Economics (Micro)

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1.1
Nature of Economics
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1.1.1
Economics as a social science
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What does ceteris paribus mean?
All other things being equal or other things held constant
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1.1.2
Positive and normative economic statements
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What are positive statements?
Positive statements are objective; can be tested, calculated or measured; can be proven right or wrong and is factually based
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What are normative statements?
Normative statements are subjective, questionable comments that are difficult to test and are influenced by the opinion or prejudice of people
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What is a value judgement?
A value judgement is a subjective statement of opinion rather than a fact that can be tested
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1.1.3
The Economic Problem
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What is meant by the term renewable resource?
A resource of economic value that can be replenished or replaced on a level equal to consumption
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What is meant by the term non-renewable resource?
A resource of economic value that cannot be readily replaced by natural means on a level equal to consumption
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What is the problem of scarcity?
It is where there are unlimited wants but only finite resources
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What is meant by the term opportunity cost?
The cost of one thing in terms of the next best option which has been given up
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1.1.4
Production possibility frontiers
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What is meant by the term production possibility frontier?
The maximum possible combinations of capital and consumer goods that the economy can produce with its current resources and technology
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What are some of the uses of a PPF?
To depict: the maximum productive potential of an economy; opportunity costs; economic growth or decline; efficient or inefficient allocation of resources; possible and unobtainable production
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What does going beyond the PPF lead to most of the time in terms of the economic cycle?
A recession
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What type of growth on a PPF would be through use of money?
Actual growth
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What type of growth on a PPF would be through use of factors of production?
Potential growth
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What are four factors of production?
Land, Labour, Capital, Entrepreneurship
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What is a capital good?
A capital good is any good used to help increase future production
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What is a consumer good?
Consumer goods are any goods used by consumers and have no future productive use
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1.1.5
Specialisation and the division of labour
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What is specialisation?
The production of a limited range of goods by a company/individual/country which means that trade is essential as it is the only way they are able to access all that they need
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What is the division of labour?
When labour becomes specialised in a particular part of the production process
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What are the advantages of the division of labour?
Some of the benefits are: workers are able to develop expertise in their areas of operation; It stimulates innovation;It saves time by eliminating the need for workers to transition from one task to the next
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What are the disadvantages of the division of labour?
Monotony in work- a worker has to do the same small task again and again; lack of responsibility- a worker performs only a part of the total job;reduced mobility of labour; decline in craftsmanship
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What are advantages of specialisation?
Higher productivity and efficiency – e.g. rising output per person hour; lower unit costs leading to higher profits; encourages investment in specific capital – economies of scale
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What are disadvantages of specialisation?
Greater cost of training workers; quality may suffer if workers become bored by the lack of variety in their job; more expensive workers; workers may eventually be replaced by machinery
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What are the functions of money?
As a medium of exchange; a measure of value; a store of value; a method of deferred payment
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1.1.6
Free market economies, mixed economy and command economy
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What is a free market economy?
It is where individuals are free to make their own choices and own the factors of production without government interference
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What are advantages of a free market economy?
The system is automatic due to the invisible hand; consumers have freedom of choice, called consumer sovereignty; there is high motivation as people know working hard could lead to high potential rewards; productive efficiency
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What are disadvantages of a free market economy?
High levels of inequality; lack of merit goods; resources could be wasted on unproductive expenses; if competition disappears then there may be monopolies
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What is a mixed economy?
In a mixed economy, more resources are allocated through government planning than in free market economies. Two key areas which distinguish mixed economies are welfare benefits and healthcare.
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What are advantages of a mixed economy?
An economy where both the free market mechanism and the government planning process allocate a significant amount of the total resources in the country
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What are disadvantages of a mixed economy?
They tend to lean more toward government control and less toward individual freedoms; unsuccessful regulations may paralyze features of production
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What is a command economy?
In a command (planned) economy, all factors of production, except labour, is owned by the state and labour is directed by the state
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What are advantages of a command economy?
The state provides a minimum standard of living; there is less wastage of resources; standardised products means that they are produced cost effectively
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What are disadvantages of a command economy?
It is impossible for the state to make so many decisions correctly; there could be an increase in bribery and corruption (an increase in bureaucracy); consumers lose their freedom
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What did Adam Smith argue?
He believed in the free market economy, argued how the invisible hand of the market would allocate resources to everyone's advantage and that the selfish pursuit of profit by every individual could lead to a whole economy where benefit was maximised
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What did Friedrich Hayek argue?
He argued that ever-greater control of the economy by the state leads to totalitarianism and the loss of individual freedom
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What did Karl Marx argue?
Marx believed that capitalist’s profit came from exploiting labour as they underpaid workers for the value that they actually created. He wanted remove the difference between the incomes of owners and workers and believed in communism
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What is the role of the state in a mixed economy?
Create a framework of rules; supplements and modifies the price system; redistributes income; stabilises the economy
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What does the tertiary sector refer to?
Services
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What does the secondary sector refer to?
Manufacturing
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What does the primary sector refer to?
Raw materials, agriculture
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1.2
How Markets Work
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1.2.1
Rational decision making
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What can we assume to be consumers aim?
To maximise utility
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What can we assume to be firms aim?
To maximise profits
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What can we assume government's aim to be?
To maximise social welfare
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1.2.2
Demand
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What is demand?
The amount of consumers that are willing to purchase at a given price over a period of time
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What is the law of demand?
As price rises, demand will fall - they are inversely proportional
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What causes a movement along the demand curve?
Movements along the demand curve are caused by a change in price
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What causes an extension in demand?
A fall in price
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What causes a contraction in demand?
A rise in price
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What causes a shift in the demand curve?
Any changes in the conditions of demand (this creates a completely new curve)
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How would a positive change be represented on a demand curve?
It would cause the demand curve to shift across to the right
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How would a negative change be represented on a demand curve?
It would cause the demand curve to shift across to the left
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What is effective demand?
It refers to the willingness and ability of consumers to purchase goods at different prices supported by their ability to pay
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What is market demand?
Total demand in a market for a good, the sum of all individuals' demand at a given price over a period of time
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What is composite demand?
A good that is in demand for more than one purpose e.g. petrol for both cars and running machines
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What is joint demand?
Where the demand for one good creates demand for another e.g. cars and petrol (have one and therefore need the other)
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What is derived demand?
Where the demand for one good or service stimulates the demand for another e.g. the demand for bread creates a demand for wheat (need one to make the other)
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What are the conditions of demand?
Changes in income; changes in tastes and preferences; advertising and branding; changes in price of complimentary and substitute goods; change in the population
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What is the concept of diminishing marginal utility?
The satisfaction derived from the consumption of an additional unit of a good will decrease as more of a good is consumed, assuming the consumption of all other goods remains constant
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1.2.3
Price, income and cross elasticities of demand
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What is meant by the term PED?
Measures the responsiveness of demand for a good or service after a change on the price of a good or service
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What is the PED formula?
Percentage change in the quantity of the good or service/ Percentage change in the price of the good or service
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Remember, you need to q...
Before you p!
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With a PED if you get a negative figure (-), what does this mean?
This means it is a normal good
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What is the first factor that determines the PED for a good or service?
The availability of substitutes - where a good has few substitutes, the PED for that good is likely to be low (inelastic). This means a rise in the price of a good will see a smaller change (contraction) in demand (inelastic response)
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What is the second factor that determines the PED for a good or service?
The time taken to switch to substitutes following a price rise, the PED for that good is likely to be low (inelastic). This means a rise in the price of a good will see a smaller change (contraction) in demand (inelastic response)
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What is the third factor that determines the PED for a good or service?
Whether the good is a luxury or necessity, the PED for that good is likely to be low (inelastic). This means a rise in the price of the luxury good will see a smaller change (contraction) in demand for that luxury (an inelastic response)
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What is the fourth factor that determines the PED for a good or service?
The proportion of income spent on the good - where the good occupies only a small percentage of income, the PED is likely to be low (inelastic). This means a rise in the price of the good will see a smaller change (contraction) in demand (inelastic)
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What would a relatively inelastic PED be?
<1 e.g 0.4. Quantity demanded changes by a smaller percentage than price so demand is relatively unresponsive to price
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What would an unitary PED be?
1
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What would a relatively elastic PED be?
>1 e.g. 2. Quantity demanded changes by a larger percentage than price so demand is relatively responsive to price
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What would a perfectly inelastic PED be?
0. A change in price has no effect on quantity supplied so demand is completely unresponsive to price. This would be shown by a vertical line
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What would a perfectly elastic PED be?
Infinity. A change in price means that quantity supplied falls to 0 and demand is very responsive to price. This would be shown by a horizontal line
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How does an elastic PED affect taxes and subsidies?
The more elastic the demand curve, the lower the incidence of tax on the consumer. This means that when PED is elastic, a tax will only lead to a small increase in price and the supplier will have to cover the majority of the cost of the tax
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How does an inelastic PED affect tax and subsidies?
When demand is inelastic, the tax will be mainly passed onto the consumer
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What is the significance of PED?
The price elasticity of demand, along with the price elasticity of supply, determine the effects of the imposition of indirect taxes and subsidies
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With a PED if you get a positive figure (+), what does this mean?
This means it is an inferior good
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In terms of PED when a demand curve is elastic how does this affect total revenue?
A decrease in price leads to an increase in revenue and an increase in price leads to a decrease in revenue
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In terms of PED when a demand curve is inelastic how does this affect total revenue?
A decrease in price leads to a decrease in revenue and an increase in price leads to an increase in revenue
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In terms of PED when a demand curve is unitary how does this affect total revenue?
A change in price does not affect total revenue
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On a demand curve if the demand is vertically sloping downwards what does this mean?
It means that the good or service is inelastic, operating in a niche market
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On a demand curve if the demand is horizontally sloping downwards what does this mean?
It means that the good or service is elastic, operating in a competitive market
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What is the formula for percentage change?
New-Old/Old *100
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What is meant by the term XED?
Measures the responsiveness of demand for a good or service after a change in the price of another good or service
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What is the XED formula?
Percentage change in quantity of good A/ Percentage change in the price of good B
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With XED if you get a negative figure (-), what does this mean?
This means that it is a complementary good
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With XED if you get a positive figure (+), what does this mean?
This means that it is a substitute good
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What kind of gradient does a substitute good have?
A positive, upward sloping gradient
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What kind of gradient does a complementary good have?
A negative, downward sloping gradient
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In terms of XED, what value would have not many close substitutes?
Inelastic/<1
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In terms of XED, what value would have some degree of sustitutability?
Unitary/1
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In terms of XED, what value would have close substitutes?
Elastic/>1
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In terms of XED, what value would have not so closely linked complementary goods?
Inelastic/<1
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In terms of XED, what value would have some degree of closeness?
Unitary/1
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In terms of XED, what value would have closely linked complementary goods?
Elastic/>1
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What is meant by the term YED?
Measures the responsiveness of demand for a good or service after a change in consumer incomes
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What is the YED formula?
Percentage change in the quantity of the good/ Percentage change in consumer incomes
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If you get a YED that is a positive figure (+), what does this mean?
