Unit 3-Firms&Technological ChangeWatch
Lets say the firm itself is making an subnormal profit- a loss it must decide whether or not to leave the market or not. If it decides to leave the market a question is when is the right time to?
This is where the price and average variable cost is accounted. If in the short run where at least one factor of production is fixed, if it decides to exit the market now it will have to pay the fixed costs aswell. Markets have to consider if they can help to ease the fixed costs and if they able to it is better to otherwise all the money has to come out the owner’s pocket.
So if Price> Average Variable Cost therefore they can help contribute to the fixed costs For example for 100 units the cost of the good is £50 so the total revenue is £5000. While Average variable cost is £40 so the total variable cost is £4000. Average total cost is £6000 is is only making a £1000 loss. Which is payable and is better than paying the whole £2000 cost.
However if the price< average variable cost therefore there is no point in carrying on. Lets say it is £30 per unit so it is £3000 revenue and total variable cost is £4000 is it is a £1000 loss plus then also a £1000 fixed cost.
Quick little Re- cap on Perfect Competition:
This is the market which has many small firms and they themselves don’t have enough market power to affect the price
No barriers to entry and exit
Factor of production perfectly mobile
Advantages of Perfect Competition
They allocate resources in the most efficient way- both productively (P=MC) and allocatively efficient (P> MC) in the long run.
There is no information failure as all knowledge is spread out evenly
Only normal profits made just cover their opportunity cost
Maximum consumer surplus and economic welfare
No Scope for economies of scale because of the high number of firms in there
Undifferentiated products- all homogeneous. Important in industries like clothes and cars
Lack of supernormal profits may mean the investment of Research and Development(R&D) is unlikely. Important for industries like pharmaceuticals.
With perfect knowledge there is no incentive to develop new technology because of the ability to share information.- FREE RIDERS of info.
HOW REALISTIC IS THE PERFECT COMPETITIVE MODEL?
In reality it is more about theory rather than pratical. This the extreme spectrum of market structure.
However it is said that being perfectly competition is the position that firms should be or similarly in due to the efficiencies it can bring to the economy. Scarce resources would be allocated well.
It is said it doesn’t have to be perfectly competition but in real life competition should have similar characteristics like:
Many firms in the market
Few barriers of entry and exit
Incentives to cut costs
profits will be lower compared in markets than monopoly power
Technological would involve 3 points
More output with the same inputs
The improvement of existing output
The creation of new ideas
Technological Change itself would contains 2 main components
Invention: This is the creation of a complete new product and the UK itself has a high number of patents with new ideas
Innovation: The putting of an invention into commercial use, the process of converting knowledge and ideas into making existing or new products much better.
Firms that are capable of innovation can LOWER their costs and come up with new products, new processes, new production techniques – DYNAMIC EFFICIENT
Additionally it would mean that the firm itself can be more competitive.
It has normally said that Technical progress is accompanied with new capital equipment, new human skills. So therefore there are limits to the speed with which changes can occur.
E.G. is Broadband which has the UK has take up on- there has been criticism saying the process is slow to keep up with the major cooperations for example changes in stock market ( but fast for individuals themselves). Therefore innovation would take time to become the norm in all industries.
Some industries will virtually experience constant technical change where new innovations continually forces costs down. These industries will involve products with short life cycle. E.G. DVD players are said to this case as 20 years ago a DVD player was selling at £500 but after years innovation had taken place over the years, cost has fallen leading to a more technical DVD player being as low as £20 nowdays.
Need to consider the type of firm: Some firms might not have the incentive to invest in innovation – perfect competition may be the case where the firms themselves might not have the incentive due to perfect knowledge leading free riders.
Type of economies: The less developed economies tend to have to settle with the old models due to the lack of funds to get new ones. So therefore costs are still quite high.
The improvement from one model to the next- in terms of machinery how much more output can this new capital equipment produce compared the old one. If it is by small margins it might not bring a huge change to costs.
Could invention cause monopoly rather than competition due to the patents that has put in place. Therefore could exploit customers with high prices.
Regulation: this is the laws to restrict economic agents freedom of action in the market place
Deregulation is the opposite this is where there are cancellation of some laws to promote freedom of action in the market place.
Free Market economists say many regulations are unneccesary and can cause create burreacacy and red tape leading to higher business costs. It can also be a barrier to entry especially when protecting monopilistic power. There could also be the problem of regulatory capture where the regulator that supposed to restrict actions of these powerful firms act in their interest rather than consumers. Like the government- some industries are important to the country in terms of international competitiveness so they would protect them instead of doing their job.
Other Microeconomic Supply Side Policies
Public Private Partnership- This is where the partnerships between the private and public sectors to produce public goods
Private Finance initiative – a form of PPP where the private sector undertake most of the work.
