The Firm: Objectives, Costs and Revenues

The Objectives of Firms:

- Main aim is to maximise profits:
o MR=MC
o If MR>MC produce increase profit
o If MR<MC dont produce decrease profit
- Other objectives:
o Maximise sales revenue:
Firms often seek to increase their market share - even if it means less profit. This
could occur for various reasons:
Increased market share increases monopoly power and may enable the firm to
put up prices and make more profit in the long run
Managers prefer to work for bigger companies as it leads to greater prestige and
higher salaries
Increasing market share may force rivals out of business. E.g. supermarkets have
led to the demise of many local shops. Some firms may actually engage in
predatory pricing which involves making a loss to force a rival out of business
o Maximise growth of a business
o Maximise revenue:
May allow them to attain economies of scale or some form of monopoly power
o Maximise managerial objectives (significant when there is divorce of ownership from
control)
- Satisficing:
o Describes the situation where a firm is run in such a way as to satisfy a key stakeholder
o One form of satisficing if where those in control of the company seek to make sufficient
profit to keep shareholders happy, by pursue their own objectives subject to this
constraint
o This is called divorce of ownership from control

Q1 = Profit maximisation (MR=MC)
Q2 = Revenue Maximisation (MR=0)
Q3 = Marginal cost pricing (P=MC) -
allocative efficiency
Q4 = Sales maximisation - maximum
sales whilst still making normal profit
(AR=ATC)








Divorce of Ownership from Control:
- Refers to the situation where the owners of the firm are not involved and therefore cannot
control its conduct
- Could be run in a way that doesnt maximise profits as those controlling it may have different
objectives from those who own it
- There are 4 types of companies:
o Sole traders: own the company and run it on a day-to-day basis
o Partnership: own the company and run it on a day-to-day basis
o Private limited company: owned by shareholders
o Public limited company: owned by shareholders. Shares can be traded on the stock
market, thus the composition of ownership can change constantly
- Effects:
o May affect the conduct (if it pursues profit maximisation or other objectives) and
performance (economic efficiency and equity)
o Affecting a firms conduct depends on:
How accountable the directors and management of the firm are to shareholders
(shareholders can remove directors)
Whether incentives are in place to encourage directors and staff to profit
maximise (by encouraging employees to be shareholders)
How large the firm is (the larger the form the most difficult it may be to exercise
control)
- Reasons for separation:
o Company may become too big to be run by owners
o Shareholders may not be interested in running the company, their motives simply lie in
profit making
o Debt borrowing
Bonds
Pay back debt, interest, no partner, fixed not determined by contract, little
uncertainty, low risk
o Equity
No deadline, dividends, has a say in the business, more return, higher risk
o Trade off facing public companies
Between having more resources but less control
Extending share capital when competition goes public, control is lost
o External finance (borrow from bank)
Has to be paid back with interest after a certain amount of time
Bank has no say
Dividend
o Internal finance:
Doesnt have a payback time
Partner has a say
Expects return share benefits



The Law of Diminishing Returns and Returns to Scale:








Short-run Production and the Law of Diminishing Returns:
- A short-term law which states that as a variable factors of production is added to fixed factors,
eventually the marginal returns of the variable product will begin to fall
- Short run:
o The time period in which at least one factor of production is fixed
- If a small firm hires employees, the workers benefit from specialisation
o The marginal product of labour will increase
o Marginal product is the increase in output that results from adding an extra worker to
the labour force
o However, the more workers there are, the sooner the benefits of specialisation will end
o The law of diminishing returns sets in when the marginal product of labour starts to fall
(when one more worker adds less to the total output than the previous worker who
joined)
-



Marginal product vs average product:











Production Theory
Short-run production theory Long-run production theory
The Law of
Diminishing
Returns
Returns to
Scale
Output
B
C
- Up to point C, MP>AP
- At point C, MP=AP which is
maximum average product of C
- If MP>AP, AP is rising
- If MP decreases, AP also
decreases
- B = diminishing marginal returns
sets in
- C diminishing average returns
sets in

Long-run Production and Returns to Scale:
- Long run:
o The time period in which no factors of production is fixed
- Three possibilities:
o Increasing returns to scale
An increase in the scale of all factors of production causes a more than
proportionate increase in output
o Constant returns to scale
An increase in the scale of all factors of production causes an exactly
proportionate increase in output
o Decreasing returns to scale
An increase in the scale of all factors of production causes a less than
proportionate increase in output

Fixed and Variable Costs, Marginal, Average and Total Costs, Short-run and Long-run Costs:
Fixed costs:
- Costs that do not vary with output. They must be pain the
short run even if no output is produced
o Rent
Variable costs:
- Costs that vary in proportion to output
o Electricity
o Gas
- When labour is the only variable factor of production, variable costs are simply wage costs.
With increasing marginal labour productivity, the total variable cost of production rise at a
slower rate than output.
- This causes the MC of production an extra unit of output to fall. However the law of diminishing
marginal productivity sets in, marginal cost rises with output. Variable costs rise faster than
output, so marginal costs also rise.
Marginal costs:
- The additional cost of making one extra unit of output
Average costs:
-



Total costs:
- Total cost of production = total fixed costs + total
variable costs
Short run costs:
- In the short run, when the inputs divide into fixed
and variable factors of production, the costs of
production can likewise be divided into fixed and
variable costs
- Total cost = total fixed cost + total variable cost
- Average total cost = average fixed cost + average
variable cost
MC
ATC
AFC
AVC
- As quantity increase, AFC decreases as it spreads the cost to products
- Shows how the firms average total cost is derived by adding the AFC and the AVC









- Shows the ATC curve without AFC and AVC
- AC is U shaped showing that AC per unit of output fall then rise as output increases
- AC must eventually rise as at high levels of output, any further spreading of fixed costs is
insufficient to offset the impact of diminishing returns upon variable costs









Long run average costs:
- If, as the firm increases its size or scale of factors of production, it benefits from increasing
returns to scale, the LRAC curve falls
o Economies of scale
- Rising long-run average costs are known as diseconomies of scale
- AC
3
represents
the lowest unit
cost and most
productively
efficient
o Optimum
size of
firm


- Other types of LRAC curves:
o Minimum Efficiency Scale is sited at
the point on the LRAC curve beyond
which no more economies of scale
are possible
o No diseconomies of scale, so all firms
beyond MES are equally productively
efficient