It means that it is a normal good, normal goods have a PED >0
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What is the first factor that determines the YED of a good?
Whether the good is a luxury - something inessential but conclusive to pleasure and comfort
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What is the second factor that determines the YED of a good?
Whether the good is a necessity - the quality or state of being necessary
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In terms of YED, what do we know about necessities?
They typically have an inelastic YED (<1) and have a relatively vertical curve on a graph
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In terms of YED, what do we know about luxuries?
They typically have an elastic YED (>1) and have a relatively horizontal curve on a graph
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What is the significance of YED?
It is important for businesses to know how their sales will be affected by changes in the income of the population
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In what ways are elasticities of demand significant to firms and the government?
In terms of: the imposition of indirect taxes and subsidies; changes in real income; changes in the prices of substitute and complementary goods
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1.2.4
Supply
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What is meant by the term supply?
The amount of producers are able and willing to offer for sale at a given price over a period of time
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What is the law of supply?
As prices rise, supply will rise, they are directly proportional
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What causes a movement along the supply curve?
They are caused by a change in price
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How is an extension in supply brought about?
By a rise in price
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How is a contraction in supply brought about?
By a fall in price
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How are shifts in supply caused?
By any changes in the conditions of supply
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What are the conditions of supply?
Changes in the cost of production; the introduction of new technology; indirect taxes; subsidies; change in the number of firms
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What is meant by the term aggregate supply?
The total supply of all goods and services in an economy
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1.2.5
Elasticity of supply
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What is meant by the term PES?
Measures the responsiveness of supply for a good after a change in the price of the good
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What is PES often used for?
To predict or explain why prices rise or fall dramatically when there are changes in demand
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What is PES usually determined by?
It is usually determined by the ability and/or willingness to respond to a change in demand
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In terms of PES, what kind of response is used in a competitive market to eliminate excess demand?
An elastic response where supply is responsive
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In terms of PES, what kind of response is used in a monopoly market to eliminate excess demand?
An inelastic response where supply is not responsive
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What is the formula for PES?
Percentage change in the quantity supplied of the good/ Percentage change in the price of the good
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Why will PES always be positive?
Because plotting supply against price will always provide a positive gradient
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What does a PES of 0 represent?
A product that is perfectly inelastic, supply does not respond at all to a change in price
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What does a PES of <1 represent?
A product that is inelastic, supply is not responsive to the change in price
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What does a PES of 1 represent?
A product that is unitary
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What does a PES of >1 represent?
A product that is elastic, supply is responsive to the change in price
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What does a PES of infinity represent?
A product that is perfectly elastic, supply is very responsive to a change in price and excess demand is completely eliminated with no increase in price
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What kind of product or resource is always inelastic?
Anything that is finite
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What is the first factor that determines the PES of a good or service?
The time taken to produce extra output - where it may take a lot of time the PES is likely to be low (inelastic). This means that a rise in price will see a smaller change (extension) in supply (inelastic response)
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What is the second factor that determines the PES of a good or service?
The degree of spare capacity in the production process - where a business is operating at full capacity, they may struggle to respond to an increase in demand creating excess demand, the response to it could be increasing prices (inelastic response)
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What is the third factor that determines the PES of a good or service?
The ability of a firm to stockpile - storage of goods in surplus. This means a rise in the price of the good may see a change (extension) in supply as they can respond in times of increased demand
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What is the fourth factor that determines the PES of a good or service?
The ability to switch between methods of production - where they can switch the PES of the good is likely to be elastic. This means a rise in price of the good may see a larger change (extension) in supply (elastic response)
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What is the fifth factor that determines the PES of a good or service?
The ease with which firms can enter or exit - where firms find this difficult the PES for the good is likely to be inelastic. This means a rise in price of the good may see a smaller change (extension) in supply (an inelastic response)
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1.2.6
Price Determination
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What happens when a perfectly inelastic response is used to eliminate excess demand?
It is where a business cannot or will not respond to an increase in demand by increasing supply. Instead it is eliminated by rocketing prices e.g. limited seat stadiums
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What happens when a perfectly elastic response is used to eliminate excess demand?
It is where a business will respond to an increase in demand by increasing supply but there is no incentive of rising prices. Excess demand is then eliminated by an increase in supply e.g. markets that are competitive, a high XPED between firms exist
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1.2.7
Price Mechanism
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What is the rationing function of prices?
Prices serve to ration scarce resources when demand outstrips supply in a market. When there is a shortage, the price is bid up, only those with willingness to pay will purchase the product
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What is the incentive function of prices?
An incentive is something that motivates a producer or consumer to change behaviour. Higher prices provide an incentive to suppliers to supply more as there is a possibility of more profit; the function can be associated with an extension of supply
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What is the signalling function of prices?
Rising prices give a signal to consumers to reduce demand or withdraw as well as signal potential producers to enter a market conversely. Whereas falling prices signal consumers to enter and producers to leave
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What is market equilibrium?
Equlibrium refers to a market position where both demand and supply are equal, equilibrium suggests stability in the market and equilibrium will remain so long the factors of demand and supply are unchanged
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What happens when there is a positive change in the factors of demand?
The demand curve shifts to the right to D1, this creates excess demand from Q1 to X and puts pressure for prices to rise. This gives sellers incentive to supply more, signals firms to enter the market and consumers to ration their income, demand less
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What happens when there is a negative change in the factors of demand?
The demand curve shifts to the left to D1, this creates excess supply from Q1 to X and puts pressure on prices to fall. This gives an incentive for sellers to supply less, signals firms to move away and incentivizes consumers to demand more
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What happens when there is a positive change in the factors of supply?
The supply curve shifts to the right to S1, this creates excess supply from Q1 to X and puts pressure on prices to fall. This signals firms to move away, incentivizes buyers to purchase more
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What happens when there is a negative change in the factors supply?
The supply curve shifts to the left to S1, this creates excess demand from Q1 to X and puts pressure on prices to rise. This incentivizes sellers to supply more, signals firms to move away and consumers to ration their income and demand less
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1.2.8
Consumer and Producer Surplus
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What is consumer surplus?
The difference between the price the consumer is willing to pay and the price they actually pay, set by the price mechanism
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What is producer surplus?
The difference between the price the supplier is willing to produce their product at and the price they actually produce at, set by the price mechanism
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How does PED affect producer and consumer surplus?
The more inelastic demand, the higher consumer surplus is likely to be. The more inelastic supply, the higher producer surplus is likely to be
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1.2.9
Indirect taxes and subsidies
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What is indirect taxes?
A tax on expenditure where the person who is ultimately charged the tax is not the person responsible for paying the sum to the government
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What is the incidence of tax?
The tax burden on the taxpayer
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In what instances will the supplier pay all the tax?
If the demand curve (PED) is perfectly elastic, or the supply curve (PES) is perfectly inelastic, the supplier will pay all the tax
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In what instances will the supplier pay all the tax?
If the demand curve is perfectly inelastic, or the supply curve is perfectly elastic, all the tax will be passed on to the consumer
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What happens when a demand curve becomes more inelastic?
the more inelastic the demand curve, the higher the revenue of tax for the government because quantity demanded falls less and the more goods that are bought, the higher the tax revenue
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What is a subsidy?
A grant given by the government and is the opposite of a tax, an extra payment to encourage production/consumption of a good or service
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1.2.10
Alternative views of consumer behaviour
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What is one reason as to why consumers don't behave rationally?
Influences of other people: sometimes individuals are influenced by social norms, known as a bias. Consumers become unwilling to change the bias, even if doing so will benefit them, if it goes against the norms of society
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What is the second reason as to why consumers don't behave rationally?
Influence of habitual behaviour: habits reduce the amount of time it takes to do something as consumers no longer have to consciously think about their actions, they create barriers to decision making as they limit consumers considering alternatives
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What is the third reason as to why consumers don't behave rationally?
Consumer weakness at computation: Many consumers aren’t willing to make comparisons between prices and so they will buy more expensive goods than needed
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1.3
Market Failure
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1.3.1
Types of Market Failure
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What is market failure?
Market failure occurs when the market fails to allocate scarce resources efficiently, causing a loss in social welfare loss
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What is one type of market failure?
Externalities: An externality is the cost or benefit a third party receives from an economic transaction outside of the market mechanism. This leads to the over or under-production of goods, meaning resources aren’t allocated efficiently.
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What is another type of market failure?
Under-provision of public goods: Public goods are non-rivalry and non-excludable, meaning they are underprovided by the private sector due to the free-rider problem
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What is the third type of market failure?
Information gaps: Occurs when a buyer does not have all the information to make an informed and rational decision
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1.3.2
Externalities
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What is meant by a private cost/benefit?
The costs/benefits to the individual participating in the economic activity
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What is meant by a social cost/benefit?
The costs/benefits of the activity to society as a whole
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What is meant by an external cost/benefit?
The costs/benefits to a third party not involved in the economic activity
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What is meant by a merit good?
A merit good is a good with external benefits, where the benefit to society is greater than the benefit to the individual
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What is meant by a demerit good?
A demerit good is a good with external costs, where the cost to society is greater than the cost to the individual
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What are the three key economic decisions?
Who to produce for; what to produce and how to produce
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What is meant by allocative efficiency?
Where a firm produces goods and services that will maximise customer satisfaction/utility
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What is a free market?
Where the factors of supply and demand dictate the prices in a market
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In what ways does the government intervene to ensure the market considers externalities?
Indirect taxes and subsidies; tradable pollution permits; provision of the good; provision of information and regulation
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1.3.3
Public Goods
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What is a public good?
A public good is non-rivalrous and non-excludable. Non-rivalrous meaning one person's use does not stop someone else's. Non-excludable meaning you cannot stop someone else from accessing it
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What is meant by a quasi-public good?
They are non-pure public goods which are not perfectly non-rivalrous and non-excludable, an example would be roads as they can be tolls
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What is the free-rider problem?
A​ free rider is someone who receives the benefits without paying for it. This says that you ​cannot charge an individual a price for the provision of a non-excludable good because someone else will gain the benefit from it without paying anything
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1.3.4
Information Gaps
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What is meant by symmetric information?
Occurs where buyers and sellers have potential access to the same information; this is perfect information.
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What is meant by asymmetric information?
When one party has superior knowledge compared toanother
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How does advertising lead to information gaps?
Most​ advertising leads to information gaps as it is designed to change attitudes ofthe consumers to encourage them to buy the good. It could cause them to think the benefits are greater than they actually are
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1.4
Government Intervention
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1.4.1
Government intervention in markets
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What is indirect taxation?
When the good has a negative externality, the government can introduce indirect taxation to prevent market failure. This will cause a fall in supply and increase the costs to the individual
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On a diagram, what are the effects of an indirect tax?
The supply curve/MPC curve will shift from S1 to S2. The free market would produce at P1Q1, where MPC=MPB, but the social optimum position is P2Q2, where MSB=MSC. Following the introduction of the tax, the equilibrium position is S2=MPB=MSB, at P2Q2.
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What are the advantages of an indirect tax?
