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Microeconomics
A level
Year 13
Assessment
Markets & Market Failure
4.1.1 Economic methodology and the economic problem (Year 1)
4.1.2. Individual economic decision-making (6 hours)
4.1.3 Price determination in a competitive market (Year 1)
4.1.4. Production, costs and revenue (8 hours + Year 1)
4.1.5 Perfect competition, imperfectly competitive markets and
monopoly (14 hours)
4.1.6 The labour market (12 hours)
4.1.7 The distribution of income and wealth: poverty and inequality
(8 hours)
4.1.8 The market mechanism, market failure and government
intervention in markets (10 hours + Year 1)
Costs of
Production
The Meaning of Costs
• Opportunity costs
– meaning of opportunity cost
– examples
• Measuring a firm’s opportunity costs
– factors not owned by the firm: explicit costs
– factors already owned by the firm: implicit costs
– irrelevance of:
• historic costs
• replacement costs
Production in the Short run
• Production functions
– factors of production
• labour
• land and raw materials
• capital
• entrepreneurship
– the relationship between inputs and output
• TPP = ƒ(F1, F2, F3, … Fn)
Production in the Short run
• Long-run and short-run production
– fixed and variable factors
– distinction between short run and long run
• The law of diminishing returns
• The short-run production function:
–
–
–
–
total physical product (TPP)
average physical product (APP)
marginal physical product (MPP)
the graphical relationship between TPP, APP and
MPP
Wheat production per year from a particular farm
Number of
workers
0
1
2
3
4
5
6
7
8
Tonnes of wheat produced per year
40
30
20
TPP
0
3
10
24
36
40
42
42
40
10
0
0
1
2
3
4
5
Number of farm workers
6
7
8
Wheat production per year from a particular farm
Number of
workers
0
1
2
3
4
5
6
7
8
Tonnes of wheat produced per year
40
30
20
TPP
0
3
10
24
36
40
42
42
40
10
0
0
1
2
3
4
5
Number of farm workers
6
7
8
Wheat production per year from a particular farm
d
Tonnes of wheat produced per year
40
TPP
Maximum output
30
Diminishing returns
set in here
20
b
10
0
0
1
2
3
4
5
Number of farm workers
6
7
8
Tonnes of wheat per year
Wheat production per year from a particular farm
40
TPP
30
20
10
DTPP = 7
0
Tonnes of wheat per year
0
1
2
3
4
5
6
7
8
Number of
farm workers (L)
8
Number of
farm workers (L)
DL = 1
14
12
10
8
MPP = DTPP / DL = 7
6
4
2
0
-2
0
1
2
3
4
5
6
7
Tonnes of wheat per year
Wheat production per year from a particular farm
40
TPP
30
20
10
0
Tonnes of wheat per year
0
1
2
3
4
5
6
7
8
Number of
farm workers (L)
8
Number of
farm workers (L)
14
12
10
8
6
4
2
0
-2
0
1
2
3
4
5
6
7
MPP
Tonnes of wheat per year
Wheat production per year from a particular farm
40
TPP
30
20
10
0
Tonnes of wheat per year
0
1
2
3
4
5
6
7
8
Number of
farm workers (L)
14
APP = TPP / L
12
10
8
6
4
APP
2
0
-2
0
1
2
3
4
5
6
7
8
MPP
Number of
farm workers (L)
Tonnes of wheat per year
Wheat production per year from a particular farm
40
TPP
30
b
20
Diminishing returns
set in here
10
0
Tonnes of wheat per year
0
1
2
3
4
5
6
7
8
Number of
farm workers (L)
b
14
12
10
8
6
4
APP
2
0
-2
0
1
2
3
4
5
6
7
8
MPP
Number of
farm workers (L)
Wheat production per year from a particular farm
Tonnes of wheat per year
d
40
TPP
30
20
10
0
0
Tonnes of wheat per year
Maximum
output
b
1
2
3
4
5
6
7
8
Number of
farm workers (L)
b
14
12
10
8
6
4
APP
2
d
0
-2
0
1
2
3
4
5
6
7
8
MPP
Number of
farm workers (L)
Wheat production per year from a particular farm
Tonnes of wheat per year
d
40
Slope = TPP / L
= APP
TPP
30
20
b
10
0
0
Tonnes of wheat per year
c
1
2
3
4
5
6
7
8
Number of
farm workers (L)
b
14
12
10
c
8
6
4
APP
2
d
0
-2
0
1
2
3
4
5
6
7
8
MPP
Number of
farm workers (L)
Costs in the Short run
• Costs and inputs
– costs and the productivity of factors
– costs and the price of factors
• Fixed costs and variable costs
• Total costs
– total fixed cost (TFC)
– total variable cost (TVC)
• TVC and the law of diminishing returns
– total cost (TC = TFC + TVC)
Total costs for firm X
Output TFC