Economies of Scale: falling long-run average costs as the size or scale of the firm increases
Internal economies of scale: result from the growth of the firm itself and are usually categorised into
technical, marketing, managerial, financial and risk-bearing economies.
Plant level:
- Technical economies: relate to production and distribution process
o Larger firms can employ and combine specialist machinery that should reduce the
average costs of production
o Within larger firms, there is also a greater scope for the specialisation of labour,
reducing average costs
o Law of increased dimensions (doubling the height and width of a tanker can lead to a
more than proportionate increase in the cubic capacity)
- Managerial economies: arise as a result of the application of the division of labour to
management
o Larger supermarkets can afford to employ specialist buyers who can reduce buying
costs
o Better use of equipment and management can raise productivity and reduce average
costs
Multi-plant:
- Occur when long-run average costs fall as a result of operating more than one plant
Firm-level:
- Marketing economies: relate to buying and selling
o As a firm grows it can spread its advertising budget over a larger output, by can
purchase its factor inputs in bulk at negotiated prices
o A firm may have monopsony power
- Financial economies: larger firms normally have greater access to credit facilities with
favourable rates of borrowing in comparison to smaller firms
- Risk-bearing economies: as firms grow they are able to reduce costs by effectively self-insuring
o Product diversification reduces the risk associated with the failure of any one product
because the firm can be sustained by more successful lines of output
Learning effects:
- Workers trained to use machines
- Trained to be managerial

External economies of scale: arise from the growth in the size of an industry as a whole
Total revenue
- Firms will experience a fall in long run average costs, especially if theyre clumped together
- Economies of concentration:
o When firms locate near each other mutual advantages (transport, storage, market
outlets)
o Cluster effect
- Economies of information:
o Worthwhile for specialist firms to undertake research and provide information through
technology and trade from which all firms can benefits
- Economies of disintegration:
o Vertically linked production processes can be provided more efficiently by independent
specialist firms

Diseconomies of Scale: rising long-run average costs as the size or scale of the firm increases
- Control:
o Monitoring how productive each worker is in a modern corporation is both imperfect
and costly
- Co-ordination:
o It is difficult to co-operate complicated production processes and they may break down
o Achieving flows of information in large businesses is expensive
- Co-operation:
o Workers in large firms may feel a sense of alienation
o If they do not consider themselves to be an integral part of the business, their
productivity may fall

Total, Average and Marginal Revenue:
Revenue: the income generated from the sale of
a good or service. The revenue earned by a firm
depends on the willingness of consumers to buy
the product at any given price and therefore
relates to demand.
Total revenue:
- Total revenue = price x quantity
- Price increase depends on price elasticity
of demand

PED>1 (elastic) PED<1 (inelastic) PED=1 (unitary)
Price rise Total revenue falls Total revenue rises Total revenue constant
Price fall Total revenue rises Total revenue falls Total revenue constant

Average revenue:
-



- Since total revenue = price x quantity, average revenue =


which reduces to
AR=P

Marginal revenue:
- The addition to revenue from selling one extra unit of the good or service

Revenue curves:
- Price takers:
o Demand curve is perfectly elastic
As the firm sells each
additional unit, AR must
equal MR
- Price makers:
o Downward sloping demand curve
Applies to firms with some
degree of monopoly power
Firm must reduce price in
order to sell an extra unit of
good
MR from the sale of the extra
unit is less than the price its
sold at


Competitive Markets









The Model of Perfect Competition:
1) Many buyers and many sellers
o 0% concentration
2) Homogenous products
o Each firms produce is identical
3) Perfect information
o Each firm and consumer has perfect knowledge of market conditions
4) No entry or exit barriers
o Complete freedom of entry and exit
5) Firms being able to sell as much as they wish at the ruling price established by demand and
supply of the market
6) Independent action by firms will not influence the ruling market price
0% INCREASING MARKET CONCENTRATION 100%
Perfect competition Monopolistic Competition Oligopoly Monopoly
A market is concentrated if a small number of firms hold a large market share. Market structure
refers to concentration; the height of any entry barriers; whether firms sell homogenous
products and the knowledge firms and consumers possess
Market structure impacts on the conduct of firms (do they set own prices? Accept market price?
Collude?)
The conduct of firms has implications for the economic performance of the market in terms of
efficient resource allocation, productive efficiency and possibly equity considerations
Short run equilibrium in perfect competition:







- The firm has to accept the ruling price determined by market supply and demand
- Supernormal profit: profit earned over and above normal profit. Shown by the shaded area
(total revenue total cost)
- Subnormal profits: is the loss a perfectly competitive firm makes when the ruling market price
lies below the firms ATC curve but above AVC curve
- If price is above P
1
, consumers will buy elsewhere
- If price is below P
1
supply will be infinite
- If firms produce lower than Q
1
, MR>MC produce
- If firms produce higher than Q
1
, MR<MC dont produce

Long run equilibrium in perfect competition:









- In the short run, new firms cannot enter the market so incumbent firms (firms already in the
market) continue to make supernormal profits
- In the long run, there are no entry or exit barriers and firms can enter or leave the market
freely
- Supernormal profits attract new firms to the market
- The entry of a new firm shifts the market supply curve to the right causing the ruling market
price to fall until it settles at P
2

- Market and firm are now both in long run and true equilibrium
Whole
market
Firm
Q
1
Q
1
Q
2
P
2
P
1
(AR=MC)
2
(AR=MC)
1
Q
1
S
1 S
2
Q
2
- Because the profit made by surviving firms is restricted to normal profit, the incentive for new
firms to enter the market no longer exists

Competition and the Efficient Allocation of Resources:
- Economic efficiency: minimises costs incurred, with minimum undesired side effects
o Static efficiency measures technical, productive, X and allocative efficiency at a
particular point in time
- Technical efficiency: maximises output from the available inputs or factors of production
o Production is technically efficient if it minimises the inputs of capital and labour needed
to produce that level of output.
- Productive efficiency: involves minimising the average costs of production
o A firm must use the factors of production which are available at lowest costs per unit of
output.
o In the short run, the lowest point on the short-run average costs curve locates the most
productively efficient level of output for a particular scale of operation
o True productive efficiency is a long-run rather than a short-run concept. A firms long
run average cost curve shows the lowest unit cost of producing different levels of
output at all the different scales of production.
o A PPF diagram can also show productive and technical efficiency.
- X-efficiency: occurs whenever, for the level of output it is producing, the firm incurs
unnecessary production costs.
o Due to organisational slack resulting from the absence of competitive pressure,
monopolies are always likely to be technically and productively inefficient.
o Any point on the ATC curve including productive efficiency point it is said to be X-
efficient.
o This can be caused either by a form being technically inefficient (over-manning) or by
paying unnecessary high wages or capital costs.
- Allocative efficiency: occurs when it is impossible to improve overall economic welfare by
reallocating resources between industries or markets (assuming an initial distribution of
income and wealth). For resource allocation in the whole economy to be allocatively efficient,
price must equal marginal cost (P=MC) in each and every market in the economy
o When P>MC consumption is discouraged and allocative inefficiency occurs
o When P<MC the price is too low, encouraging too much consumption of the good
o For any given employment of resources and any initial distribution of income and
wealth amongst the population, total consumer welfare can increase if resources are
allocated from markets where P<MC into those where P>MC, until allocative efficiency
is achieved when P=MC in all markets
- Dynamic efficiency: measures the extent to which various forms of static efficiency improve
over time
o Improvements in dynamic efficiency result from the introduction of better methods of
producing existing products, including firms ability to benefit to a greater extent from
economies of scale and also from developing and marketing new products
o In both cases, invention, innovation and research and development improve dynamic
efficiency
Concentrated Markets
Monopoly:
Structure:
- Single supplier
o 100% market concentration
- Entry barriers high enough to prevent new market entry
Conduct:
- Monopoly firms enjoy price making power
- Price setter
- No substitutes for the product
o Likely to face an inelastic demand curve
o Can raise prices while suffering a less than proportionate contraction of demand
o Total revenue and profit rises