It internalises the externality- the market now produces at the social equilibrium position and social welfare is maximised; it raises government revenue, which could be used to solve the externality in other ways such as through education
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What are the disadvantages of an indirect tax?
If demand for the good is inelastic, then the tax will be ineffective at reducing output, they are regressive, meaning they the poor spend a larger proportion of their income on indirect taxes than the rich do
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What are subsidies?
In order to solve positive externalities, the government can introduce subsidies. Subsidies can also be introduced in order to fix information gaps
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On a diagram, what are the effects of a subsidy?
This will shift the supply curve/MPC=MSC curve from S1 to S2 as it will lower the cost of production. The free market would produce where MPC=MPB at Q1P1 whilst the social optimum position is where MSC=MSB at P2Q2
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What are the advantages of subsidies?
Society reaches the social optimum output and welfare is maximised; They can have other positive impacts , such as encouraging small businesses, bringing about equality and encouraging exports
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What are the disadvantages of subsidies?
High opportunity cost; once introduced, subsidies are difficult to remove and subsidies can cause producers to become inefficient, especially if they are in place for a long time
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What is the difference between a minimum and a maximum price?
For a maximum price to have an effect, it must be set below the current price equilibrium whereas for a minimum price to have an effect, it must be above the current price equilibrium
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What is a maximum price?
A maximum price is a legally imposed price for a good that the suppliers cannot charge above. They are set on goods with positive externalities. For example, they are set on food as a lack of food will have a negative impact on the NHS
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On a diagram, what are the effects of a maximum price?
The equilibrium position is P1Q1 but the imposition of the maximum price means there is excess demand of QD-QS
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What is a minimum price?
A minimum price is a legally imposed price at which the price of the good cannot go below. They can be set on goods with negative externalities, so that the price is raised to the social optimum point and consumption is discouraged
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On a diagram, what are the effects of a minimum price?
In the diagram, the market equilibrium price is P1Q1. However, the minimum price is set at P2 and as a result QD is demanded but QS is supplied so there is excess supply of QS-QD
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What are the advantages of a maximum or minimum price?
A minimum price will ensure that goods are affordable, whilst a maximum price will ensure that producers get a fair price. Both of these are able to reduce poverty and can increase equity/equality
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What are the disadvantages of a maximum or minimum price?
A distortion of price signals and this causes excess supply/demand. Excess demand will lead to questions about how to allocate goods and excess supply will lead to questions about what to do with the surplus goods and black markets
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What is a tradable pollution permit?
It allows the owner to pollute up to an amount and the government controls how many permits there are, limiting pollution. Companies buy permits in order to pollute so, in an attempt to cut costs and increase profits, companies may use greener tech
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What are the advantages of a tradable pollution permit?
It is guaranteed that pollution will fall to the targets set by the government due to caps; the government can raise revenue; encourages companies to use and invest in green tech; encourages firms to be efficient
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What are the disadvantages of a tradable pollution permit?
Can be expensive to monitor and police; it will raise costs for businesses which will be passed to the consumer; may be difficult to know how many permits the government should allow
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What is meant by the state provision of public goods?
Public goods are non-excludable and non-rivalry and so the free rider problem says they will be under-provided by the free market, leading to market failure. As a result, the government provides these public goods directly through taxation
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What are the advantages of state provision of public goods?
Corrects market failure by providing important goods; can help to bring about equality as all have access; using competitive tenders the government can ensure efficiency;
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What are the disadvantages of state provision of public goods?
Expensive and has a high opportunity cost for the government; government may produce wrong combination of goods as consumers cannot indicate their preferences; government may be inefficient at production since they have no incentive to cut costs
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What is meant by the provision of information?
When there is asymmetric information, the government provides information to allow people to make informed decisions. They may also force companies to provide information
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What are the advantages of provision of information?
This helps consumers to act rationally, which allows the market to work properly; It is best if the government uses this alongside other policies . For example, it can make demand more elastic in the long run and so indirect taxes become effective
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What are the disadvantages of provision of information?
Can be expensive for the government to do, incurring an opportunity cost; government themselves may not always have all the information, so it may be difficult to inform consumers; rational ignorance may set in
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What is meant by regulation?
Governments are able to impose laws and caps to ensure that levels are set where MSB=MSC or to ensure that companies provide full information on products
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What are the advantages of regulation?
This can ensure consideration of externalities, prevent exploitation of consumers and keep consumers fully informed. This will help to overcome market failure and maximise social welfare
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What are the disadvantages of regulation?
Laws may be expensive for the government to monitor; the government can suffer from regulatory capture; firms may pass on costs to the consumer in the form of higher prices; Excessive regulation may reduce competition in a market and efficiency
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What is an evaluative point comparing regulation and tradable pollution permits?
Regulation doesn’t take into account the different costs of following the laws for different companies. Compared with tradable pollution permits, regulation is a less efficient method of reducing pollution
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1.4.2
Government failure
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What is meant by the term government failure?
Government failure is when government intervention in the market leads to net welfare loss and a misallocation of resources. The total social costs arising from the intervention are greater than the social benefit
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Distortion of price signals is one cause of government failure, what is meant by this term?
The price mechanism aims to allocate resources to their best use and where consumers want and value them most highly. By intervening, the government distorts the mechanism and so resources may be allocated inefficiently
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How does a subsidy cause a distortion of price signals?
Government intervention change price signals in the market and distort the free market mechanism. As a result, they keep some companies in business when they are inefficient so the resources should be switched to somewhere else (subsidies)
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How does a tax cause a distortion of price signals?
Government intervention can make consumers pay too much for a good (taxes)
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How does a maximum or minimum price cause a distortion of price signals?
Maximum and minimum prices lead to excess demand/supply and make it difficult to allocate resources
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What is a real life example of the distortion of price signals?
For example, subsidies keep farmers in employment when they cannot produce cheaply enough to be competitive. The result is that the government keeps them in business when they should close down and find an alternative use for their resources
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Unintended consequences is another cause of government failure, what is meant by this term?
Some interventions cause effects which the government did not intend to happen. Consumers and producers may react to new policies in unexpected ways and so the policy doesn’t have the effect it should
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What is a real life example of unintended consequences?
The introduction of the buffer stock scheme CAP (Common Agricultural Policy) in the EU. This was meant to smooth out the price fluctuations but it ended up leading to overproduction in the EU and a fall in agricultural prices in the world
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Excessive administration costs is another cause of government failure, what is meant by this term?
In many cases, a lot of money that is allocated by the government is actually used up on basic administration costs. The social costs may be higher than social benefits, once administration costs are taken into account
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What is a real life example of excessive administration costs?
A lot of money given to the NHS etc. is actually spent on organisational administration rather than putting the money into medical care
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Information gaps is another cause of government failure, what is meant by this term?
Any decisions that the government makes must be based on some data but the information they have is always going to be limited
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What is a real life example of information gaps?
For example you cannot accurately predict the number of cancer patients or the number of cars on the road; cost and benefit forecasts of investment are often wrong and so the government invests in a system where the costs are higher than the benefit
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Theme 3
Business Behaviour and the Labour Market
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3.1
Business Growth
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3.1.1
Sizes and types of firms
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What are the reasons as to why some firms grow?
To make more money, to gain monopoly power and for greater security
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What is one benefit of growing to a firm?
A firm will be able to experience economies of scale which helps them to decrease their costs of production
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What is another benefit of growing to a firm?
A larger firm will hold a greater share of their market. This will give them the ability to influence prices and restrict the ability of other firms to enter the market, helping them to make profits in the long run
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What is a third benefit of growing to a firm?
A larger firm will have more security as they will be able to build up assets and cash which can be used in financial difficulties
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What are some of the constraints on growth causing some firms to remain small?
The size of the market, access to finance, owner objectives and regulation
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In large firms what is one way in which there is a separation of ownership and control?
Firms are owned by their shareholders, who play no part in the day to day running of the business
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In large firms what is another way in which there is a separation of ownership and control?
The chief executive and senior managers work for the company and control day-to-day decision making
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In large firms what is a third way in which there is a separation of ownership and control?
Shareholders are represented by a Board of Directors, who oversee the way the business is run
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How does the separation of ownership and control cause problems?
The owners will want to maximise the returns on their investment so will want to short run profit maximise, however directors and managers are unlikely to want the same thing
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What is the principal-agent problem?
Where one group, the agent, makes decisions on behalf of another group, the principal. In theory, the agent should maximise the benefits for those whom they are looking after but in practice agents have the temptation to maximise their own benefits
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What is meant by the term private sector?
The private sector refers to that part of the economy that is owned and run by individuals or groups of individuals, including sole traders and PLCs
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What is meant by the term public sector?
The public sector refers to that part of the economy which is owned or controlled by local or central government
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What can the private sector be split up into?
The private sector can be split into for profit and not-for-profit organisations
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What is a profit organisation?
Almost all private sector organisations are run to make a profit and to maximise the financial benefits for their shareholders . They may not necessarily profit-maximise, but their long term goal is to make money
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What is a non-profit organisation?
Some private sector organisations are not-for-profit. Any profit they do make is used to support their aim of maximising social welfare and helping individuals and groups
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What is meant by an incumbent firm?
Firms who are already existing or firmly established in a market
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What are two ways the size of a firm can be measured?
Turnover, employees
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Why are market share and and profit not good measure of a firm's size?
As the market may be small and profit taxation could be avoided like Starbucks
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How much market share is considered to be a dominant firm?
>40%
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3.1.2
Business Growth
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What are the two main types of growth?
Internal/organic growth and integration
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What is meant by organic growth?
Organic growth is where the firm grows by increasing their output , for example increased investment or more labour
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What are the advantages of organic growth?
Integration is expensive, time-consuming and high risk , with evidence suggesting that the long-term share price of the company falls following integration; The firm is able to keep control over their business
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What are the disadvantages of organic growth?
Sometimes another firm has a market or an asset which the company would be unable to gain through organic growth; Organic growth may be too slow for directors who wish to maximise their salaries; It will be more difficult for firms to get new ideas
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What is meant by integration?
Integration is growth through amalgamation, merger or takeover. A merger or amalgamation is where two or more firms join under common ownership whilst a takeover is when one firm buys another
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What is meant by vertical integration?
Vertical integration is the integration of firms in the same industry but at different stages in the production process
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What is meant by backwards integration?
If the merger takes the firm back towards the supplier of a good, it is backwards integration
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What is meant by forward integration?
Forward integration is when the firm is moving towards the eventual consumer of a good
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What are the advantages of forward/backward integration?
Increased potential for profit; less risks; With backward integration, businesses can control the quality of supplies and ensure delivery is reliable and Forward integration secures retail outlets and can restrict access to these outlets for others
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What are the disadvantages of forward/backward integration?
Firms may have no expertise in the industry they took over, for example a car manufacturing company would have deep knowledge of car manufacturing but little knowledge of selling cars and vice versa
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What is horizontal integration?
Where firms in the same industry at the same stage of production integrate
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What are the advantages of horizontal integration?
Helps to reduce competition; firms will be able to specialise and rationalise; The business is able to grow in a market where it already has expertise , which is more likely to make the merger successful
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What are the disadvantages of horizontal integration?
