies an inverse relationship between prices and quantity demanded. There are a number of possible explanations as to why we see these exceptions from the law of demand, which are due to:
1. Veblen goods: are referred to as ‘goods with a snob value’, e.g. designer bags. For some items, a higher price makes the good or service more exclusive and therefore more desirable. It explains why reducing the prices of ‘designer’ or ‘luxury’ items might decrease peoples’ preferences for buying them – because they are no longer viewed as exclusive or high end.
2. Giffen goods: are those goods that lead to people consuming less because they substitute towards cheaper alternatives, and because the price rise has a negative income effect which lowers consumption overall. A Giffen good is a type of good where the income effect works in the opposite direction to the substitution effect, and following a price increase, is sufficient to outweigh the negative substitution effects and lead to an overall increase in demand. The classic example is of an inferior quality staple foodstuff, whose demand is driven by poverty that makes purchasers unable to afford superior food items (e.g. potatoes and meat). As the price of the cheap foodstuff (potatoes) increases, they can no longer afford to supplement their diets with better food (meat), so must consume more of the staple food instead.
3. Goods with forward markets – asset prices: these are certain goods, where the current demand is partly driven by the price that’s expected in the future (i.e. people can gain by correctly speculating). These are normally financial assets such as property and stocks and shares. An increase in prices may stimulate demand as it is taken as a signal of future price increases yet to come.
Law of supply, and relationship between prices
The price of a good or service affects the quantity firms plan to sell, hence supply. The quantity supplied of a good or service is the amount that firms plan to sell during a given time period at a particular price. The law of supply states that other things remaining the same (ceteris paribus), the higher the price of a good the greater the quantity supplied, and the lower the price of a good the smaller the quantity supplied. The law of supply occurs because an increase in the quantity of a good produced results in an increase in its marginal cost. So the price must rise in order to induce firms to increase the quantity they produce. This is the make-up of the supply curve that shows how much of a good or service is supplied to the market at each price level. In general, supply is an upward sloping curve, so as the price rises the quantity supplied also increases (see Figure 5):
Figure 5 – Supply Curve
Source: Ceyhun Elci
As figure 5 illustrates, an increase in price from P1 to P2 results in an increase in the quantity supplied from Q1 to Q2, a further increase in price to P3 leads to a further increase in quantity supplied to Q3. A fall in price would have the opposite effect on quantity supplied. This relationship between supply and price is because of two main reasons:
• Profit incentives: a higher price improves margins and encourages firms to increase production.
• Increasing costs of production: the extra cost of producing additional output increases as the level of output rises, therefore a higher price is required to support firms’ involvement in the market. This could work at both:
o Firm level: to increase output a firm may have to use less efficient equipment or introduce overtime arrangements with its staff (at a higher wage rate),
o Industry level: some firms may be more efficient and can produce at lower prices than others. At low prices only efficient firms can profitably supply the market, so total supply is low. However, as the market price rises it becomes profitable for other firms to enter the market and supply rises.
As in the case for demand, movements along the supply curve are called extensions (increase) and contractions (decrease). The supply curve shows the firms’ minimum supply price; that is, for any quantity, it shows the minimum price that firms must receive in order to supply the last unit of the given quantity, which means that a supply curve is a marginal cost curve.
Market Equilibrium
A market brings together these forces of demand and supply and sets prices for individual goods and services. Equilibrium is a situation in which opposing forces balance, the market equilibrium for a good or service occurs when demand is equal to supply, which is determined at the point where the demand and supply curves intersect. The market equilibrium balances the price at which households are willing to pay for a good or service with the costs that firms face in producing it. This point is shown in figure 6.
Figure 6 – Market Equilibrium and excesses
Source: Ceyhun Elci
At price PE the quantity demanded and quantity supplied are both equal at QE. The market equilibrium is often called the price clearing or stock clearing equilibrium because there is neither excess demand (Q demanded > Q supplied) or excess supply (Q supplied > Q demanded). As a result everything supplied to the market is sold and firms do not find themselves either increasing or running down their stocks.
One of the features of the market mechanism is that prices always move towards their equilibrium so as to correct any positions of excess demand or excess supply. In this way the market is regarded as being self-regulating.
Excess demand
This situation arises when the price is below its market equilibrium or price-clearing level (P2 < PE). Consequently, and as shown in figure 6, demand exceeds supply and the market is characterised by excess demand (Q2 > Q3). Firms will therefore see their stocks running down (i.e. their warehouses emptying) and be encouraged to increase prices as demand outstrips supply. An increase in price from P2 to PE would lead to an extension in supply and a contraction in demand, both of which narrow the extent of excess demand in the market. If the price was still below the equilibrium, the prices will continue to increase until the market clearing price PE is reached at which point the excess demand is eliminated so that Q demanded = Q supplied, which is achieved at QE.
Excess supply
Is when the price is above its market equilibrium or price clearing level, supply exceeds demand and the market is said to be in a position of excess supply. This is demonstrated in figure 6. At price P1 > PE, the degree of excess supply is Q4 – Q1. In this situation firms will begin to accumulate stocks of unsold goods, and in order to clear these there will be pressure to reduce prices. Then, as prices fall there will be an extension in demand and a contraction in supply, reducing the extent of excess supply. Downward pressure on prices and excess supply will remain until the price has fallen to PE, at which point the Q demanded = Q supplied are equal at QE.
Factors that can lead to a shift in the demand and supply curve
Extensions and contractions in demand and supply refer to movements along demand and supply curves that result from changes in prices. A change in quantity demanded and supplied results from something other than a change in price, (i.e. the assumption of ceteris paribus is dropped), which can lead to shifts in demand and/or supply, as follows:
Shifts in the Demand Curve
If the demand for a good or service increases, the demand curve shifts rightward and vice-versa for decreases, the demand curve shifts leftwards. As a result, the equilibrium price will either rise or fall and the equilibrium quantity increases and decreases respectively. Therefore as figure 7 illustrates a shift in demand can be:
• inward (leftwards) signifying a fall in quantity demanded from Q1 to Q2 when the price remains unchanged at P1
• outward (rightwards) signifying an increase in quantity demanded from Q1 to Q3 when the price remains unchanged at P1
Figure 7 – Shifts in the demand curve
Source: Ceyhun Elci
There are many factors that lead to a shift in the demand curve for a particular good or service such as:
• Changes in income (falling incomes as unemployment rises in a recession will shift the demand curve inwards)
• Tastes and preferences (a successful advertising campaign might generate an outward shift in demand for a firm’s product)
• Changes in the prices of related goods and services (the demand curve will shift inwards if the price of competitor/substitute goods became cheaper, or if complementary goods became more expensive)
• Changes in population, a markets is often defined by geographical areas because of travel time and transport costs, so changes in the population in a given area may lead to changes in demand
Shifts in the Supply Curve
When any factor that influences selling plans other than the price of the good changes, there is a change in supply and the supply curve shifts. An increase in supply shifts the supply curve rightward and a decrease in supply shifts the supply curve leftward. As illustrated in figure 8, the shift in supply can be:
• Inward (leftwards) signifying a fall in quantity supplied from Q1 to Q2 when the price remains unchanged at P1
• outward (rightwards) signifying an increase in quantity supplied from Q1 to Q3 when the price remains unchanged at P1
Figure 8 – Shifts in the supply curve
Source: Ceyhun Elci
A shift in the supply curve can result from various factors other than a change in price, which leads to a change in quantity supplied. The factors that impact and change supply are:
• Prices of productive resources: is the changes in the costs of production, as falling costs means that it is cheaper to produce at all levels of output and the supply curve shifts outwards
• Prices of related goods produced or subsidies: this works in the same way as prices of productive resources. A subsidy effectively lowers the cost of production leading to an outward shift in the supply curve. As a good that can be produced using the same resources and a complement in production is a good that must be produced with the initial good. A fall in the price of a substitute in production or a rise in the price of a complement in production increases the supply of the good.
• Taxes: also works in the same way as prices of productive resources. A tax mirrors an increase in production costs so causes the supply curve to shift inwards.
• Number of Suppliers: if the number of suppliers increases, the supply increases.
• Technology and efficiency: an improvement in the production process allows more to be produced at each price; hence the supply curve would shift outwards, as technological advances increase the supply of a goods.
• Expected Future Prices: If the price of a good is expected to rise in the future, the supply of the good today decreases.
• State of nature: includes all natural forces that influence supply. Bad weather (this may lead to poor harvests and an inward shift in the supply curve) or an earthquake decreases the supply of a good
• Regulation: the supply is some industries is fixed by a government quota (e.g. fishing where the quota is designed to prevent overfishing and preserve fish stocks). Therefore, changes in the quota amount can lead to fixed changes in the quantity supplied to the market.
Market Demand and Supply Analysis
This unit has considered how markets operate in bringing demand and supply together to determine the prices of goods and services and the quantities sold. The demand and supply models offer an easy to use framework to explain changes in market outcomes that result from demand- and supply side factors. It is able to explain what happens to prices of goods and services in the past and to predict what might happen to them in the future.
Markets perform an important role in a modern capitalist/mixed economy. Prices provide signals to producers about what to produce, and ration of goods and services to consumers on the ability and willingness to pay. In a planned economy these decisions would need to be taken by state planners, and would require a huge amount of information to do successfully. In contrast, the market mechanism performs these functions relatively automatically. Markets also have a self-regulating feature, where if they are left unhindered, the price will adjust to correct any imbalances between demand and supply. However, even the most fervent advocates of markets will acknowledge that they cannot work perfectly on their own but require a range of supporting institutions. These institutions usually refer to laws to ensure that property rights are respected and monitoring and policing organisations so that contracts are enforced. Without these the transactions cost involved with market transactions might be high enough to prevent exchange-taking place between buyers and sellers of a product.
Hence, all price changes relate to underlying movements in demand and supply that result in a shift in the respective curve. Given that there are a large number of factors that can lead to shifts in the curves, the simple demand and supply model can be used to explain a rich variety of market behaviour. Using the demand and supply model in this way is commonly called a ‘comparative static’ exercise. As it is interested in analysing what has happened to the equilibrium position in the market after there has been a change in a demand- or supply-related factor. Therefore it is a comparison of equilibrium or static positions that is analysed.
End of Unit Activity
Having read the chapter and the supplementary notes, you should consider the following:
Consider with fellow students through a debate what affect the following has on the demand and/or supply curves, consider if the impact has a movement along the curves or a shift of the curves, when stating your answer provide a brief explanation for your interpretation so your colleagues may comprehend your analysis. Once you have participated, do comment of fellow colleague’s wiki submissions to bring about a more mutually agreed view of the affect.