Advantages of monopolies Disadvantages of monopolies
- May achieve large economies of scale which
may allow a monopolist to produce at a lower
price and a higher output than a perfectly
competitive industry
- Contribute to dynamic efficiency because
profits may fund R&D leading to innovation
o Lack of competition may reduce incentive
to innovate
- Firms seeking monopoly power may at in social
ways
o Sponsoring community events
o Advertising revenue helps pay for
services (ITV)
- Some focus on selling at low prices in high
quantities
- X inefficiency: because a monopolist dominates
a market, it may have less incentive to be
efficient and keep costs down. Costs will then
rise because of inefficiency
- Monopolist can earn abnormal profits due to
barriers to entry
- Allocatively inefficient (price charged is higher
than marginal cost) welfare loss
- Productively inefficient (may not produce at
minimum of AC)
- Higher prices for less output


Monopoly equilibrium:
- Supernormal profit gained has been
accompanied by a market failure
- No distinction between short run and
long run
o Entry barriers prevent new firms
entering the market, enabling the
monopoly to take supernormal
profits in both long and short run
- Black dot = X inefficiency. Cost is high
due to workers slack

Causes of monopoly and sources of monopoly power:
- Stems from the firms ability to exclude rivals from the market by imposing entry barriers
- Perfect competition is characterised by consumer sovereignty (firms respond to the wishes of
consumers)
- Monopolies exercise and exploit producer sovereignty
- Consumers cannot go anywhere else to buy the good
- Firms with monopoly power will exploit consumers by restricting output and raising prices by
restricting the consumers choice
- Monopoly power is greatest where there are no substitutes and their good is an essential good
(water)
- Factors that influence monopoly power:
o High market concentration
o Imperfect knowledge
o Geographical location
o Control over raw material supply or market outlets
o Economies of scale
o Advertising
o Branding and product differentiation as entry barriers
o Laws such as patent legislation
o High entry barriers

Dynamic efficiency in monopoly:
- Monopolies may also be more dynamically efficient than a perfectly competitive firm.
- Protected by entry barriers, a monopoly earn monopoly profit without facing the threat that
the profit disappears with new firms entering the market.
- This allows an innovating monopoly to enjoy, in the form of monopoly profit, the fruits of
successful R&D and product development.
- In perfect competition there is no incentive to innovate because firms can free-ride and gain
costless access to the results of any successful research.

Evaluating perfect competition and monopoly in terms of economic welfare:



















and price rises to P
2
.
- Consumer surplus is a measure of the economic
welfare enjoyed by consumers: surplus utility
received over and over the price paid for a good
- Producer surplus is a measure of the economic
welfare enjoyed by firms or producers: the
difference between the price a firm succeeds in
charging and the minimum price it would be
prepared to accept
Analysis:
- Market equilibrium is determined at point B:
output is Q
1
and price is P
1
. However monopoly
equilibrium is determined at point C: where
MR=MC so output is restricted to Q
2


D
MR

D=AR

LRAC
m
=LRMC
m
LRAC
pe
=LRMC
pe
P
c
P
n
P
e
P
1
Monopolies can strategically
lower their prices to just below
the new entrants level (P
e
P
n
)
so new entrants cannot enter
the market


Barriers to entry and exit:
- Designed to block potential entrants from entering a market profitably
- They seek to protect the power of existing firms and maintain supernormal profits and increase
producer surplus
- Examples of barriers:
o Cost advantage: economies of scale other firms cannot compete
o Control over supplies
o Patents and trademarks: provide firms with legal protection of their ideas and designs
o Legislation: British Gas and BT were government owned monopolies
o Production differentiation: firms can establish monopolistic position
o Control over outlets so competitors cannot get products to market
o Fear of reaction of existing firms
- Types of barriers:
o Structural: arising from differences in production costs. No one can compete. More
efficient
o Legal: barriers given for of law (patents). Strongest method for firms to engage in R&D
and innovation. Not enough to give incentive to firms for this innovation
o Strategic: most common is price limiting setting price below the entrants costs of
production

Monopolistic competition:
- Has all the characteristics of perfect competition (many buyers and sellers, perfect information
and absence of barriers)
- In perfect competition it is possible to make supernormal profits or economic loss
o Demand might be more elastic than under monopoly because of the presence of good
substitutes

- Under perfect conditions, supernormal profit cannot persist in the long run
- If a monopoly raises the price from P
1
to P
2
it gains the consumer surplus equal to the rectangle
area P
1
P
2
AD. However over and above this transfer there is a net loss of economic welfare as
output falls to Q
2
, this is shown as the deadweight welfare loss.

- Lack of entry barriers allows firms to respond to the incentive offered by supernormal profit
and enter
- As new firms enter, supernormal profit decreases as demand curve shifts to the left
- Long run equilibrium is this defined by normal profit









- Outcome is not as efficient as if the market had been perfectly competitive
o Product differentiation = higher prices (now above marginal costs)
- To raise the price, firms have do limit output so productive efficiency isnt achieved

The Growth of Firms:
- Why do firms grow?
o Profit motive: businesses grow to expand output and achieve higher profits. Stock
market valuation of a firm is influenced by expectations of future sales and profits.
o Cost motive: economies of scale increase productive capacity of the business and help
raise profit margins
o Market power motive: increased market dominance = increased pricing power.
Monopolies can engage in price discrimination
o Risk motive: expansion of a business might be motivated by desire to diversify
production
o Managerial motive: objectives differ
- How do firms grow?
o Expansion of existing production capacity
o Investment in new technology and capital
o Adding to the workforce
o Developing and launch of new products
o Growing a customer base through marketing
- Can grow externally through mergers and take overs
o Motivations for external growth include the desire to acquire greater market share and
therefore power
o Firms could achieve economies of scale, acquire valuable brand names owned by other
firms or to gain greater control over the supply chain
- Can also grow internally by expanding their operations and perhaps diversifying into new
products


Horizontal integration Where 2 firms join at the same stage of
production in the same industry
Advantages:
- Increases size of business and allows for
more internal economies of scale higher
profits
- One large firm may need fewer workers,
managers and premises than 2
rationalisation
- Mergers
- Creates a wider range of products
- Reduces competition by removing rivals
increases market share
Vertical integration Where a firm develops market power by
integrating with the different stages of production
in an industry
Advantages:
- Greater control of supply chain reduces costs
- Improved access to raw materials
- Better control over retail distribution
Creation of statutory monopoly Patents for technological advances such as Blu-ray
also confer a statutory monopoly for a certain
time
Franchises and licenses Give a firm the right to operate in a market
usually open to renewal every few years:
- Commercial radio licences
- Commercial TV
- Local taxi route licenses
- Regional rail services
- National Lottery
Internal expansion of the firm Firms can generate higher sales and increase
market share by expanding their operations and
exploiting possible economies of scale