Contractualisation- where public sector firms contract out services to the private sector. e.g. NHS contracting the catering service to Wimpy
Competitive Tendering – This is basically like a bid war for private firms where the public firm would see which firm will offer the best value of money for the service.
When say dominating they all have a large market share and concentration ratio. E.g. A 5 firm conc ratio of 85% would mean they have 85% of the market share
However it is looked on that the conduct and behaviour of these firms shows their real characteristics.
There is a high degree of uncertainty from these group of firms : Do they compete or do they collude. THIS SHOWS THEY ARE INTERDEPENDENT
When competing- Non Price competition is the better option mainly because when with price there is a higher risk of losing out.
If they don’t price compete- they will have to collude which is the act of agreement between the firms. These firms can form a CARTEL. From Game theory- oligopoly firm would want to collude as it is the option with the less risk.
This can also be shown by the Kinked Demand Curve- Which shows the curve can be split into two parts. The top part shows that the price would be elastic as if the firm raises it price it would lead to other firms not increasing their price therefore could potentially lose market share.
However it depends on the firm’s brand loyalty and also if it is the price leader because if it is other firms will tend to follow
under Kinked demand curve theory the bottom half is said to be inelastic as when firms decrease its price due to the competitiveness other firms will also decrease their price. Therefore they would not really gain much demand and there is incentive because they would be making less profit. Therefore it is best to stick at the certain price.
Developing the Kinked demand theory that marginal revenue can be added and like monopoly the MR is always under AR. However it is kinked and there is a middle gap also called the DIscontinous area. PROFIT MAXIMISATION is where MR = MC however if production costs increase e.g. raw material prices. The price would not be affected.
This shows in some kind that prices are stable in an Oligopolistic market.
LIMITATIONS: 2 significant points:
First it does not explain why the firm itself would pick that certain price as their fixed price.
Secondly the kinked demand theory does not reflect what real world firms would do as in reality firms would try to ‘test the market’ by either rising or lowering prices.
Under some circumstances it might that firms themselves would benefit by competitng on price as the strongest firm likely in order to force rival firms out. Plus this theory ignores non price competition which is extremely important feature of oligopoly.
It is likely to increase expenditure for the firm in terms of costs however it enables the firms in changing price and then provoking a price war.
Examples of Non Price Competitionupermarkets
In store advertising/marketing
loyalty cards to increase customer loyalty
Home delivery services
extension of hours
Airlines also do this for example offer larger seats, better in flight entertainment, more varied food menu.
Advertising – Large firms can spread the fixed costs of advertising so advertising cost is low ( economies of scale) while new firms will find it hard to do this.
Branding- Through advertising and allows these big firms to show their unique characteristics making demand more inelastic.
Integration – grow in size they can integrate both horizontally and vertically(forward and backwards) enabling them to pursue predatory pricing.
Research and Development- These big firms can increase their expenditure by developing new methods that would create new products to edge over their competitors.
Multiplicity of Brands – many customers like to change brands so it is good for a firm to own a number of brands from different markets. This should restrict the new firms from entering.
Non Price Competition – If they help to increase customer satisfaction this would allow them to avoid price war and build up brand loyalty.
Can take advantage of customers by exploiting producer sovereignty by manipulating consumer wants and restricting choice. – can also price discriminate aswell
Do this by using dominant power to restrict output to raise up prices.
Utility firms are said to be NATURAL MONOPOLY.
The Competition Commission and Office of Fair Trading are said to be responsible to a government ministry.
OFT would help to monitor and investigate any anti competitive behaviour in the market and if they find any they would refer this evidence to the Competition Commision for further investigation. The CC would investigate how this behaviour would affect the market and they themselves would refer to the Department of Business, Innovation and Skills to make a decision whether or not action should take place. Very seldomly there is action but on the extreme it can cause this monoply to split e.g. the selling of their assets.
However there are alternatives to this
Compulsury break up of monopolies
Taxing Monopoly profits
Removing Barriers of Entry
Restrictive Trade Practices: Examples would include the supplier restricting supply unless the distributor supplies all their product range. In contrast if there is a cartel to be found it would be referred to the RPC= Restrictive Practice Court for summoning. If guilty there would be huge fines.