What affect does each of the following cases have on the demand and.or supply curve?
a.The price of a substitute good falls
b.Costs of producing the good fall
c.Firms anticipate that the price of the good is about to fall
d.Tastes shift away from the good
Return to Blackboard to access the unit 4 wiki and expand on your views about demand and supply. You should be familiar with wikis, which is the system you used in your unit 1 activity.
At the end of the unit your tutor will provide formative feedback on views of the wiki contributions made.
Unit 5: Markets and Elasticity
Aims and Objectives:
• Understand the concepts of price elasticity of demand and supply and its relevance to market outcomes
• Consider the impact of elasticity and inelasticity in markets
• Consider the concepts of income elasticity of demand to identify inferior, normal and super-normal goods and services
• Develop an understanding and meaning of cross price elasticity of demand and how it relates to substitutes and complements
• Develop a consideration of what factors affect the price elasticity of supply for a particular good or service, and how the concept influences market outcomes
Brief Introduction:
Developing on from the demand and supply concepts in the prior unit, markets are basically anywhere that businesses sell their goods and services. The price and amount sold of a particular good or service are determined by the intersection of demand and supply. In this way, the market equilibrium reflects a balance between what consumers are willing and able to pay for a good or service and the cost faced by a firm in producing it. But to measure the responsive of demand and supply to price and other influences on buying plans and selling plans the concept of elasticity is useful. It explains how this responsiveness is calculated, and interpreted by using elasticity. Within this unit various themes will be discussed that cover:
• Price elasticity and its relevance to market outcomes
• Price elasticity of demand
• Inelastic and elastic Demand
• Income elasticity of demand
• Cross price elasticity of demand
• Price elasticity of Supply
• Inelastic and elastic Supply
Price elasticity and its relevance to market outcomes
Elasticity expands on the concepts of demand and supply to show the sensitivity of demand and supply and their response to changes in prices and other factors. It is an important concept because it affects market outcomes following shifts in either the demand or supply curves. Therefore an understanding of elasticity and its affects will help to better understand how markets work and how prices and quantities change over time.
One of the most important aspects of the price elasticity is that it affects the market outcome when there are changes (shifts) in demand and supply. These changes in prices and quantities determine when there are changes to supply and demand in the market for a good or service. Assume, that there are two types of demand curves, see figure 9. These are the same as used in previous diagrams in prior units, so D1 is a price inelastic demand curve and D2 is a price elastic demand curve. Given supply is represented by S1 equilibrium in this market is found at a price of P1 and a quantity of Q1.
Figure 9 – Demand Elasticity and Equilibrium
Source: Ceyhun Elci
Developing this with supply shifts what happens when there are shifts in supply and demand and how the outcomes differ depending on the relative price elasticity of demand.
Price elasticity of demand
The price elasticity of demand measures how responsive demanders are to a change in the price of the good. This information is often useful for both businesses and governments because it can predict the impact of a price change on total revenue or total expenditure.
To calculate the price elasticity of demand (PED), which is a units-free measure of the responsiveness of the quantity demanded of a good to a change in its price when all other influences on a buyer’s plans remain unchanged. The price elasticity of demand is equal to the absolute value of:
PED = (percentage change in quantity demanded)
(percentage change in price)
The calculated PED examines the responsive and therefore if the:
• PED > 1, demand is price elastic. This means that changes in price have a bigger than proportionate effect on the quantity demanded, so that the:
o Percentage change in quantity demanded > percentage change in price
• PED < 1, demand is price inelastic. This means that changes in price have a smaller than proportionate effect on the quantity demanded, so that the:
o Percentage change in quantity demanded < percentage change in price
• PED = 1, demand is said to be unitary price elastic. Changes in price have a proportionate effect on the quantity demanded, so that the:
o Percentage change in quantity demanded = percentage change in price
Inelastic and elastic Demand
The slope of the demand curve describes how the quantity demanded changes with respect to prices, or just how strongly the law of demand applies to that good or service see figure 10 for the difference of elasticity curves.
Figure 10 – Demand Elasticity Curves
Source: Ceyhun Elci
• Elastic demand: demand curve D1 shows that when demand is price elastic, a fall in price from Pelastic to P1, results in a large response in relative to demand from Q2 to Q1. Because changes in prices generate large extensions and contractions in quantity demanded and vice-verse for a price increase, as the demand curve is relatively flat.
• Inelastic demand: demand curve D2 shows that when demand is price inelastic, a fall in price from Pinelastic to P1, results in only a small response in relative to demand from Q2 to Q1. Because changes in prices only lead to small changes in quantity demanded and vice-versa for a price increase, as the demand curve is relatively steep.
• Unitary demand: demand curve D3 show that when demand is unitary, a fall or increase will have the same and equal response in demand and price, as the demand curve is neither steep nor flat.
There are two special cases of the price elasticity of demand that may likely to appear from time to time. These are the two limiting cases, when price elasticity is very low or very high. At points when PED = 0 demand is described as perfectly inelastic. In this case the demand curve is vertical, and the quantity demanded is totally invariant to the price. The opposite case is when PED = infinity. Here demand is said to be perfectly elastic with respect to price. Therefore very small (miniscule) changes in price can generate very large extensions and contractions in quantity demanded. The demand curve becomes horizontal; both these cases can be seen in figure 11.
Figure 11 – Special Cases of Demand Elasticity Curves
Source: Ceyhun Elci
The determinants of the price elasticity of demand can be classified through a number of factors for particular goods or services, which are the:
• Availability of substitutes: a good or service that has a large number of close substitutes will be more price elastic as consumers can easily switch their consumption to and from the alternative if relative prices were to change.
• Proportion of income: goods that take up a larger proportion of income are more likely to be price elastic as we are more sensitive to the change in price of an expensive item (automobiles, household appliances) than we are to cheaper items (box of matches, chewing gum).
• Timing: it is an accepted rule that demand for goods and services is more price elastic in the longer run as it takes time for consumers to collect information on price changes and change behaviour, e.g. where the transaction takes the form of a contract (e.g. mobile phone, energy supply) consumers are prevented from switching providers immediately.
• Brand loyalty: goods that are more differentiated and have developed more brand loyalty are expected to be more price inelastic. Brands can be built up over time and firms may try to enhance their brand value by advertising.
• Habit forming goods: goods that are addictive, like tobacco, or become important for lifestyle, e.g. petrol and car use, are likely to be relatively inelastic to price ¬– especially in the short term.
• Durable goods: these are generally more price elastic, especially in the short run because consumption can always be postponed until later.
This also brings about the importance of price elasticity of demand; there are 3 reasons why economists and businesses are interested in concept of elasticity:
1. Revenue: PED informs firms how revenue will change following a change in price.
2. Tax receipts and incidence: PED informs the government how much tax will be raised if levied on a good or service and who pays it – the consumer or producer.
3. Market outcomes following changes in demand and supply: the slope of the demand curve affects how the equilibrium position in a market will change following a shift in either demand or supply.
Furthermore, the price elasticity of demand is generally not the same at different points on the same demand curve. This means that the elasticity of demand a firm faces depends on where they are on the demand curve (which is itself determined by the existing price). So when considering how a price change, will affect revenue this also needs to be accounted for, this can be seen in figure 12, which shows the prices that are inelastic and those that are elastic:
Figure 12 – Price elasticity of demand at different points on the demand curve
Income elasticity of demand
When incomes increase, demand for goods and services are expected to increase, meaning the demand curve shifts outwards. This type of elasticity explains how sensitive demand is to changes in income – i.e. how large that shift in demand is, and also in which direction. The size of the shift in the demand curve though depends on two things the:
• size of the change in income; and
• income elasticity of demand, which describes how sensitive demand is to changes in income
For a particular good or service, the income elasticity of demand (YED) is calculated as follows:
YED = (percentage change in quantity demanded)
(percentage change in income)
The calculated YED examines the responsive and therefore there are 3 main points:
• 0 < YED < 1, when between 0 and 1 the good or service is described as normal. Changes in income can lead to changes in demand in the same direction. However, the change in demand is proportionately smaller than the change in income
o 0 < Percentage change in quantity demanded < percentage change in income
o Normal goods typically refer to everyday items that we might buy a little more of if our incomes were to grow
• YED > 1, when greater than one, then the good or service is referred as super normal. Demand changes in the same direction as income, but in this case the change in demand is proportionately larger than the change in income
o Percentage change in quantity demanded > percentage change in income
o Super normal goods typically refer to luxury goods – which tend to buy infrequently as and when income allows, or those we cannot afford on the basis of current incomes but we would buy if we were richer.
• YED < 0, when less than zero the good or service is described as inferior. This means that the quantity demanded moves in the opposite direction to changes in income, i.e. a rise in income would see a fall in demand. These are typically basic goods that have a higher quality and more expensive alternative that people switch to when their incomes allow.
o Percentage change in quantity demanded < percentage change in income
o Inferior good is one for which demand decreases as income increases.
YED does not affect the slope of the demand curve, but how far and in what direction the curve will shift following a given change in income. Figure 13, shows how demand might shift for the three types of good or service introduced above:
Figure 13 – Shifts in demand for products with different YEDs with an increase in income
Cross price elasticity of demand
The cross price elasticity of demand measures the responsiveness of the prices of related goods and services and how they impact the demand curve for a particular good or service to shift. This measure of elasticity informs whether and the extent to which that related good or service is a substitute or a complement. When the price of a good or service increases the expect quantity supplied to the market should also increase for firms to take advantage of greater profit opportunities and the higher price enables higher cost firms to supply the market. This measure of elasticity tells how sensitive supply is to price.
To calculate the cross price elasticity of demand (XED), which measures the responsiveness of the quantity demanded of a good to a change in its price of related goods and services when all other influences on a buyer’s plans remain unchanged. The cross price elasticity of demand is equal to the absolute value of:
XED = (percentage change in quantity demanded for product A)
(percentage change in price for product B)
There are three main outcomes from the calculation of XED, each describing the relationship between the two products (goods or services):
• XED > 0, product A and B are substitutes, an increase in price of good B increases demand for good A
o Percentage change in quantity demanded for product A > percentage change in price for product B
• XED < 0, product A and B are complements, an increase in price of good B reduces demand for good A
o Percentage change in quantity demanded for product A < percentage change in price for product B
• XED = 0, product A and B are unrelated, an increase in price of good B has no effect on the demand for good A
o Percentage change in quantity demanded for product A = percentage change in price for product B
The higher the cross elasticity of demand, the closer the substitutes. If the XED = infinity, then products A and B are described as perfect substitutes. It is either or in this case. However, if the XED = negative infinity then products A and B are said to be perfect complements and consumed in joint demand.