How do small firms survive?
1) Niche markets
o Small firms often produce specialised products where consumer demand is inelastic
allowing them to charge a price premium
2) Quality of service
o Excellent customer service can be important in helping small firms can apply to local
convenience stores
3) Innovation
o Highly innovative small companies have an excellent change of survival and may grow
into large companies
4) Internet retailing
o Made it easier for small firms to survive as they can reduce the fixed costs of running a
business
5) Government funding support
o May be available to small companies (tax relief)
x
y
z
Price discrimination:
- When a firm charges different prices to different groups of consumers for an identical good or
service
Necessary conditions:
- Different PED for the product from each group
o Firms will then charge a higher price to those with a more inelastic PED and lower to
others
- Cost of selling must not be prohibitive
- The monopolist must have a price making power
Degrees of discrimination:
- 1
st
degree:
o Perfect discrimination
o Firm charges each individual consumer the maximum price they are willing to pay
o Consumer surplus is turned into additional revenue










- 2
nd
degree:
o When firms discount spare capacity to
below the published price
o Fixed costs of production are high
o Marginal costs are low
o Spare capacity equal to the difference
between Q
m
and full capacity (Q
fc
)
o Firm can sell this excess capacity at a
price lower than P
2

o This benefits consumers who are able
to purchase the service at the last
minute as they pay a lower price
o This will increase total consumer surplus by xyz
- 3
rd
degree:
o Most frequent form
o Charges different prices for the same product
o Market usually separated in 3 ways:
By time:
Telephone and electricity
3 rates for telephone: daytime peak rate, off peak evening rate and
cheaper weekend rate
By geography:
Exporters may charge higher prices in overseas markets if demand is
more inelastic
By age:
Children and pensioners are charged less than others










- Firm aims to charge a profit maximising price to each group
- In the peak market firm will produce where MR=MC and so will off peak
- Consumers with an inelastic demand will pay a higher price
Does it benefit the consumer?
- Consumer surplus is reduced in most cases
- Price is greater marginal cost in most cases and so firms are not achieving allocative efficiency
- Price discrimination is clearly in the interest of firms who achieve higher profits

Monopsony:
- When there is a sole buyer of a product (single buyer)
- Exists when a firm buys a large enough proportion of market output to drive down prices
- When their power is strong, it is unlikely that supplying firms can make more than normal profit
o Can be advantageous in countering any monopoly power that might be present on the
supply side of the market
o Resource allocation is likely to be more efficient when prices are lower and driven down
to normal profit level
- Monopsony can threaten the viability of supplying businesses

Oligopoly:
Structure:
- An oligopoly is a concentrated market dominated by a few producers
- Firms offer differentiated products
- Entry barriers are present and vary in size
- Examples:
o Electricity (British Gas, EDF)
Peak Off-peak
o Petrol (BP, Shell)
o Telecommunications (Virgin, BT)
o Washing powder (Persil, Ariel)
Conduct:
- The concentrated nature ensures firms are interdependent
- Pricing and output decisions depend on strategies chosen

Collusion:
- When a firm refrains from competition and act as if they were one joint monopoly
- Formally cartel where firms agree a prices and a fixed quota of output for each firm
- Implicit where firms do not reach an agreement with each other by come to recognise that it
is not in any firms interests to spark a price war
Competitive:
- When firms compete on price
- Prices under competitive oligopoly tend to be driven to lower levels while output is high

To compete of collude?
Collude Compete
- Small number of firms
- Firms have similar costs
- High barriers
- Effect of cheating is not easily detected
- Ineffective competition policy
- Consumer loyalty making gains from
price competition less attractive
- Consumer inertia ^
- More firms
- New market entry
- One firm as significant cost advantages
- Collusion produces
o Higher prices
o Lower output
o Allocative inefficiency
- Therefore collusive monopoly produces market failure
Non price competition:
- Assumes increased importance in oligopolistic markets
- Involves advertising and marketing strategies to increase demand and develop brand loyalty
among customers
- Can use other policies to increase market share:
o Better quality of service
o Longer opening hours
o Discounts on product upgrades
o Contractual relationships with supplies
o Advertising most popular method
Role of advertising:
- Generates awareness, interest, desire and action AIDA model
- Can persuade
- Inform
- Increase demand
But it can also
- Mislead
- Create barriers to entry by making demand inelastic

Interdependences in oligopolistic markets:
- Kinked demand curve can explain long periods of
price stability under oligopoly
- Assumptions:
o When a firm raises its price, other firms
do not follow. Therefore the firm who
raises the price faces more than a
proportionate contraction in demand
o When one firm cuts its price, other firms
do likewise. No market share is gained
from rivals. Demand extends less than
proportionately

Pricing strategies:
- Price leadership
o When all firms follow the price decisions of one of the other firms
- Limit pricing
o Selecting the highest price possible without encouraging entry
o If competitors entered the extra supply would drive down the price to a level at which
they could not survive so they dont enter
- Predatory pricing
o Occurs when firms deliberately undercut competitors to force them out of the market
Anti-competitive
Game theory:
- The decision that a firm makes in oligopoly depends on its assumption of other firms
- Firms will try and calculate the best course of action depending how others behave
- Helps explain the breakdown of price-fixing agreements between producers which can lead to
price-wars
- Game theory provides an insight into the interdependent decision-making that lies at the heart
of interaction between businesses in an oligopolistic market

Contestable Markets:
Definition:
- When a market is open to entrants:
o Low entry and exit barriers particularly sunk costs (costs that are not recoverable on
leaving a market start-up costs, advertising costs)
o The potential for post-entry supernormal profit for new firms
- A market with no entry or exit barriers is regarded as perfectly contestable
- A monopoly could be perfectly contestable if there was a single firm but an absence of entry
and exit barriers

Patents Give a firm legal protection to produce a patented product
for a number of years. Government enforced property
rights to prevent entry of rivals. E.g. Dyson vacuum cleaner
Vertical integration Control over supplies and distribution can be important.
E.g. oil companies
Limit pricing Firms may adopt predatory pricing policies by lowering
prices to cause new entrants losses
Absolute cost advantages Lower costs allow the existing monopolist to cut prices
Advertising Enable firms to establish branded products and win
customer loyalty
Sunk costs High start-up costs could be unrecoverable if entrant ops
out
International trade restrictions Trade restrictions (tariffs) are also barriers

Entry limit pricing:
- In a market with low entry barriers, supernormal
profits is likely to attract new entry
- Incumbent firms lower prices which would create
maximum profit in short run
- If there are no entry barriers, monopoly may be
forced to price at normal profit level AR=AC

