Introduction to












Study Guide






1                                Introduction to Economics


2                                The Market Mechanism


3                                Elasticity


4                                Costs of Production


5                                Price Takers – Perfect competition


6                                Price Makers – Monopoly


7                                Imperfect competition


8                                Labour Market


9                                Market Failure – The Case for Government Intervention


10                            Privatisation versus Nationalisation










·                     To teach students the basic principles of elementary microeconomics


·                     To develop student understanding of the relevance of these principles in analyzing real world situations.


·                     To introduce and develop essay writing skills.









1.1              THE ECONOMIC PROBLEM


What Is The Economic Problem ?


The scarcity of resources in relation to the calls made upon them imposes a choice on society as to the range of wants it wishes to satisfy.  A decision to satisfy one set of wants necessarily means sacrificing some other set: this is what economists refer to as the opportunity cost of satisfying wants.


The basic economic problem is that of allocating scarce resources among the competing and virtually limitless wants of individuals in a society.


The three basic questions that all nations have to decide in some way are what goods and services to produce, how to produce them and for whom to produce them.  In order to do this choices are made by households, firms and governments and these choices are coordinated through markets for both goods and services and factors of production.


The Distinction Between Micro and Macro Economics


Microeconomics is concerned with the behaviour of individual forms, industries, markets and consumers (or households).  This branch deals with the problems of resource allocation, considers problems of income distribution and is chiefly interested in the determination of relative prices of goods and services.


Macroeconomics concerns itself with large aggregates, particularly for the economy as a whole.  It deals with factors such as the determination of output and employment, the general price level, spending and saving, total imports and export, the demand and supply of money.


This course maintains the tradition and in the first semester we will look at aspects of microeconomics, whilst the second semester will be concerned with looking at the macro economy.  It should be pointed out that these two branches can never been completely separated from each other as there are many linkages and overlaps between them.  The analysis of unemployment, for example, draws on both micro and macro analysis.


Economic Methodology


Economic science seeks to understand the principles which determine the behaviour of households and firms and governments when they take decisions in the economy.  It is made up of two components 1) careful and systematic observation and measurement 2) The development of a body of theory to direct and interpret observations.  Thus an economic theory is a reliable generalization that enables up to predict the economic choices that people make and the economic effects of their choices.  The term methodology refer to the way in which economists go about the study of the subject matter.  There are broadly two approaches:


Positive economics is objective in that the validity of positive statements such as what is, was or will be can be tested by reference to facts.


Normative economics is concerned with making suggestions about the ways in which society is goal might be more efficiently realized.  This involves economists in such ethical questions as what should or ought to be.


For many years after the second world war economics was dominated by the positive approach to the subject, but there is a growing opposition to positivism and the hypo deductive methodology.  There is an increasing recognition that economics is a value laden subject.



Economists try to find economic principles by building models.  The predictions of the models form the basis of economic theories.



One of the simplest ways of constructing an economic model is the use of production possibility frontiers. What follows are examples of how these can be used to illustrate different economic situations.

Production possibility frontier - diminishing returns

A production possibility frontier will normally tend to be concave to the origin because of diminishing returns to factors of production. In other words switching resources from one use to another will lead to progressively smaller increases in output of the other good.

Production possibility frontier – growth (both goods)

An increase in the level of resources (or the efficiency of the resources) will shift the production possibility frontier outwards.


Production possibility frontier – unemployment



Any point inside the production possibility frontier indicates that there is unemployment or under-employment of some resources. Points on the PPF indicate that resources are being fully used and that an increase in the production of one good is only possible by decreasing production of another.


Production possibility frontier - growth (one good)


An increase in the level of resources (or the efficiency of the resources) for the production of just one good will lead to the production possibility frontier shifting at just one end.

Production possibility frontier - growth (both goods)

An increase in the level of resources (or the efficiency of the resources) will shift the production possibility frontier outwards.




The basic economic problem can be resolved through a number of different economic systems. We will examine the extreme cases of the free market and command economies.  In the real world, however, most economies are mixed to one degree or another.


A Free Market Economy


A free market economy is an economy where all economic decisions are taken by individual households and firms.




·                     Firms seek to maximize profits and households aim to maximize utility

·                     Workers seek to maximize their wages relative to the human costs of working in a particular job.


The Price Mechanism (Adam Smith’s Invisible Hand)


The system in a market economy whereby changes in price in response to changes in demand and supply have the effect that demand equals supply.


Goods Market


·                     Demand for a good rises creating a shortage

·                     This causes the price of the good to rise choking off the shortage and encouraging firms to produce more


Factor Market


·                     The increase in the supply of the good causes an increase in the demand for factors of producing used in making that good

·                     This causes a shortage of those inputs and causes the price to rise eliminating the shortage by choking off some of the demand and encouraging the suppliers of inputs to supply more.




·                     Functions automatically, no need for costly and complex bureaucracies.  Can quickly adapt to changing supply and demand decisions.


·                     Markets are competitive, which not only keeps prices down but is an incentive to firms to be efficient.


Adam Smith argued that the market mechanism ensured that an individual pursuing private gain results in the social good.




·                     Competition between firms often limited, the existence of monopolies or oligopolies results in higher prices and large profits.


·                     The market system is said to be efficient, but may ignore the principal of equity.  Power and property may be unequally distributed.




·                     Ignores social costs and benefits, therefore on the one hand there may be practices which are socially undesirable, and on the other some socially desirable goods would simply not be produced e.g. police force.


·                     Ethical objection, that a free market rewards self interested behaviour.


The Command Economy


A centrally planned economy is an economy where all decisions are taken by central authorities.




·                     The allocation of resources between current consumption and investment is planned.


·                     At a microeconomic level the output of each industry and firm is planned, along with the techniques used, the labour and resources that will be used.


·                     The distribution of output between different consumers is planned.






·                     Government could take an overall view of the economy and direct the nations resources in accordance with specific national goals.

·                     High growth rates possible if the government directed a large amount of resources into investment.

·                     Unemployment could be avoided if government carefully planned the allocation of resources.

·                     National income could be distributed according to need.

·                     Social repercussions of consumption and production can be taken into account.




·                     Costly to administer and cumbersome bureaucracy.

·                     No system of prices.  As prices are set arbitrarily, rational decisions are hard as they do not reflect scarcity.

·                     Difficult to devise appropriate incentives to ensure quality and motivation.

·                     May involve loss of individual liberty as consumers have little choice as to what to purchase.

·                     Difficult to avoid shortages and surpluses.


Most economies fall some way between the two extremes.  In a mixed economy the government may control the following:


·                     Relative prices of goods and inputs, by taxing or subsidising them or direct price controls.

·                     Relative incomes by the use of income taxes, welfare payment or direct controls over wages, rent and profits.

·                     Pattern of production or consumption by the use of legislation, by the direct provision of goods, by taxes and subsidies of goods and services provision.

·                     Macroeconomic problems: inflation, unemployment, lack of growth, balance of payments deficits, by the use of fiscal and monetary policy, the direct control of prices and incomes and the control of the foreign exchange rate.




The efficiency of the market as a way of allocating resources in a society underpins much of the content of microeconomics.  It raises pertinent questions such as, should the health service be provided by the market.  I will be elaborating on many of the ideas touched on in this lecture, such as perfect competition, market imperfection and market failure.




KEY CONCEPTS – you are advised to learn ALL of these



Opportunity cost

Production possibility curve

Resource allocation

Market mechanism

Centrally planned or command economy

Pur free market economy

Mixed economy






2.1              DEMAND


The Law of Demand


The quantity demanded is the amount of a good or service that consumers plan to buy in a given period.


When the price of a good rises the quantity demanded will fall.  There are two reasons for this law:


·                     The Income Effect means that the people’s income will be reduced and therefore they buy less or the good.


·                     The Substitution Effect means that as the good is more expenses relative to other goods, people will switch to buying other goods.


The Demand Curve


The market demand schedule shows the total demand by consumers at each price over a given time period.



A demand curve shows the quantity that a consumer is willing                        
and able to buy at each price level. The market demand curve
will be the combination of all the individual demand curves.