Price Elasticity of Supply
Elasticity is also an important concept for the supply of goods and services. It describes how responsive and sensitive the supply of a particular good or service is to price. To calculate the price elasticity of supply (PED), which is a units-free measure of the responsiveness of the quantity supplied of a good to a change in its price when all other influences on a producer’s plans remain unchanged. The price elasticity of supply is equal to the absolute value of:
PES = (percentage change in quantity supplied)
(percentage change in price)
The calculated PES examines the responsive and therefore if the:
• PES > 1, (greater than one) supply is price elastic. This means that changes in price generate a greater than proportional increase in supply, so that the:
o Percentage change in quantity supplied > percentage change in price
• PES < 1, (less than one) supply is price inelastic. In this case, changes in price generate a less than proportionate increase in the quantity supplied, so that the:
o Percentage change in quantity supplied < percentage change in price
• PED = 1, (equal to one) supply is said to be unitary price elastic. Changes in price have a proportionate effect on the quantity demanded Changes in prices have proportional effects on the quantity supplied, so that the:
o Percentage change in quantity supplied = percentage change in price
Inelastic and elastic Supply
The slope of the supply curve describes how the quantity supplied changes with respect to prices, or just how strongly the law of supply applies to that good or service see figure 14 for the difference of elasticity curves.
Figure 14 – Supply Elasticity Curves
Source: Ceyhun Elci
• Elastic demand: supply curve S1 shows that when supply is price elastic, a fall in price from Pelastic to P1, results in a large response in relative to supply from Q2 to Q1. Because changes in prices generate large extensions and contractions in quantity supplied and vice-verse for a price increase, as the supply curve is relatively flat.
• Inelastic demand: supply curve S2 shows that when supply is price inelastic, a fall in price from Pinelastic to P1, results in only a small response in relative to supply from Q2 to Q1. Because changes in prices only lead to small changes in quantity supplied and vice-versa for a price increase, as the supply curve is relatively steep.
• Unitary demand: supply curve S3 show that when supply is unitary, a fall or increase will have the same and equal response in supply and price, as the supply curve is neither steep nor flat.
There are two special cases of the price elasticity of supply that may likely to appear from time to time. These are the two limiting cases of supply curves corresponding to the limits of elasticity. At points when PES = 0 supply is described as perfectly inelastic. In this case the supply curve is vertical, and any changes in price have no effect on the quantity supplied. The opposite case is when PES = infinity. Here supply is said to be perfectly elastic with respect to price. Therefore very small (miniscule) changes in price can generate very large extensions and contractions in quantity supplied. The supply curve becomes horizontal; as changes in price have very large effects on supply, these cases can be seen in figure 15.
Figure 15 – Special Cases of Supply Elasticity Curves
Source: Ceyhun Elci
The determinants of the price elasticity of supply can be classified through a number of factors for particular goods or services, which are the:
• Costs rise in line with output: supply will be relatively inelastic if the costs of production increase quickly with output.
• Time: supply is almost always more elastic in the long run as businesses have more scope to change production operations, enter markets or leave existing ones
• Capacity/supply chain constraints: prevents supply responding to price
• Technological feasibility in changing output quickly: many production processes have significant lags such as agriculture
• Stocks and inventories: can be used to quickly supply the market in the short-term.
End of Unit Activity
Having read the chapter and the supplementary notes, you should consider the following statement:
“A business always operates in the short run, it has production facilities (work space) and it chooses how intensively it uses them, i.e. how much it will produce and etc.” Return to the blackboard site and discuss and consider when long run costs are relevant to business decisions.
As you return to Blackboard to access the unit 5 wiki you should discuss the above statement in view of long run business and market decision making and expand on your views about economies of scale. You should be familiar with wikis, which is the system you used in your unit 1 and 4 activities.
At the end of the unit your tutor will provide formative feedback on views of the wiki contributions made.
Formative Revision Assessment
Within the period of this unit you will undertake a formative assignment test for revision. This is a time-constrained test of 1 hour (not invigilated and taken in private study time), and can be found in the assessment section on Blackboard.
This test covers materials from the first 4 unit topics:
• Introduction to the Scope of Business Market Economics and Strategy
• Economic Problems
• The Market Firm
• Markets, Prices: Demand and Supply
The test is integrated within Blackboard and when you take the test feedback will automatically be provided. You may take this test at your convenience.
Unit 6: Market Production and costs
Aims and Objectives:
• Develop and distinguish between the short run and long run
• Consider an understanding of why diminishing returns and increasing average and marginal costs occur in the short run
• Explain economies of scale and why they occur
• Understand what is meant by the minimum efficient scale and diseconomies of scale
Brief Introduction:
The relationship between a firm’s output and its costs in both the short run and the long run are important in market economics for understanding costing decisions by firms. The two important concepts of this are:
• economies of scale – which is the process by which a firm’s long run costs fall as output expands; and
• diseconomies of scale – where beyond a certain level of output, called the minimum efficient scale, a firm experiences an increase in costs as output expands.
Economies and diseconomies of scale are important because long run costs affect the price at which firms can supply the market, and their level of profitability. The analysis in this unit will also be useful in the following unit when looking at different types of market structures. The unit discusses the following various themes:
• Distinguish between the short and the long run
• Short run Production
• Concepts of costs: average, variable and marginal cost
• Long run Production
• Economies of scale
• Diseconomies of scale
• Importance of economies of scale provide a motive for the growth of firms
Distinguish between the short and the long run
In economics the short run and long run are not defined as specific amounts of calendar time but relate to the amount of flexibility a firm has to change the scale of its operations.
• The short run: is a period of time in which at least one or more resources (factors of production) which are: land, labour, capital or entrepreneurship are fixed. Therefore:
o the firm has a fixed capacity and the choice is determined by how intensively to use this capacity,
• The long run: is a period of time in which all resources and factors are variable and the firm can effectively change its scale.
o This relates to investment decisions, i.e. decisions to increase or reduce capacity.
Short Run Production
In the short run the amount of capital technology (capital machinery) or number of work-spaces operated by the firm is fixed. So for a firm to increase output in the short run, a firm must increase the amount of labour employed. Three concepts to describe the relationship between output and the quantity of labour input/employed:
• Total product: this is the total amount that a given quantity of labour can produce.
• Marginal product: this is the increase in total product that results from a one-unit increase in the quantity of labour employed, with all other inputs remaining the same.
• Average product: this equals the total product divided by the quantity of labour employed.
These can be staged into five distinct phases that describe how total output changes as the amount of labour increases as described below and in figure 16. This is the product curve, illustrates the total product schedule. It shows how the total product increases with the level of labour employed. The slope of the total product curve equals the marginal product of labour at that quantity of labour. It is similar to the PPF in that it separates attainable output levels from unattainable output levels in the short run. The marginal product curve for labour shows the change in total product for each unit of labour employed. The total and marginal product curves are directly related. The height of the marginal product curve is the slope of the total product curve, as visualised in figure 16.
Figure 16 – Output and labour inputs in the short run
Source: Ceyhun Elci
1. Increasing returns: initially as labour input rises, output increases at a growing rate. As the capital technology owned by the firm is being underutilised, labour needs to increase, and hence output rises not just because there is more labour but because the firm is operating more efficiently.
2. Constant returns: describes how output increases at a constant rate as labour inputs increase. Here the firm’s capital technology is being used efficiently, and extra output simply reflects more labour input. The firm’s efficiency or productivity is constant.
3. Diminishing returns: eventually the firm may reach a level of output (O*), where the capital technology is being used at its full capacity level. The firm can increase output further by hiring more labour, but it becomes more difficult to squeeze out extra production as efficiency/productivity is now falling.
4. Zero returns: afterwards the firm will eventually reach a point where extra labour does not produce any extra output but is just idle within the work-space.
5. Negative returns: at some point it might even be that output will start to fall as labour input increases further. This is because workers might start getting in the way of each other and impede production.
Concepts of Costs: Average, Variable and Marginal Cost
This develops onto the costing structure, which is required to understand how to produce more output in the short and long run (but more in the short). This is considered through the concepts of cost as the firm must employs more labour; this means that it must increase its costs. These costs can be described in a way that relates cost with output, which can be categorised into short and long run costs:
• Total Cost (TC): is a market firm’s overall cost of all resources used, this has two elements – fixed costs and variable costs:
o Total Cost (TC) = Total Fixed Costs (TFC) + Total Variable Costs (TVC)
o Total fixed Costs (TFC): is the cost of the firm’s fixed inputs. Fixed costs do not change with output.
o Total variable Costs (TVC): is the cost of the firm’s variable inputs. Variable costs do change with output.
• Marginal Cost (MC): is the increase in total cost that results from a one-unit increase in total product, which over the output range with:
o increasing marginal returns, marginal cost falls as output increases.
o diminishing marginal returns, marginal cost rises as output increases
o The marginal cost formula is:
MC = (change in total cost)
(change in quantity)
• Average Cost (AC): measures various total costs:
o Average Total Cost (ATC): this is the total cost per unit of output.
o Average Fixed Cost (AFC): this is the total fixed cost per unit of output.
o Average Variable Cost (AVC): this is the total variable cost per unit of output.
• The connection between the average costs is:
Average Cost (AC) = Average Fixed Costs (AFC) + Average Variable Costs (AVC)
The relationship of these costs is illustrated in figure 17:
Figure 17 – Relationship of average and marginal costs
Source: Ceyhun Elci
• The marginal cost curve illustrates the cost of producing one extra unit of output and is a U-shaped curve and diminishing returns set in at output O1.
• The average fixed cost curve illustrates a continuous fall as fixed costs are spread over a larger output as output increases.
• The average variable cost curve, this is also a U-shaped curve reflecting increasing and then diminishing returns in production. The marginal cost curve passes through the lowest point of the AVC curve at output O2.
• The average total cost curve is the total of the AVC + AFC. The marginal cost curve passes through the lowest point of the ATC curve at output O3.
Long Run Production
In the long run, all input levels are variable; the firm incurs no fixed cost to production and all costs are variable. Hence, once the firm sees output becoming subject to diminishing returns and as a result its average costs of production increasing, it may consider changing the scale of its production. This it can do in the long run as all factors of production are variable.
When a firm changes its scale the relationship between output and factor inputs are described as ‘returns to scale’:
• increasing returns to scale
• constant returns to scale
• decreasing returns to scale
This is illustrated in figure 18:
Figure 18 – Long run production: returns to scale
Source: Ceyhun Elci
The long run is a succession of short runs, as was discussed above about the short run costs, the combination of multiple short runs together will make run the long run. As each of the short runs reflect a different scale of the firm. This due to each work-space size has a different short-run ATC curve. Each short-run ATC curve is U-shaped and the larger the work-space size, the greater is the output at which the average total cost is a minimum.