The problem is that it will increase risk for the business as if that particular market fails, they have nothing to fall back on and will have invested a lot of money into that area. They are ‘placing all their eggs in one basket'
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What is conglomerate integration?
Where firms in different industries with no obvious connections integrate.
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What are the advantages of conglomerate integration?
useful for firms where there may be no room for growth in the present market; range of products reduces the risk for firms; It will make it easier for each individual part of the business to expand than if they were on their own
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What are the disadvantages of conglomerate integration?
The problem with this is that firms are going into markets in which they have no expertise. It can often be damaging for the business
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How is the size of a market a constraint to business growth?
A market is limited to a certain size and so not all businesses are able to mass produce because their goods would not be bought by consumers. This can happen no matter how big the market is, and there will always be limits on growth
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How is access to finance a constraint to business growth?
Firms use two main ways to finance growth: retained profits and loans. If they do not make enough profits they cannot use retained profits and banks may be unwilling to lend money as it is a risk, restricting growth
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How are owner objectives a constraint to business growth?
Some owners may not want their business to grow any further as they are happy with their current profits and do not want the extra risk or work that comes with growth
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How is regulation a constraint to business growth?
In some markets, the government may introduce regulation which prevents businesses from growing
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How much market share is considered to be a monopoly?
25%
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What is meant by synergies?
Involved with horizontal integration, similar market they are experienced
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What is meant by diversification?
When a firm takes over or makes an acquisition into a new market to benefit from economies of scope
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3.1.3
Demergers
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What is a demerger?
A demerger is a business strategy in which a single business is broken into two or more components, either to operate on their own, to be sold or to be dissolved
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What are the four reasons for demergers?
Lack of synergies; value of the company/share price; focussed companies and They may also want to avoid attention from the competition authorities
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How is the lack of synergies a reason for demerger?
When different parts of the company have no real impact on each other and fail to make each other efficient. Lack of synergy means managers are splitting their time between areas which are different, it could lead to diseconomies of scale
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How is the value of the company/share price a reason for demerger?
Companies demerge as the value of the parts of the company is worth more than the company combined. This is because some parts of the business are operating well and have potential to grow but the overall value is brought down by lack of success
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How are focussed companies a reason for demerger?
Some people believe if the company and the management are more focussed on individual markets they become more efficient and successful, and make higher profits
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What is one impact of a demerger?
Workers: Workers could gain or lose through a demerger. Separate firms may need their own managers and leaders so people could get a promotion. However, the goal of making the firm more efficient may result in job losses
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What is another impact of a demerger?
Businesses: Concentrating on a smaller core business may enable it to be efficient and may lead to innovation and survival. However, the smaller size of the business could lead to a loss of economies of scale and reduced efficiency
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What is another impact of a demerger?
Consumers: Again, consumers could gain or lose. They may gain from innovation and efficiency, leading to better products and cheaper prices . However, demerged firms may be less efficient through loss of economies of scale or raised prices
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3.2
Business Objectives
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3.2.1
Business Objectives
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Who can a firm's motives be determined by?
Owners or shareholders, directors and managers, the workers, the state, consumers and pressure groups
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What is a firm's first objective?
Profit maximisation - neo-classical economics assume that the interests of owners are the most important and therefore the goal of firms is to profit maximise in the short run, in order to maximise owners’ returns also helping survival in the future
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On a diagram how is profit maximisation represented?
It has one equilibrium point where the quantity demanded is determined by where MC=MR and the price is determined by when it hits the AR in order to maximise profits
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What is a firm's second objective?
William Baumol suggested managers are interested in the level of revenue as this is what their salary depended on, they knew that a growth in revenue was always likely to be a positive for the business.
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What is a firm's third objective?
Sales Maximisation - it is often easier for people to judge the level of growth achieved rather than the level of profit. This will increase the prestige of the business and can help increase market share as well as help survival - Robert Marris
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What is a firm's fourth objective?
Satisficing - the principal-agent problem states owners and directors have different goals. Therefore, managers will follow the objective of profit satisficing: they will make enough profit to keep owners happy whilst following other objectives
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What are two other aims a firm may have?
Managerial utility maximisation and marginal cost pricing/allocative efficiency
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3.3
Revenues, Costs and Profits
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3.3.1
Revenue
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What is revenue?
The money earned from the sale of goods and services
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What is total revenue?
The total amount of money coming into the business through the sale of goods and services. Price x Quantity
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What is average revenue?
Demand is equal to AR: Total Revenue/Output
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What is marginal revenue?
The extra revenue that the firm earns from selling one more unit of production: total revenue from 'N' goods - total revenue from (N - 1) goods or Change in total revenue/Change in output
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When the demand curve is perfectly elastic what does this mean in terms of the market?
These are firms in perfect competition and these firms have no price setting power. As the TR curve is upward sloping this means the more goods that are sold, the higher the revenue made
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For most firms the demand curve is downward sloping, what does this mean for revenue?
The demand curve for the firm is the same as the firm's AR revenue curve, this indicates a firm that is in imperfect competition and so they have some price setting power
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What can linked to goods with a downward sloping demand curve?
The elasticity of the curve is linked to marginal revenue
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What happens if marginal revenue is positive?
When the firm sells the product at a lower price (or when they increase output), total revenue still grows and so the demand curve is elastic. Up until output Q, the demand curve is elastic
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What happens if MR is negative?
TR decreases as price decreases (or output increases) and so the demand curve is inelastic. After output Q, the demand curve is inelastic
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What happens when MR=0?
When MR=0, TR is maximised and the demand curve is unitary elastic; this is at the point Q
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Why is the TR curve U-shaped?
At first total revenue rises with output (when MR is positive) but it then begins to decline (when MR is negative)
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3.3.2
Costs
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What is the economic cost of production for a firm?
It is the opportunity cost of production; the value that could have been generated had the resources been employed in their next best use
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If at least one factor of production is fixed and cannot be changed what does this mean?
In means it is in the short run
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What is meant by total cost (TC)?
The cost of producing a given level of output: fixed + variable costs
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What is meant by total fixed cost (TFC)?
Costs that do nor change with output and remain constant e.g. rent, machinery
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What is meant by total variable cost (TVC)?
Costs that change directly with output e.g materials
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What is average (total) cost (ATC)?
Total costs/Output
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What is average fixed cost (AFC)?
Total fixed cost/Output
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What is average variable cost (AVC)?
Total variable cost/Output
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What is meant by marginal cost (MC)?
The extra costs of producing one extra unit of a good: total cost of producing N goods - total cost of producing (N - 1) goods OR change in total cost/change in output
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What is meant by the short run?
The length of time when at least one factor of production is fixed and cannot be changed
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What is meant by the long run?
When all factors of production become variable
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What is meant by diminishing marginal productivity?
It states that if a variable factor is increased when another factor is fixed, there will come a point when each extra unit of the variable factor will produce less extra output than the previous unit
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If more inputs are added in the short run marginal output will decrease but what does this mean for the marginal cost of production?
It means that the marginal cost of production will rise
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What is the shape of the average fixed cost curve?
It starts high as the whole fixed costs are being divided by a small output. As output is increased, AFC falls as the same amount is divided by a larger number
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What is the shape of the average total cost curve?
It is U-shaped due to the law of diminishing marginal productivity. Costs initially fall as machinery is used more efficiently but as production continues to expand, efficiency falls as machinery is overused
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What is the shape of the average variable cost curve?
It is U-shaped but it gets closer to ATC as output increases since AFC gets smaller
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What is the shape of the marginal cost curve?
It is U-shaped due to the law of diminishing marginal productivity. It will initially fall as the machines are used more efficiently but will rise as production continues to rise
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Why does the marginal cost line always cut the AC line at the lowest point on the AC curve?
As if MC is below AC, then AC will continue to fall since producing one more cost less than the average so the average falls; but if MC is above AC, then AC will rise
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What is the relationship between short-run and long-run cost curves?
Short run average cost curves are U-shaped because of the law of diminishing marginal returns whilst long run average cost cirves are U-shaped because of economies and diseconomies of scale
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Why is the LRAC an 'envelope' for all associated SRAC curves?
It is because the LRAC is either equal to or below the relevant SRAC
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What does the LRAC curve represent?
A boundary representing the minimum level of average costs attainable at any given level of output; points below the LRAC are unattainable and producing above the LRAC is inefficient
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How is a movement along the LRAC curve caused?
It is due to a change in output which changes the average cost of production due to internal economies/diseconomies of scale
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How is a shift of the LRAC curve caused?
A shift can occur due to external economies/diseconomies, taxes or technology, which affects the cost of production for a given level of output
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3.3.3
Economies and diseconomies of scale
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What is meant by economies of scale?
They are the advantages of large scale production that enable a large business to produce at a lower average cost than a smaller business
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What is meant by diseconomies of scale?
They are the disadvantages that arise in large businesses that reduce efficiency and cause average costs to rise, operating beyond MES
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What is meant by constant returns to scale?
Where firms increase inputs and receive an increase in output by the same percentage
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What is meant by the minimum efficient scale?
The minimum level of output needed for a business to fully exploit economies of scale. It is the point where the LRAC curve first levels off and when constant returns to scale is first met
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What is meant by an internal economy of scale?
An advantage that a firm is able to enjoy because of a growth in the firm, independent of anything happening to other firms or the industry in general
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What arises as a result of the production process?
Technical economies
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What is specialisation?
Large firms will be able to appoint specialist workers and buy specialist machines which will be able to do their jobs more quickly and better than machines/workers which are not specialised
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What is meant by balanced teams of machines?
Large firms can afford to buy a number of every kind of machine for each stage of production. By combining these machines, they can ensure they run each machine at its optimal level
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What is meant by increased dimensions?
This relates to the fact that if you double the size of the walls you can increase the area by four times, this occurs without doubling the cost
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What is meant by the indivisibility of capital?
Some processes require huge items of machinery and investment that make it only possible for them to produce on large scale
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What is meant by research and development?
Often it is only large firms that can afford to carry out large scale research and development, which means they are able to gain a large advantage over their competitor
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What is meant by financial economies of scale?
Large firms have greater security as they have more assets and so are less likely to be forced out of business over night. As a result, it is easier to obtain finance and interest rates will be lower due to less risk
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What is meant by risk bearing economies of scale?
Large companies are able to operate in a range of different markets, producing different products meaning if one area of business fails, their whole business will not collapse
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What is meant by managerial economies of scale?
Large companies can afford to appoint specialist managers in every field, who are specialised and so have greater knowledge and are able to do their job better or it is a fall in labour costs
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What is meant by purchasing economies of scale?
When your unit costs go down so your profits go up (buying in bulk)
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What is meant by technological economies of scale?
Technology reducing production costs
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What is meant by economies of scope?
Reduces risk by being in multiple markets
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What are advantages of marketing and purchasing economies?
Buying in bulk; specialisation and distribution
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What is meant by an external economy of scale?
An advantage which arises from the growth of the industry within which the firm operates independent to the firm itself. These cause the LRAC curve to shift downwards
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What is one advantage of an external economy of scale?