It is possible for a demand curve to slope the wrong way (an increase in price leads to an increase in demand) in certain circumstances. For example, a Giffen good, or a good that has 'snob value' and is therefore bought because of its price.







Other Determinants of Demand


1.                               The price of related goods

2.                               Income

3.                               Expected future prices

4.                               Population

5.                               Preferences



Movements Along and Shifts in the Demand Curve


A movement along the demand curve occurs as a result of a change in price.  A shift in demand is when a change in a determinant other than price causes demand to all or rise, in this case the whole demand curve will shift to the left or right.

When price changes, the consumer will move along the demand curve. This may be a contraction in demand (less demand because price has risen) or an extension in demand (more demand because price has fallen).


Contraction in Demand – Under “Movement along same demand schedule”
Shift diagrams, left and right



2.2              SUPPLY


The quantity supplied is the amount of a good that producers plan to sell in a given period of time.



Supply Curve

Shifts and movements in supply.

Contraction in supply

Extensions in supply

















When the price of a good rises the quantity supplied will also rise.  There are three reasons for this:


·                     As more is supplied, producers will find beyond a certain output costs rise more rapidly.  (This will be explained in detail when the costs of production are examined).  Thus if higher output involves higher costs of production, producers will need to get a higher price in order to persuade them to produce extra output.


·                     The higher the price, the more profitable it becomes to produce.  Firms will produce more by switching production from producing less profitable goods.


·                     In time a higher price will attract new producers to the market and total market supply thus rise (Diagram 2.3).



Other Determinants of Supply


1.                               Prices of factors of production

2.                               Prices of related goods

3.                               Expected future prices

4.                               The number of suppliers

5.                               Technology



Movements Along and Shifts in the Supply Curve


The effect of change in price is illustrated by a movement along the supply curve.  If a determinant other than price changes the whole supply curve will shift left or right.


2.3              PRICE DETERMINATION


The determination of equilibrium price and output can be shown by using demand and supply curves.  Equilibrium is the point at which the two curves intersect.


At any price above the equilibrium price there will be a surplus as supply will exceed demand.  The price will fall in order to clear the market.  At any price below the equilibrium price there will be an excess demand.  The shortage will bid the price upwards.



Market Equilibrium (pl)





KEY CONCEPTS – you are advised to learn ALL of these



Determinants of demand

Shifts in demand

Movements along demand curve


Shifts in supply

Movements along supply curve








Price Elasticity of Demand is the responsiveness of quantity demanded to a change in price.


PED =   percentage change in the quantity demanded

                        percentage change in price


Normally we would expect n to have a negative sign since either price or quantity in the equation above will be a minus figure.


The Value


Ignoring the sign and concentrating on a value of the figure, tells us whether demand or supply is elastic or inelastic.


Elastic (n > 1) where a change in the price causes a proportionately larger change in demand.


Inelastic (n < 1) where a change in the price causes a proportionately smaller change in demand.


Unit elasticity ( = 1) where demand changes by the same amount as the price.




Calculate the price elasticity of demand in the following examples:


1.                               When the price of salt increases by 50% the quantity demanded falls by 5%.


PED = 5%/50% = -0.1.


2.                               When the cost of mortgages goes up by 5% the quantity demanded falls by 15%.


PED = 15%/15% = -0.3.


3.                               When the price of sports shoes goes up by 10% the quantity demanded falls by 5%.


PED = 10%/5% = -2.0.


4.                               When the price of Reeboks increases by 10% demand falls by 15%.


PED = 15%/10% =  -1.5.


Factors Affecting The Price Elasticity of Demand


1.                               The ease of substitution of another good or service.


2.                               The proportion of income spent on a good.


3.                               Whether the good is s necessity or a luxury.


4.                               The period of time since the price change.






1.                               Pricing strategy of firms


The total sales revenue (TR) is price times quantity (TR = PxQ).


Elastic demand


P rises, Q falls disproportionately, TR falls


P falls, Q rises disproportionately, TR rises


Inelastic demand


P rises, Q falls proportionately less, TR rises


P falls, Q rises proportionately less, TR falls


2.                               Advertising Strategy


It is in the interests of firms to try to make demand inelastic by creating brand loyalty and reducing substitutes.


3.                               Government Taxation


It helps to explain why the government tax goods with price inelastic demand such as alcohol and cigarettes rather than goods with elastic demand.


**All diagrams here***

3.2                          INCOME ELASTICITY OF DEMAND


Income elasticity is the responsiveness of demand for a commodity to changes in income.


YED    =          percentage change in the quantity demanded

                                    percentage change in income


Income elastic                           n > 1


Income inelastic                        n between 1 and 0

(normal good)


negative income elasticity           n < 0

inferior good



Factors Affecting Income Elasticity of Demand


1.                               Degree of necessity of a good


2.                               The rate at which the desire for a good is satisfied as consumption increases.


3.                               The level of income of consumers




Income elasticity is an important concept of firms in considering the size of the market for this product, in response to changes in national Income over the long term and short term fluctuations in the economy.


*Income Elasticity Diagrams, if there*


3.3                          CROSS ELASTICITY OF DEMAND


This is the responsiveness of demand for one good to a change in the price of another.


CEDab  =  percentage change in quantity demanded of Good A

                        percentage change in the price of Good B


This relationship will be positive if the goods are substitutes and negative if the good are complements.




Provides a measure for firms of the extent to which their goods are substitutes for other goods, and therefore indicates the degree of competition in the market.



3.4                          PRICE ELASTICITY OF SUPPLY


PES =   percentage change in quantity supplied

                    percentage change in price


Factors Affecting Elasticity of Supply


1.                               Spare Capacity


2.                               Time lags


Supply elasticities are usually positive with values greater than zero.


Supply Diagrams, if there





1.         Rising prices when there is insufficient spare capacity in the economy to respond to an increase in demand.


2.         Inelasticity of supply in the short run contributes to understanding why the price of primary products tends to be more volatile than the price of manufactured goods.








KEY CONCEPTS – you are advised to learn ALL of these


You need to know the definition and the formulae in all cases


Price elasticity of demand

Income elasticity of demand

Cross elasticity of demand

Price elasticity of supply

Time lags








The theory of production and costs provides an analysis of how price signals should be translated into effective production decision, so that not only are markets provided with what they demand but also production is by the least cost method.


Market constrains are technology constraints limit the amount of profit a firm can make.  Most firms are in business to make the most profit possible bearing in mind these two constraints and they attempt to do so by maximizing output and/or minimizing cost.


Firms in wishing to alter its total product (i.e. the total quantity produced) are constrained by limited factors of production.  In the short run they may be able to only alter one input, for example it may take several months or years to obtain a new machine that makes the production process more efficient, but in the meantime they can increase the amount of labour used.  The new machine may come on stream in the long run, which is a period of time when all input can be varied.  With increased labour and new machinery, production cannot go on increasing indefinitely and firms are subject to the law of diminishing returns.


The Law of Diminishing Returns


This underpins the short run production function.  The Law of Diminishing Returns states that as successive increases in a variable factor are added to other fixed factors of production, such as capital, there will be a point beyond which the extra or marginal product will decline.


Diminishing Returns








The short run is a period of time over which at least one factor of protion is fixed, the calendar time will vary from firm to firm.


All firms are subject to costs which can be split up into fixed and variable costs as follows:


Fixed Costs are fixed in the short run e.g. rent, interest.


Variable costs vary with output e.g. raw materials, components, labour.




Total cost (TC)             =          total fixed cost (TFC) + total variable cost (TVC)


Average total cost (ATC)   =                 total cost           =          TC       =          TFC+TVC

                                                                  Q                           Q                           Q


Average fixed cost (AFC)         =          total fixed cost          =               TFC

                                                                 output                                    Q



Average variable cost (AVC)    =          total variable cost          =          TVC

                                                                   output                                  Q



Marginal cost is the increase in total cost resulting from a unit increase in output:


Marginal cost (MC)       =          change in total cost        =          r      TC

                                                  change in output                        r       Q



Note: as total fixed costs do not change, it is only affected by changes in variable costs therefore:


Marginal cost (MC)       =          r      TVC

                                                r        Q



Table 4.2
















Diagram 4.2









Diagram that shows total fixed costs, total variable costs, and total costs.