The LRAC curve reflects the minimum possible short run ATC the firm can attain for any given level of output. For any level of output the firm may choose to produce, the LRAC reflects the lowest possible ATC taken from an ATC curve that corresponds to a particular work space size. Once the firm has chosen that work space size, it will incur production costs corresponding to the ATC curve associated with that work space size. As reflected in figure 19, a point will eventually be reached whereby the firm sees diminishing returns set in and average costs begin to increase (SRAC1). This may motivate the firm to increase its scale of production by opening a new, second, work space.
The firm may also move onto a lower cost curve as a result (SRAC2) – for instance there may be some synergies such as being able to share activities and lead spillovers between the work spaces. And again the firm will once again reach a point where it experiences diminishing returns. Increasing the sale of the production to 3 work spaces may prevent this, and allow the firm to continue to lower its average costs of production as output increases (SRAC3).
However, with continued expansion there will come a time when increasing the scale of production fails to offset diminishing returns and actually leads to the firm shifting to a higher short run cost curve. For instance when the firm opens its 4th and 5th work spaces, this will move the firm onto a higher, not lower, average cost curves. This might be because the firm is becoming too large to manage efficiently.
Figure 19 – Average costs and changes in scale of production
Source: Ceyhun Elci
In the long run the average cost is simply an envelope of the firm’s successive short run cost curves, touching the each of the short run curves and making a U-shaped cost curve as illustrated in figure 20. When the firm increases output and the average costs of production fall it is said to be experiencing economies of scale. The level of output where the firm is producing at its lowest possible average cost is called the minimum efficient scale (MES). Once output expands beyond the MES average costs start to rise and the firm is said to be experiencing diseconomies of scale.
Figure 20 – Long run average cost curve including economies and diseconomies
Economies of Scale
Economies of scale are the process by which a firm’s long average costs falls as output increases. There are three basic reasons why this might occur:
• High fixed costs: certain industries where fixed costs are very large, falling average fixed costs as output increases has a very strong effect on overall average total costs.
• Real economies of scale (increasing returns to scale): occur when output increases at a faster rate as inputs into production grow. There are various scenarios that lead to this:
o specialisation and the division of labour – as the scale of the firm is increased it may become possible to break down production into a series of specialised steps such that each worker becomes very proficient at performing a certain task.
o economies of increased dimensions – this refers to the increasing capacity and size of work spaces dimensions, e.g. the increased volume of cargo ships for instance.
o technical economies of scale – there are certain technologies that allow firms to produce more efficiently, but can only be economically implemented if production is on a larger scale.
o learning by doing – this is the process by which people/firms become more proficient at something by doing it in greater amounts.
• Pecuniary economies: arising because larger firms may be able to use their economic size to negotiate better costs terms, for instance:
o financial economies – larger firms have more assets and are more likely to be able to absorb shocks to costs and revenue than smaller firms.
o marketing – advertising and promotional activities can be spread over a larger range of outputs
o buying power – large firms may be able to act as a ‘monopsonist’ – meaning they can dictate lower prices to their suppliers.
Diseconomies of Scale
After reaching the minimum efficient scale (as seen in figure 20 above) any advancement to increase will lead to diseconomies of scale, which means increasing the cost of output, this may be due to several reasons like:
• Managerial red tape: slow and expensive decision making as the firm becomes progressively larger.
• Industrial relations: in large firms workers are more likely to form collective unions.
• Loss of motivation: the feeling of being a ‘cog in the machine’ may reduce the job satisfaction and proficiency of workers.
Importance of Economies of Scale Provide a Motive for the Growth of Firms
Being able to produce at lower costs is important for both firms and consumers. If lower costs are passed onto consumers in lower prices that will increase consumer surplus and possibly the firm’s market share. However, if businesses maintain their current prices falling average costs would allow them to achieve higher profit margins. Firm are motived to understand the present situation they are in to understand where they are heading as they wish to:
• Increasing market size and economies of scale: The size of the market is important for allowing economies of scale to be achieved in practise. If the minimum efficient scale requires a large output level, it can only be realised if the market size is also sufficiently large.
• Economies of scale and competition: being able to compare the minimum efficient scale of a product with the size of the overall market gives a good indication of the number of firms that can be supported by the size of the market. If the MES is a high proportion of the overall market size then the industry structure will tend towards monopoly. This is especially the case with ‘natural monopolies’ where the MES is so high that the long run average cost curves falls throughout the market range. When the MES is small relative to the market size the industry will tend towards being competitive, with a larger number of firms. In these types of industry economies of scale though are usually less significant, often because they are service-based or products with a high degree of customisation.
End of Unit Activity
Having read the chapter and the supplementary notes, you should consider the following statement:
“A business always operates in the short run, it has production facilities (work space) and it chooses how intensively it uses them, i.e. how much it will produce and etc.” Return to the blackboard site and discuss and consider when long run costs are relevant to business decisions.
As you return to Blackboard to access the unit 5 wiki you should discuss the above statement in view of long run business and market decision making and expand on your views about economies of scale. You should be familiar with wikis, which is the system you used in your unit 1 and 4 activities.
At the end of the unit your tutor will provide formative feedback on views of the wiki contributions made.
Unit 7: Market Efficiency, Revenue and Profits, Firms in competitive markets
Aims and Objectives:
• Recognise how the firm’s output decision affects its costs when the firm allocates its resources efficiently
• Understanding the need to establish short-run productivity and cost measures
• Consider the difference between business and economic profits
• Draw analysis on the relationship between firm managers making profitable output decisions and make commitments to bring about an efficient plant size
• Examine the pricing decisions used by market firms
• Explain how and why firms may engage in price discrimination
• Identify the economic costs and benefits of advertising
Brief Introduction:
A firm’s output decision can affect its costs when the firm allocates its resources efficiently in the short run and in the long run. Therefore firms need to establish their short-run productivity and cost measures and understand how these are related, the firm can reveal how it can predict that its production costs will change with the level of output. This relationship helps firm managers make profitable output decisions in the short run and make commitments to bring about an efficient plant size in the long run. Within this unit various themes will be discussed that cover:
• Output and costs
• Resource Allocations
• Nature and function of profits
• Pricing strategies used by firms
• Benefits, Costs and Surplus
• Price discrimination
• Economic costs and benefits of advertising
• Characteristics of firm competitive markets
• Invisible hand
Output and Costs
The choice of any firm is its decisions on its output and the costs involved in undertaking business within the market economy. Firm make these decisions in order to achieve its main objective: profit maximization.
Some decisions are relatively critical to the survival of the firm, or are irreversible (or very costly to reverse). Other decisions are easily reversible or are much less critical to the survival of the firm (but still influence profitability). A firm owner’s decisions can be categorized as short-run decisions and long-run decisions, the difference are:
• in the short run: a firm needs to increase the quantity of labour employed in order to increase its production and output volume;
• in the long run: a firm can increase the quantity of any or all of the factors of production it employs to increase its production while reducing its costs.
Resource Allocations
The ability of markets to allocate resources efficiently and fairly is an important necessity in order to be able to compare the market with its alternatives. Resources might be allocated by:
• Market price: here the people who are willing and able to buy a resource get the resource.
• Command: through the system people are allocated resources by the order of someone in authority. A command system works well in organisations with clear lines of authority but does not work well at allocating resources in the entire economy.
• Majority rule: here resources are allocated in accordance with majority vote. Majority rule works well when the allocation decisions being made affect a large number of people and self-interest leads to bad decisions.
• Contest: is when resources are allocated to the winner. Contests work well when the efforts of the players are hard to measure, e.g.: such as top managers being in a contest to be named CEO of a company.
• First-come, first-served: resources are allocated to those who are first in line. This allocation method works well when the resource can serve just one user at a time in a sequence, e.g.: as is the case with, a bank teller, or an ATM.
• Lottery: here resources are allocated to the people who pick the winning numbers, choose the lucky card, etc. Lotteries work best when there is no effective way to distinguish among potential users of a scarce resource.
• Personal characteristics: resources are allocated to people with the ‘right’ characteristics.
• Force: resources are allocated to those who can forcibly take the resources.
Nature and Function of Profits
Profits are generally deemed to be useful indicators of the health and performance of an organisation. However, the way profits are measured is a rather complicated and controversial issue. Profit is not simply a measure of total revenue minus total expenditures; tax codes allow for other variables – such as interest, depreciation, and taxes – to alter the final measure of profit. There are 2 profit concepts, which are:
• Business Profit: this concept accounts only for the explicit costs incurred by the firm, while ignoring implicit costs that is considered in the alternative profit concept, the business profit is calculated as:
o Total revenue minus the explicit or accounting costs of production.
• Economic Profit: considers the explicit and implicit costs, which is very important in help the firm to direct its resources appropriately, the economic profit is calculated as:
o Total revenue minus the explicit and implicit costs of production.
Profits can often signal the overall strength and viability of a given industry, which may serve to attract or discourage competitors from entering. While the measure of profit can prove fruitful, it is also important to realise that this measure has limitations due to governmental regulations or other societal constraints, such as environmental concerns.
Profit Maximisation
Profit maximising behaviour is consistent with firms achieving the highest rate of return on their activities. There are 2 types of profits:
1. Normal profit: this is the minimum level of profit that a firm can make and still find it worthwhile to stay in the industry. This can be thought of as the opportunity cost of the firm’s capital and entrepreneurial activity. If the firm made a lower amount of profit than normal profits it would leave the industry and do something else instead. Normal profits can be thought of as a simple cost of production. Labour is paid in wages; rent is paid on factory premises; interest on finance; so normal payments are just the equivalent factor payments to entrepreneurs.
2. Supernormal profits: this is any profit over and above normal profits and reflects a surplus to the firm – i.e. a profit level over and above the minimum level required to keep it in the industry.
Pricing Strategies used by Firms
The most basic pricing practices followed by firms are:
• Cost-plus pricing, or mark-up pricing: is a pricing method used by companies to maximise their rate of returns, this is achieved by increasing production until marginal revenue equals marginal costs, (this technique ignores economic costs, as the formula only incorporates accounting costs).
While the alternative common practice is:
• Incremental analysis: is a pricing to determine the true cost difference between alternatives. Incremental analysis ignores sunk costs and costs that are the same between the two alternatives to look only at the remaining costs. It is vital for making proper decisions regarding pricing and output. This analysis is similar to the marginal analysis of output, as it considers the changes in revenue as compared to changes in costs when production levels are changed or a new product is introduced. However, the analysis goes beyond marginal analysis by taking into account all of the direct as well as indirect changes in revenues and costs. Changes in the price or production of one product may affect the demand for another of the firm’s products. Thus, it is important to examine the possible changes that will be necessary or that may occur when a firm introduces a new product to take advantage of idle capacity or lowers the price of a product to increase sales.