Not all cartels are against the public interest for example such Collective Training scheme for workers have jointly helped each other in research and development
AT THE BEGINNING OF 2000, THE PRICE OF A BARREL OF CRUDE OIL WAS ABOUT $26, RISING TO ABOUT $141 IN MID-2008. THE PERCENTAGE CHANGE OVER THE PERIOD CAN BE CALCULATED BY DIVIDING THE ABSOLUTE CHANGE ($115) BY THE ORUCE IN 2008 ($26) AND MULTIPLYING THIS NUMBER BY 100. THE ANSWER TO THE FIRST PART OF THE QUESTION IS A 442% INCREASE IN THE PRICE OF CRUDE OIL. A SIGNIFICANT FEATURE OF THE DATA IS THAT FOR THE LAST 6 MONTHS OF 2008, THE PRICE FELL RAPIDLY FROM THE PEAK OF $141 A BARREL TO A TROUGH OF ABOUT $28 A BARREL.
Evaluate the view that outsourcing abroad of service activities such as customer service and accounts inevatabley improves the effecincy of British businesses.(25)
THE TWO EFFECINCY CONCEPTS PARTICULARY RELEVANT FOR THIS QUESTION ARE PRODUCTIVE EFFIENCY AND DYNAMIC EFFECINCY. FOR A FIRM, PRODUCTIVE EFFECINCY AND DYNAMIC EFFECINCY. FOR A FIRM, PRODUCTIVE EFFECINCY OCCURS WHEN AVERAGE COSTS OF PROUDCTION ARE MINIMISED. IT IS A STATIC CONCEPT.
BY CONTRAST, AS THE NAME INDICATES, DYNAMIC EFFECINCY REFERS TO REDUCTIONS IN AVERAGE COSTS OCCURING OVER TIME; EG THROUGH A FIRMS GROWTH ENABLING IT TO BENEFIT FROM ECONOMIES OF SCALE. THE DIFFERENCE BETWEEN PRODUCTIVE EFFICINECY AND DYNAMIC EFFECINCY IS SHOWN IN THE DIGRAM.
IF FIRM A PRODUCES THE LEVEL OF OUTPUT Q1 IT IS PRODUCITIVLEY EFFECINET BUT ONLY IN THE STATIC SENSE OF A SMALL FIRM THAT HAS NOT GAINED BENEFITS OF ECONOMIES OF SCALE. FIRM B IS A MUCH LARGER FIRMS THAT HAS GAINED THE BENEFITS OF ECONOMIES OF SCALE. PRODUCING OUTPUT Q2, IT IS THEREFORE DYNAMICALLY EFFEICNT ENJOYING LOWER COSTS THAN FIRM A.
HOWEVER, DYNAMIC EFFECINCY EXTENDS BEYOND ACHIEVING LOWER AVERAGE COSTS THROUGH GAINING THE BENEFITS OF ECONOMIES OF SCALE. IT INCLUDES APODTING MORE RELIABLE METHODS OFPRODUCTION WHICH ALLOW BETTER QUALITY GOODS TO BE PRODUCED, AS WELL AS INOVATION AND RESEARCH AND DEVELOPMENT LEADING TO THE PRODUCTION OF COMPLETELY NEW TYPES OF GOOD THAT DID NOT PREVOUSLY EXIST.
PROVIDED THE FOUR FACTORS ENABLE A FIRM TO REDUCE AVERAGE COSTS OF PRODUCTION, OUTSOURCING ABROAD OF SERVICE ACTVITIES SUCH AS CUSTOMER SERVICE AND ACCOUNTS SHOULD IMPROVE ITS PRODUCTIVE EFFEINCY. THIS CAN CAN BE ILLUSTRATED BY THE FIRMS SHORT RUN AVERAGE COST CURVE SHIFTING DOWNWARD,AS SHOWN BELOW
IN THE LONG RUN , OUTSOURCING MAY ALSO IMPROVE THE FIRMS DYNAMIC EFFEICNY. HOWEVER,WHEN EVALUATING, THE KEY WORD IN THE QUESTION IS INEVATABLY. IT IS MORE THAN LIKELY, BUT NOT INEVTIABLE THAT OUTSOURCING ABROAD WILL IMPROVE PRODUCTIVE AND POSSIBLE DYNAMIC EFFECINCY. FOR THE REASON I EXPLAINED IN MY ANSWER TO PART, OVERSEAS LOCATION OF CALL CENTRES MAY LEAD TO DISSATISFACTION AMONG UK CONSUMERS.
LOCATION IN A COUNTRY SUCH AS THE CONGO, WRACKED BY CIVIL WAR, CORRUPTION AND UPHEAVEL IS LIKELY TO PRODUCE BAD RESULTS THAN......
FINALLY IF OUTSOURCING DOES IMPROVE UKS FIRMS EFFECINCY, THE EFECT MAY BE EXTREMELY MARGINAL.
Production theory divides into short-run production theory and long-run production theory. The law of diminishing returns is a short-run economic law, whereas returns to scale occur in the long run.