Hit and run competition:
- Possible for new firms to enter for brief periods of
time and make supernormal profits even if they
are forced to leave

The Labour Market

Demand for labour and the marginal productivity theory:
- Demand for labour is derived demand
- Employers hire workers to make products to sell for profit
Factors influencing demand for labour:
- Availability and price of substitutes: capital
- Price: wages
- Availability and price of complements: tools
- Elasticity of demand for the product
Why is it downward sloping?
- Long run: substitute machinery for workers
- Short run: fixed amount of capital
o Last worker employed will be less productive than the worker before so wage should fall
Law of diminishing returns
Main factor influencing demand for labour:
- Marginal Revenue Product: the value of the physical addition to output of an extra unit of a
variable factor of production
- In perfect competition: MR=P
- Marginal Physical Product: the physical addition to output of an extra unit of a variable factor of
production
- MPP x P = MRP
Shifts in the labour demand curve:
- Marginal revenue productivity of labour will increase when there is
o An increase in labour productivity (MPP) e.g. arising from improvements in the quality
of the labour force through training, better capital inputs, or better management.
o A higher demand for the final product which increases the price of output so firms hire
extra workers and thus demand for labour increases, shifting the labour demand curve
to the right.
o The price of a substitute input e.g. capital rises this makes employing labour more
attractive to the employer assuming that there has been no change in the relative
productivity of labour over capital

The supply of labour to different markets:
- All those who are economically active
- As firms supply more their costs rise due to law of diminishing marginal returns so need a
higher price to justify the extra production
- The higher the price of the good the more profitable it becomes to produce
Monetary factors influencing supply of labour:
- As wages increase, more people want to swap leisure for work substitution effect
o But if wages get too high, they swap work for leisure
- The real wage rate on offer in the industry itself higher wages raise the prospect of increased
factor rewards and should boost the number of people willing and able to work
- Overtime: Opportunities to boost earnings come through overtime payments, productivity-
related pay schemes, and share option schemes and financial discounts for employees in a
certain job.
- Substitute occupations: affects the wage and earnings differential that exists between two or
more occupations.
- Barriers to entry: Artificial limits to an industrys labour supply (e.g. through the introduction of
minimum entry requirements or other legal barriers to entry) can restrict labour supply and
force average pay and salary levels higher







Substitution effect > income effect
Substitution effect < income effect
Substitution effect = income effect
Income effect:
- As price of goods increases the real income of consumers decreases and they are not able to
buy the same basket of goods as before
- Work is an inferior good therefore if wages increase income increases so there is less demand
for work
Non-monetary factors:
- Improvements in the occupational mobility of labour: For example if more people are trained
with the necessary skills required to work in a particular occupation
- Non-monetary characteristics of specific jobs they include factors such as the level of risk
associated with different jobs, the requirement to work anti-social hours or the non-pecuniary
benefits that certain jobs provide including job security, opportunities for promotion and the
chance to live and work overseas, employer-provided in-work training, employer-provided or
subsidised health and leisure facilities and other in-work benefits including occupational
pension schemes
- Net migration of labour A rising flow of people seeking work in the UK is making labour
migration an important factor in determining the supply of labour available to many industries

Determination of relative wage rates and level of employment in perfectly competitive labour
markets:
- Downward sloping demand indicates more labour
will be demanded the lower the real wage rate
- Upward sloping supply indicates more labour is
supplied if real wages increase
- Demand for labour increase:
o Productivity increases (technological
change)
o Increase in selling price of product
increase value of each workers output
o Price of capital increases leading to a substitution of labour
o Price of complements falls
- Supply of labour increase:
o Increase number of workers in population due to change in demographic changes
o Wages deteriorate in other industries
Perfectly competitive labour market:







- The employer employs up to where MC=MR
Wage



W*
S
L
= AC
L
= MC
L


Wage

MPR = D

o Profit maximisation
Why do wages differ?
- Labour is not homogenous:
o Age
o Sex
o Ethnicity
o Education
o Ability
- Workers to not necessarily seek to maximise wages aim to maximise net benefits
- Labour is not perfectly mobile
Footballers and nurses:
- Supply of footballers is
inelastic
o Barriers to entry for
footballers are high
due to the fact that
natural ability is
needed for football
and few people
possess talent
- Supply of nurses is elastic
o Wage differentials:
Nursing has a
non-monetary
benefit
o Supply side reasons
for wage differences is the larger pool of nurses that can be employed
- Demand for footballers is inelastic
o Demand determined by MRP
o Footballers = higher MRP
Reflected by willingness and ability for people to pay to watch football
o Difficult to substitute as few people have the talent
- Demand for nurses is elastic
o Easier to substitute than footballers
o Wages take up NHS production costs
o Lower wages due to net MRP costs for training and so depresses wages
o NHS monopoly
Economic rent and transfer earnings:
- Economic rent: the difference between what a person gets paid and what they could earn in
their next best employment opportunity
o Tends to be greater the more inelastic the supply of labour is
- Transfer earnings: what they could earn in their next best occupation (footballer electrician)







Determination of relative wage rates and level of employment in imperfectly competitive labour
markets:
- Immobility of labour:
o Occupational:
When workers are prevented from moving between jobs
Natural or artificial barriers
o Geographical:
When factors such as family ties, finance costs etc. prevent a worker filling a job
vacancy
Trade unions:
- Role is to seek better payments for its members
- If a trade union is formed and bargains wages
above market clearing wage (W
1
to W
2
), L
2
are
employed rather than L
1
and creates
unemployment of L
2
-L
3

- S
L
becomes linked at X
Closed shop:
- Compulsory union membership the firm will
not receive a supply of labour until it accepts
wage demands of the union

Union membership in the UK:
- Factors explaining decline in union membership:
o Government policy:
Reducing union power was one of the key supply side policies of the
conservative government. TU were views as a major obstacle to labour flexibility
Policies to decrease TU power:
Making secondary picketing illegal
Requiring secret ballots of workers
Making closed shop agreements
o Restructuring of economy
Decline in heavy industry where TU were strong
Labour more dispersed in service sector harder for TU to organise
o Increasing product market pressure
ER

TE

Electrician

Footballer

Benefits of a trade union:
- Reduce wage discrimination by collective negotiations
- Reduce exploitation
- Raise standards of health and safety
- Train and development for workers
FACTS AND FIGURES:
- 33 million in workforce
- 7 million in TU (20%)
- 15% in private sector
- 60% in public sector

Monopsony:
- A sole employer in a market
- Occurs as a result of lack of competition on the demand side of the market

Monopsony without trade union:
- Not a wage taker
- If it wishes to employ an extra worker, it must
offer higher wages
o MCL>AC
L
as increased wage must be paid
to not just the extra worker but all the
other workers
- Monopsonist will hire an extra worker if
MRP>MC
L