Pricing strategy actions have both short- and long-run implications, and firms must be able to understand how the relationships between demand and production will affect pricing policies.
There are several alternative pricing practices, which are:
• Peak-load pricing: is a pricing technique applied to public goods, that implies the prices will be set at the highest level during times when demand is at a peak;
• Two-part tariff: is a price discrimination (as discussed below) technique in which the price of a product or service is composed of two parts – a lump-sum fee as well as a per-unit charge;
• Tying: is the practice of selling one product or service as a mandatory addition to the purchase of a different product or service; it also is sometime s form of price discrimination;
• Bundling: is a pricing strategy whereby sellers bundle together many different goods/items being sold and offer the entire bundle at a single price;
• Prestige pricing: is a practice of giving a product a high price to convey the idea that it must be of high quality or status;
• Price lining: a practice used by retailers of separating goods into cost categories in order to create various quality levels in the minds of consumers;
• Skimming: a practice used by marketers to set a relatively high price for a product or service at first, then lower the price over time. It allows the firm to recover its sunk costs quickly before competition steps in and lowers the market price.
• Value pricing: is a practice to set prices at a fair and reasonable price that makes sense to the consumer, the price of the product or service is set according to value perceived by the customer;
• Price matching: is a practice in which firms promises to match another firms’ prices for certain products;
• Auction pricing: is a practice to set prices, though the means of bidders submitting (possibly multiple) bids, designating both the quantity of units desired and the price they are willing to pay per unit, which helps set the price.
Benefits, Costs and Surplus
There are various concepts that have an impact, this may be positive or negative and will affect many market economy stakeholders. Therefore, the marginal benefit is the maximum price that people are willing to pay for an extra unit of a good or service. And the willingness to pay for a good or service determines the demand for it. The demand curve for a good or service is also its marginal benefit curve. Hence, the demand curve is also the economy’s marginal social benefit (MSB) curve. This reflects the money value worth of one unit to another unit of goods and services and the willingness to given up or obtain one more unit of a good or service. If the price is lower, then the consumer has a benefit, while if the price is higher than the willingness to pay level then the consumer has a cost incurred. Hence, the consumer surplus is the value (or marginal benefit) of a good minus the price paid for it, summed over the quantity bought. Where the:
• price paid is the market price, which is the same for each unit bought.
• quantity bought is determined by the demand curve; and the
• consumer surplus is measured by the area under the demand curve and above the price paid, up to the quantity bought, (see figure 21)
Figure 21 – Output and labour inputs in the short run
Source: Ceyhun Elci
Price discrimination
Price discrimination refers to the charging of different prices for different quantities of a product at different times, to different customer groups or in different markets, when these price differences are not justified by cost differences. There are various degrees of price discrimination:
• First-degree: involves selling each unit of the product separately and charging the highest price possible for each unit sold. By doing so, the firm extracts the consumers’ entire surplus from consumers and maximises the total revenue and profit from the sale of a particular quantity of the product.
• Second-degree: a more practical and common policy, involving the charging of a uniform price per unit for a specific quantity or block of the product sold to each customer, a lower price per unit for an additional batch or block of the product and so on. By doing so, the firm will extract part, but not all, of the consumers’ surplus.
• Third-degree: involves the charging of different prices for the same product in different markets until the marginal revenue of the last unit of the product sold in each market equals the marginal cost of producing the product.
Economic costs and benefits of advertising
Advertising is an important competitive tool to increase economies of scale in production which requires mass markets; hence advertising is able to stimulate demand for products and shift product demand curve outwards, there are 2 methods of economic advertising, which are:
• Informative advertising: this encourages competition, so makes the demand more elastic;
• Persuasive advertising: encourages brand loyalty and makes demand more inelastic
Therefore, the overall net effect of advertising on prices depends on informative/persuasive role and economies of scale
Characteristics of Firm Competitive Markets
The main characteristic of a competitive equilibrium is through maintaining efficient, which only achievable if no external benefits or costs exist.
• External benefits are benefits that accrue to people other than the buyer of a good or service; the marginal benefit to the entire society is the marginal social benefit curve, MSB.
• External costs are costs that are borne not by the producer of a good or service but by someone else, the marginal cost to the entire society is the marginal social cost curve, MSC.
Therefore, when the marginal social benefit of the last unit produced equals its marginal social cost, society attains efficiency. However, because the demand curve is the same as the MSB curve and the supply curve is the same as the MSC curve, the efficient quantity that sets the MSB equal to the MSC also sets the quantity demanded equal to the quantity supplied and so is the equilibrium quantity. In equilibrium, the quantity demanded equals the quantity supplied. At the equilibrium quantity, marginal benefit equals marginal cost, so the quantity is the efficient quantity. The sum of consumer and producer surplus is maximised at this efficient level of output (as discussed in figure 21, above).
Invisible hand
There is incredibly coordinated and socially beneficial activity behind the dynamics of a competitive market, despite the lack of any coordinating body of decision makers to monitor and control the flow of resources. This helps determine what the self-interested firm produces and sells as output and at the lowest possible cost per unit in the long run.
As firm seek to maximise profit rather than social benefits, it is unable to charge a price higher than the minimal amount necessary to cover its average total cost. Also, the high degree of competition from the numerous firms in the market forces the firm to produce at the lowest possible cost per unit, because each competitor has access to the same technology and resulting production cost curves.
Therefore if the firm attempted to charge a premium above minimum ATC, it will lose its entire market share. As the ‘invisible hand’ idea by Adam Smith (1766) implies the competitive market sends resources to their highest valued use in society, and therefore consumers and producers pursue their own self-interest and interact in markets. In order for market transactions to generate an efficient, highest valued use of resources.
End of Unit Activity
Having read the chapter and the supplementary notes, you should consider the following:
Various problems prevent markets from providing a socially optimal allocation of resources, which are:
i. Externalities
ii. Monopoly/oligopoly power
iii. Ignorance and uncertainty
iv. Public goods and services
v. Merit goods
After you have investigated what each of the above means, match each problem to the following examples of failures of the free market. In each case below, assume that everything has to be provided by private enterprise: that there is no government provision or intervention whatsoever. (Note that there may be more than one example of each category of problem).
a. There is an inadequate provision of street lighting because it is impossible for companies to charge all people benefiting from it
b. Advertising allows firms to sell people goods that they do not really want
c. A firm tips toxic waste into a river because it can do so at no cost to itself
d. People may not know what is in their best interests and thus may under-consume certain goods or services (such as education)
e. A firms’ marginal revenue is not equal to the price of the good and thus they do not equate MC and price.
f. Firms provide an inadequate amount of training because they are afraid that other firms will simply come along and ‘poach’ the labour they have trained.
Return to Blackboard to access the unit 7 wiki and expand on your views about the above statement in regards to market efficiency, revenue and profits and firms in competitive markets. You should be familiar with wikis, which is the system you used in your unit 1 & 4 activities.
At the end of the unit your tutor will provide formative feedback on views of the wiki contributions made.
Summative Marked Assessment 1
Assignment 1 (Test) – within the period of this unit you will undertake a summative assignment a test (weighed 40%). This is a time-constrained test of 1 hour, and can be found in the assessment section on Blackboard. This is an invigilated test, the marks will be recorded, but the test is open book with the possibility to have note.
This test covers materials from the units 1-7, which include topics:
• Introduction to the Scope of Business Market Economics and Strategy
• Economic Problems
• The Market Firm
• Markets, Prices: Demand and Supply
• Markets and Elasticity
• Market Production and costs
• Market Efficiency, Revenue and Profits, firma in competitive markets
The test is integrated within Blackboard and when you take the test your grades will automatically be recorded in the grade area. You should not open either of these tests until you are ready to take them. You will only be allowed to open the tests once.
Unit 8: Market Structure
• Unit Introduction
Aims and Objectives:
• Recognise the effect the number of firms, the type of product and barriers to entry have on the structure of the market
• Develop and undertaking to identify the characteristics between market structures
• Understand the factors that give firms power over a market
• Explain how and why governments may regulate monopoly markets
Brief Introduction:
There are various different types of market structures, which affect the behaviour of firms and the outcomes of markets. This unit examines and focuses on the various types of market structures; covering: perfect competition, which is where markets are highly competitive, monopolistic, oligopolistic and monopoly, which is the least competitive market. Within this unit various themes will be discussed that cover:
• Market Structure
• Efficient markets
• Market Characteristic
• Prefect Competition
• Monopolistic
• Oligopoly
• Porter’s Forces
• Duopoly
• Monopoly
• Natural Monopolies
• Monopsony
Aims and Objectives:
• Recognise the effect the number of firms, the type of product and barriers to entry have on the structure of the market
• Develop and undertaking to identify the characteristics between market structures
• Understand the factors that give firms power over a market
• Explain how and why governments may regulate monopoly markets
Brief Introduction:
There are various different types of market structures, which affect the behaviour of firms and the outcomes of markets. This unit examines and focuses on the various types of market structures; covering: perfect competition, which is where markets are highly competitive, monopolistic, oligopolistic and monopoly, which is the least competitive market. Within this unit various themes will be discussed that cover:
• Market Structure
• Efficient markets
• Market Characteristic
• Prefect Competition
• Monopolistic
• Oligopoly
• Porter’s Forces
• Duopoly
• Monopoly
• Natural Monopolies
• Monopsony
How long it should take to study? 1 week
Any technologies used: wiki, journals, forums and case studies.
This is the process of classifying markets by the extent of competition within the market. There are three key factors, which determine how competitive a particular market might be:
1. Number of firms and consumers: the higher the number the more competitive is the market. This is because consumers have a greater choice of suppliers, and no individual consumer is important enough to dictate prices to firms.
2. Barriers to entry: or called the freedom to enter and exit, considers that the fewer barriers to entry in a market the more competitive it generally is. This is because firms operating in the market must consider the threat of potential new entrants. Likewise, the easier it is to exit a market the more likely it is that firms will enter it – because the costs of reversing that decision if they have to is also lower.
3. Nature of product: the more homogeneous or standardised the product the greater the degree of competition between firms – as each product is a close substitute to the other alternatives. If a firm can differentiate its product by making it qualitatively different to others it reduces the extent to which is substitutable, and hence lowers the extent of completion it faces.
These three factors determine the number of possible substitutes there are for a particular product and therefore the shape/nature of the firm’s demand curve.
Efficient markets
The market structure also determines the efficiency of market, as it’s the case that when competition is fierce, i.e. plenty of close substitutes, demand is price elastic and the demand curve is flatter. In this case the firm has little control over the price of its product. Likewise, when competition is limited, fewer substitutes result in demand becoming more price inelastic. In this case the demand curve is steeper and the firm has more control over the price of its product.