Labour - business established in an area with other successful firms from the same industry find that labour tends to come to that area; local education and training providers are more likely to develop
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What is another advantage of an external economy of scale?
Support services - businesses who provide products or services for large businesses will naturally move to the area where those businesses are based, which reduces transport cost/time delays for the business
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What is a disadvantage of diseconomies of scale?
Workers - in large businesses workers can think their efforts go unnoticed and have less chance of promotion so lose motivation and work less hard
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What is another disadvantage of diseconomies of scale?
Geography - a firm may have to transport finished products huge distances and firms may find it harder to control parts of the business which is miles away
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What are other disadvantages of diseconomies of scale?
Difficult for a large firm to change; prices of materials can increase; poor coordination, control and communication
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3.3.4
Normal profits, supernormal profits and losses
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What is profit?
The difference between revenue and costs
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What is one condition for profit maximisation?
Profit is maximised when TR and TC are furthest apart, with TR above TC
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What is another condition for profit maximisation?
It also occurs when MC=MR: this will always be true because if producing one more adds more to revenues than it does to cost
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What is normal profit?
The return that is sufficient to keep the factors of production committed to the business
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What does costs include in economics?
It includes the level of profit needed to keep the producer in the market and to cover the opportunity cost
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What is meant by earning supernormal, abnormal or monopoly?
If the profit is greater than normal profit, this occurs where AR>AC or TR>TC
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What is a loss?
Where the firm fails to cover its costs, AR
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Why may it not be necessary to shut a business down straight away when making a loss?
This depends on the average variable cost
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In what instance should firms continue production?
When AVC
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In what instance should firms leave the industry?
When AVC>AR
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What is the short run shut-down point?
Where AVC=AR
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Why do firms tend to produce on the shut run point?
As they do not want to let go of their workers or let down customers
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Why do firms tend to produce on the shut run point?
As they do not want to let go of their workers or let down customers
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3.4
Market Structures
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3.4.1
Efficiency
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What can efficiency be used for?
Efficiency can be used to judge how well the market allocates resources, and the relationship between scarce inputs and outputs. There are a range of different types of efficiency
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What is allocative efficiency?
This is achieved when resources are used to produce goods and services which consumers want and value most highly and social welfare is maximised. It will occur where P=MC
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What is productive efficiency?
A firm has productive efficiency when its products are produced at the lowest average cost so the fewest resources are used to produce each product. The minimum resources are used to produce the maximum output, in the short run this is where MC=AC
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When is productive efficiency possible?
It is only possible if there is technical efficiency, where a given output is produced with minimum inputs- but not all technically efficient firms are productively efficient
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What is dynamic efficiency?
This is achieved when resources are allocated efficiently over time. It is concerned with investment, which brings new products and new production techniques
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What is the alternative to dynamic efficiency?
The alternative is static efficiency: efficiency at a set point in time. Allocative and productive efficiency are examples of static efficiency
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In what type of markets will dynamic efficiency be achieved?
Dynamic efficiency will be achieved in markets where competition encourages innovation but where there are differences in products and copyright/patent laws
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What is X-inefficiency?
If a firm fails to minimise its average costs at a given level of output, it is X-inefficient. This is a specific type of productive inefficiency as it occurs when they fail to minimise their cost for that specific output
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What is an example of X-inefficiency?
For example, the minimum point on the AC curve may be at 100 goods at a cost of £5 each. The firm is producing 125 goods and so is not productively efficient. It costs them £8 to produce each good, but they could produce 125 goods at £7
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3.4.2
Perfect competition
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What is perfect competition?
Perfect competition is a market where there is a high degree of competition, but the word ‘perfect’ does not mean it maximises welfare or produces ideal results
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What is an example of perfect competition?
There are few industries which fit this type of market structure, one example may be agriculture but government intervention may prevent it from being so
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How many key characteristics are there for a market to be perfectly competitive?
For a market to be perfectly competitive, there must be four key characteristics. These mean that demand for the firm’s goods is perfectly elastic, and prices are solely determined by interaction of demand and supply; the firms are price takers
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What is one key characteristic for a market to be perfectly competitive?
There must be many buyers and sellers. This means that no one firm or customer will be able to influence the market
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What is a second key characteristic for a market to be perfectly competitive?
There must be freedom of entry and exit from the industry . This is important as it means that when a business is making profits anyone can enter that market and start producing that product for themselves
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What is a third key characteristic for a market to be perfectly competitive?
There must be perfect knowledge. This enables firms to know when other firms are making profits which will attract them to join the market. Moreover, all firms have the same costs as they can use the same production techniques
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What is a fourth key characteristic for a market to be perfectly competitive?
The product must be homogenous, where they are identical so it is impossible to tell the difference between one make and another e.g. semi-skimmed milk
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At what point do firms produce at to short run profit maximise?
Firms are assumed to short run profit maximise and so the firm will produce at MC=MR
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When can firms in perfect competition make normal profit?
Firms in perfect competition can only make normal profit in the long run
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What comments can be made regarding perfect competition and its efficiency?
Perfect competition is productively efficient, since they produce where MC=AC. They are also allocative efficient since they produce where P=MC. Thus, they are static efficient
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Why is perfect competition not dynamic efficient?
No single firm will have enough for R & D and small firms struggle to receive finance. The existence of perfect information also means one firms’ invention will be adopted by another firm and so the investment will give the firm no benefit
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Why may perfect competition cause inefficiency in production?
Competition should keep costs, and therefore prices, low. However, firms will be unable to benefit from economies of scale and this may mean costs are higher than they otherwise could be
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3.4.3
Monopolistic competition
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What is monopolistic competition?
Monopolistic competition is a form of imperfect competition, with a downward sloping demand curve. It lies in between the two extremes of perfect competition and monopoly, both of which rarely exist in a pure form in real life
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What is an example of monopolistic competition?
Some examples of firms in monopolistic competition are hairdressers, estate agents and restaurants
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What is one characteristic of a monopolistic competition?
There must be a large number of buyers and sellers in the market, each of whom are relatively small and act independently. This means that no one buyer or seller has a large price setting power
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What is a second characteristic of a monopolistic competition?
There are no barriers to entry or exit , allowing new firms to enter when supernormal profits are being made and some to leave in the case of losses. As a result, only normal profits can be made in the long run
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What is the difference between monopolistic competition and perfect competition?
The difference between monopolistic competition and perfect competition is that in monopolistic competition firms produce differentiated, non-homogenous goods or services
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In monopolistic competition do firms have price setting power and how does this affect the curve?
Individual firms do have some price setting power, and so the curve is downward sloping
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What profits can firms make in the short and long run?
In the short run, firms can make supernormal profits, losses or normal profits. However, due to the lack of barriers to entry/exit, firms can only make normal profits in the long run
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Are firms in monopolistic competition going to be allocatively or productively efficient?
The firm will not be allocatively or productively efficient, as MR does not equal AR so AC cannot equal MC and AC cannot equal MR
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Are firms in monopolistic competition going to be dynamically efficient?
They are likely to be dynamically efficient since there are differentiated products and so know that innovative products will give them an edge over their competitors and enable them to make supernormal profits in the short run
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In comparison to perfect competition is less or more sold at a higher price?
In monopolistic competition compared to perfect competition, less is sold at a higher price and firms may not necessarily be producing at the lowest cost
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What are some advantages of monopolistic competition?
The market will offer greater variety and may be able to enjoy some degree of economies of scale
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3.4.4
Oligopoly
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What is oligopoly?
Oligopoly is where there are a few firms that dominate the market and have the majority of market share, although this does not mean there won’t be other firms in the market
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What is one key characteristic of oligopoly?
Products are generally differentiated
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What is the second key characteristic of oligopoly?
Supply in the industry must be concentrated in the hands of a relatively small number of firms, meaning there is a high concentration ratio
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What is the third key characteristic of oligopoly?
Firms must be interdependent (so the actions of one firm will directly affect another)
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What is the fourth key characteristic of oligopoly?
There are barriers to entry
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How is the concentration of supply in the industry indicated?
The concentration of supply in the industry can be indicated by the concentration ratio which measures the percentage of the total market that a particular number of firms have
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What does the 3 firm and 4 firm concentration ratio show?
The 3 firm concentration ratio shows the percentage of the total market held by the three biggest firms, whilst the 4 firm ratio shows the percentage by the four biggest firms and so on
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How is the concentration ratio worked out?
It is worked out by adding the percentages of market share for the firms or using the formula total sales of n firms/total size of market x100
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What is concentration ratio?
It measures the percentage of output, or sales of a group of firms in a given industry
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What is collusion?
Collusion is when firms make collective agreements that reduce competition
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How do you refer to a situation when firms do not collude?
When firms don’t collude, this is a competitive oligopoly
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What is a benefit of collusion?
If firms compete, they know lowering prices to gain new customers is likely to cause other firms to lower their prices;. However, if they work together, they could maximise industry profits
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What is another benefit of collusion?
Collusion reduces the uncertainty firms face and reduces the fear of engaging in competitive price cutting or advertising, which will reduce industry profits
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Why may firms decide to be a non-collusive oligopoly?
Firms may decide to be a non-collusive oligopoly since collusion is illegal and due to the risks of collusion , such as other firms breaking the cartel or prices being set where they don’t want it
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What is another reason as to why firms may decide to be a non-collusive oligopoly?
A firm with a strong business model and something that sets it apart from other firms will not want to collude if they feel they can increase market share and/or charge higher prices than competitors
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When does collusion between firms work best?
When there are a few firms which are all well known to each other; the firms are not secretive about costs and production methods and the costs and production methods are similar; they produce similar products
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When firms engage in collusion what actions may they take?
When firms engage in collusion, they may agree on prices, market share or advertising expenditure
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What are the two main types of collusion?
Overt and tacit collusion
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What is overt collusion?
Overt collusion is when firms come to a formal agreement
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What is tacit collusion?
Tacit collusion means there is no formal agreement
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What is a cartel?
A group of firms who enter into agreement to mutually set prices. The rules will be laid out in a formal document which may be legally enforced and fines will be charged for firms who break these rules
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What are the two ways a cartel could operate?
Agree on a price for the goods and then compete freely using non-price competition to maximise their market share; or agree to divide up the market according to the present market share of each business
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What is the problem with a cartel?
No firm is likely to set their prices/output at the level they would not ideally choose and there is constant temptation to break the cartel
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As collusion is illegal, what may firms do?
Firms may be involved in tacit collusion such as price leadership and barometric firm
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What is price leadership?
Price leadership is where one firm has advantages due to its size or costs and becomes the dominant firm. Other firms will tend to follow this firm because they would be fearful of taking on the firm on in any form of price war
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What is barometric price firm leadership?
Barometric firm price leadership is where a firm develops a reputation for being good at predicting the next move in the industry and other firms decide to follow their leader
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What influences the behaviour of a firm under non-collusive oligopoly?
The behaviour of a firm under non-collusive oligopoly will depend on how it thinks other firms will react to its policies
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What is game theory?