The law of diminishing returns has the status of an economic ‘law’, because in the short run at least one of the factors of production (usually assumed to be capital) is held fixed. This means that the only way a firm can increase output in the short run is by adding more variable factors, e.g. labour, to fixed capital. Eventually, as labour is added to fixed capital, an extra worker (the marginal worker) gets in the way of the already existing labour force and the additional output attributable to the marginal worker begins to fall. This is when the law of diminishing returns has set in.
Returns to scale by contrast occur in the long run when all the factors of production increase. The firm increases its scale or size of operation. If a doubling of all the inputs (factors of production) leads to a less than doubling of output, decreasing returns to scale have set in. (Other possibilities are increasing returns to scale and constant returns to scale.)
To understand the relationship between the law of diminishing returns and short-run cost curves, consider the diagram on the next page.
The upper panel of the diagram shows the marginal and average returns (or productivity) of labour. Diminishing marginal returns begin at point A. Increasing marginal productivity of labour (or increasing marginal returns) is shown by the positive (or rising) slope of the marginal product curve, while diminishing marginal returns are represented, beyond point A, by the curve’s negative (or falling) slope.
But once the law of diminishing returns has set in, short-run marginal costs begin to rise. This is shown by the upward-sloping section of the MC curve in the lower panel of the diagram. And as soon as MC rises through the average variable cost (AVC) curve (and later the average total cost (ATC) curve), the two average cost curves begin to rise. This means that the AVC and the ATC curves are U-shaped.
Just as short-run cost curves are derived from the short-run law of diminishing returns, so long-run cost curves result from the nature of returns to scale. When a firm changes the scale of all the factors of production in the economic long run, it is usual to assume that to start with it benefits from increasing returns to scale but that eventually decreasing returns to scale set in. Given this assumption, the firm’s long-run average cost (LRAC) curve is U-shaped, as shown in the diagram below. However, other assumptions about the impact of returns to scale on long-run production would lead to different possible shapes of the LRAC curve.
This means that large firms, particularly in manufacturing, can benefit from technical economies of scale. Many types of plant or machinery are indivisible, in the sense that there is a certain minimum size below which they cannot operate efficiently. A firm requiring only a small level of output must therefore choose between installing plant or machinery that it will be unable to use continuously, or using a different but less efficient method to produce the smaller level of output required. Large firms can also benefit from volume economies of scale. With many types of capital equipment (for example, metal smelters, transport containers, storage tanks and warehouses), costs increase less rapidly than capacity. When a storage tank or boiler is doubled in dimension, its storage capacity actually increases eightfold. Since heat loss depends on the area of the container’s walls (which will only have increased fourfold) and not upon volume, a large smelter or boiler is technically more efficient than a small one. Volume economies are thus important in industries such as transport, storage and warehousing, as well as in metal and chemical industries, where an increase in the scale of plant provides scope for the conservation of heat and energy.
When there are substantial economies of scale available to a firm, its LRAC curve will look like the one in diagram (a) of the following:
When firms can benefit from substantial economies of scale (and economies of large-scale production), this will benefit firms. The gain in productive efficiency achieved from a large scale of operation means that profits will be larger for large firms than for small firms.
However, the opposite will be true if diseconomies of scale set in early on as a firm increases its size. Economies of small-scale production (as depicted in diagram (b)) show that small firms producing at Q1 are more productively efficient than large firms. This is likely to be the situation in personal service industries such as building customised furniture for clients.
A range of other issues are also relevant to this question. Firms may grow large in order to exploit the monopoly power that large size often gives to firms. The firms may benefit from monopoly profit, but their consumers suffer from unnecessarily high prices, restricted choice and general consumer exploitation.
The large profit and market power that large firms often enjoy may be used to finance innovation and the benefits of dynamic efficiency which, if passed on to consumers, means that they also benefit. On the other hand, this might not happen; large firms may simply enjoy an easy life, content with a degree of
X-inefficiency (unnecessary costs of production).
In conclusion, the answer to the question depends on the assumptions made about whether economies of scale are possible, the motives of firms, and the extent to which they can exploit monopoly power to the detriment of consumers. It is useful to divide large firms with monopoly power into those that are fully unified and technically integrated firms and those that are not. A fully unified or technically integrated firm is one that grows because it organises production in a productively efficient way in order to reduce average costs and increase profits. If monopoly power results, it is almost by accident. Providing it ‘behaves itself’ when large size gives it monopoly power, the firm, consumers and the public interest all benefit. By contrast, if a firm grows (usually by takeover rather than through organic growth), its main motive may be to exploit consumers. Clearly such firms are not ‘best’.
Technical efficiency. A production process is technically efficient if it maximises the output produced from the available inputs or factors of production.