The Long Run Total Cost Curve


This describes the cost of producing each output level when the firm is able to adjust all inputs optimally, in other words in the long run all costs are variable and it depends on the firm’s production function.


Returns to Scale


Constant – the percentage increase in output = the percentage increase in inputs.


Increasing – the percentage increase in output > the percentage increase in inputs.


Decreasing – the percentage increase in output < the percentage increase in inputs.



Diagram 4.3








Diagram that shows economies of scale, diseconomies of scale and constant costs.


























Plant Economies of Scale or Technical Economies of Scale


1.                   Specialisation and divisions of labour.  Workers and managers can be employed who have specific skills in particular areas.


2.                   Indivisibilities.  Some inputs are a minimum size.  If there are two types of machines, one producing 6 units per day and one 4 units per day.  A minimum of twelve units would have to be produced, with two producing machines and three packaging machines if all machines are to be fully utilized.


3.                   The Container principle.  Any capital equipment that contains things (blast furnaces, pipes, vats, lorries) tend to cost less per unit of output the larger the size.


4.                   Greater efficiency of large machines.  Only one worker may be required to operate the machine.


5.                   Multi stage production.  A large factory will be able to take a product through several stages of its manufacture.


Other Economies of Scale include:


Organisational economies


Research and development


Spreading Risk


Financial economies


Diseconomies of Scale


When firms get beyond a certain size, costs per unit of output may start to increase.  There are several reasons for these diseconomies of scale.


Management problems of coordination.


Workers’ motivation may decrease and industrial relations may deteriorate.


Complex interdependencies of mass production may lead to disruption if there are any hold ups in any particular part of the firm.


External Economies


There has been a revival of interest in Marshallian industrial districts.  It is argued by some economists and economic geographers that there are substantial benefits to be gained from firms in the same area of production clustering together.  They may benefit from the presence of suppliers, distributors, a skilled labour market, specialist research and development institutions.  Areas frequently quoted as examples are the Emilia Romagna area of Italy, Baaden Wurtemburg in Germany (engineering) a, Silicon Valley in California USA.





KEY CONCEPTS – you are advised to learn ALL of these


Fixed costs

Variable costs

Law of diminishing returns

Long run

Short run

Economies of scale

Diseconomies of scale








The market structure under which a firm operates will determine its behaviour.  Firms under perfect competition will behave differently from firms which are monopolies.  This behaviour or conduct will in turn affect the firm’s performance, profits, prices and efficiency.  Economists thus see a casual chain running from market structure to the performance of that industry.




Table 5.1


Features of the Four Market Structures




Type of market


Number of Firms

Freedom of entry

Nature of product


Implication for demand curve for firm




Very many




Cabbages, carrots

(these approximate to perfect competition)

Horizontal.  The firm is a price taker.

Monopolistic competition





Plumbers, restaurants

Downward sloping, but relatively elastic.  The firm has some control over price





1. Undifferentiated or 2. Differentiated

1. Cement 2. Cars electrical appliances

Downward sloping, relatively inelastic but depends on reactions of rivals to a price change



Restricted or completely blocked


British Gas (in many parts of Britain), local water company

Downward sloping, more inelastic than oligopoly.  The firm has considerable control over price




5.2              PERFECT COMPETITION


Perfect competition is considered as the ideal or the standard against which everything is judged. Perfect competition is characterised as having:


Many buyers and sellers. Nobody has power over the market.

Perfect knowledge by all parties. Customers know that all products are the same. Advertising cannot persuade them otherwise.

Any seller has only a very small portion of the market. Again, suppliers cannot put pressure on the market.

Firms can sell as much as they want, but at the price ruling. Thus sellers have no control over market price. They are price takers, not price makers.

All firms produce the same product, and all products are perfect substitutes for each other.

There is no advertising.

There is freedom of entry and exit from the market. Sunk costs are few, if any. Firms can, and will come and go as they wish. Potential losses are zero, or very small.

Companies in perfect competition in the long-run are both productively and allocatively efficient.


Equilibrium under perfect competition



In perfect competition, the market is the sum of all of the individual firms. The market is modelled by the standard market diagram (demand and supply) and the firm is modelled by the cost model (standard average and marginal cost curves). The firm as a price taker simply 'takes' and charges the market price (P* in figure 1 below). This price represents their average and marginal revenue curve. Onto this we superimpose the marginal and average cost curves and this gives us the equilibrium of the firm.




Figure 1 Equilibrium of the firm and industry in perfect competition





Firms in equilibrium in perfect competition will make just normal profit. This level of profit is just enough to keep them in the industry and since profits are adequate they have no incentive to leave.



Normal profits


Normal profit is the level of profit that is required for a firm to keep the resources they are using in their current use. In other words it is enough profit to keep them in the industry. Anything in excess of normal profits is called abnormal or supernormal profits.






Any profit above normal profit is a 'bonus' for the firms, as it is more then they need to keep them in the industry. We call this supernormal (or abnormal) profit. However, this supernormal profit will be a signal to other firms and will attract more firms into the industry. If firms are making consistently below normal profits then they will choose to leave the industry.



What does this mean for prices and competition? Consider the following case.



A firm enters a perfectly competitive market with a product. It sells Q1 units of its product at price P1. It is able to make supernormal profits at this stage. It sells at P1 but has a cost of only C. It makes SNP's of P1 - C per unit sold. This is shown below.



Figure 2 Firm in perfect competition making supernormal profit



Competition is perfect. New firms enter the market. Supply increases (the supply curve shifts to the right - S2 in figure 3 below) and prices fall. The original firm has to lower its price or it will sell nothing. It charges P2 (the same as the market price) and so now sells only Q2. The market size expands from Q1 to Q2. Look at the modified diagram below.




Figure 3 The impact on a market of supernormal profit



The presence of SNP's has attracted more firms to the market and this led to the price falling. The supernormal profits were competed away and equilibrium was reached where only normal profit was earned. Each of the firms will now be in long run equilibrium earning only normal profit. The long run equilibrium is where MC = MR = AC = AR. This can be seen in figure 4 below.



Figure 4 Long run equilibrium in perfect competition



The falling prices put pressure on the less efficient firms. They may be forced to close and transfer their assets elsewhere.



Short-run losses



A firm with high costs may face a short-term loss-making situation during this process. It is not at risk in the short-run provided price at least covers its variable cost. Its fixed costs are prepaid, so it has breathing time. This is shown below. The price, P*, covers variable costs and some fixed costs. A loss of C - P* is made, but they have breathing time.



Figure 5 Short-run losses



The firm will have to get more efficient, or others will have to leave the industry so that prices may rise. If this happens in the short-run the market will be back in equilibrium, no firm will make SNP's and no firm will be making a loss. The market will settle down with no firms making losses and no firm making SNP's. It will be in equilibrium, as shown earlier. Look at the diagram again, you must know it and be able to explain its development.




Figure 6 Long-run equilibrium of firm and industry in perfect competition



So, perfect competition is a model of an efficient form of competition. Efficient firms face well informed consumers. Only normal profits are made, so prices are not excessive. Resources are used effectively and efficiently.


Allocative Efficiency.



Do perfectly competitively industries exist?



No 'perfect' perfectly competitive industries exist. Ironically, one of the closest today is probably the market for shares. However, as we mentioned before it is still an important model as it provides a benchmark of what we, as economists, regard as ideal and allows us to judge other industries against the 'ideal'. This should help us formulate appropriate policies to improve uncompetitive



Perfect Competition and the Public Interest




·                     Price equals marginal cost.  Given that price equals marginal utility (how much satisfaction a consumer places on a good), marginal utility will equal marginal costs.  This it is argued is optimal. 


·                     If a firm is less efficient than other firms it will make less than normal profit and be driven out of business.  If it is more efficient it will earn supernormal profits.  Thus competition will act as a spur to efficiency.


·                     The desire to earn supernormal profits and to avoid making a loss, will encourage the development of new technology.


·                     The lack of advertising (all goods are homogenous) will lower firms costs.


·                     The long run equilibrium is at the bottom of the firm’s long run average cost curve therefore will produce at the lowest cost output.