Different types of market structures reflect different degrees of competition and efficiency. The two limiting cases are:
• Perfect competition: when there are large numbers of firms producing the same product with no barriers to entry or exit; and
• Pure monopoly: when there is one firm in the industry protected by barriers to entry and with significant control over price.
The ranging market structures between these two limiting cases are called imperfect competition. The two specific types that are imperfect competitive structures are:
• Monopolistic competition: where markets are competitive but each firm produces a slightly differentiated product. This may characterise industries where there are a large number of small and medium sized enterprises which compete with each other in terms of both price and non-price factors (quality); and
• Oligopoly: this type of market structure is where the market consists of a small number of large firms, each with some degree of market power. This is often an interesting type of market to look at because of possible strategic interactions between the behaviour of firms.
Market Characteristic
There are various market characteristics that determine the market structure of the firms, figure 22, and determine the difference in market characteristics for the differing types of market structures:
Figure 22 – Market structure characteristics
Type of Market structure Perfect Competition Monopolistic
Competition Oligopoly Monopoly
Number of firms Very many Several 20-30 Few One
Size of firms Very small Small/
Medium Large Large
Product Homogeneous
(undifferentiated) Differentiated Differentiated or undifferentiated Unique
Information Perfect Imperfect Imperfect Imperfect
Entry Free Entry Free Entry Barriers Barriers
Demand curve of firm Horizontal Downward Sloping Downward Sloping Downward Sloping
Elasticity Perfectly elastic Relatively elastic Relatively Inelastic More inelastic than oligopoly
Price position Firm is price taker Firm has some control over price Firm has some control over price Firm is price maker
Source: Ceyhun Elci
Perfect Competition
This type of market structure has the following characteristics:
1.Large numbers of buyers and sellers;
2.All producers make a homogeneous product with a large number of substitutes;
3.There are no barriers to entry or exit from the market;
4.Perfect information- simple product, no search costs;
Perfect information or perfect knowledge means that consumers are aware of all the products available and their respective prices. This makes it is easy for them to change supplier to the cheapest option. The absence of search and information gathering costs helps to make markets more competitive. Under perfect competition all firms are price takers (hence, they have no market power) and each faces a horizontal (perfectly elastic) demand curve. Firms have no control over price because the large number of substitutes means that any change in price will lead to large changes in demand. Any firm that raises its price will see demand contract to zero as consumers substitute to now-cheaper alternatives. Likewise, any firm that lowers price will attract the entire market, so prices tend to be competed down to their lowest possible level for all firms (equal to average costs).
The benefits and costs of perfect competition markets differs between stakeholder, it is said that they are good for consumers as they achieve:
• Allocative efficiency: as P = MC, so the consumer pays a price that is equal to the cost of producing the last marginal unit of output. Perfect competition balances the consumer’s willingness to pay with the producers’ ability to produce;
• Productive efficiency: reflects that the firm produces an output consistent with the lowest point on its average cost curve, i.e. the market price is as low as possible given the available technology and maximum efficiency.
While also free entry and exit from the market acts to enforce these efficient outcomes and ensures that firms can only make normal profits. Supernormal profits result from pricing above average costs so reflects a transfer from consumer to producer. Perfect competition prevents this transfer from being too large by firms making excessive profits.
However, there are a number of recognised disadvantages with perfect completion, which are:
• Economies of scale: requires fewer firms producing higher output in order to achieve lower costs of production;
• Supernormal profits: may be used to fund costly investment, for example research and development
• Perfect competition: requires standardised/homogeneous products whereas consumer may prefer more variety
• Free entry and exit: from the market means there is often a high turnover of firms in the industry depending on economic conditions
Monopolistic
This type of market structure has the following characteristics:
1. Composed of many sellers
2. Producers make heterogeneous or differentiated product;
3. Entry into and exit from the industry are rather easy in the long run.
This type of market structure is fairly recognisable in the retail and service sectors of the economy, such as telecommunication services. Products and services are similar and serve to satisfy the same general need, yet they differ in some way, such as colour, style, taste, packaging, etc.
These firms also have the ability to make changes to some of the features or characteristics of their products in order to distinguish them from competitors and make them more appealing to buyers. Firms in this market structure also engage in various selling activities, such as advertising and training of sales personnel, to encourage buying. However, these selling activities and product variations also increase the costs for the firm. These elements can positively impact short-run performance but will most likely be copied by other firms in the long run.
Oligopoly
This type of market structure has the following characteristics:
1. A few sellers;
2. Producers make homogenous or differentiated product;
3. Interdependent firms – due to small number of firms involved, any action taken by one firm can have significant impact on the other firms, so all firms are very aware of what their competitors are doing.
Within most industrialised nations, the oligopoly is the most common form of market organisation with regards to manufacturing. The oligopoly industry structure is dominated by a few large firms, and the market concentration is derived with concentration ratios, which provides the percentage of total industry sales of the largest firms in the industry.
The closer to 100 that this percentage approaches, the more oligopolistic the industry is. A second method for examining market concentration is the Herfindahl index, which uses information on all the firms in the industry, with a higher number representing a higher degree of concentration.
Porter’s Forces
This approach was developed as conceptual framework that demonstrates the forces affecting an industry and helps firms to better understand the industry context in which their firm operates. The framework outlines the five forces that affect the intensity of competition and profitability of firms within an oligopolistic market. The degree of each of the five determinants in the framework plays an important role in the profits earned by the firm.
1. If the firm faces little threat from substitute products, it is able to charge more for its own product, usually resulting in higher-than-average profits. Firms often go to great lengths to differentiate their product from the competition in order to pass on a higher price.
2. Firms are also able to raise prices if there is little possibility of the threat to entry or new firms entering the industry. This can be the result of extremely high start-up costs or other barriers to entry.
3. The bargaining power of suppliers is an important consideration of profitability for the oligopolistic firm, if a firm faces a small and organised supplier bases, then the suppliers, have a high degree of power regarding the price of the product.
4. While the bargaining power of buyers, is also important consideration of profitability for the oligopolistic firm; likewise if a firm faces a small and organised customer bases, then the customers, have a high degree of power regarding the price of the product.
5.The final consideration in Porter’s framework is the intensity of rivalry between firms in the market. There are six elements to consider within this element:
• Degree of concentration
• Non-price versus price competition
• Exit barriers
• Ratio of fixed to total costs
• Switching costs
• Growth of the industry
While Porter’s strategic framework is useful for examining profitability, the analysis focuses on the short run. To examine the long run, it is necessary to look at the efficiency of the oligopolistic firm.
Duopoly
A duopoly is an oligopoly market with two firms. Hence a duopoly has the same characteristics as an oligopoly.
Monopoly
This type of market structure has the following characteristics:
1. A single firm selling a product that has no close substitutes;
2. Complete control over the entire supply of raw materials needed to make the product;
3. Legal right to sole production, through a patent or copyright;
A monopoly can set the price level at which it sell its product, the conditions for determining the best level of output are different from perfect competition. Under monopoly structure, a firm seeking to maximise profits should continue to lower its price – which increases output – for as long as the price is greater than the marginal revenue earned.
However, it may be necessary for a monopoly to minimise costs rather than maximise profits. In this case, it is necessary to examine average variable costs or average total costs. In the long run, the firm must consider the optimal scale of plant needed to produce the best level of output – the same as for perfect competition.
Natural Monopolies
This type of market structure has the following characteristics:
1. Minimum efficient scale is large so that the market is unable to support a large number of firms and produce at the efficient scale.
2. Economies of scale form a natural barrier to entry.
3. Established by government
The existences of natural monopolies or those established by government are seldom seen. This is especially true in the United States, where legislation has made the monopoly illegal, except where regulated such as certain utilities and the postal service.
Monopsony
Similar but opposite to a monopoly, but this is a market structure where only one buyer faces many sellers.
End of Unit Activity
Having read the chapter and the supplementary notes, you should consider blogging about the following questions:
It is usual to divide markets into four categories. In ascending order of competitiveness list the market structures via a hierarchy diagram, like below:
Once you have listed the common market structures consider, which of the above four categories apply to the member firms? (There may be more than one market category in each case).
a.Firms face a downward sloping demand curve
b.New firms can freely enter the industry
c.Firms produce a homogeneous product
d.Firms are price takers
e.Firms face an elastic demand (but less than infinity) at the profit-maximising output
f.Firms will produce where MR = MC if they wish to maximise profits
g.There is perfect knowledge on the part of consumers of price and product quality
Return to Blackboard to access your blog and expand on this topic and evaluate the market structures.
In preparation for the blog, the tutors will set-up the blog and provide a session via content on blackboard, as was the case in unit 2.
At the end of the unit your tutor will read your blogs to provide a formative overview on your understanding of market structures the blogs will be developed over the term of the module to help develop your learning.
Further resources
Core references:
Parkin, M., Powell, M., & Matthews, K., (2011). Economics. (8/ed). Pearson Education. (Chapter 11, 12, 13 & 14)
Further references:
Begg, D., Vernasca, G., Fischer, S., & Dornbusch, R. (2011). Economics. (10/ed). McGraw-Hill. (Chapter 8 & 9)
Begg, D., & Ward, D. (2009). Economics for Business. (3/ed). McGraw-Hill. (Chapter 5, 6 & 8)
Lipsey, R., & Chrystal, A. (2011). Economics. (12/ed). Oxford University Press. (Chapter 7, 8 & 9)
Mankiw, G., & Taylor, M. (2011). Economics. (2/ed). Cengage Learning. (Chapter 14, 15 & 16)
Parkin, M, Powell, M., & Matthews, K., (2012). Essential Economics. Pearson Education. (Chapter 7, 8 & 9)
Sloman, J., & Garratt, D. (2009). Essentials of Economics. (5/ed). Prentice Hall. (Chapter 4 & 5)
Sloman, J., Hinde, K., & Garratt, D., (2013). Economics for Business. (6/ed). Pearson Education. (Chapter 11, 12, 16, 21 & 22)
Sloman, J., & Jones, E. (2011). Economics and the Business Environment. (3/ed). Prentice Hall. (Chapter 4, 5 & 9)
Sloman, J., & Wride, A. (2009). Economics. (7/ed). Prentice Hall. (Chapter 5, 6 & 7)
Unit 9: Market Economic Strategies and Regulation
Aims and Objectives:
• Describe and appreciate various strategic approaches and how they would change the firms behaviour
• Consider the strategic views of tactical decisions in the market economy between firms
• Understand the concepts of price and non-price competition in imperfectly competitive markets
• Examine how and why firms in oligopolistic markets might collude with one another
• Consider the impact of regulations is competitive industry
• Determine the impact of regulation and its consideration in business and government decision-making.