(Q)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
40
20
0
0
1
2
3
4
5
6
7
8
Total costs for firm X
Output TFC
(Q)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
40
20
TFC
0
0
1
2
3
4
5
6
7
8
Total costs for firm X
Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
0
10
16
21
28
40
60
91
40
20
TFC
0
0
1
2
3
4
5
6
7
8
Total costs for firm X
Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
0
10
16
21
28
40
60
91
TVC
40
20
TFC
0
0
1
2
3
4
5
6
7
8
Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
TC
(£)
0
10
16
21
28
40
60
91
Total costs for firm X
12
22
28
33
40
52
72
103
TVC
40
20
TFC
0
0
1
2
3
4
5
6
7
8
Output TFC TVC
(Q)
(£)
(£)
100
0
1
2
3
4
5
6
7
80
60
12
12
12
12
12
12
12
12
TC
(£)
0
10
16
21
28
40
60
91
Total costs for firm X
TC
12
22
28
33
40
52
72
103
TVC
40
20
TFC
0
0
1
2
3
4
5
6
7
8
Total costs for firm X
TC
100
TVC
80
Diminishing marginal
returns set in here
60
40
20
TFC
0
0
1
2
3
4
5
6
7
8
Costs in the Short run
• Marginal cost
– marginal cost (MC) and the law of
diminishing returns
Average and marginal costs
Costs (£)
MC
Diminishing marginal
returns set in here
x
Output (Q)
Costs in the Short run
• Marginal cost
– marginal cost (MC) and the law of
diminishing returns
– the relationship between MC and TC curves
Average and marginal costs
Costs (£)
MC
x
Output (Q)
Costs in the Short run
• Average cost
– average fixed cost (AFC)
– average variable cost (AVC)
– average (total) cost (AC)
• Relationship between average and
marginal cost
Average and marginal costs
MC
AC
Costs (£)
AVC
z
y
x
AFC
Output (Q)
Production in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
Short-run and long-run increases in output
Short run
Long run
Input 1
Input 2
Output
Input 1
Input 2
Output
3
1
25
1
1
15
3
2
45
2
2
35
3
3
60
3
3
60
3
4
70
4
4
90
3
5
75
5
5
125
Short-run and long-run increases in output
Short run
Long run
Input 1
Input 2
Output
Input 1
Input 2
Output
3
1
25
1
1
15
3
2
45
2
2
35
3
3
60
3
3
60
3
4
70
4
4
90
3
5
75
5
5
125
Short-run and long-run increases in output
Short run
Long run
Input 1
Input 2
Output
Input 1
Input 2
Output
3
1
25
1
1
15
3
2
45
2
2
35
3
3
60
3
3
60
3
4
70
4
4
90
3
5
75
5
5
125
Short-run and long-run increases in output
Short run
Long run
Input 1
Input 2
Output
Input 1
Input 2
Output
3
1
25
1
1
15
3
2
45
2
2
35
3
3
60
3
3
60
3
4
70
4
4
90
3
5
75
5
5
125
Production in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
Production in the Long run
• All factors variable in long run
• The scale of production:
– constant returns to scale
– increasing returns to scale
– decreasing returns to scale
• Returns to scale and economies and
diseconomies of scale
Production in the Long run
• Economies of scale
–
–
–
–
–
–
–
–
specialisation & division of labour
indivisibilities
container principle
greater efficiency of large machines
by-products
multi-stage production
organisational & administrative economies
financial economies
• Economies of scope
Production in the Long run
• Diseconomies of scale
– managerial diseconomies
– effects of workers and industrial relations
– risks of interdependencies
• External economies of scale
• External diseconomies of scale
• Location
– balancing the distance from suppliers and
consumers
– importance of transport costs
Production in the Long run
• Decision making in different time periods
– very short run
– short run
– long run
– very long run
– decisions can be made for all time periods at the
same time
Costs in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
Costs
Alternative long-run average cost curves
Economies of Scale
LRAC
O
Output
Alternative long-run average cost curves
LRAC
Costs
Diseconomies of Scale
O
Output
Alternative long-run average cost curves
Costs
Constant costs
O
LRAC
Output
A typical long-run average cost curve
Costs
LRAC
O
Output
Costs
A typical long-run average cost curve
O
Economies
of scale
Constant
costs
Output
Diseconomies
of scale
LRAC
Costs in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
Costs
Long-run average and marginal costs