·                     Consumer gains from lower prices, since not only are costs low, but there are no long run supernormal profits.


·                     If consumer tastes change the price change will lead to the form to respond.


These last two points are said to lead to consumer sovereignty.  Consumers through the market decode what, and how much is produced.




·                     Even though firms may have the technology to develop new technology they may not be able to afford the necessary research and development.  May be afraid that if their rivals copy them the investment would have been a waste of money.


·                     Perfectly competitive industries produce undifferentiated products.  This lack of variety may be seen as a disadvantage to the consumer.


This occurs when no resources are wasted – when no one can be made better off without making someone else worse off.  Three conditions must be satisfied to achieve allocative efficiency:


Obstacles to Efficiency


The two main obstacles to efficiency are:


External costs and benefits and the existence of monopoly.


Thus we have seen how a firm in a perfectly competitive market chooses its profit maximizing output.  We have seen how the actions of all firms combine to determine a market supply.  We have seen how a competitive industry operates in the short run, we have studied the dynamic forces and move such a market to along run equilibrium.  The model of perfect competition allows us to understand important features of real world markets even though many markets do not approximate this model.





KEY CONCEPTS – you are advised to learn ALL of these


Perfect competition


Price taker


Short run under perfect competition


Long run under perfect competition


Normal profit


Supernormal profit


Profit maximization under perfect competition


Long run equilibrium


Close down point


Allocative efficiency




What Is A Monopoly


An industry where there is a single supplier of a good or service that has no close substitutes and in which there is a barrier preventing new firms from entering is a monopoly.  In practice the boundaries of an industry are arbitrary, and the determination of monopolies is along and costly business for institutions such as the Monopolies and Mergers Commission.


Barriers To Entry

·                     Legal barriers e.g. law, licence or patent restrictions.

·                     Natural monopoly e.g. a unique source of supply of a raw material or economies of scale.

·                     Economies of scale.

·                     Production differentiation and brand loyalty.

·                     Ownership of wholesale and retail outlets.

·                     Mergers and takeovers.

·                     Aggressive tactics and intimidation


Demand and Revenue


Since in a monopoly there is only one firm, the demand curve facing the firm is the demand curve facing the industry.

Table 6.1

                Price                        Total haircuts demanded            Total revenue                Marginal revenue

            £ per haircut             (per hour)                         (TR = P X Q)              


                    10                         0                                              0

                                                                                                       ……………..   9

                      9                                    1                                              9

                                                                                                        ……………..  7

                      8                                    2                                              16

                                                                                                        ……………..   5

                      7                                    3                                              21

                                                                                                         …………….   3

                      6                                    4                                              24

                                                                                                          ……………   1

                      5                                    5                                              25

                                                                                                          …………  -1

                      4                                    6                                              24

                                                                                                          …………  -3

                      3                                    7                                              21

                                                                                                          ……………   -5

                      2                                    8                                              16

                                                                                                          ……………   -7

                       1                                   9                                                9

                                                                                                           …………  -9

           1                                   10


It is important to notice that the marginal revenue curve is below the demand curve (average revenue).  Why is marginal revenue less than price?  Because when the price is lowered to sell one more unit, there are two opposite effects on revenue.  The lower price results in a revenue loss but the increased quantity results in a revenue gain.  Over the range 0 to 5 haircuts marginal revenue is positive.  When more than 5 haircuts are sold marginal revenue becomes negative.



When marginal revenue is positive total revenue is increasing.  When marginal revenue is negative total revenue is declining.  When marginal revenue is zero total revenue is at a maximum.


Revenue and Elasticity


We have already established a connection between elasticity of demand and the effect of a change in price on total revenue.  If demand is elastic total revenue increases when the price falls.  If demand is inelastic, total revenue decreases when price falls.  The output range over which total revenue increases when price decreases is the same as that over marginal revenue is positive.  Thus the output range over which MR is positive is also the output range over which demand is elastic.



Diagram 6.1 AR and MR Curves for Firm Facing a Downward Sloping

Demand Curve


























This relationship has an important application which is that a profit maximizing monopoly never produce an output in the inelastic range or the demand curve.  But exactly what price and quantity does a profit maximizing monopoly firms choose?


Equilibrium price and output


Although the monopolist is a price maker and can choose which price to charge, it is still constrained by the demand curve.


A monopolist (like a perfectly competitive firm) will maximize profits where MR = MC.  The economic profit is shown by the shaded area.





Diagram 6.2    Profit Maximisation Under a Monopoly



























Monopoly and the Public Interest


Disadvantages of monopoly


·                     Higher price and lower output than under perfect competition (Diagram 6.3)

·                     Possibility of higher cost curves due to lack of competition (x-inefficiency)

·                     Less innovative.



Diagram 6.3




















Advantages of monopoly:


·                     Economies of scale and scope.

·                     Possibility of lower cost curves due to more research and development

·                     Innovation and newer products.


Monopolists and Price Discrimination


Price discrimination is the practice of charging some customers a higher price than others for an identical good.  British Rail is an example of this with higher prices for commuters and off-peak discounts for students and elderly people.  Price discrimination increases a monopolist’s profits by increasing its revenue.  Three conditions are necessary.


1.                               The firm must be a price setter.

2.                               Markets must be separate, with no leakages.  That is consumers in the low price market must be able to resell the good or service in the higher priced market.

3.                               Demand elasticity must differ in each market.  The firm will charge a higher price in the market where demand is less elastic, and thus less price sensitive.


Case Study – Car Prices in the European Union


The discriminating monopolist divides sales between the two markets.  In the combined market it equates MR with MC, this would given an output of 25,000 cars at a price of £3250, giving a total revenue of £81.25m.  However by equating MR and MC in the separate markets it increases total revenue while keeping costs the same.  In Market A 15,000 cars are sold at £3000, total revenue £45m. and in Market B 10,000 cars are sold at £4000, total revenue £40,.  Total revenue £85m. an increase of £3.75m on the combined market price.


Diagram 6.4

















Combined market = £3,250 X 25,000 = £81.25 million


Market A = £3000 X 15,000 = $45 million

Market B = £4000 X 10,000 = £40 million


Original revenue = £81.25 million                        New revenue with price discrimination = £85 million



Comparing Monopoly and Competition


·                     Monopoly charges a higher price and produces a lower quantity than under competition.

·                     Monopoly prevents some of the gains from trade so is less efficient than competition.

·                     Monopoly reallocates surplus from the consumer to the producer.

·                     Monopoly may be more efficient than competition where economies of scale or scope are available.


Theory of Contestable Markets


Recently some economists have suggested that what is crucial in determining price and output is not whether an industry is actually a monopoly or competitive, but whether the treat of competition exists.


A market is said to be perfectly contestable when the costs of entry and exit by potential rivals are zero, and when such entry can be made rapidly.  In such cases the possibility of earning economic profits attracts new firms to enter, thus driving profits down to a normal level.  The theory argues that the threat of this happening, will ensure that firms already in the market will a) keep prices down so that it just makes normal profit, and b) produces as efficiently as possible taking advantage of economies of scale and new technology.  If the existing firm did not do this, entry would take place and potential competition would become actual competition.


UK Policy Towards Monopolies and Mergers


There are two main bodies concerned with the operation of monopoly and merger policy; the Office of Fair Trading (OFT) and Competition Commission (CC).


The CC is an advisory body which investigates suspected abused of monopoly power or proposed mergers.  This includes investigating:


·                     Any single firm whose current market share is 25 per cent of the national or local market.  Or two firms whose joint share is 25 per cent or more.

·                     Any proposed merger that would result in a firm having assets of 30 million, or a 25 per cent share of the market.


The OFT investigates and reports on any anti-competitive practices.  These were specified by the 1980 Competition Act as the following:


·                     Price discrimination.

·                     Predatory pricing (selling below cost to drive out competitors).

·                     Vertical price squeezing (where a vertically integrated firm which controls the supply of a good charges a higher price for that input to competitors).

·                     Tie in sales (where the firm controlling the supply of a first product insists that its customers buy a second product from it rather than its rivals.

·                     Selective distribution: where a firm is prepared to supply only certain retail outlets.