Monopsony with trade union:
- Labour supply is perfectly elastic when trade unions withhold labour (when wages offered less
than target) monopsonist becomes a
wage taker MC
L
is constant
- In order to combat a monopsony, a
monopoly will form (TU)
o It uses collective bargaining
and the threat of industrial
action to bargain wages up
o Any point above W
m
and below
W
x
the actions of the TU result
in more workers employed
than before the TU
o DWL of ABC is reduced in size

National minimum wage:
For Against
NMW will help alleviate poverty for those who
receive it
Raising wages leads to a contraction of labour
demand and creates unemployment
The morale boost from higher wages could lead Any unemployment created will
N
1


A
B
to a productivity boost disproportionately affect the young
NMW should help reduce labour turnover at
companies, lowering recruitment and training
costs
NMW raises costs of firms and may make them
uncompetitive
Firms paying more to their workers have a
stronger incentive to train them raising MRP
NMW is potentially inflationary
NMW can help counter the power of
monopsonist employers
Fails to take into account the regional differences
in the cost of living
Recipients of the NMW are disproportionately
female
Not well targeted. May recipients are second
wage earners not in poverty
NMW offers a greater incentive to work Many recipients are employed by the state,
affecting public sector finances
Reduces male-female differentials Tax and welfare benefits more effective

- Introduced April 1999
o 6.08: 21+
o 4.98: 18-20
o 3.68: 16-17
o 2.60: apprentice rate (first year of
apprenticeship)
- If minimum wage is set below market wage it will
have no impact on the labour market
- When NMW is at W
m
the employer will employ
labour at N
1
lower than competitive market so
higher the NMW the lower employment will be

The distribution of income and wealth:
Wealth: the stock of assets (house, cars) with a marketable value
Income: the flow concept measured over a given period

The Lorenz curve:
- A representation of inequality
- Plots the percentage of a nations income
that is enjoyed by the poorest x per cent
of the population
- Diagonal = complete equality
- The further away from the diagonal, the
more unequal

Gini coefficient:
- Numerical representation of inequality
- Gini coefficient



- 0 = complete equality
- 1 = total inequality


Factors affecting distribution of income:
1) Wage differentials
High levels of qualifications or people in inelastic supply tend to generate high MRP
2) Differences in income earned from assets
The most important are financial assets such as savings
3) Age
Earning potential peaks in 40s and 50s
4) Influence of government policies
Governments operate progressive systems of taxation
Means tested benefits have the greatest effect on distribution of income but
universal benefits also have an impact
Factors affecting distribution of wealth:
1) Inherited wealth
2) Asset prices increase faster than incomes
3) Less easy to distribute

Poverty:
- Absolute poverty: when income is below a particular
level when living on $2 a day
- Relative poverty: when income is below a specified
proportion of average income when household
income is below 60% of median income
- Water poverty: spending more than 3% of disposable
income on water bills
- Fuel poverty: a household which spends more than
10% of its income on fuel
Causes of poverty:
- Low wages
- Unemployment
- Illness/disability
- Poor parents
- Racial discrimination
- Single parenthood

Poverty trap and marginal tax rates:
- Disincentive to work
- Affects those in poverty and is created by:
o Means tested benefits
o Progressive taxation
- Those on low incomes may face effective marginal tax rates of greater than 100%
- If unemployment benefit is high, replacement ratio may be close to greater than one
incentive to work is reduced
- Poverty trap could be government failure from a conflict of objectives between equity and
efficiency

Measures to tackle poverty:
- Withdraw benefits
- Universal not means tested (family allowances)
- Withdrawing means tested as income is earned
- Progressive tax
- Transfers to the poor
- Tax credits (negative income tax)
- NMW
- Government intervention redistribution of income:
o Effect on incentives
o Targeting
o Expense
o Take up rates
o Stigma

Means tested benefits:
Advantages:
- They allow money to be targeted to those who need it most. E.g. family tax credit or pension
credit.
- It is cheaper than universal benefits and reduces the burden on the tax payer
Disadvantages:
- Often unpopular because people are branded as being poor
- May create a disincentive to earn a higher wage, because if you do get a higher paid job you
will lose at least some of your benefits and pay more tax. This is known as the benefit trap or
the poverty trap
- Some relatively poor may fall just outside the qualifying limit
- Not everyone entitled to means tested benefit will collect them because of ignorance or
difficulties in applying
- The government used to prefer universal benefits because it avoided the above problem, and
people feel if they contribute towards taxes they deserve their benefits regardless of their
wealth

Government Intervention in the Market
Market failure: when a market fails to reach an optimal allocation of resources for society due to the
market mechanism performing unsatisfactorily
- Monopoly: market outcome is both allocatively and productively inefficient
- Missing market: when the incentive function breaks down
Goods:
- Pure public goods: ones which are non-excludable and non-rival
o Thames Barrier - cannot be restricted to those who have paid for the service and the
consumption of the service by one household will not reduce its availability to others
o If left to the free market mechanism, no public goods would be provided and, as a
result, there would be a clear market failure. No individual consumer would pay for a
product that could be consumed for free if another household decided to purchase it
- Non pure public good (Quasi good): ones with elements of both public and private goods
Exam Question: How does imperfect information lead to market failure for the provision of merit
and demerit goods? (15 marks)
- Market failure: inability to reach societys optimal allocation of resources
- Information failure: where differences arise from perceived and actual benefits/costs
meaning there isnt a perfect market
o Consumer/producers arent fully aware of the costs/benefits of a good
o So they are under/over consumed

- Imperfect information may arise leading to under consumption/production of a good that
might generate positive externalities
o Arent fully aware of the benefits the good provides
- E.g. Education
o Some wont continue education in sixth form
o Arent fully aware of the benefits in the long run under consumption diagram
- E.g. Engineering
o Too little is produced by universities with preferences to foreign students shortage
of engineers who are needed to help the UK improve infrastructure
o But externalities are difficult to measure universities arent aware of the issue
(dont take into account benefits to third parties)
- Unaware of costs to society and negative externalities
- Signalling function broken down good is over consumed/produced arent enough
regulations imposed making the good too cheap
- E.g. smoking
o Long term negative effect on third parties
o Costs arent taken into account despite tariffs
MSB = MPB + negative externality
A
B
MPB
C
o These are products that are essentially public in nature, but do not exhibit fully the
features of non-excludability and non-rivalry
o The road network in the UK is currently available to all, but could be made excludable
via a system of electronic road pricing. There is also non-rivalry in consumption, but only
up to an extent
o Once roads are congested rival

Environmental market failure: relate to land (factor of
production)
1) Resource depletion
When there are fewer natural
resources available compared to the
previous time periods non renewable
Negative externality with future
generations being the third party
2) Resource degradation
When natural resources are rendered
less productive than it was in previous
P
s