Game theory explores the reactions of one player to changes in strategy by another player
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What is the aim of game theory?
The aim is to examine the best strategy a firm can adopt for each assumption about its rival’s behaviour and it provides insight into interdependent decision making that occurs in competitive markets
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What is game theory used for?
Game theory can be used to examine the best strategy a firm can adopt for each assumption about its rivals
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Where is the easiest way of demonstrating game theory?
The easiest way of demonstrating this is where duopoly exists in the market, so there are two identical firms
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What is the maximin policy?
Maximin policy involves firms working out the strategy where the worst possible outcome is the least bad
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What is the maximax policy?
Maximax policy involves firms working out the policy with the best possible outcome
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What is it called when the maximin and maximax policy have the same solution?
If the maximin and maximax strategies end up with the same solution, this is called the dominant strategy. However, dominant strategies aren’t that common in real life and the best strategy for a firm tends to depend on what the other firm does
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What is Nash Equilibrium?
It is where neither player is able to improve their position and has optimised their outcome based on the other players expected decision
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Price wars are one type of price competition, what will it do?
A price war will drive prices down to levels where firms are frequently making losses. It lowers industry profits
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How will a price war affect firms in the short and long run?
In the short term, firms will continue to produce if their AVC is below AR but in the long run, they will leave the market and prices will have to rise since supply falls
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Where do price wars occur?
These occur in markets where non-price competition is weak ; where goods have weak brands and consumers are price conscious. They also occur when it is difficult to collude
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Predatory pricing is another type of price competition, what is it?
The established firm will set such a low price that other firms are unable to make a profit and so will be driven out the market. The existing firm is then able to put their price back up
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When does predatory pricing occur?
This occurs when an established firm is threatened by a new entrant or if one firm feels that another is gaining too much market share
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Is predatory pricing legal or illegal?
This is illegal and only works when one firm is large enough to be able to have low prices and sustain losses
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Limit pricing is another type of price competition, what is it?
In order to prevent new entrants, firms will set prices low (the limit price). The price needs to be high enough for them to make at least normal profit but low enough to discourage any other firm from entering the market
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In limit pricing, how does the barriers to entry affect the limit price?
The greater the barriers to entry, the higher the limit price. It is mainly used in contestable markets
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What is a drawback of limit pricing and the barriers to entry?
The drawback of this is that it means firms cannot make profits as high as they would be otherwise be able to
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Does an oligopolistic market tend to have a lot of non-price competition?
An oligopolistic market tends to have a lot of non-price competition due to the fact that prices are relatively stable. They spend a long time and a lot of money on advertising and promotions
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What is one type of non-price competition?
Advertising: This creates an awareness of the company/product and can persuade a customer to purchase the product. If advertising is successful, it can increase sales and market share for a business which in the long run can increase profits
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What is another type of non-price competition?
Loyalty cards: These encourage repeat purchases by rewarding customers for their loyalty. They also provide firms with lots of data on consumers’ buying habits, which the firm can use to increase sales
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What is another type of non-price competition?
Branding: A successful brand can help increase loyalty and repeat purchases for a business. People will trust the brand and so will more likely keep buying from them. An established brand should find it easier to release new products
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What is another type of non-price competition?
Quality: A firm that is known for good quality may be able to charge higher prices, and is likely to have strong brand loyalty. They are likely to have good reputation and benefit from positive recommendations
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What is another type of non-price competition?
Customer service: This will encourage loyalty amongst customers and give the business a more positive reputation
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What is another type of non-price competition?
Product development: A business that invests in product development will have a competitive advantage over rivals. If they're the first firm to release a new product, they would see an increase in sales and this is likely to help with branding
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What is a downside of non-price competition?
The problem with these methods is that they are often expensive and require large investment. Similarly, only large firms will be able to do large scale advertising, R & D etc and there is no guarantee it will be successful
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How statically efficient will firms engaging in non-price competition be?
Firms will be statically inefficient, since they are not productively or allocative efficient but they will experience economies of scale lowering costs
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How dynamically efficient will firms engaging in non-price competition be?
They are likely to be dynamically efficient. They make supernormal profits, so have the funds to invest, and they have an incentive to invest, due to competition
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3.4.5
Monopoly
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What is pure monopoly?
Pure monopoly exists where one firm is the sole seller of a product in a market
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Does pure monopoly exist in the real world?
Pure monopoly rarely exists but a firm can be legally considered as having monopoly power if it has more than 25% of the market
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MAKE SURE YOU KNOW THE...
DIAGRAMS!
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What is third degree price discrimination?
This is when monopolists charge different prices to different people for the same good or service
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What are examples of third degree price discrimination?
Different times of the day, for example peak and off-peak train times; different prices in different places, such as between London and smaller towns; and between different incomes, for example discounts for elderly people
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What is required in order for price discrimination to occur?
The firm must be able to clearly separate the market into groups of buyers; the customers must have different elasticities of demand; and they must be able to control supply and prevent buyers from the expensive market from buying in the cheaper one
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What is a benefit of third degree price determination?
Firms benefit since they are able to increase their profits. This can go into research and development, improving dynamic efficiency
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What is another benefit of third degree price determination?
Those in the elastic market gain as they are able to pay a lower price than they otherwise would; they benefit from cross subsidisation
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What is a downside of third degree price determination?
Consumers lose some of their consumer surplus to the producers and some consumers have to pay a higher price
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What are natural monopolies?
In these industries, the economies of scale are so large that even a single producer is not able to fully exploit all of them . These are decreasing cost industries. There are no pure natural monopolies in real life
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In a market with natural monopolies why is it pointless to encourage consumption?
It would be pointless to encourage competition since it would raise average costs for the industry. If any new firm enters the market, they will be easily priced out as their costs will be so much higher
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Do natural monopolies tend to be found in industries with high fixed costs?
Yes, natural monopolies do tend to be found in industries with very high fixed costs , such as railways
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What is the efficiency of a firm with natural monopolies?
These firms are neither allocative nor productively efficient as there is no minimum on the AC curve and at allocative efficiency there would be a loss
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What is a benefit of monopolies to a firm?
Monopolists have the potential to make huge profits for their shareholders through profit maximisation
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What is another benefit of monopolies to a firm?
The existence of supernormal profits means firms will have finance for investments and will be able to build up reserves to overcome short term difficulties
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What is another benefit of monopolies to a firm?
Firms with monopoly power will be able to compete against large overseas organisations and large firms will be able to maximise economies of scale, reducing costs and increasing profit
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Why may firms not choose to profit maximise?
Firms may not always choose to profit maximise because of X-inefficiencies, sales or revenue maximising, profit satisficing or contestability leading to limit pricing
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What is a benefit of monopolies to employees?
The inefficiency of the monopoly may mean employees receive higher wages, particularly directors and senior managers. Profit satisficing or sales/revenue maximising may mean output is higher and so more employees are employed
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What is a downside of monopolies to employees?
Monopolists produce at lower outputs, so will employ fewer workers
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For suppliers what does the impact of a monopolist depend on?
It will depend on the extent to which the monopolist is also a monopsonist . If the monopolist buys all or most of the suppliers’ goods (so is a monopsonist), it will reduce the suppliers’ profits as the monopolist will decrease prices
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Is it better or worse for consumers if there is a natural monopoly for a firm?
With a natural monopoly, consumers tend to be better off than if there was competition
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What is a benefit of monopolies to consumers?
When firms enjoy economies of scale , they will be more efficient and customers will enjoy a higher consumer surplus
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What is another benefit of monopolies to consumers?
An increased range of goods or services due to cross subsidisation
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What is a downside of monopolies to consumers?
Consumers may pay higher prices and see a poorer quality service, due to a lack of competition
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What is another downside of monopolies to consumers?
There is less choice for consumers, since there is only one firm producing the good
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How productively and allocatively efficient are monopolies?
A monopoly is productively inefficient, since they don’t produce at MC=AC. They are also not allocative efficient as P>MC
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How dynamically efficient are monopolies?
Since a monopolist is likely to make supernormal profits, they will be dynamically efficient. However, if there is no competition, they may have no incentive to invest
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What did Schumpeter argue about monopolies?
Schumpeter argued that monopolies will have large retained profits and will be able to exploit new products or production techniques without worrying about competitors
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What does Schumpeter's argument mean for the efficiency of monopolies?
This would make them more productively efficient, as costs are lower, more allocative efficient, as there are new products in the market, and dynamically efficient
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Why are there few permanent monopolies?
There are few permanent monopolies since supernormal profits give an incentive for other firms to break down the monopoly through a process of creative destruction.
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3.4.6
Monopsony
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What is a monopsony?
This is where there is only one buyer in the market, and other than this it has the same basic characteristics as monopoly. They can prevent new firms entering the market and aim to profit maximise
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Are there examples of monopsonies in real life?
In real life, pure monopsonies rarely exist but many firms experience monopsony power, when they buy a large percentage of the market
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What is a characteristic of a monopsony?
They will pay their suppliers the lowest price possible to minimise their costs and make the most of their position as the only buyer. This will enable them to maximise their profit
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What is the benefit of a monopsony to firms?
The monopsony gains higher profits by being able to buy at lower prices. This increases the funding for research and development and leads to more return for shareholders
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What is another benefit of a monopsony to a firms?
They achieve purchasing economies of scale, which will lower costs and increase profits
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What is the benefit of a monopsony to consumers?
Customers may gain from lower prices as reduced costs are passed on
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What is a downside of a monopsony to consumers?
It could lead to a fall in supply, since the business buys fewer inputs. The extent to which supply to customers will fall will depend on the price elasticity of supply in the market of which the monopsonist is a buyer
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What is another downside of a monopsony to consumers?
There may be a fall in quality as prices are driven down
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What is a benefit of a monopsony to employees?
Monopsonists may pay higher wages as they are making higher profits
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What is a downside of a monopsony to employees?
The supplier will sell less goods and so employ less people, whilst the monopsonist may employ fewer, more or the same amount of people since they have less inputs to use for production but their costs are also lower
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What is a downside of a monopsony to suppliers?
Suppliers will lose out as they will receive lower prices; less will be supplied leading to some firms leaving the market
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3.4.7
Contestability
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What is contestability?
This model is concerned with the possibility of other firms entering the market if they see the opportunity to make money, rather than the number of firms in the industry at a point in time
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What is meant by a contestable market?
A contestable market is one with a high threat of new entrants, which keeps firms producing at a competitive level
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What is one characteristic of a contestable market?
Within a contestable market there is perfect knowledge so if one firm is making abnormal profits, other firms will enter the market
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What is another characteristic of a contestable market?
There is freedom of entry and exit meaning any firms can enter/leave the market. There will be a relative absence of sunk costs
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What is another characteristic of a contestable market?
Firms will be able to and have the legal right to use the best available technology, meaning their average cost curve will be the same as the original firms’
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What is another characteristic of a contestable market?
There will be low product loyalty, meaning people don’t consistently use one brand and are happy to switch if a new one enters the market
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What is one more characteristic of a contestable market?
We assume firms are short run profit maximisers and do not collude with each other
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When will firms enter a contestable market?
