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A2 Economics

Microeconomics

Course Companion

2009

A2 Economics Microeconomics Course Companion 2009

2

Introduction to the A2 Microeconomics Study Companion

Welcome to this 2008­ 09 edition of the Tutor2u A2 microeconomics study companion. The edition has been revised throughout and seeks to provide a comprehensive coverage of some of the key ideas in the A2 business economics courses together with coverage of environmental market failure issues and aspects of labour market economics .

The digital version of this study companion contains many links to selected online resources such as recent news articles fro m recommended newspapers and magazine. And also to the Tutor2u economics blog so that when you click on such a link, you will be guaranteed to be taken to the latest blog features written after this study companion was completed.

This study c ompanion is designed as a complement to your studies in A2 Economics and should not be regarded as a substitute for taking effective notes in your lessons. Points raised and issues covered in class analysis and discussion invariably go beyond the confines of this guide. And with Economics being the subject that it is, events and new economic policy debates will inevitably surface over the next twelve months that take you into new and exciting territory.

Economics is a dynamic subject, the issues change from day to day an d there is a wealth of comment and analysis in the broadsheet newspapers, magazines and journals that you can delve into. The more reading you manage on the main issues of the day the wider will be your appreciation of the theory and practice of economics.

Further resources including online tests and revision notes are available from the Tutor2u virtual

learning environment (VLE) at

subscription to this resource and EconoMax Tutor2u ’s digital magazine for Economics.

I acknowledge the help given in the preparation of this study companion by my own students and I also acknowledge some of the ideas and arguments put forward in articles written by Bob Nut ter, Jim Riley, Liz Veal and Mark Johnston some of my fellow writers for the EconoMax digital magazine from which a small number of articles have been adapted as mini case studies.

Good luck with your studies

Geoff Riley

This study companion follows the AQA syllabus and chapters are grouped into five main sectors:

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Check to see if your school or college has a

1. The Firm: Objectives, Costs and Revenues

2. Competitive Markets

3. Concentrated Markets

4. The Labour Market

5. Government Intervention in the Market

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Contents

1. Production in the Short and the Long Run

4

2. How can we calculate the costs of a firm?

8

3. Long Run Costs: Economies and Diseconomies of Scale

13

4. Business Revenues

23

5. Profits

26

6. What Objectives Do Firms Have?

34

7. Divorce between Ownership and Control

38

8. Technological Change, Costs and Supply in the Long­ run

42

9. The Growth of Firms

45

10. Perfect Competition

51

11. Monopolistic Competition

59

12. The Model of Monopoly

62

13. Barriers to Entry and Exit in Markets

65

14. Price D iscrimination

69

15. Monopoly and Economic Efficiency

76

16. Collusive and Non ­ Collusive Oligopoly

84

17. Oligopoly and Game Theory

90

18. Contestable Markets

97

19. Monopsony Power in Product Markets

101

20. Consumer and Producer Surplus

103

21. Price Takers and Price Makers Pricing Power

106

22. Competition Policy and Regulation

111

23. Privatisation and Deregulation

116

24. The Labour Mark et

124

25. Monopsony in the Labour Market

137

26. Discrimination in the Labour Market

139

27. Trade Unions in the Labour Market

142

28. The Distrib ution of Income and Wealth

146

29. Market Failure ­ Externalities

153

30. Carbon Emissions Trading and the Stern Review

159

31. Cost Benefit Analysis

165

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1. Production in the Short and the Long Run

We take it for granted that goods and services will be available for us to buy as and when we need

them. But

Production Functions

The production function elates the quantity of factor inputs to the volume of outputs that result. We make use of three measures of production and productivity.

production
production

and supplying to the market is often a complicated business.

o

Total product means total output. In most manufacturing industries such as motor vehicles, motor homes and DVD players, it is straight forward to measure production from labour and capital inputs. But in many service or knowledge ­ based industri es, where the output is less “ tangible” or perhaps weightless we find it harder to measure productivity.

o

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

o

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

more machine to the production process in the short run . The length of time required

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

something the UK government has to consider as it

rev iews our future sources of energy .

Short Run Production Function

The short run is a time period where at least one factor of production is in fixed supply ­ it cannot be changed . We normally assume that the quantity of plant and machinery is fixed and that production can be altered through changing variable inputs such as labour, raw materials and energy.

The time periods used in economics must differ from one industry to another. The short ­ run for the electricity generation industry or telecommunication s differs from m agazine publishing and local sandwich bars . If you are starting out in business this autumn with a new venture selling sandwiches and coffees to office workers, how long is your short run? And how long is your long run? (!!) . The

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long run c ould be as short as a few days enough time to lease a new van and a sandwich making machine!

D iminishing R eturns

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

What happens to marginal product is linked directly to the productivity of each extra worker . Beyond a certain point new workers will not have as much c apital to work with so it becomes diluted among a larger workforce. As a result, the marginal productivity tends to fall this is the principle of diminishing returns . An example is shown below. We assume that there is a fixed supply of capital

(20 units) available in the

Initially the margin al product is rising – e.g. the 4 t h worker adds 26 to output and the 5 t e.g. the 4 th worker adds 26 to output and the 5 th worker adds 28.

production
production

process to which extra u nits of labour are added.

It peaks when the sixth worked is employed when the marginal product is 29.process to which extra u nits of labour are added. Marginal product then starts to fall.

Marginal product then starts to fall. At this pointproduction demonstrates diminishing returns.

production

demonstrates diminishing returns.

The Law of Diminishing Returns

Capital Input

Labour Input

Total Output Marginal Product Average Product of Labour

20

1

5

5

20

2

16

11

8

20

3

30

14

10

20

4

56

26

14

20

5

85

28

17

20

6

114

29

19

20

7

140

26

20

20

8

160

20

20

20

9

171

11

19

20

10

180

9

18

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Total

Output

(Q)

Slope of the curve gives the (Q) marginal product of labour Diminishing returns are apparent
Slope of the curve gives the
(Q)
marginal product of labour
Diminishing returns are apparent
here – total output is rising but at a
decreasing rate

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

This is an important example of the relationship between marginal and average values that we will return to later on when studying costs and revenues.

Criticisms of the Law of Diminishing Returns

How realistic is this assum ption of diminishing returns? Surely ambitious and successful businesses will do their level best to avoid such a problem emerging?

Units of Labour Employed (L)

It is now widely recognised that t he effects of

corporations to source their inputs from more than one country and engage in transfers of business technology , makes diminishing returns less relevant . Many businesses are multi ­ plant meaning that they operate factori es in different locations can s witch output to meet changing

demand.

A rise in productivity and the production function

In the following diagram we trace the effects of a rise in the productivity of the labour force at each level of employment.

globalisation

and the ability of trans­ national

If average productivity rises, then the production curve shifts upwards.globalisation and the ability of trans­ national Diminishing returns are still assumed to exist in this

Diminishing returns are still assumed to exist in this diagram as shown by the shape of the production curve, but total output is higher for each number of people employed.rises, then the production curve shifts upwards. If productivity rises, for a given level of wages,

If productivity rises, for a given level of wages, this will cause a fall in the unit labour costs of production.total output is higher for each number of people employed. Other things remaining the same, there

Other things remaining the same, there is an inverse relationship between productivity and cost .

This is an important relationship for businesses to understand when they are seeking

as a means of boosting

Long Run Production ­ Returns to Scale

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

efficiency gains

profits .
profits .