Economies of Scale
LRAC
LRMC
O
Output
Long-run average and marginal costs
LRMC
Costs
Diseconomies of Scale
O
Output
LRAC
Long-run average and marginal costs
Costs
Constant costs
O
LRAC = LRMC
Output
Long-run average and marginal costs
Initial economies of scale,
then diseconomies of scale
LRAC
Costs
O
LRMC
Output
Costs in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and shortrun average costs
Costs in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and shortrun average costs
– the envelope curve
Deriving long-run average cost curves: factories of fixed size
Costs
SRAC1 SRAC
2
SRAC3
1 factory
2 factories
3 factories4 factories
O
Output
SRAC5
SRAC4
5 factories
Deriving long-run average cost curves: factories of fixed size
SRAC1 SRAC
2
SRAC3
SRAC5
SRAC4
Costs
LRAC
O
Output
Costs
Deriving a long-run average cost curve: choice of factory size
Examples of short-run
average cost curves
O
Output
Deriving a long-run average cost curve: choice of factory size
Costs
LRAC
O
Output
Costs in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and shortrun average costs
– the envelope curve
• Long-run cost curves in practice
Costs in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and shortrun average costs
– the envelope curve
• Long-run cost curves in practice
– the evidence
Costs in the Long run
• Long-run average costs
– shape of the LRAC curve
– assumptions behind the curve
• Long-run marginal costs
• Relationship between long-run and shortrun average costs
– the envelope curve
• Long-run cost curves in practice
– the evidence
– minimum efficient plant size
A 15 marker!
1. Explain the difference between
diminishing returns to a factor in the
short run, and returns to scale in the
long run. (June 2016)
Theory of Costs
• Explain the effect on output when
increasing inputs
• Show the link between SR and LR cost
curves
• Apply to economies of scale
• Evaluate business decisions based on
theory
Production in the Long run
Long run – a period of time when
all inputs are variable.
e.g Capital and labour can
change
•
What could happen to output if the
firm were to double all its inputs?
1. Output doubles
2. Output more than doubles
3. Output increases but does not double
Returns to Scale
• Increasing returns to scale
• Constant returns to scale
• Decreasing returns to scale
What do you think will happen to average
costs of production in the examples
above?
Show each on a diagram
Long run and short run ATC
•
•
Consider what would happen to the
short run ATC curve if Ford built a
new assembly line?
What is likely to be the cost of
producing one car? Why?
What would happen to the cost if
production increased to 1000 cars?
Why?
SRAC and LRAC
Economies of Scale (revisited)
• Types of Economies of Scale
(Internal)
• Purchasing Economies
• Technical Economies
• Managerial Economies
• Financial Economies
• Risk bearing economies
• External economies
• Economies of scope
Optimal Level of Production and
Minimum Efficient Scale of Production
(MES)
The LRAC curve is a boundary which can
shift depending on factors such as
taxation and technology.
What would be the effect of the
following?
1. An increase in taxation on a business
(corporation tax)
2. A technologically more efficient
method of production
Thoughts on…..
• Closing ‘efficient’ firms
• Preventing competition
• ‘Big’ firms domination
Revenue
• Be able to calculate revenues
• Show the effect of elasticity
• Analyse the impact for a business
• Revenue (or sales turnover) is the
income from selling output
• Total revenue (TR) = price per unit x
output
• Average revenue = price per unit (AR)
• Marginal revenue = addition to total
revenue from selling an extra unit of
output
Is this correct?
Back to basics….
Plot AR and MR
Look at the original data
Why does this happen?
Price-taking firms
• What?
• Who?
Which of these are
monopolies?
•
•
•
•
•
•
Microsoft
Apple
Tesco
Thames Water
Keele Motorway Services
Brewood Corner Shop
Taskette 1
Draw the model
5 mins
Make it good!