Productive efficiency or cost efficiency. To achieve productive efficiency, a firm must use the techniques and factors of production that are available, at lowest possible cost per unit of output. In the short run, the lowest point on the relevant short-run average total cost curve locates the most productively efficient level of output for the particular scale of operation.
X-efficiency. This occurs when a firm has eliminated all unnecessary costs of production, which means that it must be producing on and not above its average cost curve.
Allocative efficiency. This occurs when it is impossible to improve overall economic welfare by reallocating resources between industries or markets (assuming an initial ‘fairness’ in the distribution of income and wealth among the population). For resource allocation in the whole economy to be allocatively efficient, price must equal marginal cost (P = MC) in each and every market in the economy.
Dynamic efficiency. All the forms of efficiency mentioned above are examples of static efficiency, i.e. efficiency measured at a particular point in time. By contrast, dynamic efficiency measures improvements in technical and productive efficiency that occur over time. Improvements in dynamic efficiency result from the introduction of better methods of producing existing products (including firms' ability to benefit to a greater extent from economies of scale), and also from developing and marketing completely new products.
The diagram below shows that a perfectly competitive firm achieves both productive and allocative efficiency in the long run, but only under the assumption that there are no economies of scale. The firm is productively efficient because it produces the optimum output at the lowest point on the ATC curve, and it is allocatively efficient because P = MC. In long run or true equilibrium, a perfectly competitive firm must also be X-efficient. The reason is simple. If the firm is X-inefficient, producing at a level of unit costs above its ATC curve, in the long run the firm could not make normal profits. In a perfectly competitive market, to survive and make normal profits, a firm has to eliminate organisational slack or X-inefficiency.
The first sentence in the previous paragraph asserted that perfect competition is efficient provided there are no economies of scale. Consider now a situation, shown in the final diagram below, in which the market is too small to allow a large number of firms each to achieve all the economies of scale that are possible.
For a firm to benefit from economies of scale to the full, and hence to be productively efficient in the long run as well as in the short run, its short-run cost curve would have to be positioned at SRATCN, or indeed further to the right than this. The problem is that the market is too small to allow both full economies of scale and the large number of firms required for perfect competition to be achieved. Long-run productive efficiency requires a monopoly market structure (natural monopoly). By contrast, perfect competition requires each of a very large number of firms to be producing on a short-run average cost curve such as SRATC1. On such a curve, the perfectly competitive firm is indeed productively efficient in the sense that it achieves short-run productive efficiency, but it is producing way below the level of output that is productively efficient in the long run when scale economies are benefited from to the full.
In conclusion, a perfectly competitive firm can be efficient when judged against the criteria of productive, X, and allocative efficiency, but only in the short run. Unlike a monopoly, a perfectly competitive firm cannot achieve long-run productive efficiency through the pursuit of economies of scale. Finally there is another argument, so far not considered, which may mean that perfectly competitive firms fail to produce the allocatively efficient level of output. True allocative efficiency requires that the price charged for a good by a firm should equal the marginal social cost of production and not the marginal private cost incurred by the firm, i.e. P = MSC and not P = MPC. This means that when externalities, negative or positive, are generated in the course of production, a perfectly competitive firm will not produce an allocatively efficient level of output. Nor will the whole market.
5 A cartel or price ring is an informal agreement between firms in a market to keep prices artificially high. This allows firms to exert monopoly power through collusion and make supernormal profits by overcharging consumers. This allows poorly managed and inefficient firms to continue to make profits and deprives consumers of the lower prices that could be offered by more efficient firms that have more innovative production methods and are less wasteful. Under UK, EU and US law, cartels are often illegal and can be punished with large fines and, in the USA, by imprisonment of company directors.
Cartels can, however, provide benefits to the public. If a cartel can protect firms from the pressures of competition and allow firms to invest in research and development to invent new products, it can be extremely beneficial to the public. Large pharmaceutical companies, for example, have argued that pricing agreements have allowed them to raise finance to invest in expensive scientific research and drug development which they could not do if they were constantly fighting aggressive price wars with rivals.
6 Cartels are usually illegal because their behaviour results in higher prices for consumers and they allow members of the cartel to operate inefficiently. In the case of the cement industry cartel broken up by the European Union competition authorities, firms were able to charge customers artificially high prices for cement, which pushed up the costs of production for the construction and building industry. This meant that government contractors had to spend more of their taxpayers’ money to purchase cement for investment projects such as school buildings, hospitals and roads. Private sector companies also had to pass on higher prices to businesses and households, which depleted levels of household disposable income and reduced households’ ability to spend on other goods and services. Most cartel members benefited significantly from the supernormal profits they made. Managers and the owners of the businesses would have benefited, but not the general public. Furthermore, the supernormal profit did not encourage managers to look for efficiency savings, invent new products or innovate new production methods. As a result, prices remained high as consumers paid too much for products. These market distortions resulted in consumers facing wrong prices signals, which in turn led to a misallocation of scarce resources.