N umerical e xample of long run returns to s cale

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Units of

Units of

Total

% Change in

% Change in

Returns to Scale

Capital

Labour

Output

Inputs

Output

20

150

3000

40

300

7500

100

150

Increasing

60

450

12000

50

60

Increasing

80

600

16000

33

33

Constant

100

750

18000

25

13

Decreasing

In our example when we double the factor inputs from (150L + 20K) to (300L + 40K) then the percentage change in output is 150% ­ there are increasing returns to scale.Constant 100 750 18000 25 13 Decreasing In contrast, when the scale of production is changed

In contrast, when the scale of production is changed from (600L + 80K0 to (750L + 100K) then the perc entage change in output (13%) is less than the change in inputs (25%) implying a situation of decreasing returns to scale.in output is 150% ­ there are increasing returns to scale. Increasing returns to scale occur

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

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

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

T he nature of the r eturns to scale affects the shape of a business’s long run average cost curve.

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2. How can we calculate the costs of a firm?

In this chapter we look at

production is fixed , output can be increased only by adding more variable facto rs.

Fixed costs

production costs .

In the short run, because at least one factor of

Fixed costs
Fixed costs

do not vary directly with the level of output

Examples of fixed costs include the rental costs of buildings; the costs of leasing or purchasing

capital equipment such as plant and machinery; the annual

authorities ; the costs of full ­ time contracted salaried staff; the costs of meeting interest payments on

loans; the depreciation of fixed capital (due solely to age) and also the costs of

Fixed costs are the overhead costs of a business.

Key points:

business rate charged by local

business insurance.

Total fixed costs

(TFC)

these remain constant as output increases

Average fixed cost

(AFC) =

total fixed costs divided by output

Average fixed costs must fall continuously as output increases because total fixed costs are

being spread over a higher le vel of production. In industries where the ratio of fixed to variable costs

is extremely high, there is great scope for a business to exploit lower fixed costs per unit if it can

produce at a big enough size. Consider the Sony PS3 or the new iPhone where the fixed costs of developing the product are enormous, but these costs can be divided by millions of individual units sold across the world. Successful product launches and huge volume sales can make a huge difference to the average total costs of production.

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

Variable C osts

Variable costs are costs that vary directly with output .

Examples of variable costs include the costs of raw materials and components, the wages of part ­ time staff or employees paid by the hour , the costs of electricity and gas and the depreciation of

capital inputs due to wear and tear. Average variable cost (AVC) = total variable costs (TVC) /output

(Q)

Average Total Cos t (ATC or AC)

Average total cost is the cost per unit producedcosts (TVC) /output (Q) Average Total Cos t (ATC or AC) Average total cost (ATC) =

Average total cost (ATC) = total cost (TC) / output (Q)(ATC or AC) Average total cost is the cost per unit produced Marginal Cost Marginal cost

Marginal Cost

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

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

A numerical example of short run costs is shown in the table below. Fixed costs are assumed to be

constant at £200. Variable costs increase as more output is produced.

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Output

Total Fixed

Total Variable

Total Cost

Average Cost

Marginal Cost

(Q)

Costs (TFC)

Costs (TVC)

Per Unit

(the change in total

 

(TC= TFC + TVC)

(AC = TC/Q)

cost from a one unit change in output)

0

200

0

200

50

200

100

300

6

2

100

200

180

400

4

2

150

200

230

450

3

1

200

200

260

460

2.3

0.2

250

200

280

465

1.86

0.1

300

200

290

480

1.6

0.3

350

200

325

525

1.5

0.9

400

200

400

600

1.5

1.5

450

200

610

810

1.8

4.2

500

200

750

1050

2.1

4.8

In our example, average cost per unit is minimis ed at a range of output ­ 350 and 400 units.1.8 4.2 500 200 750 1050 2.1 4.8 Thereafter, because the marginal cost of production exceeds

Thereafter, because the marginal cost of production exceeds the previous average, so the average cost rises (for example the marginal cost of each extra unit between 450 and 500 is 4.8 and this increase in output has the effect of raising the cost per unit from 1.8 to 2.1).is minimis ed at a range of output ­ 350 and 400 units. An example of

An example of fixed and variable costs in equation format

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

SRTC = $(10 000 + 5X 2 ) where X is the level of output.

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

The firm’s average fixed costs are $10,000 / Xlevel of output. The firm’s total fixed costs are $10,000 If the level of output produced

If the level of output produced is 50 units, total costs will be $10,000 + $2,500 = $12,500are $10,000 The firm’s average fixed costs are $10,000 / X The Shape of Short Run

The Shape of Short Run Cost Curves

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

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

Costs

Marginal Cost (MC) Average Total Cost (ATC) Average Variable Cost (AVC) Average Fixed Cost (AFC)
Marginal Cost
(MC)
Average Total
Cost (ATC)
Average
Variable Cost
(AVC)
Average Fixed
Cost (AFC)
Output (Q)
Q1
Q2

Key point: The marginal cost curve must intersect the average curves at their minimum levels

A change in variable costs

A rise in the variable costs of production perhaps due to a rise in oil and gas prices or a rise in the

national minimum wage

not able to sup ply as much output at the same price. The effect is that of an inward shift in the supply

curve of a business in a competitive market.

­ leads to an upward shift both in marginal and average total cost. The firm is

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Costs

MC2 AC2 Marginal Cost (MC1) Average Total Cost (ATC1) Average Variab le Cost (AVC1) AVC2
MC2
AC2
Marginal Cost
(MC1)
Average Total
Cost (ATC1)
Average
Variab le Cost
(AVC1)
AVC2

Output (Q)

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

Costs

MC AC2 (after rise in fixed costs) AC1
MC
AC2 (after rise
in fixed costs)
AC1

Output (Q)

Suggestions for background reading on changes in business costs

Cadbury’s plans to increase prices

Dry cleaners facing rising costs

 

Grain prices are squeezing bakers

(BBC news, February 2008)

(BBC news, June 2008)

(BBC news, April 2008)

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Milk costs hit Stilton producers

(BBC news, July 2007)

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3. Long Run Costs: Economies and Diseconomies of Scale

Economies of Scale

Economies of scaleEconomies and Diseconomies of Scale Economies of Scale are the cost advantages from expanding the scale

Diseconomies of Scale Economies of Scale Economies of scale are the cost advantages from expanding the

are the cost advantages from expanding the scale of production in

the long run . T he effect is to red uce average costs over a range of output.

These lower costs represent an improvement in productive efficiency and can also give a business a competitive advantage in the market­ place. productive efficiency and can also give a business a competitive advantage in the market­ place. They lead to lower prices and higher

profits
profits

a positive sum game for producers and consumers.

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

Long Run Output (Units)

Total Costs (£s)

Long Run Average Cost (£ per unit)

1000

12000

12

2000

20000

10

5000

45000

9

10000

80000

8

20000

144000

7.2

50000

330000

6.6

100000

640000

6.4

500000

3000000

6

Returns to scale and costs in the long run

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

Factor Inputs

Production

Costs

 

(K)

(La)

(L)

(Q)

(TC)

(TC/Q)

Capital

Land

Labour

Output

Total Cost

Average

 

Cost

Scale A

5

3

4

100

3256

32.6

Scale B

10

6

8

300

6512

21.7

Scale C

15

9

12

500

9768

19.5

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

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

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Increasing Returns to Scale

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

An example of this is the computer software business. The overhead costs of developing new

software programs

running into hundreds of millions of dollars ­ but the marginal cost of producing one extra copy for sale is close to zero, perhaps just a few cents or pennies . If a company can establish itself in the market in providing a piece of software, positive feedback from consumers w ill expand the installed customer base, raise demand and encourage the firm to increase production. Because the marginal cost is so low, the extra output reduces average costs creating economies of size .