Assessing UK Monopoly and Merger Policy


Monopoly Policy


·                     Too often the CC has been ready to accept a firms assurances and there has been too little follow up to ensure that firm has done what it said

·                     Minister can accept or reject the CCs findings

·                     Out of thousands of possible cases for investigation only some 160 have been referred to CC since 1948.


Merger policy


The vast majority over (97 per cent) of proposed mergers have not been referred to the CC.  A major criticism that the policy has not been tough enough, with many mergers not referred which should have been.  Many studies show that mergers have not been in the public interest with anti competitive effects outweighing those that economies of scale may have produced.




1.                               Explain why the marginal revenue curve lies below the average revenue curve for a monopolist.


2.                               Why will a monopolist chose not to produce in the range or output where the demand curve is inelastic?


3.                               Answer the following questions in relation to Diagram 6.5.


(i)                                                      At what price will the monopolist sell the product?

(ii)                                                    What is the average cost per unit of output at the selling price?

(iii)                                                   Which area represents the monopolist total profit?

(iv)                                                  What is the optimum level out output?

(v)                                                    What is the highest possible level of price the monopolist could charge and still break even?

(vi)                                                  What level of output corresponds to the perfectly competitive level of output?


Diagram 6.5





KEY CONCEPTS – you are advised to learn ALL of these




Barriers to market entry


Downward sloping demand curve


Revenue and elasticity


Profit maximizing price and output


Monopoly and public interest


Monopoly and competition compared


Contestable markets


Monopoly and merger legislation









·                     Quite a large number of firms.  Each firm has an insignificantly small share of the market.


·                     Independence.  As a result of the above it is unlikely to affect its rivals to any great extent.  In making decisions it does not have to think about how its rival will react.


·                     Freedom of entry.  Any firm can set up business in this market.


·                     Product differentiation.  Each firm produces a different product or service different from its rivals.  Therefore each firm faces a downward sloping demand curve.


Examples:  Petrol stations, restaurants, hairdressers and builders are all examples of monopolistic competition.  A typical competition.  A typical feature is that there is only one firm in a particular location.  There may be many chip shops in town but only one in a particular street.  People may be prepared to pay high prices than go elsewhere.


Short Run – Output and Price


Profits are maximized where MC = MR.

AR and MR are more elastic than for a monopolist.

Profits depend on the strength of demand, the position and elasticity of the demand curve.


Long Run – Output and Price


·               Firms will enter the industry attracted by economic profits.

·               Demand will fall and AR will shift to the left.

·               Long run equilibrium is where only normal profits are being made.

·               Demand (AR) will be tangential to the firm’s long run average cost curve.


Diagram 7.1   Equilibrium Under Monopolistic Competition



















Limitations of Model


·                     Imperfect information

·                     Difficulties in deriving the demand curve for the industry as a whole

·                     Size and cost structure mean that normal and supernormal profits can be made in the long run by firms in the same industry.

·                     The simple model concentrates on price and output, however in practice the firm will need to decide the variety of the product and advertising.


Monopolistic Competition and the Public Interest


·                     Monopolistically competitive firms, may have higher costs than perfectly competitive firms, but consumers gain from greater diversity.

·                     Monopolistically competitive firms may have fewer economies of scale and conduct less research and development, but competition may keep prices lower than under monopoly.


2.2              OLIGOPOLY




Oligopoly is defined as an industry in which there are a few firms.


·                     By a few it is meant that the number of firms should be sufficiently small for there to be conscious interdependence, with each firm aware that its future prospects , depend not only on its own policies, but also those of its rivals.

·                     An industry is defined as a group of firms where the firms products are close substitutes for one another, that is have a high and positive cross elasticity of demand.




The rise of oligopolies can be charted in a number of ways.


1.                               The Size distribution of firms.  This is measured in terms of output, employment or turnover.

2.                               Concentration ratios.  This shows the proportion of output accounted for by the five largest firms.

3.                               Advertising expenditure.  This is an indirect method of gauging the rise of oligopoly markets and the tendency towards product differentiation.


Competition and Collusion


Oligopolies are pulled in two different directions.


·                     The interdependence of firms makes them wish to collude with each other.  By behaving as a monopoly they could maximize industry profits.


·                     On the other hand they will be tempted to compete with their rivals to gain a bigger share of industry profits.


2.3              COLLUSIVE OLIGOPOLY


When a oligopoly is non-collusive the firm uses guesswork and calculation to handle the uncertainty of its rivals reactions.  However another way of handling uncertainty in markets which are interdependent is by some form of central co-ordination.  One form of collusion is to form a cartel.  A cartel is the establishment of some central body with responsibility for setting the industry price and output.  They are against the law in most countries including Britain.

When firms engage in collusion they may agree on prices, market share, advertising expenditure etc.


The cartel will maximize profits if it behaves as monopoly.


The total market demand curve is shown with the corresponding market MR curve.  The cartel’s marginal cost curve (MC) is the horizontal sum of the MC curves of its members.  Profits are maximized at Q1 where MC = MR.  The cartel must therefore set a price of P1 at which Q1 will be demanded.


Having agreed on the cartel price the members may then compete against each other using non-price competition to gain a bigger share of Q1 as is possible or they may somehow decide to share the market between them.


Diagram 7.2  Profit Maximising Cartel


















Tacit collusion – Price leadership


As we saw in the previous chapter cartel are effectively prohibited in the United Kingdom and many other countries.  Firms may try to break the law or likely they will remain within the law, by tacitly colluding by watching each others prices and keeping theirs similar,  Thus firms tacitly agree to avoid price wars or aggressive adverting campaigns.


Dominant firm price leadership.  Where firms (the followers) choose the same price as that set by a dominant firm in the industry (the leader).


Barometric price leadership.  Where the price leader is the one whose prices are believed to reflect market conditions in the most satisfactory way.  This may be a smaller firm.


Average cost pricing.  Where a firm sets its price by adding a certain percentage on top of the average costs.


Breakdown of collusion


Cartels can be vulnerable to pressures.  For example, the International Transport Association (IATA) the cartel for international airlines sought to set prices for each route.  During the 1970s it was seriously weakened by price cutting competition from non-member airlines.  It was further weakened by the world recession with lower incomes causing weak demand for air travel (with a high income elasticity of demand) to fall dramatically.  In order to fill seats they began to compete amongst themselves.






The Kinked Demand Curve Theory


Output and Price of Oligopolies


The central theory of market theory is to predict how firms will set prices and outputs.  In oligopoly where there are a few firms and product differentiation, there is not the precision as with perfect competition and monopoly.


The Kinked Demand Curve


The most popular theory of the oligopolist this theory of the kinked demand curve proposed by Hall and Hitch in the UK and Sweezy in the US.  From extensive interviews with managers Hall and Hitch conclude that most firms have learnt a common lesson from past experience as to how their rivals react.


If the firm raises it price above a certain level Po, then its rivals will not follow suit and the firm will lose sales.  The firm would expect its demand curve to be relatively elastic for rises in price.  An increase in price of P2 would bring about a relatively large fall in quantity demanded.


If the firm were to reduce its price rivals would follow suit in order to protect its market share.  Thus a reduction in price to P1 would bring about only a small increase in quantity demanded.  Thus the firm would expect its demand curve to be relatively inelastic for reduction in price.


Overall the firm will believe its demand curve to be kinked at the current price Po.


Diagram 7.3  Kinked Demand Curve Under Oligopoly
























Price cutting as a strategy tends to lead to a competitive downward spiral in firms prices and price wars which in turn leads of a fall in revenue.  Oligopolistic firms tend to prefer to engage in non-price competition.




The Problems with the Kinked Demand Curve


·                     The theory does not explain how oligopolists se the initial price, only why the price might be stable.


·                     The stickiness of price may have little to do with rival firms reaction patterns but with the administrative expense of changing price.


6.6                          Oligopoly and the Public Interest


If oligopolists act together collusively and jointly maximize profits then the same disadvantages as those experienced under a monopoly will be experienced.


·                     Depending on the size of the oligopoly there may be less scope for economies of scale to mitigate the effects of market power.


·                     Oligopolists are likely to engage in much more extensive advertising which increases the demand of the product.