Times up!
What did you include?
MC=MR
AC
Abnormal Profit
Or should you……..
For the clever……
Analyse the effect
elasticity has on the
levels of abnormal
profit a monopoly
earns
5 mins
Did you get it?
Barriers to entry
Or
What factors make
a
monopoly noncontestable?
5 mins……..again
Did you find your way to Oz?
Mayfair or Old Kent Road?
Are monopolies good
or bad. Discuss.
10 mins
It’s economics Captain, but not as
we know it
Time for a break?
Monopolistic Competition
a market structure in which firms have
many competitors, but each one sells a
slightly different product.
Characteristics
• Each firm makes independent decisions
• Knowledge is widely spread between participants, but
it is unlikely to be perfect.
• There is freedom to enter or leave the market, as
there are no major barriers to entry or exit.
• Products are differentiated
• Firms are price makers
• Firms usually have to engage in advertising
• Profit maximisers
• large numbers of firms
Differentiation
– Physical product differentiation.
– Marketing differentiation.
– Human capital differentiation.
– Differentiation through distribution.
SR Pmax. Abnormal profit
LR Pmax. Normal profit
Examples of monopolistic
competition
Monopolistically competitive firms are
most common in industries where
differentiation is possible, such as:
• The restaurant business
• Hotels and pubs
• General specialist retailing
• Consumer services, such as hairdressing
The advantages of
monopolistic competition
• There are no significant barriers to
entry; therefore markets are relatively
contestable.
• Differentiation creates diversity,
choice and utility.
• The market is more efficient than
monopoly but less efficient than
perfect competition.
The disadvantages of
monopolistic competition
• Some differentiation generates unnecessary
waste, such as excess packaging.
• Advertising may also be considered wasteful,
though most is informative rather than
persuasive.
• There is allocative inefficiency in both the
long and short run.
Oligopoly
A Market Structure
Market Structure
• Measuring Oligopoly:
• Concentration ratio – the proportion of
market share accounted for by top X number
of firms:
– E.g. 5 firm concentration ratio of 80% - means top
5 five firms account for 80% of market share
– 3 firm CR of 72% - top 3 firms account for 72% of
market share
Market Structure
• Examples of oligopolistic structures:
–
–
–
–
–
–
Supermarkets
Banking industry
Chemicals
Oil
Medicinal drugs
Broadcasting
What has happened to the competition?
What is the likely impact on consumers?
Market Structure
• Oligopoly – Competition amongst the few
–
–
–
–
–
–
–
–
–
Industry dominated by small number of large firms
Many firms may make up the industry
High barriers to entry
Products could be highly differentiated – branding or
homogeneous
Non–price competition
Price stability within the market - kinked demand curve?
Potential for collusion?
Abnormal profits
High degree of interdependence between firms
Market Structure
Price
Kinked Demand Curve
£5
Kinked D Curve
D = elastic
D = Inelastic
100
Quantity
Complete!
Type of
market
Perfect
competition
Monopoly
Oligopoly
Monopolistic
Competition
Number of
firms
Freedom of
entry
Nature of
product &
examples
Demand
curve
implications
Non-price competition
What could oligopolies use?
Data sheet
1.
2.
3.
4.
5.
6.
7.
8.
9.
10.
The sugar industry is an example of what type of market?
What are the main characteristics of this type of market?
What is a cartel?
What were the sugar companies hoping to achieve by forming
a cartel?
Why are prices sticky in the sugar market? Explain you
reasoning.
Is the demand for sugar elastic or inelastic for one of these
companies considering a price rise?
Draw a diagram which explains your answer in question 6.
How could 'slashing prices' drive out competitors?
How else could sugar producers attempt to increase their
market share?
Why does the OFT and the Commission outlaw such practices?
Industrial Policy
• Competition Policy
• Public ownership and privatisation
• Regulation and deregulation of markets
Industrial Policy
• Aimed at improving the performance of
individual (micro) economic agents
(firms) on the supply side of the
economy (supply-side policy)
• Competition policy is the part of
Industrial Policy that deals with
monopolies, mergers and restrictive
trade practices
Who implements these policies?
• Competition and Markets Authority
(CMA)
– Formerly known as Competition Commission
and Office of Fair Trading (OFT)
• European Commission
Why intervene?