Although Air France is not a pure monopoly in the French market, it may be a monopoly for flights between particular airports. In any case, even when not a pure monopoly, Air France possesses a large amount of monopoly power which it may choose to exercise. As the diagram below shows, on routes where its monopoly power is complete, it may hike up the price it charges to P2, compared to a competitive market price of P1. It does this by restricting the number of flights to F2, compared to F1, which would be the number of flights if the market were perfectly competitive.
In the latter case, market equilibrium would be determined at point A on the diagram. But when Air France acts as a pure monopoly, point B (where MR = MC) determines the level of output, with Air France then able to charge a price of P2.
Air France could also use its monopoly power in other ways. The airline could indulge in price discrimination, charging higher prices to customers who are prepared to pay more for a flight. Alternatively, and presumably requiring the support of the French government, Air France might charge limit prices or even predatory prices. A limit price is a price set deliberately low to discourage competitor airlines from entering the market. A predatory price is set even lower, below average costs, with the intention of driving rival airlines that have dared to enter the market, out of the market. However, perhaps the main way Air France might exercise its monopoly power is by gaining control of landing and take-off slots at French airports, to make it uneconomic or impossible for rivals to use the airports.
Currently, within the European Union, cartels are usually deemed to be illegal, both by national competition authorities such as the Competition Commission in the UK, and by EU competition policy. In both national and EU competition policy, a cartel agreement is treated as an anti-competitive trading restrictive practice, collectively undertaken by the member firms of the cartel. Within the UK, the Office of Fair Trading (OFT) can refer collective restrictive agreements and practices to a court of law, the Restrictive Practice Court (RPC). Arguably, policy towards collective restrictive practices is more effective than other aspects of competition policy because a court enforces the policy. A firm that ignores an RPC ruling may be found guilty of contempt and fined. Nevertheless, the punishments that the RPC can hand out are quite weak — usually a fine of just a few thousand pounds. Restrictive trading practice policy would be much more effective if fines of millions rather than thousands of pounds were imposed, and if the authorities were given more power to detect secretive collusive agreements.
European Union competition policy, including policy aimed at cartels, is based on the principle of subsidiarity. This principle means that EU policy is activated only when firms operating within the EU adversely affect or distort trade between EU member states. Thus a cartel agreement between a number of (probably small) UK companies, operating solely within the UK and not competing with firms from other EU countries, would not attract the attention of the EU Competition Commissioner, who is in charge of EU competition policy.
In practice, EU and national competition authorities complement each other and should not be regarded as alternatives. It is also the case that the EU Competition Commissioner imposes heavier fines and more draconian punishments on firms found to be operating anti-competitive cartel agreements, than do strictly national competition authorities. This is evidenced by the case study in Extract C in the question. The case study reported that the EU fined 11 national airlines about €800 million for fixing the price of air cargo between 1999 and 2006. British Airways was fined €104 million, Air France-KLM €340 million and Cargolux Airlines €79.9 million. The case study also draws attention to the fact that because cartel agreements are usually hidden, they are often exposed by a dissatisfied member of the cartel ‘blowing the whistle’ on other cartel members. Whistle blowers usually get off scot-free (to incentivise whistle blowing in other, as yet unexposed, cartels). Meanwhile, the other cartel members are heavily punished. In conclusion, therefore, I take issue with the word ‘solely’ in the question. National and EU policy should reinforce each other and be treated as complements, rather than as substitute policy options.
Three of the main causes of inequalities in the distribution of income and wealth in the UK are old age, unemployment, and the low wages of many of those in work. Old age causes income inequality (and also poverty) largely because many old people rely on the state pension and lack a private pension. Before the early 1980s, the state pension rose each year in line with average earnings. This meant that pensioners, albeit from a lower base, shared in the increase in national prosperity delivered by economic growth and higher real earnings. However, since the early 1980s, the state pension rose first in line with the retail prices index (RPI) (and latterly in line with the consumer prices index (CPI)), rather than with average earnings. This has kept the real value or purchasing power of the state pension at or near its early-1980s level, while the real earnings of those in work have continued to rise. Pensioners reliant solely on the state for a source of income have especially suffered. The state pension is now regarded very much as a ‘poverty income’. Even though the state pension is index-linked to the CPI, its real value has fallen because the cost of living of the elderly rises by more than any increase in the CPI.