MSC = MPC + negative
externality
MPC
MPB = MSB
A
B
C
Q
s
Q
p

P
p

periods
Result of air/water pollution
Negative externality with future generations being the third party
3) Public good aspects of environment
Air can be seen as a public good (non-rivalrous, non-excludable and non-rejectable)
Government intervention is necessary if clean air is desired
4) Negative externalities
Pollution
Overprovided in market
5) Positive externalities
Planting trees
Under produced in market
Indirect taxation/regulation/pollution permits

Methods of internalising externalities:
1) Taxation (Pigovian tax making polluter pay)
Creates incentive for less of the negative externality to be produced
Negative externality in production
i. Tax BC which could create compulsory employers liability insurance (if a worker
was injured, they have property rights by law to remain healthy firm has to
provide safety)
Negative externality in consumption
i. Tax BC so reduce benefit (demerit good)
Problem when consumption of demerit goods forms a higher proportion of spending in
lower income households than in higher income households
i. Cigarettes and alcohol: taxed regressively and lead to increased inequality
2) Subsidy
Positive externality in production
i. Subsidise AC
Opportunity cost of government funding
Lack of or reduction in profit motive: a subsidised producer may allow other costs to rise
(productive inefficiency), fail to produce enough of the good to a high enough standard
(allocative inefficiency) or fail to innovate (dynamic in efficiency)
3) Regulation
Banning
Quantity controls
Minimum standards for health and
safety
4) Pollution permits
Assumes technology is fixed in
short run, government aims to
maximise societys welfare
Involves regulation: imposition of maximum limit on amount of pollution
Main advantage over regulation
i. Costs should be lower
Firm wants to produce at Q
p
but government wants to produce at Q
s

Government issues Q
s
of pollution permits firms then trade permits
Thus societys welfare is maximised
Advantages:
i. More efficient wat of reaching desired level of pollution
ii. Trade schemes or caps can address international distribution of income. If poor
countries are allocated sufficient permits, they can sell them to richer countries
iii. Externality has been internalised and those who pollute have to pay
Disadvantages:
i. Scheme doesnt require a judgment to be reached about the optimal level of
pollution. Not sufficient information to reach judgement accurately
ii. New market in pollution permits can lead to market failure
iii. Trading permits affects geographical distribution of pollution some pollutants
may cause more damage if they are in a concentrated areas
Kyoto Protocol:
i. Set up in January 2005
ii. 15 member states of EU participating
iii. Covers almost 46% of EUs carbon dioxide emissions
5) Property rights
If property rights are fully assigned and parties can negotiate at low cost with one
another they will arrive at efficient solutions to problems caused by externalities
without the need for explicit government intervention in the form of regulation or
taxation
E.g. water companies can seek compensation from companies/individuals who pollute
rivers
Absence can lead to consequences:
i. Opportunism may be encouraged, with individuals or groups exploiting the lack
of private ownership. With modern technology, it is easily possible to copy CDs
without paying for them another example of the free rider problem, which
means that the price mechanism is less effective at pricing goods that can easily
be stolen
ii. Misuse of scarce resources such as dropping litter on pavements, or deliberately
spilling oil in the sea. This problem is made worse is accompanied by moral
hazard, assuming that someone else will pick up the litter, or clean the seas
iii. Over-use of resources such as the depletion of rain forests, over-fishing, and
traffic congestion, can also result in the general exhaustion

























Government failure:
Causes:
- High administrative costs resulting from government intervention
o Competition policy carries a significant administration cost
- Inadequate information
o Regulators may make wrong decision if they have insufficient information
- Unintended consequences
o Side effects may be harmful (tightening enforcement of underage drinking laws by
raiding pubs more frequently may reduce alcohol problems in pubs but may lead to
more illegal drinking)
o Regulation to prevent overfishing has caused fishermen to throw fish back into sea even
though they are dead
- Conflict between objectives
o Potential for an equity-efficiency trade off
o Taxes on petrol
Competition policy:
- When concentrated markets fail to produce efficient outcomes, government intervention is
likely
- Involves government intervention to regulate markets to help them operate more efficiently
- Aims:
o Encourage business start ups
o Encourage entry into markets by removing barriers
o Take actions against anti-competitive practices
o Prevent firms from abusing monopoly power
- Has to power to:
o Fine firms
o Force firms to remove barriers
o Make firms sell off assets
o Introduce price controls
o Stop collusion
o Block mergers
- Advantages:
o Low prices for all: the simplest way for a company to gain a high market share is to offer
a better price. In a competitive market, prices are pushed down. Not only is this good
for consumers - when more people can afford to buy products, it encourages businesses
to produce and boosts the economy in general.
o Better quality: Competition also encourages businesses to improve the quality of goods
and services they sell to attract more customers and expand market share. Quality can
mean various things: products that last longer or work better, better after-sales or
technical support or friendlier and better service.
o More choice: In a competitive market, businesses will try to make their products
different from the rest. This results in greater choice so consumers can select the
product that offers the right balance between price and quality.
o Innovation: To deliver this choice, and produce better products, businesses need to be
innovative in their product concepts, design, production techniques, services etc.
o Better competitors in global markets: Competition within the EU helps make European
companies stronger outside the EU too and able to hold their own against global
competitors.
The rationale for competition policy:
- Monopoly equilibrium sees price
forced above MC creating a
misallocation of resources and
deadweight welfare loss
- Perfectly competitive equilibrium
MC=AR(P) allocatively efficient

Targets three practices:
- UK monopoly policy: abuse of
monopoly power
o It is illegal for a dominant
firm to exercise its market
power in such a way as to
reduce competition


o OFT identifies the anti-competitive practices
Excessively high prices
Price discrimination
Predatory pricing pricing set below own cost to prevent competitors entering
Vertical restrains supplying firm imposes conditions on a purchasing firm
o Seeks to prevent firms from abusing monopoly power
o Targets behaviour not dominance
- UK restrictive practices policy: (cartels, horizontal collusion)
o Under the 2002 Enterprise Act it is a criminal offence to engage in cartel agreements
irrespective of whether they are appreciable effects on competition
o Cartel agreements involve:
Price fixing
Limiting supply
Each firm agreeing an output quota
Collusive tendering
- UK merger policy:
o Seeks to prevent mergers that are likely to result in a substantial lessening of
competition
o Need to be monitored as they could become a monopoly
o Horizontal mergers may allow economies of scale to be gained

UK competition policy:
- Based on 3 legislations
o 1998 Competition Act and 2002 Enterprise Act
- Office of Fair Trading
o Body charged with ensuring that prohibitions are carried out
o Can investigate any firms suspected of engaging in one or more of the prohibited
practices
o Funded by government
- Competition Commission
o Charged with determining whether the structure of an industry or the practices of firms
within it are harmful to competition
o Investigates monopoly situations