Lower costs normally mean higher profits and increa sing financial returns for the

shareholder s . What

is true for software developers is also important for telecoms companies, transport operators and music distributors . We find across so many different markets that a high percentage of costs are fixed the higher is demand and output, the lower will be the average cost of production.

such as Microsoft Vista

or computer games such as Halo 3 are huge ­ often

Long Run Average Cost Curve

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

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

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

Costs SRAC1 SRAC3 SRAC2 AC1 LRAC AC2 AC3 Q1 Q2 Q3 Output (Q)
Costs
SRAC1
SRAC3
SRAC2
AC1
LRAC
AC2
AC3
Q1
Q2
Q3
Output (Q)

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There are many different types of economy of scal e. Depending on the characteristics of an industry or market, some are more important than others.

Internal economies of scale (IEoS)

Internal

economies of scale

come from the long term growth of the firm itself . Examples include:

1. Technical economies of scale : (these relate to aspects of the production process itself):

a.

Expensive capital inputs: Large­ scale businesses c an afford to invest in specialist capital machinery. For example, a supermarket might invest in database technology that improves stock control and reduces transportation and distribution costs. H ighly expensive fixed units of capital are common in nearly every mass manufacturing production proces s .

b.

Specializ ation of the workforce : L arger fir ms can split the production process es into

separate t asks to boost productivity . Examples include the use of

division of labour

in the mass production of motor vehicles and in manufacturing electronic products .

c.

The law of increased dimensions ( or the “container principle” ) This is linked to the cubic law where doubling the height and width of a tanker or building leads t o a more

than proportionate increase in the cubic capacity the application of this law opens up

the possibility of scale economie s in distribution and

freight industries

and als o in

travel and leisure sectors with the emergence of super ­ cruisers such as

P&O’s

 

Ventura. Consider the new generation of super ­ tankers and the development of

 

enor mous passenger aircraft such as the Airbus 280 which is capable of carrying well over 500 passengers on long haul flights. The law of increased dimensions is also important in the energy sectors and in industries such as office rental and

warehousing.

Amazon

UK for example has invested in several huge warehouses at its

central distribution points capable of storing hundreds of thousands of items.

d.

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

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Cost

(Per unit of output)

Economies of Scale A B LRAC 1 Learning C LRAC 2
Economies of Scale
A
B
LRAC
1
Learning
C
LRAC
2

economies

Output

2. M onopsony power : A large firm can purchase its factor inputs in bulk at discounted prices

if it has monopsony

(buying) power. A good example w ould be the ability of the electricity

generators to negotiat e lower prices when finalizing coal and gas supply contracts. The national food retailers have monopsony power when purchasing their supplies from farmers

and wine growers and in completing s upply contracts from food processing businesses . Other

controversial examples of the use of monopsony power include the

prices paid by coffee

roasters an d other middle men to coffee producers

 

3. Managerial economies of scale : This is a form of

division of labour

in some of the poorest parts of the world.

where fir ms can

employ specialists to supervise produc tion systems. Better management; increased investment in human resources and the use of specialist equipment, such as networked computers can i mprove communication, raise productivity and thereby reduce unit cos ts.

4. Financial economies of scale : Larger firm s are usually rated by the financial markets to be mor e ‘credit worthy’ and ha ve access to credit with favourable rates of borrowing. In contrast, smaller firms often pay higher rates of interest on overdrafts a nd loans. Businesses quoted on the s tock market can normally raise new financial capital more c heaply through the sale of equities to the capital market .

5. Network economies of scale : (Please note: This type of economy of scale is linked more to the growth of demand for a product but it is still worth understanding and applying.) There is growing interest in the concept of a network economy . Some networks and services have huge potential for economies of scale. That is, as they are more widely used (or adopted) , they become more valuable to the busines s that provides them. We can identify networks economies in areas such as online auctions and air transport networks . The marginal cost of adding one more user to the network is close to zero, but the resultin g financial benefits may be huge because each new user to the network can then interact , trade with all of the existing members or parts of the network. The rapid expansion of e­ commerce is a

is a classic example of

great example of the exploitation of network economies of scale. exploiting network economies of scale as part of its operations.

EBay

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17 The container principle at work ! Economies of scale – the effects on price, output

The container principle at work !

Economies of scale the effects on price, output and profits for a profit maximizing firm

Scale economies allow a supplier to move from SRAC1 to SRAC2. A profit maximising producer will produce at a higher output (Q2) and charge a lower price (P2) as a result but the total abnormal profit is also much higher (compare the two shaded regions).

Both consumer and producer surplus (welfare) has increased – there has been an improvement in
Both consumer and producer surplus (welfare) has increased – there has been an improvement in
economic welfare and economic efficiency – the key is whether cost savings are passed onto
consumers!
MC1
Costs
Profit at Price P1
Profit at Price P2
P1
SRAC1
SRAC2
P2
MC2
AR
(Demand)
MR
Q1
Q2

Output (Q)

External economies of scale (EEoS)

External economies of scale o ccur outside of a firm but within an industry . For example investment in a better transportation network servicing an industry will resulting in a decrease in

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cost s for a company working within that in dustr y, thus external economies of scale have been achieved. Another example is the development of research and development facilities in local universities that several businesses in an area can benefit from. Likewise, the relocation of component supplier s and other support businesses close to the centre of manufacturing are also an external cost saving.

Agglomeration economies may also result resulting from the clustering of similar businesses in a distinct geographical location be it software businesses in Silicon Valley or investment banks in the City of London.

Economies of Scale The Importance of Market Demand

The market struct ure of an industry is af fected by the extent of economies of scale available to individual supplier s and by the total size of market demand. In many industries , it is possible for small er firms to make a profit because the cost disadvanta ges they face are relatively small. Or because product di fferentiation allow s a business to charge a price premium to consumers which more than covers their higher costs.

A good example is the retail market for furniture. The industry has some major players in each of its

different segments (e.g. flat ­ pack and designer furniture) including the Swedish giant IKEA. Howe ver, much of the market is taken by smaller ­ scale suppliers with consumers willing to pay higher prices for bespoke furniture owing to the low price elasticity of demand for high­ quality, hand crafted furniture products. Small ­ scale manufacturers can therefore extract the consumer surplus that is present

when demand is estimated to have a low elasticity of demand.

Economies of Scope

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

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

profits
profits

from higher ­ profit­ margin and fast growing m arkets.

A company’s management structure , administration systems and marketing departments are

capabl e of carrying out these functions for more than one pro duct.

Expanding the product range to exploit the value of existing brands is a good way of exploiting

economies of scope. Perhaps a good example of “brand extension” is the

control of Stelios where the distinctive Easy Group business model has been applied (with varying degrees of success) to a wide range of markets easy Pizza, easy Cinema, easy Car rental, easy

Bus and easy Hotel to name just a handful!

Easy Group under the

Procter and Gamble

is the largest consumer household

products maker in the world. Its brands include Crest, Duracell, Gillette, Pantene, and Tide, to name just a few. Twenty four of its brands make over $1 bi llion in sales annually.

Another example of an economy of scope might be a restaurant that has catering facilities and uses

it for multiple occasions as a coffee shop during the day and as a supper ­ bar and jazz room in the evenings. Or a computing business can use its network and databases for many different uses.

Case Study: Investment in Sports Grounds

Hotels are a hot topic at sports venues. The owners of these venues are looking for ways to make better return on their assets. The solution is to explor e new business opportunities, invest in extensive modernisation and spend cash on large ­ scale redevelopment schemes.