Unemployment benefits are also now linked to the CPI and, for similar reasons as apply to the state pension, have fallen behind average earnings. Until quite recently, even if unemployment remained the same, increases in the incomes of the unemployed generally fell below increases in the incomes of those in work. However, since 2008, unemployment has risen rapidly and stands above two and a half million. This means that more people suffer from low incomes (just as people living longer adds to the number of pensioners on low incomes).
(Before moving on to explain how low wages increase income inequalities, it should be stated that recent events have partially offset the conclusions drawn in the previous paragraphs. Since 2009, the wages and salaries of much of the UK population in work have hardly changed at all, but the state pension and unemployment benefits have risen by rather more, albeit from a lower starting point. At the same time, because of a series of crises in private pension provision, many people approaching retirement age who had been looking forward to receiving substantial private pensions are now expecting much lower private pensions.)
Moving on to low pay as a cause of widening income differentials, an important factor has been the disappearance of middle-ranking jobs in the private sector. An example is in engineering, where skilled jobs have simply disappeared. Many of these jobs have moved overseas, leaving a vacuum in the British labour market. There is now a worrying gap between low-skilled, low-paid jobs (so called McJobs) at the bottom of the pile, and highly-paid jobs in industries such as investment banking where the rate of pay has risen astronomically in recent years, in both real and nominal terms.
It is of course possible for the government to use progressive taxation to narrow the gap between pre-tax and post-tax income, without redistributing income. The tax revenue could for example be spent on tanks and guns. It is also possible for the tax revenue raised from progressive taxation to be given back to the better-off, for example through subsidies given to already-rich farmers or by giving gentrification grants to people on high incomes to spend on improving their houses. However, usually when we think of progressive taxation and transfers, the implicit assumption is that the rich are taxed more than the poor and that much of the tax revenue is transferred and given as welfare benefits to the poor.
There is no doubt that progressive taxation and transfers provide an obvious way to reduce inequalities in the distribution of income and wealth. Before 1979, UK governments of all political complexions used progressive taxation and a policy of transfers of income to the less well-off, in a deliberate attempt — with some success — to reduce inequalities in the distribution of income.
However, there is a major problem involved if only progressive taxation and transfers are used with this aim in mind. The reason for this relates to the conflict between two of the principles or canons of taxation: equity and efficiency. Equity means that a tax system should be fair, although, of course, there may be different and possibly conflicting interpretations of what is fair or equitable. Specifically, a particular tax should be based on the taxpayer’s ability to pay. This principle is one of the justifications of progressive taxation, since the rich have a greater ability to pay than the poor. Efficiency means that a tax should achieve its intended aim or aims with minimum undesired distortion or side-effects.
Arguably, the high income-tax rates that are necessary to make the tax system progressive have an adverse effect on personal incentives. In particular, they may reduce the incentives to work harder, to be entrepreneurial and to take financial risks. Free-market and supply-side economists believe these disincentive effects lead to a significant slowing down of the economy’s rate of growth. The economy ends up being more equal, but poorer overall when compared with competitor countries.
Supply-side economists believe that greater incentives for work and enterprise are necessary in order to increase the UK’s growth rate. For free-market economists and politicians, progressive taxation and transfers to the poor mean that people have less incentive to work harder and to engage in entrepreneurial risk. Moreover, the ease with which the poor can claim welfare benefits and the level at which they are available creates a situation in which the poor rationally choose unemployment and state benefits in preference to low wages and work. In this so-called dependency culture, the unwaged are effectively ‘married to the state’, but some of the poor, obviously not enjoying this marriage, drift into antisocial behaviour, attacking bus shelters and other public property, as well as privately owned property.
Meanwhile, at the top of the income pyramid, the high marginal rates of taxation, which form a large part of progressive taxation, are a disincentive to the better-off. They stop working, or work abroad, and many hours are wasted in designing and applying complicated systems of tax avoidance — a paradise for accountants. Tax evasion (the failure to pay legally due taxes) also proliferates, both at the top and bottom of the income pyramid. Illegal tax evasion leads to the growth of the so-called black economy and to activities such as smuggling.
Supply-side economists believe that tax and benefit cuts, which are the opposite of progressive taxation and transfers, alter the labour/leisure choice in favour of supplying labour, particularly for benefit claimants who lack the skills necessary for high-paid jobs. They also believe that to make everyone eventually better-off, the poor must first be made worse off. Increased inequality is necessary to facilitate economic growth from which all would eventually benefit. Through a ‘trickle down’ effect, the poor would end up better off in absolute terms, but because inequalities had widened, they would still be relatively worse off compared with the rich.