Privatisation, public ownership, regulation and de-regulation of markets:
Privatisation:
- The transfer of assets from the public sector (government) to the private sector
- In the UK, state-owned enterprises now contribute less than 2% of GDP and less than 1.5% of
total employment
- Nationalisation: when assents are taken back into state ownership
o Most recent examples in the UK are the re-nationalisation of Northern Rock and
Network Rail
- Major privatisations in the UK
o British Airways in 1987 and BP in 1998
- Has become more complex
o Focus has switched to breaking up existing statutory monopoly power through
deregulation and liberalisation of markets
o Designed to introduce competition
- Huge rise in total public sector employment
- Public sector businesses:
o British Nuclear Fuels
o Network Rail
o Royal Mail
- Main arguments for privatisation:
o Private sector and discipline of the free market forces are a better incentive for
businesses to be run efficiency and thereby achieve improvements to economic welfare
o Extra competition will lead to reductions in price level for consumers and improvements
in dynamic efficiency
o Seen as a way of reducing trade union power and encouraging an increase in capital
investment
Businesses now free to raise extra financial capital through stock market
o Provides government with short term source of revenue reduction in public borrowing
and state spending
o Improved efficiency
Publicly owned companies have no incentive to cut costs X inefficiency
Privatised firms have incentive to reduce cost due to higher profits so greater
productive efficiency
o Lack of political interference
Governments make poor economic managers - they are motivated by political
pressures rather than sound economic and business sense
- Main arguments against privatisation:
o State owned enterprises faced competition when part of public sector
Transfer of ownership merely replaced a public sector monopoly with a private
sector
o State assets where sold off by governments at too low a price
Decreased investment and employment as privatised businesses have sought to
cut operating costs
o Increases monopoly abuse by transferring socially owned monopolies into weakly
regulated monopolies
o Natural monopoly
Occurs when the most efficient number of firms in an industry is one.
E.g. Tap water has very significant fixed costs; therefore there is no scope for
having competition amongst several firms.
Privatisation would create a private monopoly which might seek to set higher
prices which exploit consumers.
o Public Interest
There are many industries which perform an important public service, e.g health
care, education and public transport.
In the case of health care, it is feared privatising health care would mean a
greater priority is given to profit rather than patient care.
o Government loses out on potential dividends
Many of the privatised companies in the UK are quite profitable. This means the
government misses out on their dividends, instead going to wealthy
shareholders.
o Problem of regulating private monopolies
Privatisation creates private monopolies, such as the water companies and rail
companies. These need regulating to prevent abuse of monopoly power.

Example: Network Rail/Rail Track
Privatised for these reasons:
- Loss making nature of British Rail
- Heavy dependence on external subsidies for rural and provincial services
- The need to see safety as an overriding priority
- Positive externalities of railways, - taking traffic off congested roads
- BR was an integrated national network with a complex systen of fares and railcards.
- Railways had an extensive national infrastructure

Arguments for rail privatisation:
- Increased efficiency through reducing costs and cutting waste
- Increased concern for consumer need
- less subsidy from government
- MBOs giving a market led service
-
Arguments for rail privatisation:
- Rail is a natural Monopoly, therefore there is little scope for competition because duplication
would lead to lower average costs
- Lack of organization of the national network
- It is not clear where responsibility for safety lies in a fragmented network. E.g. chairman of rail
track stated that it is impossible to lower prices, increase investment for improved safety and
meet targets for improved punctuality
- It has not been easy to cut subsidies, many argue the government needs to spend more
subsidies to improve safety
- Less profitable services are always under threat
- Many fares have risen
Deregulation:
- The process of removing controls
- To open up markets and encourage the entry of new suppliers
- E.g.
o Opening up of markets for household energy supplies
o Liberalisation of household mail services
o Financial deregulation affecting banks and building societies
- Designed to improve resource allocation
o Makes markets more contestable (forces incumbent firms to lower prices and increase
output)

Notions of equity:
- Equity: fairness
o Involves a valued judgement
- Equality: equal
Horizontal equity:
- Concerned with the fair treatment of people whose circumstances are the same
o People with a similar ability to pay taxes should pay similar amounts
Vertical equity:
- The fair treatment of people whose circumstances differ
- People with a greater ability to pay taxes should pay more
Cost-Benefit Analysis (CBA):
- The method used to appraise major investment projects
- Project is commercially viable if its private benefits exceed private costs
- CBA attempts to establish whether the project carries a net social benefit (social benefit-social
costs)
- Governments may choose to carry out CBA to improve allocation of resources
- Examples:
o New line in London Underground
o New run ways
o Nuclear power station
- Projects have to have an efficient use of resources
where MSB=MSC
Method:
- Identify all costs and benefits
- Attach a monetary value to each cost and benefit
- Find social benefit and social cost using:
o Social benefit = private benefit + external benefit
o Social cost = private cost + external cost
- Subtract social cost from social benefit to find net social benefit
- Opportunity cost
o Look at alternative uses for the resources to establish if the project is the best use of the
resources

Problems:
1) Identifying all costs and benefits:
Governments may not have the information to identify accurate costs and benefits
2) Putting a monetary value on costs and benefits
Valued by market transactions and therefore may seem relatively easy to measure
But future demands may be hard to estimate (costs may exceed budget)
3) Valuing costs or benefits that may/may not occur
E.g. nuclear plant possibility of a nuclear accident should be considered
Necessary to attach a probability to the cost/benefit concerned
4) Valuing costs or benefits that occur in the future
Discount future costs and benefits to find their present value
Difficult to choose appropriate rate of discount
5) The CBA may not cover everyone affected (i.e. all third parties)
Inevitably with major construction projects such as a new airport or a new road, there
are a huge number of potential stakeholders who stand to be affected by the
decision. CBA cannot hope to include all stakeholders there is a risk that some groups
might be left out of the decision process
6) Distributional consequences
Benefits to the poor are usually worth more. Those receiving benefits and those
burdened with the costs of a project may not be the same. The equity issue is as
important as the efficiency argument.

7) Valuing the environment:
How are we to place a value on public goods such as the environment where there is no
market established for the valuation of property rights over environmental resources?
How does one value nuisance and aesthetic values?


8) Valuing human life:
Some people are against valuation of human life. This objection can be partly overcome
if we focus instead on the probability of a project reducing the risk of death and
there are insurance markets in existence which tell us something about how much
people value their health and life when they take out insurance policies.
9) Attitudes to risk:
E.g. a cost benefit analysis of the effects of genetically modified foods
i. Precautionary Principle: Assume toxicity until proven safe
If in doubt, then regulate
i. Free Market Principle: Assume it is safe until a hazard is identified
If in doubt, do not regulate




Exam Question: Evaluate the advantages and disadvantages of using CBA when deciding
whether or not to invest in snow-clearing equipment. (25 marks)
- Advantages:
o Puts information in from of decision makers
o Encourages transparency about the claims that are made
- Disadvantages:
o Collects too much information
o Clouds the issue
o False objectivity
- Arguments that CBA could reveal in favour of investment:
o Prices
o Output
o Profits
o Earnings
o Employment
- Arguments against that CBA could reveal:
o Costs
o Taxes
o Government budgets
o Waste of resources