In a contestable market, firms will enter the market if they see other firms are making huge profits
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When will firms remain in a contestable market?
They will remain in the market until competition prevents them from making a profit
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What type of profits are firms able to make in a perfectly contestable market?
In a perfectly contestable market, firms will only be able to make normal profits and produce where AC=AR because new firms will enter the market if price was any higher and they were making monopoly profits
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What are natural barriers sometimes called?
Some barriers are natural barriers, sometimes called innocent entry barriers
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What are legal barriers?
Legal barriers can prevent new firms from entering an industry. Laws are put in place which make it more difficult for firms to enter the market, or explicitly mean they cannot enter
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What is an example of legal barriers?
Patents and exclusive rights to production (such as with television) mean other firms cannot enter the market
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What are marketing barriers and what is an example of them?
Marketing barriers - high levels of advertising build up consumer loyalty, so demand becomes more price inelastic, and consumers are less likely to try other brands
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What is another type of barrier to entry and exit?
The pricing decisions of incumbent firms can be a barrier to entry. Predatory pricing means prices are so low that firms are driven out of the market, and so it would be extremely difficult for new firms to enter
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What is another type of barrier to entry and exit?
Some industries have high capital start up costs, for example buying the machinery necessary to begin production. Sunk costs may also be high
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What is another type of barrier to entry and exit?
Economies of scale mean that new firms are unable to produce on the same AC curve as large, incumbent firms. If they were to enter the industry, their costs would be higher and so prices would be higher and they would be unable to compete
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What do barriers prevent?
Barriers to exit prevent firms from leaving a market quickly and cheaply. They include the cost to write off assets, pay leases and make workers redundant.
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What is a sunk cost?
A sunk cost is a fixed cost that a business cannot recover if it leaves the industry
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Why do all businesses face sunk costs?
All businesses will face sunk costs because even if things are resold it is generally for a lower price
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What is the degree of contestability measured by?
The degree of contestability is measured by the extent to which the gains from market entry for a firm exceed the costs of entering the market . A market with no sunk costs and no barriers to entry and exit is a perfectly contestable market
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What is the link between contestability and instability?
The more contestable a market, the more unstable it will be as there can be regular hit and run competition
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Why is no market likely to be perfectly contestable?
In reality, no market is likely to be perfectly contestable as there is always likely to be some sunk cost
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3.5
Labour Markets
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3.5.1
Demand for labour
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What does the demand curve for labour show?
The demand curve for labour shows the quantity of labour that employers would wish to hire at each possible wage rate
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What is derived demand?
Firms hire workers in order to produce goods to meet their aim, usually of making a profit. Therefore, the demand for labour is derived demand as it is derived from demand for the product the labour produces
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What is a wage?
A wage is the price of labour and so has the same influence on demand for labour as price has on the demand for a product
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What is one factor influencing demand for labour?
Wage rates: As wage rates increase, demand for labour contracts since the MRP of labour must be higher for it to be worthwhile employing more people, so less people are employed
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What is another factor influencing demand for labour?
Demand for the product: Since labour is a derived demand, if there is no demand for the product, there is no demand for the labour. Firms won’t employ people if the goods they make aren’t going to be sold and make a profit
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What is the concept of MRP?
An increase in output or price of a good will increase demand for the labour that produces that good
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What is another factor influencing demand for labour?
Prices of other factors of production: If machinery and equipment becomes cheap, people will switch machinery for labour and therefore the demand for labour will fall
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What is another factor influencing demand for labour?
Wages in other countries: If wages are lower in other countries and therefore wages in the UK are relatively high, people will be employed in other countries as it represents a lower cost for businesses. This means that demand in the UK is low
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What is another factor influencing demand for labour?
Technology: Improvements in computers and technology means that many jobs have been lost with the work being done by machines. This means that there is less demand for labour, but demand for labour in technological based industries is increasing
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What is another factor influencing demand for labour?
Regulation: As laws are passed some jobs disappear, such conductors, whilst other jobs are made. High regulation within the labour market is likely to discourage firms from hiring since it can be costly and time-consuming reducing demand for labour
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What is meant by the PED of labour?
This is the responsiveness of the quantity demanded of labour to the wage rate
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What is one factor affecting the PED of labour?
It is directly correlated to the price elasticity of demand for the product the labour produces
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How does an elastic PED good affect the PED of labour?
If the good is elastic, then a rise in wages and hence a rise in prices for consumers will have a large impact on the quantity the business sells. This will mean that the business will reduce the people it employs, in order to help make profit
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What is another factor affecting PED of labour?
It is affected by the proportion of wages to the total cost of production: if wages are a big proportion of costs, then an increase in wages will increase costs massively and so there will be a large fall in demand for labour hence it will be elastic
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What is another factor affecting PED of labour?
If there are many substitutes, such as machinery and labour in other countries, then the demand will be elastic. This means high skilled jobs tend to be more inelastic than low skilled jobs as the labour cannot be easily replaced
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What is another factor affecting the PED of labour?
Time also plays a role. In the long run, it is more elastic as machinery can be developed and jobs can be moved whilst in the short run firms have to employ workers and redundancy payments can be expensive
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3.5.2
Supply of labour
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What does the supply of labour curve show?
The supply of labour curve shows the ability and willingness of people to make themselves available to work at different wage rates
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What is one factor influencing the supply of labour?
Wages: The supply of labour curve for an individual is a backward bending curve: an increase in wages will lead to an increase in hours worked at first but beyond a certain point, it will lead to a decrease in hours worked
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What are the two ways firms can increase the number of hours worked by its workforce?
It can increase the number of hours by its existing labour force or it can recruit new workers. Therefore, although an increase in wage rates may not increase the number of hours worked by existing labour, it will increase the number of workers
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What is another factor influencing the supply of labour?
Population and distribution of age: A high population will mean there is a large supply of labour. The distribution of age is important as there needs to be many people of high working age to ensure there is lots of labour
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What is another factor influencing the supply of labour?
Non-monetary benefits: Supply of labour will increase if there is high job satisfaction, for example in vocational jobs. Some jobs are attractive because they are close by or in an area with good social life, such as London, require little commuting
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What is another factor influencing the supply of labour?
Education/training/qualification: More educated workers means there is a higher supply of workers. This is particularly important for some industries which require qualifications
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What may higher skilled jobs suffer from?
Occupations which require high levels of education may suffer from lower supply of labour compared to low skilled jobs
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What is another factor influencing the supply of labour?
Trade unions and barriers to entry: Trade unions may be able to restrict the supply of labour by introducing barriers to entry, for example you have to have a degree for teaching
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What is another factor influencing the supply of labour?
Wages and conditions of other jobs: If many jobs in a local area are considered to be unpleasant and offer low wages, then supply for alternatives will be higher
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What is another factor influencing the supply of labour?
Legislation: The government rules can affect supply of labour, for example school leaving age and the retirement age
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What can cause market failure in the labour market?
Immobility: Labour can suffer from either occupational or geographical immobility
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What is another type of immobility labour can suffer from?
They can suffer from geographical immobility where they find it difficult to move from one place to another due to the cost of movement, family etc. There may be no jobs available in Glasgow, but jobs in London
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In general how does immobility affect labour?
Immobility can mean that there can be excess supply of labour in one area/occupation and excess demand in another. Even if wages are higher where there is excess demand, people will be unable to leave where there is excess supply
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What is meant by the elasticity of supply?
This is the responsiveness of supply to a change in wage rates
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What does elasticity of supply depend on?
It will depend on the level of qualifications and training since if there is a high level of qualifications necessary for the job, people will not easily be able to take up the job so the supply of labour will be inelastic
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What else does elasticity of supply depend on?
availability of suitable labour in other industries , for example if a company can ‘poach’ workers from other industries, then it will be more elastic
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What is one more factor that elasticity of supply depends on?
It depends on time as in the long run supply of labour will be more elastic as people will have time to train. If the job is vocational, it will be inelastic since even if wages fall people won’t leave the job
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3.5.3
Wage determination in competitive and non-competitive markets
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Why do wage rates differ within an occupation?
Wage rates differ within an occupation due to age, education, training, work experience, skill/talent/ability to perform tasks, sex and ethnic background. These last two are illegal but average wages suggest that this still can be an issue
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What is the link between elasticity of supply/demand and the real wage rate?
The lower the elasticity of supply/demand, the greater the change in the real wage rate and the smaller the change in employment as a result of a change in demand/supply for labour. The effect will also depend on the size of the shift
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What is one factor influencing/determining wages?
Perfect competition: in a perfectly competitive labour market, we make the same assumptions as in a perfectly competitive product market. Therefore, wages are determined purely by demand and supply and all workers are paid the same
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What is an example of perfect competition affecting wages?
For example, a waiter in Liverpool would move to be a waiter in Portsmouth if the wage rate was higher. This would reduce supply and lead to an increase in wages in Liverpool, and increase supply and lead to a fall in wages in Portsmouth
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In an imperfectly competitive market are wages set where demand equals supply?
In an imperfectly competitive market, wages will not always be set where demand equals supply
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What is another factor influencing/determining wages?
Monopsony in the labour market: In this situation there is only one buyer of labour, businesses know if they want to increase their labour force they will have to increase the wage they offer and, an increase in the wage for one increases it for all
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What is another factor influencing/determining wages?
Monopoly in the labour market: The existence of trade unions means they can operate as the only seller of labour.
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What are the two ways trade unions can increase wages?
There are two ways they could increase wages. Firstly, they could set barriers of entry which would reduce supply. Alternatively, they could set wages at a specific wage and ensure workers are not prepared to work for less
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What is a bilateral monopoly?
It is possible for there to be both monopoly and monopsony in a labour market, called a bilateral monopoly
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What is another factor influencing/determining wages?
Bilateral monopoly: The firm is a monopsonist and wants to employ at Q2W2. However, the union may decide to set a minimum wage at W1 and ensure that there is no one willing to work below this price, creating a kinked supply curve
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How does the state of the economy affect the strength of unions?
In a time of economic recession and unemployment the unions may have less bargaining power and wage is most likely to be down at W1. In times of full employment, they may have the power to influence and wages could be at W3
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What is one labour market issue?
Skills shortages: The UK suffers from geographical and occupational immobility, which means that even if there are enough engineers, there aren’t enough engineers in certain areas
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What is another labour market issue?
Young workers: Workers who join the workforce during recessions tend to receive lower lifetime earnings than those who enter the labour force in better times
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What is another labour market issue?
Retirement: Rising life expectancy and an increase in the number of people reaching retirement age, as the ‘baby boomers’ reach retirement, has negative effects on the government budget. Pensioners now makeup over 50% of welfare spending
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What is another labour market issue?
Wage inequality: Over time, those on the highest wages have seen their wages grow by a bigger percentage than those on the lowest wages. This is a contentious issue and raises questions over relative poverty and the level of redistribution required
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What is another labour market issue?
Zero-hour contracts: There has been a rise in zero-hour contracts and this causes problems for employees who do not know how much they will earn a week and receive little notice of when they will be required to work
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What is another labour market issue?