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19

Capacity utilisation is an important challenge facing a sporting venue. There are only so many cricket matches, grand prix races or rugby g ames that draw spectators.

By adding purpose ­ built conference, banqueting and leisure facilities, sports venues can tap into a different customer base . A hotel facility can attract demand from businesses looking for corporate hospitality and conferences. H aving a hotel also allows a venue to access consumer spending on short breaks one of the fastest growing segments of the leisure industry. Most of the planned hotels will be branded (e.g. Holiday Inn, Marriott) which allows the venue to benefit from a tr usted hotel name and gets access to established distribution channels.

Source: Business Cafe

M inimum Efficient S cale (MES)

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

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

Costs

Revenues

LRAC Increasing return to scale – economies of scale ­ falling LRAC Decreasing returns –
LRAC
Increasing return to scale – economies of
scale ­ falling LRAC
Decreasing returns –
diseconomies of scale
LRAC Increasing return to scale – economies of scale ­ falling LRAC Decreasing returns – diseconomies

MES

Q2 Output (Q)
Q2
Output (Q)

The MES depends on the nature of costs of production in a specific sector or industry.

1. In industries where the ratio of fixed to variable costs is high , there is plenty of scope for

reducing unit cost by increasing the scale of output. This is likely to result in a concentrated

market structure (e.g. an

may act as a barrier t o entry because existing firms have achieved cost advantages and

they then can force price s down in the event of new businesses coming in!

oligopoly, a duopoly or a

monopoly) indeed economies of scale

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

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

Diseconomies of scale

Diseconomies are the result of decreasing returns to scale .

The potential diseconomies of scale a firm may experience relat e to:

1. Control monitoring the productivity and the quality of output from thousands of employees in big corporations is imperfect and costly this links to the concept of the principal­ agent problem how best can managers assess the performance of their workforce when each of

the stakeholders

conflict?

may have a different objective or motivation which can lead to stakeholder

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

3. Co ­ operation ­ workers in large firms may develop a sense of alienation and loss of morale.

If they do not c onsider themselves to be an integral part of the business, their prod uctivity

may fall leading to wastag e of factor inputs and higher costs . Traditionally this has been seen

as a problem experienced by the la rger state sector businesses, examples being the

Royal

Mail

and the Firefighters ,

the result being a poor and costly industrial relations performance.

However, the problem is not concentrated solely in such industries. A good recent example of

a

bitter

industrial relations dispute

was between

Gate Gourmet
Gate Gourmet

and its workers.

Avoiding diseconomies of scale

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

1. Developments in human resource management (HRM). HRM is a horrible phrase to

describe improvements that a busines s might make to procedures involving worker recruitment, training, promotion, retention and support of faculty and staff . This becomes

cr itical to a business when the skilled workers it needs are in short supply. Recruitment and

retention of the most productive and effective employees makes a sizeable difference to

corporate performance in the long run .

2. Performance related pay schemes (PRP) can pr ovide financial incentives for the workforce

leading to an improvement in industrial relations and higher productivity. Another

is for businesses to reward and hang onto t heir most efficient workers. The

aim of PRP John Lewis

aim of PRP

John Lewis

John Lewis

Partnership

is often cited as an example of how a business can empower its employees by

giving them a stake in the financial success of the organization.

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

Case Study: Amazon Economies of Scale and Scope

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21

21 Increased dimensions : Firstly, the company invested in enormous warehouses to stock its inven tory

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

Buying power:

publishers, thereby bypassing its reliance on wholesalers and giving it a higher profit margin.

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

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

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

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

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

Amazon
Amazon

has significant

monopsony
monopsony

power when it purchases books directly from

Merchants@/Marketplace which gives independent (third party) sellers the opportunity to sell their products through the Amazon platformmonopsony power when it purchases books directly from Amazon Enterprise Solutions – where Amazon provides e

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

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

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

Amazon
Amazon

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

Suggestions for further reading on economies of scale and scope

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22

Consoles look to hit their stride

(BBC news, July 2008)

Cost headache for games deve lopers

(BBC news, December 2007)

Economies of scale in printing

( Tutor2u economics blog, March 2008)

GM installs world's biggest rooftop solar panels

(Guardian, July 2008)

How world's biggest ship is delivering our Christmas ­ all the way from China

Mobile web reaches critical mass

(BBC news, July 2008)

Salad production on a massive scale

(BBC news, June 2008)

(Guardian)

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23

4. B usiness Revenues

Revenue
Revenue

(or turnover) is the income generated from the sale of output in product markets.

o

Average Revenue (AR) = Price per un it = total revenue / output

o

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

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

Price per unit (average revenue)

Quantity Demande d (Qd)

Total Revenue

(TR) (PxQ)

Marginal Revenue (MR)

£s

units

£s

£s

400

220

88000

370

340

125800

315

340

460

156400

255

310

580

179800

195

280

700

196000

135

250

820

205000

75

220

940

206800

15

190

1060

201400

­ 45

Average and Marginal Reven ue

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

Because the price per unit is declining, total revenue is rising at a decreasing rate and will eventually reach a maximum (see the next paragraph).

Elasticity of Demand and Total R evenue

When a firm faces a perfectly elastic demand curve , then average revenue = marginal revenue ( i.e. extra units of output can all be sold at the ruling market price).

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

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

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24

Revenue

Total revenue is maximised when MR = 0 Total Revenue (TR) Ped >1 for a
Total revenue is
maximised when
MR = 0
Total Revenue
(TR)
Ped >1 for a price
fall along this
length of AR
Price elasticity of
demand = 1 at this
output
Average Revenue
Marginal Revenue
(Demand) AR
(MR)
Output (Q)

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

Total revenue (TR) refers to the amount of money received by a firm from selling
Total revenue (TR) refers to the amount of money received by a firm from selling a given
level of output and is found by multiplying price (P) by output ie number of units sold
Costs
Total revenue at price P1 where marginal
revenue is zero
P2
P1
A rise in price to P2 causes a reduction in total
revenue
Average revenue AR
Total revenue at price P2
Q2
Q1
Marginal revenue MR
Output (Q)
Suggestions for further reading on business revenues

Carmakers tackle profit problems

(BBC news, July 2008)

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25

Revenue fears hit Vodafone shares

Revenue fears hit Vodafone shares Price elasticity of demand an d total revenue
Revenue fears hit Vodafone shares Price elasticity of demand an d total revenue
Revenue fears hit Vodafone shares Price elasticity of demand an d total revenue
Price elasticity of demand an d total revenue

Price elasticity of demand an d total revenue

(BBC news, July 2008)

(Bryn Jones Online, You Tube video)

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26

5. Profits

The Nature of Profit

Profit
Profit

measures the return to

risk
risk

when committing scarce r esources to a market or industry.

Entrepreneurs take risks for which they require an adequate expected rate of return . The higher the market risk and the longer they expect to have to wait to earn a positive return, the greater will be the minimum required return that an entrepreneur is l ikely to demand.

1. Normal p rofit ­ is the minimum level of profit required to keep factors of production in their current use in the long run . Normal profits reflect the opportunity cost of using funds to finance a business. If you dec ide to put £200,000 of your personal savings into a new business , those funds could have earned a low ­ risk rate of return by being saved in a bank or building society deposit account. You might therefore use the rate of interest on that £200,000 as the minimum rate of return that you need to make from your investment in order to keep going in the long run!

Of course we are ignoring here differences in risk and also the non­ financial benefits of running and building your own business or investing funds in someone else’s project.

Because we treat normal profit as an opportunity cost of investing financial capital in a business, we normally include an estimate for normal profit in the average total cost curve , thus, if the firm covers its ATC (where AR meets AC) then it is making normal profits.