• Contestable Market Theory
– To ensure efficient and non-exploitative
behaviour
– Actual competition or potential competition
– Barriers to entry and exit (no sunk costs)
– Monopolies are fine providing there is
potential for competition
Why intervene?
• Merger Policy
– Mergers, acquisitions and takeovers
– Will these be in the public interest or lead
to anti-competitive effects?
– Lateral or diversifying not investigated
– Overseas based are not investigated
– EU Competition Policy limits UK ability
• UK policy seen as weak as only deals with
smaller mergers. EU deals with larger ones.
Question
1. Governments often justify patent
legislation as a way of improving
dynamic efficiency in the economy.
Explain what a patent is and how this
might lead to such an efficiency (10).
How do they regulate?
• Break-up of monopolies
• Price controls
– RPI-X
• Taxation of monopoly profits
• Public ownership
– Government ownership
• Privatisation
• Removal of entry barriers
• Deregulation (market based solution)
– Regulatory capture
Barriers to Entry
Long Run: Barriers to Entry
• Barriers to entry are designed to block
potential entrants from entering a market
profitably
• They seek to protect the monopoly power of
existing firms and therefore maintain
supernormal profits in the long run
• Barriers to entry make a market less
contestable – i.e. they affect market structure
in the long run
Types of Entry Barrier (1)
• • (1) Structural barriers (or Innocent Barriers) – due to
differences in production costs and being in the market for
some time
•
•
•
•
•
•
•
–
–
–
–
–
–
Economies of scale (e.g. Natural monopoly)
Vertical integration (e.g. Backwards and forwards)
Control of essential resources e.g. technologies / commodities
Expertise and reputation of the incumbent
Brand loyalty
Inherent suspicion among consumers about new ideas
(2) Strategic barriers
• – Predatory pricing / limit pricing
• – Marketing / product differentiation
Types of Entry Barrier (2)
• (3) Statutory (legal) barriers - entry
barriers given force of law
• – Licences (e.g. Professional
qualifications)
• – Patents
• – Copyrights
• – Public franchises
• – Tariffs, quotas and other trade
restrictions
Protecting Monopoly
Power through Patents
• – Government enforced property rights
• – Generally valid for 12-20 years – they give
the owner an exclusive right to prevent
others from using patented products,
inventions, or processes
• – A patent should protect your ‘intellectual
property’.
• – Patent licenses can be sold to other
producers
• – Designed to encourage innovation and
invention
Integration and Pricing
Tactics
Vertical Integration
• – Control over supply chain and distribution
Limit Pricing and Predatory Pricing
• – Predatory pricing involves
• lowering prices to a level that would force new
entrants to operate at a loss (price < average cost)
• – Sacrificing some short term profits but to restore
and maintain supernormal profits in the long run
Cost Advantages and
Marketing/Branding
Absolute cost advantages
• – Lower costs (e.g. economies of
scale) - allows the existing
monopolist to cut prices and win
price wars
Advertising and Marketing
• – Developing consumer loyalty by
establishing branded products can
make successful entry into the
market by new firms more expensive
Brand Proliferation
• – Brand proliferation disguises from
consumers the actual concentration
in markets such as detergents,
confectionery and household goods.
Barriers to Exit
Barriers to exit increase the intensity of competition in a market
because existing firms “stay and fight”
There are costs associated with exiting an industry
(1) Asset-write-offs
• – E.G. plant and machinery, stocks and “goodwill”
(2) Closure costs
• – Redundancy costs, contract contingencies with suppliers
• – Penalty costs from ending leasing arrangements for property
(3) Lost reputation
• – Lost goodwill, damage to the brand
• Sunk costs are costs incurred when entering a market that are
irrecoverable should a firm decide to leave the market
Reducing entry barriers
Technological change in markets
• – E.g. impact of e-commerce in
• many markets
• – Impact of disruptive technologies
Removal of statutory entry barriers
• – e.g. the liberalisation of markets
• – Utilities
• Postal services
• Electricity
• Gas
• Banking / Finance
Globalisation of markets
• – Emergence of foreign competition
Cereal Barriers
What are the entry barriers
for new businesses and
products in the breakfast
cereal market?
How does a firm like Kellogg’s
protect its market position in
the long term?
Give some examples of product
innovation in the cereal
market in recent years