·                     Countervailing power may exist.  For example, when the buyer of the goods is also a big firm they may prevent prices from being pushed up.


Advertising and the Public Interest


Under perfect competition and monopoly advertising is pointless.  Under imperfect competition advertising is often a major means of competing.


Supporters of advertising claim:


·                     Advertising provides information on new products

·                     It is necessary to introduce new products

·                     Aids development by emphasizing special features

·                     May encourage price competition

·                     Increases sales and enables economies of scale


Critics suggest that advertising imposes serious costs on the consumer and society.


·                     Consumers do not have perfect knowledge and may be misled

·                     Creates wants and therefore increases scarcity

·                     Waste of valuable resources which have an opportunity cost

·                     Increases the price paid by the consumer

·                     Creates a barrier to the entry of new firms

·                     May impose a cost of society by being annoying tasteless and unsightly














1.                               Look at Diagram 7.4 below.


(i)                                                      Identify Curves I, II, III and IV.

(ii)                                                    What is the long run equilibrium price and quantity





2. Why is advertising expenditure a measure of the rise of oligopoly?


3.In what ways to the following industries differentiate their product: cars, banks petrol stations, supermarkets.



KEY CONCEPTS – you are advised to learn ALL of these


Monopolistic Competition


Oligopoly – measurement of

Collusive Oligopoly


Joint profit maximization

Tacit collusion

Price leadership

Non collusive oligopoly

Kinked demand curve









In a market economy not only goods but the factors or production which go towards the making of those goods are also no sale.  Indeed in many cases the same commodity could be regarded as a factor of production or a consumer good satisfying final demand depending upon the use to which it is put.  Thus a hi-fi system which is bought and installed in someone’s home is a consumer good; the same hi-fi system installed in a shop or a pub is properly thought of as a factor of production since its purpose is to contribute to the output and profits of that firm however measured.  The principal factors of production:  land, labour, and capital each have markets and therefore prices generally referred to as: rent, wages and interest.


The demand for factors of production is normally referred to as ‘derived’ demand, which is to say that the factor is not wanted for itself but rather for what it can contribute to final output.  The supply clearly comes from individuals who own factors of production.  Typically in the case of land and capital its ownership is concentrated in a relatively small group while labour (the ability to do useful work) may well be the only factor of production that many households own.  In order to convert the ownership of a factor into an income it is necessary, of course, to enter the factor market.


In this lecture we look at labour markets and briefly at the market for land.  In the next lecture we will examine returns to capital in more detail.




The price (wages) in the labour market depends, like any other price, on the demand and supply.  Traditional analysis relates the demand of potential employers to the marginal revenue product (MRP) which measures the employers evaluation of the impact of an additional worker on the firm’s total revenue.


8.1                                                                                                                                                                                                              WAGE DETERMINATION UNDER PERFECT COMPETITION


The Supply of Labour


The supply of labour is offered by households and the traditional assumption is that more work will be offered for higher wages.  However, it has long be recognized that for some individuals or groups or workers higher wages might lead to a reduction in hours of work offered, the worker in effect taking the higher real income as leisure preference.  The outcome would be a ‘backward bending’ labour supply curve.


Diagram 8.1

















The Demand for Labour


Under competitive conditions MRP equals MPP (marginal physical product) times price, since each additional unit produced by the marginal worker can be sold at a given price.  Under monopoly conditions MRP will be less than MPP times price since additional units, could only be sold if the price of the product as a whole were reduced.


Labour              Output              Marginal product           Marginal Value             Wage rate         Extra

Input                 (Goods)            of labour                       (MPL x £500)               (£)                    profit (£)



0                                                                                                                  0


1                      0.8                                                        400                               300                   100


2                      1.8                                                        500                               300                   200


3                      3.1                                                        600                               300                   350


4                      4.3                                                        600                               300                   300


5                      5.4                                                        550                               300                   250


6                      6.3                                                        450                               300                   150


7                      7.0                                                        350                               300                     50


8                      7.5                                                        250                               300                   -50



Firm’s Employment Rule


Employ workers up to point where Wage = Marginal Revenue Product

















The firm sells output for a given price and hires labour at the given wage Wo.  Marginal productivity makes the MRP curve slope downwards.  Below L* extra employment adds more to revenue than labour costs.  Above L* extra employment adds more to revenue than labour costs.



8.2                                                                                                                                                                                                              WAGE DETERMINATION IN IMPERFECT MARKETS


In the real world few markets correspond to perfect markets:


·                     Firms have market power in selling goods, they may be operating under conditions of monopoly, oligopoly or perfect competition.


·                     Firms may have market power in employing labour.  This situation is called monopsony.  When there are just a few employers it is called a oligopsony.


·                     Workers may have market power as members of unions.


·                     A monopolist employer faces a monopolist union.  This is called a bilateral monopoly.


We examine one of these situations.


Labour with Market Power (union monopoly)


Diagram 8.3



























If unions force the wage rate up from W1 to W2 employment will fall from Q1 to Q2 and there will be a surplus of people (Q3-Q2) wishing to work in this industry for whom no jobs are available.


This model suggests that wages can only be increased at the expense of employment, unless productivity is increased.  This is called a productivity deal and would shift the MRP curve to the right.





8.3                                                                                                                                                                                                              TRANSFER EARNING AND ECONOMIC RENT


Transfer earnings are what a factor must earn to prevent it from moving to an alternative use (To persuade people to stay in their current job equivalent to economic profit for a firm).


Mary Jones manager of store earns £20,000.


She could earn £15,000 in another job and would transfer if her salary were cut below £15,000.


Take the market for nurses.


At each higher wage the new nurses attracted are getting just enough to persuade them into the profession.  The wage for them is entirely transfer earnings.  But nurses already in the profession will be getting economic rent, as they are now getting more than the minimum to keep them in the profession.


Workers economic rent is the difference between the actual wage rate and the point of the supply curve at which they entered the market.


The more inelastic the supply curve, the greater will be the proportion that is economic rent.  The bigger the wage increase necessary to attract new workers the more economic rent existing workers will get.


If we take an individual with “unique talent” there is a totally inelastic demand curve.  As a result his income is determined entirely by demand and is entirely economic rent.


Diagram 8.4






























Other Labour Market Influences


The market for labour is such a significant one, both in its impact on the value of goods and services and the source of economic welfare for households that a vast amount of economic literature has been devoted to its analysis.  In answer to the question why do some individuals/groups earn more than others a number of elaborations on the basic market model have been offered:


1.         Earnings differences might relate to differences in skill (which will affect the firm’s calculations of MRP) and these skill differentials may relate to differences in education and training.  Alternatively some economists have argued that education (e.g. the English public school system) simply represents a form of screening which allows higher paid jobs to be offered to those who have similar backgrounds, accents, etc.


2.         Earnings differentials may well relate to trade union/trade association membership.


3.         Discrimination on the grounds of age, sex, race, disability, etc may explain significant amounts of earnings differentials.  In the UK full-time female employees earn about 70% of the wage of their male equivalents and equal pay legislation appears to have had comparatively little impact upon this differential.




“Land” in economies refers to natural resources and so would include, in addition to physical space, climate, raw materials, mineral extractions and fishing rights etc.  The market for the use of these resources again can be analysed in terms of greater productivity and so a shop in Hatfield’s Galleria would attract a lower rent than one in, say London’s Oxford Street (i.e. one which shoppers actually visit).  Interestingly economists have argued since Ricardo’s time that land with high rent but no alternative use can be heavily taxed with no detrimental economic effect.  Thus the analysis of rent is closely linked to the concept of transfer earnings.




1.                   The diagrams below show the local market for plasterers.  Which of the two curves would shift and in which direction as a result of each of the following changes?


·                                             A deterioration in the working conditions of plasterers

·                                             A decrease in the prices of plasterers

·                                             A decrease in the demand for new houses

·                                             An increased demand for plasterers in other parts of the country

·                                             Increased wages in other parts of the building trade




2. A fashion model could earn £80 per week as a gardener, £160 per week working on a building site or £240 as a lorry driver.  As a model he earns £320 per week.  Assuming he likes all four jobs, what is his economic rent for being a fashion model?


3. What factors affect the labour market for teachers?  How might the labour market for English and Economics teachers be different?