2.

Sub ­ normal p rofit ­ is any profit less than normal profit (where pri ce < average total cost)

3.

Abnormal p rofit ­ is any profit achieved in excess of normal profit ­ also known as supernormal profit . A firm earns supernormal profit when its profit is above that required to keep

its resources in their present use in the long r un. When firms are making abnormal

an incentive for other producers to enter a market to try to acquire some of this profit. Abnormal

profit persists in the long run in imperfectly competitive markets such as

monopoly

when we consider

profits , there is

oligopoly and

where firms can successfully block the entry of new firms. We will come to this later

barriers to entry in mon opoly.

Case Study: Sub ­ normal profits drive mortgage lenders out of the market for now

What is happening in the UK mortgage market? Rarely a day goes by without news of another mortgage lender reassessing the risk of their housing loans and deciding to pull the plug on some of their mortgage products. Following on from the Northern Rock which has virtually stopped lending at all and wants to shift a sizeable portion of its mortgage book onto others, t he Co­ operative Bank, Lehman Brothers and First Direct have all announced that they are withdrawing two ­ year fixed rate mortgage products for th e time being.

All of this is one of the direct results of the credit crunch. The lenders are spinning this as a way of providing better service ­ levels to their exist ing customers but the reality is that the supply of finance in the wholesale money markets has been badly squeezed and this is now feeding through to the retail market for housing loans. It is costing the mortgage lenders more to borrow funds and their profit margins have been squeezed to a level where sub ­ normal profits are being made. Little wonder that some of the major players are effectively exiting the market by withdrawing some mortgage products from sale. Only when conditions improve will they consi der a return.

Source: Tutor2u Economics Blog, April 2008

Calculating economic profit

Consider the following example:

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27

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

T otal revenue £320,000data for an owner ­ managed firm for a particular year. R aw material costs £30,000

R aw material costs £30,000managed firm for a particular year. T otal revenue £320,000 Wages and salaries £85,000 Interest paid

Wages and salaries £85,000year. T otal revenue £320,000 R aw material costs £30,000 Interest paid on bank loan £30,000

Interest paid on bank loan £30,000R aw material costs £30,000 Wages and salaries £85,000 Salary that the owner could have earned

Salary that the owner could have earned elsewhere £32,000and salaries £85,000 Interest paid on bank loan £30,000 Interest forgone on owner's capital invested in

Interest forgone on owner's capital invested in the business £20,000Salary that the owner could have earned elsewhere £32,000 In a simple accounting sense, the business

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

Profit maximisation

Profits are maximised when marginal revenue = marginal cost

Price Per Unit

Demand /

Total

Marginal

Total

Margi nal

Profit

(£)

Output

Revenue

Revenue

Cost

Cost

(£)

(units)

(£)

(£)

(£)

(£)

50

33

1650

2000

­

350

48

39

1872

37

2120

20

­

248

46

45

2070

33

2222

17

­ 152

44

51

2244

29

2312

15

­ 68

42

57

2394

25

2384

12

10

40

63

2520

21

2444

10

76

38

69

2622

17

2480

6

142

36

75

2700

13

2534

9

166

34

81

2754

9

2612

13

142

Consider the example in the table above. As price per unit (average revenue) declines, so demand expands. Total revenue rises but at a decreasing rate (as shown by column 4 marginal revenue). Initially the firm is making a loss because total cost exceeds total revenue. The firm moves into profit at an output level of 57 units. Thereafter profit is increasing because the marginal revenue from selling units is greater than the marginal cost of producing them. Consider the rise in output from 69 to 75 units. The MR is £13 per unit, whereas marginal cost is £9 per unit. Profits increase from £142 to £166.

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

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Revenue

And Cost

Marginal Cost

Prof its are increasing when MR > MC
Prof its are
increasing when
MR > MC

Profits are decreasing when MR < MC

MR > MC Profits are decreasing when MR < MC Q1 Marginal Revenue Output (Q) As

Q1

Marginal Revenue

Output (Q)

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

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

The difference between pri ce and average cost marks the profit margin per unit of output.(using the demand curve) and then (ii) the cost per unit. Total profit is shown by

Total profit is shown by the shaded area and equals the profit margin multiplied by
Total profit is shown by the shaded area and equals the profit margin multiplied by output
Costs
Revenue
Supernormal profits at
Price P1 and output Q1
Normal profit at Q2 where
AR = AC
SRAC
P1
SRMC
AC1
AC2
AR
(Demand)
Q1
Q2
MR
Output (Q)

The short run supply decision ­ the shut ­ down point

The theory of the fi rm assumes that a business needs to make at least normal profit in the long run to justify remaining in an industry but this is not a strict requirement when the firm will continue to produce as long as total revenue covers total variable costs or put anot her way, so long as price per

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29

unit > or equal to average variable cost (AR = AVC). This is sometimes referred to as the down price .

= AVC). This is sometimes referred to as the down price . shut­ The reason for

shut­

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

MC ATC Costs, P1 is below average variable cost Revenues AVC A AC1 B P2
MC
ATC
Costs,
P1 is below average variable cost
Revenues
AVC
A
AC1
B
P2
P1
C
AR
MR
Output (Q)
Q1
Consider the cost and revenue curves facing a business in the short run in the diagram above.

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

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

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

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

Northern Foods decides to mothball a factory

Northern Foods, which supplies Marks and Spencer, is to mothball a factory making ready­ meals

because it is no longer economical. They said that, whilst the plant had been profitable in recent years it was no longer generating enough money to give an adequate return to shareholders. Some

analysts have argued that the d ecision might be due to the effects of the

and Spencer whic h has demanded discounts of up to 6% from its top suppliers including Northern Foods.

monopsony

power of Marks

Source: Adapted from news reports , May 2008

Deriving the Firm’s Supply Curve in the Short Run

May 2008 Deriving the Firm’s Supply Curve in the Short Run In the short run, the

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

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30

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

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

T he concept of a ‘supply curve’ is inappropriate when dealing with monopoly because a monopoly is

a price­ maker, not a “passive” price ­ taker , and can thus select the price and output combination on the demand curve so as to maximise profits where marginal revenue = marginal cost.

Changes in demand and the profit maximising price and output

A change in demand a nd/or production costs will lead to a change in the pr ofit maximising price and

output. In exams you may often be asked to analyse how changes in demand and costs affect the equilibrium output for a business. Make sure that you are confident in drawing these diagrams and you can produce them quickly and accur ately under exam conditions.

In the diagram below we see the effects of an outward shift of demand from AR1 to AR2 (assuming

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

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

Costs

P2

P1

AC1

AC2

Profit Max at Price P2 Profit Max at Price P1 AC MC AR2 AR1 (Demand)
Profit Max at Price P2
Profit Max at Price P1
AC
MC
AR2
AR1
(Demand)
MR2
Q1
Q2
Output (Q)
MR1

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Wiseman dairies hit by profits blow

Shares in Robert Wiseman, Scotland’s biggest milk supplier, have taken a hit following news of lower profits. Operating profits were reported as falling by 16% after a £6.1m fine levied by the Office for Fair Trading for alleged price fixing . The company is also suffering from the effects of higher energy, packaging and distribution costs caused by the r ising world price of oil . A third factor is a slump in the market price of cream. The company has found that it cannot always pass on higher input prices to customers, partly because of pre ­ existing milk delivery contracts with some of the major supermarkets.