The ‘Gig economy”: Many more people are now self-employed and undertake short term contracts, working for companies such as Uber and Deliveroo. There are concerns over the rights of these workers and the unreliability of their pay each week
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What is another labour market issue?
Migration: Many people suggest that migration causes a fall in wages but it allows employers to recruit from a larger pool of workers and helps to fill skills shortages
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What is one way the government intervenes to help tackle labour market issues?
National minimum wage: Labour introduced the National Minimum Wage in April 1999 to raise people out of poverty and decent minimum standards in the workplace
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What are arguments for the national minimum wage?
The wage is able to reduce poverty as it mainly impacts the lowest wages and ensures that these people have enough to live on and it reduces male/female wage differentials
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What are arguments against the national minimum wage?
The potential loss of jobs in the industry; the minimum wage will raise costs for the companies and so may increase their prices, which is liking to lead to a fall in profit; the wage spiral as individuals will try to protect wage differentials
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What is the level of job losses dependent on?
The level of job losses is dependent on the elasticity of supply and demand. If both are relatively elastic, there will be large job losses but if both are relatively inelastic, the losses will be small
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What is another way the government intervenes to help tackle labour market issues?
Maximum wages: The introduction of maximum wages will lead to excess demand within the industry, since people may not put themselves forward for the job if they don’t think the salary matches the stress and responsibilities
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What is another way the government intervenes to help tackle labour market issues?
Public sector wage setting: Since trade unions in the UK are weak, in the short run, the government can effectively make whatever wage decisions it decides in order to improve the budget
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What is one way the government attempts to improve geographical mobility of labour?
They could improve the supply of houses and reduce the price of properties making it easier for people to move. They could make renting cheaper to help people working in temporary jobs
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What is another way the government attempts to improve geographical mobility of labour?
They could improve transport links which will allow people to work further away from where they live and if they do move, it will be easier for them to visit family and get to job interviews
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What is another way the government attempts to improve geographical mobility of labour?
National advertising could be used so people know about jobs all over the country and the government could introduce subsidies on houses, taxes etc. in areas where there are labour shortages to encourage people to move to the area and take up jobs
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What is a real life example the UK used to improve geographical mobility of labour?
The DVLA was moved to Swansea . Although this doesn’t improve the mobility of labour, it helps to prevent excess demand for labour in one place and excess supply in another
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How can the government improve occupational mobility of labour?
They can improve occupational mobility of labour, through education. This will help to make the workforce more employable and better at a wider range of jobs
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3.6
Government Intervention
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3.6.1
Government Intervention
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What does the CMA do?
The Competition and Markets Authority (CMA) work to promote competition for the benefit of consumers and investigate mergers and breaches of UK and EU competition law, enforce consumer protection law and bring criminal cases against cartel users
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How are mergers controlled?
In the UK, mergers are assessed in terms of the specific circumstances of each case, considering whether there will be a substantial lessening of competition (SLC)
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When is a merger investigated?
A merger is investigated if it will result in market share greater than 25% or if it meets the turnover test of a combined turnover of £70 million or more
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Why are mergers investigated?
To prevent two large companies merging is so they do not exploit their customers by raising price, offering poorer quality service and reducing choice. It can prevent firms from gaining monopoly power
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What is the problem with investigating mergers?
The problem is that very few mergers are investigated each year. The CMA can suffer from regulatory capture and may not have all the information necessary to make a decision
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Why do monopolies need to be controlled?
Monopolies are allocative and productively inefficient and so it can be argued that they need to be controlled
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What is one way monopolies are controlled?
Price regulation: Regulators can set price controls to force monopolists to charge a price below profit maximising price, using the RPI-X formula. This is used in the airport industry
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What could be a better system than the RPI-X formula?
Arguably, a better system is ‘RPI-X+K’, where K represents the level of investment. This is used in the water industry and has allowed investment of £130bn
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What is a positive about price regulation?
It gives an incentive for firms to be as efficient as possible as if they can lower costs by more than X they will enjoy increased profit. It prevents excessive prices and ensures that gains are passed onto the consumer
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What is a downside about price regulation?
The problem is that it is difficult to know where to set X due to rapid improvement in technology and because any information on what the efficiency gains will be have to come from the firm, who could easily lie as there is asymmetric information
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What is another way monopolies are controlled?
Profit regulation: This aims to encourage investment and prevents firms from setting high prices. However, it gives firms an incentive to employ too much capital in order to increase their profits
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What is an example of profit regulation in real life?
In the USA, ‘rate of return’ regulation is used where prices are set to allow coverage of operating costs and to earn a ‘fair’ rate of return on capital invested, based on typical rates of return in a competitive market
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What is a downside of profit regulation?
It is also criticised since a reduction in costs will not improve the firm’s situation and so there is little incentive to be efficient
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What is another way monopolies are controlled?
Quality standards: Monopolists will only produce high quality goods if this is the best way to maximise profits. The government can introduce quality standards, which will ensure that firms do not exploit their customers by offering poor quality
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What is a downside of quality standards?
The problem is that it requires political will and understanding to introduce
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What is another way monopolies are controlled?
Performance targets: They could set targets over price, quality, consumer choice and costs of production. It will help firms to improve their service and lead to gains for customers
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What is a problem with performance targets?
The problem is that firms will resist the introduction of targets, so again it requires political will and understanding. They will also attempt to find ways to meet targets without actually improving
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What is one way competition and contestability are promoted?
Promotion of small business: The government can give training and grants to new entrepreneurs and encourage small businesses through tax incentives or subsidies . This will increase competition since there will be more firms within the market
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What is a positive of the promotion of small businesses?
It increases innovation and efficiency , since new firms are likely to provide new products and incumbent firms will no longer be able to be X-inefficient
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What is another way competition and contestability are promoted?
Deregulation: This is the removal of legal barriers to entry to a previously protected market to allow private enterprises to compete. This will increase efficiency in the market by allowing greater competition as more firms can enter
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What is a downside of deregulation?
It can lead to poor business behaviour
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What is another way competition and contestability are promoted?
Competitive tendering: The government can contract out the provision of a good or service to private companies e.g. private firms could be employed to run hospitals
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What is a positive of competitive tendering?
This helps to minimise costs for the government and ensures efficiency by allowing for competition in the market. The private sector will have more experience running the projects, so it is likely they will be better managed
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What is a downside of competitive tendering?
The process of collecting bids is costly and time-consuming . The private sector may not aim to maximise social welfare in the same way the government would and could use cost-cutting methods that reduce quality
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What is one way suppliers and employees are protected?
Restrictions on monopsony power: The government can prevent these by passing anti-monopsony laws which make certain practices illegal and can introduce an independent regulator who will force monopsonists to buy fairly
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What is another way suppliers and employees are protected?
Workers’ rights: The government protects employees through health and safety laws, employment contracts, redundancy processes, maximum hours at work and the right to be in a trade union
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What is a downside of workers' rights?
The problem is that if workers’ rights are too strong, employers will be unwilling to take on new workers due to the extra cost of employing these workers
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What is privatisation?
Privatisation is the sale of government equity in nationalised industries or other firms to private investors. The aim is to revitalise inefficient industries but can sometimes lead to higher prices and poor services
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What is nationalisation?
Nationalisation is when a private sector company or industry is brought under state control, to be owned and managed by the government
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What is an advantage of privatisation?
It encourages greater competition, which reduces X-inefficiency and ensures low prices and high quality as firms realise they need to be competitive
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What is another advantage of privatisation?
Managers become more accountable, since they know poor performance will mean a fall in share prices and/or shareholders wanting them to be replaced
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What is another advantage of privatisation?
In both the long and short run, it can reduce the public sector net cash requirement (PSNCR) as the initial sale of shares raises revenue for the government and they no longer have to cover any of the firm’s losses
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What is another advantage of privatisation?
It reduces government interference which some see as a benefit in itself. This also means that firms can invest with greater certainty , instead of worrying about change when a government is elected every 5 years
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What is a disadvantage of privatisation?
When there are natural monopolies it may be fairer for the government to own the firm since they won’t abuse their monopoly position
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What is another disadvantgae of privatisation?
There are problems over externalities and inequality
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What is another disadvantage of privatisation?
Some argue that it negatively affects that the PSNCR as firms are under-priced when they are sold and the government no long receives a firm’s profit
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What is an advantage of nationalisation?
Investment is needed for the long term , but in a private company investment is only short term as shareholders will see no benefit from long term investment. This may lead to a poor quality of service
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What is another advantage of nationalisation?
In the case of a natural monopoly, it is better for monopoly to be run by the state as they aim to maximise social welfare rather than a private business who will maximise profits
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What is another advantage of nationalisation?
The government will guarantee a minimum level of service for people who suffer the risk of being cut off from the service, due to the lack of potential profit from providing for them
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What is a disadvantage of nationalisation?
Nationalised industries suffer from the principal-agent problem and moral hazard, as managers know that any loss they make will be covered by the government
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What is another disadvantage of nationalisation?
They will experience X-inefficiency and this could cause higher prices for consumers, especially since the industry will become a monopoly
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What is another disadvantage of nationalisation?
They will be influenced by government’s decisions and the government may not have enough money to invest
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Why do monopolies bring about the idea of nationalisation?
Natural monopolies bring about the question of nationalisation. It is argued that if the industry is likely to end up as a monopoly it is better for the consumer if that monopoly is controlled by the government, who will maximise welfare
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3.6.2
The impact of government intervention
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What is one impact of government intervention?
Governments are able to prevent monopolies charging excessive prices and aim to limit their profit. They try to ensure that consumers pay fair prices, receive a good quality service and have a lot of choice of regulation
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What is another impact of government intervention?
They can increase efficiency in a market by increasing competition and contestability. By regulating prices, they ensure a business keeps their costs low and so prevent X-inefficiency. They try to increase dynamic efficiency by encouraging investment
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What is an impact of excessive government intervention?
If the government regulates too strongly, they can push costs up and led to inefficiency
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What is another impact of government intervention?
A public sector business is likely to be allocative efficient, as they aim to maximise social welfare. They will see lower costs due to economies of scale
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Why is government intervention limited?
Government intervention on the whole tends to be limited because of the political power of large firms and industries as a whole. They are able to lobby the government and set up pressure groups
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When does regulatory capture occur?
This occurs when the regulator is captured by the firm/industry they are regulating
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What is one limit to government intervention?
Regulatory capture: The fact that the regulator will often meet with the firm’s employees will mean they become more empathetic and able to ‘see things from their perspective’ , which will remove impartiality and weakens their ability to regulate
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How does regulatory capture work?
Large corporations can invest huge amounts in learning how to play the system and in gaining the support of their regulator. It also is likely that the regulator will have worked in the sector for many years, as these people will have experience
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What is another limit to government intervention?
Asymmetric information: This is where regulatory bodies have to use information provided to them by the industries when setting price targets etc. It is in the industry’s best interest to maximise their profits and so may provide inaccurate info
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How does government intervention lead to government failure?
Government failure may occur if regulation such as RPI-X or quality standards are not set correctly. The government will be unable to regulate the companies accurately
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