4.Given that a wage above the equilibrium reduces employment, why is there a case for a minimum wage?



KEY CONCEPTS – you are advised to learn ALL of these


Factor markets


Supply of labour under perfect competition


Demand for labour under perfect competition


Marginal physical product


Marginal revenue product


Imperfect labour markets




Trade unions


Economic rent


Transfer earnings


















Most developed economies contain relatively sophisticated capital markets but in essence their operation is much the same as any other market.  There is a demand for capital by firms in order to purchase plant and machinery, which in turn through an estimation of its marginal productivity should increase the revenue and profit of the company (it is common to talk of capital as both the ‘real’ purchases of machinery and equipment and also the finance borrowed from the banking sector in order to buy the equipment).


Discounting Theories


When making the decision to buy it is essential that estimated future returns are discounted to give a present value.


The supply of capital comes from savers (either households or firms) and is assumed to be positively related to the rate of interest.  The capital market therefore relates the supply and demand of funds available for loan to the current rate of interest.  There are, of course, many rates of interest in a developed economy, depending on the nature of the loan: length of time, security, etc.  However they all tend to move up and down in concert and so it is convenient to think of a simplified model of one interest rate that clears the market.


Discounting to Present Value


Compound interest means that £100 at a rate of 10 per cent is worth £110 in one years time and £121 in two years time.  If we turn this idea around we can say that £110 in one years time is £100 today.  This is the principle beyond discounting a future flow of returns to a present value.




P = Present value          A = Future flow            I = Market rate of interest          n = number of years




A firm is considering buying a machine which costs £3000.  It is predicted that it will give a flow of revenue from the goods it produces as follows:



(Year 1) £900 + (year 2) £800+ (year 3) £700+ (year 4) £600+ (Year 5) £500  =  £3500.


This flow or revenue appears to be greater than the initial cost of buying the machinery.  But if this flow is discounted at a rate of interest of 10 per cent a different picture emerges:



£900     +          £800     +          £700     +          £600     +          £500     =

 1.10                 (1.10)2              (1.10)3              (1.10)4              (1.10)5


£181 + £661 + £526 + £410 + £310  =  £2736






Non discounting Methods


·                     Average rate of return


·                     Pay back period


4.2              Alternative Maximising Theories


·                     Problems with traditional theory

·                     Alternative aims

-          Long run profit maximization

-          Sales revenue maximization

-          Growth survival

·                                                                     Behavioural theories of the firm







Adam Smith (1776) suggested the people by pursuing their own interests are led by ‘and invisible hand’ to promote the interests of society.  If there is an invisible hand and markets allocate resources efficiently so that consumer wants are met at minimum cost, why should governments intervene in the economy?  The general argument of government intervention is that of market failure, which will be examined in the lecture.  In the second half we will discuss a practical application of some of these ideas in the form of Cost Benefit Analysis which has been used to aid decision making in the public sector.


5.1              MARKET FAILURE


Market failure is the inability of an unregulated market to achieve allocative efficiency in certain circumstances.  There are various reasons why allocative efficiency may not be achieved and these are:


1.                               Public goods

2.                               Immobility of Factors and time lags in Response

3.                               Imperfect information

4.                               Monopolies and cartels

5.                               Externalities


1.                              Public Goods


Certain goods and services would not be provided without the intervention of the government.  We cannot perhaps imagine this country without a legal system, defence forces, schools, roads and health services but all of these goods and services are provided largely by the government although there are elements now of the private sector in each category.


A pure public good is a good or service which is consumed by everyone and from which no-one can be excluded, defence is a good example.  It has two characteristics, non-rivalry i.e. one person’s consumption of the good does not reduce the amount available for someone else and non-excludability i.e. no-one can be excluded from consumption of the good.


This brings in the problem of free riders, which is someone who consumes a good or service without paying for it.  This problem arises with public goods because why should one person pay when everybody else will contribute to the cost.  If everyone took this attitude the good would not be provided hence the need for government intervention.


·                     Public good.  A good or service which has the features of non rivalry; and non excludability and as a result would not be provided by the free market.


·                     Non-rivalry.  Where the consumption of a good or service by one person will not prevent others for enjoying it.


·                     Non-excludability.  Where it is not possible to provide a good or service to one person without it thereby being available for others to enjoy.


2.         Immobility of Factors and Time Lags in Response


Even under perfect competition factors may be slow to respond to changes in demand and supply conditions.  Labour is often geographically and occupationally immobile.  This can lead to unemployment, one the one hand and high wages for those in sectors or rising demand,  In the meantime other changes will occur.  Thus the economy is in a continuous state of disequilibrium and the long run never comes.




3.         Imperfect Information


It is assumed under perfect competition that consumers have perfect knowledge about prices and products.  Whilst this may be the case if a vacuum cleaner is being purchased and magazines such as Which exist to help people make an informed choice.  In the case of health care full information is much more difficult and the consequences of purchasing the wrong service are much more serious.


4.         Inequality


One major criticism of the free market is the problem of inequality.  Optimality is achieved representing the efficient allocation of resources for any given distribution of income.


5.         Market Power


We have already explored in some detail the way in which the conditions for perfect competition rarely exist and many sectors are dominated by oligopolies.


6.                              Externalities


An externality is said to exist when the production or consumption of a good directly affects businesses or consumers not involved in the buying or selling of it and when those spillover effects are not reflected in market prices.





Advocates of free health care argue that there are a number of fundamental objections to relying on a market system to allocate health care for the following reasons:


·                     Equity.  Because income in unequally distributed some people will be able to afford better treatment than others.  On the grounds of equity health care should be free, at least for poor people.


·                     Difficulty for people predicting their future medical needs.  There is great uncertainty about people’s future medical needs.  Medical insurance is one way round this, but what about the problem of equity.  Would the premiums be high for some people?


·                     Externalities.  Health care generates a number of benefits external to the patient.  Curtailment of infectious diseases benefits everybody.  Employers benefit from having a healthy workforce.


·                     Patient Ignorance.  The consumer (the patients) may have poor knowledge.  You rely on the doctor, the supplier of treatment.  Some patients may be advised to take a more expensive treatment than is necessary.


·                     Oligopoly.  If doctors and hospitals operated in the free market as profit maximisers, they may act as an oligopoly and collude to fix standard prices to protect their incomes.


5.3              Externalities in More Detail


External benefits.  Benefits from production (or consumption) experienced by people other than the producer (or consumer).


External costs.  Costs of production (or consumption) borne by people other than the producer (or consumer).



Social costs.  Private cost plus externalities in production.


Social benefits.  Private benefit plus externalities in consumption.


External costs of production (MSC > MC)


When a chemical firm dumps waste in a river or pollutes the air the community bears an additional cost.


Diagram 10.1 shows that the socially optimum output for the firm would be Q2 where P = MSC.  The firm however, produces Q1 which is more than the optimum.  Thus external costs lead to overproducing from society’s point of view.


External benefits of production (MSC < MC)


If a bus company spends money on training drivers who when leave to work for haulage or coach companies, the costs of these companies are reduced as they do not have to train drivers.  Society has benefited from their training although the bus company has not.


External costs of consumption (MSB > MB)


When people use their cars other people suffer from exhaust fumes, congestion and noise.  These negative externalities make the marginal social benefit of using cars less than the marginal private benefit (i.e. marginal utility).  Diagram 10.2 shows the marginal utility (reflected in the demand curve) and price to the consumer of using a car.  The distance traveled by the motorist will be Q1 miles where MU (D) = P.  The social optimum, however, would be less than this, namely Q2, where the MSB = P.


External benefits of consumption (MSB > MB)


When people travel by train rather than by car other people benefit by there being less congestion and exhaust and fewer accidents.  Thus the marginal social benefit of rail travel is greater than the marginal private benefit.



























Changes in property rights


One cause of market failure in the limited nature of property rights.  One solution may be to extend property rights to define who owns property, what use it can be put to, the rights other people have over it and how it may be transferred.  Individuals may be able to prevent other people imposing costs on them.