Source: Adapted from news reports , May 2008

The Functions of Profit in a Market Economy

serve a variety of purposes to businesses in a market ­ based economic system, May 2008 The Functions of Profit in a Market Economy 1. Finance for investment Retained

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

markets especially in the aftermath of the credit crunch . 2. Market entry: Rising profi ts

2. Market entry: Rising profi ts send signals to other producer s within a market. When the

existing firms are earning supernormal profits, this signal s that pr ofitable entry may be

possible. In

in a monopoly, the dominant firm(s) may be able to protect their position through

contestable markets,

we would see a rise in market supply and lower prices. But

barriers to

entry. .

3. Demand for factor resources: Scarc e factor resources tend to flow where the expected rate of return or profit is highest. In an industry where demand is strong more land, labour and

capital are then committed to that sector. Equally in a

incomes and investment all fall leading to a squeeze on profit margins and attempts by businesses large and small to cut costs and preserve their market position. In a flexible labo ur

market, a fall in demand can quickly lead to a reduction in investment and cut ­ backs in labour demand.

recession, national output, employment,

4. Signals about the health of the economy: The profits made by businesses throughout the economy provide important signals about the health of the macroeconomy. Rising profits

might reflect improvements in supply­ side performance (e.g. higher productivity or lower costs through innovation). Strong profits are also the result of high levels of demand from domestic

from businesses could be a lead

and overseas markets. In contrast, a

indicator of a macroeconomic downturn.

string of profit warnings

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32

Net Profit for Manufacturing and Service Businesses

Net percentage rate of return on capital employed, seasonally adjusted

22.0 22.0 20.0 20.0 18.0 18.0 Services 16.0 16.0 14.0 14.0 12.0 12.0 Manufacturing 10.0
22.0
22.0
20.0
20.0
18.0
18.0
Services
16.0
16.0
14.0
14.0
12.0
12.0
Manufacturing
10.0
10.0
8.0
8.0
6.0
6.0
4.0
4.0
2.0
2.0
90
91
92
93
94
95
96
97
98
99
00
01
02
03
04
05
06
07
Source: Reuters EcoWin
Ra t e o f re t u rn (% )

Steps to higher profits

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

Method 1: Grow the “Top Line”

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

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

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

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

4. Defending a

market share
market share

against competitors is easier than defending high profit margins.

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33

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

Method 2: Keep Costs under Control

If a business has a low gross profit margin, red ucing direct costs increases the profit on eac h sale.

Eliminating overheads has an immediate impact on profit. Every business can increase profitability by

reducing hidden costs. Hidden costs include the costs of employing inappropriate p eople since poor recruitment can lead to lower quality, increased training costs and ultimately redundancy costs.

Suggestions for further reading on

A selection of recent news articles on the profitability of businesses in different markets and

industries and how changes in demand and costs affect prices and profits.

profits
profits

Dominos delivers stronger profits

(BBC news, July 2008)

 

Fuel costs eat into Fedex profit

(BBC news, March 2008)

Grand Theft Auto IV set to break all records

 

Gregg’s warns of increased costs

(BBC news, March 2008)

 

Higher oil prices see BP’s profits surge

(Guardian, July 2008)

Pubs close as beer sales fall

(BBC news, July 2008)

Ryanair slashes fares to boost demand and fill airline capacity

Should the British pub get a government subsidy?

 

Silverjet calls in administrators

(BBC news, June 2008)

 

Supporters count the cost of following a Premiership footie club

Weak dollar boosts Nike profits

(BBC news, March 2008)

 

Wolseley hit by housing slowdown

(BBC news, July 2008)

(BBC news, April 2008)

(Guardian, August 2008)

(BBC news, July 2008)

( Tutor2u blog, March 2008)

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6. What Objectives Do Firms Have?

In this chapter we consider a range of different business objectives much depends on the ownership and control of a business and the type of market in which it operates.

Profit maximisation

The traditional theory of the firm tends to assume that businesses possess sufficient information, market power and moti vation to set prices or their products

that maximi se profits .

criticised by economists who have studied the

organisation and objectives of modern ­ day corporations.

This assumption is now

of modern ­ day corporations. This assumption is now Why might a business depart from profit

Why might a business depart from profit maximisation?

There are numerous possible explanations. Some relate o the lack of accurate information required to undertake profit maximising behaviour. Others concentrate on the alternative objectives of businesses. We start first with the effects of imperfect information .

It might be hard for a business to pinpoint precisely their profit maximising output, as they c annot accurately calculate marginal reve nue and marginal costs. Often the day­ to­ day pricing decisions of businesses are taken on the basis of “ estimated demand c onditions.”

Secondly, m ost modern businesses are multi ­ product firms operating in a range of separate markets across countries and continents as a result the volume of information that they have to handle can be vast. And they mus t keep track of the ever­ changing preferences of consumers. Th e idea that there is a neat, single pr ofit maximising price is redundant.

Behavioural Theories of the Firm

Behavioural

various stakeholders.

activit y of a business. Examples might include:

eco nomists believe that modern corporations are complex organizations made up

Stakeholders

are defined as any groups who have a vested interest in the

o

o

o

o

o

o

Employees within a business

Managers employed by the firm

Shareholders
Shareholders

people who have an equity stake in a business

Customers in the market

The local c ommunity

The government and it’s agencies including local government

Each of these groups is likely to have different objectives or goals at points in time . The dominant group at any moment can give greater emphasis to their own objectives for example price and

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35

output decisions may be taken at local level by managers with shareholders taking only a distant and imperfectly informed view of the company’s performance and strategy.

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

1.

Satisficing

behaviour involves the owners setting minimum acceptable levels of

achievement in terms of business revenue and profit.

2.

Sales Revenue Maximisation

The objective of maximising sales revenue rather than profits was initially developed by the work of

William Baumol

Baumol argued that annual salaries and other perks might be closely correlated with total sales

revenue rather than profits. Companies geared towards maximising revenue are likely to make

frequent and extensive use of

extra revenue and profit from consumers.

(1959). His research focuse d on the behaviour of manager ­ controlled businesses.

price discrimination

(or yield management) as a means of extracting

3. Managerial Satisfaction model

An alternative view was put forward by

Oliver Williamson

(1981), who developed the concept of

managerial satisfaction ( or managerial utility). Thi s can be enhanced by raising sales revenue.
managerial satisfaction ( or managerial utility). Thi s can be enhanced by raising sales revenue.
Costs
Profit Max at Price P1
Revenue Max at Price P2
AC
P1
MC
P2
AC1
AC2
AR (Demand)
Q1
Q2
Output (Q)

MR

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

The profit maximising price is P2 at output Q2 whilst the revenue maximising price is P1 at output

Q1.

A change in the objectives of the bus iness has an effect on welfare and in particular the balance

between consumer and producer surplus. Consumer surplus is higher with sales revenue

maximisation because outpu t is higher and price is lower.

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Cadbury abandons its profit target

Cadbury Schweppes Plc ,

the manufacturer of Dairy Milk chocolate has decided to scrap its

profitability target in the wake of a sharp increase in the c osts of their raw materials . Three years ago

Cadbury a nnounced targets for annual improvements in profit margins ranging from 0.5 to 0.75%. But the rising price of oil ­ based raw materials and the world market price of cocoa and sugar have conspired to make meeting this target impossible. Prospects for profits have also been adversely

affected by the hot summer which has hit demand for chocolate and the

high profile products

presence in the confectionery market with an estimated ten per cent world market share. In June

2007, Cadbury announced that it planned to Cadbury about £450m in a one­ off charge.

unplanned recall of several

The reorganisation will cost

because of fears of salmonella poisoning. The business is a major global

cut its workforce by 15% .