Brief Introduction:
The dependence that firms have with regards to pricing or advertising strategies provides an important strategic decision-making process within the market economy. Firms find it imperative to consider how their actions will be met by competitors and what effects these competitor reactions will have on their own profits or costs. While all businesses also part-take in the economy and have an interaction with the government. The role that governments have taken is regulating businesses are for the purpose of protecting consumers, workers, and the environment. The laws or issues may not directly apply to all businesses and consumers, the actions that governments can or have taken can directly affect the actions of business and competition. Within this unit various themes will be discussed that cover:
• Product Development and Marketing
• Strategic Behaviour
• Price and non-price competition
• Game Theory
• Prisoner’s Dilemma
• Strategic Decisions
• Role of governments in Business
• Enforcement of competition/antitrust laws
• Deregulation
• Regulation of international competition
• Taxation and its effects
Product Development and Marketing
To keep earning an economic profit, a firm in monopolistic competition must be in a state of continuous product development. New product development allows a firm to gain a competitive edge, if only temporarily, before competitors imitate the innovation.
Strategic Behaviour
This is the behaviour that takes into account the expected behaviour of others and the recognition of mutual interdependence. It refers to the plan of action of behaviour by firms after taking into consideration all possible reactions of its competitor, as they compete for profits or other advantages. This is particularly dominant in markets structures that have a few firms (like oligopolistic markets), as the actions of each firm affects the another’s strategy, and therefore the reaction of the other firms must be kept in the mind by the first mover, in order to chart the best course of action. The study of such strategic behaviour helps in view of price and non-price competition and is the main subject of game theory (as discussed on the following page).
Price and non-price competition
Firms frequently charge different prices to different customer groups or in different markets, but often the underlying reason is the costs involved with providing the product to that particular group or market. A buyer that purchases large quantities from a firm may receive price breaks because the average costs associated with the purchase are lower due to the higher volume. However, there are other scenarios in which organisations charge different prices to different customers in the absence of cost differences. Some governments regulate the ability of firms to charge different prices to different customers. The United Kingdom, the EU and the United States have antitrust laws that create general guidelines as to when such practices are illegal or not. However, there are many examples of lawful price discrimination, such as charging lower prices for senior citizens, business customers, or low-income customers.
Game Theory
A commonly used rationale for explaining and predicting how actions and reactions of firms will affect costs or profits is through game theory. This theory studies the strategic interactions among firms (players) and the subsequent outcomes (payoffs) that result from strategic decisions. Payoff matrices can be developed to show the results for different game scenarios, as considered below. The intention of matrices is to show what the dominant strategy of each firm, based on the relevant profits for each possibility – would be, regardless of the possible actions of the other firm. The dominant strategy will always be the option of choice for a firm, regardless of the opponent’s choice.
Prisoner’s Dilemma (Payoff matrices)
The Prisoner’s Dilemma captures many of the essential features of games and gives a good illustration of how game theory works and generates predictions. This is a good tool to consider the strategic decisions firms have to make on a daily bases to maintain a competitive advantage or at times consider, follow the market strategy. All market oriented games share four common features:
• rules: which specifies what each player can do;
• strategies: are all the possible actions of each player;
• payoffs: a table that shows the payoffs for every possible action by each player for every possible action by each other player; and
• an outcome: which is determined by the choices of both players.
The concept of Nash equilibrium is used to predict the outcome of a game. As it helps explain the strategic behaviours of firms. This concept incorporates the idea that not all games, or scenarios, will have a dominant strategy for each player; thus, each firm must decide what its optimal strategy is, given the strategy chosen by the other firm.
Strategic Decisions
Decisions are important to consider when often faced with difficult choice for firms to make, for instance the price to charge for a product. Previous discussions highlighted the philosophy that a firm should charge the price where marginal revenue equals marginal costs. However, this analysis contained assumptions that were basic and simplistic. In the real world, firms are not held to these simple assumptions and must account for various factors. One of the issues facing many organisations is how to price multiple products that they produce and that have interrelated demands.
Firms with multiple products must be aware of how the price of each product will affect the demand for others. While lowering the price of some products may increase the sale of complementary products, it may also result in a lower demand for substitute products. Failure to take into account these interrelationships could result in pricing and output decisions that are less than optimal. Understanding the need to make full use of an organisation’s plant capacity is also imperative in optimal pricing of products. Optimal production of one product could result in idle capacity (and suboptimal use of the plant), so it is necessary to examine what combination of production will enable the firm to make the best use of its production capacity.
Role of Governments in Business
The role of government in regulating the economy of a nation has been a long-debated issue: one that divides individuals and serves as the foundation for many political parties. The role of government in business can be considered in 2 forms:
• Economic theory of regulation: develops on the application of laws of governments for the purposes, of centrally-planning an economy, remedying market failure, and/or enriching well-connected firms, while
• Capture theory of regulation: states that government regulation is derived from the resulting pressure of group action and the subsequent effects of laws and policies that are enacted to support business and should also protect consumers, workers, and the environment.
With regulation, certain practices, such as licensing and patents, serve dual purposes. While licensing is intended to protect consumers by maintaining minimum standards and patents are intended to encourage inventions, both also restrict competition within the economy. Licences, such as those required in certain professions, create barriers to entry, enabling businesses to charge higher prices and make larger profits. Patents create monopolies by enabling only one firm to produce a product, which also causes higher prices to consumers and larger profits for firms. These regulatory practices have often come as a result of strong pressure from associations or labour groups that desire to restrict entry and competition.
Governments also enact certain regulations with the intent of protecting consumers, workers, and the environment. For example many governments have passed several acts to protect consumers against unfair business practices, workers against adverse and unsafe work conditions, and the environment against undesirable pollution. For instance, the European Union (EU) has developed a series of consumer protection regulations, and most European environmental laws are in line with US environmental laws that protect consumers. In addition, EU employment legislation has been designed to guarantee minimum levels of protection for workers with regards to health and safety, equal opportunity, and discrimination.
While consideration regulation, businesses need to consider the importance of externalities with regards to government regulation. This concept has been developed under the public interest theory of regulation, which postulates that government regulation occurs for the purpose of overcoming market failures. These actions are designed to ensure that the economic system consistently operates in a manner that aids the public interest. It is stated that government have two basic options for correcting market failures: prohibition of the activity or taxation on the activity.
Enforcement of competition/antitrust laws
Businesses and governments need to consider the importance competition/antitrust laws that may be enacted by various governments for the purpose of restricting unfair business practices, restraints of trade, or monopolisation that are detrimental to consumers.
The difficulty arising from all competition/antitrust laws are their interpretation or, more specifically, how the legal system within the country is to enforce these regulations. Many competition/antitrust regulations are enforced through exploring the evolution of anti-competition problems over the past several decades. Courts have made decisions regarding monopolies based on their structure as well as their conduct. The basis for these decisions may sometimes contradict or reverse previous judgements, showing that the criteria for determining antitrust actions have evolved with the business and social environment. And are continuingly been observed and updated.
Deregulation
While government regulation is intended to protect certain groups or overcome market failures, there are many arguments against regulation because of the high costs that are imposed upon society as a consequence of regulation. As the regulatory passage of legislation often creates a new government agency with the powers to ensure that regulations are followed and to impose penalties when they are not. The costs of these government agencies and their administrative workings ensuing bureaucracies, along with other costs of compliance, can often cause the benefits of such regulation to be outweighed by the costs. This has led to a growing deregulation movement in the many countries, for instance the UK, the EU and the US. The intention of deregulation is to increase competition and overall efficiency with the hopes of creating lower prices for consumers while maintaining levels of safety and quality.
The practice of deregulation is an act or process of removing or reducing state regulations. It is the opposite of regulation, which refers to the process of the government regulating certain activities. While the rationale for deregulation is often that fewer and simpler regulations will lead to a raised level of competitiveness, therefore higher productivity, more efficiency and lower prices overall. However, like regulation, deregulation has its opponents that are of the view that deregulation can lead to environmental pollution and reduce environmental quality standards (such as the removal of regulations on hazardous materials), financial uncertainty, and constraining monopolies.
Sometimes there is a need for governments to allow such monopolies to occur; however, there also exists a strong need to regulate companies with regards to the rates they charge. These issues raise some difficult decisions for governments, as regulations can often lead to inefficiencies on the part of the utility, hence to questions to regulate or deregulate.
Regulation of international competition
Governments have a strong desire and need to regulate the actions of international organisations with respect to dumping practices. Domestic companies have an involved interest with ensuring that the demand for their products remains strong within their country. Because of this, governments often enact tariffs, quotas, or antidumping duties. Governments may also ask that international companies to enact voluntary restraints on exports, in lieu of stronger trade restrictions, when certain exports have been found to pose a significant threat to an industry.
These regulations that governments impose on international competition are generally intended to only protect businesses. The subsequent effects of tariffs, quotas, or other restrictions are often higher costs to consumers and higher profits to both domestic and international firms. The prices of exported goods are higher because of the restrictions, and the prices of domestic goods are often higher because of the unwillingness of domestic firms to forfeit higher profits. This means that consumers are generally faced with products that are similar in price, regardless of whether they are domestic or imported products. While these regulations are not beneficial in terms of prices, they generally benefit the country by keeping domestic firms in operation, which helps in maintaining or creating jobs.
Taxation and its effects
Taxes are generally accepted as the alterative government intervention and also being necessary for the purpose of providing and maintaining infrastructure, education, and national defence. However, governments also use taxes for the purpose of regulating certain industries or products. Such action may be intended to discourage use (e.g. cigarettes) when taxes are imposed or to encourage use (e.g. education) when tax reductions are allowed. The use of taxes for such purposes has important impacts on business decisions through their influence on work and investments.
There are a variety of government regulations with varying impacts on consumers, workers, business decisions, and the environment. It is important to understand that regulations, while designed to serve an important purpose, often have the ability to be detrimental to consumers or businesses through subsequent higher prices or costs. It is for these conflicting implications that governments must seriously consider the cost–benefit analysis of such regulations.
End of Unit Activity
Having read the chapter and the supplementary notes, you should debate the following question:
“When and why might consumers be better of when firms engage in price discrimination?” Return to the blackboard site and discuss and consider when price discrimination may benefit consumers.
As you return to Blackboard to access the unit 9 wiki you should discuss the above question in view of market economic strategies and price discrimination decisions and expand on your views about the impact of strategic behaviour, game theory and price and non-price discrimination in view of strategic decision. You should be familiar with wikis, which is the system you used in your unit 1, 4 and 5 activities.
At the end of the unit your tutor will provide formative feedback on views of the wiki contributions made.