Taxes and subsidies


Assume a chemical firm in the course of production pollutes the atmosphere.  In the Diagram 10.3 below the firm produces Q1 where P = MC, but takes no account of the external costs imposed on society.  If the government imposes a tax on production equal to the marginal pollution cost the firm will internalize the externality.  The firm will now maximize profits at Q2, which is the socially optimum output where MSB = MSC.


Diagram 10.3


Using taxes to correct a distortion





















5.4              COST BENEFIT ANALYSIS


Cost benefit analysis is a procedure for making long run decisions such as whether to build a university or where to build an airport.  It attempts to evaluate the social costs and benefits of proposed investment projects as a guide to the desirability of particular projects.  CBA differs from ordinary investment in that the latter only considers private costs and benefits.


·                     Procedure

·                     Identifying costs and benefits

·                     Measurement of costs and benefits

·                     Risk and uncertainty

·                     Discounting future costs and benefits

·                     Distributional consequences





Mergers, Economies of Scale and Market Power


6.1              THE SINGLE MARKET


The Removal of Non-Tariff Barriers


Tariffs and quantitiative restrictions such as quotas have, at least in theory, long been eliminated in the EU.  The Single Market Act 1992 is to eliminate remaining non-tariff barriers which includes removing:


·                     Cost increasing barriers – delays at customs, collection of statistics or verification of technical regulations.

·                     Market entry restrictions.  The main example here is state procurement, where the government favour domestic suppliers.

·                     Market distorting subsidies and practices.  Barriers that distort the market so as to give domestic producers an unfair advantage.


The Cecchini Report


This report is the result of 27 volumes of research by economists and management consultants, which argues that there will be substantial gains from the completion of the internal European market which they estimate at 210 billion ECU.  They suggest that benefits are grouped in the following categories:


1.                   Trade creation.  Costs and prices are likely to fall as countries produce those goods or services they are most efficient in.

2.                   Economies of scale.  Industries on a European basis can exploit economies of scale.  The EU is the largest industrialized market in the developed world.

3.                   Static and dynamic effects.  Greater competition in both the short and long run.  In the short run this would being profits down and encourage reducing costs and in the long run there would be greater innovation and restructuring.


The Paradox


There is, however, one major contradiction in the Cecchini report.  On the one hand the Report foresees increased competition leader to power prices and thereby increasing consumer welfare, on the other however this is to be achieved through restructuring where economies of scale will be achieved through mergers increasing the market power of larger firms.  In order to examine this apparent paradox we need to look at some of the empirical evidence on economies of scale and mergers more closely.




·                     A comparative study of results from various EU countries concerning full legal mergers, (Mueller 1980) draws the conclusion that tests to identify economies of scale as a possible objective for merger proved that it was not significant.  The size of the acquiring firm was often already greater than the minimum optimum scale.


·                     A further weakness in the Commission evidence is cited as being that the conclusions on the Minimum Efficient Scale and economies of scale are drawn from Pratten’s work in the 1960s.  On updating his research he gives a cautious warning that economies of scale are elusive and that the long run average costs curve only slopes very gently to the right.


·                     Further in the Commission Report (1988) itself contradictory evidence emerges as to the scope for economies of scale in financial services.


·                     According to Mueller (1989) post-merger profitability suggested little or no effect on the profitability of the merging firm in the three to five years following.   Finally he found that the cost of changes to the organization were often greater than the benefits.


The evidence ranging from empirical studies to econometric models leads to the conclusion that there is no real trade off between efficiency gains from mergers and an increase in monopoly power since the net efficiency are not there.




The New Industry Structure Which Follows Mergers

Jacquemin argues that a crucial aspect of horizontal merger is the response of non-participant firms to any output reductions by merging parties.  If the non-participating firms reduce output, the merger even though profitable will reduce welfare.  On the other hand if non-participating firms with large mark ups respond by expanding output in response to mergers, significant gains in welfare may be provided.


The International Dimension

The international dimension is a crucial factor for evaluating the impact of European mergers.  Competition from imports limits the market power of domestic producers.  Therefore mergers in industries that are less open are more dangerous for competition than mergers in relatively closed industries.  There have been accusations that Europe has a free market within its boundaries but a restrictive attitude to trade with the rest of the world.


The Role of Mergers In High Technology Industries

The Cecchini Report argues that the Community lags behind its competitors in industrial activities which are characterized by strong growth in demand and high technological content and are therefore R & D intensive.  It argues that the fragmentation of the Community industry constitutes a serious handicap to these industrial markets, and that the critical mass of spending on research requires the active co-operation, if not integration of European firms to realize these economies of scale, and match expenditure in this area by the US and Japan.


It is suggested that mergers or joint ventures would increase resources available and encourage the undertaking of risky and/or ambitious projects, cutting duplication and encouraging the transfer of technology, and speeding up the innovative process.  Even if there is a static loss due to concentration there is a dynamic gain in the long run.  The existence of such a trade off is questionable, in that evidence suggests that R & D is not characterised by substantial economies of scale and that monopoly power in the long run can be expected to inhibit R & D and technological advance.  The rapid rise in the number of mergers has been less in high growth and high technology sectors.


Are Economies of Scale A Motive For Merger?


Not only is there little evidence to support the existence of international economies of scale, but there is little evidence to suggest that these are a primary motivation.  In a survey quoted y Davis (1991) economies of scale as a merger motive is only given in 7% of cases.  The Hill Samuel Bank case studies of ten European mergers found that the most important reasons offered were the exploitation of distribution links, international branding, technology or skills transfer, suggesting that the overwhelming motive for mergers is access to new markets.



·                     An examination of the structure and pattern of merger activity in the past decade, disputes the Cecchini prediction of widespread mergers between European firms to increase competitiveness through the realization of economies of scale.


·                     Between 1983 and 1987 the number of mergers per year increased approximately three fold.  The data however, suggests a rather perverse increase in the number of national mergers as 1992 approached.  A similar but less pronounced pattern occurred in the service sector, which may reflect the fact that barriers to entry in this sector are greater than manufacturing.  Sectorally chemical, electrical and mechanical engineering and food accounted for 60% of all mergers, which appears to be out of line with the Cecchini Report.


·                     The most striking feature of European mergers is the number of mergers and their value between different countries with the UK accounting for most mergers.  Belgium, Luxembourg and Spain have acquired only EU firm, whilst at the other extreme the UK shows a relative lack of interest in acquiring EU partners.  Germany and Denmark are also relatively non-EU orientated whilst the remaining six countries display marked preferences for intra-EU mergers, choosing a EU partner two times out of three.


·                     UK firms have also been very attractive for US firms, in that total US merger activity outside the US involves seeking out UK or Canadian partners.  This relationship is reciprocal in that the UK are the most important acquirers of US firms over the period 1985 to 1988, suggesting that UK firms regard the US market as having more potential than the single European market.  Several reasons could be put forward to explain this such as few barriers to foreign takeovers, the depreciation of the US dollar, fear of protectionist measures in the USA, limited opportunities in the home market and negative obstacles in the way of European acquisitions.  There has also been an increase in non-EU cross border mergers as some companies outside the EU wish to gain an existing foothold or expand their interests.




1.                   Distinguish between and give examples of:  static/technical economies, learning economies, economies of scope.


2.                   Suggest reasons why mergers have tended to be higher in manufacturing rather than the service sector.


3.                   What sort of barriers still exist between mergers in different countries.  To what extent do these explain why the UK has preferred to merge with the US rather than European firms?


4.                   What problems do you think exist in controlling and implementing competition policy in Europe?




The lecture will briefly outline the main arguments.  A case study approach will be taken in the lecture and seminar in order to highlight some of the topical debates.


1.1                   OUTLINE OF THE MAIN ARGUMENTS


Arguments For Public Ownership : Market Failure


·                     Natural Monopoly

·                     High capital costs/Barriers to entry

·                     Lack of investment

·                     Planning and co-ordination of industry

·                     Externalities

·                     Lame ducks

·                     Management of the Economy


Arguments For Privatisation


·                     Increases Efficiency

·                     Reduced Interference

·                     Reduction of the PSBR

·                     Increased ownership/popular capitalism


Arguments Against Privatisation


·                     Natural monopoly

·                     Insufficient regulation

·                     Public interest

·                     Valuation of shares