Adapted from Tutor2u blog, November 2006 and news reports , June 2 007

Social Entrepreneurs – “not just for profit” businesses

Underneath the surface of an economy dominated by corporate giants, a new breed of business is flourishing, where profit is not always the bottom line; these are entrepreneurs operating for a social purpose and not just for profit . A social enterprise is a business that has social objectives whose surpluses are reinvested for that purpose in the business or the community, rather than being driven

by the need to seek profit to satisfy investors. Ra ther than maximise sharehol der value and distribute

dividends, a social enterprise is looking to achieve social and

aims over the long term.

Examples include

environmental
environmental

o

Café Direct

 

o

Fifteen Foundation

(Jamie Oliver)

o

Fair Trade

o

Housing Associations

 

o

Traidcraft

 

o

Micro ­ credit developed by the

o

Divine Chocolate

Grameen Bank

and its founder, the

o

The Eden Project

Nobel ­ Prize winner Muhammad Yu

Social Entrepreneurship

An example from Indi a

Devi Prasad Shetty strives to make sophisticated health care in India available to all irrespective of their economic situation or geographic location. He founded the Narayana Hrudayalaya Hospital in Bangalore in 2001 and co­ founded the Asia Heart Founda tion. In addition, Shetty has built a network of 39 telemedicine centres to reach out to patients in remote rural areas. Together, the network of hospitals performs 32 heart surgeries a day. Almost half the patients are children and babies. Sixty percent of the treatments are provided below cost or for free.

And one from the UK

The 2008 Independent Social Entrepreneur of the Year award went to

company that donates all of its profits to global clean water projects. The company uses carbon ­ neutral packaging in the form of a compostable bottle made from corn. Belu is the first carbon ­ neutral product being stocked at Tesco. The bottles look like ordinary bottles and can be recycled with plastics o r commercially composted back to soil in just eight weeks. Among its clean water projects, Belu has installed hand pumps and wells for 20,000 people in India and Mali, and it is also working on a rubbish ­ muncher to clean up the Thames. The company has a pl edge that each

bottle of mineral water sold will translate as clean water for one person for one month.

a bottled water

Belu Water,

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37

Source: Adapted from news reports , January 2008

See Young, Gifted and not for Profit (BBC radio 4 In Business)

and also the

economic impact of

the Eden project.

Other good sites include:

Schwab Foundation for Soc ial Entrepreneurship

 

Not for Profit Business es

These are c harities, community organisations that are r un on commercial lines e.g. Network Rail:

Network Rail
Network Rail

o

Took over the rail network in October 2002

o

Stated purpose is to deliver a safe, reliable and efficient railway for Britain.

o

It is a company limited by guarantee whose debts are secured by the government

o

Network Rail

is a private company o perating as a commercial business and regulated by

the

Office of Rail Regulation

 

o

Network Rail is a "not ­ for ­ dividend" company, which means that all of its profits are in vested in the railway network.

o

Train oper ating companies pay Network Rail for use of the rail infrastructure

Businesses required to main a loss ­ making service on social grounds

A good example here is the

delivery service throughout the UK for a uniform price. Household mail makes a loss, cross ­ subsidised by business mail although this market is shrinking for the Royal Mail because of the introduction of fresh competition from Jan 2006. The Post Office Ltd is a subsidiary of the Royal Mail Group plc it runs substantial losses on the network or rural post offices and has been under

great pressure to close hundreds of offices to stem losses.

Royal Mail

which is required to maintain a universal national postal

Suggestions for further reading on business objectives and

business ownership

Australian expansion proves a move too far for Starbucks

 

Founder of bottled water company honoured for work in Third World

How business embraced charity

(The Observer, June 2008)

Making profit with a conscience

(BBC news, March 2008)

 

Motivated by change

(Independent, July 2004)

 

Mysterious death of the petrol station

(VVC news, March 2008)

Network Rail announces pre ­ tax profit of £1.6bn

 

Ryanair flies into the path of an economic storm

Sony predicts TV and game profits

(BBC news, June 2008)

Survival challenge for social enterprises

(Guardian, July 2008)

Wind farm co ­ op raises thousands

(BBC news, July 2008)

 

( Tutor2u blog, July 2008)

(Independent, Jan 2008)

(BBC news, Jun e 2008)

(Tutor2u blog, July 2008)

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38

7. Divorce between Ownership and Control

Ownership and control

The owners of a private sector company normally elect a board of directors to control the

business’s resources for them. However, when the owner sells shares, or takes out a loan or bond

to raise finance, they may sacrifice some of their contro l. Other

voting rights , and providers of loans often have some control (security) over the assets of the

business.

This may lead to a degree of conflict between them as these different stakeholders may have different objectives. The flow chart below attempts to show the divorce between ownership and control.

shareholders

can exercise their

Principals:

Shareholders

Principals: Shareholders
Principals: Shareholders
OWNERSHIP CONTROL
OWNERSHIP
CONTROL

Control Mechanisms:

Pressures from the stock mar ket and from hedge funds and private investors

Regular meetings with shareholders (e.g. the AGM)

Scrutiny in the financial press

Performance related pay (to provide incentives)

the financial press Performance related pay (to provide incentives) Agents: Board of Directors Senior Management

Agents:

Board of Directors

Senior Management

The Principal Agent Problem

How do the owners of a large business know that the managers they have employed and who are making the key day­ to­ day decisions operate with the aim of maximising shareholder value in both the short term and the long run?

This lack of information is known as the principal­ agent problem or “agency problem”. In other words, one person, the principal, employs an agen t (e.g. a sales or finance manager) to perform tasks on his behalf but he or she cannot ensure that the agent always performs them in precisely the way the principal would like. The decisions and the performance of the agent are both impossible and expensi ve to monitor and the incentives of the agent may differ from those of the principal . The principal agent problem is illustrated in the flow chart above.

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39

Examples of the principal ­ agent problem that have hit the headlines recently in the UK include the

mis­ management of financial assets on behalf of investors (e.g. the case surrounding

Life) and the management of companies on behalf of shareholders (e.g. during the turbulent years experienced by Marks and Spencer and Shell ). The classic case in the United States is of course

the

Many investors in a business are 'passive' , they might monitor the performance of the corporation by following the news in the financial press and (occasionally) attend ing and voting at annual general meetings but their direct involvement is limited and unlikely to have a bearing on the crunch decisions of the business. The biggest investors in UK listed companies tend to be large institutional shareholders such as pension funds and insurance companies.

Equitable

Enron
Enron

fraud and debacle. Follow this BBC news link for more

background on the Enron case.

Incentives Matter! ­ Employee Share Ownership Schemes

There are various strategies available for coping with the principle ­ agent problem. One is the rapid expansion of employee share­ ownership schemes and share­ options p rogrammes. The government has encouraged the wider use of share­ ownership schemes through a series of tax incentives. But the use and occasional misuse of share options schemes has been controversial

for several years. A recent example involved the

US computer giant Apple.

The growth of "shareholder activism"

Many commentators question the assumption that shareholders play little direct role in influencing corporate strategy in modern corpor ations. There are plenty of examples in recent times when both institutional and individual shareholders have exercised their voting rights to express views on the direction that a company is taking or its performance. Typically they are critical of a perc eived failure of a business to maximise shareholder value measured in terms of share price, the flow of dividend incomes etc.

shareholders

in putting executive management under pressure ­ these are known as activist shareholders . At the forefront of this change has been the expansion of private hedge funds and a number of high profile and very wealthy private investors. Latterly, the sovereign wealth fun ds have appeared on the scene.