Further resources
Core references:
Parkin, M., Powell, M., & Matthews, K., (2011). Economics. (8/ed). Pearson Education. (Chapter 6, 14, 17, 18 & 19)
Further references:
Begg, D., & Ward, D. (2009). Economics for Business. (3/ed). McGraw-Hill. (Chapter 2 & 6)
Lipsey, R., & Chrystal, A. (2011). Economics. (12/ed). Oxford University Press. (Chapter 8 & 9)
Mankiw, G., & Taylor, M. (2011). Economics. (2/ed). Cengage Learning. (Chapter 15, 16 & 17)
Parkin, M, Powell, M., & Matthews, K., (2012). Essential Economics. Pearson Education. (Chapter 5)
Sloman, J., & Garratt, D. (2009). Essentials of Economics. (5/ed). Prentice Hall. (Chapter 5)
Sloman, J., Hinde, K., & Garratt, D., (2013). Economics for Business. (6/ed). Pearson Education. (Chapter 8, 12, 16, 17 & 20)
Sloman, J., & Jones, E. (2011). Economics and the Business Environment. (3/ed). Prentice Hall. (Chapter 3, 5, 9 & 10)
Sloman, J., & Wride, A. (2009). Economics. (7/ed). Prentice Hall. (Chapter 7 & 8)
Unit 10: Labour Markets
Aims and Objectives:
• Develop an understanding of the labour force, considering the unemployment rate, and the employment-to-population ratio
• Consider views of the natural of unemployment and wages
• Examine the fluctuations of the unemployment rate over the business cycle.
• Determine the impact of the price level and the inflation rate as well as other price indexes.
Brief Introduction:
There are various types and sources of unemployment and employment, and the labour markets provide an overview of these as they play a role in the market economy. Within this unit various themes will be discussed that cover:
• Labour force
• Employment and wages
• Productivity
• Unemployment and full employment
• Unemployment rate fluctuation over business cycle
• Price level, inflation and deflation
Labour force
The population is divided into two groups:
1. The working-age population, which is the number of people aged 16 years and older who are not in jail, hospital or other institution (in the UK).
2. People too young to work (less than 16 years of age) or in institutional care are not counted in the workforce.
The working-age population is further divided into two groups:
1. people in the workforce and
2. people not in the workforce.
The workforce is the sum of employed and unemployed workers. To be considered unemployed, a person must be:
a. Without work and have made specific efforts to find a job within the past 4 weeks, or
b. Waiting to be called back to a job from which he or she was laid off, or
c. Waiting to start a new job within 30 days.
Employment and wages
Employment and the rights of wages is the socioeconomic relationship between a worker (labourer) and an employer, where the worker sells their labour under a formal or informal employment contract. The transactions occur in a labour market, where wages are determined by the market. The most common form of wage labour is ordinary direct, or “full-time”, employment in which a worker sells his or her labour for an indeterminate time. This is in return for a money-wage or salary and a continuing relationship with the employer. However, wage labour takes many other forms, and explicit as opposed to implicit (i.e. conditioned by local labour and tax law) contracts are not uncommon. The main differences of employment and wages are the status, which can be;
• employment status: a worker could be employed full-time, part-time, or on a casual basis
• civil (legal) status: depends on the status of the individual worker, which could be:
o a free citizen, able to apply for any freely available job
o an indentured labourer, is a form of labour to pay off debt (for example for travels) which may be in the form of servants, or slavery as was in the North American.
o forced labour; this includes some prison or army labour
o a worker could be assigned by the political authorities to a task, they could be a semi-slave or a serf bound to the land who is hired out part of the time.
Therefore, labour might be performed on a more or less voluntary basis, or on a more or less involuntary basis, in which there are many gradations.
Productivity
Thus is the ratio of output to inputs in production; it is a measure of the efficiency of production. And a main component is labour productivity, which is rate of goods and services produced in a period of time, divided by the hours of labour used to produce them. In other words labour productivity measures output produced per unit of labour, usually reported as output per hour worked or output per employed person.
Unemployment and full employment
The market of labour forces is segmented into 2 categories that are the unemployment and the fully employed. The types of unemployment are classified into three types:
1. Classical unemployment: is the unemployed arising from job losses due to real wages are too high relative to the market-equilibrium;
2. Frictional unemployment: is the unemployment that arises from normal labour market turnover (temporarily between jobs). These workers are searching for jobs. The unemployment related to this search process is a permanent phenomenon in a dynamic, growing economy. Frictional unemployment increases when more people enter the labour market or when unemployment compensation payments increase.
3. Structural unemployment: is the unemployment that arises when changes in technology or international competition change the skills needed to perform jobs or change the locations of jobs. Sometimes there is a mismatch between skills demanded by firms and skills provided by workers, especially when there are great technological changes in an industry. Structural unemployment generally lasts longer than frictional unemployment. Minimum wages and efficiency wages create structural unemployment.
4. Cyclical unemployment: is the fluctuation in unemployment caused by the business cycle. Cyclical unemployment increases during a recession and decreases during an expansion.
5. Seasonal unemployment: is due to regular seasonal changes in the employment in the economy, due to temporary contracts and seasonal industry employment.
6. Hidden unemployment: is the unemployment of potential workers that is not reflected in official unemployment statistics, due to the way the statistics are collected
7. Technological unemployment: is due to the steady increase in labour productivity due to technological introduction that mean that fewer workers are needed to produce the same level of output.
While the fully employed is made up from in two categories:
1. Natural unemployment is the unemployment that arises from frictions and structural changes when there is no cyclical unemployment – when all the unemployment is frictional and structural. Natural unemployment as a percentage of the labour force is called the natural unemployment rate.
2. Full employment is defined as a situation in which the unemployment rate equals the natural unemployment rate. The natural unemployment rate is determined by the:
• age distribution of the population: an economy with a young population has a large number of new job seekers every year and has a high level of frictional unemployment.
• scale of structural change: the scale of structural change is sometimes small but sometimes there is a technological upheaval. When the pace and volume of technological change, and when the change driven by international competition increases, natural unemployment rises.
• real wage rate: the natural unemployment rate increases if minimum wage is raised to exceed the equilibrium wage rate or if more firms use an efficiency wage (a wage set above the equilibrium real wage to enable the firm to attract the most productive workers and motivate them to work hard and discourage them from quitting).
• unemployment benefits: unemployment benefits increase the natural unemployment rate by lowering the opportunity cost of job search.
Unemployment rate fluctuation over business cycle
GDP helps evaluate the business cycle, so when considering that potential GDP, which is the quantity of real GDP produced at full employment. It corresponds to the capacity of the economy to produce output on a sustained basis; actual GDP fluctuates around potential GDP with the business cycle. While, when the economy is at full employment, the unemployment rate equals the natural unemployment rate and real GDP equals potential GDP. When the unemployment rate is greater than the natural unemployment rate, real GDP is less than potential GDP. And when the unemployment rate is less than the natural unemployment rate, real GDP is greater than potential GDP. The gap between real GDP and potential GDP is called the output gap.
The business cycle occurs because the aggregate demand and the short-run aggregate supply fluctuate but the money wage does not change rapidly enough to keep real GDP at potential GDP. Therefore the 2 scenarios are:
1. A below full-employment equilibrium: is an equilibrium in which potential GDP exceeds real GDP. The gap between real GDP and potential GDP is the output gap and this gap is called a recessionary gap.
2. An above full-employment equilibrium: is an equilibrium in which real GDP exceeds potential GDP. The amount by which real GDP exceeds potential GDP is called an inflationary gap.
Price level, inflation and deflation
The price level is the average level of prices. The average level of prices can be rising, falling or stable, therefore:
• Inflation; occurs when the price level persistently rises; and is the percentage change in the price level.
• Deflation; occurs when the price level persistently falls.
The concerns of inflation and deflation are due to the unexpected inflation or deflation which is a problem for society because they redistribute income and wealth, as:
• unexpected inflation; benefits workers and borrowers;
• unexpected deflation; benefits employers and lenders.
They motivate people to divert resources from producing goods and services to forecasting and protecting themselves from the inflation or deflation. While also:
• unexpected deflation; hurts businesses and households that are in debt (borrowers) who in turn cut their spending. A fall in total spending brings a recession and rising unemployment.
End of Unit Activity
Having read the chapter and the supplementary notes, you should consider blogging about the following questions:
It is not usual for countries to impose a minimum wage, however considering the minimum wage imposed by governments, considering the following 2 questions:
a. What does the ‘face’ of a minimum wage worker look like? (Describe the profile of a minimum wage worker, consider using relevant examples that you may have)
b. Will raising the minimum wage help or hurt those who need help the most?
Return to Blackboard to access your blog and expand on this topic and evaluate the consideration of the labour market.
In preparation for the blog, the tutors will set-up the blog and provide a session via content on blackboard, as was the case in unit 2 and 8.
At the end of the unit your tutor will read your blogs to provide a formative overview on your understanding of labour market as you develop your blogs over the term of the module to help develop your learning.
Further resources
Core references:
Parkin, M., Powell, M., & Matthews, K., (2011). Economics. (8/ed). Pearson Education. (Chapter 21 & 24)
Further references:
Lipsey, R., & Chrystal, A. (2011). Economics. (12/ed). Oxford University Press. (Chapter 11 & 24)
Parkin, M, Powell, M., & Matthews, K., (2012). Essential Economics. Pearson Education. (Chapter 11 & 15)
Sloman, J., Hinde, K., & Garratt, D., (2013). Economics for Business. (6/ed). Pearson Education. (Chapter 18)
Sloman, J., & Jones, E. (2011). Economics and the Business Environment. (3/ed). Prentice Hall. (Chapter 8)
Unit 11: Coursework 2 – Business Case Study based Test
• Unit Introduction
Aims and Objectives:
• Demonstrate knowledge of basic economic models and the measurement of concepts used in the analysis of markets and pricing strategies in firms and industries.
• Demonstrate ability to use basic economic models to analyse a real world market, industry or problem.
Brief Introduction:
Within this unit students will undertake the final summative assessment
How long it should take to study? 2 hours
Any technologies used: case study
• Summative Marked Assessment 2
Assignment 2 (Case-study based Test) – within the period of this unit you will undertake the final assignment a case study based test (weighed 60%). This is a time-constrained test of 2 hours, and can be found in the assessment section on Blackboard. This is an invigilated, but open book and seen case study based test via blackboard.
The final test is based on a business case study, which students analyse before taking the test. The test focuses on the results of the student’s analysis. To be taken at or around the final week of the module.
This test covers materials from the full module topics, developed through a seen case study.
The test is integrated within Blackboard, but as it’s a case study based text, grades will be released after marking and then recorded in the grade area. You should not open either of these tests until you are ready to take them. You will only be allowed to open the tests once.