Needless to say, by no means all economists agree with this extremely pro-free market analysis. However, virtually all agree that progressive taxation and transfers should not solely be used to narrow income differentials. Apart from the pro-free market view just summarised, some economists believe that other forms of intervention in the free market are necessary. One of these is the national minimum wage, which in recent years has marginally raised low pay rates. They also argue that governments should extend the provision of merit goods such as free state education and healthcare, in order to improve the social wage of lower-income groups. The social wage is that part of a worker’s standard of living received as goods and services provided at zero price or as ‘income in kind’ by the state, being financed collectively out of taxation. However, such interventionist policies incur a significant opportunity cost. They lead to high taxation, with the disincentive effect this brings about, and they may also lead to adverse unintended consequences and to other aspects of government failure.
The gases and pollutants that are emitted into the atmosphere and lead to global warming are both externalities and a form of public ‘bad’. (A public ‘bad’ is the opposite of a public good. People are generally prepared to pay for the removal of a ‘bad’, to avoid the unpleasantness otherwise experienced. But in the case of public ‘bads’, such as rubbish or garbage, payment can be avoided by dumping the ‘bad’ in a public place, or on someone else’s property.) Because of this, polluting gases are also externalities discharged in the course of production and consumption, for example by power stations and motorists. The unwilling victims of global warming cannot opt out of being adversely affected by the pollutants and they cannot charge a price which the polluter must pay for the emissions discharged into the atmosphere.
Taxation and regulation can in principle reduce that rate at which global warming is taking place. However, as Extract B explains, the emission of global-warming gases is different from the emission of many other negative externalities, for example traffic congestion. In the first place, the emission is international. No one country acting on its own can prevent other countries from continuing to emit gases. In the second place, the problem is historical. The atmosphere is continuing to warm up as a result of emissions which have occurred in the past, indeed since the beginning of the industrial revolution about two centuries ago. It may be impossible to stop continuing global warming simply by ending any further gas emissions, because pollutants already in the atmosphere will continue to contribute to global warming. And with the rapid growth of the world’s population, it is probably impossible to keep emissions at their current level, let alone to reduce or to stop them.
Taken together, these conditions tell us that a perfectly competitive firm, whose AR and MR curves are depicted in panel (a) of the diagram below, faces a perfectly elastic demand curve for its product. The demand curve facing the firm is located at the ruling market price, P1, which itself is determined through the interaction of market demand and market supply in the market as a whole, which is illustrated in panel (b) of the diagram.
ONE FIRM STRAIGHT LINE D=MR=AR TWO CROSSSES MARKET DEMAND MARKET SUPLY DIAGRAM WITH MARKET RULING PRICE CROSSING MEETING POINT HORIZONTALLY
The assumption that a perfectly competitive firm can sell whatever quantity it wishes at the ruling market price P1, but that it cannot influence the ruling market price by its own action, means that the firm is a passive price-taker. Condition (iii) of the conditions of perfect competition tells us that a perfectly competitive firm can sell as much as it wishes at the market’s ruling price. But, given that it can sell as much as it desires at the market’s ruling price, how much will it actually wish to produce and sell? Providing we assume that each firm’s business objective is solely to maximise profit, the answer is shown in panel (a) of the next diagram:
SUPERNORMAL DIAGRAM IN ONE FIRM DIAGRAM AND WHOLE CROSS MARKET DIAGRAM, WITH MARKET RULING PRICE CROSS POINT HORIZONTALLY AT P1 Q1
Panel (a) in the diagram above adds the perfectly competitive firm’s average total cost (ATC) curve and its marginal cost (MC) curve to the revenue curves shown in the earlier diagram. Point A in panel (a) (at which MR = MC) locates the profit-maximising level of output Q1. At this level of output, total sales revenue is shown by the area OQ1AP1. Total cost is shown by the area OQ1BC1. Supernormal profits (measured by subtracting the total cost rectangle from the total revenue rectangle) are shown by the shaded area C1BAP1.
Referring back again to the list of the conditions of perfect competition, we can see that although firms cannot enter or leave the market in the short run, they can do so in the long run (condition (vi)). Suppose that in the short run, firms make supernormal profit. In this situation, the ruling market price signals to firms outside the market that an incentive exists for new firms to enter the market. The next diagram shows what might then happen:
ABOVE DIAGRAM WITH LOADS OF LINES- FIRMS MAKING A LOSS DIAGRAM
Initially, too many new firms enter the market, causing the supply curve to shift to the right to S2 in panel (b) of the diagram. This causes the price line to fall to P2, which lies below each firm's ATC curve. When this happens, firms make a loss (or subnormal profit). But just as supernormal profit creates the incentive for new firms to enter the market, subnormal profit provides the incentive for marginal firms to leave the market. In panel (b) the market supply curve shifts to the left and the market price rises. Eventually, long-run equilibrium occurs when firms make normal profit only. For the market as a whole, this is shown at output Q/// and price P3.