An activist shareholder uses an equity stake in a corporation to put pressure on its existing management. The goals of activist shareholders range from finan cial (increase of shareholder value through changes in dividend decisions, plans for cost cutting or capital investment projects etc.) to non ­ financial (dis ­ investment from particular countries with a poor human rights record, or pressuring a business to speed up the adoption of environmentally friendly policies and build a better reputation for ethical behaviour, etc.).

Activist shareholders do not have to hold large stakes in a business to make an impact. Even those with relatively small stakes or 3 or 4 per cent can launch publicity campaigns and make direct contact with the senior management. Private equity / hedge funds have been among those most involved in the rise of shareholder activism. They tend to focus on under­ performing businesses

Is this new breed of shareholder activists an important voice and counter ­ balance to the power of entrenched management and willing to stand up to corporate corruption and highlight poor management? Can they help to overcome the principle­ agent problem? Or are they merely aggressive corporate raiders seeking short ­ term corporate change merely for their own personal gain?

Increasingly we are seeing a new breed of

who are seen to be much more proactive

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40

Environmental groups

such as Friends of the Earth have also latched onto the potential for

shareholder activism to impact on businesses especially in the areas of the environmental impact of their business activities.

That said it remains the case that the pattern of ownership and control within British industry is dispersed. T ypically the largest shareholder in any large business listed on the stock m arket is likely to own a minority of the shares. Majority ownership by a single shareholder is unusual.

Examples of recent shareholder activism

Sainsbury's : In 2004, a third of J Sainsbury's shareholders voted against the supermarket's pay policy, objecting to its decision to give a £2.3m bonus to ousted chairman Sir Peter D avis. Sainsbury's subsequently decided to cancel the controversial pay award. Sir Peter Davis quit Sainsbur y's after a group of major institutional shareholders demanded management changes. He was replaced by Justin King .

Disney: In 2004,

after 43% of Disney shareholders voted against his re ­ election.

EuroTunnel : In 2004, the management board of AGM.

Vodafone : In May of 2006, Vodafone announced the biggest loss in British corporate

history (£14.9 billion) . In Jul y 2006, the CEO of Vodafone Arun Sarin came under

Michael Eisner ,
Michael Eisner ,

the chairman and chief executive of Disney, resigned

Euro Tunnel

was ousted at the company's

huge

pressure from a group of shareholders

unhappy about the performance of the struggling

telecoms company. In the event, s hareholders voted 86% in favour of Mr Sarin, with 9.5% voting against, and 4.5% abstaining.

Daimler­ Chrysler: In April 2007, about 9,000

shareholders attended the German­ US

carmaker's annual meeting

and voiced strong criticisms of the businesses’ performance.

Many shareholders stood up during the meeting to condemn the transatlantic took place between Daimler ­ Benz and Chrysler in 1998.

Motorola versus Carl Icahn : The financier Carl Icahn has a reputation as one of the

leading shareholder activists. He has been in a

Photo ­ Me: In October 2007 the chairman and chief executive of the passport booth operator Photo­ Me agreed to quit in the face of growing opposition

More reading on shareholder activism :

merger which

battle with Motorola

over their strategy.

Hail shareholder!

Owner ­ drivers

(The Economist May 2007)

(The Economist, May 2007)

Corporate Social Responsibility

and Business Ethics

Business ethics is concerned with the social responsibility of management towards the firm’s

stakeholders, the environment and socie ty in general. There is a growing belief that ethical and ‘green’ business are linked to improve d business performance because of increased public concer n for human rights and the environment. Many businesses are now trumpeting their progress in making their activities carbon neutral by offsetting the impact of their production

activities on their environment through offset activities. Businesses such as

means by which organisations can fin d ways to offset their carbon

Business ethics extends to treating

and safety issues, good working practices and the like in business decision ­ making.

sta keholders

emissions . Carbon Clear
emissions .

emissions .

Carbon Clear

Carbon Clear

emissions . Carbon Clear

provide a

‘fairly’; hence the growing emphasis on health

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41

For more reading on this try this link to the

Studies includes one on

Institute for Business Ethics . The Times 100 Case

Cadbury’s and corporate social responsibility.

Click here for BBC news

articles
articles

on carbon neutrality.

Suggestions for further reading on business ownership and control

Stuar t Rose faces shareholder revolt at M&S annual meeting

Napster shareholders revolt over iTunes failure

 

Yell chiefs face investor revolt over big bonuses

(Guardian, June 2008)

(New Zealand Herald, June 2008)

(The Times, July 2008)

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8. Technological Change, Costs and Supply in the Long ­ run

What is innovation?

The Oxford E nglish Dictionary defines

innovation

something established ”. Invention, by contrast, is the act of “ coming upon or finding: discovery ”. Inn ovations frequently

disrupt the way that businesses do things and may have been doing so for years .

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

for example how important innovation is in these markets: as “ making changes to o o

as “ making changes to

o

o

o

o

o

o

Telecommunications

Pharmaceutic als Transport

Audio­ visual products

Markets for low ­ carbon products

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

Product innovation is often associated with many small, subtle changes to the characteristics and performance of a product. Gr ound­ breaking product innovation appears to becoming rarer despite the billions of dollars spent each year by global pharmaceutical companies and household goods manufacturers.

New markets and “synergy demand”:

Product innovation c reates new markets , especially when new technology creates radically different products for consumers. Innovation is also a source of synergy demand . For example, Gillette (a business unit of Proctor and Gamble) launched in 2004 the successor to its top branded product the Mach3 and Mach3 “turbo” razor. The new “wet­ shave” razor is battery powered – handy given that Gillette also owns the Duracell brand!

Sustaining and disruptive innovations

Many new products are similar to existing ones on the market companies are often satis fied with sustaining innovations” rather than “disruptive innovations” which have the power to upset

the status quo and make serious inroads into the

Joseph Alois Schumpeter famously made reference to innovation creating “ gales of creative

market share

of well ­ established businesses.

of creative market share of well ­ established businesses. destruction”. Examples of disruptive innovation s :
destruction”.
destruction”.

Examples of

disruptive innovation s :

o

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

o

Consider online music download businesses such as

iTunes
iTunes

and peer to peer file sharing.

o

Voice over Internet Protocol VoIP such as phone service provi ders.

Skype

versus traditional telephone and mobile

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Gains in dynamic efficiency:

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

Innovation as a barrier to entry

Innovative behaviour can be an important barrier to entry in markets. Firstly because some the property rights embedded in product innovations might be protected by patent laws . There is nearly always a first mover advantage for successful innovators that gives them scope to

exploit some

Set against this argument is that view that high rates of innovation reduce

they challenge existing market power enjoyed by well ­ established businesses.

Process innovation

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

monopoly power

in a market.

barriers to entry

because

MC1 Profit at Price P1 Costs Profit at Price P2 P1 SRAC1 SRAC3 P2 MC2
MC1
Profit at Price P1
Costs
Profit at Price P2
P1
SRAC1
SRAC3
P2
MC2
AR
(Demand)
MR
Q1
Q2
Output (Q)

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

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

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44

Government policy and innovation

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

Which policies might encourage more innovation?

o

o

o

o

o

Tax credits / capital investment allowances .

Policies to encourage small business creation and entrepreneurship .

Toughening up of competition policy to expose cartel behaviour, but to allow and promote

joint ventures
joint ventures

to fund research and development .

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

Increased funding f or research in our universities.

Im portant developments:

1. Increasingly most innovation is done by smaller firms and by entrepreneurs indeed

multinational corporations are now out ­ sourcing their research and development spending to small businesses at home and overseas much is being shifted to cheaper locations

“offshore” — in India and Russia .

See this article on entrepreneurship in the Economist .

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